Categories: Career, Crypto, Finance, Quant, Tech
Quantitative Finance and FinTech
Written by Nasr Ullah Khan on Thursday, October 31, 2019
Machine Learning in Quantitative Finance and FinTech
Quantitative finance, also known as financial engineering or mathematical finance, is a branch of applied mathematics that deals with the mathematical modelling of financial markets. Financial technology is an industry composed of companies that use new technology and innovation to revolutionise financial institutions and financial markets.
Assessing the two definitions, the main point of intersection can be identified as financial markets. So, the next question is, how does mathematical finance solve problems in financial markets? It does so by using stochastic calculus, which is a field linking calculus, probability and statistics. Application of it involves dealing with large data sets, so programming software such as C++ and Python are used in such data analysis.
Machine learning is a pivotal point where the fields of mathematical finance and financial technology overlap. Machine learning is the utilisation of statistics and algorithms in creating mathematical models using sample data and using that data in making future predictions. Machine learning models are different in the financial mathematics world, and the traditional finance world. While the models that focus on explainability are preferred by financial mathematicians, the interpretability of models is preferred by the traditional finance world. However, the models are fundamentally the same.
On a side note, I would like to add that such a similarity can be seen when comparing the fields of computational finance and financial technology. This is because computational finance is just the field of intersection of financial mathematics, and numerical methods are found everywhere when it comes to the mathematics of machine learning.
Options Pricing of Cryptocurrencies
The rise in FinTech developments is mostly a story of the past 30 years. With that, the field of quantitative finance is relatively new as well. Louis Bachelier is the pioneer of quantitative finance, who linked stock options pricing to the concept of Brownian motion in his PhD thesis “The Theory of Speculation” in 1900. Today, using such stochastic processes in pricing options is widely used in hedge funds and other financial institutions. With the rise of cryptocurrencies in the 21st century, could we be seeing options pricing of cryptocurrencies becoming as common as stock options in the future?
Currently, cryptocurrency trading does take place as it possesses several advantages. First, there exists the ability of trading them globally using exchanges such as Coinbase. Secondly, such trading can take place 24 hours a day throughout the year, thanks to its decentralised system.
However, cryptocurrencies are subject to the volatility that comes with a decentralised system left on the market forces. Hence, this means that buying a cryptocurrency option is very expensive. Both concepts are connected by the principle of implied volatility. Implied volatility is essential to understand, if you want to grasp the technical analysis or quantitative analysis sides of trading. On a side note for the academically curious, implied volatility is plugged into the famous Black-Scholes options pricing formulae to evaluate the market price. With bitcoin options, the implied volatility ranges from 90% to over 200%. Now think of it this way: during the 2008 financial crisis, implied volatility levels had reached record high levels of 65%. Therefore, bitcoin options trading is not for the faint-hearted, and certainly not for the ones not well-versed with cryptocurrencies and trading.
Nevertheless, bitcoin options trading takes place in a few countries with the US considering it as an option as well. Currently, the Chicago Mercantile Exchange offers bitcoin futures, as futures pricing is generally easier to understand than options. With the rise of stable coins such as JPM Coin, they can act as a better alternative to cryptocurrencies when it comes to options trading. This is because of their reduced volatility. Nevertheless, it would take at least a few more years before cryptocurrency options trading gains a position in the lingo of the trading world.
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