Monday, November 4, 2013

Basic Ideas of Finance

We often have students take a micro course in economics. But what they also need to learn are the basic ideas of finance and decision.

In thinking about real options (not about securities, but about future choices, such as the possibility of expanding the factory three years from now and the need to spend money now to make the foundation stronger if we want to have the chance/option of doing so), . . .

and how they might be taught outside of a mathematically mature audience, I see that the basic ideas of finance that our students might learn, without any mathematics beyond 

--expectation (prob x $) 
--time value of money (interest rate), and
--a notion of variance (volatility). 

All these surely have complications galore, but the basic ideas are straightforward. 

There is nothing so essential in the mathematically more demanding formulations that cannot be explained using decision trees (binomial). The hardest part is convincing people that a random walk moves away as the square root of time, and that might well be done with simulations. 

The Big Ideas of Finance

1. no arbitrage
2. random walk and volatility, variance  
    risk and volatility
    price as discounted future cash flow
3. time value of money and risk free asset, rate of return
    decision analysis as expectation value
4. paying for an option to make a future action (or not doing it)
5. portfolio optimization for greatest return given different risk and return, and volatilities--this may be hardest to explain.

Have I left out anything important?

N. Kaza suggests: "the link between uncertainty and irreversibility: The larger the cost of reversibility an action and higher the uncertainty about the effects of the action, the longer we wait before committing to it. Also it becomes cheaper to seek information and make plans while waiting, which can potentially reduce uncertainty."