0:02

In this module, we're going to give you a brief overview

of the entire course of Financial Engineering and Risk Management.

We'll introduce the ideas of financial markets, financial products,

what do financial markets and financial products do for you.

We'll introduce the ideas of the main

problems in financial engineering, and how these relate

to the different issues that come up

in practical application financial engineering and risk management.

0:26

Why do we need financial markets?

Financial markets enable efficient allocation of resources

both across time, and across states of nature.

What do you mean by across time?

What we mean is, that you have income available today, but

you want to allocate that income for sometime in the future.

You have income available today, but

tomorrow the states of nature are uncertain.

You don't know whether you would have income available there.

You don't know what your costs are going to be in the future.

Depending upon various events happening,

you might need more or less amount of funds.

And financial markets allow you the possibility

of taking funds that are available today,

move them across time, and move them

across to states of nature that are uncertain.

1:06

A young worker with a high salary right now, what should she do?

If there are financial markets available, she could invest in stocks

and bonds to finance retirement, home ownership, education and so on.

If there were no financial markets

available, she would have such as, a home car and so on.

1:34

This idea of states of nature actually becomes more clearer if you consider the

example of a farmer producing oranges. The farmer is producing oranges, and she

is open to the risk of the price of orange when she

produced when he product gets ready and it goes into the market.

If there were financial markets available, as they are right now, she could

hedge the price of the oranges in the future using the futures market.

She could also buy vetter related derivatives,

and use these derivatives to protect against

the possibility of her produce going bad as a result of freeze, and so on.

If there were no financial markets available, she would

be open to the vagaries of the spot market.

She can not hedge the price, nor can she hedge against the uncertainty

of a produce not coming through, because of some weather-related emergency.

2:30

What do markets do?

They essentially do three things. They gather information.

Markets are a place

where buyers and sellers come together.

They take action based on their information.

This information gets aggregated, and that aggregated information

gets deflected in the price of the product.

2:48

And in some sense, this information gathering is necessary

in order for a fair price to be created.

It aggregates liquidity, so there are many

buyers and sellers for a particular product.

If there was no market, the buyers and

the sellers would have to go looking for a counter party.

Looking for a person who wants to take the opposite position.

With a market, all the buyers and

sellers come together, the liquidity gets aggregated,

and as a result, the, both the buyers and sellers get a better price.

3:32

New products hedge risk. They also allow for speculation.

Products allow to, one to raise funds for an operation, for example, using

by, by issuing shares and an IPO. They also allow you to fund liabilities.

3:47

Financial markets can be modeled in several different ways.

There are two standard market

models that are out there.

One of them is called a discrete time

model, in which time goes forward in discrete steps.

There are single period discrete time models

and there are multiperiod discrete time models.

4:14

The pros and cons of discrete time models are as follows.

The good thing about a

discrete time model is that it's simple.

We can introduce all important concepts with very easy mathematics.

Much less sophisticated mathematics than is

necessary for the continuous time model.

The problem with discrete time models is

there are no closed form solutions possible.

Solutions are not as elegant as those available for continuous

time models, and one has to resort to numerical calculations.

This used to be a problem

when computation was hard, and you couldn't

do sophisticated comput, computation on simple machines.

But as the price of computers have been coming down, people have tended

to move more and more into discrete time models because they are simpler.

You can introduce all kinds of interesting effects and compute

them, rather than trying to look for a closed form solution.

The focus of this course will be on discrete time multi-period models.

We want to keep the mathematics simple, and yet be able to introduce all

the concepts that are necessary, for you

to understand financial engineering and risk management.

There is a little bit of a caveat.

Very, very few continuous time concepts will be used.

For example, the Black-Scholes formula, which comes from continuous time

analysis will be introduced because this is a very classic formula.

And anyone graduating from a course on financial engineering and

risk management, ought to know this formula.

5:37

Another topic that's of interest, is what's

the difference between financial economics and financial engineering.

Financial economics is concerned with using equilibrium

concepts to price something called primary assets.

These are equities, bonds, interest rates, and so on.

Financially engineering on the other hand assumes the price of the primary assets

such that equities and interest rates are given.

And the focus of this field is on pricing

derivatives and these primary assets using the no arbitrage condition.

But these distinction between financial economics and financial

engineering is by no means a complete separation.

For example, the capital asset pricing model, which prices assets

is of interest to both financial engineering and financial economics.

6:37

The main focus of security pricing is

to price derivative securities such as forwards,

swaps, futures, and options on the underlying

primary securities using the no arbitrage condition.

6:56

It turns out that portfolio selection is very intimately related to security

pricing, and this will become clearer as we go through the course.

Single-period models, such as Markowitz portfolio

selection, are very widely used in industry.

Multi-period models are much harder, but starting to get more traction.

7:25

The third important topic is risk management.

And the goal of this area is to understand the risks inherent in the portfolio.

Here, we are not trying to choose a portfolio, the portfolio is already given.

We just want to stress test the, the portfolio

to understand how it performs in different market conditions.

The important topics that come up in risk management are tail risk,

which is a probability of large losses.

Two risk measures that have become very important for tail risk,

are the value at risk and the condition of value at risk.

8:04

Financial engineering has led to some very

interesting problems in applied math and operations research.

For example, how does

a company manage its operational risks using financial products?

This is a marriage between supply chain management one side,

which is one of the core ideas in operations research.

And financial engineering on the other side,

which talks about risk management and portfolio selection.

You bring the two together, and now you have the possibility of

hedging operational risks, which have got

nothing to do with financial engineering per

se, and combining them with financial products to get an

idea of how one could hedge the risk across different areas.