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Springer Undergraduate Texts in Mathematics and Technology

Arlie O. Petters Xiaoying Dong

in Mathematics and Technology Arlie O. Petters Xiaoying Dong An Introduction to Mathematical Finance with Applications

An Introduction to Mathematical Finance with Applications

Understanding and Building Financial Intuition

Xiaoying Dong An Introduction to Mathematical Finance with Applications Understanding and Building Financial Intuition

Springer Undergraduate Texts in Mathematics and Technology

Series Editors:

J.M. Borwein

H. Holden

V.H. Moll

More information about this series at http://www.springer.com/series/7438

Arlie O. Petters • Xiaoying Dong

An Introduction to Mathematical Finance with Applications

Understanding and Building Financial Intuition

Arlie O. Petters Department of Mathematics Duke University Durham, NC, USA

Xiaoying Dong Department of Mathematics Duke University Durham, NC, USA

ISSN 1867-5506

Springer Undergraduate Texts in Mathematics and Technology

ISBN 978-1-4939-3781-3 DOI 10.1007/978-1-4939-3783-7

ISSN 1867-5514

(electronic)

ISBN 978-1-4939-3783-7

(eBook)

Library of Congress Control Number: 2016939449

Mathematics Subject Classification (2010): 91Gxx

© Arlie O. Petters and Xiaoying Dong 2016 This work is subject to copyright. All rights are reserved by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made.

Printed on acid-free paper

This Springer imprint is published by Springer Nature The registered company is Springer International Publishing AG Switzerland

To my loving wife, Elizabeth Petters, for being at my side unconditionally and my child, Preston Petters, who inspires me with his intense curiosity. A.O. Petters

To my dear husband and best friend, Xin Zhou. I could not imagine to complete my part of the contribution to this book without his love and support.

X. Dong

Preface

Rationale and Aim

Given the increasing intricacies and interconnectedness of financial firms’ ac- tivities and the potential opportunities and risks to which they expose them- selves and the world’s economy, the next generation of financial engineers needs to master an extensive array of mathematical financial models. Indeed, one of the current challenges in finance is that the complexity of modern se- curities and markets has forced modelers to employ increasingly sophisticated mathematical tools to address financial issues, creating a widening gap be- tween the qualitative and quantitative approaches to finance. Our book seeks to address this gap by introducing the quantitative aspects of finance to students with either a qualitative background or no background in the subject. At a firm the traders, risk managers, etc. employ proprietary an- alytical and numerical models custom made to the needs of their firm. How- ever, since open access to such models is prohibited, the book instead strives to give students a fundamental understanding of key financial ideas and tools that form the basis for building more realistic models, including those of a proprietary nature.

Distinctive Features and Benefits

This book is distinct in how it emphasizes and pedagogically conveys in an accessible manner the theoretical understanding and applications of the math- ematical models forming key pillars of modern finance. First, the book keeps a good balance between mathematical derivation and description for the sake of providing an adequate level of rigor and depth in mathematics and maintaining accessibility to the reader, which in turn adds flexibility of material selection for the instructor (e.g., Chapter 7 may be taught earlier). Specifically, this book addresses the gap between textbooks that of-

viii

Preface

fer a theoretical treatment without many applications and those that simply present and apply formulas without appropriately deriving them. Indeed, the- oretical understanding is incomplete without enough practice in applications, and applications are risky without a rigorous theoretical understanding. To accomplish this, the book contains numerous carefully chosen examples and exercises that reinforce a student’s conceptual understanding and develop a facility with applications. Indeed, the exercises are divided into conceptual, application, and theoretical problems that probe the material deeper. Second, beyond a few required undergraduate mathematics courses (see Prerequisites below), this book is essentially self-contained. The large num- ber of necessary financial terminologies and concepts can be overwhelming to a student new to finance. For this reason, after introducing some central, big-picture financial ideas in the first chapter, we present the financial minu- tia along the way as needed. We have tried to make the book self-contained in this regard through thoughtfully chosen illustrative applications starting at the ground level with simple interest. We then gradually increase the difficulty as the book develops, ranging across compound interest, annuities, portfolio theory, capital market theory, portfolio risk measures, the role of linear factor models in portfo- lio risk attribution, binomial tree models, stochastic calculus, derivatives, the martin- gale approach to derivative pricing, the Black-Scholes-Merton model, and the Merton jump-diffusion model. Third, the book is also useful for students preparing either for higher level study in mathematical finance or for a career in actuarial science. For example, the syllabi for the actuarial Financial Mathematics Exam (Exam 2/FM) and Models of Financial Economics Exam (Exam 3F/MFE) include many topics covered in the book.

Prerequisites

The required mathematics consists of introductory courses on multivariable calculus, probability, and linear algebra. Along the way, we introduce addi- tional mathematical tools as needed—e.g., some measure theory is presented from scratch. No background in finance is assumed. As noted above, the necessary financial concepts and tools are introduced in the text, with the first chapter giving an overview of several common finance terminologies associated with securities and securities markets. Our book does not require computer programming. In our experience, fi- nance courses based on computer programming are best taken after students have developed a fundamental understanding of the theoretical architecture of financial models.

Preface

ix

Audience

The text is aimed at advanced undergraduates and master’s degree students who are either new to finance or want a more rigorous treatment of the mathematical models used in finance. The students typically are from economics, mathemat- ics, engineering, physics, and computer science. We also believe that a faculty member who is teaching finance for the first time will find this introduction readily manageable. Professionals working in finance who would like a refresher or even clarification on some of the the- oretical and conceptual aspects of mathematical finance will benefit from the text.

Scope and Guide

The chapters are organized naturally into four parts and range over the fol- lowing topics:

- Part I (Chapters 1 and 2):

introduction to securities markets and the time value of money

- Part II (Chapters 3 and 4):

Markowitz portfolio theory, capital market theory, and portfolio risk measures

- Part III (Chapters 5 and 6):

modeling underlying securities using binomial trees and stochastic calculus

- Part IV (Chapters 7 and 8):

derivative securities, BSM model, and Merton jump-diffusion model The material was tested in courses offered to upper-level undergraduates and master’s degree students. Below are two examples of possible topics that may serve as a guide for semester-long courses:

- Introduction to Mathematical Finance: securities markets (Chapter 1), the time value of money (Chapter 2), Markowitz portfolio theory, capital market theory, and portfolio risk measures (Chapters 34), binomial security pric- ing (Chapter 5, omit most derivations), Itˆo’s formula and geometric Brow- nian motion (Sections 6.8 and 6.9), forwards, futures, and options (Sec- tions 7.2, 7.3, and 7.5), and call option pricing with applications (Sections 8.3, 8.2.2, 8.5, and 8.6.2).

- Introduction to Financial Derivatives: modeling underliers in discrete time (Sections 5.15.3), stochastic calculus and modeling underliers in continuous time (Section 5.4 and Chapter 6), general aspects of forwards, futures, swaps, and options, including trading strategies (Chapters 7), the Black-Scholes- Merton (BSM) model, BSM p.d.e. approach to pricing European-style op- tions, risk-neutral approach to pricing European-style options, applications to warrants, delta hedging, managing portfolio risk, and extension of the BSM model to the Merton jump-diffusion model (Chapter 8).

x

Preface

A year-long course on introductory mathematical finance can be based on the entire book. The book can also be used as a reference for students enrolled in a mathematical finance independent study course.

Acknowledgments

Specials thanks to the following individuals for their feedback and assistance:

Daniel Aarhus

Amir Aazami

Stanley Absher

Vibhav Agarwal

Hengjie Ai

Mitesh Amarthaluru Vlad Bouchouev Michael Brandt Esteban Chavez Rui Chen Kyuwon Choi Qian Deng Christian Drappi Zachary Freeman Tingran Gao William Grisaitis Xiaosheng Guo Zhonglin Han John Hyde Huseyin Kortmaz Baolei Li Junchi Li

Li Li

Nan Li

Qiao Li

Li

Liang

Lu Liu

Ruisi Ma

Tanya Mallavarapu

Xavier Mela

Vadim Mokhnatkin

Julia Ni

James Nolen

Vivek Oberoi

Feng Pan

Chloe Peng

Hal Press

Hui Qi

Zhaozhen Qian

Hayagreev Ramesh

Emma Rasiel

Tianhua Ren

Chelsea Richwine

Irving Salvatierra

Andrew Schretter

Yuhang Si

John Sias

Maxwell Stern

Lingran Sun

Alberto Teguia

Nicholas Tenev

Dominick Totino

Chi Trinh

Dan Turtel

Kari Vaughn

Robert Vanderbei

Kevin Wan

Chenyu Wang

David Williams

Chao Xu

Hangjun Xu

Lu Xu

Junkai Xue

Chao Yang

Jiahui Yang

Ashley Yeager

Jeong Yoo

Yanchi Yu

Yunliang Yu

Javier Zapata

Xiaodong Zhai

Biyuan Zhang

Yang Zhang

Bowen Zhao

Ruiyang Zhao

Xiaoyang Zhuang

Zilong Zou

We are also thankful to Elizabeth Loew of Springer for her support and guid- ance along the entire way and to Lisa Goldberg for her valuable comments and constructive suggestions. AP is indebted to Duke University for providing the financial support needed to hire many students who assisted with writ- ing computer codes, checking calculations, etc. He is also extremely grateful to his wife, Elizabeth Petters, for her patience, love, and steadfast encouragement throughout the project. XD would like to express her gratitude to her husband Xin Zhou who saw her through this book and offered great suggestions.

Durham, NC, USA

A.O. Petters

Durham, NC, USA

X. Dong

2016

Contents

1 Preliminaries on Financial Markets

 

1

1.1 A Primer on Banks and Rates

 

2

1.1.1 Banks and the Federal Funds Rate

 

2

1.1.2 Short-Term and Long-Term Rates and Yield Curves

 

4

1.2 A Primer on Securities Markets

 

6

1.2.1 Securities Markets Organization

 

6

1.2.2 Professional Participants in Securities Markets

 

8

1.2.3 Bid-Ask Spreads and Market Liquidity

 

8

1.2.4 Trading Costs

 

9

1.3 Economic Indicators That May Affect Financial Markets

 

10

2 The Time Value of Money

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2.1 Time

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14

2.2 Interest Rate and Return Rate

 

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2.2.1 Interest

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2.2.2 Required Return Rate and the Risk-Free Rate

 

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2.2.3 Total Return Rate

 

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2.3 Simple Interest

 

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20

2.4 Compound Interest

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2.4.1 Compounding: Nonnegative Integer Number of Periods

 

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2.4.2 Compounding: Nonnegative Real Number of Periods

 

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2.4.3 Fractional Compounding Versus Simple Interest

 

30

2.4.4 Continuous Compounding

 

31

2.5 Generalized Compound Interest

 

31

2.5.1 Varying Interest and Varying Compounding Periods

 

31

2.5.2 APR Versus APY

 

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2.5.3 Geometric Mean Return Versus Arithmetic Mean Return

 

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2.6 The Net Present Value and Internal Rate of Return

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38

2.6.1 Present Value and NPV of a Sequence of Net Cash Flows .

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2.6.2 The Internal Return Rate

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41

xii

Contents

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NPV and IRR for General Net Cash Flows

 

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2.7 Annuity Theory

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2.7.1 Future and Present Values of Simple Ordinary Annuities

 

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2.7.2 Amortization Theory

 

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2.7.3 Annuities with Varying Payments and Interest Rates

 

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2.8 Applications of Annuities

 

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2.8.1 Saving, Borrowing, and Spending

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59

2.8.2 Equity in a

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2.8.3 Sinking Funds

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2.9 Applications to Stock Valuation

 

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2.9.1 The Dividend Discount Model

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2.9.2 Present Value of Preferred and Common Stocks

 

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2.10 Applications to Bond Valuation

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2.10.1 Bond

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2.10.2 Bond Prices Versus Interest Rates and Yield to Maturity

 

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2.11 Exercises

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72

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2.11.2 Application Exercises

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2.11.3 Theoretical Exercises .

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78

81

3

Markowitz Portfolio Theory

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83

3.1 Markowitz Portfolio Model: The Setup

 

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3.1.1 Security Return Rates

 

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3.1.2 What About Multivariate Normality of Security Return

 

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3.1.3 Investors and the Efficient Frontier

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3.1.4 The One-Period Assumption, Weights, and Short Selling

 

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3.1.5 Expected Portfolio Return Rate

 

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94

3.1.6 Portfolio

Risk

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96

3.1.7 Risks and Covariances of the Portfolio’s Securities

 

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3.1.8 Expectation and Volatility of Portfolio Log Return

100

3.2 Two-Security Portfolio Theory

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104

3.2.1 Preliminaries

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105

3.2.2 Efficient Frontier of a Two-Security Portfolio

 

107

3.2.3 Reducing Risk Through Diversification

 

114

3.3 Efficient Frontier for N Securities with Short Selling

 

117

3.3.1 N-Security Portfolio Quantities in Matrix Notation

 

118

3.3.2 Derivation of the N-Security Efficient Frontier

 

120

3.4 N-Security Efficient Frontier Without Short Selling

 

126

3.5 The Mutual Fund Theorem

 

128

3.5.1 The Global Minimum-Variance Portfolio

 

128

3.5.2 The Diversified Portfolio

 

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130

Contents

xiii

3.5.3

The Mutual Fund Theorem

 

130

3.6 Investor Utility Function

131

3.6.1 Utility Functions and Expected Utility Maximization

 

131

3.6.2 Risk-Averse, Risk-Neutral, and Risk-Seeking Investors

 

133

3.7 Diversification and Randomly Selected Securities

 

138

3.7.1 Mean Portfolio Variance and the Uniform Dirichlet

 

Distribution

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138

3.7.2 Mean Portfolio Variance using the NASDAQ

 

142

3.8 Exercises

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143

143

3.8.2 Application Exercises

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144

 

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146

4

3.8.3 Theoretical Exercises .

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Capital Market Theory and Portfolio Risk Measures

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149

151

4.1 The Capital Market Theory

152

4.1.1 The Capital Market Line (CML)

 

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4.1.2 Expected Return and Risk of the Market Portfolio

 

157

4.1.3 The Capital Asset Pricing Model (CAPM)

 

158

4.1.4 The Security Market Line (SML)

 

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163

4.1.5 CAPM Security Risk Decomposition

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164

4.2 Portfolio Risk Measures

165

4.2.1 The Sharpe Ratio

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166

4.2.2 The Sortino Ratio

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170

4.2.3 The Maximum Drawdown

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172

4.2.4 Quantile

Functions

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174

4.2.5 Value-at-Risk

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4.2.6 Conditional Value-at-Risk

 

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4.2.7 Coherent Risk Measures

 

183

4.3 Introduction to Linear Factor Models

 

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4.3.1 Definition and Intuition

 

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4.3.2 Portfolio Variance Decomposition

 

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4.3.3 Factor Categorization

191

4.3.4 Alpha and Beta

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192

4.3.5 CAPM Beta Versus Linear Factor Beta

 

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4.3.6 Fama-French Three-Factor Model

 

196

4.4 Exercises

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References

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199

199

4.4.2 Application Exercises

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