The extra return over and above that which is compensation for the riskiness of an investment.

Cash flows from assets (e.g. bonds, loans) which are bundled together and then sold as an ABS.

Cash flows from several ABSs are combined, into tranches, which determine the order of payment.

Interest earned on a bond since the last coupon payment.

Investment strategies which aim to achieve abnormal returns.

Costs associated with monitoring contracts.

Option which may be exercised at any time up to the expiry date.

Returns which cannot be explained by known asset pricing models.

An investment strategy that enables a risk-free profit to be made by an arbitrageur. Usually involves trading in two (or more) securities.

A model of time varying conditional volatility estimated using historical data.

Option whose payoff depends on the average price of the underlying asset over the life of the option.

The price at which a market maker/dealer offers to sell a security.

General term for anything with economic value.

Decision on how to split your wealth into different asset classes, for instance stocks, bonds, and cash.

Situation where one party has more information than another party.

An option with a strike price (or the present value of the strike price) equal to the current market price of the underlying security.

An option whose payoff depends on an average of the underlying asset price (relative to the strike price), over the life of the option.

An option whose payoff depends on the final asset price relative to an average of the asset price, over the life of the option.

A method used to assess forecasting accuracy, particularly in value at risk (VaR).

A condition in which the forward/futures price is below the current spot price. Also referred to as selling at a discount – see Contango.

An option whose final payoff at maturity depends on whether the underlying asset has reached or crossed a predetermined value (the barrier).

The difference between the spot price of the underlying asset and the futures price.

1/100 of 1% (0.01 per cent, 0.001 as a decimal).

The risk to a hedger associated with variation in the basis over time.

A swap where cash flows are exchanged based on two different floating interest rates.

A credit default swap on several reference entities.

A market in which prices are falling.

Describes the payoff profile of selling a call with a low strike price and buying a call with a higher strike price. Both calls have the same maturity and underlying asset.

An option that can only be exercised on specific dates.

Duty of a broker-dealer to provide the lowest available price (when buying stock) or the highest available price (when selling stock) for customers.

A measure of the responsiveness of a stock's return to changes in the market return – a measure of the systematic (market) risk of the stock.

The price a market maker/dealer pays to buy a security.

Difference between the bid and ask (offer) price – see Bid price, Ask (offer) price.

A credit default swap (CDS) with a fixed dollar payoff if default occurs.

A model to price European options on futures contracts. Can be applied whenever the underlying asset price at maturity is lognormal.

A model for pricing European options.

Market where long-term cash-market fixed income securities are traded.

Statistical technique to extract a ‘representative’ sample from a given data set. The sample is generated by repeated re-sampling of the original observations, usually with replacement. Alternatively, a procedure for calculating spot yields.

In each short period of time only two outcomes for the asset price are possible.

Agents who find best buying and selling prices and also provide IT services, facilitate short-sales and margin finance. Usually they are large investment banks.

A specific stochastic process which describes the random path of a variable (e.g. stock price) over small intervals of time.

Market in which prices are rising.

Describes the payoff profile from buying a call with a low strike price and selling a call which has the same maturity but with a higher strike price.

Payoff profile engineered by buying a low price call and a high price call and selling two calls with an intermediate strike price. (Can also use puts.)

A long–short position in two options with different times to maturity.

A European option giving the holder the right (but not the obligation) to buy the underlying security on a specified (expiry) date at a (strike) price agreed at the outset of the contract. An American option can be exercised at any time on or before the expiry date.

Price of a call option.

Bond which can be redeemed at a predetermined price by the company that issues it, before its maturity date.

Set of interest rate caplets which have different maturity dates.

An equilibrium model which states that the expected excess return on a stock equals the stock's beta multiplied by the excess return on the market portfolio.

Call option, which pays off if the floating interest rate at expiry (e.g. LIBOR) exceeds the strike (interest) rate.

Process of converting actual cash flows at different dates into cash flows at standardized dates in order to simplify the calculation of value at risk.

A procedure applicable to certain futures and options contracts wherein a cash transfer is employed at contract settlement rather than the actual delivery of the asset underlying the derivatives contract.

A (riskless) arbitrage trading strategy that determines forward/futures prices.

The average of the highest and lowest temperatures (midnight to midnight) at a particular location if the temperature is greater than 65 °F. If the temperature is less than 65 °F, CDD is zero.

A combination of debt instruments which are tranched so that the order of cash payments are in the form of a ‘waterfall’, depending on the seniority of the holder of the CDO.

A security formed by splitting a particular tranche of a CDO into several other tranches, with different levels of seniority.

The holder of a CDS, receives the face value of a reference bond, if the reference entity defaults.

Amount that must be paid each year (bps) by the holder of a CDS.

Refers to the cheapest bond which can be delivered by the short in a T-bond futures contract on the CME. The exchange denotes the set of bonds which are eligible for delivery.

The holder has the right to choose whether the option should be a call or put, at some point during the option's life.

Quoted price of a bond which excludes accrued interest or rebate interest.

The clean price is the quoted price. The cash price (‘dirty price’) actually paid is the clean price plus accrued interest.

A firm associated with an options or futures exchange, that guarantees contract performance and otherwise facilitates trading.

A mathematical solution of the form .

Selling an asset you already hold or buying an asset you have previously shorted (sold).

Price of the last trade on a particular day for a specific security.

A mortgage-backed security where the cash flows from the mortgages may be split between interest only payments and payments which reduce the principal of the mortgage.

Holding stocks and buying a low strike put and selling a high strike call.

The value of any asset held against the possible fall in value of another asset.

A form of zero-coupon bond issued by companies to raise funds. Maturity 7 days to 2 years. Active secondary market.

A swap where the two cash flows to be exchanged are based on commodity prices.

An option on an option.

See Perpetuity.

An asset held primarily for use in the production process (e.g. wheat, oil, natural gas, electricity).

A condition in which the forward price is above either the current or expected future spot price. See also Backwardation.

A binding agreement between two parties.

An implicit return earned by the holder of a consumption asset, because she wishes to be in a position to supply her customers in the future.

Used to adjust the value of a deliverable Treasury note or Treasury bond in a futures contract.

A corporate bond which gives the holder the right but not the obligation to convert all or part of the bondholding into common stock, on specified dates and on specified terms.

Measures the curvature of the price–yield relationship for bonds.

Form of ownership where the company is owned by its shareholders. In the case of bankruptcy the personal assets of the shareholders cannot be used to pay off any residual debt of the company.

A measure of the (linear) dependence between two variables. The correlation coefficient lies between +1 and –1.

The cost of holding a spot asset between two time periods – may involve a storage cost, an interest cost net of any cash flows accruing to the spot asset (e.g. dividends) and any convenience yield on the spot asset (i.e. consumption commodity).

The trader/agent on the other side of a financial transaction.

Interest paid on a bond, usually in two equal, semi-annual instalments. Sometimes expressed as a cash amount and sometimes as a percentage of the nominal (par) value of the bond – then it is called the coupon rate.

Process which refers to selling the coupons from a bond to various counterparties. This creates a series of zero-coupon bonds. The final payment of principal (maturity) on the bond may also be sold separately.

A measure of linear dependence between two variables. A positive covariance implies two variables tend to move in the same direction. The value of the covariance depends on the units used to measure the two variables.

A short position in a call with a long position in the underlying asset.

Relationship which describes a no-arbitrage condition in the foreign exchange market. The interest differential in favour of country-A is equal to the forward discount of country-A's currency.

Difference between the spot price of heating oil and the spot price of crude oil. Derivatives are written on the crack spread so that oil refiners can offset risk to their profit margins from changes in these two spot prices.

A derivative where the payoff depends on a ‘credit event’ (e.g. failure to meet several contractual periodic payments or outright default).

An event such as default or debt restructuring which triggers a payout on a CDS.

Describes the general risk that the counterparty will default and not honour the contract – see also Default risk.

A futures hedge in which the asset underlying the futures contract differs from the asset being hedged.

An exchange rate between two currencies that is implied by their exchange rates with a third currency. For example, dollar-sterling and dollar-euro gives rise to the cross-rate, sterling-euro.

An asset purchased ‘cum-dividend’ gives the purchaser the right to the next interest (or dividend) payment – see Ex-dividend.

In a plain vanilla currency swap two parties agree to exchange two currencies at recurrent intervals based on agreed (fixed) interest rates in the two currencies and on agreed notional principal amounts. The principal amounts in the currency swap are also exchanged at the beginning and end of the swap.

Barriers which indicate the cessation of trading for that day, if certain price limits are reached.

Convention about the number of days used for calculating interest. The day-count convention sets the number of days to payment and the number of days to represent one year. An example is the actual/360 day-count convention.

Buying and selling the same securities within the same day. Closing out the position before the end of the trading day.

See Market maker.

Borrow funds on which cash repayments are required in future periods. Debt holders (e.g. bondholders) can place a firm into liquidation.

The risk that one counterparty will fail to honour its part of an agreed set of financial transactions.

Day when the underlying ‘asset’ in a derivative contract has to be delivered and the long position in the contract pays the short (i.e. trader with an outstanding short position) in cash.

The change in price of a derivative with respect to the change in price of the underlying asset.

To create a hedge (riskless) position which takes into account the sensitivity of an option's premium to changes in the price of the underlying security on which the option is based.

A portfolio whose value is not affected by (small) changes in the value of the underlying asset, over short periods of time.

An asset whose price is dependent, or contingent, upon the price of the underlying asset in the derivative contract.

The price of a bond including accrued interest.

Firm which offers a limited brokerage service at reduced prices compared to brokers who offer a full range of services.

The difference between the redemption (maturity/par) value and the purchase price of a T-bill, expressed as a percentage of the par-value of the T-bill.

A process of adding assets to a portfolio, whose returns have a less than perfect positive correlation with each other – this helps reduce the overall risk (standard deviation) of portfolio returns.

The ratio of the (annual) dividend per share to the share price.

Cash payments made to shareholders of a firm. They can vary over time and are not guaranteed.

An option that comes alive when the underlying asset price falls to a pre-specified level.

An option that dies when the underlying asset price falls to a pre-specified level.

A measure of the sensitivity of a bond's percentage price change to the change in a market yield. The percentage change in the bond price (approximately) equals the duration multiplied by the absolute change in the yield.

A strategy in which the risk of an option's position is offset by continuous trading in the underlying asset or appropriate futures contract.

A market in which asset prices reflect the ‘true’ or ‘fair value’ of the asset. The fair value is often determined by calculating the discounted present value of the expected future cash flows accruing to the asset.

An option which is ‘part of’ a security. For example, a convertible bond has an embedded call option to convert the bond into stocks at possible future dates, at a predetermined price.

The share capital in a company = number of shares × current price. The shares themselves are also referred to as stock or equities.

Any market where shares of companies are traded.

A swap where the return on an equity index is (usually) exchanged for a (fixed or floating) rate of interest.

Interbank market rate for borrowing and lending between banks in the Eurozone.

A dollar-denominated deposit in a bank located outside the USA.

A futures contract written on a Eurodollar deposit.

Any market where Eurodollar deposits/loans are traded.

Option which may only be exercised on the expiry date.

Return on an asset minus the return on a risk-free asset.

Date on which a holder of stock/bond becomes entitled to receive the next cash payment (e.g. Dividend/coupon), after which the asset trades ‘ex-dividend’.

An investor who owns the stock before the ex-dividend date will receive the next dividend payment.

The price at which an option holder may buy or sell the underlying asset, if the option is exercised.

Generic term for options with relatively complex payoffs which can be path dependent. Examples of exotic options include Asian, lookback, barrier, and chooser options.

A theory of the term structure of interest rates in which forward rates of interest represent the market's unbiased expectation of future (spot) interest rates.

Date when an option expires and the underlying asset has to be delivered (if the contract has not been closed out).

Statistical method which calculates the volatility of an asset's return, allowing the forecast of volatility to change over time.

See Nominal value.

The process of designing new financial instruments. Often describes a combination of different derivatives (e.g. calls, puts, futures) to create certain desired payoffs. See Synthetic securities.

A futures contract written on a financial asset such as a bond, stock, stock index, interest rate or two currencies (FX).

(Interest yield or running yield.) The annual coupon payment on a bond as a percentage of the market price of the bond.

Set of floorlets, with different maturity dates and often different strike prices.

Put option, which pays off if the floating interest rate at expiry (e.g. LIBOR) is below the strike (interest) rate.

An option contract to exchange one currency for another.

An agreement between two parties to buy or sell an underlying asset at a known future date, at a price agreed today. Forward contracts usually go to delivery.

Rate of exchange of one currency for another, agreed today but executed in the future.

Interest rate applicable between two dates in the future.

Difference between the forward and spot rate for FX.

An agreement today, to enter into a swap at some point in the future, at a fixed rate of interest agreed today, known as the forward swap rate.

The parties involved agree to pay the difference in cash flows between the out-turn rate of interest at some point in the future (e.g. LIBOR) and the rate of interest agreed at the outset of the contract (the FRA rate), based on an agreed notional principal amount.

An interest-bearing security where the coupons paid are based on what interest rates turn out to be at specified future dates.

A contract between two parties to trade a specific asset in the future for a known price determined at contract inception. A key difference between a forward and a futures contract is that the latter can be easily ‘closed out’.

An option where the underlying asset is a futures contract.

A price agreed today for delivery of an underlying asset, at some point in the future.

The change in an option's delta due to a small change in the underlying asset price.

A portfolio of options which will not change in value for a relatively large change in the underlying asset price.

Valuation formula for European-style foreign currency options.

Stochastic process for the growth in an asset price, which follows a generalised Wiener process.

Sterling, marketable, interest-bearing bonds issued by the United Kingdom Government.

Economic model to calculate the value of a firm's stock. It assumes that the value of a firm's stock is determined by the level of current dividends, the future dividend growth rate, and the (risk-adjusted) discount rate.

Summary statistics to calculate (the approximate) change in the price of an option, as the variables which determine the option price change (e.g. option's delta, gamma, theta, vega).

The small commission a broker takes for organising a transaction for a client (e.g. to allow the client to borrow stock for short-sales, or to undertake a repo transaction). ‘Haircut’ has several different meanings.

The probability of default over a short time period, conditional on no earlier default.

The average of the highest and lowest temperatures (midnight to midnight) at a particular location if the temperature is less than 65 °F. If the temperature is greater than 65 °F, HDD is zero.

A transaction in which a trader tries to protect an existing risky position by taking an offsetting position in another asset.

Actively managed funds which usually use highly leveraged transactions and derivatives in their investment strategies.

The number of securities-A required to offset any change in the value of existing securities-B, which are currently held.

The magnitude of historical price fluctuations, often measured by the standard deviation of asset returns – see Volatility.

The rate of return over a specific period of time – includes capital gains and any cash payments (over the holding period) from the security, usually expressed as a proportion of the current value of the asset.

An index used to determine the change in value of an interest rate futures contract.

The market's view of the volatility of an asset return (e.g. a stock) that is reflected in the current option's price. It is that value for volatility, which makes the option's quoted price equal to the ‘theoretical price’ (e.g. as given by Black–Scholes).

An arbitrage strategy using a stock index futures contract and the actual stock index underlying the futures contract.

A futures contract on a (stock) price index (e.g. on the S&P 500 index).

An option's contract on a (stock) price index.

A form of passive portfolio management aiming to replicate the movements of a specific index of securities (e.g. S&P 500).

A ‘good faith deposit’ used to guarantee that two parties to a contract, will honour the terms of the contract. For example, when initially either buying or selling a futures contract you must place an initial margin with the clearing house. The margin might be paid in cash or Treasury bills.

An informal network of banks that lend and borrow from each other in various currencies, from overnight to one year.

A long and short position in two different futures contracts with different underlying assets, but with the same delivery date.

Futures contracts written on fixed income securities such as Treasury bills, notes, and bonds. There are also futures written on interest rates (e.g. Eurodollar futures).

Option where the payoff depends on the level of some interest rate in the future (relative to the strike ‘price/rate’ in the option contract).

See Covered interest rate parity, Uncovered interest rate parity.

A contract where a series of floating-rate (variable) interest payments are exchanged for a series of fixed-rate payments (or vice versa).

The constant rate of return which just allows a project/investment to break even. It is the single discount rate which equates the present value of the costs of the investment with the present value of the future cash flows from the investment.

A call (put) option where the underlying asset price is greater (less) than the (discounted present value of) the option's strike price.

For a call option, the amount by which the current spot price is above the strike price or zero, whichever is the greatest. For a put option the amount by which the current spot price is below the strike price, or zero, whichever is the greatest.

A mortgage-backed security where the holder receives only the interest payments from the underlying mortgage pool.

An institution which oversees over-the-counter derivatives, including the creation of master agreements.

A call option where the current spot price is greater than the strike price or a put option where the current spot price is below the strike price.

An equation which enables one to move from a stochastic process for the underlying asset (e.g. S) to the stochastic process for some function of the underlying asset (e.g. lnS).

Measure of the abnormal return on a stock after taking account of the market risk of the stock.

A random series for asset prices which experience random sudden (large) jumps.

Long-term Equity Anticipation Securities. They are long maturity options on stocks or stock indices.

Increases both the expected return on an investment strategy and the volatility of possible outcomes. Can be accomplished by borrowing or using derivatives.

A trader on the floor of a futures exchange who trades on her own account.

The interest rate at which a large AA-rated bank is willing to accept funds (in a particular currency) from another AA-rated bank.

The interest rate at which a large AA-rated bank will lend funds (in a particular currency) to another AA-rated bank.

If you purchase a primary or derivative security then you are said to ‘go long’.

A position which involves a long position in one security (e.g. stocks) and a short position in another security (e.g. a futures contract on the stock) in order to hedge the long position.

Option whose payoff depends on the maximum or minimum value of the asset price, over the life of the option.

Collateral that must be posted to allow you to transact in a futures or options contract, in order to insure the clearing house against default risk.

A request for additional payments into the margin account if the value of the mark-to-market positions fall below the maintenance margin, set by the clearing house.

A trader who quotes buying and selling prices at which she is willing to trade in specific stated amounts.

Risk which cannot be diversified away. Proportion of the asset's total risk which relates to movements in the overall market or to general changes in the economy (e.g. oil prices, interest rates – see Systematic risk.

Form of active portfolio management which shifts funds into (out of) the (stock or bond) market when the market is predicted to rise (fall).

The act of revaluing asset positions using current market prices.

Date on which an asset is redeemed. For bonds this involves a cash payment (the principal/maturity/par value). For a derivative this might involve a cash payment or delivery of the underlying asset.

A security where the holder receives cash flows from a pool of mortgages.

A technique to simulate a random variable according to a known distribution.

Process which describes the path of a time series which tends to return to its long-run average value.

A tranche in a CDO, which takes losses after the equity tranche but before all the senior tranches.

Average of the bid and offer price of an asset.

The market for borrowing and lending funds with less than one year to maturity.

Economic concept often observed in insurance markets where the likelihood of a claim being made increases after the insurance has been taken out.

A fund management company that buys/sells a portfolio of assets (e.g. stocks, bonds, real estate, commodities).

A risky position in an asset – either net long or net short.

Value today of ‘future positive cash flows less negative cash flows’ from an asset.

Calculating the net position for assets and liabilities with a specific counterparty, which then determines collateral requirements.

Person with no income, no job, and no assets.

A set of interest rates which do not allow any risk-free arbitrage profits to be made.

A set of asset prices which does not allow risk-free profits to be made.

(Face or par value.) The fixed amount in a contract which is used to determine cash flows. For example, the dollar amount on which interest payments are calculated in an interest rate swap contract.

Bell-shaped, symmetric probability distribution for a continuous random variable.

The principal used to calculate (dollar) interest payments in a fixed income asset such as a plain vanilla interest rate swap, an FRA, cap, floor, or swaption. The principal itself is (usually) not swapped.

See Clearing house.

See Ask price.

An overnight index swap.

Total number of futures or option contracts (of a specific type) which have not been closed out (or reached expiry/maturity).

Contract which gives the purchaser the right, but not the obligation, to buy (a ‘call’ option), or to sell (a ‘put’ option), a specified amount of a commodity or financial asset at a specified price, by or on a specified date.

Price of an option.

The organisation that serves as the clearing house for options traded on US exchanges.

Ordinary shares represent a claim on the profits of a firm. Ordinary shareholders have voting rights and the shareholders are the owners of the firm.

A call (put) option where the underlying asset price is below (above) the option's strike price (or present value of the strike price).

Transaction between two counterparties (often two banks or a bank and a corporate), the details of which are directly negotiated between the issuer and purchaser.

A company's current share price divided by its earnings per share (measured over some recent historic period).

See Nominal value.

The principal amount of a bond, payable at maturity.

The coupon rate on the bond which makes the market price equal to the principal value.

A movement in the yield curve, where rates at all maturities move up or down by the same amount.

Barrier option where the underlying asset price has to be above or below a pre-specified barrier for a pre-specified period of time, before the option is knocked-in or knocked-out.

See index tracking.

An option whose payoff depends upon the complete path of the underlying asset (and not just the price of the underlying asset at maturity of the option).

The cash value of the option, at maturity of the option.

A ‘statistic’ to measure the performance of a portfolio relative to some benchmark portfolio. Differences in risk of the different portfolios are usually incorporated in the performance measure.

Fixed income security which is never redeemed by the issuer and pays coupons for ever.

An area on the trading floor of a futures or options exchange where contracts are traded by ‘open outcry’.

A standard cash market or derivative security.

A term which describes a basic fixed-for-floating interest rate swap or a simple currency swap.

A mortgage-backed security where the holder receives only the principal payments from the pool of mortgagees.

A strategy in which a portfolio of stocks and futures contracts mimics the price movements of a portfolio of stocks and put options. Portfolio insurance is designed to ensure a minimum future value for an equity portfolio but also allows upside capture.

The maximum amount held in a particular asset or set of assets. This limit might be set by the individual trader, a broker or the exchange itself (e.g. CME Group).

Trader who holds speculative positions over horizons of 1 day to 1 month or even longer.

Value today of all future cash receipts less cash payments.

Market where new issues of securities are offered to the public.

Par, maturity, face value of an debt instrument (e.g. bond) which is paid at maturity.

Describes a conflict of interest which can arise between different agents in or connected with an organisation (e.g. shareholders and directors).

The use of computers to simulate real-time data in order to detect arbitrage opportunities.

Holding the underlying asset and a long position in a put option (on the underlying asset).

See Zero-coupon bond.

A derivative security giving the buyer the right to sell an underlying asset at a known strike price on or before a specified maturity date.

Price of a put option.

A pricing relation between put and call premia, the price of the underlying asset and a risk-free amount of cash, that ensures no arbitrage profits can be made.

An option where the payoff is determined in one currency but is paid in another currency.

An option where the payoff is determined by two or more underlying assets.

A model where the changes in a variable (e.g. stock price, exchange rate) are random and independent over time.

Interest due to be paid by the seller of a bond to a purchaser when the bond is purchased without the right to the forthcoming interest payment (i.e. ex-dividend).

See Yield to maturity (YTM).

A named company on which a credit default swap (CDS) is written.

See Synthetic securities.

A form of collateralised borrowing. One party sells securities (e.g. T-bills) to another and at the same time commits to repurchase the securities on a specified future date, at a specified price, which is higher than the initial selling price. The difference between the two prices (expressed as a percentage) is the cost of borrowing in the repo market.

The cost of collateralised borrowing using a repo.

Dates on which a floating rate is realised.

A form of collateralised lending. A reverse repo is a repo transaction as seen from the point of view of the party who initially buys the securities and hence lends money.

Change in an option's price for a small change in the risk-free rate.

A person who will only take part in a gamble in which the expected monetary outcome for them is positive. For example, if you are willing to pay less than $1 to enter a bet on the toss of a (fair) coin with a $1 receipt for ‘heads’ and a $1 payout for ‘tails’ then you are risk averse.

A situation in which an investor is indifferent between a risky monetary outcome and an equal amount that is certain. A risk-neutral investor will take part in a gamble in which the expected monetary outcome is zero. For example, if you are willing to pay $1 to enter a bet on the toss of a (fair) coin with a receipt of $1 for ‘heads’ and a payout of $1 for ‘tails’ then you are a risk-neutral investor.

Describes the no-arbitrage approach to option pricing. To correctly price the option, we can assume that the underlying asset (e.g. stock) grows at the risk-free rate.

The rate of return on an investment which is known with certainty.

Methodology originally proposed by JPMorgan to measure the price risk of a portfolio of cash market and derivative securities.

See Flat yield.

Market where securities are traded once they have been issued.

A Federal agency charged with the regulation of US security and options markets.

A portfolio of different assets is created and then sold to final investors.

Date on which the ownership of an asset passes from one party to the other.

The futures price established at the end of each trading day upon which daily mark-to-market of margin positions is based. The settlement price is usually an average of the last few trades of the day.

Reward to variability ratio. Risk-adjusted measure of portfolio performance – it is the average excess return divided by the standard deviation of returns.

Position where a market maker (dealer) has sold more of an asset than she has purchased.

An interest rate which applies over a very short period of time.

A transaction in which a security is borrowed (from a broker) and sold in the market, with an obligation to return the borrowed security at a later date. Collateral in the form of margin payments (to the broker) are required.

The holder of the option can lock in a minimum payoff, at one point during the option's life.

Linear model which describes the relationship between the (excess) return on an individual stock (or portfolio of stocks) and the (appropriate) market return (e.g. S&P 500).

Difference between the spot price of electricity and the spot price of natural gas which is used to produce electricity (the two are connected via the heat rate). Derivatives are written on the spark spread so that electricity generating companies can offset risk to their profit margins from changes in these two spot prices.

Risk which is specific to the firm, such as strikes, patent disputes, legal challenges etc. Specific risk is relatively small (near zero) in a well-diversified portfolio of many assets (e.g. randomly chosen stocks). Also called unsystematic risk and diversifiable risk.

Taking risky bets on the future value of an asset.

An investor who takes a risky position in an asset.

The market for assets that entail immediate (or near immediate) delivery and (near) immediate cash payment.

An interest rate which applies from today to one specific date in the future.

The current price of an asset traded in the spot (or cash) market which is for (near) immediate delivery and payment.

When pricing a cap, different (interest rate) volatilities are used to price each caplet.

Difference between two ‘prices’. For example, the difference between a dealer's buying price and selling price for the same asset or the difference between the yield on corporate and government bonds (yield spread).

A trade involving two or more assets, usually involving derivatives, in order to speculate on the direction the spot (cash market) asset will move (e.g. bull spread).

When the hedge period is long, short dated futures contracts are used and rolled over into the next set of short dated futures contracts.

A strategy by which the value of an existing cash market position is maintained by using derivatives but the initial hedged position is not rebalanced.

An equation describing the random behaviour of a variable.

A weighted index of individual stock prices.

An option giving the owner the right to buy or sell a ‘stock index’ at the known strike price. These option contracts are cash-settled – there is no delivery of the underlying stocks in the index.

An option on a stock.

Payoff profile of a call and put with the same strike price and time to maturity. ‘V-shaped’ or ‘inverted V-shaped’ payoff.

Calculating the change in value of a portfolio consequent on extreme market movements.

Calculating the VaR using historical simulation over a chosen ‘crisis period’.

Price at which the option holder has the right to buy or sell the underlying commodity or financial asset, if the holder chooses to exercise the option.

This is the secondary market which trades the individual coupons that have been ‘stripped’ (i.e. legally separated) from a coupon paying bond.

Ranks behind other bondholder claims if the firm goes bankrupt.

A mortgage given to individuals with high credit risk.

An exchange of cash flows in the future, according to a prearranged contract, determined at initiation of the swap.

Financial intermediary who provides swaps to counterparties (often corporates).

The fixed (interest) rate determined at the initiation of an interest rate swap.

An option where the underlying asset is a swap contract (e.g. a fixed for floating swap).

A CDO created from selling a portfolio of credit default swaps.

A structured or financially engineered product which replicates the same cash flows as another asset, but uses different financial instruments (e.g. a long forward contract on a stock which is replicated by purchasing the stock (on the NYSE) using borrowed funds.

An adjustment in the number of futures contracts needed to hedge, because of daily marking-to-market of the futures contracts.

The difference between 90-day LIBOR and the 90-day, Treasury bill rate.

The frequency of payments in a financial contract.

Repo trades with a fixed maturity date (greater than 1 day).

The relation between yields and the time to maturity of bonds of a similar risk class (e.g. all government bonds or all corporate bonds with a particular credit rating). Also called the yield curve.

The change in the options price over a small period of time.

Units in which minimum price movements are usually recorded and measured.

Change in the price of an option as the option approaches maturity (all other things held constant).

The amount by which the option premium exceeds its intrinsic value.

The coupon and principal payments on a bond are exchanged for cash flows based on LIBOR plus a spread.

Parts of a CDO, which suffer losses in a pre-specified order.

Instrument of up to 12 months maturity (but normally less), issued by governments. It is a discount instrument – its initial selling price is below its maturity (par/ face) value. There are no intermediate cash flows.

Debt security issued by a government with maturity in excess of 12 months. Treasury bonds usually have periodic coupon payments, payable every 6 months.

US Treasury bonds with maturity of between 1 and 7 years.

A discreet representation of the possible stochastic changes in an underlying asset price. Binomial or trinomial trees can be used to price options.

Specific asset on which a derivative contract is based (e.g. Apple stock, stock index, T-bond, LIBOR rate, etc.).

An option that comes alive when the price of the underlying asset reaches or crosses a pre-specified upper boundary.

An option that dies when the price of the underlying asset reaches a pre-specified upper boundary.

Maximum expected ‘dollar’ loss over a specific time horizon at a pre-specified probability (percentile) level.

A measure of the dispersion of a random variable around its expected return. The square root of the variance is the standard error, often referred to as ‘volatility’.

A matrix containing variances on the diagonal and covariances in the off-diagonal positions. Used in calculating VaR for large portfolios of assets.

A swap where one party pays a fixed predetermined variance rate and the other pays the realised variance rate, over specific time periods (tenor), with payments based on a predetermined notional principal.

If the value in the margin account falls below a pre-specified level called the maintenance margin, then additional funds must be added to the margin account so that the amount in the margin account is made up to the predetermined initial margin.

A measure of the sensitivity of the call/put premium to small changes in the standard deviation of the (log) underlying asset price.

A portfolio of options whose value does not change (much) for a large change in the price of the underlying asset.

An index which tracks the volatility of the S&P 500 stock index.

Measure of the variability in asset returns/prices. Often measured by the standard deviation and taken as one measure of risk. See Implied volatility, Variance.

A plot of implied volatility against different strike prices for options on the same underlying asset and with the same time to maturity. This graph of implied volatility against the strike price produces a ‘non-symmetrical-smile’ or ‘skew’.

The relationship between implied volatilities calculated from the quoted prices of a set of options (on the same underlying asset, with the same expiry date) and the different strike prices of these options. For options on foreign currencies, the graph of implied volatility against the different strike prices is in the shape of a ‘smile’.

A graph or table showing implied volatilities for different strike prices and times to maturity (for an option on the same underlying asset).

The different values for implied volatility calculated from options with different maturity dates (but with the same strike prices and underlying asset).

Denotes the situation where a financial institution carries an open position on its books until a suitable offsetting transaction can be found with another counterparty.

Instrument which gives the holder the right (but not the obligation) to buy shares directly from the company at a fixed price, at some time(s) in the future. A type of call option. If exercised, the company must issue more stocks.

A set of rules to determine the order in which different tranches in a CDO will receive cash flows.

Derivative where the payoff depends on the weather (e.g. temperature, inches of snowfall, number of frost days) at a particular geographic location over a specific time period.

A stochastic process, where changes in a variable over a short period of time are independent, normally distributed and have zero-mean and a variance proportional to the time period.

The seller of an option contract. The writer of a call or put option has a short position and has to post margin payments with the clearing house.

The return on security over a specific period of time.

See Term structure of interest rates.

A single value for the yield, at a specific point in time, which when used as a discount rate makes the present value of the remaining coupon payments and the present value of the bond's maturity value equal to the quoted price of the bond. The YTM is the ‘internal rate of return’ of the bond.

A bond which does not pay any coupons and the holder only receives a single payment (i.e. the bond's par or face value or maturity value) on the maturity date of the bond. A zero-coupon bond sells at a discount to its face (par/maturity) value.

Spot rates plotted against time to maturity. In principle the spot rates are calculated from quoted prices of zero-coupon bonds.