Minors in Quantitative Finance

(FinIQ Consulting)

Numerical Methods in Finance

Lecture 1
What is this course going to be:
Key Learning:

Unit Description

Introduction to Finance, Interest Rates, Type of Rates, measuring interest rates, Zero Rates, IRR, Bond Pricing, Determining
Unit 1 Treasury Zero Rates, Convexity, Theories of Term structure of interest rates, Cashflows, Net Present Value, Discount Factors,
Bonds, Dirty Price, Clean Price, Bond Duration, Modified Duration, Accrued Interest

Unit 2 Asset Classes, Types of Options, Vanilla Options, First generation exotics, Second generation exotics, Payoffs, Digital
Option, Option Strategies and Payoffs - Protected Put, Covered Call, Straddle, Strangle, Strip, Strap, Butterfly

Unit 3 Interpolation Methods (Linear, Cubic Spline, Polynomial), Historical Volatility, Implied Volatility, Historical Volatility, Yield
Curve, Probability Distribution

Unit 4 Binomial Tree-formula, Pricing, Generalization, Introduction to Geometric Brownian Motion, Monte Carlo
Simulation, Correlation, Ito's Lemma, Wiener Process, Discrete time model

Unit 5 Black Scholes Pricing, Foreign Exchange Pricing, Lognormal distribution, Risk Neutral Valuation, Black Scholes-Merton
Pricing formula, Option Greeks (Delta, Gamma, Vega), Concept of Greeks, First Degree Greeks, Second Degree Greeks
Mathematics + $$$ = Finance
Mathematics^2 + $$$ = Quantitative
Finance
Lets Play a Scenario
Debt
Shares (Equity)
Forex (Foreign Exchange Market)
Market (Financial Markets)
Time Value of
Money

Rs. Rs.
1000 1000

Now 1 Year Later

Time Value of Money

The time value of money (TVM) is the concept that a sum of money is worth
more now than the same sum will be at a future date* due to its earnings
potential in the interim.

The time value of money is a core principle of finance. A sum of money in the
hand has greater value than the same sum to be paid in the future. Present
Discounted Value represents the present value of all future cash flows derived
using Time value of Money principles

* Few exceptions e.g. negative interest rates

Time Value of Money- Factors at play
1. Opportunity cost: Money you have today can be invested and accrue interest, increasing its value.
2. Inflation: Your money may buy less in the future than it does today.
3. Uncertainty: Something could happen to the money before you’re scheduled to receive it. Until you have it, it’s not a
given.
Time Value of Money

Present value <Rs. 1000 Rs. 1000

Now? 1 Year Later

Present Discounted Value is the application of the Time value of money Principle
Time Value of Money
PV = FV / [ 1 + (i) ] (t)

In the TVM formula:

● FV = Future value of Cashflow

● PV = Present value of Cashflow
● i = Nominal annual interest rate (when calculating future value) or discount rate (when calculating present value)
● t = number of years
Time Value of Money (with compounding)
In the TVM formula:
PV = FV / [ 1 + (i / n) ] (n x t)

● FV = Future value of cash flow

● PV = Present value of cash flow
● i = nominal annual interest rate
● n = number of compounding periods per year ( n=2 for semi-annually compounding & n=4 for
quarterly compounding)
● t = number of years

Similarly, Future value can be calculated as FV = PV x [ 1 + (i / n) ] (n x t)

Time Value of Money

PV = ? Rs.
1050

Now 1 Year Later

PV = FV / [ 1 + (i) ] (t)
PV = 1050 / [ 1 + 0.07 ] 1 FV = 1050
PV = 981.30
Assume discount rate of 7% per annum
NPV : Net Present Value

Net Present Value (NPV) is the value of all future cash flows (positive and
negative) over the entire life of an investment discounted to the present.

NPV analysis is a form of intrinsic valuation and is used extensively across finance
and accounting for determining the value of a business, investment security, capital
project, new venture, cost reduction program, and anything that involves cash flow.
NPV : Net Present Value
NPV : Applications in Finance
NPV of a Business:
To value a business, an analyst will build a detailed discounted cash flow DCF model in Excel. This financial model will include all
revenues, expenses, capital costs, and details of the business

NPV of a Project
To value a project is typically more straightforward than an entire business. A similar approach is taken, where all the details of the project
are modeled into Excel, however, the forecast period will be for the life of the project, and there will be no terminal value. Once the free
cash flow is calculated, it can be discounted back to the present at either the firm’s WACC or the appropriate hurdle rate
IRR : Internal rate of return
The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of potential
investments.

IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a
discounted cash flow analysis.

The ultimate goal of IRR is to identify the

rate of discount, which makes the present The higher an internal rate of return,
value of the sum of annual nominal cash the more desirable an investment is to undertake.
inflows equal to the initial net cash outlay for
the investment.

​NPV = 0 =
Questions:
● Invest 20,000 USD now and receive 3 yearly payments of 5,000 USD each along with 12,000 USD in
the 3rd year. Assume Discount rate as 10%. Justify whether it is a good Investment opportunity or not.

● A project with a 4-year life and a cost of Rs. 225,000 generates revenue of Rs. 48,000 in year 1,
Rs.67,000 in year 2, Rs. 95,000 in year 3 and Rs. 110,000 in year 4. If the discount rate is 15%,
should we accept this project?

● Invest 9,000 USD now and receive three yearly payments of 2,500 USD each along with 4,000 USD
in the 3rd year. What is the IRR ? At what discount rate it will be a good investment opportunity?

● Find the NPV & IRR of an investment having initial cash outflow of Rs. 280,000. The cash inflows at
first, second, third and fourth years are expected to be Rs. 72,000, Rs. 97,000, Rs.105,000 and Rs,
110,000 respectively. Assume discounting rate of 8%