NATIONAL UNIVERSITY OF SCIENCE AND TECHNOLOGY
DEPARTMENT OF FINANCE
CFE 5102 Stochastic Analysis and Optimization in Finance
LECTURER: N. C. MUPONDO
OFFICE N0: AF30, ADMINISTRATION BUILDING
Office hours: Monday and Thursday 14:00hrs-16:30hrs
Course Description
The objective of this module is to provide the background, basic ideas and methods of stochas-
tic calculus and to apply these methods to financial models. The module introduces the con-
cepts of arbitrage and risk-neutral pricing in a discrete-time setting. In addition, it provides
an introduction to those aspects of partial differential equations and diffusion processes most
relevant to finance, Random Walk and first-step analysis, Markov property, Martingales and
Semi-martingales, Brownian Motion, Stochastic Integrals, Itos Formula, backward and forward
Kolgomorov equations, the Feynman-Kac formula, stepping times, Hull and White models,
Cox-Ingersoll-Ross Model. It covers fundamental techniques for portfolio optimization, pricing
and hedging derivative securities and other aspects of continuous time finance. Finally, the
module will introduce and study Levy processes both from an analytic point of view and also
from a probabilistic one.
Course Content
1. Introduction to Probability Theory
• Finite Probability Spaces
• Lebesgue Measure and the Lebesgue Integral
• Independence
• Independence of sets
• Independence of σ-algebras
• Independence of random variables
• Correlation and independence
• Independence and conditional expectation
• Law of Large Numbers
• Central Limit Theorem
2. Conditional Expectation
• A Binomial Model for Stock Price Dynamics
• Information
• Conditional Expectation
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• Definition of Conditional Expectation
• Further discussion of Partial Averaging
• Properties of Conditional Expectation
• Examples from the Binomial Model
• Martingales
3. Arbitrage Pricing
• Binomial Pricing
• General one-step APT
• Risk-Neutral Probability Measure
• Portfolio Process
• Self-financing Value of a Portfolio Process ∆
• Simple European Derivative Securities
• The Binomial Model is Complete
4. The Markov Property
• Binomial Model Pricing and Hedging
• Computational Issues
• Markov Processes
• Different ways to write the Markov property
• Showing that a process is Markov
• Application to Exotic Options
5. Stopping Times and American Options
• American Pricing
• Value of Portfolio Hedging an American Option
• Information up to a Stopping Time
6. Random Walks
• First Passage Time
• τ is almost surely finite
• The moment generating function for τ
• Expectation of τ
• The Strong Markov Property
• General First Passage Times
• Example: Perpetual American Put
• Difference Equation
• Distribution of First Passage Times
• The Reflection Principle
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7. Pricing in terms of Market Probabilities: The Radon-Nikodym Theorem
• Radon-Nikodym Theorem
• Radon-Nikodym Martingales
• The State Price Density Process
• Stochastic Volatility Binomial Model
• Another Application of the Radon-Nikodym Theorem
8. Capital Asset Pricing
• An Optimization Problem
9. General Random Variables
• Law of a Random Variable
• Density of a Random Variable
• Expectation
• Two random variables
• Marginal Density
• Conditional Expectation
• Conditional Density
• Multivariate Normal Distribution
• Bivariate normal distribution
• MGF of jointly normal random variables
10. Semi-Continuous Models
• Discrete-time Brownian Motion
• The Stock Price Process
• Remainder of the Market
• Risk-Neutral Measure
• Risk-Neutral Pricing
• Arbitrage
• Stalking the Risk-Neutral Measure
• Pricing a European Call
11. Brownian Motion
• Symmetric Random Walk
• The Law of Large Numbers
• Central Limit Theorem
• Brownian Motion as a Limit of Random Walks
• Brownian Motion
• Covariance of Brownian Motion
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• Finite-Dimensional Distributions of Brownian Motion
• Filtration generated by a Brownian Motion
• Martingale Property
• The Limit of a Binomial Model
• Starting at Points Other Than 0
• Markov Property for Brownian Motion
• Transition Density
• First Passage Time
12. The Itob Integral
• Brownian Motion
• First Variation
• Quadratic Variation
• Quadratic Variation as Absolute Volatility
• Construction of the Itob Integral
• Itob integral of an elementary integrand
• Properties of the Itob integral of an elementary process
• Itob integral of a general integrand
• Properties of the (general) Itob integral
• Quadratic variation of an Itob integral
13. Itob’s Formula
• Itob’s formula for one Brownian motion
• Derivation of Itob’s formula
• Geometric Brownian motion
• Quadratic variation of geometric Brownian motion
• Volatility of Geometric Brownian motion
• First derivation of the Black-Scholes formula
• Mean and variance of the Cox-Ingersoll-Ross process
• Multidimensional Brownian Motion
• Cross-variations of Brownian motions
• Multi-dimensional Itob formula
14. Markov processes and the Kolmogorov equations
• Stochastic Differential Equations
• Markov Property
• Transition density
• The Kolmogorov Backward Equation
• Connection between stochastic calculus and KBE
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• Black-Scholes
• Black-Scholes with price-dependent volatility
15. Girsanov’s theorem and the risk-neutral measure
• Conditional expectations under equivalent probability measure
• Risk-neutral measure
16. Martingale Representation Theorem
• Martingale Representation Theorem
• A hedging application
• d-dimensional Girsanov Theorem
• d-dimensional Martingale Representation Theorem
• Multi-dimensional market model
17. A two-dimensional market model
• Hedging when 1 < ρ < 1
• Hedging when ρ = 1
18. Asian Options
• Feynman-Kac Theorem
• Constructing the hedge
• Partial average payoff Asian option
19. Summary of Arbitrage Pricing Theory
• Binomial model, Hedging Portfolio
• Setting up the continuous model
• Risk-neutral pricing and hedging
• Implementation of risk-neutral pricing and hedging
20. Recognizing a Brownian Motion
• Identifying volatility and correlation
• Reversing the process
21. An outside barrier option
• Computing the option value
• The PDE for the outside barrier option
• The hedge
Recommended Texts/Reading Lists:
The following textbooks are recommended for studying in this course, however any other text-
book with content relevant to the course is appropriate for personal enrichment.
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(a) Lawrence Evans. An Introduction to Stochastic Differential Equations Version 1.2. http://math.berkeley.ed
evans/SDE.course.pdf
(b) Bernt ksendal. Stochastic Differential Equations. Springer-Verlag Berlin Heidelerg, 2007.
(c) K. L. Chung and R. J. Williams. Introduction to Stochastic Integration. Birkhauser
Boston, 1990.
(d) A. N. Kolmogorov and S. V. Fomin. Introductory Real Analysis. Translated by Richard
A. Silverman. Dover Publications, 1975. p.328-332, 367-370.
(e) Morris Tenenbaum and Harry Pollard. Ordinary Differential Equations. Harper Row,
Publishers, 1963. p.720-741
