SYLLABUS: INTRODUCTORY MATHEMATICAL FINANCE FIN 6384

ALAIN BENSOUSSAN

Fall 2009
Monday: 1.30 p.m.
First Class: August 24th

CONTEXT

Quantitative Finance has seen remarkable progress in the last decades, both in
the development of models and in the creation of new tools to mitigate risks.
Mathematical Finance is a well-established scientific discipline, and Financial
Engineering has expanded considerably. It is now almost impossible to become
an expert in Finance without a solid knowledge of concepts and methods of
Quantitative Finance. “Quants” are very much sought after in Banks and
Financial institutions, and job opportunities are excellent. In fact, problems
which occur periodically, like crashes or large fluctuations, lead to more
research to overcome the complexity of financial situations independent of
better organization and understanding of behaviors. The global crisis that has
occurred since 2008 will naturally have consequences on the nature and use of
models, but this will require more innovation research and education.

Top universities offer educational programs in Mathematical Finance, which

are very popular. The objective of this class is to propose a comparable training
at UTD, School of Management.

OBJECTIVES

The overwhelming issue in Finance is valuation in the context of risks and

uncertainties. In fact, recent difficulties in financial markets show how much a
lack of visibility in the valuation of assets can result in dysfunction and erratic
behavior.

Valuation of assets is the main objective of the study of financial markets and
represents the core of this class. The main challenge consists giving a fair
valuation of the risk related to the asset.
“Fair” in the context of financial markets means absence of arbitrage. There is
arbitrage when there is a possibility of profit without risk. Markets eliminate
this possibility, and valuation should result from models and theories accepted
by all players. This is why good models and theories are as important in
Finance as they are in the physical sciences.

Valuation (or pricing) of assets like stocks extend to the valuation of financial
products created to protect investors against risks. In this class, students will
learn the concepts and techniques to valuate assets and financial products which
are currently used or under investigation.

Uncertainties and risk modeling relies on probability theory and stochastic

processes. Naturally, time is an essential element. We consider one-period and
multi-period models as well as continuous time models. Continuous time
models are popular because events occur fast in financial markets and the
possibility of analytic formulas is higher in continuous time.

BACKGROUND

The course is self-contained, and complete lecture notes will be provided.

However, some understanding of probability theory will be helpful to benefit
more quickly from the class. Nevertheless, the speed of the lectures will be
adjusted to the background of students to ensure that all students get a good
base of knowledge of the current ideas and methods in order to either research
or apply to jobs offered to “Quants.”

TEXT BOOKS

Full lecture notes will be provided and will represent the main material for the
class. However, excellent text books have been published in the past years and
represent useful documents for the class.

Recommended Text Books:

Aleš Černý. Mathematical Techniques in Finance, Princeton University Press,

2009, new edition. ISBN 978-0-691-14121-3

T. Wake Epps . Quantitative Finance: Its Development, Mathematical

Foundations, and Current Scope, Wiley, ISBN 978-0-470-43199-3
Additional valuable Text Books:

Erol A. Pekoz. The Manager’s Guide to Statistics, 0979570433

Steve E. Shreve, Stochastic Calculus for Finance I & II, Springer Finance 2004.

Steven Roman. Introduction to the Mathematics of Finance, Springer

Undergraduate Texts in Mathematics, 2004.

GRADING:

Assignments: 40%
Presentations: 35%
Participation: 25%

Lectures I & II: MARKOWITZ THEORY:

• DIVERSIFICATION, MEAN VARIANCE ANALYSIS.

• TWO FUND THEOREM, EFFICIENT FRONTIER.
• PORTFOLIO WITH A RISK-FREE ASSET. ONE FUND THEOREM.
• MARKET PORTFOLIO, SCAPM: (Static Capital Asset Pricing Model).

Lectures III & IV: ONE PERIOD MODEL:

- VALUATION THROUGH SCAPM OF BASIS ASSETS

- VALUATION OF CONTINGENT CLAIMS and HEDGING
- ARBITRAGE, RISK-NEUTRAL PROBABILITY
- UTILITY FUNCTIONS
- CONSUMPTION-BASED CAPITAL ASSET PRICING MODEL
- OPTIMAL PORTFOLIO FOR COMPLETE MARKETS

Lectures V& VI: MULTI-PERIOD MODEL:

- DESCRIPTION OF THE MARKET, COMPLETE MARKETS

- OPTIMAL PORTFOLIO AND CONSUMPTION
 - MULTI PERIOD CCAPM
- DYNAMIC PROGRAMMING APPROACH, MARKOVIAN
FRAMEWORK
- CCAPM FOR THE MARKOVIAN CASE

Lectures VII & VIII: VALUATION EXAMPLES:

- EUROPEAN CALL OPTION, BLACK-SCHOLES FORMULA

- MARKOVIAN APPROXIMATION
- BINOMIAL APPROXIMATION

Lectures IX & X: BROWNIAN MOTION AND ITO's CALCULUS:

- STOCHASTIC INTEGRAL
- STOCHASTIC DIFFERENTIAL CALCULUS, ITO's FORMULA
- -STOCHASTIC DIFFERENTIAL EQUATIONS
- -REPRESENTATION OF MARTINGALES

Lectures XI & XII: CONTINUOUS TIME MODEL:

- DESCRIPTION OF THE MARKET

- OPTIMAL CONSUMPTION AND INVESTMENT
- DYNAMIC PROGRAMMING
- VALUATION OF CONTINGENT CLAIMS INDIFFERENCE
APPROACH
- EXAMPLES: LOGARITHMIC UTILITY FUNCTIONS, POWER
UTILITY FUNCTIONS.

Lectures XIII & XIV: OPTIMAL STOPPING:

- FAIR VALUE OF FLEXIBILITY

- AMERICAN OPTIONS IN DISCRETE TIME
- AMERICAN OPTIONS IN CONTINUOUS TIME