Lec 1 - Lecture Notes on Economics of Financial Risk...

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Unformatted text preview: Lecture Notes on Economics of Financial Risk Management Xiaodong Zhu September 15, 2008 Chapter 1 Introduction This course is about &nancial risk management, about using &nancial instru- ments, especially derivative securities, to manage risk. We will foucus our discussion on why, when and where there is a need for risk management and how to measure risk manage risk. To understand risk management, we &rst have to understand what is risk. According to the Webster¡s New World Dictionary, risk is the chance of injury, damage, or loss . By this de&nition, humankind has always faced and had to deal with many kinds of risk such as war, famine, deadly diseases, bad weather, theft, robbery, etc..Ideally, we would hope that we can eliminate the sources of risk so that we can live in a risk-free world. There has been some progress towards this goal. For example, most developed countries have almost certainly eliminated the possibility of famine. However, we are still living in a world that is far from risk-free. Despite enormous progress in many aspects of our daily life in the last few hundred years, risk is still everywhere in our life. A few examples: & A &rm may be taken over by another &rm and its workers may be laid o/. & An earthquake or hurricane may hit a city. & An electricity blackout may happen to a large region. & A student may not be able to &nd a good job upon graduation. & Your computer may be infected by a deadly virus or worm. 3 4 CHAPTER 1. INTRODUCTION & Weather may be unexpectedly bad. & Stock market may crash & Tuitions may increase & US dollar may devalue dramatically against the Euro When risk cannot be eliminated, the best way to deal with it is sharing it between lucky and unlucky ones. A major role of &nancial markets is to facilitate more e¢ cient risk sharing among individuals, &rms and govern- ments. Financial innovations often occur to deal with new kinds of risk or to provide new ways to deal with old risk. Over the last couple of decades, &nancial innovation has been occurring at a frantic pace. Many new &nancial institutions, markets and products have been created. Markets for deriva- tives, in particular, exploded in the late 1980s and early 1990s. By 2001, the notional value of all derivatives outstanding amounted to $111 trillion. In comparison, the world GDP was only $31.3 trillion, and the capitalization of the stock markets of the industrialized countries was $21.2 trillion. The explosive growth in derivatives has made many people rich, and the market attracted talented individuals with very di/erent backgrounds. Many Ph.D.s in economics, geophysics, chemical engineering, mathematics, computer sci- ence and other &elds went to work on Wall Street. New professional programs in Mathematical Finance, Financial Engineering or Computational Finance have also been created in many universities....
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This note was uploaded on 10/11/2010 for the course ECO 460 taught by Professor Z during the Fall '08 term at University of Toronto.

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Lec 1 - Lecture Notes on Economics of Financial Risk...

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