CISI Derivatives (CISI) flashcards

32 cards. Read the term and the definition here. The deck at the top of this page is optional.

Derivative

A financial contract whose value depends on an underlying asset, rate, index or event; examples include futures, forwards, options and swaps.

Futures versus forwards

Futures are exchange-traded, standardised and cleared daily; forwards are OTC, bespoke and settled at maturity, carrying bilateral counterparty risk.

Central counterparty

An entity that novates trades, becoming buyer to every seller and seller to every buyer, and manages default risk through margin and a default fund.

Hedger, speculator, arbitrageur

Hedgers reduce existing risk, speculators accept risk seeking profit, and arbitrageurs exploit pricing discrepancies between related instruments for riskless gain.

Initial and variation margin

Initial margin is collateral posted at inception to cover potential future exposure; variation margin settles daily mark-to-market gains and losses.

Open interest

The total number of outstanding derivative contracts that have not been closed or delivered; it differs from volume, which counts trades in a period.

Fair forward price

F = S × (1 + r − q)^T, where S is spot, r the funding rate, q the income yield and T time to maturity; it reflects cost of carry.

Contango and backwardation

Contango occurs when futures trade above spot because carry costs exceed income; backwardation occurs when futures trade below spot because income exceeds carry.

Basis

Basis equals spot price minus futures price; basis risk is the risk that spot and futures prices do not move in perfect lockstep for a hedger.

Optimal hedge ratio

β = ρ × (σS / σF), the regression coefficient of spot price changes on futures price changes, used to size a minimum-variance hedge.

Short hedge

Selling futures to protect against a fall in the price of an asset the hedger plans to sell; it locks in a future selling price.

Long hedge

Buying futures to protect against a rise in the price of an asset the hedger plans to buy; it locks in a future purchase price.

Margin call

A demand to restore equity to the initial margin level when it falls below maintenance margin; failure to meet it leads to liquidation of the position.

Intrinsic value

For a call, max(S − K, 0); for a put, max(K − S, 0). Time value is the option premium minus intrinsic value.

Put-call parity

For European options, C − P = S − K × e^(−rT); a violation permits arbitrage by combining the option and underlying positions.

Black-Scholes inputs

Spot price, strike, time to expiry, volatility, risk-free rate and dividend yield; volatility is the only input not directly observable in the market.

Delta

The change in option value for a one-unit change in the underlying price; it ranges from 0 to 1 for calls and −1 to 0 for puts.

Gamma

The rate of change of delta with respect to the underlying price; it is highest for at-the-money options near expiry and measures convexity risk.

Theta

The change in option value for a one-day passage of time; long options typically have negative theta as time value decays.

Vega

The change in option value for a one percentage point change in implied volatility; long options have positive vega.

Covered call

Selling a call against a long stock position; it generates premium income but caps upside above the strike price.

Protective put

Buying a put while holding the underlying stock; it floors downside losses at the strike minus the premium paid.

Straddle

Buying a call and a put with the same strike and expiry; it profits from large moves in either direction but loses if the price stays flat.

Implied volatility

The volatility input that equates a model option price to the observed market price; the smile or skew reflects supply and demand across strikes.

Plain vanilla interest rate swap

An exchange of fixed-rate payments for floating-rate payments on a notional principal; the notional is not exchanged and the initial value is zero.

Swap valuation as bonds

To a fixed-rate payer, swap value equals the floating-rate note value minus the fixed-rate bond value; equivalently, it is a portfolio of forward rate agreements.

Currency swap

An exchange of principal and interest in two currencies; principal is typically exchanged at inception and re-exchanged at maturity.

Credit default swap

A contract in which the protection buyer pays a periodic spread and receives a payment if a defined credit event occurs on a reference entity.

ISDA master agreement

The standard documentation framework for OTC derivatives; a credit support annex governs collateral and netting reduces counterparty exposure.

G20 clearing mandate

The 2009 Pittsburgh commitment that standardised OTC derivatives be traded on exchanges or electronic platforms, centrally cleared and reported to trade repositories.

Default waterfall

The sequence for absorbing a clearing member default: defaulter's margin, default fund contributions, CCP capital and, in some regimes, assessments on surviving members.

Market abuse

Insider dealing, market manipulation and unlawful disclosure of inside information; firms must monitor, report suspicious transactions and keep records.