0:02

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

Â of the entire course of Financial Engineering and Risk Management.

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

Â what do financial markets and financial products do for you.

Â We'll introduce the ideas of the main

Â problems in financial engineering, and how these relate

Â to the different issues that come up

Â in practical application financial engineering and risk management.

Â 0:26

Why do we need financial markets?

Â Financial markets enable efficient allocation of resources

Â both across time, and across states of nature.

Â What do you mean by across time?

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

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

Â You have income available today, but

Â tomorrow the states of nature are uncertain.

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

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

Â Depending upon various events happening,

Â you might need more or less amount of funds.

Â And financial markets allow you the possibility

Â of taking funds that are available today,

Â move them across time, and move them

Â across to states of nature that are uncertain.

Â 1:06

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

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

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

Â If there were no financial markets

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

Â 1:34

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

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

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

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

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

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

Â She could also buy vetter related derivatives,

Â and use these derivatives to protect against

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

Â If there were no financial markets available, she would

Â be open to the vagaries of the spot market.

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

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

Â 2:30

What do markets do?

Â They essentially do three things. They gather information.

Â Markets are a place

Â where buyers and sellers come together.

Â They take action based on their information.

Â This information gets aggregated, and that aggregated information

Â gets deflected in the price of the product.

Â 2:48

And in some sense, this information gathering is necessary

Â in order for a fair price to be created.

Â It aggregates liquidity, so there are many

Â buyers and sellers for a particular product.

Â If there was no market, the buyers and

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

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

Â With a market, all the buyers and

Â sellers come together, the liquidity gets aggregated,

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

Â 3:32

New products hedge risk. They also allow for speculation.

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

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

Â 3:47

Financial markets can be modeled in several different ways.

Â There are two standard market

Â models that are out there.

Â One of them is called a discrete time

Â model, in which time goes forward in discrete steps.

Â There are single period discrete time models

Â and there are multiperiod discrete time models.

Â 4:14

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

Â The good thing about a

Â discrete time model is that it's simple.

Â We can introduce all important concepts with very easy mathematics.

Â Much less sophisticated mathematics than is

Â necessary for the continuous time model.

Â The problem with discrete time models is

Â there are no closed form solutions possible.

Â Solutions are not as elegant as those available for continuous

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

Â This used to be a problem

Â when computation was hard, and you couldn't

Â do sophisticated comput, computation on simple machines.

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

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

Â You can introduce all kinds of interesting effects and compute

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

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

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

Â the concepts that are necessary, for you

Â to understand financial engineering and risk management.

Â There is a little bit of a caveat.

Â Very, very few continuous time concepts will be used.

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

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

Â And anyone graduating from a course on financial engineering and

Â risk management, ought to know this formula.

Â 5:37

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

Â the difference between financial economics and financial engineering.

Â Financial economics is concerned with using equilibrium

Â concepts to price something called primary assets.

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

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

Â such that equities and interest rates are given.

Â And the focus of this field is on pricing

Â derivatives and these primary assets using the no arbitrage condition.

Â But these distinction between financial economics and financial

Â engineering is by no means a complete separation.

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

Â is of interest to both financial engineering and financial economics.

Â 6:37

The main focus of security pricing is

Â to price derivative securities such as forwards,

Â swaps, futures, and options on the underlying

Â primary securities using the no arbitrage condition.

Â 6:56

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

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

Â Single-period models, such as Markowitz portfolio

Â selection, are very widely used in industry.

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

Â 7:25

The third important topic is risk management.

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

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

Â We just want to stress test the, the portfolio

Â to understand how it performs in different market conditions.

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

Â which is a probability of large losses.

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

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

Â 8:04

Financial engineering has led to some very

Â interesting problems in applied math and operations research.

Â For example, how does

Â a company manage its operational risks using financial products?

Â This is a marriage between supply chain management one side,

Â which is one of the core ideas in operations research.

Â And financial engineering on the other side,

Â which talks about risk management and portfolio selection.

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

Â hedging operational risks, which have got

Â nothing to do with financial engineering per

Â se, and combining them with financial products to get an

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

Â