Financial Terms Details

A GLOSSARY OF FINANCIAL TERMS

compiled by the students of Prof. Weinberger’s Fall 2015 Advanced Derivatives Classes

Act of God bond:  a bond issued by an insurance company whose payouts are linked to natural disasters, which are often called “Acts of God” in insurance contracts.

American option:  an option that can be exercised at any time prior to its maturity date.

Arbitrage:  the simultaneous purchase of a security for a given price and sale of the security at a higher price.  In an efficient market, arbitrage, by definition, is impossible.

Asian option:  an option contract in which the owner is paid the difference between the average price of the underlying and the strike price.

Asset backed security:  a security whose payouts are derived from (and thus “backed”) by a pre-specified pool of assets.

At-the-money:  A term that describes an option whose strike price is the same as the current price of the option’s underlying security.

Available for sale:  an accounting term describing securities that are neither held for trading nor held until maturity.  Mark-to-market income from such securities is included in Other Comprehensive Income, rather than Net Income in the owner’s financial statements.

Back-to-back transaction:  a pair of transactions which, when entered into simultaneously, leave the counterparty with no net exposure.  For example, an interest rate swap dealer might simultaneously contract to receive the fixed rate in an interest rate swap with one party and contract to pay the fixed rate in an otherwise identical interest rate swap with another party.  

Bid-ask spread:  the difference in the lowest price at which owners of a security are willing to sell it and the highest price that potential buyers are willing to pay for it.

Backwardation:  a term describing a condition in the commodity futures or forwards markets when futures or forward prices are less than the current spot price.

Barrier option:  an option that either ceases to exist or comes into existence only if a given price level of the underlying is crossed.

Basis risk:  the risk that the return of an imperfect hedge will fail to track the return that is to be hedged.

Bond mutual funds:  mutual funds that invest in bonds with maturities of at least a year.

Boundary conditions:  the constraints upon possible solutions to partial differential equations that are imposed in addition to those introduced by the equation itself.  The name arises because the solution is only of interest on a bounded domain, and the constraints are usually imposed on the boundaries of the domain, as dictated by the relevant application.  For example, the Black-Scholes equation for the value of a vanilla call option is defined only for times on or before the time to maturity.  The boundary condition at maturity is that the value of the call there, i.e. MAX(0, ST – X), where ST is the price of the underlying at maturity and X is the strike price of the call option.

Brownian motion:  the random motion of, for example, dust particles in the atmosphere.  Random walk models offer a crude approximation to Brownian motion; a better mode is offered by the Wiener process (See “Wiener process”, below).

Butterfly option strategy:  an option strategy that consists of going long a butterfly spread.  It will be profitable if realized volatility is less than the volatility implied by current option prices.  

Butterfly spread: an options position consisting of long positions of equal size in call options struck at S0 – a and at S0 + a and a short position of twice the size of the long positions, struck at S0, where S0 is the current price of the underlying and a > 0.

Call protection:  a feature of a bond that prevents the issuer of the bond to “call it away” from the owner when the issuer would otherwise do so.

Callable bond:  a bond where the issuer of the bond has the right, but not the obligation to buy (“call”) the bond back from the bond holder at a pre-specified price, regardless of the bond’s current market price.

Carry trade:  a trade in which it is expected that profit will be made by simply holding the traded asset over a period of time.  For example, a long position in a forward contract in a market in backwardation will appreciate in value simply because of the passage of time.

Chooser option:  an option contract that gives the option holder the right to choose whether the contract is a put or a call option at some point in the life of the contract.

Clean price:  the price of a bond, exclusive of accrued interest.

Collateral yield:  the yield (return) from the collateral set aside for performance on a futures or forward contract, pending the maturity of the contract.

Collateralized debt obligation (CDO):  a structured security with bond-like characteristics whose coupon payments are funded by payments from its associated collateral.

Contango:  a term describing a condition in the commodity futures or forwards markets when futures or forward prices are greater than the current spot price.

Convertible bond:  a bond that give the holder the right, but not the obligation to convert the bond contract into a specific number of shares of the issuer’s stock.

Collar:  an option position consisting of a long position in a put option and a short position in a call option on the same underlying and maturity date, but at a higher strike.

Comparative advantage:  the relative advantage that one country or, more generally, any group of people has over another in producing something more cheaply, faster, etc.

Consumer sentiment:  the feelings that (usually American) consumers have about their economic prospects, and thus their likelihood of spending money in the short term.  These feelings are measured monthly by the University of Michigan Consumer Sentiment Index.

Convenience yield:  an adjustment to the pricing formula for commodity futures/forwards in markets where commodity owners find benefit in holding the physical asset, rather than futures/forward contracts.  For example, an oil refiner needs a ready supply of crude oil nearby to ensure that its refinery can run continuously.