In honor of tomorrow’s math tutorial in Finance 4335: A much more “rigorous” way to calculate 1+1 = 2

One of my Baylor faculty colleagues pointed out an entertaining and somewhat whimsical parody on the use of math in applied economics and finance which first appeared in the Nov.-Dec. 1970 issue of The Journal of Political Economy, entitled “A First Lesson in Econometrics” (at least I found it entertaining :-)). Anyway, check it out!

File Attachment: JPEMathParody.pdf (30 KB)

Plans for next week’s Finance 4335 class meetings, along with a preview of future topics

We will devote next week in Finance 4335 to tutorials on probability and statistics. These tools are critically important to in the measurement of risk and development of risk management strategies for individuals and firms alike. Next Tuesday’s class meeting will be devoted to introducing discrete and continuous probability distributions, calculating parameters such as expected value, variance, standard deviation, covariance, and correlation, and applying these concepts to measure expected returns and risks for portfolios comprising risky assets. The following Thursday will provide a deeper dive into discrete and continuous probability distributions, in which we showcase the binomial and normal distributions.

While I have your attention, let me briefly explain what the main “theme” will initially be in Finance 4335 (up to the first midterm exam on Tuesday, October 1). Starting on Tuesday, September 10, we will begin our discussion of decision theory. Decision theory addresses decision making under risk and uncertainty, which at the very heart of risk management. Initially, we’ll focus attention on variance as our risk measure. Most basic finance models (e.g., portfolio theory, the capital asset pricing model (CAPM), and option pricing theory) implicitly or explicitly assume that risk = variance. We’ll learn that while this is not necessarily an unreasonable assumption, circumstances can arise where it is not an appropriate assumption. Since individuals and firms encounter multiple sources of risk, we also need to take into consideration the portfolio effects of risk. Portfolio theory implies that risks often “manage” themselves by canceling each other out. Thus the risk of a portfolio is typically less than the sum of the individual risks which comprise the portfolio.

The decision theory provides a useful framework for thinking about concepts such as risk aversion and risk tolerance. The calculus comes in handy by providing an analytic framework for determining how much risk to keep and how much risk to transfer to others. Such decisions occur regularly in daily life, encompassing practical problems such as deciding how to allocate assets in a 401-K or IRA account, determining the extent to which one insures health, life, and property risks, whether to work for a startup or an established business and so forth. There’s also ambiguity when we have incomplete information about risk.  This course will at least help you think critically about costs, benefits, and trade-offs related to decision-making whenever you encounter risk and uncertainty.

After the first midterm, the rest of the semester will be devoted to various other risk management topics, including the demand for insurance, asymmetric information, portfolio theory, capital market theory, option pricing theory, and corporate risk management.

Problem Set 1 hint…

Problem Set 1 is due at the beginning of class on Tuesday, September 3. Here is a hint for solving the 4th question on problem set 1.

The objective is to determine how big a hospital must be so that the cost per patient-day is minimized. We are not interested in minimizing total cost; if this were the case, there would be no hospital because marginal costs are positive, which implies that total cost is positively related to the number of patient-days.

The cost equation C = 4,700,000 + 0.00013X2 tells you the total cost as a function of the number of patient-days. This is why you are asked in part “a” of the 4th question to derive a formula for the relationship between cost per patient-day and the number of patient days. Once you have that equation, then that is what you minimize, and you’ll be able to answer the question concerning optimal hospital size.

Volatility, now the whole thing

I highly recommend John Cochrane’s January 2019 article entitled “Volatility, now the whole thing” which builds and expands upon yesterday’s implied volatility topic in Finance 4335. For what it’s worth, Dr. Cochrane is a senior fellow at Stanford University’s Hoover Institution and was formerly a finance professor at Univ. of Chicago. Cochrane’s article provides a broader framework for thinking critically about the implications of volatility for future states of the overall economy. This article is well worth everyone’s time and attention, so I highly encourage y’all to read it!

How to know whether you are on track with Finance 4335 assignments

At any point in time this semester, you can ensure that you are on track with Finance 4335 assignments by monitoring due dates on the course website. See http://fin4335.garven.com/readings/ for the reading assignment due dates, and http://fin4335.garven.com/problem-sets/ for the problem set due dates.  Also, keep in mind that I will administer short quizzes in class on each of the dates shown for required readings.

Lagrangian Multipliers

There is a section in the assigned “Optimization” reading due Thursday, 8/29 on pp. 74-76 entitled “Lagrangian Multipliers” which (as noted in footnote 9 of that reading) may be skipped without loss of continuity. The primary purpose of this chapter is to re-acquaint students with basic calculus and how to use the calculus to solve so-called optimization problems. Since the course only requires solving unconstrained optimization problems, there’s no need for Lagrangian multipliers.

Besides reading the articles entitled “Optimization” and “How long does it take to double (triple/quadruple/n-tuple) your money?” in preparation for this coming Thursday’s meeting of Finance 4335, make sure you complete the student information survey and subscribe to the course blog (if you haven’t already done so).

The Pursuit

“How can we lift up the world together, starting with those at the margins of society?” This question inspired former American Enterprise Institute President Arthur Brooks to travel around the world seeking answers. Released this spring, his documentary reveals insights into not only alleviating poverty, but also achieving lasting happiness for all.

Now streaming on Netflix @ https://www.netflix.com/title/81088318.

Textbook for Finance 4335

The textbook for Finance 4335 is entitled “Integrated Risk Management: Techniques and Strategies for Managing Corporate Risk”. Here’s how the Baylor Bookstore lists this title:

While the Finance 4335 textbook is “out of stock” at the Baylor Bookstore, this book is available for purchase from Amazon.com as well as various other online booksellers. Alternatively, you may also download and print assigned chapters from the course website.

I supplement Doherty’s book with readings from various other sources, as well as readings which I have authored. See http://fin4335.garven.com/readings/ for a date-ordered list of reading assignments. Since the first reading assignment from the textbook isn’t due until Tuesday, September 10, y’all have plenty of time to order the book online, or if you prefer, source textbook readings from the course website.

Finance 4335