1 00:00:00,060 --> 00:00:02,500 The following content is provided under a Creative 2 00:00:02,500 --> 00:00:04,019 Commons license. 3 00:00:04,019 --> 00:00:06,360 Your support will help MIT OpenCourseWare 4 00:00:06,360 --> 00:00:10,730 continue to offer high-quality educational resources for free. 5 00:00:10,730 --> 00:00:13,340 To make a donation or view additional materials 6 00:00:13,340 --> 00:00:17,217 from hundreds of MIT courses, visit MIT OpenCourseWare 7 00:00:17,217 --> 00:00:17,842 at ocw.mit.edu. 8 00:00:21,450 --> 00:00:24,120 JAKE XIA: This is the second time we are having this class. 9 00:00:24,120 --> 00:00:27,900 We had it last year in a smaller version. 10 00:00:27,900 --> 00:00:30,510 That was for six units of a credit, 11 00:00:30,510 --> 00:00:32,729 and we had it once a week. 12 00:00:32,729 --> 00:00:36,440 And mostly practitioners from the industry, 13 00:00:36,440 --> 00:00:38,980 from Morgan Stanley, talking about examples 14 00:00:38,980 --> 00:00:41,760 how math is applied in modern finance. 15 00:00:48,030 --> 00:00:51,000 And so we got some good response last year. 16 00:00:51,000 --> 00:00:53,480 So, with the support of the math department, 17 00:00:53,480 --> 00:00:58,600 we decided to expand this class to be 12 units of credit 18 00:00:58,600 --> 00:01:00,170 and have twice a week. 19 00:01:00,170 --> 00:01:02,900 So, we have every Tuesday and Thursday afternoon 20 00:01:02,900 --> 00:01:05,645 from 2:30 to 4:00, as you know, in this classroom. 21 00:01:08,430 --> 00:01:13,220 So last year, Dr. Vasily Strela and I-- by the way, 22 00:01:13,220 --> 00:01:16,060 I'm Jake Xia and that's Dr. Vasily, 23 00:01:16,060 --> 00:01:18,660 and we were the main instructors last year. 24 00:01:18,660 --> 00:01:22,500 Now we doubled it up to four main instructors. 25 00:01:22,500 --> 00:01:26,430 That's Dr. Peter Kempthorne and Dr. Choongbum Lee. 26 00:01:26,430 --> 00:01:30,090 The reason we doubled up the main instructors 27 00:01:30,090 --> 00:01:35,850 is we have newly added math lectures, mostly focusing 28 00:01:35,850 --> 00:01:38,510 from linear algebra, probability to statistics, 29 00:01:38,510 --> 00:01:42,100 and some stochastic calculus to give you the foundation 30 00:01:42,100 --> 00:01:45,990 to understand the math will be used 31 00:01:45,990 --> 00:01:52,680 in those examples in the lecture taught by the practitioners 32 00:01:52,680 --> 00:01:54,440 from the industry. 33 00:01:54,440 --> 00:01:57,370 And the purpose of this course is really 34 00:01:57,370 --> 00:02:02,580 to give you a sampling menu to see how mathematics is applied 35 00:02:02,580 --> 00:02:05,860 in modern finance and help you to decide if this is a field 36 00:02:05,860 --> 00:02:06,670 that you would be-- 37 00:02:06,670 --> 00:02:08,461 RECORDED VOICE: Thank you, for using WebEx. 38 00:02:08,461 --> 00:02:14,170 Please visit our website at www.webex.com. 39 00:02:14,170 --> 00:02:16,590 JAKE XIA: OK, you heard that. 40 00:02:16,590 --> 00:02:21,010 And so hopefully, this will give you enough information 41 00:02:21,010 --> 00:02:24,090 to decide this is a field you would like to pursue 42 00:02:24,090 --> 00:02:25,560 in your future career. 43 00:02:25,560 --> 00:02:29,150 In fact, last year when we finished the class, 44 00:02:29,150 --> 00:02:33,660 we had a few students coming to work in the industry. 45 00:02:33,660 --> 00:02:35,925 Some work at Morgan Stanley, some work at elsewhere. 46 00:02:38,480 --> 00:02:40,200 So that's really the goal. 47 00:02:40,200 --> 00:02:43,500 And at the same time, obviously, you 48 00:02:43,500 --> 00:02:46,940 will further solidify your math knowledge 49 00:02:46,940 --> 00:02:51,090 and learn new content. 50 00:02:51,090 --> 00:02:54,590 And we put the prerequisite about the math part a bit 51 00:02:54,590 --> 00:02:56,470 later. 52 00:02:56,470 --> 00:03:00,020 So I will use today's first lecture's time 53 00:03:00,020 --> 00:03:02,330 to give you an introduction, really, 54 00:03:02,330 --> 00:03:05,600 to prepare you some basic background knowledge 55 00:03:05,600 --> 00:03:08,150 about the financial markets. 56 00:03:08,150 --> 00:03:10,680 Some terminologies will be used, which 57 00:03:10,680 --> 00:03:13,490 you may not have heard before. 58 00:03:13,490 --> 00:03:16,370 So before I get into the introduction, 59 00:03:16,370 --> 00:03:19,160 I always like to know who are actually in the classroom, 60 00:03:19,160 --> 00:03:20,910 so let me ask you a few questions. 61 00:03:20,910 --> 00:03:23,740 You just need to raise your hands 62 00:03:23,740 --> 00:03:28,260 so I know roughly what kind of background and where you are. 63 00:03:28,260 --> 00:03:33,390 So how many undergraduate students are here? 64 00:03:33,390 --> 00:03:35,950 So I would say 80% percent. 65 00:03:38,590 --> 00:03:42,020 How many graduate students are here, just to verify? 66 00:03:42,020 --> 00:03:44,320 Yep, that's about right, 20%. 67 00:03:44,320 --> 00:03:51,500 And how many students are in finance and business major? 68 00:03:51,500 --> 00:03:53,130 Just one. 69 00:03:53,130 --> 00:03:56,510 And how many of you are a math major? 70 00:03:56,510 --> 00:03:58,260 Most of you. 71 00:03:58,260 --> 00:04:02,540 How many of you are engineering majors? 72 00:04:02,540 --> 00:04:03,650 A few. 73 00:04:03,650 --> 00:04:08,810 How many of you actually are from other universities? 74 00:04:08,810 --> 00:04:11,160 Great, because last year we had quite a few, 75 00:04:11,160 --> 00:04:13,670 so I want to specifically tell you 76 00:04:13,670 --> 00:04:17,490 that you're very welcome to attend the classes here. 77 00:04:17,490 --> 00:04:19,329 So it's open door. 78 00:04:19,329 --> 00:04:22,970 And last year I remember we had a couple of students 79 00:04:22,970 --> 00:04:24,360 from Harvard. 80 00:04:24,360 --> 00:04:26,010 That's where I actually work right now. 81 00:04:29,840 --> 00:04:32,820 I forgot to mention that, but I'm 82 00:04:32,820 --> 00:04:35,550 affiliated with both the math department and the Sloan school 83 00:04:35,550 --> 00:04:37,740 here. 84 00:04:37,740 --> 00:04:39,110 So anyway, thanks for that. 85 00:04:39,110 --> 00:04:41,900 We will be doing a bit more polling along the way, 86 00:04:41,900 --> 00:04:46,120 mainly to get feedback of how you feel about the class. 87 00:04:46,120 --> 00:04:48,630 Last year we had it online, so if you 88 00:04:48,630 --> 00:04:50,780 feel the class is going too fast, 89 00:04:50,780 --> 00:04:52,480 or the math part is going too slow, 90 00:04:52,480 --> 00:04:55,930 or the finance part is a bit confusing, 91 00:04:55,930 --> 00:04:57,730 the easiest way is really just to send us 92 00:04:57,730 --> 00:05:02,520 emails, which you will find from the class website. 93 00:05:02,520 --> 00:05:03,870 So anyway, today-- 94 00:05:03,870 --> 00:05:06,210 VASILY STRELA: And all of us got MIT emails. 95 00:05:06,210 --> 00:05:07,260 JAKE XIA: Yes. 96 00:05:07,260 --> 00:05:10,026 We all have MIT emails, which are listed on the website. 97 00:05:10,026 --> 00:05:11,150 VASILY STRELA: [INAUDIBLE]. 98 00:05:14,020 --> 00:05:17,080 JAKE XIA: And obviously, we have offices here. 99 00:05:17,080 --> 00:05:21,960 You can easily stop by Peter and Choongbum's offices. 100 00:05:21,960 --> 00:05:26,500 And Vasily and I probably will be less often on campus, 101 00:05:26,500 --> 00:05:30,810 but we'll be here quite often and definitely love to be more. 102 00:05:30,810 --> 00:05:35,240 So anyway, I will start today's lecture with a story, 103 00:05:35,240 --> 00:05:37,840 and a quiz at the end. 104 00:05:37,840 --> 00:05:39,440 Don't worry, it's not a real quiz. 105 00:05:39,440 --> 00:05:40,940 Just going to ask you some questions 106 00:05:40,940 --> 00:05:43,960 you can raise your hand and give your answer. 107 00:05:43,960 --> 00:05:46,420 But let me start with my story. 108 00:05:46,420 --> 00:05:49,340 This is actually my personal story. 109 00:05:49,340 --> 00:05:52,310 I want to tell you why I tell the story later. 110 00:05:52,310 --> 00:05:56,600 But the story actually was in the mid '90s. 111 00:05:56,600 --> 00:06:01,510 I just left Salomon Brothers -- that was my first financial 112 00:06:01,510 --> 00:06:06,990 industry job -- to go to Morgan Stanley in New York to join 113 00:06:06,990 --> 00:06:09,760 the options trading desk. 114 00:06:09,760 --> 00:06:15,320 So the first day, I sat down, I opened the trading book, 115 00:06:15,320 --> 00:06:18,890 I found something was missing. 116 00:06:18,890 --> 00:06:22,600 So, I turned around, I asked my desk quant. 117 00:06:22,600 --> 00:06:26,240 I said, where is the vega report? 118 00:06:26,240 --> 00:06:27,680 So, let me show you. 119 00:06:32,070 --> 00:06:33,050 So that's the story. 120 00:06:36,102 --> 00:06:39,060 So I'm obviously not going to tell you the story of Pi 121 00:06:39,060 --> 00:06:40,130 or "Life of Pi." 122 00:06:40,130 --> 00:06:42,830 That's not a financial story. 123 00:06:42,830 --> 00:06:45,460 The rest of the story, alpha, beta, delta, gamma, 124 00:06:45,460 --> 00:06:49,450 theta, which you will learn from Peter and Choongbum 125 00:06:49,450 --> 00:06:50,980 and Vasily's classes. 126 00:06:50,980 --> 00:06:53,079 So I'm going to talk about vega. 127 00:06:53,079 --> 00:06:54,870 So by the way, before I tell you the story, 128 00:06:54,870 --> 00:06:57,794 what's unique about vega on this list? 129 00:06:57,794 --> 00:06:59,210 AUDIENCE: It's not a Greek letter. 130 00:06:59,210 --> 00:07:00,626 JAKE XIA: It's not a Greek letter. 131 00:07:00,626 --> 00:07:02,070 That's right. 132 00:07:02,070 --> 00:07:04,390 So I turned around and asked my desk quant, I said, 133 00:07:04,390 --> 00:07:05,860 where's the vega report? 134 00:07:05,860 --> 00:07:09,862 But how many of you actually know what a vega is? 135 00:07:09,862 --> 00:07:10,820 OK, lot of people know. 136 00:07:10,820 --> 00:07:13,720 So anyway, I'm not going to-- just 137 00:07:13,720 --> 00:07:16,490 for the people who haven't heard about it before, it's 138 00:07:16,490 --> 00:07:20,230 a measurement about a book or portfolio 139 00:07:20,230 --> 00:07:22,930 or position's sensitivity to volatility. 140 00:07:22,930 --> 00:07:24,400 So, what is volatility? 141 00:07:24,400 --> 00:07:29,480 Which again, you will learn more in rigorous terms 142 00:07:29,480 --> 00:07:31,440 how it's defined in mathematics. 143 00:07:31,440 --> 00:07:36,040 But the meaning of it is really a measurement or indication 144 00:07:36,040 --> 00:07:40,880 of how volatile, or what's the standard deviation of a price 145 00:07:40,880 --> 00:07:43,080 can change over time. 146 00:07:43,080 --> 00:07:44,830 That's all you need to know right now. 147 00:07:44,830 --> 00:07:47,480 I'm not going to ask you questions later. 148 00:07:47,480 --> 00:07:52,737 So my desk quant look at me, said-- 149 00:07:52,737 --> 00:07:54,320 this is supposed to be options trading 150 00:07:54,320 --> 00:07:58,120 desk, so he look at me puzzled. 151 00:07:58,120 --> 00:08:00,020 So instead of answering my question, 152 00:08:00,020 --> 00:08:02,780 he handed over me a training manual 153 00:08:02,780 --> 00:08:06,940 for new employees and new analysts. 154 00:08:06,940 --> 00:08:10,370 So I opened the training manual and looked it through. 155 00:08:10,370 --> 00:08:12,630 I actually found my answer. 156 00:08:12,630 --> 00:08:16,150 So actually, at Morgan Stanley this is not called vega, 157 00:08:16,150 --> 00:08:17,760 it's called kappa. 158 00:08:17,760 --> 00:08:20,030 So now, I remember to call it kappa. 159 00:08:20,030 --> 00:08:21,980 Kappa is actually a Greek letter. 160 00:08:21,980 --> 00:08:25,590 So further, I look on the same page 161 00:08:25,590 --> 00:08:29,750 there was actually a footnote, which I copied down. 162 00:08:29,750 --> 00:08:39,659 So the footnote about why it's called kappa at Morgan Stanley. 163 00:08:39,659 --> 00:08:43,244 Kappa is also called vega by some uneducated traders 164 00:08:43,244 --> 00:08:45,099 at the Salomon Brothers. 165 00:08:45,099 --> 00:08:46,140 That's where I came from. 166 00:08:46,140 --> 00:08:47,850 I just joined. 167 00:08:47,850 --> 00:08:50,800 They have mistaken vega as a Greek letter 168 00:08:50,800 --> 00:08:52,080 after gambling at Vegas. 169 00:08:55,370 --> 00:08:58,510 So anyway, so that was my first day. 170 00:08:58,510 --> 00:09:02,640 So obviously, I learned how to call kappa 171 00:09:02,640 --> 00:09:05,580 very quickly, because I came from Salomon Brothers. 172 00:09:05,580 --> 00:09:09,790 And I called it kappa in the last 17 years, 173 00:09:09,790 --> 00:09:12,090 but you will hear people calling it vega. 174 00:09:12,090 --> 00:09:14,580 Obviously, I have probably more people calling it the vega. 175 00:09:14,580 --> 00:09:19,300 But anyway, so that's my first day at Morgan Stanley. 176 00:09:19,300 --> 00:09:21,750 But why did I tell you the story? 177 00:09:21,750 --> 00:09:24,960 What point I try to make? 178 00:09:24,960 --> 00:09:29,270 So this story is actually-- when you think about it, 179 00:09:29,270 --> 00:09:33,970 mathematical or quantitative finance is a rather new field. 180 00:09:33,970 --> 00:09:37,990 A lot of these terms were newly introduced. 181 00:09:37,990 --> 00:09:42,860 And the pricing model of options, as you know, 182 00:09:42,860 --> 00:09:47,410 was introduced in the Black-Scholes in the '70s, 183 00:09:47,410 --> 00:09:49,830 or some of the ground work may be done a bit earlier. 184 00:09:49,830 --> 00:09:55,770 But it's not like finance was a quantitative profession 185 00:09:55,770 --> 00:09:57,090 to start with. 186 00:09:57,090 --> 00:09:59,720 So what we witness in the last 30 years 187 00:09:59,720 --> 00:10:04,490 was really a transformation of the trading profession coming 188 00:10:04,490 --> 00:10:09,320 from mostly under-educated traders. 189 00:10:09,320 --> 00:10:13,280 Some of them typically joined the firms in the mail room 190 00:10:13,280 --> 00:10:15,080 and became trader later on. 191 00:10:15,080 --> 00:10:17,360 That's typical career path. 192 00:10:17,360 --> 00:10:20,260 And to nowadays, if you walk on the trading floor, 193 00:10:20,260 --> 00:10:24,510 you talk to the traders, most of them have advanced degrees 194 00:10:24,510 --> 00:10:29,950 and quite a few of them have very high training 195 00:10:29,950 --> 00:10:32,580 in mathematics and computer science. 196 00:10:32,580 --> 00:10:36,820 So what has changed over the last 20 or 30 years? 197 00:10:36,820 --> 00:10:40,690 I myself, personally, was probably one of the data 198 00:10:40,690 --> 00:10:44,370 point experiencing this change. 199 00:10:44,370 --> 00:10:49,270 And I certainly didn't expect I would 200 00:10:49,270 --> 00:10:51,880 be doing this when I was at MIT, but I 201 00:10:51,880 --> 00:10:55,990 did that in the last 20 years. 202 00:10:55,990 --> 00:10:59,030 So the point I'm trying to tell you 203 00:10:59,030 --> 00:11:04,120 is, before you dive into any details of mathematics 204 00:11:04,120 --> 00:11:11,220 or any concept in finance in this class, just bear in mind, 205 00:11:11,220 --> 00:11:16,240 this is a field developed in the last mostly 30 years, or even 206 00:11:16,240 --> 00:11:17,170 shorter. 207 00:11:17,170 --> 00:11:19,890 And what you really need to ask questions 208 00:11:19,890 --> 00:11:26,790 is-- it's not really is it right or wrong in mathematics, 209 00:11:26,790 --> 00:11:28,975 is it right or wrong in physics? 210 00:11:28,975 --> 00:11:31,920 So, how the concepts are established 211 00:11:31,920 --> 00:11:35,110 and defined and verified. 212 00:11:35,110 --> 00:11:37,170 Because this is a field-- the transformation 213 00:11:37,170 --> 00:11:42,310 about the participants, products, models, methodology, 214 00:11:42,310 --> 00:11:44,400 everything are changing very rapidly. 215 00:11:44,400 --> 00:11:46,630 Even nowadays, they're still changing. 216 00:11:46,630 --> 00:11:51,720 So with that, I will give you some background 217 00:11:51,720 --> 00:11:57,160 on how the financial markets actually started, 218 00:11:57,160 --> 00:12:03,700 and that's really the history part of this industry. 219 00:12:03,700 --> 00:12:07,960 So, when we talk about markets, we know in early days 220 00:12:07,960 --> 00:12:10,430 people need to exchange goods. 221 00:12:10,430 --> 00:12:11,970 You have something I don't have, I 222 00:12:11,970 --> 00:12:15,730 have something you don't have, so there's exchanges. 223 00:12:15,730 --> 00:12:17,500 Then it becomes centralized. 224 00:12:17,500 --> 00:12:20,530 There are stock exchanges, futures exchanges all 225 00:12:20,530 --> 00:12:22,940 over the world where these products will 226 00:12:22,940 --> 00:12:27,310 be listed as securities on these exchanges. 227 00:12:27,310 --> 00:12:30,560 That's one way of trading, which is centralized. 228 00:12:30,560 --> 00:12:32,680 Obviously, in the last 10, 15 years, 229 00:12:32,680 --> 00:12:37,010 now we have ECNs, electronic platforms. 230 00:12:37,010 --> 00:12:41,270 Trade over-- you know, even larger volume of those trades. 231 00:12:41,270 --> 00:12:47,070 So, financial products is really just one form of trading. 232 00:12:47,070 --> 00:12:52,070 There are many other ways of trading aside from exchanges. 233 00:12:52,070 --> 00:12:55,650 One of them, which is called OTC, 234 00:12:55,650 --> 00:13:00,600 is over-the-counter, meaning two counterparties agree 235 00:13:00,600 --> 00:13:05,920 to do a trade without really subject to the exchange rules, 236 00:13:05,920 --> 00:13:09,580 or the underlying trading agreement does not 237 00:13:09,580 --> 00:13:13,640 have to be a securitized product, or standardized, 238 00:13:13,640 --> 00:13:16,390 or whatever ways you define it. 239 00:13:16,390 --> 00:13:18,770 And the different regions have different exchanges 240 00:13:18,770 --> 00:13:20,730 and markets, as well. 241 00:13:20,730 --> 00:13:25,160 And they typically specialize in local products, local company 242 00:13:25,160 --> 00:13:31,900 stocks, local bonds, and local currencies. 243 00:13:31,900 --> 00:13:33,910 So, there are many different forms. 244 00:13:33,910 --> 00:13:37,780 So again, what's in common? 245 00:13:37,780 --> 00:13:39,650 That's the question you need to ask. 246 00:13:39,650 --> 00:13:42,350 Also, you don't know the specifics. 247 00:13:42,350 --> 00:13:47,280 And the currencies, money itself, are also traded. 248 00:13:47,280 --> 00:13:50,490 And that's where different currencies 249 00:13:50,490 --> 00:13:52,510 issued by different countries. 250 00:13:52,510 --> 00:13:54,810 So, when we talk about trading stocks-- 251 00:13:54,810 --> 00:13:57,750 there are also people trade baskets of stocks, 252 00:13:57,750 --> 00:14:00,300 trade groups of stocks together, and that's 253 00:14:00,300 --> 00:14:03,720 stock index or indices. 254 00:14:03,720 --> 00:14:06,090 So, there are different products. 255 00:14:06,090 --> 00:14:09,170 How the stock get listed on the stock exchange? 256 00:14:09,170 --> 00:14:13,210 It goes through IPO-- Initial Public Offering process. 257 00:14:13,210 --> 00:14:17,340 So, when a company changes from private to public, 258 00:14:17,340 --> 00:14:19,490 it goes through this IPO process. 259 00:14:19,490 --> 00:14:23,160 It's called primary market, primary listing. 260 00:14:23,160 --> 00:14:28,240 And once the stock is listed on the exchange 261 00:14:28,240 --> 00:14:30,800 and it becomes traded in the market, 262 00:14:30,800 --> 00:14:32,420 we call it secondary trading. 263 00:14:32,420 --> 00:14:36,270 So, that's after the primary market. 264 00:14:36,270 --> 00:14:40,840 And equity or stock is one form of trading 265 00:14:40,840 --> 00:14:43,670 or one form of financial products. 266 00:14:43,670 --> 00:14:45,500 What are other forms? 267 00:14:45,500 --> 00:14:46,520 Loans. 268 00:14:46,520 --> 00:14:52,110 Actually, debt products are more generic than equity products. 269 00:14:52,110 --> 00:14:55,700 When you started thinking about it, 270 00:14:55,700 --> 00:14:57,430 what is really finance is about? 271 00:14:57,430 --> 00:15:01,560 It's really about someone has money, someone doesn't. 272 00:15:01,560 --> 00:15:05,480 Someone has money to lend out, someone needs to borrow money. 273 00:15:05,480 --> 00:15:07,220 So, that's loan. 274 00:15:07,220 --> 00:15:09,490 Loan is really a private agreement 275 00:15:09,490 --> 00:15:13,140 between two counterparties or multiple counterparties. 276 00:15:13,140 --> 00:15:16,610 When you securitize them, they become bonds. 277 00:15:16,610 --> 00:15:20,370 And when you look at bonds, every government 278 00:15:20,370 --> 00:15:22,830 will issue large sovereign debt. 279 00:15:22,830 --> 00:15:27,660 So, US government has large outstanding US Treasury debt-- 280 00:15:27,660 --> 00:15:29,890 bonds, notes, bills. 281 00:15:29,890 --> 00:15:34,810 And corporates have issued a lot of debt product, as well. 282 00:15:34,810 --> 00:15:37,640 They borrow money when they need to build a new factory 283 00:15:37,640 --> 00:15:39,190 or expand. 284 00:15:39,190 --> 00:15:41,190 Universities borrow money. 285 00:15:41,190 --> 00:15:45,270 When MIT needs to build a new building, some of the money 286 00:15:45,270 --> 00:15:47,640 will come from the endowment support, 287 00:15:47,640 --> 00:15:52,440 some will come from some other form of research budget, 288 00:15:52,440 --> 00:15:55,570 or some will come from debt financing. 289 00:15:55,570 --> 00:15:58,820 Just borrow from the public-- local governments, 290 00:15:58,820 --> 00:16:01,370 states, counties, even. 291 00:16:01,370 --> 00:16:04,510 So, they have various forms. 292 00:16:04,510 --> 00:16:05,620 So, that's debt product. 293 00:16:05,620 --> 00:16:10,120 Commodities, actually, you know. 294 00:16:10,120 --> 00:16:13,490 Metal, energy, agriculture products 295 00:16:13,490 --> 00:16:15,580 are traded, mostly in the futures 296 00:16:15,580 --> 00:16:17,610 format and some in physical format, 297 00:16:17,610 --> 00:16:19,350 meaning you take deliveries. 298 00:16:19,350 --> 00:16:21,590 When you actually buying and sell, 299 00:16:21,590 --> 00:16:23,540 you build a warehouse to take them. 300 00:16:23,540 --> 00:16:29,870 You ship a tank to store above the ocean. 301 00:16:29,870 --> 00:16:33,480 And the real estate, you're buying and sell houses. 302 00:16:33,480 --> 00:16:36,960 2008 financial crisis, if you read about it, 303 00:16:36,960 --> 00:16:39,000 this has a lot to do with the real estate 304 00:16:39,000 --> 00:16:44,580 market, the mortgages, and asset-backed securities. 305 00:16:44,580 --> 00:16:46,720 So, I'm not trying to give you all the definition, 306 00:16:46,720 --> 00:16:48,130 dumping the information on you. 307 00:16:48,130 --> 00:16:52,030 But I like you at least hearing it once today, 308 00:16:52,030 --> 00:16:56,000 and then you have more interest, you can read on the side. 309 00:16:56,000 --> 00:17:00,220 So asset-backed securities is when you have an asset, 310 00:17:00,220 --> 00:17:06,150 you basically issue a debt with the asset backing it. 311 00:17:06,150 --> 00:17:11,130 And how do you rate the asset's risk level 312 00:17:11,130 --> 00:17:14,339 and what's the income stream, cash flow? 313 00:17:14,339 --> 00:17:19,089 And before 2008 financial crisis, 314 00:17:19,089 --> 00:17:25,730 as you heard, large amount of CMBS-- basically, 315 00:17:25,730 --> 00:17:29,390 it's a commercial real estate backed 316 00:17:29,390 --> 00:17:33,730 securities, mortgage securities, and the residential, as well. 317 00:17:33,730 --> 00:17:37,180 And further of all of these, you heard probably a lot 318 00:17:37,180 --> 00:17:39,040 about the derivative products. 319 00:17:39,040 --> 00:17:42,230 So, that started with swaps, options. 320 00:17:42,230 --> 00:17:44,460 And the structure of the products, it 321 00:17:44,460 --> 00:17:51,320 become more tailor-made for either investors or borrowers 322 00:17:51,320 --> 00:17:54,440 to structure the products in a way to suit their needs. 323 00:17:54,440 --> 00:17:59,420 And some of the complexity of those structured products 324 00:17:59,420 --> 00:18:02,730 become quite high, and the mathematics 325 00:18:02,730 --> 00:18:05,950 involved in pricing them and the risk management 326 00:18:05,950 --> 00:18:07,380 become rather challenging. 327 00:18:14,950 --> 00:18:23,050 So coming back to the players in the market, 328 00:18:23,050 --> 00:18:25,850 one large type of player is really bank. 329 00:18:29,000 --> 00:18:34,500 Essentially, after 1933 Glass-Steagall legislation, 330 00:18:34,500 --> 00:18:36,780 there were two main types of banks. 331 00:18:36,780 --> 00:18:40,340 One is called commercial bank, the other is investment bank. 332 00:18:40,340 --> 00:18:43,690 Commercial bank is supposedly, you're 333 00:18:43,690 --> 00:18:46,680 taking deposits and lend out the money, 334 00:18:46,680 --> 00:18:51,200 and doing more commercial services. 335 00:18:51,200 --> 00:18:55,200 Investment bank supposed to focus on the capital markets, 336 00:18:55,200 --> 00:19:00,870 raising capital, trading, and asset management. 337 00:19:00,870 --> 00:19:08,140 But obviously, after 1999, the Glass-Steagall was repealed. 338 00:19:08,140 --> 00:19:10,040 There's no longer that. 339 00:19:10,040 --> 00:19:12,300 Some people blame that, and probably 340 00:19:12,300 --> 00:19:18,090 for a very good reason, for the cause of 2008 financial crisis. 341 00:19:18,090 --> 00:19:22,675 But I want to tell you how currently investment banks are 342 00:19:22,675 --> 00:19:23,175 organized. 343 00:19:25,750 --> 00:19:31,100 Vasily just mentioned he works in the fixed income. 344 00:19:31,100 --> 00:19:35,470 So banks typically organized by institutional business 345 00:19:35,470 --> 00:19:37,150 and asset management. 346 00:19:37,150 --> 00:19:40,200 So, within the institutional client business, 347 00:19:40,200 --> 00:19:43,590 it has typically three main parts. 348 00:19:43,590 --> 00:19:46,540 Fixed income, which trade the debt 349 00:19:46,540 --> 00:19:48,990 and the derivative products. 350 00:19:48,990 --> 00:19:52,850 Equity, trade stocks and the derivative products. 351 00:19:52,850 --> 00:19:57,120 And IBD, stands for Investment Banking Division, 352 00:19:57,120 --> 00:20:00,240 which really covers corporate finance, 353 00:20:00,240 --> 00:20:05,290 raising capital, listing a stock, IPO, and merger 354 00:20:05,290 --> 00:20:08,370 and acquisition, and advisory. 355 00:20:08,370 --> 00:20:11,700 So that's how banks are organized. 356 00:20:11,700 --> 00:20:16,640 Outside banks, other players, basically, the asset managers, 357 00:20:16,640 --> 00:20:19,935 are obviously a very big force in the financial markets. 358 00:20:22,500 --> 00:20:24,120 So the question a lot of people ask 359 00:20:24,120 --> 00:20:27,420 is, is this a zero sum game? 360 00:20:27,420 --> 00:20:30,420 I'm sure you've heard this many times. 361 00:20:30,420 --> 00:20:32,900 So, in the financial markets, some people win, 362 00:20:32,900 --> 00:20:34,790 some people lose. 363 00:20:34,790 --> 00:20:38,360 A lot of times, it depends on the specific products you 364 00:20:38,360 --> 00:20:40,380 trade, the market you're in. 365 00:20:40,380 --> 00:20:44,950 It is, lot of times, pretty net zero. 366 00:20:44,950 --> 00:20:49,280 But why do we need financial markets? 367 00:20:49,280 --> 00:20:53,670 This comes back to what I described before. 368 00:20:53,670 --> 00:20:55,920 Because something existed-- actually, 369 00:20:55,920 --> 00:20:57,250 there's a need for it. 370 00:20:57,250 --> 00:21:02,310 It's really the need to bridge between the lenders 371 00:21:02,310 --> 00:21:03,930 and the borrowers. 372 00:21:03,930 --> 00:21:07,770 That's really coming down to the essential relationship. 373 00:21:07,770 --> 00:21:10,700 So, investors who have money need 374 00:21:10,700 --> 00:21:14,260 to have better yield or better return, better interest. 375 00:21:14,260 --> 00:21:18,490 In the current environment, when you have a savings account, 376 00:21:18,490 --> 00:21:21,240 you don't really earn much at all. 377 00:21:21,240 --> 00:21:26,810 And so you would have to take more risk to generate more 378 00:21:26,810 --> 00:21:30,400 return, or you have longer horizon 379 00:21:30,400 --> 00:21:34,620 CDs, other type of products, or trade the stocks. 380 00:21:34,620 --> 00:21:37,610 So, when somebody has money, when you trade stocks, 381 00:21:37,610 --> 00:21:41,210 you're essentially-- you're buying a stock, 382 00:21:41,210 --> 00:21:43,060 you give the money somewhere. 383 00:21:43,060 --> 00:21:45,490 Supposedly, it will go to the company. 384 00:21:45,490 --> 00:21:50,400 Company use the money to generate a better return. 385 00:21:50,400 --> 00:21:54,580 And for the borrowers, whoever needs money, 386 00:21:54,580 --> 00:21:58,030 they need to have access to the capital. 387 00:21:58,030 --> 00:22:02,000 So obviously, different borrowers have different risks. 388 00:22:02,000 --> 00:22:04,250 Some people borrow money, never return. 389 00:22:04,250 --> 00:22:07,000 So, never generate any returns, or never even 390 00:22:07,000 --> 00:22:08,690 return the principal. 391 00:22:08,690 --> 00:22:12,566 And so the trade between lenders and the borrowers, 392 00:22:12,566 --> 00:22:15,004 is again, essentially the main driver 393 00:22:15,004 --> 00:22:16,045 of the financial markets. 394 00:22:20,280 --> 00:22:24,580 So, a few more words about the market participants. 395 00:22:24,580 --> 00:22:30,240 So, banks and so-called dealers play the role of market making. 396 00:22:30,240 --> 00:22:32,020 What is market making? 397 00:22:32,020 --> 00:22:36,930 So, when you or some end user go to the market, 398 00:22:36,930 --> 00:22:41,610 wants to buy or sell, typically, if there's no market, 399 00:22:41,610 --> 00:22:43,070 you don't really find the match. 400 00:22:43,070 --> 00:22:46,130 And some of the products you want to buy or sell 401 00:22:46,130 --> 00:22:48,810 may not necessarily be liquid. 402 00:22:48,810 --> 00:22:53,050 So, the dealers step in the middle, make you a price. 403 00:22:53,050 --> 00:22:55,410 Say, OK, you want to buy or sell. 404 00:22:55,410 --> 00:23:00,600 I can tell you-- this stock, I make you price. 405 00:23:00,600 --> 00:23:08,120 $0.99, and that's my bid. $0.95, that's my offer. 406 00:23:08,120 --> 00:23:12,990 So, that's the price I'm willing to buy or sell. 407 00:23:12,990 --> 00:23:15,620 But what the result of the trade-- the dealer 408 00:23:15,620 --> 00:23:18,140 actually takes the other side of your trade. 409 00:23:18,140 --> 00:23:21,840 So, they take principal risk, in this case. 410 00:23:21,840 --> 00:23:23,630 So, that's the difference between dealers 411 00:23:23,630 --> 00:23:24,860 and the brokers. 412 00:23:24,860 --> 00:23:28,480 So, brokers don't really take principal risks. 413 00:23:28,480 --> 00:23:31,650 If you want to buy something or sell something, 414 00:23:31,650 --> 00:23:34,980 if I'm a broker, I don't make you a price. 415 00:23:34,980 --> 00:23:37,230 I go to the market makers. 416 00:23:37,230 --> 00:23:40,960 I actually put two people together, 417 00:23:40,960 --> 00:23:43,500 matchmaking, make that trade happen. 418 00:23:43,500 --> 00:23:44,940 So, I earn the commission. 419 00:23:44,940 --> 00:23:47,290 So, that's a broker's role. 420 00:23:47,290 --> 00:23:49,850 So obviously, there are individual investors, 421 00:23:49,850 --> 00:23:52,630 retail investors, same meaning. 422 00:23:52,630 --> 00:23:57,690 Mutual funds, who actually manage public investors' money, 423 00:23:57,690 --> 00:24:02,400 typically in the long-only format. 424 00:24:02,400 --> 00:24:04,190 Long means you buy something. 425 00:24:04,190 --> 00:24:09,870 So, you don't really short sell a particular security. 426 00:24:09,870 --> 00:24:12,130 Insurance companies has large asset. 427 00:24:12,130 --> 00:24:14,410 They need to generate a return, generate cash flow 428 00:24:14,410 --> 00:24:17,010 to meet their liability needs. 429 00:24:17,010 --> 00:24:18,870 So, they need to invest. 430 00:24:18,870 --> 00:24:20,990 And the pension funds, same thing. 431 00:24:20,990 --> 00:24:22,650 As inflation goes higher, they need 432 00:24:22,650 --> 00:24:26,970 to pay out more to the retirees, so where do you get the return? 433 00:24:26,970 --> 00:24:29,440 Sovereign wealth fund, similarly, endowment 434 00:24:29,440 --> 00:24:32,740 funds-- they all have this same situation, 435 00:24:32,740 --> 00:24:36,360 have capital and needs to deploy and to make better return. 436 00:24:36,360 --> 00:24:40,750 So this other type of players, hedge funds. 437 00:24:40,750 --> 00:24:45,280 So, how many of you have heard hedge funds? 438 00:24:45,280 --> 00:24:45,890 OK, good. 439 00:24:45,890 --> 00:24:48,130 Almost everyone. 440 00:24:48,130 --> 00:24:51,610 And Peter mentioned that he used to work at a hedge fund. 441 00:24:51,610 --> 00:24:55,490 And so, there are different types 442 00:24:55,490 --> 00:24:58,290 of strategies, which I will dive into a bit more, 443 00:24:58,290 --> 00:25:02,570 but hedge fund play the role in the market-- they basically 444 00:25:02,570 --> 00:25:08,380 find opportunities to profit from inefficient market 445 00:25:08,380 --> 00:25:13,200 positioning or pricing, so they have different strategies. 446 00:25:13,200 --> 00:25:16,790 And the private equity is different type of funds. 447 00:25:16,790 --> 00:25:22,190 They basically look to invest in companies 448 00:25:22,190 --> 00:25:29,140 and either take them private or invest in a private equity form 449 00:25:29,140 --> 00:25:33,130 to hopefully improve the company's profitability, 450 00:25:33,130 --> 00:25:35,550 and then catch up. 451 00:25:35,550 --> 00:25:40,430 And governments obviously have a huge impact on the market. 452 00:25:40,430 --> 00:25:45,410 So, we know in the financial crisis, government intervened. 453 00:25:45,410 --> 00:25:49,160 And not only that, at the normal market condition, 454 00:25:49,160 --> 00:25:52,510 government always have a very large impact on the market, 455 00:25:52,510 --> 00:25:54,360 because they are the policymakers. 456 00:25:54,360 --> 00:25:57,530 They decide the interest rate and interest rate curve. 457 00:25:57,530 --> 00:26:01,500 And the different policies they push out, obviously, 458 00:26:01,500 --> 00:26:05,630 will generate different outlook for the future markets, 459 00:26:05,630 --> 00:26:07,594 therefore, profitability. 460 00:26:07,594 --> 00:26:09,510 Then the corporate hedges and the liabilities. 461 00:26:09,510 --> 00:26:13,170 When corporates borrow money, they create some risk, 462 00:26:13,170 --> 00:26:16,280 so they need to be sensitive to the market, it changes. 463 00:26:20,920 --> 00:26:25,230 So, to summarize the types of trading. 464 00:26:25,230 --> 00:26:28,560 The first type is really just hedging. 465 00:26:28,560 --> 00:26:30,450 That means you're not proactively 466 00:26:30,450 --> 00:26:33,080 adding risk to what you have. 467 00:26:33,080 --> 00:26:34,615 You already have some exposure. 468 00:26:37,930 --> 00:26:39,202 Just give you an example. 469 00:26:39,202 --> 00:26:41,160 Let's say you borrow money, you bought a house, 470 00:26:41,160 --> 00:26:44,090 so you have mortgage. 471 00:26:44,090 --> 00:26:51,490 So, let's say it's a floating rate mortgage payments. 472 00:26:51,490 --> 00:26:55,210 And you're worried about interest rates going higher, 473 00:26:55,210 --> 00:26:59,600 so you can lock that rate in into the fixed rate format. 474 00:26:59,600 --> 00:27:03,770 Or you can find ways to hedge your exposure. 475 00:27:03,770 --> 00:27:09,170 Or your corporate has a large income coming from Europe. 476 00:27:09,170 --> 00:27:12,950 So, you have euros coming in, but you're not sure 477 00:27:12,950 --> 00:27:17,410 if euro would trade stronger to the US dollar in the future, 478 00:27:17,410 --> 00:27:19,870 or trade weaker. 479 00:27:19,870 --> 00:27:22,150 If you think it will be stronger, you just leave it. 480 00:27:22,150 --> 00:27:25,020 But if you think it will trade weaker, 481 00:27:25,020 --> 00:27:26,535 so you may want to hedge it, meaning 482 00:27:26,535 --> 00:27:30,790 you want to sell euro and buy US dollars. 483 00:27:30,790 --> 00:27:32,560 And so that's the hedging type. 484 00:27:32,560 --> 00:27:35,650 The second type, as I mentioned, is a market maker. 485 00:27:35,650 --> 00:27:38,770 So, market maker also takes principal risk, 486 00:27:38,770 --> 00:27:44,190 but the main source of profit is really to earn the bid offer. 487 00:27:44,190 --> 00:27:48,300 I gave you the example $0.90 bid, $0.95 offer. 488 00:27:48,300 --> 00:27:53,030 So, that's what the market maker is trying to profit from. 489 00:27:53,030 --> 00:27:55,620 But obviously, they have residual risks 490 00:27:55,620 --> 00:27:56,620 sitting on the book. 491 00:27:56,620 --> 00:27:59,090 Not every trade is matched. 492 00:27:59,090 --> 00:28:03,760 So, how to optimize those group of trades, 493 00:28:03,760 --> 00:28:06,420 that's what market maker is doing. 494 00:28:06,420 --> 00:28:08,900 Most of the bank's dealers are market makers. 495 00:28:08,900 --> 00:28:14,290 In the new regulation, obviously, proprietary trading 496 00:28:14,290 --> 00:28:18,260 is banned, right? 497 00:28:18,260 --> 00:28:21,510 And so the third type is really the proprietary trader, 498 00:28:21,510 --> 00:28:23,350 the risk taker. 499 00:28:23,350 --> 00:28:27,020 So, these are the hedge funds or some portfolio managers. 500 00:28:27,020 --> 00:28:33,180 They need to focus on generating return and control the risk. 501 00:28:33,180 --> 00:28:37,240 So, that's where the beta and alpha, the concept comes in. 502 00:28:37,240 --> 00:28:41,455 So, if you're a portfolio manager, some people say, 503 00:28:41,455 --> 00:28:42,020 don't worry. 504 00:28:42,020 --> 00:28:43,360 Don't go pick any stocks. 505 00:28:43,360 --> 00:28:46,340 Just buy S&P 500 index fund. 506 00:28:46,340 --> 00:28:47,280 Very cheap. 507 00:28:47,280 --> 00:28:50,560 You can pay very little cost to do it. 508 00:28:50,560 --> 00:28:52,080 That's true. 509 00:28:52,080 --> 00:28:55,210 But if you want to beat the S&P 500 510 00:28:55,210 --> 00:29:03,750 index-- let's assume we call S&P 500 index fund is asset b. 511 00:29:03,750 --> 00:29:05,640 So, the return of that, R(b). 512 00:29:05,640 --> 00:29:08,370 That's a return of that index. 513 00:29:08,370 --> 00:29:11,868 Now, you have a portfolio a. 514 00:29:11,868 --> 00:29:16,000 Your time series of return of your asset a, 515 00:29:16,000 --> 00:29:18,960 obviously, you can do linear regression. 516 00:29:18,960 --> 00:29:21,150 A lot of you are math major here, 517 00:29:21,150 --> 00:29:26,900 and you can find a correlation between those two time series. 518 00:29:26,900 --> 00:29:31,730 So, how the two returns are related in a simplified form. 519 00:29:31,730 --> 00:29:35,270 So you can say, this actually-- somehow it came out. 520 00:29:35,270 --> 00:29:37,240 It's supposed to be alpha and beta, 521 00:29:37,240 --> 00:29:41,950 but it turned out to be the letters. 522 00:29:41,950 --> 00:29:45,760 So, in a short description, beta is really-- just 523 00:29:45,760 --> 00:29:50,950 think as correlated move with the other asset. 524 00:29:50,950 --> 00:29:56,340 Alpha is really the difference in the return. 525 00:29:56,340 --> 00:29:57,060 It's a format. 526 00:29:57,060 --> 00:30:00,640 You want to beat S&P 500, so you want to basically 527 00:30:00,640 --> 00:30:02,720 have certain tracking of this index, 528 00:30:02,720 --> 00:30:05,038 but you want to return more on top of that. 529 00:30:10,750 --> 00:30:13,960 So let me just go in bit of details 530 00:30:13,960 --> 00:30:18,000 of how each type of trade actually occurs. 531 00:30:18,000 --> 00:30:20,030 So, when we talk about hedging, I 532 00:30:20,030 --> 00:30:21,460 mentioned the currency example. 533 00:30:21,460 --> 00:30:23,340 Let me give you another example. 534 00:30:23,340 --> 00:30:27,270 There are a lot of people issue bonds, or issue debt. 535 00:30:27,270 --> 00:30:29,680 So this example I'm going to give you is, 536 00:30:29,680 --> 00:30:34,060 let's think about Australian corporate. 537 00:30:34,060 --> 00:30:36,620 Because interest rate in Australia 538 00:30:36,620 --> 00:30:40,390 is higher than in Japan, so typically, 539 00:30:40,390 --> 00:30:44,730 people like to borrow money in Japan, because you 540 00:30:44,730 --> 00:30:47,250 pay smaller interest. 541 00:30:47,250 --> 00:30:49,670 And they invest it in Australia. 542 00:30:49,670 --> 00:30:54,190 You earn higher interest rate. 543 00:30:54,190 --> 00:30:57,350 So let me ask you a question. 544 00:30:57,350 --> 00:30:59,000 Who can tell me, why don't people 545 00:30:59,000 --> 00:31:02,030 just do that all day long, just borrow from Japan 546 00:31:02,030 --> 00:31:05,720 and invest it in Australia? 547 00:31:05,720 --> 00:31:08,250 Then that interest rate, I'm giving you 548 00:31:08,250 --> 00:31:15,030 example of a difference is about 3.5% for the roughly 10 year 549 00:31:15,030 --> 00:31:17,135 swap rates. 550 00:31:17,135 --> 00:31:17,760 Yeah, go ahead. 551 00:31:17,760 --> 00:31:19,900 AUDIENCE: [INAUDIBLE]. 552 00:31:19,900 --> 00:31:21,060 JAKE XIA: Right. 553 00:31:21,060 --> 00:31:22,800 Because you invest in the Australia 554 00:31:22,800 --> 00:31:24,110 Ozzie, Australian dollar. 555 00:31:24,110 --> 00:31:27,540 The Australian dollar may become weaker to the yen. 556 00:31:27,540 --> 00:31:30,860 You may lose all your profit, or even more. 557 00:31:30,860 --> 00:31:35,290 And further, if everybody plays the same game, then 558 00:31:35,290 --> 00:31:39,510 when you try to exit, you have the adverse impact 559 00:31:39,510 --> 00:31:41,050 of your trade. 560 00:31:41,050 --> 00:31:44,690 So, let's say you think that's the right time to do it, 561 00:31:44,690 --> 00:31:47,190 but then at one time, you wake up, 562 00:31:47,190 --> 00:31:49,450 you said, huh, I think too many people are doing this. 563 00:31:49,450 --> 00:31:50,850 I want to hedge myself. 564 00:31:50,850 --> 00:31:51,822 So, what do you do? 565 00:31:51,822 --> 00:31:52,738 AUDIENCE: [INAUDIBLE]? 566 00:31:55,047 --> 00:31:55,630 JAKE XIA: Yep. 567 00:31:55,630 --> 00:31:57,120 So, you try to lock in, right? 568 00:31:57,120 --> 00:32:00,920 So basically, you sell the Australian dollars, 569 00:32:00,920 --> 00:32:02,980 buy the Japanese yen. 570 00:32:02,980 --> 00:32:04,900 Or on the interest rate terms, you 571 00:32:04,900 --> 00:32:09,970 say you'll basically pay the Australian dollar in the swap 572 00:32:09,970 --> 00:32:11,850 leg, and receive yen. 573 00:32:14,940 --> 00:32:19,760 This involves foreign exchange trade, interest rate swap, 574 00:32:19,760 --> 00:32:21,860 and the cross-currency swap. 575 00:32:21,860 --> 00:32:26,130 So, your answer about currency forward is roughly right, 576 00:32:26,130 --> 00:32:31,290 but obviously involves a bit more in actual execution. 577 00:32:31,290 --> 00:32:32,790 So that's just to give you example. 578 00:32:32,790 --> 00:32:35,340 Even if you are not a finance guy, 579 00:32:35,340 --> 00:32:39,390 you work in a corporate, you just do you import, export, 580 00:32:39,390 --> 00:32:43,440 or building a factory, you have to know, actually, 581 00:32:43,440 --> 00:32:44,880 what the exposure is. 582 00:32:44,880 --> 00:32:49,180 So, risk management, nowadays, becomes pretty widespread 583 00:32:49,180 --> 00:32:50,240 responsibility. 584 00:32:50,240 --> 00:32:55,310 It's not just the corporate treasury's responsibility. 585 00:32:55,310 --> 00:32:56,860 So, that's on the hedging side. 586 00:32:56,860 --> 00:33:01,930 Obviously, if you are Intel, for example, 587 00:33:01,930 --> 00:33:05,920 you sell a lot of chips overseas. 588 00:33:05,920 --> 00:33:07,660 And your income-- actually, Intel does 589 00:33:07,660 --> 00:33:11,790 have lot of overseas income sitting outside the States. 590 00:33:11,790 --> 00:33:16,570 So, the exposure to them is if the exchange rate fluctuates, 591 00:33:16,570 --> 00:33:20,330 dollar becomes a lot stronger, they actually lose money. 592 00:33:20,330 --> 00:33:24,590 So, they need to think about how to hedge the revenue produced 593 00:33:24,590 --> 00:33:26,660 overseas. 594 00:33:26,660 --> 00:33:30,080 And obviously, for import-exporters, 595 00:33:30,080 --> 00:33:32,250 that's even more apparent. 596 00:33:32,250 --> 00:33:36,350 And if you're entering in a merger deal, 597 00:33:36,350 --> 00:33:38,670 and one company is buying another, 598 00:33:38,670 --> 00:33:41,400 you need to hedge your potential currency 599 00:33:41,400 --> 00:33:44,250 exposure and your interest rate exposure. 600 00:33:44,250 --> 00:33:48,315 And whatever is on the assets, or the liability, 601 00:33:48,315 --> 00:33:50,565 or the balance sheet, you need to hedge your exposure. 602 00:33:56,080 --> 00:33:58,450 So we talked about hedging activity. 603 00:33:58,450 --> 00:34:01,390 Let's talk about market making. 604 00:34:01,390 --> 00:34:05,010 So if it's a simple transparent product, 605 00:34:05,010 --> 00:34:07,320 everybody pretty much knows where the price is. 606 00:34:07,320 --> 00:34:10,480 So, if you buy Apple stock, I think a lot of people 607 00:34:10,480 --> 00:34:12,179 know pretty much where it is. 608 00:34:12,179 --> 00:34:15,389 You may even have it on your cellphone, 609 00:34:15,389 --> 00:34:18,250 know where that stock is. 610 00:34:18,250 --> 00:34:21,960 But if it's not transparent, so what do you do? 611 00:34:21,960 --> 00:34:24,150 So, if instead of asking you where Apple is, 612 00:34:24,150 --> 00:34:26,129 probably you're going to tell me $495 today. 613 00:34:26,129 --> 00:34:27,378 AUDIENCE: I don't really know. 614 00:34:27,378 --> 00:34:28,590 JAKE XIA: OK. 615 00:34:28,590 --> 00:34:31,870 But if I asked you instead, what is the call option 616 00:34:31,870 --> 00:34:37,199 on Apple stock in two month's time? 617 00:34:37,199 --> 00:34:40,159 I'll give you a strike, let's say, 500. 618 00:34:40,159 --> 00:34:41,790 So you're probably less transparent. 619 00:34:41,790 --> 00:34:46,860 So that market maker comes in to provide that liquidity, 620 00:34:46,860 --> 00:34:48,440 and then takes the risk. 621 00:34:48,440 --> 00:34:52,650 They manage the book by balancing those Greeks, which 622 00:34:52,650 --> 00:34:53,929 I mentioned earlier. 623 00:34:53,929 --> 00:34:59,540 Delta, which describes the [INAUDIBLE] relationship 624 00:34:59,540 --> 00:35:02,440 of this whole book to the underlying stock, or underlying 625 00:35:02,440 --> 00:35:03,700 whatever currency. 626 00:35:03,700 --> 00:35:05,180 That's called delta. 627 00:35:05,180 --> 00:35:11,220 Gamma is really the change of the portfolio. 628 00:35:11,220 --> 00:35:14,920 Take the derivative to the delta, 629 00:35:14,920 --> 00:35:16,490 or to the underlying spot. 630 00:35:16,490 --> 00:35:20,230 So, that's second-order derivative. 631 00:35:20,230 --> 00:35:21,430 Delta is the first order. 632 00:35:21,430 --> 00:35:27,570 So gamma, now you have curvature or convexity coming in. 633 00:35:27,570 --> 00:35:32,180 And theta is really-- nothing changes in the market. 634 00:35:32,180 --> 00:35:34,130 Nothing changes in your position. 635 00:35:34,130 --> 00:35:39,280 How your trading book is carrying or bleeding away 636 00:35:39,280 --> 00:35:40,690 money. 637 00:35:40,690 --> 00:35:44,120 And we talk about the volatility exposure was vega. 638 00:35:44,120 --> 00:35:47,450 And on top of that, what are the tail risks? 639 00:35:47,450 --> 00:35:52,030 What are the events can actually get you into big trouble? 640 00:35:52,030 --> 00:35:54,330 So people use value at risk. 641 00:35:54,330 --> 00:35:56,680 So you will hear this "VaR" concept 642 00:35:56,680 --> 00:35:59,650 in some of the lectures, which is also, obviously, 643 00:35:59,650 --> 00:36:01,150 a very important concept. 644 00:36:01,150 --> 00:36:03,900 I think Peter will-- or Choongbum will-- probably 645 00:36:03,900 --> 00:36:06,340 Peter will teach. 646 00:36:06,340 --> 00:36:09,570 Then capital. 647 00:36:09,570 --> 00:36:11,220 How much capital are you using? 648 00:36:11,220 --> 00:36:13,860 It becomes a very important issue nowadays. 649 00:36:13,860 --> 00:36:16,520 And balance sheet. 650 00:36:16,520 --> 00:36:18,760 Again, you have asset, you have liability. 651 00:36:18,760 --> 00:36:19,770 How do you leverage? 652 00:36:19,770 --> 00:36:21,290 How much leverage you have? 653 00:36:21,290 --> 00:36:24,140 Before the crisis, for example, lot of the banks leverage up 654 00:36:24,140 --> 00:36:29,010 40 times, meaning when you have $1, you had $40 exposure. 655 00:36:29,010 --> 00:36:31,360 So when the market moves little, you get wiped out. 656 00:36:31,360 --> 00:36:36,530 That's really what amplified in the 2008 financial crisis. 657 00:36:36,530 --> 00:36:40,870 And how do you measure the asset in balance sheet 658 00:36:40,870 --> 00:36:43,630 when you have derivatives rather than a straightforward 659 00:36:43,630 --> 00:36:44,130 notional? 660 00:36:50,600 --> 00:36:53,370 So lot of quantitative type of people 661 00:36:53,370 --> 00:36:56,990 like to focus a bit more on the risk taking side, 662 00:36:56,990 --> 00:37:01,120 because people heard stories about successful cases 663 00:37:01,120 --> 00:37:03,630 of some hedge funds using high math. 664 00:37:03,630 --> 00:37:06,820 They generated very impressive returns 665 00:37:06,820 --> 00:37:09,060 and they seem to have an edge. 666 00:37:09,060 --> 00:37:12,250 So now, people focus on trading strategies. 667 00:37:12,250 --> 00:37:17,490 So that falls into the category of proprietary trading or risk 668 00:37:17,490 --> 00:37:18,460 taking. 669 00:37:18,460 --> 00:37:21,300 So that you can just simply doing directional trading 670 00:37:21,300 --> 00:37:21,990 strategies. 671 00:37:21,990 --> 00:37:24,470 Just go long or short the stock. 672 00:37:24,470 --> 00:37:25,990 That's very simple. 673 00:37:25,990 --> 00:37:29,530 Those so-called the gut traders, gut feeling. 674 00:37:29,530 --> 00:37:30,550 Go with your gut. 675 00:37:30,550 --> 00:37:31,720 You don't even think. 676 00:37:31,720 --> 00:37:38,410 You say, I'm eating curry today, so I go long. 677 00:37:38,410 --> 00:37:42,310 I'm eating rice tomorrow, so I go short. 678 00:37:42,310 --> 00:37:44,400 So, this arbitrage. 679 00:37:44,400 --> 00:37:50,990 Arbitrage is really to find the relationships between prices, 680 00:37:50,990 --> 00:37:56,380 and try to profit from those relationship mispricing. 681 00:37:56,380 --> 00:37:59,170 This is actually very interesting. 682 00:37:59,170 --> 00:38:01,410 Not many people focus on arbitrage, 683 00:38:01,410 --> 00:38:04,320 because lot of people are gut traders. 684 00:38:04,320 --> 00:38:06,230 You essentially just watch your own market. 685 00:38:06,230 --> 00:38:07,813 You don't really care what's going on. 686 00:38:07,813 --> 00:38:13,740 If you trade gold in the States, the gold price 687 00:38:13,740 --> 00:38:17,070 happen in Asia and in Europe matters, right, 688 00:38:17,070 --> 00:38:18,760 because you're trading the same thing. 689 00:38:18,760 --> 00:38:20,520 If they are not priced the same way, 690 00:38:20,520 --> 00:38:22,760 you can profit from the difference. 691 00:38:22,760 --> 00:38:25,880 And that's just a simple example. 692 00:38:25,880 --> 00:38:29,920 But a spot price versus forward price, that's 693 00:38:29,920 --> 00:38:31,610 a deterministic relationship. 694 00:38:31,610 --> 00:38:33,300 It's a mathematical relationship. 695 00:38:33,300 --> 00:38:36,050 If that relationship breaks down, you can also profit. 696 00:38:36,050 --> 00:38:40,080 So there are many examples mathematical relationship 697 00:38:40,080 --> 00:38:44,010 which gives you the arbitrage opportunity. 698 00:38:44,010 --> 00:38:47,730 The other type is called a value trader, or relative 699 00:38:47,730 --> 00:38:48,850 value strategies. 700 00:38:51,570 --> 00:38:55,790 Think there's a deterministic, temporary mathematical 701 00:38:55,790 --> 00:38:56,900 relationship. 702 00:38:56,900 --> 00:38:59,190 You look at the longer term in horizon, 703 00:38:59,190 --> 00:39:01,610 trying to determine what is really the underlying 704 00:39:01,610 --> 00:39:03,910 value of a particular instrument, 705 00:39:03,910 --> 00:39:06,820 then trade on the relative value. 706 00:39:06,820 --> 00:39:10,950 Obviously, there are successful value investors out there. 707 00:39:10,950 --> 00:39:15,500 And the systematic trader builds computer models. 708 00:39:15,500 --> 00:39:20,330 One example is trend following, so just follow the price trend. 709 00:39:20,330 --> 00:39:25,490 That used to be an effective strategy for some time, 710 00:39:25,490 --> 00:39:28,220 but when lot of people doing the same thing, that 711 00:39:28,220 --> 00:39:31,750 becomes much less effective. 712 00:39:31,750 --> 00:39:33,730 Or momentum, same thing. 713 00:39:33,730 --> 00:39:38,480 Stat arb, finding statistical relationship 714 00:39:38,480 --> 00:39:42,490 among large number of stocks, then 715 00:39:42,490 --> 00:39:46,430 trade at the higher frequency. 716 00:39:46,430 --> 00:39:48,470 And fundamental analysis, you're really 717 00:39:48,470 --> 00:39:50,890 trying to understand what's going on in the world. 718 00:39:50,890 --> 00:39:54,090 What is the trade balance? 719 00:39:54,090 --> 00:39:58,190 What is the earning potential of a company? 720 00:39:58,190 --> 00:40:00,220 What's the trade balance of a country? 721 00:40:00,220 --> 00:40:01,830 What is a policy change? 722 00:40:01,830 --> 00:40:03,760 What does it mean when Federal Reserve 723 00:40:03,760 --> 00:40:08,300 announce they're going to taper the quantitative easing? 724 00:40:08,300 --> 00:40:12,890 Why the stock market is sold off in the last couple months, 725 00:40:12,890 --> 00:40:17,100 especially why stocks in India, Brazil, Indonesia, 726 00:40:17,100 --> 00:40:18,590 sold out more. 727 00:40:18,590 --> 00:40:19,490 Why is that? 728 00:40:19,490 --> 00:40:22,850 So it goes through those fundamental analysis. 729 00:40:22,850 --> 00:40:25,770 And there are special situations. 730 00:40:25,770 --> 00:40:31,500 Some companies are going through particular difficulties, 731 00:40:31,500 --> 00:40:33,610 assets are priced very cheaply. 732 00:40:33,610 --> 00:40:39,290 So, there are firms out there -- you probably heard Bain Capital 733 00:40:39,290 --> 00:40:42,740 and many others -- where they focus on these private equity 734 00:40:42,740 --> 00:40:45,085 and special situation opportunities. 735 00:40:49,550 --> 00:40:55,690 So what have all of these to do with mathematics? 736 00:40:55,690 --> 00:40:58,080 Where does math come in? 737 00:40:58,080 --> 00:40:59,650 How do you use math? 738 00:40:59,650 --> 00:41:02,890 So, I want to give you some aspects of that. 739 00:41:02,890 --> 00:41:07,300 So from my personal experience, I joined the market, 740 00:41:07,300 --> 00:41:09,980 really start to working on pricing models. 741 00:41:09,980 --> 00:41:11,500 So, that's the first area. 742 00:41:11,500 --> 00:41:14,160 So, math is very effective, because when 743 00:41:14,160 --> 00:41:19,060 you, your bank, your corporate, you 744 00:41:19,060 --> 00:41:21,830 want to buy some financial instruments, 745 00:41:21,830 --> 00:41:25,540 you have to know where is the price. 746 00:41:25,540 --> 00:41:28,400 It's easy to observe a stock in the market, 747 00:41:28,400 --> 00:41:31,470 but when it comes to more complex products, 748 00:41:31,470 --> 00:41:35,350 they just take one step forward on the complexity, 749 00:41:35,350 --> 00:41:36,720 which is the option. 750 00:41:36,720 --> 00:41:38,490 You have to know how to price an option. 751 00:41:38,490 --> 00:41:40,660 So, that's where the math comes in. 752 00:41:40,660 --> 00:41:43,450 You actually have to be able to solve differential equations 753 00:41:43,450 --> 00:41:47,270 to get a model price, then you obviously 754 00:41:47,270 --> 00:41:51,640 adjust to your assumptions to fit into the market. 755 00:41:51,640 --> 00:41:57,660 So, pricing model, which Vasily and many of his colleagues 756 00:41:57,660 --> 00:42:00,690 can tell you more-- which is very much 757 00:42:00,690 --> 00:42:03,290 a very interesting and challenging area. 758 00:42:03,290 --> 00:42:06,050 How do you price all these instruments? 759 00:42:06,050 --> 00:42:09,375 And when I say pricing, it's not in the narrow definition 760 00:42:09,375 --> 00:42:11,380 of just coming up with the price. 761 00:42:11,380 --> 00:42:13,140 When you build a pricing model, you also 762 00:42:13,140 --> 00:42:18,220 generate the risk parameters of these instruments, 763 00:42:18,220 --> 00:42:21,020 and how do you risk manage them. 764 00:42:21,020 --> 00:42:23,010 So, that comes to the second part. 765 00:42:23,010 --> 00:42:26,840 So math is very useful in risk management, 766 00:42:26,840 --> 00:42:29,600 which I will give you some -- not quiz -- 767 00:42:29,600 --> 00:42:31,920 questions after this slide. 768 00:42:31,920 --> 00:42:35,610 You can see that risk management itself is very challenging. 769 00:42:35,610 --> 00:42:37,460 It's not a purely mathematical question, 770 00:42:37,460 --> 00:42:40,140 but yet, math plays a very important role 771 00:42:40,140 --> 00:42:44,050 to quantify how much exposure you have. 772 00:42:44,050 --> 00:42:47,010 Then, the third is trading strategies. 773 00:42:47,010 --> 00:42:50,630 Again, I think a lot of people with math background, 774 00:42:50,630 --> 00:42:52,660 or in general, people are looking 775 00:42:52,660 --> 00:42:57,170 for the so-called holy grail trading strategies. 776 00:42:57,170 --> 00:43:00,330 It's almost like perpetual motion machines people 777 00:43:00,330 --> 00:43:02,005 looking for 100 years ago. 778 00:43:02,005 --> 00:43:03,570 You just turn it on. 779 00:43:03,570 --> 00:43:05,660 It makes money by itself. 780 00:43:05,660 --> 00:43:08,350 You go to sleep, you go on vacation, you come back, 781 00:43:08,350 --> 00:43:10,760 you'll have more in your bank account. 782 00:43:10,760 --> 00:43:13,560 Obviously, that's not going to happen. 783 00:43:13,560 --> 00:43:20,040 The robotrader, a robotic trader, is a dream. 784 00:43:20,040 --> 00:43:26,350 It has its place or its use, but it's a fast evolving market. 785 00:43:26,350 --> 00:43:31,440 You have to constantly either upgrade your research 786 00:43:31,440 --> 00:43:34,460 and adjust your strategies. 787 00:43:34,460 --> 00:43:38,380 There's no such thing you can build and leave it alone, 788 00:43:38,380 --> 00:43:40,480 it runs for itself forever. 789 00:43:40,480 --> 00:43:45,030 But I just want to mention that because maybe 790 00:43:45,030 --> 00:43:47,100 towards the end of the term you will feel, hmm, 791 00:43:47,100 --> 00:43:50,280 I came up with this brilliant trading strategy. 792 00:43:50,280 --> 00:43:52,240 I think it's going to make money forever. 793 00:43:52,240 --> 00:43:55,785 Please let me know first. 794 00:43:55,785 --> 00:43:59,260 AUDIENCE: And me second. 795 00:43:59,260 --> 00:44:04,700 PROFESSOR: So, I want to leave some time to Vasily. 796 00:44:04,700 --> 00:44:07,420 Actually, he can give you some examples 797 00:44:07,420 --> 00:44:10,400 of projects of last year's students 798 00:44:10,400 --> 00:44:16,030 who actually came to this class and did some real application 799 00:44:16,030 --> 00:44:17,390 at Morgan Stanley. 800 00:44:17,390 --> 00:44:20,120 But before I hand it over to Vasily, 801 00:44:20,120 --> 00:44:22,050 let me ask you some questions. 802 00:44:22,050 --> 00:44:25,060 I just want to-- not really to quiz you, just give you 803 00:44:25,060 --> 00:44:30,490 the sense how math and intuition and judgment 804 00:44:30,490 --> 00:44:32,330 can come into the same place. 805 00:44:32,330 --> 00:44:35,820 So, let me first give you an example I call risk aversion. 806 00:44:35,820 --> 00:44:41,306 So, you are facing two choices, choice A and a choice B. Choice 807 00:44:41,306 --> 00:44:45,540 A being you have 80 chance to lose $500. 808 00:44:45,540 --> 00:44:50,696 You have 20% chance to win $500. 809 00:44:50,696 --> 00:44:51,820 That's pretty clear, right? 810 00:44:51,820 --> 00:44:56,780 That's choice A. Or choice B, you basically 811 00:44:56,780 --> 00:45:01,960 just lock in you have 100% chance to lose $280. 812 00:45:01,960 --> 00:45:08,850 Let me ask you, for whoever likes to choose choice A, 813 00:45:08,850 --> 00:45:10,154 please raise your hand. 814 00:45:15,024 --> 00:45:16,980 One, two, three, four. 815 00:45:16,980 --> 00:45:22,280 About six out of say, let's call it 50. 816 00:45:22,280 --> 00:45:25,733 So, can I ask you why you think choice A makes sense? 817 00:45:25,733 --> 00:45:27,774 AUDIENCE: So, I know it's a lower expected value, 818 00:45:27,774 --> 00:45:35,370 but I enjoy gambling and I would rather take the chance of-- 819 00:45:35,370 --> 00:45:39,080 JAKE XIA: Right, because you don't want to lock in that $280 820 00:45:39,080 --> 00:45:39,900 loss, right? 821 00:45:39,900 --> 00:45:41,740 That, or you still have 20% chance to win. 822 00:45:44,380 --> 00:45:46,250 For the ones raised their hand for choice A, 823 00:45:46,250 --> 00:45:48,190 are there any other reasons? 824 00:45:48,190 --> 00:45:48,910 Same reason. 825 00:45:51,285 --> 00:45:52,160 AUDIENCE: [INAUDIBLE] 826 00:45:56,280 --> 00:45:57,770 JAKE XIA: I assume the rest of you 827 00:45:57,770 --> 00:46:00,840 would choose choice B, unless you-- Neither? 828 00:46:00,840 --> 00:46:02,600 How many of you choose choice B? 829 00:46:06,410 --> 00:46:10,040 Choice B. And are there anybody think neither is right? 830 00:46:12,770 --> 00:46:15,000 You have to choose. 831 00:46:15,000 --> 00:46:16,590 No, you have to choose. 832 00:46:16,590 --> 00:46:19,520 So, either choice A or choice B. 833 00:46:19,520 --> 00:46:22,320 So, let me just talk a little bit about this. 834 00:46:22,320 --> 00:46:24,880 Again, I'm not trying to tell you which one is right, 835 00:46:24,880 --> 00:46:27,840 but I just share my thoughts how we look at these. 836 00:46:27,840 --> 00:46:29,450 Why it called risk aversion? 837 00:46:29,450 --> 00:46:33,260 So, this is very common human behavior. 838 00:46:33,260 --> 00:46:36,580 When you go to the market, you buy a stock. 839 00:46:36,580 --> 00:46:40,050 When the stock goes up, makes bit of money, 840 00:46:40,050 --> 00:46:44,590 the natural tendency -- for especially someone is new 841 00:46:44,590 --> 00:46:47,565 to the market -- is to let's take profit. 842 00:46:47,565 --> 00:46:48,290 Let's sell. 843 00:46:48,290 --> 00:46:49,670 Oh, I made $1000. 844 00:46:49,670 --> 00:46:51,170 I made $500. 845 00:46:51,170 --> 00:46:54,930 Let's go have a nice meal or whatever. 846 00:46:54,930 --> 00:46:58,410 Buy an iPad. 847 00:46:58,410 --> 00:47:02,456 But when the stock loses money, what's the natural tendency? 848 00:47:02,456 --> 00:47:04,910 AUDIENCE: [INAUDIBLE] 849 00:47:04,910 --> 00:47:05,660 JAKE XIA: That's-- 850 00:47:05,660 --> 00:47:06,990 AUDIENCE: [INAUDIBLE] 851 00:47:06,990 --> 00:47:08,390 JAKE XIA: I think natural tendency, lot of people 852 00:47:08,390 --> 00:47:09,060 will keep it. 853 00:47:09,060 --> 00:47:11,580 I think if you have the discipline to get out, 854 00:47:11,580 --> 00:47:14,030 that's great. 855 00:47:14,030 --> 00:47:18,460 Trading is really all about how do you risk manage, 856 00:47:18,460 --> 00:47:22,375 have the discipline, and how to manage your losses. 857 00:47:22,375 --> 00:47:24,000 The natural tendency of a lot of people 858 00:47:24,000 --> 00:47:26,980 is, well, I think there's a 20% chance to come back, 859 00:47:26,980 --> 00:47:29,490 and I'm going to make $500 more. 860 00:47:29,490 --> 00:47:34,330 Why do I want to lock in to stop myself out at 280? 861 00:47:34,330 --> 00:47:38,960 So even though the expected value-- I think lot of people 862 00:47:38,960 --> 00:47:44,510 said, you lose expected value, which is $300 in choice A, 863 00:47:44,510 --> 00:47:49,580 but you would still not to choose choice B, 864 00:47:49,580 --> 00:47:52,300 because you don't want to lock in the $280 loss. 865 00:47:52,300 --> 00:47:57,900 Again, I'm not trying to inject the idea to you of which one 866 00:47:57,900 --> 00:48:00,260 is right or wrong, but think about it. 867 00:48:00,260 --> 00:48:05,360 So, that's really the common behavior, which mathematically 868 00:48:05,360 --> 00:48:10,270 may not make sense, but lot of people still would like to do. 869 00:48:10,270 --> 00:48:14,020 And also, really, when you think about it, 870 00:48:14,020 --> 00:48:16,120 depends on your situation. 871 00:48:16,120 --> 00:48:23,320 And let's say, you think the market-- 872 00:48:23,320 --> 00:48:26,030 I'm giving you the stock example again. 873 00:48:26,030 --> 00:48:29,240 If you're not purely following the discipline of stop loss, 874 00:48:29,240 --> 00:48:32,150 but you just think the fundamental picture 875 00:48:32,150 --> 00:48:33,090 has changed. 876 00:48:33,090 --> 00:48:36,350 You really don't think the stock should go up anymore. 877 00:48:36,350 --> 00:48:40,530 Obviously, at whatever level you should get out, regardless 878 00:48:40,530 --> 00:48:41,820 how much loss you lock in. 879 00:48:44,420 --> 00:48:47,280 But if you think the fundamental story is still very sound, 880 00:48:47,280 --> 00:48:51,010 you should think about as if you don't have a position, what 881 00:48:51,010 --> 00:48:52,660 you want to do next. 882 00:48:52,660 --> 00:48:54,830 But anyway, mathematically, I just 883 00:48:54,830 --> 00:48:59,670 want to see-- I guess this is MIT, 884 00:48:59,670 --> 00:49:02,450 so many people think mathematically 885 00:49:02,450 --> 00:49:07,140 where you would actually choose choice B, because that's 886 00:49:07,140 --> 00:49:08,740 low expectation, which makes sense. 887 00:49:08,740 --> 00:49:12,300 But I think if you ask a larger audience, 888 00:49:12,300 --> 00:49:15,687 I think a lot of people don't really want to choose choice B, 889 00:49:15,687 --> 00:49:17,520 because they don't want to lock in the loss. 890 00:49:21,030 --> 00:49:24,820 Now, let me change the question a little bit. 891 00:49:24,820 --> 00:49:29,590 So, choice A becomes instead of the 80% chance to lose, 892 00:49:29,590 --> 00:49:34,690 now you have 80% chance to win $500 and 20% chance 893 00:49:34,690 --> 00:49:37,130 to lose $500. 894 00:49:37,130 --> 00:49:43,240 Choice B, you have 100% chance to win $280. 895 00:49:43,240 --> 00:49:44,560 Who would choose choice A? 896 00:49:48,060 --> 00:49:50,510 Again, minority of this audience. 897 00:49:50,510 --> 00:49:52,480 Let's say less than 10%. 898 00:49:52,480 --> 00:49:54,700 Who would choose choice B? 899 00:49:54,700 --> 00:49:56,370 The rest of you. 900 00:49:56,370 --> 00:49:59,120 All right. 901 00:49:59,120 --> 00:50:04,519 Can someone choose choice A give me an argument why would you? 902 00:50:04,519 --> 00:50:05,394 AUDIENCE: [INAUDIBLE] 903 00:50:15,090 --> 00:50:15,980 JAKE XIA: Yep. 904 00:50:15,980 --> 00:50:18,320 Anyone want to give me a reason for choice B? 905 00:50:18,320 --> 00:50:20,670 AUDIENCE: Higher Sharpe. 906 00:50:20,670 --> 00:50:22,136 JAKE XIA: Higher Sharpe? 907 00:50:22,136 --> 00:50:22,950 Mm-hm. 908 00:50:22,950 --> 00:50:25,530 Yup. 909 00:50:25,530 --> 00:50:28,170 Well, let me just leave it here. 910 00:50:28,170 --> 00:50:33,154 Again, I think we can talk a bit more along in the class. 911 00:50:33,154 --> 00:50:34,570 I mean, the last day of the class, 912 00:50:34,570 --> 00:50:38,890 hopefully we'll have much deeper discussion on this. 913 00:50:38,890 --> 00:50:39,840 It's not unique. 914 00:50:39,840 --> 00:50:44,190 The answer, I think it can go you either way, as you said. 915 00:50:44,190 --> 00:50:47,920 If your bank account balance is-- let's 916 00:50:47,920 --> 00:50:50,010 say you are a freshman student. 917 00:50:50,010 --> 00:50:54,810 Your bank account is $800. 918 00:50:54,810 --> 00:50:58,000 Your choice will be very different from someone has 919 00:50:58,000 --> 00:51:01,690 $100,000 in his bank account. 920 00:51:01,690 --> 00:51:11,181 And also, your risk tolerance, how much you can tolerate. 921 00:51:11,181 --> 00:51:13,430 I'm not going to give you say, this is right or wrong. 922 00:51:13,430 --> 00:51:17,715 But with that, let me move on and give you some homework. 923 00:51:23,350 --> 00:51:25,090 So, before I give you the homework, 924 00:51:25,090 --> 00:51:27,840 I want to make a few more comments. 925 00:51:27,840 --> 00:51:30,620 Do people always learn from their experiences? 926 00:51:30,620 --> 00:51:35,480 In science, we collect evidence, we build models. 927 00:51:35,480 --> 00:51:36,860 We first understand the physics. 928 00:51:36,860 --> 00:51:40,460 We build mathematical models, then we verify in physics, 929 00:51:40,460 --> 00:51:41,900 doing experiments. 930 00:51:41,900 --> 00:51:45,392 But is that the same investigation process 931 00:51:45,392 --> 00:51:48,270 in finance? 932 00:51:48,270 --> 00:51:50,890 Market cycles are typically very long, 933 00:51:50,890 --> 00:51:53,720 but people tend to have short memories. 934 00:51:53,720 --> 00:51:56,160 So, how do people really learn from their experiences? 935 00:51:56,160 --> 00:51:57,870 A very interesting question. 936 00:51:57,870 --> 00:52:01,720 And very natural tendency is to extrapolate 937 00:52:01,720 --> 00:52:03,430 historical experience. 938 00:52:03,430 --> 00:52:04,940 What happened in 2008? 939 00:52:04,940 --> 00:52:06,460 People still remember. 940 00:52:06,460 --> 00:52:09,890 What happened in 1970s? 941 00:52:09,890 --> 00:52:11,370 Maybe some people still remember. 942 00:52:11,370 --> 00:52:13,940 What happened 100 years ago? 943 00:52:13,940 --> 00:52:17,930 So, people tend to extrapolate, drawing conclusions 944 00:52:17,930 --> 00:52:20,440 from very recent experience. 945 00:52:20,440 --> 00:52:24,950 And deterministic relationship versus statistical relationship 946 00:52:24,950 --> 00:52:27,010 is very interesting, as well. 947 00:52:27,010 --> 00:52:31,344 When you try to trade on those, how do you really build models? 948 00:52:31,344 --> 00:52:32,635 Is the market really efficient? 949 00:52:35,890 --> 00:52:37,660 What part is efficient? 950 00:52:37,660 --> 00:52:40,090 How do you really apply those theories 951 00:52:40,090 --> 00:52:43,800 in your day-to-day risk management or trading 952 00:52:43,800 --> 00:52:45,470 activities? 953 00:52:45,470 --> 00:52:49,410 And sometimes, people tend to oversimplify. 954 00:52:49,410 --> 00:52:51,640 Just say, oh, I can model this. 955 00:52:51,640 --> 00:52:54,030 This is one important parameter. 956 00:52:54,030 --> 00:52:55,450 I just take that. 957 00:52:55,450 --> 00:52:57,130 So I just give you all the warnings 958 00:52:57,130 --> 00:53:02,220 that the-- again, very young, new field 959 00:53:02,220 --> 00:53:07,550 and largely, often, this is art, than science. 960 00:53:07,550 --> 00:53:09,700 So keep that in mind, even though we're talking 961 00:53:09,700 --> 00:53:12,290 about mathematics in finance. 962 00:53:12,290 --> 00:53:15,980 Math is very powerful and useful in finance. 963 00:53:15,980 --> 00:53:18,700 So learn the math, learn the finance first, 964 00:53:18,700 --> 00:53:21,550 but keep those questions along the way 965 00:53:21,550 --> 00:53:23,570 when you are learning during this class. 966 00:53:27,130 --> 00:53:29,055 So suggested homework, optional. 967 00:53:32,150 --> 00:53:35,780 I mentioned a lot of terminologies today. 968 00:53:35,780 --> 00:53:39,360 Go to the course website, read what we have put up 969 00:53:39,360 --> 00:53:41,420 for the financial glossary. 970 00:53:41,420 --> 00:53:45,110 So if you still have things you don't understand, 971 00:53:45,110 --> 00:53:49,430 compile your own list of financial concepts, which 972 00:53:49,430 --> 00:53:53,300 you can search on the web or even ask us. 973 00:53:53,300 --> 00:53:54,920 But I encourage you to do that. 974 00:53:54,920 --> 00:53:56,730 It will prepare you well. 975 00:53:56,730 --> 00:53:59,940 So, that's really-- and read other materials 976 00:53:59,940 --> 00:54:01,950 on the course work. 977 00:54:01,950 --> 00:54:04,740 So we got maybe-- how about this? 978 00:54:04,740 --> 00:54:08,290 We still got about 15 minutes or 12 minutes left, 979 00:54:08,290 --> 00:54:11,080 so I'll pass it to Vasily, then maybe we 980 00:54:11,080 --> 00:54:12,930 can leave five minutes for some questions. 981 00:54:12,930 --> 00:54:13,763 VASILY STRELA: Yeah. 982 00:54:13,763 --> 00:54:15,150 JAKE XIA: Yeah, OK. 983 00:54:15,150 --> 00:54:16,650 VASILY STRELA: [INAUDIBLE] mentioned 984 00:54:16,650 --> 00:54:30,485 that, Apple trades, that now it's $494.4 Yeah, just a couple 985 00:54:30,485 --> 00:54:31,110 of [INAUDIBLE]. 986 00:54:31,110 --> 00:54:42,552 Well, first of all, no offense to people who were [INAUDIBLE], 987 00:54:42,552 --> 00:54:47,644 but I just wanted to give an example of [INAUDIBLE]. 988 00:54:51,102 --> 00:54:52,018 AUDIENCE: [INAUDIBLE]. 989 00:55:01,760 --> 00:55:04,150 VASILY STRELA: --because he was working in our group, 990 00:55:04,150 --> 00:55:11,080 and it just will give you a little bit of an idea what 991 00:55:11,080 --> 00:55:13,130 we will be talking about and what actually we 992 00:55:13,130 --> 00:55:18,160 do in the daily life, or what an intern or somebody who 993 00:55:18,160 --> 00:55:22,150 comes to work in this industry could do. 994 00:55:22,150 --> 00:55:26,790 And one project is [INAUDIBLE] worked 995 00:55:26,790 --> 00:55:31,470 was on estimating the noisy derivative. 996 00:55:31,470 --> 00:55:33,150 Derivative is called delta. 997 00:55:33,150 --> 00:55:36,040 Delta is usually the first derivative to a function. 998 00:55:36,040 --> 00:55:42,140 And as we will see in the class, quite often, to obtain a price, 999 00:55:42,140 --> 00:55:45,870 you do it through Monte Carlo, meaning running a lot of paths 1000 00:55:45,870 --> 00:55:48,950 and then averaging along them. 1001 00:55:48,950 --> 00:55:50,200 So, it's a statistical method. 1002 00:55:50,200 --> 00:55:56,320 So obviously, there is a noise to your answer every time. 1003 00:55:56,320 --> 00:56:01,560 So, if you want to differentiate this functions 1004 00:56:01,560 --> 00:56:06,910 and get a derivative, then this derivative will be quite noisy. 1005 00:56:06,910 --> 00:56:10,240 And so, instead of getting the true derivative, 1006 00:56:10,240 --> 00:56:14,290 you might obtain something quite different from true derivative 1007 00:56:14,290 --> 00:56:16,490 just because there is a confidence 1008 00:56:16,490 --> 00:56:19,580 interval around any point. 1009 00:56:19,580 --> 00:56:22,420 And obviously, there is a trade off here, as well, 1010 00:56:22,420 --> 00:56:28,950 because you can run more paths, throw more computational power, 1011 00:56:28,950 --> 00:56:31,920 which will reduce your confidence interval. 1012 00:56:31,920 --> 00:56:37,890 You will know better where you are, more precise. 1013 00:56:37,890 --> 00:56:42,390 Or the other solution could be, if you 1014 00:56:42,390 --> 00:56:45,710 know that your function is not too concave and reasonably 1015 00:56:45,710 --> 00:56:52,070 flat, you might do the numerical differentiation 1016 00:56:52,070 --> 00:56:53,760 on wider interval. 1017 00:56:53,760 --> 00:56:56,995 Basically, reducing the significance of the error, 1018 00:56:56,995 --> 00:57:00,770 and you will hope to arrive to a better approximation. 1019 00:57:00,770 --> 00:57:05,790 So obviously, there is somewhere balance, and the question was, 1020 00:57:05,790 --> 00:57:13,270 is there an optimal shift size to get the derivative? 1021 00:57:13,270 --> 00:57:20,010 And that's what-- uh oh, the slide got corrupted. 1022 00:57:20,010 --> 00:57:23,170 So, there was quite a bit of mathematics 1023 00:57:23,170 --> 00:57:26,560 involved and minimization and optimization. 1024 00:57:26,560 --> 00:57:27,470 There was an answer. 1025 00:57:27,470 --> 00:57:35,440 And that's actually what we finally arrived at. 1026 00:57:35,440 --> 00:57:38,900 And that's some toy example, but still, it 1027 00:57:38,900 --> 00:57:41,600 shows you that if you use constant size 1028 00:57:41,600 --> 00:57:45,890 and not optimal size, that would be your numerical derivative 1029 00:57:45,890 --> 00:57:49,770 of this blue function. 1030 00:57:49,770 --> 00:57:51,750 While if you use an optimal shift 1031 00:57:51,750 --> 00:57:54,000 size, which [INAUDIBLE] computed, 1032 00:57:54,000 --> 00:57:57,370 it would be much smoother and much better. 1033 00:57:57,370 --> 00:58:01,130 So, that's one of example, and that's what he did. 1034 00:58:01,130 --> 00:58:05,580 And we actually are implementing it in our systems and plan 1035 00:58:05,580 --> 00:58:09,670 to use it in practice. 1036 00:58:09,670 --> 00:58:14,470 Another project was actually quite different. 1037 00:58:14,470 --> 00:58:17,530 And it was about electronic trading 1038 00:58:17,530 --> 00:58:27,690 and basically how to better predict prices of currencies 1039 00:58:27,690 --> 00:58:29,220 and exchange rate. 1040 00:58:29,220 --> 00:58:32,980 And funny enough, it was on ruble/US dollar, 1041 00:58:32,980 --> 00:58:38,360 because it was actually aimed for our Moscow office. 1042 00:58:38,360 --> 00:58:42,150 And basically, what we had, we had the noisy observation 1043 00:58:42,150 --> 00:58:46,790 of broker data and it was coming out 1044 00:58:46,790 --> 00:58:50,280 at different non-uniform times. 1045 00:58:50,280 --> 00:58:52,160 Basically, at random times. 1046 00:58:52,160 --> 00:58:57,230 So, we decided to use Kalman filter 1047 00:58:57,230 --> 00:59:01,100 and to study how it can predict. 1048 00:59:01,100 --> 00:59:07,880 And that's one of the nice graphs [INAUDIBLE] 1049 00:59:07,880 --> 00:59:13,580 produced, which again, we will use this strategy 1050 00:59:13,580 --> 00:59:17,870 and the Kalman filters which he constructed 1051 00:59:17,870 --> 00:59:23,920 in our e-trading platform in Moscow. 1052 00:59:23,920 --> 00:59:27,120 So, that's just a couple of examples, 1053 00:59:27,120 --> 00:59:30,605 which I wanted to give you as a preview of what we 1054 00:59:30,605 --> 00:59:33,980 will be talking in the class. 1055 00:59:33,980 --> 00:59:38,850 Just to remind, the website is fully functional. 1056 00:59:38,850 --> 00:59:44,080 We put syllabus there, a short list of literature. 1057 00:59:44,080 --> 00:59:47,750 We will be posting a lot of materials there. 1058 00:59:47,750 --> 00:59:51,120 Probably most lectures will be published there. 1059 00:59:51,120 --> 00:59:54,480 Jake's slides are there already. 1060 00:59:54,480 --> 00:59:56,340 So, any questions? 1061 00:59:59,650 --> 01:00:03,770 JAKE XIA: Please hand back the sign up sheets. 1062 01:00:03,770 --> 01:00:07,390 We like to get your emails so we can put you 1063 01:00:07,390 --> 01:00:10,264 on the website for further announcements, 1064 01:00:10,264 --> 01:00:13,930 but you can also add yourselves. [INAUDIBLE]. 1065 01:00:13,930 --> 01:00:16,490 But it's probably easier if you put your email 1066 01:00:16,490 --> 01:00:19,839 on the sign up sheet, so we can [INAUDIBLE]. 1067 01:00:19,839 --> 01:00:21,380 VASILY STRELA: Yeah, but please visit 1068 01:00:21,380 --> 01:00:23,755 and sign up here, because there will 1069 01:00:23,755 --> 01:00:25,005 be announcements to the class. 1070 01:00:27,750 --> 01:00:29,700 Thank you very much.