In his video lesson entitled “Visualizing Taylor polynomial approximations“, Sal Kahn essentially replicates the tail end of last Thursday’s Finance 4366 class meeting in which we approximated y = eˣ with a Taylor polynomial centered at x=0. Sal approximates y = eˣ with a Taylor polynomial centered at x=3 instead of x=0, but the same insight obtains in both cases, which is that one can approximate functions using Taylor polynomials, and the accuracy of the approximation increases as the order of the polynomial increases (see pp. 18-23 in my Mathematics Tutorial lecture note if you wish to review what we did in class last Thursday).
Next week in Finance 4366 will be devoted to tutorials on probability and statistics. These tools are foundational for the theory of pricing and managing risk with financial derivatives, which is what this course is all about. Next Tuesday’s class meeting will be devoted to introducing discrete and continuous probability distributions, calculating parameters such as expected value, variance, standard deviation, covariance and correlation, and applying these concepts to measuring expected returns and risks for portfolios consisting of risky assets. Next Thursday will provide a deeper dive into discrete and continuous probability distributions, in which the binomial and normal distributions are showcased.
Beginning Tuesday, January 28, we introduce financial derivatives, We will begin by defining financial derivatives and motivating their study with examples of forwards, futures, and options. Derivatives are so named because the prices of these instruments are derived from the prices of one or more underlying assets. The types of underlying assets upon which derivatives are based are often traded financial assets such as stocks, bonds, currencies, or other derivatives, but they can be pretty much anything. For example, the Chicago Mercantile Exchange (CME) offers exchange-traded weather futures contracts and options on such contracts (see “Market Futures: Introduction To Weather Derivatives“). There are also so-called “prediction” markets in which derivatives based upon the outcome of political events are actively traded (see “Prediction Markets“).
Besides introducing financial derivatives and discussing various institutional aspects of markets in which they are traded, we’ll consider various properties of forward and option contracts, since virtually all financial derivatives feature payoffs that are isomorphic to either or both of these schemes. For example, a futures contract is simply an exchange-traded version of a forward contract. Similarly, since swaps involve exchanges between counter-parties of payment streams over time, these instruments essentially represent a series of forward contracts. In the option space, besides traded stock options there are also embedded options in corporate securities; e.g., a convertible bond represents a combination of a non-convertible bond plus a call option on company stock. Similarly, when a company makes an investment, there may be embedded “real” options to expand or abandon the investment at some future date.
Perhaps the most important (pre-Midterm 1) idea that we’ll introduce is the concept of a so-called “arbitrage-free” price for a financial derivative. While details will follow, the basic idea is that one can replicate the payoffs on a forward or option by forming a portfolio consisting of the underlying asset and a riskless bond. This portfolio is called the “replicating” portfolio, since it is designed to perfectly replicate the payoffs on the forward or option. Since the forward or option and its replicating portfolio produce the same payoffs, then they must also have the same value. However, suppose the replicating portfolio (forward or option) is more expensive than the forward or option (replicating portfolio). It this occurs, then one can earn a riskless arbitrage profit by simply selling the replicating portfolio (forward or option) and buying the forward or option (replicating portfolio). However, competition will ensure that opportunities for riskless arbitrage profits vanish very quickly. Thus the forward or option will be priced such that one cannot earn arbitrage profit from playing this game.
I especially like the fact that Ian Stewart includes the famous Black-Scholes equation (equation #17) on his list of the 17 equations that changed the course of history; Equations (2), (3), (7), and (17) play particularly important roles in Finance 4366!
Since many of the topics covered in Finance 4366 require a basic knowledge and comfort level with algebra, differential calculus, and probability & statistics, the second class meeting during the Spring 2020 semester will include a mathematics tutorial, and the third and fourth class meetings will cover probability & statistics. I know of no better online resource for brushing up on (or learning for the first time) these topics than the Khan Academy.
So here are my suggestions for Khan Academy videos which cover these topics (unless otherwise noted, all sections included in the links which follow are recommended):
- Algebra: Intro to the Binomial Theorem, Pascal’s Triangle and Binomial Expansion
- Calculus: Taking derivatives, Optimization with calculus, Visualizing Taylor Series for e^x
- Probability and statistics: Basic probability, Compound, independent events, Permutations, Combinations, probability using combinatorics, Random variables and probability distributions, Binomial distribution, Law of Large Numbers, and Introduction to the Normal Distribution.
Finally, if your algebra skills are generally a bit on the rusty side, I would also recommend checking out the Khan Academy’s review of algebra.