CFA - Derivatives

spot markets(cash markets)

Markets in which specific assets are exchanged at current prices.

derivative

A financial instrument that derives its value from the performance of an underlying asset or factor (e.g., stock price, interest rate, or exchange rate).

underlying

The asset referred to in a derivative contract.

forward contract

A derivative contract for the future exchange of an underlying at a fixed price set at contract signing.

counterparty

Legal entities entering a derivative contract.

counterparty credit risk

The likelihood that a counterparty is unable to meet its financial obligations under the contract.

settlement

The closing date at which the counterparties of a derivative contract exchange payment for the underlying as required by the contract.

embedded derivative

A derivative within an underlying, such as a callable, putable, or convertible bond.

firm commitment

A pre-determined amount (price and quantity) is agreed to be exchanged at settlement. Examples of this include forward contracts, futures contracts, and swaps.

swaps

A firm commitment involving a periodic exchange of cash flows.

contingent claim

A type of derivative in which one of the counterparties determines whether and when the trade will settle. An option is a common type

hedging

The use of a derivative contract to offset or neutralize existing or anticipated exposure to an underlying.

market reference rate

The interest rate underlying used in interest rate swaps. These rates typically match those of loans or other short-term obligations.

dealers

Financial intermediaries, such as commercial banks or investment banks, who transact as counterparties with derivative end users.

market makers

Over-the-counter (OTC) dealers who typically enter into offsetting bilateral transactions with one another to transfer risk to other parties.

exchange-traded derivative

Futures, options, and other financial contracts available on exchanges.

clearing

An exchange’s process of verifying the execution of a transaction, exchange of payments, and recording of participants.

central clearing mandate

A requirement instituted by global regulatory authorities following the 2008 global financial crisis that most over-the-counter (OTC) derivatives be cleared by a central counterparty (CCP).

swap execution facility

A swap trading platform accessed by multiple dealers.

novation process

A process that substitutes the initial swap execution facility (SEF) contract with identical trades facing the central counterparty (CCP). The CCP serves as counterparty for both financial intermediaries, eliminating bilateral counterparty credit risk and providing clearing and settlement services.

OTC

A(n) ______ derivatives market offers more confidentiality.

ETD

A(n) ______ derivatives market uses standardized contracts.

dealers

In the over-the-counter derivatives market, most transactions occur between end users and:

European option

an option that can be exercised by the option holder only at maturity

American option

an option that can be exercised by the options holder at any time

cash flow hedge

hedging variable cash flows from forecasted transactions; ex. interest rate swaps from floating to fixed rate to have more predictable cash flows

fair value hedge

hedging changes in fair value of assets/liabilities; ex. buying a put option to hedge a price drop in a large equity investment

net investment hedge

hedging exposure from investments in foreign subsidiaries; ex. currency swaps to stabilize currency swings in foreign areas of a business

calls

Higher interest rates favor ________(calls/puts).

puts

Lower interest rates favor ________(calls/puts).

bad

A stock paying dividends is _______(good/bad) for call option holders.

exercise price

The value of a European put is directly related to the: