The Risk Limited Glossary
A:
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American Option - an option contract that may be exercised at any time prior to expiration. This differs from a European Option, which may only be exercised on the expiration date.
Annualized Return - a return calculated over one period, but adjusted to be comparable to a return calculated over a year.
ARCH - an acronym for autoregressive conditional heteroskedasticity.
Asian Option - an exotic option whose payoff depends on the price movements of the underlying asset during some portion of the life of the option.
Average Price Option - an average rate option. Also referred to as an APO.
Average Rate Option - A form of Asian option whose payoff is linked to the average underlier value over a specified period.
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B:
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Backwardation - market situation in which futures prices are progressively lower in the distant delivery months.
Barrier Option - a path-dependent option that terminates or is activated by the underlier reaching some "barrier" price level.
Basle Accord (1988) - an international accord on bank capital requirements. Amended in 1996 to add capital requirements for market risk.
Below Investment Grade Bond - a junk bond.
Bid-Ask Spread - the difference between prices at which dealers are willing to buy or sell. Also referred to as the Bid-Offer Spread.
Binary Option - a type of option which features a discontinuous expiration value.
Black-Scholes Model - an options pricing formula first developed in 1973 by Fisher Black and Myron Scholes for securities options and later applied to a range of other option structures.
Brownian Motion - a stochastic process which has stationary independent increments which follows a normal distribution and also has continuous sample paths. It is a Markovian process, and is also known as a Wiener process.
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C:
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Call Option - option that gives the buyer the right, but not the obligation, to buy a futures contract for a specified price within a specified period of time in exchange for a one-time premium payment. See also Put Option.
Cash Flow Hedges - in U.S. accounting terminology, a hedge of a forecasted asset and liability acquisition, for which the gain or loss on the hedging instrument will remain in equity when the asset or liability is acquired. That gain or loss will subsequently be included in net profit or loss in the same period as the asset or liability affects net profit or loss. See also FAS 133.
Contango - market situation in which prices in succeeding delivery months are progressively higher than in the nearest delivery month; the opposite of backwardation. See also Backwardation.
Cox-Ross-Rubinstein Option Pricing Model - an option pricing model developed by John Cox, Stephen Ross, and Mark Rubinstein that can be adapted to include effects not included in the Black-Scholes Model (e.g., early exercise).
Crack Spread - a commodity-product spread involving the purchase of crude oil futures and the sale of gasoline and heating oil futures.
Credit Default Swap - a bilateral over-the-counter (OTC) contract in which the seller agrees to make a payment to the buyer in the event of a specified credit event in exchange for a fixed payment or series of fixed payments; the most common type of credit derivative; also called Credit Swap.
Credit Derivative - derivative product with a payoff that depends on risk factors related to credit quality, such as yield spread over Treasuries, price discount from par, or a "credit event" such as a drop in credit rating or some sort of failure, such as occurrence of default, insolvency or bankruptcy.
Credit Risk - the risk that a counter party to a transaction or contract does not perform.
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D:
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Delta - sensitivity of an option's value to a change in the price of the underlying futures contract, also referred to as an option's futures-equivalent position. Deltas are positive for calls, and negative for puts. Deltas of deep in-the-money options are approximately equal to one; deltas of at-the-money options are 0.5; and deltas of deep out-of-the-money options approach zero.
Delta Neutral - refers to a position involving options that is designed to have an overall delta of zero.
Default Probability - the likelihood that a transaction counterparty will default on an obligation.
Derivative Instrument - an instrument which derives value from the value of some commodity or other financial instrument.
Differential Swap - a quanto swap.
Duration-Convexity Matching - a technique of asset-liability matching.
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E:
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Efficient Frontier - a theoretical set of portfolios offering optimal risk-reward tradeoffs.
Embedded Derivatives - within a U.S. accounting context, portions of contracts that meet the definition of a derivative when the entire nonderivative contract cannot be considered a financial instruments derivative. See also FAS 133.
European Option - an option that can only be exercised on its expiration date. See also American Option.
Exchange for Physicals (EFP) - a transaction in which the buyer of a cash commodity transfers to the seller a corresponding amount of long futures contracts, or receives from the seller a corresponding amount of short futures, at a price difference mutually agreed upon. In this way, the opposite hedges in futures of both parties are closed out simultaneously.
Exchange Traded - traded on a regulated exchange such as the New York Stock Exchange, Chicago Board of Trade, or New York Mercantile Exchange.
Exercise Price (Strike Price) - the price, specified in the option contract, at which the underlying futures contract, security, or commodity will move from seller to buyer.
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F:
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Fallen Angel - a bond that was investment grade when issued, but has since degraded to junk quality.
FAS 133 - Financial Accounting Standard 133, Accounting for Derivative Instruments and Hedging Activities, Statement issued by the Financial Accounting Standards Board in June 1998. FAS 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. See also Hedge Accounting.
FASB - the Financial Accounting Standards Board, which is the designated organization in the U.S. private sector for establishing standards of financial accounting and reporting. The standards are officially recognized as authoritative by the U.S. Securities and Exchange Commission and the American Institute of Certified Public Accountants.
Fence - a long (short) underlying position together with a long (short) out-of-the-money put and a short (long) out-of-the-money call, with the options all having the same expiration date.
FCM - Futures Commission Merchant; an individual or organization accepting orders to buy or sell futures or futures options. A person or organization in this role needs to be certified by the Commodities and Futures Trading Commission.
Floor - a type of derivative instrument that offers protection against declining prices, exchange rates or interest rates.
Financial Engineering - the field of applied finance devoted to the design and pricing of derivative instruments and structured products.
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G:
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G - the Commodity Futures Symbol which represents the February Delivery Month.
Gamma - the sensitivity of an option's delta to changes in the price of the underlying futures contract.
Generalized ARCH - a generalization of the autoregressive conditional heteroskedasticity model. Also referred to as GARCH.
Geometric Return - log return.
Glass-Steagal Act - the United States 1933 Banking Act that separated commercial and investment banking and formed the FDIC.
Greeks - a set of factor sensitivities used for measuring risk exposures related to options or other derivatives.
Group of 30 Report - an influential 1993 industry report on OTC derivatives. Also referred to as the G-30 Report.
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H:
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Hammersmith and Fulham decision - a 1992 legal decision that invalidated existing derivatives contracts with numerous U.K. local councils.
Hedge accounting - accounting methodology established by provisions of FAS 133 for reporting of gains and losses on transactions intended to hedge exposed positions. See also FAS 133.
Henry Hub - a natural gas pipeline hub in Louisiana that serves as the delivery point for New York Mercantile Exchange natural gas futures contracts and often serves as a benchmark for wholesale natural gas prices across the U.S.
Herstatt risk - settlement risk; named after the German bank, Herstatt, whose 1974 failure highlighted the dangers of settlement risk.
Heteroskedasticity - a condition where a stochastic process has non-constant second moments.
Historical Volatility - the annualized standard deviation of percent changes in prices over a specific period. It is an indication of past volatility in market prices.
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I:
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Implied Volatility - a volatility inferred from an option price.
In-The-Money - a term used to describe an option contract that has a positive value if exercised.
Interest Rate Parity - an arbitrage condition that must hold between the spot interest rates of different currencies.
International Accounting Standards Committee (IASC) - an organization headquartered in London that has been charged with developing international accounting standards.
Inverse Floater - a floater whose coupon varies inversely to its reference rate.
ISDA - the International Swaps and Derivatives Association.
Intrinsic Value - the amount by which an option is in-the-money. An option which is not in-the-money has no intrinsic value. For calls, intrinsic value equals the difference between the underlying futures price and the option's strike price. For puts, intrinsic value equals the option's strike price minus the underlying futures price. Intrinsic value is never less than zero.
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J:
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J - the Commodity Futures Symbol which represents the April Delivery Month.
January Effect - the tendency for small capitalization stocks to exhibit an upward bias in their price behavior during the month of January. Some observers believe this may be partially attributable to the influence of index funds buying stocks for various retirement plans when new contributions would be qualified to commence in January.
Jensen Index - an index that uses the capital asset pricing model to determine whether a money manager outperformed a market index.
Joule - a measurement unit for energy.
Jump-Diffusion Model - a stochastic process that combines random jumps with a geometric Brownian motion.
Junk Bond - a bond whose credit rating is below BBB.
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K - the Commodity Futures Symbol which represents the May Delivery Month.
Kappa - a value representing the expected change in the price of an option. Also known as Lambda.
KMV Model - a commercial implementation of the asset value model of credit risk. [KMV was a boutique software firm that is now owned by Moodys.]
Knockin Option - an option feature which triggers the activation of an option contract. Also referred to as Down-and-In and Up-and-In, depending on the structure.
Knockout Option - an option that becomes worthless in the event that the underlying commodity or currency crosses a certain price level.
Kurtosis - a parameter describing the peakedness and tails of a probability distribution relative to the benchmark log normal distribution.
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Least Squares Remapping - a global remapping implemented using the method of least squares
LIBOR - the London Interbank Offered Rate. The rate of interest at which banks borrow funds from other banks, in marketable size, in the London interbank market.
Liquidity - a market is said to be "liquid" when it has a high level of trading activity and open interest.
LME - the London Metal Exchange.
Log Normal Distribution - a probability distribution.
Long Position - the state of actually owning a security, contract, or commodity. also called long. Opposite of short.
Lookback Option - an exotic option whose payoff depends on the minimum or maximum price of the underlying asset during some portion of the life of the option.
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M:
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M - the Commodity Futures Symbol which represents the June Delivery Month.
Mark-to-Market - the act of assigning a current market value to an asset.
Market Cap or Market Capitalization - a value placed on a shareholder-owned company. It is computed by multiplying the number of outstanding shares by the current share price.
Markov Process - a stochastic process where the future expected value of a value (such as an asset price) is dependent only on the current value. Named after the Russian mathematician Andrey Andreyevich Markov (1856-1922).
Mean - is often considered as the simple arithmetic average of the sum of the observed values divided by the number of observations.
Mean Reversion - a tendency for a stochastic process to remain near, or return over time to a long-run average.
Monte Carlo - an analytical technique in which a large number of simulations are run using random quantities for uncertain variables and using the distribution of results to infer which values are most likely. The name comes from the Monte Carlo section of the city-state of Monaco, which is known for its casinos and gambling.
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N:
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N - the Commodity Futures Symbol which represents the July Delivery Month.
NASDAQ - the acronym for the National Association of Securities Dealers Automated Quotations or Quote system that links brokers and dealers in an unified price quotation system.
Net Settlement - a contract provision that allows for netting out payables and receivables in terms of cash or items that can be readily converted to cash in an established market.
NGL - natural gas liquids; a general term for all liquid products separated from natural gas in a gas processing plant. NGL's include propane, butane, ethane, and natural gasoline.
Negative Carry - the condition whereby a portfolio after financing considerations generates a negative income stream or loss.
Normal Distribution - a continuous probability distribution whose probability density function has a "bell" shape.
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Option Premium - the amount that an option buyer pays to the seller.
Open Interest - the total number of futures contracts or option contracts that have not yet been exercised, expired, or fulfilled by delivery.
Operational Risk - the risk to financial or other institutions from inadequate or failed internal processes, people and systems or from external events.
Outliers - probabilistically remote events that are often viewed as statistically independent as well. Various techniques can test if actual data differ in a statistically significant manner from the benchmark or normal distribution.
Over The Counter - (OTC); traded in some context other than a formal exchange.
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Parametric VaR - linear Value at Risk.
Path Dependent Option - an option whose valuation and payoff depends on the realized price path of the underlying asset, such as an Asian option or a Lookback option.
Payoff Diagram - a graph of a transactions payoff as a function of underlier value at expiration.
Put-Call Parity - a relationship between the prices of European put and call options on the same underlier.
Put Option - an option which gives the option buyer the right, but not the obligation, to sell a futures contract at a specific price within a specific period of time in exchange for a one-time premium payment. See also Call Option.
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Quadratic Portfolio - in the context of Value-at-Risk, a portfolio whose portfolio mapping function is a quadratic polynomial.
Quantile - a notion from probability.
Quanto Option - an option in one currency, but which pays out in another.
Quick Asset Ratio - refers to the ratio of cash, cash equivalents and accounts receivable relative to the total current liabilities. Also known as the Acid Test Ratio. This measure of liquidity is more rigorous than the Current Ratio.
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R:
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Range Forward - a type of derivatives hedge.
Ratio Spread - an options strategy using either puts or calls, in which one buys options and then sells a different amount of options.
Reverse Crack - the sale of crude oil against the purchase of the refined products. In futures trading, it is the simultaneous sale of crude oil futures versus the purchase of heating oil and gasoline futures.
Rho - the interest rate sensitivity of an option relative to a change in the interest rate option pricing variable. It measures an option's change in value for a given change in the interest rate.
Risk Register - a basic document of risk management control systems, on which all significant risk factors for an entity are identified, ranked and assigned.
Risk/Reward Ratio - the relationship between the probability of loss and profit. This ratio is often used as a basis for trade selection or comparison.
Rollover - transfer of a position to a different delivery month.
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S:
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Sarbanes-Oxley Act of 2002 - U.S. legislation enacted in response to the accounting scandals of 2001-2002. The Act was named after Senator Paul Sarbanes and Representative Michael Oxley and is arranged in eleven titles. Compliance with provisions of the Act is mandatory.
The Sarbanes-Oxley Act of 2002 is generally considered the single most important piece of legislation affecting corporate governance, financial disclosure, and public accounting since the U.S. securities laws enacted in the 1930's. The Act is often referred to variously as SOX, S-O, or SOA. The full text of the legislation is shown here in a PDF format. A summary of the Act is provided by the American Institute of Certified Public Accountants.
Settlement Price - the closing range of prices after a trading session, used to calculate gains and losses, margin calls, and invoice prices for deliveries in futures market accounts.
SFAS 133 - Statement of Financial Accounting Standard 133. See FAS 133.
Six Sigma - terminology used to designate a quality measure or characteristics such as defects-per-unit, parts-per million defective, and the probability of a failure/error. The term "sigma" is used to designate the distribution or spread about the mean (average) of any process or procedure. Six Sigma denotes a failure rate of 3.4 parts per million or 99.99966% good. Sigma is a letter in the Greek alphabet.
Skewness - indicates any asymmetric "leaning" to either left or right of a probability distribution. Skewness is the third 'moment' of a distribution.
Spark Spread - the relationship between the price of electricity and the price of natural gas or other fuel used to generate electricity. The spark spread reflects the costs, or anticipated costs, of producing power.
It can be used as a method of converting millions of British thermal units (Btu's) to megawatt hours, and vice versa. The spread is simply the heat rate (a proxy for efficiency) of a specific generating plant or power system (the number of Btu's needed to make one kilowatt hour of electricity), multiplied by the cost of energy expressed as dollars per Btu's.
Standard Deviation - the square root of the variance of a probability distribution. The Standard Deviation is one of several indices of variability that characterize the dispersion among the measures in a given population.
Stochastic - a process that is random.
Stress Test - a test of a model for pricing or risk management, using an extreme scenario or range of scenarios.
Structured Note - a derivative instrument whose value is based on that of an underlying index.
Sunshine Option - a derivative instrument that is triggered by the number of hours of sunshine during some defined period for the life of the option. Such options can be of use as hedges of revenues, for example, by summer holiday resorts that could be compensated if the number of hours of sunshine fell below a certain specified level.
Swaption - an option to enter into a swap—i.e., the right, but not the obligation, to enter into a specified type of swap at a specified future date.
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Theta - sensitivity of an option's value to a change in the amount of time remaining until expiration.
Time Decay - the tendency of an option to decline in value as the expiration date approaches, especially if the price of the underlying instrument is exhibiting low volatility.
Tombstone Ad - a pulished announcement of a new issue by the underwriters after the fact.
Total Return Swap - a type of credit derivative.
Triple Witching Hour - the final hour of the stock market trading session on the third Friday of March, June, September, and December, when option contracts and futures contracts expire on market indexes used by program traders.
Tranche - the piece, portion or slice of a deal or structured financing.
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U - the Commodity Futures Symbol which represents the September Delivery Month.
Underlying - in an option contract, the security or commodity that is delivered when the contract is exercised.
Unit Investment Trust - an investment vehicle which is funded at the beginning and once investments are acquired acts like a liquidating investment. For example, commodity rights, corporate bonds, or mortgage backed securities would be acquired.
Universal Volatility Model - any of a class of option pricing models that model volatility skew by combining elements of local volatility, jump-diffusion and stochastic volatility models.
Up-and-Out - an options structure by which option contract dies or ceases to be active when an indicator, such as price, goes through an upside trigger point or threshold.
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V - the Commodity Futures Symbol which represents the October Delivery Month.
Value at Risk - a methodology for estimating market risk.
Variance - a measure of volatility, risk, or statistical dispersion. It is the square of the standard deviation.
Variance-Covariance VaR - Linear VaR.
Vega - the measure of change in an option value given a change in the volatility.
Volatility - a measurement of the rate of price change of a futures contract, security, or other instrument underlying an option. See also Historical Volatility, Implied Volatility.
Volatility Smile - a condition where implied volatilities for in-the-money and out-of-the-money strikes exceed those for at-the-money strikes. Graphically depiction of this condition is a curve in the form of a 'smile'.
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Wasting Asset - a derivative instrument that may expire worthless after a stated time or event. Options, Rights, and Warrants are examples.
Weather Derivative - a derivative instrument whose payoff is based on a specified weather event and is used to hedge the financial impact of weather fluctuations.
Wiener Process - a type of Markov Stochastic process. It refers to changes in value over small time periods. Sometimes, this process is also called Brownian motion.
Wrangle - an options spread that is long (short) both a ratio call spread and a ratio put spread.
Writer Extendible Option - an option whose expiration is extended if some pre-defined condition is met.
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X - the Commodity Futures Symbol which represents the November Delivery Month.
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