BUS 35132 Pietro Veronesi

Winter 2005 Office: HPC 409

(773) 702-6348
pietro.veronesi@gsb

FINANCIAL ENGINEERING
Mathematical Models of Option Pricing and Their Estimation

Course Objectives and Brief Overview

This course covers the analytical and numerical techniques currently used to price
financial derivative securities. The main objectives of the course are first, to provide the
students with a thorough understanding of state-of-the-art option pricing models, and
second, to develop the econometric, analytical and numerical tools necessary to calculate
complex derivative security prices and their hedging strategies. Specific topics include
the following: (1) continuous-time stochastic processes, risk-neutral pricing and
econometric techniques, (2) option pricing with stochastic volatility and transaction
costs, (3) optimal option replication strategies, (4) numerical methods for trees, partial
differential equations and the Feynman-Kac solution; (5) applications to (i) arbitrage-free
interest-rate derivatives; (ii) American options and early exercise; (iii) exotic and path-
dependent options, (iv) commodity derivatives; and (v) credit risk derivatives.

The course is intended for students with a strong mathematical background and requires
familiarity with a variety of advanced mathematical concepts, such as partial differential
equations. The course is also very demanding: the average student may expect to spend
10-15 hours/week outside the classroom. At the end of the course, students will be
comfortable with modern option pricing techniques and will be able to read and
understand the current technical literature on derivative securities. The ability to pose,
tackle and solve difficult problems are precious skills in today’s financial markets. This
course will help the students to develop such important skills.

Required Material

A packet of readings.
Teaching notes are distributed in class.

Optional Material

a) Paul Wilmott, Paul Wilmott on Quantitative Finance, John Wiley & Sons, 2000,
ISBN 0-471-87438-8
b) John C. Hull, Options, Futures and Other Derivatives, Fifth Edition, Prentice Hall,
2003, ISBN 0-13-009056-5

c) Salih N. Neftci, Principles of Financial Engineering, Elsevier Inc., 2004, ISBN 0-12-
515394-5

d) John Y. Campbell, Andrew W. Lo, A. Craig MacKinlay, The Econometrics of

Financial Markets, Princeton University Press, 1997, ISBN 0-691-04301-9

e) Stephen Figlewski, William Silber and Marti Subrahmanyan (Eds.) Financial

Options: From Theory to Practice, McGraw-Hill, 1990, ISBN - 1-55623-872-X

f) Martin Baxter and Andrew Rennie, Financial Calculus: An Introduction to

Derivative Pricing, Cambridge University Press, 1996, ISBN 0-521-55289-3

g) Paul Wilmott, Jeff Dewynne, Sam Howison, Option Pricing: Mathematical Models
and Computation, Oxford Financial Press, 1993, ISBN 0 -9522082-0-2

h) Michael A.H. Dempster, Stanley R. Pliska (Eds.), The Mathematics of Derivative

Securities, Cambridge University Press, 1997, ISBN 0-521-58424-8

i) James D. Hamilton: Time Series Analysis, Princeton University Press, 1994, ISBN 0-
691-04289-6

Relevant chapters of the books as well as journal articles are collected in a reading
packet.

Requirements

Strict prerequisites for this course are the following courses:

• 35000: Investments
• 35100: Financial Instruments

Homework assignments and final projects will require the use of a spreadsheet package,
such as Excel, or a programming package (such as C, Fortran, Gauss, Mathematica,
Matlab etc.). I will not require the use of one or another packages: you may choose.
However, I strongly encourage the use of Matlab, as solutions to homeworks and
additional files will be in Matlab.

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Course Requirements

The course requirements consist of problem sets, a midterm exam and a final project.
There is no final exam.

Problem sets

Weekly problem sets contain both theoretical questions and computer exercises. Group
work is allowed and encouraged, with a limit of 4 students per group. Only one copy of
the (joint) homework should be turned in. Make sure that your names, ID and section
numbers appears on the cover of the homework. Please try not to change groups during
the quarter. If you must change groups, make sure to write a note on the cover of the first
problem set after the change.

Midterm Exam
The midterm will take place in class on week 7 and will last 1 1/2 hours. The midterm
will be both on theoretical and practical issues. Of course, the use of a computer won't be
necessary to solve the exercises, but bring your calculator. You are allowed to bring to
the exam a single, two-sided, 8½x11 sheet with formulas.

Regrade policy: If you think that a serious mistake has been committed in grading your
exam, you must submit the exam for a complete regrade along with a detailed written
explanation of your objection within 10 business days of receiving the graded exam.
There is absolutely no guarantee that the grade will not be lowered with the regrade.

Term Project

Two options are available: a derivative pricing project or an academic-style paper.

In either case, you choose your own subject keeping in mind the following caveats:

(a) The subject must be related to the subject of the course (derivative pricing and
financial econometrics)
(b) The project can be done in groups, but again no more than 4 people can be in any
group.
(c) You may choose the topic from a number of sources, including particular derivative
products you have encountered in your previous work experience, summer job etc.

After you have selected the exercise you want to perform, use one or more methods
developed in class to value the instrument (binomial trees, discretization of the pricing
PDE etc). Using more than one method will improve the quality of your project. You
must comment on your results and compare them to market prices (if available).

A valuation project write-up must include: (a) a description of the security; (b) an
explanation of why it is interesting or what purpose it serves; (c) the valuation method(s)

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you chose and why and (d) a discussion of results. Equations that describe the
methodology should be included in the text. Importantly, include all supporting
documents (institutional features, data sources, a diskette with computer code, computer
printouts, etc.) in an appendix. Do not mix them up with the text of the project. The text
should be approximately 5 to 10 pages, typed and double-spaced.

The project is due on the Wednesday of Week 11. Please, turn in two copies of the
project in an envelope with the return address of one group member. I will mail back the
projects with the comments.

Grading

Problem sets, Midterm and Project are graded between 0-100 and then your score is
given by the formula:

Score = max ( 0.2 * problem sets + 0.3 * Midterm + 0.5 * Project,

0.2 * problem sets + 0.4 * Midterm + 0.4 * Project)

We will discuss some of the solutions to problem sets in class. The class participation is
part of the grade that accumulates to “problem sets.” Come to class prepared to discuss
your solution in detail.

If you are a graduating student, you can get a provisional grade (D) if your midterm is
above the 25th percentile and you submitted all the homework showing a good work.
Alternatively, you must show substantial progress in the write up of the term project.

Honor Code

Students in my class are required to adhere to the standards of conduct in the GSB Honor
Code and the GSB Standards of Scholarship. The GSB Honor Code also require students
to sign the following GSB Honor Code pledge. "I pledge my honor that I have not
violated the Honor Code during this examination," on every examination, as well as on
the term project.

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Course Outline and Readings

Please, note the following class schedule is preliminary and could be subject to some
modifications. Reading indicated by "Î" are mandatory and must be done before the
class meets.

Preparing the Tools

Class 1 Continuous Time Finance

(a) Stochastic Calculus
(b) Example 1: The Vasicek Model
(c) Example 2: The Black and Scholes model
(d) No Arbitrage and Asset Pricing: Simple Models

ÎTN #1

Class 2 (I) Estimation Methods for financial variables

(a) OLS
(b) GLS
(c) MLE
(d) GMM

ÎTN #2

Hamilton, Ch. 5, 8, 14 (in packet.)

No Arbitrage and Introduction to Numerical Methods

(II) No Arbitrage: PDE, Transition Probabilities and Risk-Neutral

Pricing

ÎTN #3

Hull: Ch. 11, 12

Class 3 Numerical Methods: Trees, Monte Carlo Simulations and Finite

Difference Methods.

ÎTN #4

Hull: Ch. 18 (1-4, 6, 8)

ÎCourtadon G: An Introduction to Numerical Methods in Option Pricing,

in Financial Options from Theory to Practice (Ch. 14)

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 Boyle, P.: Options: A Monte Carlo Approach. Journal of Financial
Economics. (1976) Pages 323-338

Boyle, P., M. Broadie and P. Glasserman: Monte Carlo Methods for

Security Pricing, Journal of Economic Dynamics and Control (1997),
Pages 1267-1321.

Class 4 American Options and Early Exercise: Numerical Methods

(a) Finite Difference Methods

ÎTN # 5

Wilmott, Dewynne and Howison: Ch. 20-21

Mark Broadie and Jerome Detemple: American Option Valuation: New

Bounds, Approximations and a Comparison of Existing Models, (1996),
Review of Financial Studies, 1211-1250.

(b) Monte Carlo Simulations

Î Longstaff and Schwartz: Valuing American Options by Simulations: A

Simple Least Square Approach, (2001), Review of Financial Studies,
Spring

Pricing Options in Practice

Class 5 Stochastic Volatility and Jumps: Models and Estimation

ÎTN #6

Î Hull: Ch. 15, 17

(a) Implied Trees and Volatility Surfaces

ÎDupire, B.: Pricing and Hedging with Smiles, RISK, 1994.

Derman, E., Kani, I.: The Volatility Smile and Its Implied Tree. Goldman
Sachs Financial Strategies Group. (1994) Pages 1-25.

Rubinstein, M.: Implied Binomial Trees. Journal of Finance. (1994)

Pages 771-818.

(b) Stochastic Volatility and Jumps

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 Î Hull, J., White, A.: The Pricing of Options on Assets With Stochastic
Volatilites. Journal of Finance. (1987) Pages 281-300

Heston, S.: A Closed-Form Solution for Options with Stochastic

Volatility with Applications to Bond and Currency Options. Review of
Financial Studies. (1993) Pages 327-343

ÎMerton, R.: Option Pricing When Underlying Stock Returns are

Discontinuous. Journal of Financial Economics. (1975) Pages 125-144

Î Bakshi, G., C. Cao and Z. Chen: Empirical Performance of Alternative

Option Pricing Models, Journal of Finance, 52, No. 5, 1997, 2003-2049

(c) On estimation

Brown: Estimating Volatility

Hamilton, Ch. 21: Time Series Models of Heterskedasticity
Engle and McFadden: Arch Models.
Campbell, Lo, MacKinlay, Ch. 9: Implementing Parametric Option
Pricing Models

Class 6 (I) Stochastic Volatility (cntd.)

(II) Discrete-time Hedging and Transaction Costs

ÎTN #7

ÎBertsimas, Kogan and Lo (1997): ''Pricing and Hedging Derivative

Securities in Incomplete Markets: an ε-approach'' NBER Working Paper

Clelow and Hodges: Optimal Delta-Hedging under Transaction Costs

Journal of Economic Dynamics and Control (1997)

Class 7 (I) Midterm Exam

(II) Discrete-time Hedging and Transaction Costs (cntd.)

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Pricing Exotic and Path-Dependent Options

Class 8 (B) Exotics

Î TN #8

Hull: Ch 19

Credit Risk Derivatives

Class 9 Credit Risk

ÎTN #9

(a) Intensity Based Models

Î Duffie and Singleton, Modeling Term Structures of Defaultable Bonds,

Review of Financial Studies, 1999
ÎLando, D: Modeling Bonds and Derivatives with Default Risk, in
Mathematics of Derivative Securities (1997)

(b) Structural Models

Î Merton R. C., On the Price of Corporate Debt: The Risk Structure of

Interest Rates, Journal of Finance, 1974

Class 10 Credit Risk and Credit Derivatives (cntd)

ÎTN #9
Das, S.: Pricing Credit Derivatives. Unpublished Work. (1998) Pages 0-
40

Hull and White: Valuing Credit Default Swaps I: No Counterparty Default

Risk, Journal of Derivatives, 2000

Mashal, Naldi and Zeevi: The dependence structure of Asset Returns,

Lehman Brothers, Quantitative Credit Research