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COMPUTATIONAL FINANCE EXECUTIVE SUMMARY Computational finance is a process that relies on the application of several factors in order to arrive at conclusions regarding such matters as investments in stocks and bonds, futures trading, and hedging on stock market activity. Generally speaking, the wide umbrella of computational finance will employ the disciplines of mathematical science, number theories, and the use of computer simulations to explore the potential risks as well as the probably outcomes of any such transaction. Here are a few examples of how computational finance is used each day in a number of different scenarios. One of the most common applications of computational finance is within the arena of investment banking. Because of the sheer amount of funds involved in this type of situation, computational finance comes to the fore as one of the tools used to evaluate every potential investment, whether it be something as simple as a new start-up company or a well established fund. Computational finance can help prevent the investment of large amounts of funding in something that simply does not appear to have much of a future. Another area where computational finance comes into play is the world of financial risk management. Stockbrokers, stockholders, and anyone who chooses to invest in any type of investment can benefit from using the basic principles of computational finance as a way of managing an individual portfolio. Running the numbers for individual investors, just alike for larger concerns, can often make it clear what risks are associated with any given investment opportunity. The result can often be an individual who is able to sidestep a bad opportunity, and live to invest another day in something that will be worthwhile in the long run.

In the business world, the use of computational finance can often come into play when the time to engage in some form of corporate strategic planning

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arrives. For instance, reorganizing the operating structure of a company in order to maximize profits may look very good at first glance, but running the data through a process of computational finance may in fact uncover some drawbacks to the current plan that were not readily visible before.

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INTRODUCTION Computational finance or quantitative finance is a cross-disciplinary field which relies on computational intelligence, mathematical finance, numerical methods and computer simulations to make trading, hedging and investment decisions, as well as facilitating the risk management of those decisions. Utilising various methods, practitioners of computational finance aim to precisely determine the financial risk that certain financial instruments create. y y y y y y y Mathematical finance Numerical methods Computer simulations Quantitative techniques Financial risk Quantitative management Applied mathemathics

Computational finance is applied mathematics concerned with financial markets. The subject has a close relationship with the discipline of financial economics, which is concerned with much of the underlying theory. Generally, it will derive, and extend, the mathematical or numerical models suggested by financial economics. Thus, for example, while a financial economist might study the structural reasons why a company may have a certain share price, a financial mathematician may take the share price as a given, and attempt to use stochastic calculus to obtain the fair value of derivatives of the stock The fundamental theorem of arbitrage-free pricing is one of the key theorems in mathematical finance. Many universities around the world now offer degree and research programs in computational finance. The frontiers of finance are shifting rapidly, driven in part by the increasing use of quantitative methods in the field. Quantitative Finance welcomes original research articles that reflect the dynamism of this area. The journal provides an interdisciplinary forum for presenting both theoretical and

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quantitative analysts support sales functions and trading by developing models that manage stocks and bonds. stockholders. This provides the bank with a solution to problems with market prices and other issues. Computational finance can help prevent the investment of large amounts of funding in something that simply does not appear to have much of a future. Another area where computational finance comes into play is the world of financial risk management. requiring the use of sophisticated mathematical tools in both research and practice. whether it be something as simple as a new start-up company or a well established fund.C. Modern finance is becoming increasingly technical. The readership is broad. Computational finance comes to the fore as one of the tools used to evaluate every potential investment. Quantitative Finance is a high-quality journal which brings together work on the mathematical aspects of finance theory from such diverse fields as finance. mathematics. can often make it clear what risks are associated with any given investment opportunity. just alike for larger concerns. Running the numbers for individual investors. and live to invest another day in something that will be worthwhile in the long run. The result can often be an individual who is able to sidestep a bad opportunity. While quantitative analysis can be applied to many different fields. Computational Finance Page 4 . In the banking industry. the journal publishes clear and concise articles which present the latest theoretical developments in an accessible way. usually only people who use the concept in finance analysis are actually known as quantitative analysts. All articles should aim to be of interest to this broad readership. Stockbrokers. and statistics. Quantitative Finance offers a forum for the publication of articles which employ these techniques.College empirical approaches and offers rapid publication of original new work with high standards of quality. embracing researchers and practitioners across a range of specialisms and within a variety of organizations. economics. as well as providing a much-needed bridge between mathematical scientists and financial economists. and anyone who chooses to invest in any type of investment can benefit from using the basic principles of computational finance as a way of managing an individual portfolio.K. An essential resource for academic finance researchers and practitioners alike.

Being aware of the complete and true expenses associated with the restructure may prove to be more costly than anticipated. reorganizing the operating structure of a company in order to maximize profits may look very good at first glance. Computational finance can help get past the hype and provide some realistic views of what could happen. For instance.K. before any corporate strategy is implemented. and in the long run not as productive as was originally hoped.C. Computational Finance Page 5 . the use of computational finance can often come into play when the time to engage in some form of corporate strategic planning arrives.College In the business world. but running the data through a process of computational finance may in fact uncover some drawbacks to the current plan that were not readily visible before.

Thanks to Robert Merton and Paul Samuelson. Markowitz and Sharpe. Brownian-motion models. However. With time. Merton.K.C. variance) and return (i. the mathematics has become more sophisticated. an optimization strategy was used to choose a portfolio with largest mean return subject to acceptable levels of variance in the return. Using a linear regression strategy to understand and quantify the risk (i. concave utility functions. it hardly caught any attention outside academia. by modeling financial markets with stochastic models. which discussed the use of Brownian motion to evaluate stock options. for the first time ever awarded for a work in finance.e. mean) of an entire portfolio of stocks and bonds. The portfolio-selection work of Markowitz and Sharpe introduced mathematics to the ³black art´ of investment management. causing a shift away from the concept of trying to identify the best individual stock for investment.College HISTORY The history of Computational finance starts with The Theory of Speculation (published 1900) by Louis Bachelier. For their pioneering work. The next major revolution in mathematical finance came with the work of Fischer Black and Myron Scholes along with fundamental contributions by Robert C. The first influential work of computational finance is the theory of portfolio optimization by Harry Markowitz on using mean-variance estimates of portfolios to judge investment strategies. William Sharpe developed the mathematics of determining the correlation between each stock and the market.e. Simultaneously. and the quadratic utility function implicit in mean±variance optimization was replaced by more general increasing. shared the 1990 Nobel Memorial Prize in Economic Sciences. one-period models were replaced by continuous time. along with Merton Miller. Computational Finance Page 6 .

College For this M. Bodies such as the Institute for New Economic Thinking are now attempting to establish more effective theories and methods Computational Finance Page 7 . Scholes and R. Merton were awarded the 1997 Nobel Memorial Prize in Economic Sciences. More sophisticated mathematical models and derivative pricing strategies were then developed but their credibility was damaged by the financial crisis of 2007±2010.K. Black was ineligible for the prize because of his death in 1995.C.

The methodology helps us in studying the scientific methods with respect to phenomenon connected with human behavior like formulating the problem. validating the model. This study material is presented with variety of these techniques with real life problem areas. The major advantage of mathematical model is that its facilitates in taking decision faster and more accurately. defining decision variable and constraints. Computational Finance Page 8 . with greater accuracy and in the most economical way. solving the model. emerges due to the impact of political. Managerial activities have become complex and it is necessary to make right decisions to avoid heavy losses. economic or cultural factors the talents from all walks of life amalgamate together to overcome the situation and rectify the problem. In this chapter we will see how the quantitative techniques had facilitated the organization in solving complex problems on time with greater accuracy. or a service organization.K.College QUANTITATIVE MANAGEMENT INTRODUCTION OF QUANTITATIVE MANAGEMENT Scientific methods have been man¶s outstanding asset to pursue an ample number of activities. developing a suitable model. In such situations. Whether it is a manufacturing unit. the resources have to be utilized to its maximum in an efficient manner. several scientific management techniques are available to solve managerial problems and use of these techniques helps managers become explicit about their objectives and provides additional information to select an optimal decision. Today. social. It is analysed that whenever some national crisis.C. there is a greater need for applying scientific methods to decision-making to increase the probability of coming up with good decisions. Quantitative Technique is a scientific approach to managerial decision-making. implementing the results. acquiring the input data. The future is clouded with uncertainty and fast changing. and decision-making ± a crucial activity ± cannot be made on a trial-and-error basis or by using a thumb rule approach. The historical development will facilitate in managerial decision-making & resource allocation. The successful use of Quantitative Technique for management would help the organization in solving complex problems on time.

C.College AIMS AND OBJECTIVES In this first lesson we discuss the distinguished approaches to quantitative techniques and its various applications in management.K. they were later adopted by the industrial sector in managerial decision-making and resource allocation.S. in any organization. people who perform quantitative analysis are frequently called quants. a pioneer of quantitative analysis. Here we will discuss the approaches of quantitative techniques.D thesis "Portfolio Selection" was one of the first papers to formally adapt mathematical concepts to finance. Similar work is done in most other modern industries. At present. Although the original quants were concerned with risk management and derivatives pricing. The usefulness of the Quantitative Technique was evidenced by a steep growth in the application of scientific management in decision-making in various fields of engineering and management. statistical analysis and other industries. In the investment industry. Quantitative finance started in the U. whether a manufacturing concern or service industry. Taylor developed the scientific management principle which was the base towards the study of managerial problems. Later. A quantitative management is working in finance using numerical or quantitative techniques. in the 1930s as some astute investors. the work is called quantitative analysis. Fredrick W. Robert C. during World War II. Markowitz Computational Finance Page 9 . many scientific and quantitative techniques were developed to assist in military operations. introduced stochastic calculus into the study of finance. HISTORICAL DEVELOPMENT During the early nineteen hundreds. Quantitative Techniques and analysis are used by managers in making decisions scientifically. Merton. As the new developments in these techniques were found successful. the meaning of the term has expanded over time to include those individuals involved in almost any application of mathematics in finance. Harry Markowitz's 1952 Ph.

Although the language of finance now involves minimization of risk in a quantifiable manner underlies much of the modern theory. showed how to price numerous other "derivative" securities. In 1981.e.. which is the classical economics question of "equilibrium. i. causing a shift away from the concept of trying to identify the best individual stock for investment. variance) and return (i.College formalized a notion of mean return and covariances for common stocks which allowed him to quantify the concept of "diversification" in a market. Fischer Black and Myron Scholes were developing their option pricing formula." and in later papers he used the machinery of stochastic calculus to begin investigation of this issue. It provided a solution for a practical problem. mean) of an entire portfolio of stocks and bonds. William Computational Finance Page 10 . Harrison and Pliska used the general theory of continuous-time stochastic processes to put the Black-Scholes option pricing formula on a solid theoretical basis. that of finding a fair price for a European call option. the right to buy one share of a given stock at a specified price and time. The history of mathematical finance starts with the theory of portfolio optimization by Harold Markowitz on using mean-variance estimates of portfolios to judge investment strategies.e.K. He showed how to compute the mean return and variance for a given portfolio and argued that investors should hold only those portfolios whose variance is minimal among all portfolios with a given mean return. and as a result. Merton was motivated by the desire to understand how prices are set in financial markets.C.e. an optimization strategy was used to Computational finance choose a portfolio with largest mean return subject to acceptable levels of variance in the return. Simultaneously. At the same time as Merton's work and with Merton's assistance. Such options are frequently purchased by investors as a risk-hedging device. In 1969 Robert Merton introduced stochastic calculus into the study of finance. which led to winning the 1997 Nobel Prize in Economics. Using a linear regression strategy to understand and quantify the risk (i.

ABOUT QUANTITATIVE TECHNIQUES Quantitative Techniques adopt a scientific approach to decision-making. or mutual funds. the mathematics has become more sophisticated. concave utility functions. In cases where the scope of quantitative data is limited. or in shares of a company. With time. In such cases. or in Life Insurance Corporation. quantitative factors are considered in decision-making. Thanks to Robert Merton and Paul Samuelson.College Sharpe developed the mathematics of determining the correlation between each stock and the market. Brownian-motion models. For example. Application of scientific management and Analysis is more appropriate when there is not much of variation in problems due to external factors. For their pioneering work. a model can be Computational Finance Page 11 . along with Merton Miller. Qualitative factors are important situations like sudden change in tax-structures. Markowitz and Sharpe. or the introduction of breakthrough technologies. consider a person investing in fixed deposit in a bank.C. The use of past data in a systematic manner and constructing it into a suitable model for future use comprises a major part of scientific management. We can use the scientific management analysis to find out how much the investments made will be worth in the future. qualitative factors play a major role in making decisions. shared the 1990 Nobel Prize in economics.period models were replaced by continuous time. The expected return on investments will vary depending upon the interest and time period.K. There are many scientific method software packages that have been developed to determine and analyze the problems. past data is used in determining decisions that would prove most valuable in the future. and where input values are steady. In this approach. for the first time ever awarded for a work in finance. and the quadratic utility function implicit in mean± variance optimization was replaced by more general increasing. In case of complete non-availability of past data. one. The portfolio-selection work of Markowitz and Sharpe introduced mathematics to the ³black art´ of investment management.

Computational Finance Page 12 .College developed to suit the problem which helps us to take decisions faster. this data is manipulated or processed into information that is valuable to people making decision.C. Like raw material for a factory. This approach starts with data. while emotion and guess work are not part of the scientific management approach.K. This processing and manipulating of raw data into meaningful information is the heart of scientific management analysis. Quantitative Technique is the scientific way to managerial decision-making. use of Quantitative Techniques with support of qualitative factors is necessary. In today's complex and competitive global marketplace.

Firstly. it is necessary to clearly understand the problem situations. It is important to know how it is characterized and what is required to be determined.K. Computational Finance Page 13 . the key decision and the objective of the problem must be identified from the problem.College METHODOLOGY OF COMPUTATIONAL FINANCE The methodology adopted in solving problems is as follows: Formulating the Problem As a first step. the number of decision variables and the relationship between variables must be determined.C. Then.

This helps us in determining how good and realistic the solution is. in order to address any proposed changes that call for modification. A trial and error method can be used to solve the model that enables us to find good solutions to the problem. The practical limitations or constraints are also inferred from the problem. Solving the Model Solving is trying for the best result by manipulating the model to the problem. Computational Finance Page 14 . During the model validation process. Close administration and monitoring is required after the solution is implemented.College The measurable guaranties that are represented through these variables are notified. This is done by checking every equation and its diverse courses of action. Validating the Model A validation is a complete test of the model to confirm that it provides an accurate representation of the real problem. Acquiring the Input Data Accurate data for input values are essential. until the model is found to be fit. under actual working conditions.C.K. Inaccurate data will lead to wrong decisions. inaccuracies can be rectified by taking corrective actions. it is ready for implementation. Implementing the Results Once the model is tested and validated. it is important that the input data is correct to get accurate results. Implementation involves translation/application of solution in the company. Even though the model is well constructed.

interest rate risk.K. credit risk and operational risk.College SOME MAJOR CONTRIBUTORS TO COMPUTATIONAL FINANCE INCLUDE: y y y y y y y y y y y y Fischer Black Phelim Boyle Emanuel Derman Robert Jarrow Harry Markowitz Robert C. Computational Finance Page 15 .C. other financial services companies and corporations. Merton Stephen Ross Myron Scholes Paul Wilmott Blake LeBaron Darrell Duffie Edward Tsang COMPUTATIONAL FINANCE COVERS APPLICATIONS SUCH AS: y y y y y y y y y y Asset-liability management Behavioural finance Corporate finance Corporate valuation Derivatives pricing Financial engineering Liquidity modelling Portfolio management Price formation Risk management Asset Liability management In banking. Asset Liability management (ALM) is a strategic management tool to manage interest rate risk and liquidity risk faced by banks. asset and liability management is the practice of managing risks that arise due to mismatches between the assets and liabilities (debts and assets) of the bank. Banks face several risks such as the liquidity risk.

rational "wealth maximizers". there are many instances where emotion and psychology influence our decisions. According to conventional financial theory. Behavioural Finance A field of finance that proposes psychology-based theories to explain stock market anomalies. Behavioral finance attempts to fill the void.K.College Banks manage the risks of Asset liability mismatch by matching the assets and liabilities according to the maturity pattern or the matching the duration. Within behavioral finance. Modern risk management now takes place from an integrated approach to enterprise risk management that reflects the fact that interest rate risk. There have been many studies that have documented long-term historical phenomena in securities markets that contradict the efficient market hypothesis and cannot be captured plausibly in models based on perfect investor rationality. the world and its participants are. causing us to behave in unpredictable or irrational ways. it is assumed that the information structure and the characteristics of market participants systematically influence individuals' investment decisions as well as market outcomes. However. Much of the techniques for hedging stem from the delta hedging concepts introduced in the Black-Scholes model and in the work of Robert C. by hedging and by securitization.C. for the most part. credit risk. Behavioral finance is a relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions. Jarrow. Merton and Robert A. market risk. and liquidity risk are all interrelated. Corporate Finance Computational Finance Page 16 .

the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.K. sale of stock) or debt (e. Acquisition and allocation of a corporation's funds or resources.. See also business finance. and market value of assets.College Corporate finance finance dealing with financial decisions business enterprises make and the tools and analysis used to make these decisions. Corporate finance must balance the needs of employees. Resource allocation is the investment of funds. the composition of its capital structure. The primary goal of corporate finance is to maximize corporate value while managing the firm's financial risks. Funds are acquired from both internal and external sources at the lowest possible cost and may be obtained through equity (e. stock value). bonds..e. prospect of future earnings. while calculating intrinsic value based on future earnings would be an objective technique. rather than corporations alone. Corporate Valuation The process of determining the current worth of an asset or company. bank loans). with the goal of maximizing shareholder wealth (i.g. an analyst valuing a company may look at the company's management. Judging the contributions of a company's management would be more of a subjective valuation technique. and suppliers against the interests of the shareholders. Although it is in principle different from managerial finance which studies the financial decisions of all firms. some are subjective and others are objective. For example.. There are many techniques that can be used to determine value. these investments fall into the categories of current assets (such as cash and inventory) and fixed assets (such as real estate and machinery).g. customers.C. Derivative pricing Models Computational Finance Page 17 .

College It relates a number of variables and yield a theoretical price that is useful in judging whether an option or other derivative is fairly priced by the market or is overvalued or undervalued. Interest and Money (1936) to explain determination of the interest rate by the supply and demand for money. Interest rates. engineering methodologies and quantitative methods to finance. Instead of a reward for saving. using tools of mathematics. the methods of financing. developed by Fischer Black and Myron Scholes in the 1960s for options on stocks and modified in the 1970s for options on futures. interest in the Keynesian analysis is a reward for parting with liquidity. or by quantitative analysts in corporate treasury and finance departments of general manufacturing and service firms. The best-known and most widely adapted model is the basic Black-Scholes Option Pricing Model. cannot be a reward for saving as such because. if a person hoards his savings in cash. keeping it under his mattress say. refrained from consuming all his current income. The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds. and financial management and consulting industries.K. computation and the practice of programming to achieve the desired end results. The concept was first developed by John Maynard Keynes in his book The General Theory of Employment. he will receive no interest. The financial engineering methodologies usually apply social theories. banking. he argues.C. Liquidity modeling Liquidity modeling in macroeconomic theory refers to the demand for money. Financial engineering It is a multidisciplinary field involving financial theory. Computational Finance Page 18 . considered as liquidity. although he has nevertheless. It is normally used in the securities.

which are repetitive. the lower the interest rate. however technically a program is actually a higher level construct: a group of related and somehow interdependent projects. permanent or semi-permanent functional work to produce products or services. 2.K. securing and managing resources to bring about the successful completion of specific project goals and objectives. the precautionary motive: people prefer to have liquidity in the case of social unexpected problems that need unusual costs. for their income is not constantly available. demand for liquidity is determined by three motives: 1. The amount of money demanded also grows with the income. It is sometimes conflated with program management. Computational Finance Page 19 . but can be by funding or deliverables.College According to Keynes. The amount of liquidity demanded is determined by the level of income: the higher the income.C. 3. having a defined beginning and end (usually constrained by date. and as such requires the development of distinct technical skills and the adoption of separate management. which would drive down the price of an existing bond to keep its yield in line with the interest rate. speculative motive: people retain liquidity to speculate that bond prices will fall.usually to bring about beneficial change or added value.undertaken to meet unique goals and objectives. A project is a temporary endeavor. The temporary nature of projects stands in contrast to business as usual (or operations). Portfolio Management Project management is the discipline of planning. the management of these two systems is often found to be quite different. When the interest rate decreases people demand more money to hold until the interest rate increases. organizing. the more money demanded for carrying out increased spending. the more money demanded (and vice versa). In practice. the transactions motive: people prefer to have liquidity to assure basic transactions. Thus.

K. particularly credit risk and market risk. and plans to address them. avoiding the risk. Volatility. Computational Finance Page 20 . Shape. and accepting some or all of the consequences of a particular risk. Liquidity. Financial risk management can be qualitative and quantitative. The strategies to manage risk include transferring the risk to another party.C. Other types include Foreign exchange. reducing the negative effect of the risk. financial risk management requires identifying its sources. measuring it.College Risk Management Financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk. Certain aspects of many of the risk management standards have come under criticism for having no measurable improvement on risk even though the confidence in estimates and decisions increase. Similar to general risk management. Sector. Inflation risks. financial risk management focuses on when and how to hedge using financial instruments to manage costly exposures to risk. As a specialization of risk management. etc.

In practice the process can be very difficult. Methods.. security. Intangible risk management identifies a new type of a risk that has a 100%probability of occurring but is ignored by the organization due to a lack of identification ability. the National Institute of Science and Technology. 1. Several risk management standards have been developed including the Project Management Institute. determine the risk 4. For the most part. credit risk. For example. and risks with lower probability of occurrence and lower loss are handled in descending order. accidents. these methodologies consist of the following elements. identify ways to reduce those risks 5. performed. project failures. definitions and goals vary widely according to whether the risk management method is in the context of project management.K. characterize. identify. engineering. actuarial societies. in the following order. when deficient knowledge is Computational Finance Page 21 . monitor. In ideal risk management. assessment.College Risk Management is the identification. and balancing between risks with a high probability of occurrence but lower loss versus a risk with high loss but lower probability of occurrence can often be mishandled. reducing the negative effect of the risk. or public health and safety. industrial processes. and prioritization of risks followed by coordinated and economical application of resources to minimize. and ISO standards. more or less. and assess threats 2. a prioritization process is followed whereby the risks with the greatest loss and the greatest probability of occurring are handled first. Riskscan come from uncertainty in financial markets. actuarial assessments. avoiding the risk. legal liabilities. and accepting some or all of the consequences of a particular risk. financial portfolios. assess the vulnerability of critical assets to specific threats 3.C. natural causes and disasters as well as deliberate attacks from an adversary. prioritize risk reduction measures based on a strategy The strategies to manage risk include transferring the risk to another party. and control the probability and/or impact of unfortunate events.

Again. Resources spent on risk management could have been spent on more profitable activities. Relationship risk appears when ineffective collaboration occurs. y Risk management should take into account human factors. y Risk management should be dynamic. y Risk management should be based on the best available information. Process-engagement risk may be an issue when ineffective operational procedures are applied. iterative and responsive to change. a knowledge risk materialises. Intangible risk management allows risk management to create immediate value from the identification and reduction of risks that reduce productivity. service. brand value. reputation. y Risk management should be part of decision making. profitability.College applied to a situation. y Risk management should be tailored. decrease cost effectiveness. This is the idea of opportunity cost. Computational Finance Page 22 . y Risk management should be capable of continual improvement and enhancement. ideal risk management minimizes spending while maximizing the reduction of the negative effects of risks. PRINCIPLES OF RISK MANAGEMENT The International Organization for Standardization identifies the following principles of risk management: y Risk management should create value. and earnings quality.K. y Risk management should explicitly address uncertainty. These risks directly reduce the productivity of knowledge workers. y Risk management should be systematic and structured. quality. y Risk management should be transparent and inclusive. Risk management also faces difficulties allocating resources. y Risk management should be an integral part of organizational processes.C.

a team member other than a project manager who is responsible for foreseeing potential project problems. when. Uncertainty concerning which outcome (or external events) will actually happen. title. probability and importance. Typical characteristic of risk officer is a healthy skepticism. Each risk should have the following attributes: opening date. short description.K. 2. 2. Assigning a risk officer .C. Plan should include risk management tasks.College Risk-management activities as applied to Quantitative management Planning how risk will be managed in the particular project. There is a clearly stated objective. effectiveness of mitigation activities. Creating anonymous risk reporting channel. Preparing mitigation plans for risks that are chosen to be mitigated. responsibilities. There is a calculable measure of the benefit or worth of the various alternatives. 3. The purpose of the mitigation plan is to describe how this particular risk will be handled ± what. Optionally a risk may have an assigned person responsible for its resolution and a date by which the risk must be resolved. activities and budget. Each team member should have possibility to report risk that he foresees in the project. and effort spent for the risk management. Summarizing planned and faced risks. Uncertainties for which allowance must be made or probabilities calculated may include 1. Computational Finance Page 23 . by who and how will it be done to avoid it or minimize consequences if it becomes a liability. There are several alternative courses of action. Maintaining live project risk database. QUANTITATIVE DECISION MAKING Quantitative decision making methods can be used when: 1. Events beyond the control of the decision maker.

C. The journal publishes papers on the following: modelling of financial and economic primitives (interest rates. Obtaining a more realistic feel of the world that cannot be experienced in the numerical data and statistical analysis used in quantitative research. asset prices etc). mass surveys. Flexible ways to perform data collection. Following firmly the original set of research goals. determining the issues of causality. modelling market behaviour. pricing of financial derivative securities. subsequent analysis. or other form of research manipulations Eliminating or minimizing subjectivity of judgment Allowing for longitudinal measures of subsequent performance of research subjects. Provide a holistic view of the phenomena under investigation Ability to interact with the research subjects in their own language and on their own terms Descriptive capability based on primary and unstructured data Computational Finance Page 24 . modelling market imperfections. arriving at more objective conclusions.College ADVANTAGES OF COMPUTATIONAL FINANCE The journal encourages the confident use of applied mathematics and mathematical modelling in finance. Achieving high levels of reliability of gathered data due to controlled observations. Stating the research problem in very specific and set terms Clearly and precisely specifying both the independent and the dependent variables under investigation.K. testing hypothesis. and interpretation of collected information. numerical methods. hedging strategies. laboratory experiments.

Inability to investigate causality between different research phenomena. non-consistent conclusions. Inability to control the environment where the respondents provide the answers to the questions in the survey.College DIS-ADVANTAGES OF COMPUTATIONAL FINANCE The weaknesses of the Computational finance include: Failure to provide the researcher with information on the context of the situation where the studied phenomenon occurs. Not encouraging the evolving and continuous investigation of a research phenomenon. Requiring a high level of experience from the researcher to obtain the targeted information from the respondent. Computational Finance Page 25 . Arriving to different conclusions based on the same information depending on the personal characteristics of the researcher.K. Departing from the original objectives of the research in response to the changing nature of the context (Cassell & Symon. 1994). Difficulty in explaining the difference in the quality and quantity of information obtained from different respondents and arriving at different.C. Lacking consistency and reliability because the researcher can employ different probing techniques and the respondent can choose to tell some particular stories and ignore others. Limited outcomes to only those outlined in the original research proposal due to closed type questions and the structured format.

This helps the analysts and researchers to take accurate and timely decisions. Scheduling of training programmes.K. Today. Marketing Management: Selection of product mix. Manufacturing. Personnel Management: Manpower planning. Sales resources allocation and Assignments. Software Process Management and Knowledge Management. Aggregate planning. Staffing. Inventory control. General Management: Decision Support System and Management of Information Systems. In general. Dividend and Portfolio management. Resource allocation. Job sequencing. Quality control. Financial planning. Organizational design and control. there are a number at quantitative software packages available to solve the problems using computers.College SCOPE OF QUANTITATIVE TECHNIQUE The scope and areas of application of scientific management are very wide in engineering and management studies. Maintenance and Project planning and scheduling. Work scheduling. From the various definitions of Quantitative Technique it is clear that scientific management has wide scope. Computational Finance Page 26 .C. MIS. Production Management: Facilities planning. Capital budgeting. whenever there is any problem simple or complicated the scientific management technique can be applied to find the best solutions. A few specific areas are mentioned below: Finance and Accounting: Cash flow analysis.

College Areas of application of Computational Finance Areas where computational finance techniques are employed include: Investment banking Forecasting Risk Management software Corporate strategic planning Securities trading and financial risk management Derivatives trading and risk management Investment management Pension scheme Insurance policy Mortgage agreement Lottery design Currency peg Gold and commodity valuation Credit default swap Bargaining Market mechanism design QUANTITATIVE AND COMPUTATIONAL FINANCE Computational Finance Page 27 .K.C.

College µQuantitative Finance¶ as a branch of modern finance is one of the fastest growing areas within the corporate world. in particular derivative pricing. MATHEMATICAL AND STATISTICAL APPROACHES According to Fund of Funds analyst Fred Gehm. perhaps because these types demand different skill sets and. A typical problem for statistically oriented quantitative analyst would be to develop a model for deciding which stocks are relatively expensive and which stocks are relatively cheap. much more important. While there is no logical reason why one person can't do both kinds of work. therefore. Alternative names for this subject area are Mathematical Finance or Financial Mathematics. Computational Finance Page 28 .K. this doesn¶t seem to happen. Together with the sophistication and complexity of modern financial products. selling the overpriced stocks or both. An investment manager might implement this analysis by buying the underpriced stocks. One of the principal mathematical tools of quantitative finance is stochastic calculus. its trailing earnings to price ratio and other accounting factors. One type works primarily with mathematical models and the other primarily with statistical models. "There are two types of quantitative analysis and." A typical problem for a numerically oriented quantitative analyst would be to develop a model for pricing and managing a complex derivative product. two types of quants. different psychologies. This is a course in the applied aspects of mathematical finance.C. The model might include a company's book value to price ratio. this exciting discipline continues to act as the motivating factor for new mathematical models and the subsequent development of associated computational schemes.

Mathematical finance Mathematical finance comprises the branches of applied mathematics concerned with the financial markets. and attempt to use stochastic calculus to obtain the fair value of derivatives of the stock . while the former focuses on modeling and derivation The fundamental theorem of arbitrage-free pricing is one of the key theorems in mathematical finance. these arelargely synonymous. mathematical finance also overlaps heavily with the field of computational finance Arguably. hedging and investment decisions. for example. The subject has a close relationship with the discipline of financial economics.K.College CLASSIFICATION OF METHOD Computational finance relies on mathematical finance. as well as facilitating the risk management of those decisions. while a financial economist might study the structural reasons why a company may have a certain share price. computational intelligence and computer simulations to make trading. Computational Finance Page 29 . and extend. In terms of practice. numerical methods. Generally. Utilizing various methods.C. a financial mathematician may take the share price as a given. which is concerned with much of the underlying theory. mathematical finance will derive. the mathematical or numerical models suggested by financial economics. Thus. although the latter focuses on application. practitioners of computational finance aim to precisely determine the financial risk that certain financial instruments create.

but rather using it. These areas of mathematics were intimately tied to the development of Newtonian Physics. Even fields such as number theory that are part of pure mathematics are now important in applications (such as cryptology). A biologist using a population model and applying known mathematics would not be doing applied mathematics. applied mathematics consisted principally of applied analysis. the term applied mathematics is used in a broader sense. and in fact the distinction between mathematicians and physicists was not sharply drawn before the mid-19th century. Mathematicians distinguish between applied mathematics. and degrees. Divisions of applied mathematics There is no consensus of what the various branches of applied mathematics are. which is concerned with mathematical methods. approximation theory (broadly construed. Today. The use of mathematics to solve industrial problems is called industrial Computational Finance Page 30 . most notably differential equations.K. Sometimes the term applicable mathematics is used to distinguish between the traditional field of applied mathematics and the many more areas of mathematics that are applicable to real-world problems. It includes the classical areas above. variational methods. and the applications of mathematics within science and engineering. as well as other areas that have become increasingly important in applications. This history left a legacy as well. and applied probability. and numerical analysis). and also by the way universities organize departments.C. until the early 20th century subjects such as classical mechanics were often taught in applied mathematics departments at American universities rather than in physics departments.College Applied Mathemathics Applied mathematics is a branch of mathematics that concerns itself with the mathematical techniques typically used in the application of mathematical knowledge to other domains. though they are not generally considered to be part of the field of applied mathematics per se. asymptotic methods. courses. Such categorizations are made difficult by the way mathematics and science change over time. to include representations. However. and fluid mechanics may still be taught in applied mathematics departments. nonmathematicians do not usually draw this distinction. Historically.

or bioinformatics. These are often considered interdisciplinary programs. but other areas of mathematics are proving increasingly useful in these disciplines. as well as using computers to study problems arising in other areas of science (computational science). and lattice theory). after World War II. formal logic. mathematics was most important in the natural sciences and engineering. and computational engineering. The advent of the computer has created new applications. such as game theory. which uses combinatorics. Industrial mathematics is sometimes split in two branches: techno-mathematics (covering problems coming from technology) and econo-mathematics (for problems in economy and finance). Computational Finance Page 31 . both in studying and using the new computer technology itself (computer science. which arose out of the study of the brain in neuroscience.C. which grew out of economic considerations. or neural networks. and of course studying the mathematics of computation (numerical analysis). The success of modern numerical mathematical methods and software has led to the emergence of computational mathematics. fields outside of the physical sciences have spawned the creation of new areas of mathematics. which use high performance computing for the simulation of phenomena and solution of problems in the sciences and engineering.K. Statistics is probably the most widespread application of mathematics in the social sciences. from the importance of analyzing large data sets in biology.College mathematics. computational science. especially in economics and management science. Utility of applied mathematics Historically. However.

generating alpha in a consistent manner is not an easy task. it is difficult to ascertain whether their investment performance is the result of skill or simply luck.K. Computational finance strategies have an advantage in this regard Computational Finance Page 32 . they have steadily gained in popularity in recent years.College ADVANTAGES OF A QUANTITATIVE APPROACH Over the last three decades the exponential growth in computing power. As a result. RETURNS ADVANTAGES y Computational finance strategies can be time-tested to determine the significance of their edge: The primary objective of active portfolio management is to generate alpha (excess risk-adjusted returns) over what is available at negligible cost with a passive alternative.C. the development of sophisticated analytical tools. and sustainable edge if they are expected to outperform. Without this information. and cost advantages over traditional subjective strategies when properly designed and implemented. As computational finance strategies can provide meaningful return. risk. and significant improvements in the accuracy and size of research databases have led to tremendous advances in the fields of finance. Unfortunately. computational finance strategies have become increasingly more powerful and effective for all asset classes. due to the reliance of traditional strategies on subjective forecasts and qualitative judgments that are difficult to quantify. statistically significant. It is therefore critical that managers have a well-defined. few managers can provide the data necessary to determine with a high degree of confidence the source or significance of their edge. Given that the capital markets are fairly efficient and that the additional costs associated with active management can be high. and statistics. This trend is expected to continue as investors more fully recognize the disciplined manner in which quantitative strategies can increase the probability of long-term success. econometrics.

Accordingly. they can be empirically tested over long periods of time and through several types of market environments to better understand their behavior.College as. any edge can be statistically evaluated as to its significance. but have the highest probability of generating superior results over the long-term. and research in behavioral finance provides compelling evidence that investors often act irrationally. In addition to Midwest¶s internal research (1952 to 2005). and allocation decisions can be made with greater confidence.C. rather than contribute to them. 1951 to 20035) that clearly demonstrate the meaningful edge that can be achieved with a properly designed and implemented computational finance strategy. a sound quantitative strategy enables investors to make decisions that are emotionally difficult. The number of securities that can Computational Finance Page 33 . This discipline allows quantitative strategies to exploit behavioral inefficiencies. Greed and fear are powerful forces. a vast number of securities can be monitored and evaluated on a real-time basis to efficiently identify and capitalize on the best reward/risk opportunities. due to their mechanical nature. y Computational finance strategies can evaluate a large opportunity set Because investment decisions are driven by objective computer models. Accordingly. temporary price fluctuations and random market "noise" do not cause sub-optimal short-term deviations from a viable long-term plan. y Computational finance strategies can eliminate behavioral biases from the investment process: Due to their subjective nature.K. 1968 to 1990. This is in stark contrast to traditional strategies which are significantly constrained by the tremendous amount of time and resources required to subjectively evaluate each security on a case-by-case basis. and repeatedly make sub-optimal decisions when confronted with uncertainty.7 By eliminating behavioral biases from the investment process. many traditional strategies suffer from various behavioral and emotional biases which can hinder consistently superior results. there are several independent long-term studies (1937 to 1962.

Management turnover: The departure of key managers at quantitative firms has little impact as the investment strategies are mechanical and not dependent on the subjective abilities of any single individual. Not only is it important to understand the sources of risk in a portfolio. and style risks.C. Statistical analysis can be used to separate risks that are well-rewarded from those that are not. and disciplined. y Computational finance strategies can reduce operational risks: Investors are also subject to manager-specific operational risks that can lead to sub-par performance. and exposure can be managed accordingly. but also the manner in which they are compensated. These risks are notably less severe with quantitative strategies: o Style drift: Because quantitative strategies are well-defined. This opportunity loss often outweighs the benefits of additional securityspecific insights generated through such a case-by-case process.College be effectively monitored in this manner is limited. and consequently many attractive opportunities are missed with regularity. sector. Page 34 o Computational Finance . RISK ADVANTAGES y Quantitative strategies can identify virtually all sources of risk in a portfolio: Effective risk management is crucial to long-term investment success. security-specific and other nonsystematic risks often go uncompensated since they can be eliminated through diversification. With traditional strategies the underlying risks are often unclear. they should not be subject to style drift. Comprehensive empirical research into the nature of these risks is the foundation of sound quantitative strategies. and portfolios can be inadvertently exposed to many which are either unnecessary or lack adequate compensation.K. Whereas investors should expect to be rewarded for exposure to systematic market. consistent.

Because quantitative strategies can be tested over long-periods of time and risks can be thoroughly researched. and quantitative strategies enable that ability. investors often abandon a strategy due to increased uncertainty regarding the manager¶s skill. frontrunning. etc. as the managers fired by institutional investors tend to subsequently outperform those that are hired. it is difficult for investors to differentiate skill from luck when evaluating active managers.College o Ethical and legal risk: A quantitative portfolio can be constructed to address most investor concerns (social.) should be virtually non-existent. Even a superior track record is insufficient evidence of investment ability.C. The discipline to maintain confidence and objectivity in the face of short-term underperformance is an important characteristic of successful long-term investors. Therefore. and helps to protect those with a fiduciary responsibility. as research has shown that past performance is generally an unreliable indicator of future success. o y Computational finance strategies can reduce the risk of being fooled by randomness: As previously mentioned. This enables them to differentiate skill from luck with greater confidence. Transaction and other errors: A quantitative structure can reduce these events and. y Computational finance strategies can help investors to maintain confidence: The increased informational content of quantitative strategies helps investors to maintain confidence during inevitable periods of underperformance. etc.K. Computational Finance Page 35 . environmental. equally important. additional information is necessary to make a reasonable determination. Once established only minor adjustments should be necessary and legal issues (insider trading.). investors have more data on which to base their decisions. make them more transparent to fiduciaries. Without this confidence. Research indicates that this is not an optimal response. reduces their risk of being fooled by randomness.

If excessive. Moreover. they can quickly consume the excess returns generated by a skilled manager. Their low correlation can help to decrease aggregate risk and improve return consistency. they are an excellent complement to traditional strategies already employed in a multi-manager portfolio. expenses have a dramatic impact on long-term portfolio growth when compounded over time. Computational Finance Page 36 . Because alpha is difficult to consistently generate in a fairly efficient market.K. As computational finance strategies are driven by objective computer models. By eliminating the need for expensive and time-consuming qualitative research into each security in the portfolio.C.College y Computational finance strategies can further diversify a multimanager portfolio: Because quantitative strategies identify opportunities in a unique manner. research indicates that not only do low-cost managers outperform on average. portfolios can be managed more efficiently and at lower cost than most traditional strategies. quantitative strategies can often save more in expenses than traditional strategies can generate through their deeper understanding of unique security-specific characteristics. any manager that can minimize expenses has a notable advantage. COST ADVANTAGES Computational finance strategies can be highly cost-effective: Although often downplayed (especially during periods of superior performance). but they do so by a greater amount than their cost savings.

Utilizing various methods. the methods approximate equations and models defined in a continuous.College CONCLUSION This topic lays the mathematical foundations for careers in a number of areas in the financial world. In particular. Computational finance or financial engineering is a cross-disciplinary field which relies on mathematical finance. In general. numerical methods. Quantitative management In quantitative management we discuss a number of concepts and methods that are concerned with variables. functions and transformations defined on finite or infinite discrete sets. We also introduce probability theory and statistics as well as a number of sections on numerical analysis. These methods lie at the heart of computational finance and a good understanding of how to use them is vital if you wish to create applications. This topic is also suitable for IT personnel who wish to develop their mathematical skills. Numerical Methods The goal of this part of the topic is to develop robust. efficient and accurate numerical schemes that allow us to produce algorithms in applications. computational intelligence and computer simulations to make trading.C. this suitable for novice quantitative analysts and developers who are working in quantitative finance.K. practitioners of computational finance aim to precisely determine the financial risk that certain financial instruments create. hedging and investment decisions. as well as facilitating the risk management of those decisions. In particular. Computational Finance Page 37 . infinite-dimensional space by models that are defined on a finite-dimensional space. linear algebra will be important because of its role in numerical analysis in general and quantitative finance in particular. The latter group is of particular importance when we approximate differential equations using the finite difference method.

C.College BIBLIOGRAPHY y en.edu Computational Finance Page 38 .com/doc/38412567/Computational-Finance-Tutorial y http://www.wikipedia.com/doc/18751081/COMPUTATIONAL-FINANCE y http://www.html y www.scribd.caltech.wikipedia.acm.pdfebook.scribd.K.org/wiki/Computational_finance y en.org/wiki/Quantitative_behavioral_finance y http://www.net/ebook___SCRIBD--PROJECTFINANCE_2.

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