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This lecture reviews the intuition from the previous class, where the idea of dynamic hedging was introduced. We learn why the crucial idea of dynamic hedging is marking to market: even when there are millions of possible scenarios that could come to pass over time, by hedging a little bit each step of the way, the number of possibilities becomes much more manageable. We conclude the discussion of hedging by introducing a measure for the average life of a bond, and show how traders use this to figure out the appropriate hedge against interest rate movements.
This course attempts to explain the role and the importance of the financial system in the global economy. Rather than separating off the financial world from the rest of the economy, financial equilibrium is studied as an extension of economic equilibrium. The course also gives a picture of the kind of thinking and analysis done by hedge funds.
