Arbitrage - The simultaneous purchase and sale of an asset in order to profit from a difference

in the price. It is a trade that profits by exploiting price differences of identical or similar
financial instruments, on different markets or in different forms. Arbitrage exists as a
result of market inefficiencies; it provides a mechanism to ensure prices do not deviate
substantially from fair value for long periods of time.

Bull spread -

Bear spread -

Cross hedging – Occurs when the two assets being hedged are different. For example, using
heating oil futures to hedge exposure to jet fuel. Hedge ratio is the ratio of the size of the
position taken in futures to the size of the exposure to jet fuel. When cross hedging used,
hedge ratio is not always 1.

Futures vs Forwards – are prices equal? When are prices equal? When risk free interest rate
is constant and the same for all maturities, then future and forward with same delivery
date is same price. In theory (before), but in practice? What could cause future & forward
price differences aside from risk free interest rate? Taxes, transaction costs, treatment of
margins, risk of default

Options – risk factors affecting price: stock price, strike price, interest rate, volatility, time to
expiration.
- upper bound for option prices (c <= S0, p <= K)
- Put-Call parity (c + Ke-rT = p + S0)
- Put-Call parity with dividends (c + D + Ke-rT = p + S0)

Variance swap – an over-the-counter financial derivative that allows one to speculate on or

hedge risks associated with the magnitude of movement, i.e. volatility, of some
underlying product, like an exchange rate, interest rate, or stock index.
- One leg of the swap will pay an amount based upon the realised variance of the
price changes of the underlying product. Conventionally, these price changes will
be daily log returns, based upon the most commonly used closing price. The other
leg of the swap will pay a fixed amount, which is the strike, quoted at the deal's
inception. Thus the net payoff to the counterparties will be the difference between
these two and will be settled in cash at the expiration of the deal, though some
cash payments will likely be made along the way by one or the other counterparty
to maintain agreed upon margin.

Rho – of a European call/put based on the BS model?

- rho(call) = KTe-rTN(d2)
- rho(put) = -KTe-rTN(-d2)