Chapter 1 – What is quant finance?

- Quant finance is the application of probability and stats to finance.

- It’s the empirical observation of prices, exchange rates, and interest rates
 Efficient Markets
o Markets that are efficient means the prices reflect known info and thus follow a random
walk.
 3 types of efficiency
 Weak – When prices cant be predicted from past prices
 Semi String – is when prices cant be predicted with all available public
info.
 Strong – cant be predicted at all
o Markets are efficiently but not perfect.
 3 functions of Money
o Store of value
o Means of exchange
o Unit of account
 Borrowings
o Bonds – Form of a loan where a lender gives the borrower $ in return of the principal
and interest payments called coupons
 Lender can sell the bond to someone else
o Stocks – represent ownership in company.
 Options
o Gives you the right but not obligation to buy or sell a financial asset such as a bond at a
time in the future at a price agreed now.
 Price of a option depends on:
 Risk free rate
 Volaitility of asset
 Time to expiry
 Strike price
o Can be used for leverage or the returns can be similar to using borrowed $ to buy shares
or hedging against market moves.
 Managing risk
o Options allow you to protect yourself against adverse price movements but for a
premium up front.
o Typically value at risk or VaR is used to measure portfolio riskiness
o For a portfolio you should know
 Expected return of your assets
 Volatility of your assets
 Correlations between assets
o Try to apply MPT but it can be hard
Chapter 2 – Probability and Statistics

 Define a return r_n of an asset on day n and price on day n p_n to be r_n= (p_n-P_n-1)/P_n-1
 What is a random variable?
o Measurement or characteristic that takes on its value by chance.
o Don’t know the value till the xperiment is done
o Can be discrete/continuous
o Expected Value: E[X] = ∑𝑀 𝑗=1 𝑥𝑗 𝑝𝑗 where M is the # of possible outcomes.
 Weighted average
 What is statistics?
o All about fitting distributions to data
o Normal Distribution
 CLT – States that if you have a sum of many random variables it tends to a
normal distribution
 x_i represents the ith elements in a sample of size N
 A distribution can be characterized by following statistics
 Average, STDDEV
 Skew – measures how lob sided a distribution is. Positive is right skewed
vice versa.

 Kurtosis – measures how fat the tails of the distribution are.

Chapter 3 – Taking look @ Random Behaviors

Factors affecting price of a stock despite stock prices being random

1) Global economic activity

2) Factors affecting a specific company
3) Sale of stock or commodity

Setting up the Random Walk

1) Suppse that X_i is a step in a RW taking on +1 or -1.

2) R_N = X_1+…+X_N is the position after N Steps
3) 𝐸[𝑅_𝑁] = ∑𝑁 𝑖=1 𝑋_𝑖 = 0 𝑎𝑠 𝐸[𝑋𝑖 ] = 0
2
4) 𝐸[𝑅_𝑁^2] = ∑𝑁
𝑖=1 𝑋𝑖 = 0 = 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒(𝑅𝑁 )
Suppose now we have a RW with drift so now there is bias introduced.
Let
1) ∆ : Time it takes for each step
2) ∂ : distance of each step
3) The RW goes ∂ with probability p and -∂ with (1-P)