Derivatives Terminology Crash Course 2020

DERIVATIVES – THE
TERMINOLOGY CRASH COURSE

By Jawwad Ahmed Farid

D E R I VAT I V E S - T H E T E R M I N O L O G Y C R A S H C O U R S E
Copyright © 2006 – 2017, Jawwad Ahmed Farid, Fawzia Salahuddin

All rights reserved. Except for brief passages quoted for purposes of review or scholarly comment,
no part of this publication may be reproduced, stored in a retrieval system, or transmitted by any
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This publication is sold subject to the condition that it shall not by way of trade or otherwise, be
resold, or circulated in any form of binding or cover other than that in which it is published.

Editors: Jawwad Farid, Agnes Paul and Uzma Salahuddin

Please do not photocopy or distribute without permission. All rights reserved Jawwad Ahmed Farid
http://FinanceTrainingCourse.com
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CONTENTS
DERIVATIVES – THE TERMINOLOGY CRASH COURSE ............................................................................................ 4
1. INTRODUCTION ................................................................................................................................... 4
i. What are the different types of derivative instruments? ................................................................... 4
ii. Forward Contracts ............................................................................................................................. 5
Example - The Investment Bank Intern ......................................................................................... 5
iii. Future Contracts ............................................................................................................................... 5
iv. Options .............................................................................................................................................. 6
Maturities and Exercise date ........................................................................................................ 6
2. PAYOFF PROFILES ................................................................................................................................ 7
i. The Payoff profile for a forward contract ........................................................................................... 8
ii. Payoff profiles for Calls and Puts ....................................................................................................... 10
3. BUILDING BLOCKS AND SYNTHETIC CONFIGURATIONS ................................................................................... 13
i. Comparing a Call with a Forward contract .......................................................................................... 13
ii. Comparing a Call and a Put with a Forward contract ........................................................................ 14
iii. Combining a long call with a short put to create a long forward ..................................................... 14
DISCLAIMER .............................................................................................................................................. 15

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D ERIVATIVES – T HE T ERMINOLOGY C RASH C OURSE

1. Introduction
Think about a bottle of ice cold spring water in New York, in the Gobi Desert and in the Swiss Alps
where the water was bottled.

You can assume that the bottle can be safely and cheaply beamed (as in 'Beam me up Scottie') from
the Alps to New York as well as to the Gobi Desert. Would the price of the bottle be different at the
three locations? Why?

The value of the bottle at each location is dependent not on itself but on an external factor. The
environment! -reflected by paying capacity in New York, abundance in the Alps and, heat and
scarcity in the Gobi Desert.

A derivative instrument is very similar to bottled water in the Gobi Desert. Its value is determined
completely by external variables. The external factor could be anything but in general is either a
financial asset or an economic variable (such as interest rates). The external factor or variable is
called the underlying.

For example:
A stock index is a derivative instrument. A stock index calculates its value by using the current prices
of all the stocks included in that index.

v An Asian index would include the prices of selected Asian stocks.
v A technology index would include the prices of selected technology stocks.
v An Internet index would include the prices of selected Internet stocks.

A stock index would rise as it underlying stocks rise and will fall as its underlying stocks fall. Without
the underlying stocks, the index has no meaning or value.

i. What are the different types of derivative instruments?
The five types of derivative instruments that we will cover in this course are:
v Forward contracts- for example a forward contract that allows you to exchange the Euro for
US dollars 3 months in the future.
v Future contracts- for example a future contract that allows you to buy silver on the New
York Metal Exchange.
v Options- for example a Put option on Google.
v Swaps- for example an interest rate swap that allows you to pay a fixed interest rate and
receive a floating interest rate on 10 million US dollars over the next three years.
v Exotics- for example a contract that allows the buyer to link what he makes to the average
spread between West Texas Intermediate (WTI) Crude Oil, Brent and Arab Light prices in the
month ended 30th June 2010.

Let’s take a look at each of these contracts one by one.

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ii. Forward Contracts

When you buy a Metro Card, you enter into an agreement with the Transit Authority. You agree to
buy transport services in the future while the MTA agrees to sell you the same. The price for these
future purchases is set by MTA today.

A forward contract is analogous to a Metro Card. It is an agreement between two parties to buy and
sell an asset in the future for a certain price (the delivery price) set today.

If you agree to be on the buy side (you are the party purchasing the asset) you have a long position.
If you agree to be on the sell side (you are the party selling the asset) you have a short position.

A forward contract is generally an agreement between institutions. It is not traded on an exchange.
On the maturity or settlement date the gain or loss to a party is the difference between the delivery
price and the market price.

Both parties involved are obligated to perform their side of the transaction. A forward contract is
also a zero sum game. This means that if I win, you will most definitely lose.

Example - The Investment Bank Intern
Your first year internship in Europe with a bulge bracket investment bank will pay you 10,000 pounds
net of taxes and expenses. You are worried that the British Pound is overvalued right now and by the
time you take the money home, it would be worth less in dollars.

You buy a forward contract from the FX desk in your bank to exchange 10,000 pounds for 15,000
dollars three months from now. The contract locks in the current exchange rate of 1.5 dollars for a
pound.

Three months later if your prediction was correct and the pound falls to a new exchange rate of 1.3
dollars to a pound you win and gain 2,000 dollars [(1.5-1.3) * 10,000)]. If you had not used forwards
you could only get 13,000 dollars for your pounds. With the forward you can get 15,000 dollars,
hence the gain.

On the other hand if the pound rises to a new exchange rate of 1.9 dollars to a pound you would lose
4,000 dollars [(1.9-1.5)* 10,000]. You can get 19,000 dollars for your pounds but with the forward
will only get 15,000, hence the loss.

In both cases you would end up with 15,000 US dollars in exchange for 10,000 Sterling.

iii. Future Contracts
Let's go back to our example in the previous section about forward contracts. Suppose instead of
buying the contract from the FX desk, you bought it from a friend at work who disagreed with your
assessment of the British pound. The two of you agree to exchange 10,000 British pounds for 15,000
US dollars three months later.

When the time comes to settle the account the pound is trading at 1.3 dollars to a pound. You saved
two thousand dollars and feel very lucky. Then your friend calls up and tells you that he will not be
able to keep his end of the bargain. He has lost everything he had on his bets on the British pound.

What can you do now? Your only option is to exchange pounds at the current rate of 1.3 dollars to a
pound. Although your prediction was correct and you took timely action, you were still not able to

Page 5 of 15
protect yourself. This is called Counter party or Credit risk; the risk that the party on the other side
of the transaction will not be able to keep their end of the deal.

Was there anything you could have done differently? Yes, you could have bought a future contract.
A future contract is very similar to a forward contract except that it has very little Credit Risk. First,
instead of dealing directly with a third party, you deal with an exchange. The exchange guarantees
performance of the contract. If the party on the other side reneges, the exchange will settle with you
first and then recover what it can from the third party.

To enter into a future contract an initial margin is posted by both parties at the exchange. This is
money held on by the exchange as a performance bond. The exchange further reduces its risk by
calculating the net gain and loss on a daily basis from closing market prices. Net gains and losses at
the end of each trading day are posted to your margin account. If total losses on your account
exceed a set % of the margin you have to bring the margin back to its original balance by making
additional deposits. In case of gains you can take out any amounts over the initial margin. If you fail
to do so, your account is closed and the remaining margin is used by the exchange to recoup its
losses.

A future contract is also different from a forward contract in two other ways. First a future contract
is a standardized contract used all over the exchange, while a forward contract is customized.
Second a future contract has a settlement month, but no exact settlement date. A forward contract
has a fixed maturity date.

iv. Options
The problem with forwards and futures is that although you are protected against the downside, you
also lose the upside. Options address this problem. They protect you against adverse outcomes,
while allowing you to profit from favourable events.

Like forwards and futures, options give you the right to buy or sell a financial asset for a certain price
before a certain date in the future. The price is set today and is known as the exercise price. Unlike
forwards and futures as a buyer there is no obligation to perform. You can exercise the option if you
benefit from it; if you don't you can walk away. But unlike forwards and futures you have to pay a
premium to buy an option.

The two simplest (aka vanilla) options type that we will work with in this course are call and put
option contracts.

Calls give you the right to buy a financial asset for a set price in the future. You would use a call if
you expect the underlying price to go up. You would exercise the call if the underlying price at
maturity was greater than the exercise price. For this reason a call is classified as a bullish
instrument.

A Put option is the opposite of a call option. A Put option gives you the right to sell a security at a set
price at a set date in the future. You would use a Put if you expect the underlying price to go down.
You would exercise the put if the underlying price at maturity was less than the exercise price. For
this reason puts are classified as bearish instruments.

Maturities and Exercise date
Options generally come with exercise choices. Options that can be exercised at any time prior to
maturity are known as American options. Options that can only be exercised at maturity are known

Page 6 of 15
as European options. Other configurations are also possible and include Bermudan or Mid-Atlantic
(exercisable on multiple pre-set dates before expiry) and Asian (based on an average of prices that
replaces the exercise price of the option or the price of the underlying at maturity.)

2. Payoff Profiles

A payoff profile shows the scenarios under which a trade will make money and the scenarios under
which a trade will lose money. In the most common case it is a simple graph that plots the change in
price of the underlying security on the horizontal axis and the change in price of the derivative
security on the vertical axis.

Depending on the type of instrument the changes in value may either be linear or non linear. In our
case the horizontal and vertical axis have the same units implying that the change in value is linear.
O or origin represents the current underlying price, and the change in the underlying as well as the
derivative instrument is marked in a single unit (+1, +2, +3).

For most contract types, this simple tool can be used to highlight the cashflow profile of a
transaction type. We use the same tool for Forwards, Futures, Interest Rate Swaps and Options as
well as to dissect exotic products into more basic forms.

Page 7 of 15

i. The Payoff profile for a forward contract
A long position (you are a buyer) forward contract is used when you wish to hedge yourself against
the risk of rising prices in the future. A short position (you are a seller) is used when you wish to
hedge yourself against the risk of falling prices in the future. The next four figures walk through the
calculation of payoff profiles for a long forward contract.

There are four quadrants, I, II, III, IV, rotating clockwise through the grid above (starting from the top
left hand quadrant).

Quadrant I – Underlying prices fall, derivative value increases
Quadrant II – Underlying prices rise, derivative value rises
Quadrant III – Underlying prices rise, derivative value falls
Quadrant IV – Underlying prices fall, derivative value falls

Page 8 of 15

In the case of a forward contract, the resulting payoff profile across all four quadrants is the same as
if you actually own and hold the security. The value of your portfolio increases as the underlying
prices rise and decreases as the underlying prices falls.

Page 9 of 15
ii. Payoff profiles for Calls and Puts

Compare this to an option:

Unlike a forward, there is only a limited downside with option contracts. An option gives its owner
the right to exercise but not the obligation to perform if the exercise would result in a loss. For that
additional protection there is a price and it is charged upfront as a premium.

Once again, a Call option gives it owner the right to buy the underlying at a price and time agreed
upon on the date of purchase of the option contract.

A Put option gives it owner the right to sell the underlying at a price and time agreed upon on the
date of purchase of the option contract.

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A Call option is a bullish instrument, which is purchased when you expect prices to rise and want to
benefit from that rise. As you can see in the payoff diagram above the value of call option increases
when prices rise but the downside when prices fall is limited to the premium lost when the option is
not exercised.

Unlike the buyer of a call, the seller of a call is obligated to perform. His upside is the premium that
he retains when the call option is not exercised; his downside is the direct inverse of the payoff
profile of the buyer of the call.

Page 11 of 15
The same rules hold true for the buyer and seller of the put option as shown in the next two
diagrams:

The following table summarizes and reviews the above concepts.

PRODUCT POSITION TRANSLATION DOWNSIDE
Call Long Bought – Owns the option Premium paid
Call Short Sold – Wrote the option If the option is exercised, the difference between Market price
and Strike price
Put Long Bought – Owns the option Premium paid
Put Short Sold – Wrote the option If the option is exercised, the difference between Strike price and
Market price
Forward Long Bought the underlying The difference between Forward price and Market price, if prices
decline
Forward Short Sold the underlying The difference between Market price and forward price, if prices
rise

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3. Building blocks and synthetic configurations

The basic building blocks in the derivative world are the three contract types that we have just
discussed. It is possible to combine any number of them in a configuration that has a desired payoff
profile.

PRODUCT POSITION DIRECTION
Call Long Bullish
Call Short Bearish
Put Long Bearish
Put Short Bullish
Forward Long Bullish
Forward Short Bearish

A user can combine any two of the above three products to synthetically create the third. For
example we can combine calls and puts to synthetically create both long and short forward
contracts.

PRODUCT A PRODUCT B = PRODUCT THREE
Long Call Short Put Long Forward

Long Put Short Call Short Forward

The concept in the above table is illustrated in the following three diagrams.

i. Comparing a Call with a Forward contract

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ii. Comparing a Call and a Put with a Forward contract

iii. Combining a long call with a short put to create a long forward

?!Reader exercise – What is wrong with the diagram in 3iii above?!

For an answer to this question follow this link at financetrainingcourse.com:
http://financetrainingcourse.com/education/2012/01/derivatives-crash-course-for-dummies-what-
is-wrong-with-the-payoff-profile-of-the-synthetic-forward/

Page 14 of 15
D ISCLAIMER
This material is for informational purposes only and should not be considered as advice about risk or
the relative risk of a specific security in isolated or portfolio settings. The information shared in this
document is generated from the application of approximate mathematical models on price data
captured from financial markets. Some of this price data is indicative in nature which leads to
distortions in risk and price levels when actual trades hit local markets and significant distortions in
risk and price levels when the size of these trades is larger than average volumes.

The basis for these models and the dataset used are shared within the document.

Any opinions expressed herein are given in good faith, are subject to change without notice, and are
only correct as of the stated date of their issue and dependent on the underlying dataset and
mathematical models mentioned above.

A reference to a particular investment or security is not a recommendation to buy, sell, or hold such
investment or security, nor is it considered to be investment advice. Accordingly, Alchemy does not
assess the suitability (or the potential value) of any particular investment or provide tax advice on
the impact of an investment decision.

We utilize third-party data. While Alchemy believes such third-party information is reliable, we do
not guarantee its accuracy, timeliness or completeness. You should review and consider any recent
market or company specific news before taking any action. Stocks go down as well as up and
investors (including clients) may lose money, including their original investment. Past history is no
indication of future performance and returns are not guaranteed.

Alchemy provides a wide range of services to, or relating to, many organizations, including issuers of
securities, investment advisers, broker-dealers, investment banks, other financial institutions and
financial intermediaries, and accordingly may receive fees or other economic benefits from those
organizations, including organizations whose securities or services they may recommend, rate,
include in model portfolios, evaluate or otherwise address.

Where an investment is described as being likely to yield income, please note that the amount of
income that the investor will receive from such an investment may fluctuate. Where an investment
or security is denominated in a different currency to the investor’s currency of reference, changes in
rates of exchange may have an adverse effect on the value, price or income of or from that
investment to the investor.

This material is not intended for any specific investor and does not take into account your particular
investment objectives, financial situations or needs and is not intended as a recommendation of
particular securities, financial instruments or strategies to you.

Before acting on any recommendation (if any) in this material, you should consider whether it is
suitable for your particular circumstances and, if necessary, seek professional advice.

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DERIVATIVES – THE

TERMINOLOGY CRASH COURSE

Copyright © 2006 – 2017, Jawwad Ahmed Farid, Fawzia Salahuddin

D ERIVATIVES – T HE T ERMINOLOGY C RASH C OURSE

ii. Forward Contracts

ii. Payoff profiles for Calls and Puts

3. Building blocks and synthetic configurations

Long Call Short Put Long Forward

ii. Comparing a Call and a Put with a Forward contract

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