On pp. 18-23 of the Mathematics Tutorial, I show how y = ex can be approximated with a Taylor polynomial centered at x=0 for values ranging from -2 to +2. In his video lesson entitled “Visualizing Taylor polynomial approximations”, Sal Kahn essentially replicates my work; the only difference between Sal’s numerical example and mine is that Sal approximates y = ex with a Taylor polynomial centered at x=3 instead of x=0. The important insight provided in both cases is that the accuracy of Taylor polynomial approximations increases as the order of the polynomial increases.
The August 29th assigned reading entitled “The New Religion of Risk Management” (by Peter Bernstein, March-April 1996 issue of Harvard Business Review) offers a concise overview of the same author’s 1996 book entitled “Against the Gods: The Remarkable Story of Risk“. An intriguing excerpt from page 33 of “Against the Gods” elucidates the historical roots of the term “algorithm.” An intriguing excerpt from page 33 of “Against the Gods” elucidates the historical roots of the word “algorithm.”
“The earliest known work in Arabic arithmetic was written by alKhowarizmi, a mathematician who lived around 825, some four hundred years before Fibonacci. Although few beneficiaries of his work are likely to have heard of him, most of us know of him indirectly. Try saying “alKhowarizmi” fast. That’s where we get the word “algorithm,” which means rules for computing.”
Equations (2), (3), and (7) from this list play particularly important roles in Finance 4335!
Besides going over the course syllabus during the first day of class on Tuesday, August 22, we will also discuss a particularly important “real world” example of financial risk. Specifically, we will study the relationship between realized daily stock market returns (as measured by daily percentage changes in the SP500 stock market index) and changes in forward-looking investor expectations of stock market volatility (as indicated by daily percentage changes in the CBOE Volatility Index (VIX)):
As indicated by this graph (which also appears in the lecture note for the first day of class), daily percentage changes in closing prices for the SP500 (the y-axis variable) and for the VIX (the x-axis variable) are strongly negatively correlated with each other. The blue dots are based on 8,470 contemporaneous observations of daily returns for both variables, spanning the 33-2/3-year period of time starting on January 2, 1990, and ending on August 15, 2023. When we fit a regression line through this scatter diagram, we obtain the following equation:
where corresponds to the daily return on the SP500 index and corresponds to the daily return on the VIX index. The slope of this line (-0.1147) indicates that on average, daily closing SP500 returns are inversely related to daily closing VIX returns. Furthermore, nearly half of the variation in the stock market return during this time period (specifically, 48.87%) can be statistically “explained” by changes in volatility, and the correlation between and came out to -0.70. While a correlation of -0.70 does not imply that daily closing values for and always move in opposite directions, it does suggest that this will be the case more often than not. Indeed, closing daily values recorded for and during this period moved inversely 78% of the time.
You can also see how the relationship between the SP500 and VIX evolves prospectively by entering http://finance.yahoo.com/quotes/^GSPC,^VIX into your web browser’s address field.
Since many of the topics covered in Finance 4335 require a basic knowledge and comfort level with algebra, differential calculus, and probability & statistics, the second class meeting will include a mathematics tutorial, and the third and fourth class meetings will cover probability & statistics. I know of no better online resource for brushing up on (or learning for the first time) these topics than the Khan Academy.
So here are my suggestions for Khan Academy videos that cover these topics (unless otherwise noted, all sections included in the links which follow are recommended):
- Algebra: Intro to the Binomial Theorem, Pascal’s Triangle and Binomial Expansion
- Calculus: Taking derivatives, Optimization (profit maximization) with calculus, Visualizing Taylor Series for e^x
- Probability and statistics: Basic probability, Compound, independent events, Permutations, Combinations, probability using combinatorics, Random variables and probability distributions, Binomial distribution, Law of Large Numbers, and Normal Distribution.
Finally, if your algebra skills are a bit on the rusty side, I would also recommend checking out the Khan Academy’s review of algebra.