An Introduction to Financial Markets

A Quantitative Approach

Paolo Brandimarte

• Publisher: Wiley
• Year: 2018
• ISBN:
  9781118594667
• Edition: 1
• Topic: Matemáticas
• Subtopic: Probabilidad y estadística

COVERS THE FUNDAMENTAL TOPICS IN MATHEMATICS, STATISTICS, AND FINANCIAL MANAGEMENT THAT ARE REQUIRED FOR A THOROUGH STUDY OF FINANCIAL MARKETS

This comprehensive yet accessible book introduces students to financial markets and delves into more advanced material at a steady pace while providing motivating examples, poignant remarks, counterexamples, ideological clashes, and intuitive traps throughout. Tempered by real-life cases and actual market structures, An Introduction to Financial Markets: A Quantitative Approach accentuates theory through quantitative modeling whenever and wherever necessary. It focuses on the lessons learned from timely subject matter such as the impact of the recent subprime mortgage storm, the collapse of LTCM, and the harsh criticism on risk management and innovative finance. The book also provides the necessary foundations in stochastic calculus and optimization, alongside financial modeling concepts that are illustrated with relevant and hands-on examples.

An Introduction to Financial Markets: A Quantitative Approach starts with a complete overview of the subject matter. It then moves on to sections covering fixed income assets, equity portfolios, derivatives, and advanced optimization models. This book's balanced and broad view of the state-of-the-art in financial decision-making helps provide readers with all the background and modeling tools needed to make "honest money" and, in the process, to become a sound professional.

• Stresses that gut feelings are not always sufficient and that "critical thinking" and real world applications are appropriate when dealing with complex social systems involving multiple players with conflicting incentives
• Features a related website that contains a solution manual for end-of-chapter problems
• Written in a modular style for tailored classroom use
• Bridges a gap for business and engineering students who are familiar with the problems involved, but are less familiar with the methodologies needed to make smart decisions

An Introduction to Financial Markets: A Quantitative Approach offers a balance between the need to illustrate mathematics in action and the need to understand the real life context. It is an ideal text for a first course in financial markets or investments for business, economic, statistics, engi­neering, decision science, and management science students.

Part One
Overview

Chapter One
Financial Markets: Functions, Institutions, and Traded Assets

Providing a simple, yet exhaustive definition of finance is no quite easy task, but a possible attempt, at least from a conceptual viewpoint, is the following:¹

Finance is the study of how people and organizations allocate scarce resources over time, subject to uncertainty.

This definition might sound somewhat generic, but it does involve the two essential ingredients that we shall deal with in practically every single page of this book: Time and uncertainty. Appreciating their role is essential in understanding why finance was born in the past and is so pervasive now. The time value of money is reflected in the interest rates that define how much money we have to pay over the time span of our mortgage, or the increase in wealth that we obtain by locking up our capital in a certificate of deposit issued by a bank. It is common wisdom that the value of $1 now is larger than the value of $1 in one year. This is not only a consequence of the potential loss of value due to inflation.² A dollar now, rather than in the future, paves the way to earlier investment opportunities, and it may also serve as a precautionary cushion against unforeseen needs. Uncertainty is related, e.g., to the impossibility of forecasting the return that we obtain from investing in stock shares, but also to the risk of adverse movements in currency exchange rates for an import/export firm, or longevity risk for a worker approaching retirement. As we show in Chapter 2, we may model issues related to time and uncertainty within a mathematical framework, applying principles from financial economics and tools from probability, statistics, and optimization theory. Before doing that, we need a more concrete view in order to understand how financial markets work, which kinds of assets are exchanged, and which actors play a role in them and what their incentives are. We pursue this “institutional” approach to get acquainted with finance in this chapter. Some of the more mathematically inclined students tend to consider this side of the coin modestly exciting, but a firm understanding of it is necessary to put models in the right perspective and to appreciate their pitfalls and limitations.

In Section 1.1, we discuss the role of time and uncertainty in a rather abstract way that, nevertheless, lays down some essential concepts. A more concrete view is taken in Section 1.2, where we describe the fundamental classes of assets that are traded on financial markets, namely, stock shares, bonds, currencies, and the basic classes of derivatives, like forward/futures contracts and options. In order to provide a proper framework, we also hint at the essential shape of a balance sheet, in terms of assets, liabilities, and equity, and we emphasize the difference between standardized assets traded on regulated exchanges and less liquid assets, possibly engineered to meet specific client requirements, which are traded over-the-counter. In Section 1.3, we describe the classes of players involved in financial markets, such as investment/commercial banks, common/hedge/pension funds, insurance companies, brokers, and dealers. We insist on the separation between the institutional form and the role of those players: A single player may be of one given kind, in institutional terms, but it may play different roles. For instance, an investment bank can, among many other things, play the role of a prime broker for a hedge fund. Furthermore, depending on circumstances, players may act as hedgers, speculators, or arbitrageurs. The exact organization of financial markets is far from trivial, especially in the light of extensive use of information technology, and a full description is beyond the ...