Chapter 1: Introduction

This chapter introduces some nancial and mathematical concepts needed to measure the risk of a portfolio that invests not only in stocks, but also in nancial derivatives. Unit 1.1 provides an overview of the tasks that we need to complete before we can model and quantify nancial risks. A nancial asset can be a commodity, a stock, a bond, an interest rates or a currency. In this course we will restrict our attention mainly to assets that are stocks. In Unit 1.2 we examine examples of time series of prices of nancial assets and describe some of their characteristics. Experienced portfolio managers invest in a variety of assets and nancial products. This diversication tends to reduce the risk of the investment: While some of the nancial instruments in the portfolio could lose value in a given period, others could increase their worth, compensating for the losses. For this reason we will analyze how to build a portfolio that invests in several assets and examine the time evolution of its value [Unit 1.3]. The time series of asset prices will be the inputs to our risk models. To build these models it is convenient to perform some transformations of the time series of prices rst. Simple returns [Unit 1.4] and log returns [Unit 1.5] are two types of transformed quantities commonly used in nance. In this course we will use mainly log returns because of their convenient time aggregation properties. Financial risk is quantied in terms of the loss of value of an investment portfolio. Since losses are measured in some monetary unit (euros, dollars, yuans, ...), we need to understand how the value of money changes with time; in particular, we will see that the amount deposited in a bank account at a xed interest rate grows exponentially [Unit 1.6]. Assuming an ideal market, in which all the information about expectations on the future evolution of an asset are reected in its price, we will formulate stochastic models in which the changes in asset prices are unpredictable on the basis of the past. In particular, we consider two historically important stochastic models of the evolution of stock prices: The Bachelier model, in which price changes are assumed to be normally distributed, and the Black-Schloles model, which assumes that the log returns are Gaussian [Unit 1.7]. Most portfolios include investments in nancial instruments whose value depends on the level of another more fundamental quantity, which is called the underlying. These products are called derivatives. The underlying of a derivative product can be an asset, a nancial index or an interest rate. Derivatives will be analyzed in detail in Chapters 7 and 8. In [Unit 1.8] of this chapter we will learn the basics of spot and forward contracts and of nancial options. To compute the correct price of a derivative product (correct in the sense that it is consistent with the prices of other products in the market so that no opportunities of arbitrage occur) one needs to use a stochastic model of the evolution of the asset prices (e.g. the Black-Scholes model) that is risk-neutral [Unit 1.9]. In simple terms, risk-neutrality means that the expected value of 1

the asset price increases in the same way as the amount of money deposited in a bank account using a risk-free interest rate. To conclude this chapter we will compute the price of a European option assuming risk-neutrality. The buyer of this type of nancial derivative acquires the right, but not the obligation, to purchase a specied number of shares of an asset at a specic time in the future (maturity) for a price that is set at the writing of the option (the strike price). If the buyer of the option decides to exercise this right, the seller has the obligation to complete the transaction. To acquire this right, the buyer needs to pay a fee, which is called the premium of the option [Unit 1.10]. For this introductory chapter, it may be helpful to read some of complementary material: The rst chapter of [Baxter and Rennie, 1996] contains an excellent introduction to the subject matter of this course. Make sure you do not not miss The parable of the bookmaker that precedes this introductory chapter. The rst chapters of [Hull, 2009] and [Wilmott, 1998] also provide a good introduction to nancial derivatives. The textbook [Luenberger, 2013] is also a good reference for quantitative nance. [Glasserman] is an excellent reference for Monte Carlo methods in nance. Please be aware that the references given contain some material that is beyond the level or the scope of this course. You can also read the classical works of Eugene F. Fama on ecient markets [Fama, 1970]. Eugene F. Fama shared the 2013 Nobel prize in Economics for his contributions to the understanding of how asset prices behave. The original articles on derivative pricing by Fischer Black and Myron S. Scholes [Black and Scholes, 1973] and by Robert C. Merton [Merton, 1973] are also accessible and very enjoyable to read. Robert C. Merton and Myron S. Scholes received the 1997 Nobel prize in Economics for this work. Unfortunately, Fischer Black could not receive the prize that year because of his passing away two years earlier, in 1995.

References
M. Baxter and A. Rennie. Financial Calculus: An Introduction to Derivative Pricing. Cambridge University Press, 1996. Fischer Black and Myron S Scholes. The pricing of options and corporate liabilities. Journal of Political Economy, 81(3):63754, May-June 1973. Eugene F. Fama. Ecient capital markets: A review of theory and empirical work. Journal of Finance, 25(2):383417, May 1970. 2

P. Glasserman. Monte Carlo Methods in Financial Engineering. J. Hull. Options, Futures and Other Derivatives. Prentice Hall nance series. Pearson/Prentice Hall, 2009. D.G. Luenberger. Investment Science. Oxford University Press, Incorporated, 2013. Robert C. Merton. Theory of rational option pricing. Bell Journal of Economics, 4(1):141183, Spring 1973. P. Wilmott. Derivatives: the theory and practice of nancial engineering. Wiley Frontiers in Finance Series. J. Wiley, 1998.