I checked out the "Principles of Financial Engineering" from the library near the beginning of the school year and finally had time to read a bit. This book received excellent reviews on Amazon so I've been eager to read it.

CH1 is a brief into and CH2 covers how markets and their participants interact and what conventions are typically followed. This entry will take the form of my notes on especially clear definitions and information I hadn't previously known.

A market maker can be thought of as a warehouse. Sort of like how a fisherman might sell his fish to a market and then the market sells the fish to consumers, the market maker buys securities from people who wish to sell and then holds them for a brief time until a buyer comes along. This definition makes it self-explanatory how a high-volume player like DE Shaw could become a market maker.

Order confirmation and settlement follows a standard known as SWIFT. The Society for Worldwide Financial Telecommunications standardizes bank transfers, FX, loans, and deposits between 8 thousand financial institutions and more than 200 countries. I think it's amazing that such an international standard exists since governments can't seem to negotiate anything quite so inclusive. SWIFT is owned by a group of international banks.

Different day count conventions require explicit specification in derivatives contracts. For example in an interest rate swap you may receive a fixed rate but pay Libor. The fixed rate could be quoted in 30/365 but Libor is ACT/360 so the rates on each side are not directly comparable. International contracts also need to stipulate which holiday schedule to follow. A similar situation occurs when quoting yields since there are a few different formulas to calculate the yeild.

I hadn't realized a money market account traded fixed income investments. I used to have my money invested in a money market account in high school due to the high yeilds (esp compared to CDs) and safety but I never knew how it worked. This was back when they were getting >5%.

I finally settled on a decent metaphorical explanation of what it means to short something. You borrow your friend's baseball card before he goes on vacation for a week. You think the value of this card will fall dramatically once some news comes out tomorrow that only you know about. So you sell your buddy's favorite card for $100 and then after the news is released you buy it back for $50. When your friend returns from vacation you return the card and he's none the wiser, and you keep the $50. Replace baseball card with BSC or LEH.

The book also has a very simple definition of the greeks (Δ, Γ, ν, Θ, ρ): Partial derivatives of price, which measure sensitivities. I actually checked out "Trading Option Greeks" from the Haas Library recently in order to understand them more intuitively and to start building a real-world foundation for what I'll learn about in more depth in future math courses.

Futures are nothing more than a contract to buy something at time t+δ. Since you don't purchase the underlying, you do not actually need much funding to gain exposure to the potential gains. Which precedes a priceless little quote which succinctly explains the current crisis:

This illustrates one of the basic premises of financial engineering. Namely that as much as possible, one should operate by taking positions that do not require new funding.

This chapter was interesting because it explained many of the things taken for granted in a well-functioning capital market. I probably won't have the time or the background knowledge to finish the whole book, but from what I've read so far it's well written and very clear.