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Financial Data Science

Applying data science methods to financial markets. Covers portfolio theory, risk metrics, derivatives basics, and quantitative analysis patterns.

Portfolio Theory

Key Metrics

  • Expected return: weighted average of asset returns
  • Portfolio volatility: sqrt(w^T * Cov * w) where w = weight vector
  • Sharpe ratio: (return - risk_free_rate) / volatility
  • Beta: sensitivity to market movements

Efficient Frontier

Set of portfolios maximizing return for given risk level. Found via Monte Carlo simulation or quadratic programming.

# Monte Carlo portfolio optimization
port_return = weights @ daily_returns.mean() * 252
port_vol = np.sqrt(weights @ cov_matrix @ weights) * np.sqrt(252)
sharpe = port_return / port_vol

Financial Derivatives

Options

  • Call: right to buy at strike price. Payoff = max(0, spot - strike)
  • Put: right to sell at strike price. Payoff = max(0, strike - spot)
  • Premium: price paid for the option

Forwards/Futures

Lock price for future delivery. Mark-to-market: daily P&L based on spot vs contract price.

Risk Metrics

Value at Risk (VaR)

Maximum expected loss at confidence level over time period.

# Historical VaR (95%)
var_95 = np.percentile(returns, 5)

# Parametric VaR
var_95 = returns.mean() - 1.645 * returns.std()

Volatility

Standard deviation of returns. THE fundamental risk measure in finance.

daily_vol = returns.std()
annualized_vol = daily_vol * np.sqrt(252)

68-95-99.7 rule applied to returns: 95% of daily returns within +/- 2*sigma.

Financial Constants

  • Trading days per year: 252
  • Trading days per month: ~20
  • Trading days per quarter: ~60
  • Annualization factor: sqrt(252) for volatility

Asset-Backed Securities (ABS)

Securitization: convert illiquid assets (mortgages, loans) into tradable bonds. - SPV (Special Purpose Vehicle): legally separate entity holding asset pool - Tranching: redistribute cash flows into bonds with different risk/return profiles - Senior tranche: first to be paid, lowest risk (AAA rating) - Equity tranche: residual after all other tranches paid, highest risk/return

Key Financial Ratios

Category Metrics
Profitability EBIT, EBITDA, net margin
Liquidity Current ratio, quick ratio
Solvency Debt/equity, interest coverage
Valuation P/E, EV/EBITDA, P/B
Cash flow FCF, operating cash flow

Free Cash Flow (FCF): most important metric for cash generation capacity. Accounts for working capital changes and CapEx.

Gotchas

  • Financial returns are NOT normally distributed - heavy tails (kurtosis > 0)
  • Past performance does not predict future returns
  • Correlation between assets changes during crises (correlation goes to 1)
  • VaR underestimates tail risk - use CVaR (expected shortfall) for extreme scenarios
  • Always use log returns for multi-period analysis, simple returns for single period

See Also