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ECON 405: Quantitative Finance

Course Description
Winter 2009

Instructor: Tony S. Wirjanto Location: PAS1229


Office: 204 Hagey Hall Time: 05:30-06:50TTh
Telephone #: 519 888 4567 x 35210 Office Hours: 9:30-11:30W
Email: twirjant at uwaterloo dot ca

This course introduces students to data analysis and statistical modeling in finance. It is a course
designed to focus on statistical and computational aspects of finance. The emphasis of the course
is on making a transition from a financial model to a statistical model using financial data. It
involves specification of a financial model; estimation of a statistical model; testing of the
assumptions of the statistical model; testing the implications of the financial model; forecasting
from the statistical model. The modeling process involved in this course requires the use of
finance theory, probability models, optimization techniques, statistical theory and analysis and
computational skill.

Topics in finance include asset-return calculations, portfolio theory, index models, factor pricing
models, investment performance analysis, asset-return predictability, asset-return volatility
modeling, Value at Risk, etc. Mathematical topics include optimization techniques involving
equality and inequality constraints, basic matrix algebra, etc. Statistical topics include
probability and statistics, such as distributions, shapes and characteristics of distributions,
sampling distributions, estimation, hypothesis testing, forecasting etc.- with the use of calculus,
descriptive statistics and data analysis, regression, time series methods, simulation of random
data and resampling methods..

Course Requirements

• Problem sets with computer labs (50%)


• Midterm test (25%)
• Final Examination (25%)

The problem sets and computer labs constitute the core of the course and have been weighted
accordingly in the grading scheme.

Pre-requisites

Formally, the prerequisite is Econ321 or the equivalents. Econ371 is a co-requisite. More


realistically, the ideal prerequisites are a course in calculus (through partial differentiation and
constrained optimization using Lagrange multipliers), some familiarity with matrix algebra, a
course in probability and statistics, an interest in finance (Econ371/372 or the equivalents would
be helpful) and/or experience in working at a financial institution.


 
Required Textbook

Statistics and Finance: An Introduction, by David Ruppert, 2004, Springer-Verlag, New York.

Recommended Textbooks

• Introductory Statistics with R, Second Edition (Statistics and Computing, Paperback), by


Peter Dalgaard, Springer-Verlag, New York.
• Modern Portfolio Theory and Investment Analysis, Sixth Edition, by E.J. Elton and M.J.
Gruber, Wiley, New York, 2002. This text gives a very detailed treatment of portfolio
theory.
• Financial Modeling, Second Edition, by Simon Benninga. MIT Press, 2000. This
textbook covers financial modeling using Microsoft Excel.
• Value at Risk – The New Benchmark for Managing Financial Risk, 3rd Edition, by
Philippe Jorion, McGraw–Hill, 2007.
• Risk Management and Financial Institutions, by John C. Hull. Prentice Hall, 2006.
This textbook deals with the ways in which risks are quantified and managed by financial
institutions. Among the topics covered are market risk, credit risk, operational risk, the
regulation of banks, and the credit derivatives market.
• The Econometrics of Financial Markets by John Y. Campbell, Andrew W. Lo, & A.
Craig MacKinlay, Princeton University Press, 1996.

 Software

The course will utilize Microsoft Excel for spreadsheet modeling, and R or Matlab for data
analysis and statistical modeling. However you are free to use the software of your choice (such
as SHAZAM, STATA, etc) with the permission of the instructor. R is a free open-source
statistical modeling and graphical analysis language built upon the S language developed at Bell
Labs, R can be downloaded from www.r-project.org. We will be using several user-created
packages (libraries of R functions) specifically designed for the analysis of financial time series
data.

Lecture Topics

1. Asset Return Calculations


2. Probability Review: univariate random variables and probability distributions; bivariate
distributions, linear combinations of random variables
3. Time Series Concepts: stationarity, AR, MA and ARMA models
4. Review of Matrix Algebra
5. Descriptive Statistics: histograms, sample statistics, qq-plots, boxplots, scatterplots,
sample autocorrelations
6. Constant Expected Return (CER) Model: Representation, Bootstrapping, and Hypothesis
Testing
7. Portfolio Theory: Introduction, Matrix Algebra Representation
8. Single Index Models: Representation, Linear Regression Framework, Rolling Analysis,
Capital Asset Pricing Model


 
9. Multi Index Models
10. Measuring Portfolio Performance
11. Asset Return Predictability
12. Asset Return Volatility Modeling
13. Concepts and Tools of Quantitative Risk Management

Policies
Notes on problem sets and a midterm test: Problem sets will be both analytical and involving
computer applications. Problem sets are due at the beginning of class on the specified due date.
While collaborative work is encouraged, you must write the answers to the assignments in your
own word, submit your own copy of the assignment, including a copy of your printed computer
output for any computer assignment. There is no make-up midterm test in this course. For
students with a valid medical certificate for the missed test, the weight of the test will be
transferred to the final examination. For this to take effect, you must provide supporting
documentations within 14 calendar days of the day of the test.

Note on avoidance of academic offenses. All students registered in the courses of the Faculty of
Arts are expected to maintain a culture of academic integrity by upholding honesty, trust,
fairness, respect and responsibility.

Grievance: A student who believes that a decision affecting some aspect of his/her university
life has been unfair or unreasonable may have grounds for initiating a grievance. Read Policy 70
- Student Petitions and Grievances, Section 4,

http://www.adm.uwaterloo.ca/infosec/Policies/policy70.htm

Discipline: A student is expected to know what constitutes academic integrity, to avoid


committing academic offenses, and to take responsibility for his/her actions. A student who is
unsure whether an action constitutes an offense, or who needs help in learning how to avoid
offenses (e.g., plagiarism, cheating) or about “rules” for group work/collaboration should seek
guidance from the course professor, academic advisor, or the Undergraduate Associate Dean.
When misconduct has been found to have occurred, disciplinary penalties will be imposed under
Policy 71 – Student Discipline. For information on categories of offenses and types of penalties,
students should refer to Policy 71 - Student Discipline,

http://www.adm.uwaterloo.ca/infosec/Policies/policy71.htm

Appeals: A student may appeal the finding and/or penalty in a decision made under Policy 70 -
Student Petitions and Grievances (other than regarding a petition) or Policy 71 - Student
Discipline if a ground for an appeal can be established. Read Policy 72 - Student Appeals,

http://www.adm.uwaterloo.ca/infosec/Policies/policy72.htm

Note for students with disabilities. The Office for Persons with Disabilities (OPD), located in
Needles Hall, Room 1132, collaborates with all academic departments to arrange appropriate


 
accommodations for students with disabilities without compromising the academic integrity of
the curriculum. If you require academic accommodations to lessen the impact of your disability,
please register with the OPD at the beginning of each academic term.

Note on student access to a final examination paper. Students can review their final
examination papers informally without instituting a formal appeal procedure. Such review will
take place under supervised access only, and will be arranged in a way that is mutually
convenient for the instructor and the student.

Note on accommodation for religious or cultural observances. Students can request for
accommodation for a final examination for religious or cultural reasons. This request must be
made with Professor William Chesney, Associate Dean of Arts, Undergraduate Studies, at
wchesney@uwaterloo.ca, within a week of the posting of the final exam dates.