IFoA SP6 key terms

A financial contract whose value depends on an underlying asset, rate, index or event. Neither party necessarily holds the underlying; the contract creates rights and obligations settled at a future date.

The asset, rate, index or reference quantity from which a derivative draws its value, such as a share, bond, currency, commodity or equity index. It may be delivered physically or replaced by cash settlement.

The price payable now for immediate delivery of an asset in its cash market. Derivatives are priced relative to this level, adjusted for carry, income and expected future movements.

A privately negotiated agreement to buy or sell an asset at a fixed price on a future date. Both parties bear counterparty credit risk, and no cash changes hands at inception under a standard arrangement.

The delivery price agreed today for a forward contract. In a no-arbitrage market it equals the spot price accumulated at the risk-free rate, less income, adjusted for storage and convenience yield.

An exchange-traded, standardised agreement to trade an asset at a future date. Terms are set by the exchange, positions are marked to market daily and a clearing house stands between buyer and seller.

The daily revaluation of open futures positions against the settlement price, with gains credited and losses debited to margin accounts. It converts accumulated profit or loss into realised cash flow each day.

Collateral deposited when a futures or cleared derivative position is opened, sized to cover potential losses over the close-out period. It is returned, with variation adjustments, when the position is closed.

Cash paid or received daily to reflect changes in the value of an open cleared position. It keeps the margin balance aligned with current exposure after marking to market.

A demand for additional collateral when an account falls below the maintenance level. Failing to meet it can trigger forced liquidation of positions by the broker or clearing member.

An entity that interposes itself between trade counterparties, becoming buyer to every seller and seller to every buyer. It manages default risk through margin, default funds and netting.

A clearing house acting as legal counterparty to both sides of a trade. Novation replaces the original bilateral link with two contracts, each facing the central counterparty.

A decentralised market where participants negotiate derivative contracts privately rather than on an exchange. Terms are flexible, but transparency is lower and counterparty credit risk remains bilateral.

The risk that the other party to a contract defaults before settlement, leaving the non-defaulting party to replace the trade at a loss. It is measured as replacement cost plus potential future exposure.

Offsetting positive and negative exposures between two parties so only a single net amount is owed on default. Close-out netting reduces credit exposure and is often supported by a master agreement.

An adjustment reducing the fair value of a derivative to reflect the possibility that the counterparty defaults. It equals the expected loss from default, discounted and probability-weighted over the remaining life.

A contract giving the holder the right, but not the obligation, to buy or sell an underlying at a specified price on or before a stated date. The holder pays a premium to the writer.

An option giving its holder the right to buy the underlying at the strike price. Value rises with the underlying; the holder's loss is limited to the premium paid.

An option giving its holder the right to sell the underlying at the strike price. It gains value as the underlying falls, and protects a holding against downside moves.

The fixed price at which an option holder may buy or sell the underlying. Whether the option is in, at or out of the money is judged by comparing the strike with the current underlying price.

The price paid by the option buyer to the writer for the rights granted. It comprises intrinsic value plus time value and depends on volatility, time to expiry, rates and dividends.

The amount an option would be worth if exercised immediately: the excess of underlying price over strike for a call, or strike over underlying for a put. It is never negative.

The part of an option premium exceeding intrinsic value, reflecting the chance the option becomes more valuable before expiry. It typically erodes as expiry approaches, all else equal.

The position of the underlying price relative to the strike. In-the-money options have positive intrinsic value, at-the-money options have strike near the underlying price, and out-of-the-money options have none.

A no-arbitrage relationship linking European call and put prices with the same strike and expiry. A call plus discounted strike equals a put plus the underlying, adjusted for dividends.

An agreement to exchange cash flows, typically calculated on different bases, over a set period. Interest rate, currency and equity swaps are common, and most are valued as portfolios of forward contracts.

A contract exchanging fixed-rate and floating-rate interest payments on a notional principal. The principal is not exchanged; the swap lets parties alter their exposure to interest rate movements.

The fixed rate in an interest rate swap that makes the contract value zero at inception. It is derived from the forward curve and quoted for standard maturities.

The reference amount on which swap or derivative payments are calculated. It is usually not exchanged and may differ from the actual exposure created by the contract.

The assumption that identical future cash flows must have the same current price, and that riskless profits cannot persist. It underpins forward pricing, put-call parity and risk-neutral valuation.

A pricing method that values derivatives as discounted expected payoffs under a probability measure where all assets earn the risk-free rate. It avoids estimating real-world expected returns.

A lattice approach where the underlying moves up or down each period by fixed factors. Backward induction discounts expected option payoffs under risk-neutral probabilities to obtain today's price.

A closed-form formula pricing European options on a non-dividend-paying asset using constant volatility and lognormal prices. It yields a delta and other sensitivities used for hedging.

The volatility input that makes a pricing model reproduce an observed option price. It summarises market expectations and varies with strike and maturity, producing the volatility smile or skew.

The pattern where implied volatility is higher for options away from the money than for at-the-money options. Its shape reveals market views on tail risk and departures from lognormal assumptions.

The sensitivity of a derivative's value to a small change in the underlying price. It also approximates the number of underlying units needed to hedge the position, and equals the hedge ratio.

Rebalancing a portfolio of underlying and derivatives to keep overall delta near zero. Frequent rebalancing reduces directional risk but incurs transaction costs and leaves gamma and vega exposure.

The rate at which delta changes as the underlying price moves. High gamma means a hedge needs frequent adjustment and makes option positions convex in the underlying.

The sensitivity of a derivative's value to a change in implied volatility. It is largest for at-the-money options with longer time to expiry and is not directly hedgeable with the underlying alone.

The sensitivity of a derivative's value to the passage of time, often called time decay. Option buyers typically face negative theta because time value erodes toward expiry.

The net cost of holding an asset until delivery: financing costs plus storage, less income or convenience yield. It determines the gap between forward and spot prices.

The non-cash benefit of holding a physical commodity rather than a derivative claim on it. It lowers the forward price relative to spot plus storage and financing costs.

The difference between the spot price of an asset and the price of a related futures contract. It converges to zero at expiry and drives hedging outcomes for cross-hedgers.

The value of a derivative at expiry as a function of the underlying price, before any premium is considered. Profit differs from payoff by the initial premium and financing costs.

A graph or function showing gain or loss on a position against the underlying price at a chosen date. It includes premiums paid or received and illustrates break-even points and loss limits.

Closing a derivative by paying the cash value of the contract rather than delivering the underlying. It suits index, rate and many commodity contracts where physical delivery is impractical.

The price at which a derivative could be exchanged between knowledgeable willing parties in an arm's-length transaction. It is usually estimated by discounting expected future cash flows.

Continuously adjusting a hedge as the underlying moves, using model sensitivities to offset risk. In practice it is discrete and imperfect, leaving residual gamma and volatility exposure.