Arbitrage or risk-free profit is the purchase or sale of a security in one market and the simultaneous purchase or sale in another to take advantage of price differentials. This usually takes place on different exchanges or marketplaces.
A person who engages in arbitrage is called an Arbitrageur. The term mainly applies to trading in financial instruments, such as stocks, bonds, derivatives, commodities and currencies.
If the market prices do not allow for profitable arbitrage, the prices are said to constitute an arbitrage equilibrium or arbitrage free market.
Backwardation
It is possible for the futures price to prevail below the spot price or a far future delivery price is lower than a nearer future delivery price. Such a situation is known as Backwardation. This may happen when the cost of carry is negative, or when the underlying asset is in short supply in the cash market but there is an expectation of increased supply in future - example agricultural products. The opposite market condition to backwardation is known as Contango.
Basis
The difference between the spot price and the futures price is called the basis. Even though the spot and futures prices generally move in line with each other, the basis does not remain constant. Generally, with time, the basis decreases. On expiry, the futures price equals the spot price and the basis becomes zero.
Basis risk
Basis risk is the risk that users of the futures market suffer, owing to unwanted fluctuations of the basis. In the ideal futures market, the basis should reflect interest rates, and interest rates alone. In reality, the basis fluctuates within a band. These fluctuations reduce the usefulness of the futures market for hedgers and speculators.
Closing Buy Transaction
A Closing Buy Transaction refers to a buy transaction which has the effect of partly or fully offsetting a short position.
Closing Sell Transaction
A Closing Sell Transaction refers to a sell transaction which has the effect of partly or fully offsetting a long position.
Contango
Under normal market conditions, the futures price is higher than the spot price, or a far future delivery price is higher than a nearer future delivery price. Such a market is said to be in Contango.
The opposite market condition to Contango is called Backwardation.
Contract Month
Contract month refers to the month in which a contract is required to be finally settled.
Cost of carry
Cost of carry is the sum of all costs incurred if a similar position is taken in the spot market and carried to maturity of the futures contract less any revenue which may result within that period. In case of stock index futures, the excess of the financing cost of holding the stock over the dividend receipts constitutes the net cost of carry. Storage costs (generally expressed as a percentage of the spot price) should be added to the cost of carry of physical commodities.
Forward contracts
A simple forward-based contract obligates one party to buy and the other party to sell a financial instrument, a currency, equity or a commodity at a future date at a predetermined price. No money changes hands at the time the trade is agreed upon. Examples of forward-based contracts include forward contracts, futures contracts, forward rate agreements and swap transactions.
Futures contract
Futures contracts are exchange-traded forward contracts. A futures contract is an agreement between two parties to buy or sell a specified quantity and quality of an asset at a certain time in the future at a price agreed upon at the time of entering into the contract on the futures exchange.
Hedge
Hedging is a method of reducing the risk of loss caused by price fluctuation. It consists of the purchase or sale of equal quantities of the same or very similar assets, approximately simultaneously, in two different markets with the expectation that a future change in price in one market will be offset by an opposite change in the other market.
Initial margin
Initial margin is the amount of money required to be paid by market participant in the F&O segment at the time they place orders to buy or sell contracts.
Last Trading Day
Last Trading Day refers to the day up to and on which a derivatives contract is available for trading.
Leverage
Suppose a user of a forward market adopts a position worth Rs.100. As mentioned above, no money changes hands at the time the deal is signed. In practice, a good-faith deposit would be needed. Suppose the user puts up Rs.5 of collateral. Using Rs.5 of capital, a position of Rs.100 is taken. In this case, we say there is ''leverage of 20 times''. Thus leverage can be defined as the ability to control large monetary amounts of a financial instrument or commodity with comparatively small amount of capital.
Leverage makes derivatives useful; leverage is also the source of a host of disasters, payments crises, and systemic risk on financial markets. Understanding and controlling leverage is equivalent to understanding and controlling derivatives.
Long Position
Long Position in a derivatives contract means outstanding purchase obligations in respect of a permitted derivatives contract at any point of time.
Margin Money
Buyers and sellers in the futures market have to deposit margin money with their brokers at the time of entering into trades. The margin money is like a security deposit that acts as a performance bond for the contracting parties. The exchange members collect margin from their clients and deposit it with the clearing corporation / exchange clearing house. The prompt collection of margin by the exchange helps in avoiding the risk of default by its members or their clients in fulfilling their obligations that arise or may arise out of trades done on the exchange.
Market Lot
Market Lot refers to the number of units that can be bought or sold in a specified derivatives contract as specified by the F&O Segment of the Exchange from time to time. One can trade units of the contract only in multiples of this number.
Mark to market
Mark to Market is the process of revaluing all open derivatives positions daily using daily settlement prices to obtain profit or loss.
Open Interest
Open Interest refers to the total number of Derivatives Contracts of an underlying security that have not yet been offset and closed by an opposite Derivatives transaction nor fulfilled by delivery of the cash or underlying security or option exercise. For calculation of Open Interest, only one side of the Derivatives Contract is counted.
Open Position
Open position refers to the sum of long and short positions of the Member and his constituent in any or all of the Derivatives Contracts outstanding with the Clearing Corporation.
Opening Buy transaction
Opening buy transaction refers to a buy transaction which has the effect of creating or increasing a long position.
Opening Sell transaction
Opening Sell Transaction refers to a sell transaction which has the effect of creating or increasing a short position.
Settlement Date
Settlement Date refers to the date on which the outstanding obligations in a permitted Derivatives contract are required to be settled as specified by the exchange.
Short Position
Short position in a derivatives contract means outstanding sell obligations in respect of a derivatives contract at any point of time.
Trading cycle
Trading cycle refers to the period during which the derivatives contract will be available for trading.
Underlying Security
Underlying Security refers to a security with reference to which a derivatives contract is permitted to be traded on the Futures & Options segment of the Exchange from time to time.
