Steve Bell - Quantitative Finance For Dummies

Quantitative finance is what it says it is and involves numbers and maths but you don’t need to become bogged down by it. Only then will you see that the numbers are useful in real life in your job.

Icons are used in this book to draw your attention to certain features that occur on a regular basis. Here’s what they mean:

This icon is to give those grey cells a little jolt. It’s so easy to forget what you learned in school.

This icon points to helpful ideas that can save you time and maybe even money.

Skip paragraphs marked with this icon if you don’t want to go into the gory mathematical details. But if you do manage them, you’ll really glow with achievement.

Sometimes things can go badly wrong. Follow these sections to avoid disasters.

The obvious answer is to start with Chapter 1. In fact, that’s a good idea if you’re not too familiar with quantitative finance as Chapter 1is a bit like the book in miniature. I hope it will fire you up ready to read the rest of the book. Another obvious answer is to go to the table of contents. Just find the topic you’d like to know about and go straight there – no messing about. The book is designed to be used like that. Check out the topics you want to know about and skip what you’re not interested in. A third obvious answer is to use the index, which has been conveniently arranged in alphabetical order for you. If some quantitative finance jargon is bugging you, go to the Glossary at the back. Finally, if you’re really in a hurry, try Chapters 19and 20. They give quantitative finance to you in ten bite-sized sections.

And you can use some free online material to help. The Cheat Sheet is a goldmine of handy formulae used in quantitative finance. To view this book’s Cheat Sheet, go to www.dummies.comand search for “Quantitative Finance For Dummies Cheat Sheet” for additional bits of information that you can refer to whenever you need it.

IN THIS PART …

Realise that the chart of a stock price can look jumpy and rather random because market prices are indeed very close to being random.

Get to grips with the mathematics of random numbers and brush up on probability and statistics.

Enter the strange and fascinating world of random walks. Find out how you can use them as models for the price movement of financial assets such as stocks.

Use calculus to analyse random walks so that you can get going on the classic maths for option pricing.

IN THIS CHAPTER

Using probability and statistics in finance

Finding alternatives for cash

Looking at efficient (and not-so-efficient) markets

Tackling options, futures and derivatives

Managing risk

Doing the maths (and the machines that can help)

Quantitative finance is the application of probability and statistics to finance. You can use it to work out the price of financial contracts. You can use it to manage the risk of trading and investing in these contracts. It helps you develop the skill to protect yourself against the turbulence of financial markets. Quantitative finance is important for all these reasons.

If you’ve ever looked at charts of exchange rates, stock prices or interest rates, you know that they can look a bit like the zigzag motion of a spider crossing the page. However, major decisions have to be made based on the information in these charts. If your bank account is in dollars but your business costs are in euros, you want to make sure that, despite fluctuations in the exchange rate, you can still pay your bills. If you’re managing a portfolio of stocks for investors and you want to achieve the best return for them at minimum risk, then you need to learn how to balance risk with reward. Quantitative finance is for banks, businesses and investors who want better control over their finances despite the random movement of the assets they trade or manage. It involves understanding the statistics of asset price movements and working out what the consequences of these fluctuations are.

However, finance, even quantitative finance, isn’t just about maths and statistics. Finance is about the behaviour of the participants and the financial instruments they use. You need to know what they’re up to and the techniques they use. This is heady stuff, but this book guides you through.

My guess is that if you’ve picked up a book with a title like this one, you want to know what you’re going to get for your money. Definitions can be a bit dry and rob a subject of its richness but I’m going to give it a go.

Quantitative finance is the application of mathematics – especially probability theory – to financial markets. It’s used most effectively to focus on the most frequently traded contracts. What this definition means is that quantitative finance is much more about stocks and bonds (both heavily traded) than real estate or life insurance policies. The basis of quantitative finance is an empirical observation of prices, exchange rates and interest rates rather than economic theory.

Quantitative finance gets straight to the point by answering key questions such as, ‘How much is a contract worth?’ It gets to the point by using many ideas from probability theory, which are laid out in Chapters 2and 3. In addition, sometimes quantitative finance uses a lot of mathematics. Maths is really unavoidable because the subject is about answering questions about price and quantity. You need numbers for that. However, if you use too much mathematics, you can lose sight of the context of borrowing and lending money, the motivation of traders and making secure investments. Chapter 13covers subjects such as attitudes to risk and prospect theory while Chapter 18looks in more detail at the way markets function and dysfunction.

Just to avoid confusion, quantitative finance isn’t about quantitative easing. Quantitative easing is a process carried out by central banks in which they effectively print money and use it to buy assets such as government bonds or other more risky bonds. It was used following the credit crisis of 2008 to stimulate the economies of countries affected by the crisis.

Summarising the mathematics

I’m not going to pretend that quantitative finance is an easy subject. You may have to brush up on some maths. In fact, exploring quantitative finance inevitably involves some mathematics. Most of what you need is included in Chapter 2on probability and statistics. In a few parts of the book, I assume that you remember some calculus – both integration and differentiation. If calculus is too much for you, just skip the section or check out Calculus For Dummies by Mark Ryan (Wiley). I’ve tried to keep the algebra to a minimum but in a few places you’ll find lots of it so that you know exactly where some really important results come from. If you don’t need to know this detail, just skip to the final equation.