CISI Derivatives (CISI) key terms

A financial contract whose value is derived from an underlying asset, rate, index or event rather than from the instrument itself. Common forms are futures, forwards, options and swaps, used to hedge, speculate or arbitrage.

The reference item whose price or level determines a derivative's payoff, such as a share, bond, currency, commodity, interest rate or equity index. Its behaviour drives the pricing and risk of the contract.

The price at which an asset trades for immediate delivery in the cash market, as opposed to a price agreed now for later settlement. It anchors forward and futures pricing through the cost of carry.

A decentralised market where participants negotiate bilateral contracts directly rather than through an exchange. Terms are customisable but counterparty credit risk and documentation burden are higher.

A contract on a standardised terms set, cleared through a central counterparty and traded on an organised venue. This reduces credit risk and improves price transparency but limits customisation.

An entity that interposes itself between buyer and seller, becoming the buyer to every seller and seller to every buyer. It manages default risk through margining, a default fund and close-out procedures.

Collateral posted at the start of a position to cover potential future exposure over the close-out period. It is not a settlement of loss but a buffer held against default.

A daily or intraday payment that settles the change in a position's value since the last payment. It keeps cumulative losses current so that exposure never grows unchecked.

The risk that the other side of a contract fails to meet its obligations when due. It is most acute in over-the-counter deals and is mitigated by collateral, netting and central clearing.

The process of offsetting positive and negative values between two parties so that only a single net amount is owed. Close-out netting reduces exposure on default and is supported by standard master agreements.

A private agreement to buy or sell an asset at a fixed price on a future date, with settlement deferred. Both parties are obliged to perform and the contract is not usually tradable.

A standardised, exchange-traded agreement to buy or sell a specified quantity of an asset at a set price on a future date, margined daily and cleared centrally. It can be closed out before delivery.

The delivery price agreed today for an asset to be exchanged at a future date. For a non-income-paying asset it equals the spot price compounded at the risk-free rate over the term.

The net cost of holding an asset until delivery, combining financing charges, storage and insurance less any income or yield received. It links spot and forward prices and underpins arbitrage relationships.

The non-monetary benefit of physically holding a commodity rather than a futures position, reflecting security of supply. It can make futures trade below the full cost-of-carry level.

The difference between the spot price of an asset and the price of its related futures contract. It converges to zero at expiry and is central to hedging effectiveness.

The risk that the basis changes unexpectedly, so a hedge does not offset the underlying exposure perfectly. It arises when the hedging instrument differs in asset, maturity or location from the exposure.

A market condition where futures prices are higher than the spot price, typically because carrying costs exceed income. The futures curve slopes upward with maturity.

A market condition where futures prices are below the spot price, often reflecting strong nearby demand or a high convenience yield. The futures curve slopes downward with maturity.

The practice of revaluing a position at current market prices, usually daily, so that gains and losses are recognised and settled promptly. It underpins margining on futures and cleared swaps.

Closing a position in an expiring contract and reopening it in a later-dated one to maintain exposure. In contango this can create a negative carry for long holders.

A contract giving the buyer the right, but not the obligation, to buy the underlying at a specified strike price on or before expiry. The buyer pays a premium and has limited loss.

A contract giving the buyer the right, but not the obligation, to sell the underlying at a specified strike price on or before expiry. It gains value as the underlying falls.

The fixed price at which an option holder may buy or sell the underlying. Whether the market has moved above or below it determines whether the option is in, at or out of the money.

The price paid by an option buyer to the seller for the rights conveyed by the contract. It comprises intrinsic value and time value and is the maximum loss for the buyer.

The amount by which an option is in the money, being the gain that could be locked in by exercising now. It is zero for out-of-the-money and at-the-money options.

The portion of an option premium reflecting the chance that the underlying moves favourably before expiry. It erodes as expiry approaches and is larger when volatility and time to expiry are greater.

The relationship between the underlying price and the strike, classifying an option as in, at or out of the money. It indicates whether immediate exercise would produce a gain.

The volatility level that, when entered into a pricing model, reproduces an option's observed market price. It is a forward-looking measure used to compare relative richness across strikes and maturities.

Sensitivity measures showing how an option's value responds to changes in underlying price, time, volatility and interest rates. Delta, gamma, theta, vega and rho are the core set used in hedging.

The change in an option's price for a one-unit change in the underlying, ranging from zero to one for calls and minus one to zero for puts. It also approximates the hedge ratio.

The rate at which delta changes as the underlying price moves, measuring the curvature of an option's payoff. It is highest for at-the-money options near expiry and makes delta hedging unstable.

The change in an option's price per unit of time passing, holding other factors constant. It is usually negative for long options because time value decays toward expiry.

The change in an option's price for a one percentage point change in implied volatility. Long option positions are typically positive vega, gaining when volatility expectations rise.

A no-arbitrage relationship linking European calls, puts, the underlying and a risk-free bond with the same strike and expiry. Violations allow riskless arbitrage and it underpins synthetic positions.

An over-the-counter agreement to exchange a series of cash flows over a set period, typically calculated on notional amounts. Interest rate, currency, equity and credit swaps are common types.

A contract to exchange fixed-rate and floating-rate interest payments on a notional principal over a defined term. It is used to manage exposure to changes in interest rates.

The reference principal on which swap and derivative payments are calculated. It is usually not exchanged itself, so it magnifies risk without representing an actual cash outlay.

A set of fixed rates for swaps of varying maturities, used to price and value swaps and to derive forward rates. It is a key benchmark alongside government bond yield curves.

Simultaneously buying and selling related instruments to profit from a price discrepancy with no material risk. Arbitrage activity enforces pricing relationships such as put-call parity and cost of carry.