DERIVATIVES STUDY CENTER

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PRIMER

DERIVATIVES GLOSSARY

At-the-market.

Refers the value of the derivatives contract or the price specified in the derivatives contract in relation to the current market price. For example, a derivatives position to buy Euros at $0.95 is at-the-market when the current market price is $0.95 and would be below the market if the current price were any lower. For another example, a put on Euros at $0.95 is at-the-market if the current market price is $0.95 and is in-the-money if the price were to fall.

Basis.

The difference between price of the futures or other derivatives contract and the price of the underlying asset or commodity. Basis is usually computed in relation to the futures contract next to expire and may reflect different time periods, product forms, qualities, or locations.

Bid.

The expression of a price at which someone is willing to buy.

Bilateral trading.

Trading in which the quoting of prices and execution are conducted between two parties in such a way that other market participants do not observe the trading.

Broker.

The broker’s economic function is to connect, and possible negotiate on behalf of, the ultimate buyer and seller. Potential seller A (for ask) notifies the broker of their willing to sell at a price P_A, and then the broker contracts potential buyer B (for bid) and notifies B of the possibility of buying at P_A or inquires about their willing to buy at some other price. Once the broker negotiates a single price at which one is willing to sell and the other is willing to buy, then the transaction can be executed.

Capital or risk-based capital.

The sum of tier 1 and tier 2 capital. The former includes the value of outstanding shareholder equity, perpetual preferred stock, retained earnings and minority interests in consolidated subsidiaries. The later includes subordinated debt, other intermediate and long-term preferred stock and a portion of allowances for loan losses.

Carry.

Cost of storing a physical commodity or holding a financial instrument over a period of time. Includes insurance, storage, and interest on the invested funds as well as other incidental costs. It is a carrying charge market when there are higher futures prices for each successive contract maturity. If the carrying charge is adequate to reimburse the holder, it is called a "full charge."

Cash Commodity.

The physical or actual commodity as distinguished from the futures contract.

Cash Market.

The market for the underlying cash asset or commodity (as contrasted to the futures or derivatives market).

Corner.

Securing enough control of a commodity or security that its price can be manipulated. In the extreme case, obtaining contracts requiring the delivery of more commodities or securities than are available for delivery.

Dealer.

The dealer’s economic function is to make is to make-a-market so that buyers and sellers can readily do so in the liquid market. A potential buyer or seller contacts a dealer, by telephone or electronic trading platform, and inquires about the dealer’s bid or offer quotes. If the quote is acceptable, the potential buyer can execute a trade at the offer price (called lifting an offer) or the potential seller can sell at the bid price (hitting a bid). The dealer is the counterparty in either case.

On future exchanges, this term is sometimes loosely used to refer to a floor trader or local who, in speculating for his own account, creates a liquid market. On securities exchanges (where they are called specialists) and some OTC securities markets, the dealer has an obligation to maintain bid and offer quotes throughout the trading day.

Delivery.

The tender and receipt of the actual commodity, the cash value of the commodity, or of a delivery instrument covering the commodity (e.g., warehouse receipts or shipping certificates), used to settle a futures contract.

Derivative.

A financial instrument, traded on or off an exchange, the price of which is directly dependent upon (i.e., "derived from") the value of one or more underlying securities, equity indices, debt instruments, commodities, other derivative instruments, or any agreed upon pricing index or arrangement. Derivatives involve the trading of rights or obligations that are based on the price of an underlying product, but they generally do not directly transfer property.

Efficient Market.

A market in which new information is immediately available to all investors and potential investors. A market in which all information is instantaneously assimilated and therefore has no distortions.

End-user.

An end-user enters a derivatives contract in order to hold the position, whether for hedging, speculative or arbitrage purposes, and not for the purpose of market making.

Exchange.

Also known as a board of trade or contract market, it is a central market in which all participants can observe the bids, offers and execution prices of all other participants.

Execution price.

The price at which a trade occurs.

Exercise.

To elect to buy or sell, taking advantage of the right (but not the obligation) conferred by an option contract.

Exercise (or Strike) Price.

The price specified in the option contract at which the buyer of a call can purchase the commodity during the life of the option, and the price specified in the option contract at which the buyer of a put can sell the commodity during the life of the option.

Floating or floating rate or price.

A price or rate that changes or adjusts over time.

Floor Broker.

A trader who executes orders to enter into futures contracts.

Floor Trader or “local”.

An exchange member who trades for his own account by being personally present in the pit for futures trading. These traders act as market makers in the pits.

Forward contract.

A forward contract is the obligation to buy (or sell) a certain quantity of a specific item at a certain price or rate at a specified time in the future. For example, a foreign exchange forward contract requires party A to buy (and party B to sell) 1,000,000 euros for U.S. dollars at $1.0865 per euro on December 1, 2003. A forward rate agreement on interest rates requires party A to borrow (party B to lend) $1,000,000 for three months (91 days) at a 2.85% annual rate beginning December 1, 2003.

Fungibility.

The characteristic of interchangeability. Futures contracts for the same commodity and delivery month are fungible due to their standardized specifications for quality, quantity, delivery date and delivery locations.

Futures

Futures are like forwards (see above), except that they are highly standardized. The futures contracts traded on most organized exchanges are so standardized that they are fungible – meaning that they are substitutable one for another. This fungibility facilitates trading and results in greater trading volume and greater market liquidity. The public trading of futures in a transparent environment means that everyone can observe the market price throughout the trading day.

Hedge.

The use of derivatives to offset existing exposure to princes at a future point in time. Also known as risk shifting or more generally risk management.

In-the-money.

A term used to describe an option contract that has a positive value if exercised. For example, a call on gold at $280 is in-the-money when the spot price is above $280 dollars. See at-the-market and out-of-the money.

Long Hedge.

When the purchase of futures or other long derivatives position is used to offer existing exposure to princes at a future point in time.

Margin.

Margin can be thought of as a performance bond, a good-faith deposit or a financial safeguard to assure performance. The amount of money or collateral deposited for the purpose of insuring against loss on open futures contracts. Initial margin is the total amount of margin per contract required when a futures position is opened or established. Maintenance margin is a sum which must be maintained on deposit at all times. If the value (referred to as equity) in a customer's account drops to, or under, the maintenance level because of adverse price movement, a margin call is made and funds must be added to restore the customer's equity. The following are some special margin terms.

Initial margin.

· The amount to be deposited in order to enter in a contract (i.e. before trading); initial margin is set to approximate the largest daily price movement in preceding period.

Mark-to-market

· Also known as daily settlement. It adjustments the margin account to bring the value of contract back to the value of the market.

Maintenance margin.

· The minimum level in margin account such that if account falls below that level the trader is required to add funds to bring it back up the initial level. This additional amount of funds is called variance margin. Usually set at 75% of initial margin.

Variance margin.

· The amount of funds that must be added to margin account to bring it back to level of initial margin (not used to describe the amount that can be withdrawn without bringing the account below the initial margin level). Variance margin is the amount paid in response to a margin call.

Multilateral trading.

Trading in which all market participants observe all price quotes and trade executions in the market place.

Offer (or ask) quote.

The expression of a price at which someone is willing to sell. The price at which a trader is willing to sell (opposite of “bid,” and synonym of “ask”).

Offset.

The netting of positions in exchange traded futures or options in which some or all of an existing position is reduced by an opposing transaction (purchase for a short position or sale for a long position). The effect is to liquidate some or all of the prior position.

Open Interest.

The total number of futures contracts long or short in a delivery month or market that has been entered into and not yet liquidated by an offsetting transaction or fulfilled by delivery

Open Outcry.

Method of public auction required to make bids and offers in the trading pits or rings of commodity exchanges.

Option.

An option contract gives the holder of the option the right to buy (or sell) the underlying item at a specific price at a specific time period in the future. Buying a call option provides an investor the right to buy crude oil at $28 a barrel; if the price rise above the strike price of $28 before the option expires, then the investor can exercise the option and capture a profit equal to the market price less $28. If the price never rises above $28, then the option expires worthless or "out of the money" and the investor loses the money he paid for the option. A put option is similar. It provides an investor the right to sell coffee at a strike or exercise price of $0.65 per pound; if the price were to fall to say $0.60, then the investor would be able to exercise the put option and gain $0.05 for every pound of coffee covered by the options contract.

Whereas the buyer of the option has the right to exercise the option in order to profit from a favorable price movement, the writer or seller of the option (known as the short options position) has the obligation to fulfill the contract if it is exercised. The option writer is essentially selling price protection to the buyer who pays a “premium” for the insurance.

Options writer, issuer, seller or grantor.

The issuer of an option contract who, in return for the premium paid for the option, stands ready to purchase the underlying item the case of a put option or to sell the underlying item in the case of a call option.

OTC market.

Named for what was once an informally organized market, the over-the-counter (OTC) is today a well organized market place although with little or no regulatory oversight in comparison to an exchange.

Out-of-the-money.

A term used to describe an option that has no intrinsic value. For example, a call at $400 on gold when the market price is $390 is out-of-the-money 10 dollars. See in-the-money and at-the-market.

Pit.

A specially constructed arena on the trading floor of some exchanges where trading in a futures contract is conducted. On other exchanges the term "ring" designates the trading area for a commodity.

Position.

An interest in the market, either long or short, in the form of one or more open contracts.

Position Limit.

The maximum position, either net long or net short, in one commodity future (or option) or in all futures (or options) of one commodity combined which may be held or controlled by one person as prescribed by an exchange and/or by the CFTC.

Price Basing.

The process in which commercial transaction prices are based on the futures prices (or other derivatives prices) for an underlying or related asset or commodity. For example, an offer to sell corn at 5 cents over the December futures price.

Price Discovery.  

The process of determining the price level for a commodity, asset or other item based on supply and demand factors.

Risk.

Short position (opposite of long).

A position that is owed or borrowed or results from selling what is not owned. It also refers to the selling side of an open futures contract, or a trader whose net position in the futures market shows an excess of open sales over open purchases.

Short Selling.

Selling a futures contract with the idea of delivering on it or offsetting it at a later date.

Settlement Price.

The daily price at which the clearing house clears all trades and settles all accounts between clearing members. Settlement prices are used to determine both margin calls and invoice prices for deliveries.

Speculator.

An individual who, instead of hedging to reduce risk, trades in order to take on more risk with the objective of achieving profits through the successful anticipation of price movements.

Spot.

Market of immediate delivery of the product and immediate payment. Also refers to a maturing delivery month of a futures contract.

Spot commodity, cash commodity or “actuals.”

The actual commodity or asset as distinguished from the futures or other derivative contract. By association the cash market or alternatively the spot market is distinguished from the futures market or other derivatives market.

Spot price or cash market price.

The price at which an asset or physical commodity for immediate delivery is selling at a given time and place.

Squeeze.

A market situation in the futures market in which the lack of supply tends to force shorts to cover their positions by buying at higher prices.

Strike price.

See exercise price.

Swap.

The basic idea in a swap contract is that the counterparties agree to swap two different types of payments. A payment is either fixed or is designed to float according to an underlying interest rate, exchange rate, index or the price of a security or commodity. When the payments are to be made in the same currency, then only the net amount of the payments are made. A “vanilla” interest rate swap is structured so that one series of payments is based on a fixed interest rate and the other series is based on a floating interest rate such as LIBOR or a U.S. Treasury bill yield. A foreign exchange swap is comprised of two transactions; the first involves buying (or selling) a foreign currency at a specific exchange rate, and the second involves selling back that currency at another specific exchange rate. A foreign currency swap is structured so that one party makes a series of payments based in currency based on an interest rate in that currency and then receives another a series of payments in another currency bases on that currency's interest rate. An equity swap has one series of payments based on a long (or short) position in a stock or stock index, and the other series of payments fixed or floating according to an interest rate or a different equity position.

Underlying commodity or item.

The commodity or futures contract on which a commodity option is based, and which must be accepted or delivered if the option is exercised. Also, the cash commodity underlying a futures contract.

Volume of trade, or trading volume.

The number of contracts traded during a specified period of time. It may be quoted as the number of contracts traded or in the total of physical units, such as bales or bushels, pounds or dozens.

Warrant.

An issuer-based product that gives the buyer the right, but not the obligation, to buy (in the case of a call) or to sell (in the case of a put) a stock or a commodity at a set price during a specified period.

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