Detailed Table of Contents
1. Introduction 1
2. Financial Markets 5
2.1 Market Price Formation 5
2.2 Returns and Dividends 7
2.2.1 Simple and Compounded Returns 7
2.2.2 Dividend Effects 8
2.3 Market Efficiency 11
2.3.1 Arbitrage 11
2.3.2 Efficient Market Hypothesis 12
2.4 Pathways for Further Reading 14
2.5 Exercises 15
3. Probability Distributions 17
3.1 Basic Definitions 17
3.2 Important Distributions 20
3.3 Stable Distributions and Scale Invariance 25
3.4 References for Further Reading 27
3.5 Exercises 27
4. Stochastic Processes 29
4.1 Markov Processes 29
4.2 Brownian Motion 32
4.3 Stochastic Differential Equation 35
4.4 Stochastic Integral 36
4.5 Martingales 39
4.6 References for Further Reading 41
4.7 Exercises 41
vii
5. Time Series Analysis 43
5.1 Autoregressive and Moving Average Models 43
5.1.1 Autoregressive Model 43
5.1.2 Moving Average Models 45
5.1.3 Autocorrelation and Forecasting 47
5.2 Trends and Seasonality 49
5.3 Conditional Heteroskedasticity 51
5.4 Multivariate Time Series 54
5.5 References for Further Reading and Econometric
Software 57
5.6 Exercises 57
6. Fractals 59
6.1 Basic Definitions 59
6.2 Multifractals 63
6.3 References for Further Reading 67
6.4 Exercises 67
7. Nonlinear Dynamical Systems 69
7.1 Motivation 69
7.2 Discrete Systems: Logistic Map 71
7.3 Continuous Systems 75
7.4 Lorenz Model 79
7.5 Pathways to Chaos 82
7.6 Measuring Chaos 83
7.7 References for Further Reading 86
7.8 Exercises 86
8. Scaling in Financial Time Series 87
8.1 Introduction 87
8.2 Power Laws in Financial Data 88
8.3 New Developments 90
8.4 References for Further Reading 92
8.5 Exercises 92
9. Option Pricing 93
9.1 Financial Derivatives 93
9.2 General Properties of Options 94
9.3 Binomial Trees 98
9.4 Black-Scholes Theory 101
9.5 References for Further reading 105
viii Detailed Table of Contents
9.6 Appendix. The Invariant of the Arbitrage-Free
Portfolio 105
9.7 Exercises 109
10. Portfolio Management 111
10.1 Portfolio Selection 111
10.2 Capital Asset Pricing Model (CAPM) 114
10.3 Arbitrage Pricing Theory (APT) 116
10.4 Arbitrage Trading Strategies 118
10.5 References for Further Reading 120
10.6 Exercises 120
11. Market Risk Measurement 121
11.1 Risk Measures 121
11.2 Calculating Risk 125
11.3 References for Further Reading 127
11.4 Exercises 127
12. Agent-Based Modeling of Financial Markets 129
12.1 Introduction 129
12.2 Adaptive Equilibrium Models 130
12.3 Non-Equilibrium Price Models 134
12.4 Modeling of Observable Variables 136
12.4.1 The Framework 136
12.4.2 Price-Demand Relations 138
12.4.3 Why Technical Trading May Be Successful 139
12.4.4 The Birth of a Liquid Market 141
12.5 References for Further Reading 143
12.6 Exercises 143
Comments 145
References 149
Answers to Exercises 159
Index 161
Detailed Table of Contents ix
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