Mathematics and Applied Mathematics

Mathematical Sciences

Study Guide

WTW 364
Financial Engineering

2023
Semester 2
 DEPARTMENT OF MATHEMATICS AND APPLIED MATHEMATICS

Vision

The Department of Mathematics and Applied Mathematics strives to be internationally

recognised for academic excellence through the depth of its research and teaching, and to
be locally relevant through its role in the development of the community it serves.

Mission

The Department is an academic unit of the University of Pretoria, entrusted with the
development of mathematical skills, knowledge and insights. Its mission is to
 be actively, visibly and notably involved in research at the forefront of the
mathematical fields in which it has strength and expertise
 offer postgraduate training, up to doctoral and postdoctoral level, in its chosen fields
of research expertise
 at undergraduate and honours level, engage in mathematical training in support of its
own and other academic programmes of the University

Through its activities, the Department intends to

 contribute to the deep understanding of complex mathematical structures and their
applications
 deliver graduates with considerable mathematical skills and the desire to be involved
in problem solving
 intellectually and materially enhance the community and South African society by its
relevant research outputs and involvement in projects that depend on its
mathematical expertise
 WTW 364
FINANCIAL ENGINEERING
STUDY GUIDE 2023 (Semester 2)

Contents
1 ORGANISATIONAL COMPONENT 1
1.1 CLASS ATTENDANCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 DEPARTMENTAL INFORMATION . . . . . . . . . . . . . . . . . . . . . 1
1.2.1 Admittance to the module . . . . . . . . . . . . . . . . . . . . . . . 1
1.2.2 Test and exam arrangements . . . . . . . . . . . . . . . . . . . . . . 1
1.2.3 Disciplinary cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.3 ORGANISATION OF THE MODULE . . . . . . . . . . . . . . . . . . . . 2
1.3.1 Lecturer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.3.2 Consultation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.3.3 Assessment guidelines . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.3.4 Examination admission . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.3.5 Exemption procedures . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.3.6 Supplementary examination . . . . . . . . . . . . . . . . . . . . . . 3
1.3.7 Classes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.3.8 Tutorial classes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.3.9 Textbooks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.3.10 Calculators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.3.11 Learning hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

2 MODULE CONTENTS 5
1 ORGANISATIONAL COMPONENT
1.1 CLASS ATTENDANCE
Class attendance (mostly in person, occasionaly online) for this module is compulsory.
The study guide is nothing else but a GUIDE. Important issues such as specific learning
outcomes will only be communicated in class. All the exercises and problems that have
to be mastered for the tutorial and practical sessions will be given during the lectures.
Students should take note of the following: The order of the lectures will not necessarily
be in the same order as set out in the Module Contents section of this guide. It is the
student’s responsibility to make sure that she/he knows exactly what material has been
covered in class.

1.2 DEPARTMENTAL INFORMATION

1.2.1 Admittance to the module
For admittance to the module, you must satisfy required prerequisites, which are WST
211, WTW 124, WTW 218 and WTW 286 / WTW 264.

1.2.2 Test and exam arrangements

The exam/test instructions on the UP webpage must be followed meticulously.

Material for tests: Material for tests will be announced in class and will be published
on clickUP.
Unless otherwise indicated, class or clickUP tests will include the material covered
up to the Friday directly preceding the test.

Absence from tests: The lecturer must be notified of absence from any test due to
illness within three days of the date of the test.
Valid original sick notes are accepted if issued by a medical doctor registered at the
Health Professions Council of South Africa (HPCSA). The only other type of sick
note that is accepted are those issued by an Advanced Practice Nurse (a registered
nurse with a postgraduate qualification) as determined by the South African Nursing
Council who has a BHCF practice number, provided that the diagnosis falls only
within their specific field of specialisation. An affidavit will only be accepted if
supported by substantiating documentation, e.g. case report or criminal charge with
case number obtained from a police station, valid medical certificate for injuries, a
death certificate for a funeral, etc. Please note that submission of fraudulent sick
notes and affidavits is a criminal offense, which will lead to disciplinary action and
may result in dismissal.
In such cases of satisfactory proof for one semester test, an additional test has to be
written at a time to be announced. No other extraordinary tests will be granted.

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 In particular, a sick test will only be granted for a student who was sick in one
semester test, not both.
In the case of exams the relevant faculty administration should be informed of
absence, with documentation as described above.

Enquiries concerning tests: All queries concerning the grading of a specific test must
be finalised within 3 (three) days after receipt of the graded test. After three days
it is assumed that all marks are final and correct and no further discussion will be
entered into.

1.2.3 Disciplinary cases

The policy of the Department of Mathematics and Applied Mathematics is without excep-
tion to refer all cases where a suspicion of irregularity exists to the disciplinary committee
of the university.

1.3 ORGANISATION OF THE MODULE

1.3.1 Lecturer
Lecturer Office Tel Office Email
Dr AJ van Zyl Mathematics 2-26 012 420 2784 [email protected]
The Module Coordinator is Dr van Zyl.

1.3.2 Consultation
The lecturer’s office consultation times will be displayed on clickUP.

1.3.3 Assessment guidelines

Assessment will be on campus, unless announced otherwise.
Semester tests:
Two semester tests with a weight of 35% each.
Tutorial tests and assignments:
Tutorial tests will be written regularly during the semester on campus. ClickUP tests
or assignments may also be given. All marks from tutorial tests or assignments will count
towards the semester mark. The weights of individual tests may vary, but jointly they
will contribute 30% of the semester mark. This may include a practical Excel-based test
in the computer labs.
Final mark:
Semester Mark 50%
Exam mark 50%.

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1.3.4 Examination admission
In order to be admitted to the exam, you must obtain a semester mark of at least 40%.

1.3.5 Exemption procedures

This course, together with WTW 354 (if taken in the same year), provides the opportunity
for exemption recommendation for Actuarial Society of South Africa (ASSA) subject A205
(or equivalent Institute and Faculty of Actuaries (IFA) subject CM2) if the required
external examiner requirements based on the performance of the examination papers of
WTW 354 and WTW 364 are achieved, for students completing the BSc Actuarial and
Financial Mathematics programme. Students who have obtained a combined exam mark
satisfying the exemption requirements and wish to obtain exemption but are not enrolled
for BSc Actuarial and Financial Mathematics, may contact the Department of Actuarial
Science after they have determined that their combined exam performance exceeds the
exemption level.
Students are encouraged to work hard during the semester in WTW 364 as the practical
component in WTW 364 will assist you to develop the required knowledge and insight.
We have found in the past that candidates who have not obtained a semester mark
of 60% stand less of a chance to qualify for exemption recommendation. The external
examiner’s exemption recommendation is based on the examination performance in WTW
354 and WTW 364 in the same calendar year. No supplementary, sick or any other special
examination marks may be used for exemption purposes.

1.3.6 Supplementary examination

1) Subject to other Faculty regulations a student may be admitted to a supplementary
examination, in cases where

a) a final mark of between 40% and 49% has been obtained and either the exam-
ination or semester mark is at least 50%; or
b) a pass mark has been obtained, but the required sub-minimum in the exami-
nation has not been obtained.

2) Subject to other Faculty regulations, a student must obtain a final mark of at least
50% in order to pass an supplementary examination. The semester or year mark is
not taken into account and the supplementary mark is the final mark.

3) The highest final mark that may be awarded to a student in the supplementary
examination is 50%.

1.3.7 Classes
Unless announced otherwise, classes will be conducted in person. The venue for the
lectures is the Muller hall, unless announced otherwise.

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 Monday 12:30 – 13:20
Thursday 12:30 – 13:20

1.3.8 Tutorial classes

Tutorials will be conducted on campus, unless announced otherwise. Arrangements will
be announced on clickUP. Allocation of students to either the Wed. or Fri. tutorial session
will be done during the first lecture week.
You are expected to

• prepare the theoretical part thoroughly before the tutorial class

• do all the exercises for the tutorial class beforehand and use the tutorial class to
sort out any problems.

1.3.9 Textbooks
Lecture notes will be provided on all topics. There is no prescribed textbook.

Recommended for further reading: J Stampfli, V Goodman: The Mathematics of

Finance: Modeling and Hedging. Brooks/Cole, (2001).

Supplementary textbooks: • J C Hull: Options Futures and Other Derivatives.

(Any edition). Prentice Hall.
• T Björk: Arbitrage Theory in Continuous Time. (Any of the 2nd to 4th edi-
tions.) Oxford University Press - Especially the two chapters on Stochastic
Integrals and (Stochastic) Differential Equations.

1.3.10 Calculators
During the semester tests, class tests and the exam, only non-programmable pocket cal-
culators may be used.

1.3.11 Learning hours

A student must devote at least 10 hours of study time per week to this module. (The
weight of 18 credits translates to 180 hours by the student.) The scheduled contact time
is approximately 4 hours per week which means that a minimum of another 6 hours per
week of own study time should be devoted to the module.

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2 MODULE CONTENTS
Class notes will be given on all topics. All theorem or proposition references are to the
class notes. All page references are to the book of Goodman & Stampfli.
Important note: The student should be able to solve practical problems related to
all the topics below, using Excel as computational aid.

THEME 1: Arbitrage, replicating portfolios, the single step bi-

nomial model
Unit 1.1 Forwards
(pp 3-6) After completion of this unit the student should be able to

1. state the no-arbitrage principle and the law of one price, and explain how they relate
to each other;

2. understand the payoffs for both the holders of the long and the short positions of
the forward;

3. derive the arbitrage-free delivery price and the value of a forward contract;

4. solve related practical problems.

Unit 1.2 Options

(pp. 7-11) After completion of this unit the student should be able to

1. understand the payoffs of European options (contingent claims), including that of

the call and put;

2. derive the arbitrage-free bounds of European call and put options;

3. derive the put-call parity;

4. sketch the payoff graphs of combinations of options, and find combinations of options
that have a given payoff graph;

5. solve related practical problems.

Unit 1.3 Single-step binomial model

(pp. 29-38) After completion of this unit the student should be able to

1. derive the two conditions equivalent to no-arbitrage in the single-step binomial

model;

2. find the arbitrage-free prices of options and other contingent claims;

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 3. derive the replicating portfolio for contingent claims;
4. solve related practical problems.

THEME 2: Binomial trees

Unit 2.1 Vanilla options
After completion of this unit the student should be able to
1. extend the single-step binomial model to that of a tree;
2. use the technique of backward induction/ backward chaining to price European put
and call options (pp. 49-51), American put and call options (pp. 52-54);
3. demonstrate why it is not optimal to exercise an American call option early;
4. determine the dynamic hedging (replication) strategies for all contingent claims;
5. solve related practical problems.

Unit 2.2 Exotic options

After completion of this unit the student should be able to
1. calculate the price and determine hedging portfolios for some of the exotic and
path-dependent options (pp. 55-61);
2. solve related practical problems.

THEME 3: Brownian motion and stochastic calculus

Unit 3.1 The stochastic integral
After completion of this unit the student should be able to
1. state all the properties of Brownian motion;
2. explain mean square convergence and derive the convergence of sum of squares result
in Proposition 3.2.1;
3. define the stochastic integral as a certain mean square limit;
4. derive properties of the stochastic integral such as linearity (Proposition 3.3.1), its
first and second moments (Theorem 3.2.2);
5. calculate some simple stochastic integrals from first principles;
6. solve related practical problems.

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Unit 3.2 Stochastic calculus
After completion of this unit the student should be able to
1. explain what an Itô process is;
2. explain the significance of the second order term in the Itô formula, in comparison
with classical calculus;
3. use both the specific and general Itô formulas to find the stochastic differential forms
of functions of Itô processes;
4. solve certain stochastic differential equations using the methods of comparison to
the related ordinary differential equation, and coefficient matching;
5. solve related practical problems.

Unit 3.3 The Feynman-Kac method

After completion of this unit the student should be able to
1. explain what a (partial differentiel equation with a) terminal value problem is;
2. write down the stochastic differential equation associated to a terminal value prob-
lem;
3. use the Feynman-Kac method to find a stochastic representation of the solution of
a terminal value problem;
4. solve related practical problems.

THEME 4: Continuous-time models: the Black-Scholes theory

Unit 4.1 The Black-Scholes Partial Differential Equation (PDE)
After completion of this unit the student should be able to
1. understand the log-normal model that follows from the stochastic differential equa-
tion of the share price (p. 87);
2. explain the concept of a self-financing portfolio and write down its stochastic differ-
ential form;
3. derive the Black-Scholes PDE / terminal value problem for a European contingent
claim or option (pp. 109-113);
4. solve the Black-Scholes PDE for various options or claims (pp. 114-118);
5. derive the Black-Scholes PDE for dividend paying shares (Garman-Kohlhagen form);
6. solve related practical problems.

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Unit 4.2 Risk-neutral measures
After completion of this unit the student should be able to
1. explain how the risk-neutral measure arises from the solution of the Black-Scholes
PDE;
2. discuss the assumptions of the Black-Scholes model and their limitations;
3. use risk-neutral evaluation to price various European contingent claims (pp. 93-97);

Unit 4.3 Hedging and the Greeks (pp. 122-136)

After completion of this unit the student should be able to
1. explain the financial meaning of delta, gamma and the other “Greeks”;
2. derive the Greeks for call and put options;
3. find combinations of securities to make a portfolio neutral with respect to one or
more of the Greeks;
4. solve related practical problems.

THEME 5: The term structure of interest rates; bonds

Unit 5.1 Bonds
After completion of this unit the student should be able to
1. define continuously compounded rates, instantaneous and continuously compounded
forward rates, short rates, zero coupon bonds, the yield curve and the relationships
between these;
2. explain the dynamics of the money (bank) account process;
3. solve related practical problems.

Unit 5.2 Market price of risk

After completion of this unit the student should be able to
1. derive the result that the instantaneous growth rate of a “riskless” portfolio is
unique;
2. derive the result that two tradeable assets with common noise term have the same
market price of risk;
3. demonstrate the equivalence, for European claims, of unique market price of risk
and the Black-Scholes equation;
4. solve related practical problems.

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Unit 5.3 Term Structure
After completion of this unit the student should be able to

1. state common short rate models;

2. derive the term structure equation for bond prices for single-factor models;

3. use the affine term structure of certain short rate models to solve their term structure
equations;

4. solve related practical problems.

THEME 6: Credit Risk

Unit 6.1 Merton model (pp. 230-234)
After completion of this unit the student should be able to

1. explain the difference between structural and reduced-form models;

2. state the assumptions of the Merton model;

3. relate the position of the owners, or that of the bond holders, to a relevant call or
put option;

4. derive the price of defaultable bond using the Merton model as well as related
quantities such as the risk premium and probability of default;

5. solve related practical problems.

Unit 6.2 The Jarrow-Lando-Turnbull model (pp. 234-239)

After completion of this unit the student should be able to

1. explain the credit state(s), the default state, and the continuous-time Markov chain
that models movement between these for the two-state model;

2. explain how the transition rate matrix is related to the transition probability matrix
of the two-state model, and switch between these matrices;

3. derive the formula for the price of a defaultable bond in terms of the recovery rate
and risk-neutral probability of default;

4. show how these concepts are extended to the Jarrow-Lando-Turnbull model;

5. solve related practical problems.

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Computational methods and practical applications
As discussed in class and during the practical sessions. In particular the following with
MS Excel:

• Calibrating the (discrete) binomial model. We use the Cox-Ross-Rubenstein ap-

√ 1
proach for our binomial tree model (i.e. u = eσ ∆t , d = ).
u
• Use of market data to find implied volatilities.

• Use of implied volatilities together with the Black-Scholes formulae, binomial trees
and spreadsheets to price various derivative securities.

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