# Tag Info

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The risk-neutral measure $\mathbb{Q}$ is a mathematical construct which stems from the law of one price, also known as the principle of no riskless arbitrage and which you may already have heard of in the following terms: "there is no free lunch in financial markets". This law is at the heart of securities' relative valuation, see this very nice paper by ...

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I feel that the best way to answer your question is to first quote your problematic idea and then carefully explain the subtle alternative. :) The derivation of the Black-Scholes PDE is based on the assumption that the price of the option should change in time in such a way that ... And my question is: Why do we assume that the price of the option has ...

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This is a basic fact about futures trading and the storage of commodities. The phrase that was used by futures traders in the old days (and probably still today) was "the contango is limited by the carrying cost, there is no limit to the backwardation". This means that for example if spot gold is at 1200, gold dated one year from now cannot possibly sell ...

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Market makers, obviously, have to be willing to short an option. They will delta hedge their positions to limit risk. As for investors, they can aim for a buy-write strategy to collect extra income in lieu of unlimited upside. And lastly, someone who owns a stock he can't sell right away (such as an entrepreneur still under a vesting period after his firm ...

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FO is shrinking across the large investment banks. The market is not developing new products that will need new pricing formulas, if anything it is reverting to more vanilla structures. Nowdays FO quants typically hack existing models around the corners to manage new market conditions (change Sabr a bit to deal with negative rates, refine the treatment of ...

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Although quite simple connected scatterplots can give interesting new insights on how time series perform together: http://steveharoz.com/research/connected_scatterplot/ As an example: Gold vs. S&P 500 from 1970 till today: The green point marks 1970, the red point is today. Every point is a year, moving vertically upwards means rise in the S&P ...

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You may want to consider splitting two important, yet very different concepts: Pricing a derivative security with contingent payoff and forecasting an asset. Pricing a derivative can be achieved through setting up a hedge portfolio and track its evolution and "value" at any point in time before the derivative security pays off. Risk-neutral pricing is a ...

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And then music... Victor Neiderhoffer, in a 2001 interview: The market plays music all the time. The problem is you never know how the music of the market is going to end. But a good framework is that it will end on the tonic. Consonance to dissonance back to consonance. And whenever there's tremendous dissonance, strident moves in one direction, a good ...

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Just take something like $$\frac{\log{\frac{F_j}{F_i}}}{t_j - t_i} \times 365$$ where $t_i$ denotes the expiry (or alternatively delivery) date of future $i$. The annualization is so you can compare different futures.

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The SABR model has an overly fat right tail. If you do the CMS replication using cash-settled swaptions you find that you need ridiculously high strikes.

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A swap does not require a model because its price can be derived from the yield curve without any assumptions about how the yield curve may move in the future. The PFE however is an indication of by how much the swap's mark-to-market may move between now and a moment in the future. It is of course influenced by how volatile rates are. The more volatile ...

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To me, coloring by data value is a great way to bring applications alive. If traditional ways are not enough, probably taking 3D in use would be a way: And of course 2D heatmap is a very handy for sure. I'm developing data visualization software components with 3D technologies, so definitely all feedback and ideas are welcome :-)

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I will refer to "Interest Rate Models - Theory and Practice: With Smile, Inflation and Credit" by Damiano Brigo and Fabio Mercurio. In chapter 3 (One-factor short-rate models) they have a very nice table which lists some of the properties of instantaneous short rate models. In both of your models you know the distribution of $r_t$. The huge difference ...

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The interviewer meant that he's smart. Quoting Senior VP of People operations at Google, On the hiring side, we found that brainteasers are a complete waste of time. How many golf balls can you fit into an airplane? How many gas stations in Manhattan? A complete waste of time. They don’t predict anything. They serve primarily to make the interviewer ...

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The CMS represents the value of a swap rate for any point in time, i.e. we are interested in extrapolating the density of the swap rate in a similar way as the IBOR rate. Let us start with the fair value of a swaption under the annuity measure $\mathcal{A}$ with tenor at time $\tau$: $$\mathcal{A}(t)\mathbb{E}^\mathcal{A}_t[(\mathcal{S}(\tau)-k)^+]$$ Instead ...

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The piece you are missing is an approximation via the Taylor formula of the logarithm: $$\ln(1+x) \approx x-\frac{x^2}{2} \; .$$ Apply this to the first term in the final formula of the technical paper: \frac{2}{T}\ln\frac{F_{0}}{S^{*}} = \frac{2}{T}\ln\left(1+\left(\frac{F_{0}}{S^{*}}-1\right)\right) \approx \frac{2}{T}\left(\left(\frac{F_{0}}{S^{*}}-1\... 7 Futures are in "zero net supply", or "for every long there is a short", which means that at any time there are investors who are long a certain number of contracts and other investors who are short an (exactly matching!) number of contracts. This number is called the Open Interest. It starts at zero when the exchange introduces a new contract (like Sep 2019 ... 6 Specifically, we have a generic conditional claim, C, that is a function of the diffusion process for the underlying, S(t), and time t so C = C(S(t), t). As you pointed out, C is an Ito process becuase it is a function of a stochastic process so we use Ito's Lemma to determine how the contingent claim varies as a function of the diffusion process ... 6 Let P be the risk-neutral measure. We define the measure P_S such that \begin{align*} \frac{dP_S}{dP}\big|_t &=\frac{S_t}{e^{rt}S_0}\\ &=e^{-\frac{1}{2}\sigma^2 t+\sigma W_t}. \end{align*} Then \{\widehat{W}_t \mid t \ge 0\}, where \begin{align*} \widehat{W}_t = W_t -\sigma t, \end{align*} is a standard Brownian motion under the measure P_S. ... 6 It is incorrect to use 1m euribor or O/N euribor in a 6m Euribor forward curve. You should only use instruments based on 6M euribor, such as 1x7 FRA, 6x12 FRA or swaps v 6m Euribor, as you have done in your second example. The actual 6m euribor fixing itself can be thought of as a 0x6 FRA out of spot. Before the financial crisis basis between different ... 6 A general hedging strategy Let assume that S_1(t) and S_2(t) are the price processes of your 2 stocks and that they follow a Geometric Brownian Motion (GBM):\forall \, i \in \{1,2\}, dS_i(t) =\mu_iS_i(t)dt + \sigma_iS_i(t)dW_i(t)$$We assume both stocks have an instant correlation of \rho:$$dW_1(t)dW_2(t)=\rho dt Let also $V(t)$ be the value ...

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If you plot the function $f$, you see that you have a bear spread. You can build such vertical spreads either with call or put options. For example consider a portfolio selling one put option with strike price $K_1=30$ and purchasing one European-style put option with strike price $K_2=35$. Then, you obtain the payoff \begin{align*} \max\{35-S_T,0\}-\max\{30-...

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The answer to your first four questions is affirmative. Option-adjusting the spread makes an equivalence between everything theoretically possible, but the quality of results depends significantly on the quality of your interest rate model and its calibration. My personal opinion, though, is that the results need to be treated carefully because the OAS ...

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As a complement to chrisaycock's answer, I would also say that shorting options is useful when you want to create option strategies. Buying and shorting options on the same underlying with different strike prices allows the investor to create products with elaborate payoff which allows them to be more on a range of the underlying's price rather than on its ...

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The common approach to temperature derivatives in their first run of popularity (in the late 1990's) was to use an Ornstein-Uhlenbeck process to describe deviations of temperature from a seasonal average. So far as I know, no major innovations have arisen since then. Calibrating such a model is very simple, and so is valuing certain quantities such as ...

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This is indeed one of the most difficult tasks to do (if not next to impossible). I would say the standard reference is the following: Expected Returns: An Investor's Guide to Harvesting Market Rewards by Antti Ilmanen An abridged (but still about 170 pages long), yet more current - and free (!) version in different formats (pdf, mobi for the Kindle and ...

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First of all, I must say that it's a very general question, and the answer can vary depending on type of assets you model. In quant finance real world probabilities are generally used for risk management. It can be said, that in order to use real-world probabilities you have to calibrate your models to history. In order to obtain risk-neutral probabilities, ...

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Try to give David Spiegelhalter a read/listen to David Spiegelhalter's work and research. He is a statistician and a Professor of the Public Understanding of Risk at Cambridge England. Rather than new ways of calculating risk, he looks at ways of communicating risk to a general public that doesn't have any knowledge of stats. I Linked an interesting video-...

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What do you mean by "so we can price as usual"? What you showed is that for every $c \in \mathbb R$ we can find a probability measure such that the drift of $S$ is $c$. But that does not really say anything about pricing. You can easily see that $V_t = E^Q_t[e^{-r(T-t)} \Phi_T]$ does not give arbitrage free prices with your choice of $Q$. Indeed if \$\Phi_T ...

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