For general definitions of financial transaction terms, please click below,. You will be redirected to the glossary of the European Central Bank
Glossary for our webpage
Any interest-bearing or discounted government or corporate security that obligates the issuer to pay the bondholder a specific sum of money, usually at specific intervals, and to repay the principle amount of the loan at maturity.
Is the possibility to get a Credit Line from a financial institution
An arrangement between a financial institution, usually a bank, and a customer that establishes a maximum loan balance that the bank will permit the borrower to maintain, subject to special conditions, either secured or unsecured. The borrower can draw down on the credit line, subject to special conditions, as long as he or she does not exceed the maximum set in the agreement.
The advantage of a line of credit over a regular loan is that interest is not usually charged on the part of the line of credit that is unused, and the borrower can draw on the credit line at any time that he or she needs to. Depending on the agreement with the financial institution, the credit line may be classified as a demand loan, which means that any outstanding balance will have to be paid immediately at the financial institution's request.
- Over-the-counter contracts in which the purchase or sale of an interest rate instrument (usually a bond or note) is agreed on the contract date, for delivery at a future date, at a given price.
- A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging.
Unlike standard futures contracts, a forward contract can be customized to a commodity, amount and delivery date. Commodities traded can be grains, precious metals, natural gas, oil, or even poultry. A forward contract settlement can occur on a cash or delivery basis.
Forward contracts do not trade on a centralized exchange and are therefore regarded as over-the-counter (OTC) instruments. While their OTC nature makes it easier to customize terms, the lack of a centralized clearinghouse also gives rise to a higher degree of default risk. As a result, forward contracts are not as easily available to the retail investor as futures contracts.
- A forward contract is a customizeable derivative contract between two parties to buy or sell an asset at a specified price on a future date.
- Forward contracts can be tailored to a specific commodity, amount and delivery date.
- Forward contracts do not trade on a centralized exchange and are considered over-the-counter (OTC) instruments.
Forward Contracts Versus Futures Contracts
Both forward and futures contracts involve the agreement to buy or sell a commodity at a set price in the future. But there are slight differences between the two. While a forward contract does not trade on an exchange, a futures contract does. Settlement for the forward contract takes place at the end of the contract, while the futures contract p&l settles on a daily basis. Most importantly, futures contracts exist as standardized contracts that are not customized between counterparties.
- The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.
- The amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged.
- Leverage can be created through options, futures, margin and other financial instruments. For example, say you have $1,000 to invest. This amount could be invested in 10 shares of Microsoft stock, but to increase leverage, you could invest the $1,000 in five options contracts. You would then control 500 shares instead of just 10.
- Most companies use debt to finance operations. By doing so, a company increases its leverage because it can invest in business operations without increasing its equity. For example, if a company formed with an investment of $5 million from investors, the equity in the company is $5 million - this is the money the company uses to operate. If the company uses debt financing by borrowing $20 million, the company now has $25 million to invest in business operations and more opportunity to increase value for shareholders.
- Leverage helps both the investor and the firm to invest or operate. However, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would've been if the investment had not been leveraged - leverage magnifies both gains and losses. In the business world, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroys shareholder value.
MTNs have become a major source of financing in international financial markets, particularly in the Euro-market, which has grown at a phenomenal rate. Euro-medium-term-notes are international securities offerings not sold in a domestic market, and thus, not subject to national regulations such as registration requirements. Although Euro-MTNs can be sold throughout the world, the major underwriters and dealers are located in London, where most offerings are distributed. The Euro-MTN market accommodates a large cross-section of borrowers, including sovereign countries, supranational institutions, financial institutions, and industrial companies. Two of the more important developments have been the growth of structured Euro-MTNs and the emergence of large, discreet offerings which are underwritten and often syndicated using the fixed-price reoffering method. The easing of regulatory restrictions by foreign central banks has played an important role in the growth of the Euro-MTN market. (Federal Reserve-Bulletin)
Options are financial instruments that are derivatives based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying asset. Unlike futures, the holder is not required to buy or sell the asset if they choose not to.
- Call options allow the holder to buy the asset at a stated price within a specific timeframe.
- Put options allow the holder to sell the asset at a stated price within a specific timeframe.
Options are a versatile financial product. These contracts involve a buyer and a seller, where the buyer pays an options premium for the rights granted by the contract. Each call option has a bullish buyer and a bearish seller, while put options have a bearish buyer and a bullish seller.
Options contracts usually represent, for instance, 100 shares of the underlying security, and the buyer will pay a premium fee for each contract. For example, if an option has a premium of 35 cents per contract, buying one option would cost $35 ($0.35 x 100 = $35). The premium is partially based on the
—the price for buying or selling the security until the expiration date. Another factor in the premium price is the expiration date. Just like with that carton of milk in the refrigerator, the expiration date indicates the day the option contract must be used. The underlying asset will determine the use-by date. For stocks, it is usually the third Friday of the contract's month.
Traders and investors will buy and sell options for several reasons. Options speculation allows a trader to hold a leveraged position in an asset at a lower cost than buying shares of the asset. Investors will use options to hedge or reduce the risk exposure of their portfolio. In some cases, the option holder can generate income when they buy call options or become an options writer. Options are also one of the most direct ways to invest in oil. For options traders, an option's daily trading volume and open interest are the two key numbers to watch in order to make the most well-informed investment decisions.
American options can be exercised any time before the expiration date of the option, while European options can only be exercised on the expiration date or the exercise date. Exercising means utilizing the right to buy or sell the underlying security.
The "Greeks" is a term used in the options market to describe the different dimensions of risk involved in taking an options position, either in a particular option or a portfolio of options. These variables are called Greeks because they are typically associated with Greek symbols. Each risk variable is a result of an imperfect assumption or relationship of the option with another underlying variable. Traders use different Greek values, such as delta, theta, and others, to assess options risk and manage option portfolios.
Delta (Δ) represents the rate of change between the option's price and a $1 change in the underlying asset's price. In other words, the price sensitivity of the option relative to the underlying. Delta of a call option has a range between zero and one, while the delta of a put option has a range between zero and negative one. For example, assume an investor is long a call option with a delta of 0.50. Therefore, if the underlying stock increases by $1, the option's price would theoretically increase by 50 cents.
For options traders, delta also represents the hedge ratio for creating a delta-neutral position. For example if you purchase a standard American call option with a 0.40 delta, you will need to sell 40 shares of stock to be fully hedged. Net delta for a portfolio of options can also be used to obtain the portfolio's hedge ration.
A less common usage of an option's delta is it's current probability that it will expire in-the-money. For instance, a 0.40 delta call option today has an implied 40% probability of finishing in-the-money.
Theta (Θ) represents the rate of change between the option price and time, or time sensitivity - sometimes known as an option's time decay. Theta indicates the amount an option's price would decrease as the time to expiration decreases, all else equal. For example, assume an investor is long an option with a theta of -0.50. The option's price would decrease by 50 cents every day that passes, all else being equal. If three trading days pass, the option's value would theoretically decrease by $1.50.
Theta increases when options are at-the-money, and decreases when options are in- and out-of-the money. Options closer to expiration also have accelerating time decay. Long calls and long puts will usually have negative Theta; short calls and short puts will have positive Theta. By comparison, an instrument whose value is not eroded by time, such as a stock, would have zero Theta.
Gamma (Γ) represents the rate of change between an option's delta and the underlying asset's price. This is called second-order (second-derivative) price sensitivity. Gamma indicates the amount the delta would change given a $1 move in the underlying security. For example, assume an investor is long one call option on hypothetical stock XYZ. The call option has a delta of 0.50 and a gamma of 0.10. Therefore, if stock XYZ increases or decreases by $1, the call option's delta would increase or decrease by 0.10.
Gamma is used to determine how stable an option's delta is: higher gamma values indicate that delta could change dramatically in response to even small movements in the underlying's price.Gamma is higher for options that are at-the-money and lower for options that are in- and out-of-the-money, and accelerates in magnitude as expiration approaches. Gamma values are generally smaller the further away from the date of expiration; options with longer expirations are less sensitive to delta changes. As expiration approaches, gamma values are typically larger, as price changes have more impact on gamma.
Options traders may opt to not only hedge delta but also gamma in order to be delta-gamma neutral, meaning that as the underlying price moves, the delta will remain close to zero.
Vega (V) represents the rate of change between an option's value and the underlying asset's implied volatility. This is the option's sensitivity to volatility. Vega indicates the amount an option's price changes given a 1% change in implied volatility. For example, an option with a Vega of 0.10 indicates the option's value is expected to change by 10 cents if the implied volatility changes by 1%.
Because increased volatility implies that the underlying instrument is more likely to experience extreme values, a rise in volatility will correspondingly increase the value of an option. Conversely, a decrease in volatility will negatively affect the value of the option. Vega is at its maximum for at-the-money options that have longer times until expiration.
Those familiar with the Greek language will point out that there is no actual Greek letter named vega. There are various theories about how this symbol, which resembles the Greek letter nu, found its way into stock-trading lingo.
Rho (p) represents the rate of change between an option's value and a 1% change in the interest rate. This measures sensitivity to the interest rate. For example, assume a call option has a rho of 0.05 and a price of $1.25. If interest rates rise by 1%, the value of the call option would increase to $1.30, all else being equal. The opposite is true for put options. Rho is greatest for at-the-money options with long times until expiration.
These Greeks are second- or third-derivatives of the pricing model and affect things such as the change in delta with a change in volatility and so on. They are increasingly used in options trading strategies as computer software can quickly compute and account for these complex and sometimes esoteric risk factors.
Risk and Profits From Buying Call Options
As mentioned earlier, the call options let the holder buy an underlying security at the stated strike price by the expiration date called the expiry. The holder has no obligation to buy the asset if they do not want to purchase the asset. The risk to the call option buyer is limited to the premium paid. Fluctuations of the underlying stock have no impact.
Call options buyers are bullish on a stock and believe the share price will rise above the strike price before the option's expiry. If the investor's bullish outlook is realized and the stock price increases above the strike price, the investor can exercise the option, buy the stock at the strike price, and immediately sell the stock at the current market price for a profit.
Their profit on this trade is the market share price less the strike share price plus the expense of the option—the premium and any brokerage commission to place the orders. The result would be multiplied by the number of option contracts purchased, then multiplied by 100—assuming each contract represents 100 shares.
However, if the underlying stock price does not move above the strike price by the expiration date, the option expires worthlessly. The holder is not required to buy the shares but will lose the premium paid for the call.
Risk and Profits From Selling Call Options
Selling call options is known as writing a contract. The writer receives the premium fee. In other words, an option buyer will pay the premium to the writer—or seller—of an option. The maximum profit is the premium received when selling the option. An investor who sells a call option is bearish and believes the underlying stock's price will fall or remain relatively close to the option's strike price during the life of the option.
If the prevailing market share price is at or below the strike price by expiry, the option expires worthlessly for the call buyer. The option seller pockets the premium as their profit. The option is not exercised because the option buyer would not buy the stock at the strike price higher than or equal to the prevailing market price.
However, if the market share price is more than the strike price at expiry, the seller of the option must sell the shares to an option buyer at that lower strike price. In other words, the seller must either sell shares from their portfolio holdings or buy the stock at the prevailing market price to sell to the call option buyer. The contract writer incurs a loss. How large of a loss depends on the cost basis of the shares they must use to cover the option order, plus any brokerage order expenses, but less any premium they received.
As you can see, the risk to the call writers is far greater than the risk exposure of call buyers. The call buyer only loses the premium. The writer faces infinite risk because the stock price could continue to rise increasing losses significantly.
Risk and Profits From Buying Put Options
Put options are investments where the buyer believes the underlying stock's market price will fall below the strike price on or before the expiration date of the option. Once again, the holder can sell shares without the obligation to sell at the stated strike per share price by the stated date.
Since buyers of put options want the stock price to decrease, the put option is profitable when the underlying stock's price is below the strike price. If the prevailing market price is less than the strike price at expiry, the investor can exercise the put. They will sell shares at the option's higher strike price. Should they wish to replace their holding of these shares they may buy them on the open market.
Their profit on this trade is the strike price less the current market price, plus expenses—the premium and any brokerage commission to place the orders. The result would be multiplied by the number of option contracts purchased, then multiplied by 100—assuming each contract represents 100 shares.
The value of holding a put option will increase as the underlying stock price decreases. Conversely, the value of the put option declines as the stock price increases. The risk of buying put options is limited to the loss of the premium if the option expires worthlessly.
Risk and Profits From Selling Put Options
Selling put options is also known as writing a contract. A put option writer believes the underlying stock's price will stay the same or increase over the life of the option—making them bullish on the shares. Here, the option buyer has the right to make the seller, buy shares of the underlying asset at the strike price on expiry.
If the underlying stock's price closes above the strike price by the expiration date, the put option expires worthlessly. The writer's maximum profit is the premium. The option isn't exercised because the option buyer would not sell the stock at the lower strike share price when the market price is more.
However, if the stock's market value falls below the option strike price, the put option writer is obligated to buy shares of the underlying stock at the strike price. In other words, the put option will be exercised by the option buyer. The buyer will sell their shares at the strike price since it is higher than the stock's market value.
The risk for the put option writer happens when the market's price falls below the strike price. Now, at expiration, the seller is forced to purchase shares at the strike price. Depending on how much the shares have appreciated, the put writer's loss can be significant.
The put writer—the seller—can either hold on to the shares and hope the stock price rises back above the purchase price or sell the shares and take the loss. However, any loss is offset somewhat by the premium received.
Sometimes an investor will write put options at a strike price that is where they see the shares being a good value and would be willing to buy at that price. When the price falls, and the option buyer exercises their option, they get the stock at the price they want, with the added benefit of receiving the option premium.
- A call option buyer has the right to buy assets at a price that is lower than the market when the stock's price is rising.
- The put option buyer can profit by selling stock at the strike price when the market price is below the strike price.
- Option sellers receive a premium fee from the buyer for writing an option.
- In a falling market, the put option seller may be forced to buy the asset at the higher strike price than they would normally pay in the market
- The call option writer faces infinite risk if the stock's price rises significantly and they are forced to buy shares at a high price.
- Option buyers must pay an upfront premium to the writers of the option.
A financial swap is a derivative contract where one party exchanges or "swaps" the cash flows or value of one asset for another. For example, a company paying a variable rate of interest may swap its interest payments with another company that will then pay the first company a fixed rate. Swaps can also be used to exchange other kinds of value or risk like the potential for a credit default in a bond.
Interest Rate Swaps
In an interest rate swap, the parties exchange cash flows based on a notional principal amount (this amount is not actually exchanged) in order to hedge against interest rate risk or to speculate. For example, imagine ABC Co. has just issued $1 million in five-year bonds with a variable annual interest rate defined as the London Interbank Offered Rate (LIBOR) plus 1.3% (or 130 basis points). Also, assume that LIBOR is at 2.5% and ABC management is anxious about an interest rate rise.
Commodity swaps involve the exchange of a floating commodity price, such as the Brent Crude oil spot price, for a set price over an agreed-upon period. As this example suggests, commodity swaps most commonly involve crude oil.
In a currency swap, the parties exchange interest and principal payments on debt denominated in different currencies. Unlike an interest rate swap, the principal is not a notional amount, but it is exchanged along with interest obligations. Currency swaps can take place between countries. For example, China has used swaps with Argentina, helping the latter stabilize its foreign reserves.1 The U.S. Federal Reserve engaged in an aggressive swap strategy with European central banks during the 2010 European financial crisis to stabilize the euro, which was falling in value due to the Greek debt crisis.2
A debt-equity swap involves the exchange of debt for equity—in the case of a publicly-traded company, this would mean bonds for stocks. It is a way for companies to refinance their debt or reallocate their capital structure.
Total Return Swaps
In a total return swap, the total return from an asset is exchanged for a fixed interest rate. This gives the party paying the fixed-rate exposure to the underlying asset—a stock or an index. For example, an investor could pay a fixed rate to one party in return for the capital appreciation plus dividend payments of a pool of stocks.
Credit Default Swap (CDS)
A credit default swap (CDS) consists of an agreement by one party to pay the lost principal and interest of a loan to the CDS buyer if a borrower defaults on a loan. Excessive leverage and poor risk management in the CDS market were a contributing cause of the 2008 financial crisis.3