Chapter 1

The Economic Environment

Time present and time past Are both perhaps present in time future, And time future contained in time past.

T.S. Eliot, Burnt Norton

1.1. INTRODUCTION

A prerequisite to the successful management and hedging of financial portfolios is an understanding of how those portfolios are valued. As we shall see in Chapter 3, it is useful to distinguish between value and price. In this book we shall refer to the value of a financial instrument as the present value of any expected cashflows associated with it; generally, we shall define value as an intrinsic measure of the worth of an asset, the value calculated being predicated on assumptions about the cashflows that will accrue to the owner of the asset. A consequence of this categorization is that we can calculate a value for almost any asset with expected cashflows using only two tools: cashflow discounting and statistics. We shall consider price to be the extrinsic measure of worth that the market places on an asset, whether that price is set by the owner of the asset—the ask price—or a prospective purchaser of the asset—the bid price.

For many assets, the difference between the market price and the value calculated by market participants will be small. At times, it can be inconvenient or cumbersome to value an asset directly; instead, a price can be determined by comparing the asset to another with generally similar characteristics (e.g., using matrix pricing to price a selection of bonds). In some ...

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