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 finan
cial
engineering and risk management. Why do we need financial markets? Financial mar
kets 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 mor
e 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. 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, sh
e would have such as, a home
car and so on. But she's not going to be able to move
that later on in time to have them available when the
states of nature are not good. 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 ora
nge
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. What do markets do? They essentially do three
things.
They gather information. Markets are a place where buyers and sellers come toget
her. They take action based on their
information. This information gets aggregated, and that
aggregated information gets deflected in the price of the
product. And in some sense, this information
gathering is necessary in order for a fair price to be created. It aggregates li
quidity, 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 loo
king 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. By gathering information and by gathering
liquidity, markets introduce or promote efficiency

and fairness. What about products? Financial products are created to satisfy
needs. 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. 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. The other class of model is called
continuous time models. Continuous time models, time does not ad, advance discre
tely but in a continuous
fashion. 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 model
s 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 und
erstand financial engineering and
risk management. There is a little bit of a caveat. Very, very few continuous ti
me 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. 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 ar
e
given. And the focus of this field is on pricing derivatives and these primary a
ssets 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. There are three central problems of
Financial Engineering. Security pricing, portfolio selection, and
risk management. The main focus of security pricing is to price derivative secur
ities such as
forwards, swaps, futures, and options on the
underlying primary securities using the no arbitrage
condition. The focus of portfolio selection, is to
choose a trading strategy to maximize the utility of
consumption and final wealth. 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. There's also the issue of pricing and
using real options, such as options on gas
pipelines, oil leases, and mines. These are also part of a portfolio
selection strategy. 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 measu
res that have become very
important for tail risk, are the value at risk and the condition of
value at risk. These two risk measures were introduced
for risk management, but have started to become much more important for
portfolio selection as well. Financial engineering has led to some very interest
ing problems in applied math and
operations research. For example, how does a company manage its operational risk
s
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.