Derivatives Analysis glossary

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.

Taught in Derivative markets and instruments

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.

Taught in Derivative markets and instruments

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

Taught in Derivative markets and instruments

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).

Taught in Derivative markets and instruments

The common types:

• Asian (average-rate) options: payoff based on the underlying's average price over a period, rather than its price at a single expiration date.
• Lookback options: payoff based on the most favourable price the underlying reached during the option's life.
• Barrier options: activated or extinguished if the underlying crosses a specified price level.

Taught in Derivative markets and instruments

The types:

• Rainbow options: payoff depends on more than one underlying asset.
• Compound options: an option on another option.
• Chooser options: let the holder decide, at a specified future date, whether the option is a call or a put.

Taught in Derivative markets and instruments

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

Taught in Derivative markets and instruments

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

Taught in Derivative markets and instruments

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

Taught in Derivative markets and instruments

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

Taught in Derivative markets and instruments

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

Taught in Derivative markets and instruments

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

Taught in Derivative markets and instruments

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.

Taught in Derivative markets and instruments

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.

Taught in Derivative markets and instruments

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

Taught in Derivative markets and instruments

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

• Interest rate swaps (see the chapter on swaps) exchanging fixed for floating interest payments.
• Currency swaps exchanging cash flows in different currencies.
• Equity swaps exchanging an equity return for a fixed or floating rate.

Taught in Derivative markets and instruments

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.

Taught in Derivative markets and instruments

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

Taught in Derivative markets and instruments