Glossary: Risk Management Terms

This glossary provides definitions for key terms used in derivatives risk management and hedging. Terms are organized alphabetically for quick reference.

A-D

Backtesting: Comparing model predictions (such as VaR) to actual historical outcomes to validate model accuracy.

Basis: The difference between the price of a hedging instrument and the price of the underlying exposure being hedged.

Basis Risk: The risk that a hedge will not move in perfect correlation with the exposure, leaving residual risk.

Beta: A measure of an asset's sensitivity to market movements, where beta of 1.0 means the asset moves with the market.

Concentration Risk: The risk arising from overexposure to a single counterparty, instrument, or market.

Convexity: The second-order sensitivity of bond prices to interest rate changes, measuring how duration itself changes as rates move.

Counterparty Risk: The risk that the other party to a derivatives contract may default on its obligations.

Credit Support Annex (CSA): A legal document governing collateral arrangements between OTC derivatives counterparties.

Current Exposure: The positive mark-to-market value of a derivatives position, representing what would be lost if the counterparty defaulted today.

Delta: The first-order sensitivity of an option's price to changes in the underlying asset price.

Delta Hedging: A strategy that maintains a delta-neutral position by adjusting the hedge as the underlying price changes.

Duration: A measure of interest rate sensitivity, representing the approximate percentage change in bond price for a 1% change in yield.

DV01 (Dollar Value of 01): The change in portfolio value for a one basis point (0.01%) move in interest rates.

Dynamic Hedging: A hedging approach that continuously adjusts positions to maintain hedge effectiveness as market conditions change.

E-H

Effectiveness (Hedge): The degree to which changes in the hedge value offset changes in the hedged exposure value.

Expected Exposure (EE): The average exposure over the life of a derivatives position, accounting for potential future market moves.

Expected Shortfall (ES): Also called Conditional VaR or CVaR; the average loss beyond the VaR threshold.

Exposure: The potential financial loss from an adverse market movement or counterparty default.

Gamma: The rate of change of delta with respect to the underlying asset price; measures convexity of options positions.

Gamma Scalping: A trading strategy that profits from rebalancing delta hedges when the underlying price moves.

Greeks: Sensitivity measures for options and derivatives, including Delta, Gamma, Theta, Vega, and Rho.

Haircut: A percentage reduction applied to the market value of collateral to account for potential price declines.

Hedge Accounting: Accounting treatment that matches the timing of hedge gains/losses with the hedged exposure to reduce P&L volatility.

Hedge Ratio: The proportion of an exposure that is covered by a hedging instrument.

I-M

Initial Margin (IM): Collateral posted at trade inception to cover potential future exposure between margin calls.

Interest Rate Risk: The risk of loss from changes in interest rates affecting the value of fixed income instruments or derivatives.

Liquidity Risk: The risk of being unable to execute trades or meet margin obligations due to lack of market liquidity or available funds.

Mark-to-Market (MTM): Valuing a position at current market prices rather than historical cost.

Margin Call: A demand for additional collateral when the mark-to-market value of positions moves against the holder.

Marginal VaR: The change in portfolio VaR from adding one additional unit of a position.

Minimum Transfer Amount (MTA): The smallest collateral movement that will be made under a CSA.

Model Risk: The risk of loss arising from using incorrect or inappropriately applied models for valuation or risk measurement.

N-R

Notional Amount: The face value or reference amount used to calculate payments on a derivative, not necessarily the amount at risk.

Overlay Strategy: A derivatives-based strategy layered on top of an existing portfolio to modify its characteristics.

Potential Future Exposure (PFE): The maximum expected exposure at a future date at a specified confidence level.

Rebalancing: Adjusting hedge positions to maintain target hedge ratios or risk levels.

Residual Risk: The risk remaining after hedging, due to basis risk, model error, or incomplete hedging.

Rho: The sensitivity of an option's price to changes in interest rates.

Risk Limit: A quantitative constraint on risk-taking, such as maximum VaR, notional, or counterparty exposure.

Roll Risk: The risk of adverse price changes when replacing expiring derivatives with new contracts.

S-T

Sensitivity Analysis: Measuring how portfolio value changes in response to movements in individual risk factors.

SIMM (Standard Initial Margin Model): An industry-standard methodology for calculating initial margin on uncleared derivatives.

Static Hedging: A hedging approach where positions are established and held without adjustment until maturity.

Stress Testing: Evaluating portfolio performance under extreme but plausible market scenarios.

Tail Risk: The risk of extreme losses beyond what normal probability distributions would predict.

Theta: The sensitivity of an option's price to the passage of time (time decay).

Threshold: Under a CSA, the exposure level below which no collateral is required.

Tracking Error: The standard deviation of the difference between portfolio returns and benchmark returns.

V-Z

Value at Risk (VaR): A statistical measure of the maximum expected loss over a specified time period at a given confidence level.

Variation Margin (VM): Collateral exchanged daily to reflect changes in the mark-to-market value of derivatives positions.

Vega: The sensitivity of an option's price to changes in implied volatility.

Volatility: A measure of the dispersion of returns for a given security or market index, often measured as standard deviation.

Wrongway Risk: The risk that counterparty exposure increases at the same time as the counterparty's credit quality deteriorates.

Abbreviations

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This glossary is updated periodically. For detailed explanations and examples, see the related articles linked below.

Related articles:

• For delta hedging, see Delta Hedging Basics
• For gamma strategies, see Gamma Scalping and Volatility Trading