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10.1 Glossary of keywords

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Accrual period
Time interval between the payment of bond coupons or swap settlements.

American exercise style
Contract that can be exercised at any time during its life.

Trading strategy taking advantage of the price difference of two or more securities to make an immediate (risk free) profit.

Person who uses arbitrage as a trading strategy to make immediate (risk free) profits.

Something of value, a property owned by a person or a company.

Animal used as a symbol when the market prices are falling in an economic downturn.

Bid price
The price a potential buyer is willing to pay for a security.

Boundary conditions (natural / essential)
Conditions (usually justified by no-arbitrage arguments) that are imposed on the boundary of the domain where the solution of a differential equation is sought. Natural conditions are usually imposed through a surface term after partial integration; essential conditions are imposed explicitly in the linear system by replacing an equation by the condition.

Individual who buys and sells goods for other persons.

Animal used as a symbol when the market prices are rising in an economic upturn.

Call option
Security giving its holder the right and no obligation to buy an underlying asset.

Collection of caplets maturing at different times.

Interest rate option providing for an upper limit on the interest rate; a caplet entitles the holder to the difference between the spot rate and the strike if this is positive, or zero otherwise.

Amount of money that is invested or used to start a business.

Capital gain
Amount of cash raised by the original owners who sell shares in the initial public offering (IPO) of a company.

Capital asset pricing model (CAPM)
Linear fit measuring the relative performance of a portfolio in comparison with a market index average.

Economic system in which a country's business and industry is controlled and run for profit by private owners.

Clearing margin
A margin deposit by a member of a clearing house (e.g. a broker) that guarantees the performance of all the parties in a financial transaction.

Interest rate option combining a cap and a floor used as an insurance to guarantee that the interest rates remain within a certain interval.

Part of a cost that is proportional to the total value of a trade.

Contingent claims
A demand that can be made only if one or more specified outcomes occur.

Predetermined amount of cash payed as an interest during the life of a bond.

A written option is covered if the writer also has an opposing market position on a share-for-share basis in the underlying security.

Delivery date
The date when a forward or futures contract ends with an amount of cash payed in exchange for the underlying asset.

Delivery price
Amount of cash in a forward contract that will be payed on the maturity date in exchange of the underlying asset.

Financial instrument whose value is derived from another asset.

Which can be predicted with certainty from the past.

Amount below the par value; difference between a bond principal and the present value.

Discount bond
Zero coupon bond.

Discount factor
Present value of EUR 1 received some time in the future.

Discount function
Function measuring the present value of one unit due at a later time.

Distribution (log-normal)
Function measuring the probability density of an event using a log-normal law; incremental changes of stock prices are almost log-normally distributed.

Distribution (normal)
Function measuring the probability density of an event using the famous bell-shaped curve; incremental changes of bond prices are sometimes normally distributed.

Dividing the investment into a variety of securities.

Portion of a company's profits payed out in cash to the shareholders.

Slow systematic movement in the same direction.

Efficient market
Economy in which prices immediately and fully reflect all relevant information.

Efficient frontier
In the modern portfolio theory, it is the locus of all the portfolios where the highest possible return is achieved after reducing the specific risk through diversification.

Person who tries to make money by starting or running a business, especially when this involves taking a financial risk.

Equilibrium swap rate
Fixed coupon making the swap worthless when it is initially issued.

European exercise style
Contract that can be exercised only at the expiry date.

Exercise an option
Use the right to exchange the underlying for a fixed amount of cash.

Exercise (or strike) price
The price at which the underlying may be bought or sold.

Exotic option
Option that is not plain vanilla and is generally not traded on an exchange.

Expected value
Average value obtained by weighting possible realizations by their probabilities.

Expiry time
Date when an option contract ends.

Face (or principal) value
Amount of cash an issuer (borrower) agrees to pay at the maturity.

Fannie Mae
US government-sponsored federal national mortgage association.

Part of a cost that does not depend on the total value of a trade.

Fixed income instruments
Bonds and preferred stock that pay a predetermined amount of cash.

Fixed interest rate
Predetermined return on investment of a bond, which remains independent of the market spot rate.

Fixed leg (of a swap)
Part of the contract involving payments that are predetermined (risk-free) and remain independent of the spot rate.

Floating leg (of a swap)
Part of the contract involving payments that depend on the spot rate and therefore carry a financial risk.

Collection of floorlets maturing at different times.

Interest rate option providing for a lower limit on the interest rate; it entitles the holder to the difference between the strike and the spot rate if this is positive, or zero otherwise.

Forward rate
Interest $ F(t,T_1,T_2)$ payed today at time $ t$ for a loan with a specified maturity $ T_2$ and starting at some point in the future $ T_1$ , where $ t<T_1<T_2$ .

Forward rate agreement (FRA)
Agreement to borrow or lend an amount of cash some time in the future at an interest rate that is fixed today.

Forward contracts
Agreement between a buyer and a seller to exchange certain goods for a fixed price some time in the future.

Forward price
The delivery price in a forward contract chosen so as to make it worthless.

Freddie Mac
US government-sponsored federal home mortgage loan corporation.

Futures contract
Special type of standardized forward contract enabling anonymous trades on an exchange with a protection against defaults through a clearing margin.

Strategy increasing the return of portfolio by increasing the investment risk.

Gross domestic product (GDP)
Total value of goods and services produced by a country.

Go long
Purchase an asset in exchange of cash.

Go (or sell) short
Sell an asset that has been borrowed from another investor.

Person who buys securities to reduce the investment risk in a portfolio.

Strategy reducing the investment risk of a portfolio at the expense of smaller returns.

The purchaser of an option.

Implied volatility
Volatility of an underlying asset, as measured from the price of derivatives assuming a standard pricing model.

Subset of an option series that has a finite intrinsic value that is payed out to the holder at the expiry.

Initial / Terminal conditions
Value of a function of time that is known at the beginning of a calculation.

Initial public offering (IPO)
First sale of a company's shares to the public.

Intrinsic value
The value of an option if it would expire with the underlying at its current price.

Person or organization that buys property in the hope of making a profit.

Money used to realize a project in the hope of making a profit.

Itô's lemma
Mathematical formula relating the differential of a stochastic function to differential of its stochastic arguments.

London inter bank offered rate (LIBOR)
The rate of interest that major international banks in London charge each other for borrowings.

Occasion when people buy and sell goods.

Market maker
Person who's job it is to determine a fair price of a certain asset and to help buyers and sellers exchange that over-the-counter outside the market.

Market price of risk
Parameter measuring how much the investors are risk seeking or risk averse.

Market value
Spot price obtained via offer and demand from sellers and buyers on the market.

Markov process
Stochastic process where consecutive increments are independent from the past.


Maturity date
The end of the life of a contract.

Maximum likelyhood estimation
Statistical method built so as to maximize the chance that a model fits a given dataset.

Mean reversion
Tendency of a quantity to evolve towards a long term average.

Modern Portfolio Theory (MPT)
Description of rational investment choices based on risk-return trade-offs and efficient diversification.

Monte-Carlo simulation
Computer calculation performed with a crowd of random walkers to statistically sample the evolution of market prices by adding small increments.

Net asset Value (NAV)
Total value of the fund's investment.

Notional principal
The amount of cash used to calculate the payments in an interest rate swap; the principal is ``notional'' because it is never really exchanged.

Numeraire asset
Arbitrary asset chosen to measure the relative performance of an investment in dimensionless units.

Offer price
The price a seller is asking in exchange for a security.

Open-end fund
Mutual fund where the holdings are continually reinvested and new shares are created on demand.

Security giving its holder a right, but not the obligation, to buy or sell an asset at a set price on or before a given date.

Option class
Options having the same underlying and the same type of contract (put, call, etc).

Option series
Option from the same class having the same exercise price and expiry date.

Subset of an option series that has no intrinsic value and expires worthless.

Over-the-counter (OTC)
Non-standard exchange of goods carried out between two parties outside the market, generally without disclosing the price to the public.

Equal to the principalkeywd:principal or face value of a security.

Parameters: financial / numerical
Financial parameters entirely specify the problem; numerical parameters only serve to control the calculation and should never affect the result.

Path dependent option
Option with a payoff depending on the price history of the underlying.

Set of shares and financial instruments held by a person or an organization.

Possible realizations
Outcomes of a random variable that have a finite probability to occur.

Amount that is in excess of the par value, i.e. the positive difference between the present value and the nominal principal value.

Principal (or face) value
Amount of cash an issuer (borrower) agrees to pay at the maturity.

Principal components
Partly uncorrelated random varialbles that can explain most of the statistical observations from the markets.

Measure of the likelihood that something will occur.

Put-call parity
Relation between the price of vanilla options with the same strike price and expiry.

Put option
Security giving its holder the right and no obligation to sell an underlying asset.

Which cannot be predicted with certainty from the past.

Redemption date
Date when a debt security is has to be payed back, marking the end of the lifetime of a bond.

Random walk
Unpredictable motion resulting from increments that are generally assumed to be independent of the past (Markov property).

Reset and payment times
Beginning and end of the time interval (accrual period) between the payment of coupons in a bond or the exchange of interest payments in a swap.

The possibility of something bad happening sometime in the future.

Risk premium
Reward the investors ask for taking a larger investment risk.

Document proving that somebody is the owner of certain goods or has a right to acquire them in the future.

Graph with a minimum implied volatility for an underlying at-the-money.

Specific risk
The uncertain outcome of an investment can be divided in specific and non-specific risks. Specific risk can entirely be eliminated through combination of anti-correlated assets and diversification; non-specific risk affects the entire market.

Person who buys and sells goods in the hope of making a profit from his view on the evolution of the market.

When a growing company emits new shares to reduce the price quoted in the market. In a 2-for-1 split, 2 new shares are exchanged for every share that was previously owned.

The value for immediate delivery.

Something that includes an unpredictable random component.

Strike (or exercise) price
The price at which the underlying may be bought or sold.

In the Middle Ages, the suzerain was a person who owned the right over another (called the vassal) who promised to fight and be loyal in return for being given land to live on.

Swap (of interest rates, currency exchange rates, etc)
Contract whereby two parties agree to exchange, at known dates in the future, a fixed for a floating set of rates without ever exchanging the principal.

Tenor of a bond
Time interval between the payment of consecutive coupons.

Term structure of interest rates
Interest rates calculated for bonds of different maturities.

Time value
Difference between the intrinsic value and the value of an option before it expires.

Transaction costs
The cost of carrying out a trade (fees, commissions, plus the difference between the price obtained and the middle of the bid-offer prices quoted on the market).

Treasury rate
Interest rate payed by the central bank responsible for a given currency.

Method to approximate a dynamical system by recursively adding / subtracting a fixed number of increments to all the possible outcomes.

Security that parties agree to exchange under conditions in a derivative contract.

Simplest form of a contract.

Venture capital
High risk investment given in return for a participation in the control and the future earnings of a start-up company that develops a new product.

A measure of the uncertainty of the price of an asset.

Wiener process
Markov process where the increments are normally distributed with zero mean and a variance proportional to the time step.

The seller of an option, usually a large financial institution.

Zero-coupon bond
A bond without coupon, where the principal and the interest are paid at the maturity date.

Zero-sum game
Game where the earning from one player exactly equals the loss from another.

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