Chapter 6

An absolute pricing model attempts to describe a price level based on its underlying economic factors.

Arbitrage is the attempt to earn riskless profits (in excess of the risk-free rate) by identifying and trading relatively mispriced assets.

An arbitrage-free model is a financial model with relationships derived by the assumption that arbitrage opportunities do not exist, or at least do not persist.

An asset pricing model is a framework for specifying the return or price of an asset based on its risk, as well as future cash flows and payoffs.

An option combination in which the long option position is at the higher of two strike prices is a bear spread, which offers bearish exposure to the underlying asset that begins at the higher strike price and ends at the lower strike price.

A binomial tree model projects possible outcomes in a variable by modeling uncertainty as two movements: an upward movement and a downward movement.

Black-Scholes call option formular expresses the price of a call option as a function of five variables: the price of the underlying asset, the strike price, the return volatility of the underlying asset, the time to the option's expiration, and the riskless rate.

An option combination in which the long option position is at lower of two strikes prices is a bull spread, which offers bullish exposure to the underlying asset that begins at the lower strike price and ends at the higher strike price.

The capital asset pricing model (CAPM) provides one of the easiest and most widely understood examples of single-factor asset pricing by demonstrating that the risk overall market index is the only risk that offers a risk premium.

The carrying cost is the cost of maintaining a position through time and includes direct costs, such as storage or custody costs, as well as opportunity costs, such as forgone cash flows.

The spot market or cash market is any market in which transactions involve immediate payments and delivery: The buyer immediately pays the price, and the seller immediately delivers the product.

A collar generally refers to a long position in an asset combined with a short call option and a long put option on that asset, in which the call option has a higher strike price than the put option.

A cost-of-carry model specifies a relationship between two positions that must exist if the only difference between the positions involves the expense of maintaining the positions.

A covered call combines being long an asset with being short a call option on the same asset.

An elasticity is the percentage change in a value with respect to a percentage change in another value.

An empirical model is derived from observation. An example would be a model that recognizes that the returns of some traditional assets are correlated with their market-to-book ratios.

Ex ante models, such as ex ante asset pricing models, explain expected relationships, such as expected returns. Ex ante means "from before".

An ex post model describes realized returns and provides an understanding of risk and how it relates to the deviations of realized returns expected returns.

The excess return of an asset refers to the excess or deficiency of the asset's return relative to the periodic risk-free rate.

The Fama-French model links the returns of assets to three factors: (1) the market portfolio, (2) a factor representing a value versus growth effect, and (3) a factor representing a small-cap versus large-cap effect.

The Fama-French-Carhart model adds a fourth factor to the Fama-French model: momentum.

Financed positions enable economic ownership of an asset without the posting of the purchase price.

A forward contract is simply an agreement calling for deferred delivery of an asset or a payoff.

Idiosyncratic return is the portion of an asset's return that is unique to an investment and not driven by a common association.

Idiosyncratic risk is the dispersion in economic outcomes caused by investment-specific effects. This section focuses on realized returns and the modeling of risk.

Informational market efficiency refers to the extent to which asset prices reflect available information.

Lambda or omega for a call option is the elasticity of an option price with respect to the price of the underlying asset and is equal to delta multiplied times the quantity (S/c).

The market portfolio is a hypothetical portfolio containing all tradable assets in the world.

The market weight of an asset is the proportion of the total value of that asset to the total value of all assets in the market portfolio.

Multifactor models of asset pricing express systematic risk using multiple factors and are extremely popular throughout traditional and alternative investing.

A short option position that is unhedged is often referred to as a naked option.

Lambda or omega for a call option is the elasticity of an option price with respect to the price of the underlying asset and is equal to delta multiplied times the quantity (S/c).

Omicron is the partial derivative of an option or a position containing an option to a change in the credit spread and is useful for analyzing option positions on credit-risky assets.

An option collar generally refers only to the long position in a put and a short position in a call.

An option combination contains both calls and puts on the same underlying asset.

An option spread (1) contains either call options or put options (not both), and (2) contains both, long and short positions on options with the same underlying asset.

An option straddle is a position in a call and put with the same sign (i.e., long or short), the same underlying asset, the same expiration date, and the same strike price.

An option strangle is a position in a call and put with the same sign, the same underlying expiration date, but different strike prices.

A protective put combines being long an asset with a long position in a put option on the same asset.

Put-call parity is an arbitrage-free relationship among the values of an asset, a riskless bond, a call option, and a put option.

A relative pricing model prescribes the relationship between two prices.

Rho is the sensitivity of an option price with respect to changes in the riskless interest rate.

A long out-of-the-money call combined with a short out-of-the-money put on the same asset and with the same expiration date is termed a risk reversal.

The concept of semistrong form informational market efficiency (or semistrong level) refers to market prices reflecting all publicly available information (including not only past prices and volumes but also any publicly available information such as financial statements and other underlying economic data).

A single-factor asset pricing model explains returns and systematic risk using a single risk factor.

The spot market or cash market is any market in which transactions involve immediate payments and delivery: The buyer immediately pays the price, and the seller immediately delivers the product.

The concept of strong form informational market efficiency (or strong level) refers to market prices reflecting all publicly and privately available information.

Systematic return is the portion of an asset's return driven by a common association.

Systematic risk is the dispersion in economic outcomes caused by variation in systematic return.

The Term structure of forward contracts is the relationship between forward prices (or forward rates) and the time to delivery of the forward contract.

In a theoretical model, the factors are derived from reasoning based on known facts and relationship.

A tradable asset is a position that can be readily established and liquidated in the financial market, such as a stock position, a bond position, or a portfolio of liquid positions.

Weak form informational market efficiency (or weak level) refers to market prices reflecting available data on past prices and volumes.