Derivatives Analysis cheat sheet

Key terms

Underlying

The asset, rate or index a derivative's value is derived from, an equity share, a bond, a currency, an interest rate, a commodity.

Notional amount

The reference quantity a derivative contract is based on, used to calculate payments, but (except for physically settled contracts) not itself exchanged.

Long and short positions

The long position benefits from a rise in the underlying's value; the short position benefits from a fall.

Expiration (maturity)

The date the derivative contract's rights and obligations end.

Settlement

How the contract is finally satisfied, physical delivery of the underlying, or cash settlement based on the difference between the contract price and the underlying's market price.

Forward commitments

Obligate both parties to transact at a future date on agreed terms: forward contracts, futures contracts and swaps, each covered in its own chapter.

Contingent claims

Give one party a right, but not an obligation, to transact: options (see the chapter on option markets).

Exotic forwards

Range forwards (a forward combined with a collar-like structure, capping and flooring the effective settlement price) and break forwards (allow early termination at a pre-agreed, less favourable rate, effectively bundling in an option).

Exotic options

The common types:

Exotic options: multi-asset and compound types

The types:

Swap variants

The basic swaps, each with further structural variants (amortising, basis, forward-starting) built on the same underlying exchange-of-cash-flows logic:

Regulation

Exchange-traded derivatives (futures, listed options) are regulated similarly to the underlying securities markets (see Regulation of Financial Markets); OTC derivatives (most forwards and swaps) are more lightly regulated, though post-financial-crisis reforms have pushed increasing standardisation and central clearing even for OTC instruments.

Players

Hedgers, speculators and arbitrageurs (the commodity-market participant categories in Alternative Investments Analysis apply generally across all derivative markets).

Trading of financial versus commodity derivatives

Financial derivatives (on equities, bonds, currencies, rates) trade against purely financial underlyings with no physical delivery complication for most contracts; commodity derivatives (see Alternative Investments Analysis, on commodities) must additionally account for storage, transport and physical delivery logistics where physically settled.

Buying and shorting financial assets

Derivatives let an investor gain the economic equivalent of a long or short position in an underlying asset (the long-short strategies of Equity Investments Analysis) without necessarily owning or physically borrowing the asset itself, often at lower transaction cost and with embedded leverage.

Hedgers

Use derivatives to reduce an existing risk exposure (the three risk management chapters develop specific hedging applications in depth).

Speculators

Use derivatives to take a directional or volatility view, often with more leverage and lower transaction cost than trading the underlying directly.

Arbitrageurs

Exploit temporary mispricing between a derivative and its underlying, or between related derivatives, the activity that keeps derivative pricing (see Principles of derivative pricing, below) anchored to its theoretical no-arbitrage value.