Introduction to Derivatives
Expert-defined terms from the Professional Certificate in Derivatives Trading course at London School of Business and Administration. Free to read, free to share, paired with a globally recognised certification pathway.
Introduction to Derivatives #
Introduction to Derivatives
Derivatives are financial instruments whose value is derived from the value of a… #
These instruments can be used for hedging, speculation, or arbitrage purposes. In the Professional Certificate in Derivatives Trading course, students will learn about various types of derivatives, their characteristics, pricing models, and trading strategies.
Arbitrage #
Arbitrage
Arbitrage is the practice of simultaneously buying and selling an asset in diffe… #
Traders look for opportunities to make risk-free profits by exploiting these price differences. For example, if the price of a stock is higher in one market than another, a trader can buy the stock in the cheaper market and sell it in the more expensive market to make a profit.
Asset #
Asset
An asset is anything of value that can be owned or controlled to produce future… #
Examples of assets include stocks, bonds, commodities, currencies, and real estate. In the context of derivatives trading, the underlying asset is the financial instrument from which the derivative derives its value.
Call Option #
Call Option
A call option is a financial contract that gives the holder the right, but not t… #
The buyer of a call option pays a premium to the seller for this right. If the price of the underlying asset rises above the specified price (strike price), the buyer can exercise the option and buy the asset at a profit.
Contract for Difference (CFD) #
Contract for Difference (CFD)
A contract for difference (CFD) is a financial derivative that allows traders to… #
Instead, traders enter into a contract with a broker to exchange the difference in the price of the asset from the time the contract is opened to the time it is closed. CFDs are popular for leveraged trading and can be used to profit from both rising and falling markets.
Delta #
Delta
Delta is a measure of the sensitivity of the price of an option to changes in th… #
It is the rate at which the option price changes in response to a one-point change in the price of the underlying asset. Delta values range from 0 to 1 for call options and from -1 to 0 for put options. A delta of 0.5 means that the option price will change by $0.50 for every $1 change in the underlying asset price.
Exchange #
Traded Derivative
Exchange #
traded derivatives are standardized financial contracts that are traded on organized exchanges. These derivatives are regulated by the exchange and are subject to margin requirements and clearinghouse guarantees. Examples of exchange-traded derivatives include futures contracts, options, and swaps. Trading on an exchange provides liquidity, transparency, and price discovery for these instruments.
Futures Contract #
Futures Contract
A futures contract is a standardized financial agreement to buy or sell an under… #
Futures contracts are traded on organized exchanges and are used for hedging and speculation purposes. The buyer of a futures contract is obligated to take delivery of the asset at the contract's expiration, while the seller is obligated to deliver the asset.
Greeks #
Greeks
The Greeks are a set of risk measures used in options trading to assess the sens… #
The main Greeks are delta, gamma, theta, vega, and rho. Traders use these measures to manage risk and optimize their options positions.
Hedging #
Hedging
Hedging is a risk management strategy used to offset potential losses in one inv… #
Derivatives are commonly used for hedging purposes to protect against adverse price movements in the underlying asset. For example, a farmer can hedge against falling crop prices by entering into a futures contract to sell the crop at a fixed price.
Implied Volatility #
Implied Volatility
Implied volatility is a measure of the market's expectation of future price fluc… #
It is derived from the pricing of options and reflects the level of uncertainty or risk in the market. High implied volatility indicates that the market expects significant price swings, while low implied volatility suggests that the market is expecting stable prices.
Interest Rate Swap #
Interest Rate Swap
An interest rate swap is a financial derivative in which two parties agree to ex… #
The purpose of the swap is to manage interest rate risk or to take advantage of differences in interest rates. One party pays a fixed rate, while the other pays a floating rate based on a benchmark interest rate, such as LIBOR.
Leverage #
Leverage
Leverage is the use of borrowed funds to amplify the potential returns of an inv… #
Derivatives are inherently leveraged instruments, as traders can control a large position with a relatively small amount of capital. While leverage can magnify profits, it also increases the risk of significant losses. Traders must carefully manage leverage to avoid excessive risk.
Margin #
Margin
Margin is the amount of money that traders must deposit with their broker to ope… #
Margin requirements are set by the exchange or broker and serve as collateral to cover potential losses. Trading on margin allows traders to control larger positions than their initial investment, but it also increases the risk of losses.
Option #
Option
An option is a financial contract that gives the holder the right, but not the o… #
There are two types of options: call options, which give the holder the right to buy the asset, and put options, which give the holder the right to sell the asset. Options are commonly used for hedging and speculative purposes.
Put Option #
Put Option
A put option is a financial contract that gives the holder the right, but not th… #
The buyer of a put option pays a premium to the seller for this right. If the price of the underlying asset falls below the specified price (strike price), the buyer can exercise the option and sell the asset at a profit.
Quanto Option #
Quanto Option
A quanto option is a type of derivative in which the payoff is denominated in a… #
Quanto options are used to eliminate currency risk in international investments. The payoff of the option is calculated in the foreign currency and then converted into the investor's domestic currency at a fixed exchange rate.
Risk Management #
Risk Management
Risk management is the process of identifying, assessing, and mitigating risks i… #
Derivatives are valuable tools for risk management, as they allow traders to hedge against adverse price movements and limit potential losses. Effective risk management strategies help traders protect their capital and achieve their investment objectives.
Swaption #
Swaption
A swaption is a financial derivative that gives the holder the right, but not th… #
The buyer of a swaption pays a premium to the seller for this right. Swaptions are used to hedge against interest rate risk or to speculate on future interest rate movements. They can be either a payer swaption or a receiver swaption.
Time Value #
Time Value
Underlying Asset #
Underlying Asset
The underlying asset is the financial instrument on which a derivative contract… #
The value of the derivative is derived from the value of the underlying asset. Common underlying assets include stocks, bonds, commodities, currencies, and market indexes. Understanding the characteristics and price movements of the underlying asset is essential for successful derivatives trading.
Vega #
Vega
Vega is a measure of the sensitivity of an option's price to changes in implied… #
It indicates how much the option price is expected to change for a one-point change in implied volatility. Vega is highest for at-the-money options with longer time to expiration, as these options are most sensitive to changes in volatility. Traders use vega to assess the impact of volatility changes on their options positions.
Warrant #
Warrant
A warrant is a financial instrument that gives the holder the right, but not the… #
Warrants are often issued as part of a bond or equity offering to sweeten the deal for investors. They can be traded independently of the underlying stock and provide leverage for investors to profit from stock price movements.
X #
Value Date
The ex #
value date, also known as the ex-dividend date, is the date on which a security begins trading without the right to receive the next dividend payment. Investors who purchase the security on or after the ex-date will not be entitled to the dividend. The ex-value date is important for traders of dividend-paying stocks, as it affects the stock's price and potential returns.
Yield Curve #
Yield Curve
The yield curve is a graphical representation of the yields on bonds of differen… #
It shows the relationship between bond yields and their maturity dates. The yield curve is used by investors to assess the state of the economy, predict interest rate movements, and make investment decisions. A normal yield curve slopes upward, indicating higher yields for longer-term bonds, while an inverted yield curve slopes downward, signaling lower yields for longer-term bonds.
Zero #
Coupon Bond
A zero #
coupon bond is a debt security that does not pay periodic interest payments but is sold at a discount to its face value. The bondholder receives the face value of the bond at maturity. Zero-coupon bonds are popular for their simplicity and the ability to lock in a fixed return. These bonds are issued at a deep discount to their face value, and the difference between the purchase price and the face value represents the investor's return.