Short Notes on Financial Engineering and Risk

Management
Chapter 1: Introduction to Financial Engineering and Risk
Management
 Overview: Define financial engineering as the application of
mathematical and finance principles to create financial products and
manage risk.
 Key Topics:
o Role of Financial Instruments: Explain derivatives (futures,
options) and structured products (like mortgage-backed
securities).
o Risk Management: Outline types of risk (market, credit,
liquidity) and introduce hedging and diversification.
 Programming Languages: Introduce popular programming
languages in finance, with a focus on Python and its financial libraries.
 Objective: To build foundational knowledge on how financial
engineering shapes modern finance and risk management practices.
Chapter 2: Introduction to Stochastic Calculus and Martingales
 Overview: Introduce stochastic calculus as a tool for modeling random
financial processes, critical for understanding asset pricing and risk.
 Key Topics:
o Mathematical Functions: Review functions like positive part
and stop-loss, essential for derivative pricing.
o Probability Distributions: Discuss binomial, Poisson, normal,
and log-normal distributions.
o Stochastic Processes: Introduce concepts like Brownian motion
and Geometric Brownian motion.
 Objective: Equip students with mathematical tools for understanding
the randomness in financial markets.
Chapter 3: The Fundamental Theorem of Asset Pricing
 Overview: Explain the fundamental theorem, which asserts that in an
arbitrage-free market, assets can be valued consistently.
 Key Topics:
 o No-Arbitrage Principle: Define arbitrage and demonstrate why
it's central to financial markets.
o Binomial Trees and Risk-Neutral Valuation: Use binomial
models to simulate asset price movements.
o American Options: Explain how American options differ in
exercise flexibility.
 Objective: Establish an understanding of pricing financial assets
without arbitrage.
Chapter 4: Wiener Processes and Itô’s Lemma
 Overview: Delve deeper into continuous-time stochastic processes,
specifically Wiener processes and their application in finance.
 Key Topics:
o Markov Property: Introduce the concept and how it relates to
memoryless financial processes.
o Itô’s Lemma: Derive Itô’s Lemma and apply it to model stock
prices.
 Objective: Understand continuous-time modeling for stocks and
derivatives using stochastic calculus.
Chapter 5: The Black-Scholes-Merton Model
 Overview: Study the Black-Scholes model, foundational for option
pricing in finance.
 Key Topics:
o Lognormal Distribution of Stock Prices: Discuss why stock
prices are assumed lognormal.
o Black-Scholes Differential Equation: Derive the equation and
discuss assumptions.
o Pricing Formulas and Implied Volatility: Introduce the
formula for European options and implied volatility.
 Objective: Equip students with knowledge of the Black-Scholes model
and its applications in option pricing.
Chapter 6: The Greek Letters
 Overview: Learn about "Greeks"—sensitivity measures for option
pricing.
  Key Topics:
o Delta, Gamma, Theta, Vega, and Rho: Define each Greek and
its significance.
o Dynamic Delta Hedging: Explain hedging an option’s risk using
Delta.
 Objective: Understand how Greeks help manage risks in an options
portfolio.
Chapter 7: Basic Numerical Procedures
 Overview: Introduce computational methods essential for pricing
complex derivatives.
 Key Topics:
o Binomial Trees: Recap and expand on earlier discussion for
more complex applications.
o Monte Carlo Simulation: Simulate asset prices for pricing
derivatives.
o Finite Difference Methods: Numerical solution techniques for
differential equations.
 Objective: Develop students' computational skills to implement
pricing models.
Chapter 8: Modeling Volatility
 Overview: Explore advanced models for capturing volatility in
financial markets.
 Key Topics:
o Local and Stochastic Volatility Models: Differentiate between
constant and stochastic volatility models.
o Heston and SABR Models: Introduce popular stochastic
volatility models used in option pricing.
 Objective: Equip students with tools to model and predict market
volatility.
Chapter 9: Introduction to Fixed Income Derivatives
 Overview: Study the valuation and risk of fixed income derivatives like
bonds and swaps.
  Key Topics:
o Yield and Term Structure: Explain yield-to-maturity and the
term structure of interest rates.
o Interest Rate Swaps and Futures: Discuss the mechanics and
valuation.
 Objective: Provide a foundation in fixed income markets and
instruments.
Chapter 10: Interest Rate Derivatives
 Overview: Focus on complex products based on interest rates, such as
options on bonds.
 Key Topics:
o Interest Rate Models: Introduce models like the Binomial
approach for pricing.
o Pricing Applications: Practical methods for pricing interest rate
derivatives.
 Objective: Deepen students' understanding of products sensitive to
interest rate changes.

This outline can serve as a guide for lecture preparation, with each chapter
focusing on both theoretical foundations and practical applications, ensuring
students gain a comprehensive understanding of financial engineering and
risk management.