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COMPUTATIONAL FINANCE

EXECUTIVE SUMMARY

Computational finance is a process that relies on the application of several

factors in order to arrive at conclusions regarding such matters as
investments in stocks and bonds, futures trading, and hedging on stock
market activity. Generally speaking, the wide umbrella of computational
finance will employ the disciplines of mathematical science, number
theories, and the use of computer simulations to explore the potential risks
as well as the probably outcomes of any such transaction.

Here are a few examples of how computational finance is used each day in
a number of different scenarios.

One of the most common applications of computational finance is within the

arena of investment banking. Because of the sheer amount of funds
involved in this type of situation, computational finance comes to the fore
as one of the tools used to evaluate every potential investment, whether it
be something as simple as a new start-up company or a well established
fund. Computational finance can help prevent the investment of large
amounts of funding in something that simply does not appear to have much
of a future.

Another area where computational finance comes into play is the world of
financial risk management. Stockbrokers, stockholders, and anyone who
chooses to invest in any type of investment can benefit from using the
basic principles of computational finance as a way of managing an
individual portfolio. Running the numbers for individual investors, just alike
for larger concerns, can often make it clear what risks are associated with
any given investment opportunity. The result can often be an individual who
is able to sidestep a bad opportunity, and live to invest another day in
something that will be worthwhile in the long run.

In the business world, the use of computational finance can often come into
play when the time to engage in some form of corporate strategic planning

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arrives. For instance, reorganizing the operating structure of a company in

order to maximize profits may look very good at first glance, but running the
data through a process of computational finance may in fact uncover some
drawbacks to the current plan that were not readily visible before.

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INTRODUCTION

Computational finance or quantitative finance is a cross-disciplinary field

which relies on computational intelligence, mathematical finance, numerical
methods and computer simulations to make trading, hedging and
investment decisions, as well as facilitating the risk management of those
decisions. Utilising various methods, practitioners of computational finance
aim to precisely determine the financial risk that certain financial
instruments create.

y Mathematical finance
y Numerical methods
y Computer simulations
y Quantitative techniques
y Financial risk
y Quantitative management
y Applied mathemathics

Computational finance is à
 màmà concerned with financial

markets. The subject has a close relationship with the discipline of financial
economics, which is concerned with much of the underlying theory.
Generally, it will derive, and extend, the mathematical or numerical models
suggested by financial economics. Thus, for example, while a financial
economist might study the structural reasons why a company may have a
certain share price, a financial mathematician may take the share price as
a given, and attempt to use stochastic calculus to obtain the fair value of
derivatives of the stock

The fundamental theorem of arbitrage-free pricing is one of the key

theorems in mathematical finance. Many universities around the world now
offer degree and research programs in computational finance.

The frontiers of finance are shifting rapidly, driven in part by the increasing
use of quantitative methods in the field.
àà Fà welcomes
original research articles that reflect the dynamism of this area. The journal
provides an interdisciplinary forum for presenting both theoretical and

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empirical approaches and offers rapid publication of original new work with
high standards of quality. The readership is broad, embracing researchers
and practitioners across a range of specialisms and within a variety of
organizations. All articles should aim to be of interest to this broad
readership.

In the banking industry, quantitative analysts support sales functions and

trading by developing models that manage stocks and bonds. This provides
the bank with a solution to problems with market prices and other issues.

While quantitative analysis can be applied to many different fields, usually

only people who use the concept in finance analysis are actually known as
quantitative analysts.

Quantitative Finance is a high-quality journal which brings together work on

the mathematical aspects of finance theory from such diverse fields as
finance, economics, mathematics, and statistics. An essential resource for
academic finance researchers and practitioners alike, the journal publishes
clear and concise articles which present the latest theoretical developments
in an accessible way. Modern finance is becoming increasingly technical,
requiring the use of sophisticated mathematical tools in both research and
practice. Quantitative Finance offers a forum for the publication of articles
which employ these techniques, as well as providing a much-needed
bridge between mathematical scientists and financial economists.

Computational finance comes to the fore as one of the tools used to

evaluate every potential investment, whether it be something as simple as
a new start-up company or a well established fund. Computational finance
can help prevent the investment of large amounts of funding in something
that simply does not appear to have much of a future.

Another area where computational finance comes into play is the world of
financial risk management. Stockbrokers, stockholders, and anyone who
chooses to invest in any type of investment can benefit from using the
basic principles of computational finance as a way of managing an
individual portfolio. Running the numbers for individual investors, just alike
for larger concerns, can often make it clear what risks are associated with
any given investment opportunity. The result can often be an individual who
is able to sidestep a bad opportunity, and live to invest another day in
something that will be worthwhile in the long run.

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In the business world, the use of computational finance can often come into
play when the time to engage in some form of corporate strategic planning
arrives. For instance, reorganizing the operating structure of a company in
order to maximize profits may look very good at first glance, but running the
data through a process of computational finance may in fact uncover some
drawbacks to the current plan that were not readily visible before.

Being aware of the complete and true expenses associated with the
restructure may prove to be more costly than anticipated, and in the long
run not as productive as was originally hoped. Computational finance can
help get past the hype and provide some realistic views of what could
happen, before any corporate strategy is implemented.

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^ISTORY

The history of Computational finance starts with The Theory of Speculation

(published 1900) by Louis Bachelier, which discussed the use of Brownian
motion to evaluate stock options. However, it hardly caught any attention
outside academia.

The first influential work of computational finance is the theory of portfolio

optimization by Harry Markowitz on using mean-variance estimates of
portfolios to judge investment strategies, causing a shift away from the
concept of trying to identify the best individual stock for investment. Using a
linear regression strategy to understand and quantify the risk (i.e. variance)
and return (i.e. mean) of an entire portfolio of stocks and bonds, an
optimization strategy was used to choose a portfolio with largest mean
return subject to acceptable levels of variance in the return.
Simultaneously, William Sharpe developed the mathematics of determining
the correlation between each stock and the market. For their pioneering
work, Markowitz and Sharpe, along with Merton Miller, shared the 1990
Nobel Memorial Prize in Economic Sciences, for the first time ever awarded
for a work in finance.

The portfolio-selection work of Markowitz and Sharpe introduced

mathematics to the ³black art´ of investment management. With time, the
mathematics has become more sophisticated. Thanks to Robert Merton
and Paul Samuelson, one-period models were replaced by continuous
time, Brownian-motion models, and the quadratic utility function implicit in
mean±variance optimization was replaced by more general increasing,
concave utility functions.

The next major revolution in mathematical finance came with the work of
Fischer Black and Myron Scholes along with fundamental contributions by
Robert C. Merton, by modeling financial markets with stochastic models.

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For this M. Scholes and R. Merton were awarded the 1997 Nobel Memorial
Prize in Economic Sciences. Black was ineligible for the prize because of
his death in 1995.

More sophisticated mathematical models and derivative pricing strategies

were then developed but their credibility was damaged by the financial
crisis of 2007±2010. Bodies such as the Institute for New Economic
Thinking are now attempting to establish more effective theories and
methods

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UANTITATIVE MANAGEMENT

INTRODUCTION OF UANTITATIVE MANAGEMENT

Scientific methods have been man¶s outstanding asset to pursue an ample

number of activities. It is analysed that whenever some national crisis,
emerges due to the impact of political, social, economic or cultural factors
the talents from all walks of life amalgamate together to overcome the
situation and rectify the problem. In this chapter we will see how the
quantitative techniques had facilitated the organization in solving complex
problems on time with greater accuracy. The historical development will
facilitate in managerial decision-making & resource allocation, The
methodology helps us in studying the scientific methods with respect to
phenomenon connected with human behavior like formulating the problem,
defining decision variable and constraints, developing a suitable model,
acquiring the input data, solving the model, validating the model,
implementing the results. The major advantage of mathematical model is
that its facilitates in taking decision faster and more accurately.

Managerial activities have become complex and it is necessary to make

right decisions to avoid heavy losses. Whether it is a manufacturing unit, or
a service organization, the resources have to be utilized to its maximum in
an efficient manner. The future is clouded with uncertainty and fast
changing, and decision-making ± a crucial activity ± cannot be made on a
trial-and-error basis or by using a thumb rule approach. In such situations,
there is a greater need for applying scientific methods to decision-making
to increase the probability of coming up with good decisions. Quantitative
Technique is a scientific approach to managerial decision-making. The
successful use of Quantitative Technique for management would help the
organization in solving complex problems on time, with greater accuracy
and in the most economical way. Today, several scientific management
techniques are available to solve managerial problems and use of these
techniques helps managers become explicit about their objectives and
provides additional information to select an optimal decision. This study
material is presented with variety of these techniques with real life problem
areas.

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AIMS AND OBJECTIVES

In this first lesson we discuss the distinguished approaches to quantitative
techniques
and its various applications in management, statistical analysis and other
industries. Here
we will discuss the approaches of quantitative techniques.

^ISTORICAL DEVELOPMENT
During the early nineteen hundreds, Fredrick W. Taylor developed the
scientific management principle which was the base towards the study of
managerial problems. Later, during World War II, many scientific and
quantitative techniques were developed to assist in military operations. As
the new developments in these techniques were found successful, they
were later adopted by the industrial sector in managerial decision-making
and resource allocation. The usefulness of the Quantitative Technique was
evidenced by a steep growth in the application of scientific management in
decision-making in various fields of engineering and management. At
present, in any organization, whether a manufacturing concern or service
industry, Quantitative Techniques and analysis are used by managers in
making decisions scientifically.

A quantitative management is working in finance using numerical or

quantitative techniques. Similar work is done in most other modern
industries, the work is called quantitative analysis. In the investment
industry, people who perform quantitative analysis are frequently called
quants. Although the original quants were concerned with risk management
and derivatives pricing, the meaning of the term has expanded over time to
include those individuals involved in almost any application of mathematics
in finance.

Quantitative finance started in the U.S. in the 1930s as some astute

investors.

Robert C. Merton, a pioneer of quantitative analysis, introduced stochastic

calculus into the study of finance.

Harry Markowitz's 1952 Ph.D thesis "Portfolio Selection" was one of the
first papers to formally adapt mathematical concepts to finance. Markowitz

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formalized a notion of mean return and covariances for common stocks

which allowed him to quantify the concept of "diversification" in a market.
He showed how to compute the mean return and variance for a given
portfolio and argued that investors should hold only those portfolios whose
variance is minimal among all portfolios with a given mean return. Although
the language of finance now involves minimization of risk in a quantifiable
manner underlies much of the modern theory.

In 1969 Robert Merton introduced stochastic calculus into the study of

finance. Merton was motivated by the desire to understand how prices are
set in financial markets, which is the classical economics question of
"equilibrium," and in later papers he used the machinery of stochastic
calculus to begin investigation of this issue.

At the same time as Merton's work and with Merton's assistance, Fischer
Black and Myron Scholes were developing their option pricing formula,
which led to winning the 1997 Nobel Prize in Economics. It provided a
solution for a practical problem, that of finding a fair price for a European
call option, i.e., the right to buy one share of a given stock at a specified
price and time. Such options are frequently purchased by investors as a
risk-hedging device. In 1981, Harrison and Pliska used the general theory
of continuous-time stochastic processes to put the Black-Scholes option
pricing formula on a solid theoretical basis, and as a result, showed how to
price numerous other "derivative" securities.

The history of mathematical finance starts with the theory of portfolio

optimization by Harold Markowitz on using mean-variance estimates of
portfolios to judge investment strategies, causing a shift away from the
concept of trying to identify the best individual stock for investment. Using a
linear regression strategy to understand and quantify the risk (i.e. variance)
and return (i.e. mean) of an entire portfolio of stocks and bonds, an
optimization strategy was used to

Computational finance choose a portfolio with largest mean return subject

to acceptable levels of variance in the return. Simultaneously, William

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Sharpe developed the mathematics of determining the correlation between

each stock and the market. For their pioneering work, Markowitz and
Sharpe, along with Merton Miller, shared the 1990 Nobel Prize in
economics, for the first time ever awarded for a work in finance. The
portfolio-selection work of Markowitz and Sharpe introduced mathematics
to the ³black art´ of investment management. With time, the mathematics
has become more sophisticated. Thanks to Robert Merton and Paul
Samuelson, one- period models were replaced by continuous time,
Brownian-motion models, and the quadratic utility function implicit in mean±
variance optimization was replaced by more general increasing, concave
utility functions.

ABOUT UANTITATIVE TEC^NI UES

Quantitative Techniques adopt a scientific approach to decision-making. In

this approach, past data is used in determining decisions that would prove
most valuable in the future. The use of past data in a systematic manner
and constructing it into a suitable model for future use comprises a major
part of scientific management. For example, consider a
person investing in fixed deposit in a bank, or in shares of a company, or
mutual funds, or in Life Insurance Corporation. The expected return on
investments will vary depending upon the interest and time period. We can
use the scientific management analysis to find out how much the
investments made will be worth in the future. There are many scientific
method software packages that have been developed to determine and
analyze the
problems.

In case of complete non-availability of past data, quantitative factors are

considered in decision-making. In cases where the scope of quantitative
data is limited, qualitative factors play a major role in making decisions.
Qualitative factors are important situations
like sudden change in tax-structures, or the introduction of breakthrough
technologies. Application of scientific management and Analysis is more
appropriate when there is not much of variation in problems due to external
factors, and where input values are steady. In such cases, a model can be

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developed to suit the problem which helps us to take decisions faster. In

today's complex and competitive global marketplace, use of
Quantitative Techniques with support of qualitative factors is necessary.
Quantitative Technique is the scientific way to managerial decision-making,
while emotion and guess work are not part of the scientific management
approach. This approach starts with data. Like raw material for a factory,
this data is manipulated or processed into information that is valuable to
people making decision. This processing and manipulating
of raw data into meaningful information is the heart of scientific
management analysis.

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MET^ODOLOGY OF COMPUTATIONAL FINANCE

The methodology adopted in solving problems is as follows:

Form

à  Prob
m
As a first step, it is necessary to clearly understand the problem situations.
It is important
to know how it is characterized and what is required to be determined.
Firstly, the key
decision and the objective of the problem must be identified from the
problem. Then, the
number of decision variables and the relationship between variables must
be determined.

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The measurable guaranties that are represented through these variables

are notified.
The practical limitations or constraints are also inferred from the problem.

A
r  I
 Dàà
Accurate data for input values are essential. Even though the model is well
constructed, it is important that the input data is correct to get accurate
results. Inaccurate data will lead to wrong decisions.

So
  Mo

Solving is trying for the best result by manipulating the model to the
problem. This is done
by checking every equation and its diverse courses of action. A trial and
error method
can be used to solve the model that enables us to find good solutions to the
problem.

Và
à  Mo

A validation is a complete test of the model to confirm that it provides an
accurate
representation of the real problem. This helps us in determining how good
and realistic
the solution is. During the model validation process, inaccuracies can be
rectified by
taking corrective actions, until the model is found to be fit.

Im
m  R


Once the model is tested and validated, it is ready for implementation.
Implementation
involves translation/application of solution in the company. Close
administration and
monitoring is required after the solution is implemented, in order to address
any proposed
changes that call for modification, under actual working conditions.

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SOME MAJOR CONTRIBUTORS TO COMPUTATIONAL FINANCE INCLUDE:

y Fischer Black
y Phelim Boyle
y Emanuel Derman
y Robert Jarrow
y Harry Markowitz
y Robert C. Merton
y Stephen Ross
y Myron Scholes
y Paul Wilmott
y Blake LeBaron
y Darrell Duffie
y Edward Tsang

COMPUTATIONAL FINANCE COVERS APPLICATIONS SUC^ AS:

y Asset-liability management
y Behavioural finance
y Corporate finance
y Corporate valuation
y Derivatives pricing
y Financial engineering
y Liquidity modelling
y Portfolio management
y Price formation
y Risk management

> A Làb
 màà m

In banking, asset and liability management is the practice of managing

risks that arise due to mismatches between the assets and liabilities (debts
and assets) of the bank.

Banks face several risks such as the liquidity risk, interest rate risk, credit
risk and operational risk. Asset Liability management (ALM) is a strategic
management tool to manage interest rate risk and liquidity risk faced by
banks, other financial services companies and corporations.

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Banks manage the risks of Asset liability mismatch by matching the assets
and liabilities according to the maturity pattern or the matching the duration,
by hedging and by securitization. Much of the techniques for hedging stem
from the delta hedging concepts introduced in the Black-Scholes model
and in the work of Robert C. Merton and Robert A. Jarrow.

Modern risk management now takes place from an integrated approach to

enterprise risk management that reflects the fact that interest rate risk,
credit risk, market risk, and liquidity risk are all interrelated.

> Bào
rà
Fà

A field of finance that proposes psychology-based theories to explain stock

market anomalies. Within behavioral finance, it is assumed that the
information structure and the characteristics of market participants
systematically influence individuals' investment decisions as well as market
outcomes.

There have been many studies that have documented long-term historical
phenomena in securities markets that contradict the efficient market
hypothesis and cannot be captured plausibly in models based on perfect
investor rationality. Behavioral finance attempts to fill the void.
According to conventional financial theory, the world and its participants
are, for the most part, rational "wealth maximizers". However, there are
many instances where emotion and psychology influence our decisions,
causing us to behave in unpredictable or irrational ways.

Behavioral finance is a relatively new field that seeks to combine behavioral

and cognitive psychological theory with conventional economics and
finance to provide explanations for why people make irrational financial
decisions.

> Cor orà Fà

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Corporate finance finance dealing with financial decisions business

enterprises make and the tools and analysis used to make these decisions.
The primary goal of corporate finance is to maximize corporate value while
managing the firm's financial risks. Although it is in principle different from
managerial finance which studies the financial decisions of all firms, rather
than corporations alone, the main concepts in the study of corporate
finance are applicable to the financial problems of all kinds of firms.

Acquisition and allocation of a corporation's funds or resources, with the

goal of maximizing shareholder wealth (i.e., stock value). Funds are
acquired from both internal and external sources at the lowest possible cost
and may be obtained through equity (e.g., sale of stock) or debt (e.g.,
bonds, bank loans). Resource allocation is the investment of funds; these
investments fall into the categories of current assets (such as cash and
inventory) and fixed assets (such as real estate and machinery). Corporate
finance must balance the needs of employees, customers, and suppliers
against the interests of the shareholders. See also business finance.

> Cor orà Và

ào

The process of determining the current worth of an asset or company.

There are many techniques that can be used to determine value, some are
subjective and others are objective.

For example, an analyst valuing a company may look at the company's

management, the composition of its capital structure, prospect of future
earnings, and market value of assets.

Judging the contributions of a company's management would be more of a

subjective valuation technique, while calculating intrinsic value based on
future earnings would be an objective technique.

> Drà r Mo


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It relates a number of variables and yield a theoretical price that is useful in

judging whether an option or other derivative is fairly priced by the market
or is overvalued or undervalued. The best-known and most widely adapted
model is the basic

Black-Scholes Option Pricing Model, developed by Fischer Black and

Myron Scholes in the 1960s for options on stocks and modified in the
1970s for options on futures.

> Fàà
 r

It is a multidisciplinary field involving financial theory, the methods of

financing, using tools of mathematics, computation and the practice of
programming to achieve the desired end results.

The financial engineering methodologies usually apply social theories,

engineering methodologies and quantitative methods to finance. It is
normally used in the securities, banking, and financial management and
consulting industries, or by quantitative analysts in corporate treasury and
finance departments of general manufacturing and service firms.

> L
 mo


Liquidity modeling in macroeconomic theory refers to the demand for

money, considered as liquidity. The concept was first developed by John
Maynard Keynes in his book The General Theory of Employment, Interest
and Money (1936) to explain determination of the interest rate by the
supply and demand for money. The demand for money as an asset was
theorized to depend on the interest foregone by not holding bonds. Interest
rates, he argues, cannot be a reward for saving as such because, if a
person hoards his savings in cash, keeping it under his mattress say, he
will receive no interest, although he has nevertheless, refrained from
consuming all his current income. Instead of a reward for saving, interest in
the Keynesian analysis is a reward for parting with liquidity.

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Aor o K mà for


  rm b r
mo:

1.  ràào mo: people prefer to have liquidity to assure

basic transactions, for their income is not constantly available. The amount
of liquidity demanded is determined by the level of income: the higher the
income, the more money demanded for carrying out increased spending.

2.  rà
oàr mo: people prefer to have liquidity in the case
of social unexpected problems that need unusual costs. The amount of
money demanded also grows with the income.

3.  

à mo: people retain liquidity to speculate that bond
prices will fall. When the interest rate decreases people demand more
money to hold until the interest rate increases, which would drive down the
price of an existing bond to keep its yield in line with the interest rate. Thus,
the lower the interest rate, the more money demanded (and vice versa).

> Porfo
o Màà m

Project management is the discipline of planning, organizing, securing and

managing resources to bring about the successful completion of specific
project goals and objectives. It is sometimes conflated with program
management, however technically a program is actually a higher level
construct: a group of related and somehow interdependent projects. A
project is a temporary endeavor, having a defined beginning and end
(usually constrained by date, but can be by funding or
deliverables,undertaken to meet unique goals and objectives,usually to
bring about beneficial change or added value. The temporary nature of
projects stands in contrast to business as usual (or operations), which are
repetitive, permanent or semi-permanent functional work to produce
products or services. In practice, the management of these two systems is
often found to be quite different, and as such requires the development of
distinct technical skills and the adoption of separate management.

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> R Màà m

Financial risk management is the practice of creating economic value in a

firm by using financial instruments to manage exposure to risk, particularly
credit risk and market risk. Other types include Foreign exchange, Shape,
Volatility, Sector, Liquidity, Inflation risks, etc. Similar to general risk
management, financial risk management requires identifying its sources,
measuring it, and plans to address them. Financial risk management can
be 
à
à à 
àà. As a specialization of risk management,
financial risk management focuses on when and how to hedge using
financial instruments to manage costly exposures to risk.

The strategies to manage risk include transferring the risk to another party,
avoiding the risk, reducing the negative effect of the risk, and accepting
some or all of the consequences of a particular risk.

Certain aspects of many of the risk management standards have come

under criticism for having no measurable improvement on risk even though
the confidence in estimates and decisions increase.

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Risk Management is the identification, assessment, and prioritization of

risks followed by coordinated and economical application of resources to
minimize, monitor, and control the probability and/or impact of unfortunate
events.. Riskscan come from uncertainty in financial markets, project
failures, legal liabilities, credit risk, accidents, natural causes and disasters
as well as deliberate attacks from an adversary. Several risk management
standards have been developed including the Project Management
Institute, the National Institute of Science and Technology, actuarial
societies, and ISO standards. Methods, definitions and goals vary widely
according to whether the risk management method is in the context of
project management, security, engineering, industrial processes, financial
portfolios, actuarial assessments, or public health and safety.

For the most part, these methodologies consist of the following elements,
performed, more or less, in the following order.

1. identify, characterize, and assess threats

2. assess the vulnerability of critical assets to specific threats

3. determine the risk

4. identify ways to reduce those risks

5. prioritize risk reduction measures based on a strategy

The strategies to manage risk include transferring the risk to another party,
avoiding the risk, reducing the negative effect of the risk, and accepting
some or all of the consequences of a particular risk.

In ideal risk management, a prioritization process is followed whereby the

risks with the greatest loss and the greatest probability of occurring are
handled first, and risks with lower probability of occurrence and lower loss
are handled in descending order. In practice the process can be very
difficult, and balancing between risks with a high probability of occurrence
but lower loss versus a risk with high loss but lower probability of
occurrence can often be mishandled.

Intangible risk management identifies a new type of a risk that has a

100%probability of occurring but is ignored by the organization due to a
lack of identification ability. For example, when deficient knowledge is

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applied to a situation, a knowledge risk materialises. Relationship risk

appears when ineffective collaboration occurs. Process-engagement risk
may be an issue when ineffective operational procedures are applied.
These risks directly reduce the productivity of knowledge workers,
decrease cost effectiveness, profitability, service, quality, reputation, brand
value, and earnings quality. Intangible risk management allows risk
management to create immediate value from the identification and
reduction of risks that reduce productivity. Risk management also faces
difficulties allocating resources. This is the idea of opportunity cost.
Resources spent on risk management could have been spent on more
profitable activities. Again, ideal risk management minimizes spending
while maximizing the reduction of the negative effects of risks.

PRINCIPLES OF RISK MANAGEMENT

The International Organization for Standardization identifies the following

principles of risk management:

y Risk management should create value.

y Risk management should be an integral part of organizational
processes.
y Risk management should be part of decision making.
y Risk management should explicitly address uncertainty.
y Risk management should be systematic and structured.
y Risk management should be based on the best available information.
y Risk management should be tailored.
y Risk management should take into account human factors.
y Risk management should be transparent and inclusive.
y Risk management should be dynamic, iterative and responsive to
change.
y Risk management should be capable of continual improvement and
enhancement.

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Rmàà m à à à
 o

àà màà m

Planning how risk will be managed in the particular project. Plan should
include risk management tasks, responsibilities, activities and budget.
Assigning a risk officer - a team member other than a project manager who
is responsible for foreseeing potential project problems. Typical
characteristic of risk officer is a healthy skepticism. Maintaining live project
risk database. Each risk should have the following attributes: opening date,
title, short description, probability and importance. Optionally a risk may
have an assigned person responsible for its resolution and a date by which
the risk must be resolved. Creating anonymous risk reporting channel.
Each team member should have possibility to report risk that he foresees in
the project. Preparing mitigation plans for risks that are chosen to be
mitigated. The purpose of the mitigation plan is to describe how this
particular risk will be handled ± what, when, by who and how will it be done
to avoid it or minimize consequences if it becomes a liability. Summarizing
planned and faced risks, effectiveness of mitigation activities, and effort
spent for the risk management.

D

 



Quantitative decision making methods can be used when:

1. There is a clearly stated objective.

2. There are several alternative courses of action.
3. There is a calculable measure of the benefit or worth of the various
alternatives.

Uncertainties for which allowance must be made or probabilities calculated

may include

1. Events beyond the control of the decision maker.

2. Uncertainty concerning which outcome (or external events) will
actually happen.

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ADVANTAGES OF COMPUTATIONAL FINANCE

The journal encourages the confident use of applied mathematics and

mathematical modelling in finance. The journal publishes papers on the
following:

> modelling of financial and economic primitives (interest rates, asset

prices etc);
> modelling market behaviour;
> modelling market imperfections;
> pricing of financial derivative securities;
> hedging strategies;
> numerical methods;
> Stating the research problem in very specific and set terms
> Clearly and precisely specifying both the independent and the
dependent variables under investigation;
> Following firmly the original set of research goals, arriving at more
objective conclusions, testing hypothesis, determining the issues of
causality;
> Achieving high levels of reliability of gathered data due to controlled
observations, laboratory experiments, mass surveys, or other form of
research manipulations
> Eliminating or minimizing subjectivity of judgment
> Allowing for longitudinal measures of subsequent performance of
research subjects.
> Obtaining a more realistic feel of the world that cannot be experienced in
the numerical data and statistical analysis used in quantitative research;
> Flexible ways to perform data collection, subsequent analysis, and
interpretation of collected information;
Provide a holistic view of the phenomena under investigation
> Ability to interact with the research subjects in their own language and
on their own terms
> Descriptive capability based on primary and unstructured data

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DISADVANTAGES OF COMPUTATIONAL FINANCE

The weaknesses of the Computational finance include:

> Failure to provide the researcher with information on the context of the
situation where the studied phenomenon occurs;
> Inability to control the environment where the respondents provide the
answers to the questions in the survey;
> Limited outcomes to only those outlined in the original research proposal
due to closed type questions and the structured format;
> Not encouraging the evolving and continuous investigation of a research
phenomenon.
> Departing from the original objectives of the research in response to the
changing nature of the context (Cassell & Symon, 1994);
> Arriving to different conclusions based on the same information
depending on the personal characteristics of the researcher;
> Inability to investigate causality between different research phenomena;
> Difficulty in explaining the difference in the quality and quantity of
information obtained from different respondents and arriving at different,
non-consistent conclusions;
> Requiring a high level of experience from the researcher to obtain the
targeted information from the respondent;
> Lacking consistency and reliability because the researcher can employ
different probing techniques and the respondent can choose to tell some
particular stories and ignore others.

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SCOPE OF UANTITATIVE TEC^NI UE

The scope and areas of application of scientific management are very wide
in engineering and management studies. Today, there are a number at
quantitative software packages available to solve the problems using
computers. This helps the analysts and researchers
to take accurate and timely decisions.
A few specific areas are mentioned below:

Fà à Ao
 : Cash flow analysis, Capital budgeting, Dividend
and Portfolio management, Financial planning.

Màr Màà m: Selection of product mix, Sales resources

allocation and Assignments.

Pro
o Màà m: Facilities planning, Manufacturing, Aggregate
planning, Inventory control, Quality control, Work scheduling, Job
sequencing, Maintenance and Project planning and scheduling.

Pro
Màà m: Manpower planning, Resource allocation,

Staffing, Scheduling of training programmes.

Grà
Màà m: Decision Support System and Management of

Information Systems, MIS, Organizational design and control, Software
Process Management and Knowledge Management.

From the various definitions of Quantitative Technique it is clear that

scientific management has wide scope. In general, whenever there is any
problem simple or complicated the scientific management technique can be
applied to find the best solutions.

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Arà of à
ào of Com

àoà
Fà

Areas where computational finance techniques are employed include:

> Investment banking

> Forecasting
> Risk Management software
> Corporate strategic planning
> Securities trading and financial risk management
> Derivatives trading and risk management
> Investment management
> Pension scheme
> Insurance policy
> Mortgage agreement
> Lottery design
> Currency peg
> Gold and commodity valuation
> Credit default swap
> Bargaining
> Market mechanism design

UANTITATIVE AND COMPUTATIONAL FINANCE

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šQuantitative Finance¶ as a branch of modern finance is one of the fastest

growing areas within the corporate world. Together with the sophistication
and complexity of modern financial products, this exciting discipline
continues to act as the motivating factor for new mathematical models and
the subsequent development of associated computational schemes.
Alternative names for this subject area are Màmàà
Fà or
Fàà
Màmà. This is a course in the applied aspects of
mathematical finance, in particular derivative pricing.

MAT^EMATICAL AND STATISTICAL APPROAC^ES

According to Fund of Funds analyst Fred Gehm, "There are two types of
quantitative analysis and, therefore, two types of quants. One type works
primarily with mathematical models and the other primarily with statistical
models. While there is no logical reason why one person can't do both
kinds of work, this doesn¶t seem to happen, perhaps because these types
demand different skill sets and, much more important, different
psychologies." A typical problem for a numerically oriented quantitative
analyst would be to develop a model for pricing and managing a complex
derivative product. A typical problem for statistically oriented quantitative
analyst would be to develop a model for deciding which stocks are
relatively expensive and which stocks are relatively cheap. The model
might include a company's book value to price ratio, its trailing earnings to
price ratio and other accounting factors. An investment manager might
implement this analysis by buying the underpriced stocks, selling the
overpriced stocks or both. One of the principal mathematical tools of
quantitative finance is oà à



.

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CLASSIFICATION OF MET^OD

Computational finance relies on mathematical finance, numerical methods,

computational intelligence and computer simulations to make trading,
hedging and investment decisions, as well as facilitating the risk
management of those decisions. Utilizing various methods, practitioners of
computational finance aim to precisely determine the financial risk that
certain financial instruments create.

Màmàà
fà

Mathematical finance comprises the branches of applied mathematics

concerned

with the financial markets. The subject has a close relationship with the
discipline of financial economics, which is concerned with much of the
underlying theory. Generally, mathematical finance will derive, and extend,
the mathematical or numerical models suggested by financial economics.
Thus, for example, while a financial economist might study the structural
reasons why a company may have a certain share price, a financial
mathematician may take the share price as a given, and attempt to use
stochastic calculus to obtain the fair value of derivatives of the stock .

In terms of practice, mathematical finance also overlaps heavily with the

field of computational finance Arguably, these arelargely synonymous,
although the latter focuses on application, while the former focuses on
modeling and derivation

The fundamental theorem of arbitrage-free pricing is one of the key

theorems in mathematical finance.

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A
 Màmà

Applied mathematics is a branch of mathematics that concerns itself with

the mathematical techniques typically used in the application of
mathematical knowledge to other domains. Divisions of applied
mathematics There is no consensus of what the various branches of
applied mathematics are.

Such categorizations are made difficult by the way màmà and

 change over time, and also by the way universities organize
departments, courses, and degrees. Historically, applied mathematics
consisted principally of applied analysis, most notably differential
equations, approximation theory (broadly construed, to include
representations, asymptotic methods, variational methods, and numerical
analysis), and applied probability. These areas of mathematics were
intimately tied to the development of Newtonian Physics, and in fact the
distinction between mathematicians and physicists was not sharply drawn
before the mid-19th century. This history left a legacy as well; until the early
20th century subjects such as classical mechanics were often taught in
applied mathematics departments at American universities rather than in
physics departments, and fluid mechanics may still be taught in applied
mathematics departments. Today, the term applied mathematics is used in
a broader sense. It includes the classical areas above, as well as other
areas that have become increasingly important in applications. Even fields
such as number theory that are part of pure mathematics are now
important in applications (such as cryptology), though they are not
generally considered to be part of the field of applied mathematics per se.
Sometimes the term applicable mathematics is used to distinguish between
the traditional field of applied mathematics and the many more areas of
mathematics that are applicable to real-world problems. Mathematicians
distinguish between applied mathematics, which is concerned with
mathematical methods, and the applications of mathematics within science
and engineering. A biologist using a population model and applying known
mathematics would not be doing applied mathematics, but rather using it.
However, nonmathematicians do not usually draw this distinction. The use
of mathematics to solve industrial problems is called industrial
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mathematics. Industrial mathematics is sometimes split in two branches:

techno-mathematics (covering problems coming from technology) and
econo-mathematics (for problems in economy and finance). The success of
modern numerical mathematical methods and software has led to the
emergence of computational mathematics, computational science, and
computational engineering, which use high performance computing for the
simulation of phenomena and solution of problems in the sciences and
engineering. These are often considered interdisciplinary programs.

U
 of à
 màmà

Historically, mathematics was most important in the natural sciences and

engineering. However, after World War II, fields outside of the physical
sciences have spawned the creation of new areas of mathematics, such as
game theory, which grew out of economic considerations, or neural
networks, which arose out of the study of the brain in neuroscience, or
bioinformatics, from the importance of analyzing large data sets in biology.

The advent of the computer has created new applications, both in studying
and using the new computer technology itself (computer science, which
uses combinatorics, formal logic, and lattice theory), as well as using
computers to study problems arising in other areas of science
(computational science), and of course studying the mathematics of
computation (numerical analysis). Statistics is probably the most
widespread application of mathematics in the social sciences, but other
areas of mathematics are proving increasingly useful in these disciplines,
especially in economics and management science.

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ADVANTAGES OF A UANTITATIVE APPROAC^

Over the last three decades the exponential growth in computing power,
the development of sophisticated analytical tools, and significant
improvements in the accuracy and size of research databases have led to
tremendous advances in the fields of finance, econometrics, and statistics.
As a result, computational finance strategies have become increasingly
more powerful and effective for all asset classes.

As computational finance strategies can provide meaningful return, risk,

and cost advantages over traditional subjective strategies when properly
designed and implemented, they have steadily gained in popularity in
recent years. This trend is expected to continue as investors more fully
recognize the disciplined manner in which quantitative strategies can
increase the probability of long-term success.

RETURNS ADVANTAGES

y Com
àoà
fà rà  à b m o
rm   fà of r  :

The primary objective of active portfolio management is to generate

alpha (excess risk-adjusted returns) over what is available at
negligible cost with a passive alternative. Given that the capital
markets are fairly efficient and that the additional costs associated
with active management can be high, generating alpha in a
consistent manner is not an easy task. It is therefore critical that
managers have a well-defined, statistically significant, and
sustainable edge if they are expected to outperform.

Unfortunately, due to the reliance of traditional strategies on

subjective forecasts and qualitative judgments that are difficult to
quantify, few managers can provide the data necessary to determine
with a high degree of confidence the source or significance of their
edge. Without this information, it is difficult to ascertain whether their
investment performance is the result of skill or simply luck.

Computational finance strategies have an advantage in this regard

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as, due to their mechanical nature, they can be empirically tested

over long periods of time and through several types of market
environments to better understand their behavior. Accordingly, any
edge can be statistically evaluated as to its significance, and
allocation decisions can be made with greater confidence. In addition
to Midwest¶s internal research (1952 to 2005), there are several
independent long-term studies (1937 to 1962; 1968 to 1990; 1951 to
20035) that clearly demonstrate the meaningful edge that can be
achieved with a properly designed and implemented computational
finance strategy.

y Com
àoà
fà rà  à 
mà bàorà

bà from  m ro:

Due to their subjective nature, many traditional strategies suffer from

various behavioral and emotional biases which can hinder
consistently superior results. Greed and fear are powerful forces, and
research in behavioral finance provides compelling evidence that
investors often act irrationally, and repeatedly make sub-optimal
decisions when confronted with uncertainty.7

By eliminating behavioral biases from the investment process, a

sound quantitative strategy enables investors to make decisions that
are emotionally difficult, but have the highest probability of generating
superior results over the long-term. Accordingly, temporary price
fluctuations and random market "noise" do not cause sub-optimal
short-term deviations from a viable long-term plan. This discipline
allows quantitative strategies to exploit behavioral inefficiencies,
rather than contribute to them.
y Com
àoà
fà rà  à à

à à
àr 
o or
 

Because investment decisions are driven by objective computer

models, a vast number of securities can be monitored and evaluated
on a real-time basis to efficiently identify and capitalize on the best
reward/risk opportunities. This is in stark contrast to traditional
strategies which are significantly constrained by the tremendous
amount of time and resources required to subjectively evaluate each
security on a case-by-case basis. The number of securities that can

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be effectively monitored in this manner is limited, and consequently

many attractive opportunities are missed with regularity. This
opportunity loss often outweighs the benefits of additional security-
specific insights generated through such a case-by-case process.

RISK ADVANTAGES

y
àà rà  à f r
à

 à

o
r of r 
à orfo
o:

Effective risk management is crucial to long-term investment success.

Not only is it important to understand the sources of risk in a portfolio,
but also the manner in which they are compensated. Whereas
investors should expect to be rewarded for exposure to systematic
market, sector, and style risks, security-specific and other non-
systematic risks often go uncompensated since they can be
eliminated through diversification.

Comprehensive empirical research into the nature of these risks is

the foundation of sound quantitative strategies. Statistical analysis
can be used to separate risks that are well-rewarded from those that
are not, and exposure can be managed accordingly. With traditional
strategies the underlying risks are often unclear, and portfolios can be
inadvertently exposed to many which are either unnecessary or lack
adequate compensation.
y Com
àoà
fà rà  à r
 o ràoà
r:

Investors are also subject to manager-specific operational risks that

can lead to sub-par performance. These risks are notably less severe
with quantitative strategies:
Ê S
 rf: Because quantitative strategies are well-defined,
consistent, and disciplined, they should not be subject to style
drift.

Ê Màà m 
ror: The departure of key managers at
quantitative firms has little impact as the investment strategies
are mechanical and not dependent on the subjective abilities of
any single individual.

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Ê Eà
à
 à
r: A quantitative portfolio can be

constructed to address most investor concerns (social,
environmental, etc.). Once established only minor adjustments
should be necessary and legal issues (insider trading, front-
running, etc.) should be virtually non-existent.
Ê Tràào à or rror: A quantitative structure can
reduce these events and, equally important, make them more
transparent to fiduciaries.
y Com
àoà
fà rà  à r
  r of b
foo
 b ràom:

As previously mentioned, it is difficult for investors to differentiate skill

from luck when evaluating active managers. Even a superior track
record is insufficient evidence of investment ability, as research has
shown that past performance is generally an unreliable indicator of
future success. Therefore, additional information is necessary to
make a reasonable determination. Because quantitative strategies
can be tested over long-periods of time and risks can be thoroughly
researched, investors have more data on which to base their
decisions. This enables them to differentiate skill from luck with
greater confidence, reduces their risk of being fooled by randomness,
and helps to protect those with a fiduciary responsibility.

y Com
àoà
fà rà  à 
or o màà
of:

The increased informational content of quantitative strategies helps

investors to maintain confidence during inevitable periods of
underperformance. Without this confidence, investors often abandon
a strategy due to increased uncertainty regarding the manager¶s skill.
Research indicates that this is not an optimal response, as the
managers fired by institutional investors tend to subsequently
outperform those that are hired. The discipline to maintain confidence
and objectivity in the face of short-term underperformance is an
important characteristic of successful long-term investors, and
quantitative strategies enable that ability.

Computational Finance Page 35


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y Com
àoà
fà rà  à f
rr rf à m


màà r orfo
o:

Because quantitative strategies identify opportunities in a unique

manner, they are an excellent complement to traditional strategies
already employed in a multi-manager portfolio. Their low correlation
can help to decrease aggregate risk and improve return consistency.

COST ADVANTAGES

Com
àoà
fà rà  à b  
 off:

Although often downplayed (especially during periods of superior

performance), expenses have a dramatic impact on long-term
portfolio growth when compounded over time. If excessive, they can
quickly consume the excess returns generated by a skilled manager.

Because alpha is difficult to consistently generate in a fairly efficient

market, any manager that can minimize expenses has a notable
advantage. Moreover, research indicates that not only do low-cost
managers outperform on average, but they do so by a greater
amount than their cost savings.

As computational finance strategies are driven by objective computer

models, portfolios can be managed more efficiently and at lower cost
than most traditional strategies. By eliminating the need for expensive
and time-consuming qualitative research into each security in the
portfolio, quantitative strategies can often save more in expenses
than traditional strategies can generate through their deeper
understanding of unique security-specific characteristics.

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CONCLUSION

This topic lays the mathematical foundations for careers in a number of

areas in the financial world. In particular, this suitable for novice
quantitative analysts and developers who are working in quantitative
finance. This topic is also suitable for IT personnel who wish to develop
their mathematical skills. Computational finance or financial engineering is
a cross-disciplinary field which relies on mathematical finance, numerical
methods, computational intelligence and computer simulations to make
trading, hedging and investment decisions, as well as facilitating the risk
management of those decisions. Utilizing various methods, practitioners of
computational finance aim to precisely determine the financial risk that
certain financial instruments create.

àà màà m

In quantitative management we discuss a number of concepts and

methods that are concerned with variables, functions and transformations
defined on finite or infinite discrete sets. In particular, linear algebra will be
important because of its role in numerical analysis in general and
quantitative finance in particular. We also introduce probability theory and
statistics as well as a number of sections on numerical analysis. The latter
group is of particular importance when we approximate differential
equations using the finite difference method.

N
mrà
Mo

The goal of this part of the topic is to develop robust, efficient and accurate
numerical schemes that allow us to produce algorithms in applications.
These methods lie at the heart of computational finance and a good
understanding of how to use them is vital if you wish to create applications.
In general, the methods approximate equations and models defined in a
continuous, infinite-dimensional space by models that are defined on a
finite-dimensional space.

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BIBLIOGRAP^Y

y en.wikipedia.org/wiki/Computational_finance

y en.wikipedia.org/wiki/Quantitative_behavioral_finance

y http://www.scribd.com/doc/38412567/Computational-Finance-Tutorial

y http://www.scribd.com/doc/18751081/COMPUTATIONAL-FINANCE

y http://www.pdfebook.net/ebook___SCRIBD--PROJECT-

FINANCE_2.html

y www.acm.caltech.edu

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