Financial Engineering and Risk Management Part I and II – Garud Iyengar

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Financial Engineering is a multidisciplinary field involving finance and economics, mathematics, statistics, engineering and computational methods. The emphasis of FE & RM Part II will be on the use of simple stochastic models to (i) solve portfolio optimization problems (ii) price derivative securities in various asset classes including equities and credit and (iii) consider some advanced applications of financial engineering including algorithmic trading and the pricing of real options. We will also consider the role that financial engineering played during the financial crisis.

We hope that students who complete the course and the prerequisite course (FE & RM Part I) will have a good understanding of the “rocket science” behind financial engineering. But perhaps more importantly, we hope they will also understand the limitations of this theory in practice and why financial models should always be treated with a healthy degree of skepticism.

Syllabus – What you will learn from this course

Week 1

2 hours to complete

Mean-Variance Analysis and CAPM

Problem formulation and solution; the efficient frontier; including the risk-free asset; the Capital Asset Pricing Model (CAPM);implications of CAPM: α, β, security and capital market lines

6 videos (Total 97 min), 2 readings, 1 quiz

6 videos

Overview of Mean Variance19m

Introduction to Mean Variance in Excel9m

Efficient Frontier19m

Mean Variance with a Risk-free Asset14m

Risk-free Frontier in Excel13m

Capital Asset Pricing Model20m

2 readings

Lesson Supplements10m

Quiz Instructions10m

1 practice exercise

Mean-Variance Analysis and CAPM Problem Set14m

Week 2

2 hours to complete

Practical Issues in Implementing Mean Variance

Problems with mean-variance analysis; ETFs and leveraged ETFs; VaR and CVaR for asset allocation; survivorship bias, performance evaluation and other statistical pitfalls.

6 videos (Total 103 min), 2 readings, 1 quiz

6 videos

Implementation Difficulties with Mean Variance20m

Negative Exposures and Leveraged ETFs14m

Beyond Variance13m

Statistical Biases in Performance Evaluation17m

How Should Average Returns be Computed?14m

Survivorship Bias and Data Snooping23m

2 readings

Lesson Supplements10m

Quiz Instructions10m

1 practice exercise

Practical Issues in Implementing Mean Variance Problem Set14m

Week 3

2 hours to complete

Equity Derivatives in Practice: Part I

Problems with mean-variance analysis; ETFs and leveraged ETFs; VaR and CVaR for asset allocation; survivorship bias, performance evaluation and other statistical pitfalls.

7 videos (Total 112 min), 2 readings, 1 quiz

7 videos

Review of the Binomial Model for Option Pricing10m

The Black-Scholes Model8m

The Greeks: Delta and Gamma19m

The Greeks: Vega and Theta18m

Risk-Management of Derivatives Portfolios16m

Delta-Hedging14m

The Volatility Surface23m

2 readings

Lesson Supplements10m

Quiz Instructions10m

1 practice exercise

Equity Derivatives in Practice: Part I16m

Week 4

2 hours to complete

Equity Derivatives in Practice: Part II

More about Black-Scholes, the Greeks and delta-hedging; the volatility surface; pricing derivatives using the volatility surface; model calibration.

5 videos (Total 82 min), 1 reading

5 videos

The Volatility Surface in Action9m

Why is There a Skew?14m

What the Volatility Surface Tells Us17m

Pricing Derivatives Using the Volatility Surface21m

Beyond the Volatility Surface and Black-Scholes19m

1 reading

Lesson Supplements10m

Week 5

3 hours to complete

Credit Derivatives and Structured Products

Mechanics and pricing of CDOs; exotic structured credit securities including CDO-squared’s and CDO-cubed’s. Risk management of these products and their role in the financial crisis.

9 videos (Total 122 min), 2 readings, 1 quiz

9 videos

Structured Credit: CDOs and Beyond8m

The Gaussian Copula Model18m

A Simple Example: Part I13m

A Simple Example: Part II15m

The Mechanics of a “Synthetic” CDO Tranche10m

Computing the Fair Value of a CDO Tranche14m

Cash and Synthetic CDOs10m

Pricing and Risk Management of CDO Portfolios17m

CDO-Squared’s and Beyond13m

2 readings

Lesson Supplements10m

Quiz Instructions10m

1 practice exercise

Credit Derivatives and Structured Products12m

Week 6

2 hours to complete

Other Applications of Financial Engineering

Real options; energy and commodities modeling; algorithmic trading.

8 videos (Total 90 min), 2 readings, 1 quiz

8 videos

Liquidity, Trading Costs, and Portfolio Execution14m

Optimal Execution10m

Portfolio Execution13m

Optimal Execution in Excel 17m

Optimal Execution in Excel 25m

Real Options12m

Valuation of Natural Gas and Electricity Related Options14m

Real Options in Excel11m

2 readings

Lesson Supplements10m

Quiz Instructions10m

1 practice exercise

Other Applications of Financial Engineering8m

Week 7

3 hours to complete

Background Material

11 videos (Total 154 min), 1 reading