Derivatives –

A derivative is a contract between two or more parties whose value is based on an agreed-
upon underlying financial asset (like a security) or set of assets (like an index). Derivatives
are secondary securities whose value is solely based (derived) on the value of the primary
security that they are linked to–called the underlying. The use of derivatives to hedge risk
and improve returns has been around for generations, particularly in the farming industry,
where one party to a contract agrees to sell goods or livestock to a counter-party who
agrees to buy those goods or livestock at a specific price on a specific date. The simplest
derivative investment allows individuals to buy or sell an option on a security. The investor
does not own the underlying asset but they make a bet on the direction of price movement
via an agreement with counter-party or exchange.
Investors typically use derivatives for three reasons—to hedge a position, to increase
leverage, or to speculate on an asset's movement. Hedging a position is usually done to
protect against or to insure the risk of an asset. Derivatives can greatly increase leverage.
Leveraging through options works especially well in volatile markets. When the price of the
underlying asset moves significantly and in a favorable direction, options magnify this
movement. Investors also use derivatives to bet on the future price of the asset through
speculation. Large speculative plays can be executed cheaply because options offer
investors the ability to leverage their positions at a fraction of the cost of an underlying
asset.
Trading Derivatives –
Derivatives can be bought or sold in two ways—over-the-counter (OTC) or on an exchange.
OTC derivatives are contracts that are made privately between parties, such as swap
agreements, in an unregulated venue. On the other hand, derivatives that trade on an
exchange are standardized contracts.
Over-the-counter (OTC) refers to the process of how securities are traded via a broker-
dealer network as opposed to on a centralized exchange. Stocks that trade via OTC are
typically smaller companies that cannot meet exchange listing requirements of formal
exchanges. However, many other types of securities also trade here. Stocks that trade on
exchanges are called listed stocks, whereas stocks that trade via OTC are called unlisted
stocks.
There are many types of derivative instruments, including options, swaps, futures, and
forward contracts.
1. Futures/Futures Contracts–
Futures are derivative financial contracts that obligate the parties to transact an
asset at a predetermined future date and price. The buyer must purchase or the
seller must sell the underlying asset at the set price, regardless of the current market
price at the expiration date. If a trader bought a futures contract and the price of the
commodity rose and was trading above the original contract price at expiration, then
they would have a profit.
 A. Initial Margin –
To open a margin account at a brokerage firm, an account holder first needs to
post a certain amount of cash, securities or other collateral, known as the initial
margin requirement. Initial margin is the percentage of the purchase price of a
security that must be covered by cash or collateral when using a margin account.
B. Maintenance Margin –
Maintenance margin is the minimum amount of equity that an investor must
maintain in the margin account after the purchase has been made. Maintenance
margin is also called a minimum maintenance or maintenance requirement. It
stipulates the minimum amount of equity—the total value of securities in the
margin account minus anything borrowed from the brokerage firm—that must
be in a margin account at all times as long as the investor holds on to the
securities purchased. If the equity in a margin account falls below the
maintenance margin, the broker issues a margin call, which requires that the
investor deposit more cash into the margin account bring the level of funds up to
the maintenance margin or liquidate securities in order to fulfill the maintenance
amount.

Example –
Let's say a trader wants to speculate on the price of crude oil by entering into a
futures contract in May with the expectation that the price will be higher by
year-end. The December crude oil futures contract is trading at $50 and the
trader locks in the contract.
Since oil is traded in increments of 1,000 barrels, the investor now has a position
worth $50,000 of crude oil (1,000 x $50 = $50,000). However, the trader will only
need to pay a fraction of that amount up-front—the initial margin that they
deposit with the broker.
From May to December, the price of oil fluctuates as does the value of the
futures contract. If oil's price gets too volatile, the broker may ask for additional
funds to be deposited into the margin account—a maintenance margin.
In December, the end date of the contract is approaching, which is on the third
Friday of the month. The price of crude oil has risen to $65, and the trader sells
the original contract to exit the position. The net difference is cash-settled, and
they earn $15,000, less any fees and commissions from the broker ($65 - $50 =
$15 x 1000 = $15,000).
However, if the price oil had fallen to $40 instead, the investor would have lost
$10,000 ($40 - $50 = negative $10 x 1000 = negative $10,000).

2. Forward Contracts –
A forward contract is a customized 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 therefore regarded as over-the-counter (OTC)
instruments.
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 settles on a daily basis. Most importantly, futures contracts exist as
standardized contracts that are not customized between counterparties.

3. Swaps –
Swaps are derivatives where counterparties exchange cash flows or other variables
associated with different investments. Most swaps involve cash flows based on a
notional principal amount such as a loan or bond, although the instrument can be
almost anything. Swaps are over-the-counter (OTC) contracts primarily between
businesses or financial institutions that are customized to the needs of both parties.

• Interest Rate Swaps: Parties exchange a fixed-rate loan for one with a floating
rate. If one party has a fixed-rate loan but has floating rate liabilities, they
may enter into a swap with another party and exchange a fixed rate for a
floating rate to match liabilities. Interest rate swaps can also be entered
through option strategies while a swaption gives the owner the right but not
the obligation to enter into the swap.
• Currency Swaps: One party exchanges loan payments and principal in one
currency for payments and principal in another currency.
• Commodity Swaps: A contract where party and counterparty agree to
exchange cash flows, which are dependent on the price of an underlying
commodity.
• Debt-Equity Swaps: 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: 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.
• 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
contributing causes of the 2008 financial crisis.

4. Options –
Options are financial instruments that are derivatives based on the value of
underlying securities such as stocks. 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. Each option contract will have a specific expiration
date by which the holder must exercise their option. The stated price on an option is
known as the strike price. Options come with an upfront fee cost, called the
premium, that investors pay to buy the contract.

A. Call option –
A call option is a derivatives contract giving the owner the right, but not the
obligation, to buy a specified amount of an underlying security at a specified
price within a specified time.
When the strike price on the call is less than the market price on the exercise
date, the holder of the option can use their call option to buy the instrument at
the lower strike price. If the market price is less than the strike price, the call
expires unused and worthless. A call option can also be sold before the maturity
date if it has intrinsic value based on the market's movements.
• Long Call: You believe a security's price will increase and buy the right
(long) to own (call) the security. As the long call holder, the payoff is
positive if the security's price exceeds the exercise price by more than the
premium paid for the call.
• Short Call: You believe a security's price will decrease and sell (write) a
call. If you sell a call, the counterparty (the holder of a long call) has
control over whether or not the option will be exercised because you give
up control as the short. As the writer of the call, the payoff is equal to the
premium received by the buyer of the call if the security's price declines.
But you lose money if the security rises more than the exercise price plus
the premium.
B. Put Option –
A put is an options contract that gives the owner the right, but not the obligation,
to sell a certain amount of the underlying asset, at a set price within a specific
time. The buyer of a put option believes that the underlying stock will drop
below the exercise price before the expiration date.
The value of a put option appreciates as the price of the underlying stock
depreciates relative to the strike price. On the flip side, the value of a put option
decreases as the underlying stock increases. A put option's value also decreases
as its expiration date approaches. Conversely, a put option loses its value as the
underlying stock increases.
• Long Put: You believe a security's price will decrease and buy the right
(long) to sell (put) the security. As the long put holder, the payoff is
positive if the security's price is below the exercise price by more than the
premium paid for the put.
• Short Put: You believe the security's price will increase and sell (write) a
put. As the writer of the put, the payoff is equal to the premium received
by the buyer of the put if the security's price rises, but if the security's
price falls below the exercise price minus the premium, you lose money.

Intrinsic Value –
The intrinsic value of both call and put options is the difference between the
underlying stock's price and the strike price. In the case of both call and put options,
if the calculated value is negative, the intrinsic value is zero. In other words, intrinsic
value only measures the profit as determined by the difference between the option's
strike price and market price.

In-the-Money (ITM)
ITM indicates that an option has value in a strike price that is favorable in
comparison to the prevailing market price of the underlying asset.
• A call option is in the money if the stock's current market price is higher than
the option's strike price. It means the option holder has the opportunity to
buy the security below its current market price.
• An in-the-money put option means that the strike price is above the market
price of the prevailing market value. It means the option holder can sell the
security above its current market price.

Out-of-the-money (OTM)
An out of the money option has no intrinsic value, but only possesses extrinsic or
time value. if an option is OTM, the trader will need to sell it prior to expiration in
order to recoup any extrinsic value that is possibly remaining.
• An OTM call option will have a strike price that is higher than the market
price of the underlying asset.
• An OTM put option has a strike price that is lower than the market price of
the underlying asset.

At the Money (ATM)

At the money (ATM) is a situation where an option's strike price is identical to the
current market price of the underlying security. An ATM option has a delta of ±0.50,
positive if it is a call, negative for a put.

Put-Call Parity –
Put-call parity is a principle that defines the relationship between the price of
European put and call options of the same class, that is, with the same underlying
asset, strike price, and expiration date.

Arbitrage –
Arbitrage is the simultaneous purchase and sale of the same asset in different
markets in order to profit from tiny differences in the asset's listed price. It exploits
short-lived variations in the price of identical or similar financial instruments in
different markets or in different forms.

Binomial Tree Model – (American)

With a pricing model, the two outcomes are a move up, or a move down. By looking
at the binomial tree of values, a trader can determine in advance when a decision on
an exercise may occur. If the option has a positive value, there is the possibility of
exercise whereas, if the option has a value less than zero, it should be held for longer
periods.

Black-Scholes Model – (European)

The Black-Scholes-Merton (BSM) model, is a mathematical model for pricing an
options contract. In particular, the model estimates the variation over time of
financial instruments. It is regarded as one of the best ways of determining the fair
price of options. The Black-Scholes model requires five input variables: the strike
price of an option, the current stock price, the time to expiration, the risk-free rate,
and the volatility. It's used to calculate the theoretical value of options using current
stock prices, expected dividends, the option's strike price, expected interest rates,
time to expiration, and expected volatility.

Option Greeks –
a. Delta –
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 is relative to the underlying asset. 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.
b. Theta –
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. 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.
c. Gamma –
Gamma (Γ) represents the rate of change between an option's delta and the
underlying asset's price. Gamma indicates the amount the delta would change
given a $1 move in the underlying security. 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.
d. Vega –
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. 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.
e. Rho –
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. Rho is
greatest for at-the-money options with long times until expiration.

Bonds –
Bonds are debt securities issued by corporations, governments, or other organizations and
sold to investors. Bond details include the end date when the principal of the loan is due to
be paid to the bond owner and usually includes the terms for variable or fixed interest
payments made by the borrower. The interest rate that determines the payment is called
the coupon rate. The initial price of most bonds is typically set at par, usually $100 or $1,000
face value per individual bond. The actual market price of a bond depends on a number of
factors: the credit quality of the issuer, the length of time until expiration, and the coupon
rate compared to the general interest rate environment at the time.
Reinvestment Risk –
Reinvestment risk refers to the possibility that an investor will be unable to reinvest
cash flows received from an investment, such as coupon payments or interest, at a
rate comparable to their current rate of return.
Interest Rate Risk –
Interest rate risk is the potential for investment losses that result from a change in
interest rates. If interest rates rise, for instance, the value of a bond or other fixed-
income investment will decline. As interest rates rise bond prices fall, and vice versa.
This means that the market price of existing bonds drops to offset the more
attractive rates of new bond issues.

Discount Bond –
A discount bond is a bond that is issued for less than its par—or face—value.
Discount bonds may also be a bond currently trading for less than its face value in
the secondary market.
Bond at Premium –
A premium bond is a bond trading above its face value or in other words; it costs
more than the face amount on the bond. A bond might trade at a premium because
its interest rate is higher than current rates in the market.
Coupon Payment –
A coupon or coupon payment is the annual interest rate paid on a bond, expressed
as a percentage of the face value and paid from issue date until maturity. Coupons
are usually referred to in terms of the coupon rate (the sum of coupons paid in a
year divided by the face value of the bond in question).
Coupon Rate –
A coupon rate is the yield paid by a fixed-income security; a fixed-income security's
coupon rate is simply just the annual coupon payments paid by the issuer relative to
the bond's face or par value. The coupon rate, or coupon payment, is the yield the
bond paid on its issue date. A bond's coupon rate can be calculated by dividing the
sum of the security's annual coupon payments and dividing them by the bond's par
value.

• Yield to Maturity (YTM) –

Yield to maturity (YTM) is the total return anticipated on a bond if the bond is
held until it matures. Because yield to maturity is the interest rate an investor
would earn by reinvesting every coupon payment from the bond at a
constant interest rate until the bond's maturity date, the present value of all
the future cash flows equals the bond's market price.
• Yield to Call (YTC) –
Yield to call (YTC) is a financial term that refers to the return a bondholder
receives if the bond is held until the call date, which occurs sometime before
it reaches maturity.

Zero-Coupon Bond –
A zero-coupon bond, also known as an accrual bond, is a debt security that does not
pay interest but instead trades at a deep discount, rendering a profit at maturity,
when the bond is redeemed for its full face value. The greater the length of time
until the bond matures, the less the investor pays for it, and vice versa.

Duration –
Duration can measure how long it takes, in years, for an investor to be repaid the
bond’s price by the bond’s total cash flows. Duration can also measure the sensitivity
of a bond's or fixed income portfolio's price to changes in interest rates. As a bond's
duration rises, its interest rate risk also rises because the impact of a change in the
interest rate environment is larger than it would be for a bond with a smaller
duration.

Convexity –
Convexity is a risk-management tool, used to measure and manage a portfolio's
exposure to market risk. Convexity is a measure of the curvature in the relationship
between bond prices and bond yields. Convexity demonstrates how the duration of a
bond changes as the interest rate changes. If a bond's duration increases as yields
increase, the bond is said to have negative convexity. If a bond's duration rises and
yields fall, the bond is said to have positive convexity.

DV01 –
 The dollar duration measures the dollar change in a bond's value to a change in the
market interest rate. It is based on a linear approximation of how a bond's value will
change in response to changes in interest rates. Mathematically, the dollar duration
measures the change in the value of a bond portfolio for every 100 basis point
change in interest rates. Dollar duration is often referred to formally as DV01 (i.e.
dollar value per 01).

Portfolio Management –
Enterprise Value (EV) –
EV of the firm is the value of the firm’s core business activities and forms the basis of most
corporate valuation models. EV includes in its calculation the market capitalization of a
company but also short-term and long-term debt as well as any cash on the company's
balance sheet.
Discounted Cash Flows (DCFs) –
Discounted cash flow (DCF) is a popular method used in feasibility studies, corporate
acquisitions, and stock market valuation. This method is based on the theory that an asset's
value is equal to all future cash flows derived from that asset. These cash flows must be
discounted to the present value at a discount rate representing the cost of capital, such as
the interest rate.
Free Cash Flow (FCF) –
Free cash flow (FCF) represents the cash a company generates after accounting for cash
outflows to support operations and maintain its capital assets. It is the cash flow available
for the company to repay creditors or pay dividends and interest to investors. Unlike
earnings or net income, free cash flow is a measure of profitability that excludes the non-
cash expenses of the income statement and includes spending on equipment and assets as
well as changes in working capital from the balance sheet.
Terminal Value (TV) –
Terminal value (TV) is the value of an asset, business, or project beyond the forecasted
period when future cash flows can be estimated. Terminal value assumes a business will
grow at a set growth rate forever after the forecast period.

Weighted Average Cost of Capital (WACC) –

The Weighted Average Cost of Capital (WACC) shows a firm’s blended cost of capital across
all sources, including both debt and equity. Financial analysts use WACC widely in financial
modeling as the discount rate when calculating the present value of a project or business.
WACC has the purpose of determining the cost of each component of the structure of
capital.
Cost of Equity (Re) –
Cost of equity is the return a company requires for an investment or project, or the return
an individual requires for an equity investment. It is calculated using the CAPM model.

Cost of Debt (Rd) –

It is the yield to maturity on the firm’s debt, which is the return expected on the company’s
debt if it’s held to maturity.

Gordon Model –
The Gordon Growth Model (GGM) is used to determine the intrinsic value of a stock based
on a future series of dividends that grow at a constant rate. The GGM assumes that
dividends grow at a constant rate in perpetuity and solves for the present value of the
infinite series of future dividends. The three key inputs in the model are dividends per share
(DPS), the growth rate in dividends per share, and the required rate of return (RoR).

CAPM Model –
The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk
and expected return for assets, particularly stocks. CAPM is widely used throughout finance
for pricing risky securities and generating expected returns for assets given the risk of those
assets and cost of capital.

Capital Market Line (CML) –

The capital market line (CML) represents portfolios that optimally combine risk and return.
It is a theoretical concept that represents all the portfolios that optimally combine the risk-
free rate of return and the market portfolio of risky assets. Under CAPM, all investors will
choose a position on the capital market line, in equilibrium, by borrowing or lending at the
risk-free rate, since this maximizes return for a given level of risk. The slope of the CML is
the Sharpe ratio of the market portfolio. As a generalization, buy assets if the Sharpe ratio is
above the CML and sell if the Sharpe ratio is below the CML.
Sharpe Ratio –
The Sharpe Ratio is a financial metric often used by investors when assessing the
performance of investment management products and professionals. It is used to
 help investors understand the return of an investment compared to its risk. The
Sharpe ratio can help explain whether a portfolio's excess returns are due to smart
investment decisions or a result of too much risk. The greater a portfolio's Sharpe
ratio, the better its risk-adjusted-performance. If the analysis results in a negative
Sharpe ratio, it either means the risk-free rate is greater than the portfolio’s return,
or the portfolio's return is expected to be negative. In either case, a negative Sharpe
ratio does not convey any useful meaning.

Security Market Line (SML) –

The security market line (SML) is a line drawn on a chart that serves as a graphical
representation of the CAPM model. The SML can help to determine whether an investment
product would offer a favorable expected return compared to its level of risk. The beta of a
security is a measure of its systematic risk, which cannot be eliminated by diversification. A
beta value of one is considered as the overall market average. A beta value that's greater
than one represents a risk level greater than the market average, and a beta value of less
than one represents a risk level that is less than the market average.

Capital Market Line Vs. Security Market Line –

The SML is derived from the CML. While the CML shows the rates of return for a specific
portfolio, the SML represents the market’s risk and return at a given time, and shows the
expected returns of individual assets. And while the measure of risk in the CML is the
standard deviation of returns (total risk), the risk measure in the SML is systematic risk, or
beta. Securities that are fairly priced will plot on the CML and the SML. Securities that plot
above the CML or the SML are generating returns that are too high for the given risk and are
underpriced. Securities that plot below CML or the SML are generating returns that are too
low for the given risk and are overpriced.