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# MS&E 345 Advanced Topics in Financial Engineering

## Jim Primbs Stanford University Winter, 2010

Primbs, MS&E345

Course Facts
Room and Time: 380-380W, MW 9:00-10:15. Office hours: 444 Terman, after class Web page: http://www.stanford.edu/~japrimbs/msande345.htm Grading: Homework 30%, Project/Paper 40%, Quizzes/Midterm 30%. Prerequisites: 242, 342, 220, 221. Strong math background. (probability, odes, pdes, measure theory, functional analysis, etc. Matlab.) Course text and lecture slides posted on the web page.

Primbs, MS&E345

## What is financial engineering?

Financial Engineering: Combining or carving up existing instruments to create new financial products. (Campbell R. Harveys Hypertextual Financial
Glossary, http://www.duke.edu/~charvey/Classes/wpg/glossary.htm)

Another Definition: (from Neil D. Pearson, Assoc. Prof. UIUC) Definition 1: Financial engineering is the application of mathematical tools commonly used in physics and engineering to financial problems, especially the pricing and hedging of derivative instruments. Definition 2: Financial engineering is 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, MS&E345

Pricing Theory

## Derivatives. Pricing of risk.

Risk Management Hedging and Value at Risk.

Primbs, MS&E345

Optimization
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Pricing Theory:

## Return form (pdes)

Topics: -Absence of arbitrage -Market price of risk -Derivation of pdes for derivatives

Primbs, MS&E345

Pricing Theory:

Topics: -Linear pricing -Martingale measures -Forward measures and change of numeraire -Girsanovs Theorem -Backward equations (Markov Theory)

## Linear function form (risk neutral)

Primbs, MS&E345

Pricing Theory:

Topics: -Utility Maximization -Dynamic programming -Stochastic Lagrange Multipliers -Portfolio Optimization

Optimization
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Risk Management:

Hedging
-Greeks -Taylor expansions -Local risk reduction

Value at Risk
-Portfolios with derivatives -Computational techniques

Primbs, MS&E345

## We will cover a lot of topics at a fairly high level:

Hopefully, the course will provide you with: -The big picture of derivative pricing and hedging.
-The principles underlying pricing theory, regardless of the specific area (eg equity, interest rate, credit, etc). -The ability to use underlying principles to attack any new problem.

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