Derivatives Glossary

Backwardation: A market where future prices of distant contract months are lower than the near months.
Basis: The difference between the Index and the respective contract is the basis i.e. cash netted  for the Futures price. A negative basis means Futures are at a premium to cash and vice versa. It is the  strengthening and weakening of basis that is tracked by market players i.e. whether the basis is widening or narrowing. A widening of basis is indicative of increasing longs and narrowing means increasing short positions.
Basis Point: It is equal to one hundredth of a percentage point
Contango market: This is a market where futures prices are higher for distant contracts than for nearby delivery months.
Cost of carry: is an indicator of the demand-supply forces in the Futures market. It basically means the annualized interest cost players decide to pay (receive) for buying (selling) a respective contract. A higher carry cost is indicative of buying pressure and vice versa. Carry Cost is a widely used parameter not only because it is more interpretable being an annualized figure, as compared to basis (Cash netted for Futures) but also because it works well with the trio of Price, Volume and Open Interest in highlighting the market trend.
Delivery month: Is the month in which delivery of futures contracts need to be made.
Delivery price: The price fixed by the clearinghouse at which deliveries on futures contracts are invoiced. Also known as the expiry price or the settlement price.
Derivative: A financial instrument designed to replicate an underlying security for the purpose of transferring risk.
Fair value: Theoretical value of a futures contract derived from a mathematical model of valuation.
Hedge Ratio: The Hedge Ratio is defined as the number of Futures contracts required to buy or sell so as to provide the maximum offset of risk. This depends on the

• Value of a Futures contract;
• Value of the portfolio to be Hedged; and
• Sensitivity of the movement of the portfolio price to that of the Index (Called Beta).

The Hedge Ratio is closely linked to the correlation between the asset (portfolio of shares) to be hedged and underlying (index) from which Future is derived.
Initial margin: The money a customer needs to pay as deposit to establish a position in the futures market. The basic aim of Initial margin is to cover the largest potential loss in one day.
Mark-to-market: The daily revaluation of open positions to reflect profits and losses based on closing market prices at the end of the trading day.
Forward contract: In a forward contract, two parties agree to do a trade at some future date, at a stated price and quantity. No money changes hands at the time the deal is signed.
Futures contract: A futures contract is similar to a forward contract in terms of its working. The difference is that contracts are standardized and trading is centralized. Futures markets are highly liquid and there is no counterparty risk due to the presence of a clearinghouse, which becomes the counterparty to both sides of each transaction and guarantees the trade.
Far contract: The future that is furthest from its delivery month i. e. has the longest maturity.
Speculation: Trading on anticipated price changes, where the trader does not hold another position which will offset any such price movements.
Spread ratio: The number of futures contracts bought, divided by the number of futures contracts sold.
VaR: Value at Risk. A risk management methodology, which attempts to measure the maximum loss possible on a particular position, with a specified level of certainty or confidence.
Strike Price: The price at which an option holder may buy or sell the underlying asset, which is specified in an option contract

Benjamin Graham 's Formula

I - WHAT IS GRAHAM'S FORMULA ?

Benjamin Graham describes a formula he used to value stocks in the 11th chapter of the “Intelligent Investor”:

"Most of the writing of security analysts on formal appraisals relates to the valuation of growth stocks. Our study of the various methods has led us to suggest a foreshortened and quite simple formula for the valuation of growth stocks, which is intended to produce figures fairly close to those resulting from the more refined mathematical calculations.

Our formula is :

Intrinsic Value = Current Earnings x (8.5 + 2 x Expected Annual Growth Rate)

The growth figure should be that expected over the next seven to ten years."

Example n°1 : A stock is trading at 120$. Its current earnings are 8$ per share. The annual growth rate over the next 7 to 10 years should be around 7%. The Intrinsic Value is = 8 *( 8.5 + 2 * 7) = 180 $. The Margin of Safety is : (180 - 120) / 180 = 33%.

Example n°2 : the same stock is still trading at 120$, but its earnings are revised to 9$ per share and the annual long term growth rate should now be around 8%. The Intrinsic Value becomes = 9 *( 8.5 + 2 * 8) = 220.5. The Margin of Safety is : (220.5 - 120) / 220.5 = 56%.

Example n°3 : the same stock is trading at 120$, its earnings are 5.5$ per share, the annual growth rate around 6.5%.
The Intrinsic Value is = 5.5 *( 8.5 + 2 * 6.5) = 118. The Margin of Safety is : (118 - 120) / 118 = -1%.

A - A FEW IMPLICATIONS OF GRAHAM'S FORMULA
If we assume that Intrinsic Value = Price, then Graham's Formula is equivalent to : Price / Earnings = 8.5 + 2 x G.

1 - Price Earning Ratio (P/E) as a function of future growth (G)

In other words, the P/E for a no-growth company (G = 0) should be around 8.5.

2 - Implicit Growth derived from price and earnings.

From the fomula above, a P/E can be linked to G this way : G = (P/E - 8.5) / 2.