# Financial Glossary

by **Stewart Douglas**

This glossary contains definitions of terms commonly used in the Financial Markets.

### Accreting Swap

An interest rate swap or currency swap where the principal or notional amount increases in steps over the life of the swap.

### American Option

An option which may be exercised at any time prior to expiration. This right to exercise at any time during the option life, normally makes the option more expensive i.e. it has a higher premium. See also European Option.

### Amortising Swap

An interest rate swap or currency swap where the principal or notional amount decreases in steps over the life of the swap.

### Arbitrage

The act of gaining a risk free profit by simultaneously entering into a number of transactions in two or more markets. The standard textbook comment on arbitrage is that these risk free opportunities do not normally exist in an efficient market; as arbitrageurs take advantage of the opportunity the market adjusts and the opportunity disappears. In practice, these opportunities are only available to investors who can move quickly or transact large amounts of business so that transaction costs are not significant.

### Asset Swap

An interest rate swap or currency swap which is attached to an asset.

### At the Money (ATM)

An option where the strike price is approximately equal to the underlying price.

### Basis Point

One hundredth of a percentage point. Spreads in interest rate markets are commonly quoted in basis points.

### Basis Swap

An interest rate swap where both legs are floating, linked to different index tenors. Basis swaps can be on the same index at different tenors e.g. 3 month LIBOR versus 6 month LIBOR; on the same or different tenors on different indexes e.g. 3 month US dollar Libor against US Prime rate.

### Bid Price

The price at which the seller is prepared to make a deal. See also Offer Price.

### Binomial Option Tree

Option Pricing method which assumes that the price of the underlying can go up or down by fixed multiples. Each price jump is assigned a probability and a tree of possible underlying prices is built. Working from the tree points or nodes at the option maturity date, the worth of the option can be back calculated until the option can be valued at the desired date. This technique is commonly used to price path dependent options, such as average rate and lookback options, where the option price is dependent on the underlying’s price history. A more advanced technique, the Trinomial tree, as its name suggests, assumes that option prices cam move up, down or stay the same.

### Black-Scholes Equation

An analytical option pricing formula which is used to price European options on non-dividend paying equities. The Black-Scholes (BS) method can be extended to price American options. The Snowgold Option Calculator uses the Barone-Adesi and Whaley (BAW) method which prices an American option by valuing the corresponding European option using the BS method and then adds on an early exercise premium if the underlying price exceeds a critical stock price calculated by the model.

### Bond

A debt instrument which pays back cash to the holder at regular frequencies. The payment is normally a fixed percentage, known as a coupon. At maturity, the face value of the bond is paid.

### Call Option

A contract between a buyer and seller whereby the buyer acquires the right, but not the obligation, to buy a specified stock, commodity or index at a predetermined price on or before a predetermined date. The seller of the option assumes the obligation of delivering the underlying, should the buyer exercise the option. Opposite of a put option.

### Commodity

Any product traded on a commodity exchange. Examples include agricultural products, foreign currencies, metals, oil and financial instruments.

### Coupon

The interest rate paid on a bond issue. Quoted in percentage terms. Can be a fixed or floating rate.

### Currency Swap

Similar to an interest rate swap, except the currencies in the two legs are different, the principal amount on which the interest is paid is always exchanged at maturity. Optionally, there may also be an exchange of principal at the start of the deal.

### Delta

The rate of change of fair value of an option with respect to the change in price of the underlying. One of the Greeks.

### Dividends

Regular payments made by companies to their stock holders, which can vary over time. These payments compensate the investors for not receiving interest which they might have received with other investments. Investors can also make a profit if the stock price increases over time. Future dividends can have an impact on the worth of an option as the equity or underlying price normally drops when a dividend payment is made.

### Equity or Stock

Non-debt capital employed by companies to finance their operations. Investors earn returns in the form of dividends which can vary over time.

### Exchanged Traded Option (XT)

Exchange traded options are similar to normal options - they are traded on the floor of an exchange or electronically and have a market price like other financial instruments. OTC options, are constructed to meet a clients needs, so prices for these can only be obtained by approaching a financial institution.

### European Option

An option which may only be exercised at expiration. See also American Option.

### Exercise

The process by which the buyer of an option converts the option into a long position (in the case of a call) or a short position (in the case of a put).

### Exercise Price or Strike

The price at which the buyer and seller agree the option underlying will be exchanged for, if the option is exercised. The deal is said to be struck at the selected level.

### Expiration

The date and time after which the option may no longer be exercised.

### Extrinsic Value

Also known as time value. Extrinsic value is the price of an option minus its intrinsic value. As out of the money options have no intrinsic value, their option premium is based entirely on their extrinsic value.

### Fair Value or Theoretical Value

An estimate of an options worth produced by a mathematical pricing model, such as the Black-Scholes Equation or a Binomial Option Tree based on certain assumptions about prevailing interest rates and option volatility. See also Greeks.

### Fixed

Term used to denote one side of an interest rate swap - the payments made on this side will remain a constant percentage of the principal amount.

### Floating

Term used to denote one side of an interest rate swap - the payments made on this side will vary over the life of the swap depending on some pre-defined market index such as Libor.

### Gamma

The rate of change of an option’s delta with respect to underlying price. The second derivative of option value with respect to underlying price. Also referred to as an options curvature. See also Greeks.

### Greeks

Commonly used to indicate an options value and how this value will change as market conditions change.

### Index

A financial instrument which has been created to represent a market sector. These instruments are traded in their own right, with their own market price. The index price is normally calculated from the price of its constituent components. Examples include the FTSE100 in the UK, the S&P500 in the US and the DAX in Germany. Exchange traded options are commonly based on these indices.

### Instrument

Any tradable commodity whose price can be obtained from a Financial Market.

### In the Money (ITM)

A call (put) whose exercise price is lower (higher) than the current price of the underlying; i.e. an option which, if exercised immediately would result in a profit for the buyer of the option.

### Intrinsic Value

The amount by which the option is in the money. For a call, this is the current underlying price minus the exercise price. For a put, this is the exercise price minus the current underlying price. An out of the money has no intrinsic value. An in the money option, has some intrinsic value.

### Kappa

See Vega.

### LIBOR

London Inter-Bank Offered Rate - the rate at which major London banks offer to lend funds to other banks. Libor rates are commonly used as reference rates in interest rate swap transactions. Similar rates exist in other markets e.g. Euribor for Euro denominated transactions. Libor is often used as a generic term for all inter-bank rates.

### Liquidity

A market in a financial instrument is said to have liquidity if the market is active with many participants buying and selling. In a liquid market, large transactions can be made without a substantial change in the instrument’s price.

### Long Position

A position which in theory will increase in value should the underlying price increase. Opposite of a short position.

### Maturity Date or Exercise Date

The date when the option or swap matures. If the option has not been exercised by this date, it expires and ceases to have any value. For an interest rate swap this is the date when the final interest exchanges are made. For a bond and currency swap, the principal is paid / exchanged on this date.

### Option or Derivative

Any financial instrument who’s price is based on or derived from the price of another financial instrument. Options can be categorised by the type of instrument they are based on - Equity Derivatives, Bond Options, and Interest Rate Derivatives.

### Offer Price or Ask Price

The price a buyer is willing to pay (the price they will offer to buy the instrument from you). See also Bid Price.

### OTC Option

OTC or Over the Counter options are constructed specifically to meet certain financial requirements. A single OTC option will often only be traded once. This is in direct contrast to exchange traded options which are more liquid.

### Out of the Money (OTM)

A call (put) whose exercise price is higher (lower) than the current price of the underlying.

### Position

The sum of a trader’s open contracts or trades in a particular instrument.

### Premium

The up front payment made by the buyer of an option for the right to exercise the option in the future. If the buyer of an option decides not to exercise the option, then the option will expire and the buyer will have simply lost the premium. The seller or writer of the option, will have gained the premium.

### Present Value (NPV)

The current worth of a payment or a series of payments, discounted at a given interest rate. Net Present Value or NPV is used when calculating option, bond and swap prices.

### Put Option

A contract between a buyer and seller whereby the buyer acquires the right, but not the obligation, to sell a specified instrument at a predetermined price on or before a predetermined date. The seller (or writer) of the option assumes the obligation of taking delivery of the underlying, should the buyer exercise the option. Opposite of a call option.

### Rho

The sensitivity of an options value to a change in interest rates. The first derivative of option worth with respect to interest rates. See also Greeks.

### Roller Coaster Swap

A combination of accreting and amortising swaps - the principal amount can vary through the life of the swap, both up and down.

### Short Position

A position which in theory will increase in value if the underlying price falls. Opposite of a long position.

### Short Selling

The practice of selling securities which you do not own.

### Spread

The difference in prices or yields, often between the bid and offer rates. Commonly referred to as the bid-ask spread. When pricing interest rate swaps, the floating leg will be quoted as a spread above / below Libor or some similar rate.

### Swap

A Swap or Interest Rate Derivative is an exchange of cash flows between two parties. The cash flows are based on the interest payments made on a nominal sum known as the principal. The interest payments can be made at different rates, can be fixed or floating and can be made at different frequencies. A vanilla (or plain) swap normally involves exchanging fixed and floating rate payments on the same currency. See also Basis Swaps, Currency Swaps, Roller Coaster Swaps, Amortising Swaps, Accreting Swaps and Asset Swaps.

### Theta

The rate at which option loses value as time to maturity decreases. Also referred to as the time decay of an option. See also Greeks.

### Underlying

The instrument which the option is based or written on. This can be any tradable instrument which has a defined market price. Common examples include stocks, commodities and cash indices.

### Vega

The sensitivity of an options value to a change in volatility. Also known as Kappa. The first derivative of option worth with respect to volatility. See also Greeks.

### Volatility

One of the major factors in deciding an options worth. The degree to which the underlying price tends fluctuate over time. Historical volatility can be calculated by looking at price fluctuations over a specific period in the past. Implied volatility can be implied from option prices observed in the market place. This is achieved by using the Black-Scholes Equation, or one of its derivatives to calculate an option volatility which gives the current market option price. Historical and implied volatility can be used to estimate the price of OTC options.

### Warrant

A call option issued by a company on its own stock. The company specifies the exercise price and maturity date. Once issued, the warrant can be traded on exchanges.

### Writer

The seller of an option is said to have written the option. Option writing is normally only performed by large financial institutions due to the risks involved.

### Yield

The rate of return on any financial instrument, normally expressed as a percentage.

### Yield Curve / Interest Rates

A chart showing the relationship between yields and maturity’s for a set of similar instruments or bank deposits. The creation of this chart is a complicated process which can have a large impact on the pricing of options and interest rate derivatives. In essence, the yield curve shows the markets’ expectations of future interest rates.

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