This glossary contains definitions of terms commonly used in the Financial Markets.
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.
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.
At the Money (ATM)
One hundredth of a percentage point. Spreads in interest rate markets are commonly quoted in basis points.
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.
The price at which the seller is prepared to make a deal. See also Offer Price.
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.
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.
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.
Any product traded on a commodity exchange. Examples include agricultural products, foreign currencies, metals, oil and financial instruments.
The interest rate paid on a bond issue. Quoted in percentage terms. Can be a fixed or floating rate.
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.
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.
Non-debt capital employed by companies to finance their operations. Investors earn returns in the form of dividends which can vary over time.
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.
An option which may only be exercised at expiration. See also American Option.
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.
The date and time after which the option may no longer be exercised.
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.
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.
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.
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.
Commonly used to indicate an options value and how this value will change as market conditions change.
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.
Any tradable commodity whose price can be obtained from a Financial Market.
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.
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.
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.
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.
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.
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)
The sum of a trader’s open contracts or trades in a particular instrument.
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)
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.
The practice of selling securities which you do not own.
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.
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.
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.
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.
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.
The rate of return on any financial instrument, normally expressed as a percentage.
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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