Financial Risk Management (FRM) Keyword Index
Keyword Description Page Reference
Accounting rate of return Calculated as the average annual profit divided by the initial Module 3
(ARR) cash outlay. (p.201)
Adjusted present value An approach that assumes the project being considered is Module 3
(APV) financed using only equity, and discounts the after-tax (p.225)
operating cash flows at
the appropriate discount rate for the business. It then adjusts
this base net present value (NPV) for the valuation
implications of the financing side effects associated with the
project, which typically include the present value of interest
tax shields, flotation or capital raising costs, and the value of
subsidised financing.
Agreed price (strike price) The price that the option buyer pays or receives for the asset. Module 4
The agreed price is typically called the strike price or exercise (p.280)
price.
American depository A US dollar-denominated security that trades like a common Module 3
receipt (ADR) share on US exchanges. (p.182)
American style option An option that can be exercised at any point during its life Module 4
until expiry. See ‘Option’ and ‘European style option’. (p.285)
Amortising (re: structure of Used for derivatives where the notional principal decreases Module 7
derivative) over the life of the instrument in accordance with either a (p.483)
preset pattern or with an index of interest rates/mortgage
prepayment rates. Instruments that can be structured in this
way include caps, collars, floors, swaps and swaptions.
Annuity An annuity is a series of equal payments at regular intervals. Module 2
(p.129)
Arbitrage Instruments that have identical characteristics and so are Module 6
perfect substitutes should trade at the same price. If they do (p.394)
not, a risk-free profit can be generated by simultaneously
selling the higher-priced asset and buying
the lower-priced asset. Arbitrage is the identification and
exploitation of such price anomalies.
Asset-backed security A security that is supported by a pool of specified collateral, Module 3
typically in a trust structure. (p.175)
At-the-money The point at which an option’s strike price and the price of Module 4
the underlying asset are the same. See ‘In-the-money’ and (p.283)
‘Out-of-the-money’.
Backwardation Primarily used in commodity markets, backwardation is the Module 4
situation in which futures prices are lower than spot prices to (p.274)
produce a negatively sloped forward curve. See ‘Contango’.
Bank bill swap rate (BBSW) The bank bill rate published daily on Reuters Screen BBSW Module 3
page that is used as the Australian floating rate benchmark (p.173)
for most interest rate swaps and other interest rate
derivatives such as swaptions, caps, collars and floors.
For UK equivalent see ‘London Interbank Offered Rate
, (LIBOR)’.
Bank overdraft A form of bank lending whereby a customer can overdraw a Module 3
current account up to an agreed limit, which provides the (p.165)
customer with funding on a fluctuating basis. Typically used
to cover fluctuating working capital requirements.
Basis points This is a common term in financial transactions, especially in Module 2
respect of the spread being charged between the buy and (p.124)
sell quotes, or in terms of bank charges on foreign exchange
transactions.
One basis point is 0.0001 or 0.01 per cent, 100 basis points
equals 1 per cent. Banks often consider the impact of a basis
point change in a variable (index, FX or interest rate, etc.) on
the fair value of their positions.
Basis risk Basis risk is a risk associated with imperfect hedging using Module 4
derivatives. (p.268)
It arises through the difference between the asset whose
current price is
to be hedged and the price of the asset underlying the
derivative, and/or because of a mismatch between the
maturity date of the derivative used and the actual selling or
delivery date of the asset being hedged or its quality
or ‘grade’.
Basket A selection of stocks, indices, commodities, currencies or Module 4
interest rates that can either be traded as a unit in (p.285)
themselves or used as the underlying (i.e. underlying asset or
index, etc.) for a derivative product.
Beta (ß) This is a measure of the sensitivity of an asset’s return to an Module 2
underlying factor or index. It is most commonly used to refer (p.134)
to market beta where the underlying factor is the market.
The market’s beta is one (1), so returns on a security with a
beta of one will move in line with the market. If beta is
greater than one, the security will exaggerate market returns;
if it is less than one, it will under-reflect market moves. If
beta is negative, security and market returns move in
opposite directions.
Bill of exchange Commonly used to fund international trade or working Module 8
capital. An unconditional order in writing addressed by one (p.551)
person to another, signed by the person giving it, requiring
the person to whom it is addressed to pay on demand, or at a
fixed or determinable future time. The bill of exchange states
a fixed amount of money and is paid to the order of
a specified person or bearer. Commonly utilised as a source
of short-term funding.
Black–Scholes (Black– Developed by Fischer Black and Myron Scholes in 1973, this is Module 4
Scholes–Merton) model the classic modern option pricing model and the first general (p.288)
equilibrium solution for the valuation of options. The model
, provides a no-arbitrage value for European-style call options
on shares as a function of the share price, which is assumed
to follow a lognormal distribution. The model shows that, by
combining the underlying stock and a money market
instrument, a riskless hedge (the delta hedge) can always be
formed that exactly replicates the pay-off of the option to be
hedged. Robert Merton wrote an influential paper expanding
the understanding of the model, so it is also sometimes
known as the Black–Scholes–Merton option pricing model.
Black swan Describes an event that was unprecedented and unexpected Module 4
at the time the event occurred. They are considered rare, (p.260)
random and high-impact events.
Bond A form of long-term debt (as distinct from equity) finance. Module 2
The normal or ‘vanilla’ bond involves payment of a fixed (p.129)
amount (coupon) against the face value over a period of
years, or variable income (floating rate notes) where
payment is by reference to a benchmark rate, commonly the
bank bill swap rate (BBSW).
Bonus shares Ordinary shares that are issued by a company for no Module 3
consideration. They increase the number of ordinary shares (p.185)
on issue resulting in the price per share decreasing in direct
proportion to the number of bonus shares issued.
Call option An option to buy a pre-agreed amount of a specified Module 1 (p.62)
underlying asset at a predetermined price or rate. Buyers of
calls purchase the right to buy the underlying asset and
sellers are offering the obligation to sell the underlying asset.
Capital asset pricing model CAPM specifies the relationship between a security’s Module 2
(CAPM) systematic risk and its required return. (p.133)
Cash flow hedge A hedge under hedge accounting whereby the cash flow Module 7
changes of the derivative offset the cash flow changes of the (p.471)
underlying hedged item.
Collar A hedge arrangement that hedges either side of a specified Module 5
index, interest rate, asset price or currency rate; for example, (p.335)
if the current BBSW is 4 per cent, then the collar could hedge
above 5 per cent and below
3 per cent. A collar can be created by buying an out-of-the-
money call option and selling an out-of-the-money put option.
See ‘Range forward’.
Commercial options Commercial options are those that relate to commercial Module 4
contracts where there is a right to adjust the terms and (p.262)
conditions of that contract.
Commodity price risk The risk of a change in the price of a commodity, whether Module 6
used as an input or generated as an output. (p.417)
Compound derivative Is an option on an option. Module 4
(p.289)
Contango Describes the situation when the forward price of a Module 4
commodity exceeds the current spot price. (p.274)
,Convertible notes Debt instruments giving the holder the right to convert the Module 3
debt to a company’s ordinary shares at a future time, or to (p.189)
ask the company to refund the subscribed amount of funds.
If the right to convert is not exercised,
the notes are repaid in cash at face value on the maturity
date.
Converting preference Preference shares that enable conversion into ordinary Module 3
shares shares at a specified ratio or at a specified dollar value at a (p.195)
pre-specified future date.
Cumulative preference Preference shares that provide for preference shares to carry Module 3
shares a specified dividend rate. If any dividend is missed by the (p.195)
company in a particular period, that missed dividend is added
to the dividend that is payable in the next period.
Currency option The right but not the obligation to buy one currency for Module 1 (p.62)
another. Since the right to buy one currency for another is
the same as the right to sell that currency for the other, they
are typically described as follows: AUD call/ USD put.
Currency swap The spot sale or purchase of one currency for another, Module 6
combined with (p.377)
a simultaneous forward agreement to repurchase the agreed
currency amounts at a preset date and an agreement by the
counterparties to exchange the interest payments on their
swapped currencies. Also known as a cross-currency swap or
cross-currency interest rate swap
Current ratio Defined as Current assets / Current liabilities. This ratio is Module 2
utilised to determine whether an organisation is able to meet (p.106)
its short-term debt obligations.
Cyber risk Any risk of financial loss, disruption or damage to the Module 1 (p.50)
reputation of an organisation from some sort of failure of its
information technology systems.
Debenture Securities issued in exchange for a secured loan obtained Module 3
from an institution (or individual investors). In Australia, (p.175)
debentures normally carry a fixed interest rate, have a fixed
maturity date at which the face value is repaid, and are
secured by a fixed charge over a specific asset.
Debt A contractual obligation to deliver cash (or another financial Module 1 (p.22)
asset) to another entity. As opposed to ‘equity’, which is the
residual interest in the assets of the entity after deducting all
of its liabilities.
Debt defeasance The technique by which a debtor may be released from the Module 3
primary obligations for a debt. A legal defeasance means a (p.177)
defeasance in which the release of the debtor from the
primary obligation is either acknowledged formally by the
creditor or by a duly appointed trustee of the creditor,
or established by legal judgment.
Debt repurchase Where a company repurchases its own debt through open Module 3
market transactions. (p.177)
, Debt switch Agreement with holders of debt whereby they agree to the Module 3
early redemption of existing debentures and to receive (p.177)
alternative securities.
Delta Mathematically, delta is the rate of change of the value of a Module 4
derivative for a given change in the value of the underlying (p.268)
asset.
Depository receipts A security that trades like an ordinary share on a local Module 3
exchange and represents an economic interest in a foreign (p.182)
firm.
Derivative instrument A security or contract whose value is dependent on or Module 4
derived from the value of some underlying asset. The main (p.260)
classes of derivative instruments are forwards, futures,
options and swaps. Accounting standard IFRS 9 Financial
Instruments has a specific definition of a derivative being a
financial instrument with the following three characteristics:
1. its value changes in response to the change in a
specified interest rate, financial instrument price,
commodity price, foreign exchange rate, index of
prices or rates, credit rating or credit index, or other
variable (sometimes called the ‘underlying’)
2. it requires no initial net investment [...]
3. it is settled at a future date (‘Appendix A: Defined
terms’).
Discount securities Money market securities that are sold at a discount to face Module 3
value (e.g. bank bills, bills of exchange and promissory notes). (p.193)
Dividend reinvestment An arrangement with investors that allows the entity to Module 3
plans reinvest dividends into additional equity without the need to (p.188)
distribute cash.
Earnings at risk (EAR) Measures the quantity by which net income might change in Module 4
the event of an adverse change in assumed currency and/or (p.265)
interest rate or other key parameters. It is a risk
measurement technique which is closely linked with the
value at risk (VAR) calculations
Economic exposure An exposure that is known but is not yet quantified. Module 1 (p.49)
Embedded derivative Accounting term referring to a derivative embedded in a host Module 1 (p.62)
contract. See ‘Derivative instrument’.
Embedded option An option implicit in another instrument. Embedded Module 4
currency, commodity, equity and interest rate options have (p.260)
become commonplace in both the private and public debt
markets, as well as in trade contracts (e.g. price variation
clauses).
Equity The residual interest in the assets of the entity after Module 2
deducting all of its liabilities. As opposed to ‘debt’, which is a (p.128)
contractual obligation to deliver cash (or another financial
asset) to another entity.
Eurobond Fixed-interest bonds usually underwritten by a syndicate of Module 3
international investment banks and sold in countries outside (p.179)
Keyword Description Page Reference
Accounting rate of return Calculated as the average annual profit divided by the initial Module 3
(ARR) cash outlay. (p.201)
Adjusted present value An approach that assumes the project being considered is Module 3
(APV) financed using only equity, and discounts the after-tax (p.225)
operating cash flows at
the appropriate discount rate for the business. It then adjusts
this base net present value (NPV) for the valuation
implications of the financing side effects associated with the
project, which typically include the present value of interest
tax shields, flotation or capital raising costs, and the value of
subsidised financing.
Agreed price (strike price) The price that the option buyer pays or receives for the asset. Module 4
The agreed price is typically called the strike price or exercise (p.280)
price.
American depository A US dollar-denominated security that trades like a common Module 3
receipt (ADR) share on US exchanges. (p.182)
American style option An option that can be exercised at any point during its life Module 4
until expiry. See ‘Option’ and ‘European style option’. (p.285)
Amortising (re: structure of Used for derivatives where the notional principal decreases Module 7
derivative) over the life of the instrument in accordance with either a (p.483)
preset pattern or with an index of interest rates/mortgage
prepayment rates. Instruments that can be structured in this
way include caps, collars, floors, swaps and swaptions.
Annuity An annuity is a series of equal payments at regular intervals. Module 2
(p.129)
Arbitrage Instruments that have identical characteristics and so are Module 6
perfect substitutes should trade at the same price. If they do (p.394)
not, a risk-free profit can be generated by simultaneously
selling the higher-priced asset and buying
the lower-priced asset. Arbitrage is the identification and
exploitation of such price anomalies.
Asset-backed security A security that is supported by a pool of specified collateral, Module 3
typically in a trust structure. (p.175)
At-the-money The point at which an option’s strike price and the price of Module 4
the underlying asset are the same. See ‘In-the-money’ and (p.283)
‘Out-of-the-money’.
Backwardation Primarily used in commodity markets, backwardation is the Module 4
situation in which futures prices are lower than spot prices to (p.274)
produce a negatively sloped forward curve. See ‘Contango’.
Bank bill swap rate (BBSW) The bank bill rate published daily on Reuters Screen BBSW Module 3
page that is used as the Australian floating rate benchmark (p.173)
for most interest rate swaps and other interest rate
derivatives such as swaptions, caps, collars and floors.
For UK equivalent see ‘London Interbank Offered Rate
, (LIBOR)’.
Bank overdraft A form of bank lending whereby a customer can overdraw a Module 3
current account up to an agreed limit, which provides the (p.165)
customer with funding on a fluctuating basis. Typically used
to cover fluctuating working capital requirements.
Basis points This is a common term in financial transactions, especially in Module 2
respect of the spread being charged between the buy and (p.124)
sell quotes, or in terms of bank charges on foreign exchange
transactions.
One basis point is 0.0001 or 0.01 per cent, 100 basis points
equals 1 per cent. Banks often consider the impact of a basis
point change in a variable (index, FX or interest rate, etc.) on
the fair value of their positions.
Basis risk Basis risk is a risk associated with imperfect hedging using Module 4
derivatives. (p.268)
It arises through the difference between the asset whose
current price is
to be hedged and the price of the asset underlying the
derivative, and/or because of a mismatch between the
maturity date of the derivative used and the actual selling or
delivery date of the asset being hedged or its quality
or ‘grade’.
Basket A selection of stocks, indices, commodities, currencies or Module 4
interest rates that can either be traded as a unit in (p.285)
themselves or used as the underlying (i.e. underlying asset or
index, etc.) for a derivative product.
Beta (ß) This is a measure of the sensitivity of an asset’s return to an Module 2
underlying factor or index. It is most commonly used to refer (p.134)
to market beta where the underlying factor is the market.
The market’s beta is one (1), so returns on a security with a
beta of one will move in line with the market. If beta is
greater than one, the security will exaggerate market returns;
if it is less than one, it will under-reflect market moves. If
beta is negative, security and market returns move in
opposite directions.
Bill of exchange Commonly used to fund international trade or working Module 8
capital. An unconditional order in writing addressed by one (p.551)
person to another, signed by the person giving it, requiring
the person to whom it is addressed to pay on demand, or at a
fixed or determinable future time. The bill of exchange states
a fixed amount of money and is paid to the order of
a specified person or bearer. Commonly utilised as a source
of short-term funding.
Black–Scholes (Black– Developed by Fischer Black and Myron Scholes in 1973, this is Module 4
Scholes–Merton) model the classic modern option pricing model and the first general (p.288)
equilibrium solution for the valuation of options. The model
, provides a no-arbitrage value for European-style call options
on shares as a function of the share price, which is assumed
to follow a lognormal distribution. The model shows that, by
combining the underlying stock and a money market
instrument, a riskless hedge (the delta hedge) can always be
formed that exactly replicates the pay-off of the option to be
hedged. Robert Merton wrote an influential paper expanding
the understanding of the model, so it is also sometimes
known as the Black–Scholes–Merton option pricing model.
Black swan Describes an event that was unprecedented and unexpected Module 4
at the time the event occurred. They are considered rare, (p.260)
random and high-impact events.
Bond A form of long-term debt (as distinct from equity) finance. Module 2
The normal or ‘vanilla’ bond involves payment of a fixed (p.129)
amount (coupon) against the face value over a period of
years, or variable income (floating rate notes) where
payment is by reference to a benchmark rate, commonly the
bank bill swap rate (BBSW).
Bonus shares Ordinary shares that are issued by a company for no Module 3
consideration. They increase the number of ordinary shares (p.185)
on issue resulting in the price per share decreasing in direct
proportion to the number of bonus shares issued.
Call option An option to buy a pre-agreed amount of a specified Module 1 (p.62)
underlying asset at a predetermined price or rate. Buyers of
calls purchase the right to buy the underlying asset and
sellers are offering the obligation to sell the underlying asset.
Capital asset pricing model CAPM specifies the relationship between a security’s Module 2
(CAPM) systematic risk and its required return. (p.133)
Cash flow hedge A hedge under hedge accounting whereby the cash flow Module 7
changes of the derivative offset the cash flow changes of the (p.471)
underlying hedged item.
Collar A hedge arrangement that hedges either side of a specified Module 5
index, interest rate, asset price or currency rate; for example, (p.335)
if the current BBSW is 4 per cent, then the collar could hedge
above 5 per cent and below
3 per cent. A collar can be created by buying an out-of-the-
money call option and selling an out-of-the-money put option.
See ‘Range forward’.
Commercial options Commercial options are those that relate to commercial Module 4
contracts where there is a right to adjust the terms and (p.262)
conditions of that contract.
Commodity price risk The risk of a change in the price of a commodity, whether Module 6
used as an input or generated as an output. (p.417)
Compound derivative Is an option on an option. Module 4
(p.289)
Contango Describes the situation when the forward price of a Module 4
commodity exceeds the current spot price. (p.274)
,Convertible notes Debt instruments giving the holder the right to convert the Module 3
debt to a company’s ordinary shares at a future time, or to (p.189)
ask the company to refund the subscribed amount of funds.
If the right to convert is not exercised,
the notes are repaid in cash at face value on the maturity
date.
Converting preference Preference shares that enable conversion into ordinary Module 3
shares shares at a specified ratio or at a specified dollar value at a (p.195)
pre-specified future date.
Cumulative preference Preference shares that provide for preference shares to carry Module 3
shares a specified dividend rate. If any dividend is missed by the (p.195)
company in a particular period, that missed dividend is added
to the dividend that is payable in the next period.
Currency option The right but not the obligation to buy one currency for Module 1 (p.62)
another. Since the right to buy one currency for another is
the same as the right to sell that currency for the other, they
are typically described as follows: AUD call/ USD put.
Currency swap The spot sale or purchase of one currency for another, Module 6
combined with (p.377)
a simultaneous forward agreement to repurchase the agreed
currency amounts at a preset date and an agreement by the
counterparties to exchange the interest payments on their
swapped currencies. Also known as a cross-currency swap or
cross-currency interest rate swap
Current ratio Defined as Current assets / Current liabilities. This ratio is Module 2
utilised to determine whether an organisation is able to meet (p.106)
its short-term debt obligations.
Cyber risk Any risk of financial loss, disruption or damage to the Module 1 (p.50)
reputation of an organisation from some sort of failure of its
information technology systems.
Debenture Securities issued in exchange for a secured loan obtained Module 3
from an institution (or individual investors). In Australia, (p.175)
debentures normally carry a fixed interest rate, have a fixed
maturity date at which the face value is repaid, and are
secured by a fixed charge over a specific asset.
Debt A contractual obligation to deliver cash (or another financial Module 1 (p.22)
asset) to another entity. As opposed to ‘equity’, which is the
residual interest in the assets of the entity after deducting all
of its liabilities.
Debt defeasance The technique by which a debtor may be released from the Module 3
primary obligations for a debt. A legal defeasance means a (p.177)
defeasance in which the release of the debtor from the
primary obligation is either acknowledged formally by the
creditor or by a duly appointed trustee of the creditor,
or established by legal judgment.
Debt repurchase Where a company repurchases its own debt through open Module 3
market transactions. (p.177)
, Debt switch Agreement with holders of debt whereby they agree to the Module 3
early redemption of existing debentures and to receive (p.177)
alternative securities.
Delta Mathematically, delta is the rate of change of the value of a Module 4
derivative for a given change in the value of the underlying (p.268)
asset.
Depository receipts A security that trades like an ordinary share on a local Module 3
exchange and represents an economic interest in a foreign (p.182)
firm.
Derivative instrument A security or contract whose value is dependent on or Module 4
derived from the value of some underlying asset. The main (p.260)
classes of derivative instruments are forwards, futures,
options and swaps. Accounting standard IFRS 9 Financial
Instruments has a specific definition of a derivative being a
financial instrument with the following three characteristics:
1. its value changes in response to the change in a
specified interest rate, financial instrument price,
commodity price, foreign exchange rate, index of
prices or rates, credit rating or credit index, or other
variable (sometimes called the ‘underlying’)
2. it requires no initial net investment [...]
3. it is settled at a future date (‘Appendix A: Defined
terms’).
Discount securities Money market securities that are sold at a discount to face Module 3
value (e.g. bank bills, bills of exchange and promissory notes). (p.193)
Dividend reinvestment An arrangement with investors that allows the entity to Module 3
plans reinvest dividends into additional equity without the need to (p.188)
distribute cash.
Earnings at risk (EAR) Measures the quantity by which net income might change in Module 4
the event of an adverse change in assumed currency and/or (p.265)
interest rate or other key parameters. It is a risk
measurement technique which is closely linked with the
value at risk (VAR) calculations
Economic exposure An exposure that is known but is not yet quantified. Module 1 (p.49)
Embedded derivative Accounting term referring to a derivative embedded in a host Module 1 (p.62)
contract. See ‘Derivative instrument’.
Embedded option An option implicit in another instrument. Embedded Module 4
currency, commodity, equity and interest rate options have (p.260)
become commonplace in both the private and public debt
markets, as well as in trade contracts (e.g. price variation
clauses).
Equity The residual interest in the assets of the entity after Module 2
deducting all of its liabilities. As opposed to ‘debt’, which is a (p.128)
contractual obligation to deliver cash (or another financial
asset) to another entity.
Eurobond Fixed-interest bonds usually underwritten by a syndicate of Module 3
international investment banks and sold in countries outside (p.179)
