What are derivatives? Derivatives are financial instruments that are derived from an underlying asset's value; rather than trade or exchange the asset itself, market participants enter into an agreement to exchange money, assets or some other value at some future date based on the underlying asset.
Here, we present a glossary of derivatives-related terminology for your better understanding.
Actuals
Financial instruments that exist in one of the four main asset classes: interest rates, foreign exchange, equities or commodities. Typically, derivatives are used to hedge actual exposure or to take positions in actual markets.
Arbitrage
The act of taking advantage of differences in price between markets. For example, if a stock is quoted on two different equity markets, there is the possibility of arbitrage if the quoted price (adjusted for institutional idiosyncrasies) in one market differs from the quoted price in the other.
The term has been extended to refer to speculators who take positions on the correlation between two different types of instrument, assuming stability to the correlation patterns. Many funds have discovered that correlation is not as stable as it is assumed to be.
At-the-market
A type of financial transaction in which the order to buy or sell is executed at the current prevailing market price.
At-the-money spot
An option whose strike price is equal to the current, prevailing price in the underlying cash spot market.
At-the-money forward
An option whose strike price is equal to the current, prevailing price in the underlying forward market.
Barrier options
An option contract for which the maturity, strike price and underlying are specified at inception in addition to a trigger price. The trigger price determines whether or not the option actually exists.
In the case of a knock-in option, the barrier option does not exist until the trigger is touched. For a knock-out option, the option exists until the trigger is touched.
Benchmarking
A benchmark is a reference point. Benchmarking in financial risk management refers to the practice of comparing the performance of an individual instrument, a portfolio or an approach to risk management to a pre-determined alternative approach.
Call option
A call option is a financial contract giving the owner the right but not the obligation to buy a pre-set amount of the underlying financial instrument at a pre-set price with a pre-set maturity date.
Cap
A cap is a financial contract giving the owner the right but not the obligation to borrow a pre-set amount of money at a pre-set interest rate with a pre-set maturity date.
Cash settlement
Some derivatives contracts are settled at maturity (or before maturity at closeout) by an exchange of cash from the party who is out-of-the-money to the party who is in-the-money.
Commodity swap
A contract in which counterparties agree to exchange payments related to indices, at least one of which (and possibly both of which) is a commodity index.
Credit risk
Credit risk is the risk of loss from a counterparty in default or from a pejorative change in the credit status of a counterparty that causes the value of their obligations to decrease.
Currency swap
An exchange of interest rate payments in different currencies on a pre-set notional amount and in reference to pre-determined interest rate indices in which the notional amounts are exchanged at inception of the contract and then re-exchanged at the termination of the contract at pre-set exchange rates.
Duration
A weighted average of the cash flows for a fixed income instrument, expressed in terms of time.
Equity swap
A contract in which counterparties agree to exchange payments related to indices, at least one of which (and possibly both of which) is an equity index.
Exchange traded contracts
Financial instruments listed on exchanges such as the Chicago Board of Trade.
Exotic derivatives
Any derivative contract that is not a plain vanilla contract. Examples include barrier options, average rate and average strike options, lookback options, chooser options, etc.
Forward contracts
An over-the-counter obligation to buy or sell a financial instrument or to make a payment at some point in the future, the details of which were settled privately between the two counterparties. Forward contracts generally are arranged to have zero mark-to-market value at inception, although they may be off-market.
Futures contracts
An exchange-traded obligation to buy or sell a financial instrument or to make a payment at one of the exchange's fixed delivery dates, the details of which are transparent publicly on the trading floor and for which contract settlement takes place through the exchange's clearinghouse.
Hedge
A transaction that offsets an exposure to fluctuations in financial prices of some other contract or business risk. It may consist of cash instruments or derivatives.
Historical volatility
A measure of the actual volatility (a statistical measure of dispersion) observed in the marketplace.
Margin
A credit-enhancement provision to master agreements and individual transactions in which one counterparty agrees to post a deposit of cash or other liquid financial instruments with the entity selling it a financial instrument that places some obligation on the entity posting the margin.
Market risk
The exposure to potential loss from fluctuations in market prices (as opposed to changes in credit status).
Operational risk
The potential for loss attributable to procedural errors or failures in internal control.
Option
The right but not the obligation to buy (sell) some underlying cash instrument at a pre-determined rate on a pre-determined expiration date in a pre-set notional amount.
Over-the-counter
Any transaction that takes place between two counterparties and does not involve an exchange is said to be an over-the-counter transaction.
Speculation
Taking positions in financial instruments without having an underlying exposure that offsets the positions taken.
Spot
The price in the cash market for delivery using the standard market convention. In the foreign exchange market, spot is delivered for value two days from the transaction date or for the next day in the case of the Canadian dollar exchanged against the US dollar.
Strike price
The price at which the holder of a derivative contract exercises his right if it is economic to do so at the appropriate point in time as delineated in the financial product's contract.