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Financial Engineering 101

已有 10067 次阅读 2012-2-29 20:14 |系统分类:海外观察|关键词:<a href="http://blog.sciencenet.cn/home.php?mod=spacecp&ac=relatekw&inajax=1&subjectenc=Financial Engineering 101&a

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In US Universities, a first or basic course in any subjectis often label as “XXX 101”. Thus this blog article has to do with the basics of Financial Engineering  as I understand it (Caveat: I am only an amateur. Thisis only my view and should not be taken as professional expertise).

Principle #1. One dollar today is worth more than a dollar tomorrow (or  the future value of money)

If I lend you money, say one dollar, today for your use,then I expect to be paid back tomorrow by you for slightly more than one dollar even if there is  iron clad guarantee that you will pay me back. Thus, we are not talking about any uncertainties here. The difference or the extra amount iscalled interest for your use of my money for one day. As to how much  should this interest be is subject to supply and demand for money  and manipulation by government. The whole idea is that “use of money” should not be free and carries a cost over time.

Principle #2. There are always risks associated with the future. But people’s  attitude towards risk are different.

The best and most easily understood example is life insurance. A life insurance  company knows from statistical data to a high degree of accuracy that how  many persons will die every year at what age. Thus, she knows if she sells  so many policies on the average how much money she has to pay out  each year. By charging appropriate premium for each policy, the law of large numbers guarantees that she will make certain amount of profit  almost surely. On the other hand, an individual or family cannot  afford the catastrophic loss of a wage earner even though they can afford to lose a smallamount of insurance premium each year. Thus, over the years I have paid a considerable amount of money for the life insurance policy I purchased when Iwas young. Yet I have no regret paying that even by hindsight since I cannot afford to gamble on the average number of years I will live while the insurancecompany can afford to. Here is an example of a nonzero sum game where  everyone comes out happy. The insurance company transfers  a risk I am not willing to take to some other place or persons (the public at  large who invest in the company) successfully because different entities  have different attitude towards risk. For this she is allowed to make a profit.

Every financial transactions in the world ultimately boils down to these two  principles in my opinion. Money in my view is invented as a medium of exchange to enable the operations of the above two principles in  various forms from  the simple savings account (#1) to the sophisticated  Credit DefaultSwaps that caused the financial crisis in recent years ( CDS  is #2 taken to the extreme that became a fraud). However, even with this medium  of exchange, principles #1-2 do not always operate smoothly which causes government to intervene or to manipulate the flow of money for the public  good. But in a globalized and connected world today, single  government may not be able to implement or accomplish everything even  if they know precisely what they should do. Thus, unless you are a  hermitically sealed country, such as North Korea who has her own set of  economic problems, everyone in the world are in this together.  We don’t have enough wise men and a single entity, whether it is a much more all powerful World Bank or the IMF to make the system worksmoothly. In the mean time, we stumble forward and hope for the best.



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