Derivatives Fundamentals
eurodollars
A U.S. dollar deposited in a bank outside of the U.S. The bank could either be a foreign bank or a branch or a subsidiary of a U.S. bank.
backwardation
A commodity market where the forward or futures price is lower than the cash or spot price. Also known as backwardation.Inversions occur in commodity futures markets largely due to low near-term supply or high demand of the physical commodity, relative to forward supply and demand.
inverted market
A commodity market where the forward or futures price is lower than the cash or spot price. Also known as backwardation.Inversions occur in commodity futures markets largely due to low near-term supply or high demand of the physical commodity, relative to forward supply and demand.
cooling degree day (CDD)
A day in which the average daily temperature is greater than 65° F (18° C). Therefore, air conditioning is likely to be in demand. If the average daily temperature is 85°, for example, the CDD value for that day is 20.
heating degree day (HDD)
A day in which the average daily temperature is less than 65° F (18° C). Therefore, heat is likely to be in demand. If the average daily temperature is 55°, for example, the HDD value for that day is 10.
option
A derivative instrument that gives the purchaser the right, but not the obligation to, buy or sell an underlying asset at a certain price (exercise price) on or before an agreed upon date. For this right the purchaser pays a premium to the seller (writer) of the option. The writer has an obligation, if called upon to do so by the purchaser, to buy, in the case of puts, or sell, in the case of calls, at the exercise price.
volatility derivative
A derivative instrument whose value depends on a designated measure of volatility.
cash settlement
A feature of certain types of futures and option contracts that allow delivery or exercise to be conducted with an exchange of cash rather than by delivery of a physical asset in exchange for payment. Stock index futures contracts are the most predominant type of cash-settled contract.
weather derivative
A financial instrument whose value is derived from the behaviour of weather patterns.
foreign exchange agreement
A forward agreement based on a currency.
forward exchange agreement
A forward agreement based on a currency.
forward rate agreement
A forward agreement that is based on interest rates. The parties to a forward rate agreement are able to fix an interest rate for a transaction that is going to take place at some point in the future.
futures contract
A forward-based derivative that trades on an exchange.
offsetting transaction
A futures or option transaction that is the exact opposite of a previously established long or short position.
perfect hedge
A hedge in which the futures price behaved exactly as expected relative to the cash price.
long hedge
A hedge that involves buying the futures contract in anticipation of buying the physical asset at some point in the future. Long hedgers are concerned that the price of the underlying asset will rise in the future, making it more expensive to buy.
short hedge
A hedge that involves selling the futures contract in anticipation of selling the physical asset at some point in the future. Short hedgers are concerned that the price of the underlying asset will decline in the future, meaning they will not receive as high a price when they are ready to sell the underlying asset.
cross-hedge
A hedge where the futures contract used has an underlying asset which is similar to but not the same as the physical commodity being hedged.
over-the-counter
A market that generally consists of a loosely connected network of brokers and dealers who negotiate transactions directly with one another primarily over telephone lines and/or computer terminals.
contango
A market where the forward or futures price is higher than the spot price. For commodity futures contracts, contango markets are considered normal as there is typically a cost to carrying or holding a commodity.
normal market
A market where the forward or futures price is higher than the spot price. For commodity futures contracts, contango markets are considered normal as there is typically a cost to carrying or holding a commodity.
beta
A measure of the responsiveness of a security or portfolio to the market as a whole.
marking-to-market
A method of accounting that applies to speculative and other transactions that do not meet the requirements for hedge accounting. Gains and losses from such trading activities are recorded immediately as income.
interbank market
A network of banks across the world that buy and sell currencies 24 hours a day over telephone lines and computer terminals.
swap
A private, contractual agreement between two parties used to exchange (swap) periodic payments in the future based on an agreed to formula. Swaps are essentially equivalent to a series of forward contracts packaged together.
implied forward rate
A rate of interest derived from current spot rates that is applicable to a future time period.
bankers' acceptance
A short-term promissory note issued by a corporation that has been backed by a chartered bank.
intercommodity spread
A spread that involves the purchase and sale of futures contracts that have different but related underlying assets. The two contracts may trade on the same or different exchanges.
intermarket spread
A spread that involves the purchase and sale of futures contracts that have the same underlying asset but trade on different exchanges.
commodity product spread
A spread that involves the purchase or sale of a commodity futures contract against the opposite position in the products of the commodity.
contract for difference (CFD)
A type of cash-settled over-the-counter derivative contract where the parties agree to honour the difference in price between where a position is opened and where it is closed. One major difference between CFDs and other derivatives is that CFDs have no expiration date.
position traders
A type of speculator who is hoping to profit from longer-term price trends.
day traders
A type of speculator whose time horizon is a single day.
arbitrage
Academic or pure arbitrage refers to the simultaneous purchase and sale of instruments that are perfect equivalents in the hope of taking advantage of pricing discrepancies between them to earn a risk-free profit. Most real world arbitrage, however, is not pure. There usually is some element of risk.
time to expiration
All derivative contracts have a specific time to expiration. Both parties must honour the contract's obligations, or, if they plan to, exercise the rights (i.e., the buying or selling of a specified underlying interest) of the contract by expiration. The contract is automatically terminated upon expiration.
American terms quote
Also called a direct terms quote for U.S. based traders, indicates how many U.S. dollars equals one unit of a foreign currency.
European terms quote
Also called an indirect quote, indicates how much of a foreign currency equals one U.S. dollar.
intramarket spread
Also known as a calendar or time spread. Involves buying and selling futures contracts that trade on the same exchange and that have the same underlying interest but different expiry months.
conversion factor
An adjustment factor that equates all the different bonds that can be delivered against a bond futures contract to the deliverable grade bond underlying the contract.
margin
An amount of money deposited by both buyers and sellers of futures contracts to ensure performance of the terms of the contract (the delivery or taking of delivery of the commodity or offset of the contract). Margin is not a payment of equity, merely a performance bond or good faith deposit.
hedging
An attempt to reduce risk by making transactions that reduce exposure to market fluctuations. Hedging with derivatives involves taking an opposite position in the derivative instrument of the asset to be hedged (or one that is very close to it) that is equal in size.
electronic exchange
An exchange where designated terminals are used to enter orders on listed contracts. As orders are entered, the exchanges' electronic trading systems will sort, display and, when the rules of auction trading say so, match them (i.e., create a trade).
clearinghouse
An organization that takes care of financial settlement and helps ensure that markets operate efficiently. Clearinghouses can be set up either as a separate corporation or as a department of an exchange. The primary functions of a clearinghouse are to guarantee financial performance of each contract, clear all trades, and handle deliveries.
futures exchange
An organized exchange where futures contracts and options on futures contracts are traded.
reverse cash and carry arbitrage
Arbitrage that involves buying the futures contract and selling the underlying asset to take advantage of a situation where the futures contract is underpriced relative to fair value.
cash and carry arbitrage
Arbitrage that involves buying the underlying asset and selling the futures contract to take advantage of a situation where futures are priced higher than fair value.
buy program
Cash and carry arbitrage in the stock index futures market. Involves buying the stocks that comprise the index underlying the index futures contract and selling the futures contract to take advantage of mispricing. Often, instead of selling all the stocks in an index, the arbitrageur will sell a basket of stocks that closely correlate with the index.
mini contracts
Derivative contracts representing a fraction (typically 1/5 or 1/10) of a standard futures or options contract.
spread strategy
Describes a market strategy that attempts to take advantage of relative price changes between two different but similar futures contracts.
zero-sum game
Describes the fact that, commission fees and bid-ask spreads aside, the gain from a derivative contract by one counterparty is exactly offset by the loss to the other counterparty.
managed futures funds
Essentially mutual funds that invest in futures markets.
warehouse receipt
Even if an individual decides to take delivery, what is received/delivered in the case of most physical commodities is a warehouse receipt which the seller endorses over to the buyer. The receipt is issued by a storage point authorized by the exchange which confirms the presence and ownership of the underlying asset.
locals (scalpers)
Floor traders who trade for their own accounts.
long position
For forward-based derivatives, the party that agrees to buy the asset has the long position in the contract. For option-based derivatives, the party that pays the premium has the long position in the contract.
short position
For forward-based derivatives, the party that agrees to sell the asset has the short position in the contract. For option-based derivatives, the party that receives the premium has the short position in the contract.
exchange-traded derivatives
Forward and option products that trade on an organized exchange.
commodity futures
Futures contracts that are based on a physical or "hard" asset such as gold, soybeans or crude oil.
financial futures
Futures contracts that have a financial asset such as a bond, index or currency as their underlying interest.
fair value
If a futures contract is trading at a price that reflects full carry, it is said to be trading at fair or theoretical value.
forward contract
In a forward transaction, two parties agree to terms of a trade which is to be carried out some time in the future. The buyer does not pay the agreed upon price right away, nor does the seller deliver the underlying interest. Payment and delivery take place at a specified date in the future, known as the delivery date. The delivery price is agreed upon when the contract is entered into. Forwards that trade on an exchange are typically referred to as futures contracts. Forwards that trade OTC are typically referred to as forward agreements.
daily price limit
In a futures contract, the maximum amount the price is allowed to rise or fall in one day.
managed futures accounts
Individual accounts where a client gives discretionary authority over to a commodity trading professional.
commodity pools
Mutual funds that are allowed to use derivatives in a leveraged manner for speculation; pay incentive fees based on the total return of the fund since the last fee was paid; and to restrict redemption rights for a period up to six months after the initial purchase.
cross rate
Rate (or price) associated with the purchase or sale of currencies that are neither traded nor quoted directly against one another.
sell program
Refers to reverse cash and carry arbitrage in the stock index futures market. Involves the selling of the stocks that comprise the index underlying the index futures contract and the buying of the futures contract to take advantage of mispricing. Often, instead of selling all the stocks in an index, the arbitrageur will sell a basket of stocks that closely correlate with the index.
optimal hedge ratio
Represents the ratio used to calculate how many futures contracts should be used in a particular hedge by comparing price volatility of the futures and cash price.
systematic risk
Risk of overall stock market weakness.
whipsaw
Situation where a speculator is forced to close out a position due to an adverse price movement, only to see the price quickly rebound back in the favoured direction.
cost of carry
Term associated with the cost of holding a commodity or financial asset until it is sold or delivered. The cost of holding a commodity typically includes financing, storage and insurance charges. The cost of holding a financial asset typically includes financing costs less income received such as dividends for stocks and interest for debt instruments.
leverage
The ability to control large dollar amounts of an underlying interest with a comparatively small amount of capital. Leverage can greatly magnify the effect of price changes in an underlying interest.
open outcry auction
The auction system used in the trading pits on the floor of a futures exchange. All bids and offers are made openly and loudly by public competitive outcry and hand signals.
convenience yield
The benefit from owning the physical commodity. The value of the benefit is dependent upon the probability of shortages of the commodity. If the commodity is currently in short supply and that shortage is expected to continue, the convenience yield will be high.
cheapest to deliver (CTD)
The bond or note that can be delivered against a bond or note futures contract that either minimizes the loss on delivery or maximizes the gain.
counterparties
The buyer and seller of a derivative contract.
principle of substitution
The clearinghouse function of acting as the buyer for every seller and the seller for every buyer.
first notice day
The day that the futures contract delivery process begins. Long position holders who maintain their positions on and after first notice day may have to accept delivery of the underlying asset from the seller of the contract.
basis
The difference between the current cash price and the futures price.
comparative advantage
The mechanism through which the cost of new or existing debt may be reduced by an interest rate or currency swap. Specifically, two companies with complementary relative advantages may come together and design a swap to reduce the financing costs of both companies.
maintenance margin
The minimum balance for margin required during the life of a futures contract.
convergence
The narrowing of the basis as a futures contract nears expiration.
net equity
The net equity in a futures account is defined as the cash deposited plus/minus any open futures positions' profit/loss.
exercise price
The price at which an underlying security can be bought or sold if an option contract is exercised. Also known as the strike price.
spot price
The price of an asset on the spot market.
premium
The price of an option.
forward exchange rate
The rate (or price) associated with the purchase or sale of a currency for a specified future delivery date.
interest rate parity
The relationship between the spot and forward foreign exchange rates and the interest rates of two countries. Interest rate parity dictates that the difference between short-term interest rates between two countries should be offset by the forward exchange rate, otherwise an arbitrage opportunity would exist.
original margin
The required deposit when a futures contract is entered into.
call option
The right to buy (and lock in a purchase price) is referred to as a call option as the call buyer has the right to call the underlying asset from the call writer (seller) during the life of the contract.
put option
The right to sell (and lock in a sale price) is referred to as a put option as the put buyer has the right to put the underlying asset to the put writer (seller) during the life of the contract.
basis risk
The risk of unexpected changes in the basis.
unsystematic risk
The risk that a particular stock or group of stocks will underperform the market as a whole.
settlement price
The settlement price is determined at the end of each trading day by the "Pit Committee" of the Exchange. The price usually represents the average of futures prices for trades made toward the end of the day.
fundamental analysis
The study of an asset's current and expected supply and demand situation in order to help forecast future price movements.
technical analysis
The study of past price and volume data in order to anticipate future market movements.
program trading
The use of computers to execute complicated stock market orders.
underlying interest
The value of a derivative instrument is based on an underlying interest which may be a commodity such as wheat or a financial product such as a bond or stock, a foreign currency, or an economic/stock index.
spread traders
Trader simultaneously taking a long position in one asset and a short position in a related asset.
performance bond
What is often required upon entry into a futures contract is a performance bond or good-faith deposit, which gives the parties to a transaction a higher level of assurance that the terms of the contract will eventually be honored. The performance bond is often referred to as margin.
forward agreement
When a forward-based derivative is traded over-the-counter, it is generally referred to as a forward agreement.
delivery notice
When a short futures position holder wants to make delivery he/she notifies his/her broker who in turn tenders a delivery notice to the clearing corporation which then allocates the notice to a broker that has an account who is long that particular futures contract. Allocation by the clearing corporation and the broker is often done on a first-in first-out basis (FIFO).
