Week Seven - Flashcards - Derivatives

Derivative

A financial contract whose value depends on or is calculated from the performance of an underlying asset, index, or reference rate.

Firm commitment

A category of contracts, such as forwards, futures, and swaps, in which both counterparties are legally obligated to perform at agreed future dates.

Contingent claim

An instrument, such as an option or credit default swap, where payoff realization depends on the occurrence of a specified future event or the exercise choice of one party.

Central counterparty (CCP)

An intermediary clearing institution that stands between buyers and sellers, guaranteeing contract settlement and absorbing counterparty credit risk.

Variation margin

Cash transferred to an investor's account to restore the balance back to the initial required level after losses drop the equity below the maintenance threshold.

Basis in futures trading

$$\text{Basis} = \text{Spot price} - \text{Futures price}$$

Contango

A market state where futures contracts trade at a premium over the current spot price because carrying costs exceed the convenience yield.

Backwardation

A market state where the current spot price trades above the futures price due to a high convenience yield relative to carrying costs.

Time value of an option

The component of the premium exceeding intrinsic value, driven by volatility and the probability of favorable price movements before expiry.

Long straddle

An options position combining a purchased call and a purchased put with identical strikes and expiration dates, profiting from large price movements regardless of direction.

Long strangle

An options combination created by purchasing an out-of-the-money call and an out-of-the-money put with identical maturities but different strikes, reducing upfront premium costs.

Covered call

A position combining ownership of an underlying security with the simultaneous sale of a call option on that same security to earn premium income.

Protective put

A risk management strategy pairing long shares with a purchased put option to place a floor on potential losses while retaining upside potential.

Optimal number of futures contracts for portfolio hedging ($N$)

$$N = \frac{\text{Face value of cash exposure}}{\text{Face value of futures contract}} \times \beta$$

Credit default swap (CDS)

A financial agreement where a buyer pays a periodic spread to a seller who commits to pay compensation if a reference issuer undergoes a default or credit event.

Conversion ratio ($\text{CR}$)

The pre-specified number of ordinary common shares received when converting a single convertible security.

Conversion price

$$\text{Conversion price} = \frac{\text{Par value}}{\text{CR}}$$

Warrant

A long-dated option issued directly by a firm granting the holder the right to purchase newly created shares at a pre-set price, causing equity dilution upon exercise.