Course Plan

Module 1: Basics of Corporate We follow Principles of Corporate

Finance Finance by Brealey, Myers and Allen

Module 2: Time series for We follow Time Series Analysis and Its
financial analytics Applications by Shumway and Stoffer

Module 3: Advanced topics in Advances in Financial Machine learning

finance by Lopez de Prado
Financial Analytics
MG 258
Shashi Jain

DA226o: Financial Analytics

 • Front Office Quant:
A desk Quant works to implement models that are used directly for trading
(traders).
• Model Validation Quant:
Independently develops the pricing models to check the front office
models
• Research Quant:
Develops new pricing models.
• Quant Developer:
Different Shades of Skilled programmers who develop production ready code, well integrated
Quants with other pricing libraries.
• Statistical Arbitrage Quant:
Finds trends following statistical tools (now machine learning etc), usually
engaged with Hedge funds.
• Capital Quant (XVA Quants):
Works on models to manage the banks future exposure, and therefore
capital requirements.
• Portfolio Theorist:
Works on Markowitz Portfolio kind of problem, and is usually engaged on
the ‘buy-side’
 1. Commercial Banks: HSBC, CitiBank
2. Investment Banks: Goldman Sachs
Different Shades of 3. Hedge Funds: BlackRock, D.E. Shaw
Employers 4. Accountancy Firms
5. Software Companies: Thomson Reuters,
Bloomberg
 If you want to be a Quant, you need to honestly identify these
traits

• Good at programming skills

Things to keep in mind • Ability to do maths
• Interest in finance
 Brown (1911)
• Observed the random motion of small particles in a liquid, called it random walk
• Random walk : Now used universally to model unpredictable continuous-time
processes.
Bachelier (1923)
• Louis Bachelier was the first to quantify the concept of Brownian motion.
• Developed a mathematical theory for random walks, a theory rediscovered later by
A brief history of Einstein.

Quantitative Finance • Proposed a model for equity prices, a simple normal distribution, built on it a model for
pricing the almost unheard of options.
• His model contained many of the seeds for later work, but lay 'dormant' for many, many
years.
• His work was not appreciated during his time.
Einstein (1905)
• Albert Einstein proposed a scientific foundation for Brownian motion in 1905.
• He did some other clever stuff as well.
 Richardson (1911)
• Most option models result in diffusion-type equations.
• They can be solved either using Monte Carlo schemes, or using finite difference based
methods for solving partial differential equations.
• The very first use of the finite-difference method, in which a differential equation is
discretized into a difference equation, was by Lewis Fry Richardson in 1911, and used
to solve the diffusion equation associated with weather forecasting.
• Richardson later worked on the mathematics for the causes of war. Working on
relationship between probability of war and the length of common borders between
A brief history of countries he stumbled upon the concept of fractals

Quantitative Finance • The fractal nature of turbulence was summed up in his poem ''Big whorls have little
whorls that feed on their velocity, and little whorls have smaller whorls and so on to
viscosity.''
Wiener (1923)
• Norbert Wiener developed a rigorous theory for Brownian motion.
• The mathematics of which was to become a necessary modelling device for
quantitative finance decades later.
• The starting point, the first equation written down in most technical papers, includes
the Wiener process as the representation for randomness in asset prices.
 Samuelson (1950s)

• The 1970 Nobel Laureate in Economics, Paul Samuelson, was responsible for
setting the tone for subsequent generations of economists.
• Samuelson 'mathematized' both macro and micro-economics.
• He rediscovered Bachelier's thesis and laid the foundations for later option
pricing theories.
• His approach to derivative pricing was via expectations, real as opposed to
A brief history of the much later risk-neutral ones
Quantitative Finance
Ito (1951)
• Kiyosi Ito showed the relationship between a stochastic differential equation
for some independent variable and the stochastic differential equation for a
function of that variable.
• Some people even think finance is only about Ito calculus.
 Markowitz (1952)
• Harry Markowitz was the first to propose a modern quantitative methodology for
portfolio selection (Modern Portfolio Theory)
• His work resulted in novel ideas such as ‘efficiency’ and ‘market portfolios.’
• Diversification: Markowitz showed that combinations of assets could have better
properties than any individual assets.
• What did ‘better’ mean? Combination of expected return and its standard deviation.

A brief history of • The latter was to be interpreted as its risk.

• He showed how to optimize a portfolio to give the maximum expected return for a
Quantitative Finance given level of risk.
• Such a portfolio was said to be ‘efficient.’
• The work later won Markowitz a Nobel Prize for Economics
Sharpe, Lintner and Mossin (1963)
• Independently developed a simple model for pricing risky assets.
• This Capital Asset Pricing Model (CAPM) also reduced the number of parameters
needed for portfolio selection from those needed by Markowitz’s Modern Portfolio
Theory, making asset allocation theory more practical.
 Eugene Fama (1966)
• Concluded that stock prices were unpredictable and coined the phrase
‘‘market efficiency.’’
• In a nutshell the idea is that stock market prices reflect all publicly available
information, that no person can gain an edge over another by fair means.
Thorp (1968)
• Ed Thorp’s first claim to fame was that he figured out how to win at casino
A brief history of Blackjack.

Quantitative Finance • Ideas that were put into practice by Thorp himself and written about in his
best-selling Beat the Dealer, the ‘‘book that made Las Vegas change its
rules.’’
• His second claim to fame is that he invented and built, with Claude
Shannon, the information theorist, the world’s first wearable computer.
• His third claim to fame is that he was the first to use the ‘correct’ formulæ
for pricing options
• Thorp used these formulæ to make a fortune for himself and his clients in
the first ever quantitative finance-based hedge.
 Black, Scholes, and Merton (1973)
• Fischer Black, Myron Scholes and Robert Merton derived
the Black–Scholes equation for pricing options
• The date corresponded almost exactly with the trading
of call options on the Chicago Board Options Exchange.
• Scholes and Merton won the Nobel Prize for Economics
A brief history of in 1997. Black had died in 1995.
Quantitative Finance Merton (1974)
• Came up with the structural approach for pricing credit
risk.
• Credit risk was huge in 1990s and later in 2007 (cause for
recession)
• LTCM went bankrupt ( had Black and Merton as
principals!)
 Boyle (1977)
• Was the first to demonstrate option price can be obtained using
simulations.
• Role of Monte Carlo in finance is immense.
Vasicek (1977)
• So far quantitative finance hadn’t had much to say about pricing
A brief history of interest rate products.
Quantitative Finance • Was first to model a short-term interest rate as a random walk and
concluded that interest rate
Cox, Ross, Rubenstien (1979)
• Developed the binomial tree model for pricing options under the
Black Scholes framework
• A simple algorithm requiring only addition, subtraction,
multiplication and (twice) division. Even MBAs could now join in
the fun.
 Engle (1982)
• In econometrics, autoregressive conditional heteroskedasticity (ARCH)
(Engle, 1982) is a model used for forecasting volatility which captures the
conditional heteroscedasticity (serial correlation of volatility) of financial
returns.
• Today's conditional variance is a weighted average of past squared
unexpected returns. ARCH is an AR process for the variance.
A brief history of Bollerslev (1986)
Quantitative Finance • A generalized autoregressive conditional heteroskedasticity (GARCH) model
generalizes the ARCH model.
• Today's conditional variance is a function of past squared unexpected
returns and its own past values.
• The model is an infinite weighted average of all past squared forecast errors,
with weights that are constrained to be geometrically declining.
• GARCH is an ARMA(p,q) process in the variance.
 The Appearance of the Smile (1987)
• Before the crash (1987) options on the same stock with the same expiration but with different strikes all
had roughly the same implied volatility.
• Thus, even though the implied volatilities changed every day, at least they all moved up or down
together for different strikes.
• After the 1987 crash, low-strike index options have higher implied volatilities than higher-strike options.
• When you fit the model to different option strikes, each one implies a different future volatility for the
underlying stock.
A brief history of • But in the model a stock can only have one volatility. Now something is really wrong – the BS model

Quantitative Finance can NOT accommodate different volatilities for the same stock.
Heston (1990s)
• Introduced stochastic volatility to fit the smile and skews observed in the market.
Dupire, Rubinstien, Derman and Kani (1994)
• Came up with local volatility models which could consistently price exotics and vanilla instruments.
CVA and FVA (~2007)
• Outcome of the fall off of Lehman brothers etc during the credit crisis in 2007. Regulation of OTC
markets.
What is the
role of finance
• 33 centuries before Christ to a
5,000-year-old clay tablet found in
Mesopotamia (modern Iraq).
• It states: A total of 29,086
measures of barley were received
over the course of 37 months.
Signed, Kushim.
• The first recorded name is not
that of king, or a celebrity, but
that of an accountant!
 1. What is a derivative ?
• A derivative is an instrument whose value depends on, or is derived from, the value of
another asset.
• Examples: futures, forwards, swaps, options, exotic

2. Why are derivatives important ?

• Derivatives are instruments to manage risk (uncertainties).
• They can be used to hedge an existing market exposure (forwards and futures),
Derivatives • To obtain downside protection to an exposure even while retaining upside potential
(options),
• To transform the nature of an exposure (swaps),
• To obtain insurance against events such as default (credit derivatives).
• For corporations and financial institutions looking to manage
• exchange-rate risk,
• input costs,
• financing costs,
• or credit exposures,
Trading Derivatives:
Exchange traded Derivatives

List of Commodity Exchanges in US:

• Chicago Board Options Exchange (CBOE / CFE)
• Chicago Climate Exchange (CCE)
• CME Group
• International Monetary Market (IMM)
• Chicago Board of Trade (CBOT)
• Chicago Mercantile Exchange (CME / GLOBEX)
• New York Mercantile Exchange (NYMEX)
List of Exchanges in India
• Bharat Diamond Bourse
• Bombay Stock Exchange (BSE)
• Indian Energy Exchange (IEX)
• MCX Stock Exchange (MCX-SX)
• Multi Commodity Exchange (MCX)
• National Commodity and Derivatives Exchange (NCDEX)
• National Spot Exchange
• National Stock Exchange of India (NSE)
Trading Derivatives: OTC

• Traders working for banks, fund managers and

corporate treasurers contact each other directly
• Largely unregulated
• Banks act as market makers quoting bids and
offers
• Master agreements usually defined how
transactions between two parties would be
handled
Size of OTC market
 Lehman Brothers, one of the oldest investment filed for the largest single bankruptcy in
American history on September 14, 2008.
• Lehman Brothers was founded in 1850 by a pair of enterprising brothers
• After moving the firm to NY following the American Civil War, the firm had long
been considered one of the highest return, highest risk small investment banking
firms on the Wall Street
• Reasons include liquidity risk and high leverage.
• Due to the extensive holdings of mortgage-backed securities and dominant role to
issue commercial papers, allowing Lehman to fail is to send shock waves worldwide
Collapse of Lehman through most common instruments in the banking system.
Brothers
Why did the U.S. government let it fail?
• Although the “too big to fail” doctrine has long been a mainstay of the U.S. financial
system, this doctrine, however, had largely been confined to commercial banks rather
than investment banks which intentionally bear risk in exchange for profit
• The rescue loan from the Fed is limited by the amount of asset collateral specific
institutions, but it is not enough to save Lehman
 • A forward contract is one in which two parties
• referred to as the “counterparties” to the transaction
• commit to the terms of
• a specified trade
• to be carried out on a specified date in the future.
• Forward contracts are bilateral or “over the counter” (OTC)
contracts
Forward contract • They are negotiated directly between buyer and
seller.
• On the positive side, this means they are
customizable in terms of
• the maturity date,
• the specific quality (grade) to be delivered, etc.
• On the other hand, each party also takes on the risk
of the other counterparty’s default.
Forward Contracts
 • A futures contract is, in essence, a forward contract
• It is traded on an organized exchange, rather than
negotiated bilaterally.
• Futures contracts grew out of forward contracts in the
mid-19th century.
• Futures contract terms
Futures contract
• maturity dates,
• deliverable grade of the underlying, etc.) are
standardized,
• The exchange guarantees performance on the contract.
• Participants in futures markets are required to post
“margin,” which is essentially collateral against default.
 • Hedge an existing market exposure
• that is, to reduce cash flow uncertainty from the
exposure.
• Consider, for example, a soybean farmer anticipating a crop
of 10 tons in three months’ time.
• The farmer is exposed to fluctuations in the price of
soybean
Usage of forward and • in particular to the risk of falling soybean prices in
futures three months.
• By entering into a three-month soybean forward contract as
the seller, the farmer can lock-in a price for the anticipated
crop, and so insulate revenues received in three months
from price fluctuations.

• What are still some of the risks that remain ?

 • Since forwards and futures involve a relatively small cash flow up-front—
collateral in the case of forwards, margin in the case of futures—they
provide investors with substantial leverage,
• Leverage is a feature of particular interest for speculators (but one that, as
discussed for Lehman case, increases the riskiness of these instruments).
• The futures/forward market is a large and diverse one.
• Interest-rate forwards (or “forward rate agreements”), which may
be used by investors to lock-in an interest rate for borrowing or
Leverage lending over a specified period in the future, had a total notional
outstanding in December 2011 exceeded $50 trillion (with another
$20+ trillion in notional outstanding in interest-rate futures).
• Currency forwards, which may be used to lock-in an exchange rate
for future purchase or sale of a foreign currency, had a notional
outstanding of over $30 trillion in December 2011.
• Commodity forwards, instruments for locking-in prices for future
sale or purchase of a commodity, had a notional outstanding in
December 2011 of almost $2 trillion.
 • The party that has agreed to buy has what is
termed a long position
Terminology • The party that has agreed to sell has what is
termed a short position
Profit from a Long Forward Position (K= delivery price=forward price at time contract is entered
into)
Pay off a long forward position

Profit

Price of Underlying at Maturity, ST

K
Profit from a Short Forward Position (K= delivery price=forward price at time contract is entered
into)
Pay off of a short forward position.

Profit

Price of Underlying
at Maturity, ST
K
Options
• A call option is an option to buy a certain asset by a certain date for a certain price (the strike price)
• A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)

Option Type Buy Sell

Call No Risk (ideally) Risky

Put No Risk (ideally) Risky

Difference between option
and forwards

• A futures/forward contract gives

the holder the obligation to buy
or sell at a certain price
• An option gives the holder the
right to buy or sell at a certain
price
NSE option values
 References

1. Frequently Asked Questions in Quantitative Finance: Paul Wilmott

2. Options, Futures, and Other Derivatives: John Hull

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