FNCE 491: Quantitative Finance
The General Black-Scholes-Merton Model and Beyond
Spring 2010, Term 1
Professor Arlie O. Petters
Fuqua School of Business
Duke University
Course description:
This course is right for those who will interact with or become quantitative modelers
in finance. Indeed, quants employ increasingly sophisticated mathematical tools to
address financial issues, creating a widening gap between the qualitative and
quantitative approaches to finance. The course aims to address this gap by
introducing students to the quantitative aspects of the model building process in
finance. Financial models are dissected by isolating their central assumptions and
conceptual building blocks, showing how their governing equations and relations
are derived, and weighing critically their strengths and weaknesses. Examples and
applications are given throughout to build practical understanding, and the
necessary mathematical tools are introduced along the way. Topics may vary from
year to year.
The Spring 1, 2010, course is on The General Black-Scholes-Merton Model and
Beyond and divides into three parts:
• Modeling Security Price Behavior
Binomial trees and stochastic processes; real-world and risk-neutral probabilities;
local and global models; price fluctuations and their mean future values;
applications
• Pricing Derivatives I. The General Black-Scholes-Merton Model
European style derivatives with non-random time-dependent interest rate, dividend
yield rate, and volatility; binomial-tree, continuous-time risk-neutral, and p.d.e.
approaches; theory of Delta hedging and Gamma-Delta hedging; applications
• Pricing Derivatives II. Beyond the General Black-Scholes-Merton
Model
Critique of the Black-Scholes-Merton model; stochastic volatility, Hull-White model;
stochastic interest rates, Vasicek model, Cox-Ingersoll-Ross model, Heath-Jarrow-
Morton model; applications
Prerequisites:
Basic college level multivariable calculus and introductory probability/statistics.
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Required text:
• X. Dong and A. O. Petters, Mathematical Finance with Applications,
manuscript (2010)
Supplemental texts held on reserve at the Ford library:
• John C. Hull, Options, Futures and Other Derivatives, Prentice Hall
• Robert L. McDonald, Derivatives Markets, Addison-Wesley
Requirements and grading:
There will be group homework assignments and a final group project. Each group or
team will be selected to have at least one quantitatively strong student. Members
of different teams will not be allowed to discuss assignments or the final project;
you can discuss only with those on your team.
The assignments will consist of a mix of conceptual, application, and theoretical
problems. Teams can have no more than four members. Assignment solutions are
due at the beginning of class on the due date. No late assignments will be
accepted. The final group project will involve a detailed analysis of a specific
quantitative financial model.
Assuming your course work is completed, your final course grade will be based 60%
on your assignments and 40% on your final project.
Office hours:
TBA. Feel free to drop by my office A05-A if the door is open; otherwise, you can
also set up an appointment.
Communication:
Email: [email protected]
Honor Code:
The Fuqua School of Business Honor Code is enforced in Finance 491. By accepting
admission to the school, you have agreed to abide by the Honor Code. If you are
convicted of an Honor Code violation for cheating, lying, or stealing, which is
related to your performance in this course, you will earn an “F” in this course and
will be reported to the Judicial Board.
The Honor Code requires that I define the manner in which assignments are to be
completed. If you find the following ambiguous or incomplete, please let me know:
Group assignments and the final group project must be the original and
complete work of only the students in that group/team, all of whose names must
appear on the write-up. You may not discuss the assignments with anyone other
than the members of your group/team prior to handing in your solution.
Substantial contributions by each group/team member are expected.
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Preliminary course outline:
• Part 1: Modeling Security Price Behavior
Date Lecture topic Readings
TBA
Jan. 21 Binomial tree models: CCR and JR trees
Jan. 25 Continuum limit: geometric Brownian TBA
motion, local and global models
Jan. 28 Stochastic processes and Ito's formula TBA
Feb. 1 Risk-neutral world vs. real world; price TBA
fluctuations and their mean future values
• Part 2: Modeling Derivatives I. The General Black-Scholes-Merton
Model
Date Lecture topic Readings
Feb. 4 Assumptions of the generalized BSM model; TBA
binomial-tree approach to the standard
BSM pricing formula (with dividend)
Feb. 8 Continuous-time risk-neutral approach to TBA
the standard and generalized BSM pricing
formulas
Feb. 11 P.D.E. approach to the standard and TBA
generalized BSM pricing formulas
Feb. 15 The theory of Delta hedging and Gamma- TBA
Delta hedging
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• Part 3: Modeling Derivatives II. Beyond the General Black-Scholes-
Merton Model
Date Lecture topic Readings
Feb. 118 Critique of the Black-Scholes-Merton model; TBA
stochastic volatility and the Hull-White
model
Stochastic interest rates, Vasicek model,
Feb. 22 Cox-Ingersoll-Ross model TBA
Heath-Jarrow-Morton model TBA
Feb. 25
Mar. 1 Final project TBA
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