Intro to Econ: Second Lecture – Financial Derivative Pricing

As a last example of the application of the idea that the world is probably free of easy arbitrage opportunities I here provide a brief introduction of the idea of financial engineering. Assuming the absence of arbitrage is all one needs to price financial derivatives. A financial derivative, perhaps a bit narrowly defined, is a financial product – that is a risky investment possibility – with payoffs that depend exclusively on other “basic” financial products such as bonds and stocks. You may want to google what bonds and stocks are if you do not yet know. For our purposes all we need to know is that a stock of a company has a value or price that substantially varies over time. The future price of a stock is uncertain today and this uncertainty can be quite large.

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