Financial Market Introduction
A financial market is a market where people trade financial products. Typical financial markets are the fixed income and interest rate market, the currency market, the equity market, the commodity market and the credit market.
One of the central tenets of financial economics is the necessity of some trade off between risk and expected return. This presentation gives an overview of financial market basics. Click the links below for details.
People in financial market care about returns. Financial return is the measure of profit or loss on an investment. Return is more important than value itself.
There are several return types below:
Absolute return: R_A=V_t-V_(t-1) Relative return: R_R=V_t/V_(t-1) -1 Log return: R_L=ln(V_t/V_(t-1) )
Log return is similar to continuous compounding. also log return is additive, i.e., R_02=R_01+R_12. For a short horizon, R_R≈R_L. Returns are nearly independent and similar to a random walk. Returns in future are unpredictable.
Market price is determined by supply and demand. It is gauged in the real-world measure. The determination factors in supply side are transaction costs, liquidity, risk/reward preferences of suppliers, capital availability, tax rules, and differential information.
The determination factors in demand side are transaction costs, liquidity, accounting, and tax rules.
Model price is determined by model and calibration. It is gauged in the risk neutral measure. If a trade has the market price, then model is mainly used to compute risk, such as sensitivities. Also model price needs to be calibrated to the market price. If a trade doesn’t have a market price, model price is used for transaction.. All models should be calibrated to price Vanilla products correctly.
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