Lecture 1

Overview

References: Villalobos, Luenberger, Faerber

 Lecture Topics
• Overview of the IEE 512 and IEE 412
• Prerequisites
• Syllabus
• Organization
• Semester Portfolio Project for IEE 512 students
 Instructors
• Dan McCarville
• [email protected]
• Location: BYENG 350 (Tempe AZ Campus)

• See Canvas for Zoom Office Hours

 Books and Other Sources
• Investment Science, 2nd Edition, 2015, Luenberger, Oxford
University Press
• All About Investing: The Easy Way to Get Started, 2006,
Faerber, McGraw Hill
• References:
– Financial Engineering: The Evolution of a Profession,
Beder and Marshall, Wiley
– Financial Engineering and Arbitrage in the Financial
Markets, Dubil, Wiley
• Microsoft Office
– Excel
– Word
Internet Sources of Information
• Yahoo Finance https://finance.yahoo.com
• Google Finance www.google.com/finance
• Investopedia www.investopedia.com
– Investing 101
– Stock Basics
– Basic Financial Concepts
– Bond and Debt Basics
– IPO Basics
– Brokers and Online Trading
– Economics Basics
– Reading Financial Tables
– Understanding the P/E Ratio

• Many many others

 Prerequisites
• Basic probability and statistics
– Distribution functions, moments, correlation, covariance, multivariate, linear
regression
– Discrete and continuous stochastic (Markov) processes
• Integral and differential calculus
• Optimization principles
• Economics
– Cash flow diagrams
– Time value of money
– Interest rates
– Rate of return
– Inflation
• Microsoft Excel
– Spreadsheet management
– Advanced functions
– Statistics including covariance correlation matrices
– Matrix algebra
 Course Organization
• This is an introductory and exploratory type of course in financial
engineering.
• Financial engineering is a very large and broad subject that we can not
possibly cover in just one class.
• The focus on the course will be the use of mathematical models on
financial instruments; however, will attempt to look at the models and
financial instruments from an engineering perspective.
• Although introductory, there could be topics that hit us real time in the
news or other sources that we might want to explore as well.
• Graduate students will also be required to develop, optimize, track, and
evaluate their own portfolio. Undergrad students can complete these
assignments for fun, but will not be graded!
 Course Organization
• Relative to some of the engineering classes that you have had in the past,
this is a moderately difficult class; primarily because of the extensive and
complicated terminology.
• It should be noted that I am not a financial expert on all topics!
 Policies
• Unless otherwise instructed, no cell phones, laptops, computer tablets
allowed during the lectures.
• No plagiarism or copying other peoples work.
• See the Academic Integrity Policy in our Syllabus.
• The exams and graded assignments are to be completed individually; no
collaboration with other students, people, services, or sources.
• No late assignments will be accepted!
• All of the materials provided in this class are copyright protected
including your completed assignments, exams, answer sheets, etc.
– You can not provide, give, copy, or upload any materials to anyone!
 Assignments
• I identify recommended problems from the textbook that will not be graded.
– The answers to these problems are provided in the course website.
• The graded assignments are presented in Excel:
– Student information and instruction worksheet.
– Student ID must be entered prior to the data becoming available.
• Each question is it’s own worksheet.
– Yellow fields identify where most answers are to be provided.
– Work must be shown on the same spreadsheet as the question.
– Drawings can be pasted to the worksheet; suggest the drawings be made in
Microsoft Power Point or a drawing tool. Do not use the drawing features in
Excel.
– A little bit of partial credit may be given, but only if your work is clearly laid out
and the error can be easily found.
• Students must submit their own work!
– Do not copy other people’s work, even my examples.
– Learn how to solve these problems!
 Exams
• Closed book
• Closed notes
• But you do get one 8.5 x 11 inch hand written note sheet, both
sides!
• Pencils (as many as you would like) and eraser
• Non-programmable calculator with the 𝒙𝒙 and xy functions

• Everything else, including phones are out of the room!

 What Is Financial Engineering?
• Financial Engineering is a multidisciplinary field involving financial theory,
the methods of engineering, the tools of mathematics and the practice of
programming. Synonymous with computational finance. Wikipedia.
• May be broadly defined as the development and creative application of
innovative financial technology where financial technology includes financial
theory, quantitative techniques, financial products, and financial processes.
Beder.
• The process of researching and developing new financial products and
services that would meet customer needs and prove profitable. Yang.
• Financial engineering is the process of employing mathematical finance and
computer modeling skills to make pricing, hedging, trading and portfolio
management decisions. Utilizing various derivative securities and other
methods, financial engineering aims to precisely control the financial risk
that an entity takes on. Methods can be employed to take on unlimited risks
under certain events, or completely eliminate other risks by utilizing
combinations of derivative and other securities. Yang.
 What Is Financial Engineering?
• Combining or carving up existing instruments to create new
financial products. Charvey.
• The use of financial instruments such as forwards, futures,
swaps, options, and related products to restructure or
rearrange cash flows in order to achieve particular financial
goals, particularly the management of financial risk. Primbs.
• The application of mathematical tools commonly used in
physics and engineering to financial problems, especially the
pricing and hedging of derivative instruments. Pearson.
• The application of mathematical methods to the solution of
problems in finance. International Association of Financial
Engineers (IAFE).
 History?
1970 - 1997
• Although there are examples that are centuries old, modern financial
engineering began in the early 1970s with the deregulation of interest rates,
currencies, and commodity prices and the need to manage risks.
• Derivatives, pricing models, and risk measures were created.
• Advancements in technology enable globalization.
• Black, Scholes, Merton advancements.

1998 - 2006
• Banks, asset managers, insurers merge/combine and play in each others’
markets.
• Risk management business takes off as a result of Asian currency crisis,
Russian crisis, and other crisis.
• Ongoing deregulation.
• Huge growth in credit derivatives and securitization change the ways
risk/return are originated, held, and transferred.
 History?
2007 - Present
• Financial markets around the world were in big trouble; some are still in
trouble
– Residential mortgages
– Commercial real estate
– Financial firms
– Corporate risks
– Municipal risks
– Sovereign risks
• Trillions of dollars in bailouts create global deleveraging and de-risking.
• Government regulations reconsidered.
• New risks associated with social media!
 Financial Engineering and Risk
• Understanding and managing risk is a common statement in financial
engineering definitions.
• What do we mean by risk?
– Lack of a certain or deterministic outcome to a given investment
or decision. Villalobos.
• We have an expected outcome or return in the future from an
investment that we are making now.
– However, what will the exact outcome be?
– Can we maximize the return?
– Can we minimize the risk?
– Also, how prevalent are the scams?
• Other questions could be:
– How can we minimize the probability of losing money?
– What can I do today to prepare for a future debt? Personal?
Business?
 Financial Engineering and Risk
• As engineers, we are paid to solve problems, develop and
manufacture products with high levels of reliability (low
risk).
• We resolve uncertainty by utilizing strengths in
mathematics and statistics such as stochastic models,
probability analysis, and optimization.
 Can this be a Markov Process?
• Simple example: Diagram shows
the probabilities of the next
week being in a financial state,
Bull, Bear, Recession, based on
the current week’s state.
• Fraction of time that the
economy is in one of these states
can be calculated, or how long it
could take to change from one
state to another.
 0
1000
1500
2000
2500
3000
3500
4000

500
-0.34
-0.3
-0.26
-0.22
-0.18
-0.14
-0.1
-0.06
-0.02
0.02
0.06
0.1
0.14
0.18
0.22
0.26
0.3
0.34
100
120
140
160

0
20
40
60
80

12/12/1980

0.00%
20.00%
40.00%

-60.00%
-40.00%
-20.00%
12/12/1983

12/12/1986

12/12/1989

12/12/1992

12/12/1995

12/12/1998

12/12/2001
Adj Close

12/12/2004
Rate of Return

12/12/2007

12/12/2010

12/12/2013

12/12/2016
Quick Look at Apple Stock (AAPL)

12/12/2019
Plan for the Semester
Introduction
Review of Interest rates/Time value of Money
Fixed Income Securities
Advanced Interest Concepts
Introduction to stock data and its analysis
Introduction to Portfolio Theory: The “Markowitz” Model
Portfolio, Stock Data and Returns
Two Fund, One Fund Theorems, Minimal Variance Point
The Capital Asset Pricing Model
Factor Models
Introduction to derivatives
Introduction to Futures
Introduction to Hedging
Introduction to Options
Introduction to discrete Option Pricing
Exercises on Pricing through Binomial Lattices
Introduction to continuous option pricing: The BS formula
BS formula and the Greeks
Long Term Capital Mgmt Company
Introduction to Risk modeling (Value at Risk)
Introduction to Advanced Derivatives
Risk Analysis Conclusions
Introduction to Dynamic Hedging
 Grading
Event Comments Score

Exam #1 100

Exam #2 100

Portfolio IEE 512 students only 100

Assignments
Graded Assignments provided in Microsoft Excel. Each 200
Assignments student has unique and traceable data.
IEE 412 Total 400

IEE 512 Total 500

 Assignment
• Read chapters 1 and 2 of Luenberger.
• Read all of the Faerber book.

• Let’s talk a bit about Canvas and your assignments!