'P' Versus 'Q': Differences and Commonalities between the Two Areas of Quantitative Finance

Abstract

There exist two separate branches of finance that require advanced quantitative techniques: the "Q" area of derivatives pricing, whose task is to "extrapolate the present"; and the "P" area of quantitative risk and portfolio management, whose task is to "model the future."

We briefly trace the history of these two branches of quantitative finance, highlighting their different goals and challenges. Then we provide an overview of their areas of intersection: the notion of risk premium; the stochastic processes used, often under different names and assumptions in the Q and in the P world; the numerical methods utilized to simulate those processes; hedging; and statistical arbitrage.

Keywords: Risk Neutral, Real Measure, Sell-Side, Buy-Side, Asset Pricing, No-Arbitrage, Martingale, Calibration, Estimation, Ito Calculus, PDE, Time-Series, Econometric, Portfolio Theory, Delta-Hedging, Alpha, Statistical Arbitrage, Levy Processes, ARMA, Ornstein-Uhlenbeck, GARCH, Stochastic, Heston

JEL Classification: C1, G11