Financial Markets and Derivatives Markets Practice Flashcards

Comprehensive vocabulary flashcards covering financial derivatives, risk management strategies (hedging, speculation, arbitrage), pricing models like cost-of-carry, and advanced option investment strategies from the 25BSB027 course.

Derivative Instrument

A contract that derives its value from the value or return of an underlying asset, such as commodities, stocks, interest rates, or exchange rates.

Hedging

Investing to reduce the risk of an adverse movement in asset prices; it entails a cost such as a premium paid or profit foregone.

Speculation

The act of earning a profit in return for accepting risk; hedgers typically pay speculators for taking on this risk.

Arbitrage

The action of earning riskless, costless profit by trading, which drives markets toward equilibrium.

Leverage (Gearing)

Borrowing to increase the potential return on an investment, which increases both risk and return.

Forward Contract

A private, non-standardized agreement between two parties to buy or sell an asset at a specified future time and place at a price agreed today; it is typically traded over-the-counter (OTC).

Futures Contract

An exchange-traded, standardized contract to buy or sell an asset at a future date at a price agreed today, which is marked to market daily and guaranteed by a clearing house.

Over-the-Counter (OTC) Market

A market where traders negotiate directly with each other (bilateral) and take on each other's credit risk; forwards and swaps are primarily traded here.

Long Position

The position held by a party that has agreed to buy the underlying asset in a contract.

Short Position (Shorting)

The position held by a party that has agreed to sell the underlying asset in a contract.

Initial Margin

The funds or interest-earning securities deposited to provide capital to absorb potential losses when opening a futures position.

Maintenance Margin

The minimum reserve level a margin account must hold; if reached, the investor receives a margin call to replenish the account.

Variation Margin

The amount required to restore a margin account to its initial level after a margin call has been issued.

Marked to Market (Daily Settlement)

The process where gains and losses are settled every day based on the difference between the day's opening and closing futures prices.

Settlement Price

The price used by the clearing house to calculate daily gains and losses for marking to market.

Cost of Carry ($c$)

The net cost incurred by buying and holding an asset until a future period, calculated as financing and storage costs minus any benefits of carry (like dividends or convenience yield).

Convenience Yield ($y$)

The benefit or inventory premium of holding a physical commodity on demand; it is generally higher when there is a chance of supply shortages.

Call Option

A derivative that gives the holder the right (but not the obligation) to buy an underlying asset at a specified strike price ($X$).

Put Option

A derivative that gives the holder the right (but not the obligation) to sell an underlying asset at a specified strike price ($X$).

Strike Price (Exercise Price)

The specified price ($X$) at which an option holder can buy or sell the underlying asset.

Option Premium

The price paid by the buyer (long position) to the seller (short position) for the rights granted by an option contract.

American Option

An option that can be exercised at any time before or on the maturity date.

European Option

An option that can only be exercised on the maturity date.

In-the-money (ITM)

A state where an option has intrinsic value: for a call, $S > X$; for a put, $S < X$.

Out-of-the-money (OTM)

A state where an option has no intrinsic value: for a call, $S < X$; for a put, $S > X$.

Intrinsic Value (IV)

The gain from exercising an option immediately; for a call, it is the maximum of $0$ and $S - X$.

Time Value (TV)

The portion of an option's value exceeding its intrinsic value, representing the chance the option will expire in-the-money.

Delta ($\Delta$)

A Greek measure representing the sensitivity of an option's value to a change in the spot price of the underlying asset ($\frac{\partial C}{\partial S}$).

Theta ($\Theta$)

A Greek measure representing the sensitivity of an option's value to the passage of time ($\frac{\partial C}{\partial T}$).

Vega

A Greek measure representing the sensitivity of an option's value to the volatility of the spot price ($\frac{\partial C}{\partial \sigma}$).

Rho ($\rho$)

A Greek measure representing the sensitivity of an option's value to changes in the risk-free rate of interest ($\frac{\partial C}{\partial r}$).

Put-Call Parity

The no-arbitrage relationship between European put and call prices of the same strike and maturity, expressed as $P = C - S_0 + Xe^{-rT}$.

Synthetic Security

A portfolio of assets (like combinations of puts, calls, stocks, and bonds) created to mimic the payoff of a different financial instrument.

Bull Spread

An investment strategy involving the purchase of a call with a lower strike price ($X_1$) and the sale of a call with a higher strike price ($X_2$), appropriate when the asset price is expected to rise.

Bear Spread

An investment strategy involving the sale of a call with a lower strike price ($X_1$) and the purchase of a call with a higher strike price ($X_2$), appropriate when the asset price is expected to fall.

Straddle

An option strategy combining one call and one put with the same strike price and expiry; used when expecting large price movements but unsure of the direction.

Strangle

An option strategy similar to a straddle but using a put and a call with different strike prices.

Butterfly Spread

A strategy combining bull and bear spreads using three different strike prices ($X_1, X_2, X_3$) to profit from low volatility near the middle strike.