Quantitative Finance by Steve Bell Quantitative Finance For Dummies® Published by: John Wiley & Sons, Ltd., The Atrium, Southern Gate, Chichester, www.wiley.com © 2016 by John Wiley & Sons, Ltd., Chichester, West Sussex Media and software compilation copyright © 2016 by John Wiley & Sons, Ltd All rights reserved Registered Office John Wiley & Sons, Ltd., The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ , United Kingdom For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book, please see our website at www.wiley.com All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the permission of this publisher Designations used by companies to 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services, please contact our Customer Care Department within the U.S at 877-762-2974, outside the U.S at 317-572-3993, or fax 317-572-4002 For technical support, please visit www.wiley.com/techsupport Wiley publishes in a variety of print and electronic formats and by print-on-demand Some material included with standard print versions of this book may not be included in e-books or in print-on-demand If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com For more information about Wiley products, visit www.wiley.com A catalogue record for this book is available from the British Library Library of Congress Control Number: 2016939606 ISBN: 978-1-118-76946-1 ISBN 978-1-118-76946-1 (pbk); ISBN 978-1-118-76942-3 (ebk); ISBN 978-1-118-76943-0 (ebk) Printed and Bound in Great Britain by TJ International, Padstow, Cornwall 10 Contents at a Glance Introduction Part 1: Getting Started with Quantitative Finance CHAPTER 1: Quantitative Finance Unveiled Understanding Probability and Statistics 27 CHAPTER 3: Taking a Look at Random Behaviours 45 CHAPTER 2: Part 2: Tackling Financial Instruments 65 CHAPTER 4: Sizing Up Interest Rates, Shares and Bonds 67 Exploring Options 85 CHAPTER 6: Trading Risk with Futures 99 CHAPTER 5: Part 3: Investigating and Describing Market Behaviour 119 CHAPTER 7: Reading the Market’s Mood: Volatility 121 CHAPTER 8: Analysing All the Data 139 CHAPTER 9: Analysing Data Matrices: Principal Components 159 Part 4: Option Pricing 183 CHAPTER 10: Examining the Binomial and Black-Scholes Pricing Models 185 CHAPTER 11: Using the Greeks in the Black-Scholes Model 209 CHAPTER 12: Gauging Interest-Rate Derivatives 223 Part 5: Risk and Portfolio Management 239 CHAPTER 13: Managing Market Risk 241 Portfolio Theory 257 CHAPTER 15: Measuring Potential Losses: Value at Risk (VaR) 275 CHAPTER 14: Comprehending Part 6: Market Trading and Strategy CHAPTER 16: Forecasting 291 Markets 293 Models to Data 313 CHAPTER 18: Markets in Practice 329 CHAPTER 17: Fitting Part 7: The Part of Tens 345 CHAPTER 19: Ten Key Ideas of Quantitative Finance 347 CHAPTER 20: Ten Ways to Ace Your Career in Quantitative Finance 355 Glossary 361 Index 369 Table of Contents INTRODUCTION About This Book Foolish Assumptions Icons Used in This Book Where to Go from Here 3 PART 1: GETTING STARTED WITH QUANTITATIVE FINANCE CHAPTER 1: Quantitative Finance Unveiled Defining Quantitative Finance Summarising the mathematics Pricing, managing and trading Meeting the market participants Walking like a drunkard 10 Knowing that almost nothing isn’t completely nothing 11 Recognising irrational exuberance 14 Wielding Financial Weapons of Mass Destruction 15 Going beyond cash 17 Inventing new contracts 18 Analysing and Describing Market Behaviour 20 Measuring jumpy prices 20 Keeping your head while using lots of data 21 Valuing your options 21 Managing Risk 22 Hedging and speculating 22 Generating income 23 Building portfolios and reducing risk 23 Computing, Algorithms and Markets 24 Seeing the signal in the noise 24 Keeping it simple 25 Looking at the finer details of markets 25 Trading at higher frequency 26 CHAPTER 2: Understanding Probability and Statistics 27 Figuring Probability by Flipping a Coin Playing a game Flipping more coins Defining Random Variables Using random variables Building distributions with random variables Table of Contents 28 31 32 33 34 35 v Introducing Some Important Distributions Working with a binomial distribution Recognising the Gaussian, or normal, distribution Describing real distributions CHAPTER 3: 38 39 40 41 Taking a Look at Random Behaviours 45 Setting Up a Random Walk .45 Stepping in just two directions 47 Getting somewhere on your walk 48 Taking smaller and smaller steps 49 Averaging with the Central Limit Theorem 50 Moving Like the Stock Market 53 Generating Random Numbers on a Computer 54 Getting random with Excel 55 Using the central limit theorem again 58 Simulating Random Walks 58 Moving Up a Gear 60 Working a stochastic differential equation 60 Expanding from the origin 61 Reverting to the Mean 62 PART 2: TACKLING FINANCIAL INSTRUMENTS 65 CHAPTER 4: Sizing Up Interest Rates, Shares and Bonds 67 Explaining Interest Compounding your interest Compounding continuously Sharing in Profits and Growth Taking the Pulse of World Markets Defining Bonds and Bond Jargon Coupon-bearing bonds Zeroing in on yield Cleaning up prices Learning to like LIBOR Plotting the yield curve Swapping between Fixed and Floating Rates CHAPTER 5: Exploring Options 85 Examining a Variety of Options Starting with plain vanilla options Aiming for a simple, binary option Branching out with more exotic options Reading Financial Data Seeing your strike price vi 68 68 69 71 72 74 75 76 78 79 80 81 Quantitative Finance For Dummies 86 86 87 87 88 88 Abbreviating trading information Valuing time Getting Paid when Your Option Expires Using Options in Practice Hedging your risk Placing bets on markets Writing options Earning income from options Distinguishing European, American and other options Trading Options On and Off Exchanges Relating the Price of Puts and Calls CHAPTER 6: 89 89 90 92 92 93 94 94 95 96 96 Trading Risk with Futures 99 Surveying Future Contracts 99 Trading the futures market 101 Marking to market and margin accounts 101 Dealing in commodity futures 102 Index futures 105 Interest rate futures 106 Seeing into the Future 107 Paying in cash now 108 Connecting futures and spot prices 109 Checking trading volume 110 Looking along the forward curve 110 Rolling a Position 112 Keeping a consistent position 113 Adjusting backwards 113 Converging Futures to the Spot Price 114 Using Futures Creatively 115 Calendar spreads 116 Commodity spreads 116 Seasonality in Futures Prices 117 PART 3: INVESTIGATING AND DESCRIBING MARKET BEHAVIOUR 119 Reading the Market’s Mood: Volatility 121 CHAPTER 7: Defining Volatility .122 Using Historical Data 124 Weighting the data equally 124 Weighting returns 125 Shrinking Time Using a Square Root 127 Comparing Volatility Calculations 128 Estimating Volatility by Statistical Means 132 Table of Contents vii CHAPTER 8: The symmetric GARCH model The leverage effect Going Beyond Simple Volatility Models Stochastic volatility Regime switching Estimating Future Volatility with Term Structures 132 134 135 135 136 137 Analysing All the Data 139 Data Smoothing Putting data in bins Smoothing data with kernels Using moving averages as filters Estimating More Distributions Mixing Gaussian distributions Going beyond one dimension Modelling Non-Normal Returns Testing and visualising non-normality Maximising expectations 139 140 143 147 149 149 150 151 151 153 Analysing Data Matrices: Principal Components 159 Reducing the Amount of Data Understanding collinearity Standardising data Brushing up some maths Decomposing data matrices into ­principal components Calculating principal components Checking your model with cross- validation Applying PCA to Yield Curves Using PCA to Build Models Identifying clusters of data Principal components regression 160 163 166 167 170 173 174 177 180 180 181 PART 4: OPTION PRICING 183 CHAPTER 9: CHAPTER 10: viii Examining the Binomial and Black-Scholes Pricing Models 185 Looking at a Simple Portfolio with No Arbitrage Pricing in a Single Step Entering the world of risk neutral Calculating the parameters Branching Out in Pricing an Option Building a tree of asset prices Building a tree of option prices by working backwards Pricing an American option 186 187 188 191 192 192 192 194 Quantitative Finance For Dummies settl (settlement), 89, 101, 336 Stack Overflow (website), 358 shadows, 294 Standard and Poor 500 (S&P 500), 366 shares See also bonds; interest standard deviation (σ) about, 18, 67, 71–72 about, 41, 42, 44, 51, 123 defined, 71 calculating, 129 stock indices, 72–74 defined, 366 Sharpe ratio, 270–272, 366 over M days of returns, 124–125 shill bid, 333 standard normal distribution, 51 short position, 186, 350–351, 366 Standard & Poor’s 500 (S&P 500), 73 short position in a call option, 94 standardising data, 166–167 short put position, 94 static hedging, 211–212 short rate, 232 stationarity, 162 short selling stocks, 196 statistical means, estimating volatility by, 132–134 shorting, 186 statistics and probability short-term interest-rate, 232 about, 27–28, 31 shrinkage, 254, 268 calculating statistics, 255 sigma (Σ), 30, 141, 366 coin flipping, 28–31, 32–33 signal, 148 distributions, 38–44 simple moving average (SMA), 147–149 playing a game, 31–32 simulating prior probability, 155 random walks, 58–59 random variables, 33–38 valuing options using, 206–207 risk-neutral probability, 188–191 VaR, 283–285 usefulness of probability, 247–249 skew, 42–44, 152, 366 Statistics For Dummies (Rumsey-Johnson), 319 SMA (simple moving average), 147–149 Statistics II For Dummies (Rumsey-Johnson), 303 smoothing parameter, 126 Stiglitz, Joseph (economist), 12 solving stochastic, 234, 367 Black-Scholes equation, 199–202 stochastic differential equations, 60–61 equations, 77–78 stochastic indicator, 299–300 Soros, George (hedge fund manager), 15 stochastic volatility model, 135 sovereign bonds, 75 stock index, 72–73 speculating, 22 stock index futures, 105–106, 108 speculators, 9–10, 101 stock markets spoofing, 333, 366 defined, 71 spot interest-rate, 224, 232 random walk for, 53–54 spot price stocks about, 108, 109–110 about, 18 converging futures to, 114–115 defensive, 181 defined, 366 defined, 71 spread position, 366 spreadsheets, 160, 358 square root, 62, 127–128 dividend-paying, 204–205 short selling, 196 stop loss, 244 Index 383 storage costs, 110 tilt, 178 store of value, as a function of money, 15–16 time series, 147, 161, 367 stress testing, 286 time to expiry, calculating, 129 strike price, 19, 88–89, 128, 188, 367 time value, 89–90, 367 subadditivity, 288 Tip icon, subscripts, 167 tracker funds, 11 summary statistics, 161 traded supply, balancing demand and, 333–336 swap dealer, 81 swap rate, 82 defined, 88 price impact of, 336–337 trading swaption, 229 about, symbols, maths, 213–220 factors of, 343–344 symmetric, 169 futures markets, 101 ignoring costs of, 349 T options on/off exchanges, 96 T (AT&T Inc.), 163 tail index, 290 tail risk, estimating with extreme value theory, 289–290 tails, of distributions, 149 Taleb, Nassim Nicholas (author) unit of, 90 trading days, 128 trading volume, 110, 312 transaction costs, 196 transpose, 169 treasury notes, 75 The Black Swan: The Impact of the Highly Improbable, 357 Treasury Stock, 71 Fooled by Randomness, 357 trend following strategy, 12, 367 trend, 178 Taylor expansion, 62, 123, 233 troubleshooting model risk, 221–222 technical analysis, measuring with, 294–301 TRV (The Travelers Companies Inc.), 163 Technical Analysis For Dummies (Rockefeller), 297 t-statistics, 182 technical strategies, 326 Turing, Alan (mathematician), 340 Technical Stuff icon, 2008 banking crisis, 20 term structures, estimating future volatility with, 137–138 test set, 327 testing non-normality, 151–153 out-of-sample, 175 textbooks, 356 Thalesians, 358 The Travelers Companies Inc (TRV), 163 theta (Θ), 22, 218 321 crack spread, 117 tick size, 331 ticker codes, 163 384 Quantitative Finance For Dummies U unconstrained solution, 266 UNH (United Health Group Inc.), 163 uninformed traders, 338 unit of account, as a function of money, 15–16 unit of trading, 90 unit trusts (mutual funds), 72 United Health Group Inc (UNH), 163 United Kingdom Gilt Treasury Stock 2032 4.25% (TR32), 76 United Technologies Corp (UTX), 163 US Bureau of Labor Statistics (website), 13 defined, 162, 316, 367 US Energy Information Administration (website), 356 estimating, 282 US Treasury, 332 US Treasury yield curves, 226 estimating future volatility with term structures, 137–138 utility functions, 249–253, 263, 268 importance of, 350 UTX (United Technologies Corp.), 163 regime switching, 136 estimating by statistical means, 132–134 square root, 127–128 V V (VISA Inc.), 163 validating models, 285–286 value at risk (VaR) about, 22, 275–276 average, 286–288 constructing using covariance matrix, 279–281 controlling risk in portfolios, 276 defined, 367 stochastic, 135 using historical data, 124–127 VaR and, 277–279 volatility smile, 129 Volcker, Paul (chairman), 18–19 VZ (Verizon Communications Inc.), 163 W Walmart (WMT), 163 estimating tail risk with extreme value theory, 289–290 Walt Disney Co (DIS), 163 estimating volatilities and correlations, 282 websites simulating, 283–285 Warning icon, validating models, 285–286 Advanced Risk Management and Portfolio Management boot camp, 357 volatility and, 277–279 Bank for International Settlements, 276 value stocks, 348 CFA Institute, 357 valuing Cheat Sheet, 2–3, 4, 109, 122, 154 options using simulations, 206–207 efinancialcareers, 359 time, 89–90 Federal Reserve Economic Database (FRED), 356 variable, 151 Fitch Learning, 357 variance, 137, 259, 279, 367 International Swaps and Derivatives Association, 81 Vasicek model, 235–237 vectors, 167–168 vega (v), 213, 219 Verizon Communications Inc (VZ), 163 VISA Inc (V), 163 visualising non-normality, 151–153 volatility about, 20–21, 87, 121–124 annualised, 127–128, 162 calculations for, 128–132, 276 constancy of, 196 converting, 210 LinkedIn, 358 MathFinance Conference, 357 Professional Risk Managers International Association (PRMIA), 357 Python, 170 Quantnet, 358, 359 Stack Overflow, 358 Thalesians, 358 US Bureau of Labor Statistics, 13 US Energy Information Administration, 356 Wilmott Forum, 358 Yahoo Finance, 356 Index 385 weighting data equally, 124–125 returns, 125–127 Wilmott, Paul (author) Frequently Asked Questions in Quantitative Finance, 359 Wilmott Forum (website), 358 WMT (Walmart), 163 world markets, 72–74 writing a call, 94 writing an option, 94, 211 Y Yahoo Finance (website), 356 yield curves about, 80–81, 224–227 applying principal components analysis (PCA), 177–179 defined, 367 yield to maturity, 76 Z zero-coupon bonds, 76–77 X x variable, XOM (Exxon Mobil Corp), 163 386 Quantitative Finance For Dummies Notes Notes Notes Notes About the Author Steve Bell is a physicist who has spent much of his career working on scientific applications of mathematics and statistics for international companies such as ABB Just in time for the financial crisis of 2008, he managed to switch into finance: he worked for one of the biggest hedge funds in Europe developing ­quantitative trading strategies, specializing in energy markets He now works as a statistical consultant in his company Research in Action Ltd He has a D.Phil in theoretical physics from the University of Oxford and is a fellow of the Royal ­Statistical Society In his leisure time he enjoys gardening, walking in the ­mountains of Scotland and generally avoiding email and technology Dedication To my family and friends Author’s Acknowledgments Firstly, I’d like to thank Annie Knight at John Wiley for inviting me to write this book The opportunity is very much appreciated Thanks to my project manager Chad Sievers for keeping me on my toes and to my editor Kathleen Dobie for improving the readability of the book in so many ways Also, to all of the other members of the Wiley team who helped with the book I am very grateful to Piotr Fryzlewicz at the London School of Economics for his insightful comments as technical editor This book was mostly written in libraries I’d like to thank the Bodleian Library, University of Oxford for issuing me with a reader card The Guildhall Library in the City of London gave me some inspiration to write about finance I also enjoyed using the Bishopsgate Institute The Royal Statistical Society kindly permitted me to use their fellow’s suite for many afternoons and made me feel welcome I’d like to thank people who read and commented on chapters of the book Special thanks to former colleague Boris Afanasiev who read and helped me to improve many of the mathematical chapters and for some interesting discussions about probability theory Oliver Maspfuhl of Commerzbank AG commented on two of the chapters on risk, and Oleg Soloviev of Econophysica made suggestions on the table of contents I had many interesting discussions about quantitative finance with Oliver Brockhaus of MathFinance AG, and he also helpfully checked some equations Dave Rendell was very helpful with his detailed reading of Chapter 1 Lastly to Ulrike, Emily and Mariella for having to put up with a grumpy husband and dad during the difficult chapters Thank you so much for your love and support Publisher’s Acknowledgments Executive Editor: Annie Knight Production Editor: Kumar Chellappan Project Manager: Chad R Sievers Cover Image: ©iStock.com/PashaIgnatov Development Editor: Kathleen Dobie Copy Editor: Kim Vernon Technical Editor: Piotr Fryzlewicz Art Coordinator: Alicia B South WILEY END USER LICENSE AGREEMENT Go to www.wiley.com/go/eula to access Wiley’s ebook EULA ... Quantitative Finance by Steve Bell Quantitative Finance For Dummies Published by: John Wiley & Sons, Ltd., The Atrium, Southern Gate, Chichester, www.wiley.com © 2016 by John Wiley... handy formulae used in quantitative finance To view this book’s Cheat Sheet, go to www .dummies. com and search for Quantitative Finance For Dummies Cheat Sheet” for additional bits of information... 369 Quantitative Finance For Dummies Introduction Q uantitative finance is about applying mathematics and statistics to finance For maths lovers that’s exciting, but for the rest of