HREF="sec10.html">10 APPENDIX
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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.

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

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

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

**Bear**
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.

**Broker**
Individual who buys and sells goods for other persons.

**Bull**
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.

**Cap**
Collection of *caplets* maturing at different
times.

**Caplet**
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.

**Capital**
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.

**Capitalism**
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.

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

**Commission**
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.

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

**Covered**
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*.

**Derivative**
Financial instrument whose value is derived from another asset.

**Deterministic**
Which can be predicted with certainty from the past.

**Discount**
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.

**Diversification**
Dividing the investment into a variety of securities.

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

**Drift**
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.

**Entrepreneur**
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.

**Fee**
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.

**Floor**
Collection of *floorlets* maturing at different
times.

**Floorlet**
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
payed today at time
for a loan with a specified
maturity
and starting at some point in the future
, where
.

**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*.

**Gearing**
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.

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

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

**Holder**
The purchaser of an option.

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

**In-the-money**
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.

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

**Investment**
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.

**Market**
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.

**Martingales**

**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.

**Option**
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.

**Out-of-the-money**
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.

**Par**
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.

**Portfolio**
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.

**Premium**
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.

**Probability**
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.

**Random**
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.

**Risk**
The possibility of something bad happening sometime in the future.

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

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

**Smile**
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.

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

**Split**
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.

**Spot**
The value for immediate delivery.

**Stochastic**
Something that includes an unpredictable random component.

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

**Suzerain**
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.

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

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

**Vanilla**
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.

**Volatility**
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.

**Writer**
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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