Derivatives & Hedging

Market Risk

The potential for financial loss rising from changes in the market prices and rates

Derivative

A contract between 2 parties, the value of which is derived from the return on a market price, market rate, or event

Notional Amount

The number of units that serve as the basis for determining the settlement amount of a derivative

Underlying

The financial instrument upon which a derivative’s price is based (ex. stock, currency, commodity, etc.)

Swap Contract

A contract between 2 parties to exchange cash flows in the future based on a specified underlying notional amount

Interest Rate Swap

A type of swap contract where 2 parties agree to exchange future interest payments based on a specified notional amount. Will have multiple settlement dates.

Floating Interest Rate

An interest rate that resets every period based on the market rate such as LIBOR

Symmetrical Derivative

Gives both parties a payoff structure with the same potential for gains and losses (ex. interest rate swap, futures)

Option Contract

A control between 2 parties that gives the buyer the right, but not the obligation, to buy or sell something from/to the seller at a price agreed upon today

Call Option

An option contract that gives the buyer the right to BUY the underlying at a specified price

Put Option

An option contract that gives the buyer the right to SELL the underlying at a specified price

Premium (Option Price)

The market price of the option contract itself. The price that the buyer pays at inception to receive the option

Strike (Exercise) Price

The price at which the buyer may buy or sell the underlying

Total Value of Option Contract

Premium * Notional Amount

Intrinsic value

The value of an option contract if it were to be exercised immediately (market price - strike price)

Time Value

The value of an option contract not counting its intrinsic value

Asymmetrical Derivative

A type of derivative in which 2 parties do not have the same payoff structure and potential for gains and losses (ex. options)

In the Money

A term describing an options contract in which the option has a positive intrinsic value (strike > underlying OR intrinsic value < premium)

Out of the money

A term describing an options contract in which the option has no intrinsic value (strike < underlying OR fmv - strike < premium)

Last Price

A price listed on an option chain which shows the most recent price at which a transaction occurred. Can be used as the market price at that point in time

Futures Contract

A contract between 2 parties that creates a notional commitment to buy and sell the underlying at a price determined in the present

Futures Price

The price the underlying will be delivered for on the expiration date of a futures contract

Lock in Price

The futures price on the date when the futures contract is entered

Spot Price

The current market price at which the underlying of a futures contract could be purchased

Long

The position of the buyer in a futures contract

Short

The position of the seller in a futures contract

Net Settlement

The agreement by both parties in a futures contract to exchange cash at expiration as full settlement of the contract

Forward Contract

The same as a futures contract except not taking place on an organized exchange