Glossary

  • One-factor model

    A model or description of a system where the model incorporates only one variable or uncertainty: the future price. These are simple models, usually leading to closed-form solutions, such as the Black-Scholes model or the Vasicek model.

  • Open-ended product

    Structured products that can be used for investment for an unlimited period are sometimes called open-ended products. They stand in contrast to tranche or close-ended products.

  • Operational risk

    The risk run by a firm that its internal practices, policies and systems are not rigorous or sophisticated enough to cope with untoward market conditions or human or technological errors. Although operational risk is not as easy to identify or quantify as market or credit risk, it has been implicated as a major factor in many of the highly-publicised derivatives losses of recent years. Sources of operational risk include: failure to correctly measure or report risk; lack of controls to prevent unauthorised or inappropriate transactions being made (the so-called "rogue trader" syndrome); and lack of understanding or awareness among key staff.

  • Option

    A contract that gives the purchaser the right, but not the obligation, to buy or sell an underlying at a certain price (the exercise, or strike price) on or before an agreed date (the exercise period). For this right, the purchaser pays a premium to the seller. The seller (writer) of an option has a duty to buy or sell at the strike price, should the purchaser exercise his right. With European-style options, purchasers may take delivery of the underlying only at the end of the option's life. American-style options may be exercised, for immediate delivery, at any time over the life of the option. Holders of semi-American-style or Bermudan options may be exercised on specified dates, typically on a monthly or quarterly basis. Options can be bought on commodities, stocks, stock indexes, interest rates, bonds, currencies, etc. The trading terminology, though, may change according to the product. In most cases, the right to buy the underlying is known as a call, and the right to sell, a put. Options are traded on formal exchanges and in over-the-counter (OTC) markets. The exchanges, such as the Hong Kong Stock Exchange, the SIMEX, or the ASX provide primarily standardised options; the OTC markets are able to provide tailored products to fit specific requirements. The choice between OTC and exchange-traded options will depend on the degree of tailoring required, the relative liquidity of both markets (this varies greatly according to the underlying) and credit concerns. Pricing models for simple or vanilla options have five major inputs: the option's exercise or strike price; the time to expiration; the price of the underlying instrument; the risk-free interest rate on the underlying instrument, and the volatility of the underlying instrument. European-style options are usually priced off a closed-form analytical model first published by Fischer Black and Myron Scholes in 1973, which has subsequently been modified to fit different underlying. At maturity, an option's value depends on the value of the right to buy or sell a product. If an option is purchased giving the right to buy gold at $375 an ounce and at expiration the rice is $400, the option is worth $25.

    The extent to which an option is in-the-money (how far the strike price is below/above the current forward market price) is called its intrinsic value. Where the strike price is less favourable than the market price, the option is said to be out-of-the-money, and where the two prices are the same it is at-the-money. At any time before maturity, an option's price will be a combination of its intrinsic value (which is always either greater than, or equal to, zero) and its time value. The latter includes the cost of carry and the probability that the price of the underlying will move into or remain in the money. Options can broadly be used in two ways: for speculation or for insurance. Their usefulness, both from a buyer and a seller's point of view, derives from their payouts. In contrast to other types of hedge, options provide insurance against unfavourable moves in a product's price and the opportunity to take advantage of favourable moves. Forwards and futures, for example, require buyers and sellers to lock into one rate. In return for assuming this risk, sellers of options receive a premium, effectively a risk-taking fee. The payout of a purchased option means that the price risk of an option is limited to its premium; it is not as exposed to adverse movements as a position in the underlying. For speculators selling (writing) options, this often means taking a naked option position and therefore being exposed to adverse movements in the underlying. Hedgers may sell options to garner premium to offset any expected slight downturn in a market. Since option premiums are only a fraction of the cost of the underlying product, it is possible to achieve a much greater exposure to price changes of the underlying compared with a similar investment directly in the product - this is called leverage.

  • Option combination strategies

    Options may be combined so that their payouts produce a desired risk profile. Some combinations are primarily trading strategies, but option combinations can be useful in, for example, allowing investors to construct a strategy to take advantage of a particular view they have of the market. Other strategies allow purchasers to reduce their premiums by giving up some of the benefits they may have received from market movements.

  • Option styles

    The purchaser of a European-style option has the right to exercise it on a predetermined expiry date. In contrast, the holder of an American-style option has the right to exercise it at any time during its lifetime, up to and including its expiry date. This flexibility means there is a greater probability of an American-style option being exercised than the corresponding European-style option with the same strike. Hence the early exercise feature of an American option adds value and makes it the more expensive of the two. Most exchange-traded options are American-style. Further variations on these styles also exist. A Bermudan option, so called because it falls between American- and European-style options, has more than one possible exercise date. For example, the holder of a Bermudan option with a two-year maturity might have the right to exercise it every quarter or half year during the life of the contract. Bermudans are also known as limited exercise or semi-American-style options. Another twist is the deferred payout option, a variation on American-style options in which the option can be exercised at any time during the option's life, but the payout is delayed until the expiry date. With the similar shout option, the purchaser can lock in a profit at any time, but retains the right to profit from further favourable moves.

  • Out-of-the-money

    Describes an option for which the forward market price of the underlying is below the strike price in the case of a call, or above it in the case of a put. The more the option is out-of-the-money, the cheaper it is (since the chances of it being exercised get slimmer). Its delta also declines and it becomes less sensitive to movements in the underlying.

  • Outperformance option

    Also known as a Margrabe option. A two-factor option giving the purchaser the right to receive the outperformance of one asset over another asset. For example, a purchaser with a view that the Hang Seng Index (HSI) will outperform the Dow Jones Euro Stoxx 50 (Euro Stoxx) index should buy the outperformance option, which pays notional multiplied by the outperformance of the HSI index over the Euro Stoxx index. In this case, the payout is zero if HSI underperforms Euro Stoxx. The value of an outperformance option will largely be dictated by the historical correlation between the underlyings.

  • Over-the-counter (OTC)

    Financial products that are not traded on formal exchanges are said to be traded over-the-counter.

  • Overlay

    A strategy to change the exposure of a portfolio using derivatives, while leaving the securities in the underlying portfolio unchanged. This has the advantage of cost and flexibility, as portfolio managers can adjust portfolio risk more quickly and cheaply with derivatives than by liquidating portfolio holdings. Another reason might be tactical; the adjustment may only be desired for a brief period of perceived market threat. A third reason might be to transform a portfolio risk; an international fund manager may wish to segregate the currency aspect of a portfolio and can do so with a currency overlay programme.

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