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Home arrow Business & Finance arrow Frequently Asked Questions in Quantitative Finance

LIBOR

London Interbank Offered Rate. An interest rate at which banks offer to lend funds to other banks in the London wholesale money market. It is quoted at different maturities.

Being a standard reference rate it is often the underlying interest rate in OTC fixed-income contracts.

Market maker

Someone who gives prices at which he will buy or sell instruments, in the hope of making a profit on the difference between the bid and offer prices. They are said to add liquidity to the market.

MBS

A Mortgage Backed Security is a pool of mortgages that have been securitized. See page 477.

Mean reversion

The returning of a quantity to an average level. This is a feature of many popular interest rate and volatility models, which may exhibit randomness but never stray too far from some mean.

Monte Carlo

A name given to many methods for solving mathematical problems using simulations. The link between a probabilistic concept, such as an average, and simulations is clear. There may also be links between a deterministic problem and a simulation. For example, you can estimate n by throwing darts at a square, uniformly distributed, and counting how many land inside the inscribed circle. It should be n/4of the number thrown. To get six decimal places of accuracy in n you would have to throw approximately 1012 darts, this is the downside of Monte Carlo methods, they can be slow.

Normal distribution

A probability distribution commonly used to model financial quantities. See page 219.

PDE

Partial differential equation, as its name suggest an equation (there must be an 'equals' sign), involving derivatives with respect to two or more variables. In finance almost all PDEs are of a type known as parabolic, this includes the famous heat or diffusion equation. See page 22.

Quantlib

Definition taken from quantlib.org: 'QuantLib is a free/open-source library for modelling, trading, and risk management in real-life.'

Quanto

Any contract in which cash flows are calculated from an underlying in one currency and then converted to payment in another currency. See page 479.

Regression

Relating a dependent and one or more independent variables by a relatively simple function.

Risk

The possibility of a monetary loss associated with investments. See page 38.

Risk neutral

Indifferent to risk in the sense that a return in excess of the risk-free rate is not required by a risk-neutral investor who takes risks. To price derivatives one can imagine oneself in a world in which investors are risk neutral. Options are then priced to be consistent with the market prices of the underlying and future states of the world. This is because the risk premium on the stock is already incorporated into its current price, and the price of risk for the option and its underlying should be the same. Working in a risk-neutral world is a shortcut to that result. See page 109.

SABR

An interest rate model, by Pat Hagan, Deep Kumar, Andrew Lesniewski and Diane Woodward, that exploits asymptotic analysis to make an otherwise intractable problem relatively easy to manage. See page 446.

Skew

The slope of the graph of implied volatility versus strike. A negative skew, that is a downward slope going from left to right, is common in equity options.

Smile

The upward curving shape of the graph of implied volatility versus strike. A downward curving profile would be a frown.

Sobol'

A Russian mathematician responsible for much of the important breakthroughs in low-discrepancy sequences, now commonly used for simulations in finance. See page 240 and broda.co.uk.

Stochastic

Random. The branch of mathematics involving the random evolution of quantities usually in continuous time commonly associated with models of the financial markets and derivatives. To be contrasted with deterministic.

Structured products

Contracts designed to meet the specific investment criteria of a client, in terms of market view, risk and return.

Swap

A general term for an over-the-counter contract in which there are exchanges of cash flows between two parties. See page 492.

Swaptions

An option on a swap. They are commonly Bermudan exercise. See page 480.

VaR Value at Risk, an estimate of the potential downside from one's investments. See pages 42 and 52.

Variance swap

A contract in which there is an exchange of the realized variance over a specified period and a fixed amount. See page 482.

Volatility

The annualized standard deviation of returns of an asset. The most important quantity in derivatives pricing. Difficult to estimate and forecast, there are many competing models for the behaviour of volatility. See page 162.

Yield curve

A graph of yields to maturity versus maturity (or duration). Therefore a way of visualizing how interest rates change with time. Each traded bond has its own point on the curve.

Esoterica

And finally, some rather more exotic word or phrase searches, without any descriptions:

Art of War; Atlas Shrugged; Background check; Bloodshed; Bonus; Deal or no deal; Death; Depression; Drug test; Female; Gay; How to impress; James Bond; Lawsuit; Lonely; Sex; Suit; Test; The; Too old

From this final list one should be able to build up a personality profile of the typical quant.

 
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