Financial Economics

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

• Akerlof, George A. and Robert J. J. Shiller. 2010. Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. Princeton University Press.
• Bernstein, Peter L. 2009. Capital Ideas: The Improbable Origins of Modern Wall Street.
• Davies, Daniel. 2018. Lying for Money: How Legendary Frauds Reveal the Workings of our World. Profile Books.
• Derman, Emanuel. 2016. My Life as a Quant: Reflections on Physics and Finance.
• Graham, Benjamin. The Intelligent Investor
• Henwood, Doug. 1997. Wall Street: How It Works and for Whom. Verso.
• MacKenzie, Donald. 2008. An Engine, Not a Camera: How Financial Models Shape Markets. MIT Press.
• McCauley, Joseph L. 2009. Dynamics of Markets: The New Financial Economics, 2nd edition. Cambridge University Press.
• Thorp, Edward O. and Sheen T. Kassouf. 1967. Beat the Market: A Scientific Stock Market System.