Chapter 2
Concepts of Finance
Abstract After introducing the volatility of stocks as a central feature, the concepts
of hedging, short selling, and discounting are introduced, as well as future contracts
and options as functions—derivatives—of the underlying stocks. Before discussing
the various participants in the ensuing markets, the efficient market hypothesis and
some simplifying assumptions, in order to make the theoretical treatment feasible,
are covered.
Let us start by familiarizing ourselves with some of the concepts and the lingo used
in the financial world. One of the central items is to no one’s surprise—stocks.
2.1 Stocks and Other Tradeable Goods
Stocks or shares S in companies are examples of underlying assets that are at the
heart of financial economics. Other assets are large sums of money or even basic
commodities such as halves of hogs or grain. Think of Kellogs buying corn for their
flakes! These assets are typically traded in (stock or other) exchanges. Big ones are
in Frankfurt, London, New York, or in Chicago at the Mercantile Exchange (CME).
These exchanges often publish composite indices, such as DAX, FTSE, or the Dow
Jones to track the overall behavior of trading.
A crucial feature is the fluctuating value of these assets. It depends on many and
varying influences, such as a competitor introducing a better product, the company
losing a lawsuit, or a natural catastrophe such as an earth quake that damages production facilities. Even the expectations of market analysts affects their value. They
try to figure out whether shares are worth buying or not and if their expectations are
not satisfied, the share prices fall. All of these, and many more, factors contribute to
fluctuations of the stock values. These fluctuations are normally quantified by their
relative variation or variance V = σ
2
= =((S/S)
2
. Here the angle brackets denote
the average over a suitable period of time, such as a month or a year. The variability
or volatility σ is commonly associated with risk and plays a crucial role when dealing with stocks. Thus random fluctuations of tradeable quantities are perceived as a
© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021
V. Ziemann, Physics and Finance, Undergraduate Lecture Notes in Physics,
https://doi.org/10.1007/978-3-030-63643-2_2
5
Concepts of Finance
Abstract After introducing the volatility of stocks as a central feature, the concepts
of hedging, short selling, and discounting are introduced, as well as future contracts
and options as functions—derivatives—of the underlying stocks. Before discussing
the various participants in the ensuing markets, the efficient market hypothesis and
some simplifying assumptions, in order to make the theoretical treatment feasible,
are covered.
Let us start by familiarizing ourselves with some of the concepts and the lingo used
in the financial world. One of the central items is to no one’s surprise—stocks.
2.1 Stocks and Other Tradeable Goods
Stocks or shares S in companies are examples of underlying assets that are at the
heart of financial economics. Other assets are large sums of money or even basic
commodities such as halves of hogs or grain. Think of Kellogs buying corn for their
flakes! These assets are typically traded in (stock or other) exchanges. Big ones are
in Frankfurt, London, New York, or in Chicago at the Mercantile Exchange (CME).
These exchanges often publish composite indices, such as DAX, FTSE, or the Dow
Jones to track the overall behavior of trading.
A crucial feature is the fluctuating value of these assets. It depends on many and
varying influences, such as a competitor introducing a better product, the company
losing a lawsuit, or a natural catastrophe such as an earth quake that damages production facilities. Even the expectations of market analysts affects their value. They
try to figure out whether shares are worth buying or not and if their expectations are
not satisfied, the share prices fall. All of these, and many more, factors contribute to
fluctuations of the stock values. These fluctuations are normally quantified by their
relative variation or variance V = σ
2
= =((S/S)
2
. Here the angle brackets denote
the average over a suitable period of time, such as a month or a year. The variability
or volatility σ is commonly associated with risk and plays a crucial role when dealing with stocks. Thus random fluctuations of tradeable quantities are perceived as a
© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021
V. Ziemann, Physics and Finance, Undergraduate Lecture Notes in Physics,
https://doi.org/10.1007/978-3-030-63643-2_2
5