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Financial Economics

Summary:
This is a list of some of what I think one should know if one wants to talk to investors interested in theory. This post is not about making money and is probably not up-to-date. My references are fairly popular, and mostly old. I include one recent popular book as an example. Most of the references I do not recall very well, and I have not read Ben Graham. But many seem to know that Warren Buffet recommends this book. This post is non-critical. Keen and Quiggin in Debunking Economics and Zombie Economics, each have a chapter of criticism. Behavioral finance: The application of behavioral economics to finance. Beta: A parameter in the CAPM. Black Scholes formula: A formula for pricing options. Capital Asset Pricing Model (CAPM): A model that relates the risk of an asset to the market as

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This is a list of some of what I think one should know if one wants to talk to investors interested in theory. This post is not about making money and is probably not up-to-date. My references are fairly popular, and mostly old. I include one recent popular book as an example. Most of the references I do not recall very well, and I have not read Ben Graham. But many seem to know that Warren Buffet recommends this book. This post is non-critical. Keen and Quiggin in Debunking Economics and Zombie Economics, each have a chapter of criticism.

  • Behavioral finance: The application of behavioral economics to finance.
  • Beta: A parameter in the CAPM.
  • Black Scholes formula: A formula for pricing options.
  • Capital Asset Pricing Model (CAPM): A model that relates the risk of an asset to the market as a whole.
  • Efficient Market Hypothesis (EMH): A model in which all information is quickly built into asset prices. The EMH comes in at least three types.
  • Equity Premium Puzzle: The observed phenomena for stocks (or shares) to trade at higher prices, as compared to bonds, than can be justified by the EMH.
  • Lévy distribution: A family of probability distributions that, except for the limiting case of the Gaussian distribution, have an infinite variance. The Cauchy distribution is also a member. Benoit Mandelbrot recommends this as a model for changes in asset prices.
  • Martingale Theory: A branch of mathematics in which a stochastic process exhibits a special case of the Markov property. I recall learning about a drunkards walk and the gambler's ruin problem, but I do not recall this term in any of my formal math courses.
  • Modigliani and Miller (M and M): A model that implies, under idealizations, that it does not matter if corporations finance investments with equity or debt.
  • Noise trading: Trading on random variations in the price of an asset, instead of fundamentals. I know of this from some late 80s work of DeLong, Shleifer, Summers, and Waldmann.
  • Stochastic Calculus, also known as Ito Calculus: A branch of mathematics in which one can talk about the derivatives and integrals of a set of random variables indexed on continuous time. Such a stochastic process is different from a single realization).
  • Value-at-risk: A formula that applies to an investment portfolio.
  • Volatility skew: An anomaly, inconsistent with the Black-Scholes formula, that emerged in markets for options.

One also needs to know about puts, calls, indices, credit default swaps, types of spreads (e.g. a broken wing butterfly spread) and so on if one wants to be a financial analyst. As usual, this is an aspirational post. I do not claim to know all of this, and maybe I have gotten some of the above incorrect.

References

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