Financial Risk, Markets, and Instruments Terms

Systematic risks

Risks that cannot be diversified away because they affect all firms

Firm-specific risk

Risks that are specific to a single firm (or few firms/industry) and can hence be diversified away by investors

One-sided risk

Contains only the potential of a loss without potential for gains

Two-sided risk

 has potential to result either in a loss or a gain

Hedge

An investment position intended to offset potential losses or gains that may be incurred by a companion investment

Business Risks

Uncertainty about the future viability of the firm's chosen business model

Operational Risks

The potential losses resulting from a range of operational weaknesses including inadequate systems, management failure, faulty controls, fraud, and human errors

Hazard Risks

Risks are the potential losses of value due to an accident, a fire, a natural disaster

Financial Risks

Risks relate to the financial operations of a business (risk of financial loss and gain) and take various forms

Market Risks

Risks that change financial market prices and rates

Credit Risks

Risk of financial loss resulting from a borrower's failure to repay a loan

Liquidity Risks

Risk of loss resulting from the inability to meet payment obligations in full and on time when they become due

Standard deviations of returns

Standard deviation of returns measures how much an investment's returns deviate from its average, indicating the level of volatility or risk

Special Purpose Vehicle

A separate company with its own balance sheet to isolate financial risk

Subprime

The mortgage given to a person for a house they can not afford, e.g. with bad credit history

Leverage

The use of debt (borrowed capital) for investment

The Basel Committee

Committee expanded in 2009 to regulate bank leverage in response to the 2008 crisis by issuing recommendations

Derivative

A contract that derives its value from the performance of an underlying entity

Underlying entity

An asset, index, or interest rate that must be delivered when a warrant is exercised

In derivatives, the underlying is the security or asset that provides cash flow to a derivative

Long position

Holding or having to buy a financial asset, with the expectation that it will increase in value, facing the risk that the price will drop in the future

Betting a security will increase in value

Short position

Selling a financial asset with the intention of repurchasing or covering later at a lower price, facing the risk that the price will rise in the future

Betting a security will decrease in value

Duration

A measure of the sensitivity of the price of a debt instrument to changes in interest rates

first derivative of bond price to the rate

Clearing Houses

Intermediary between buyer and seller in the financial market

Short selling

Selling securities you do not own

Forward

A contract set up in T₀ to execute a financial transaction at a future date T_n

Spot Price (S₀)

The price at which an asset can be bought or sold for immediate delivery

Covered interest parity

the difference in interest, the interest rate differential

Carrying cost

Expenses incurred as a result of investment positions like interest and opportunity costs

Swap

An agreement to exchange cash flow at a specified future time for a fixed period time

Vanilla swap

Most common type of interest rate swap. Convert floating IR payments into fixed IR payments

LIBOR

London Interbank Offered Rate - was a benchmark interest rate

Put-call parity

The relationship between the price of a european call and put option

Fiduciary call

Long (buy) a call and enough cash (or bonds) to pay the strike price if the call is exercised. Left side of put call parity

Protective put

Long (sell) a put and the asset, so the asset can be sold for the strike price if the spot is below strike at expiry

Binomial Tree

Determines what the gain/loss will be from an option

Option Δ

Number of underlying units

Option B

Number of bond units

Delta (Δ)

measures the rate of change of the theoretical option value with respect to changes in the underlying asset's price

Gamma (Γ)

measures the rate of change in the delta with respect to changes in

the underlying price

Vega

measures sensitivity to volatility

Theta (θ)

measures the sensitivity of the value of the derivative to the passage of time: the "time decay”, the rate of decay

Rho (ρ)

measures sensitivity to the interest rate

Asian Option

the payoff is determined by the average underlying price over some pre-set period of time

Basket

underlying is a weighted sum or average of different assets that have been grouped together in a basket

Binary (or digital)

the payoff is either some fixed monetary amount or nothing at all

Bullish Option Strategy

Employed when the options trader expects the underlying stock price to move upwards

Bearish Option Strategy

Employed when the options trader expects the underlying stock price to move downwards

Neutral strategies

Employed when the options trader does not know whether the underlying asset's price will rise or fall

Interest Rate Risk

The potential for changes in the value of a security or portfolio of securities resulting from fluctuations in the level or structure of interest rates

Price Risk

associated with the potential for changes in the market value of a security or portfolio of securities due to changes in interest rates

Reinvestment Risk

associated with the potential for changes in the yield on cash flows from securities due to changes in interest rates

Yield Curve Risk

associated with the potential for changes in the shape of the yield curve due to changes in interest rates

Spread Risk

associated with the potential for changes in the spread between yields on different types of securities due to changes in interest rates

Optionality Risk

associated with the potential for changes in the value of a security due to changes in interest rates and the embedded options within the security

Basis Risk

associated with the potential for changes in the relationship between the prices of different securities due to changes in interest rates

Duration Gap Risk

associated with the potential for changes in the market value of a security or portfolio of securities due to differences in the duration of assets and liabilities

At the money

Where strike price is equal to today’s spot price (S_t)

At the money forward

Where strike price is equal to the forward price (spot price in the future)

In the money

(Call) When (S_t) is above the strike price, positive intrinsic value

(Put) When (S_t) is below the strike price

Out of the money

When the underlying security has yet to reach the strike price, option has no intrinsic value

(Put) When share price is above the the strike price

Delta hedging

When buying or selling options, you offset the delta risk by buying or selling an equivalent underlying

Delta-neutral

When the overall delta is zero

Term structure of an interest rate

Graphical representation of the relationship between interest rates and maturities (yield to maturity)

Expectations Theory

interest rates is the proposition that the long-term rate is determined purely by current and future expected short-term rates

Liquidity Preference theory

Investors have a general bias towards short term securities which have higher liquidity as compared to the long term securities which get one’s money tied up for long

Market Segmentation Theory

This theory related to the supply-demand dynamics of a market

Long- and short-term interest rates are not related to each other because they have different investors

Preferred Habitat Theory

Investor preferences can be flexible depending on their risk tolerance level. They can choose to invest in bonds outside their general preference also if they are appropriately compensated for their risk exposure

Bond yield

the internal rate of return of the bond cash flows, that a bondholder earns if he holds the bond till maturity and receive all the cash flows at the promised dates

Yield to maturity

the total rate of return an investor anticipates from holding a bond until maturity, including both coupon payments and the principal repayment at maturity

Transition risks

Financial and economic consequences of transitioning to a low-carbon economy

Physical risks

Direct, tangible impacts of climate change, like extreme weather events and sea-level rise

Liquidity

the ease with which an asset can be converted into cash

Credit Spread

The difference between the yield (return) of two bonds with the same maturity but different credit quality

Resecuritization

Taking a pool of existing securities (often from earlier securitization transactions) and repackaging them into new securities, typically in the form of collateralized debt obligations (CDOs)

Asset backed securities

The pooling of assets through securitization

Securitization

the pooling of various sources of contractual debt obligations

short squeeze

when a heavily shorted stock or commodity moves sharply higher, forcing short sellers to close out their short positions (usually at a loss) and adding to the upward pressure on the stock