1. Finance Theory And Applications
2. Game Theory Finance Applications
3. Finance Theory And Application Ch 4 Quiz

Mathematical finance, also known as quantitative finance and financial mathematics, is a field of applied mathematics, concerned with mathematical modeling of financial markets. Generally, mathematical finance will derive and extend the mathematical or numerical models without necessarily establishing a link to financial theory, taking observed market prices as input. Mathematical consistency is required, not compatibility with economic theory. Thus, for example, while a financial economist might study the structural reasons why a company may have a certain share price, a financial mathematician may take the share price as a given, and attempt to use stochastic calculus to obtain the corresponding value of derivatives of the stock (see: Valuation of options; Financial modeling; Asset pricing). The fundamental theorem of arbitrage-free pricing is one of the key theorems in mathematical finance, while the Black–Scholes equation and formula are amongst the key results.^[1]

Mathematical finance also overlaps heavily with the fields of computational finance and financial engineering. The latter focuses on applications and modeling, often by help of stochastic asset models (see: Quantitative analyst), while the former focuses, in addition to analysis, on building tools of implementation for the models. In general, there exist two separate branches of finance that require advanced quantitative techniques: derivatives pricing on the one hand, and risk- and portfolio management on the other.^[2]

French mathematician Louis Bachelier is considered the author of the first scholarly work on mathematical finance, published in 1900. But mathematical finance emerged as a discipline in the 1970s, following the work of Fischer Black, Myron Scholes and Robert Merton on option pricing theory.

Today many universities offer degree and research programs in mathematical finance.

The demand for knowledge of finance theory in day-to-day business is ever growing. Therefore, we should encourage the student to challenge finance theory by all means. We should let them fully appreciate that finance theories continuously give a profound impact on professional behavior in the financial world. This course will examine the choices households make about important financial decisions and how these individual choices can impact the aggregate economy. Each week, basic predictions from economic theory will be discussed and compared with empirical findings.

• 1History: Q versus P
• 3Mathematical finance articles

Numerous economists have explained the role of finance in the market with the help of different finance theories.The concept of finance theory involves studying the various ways by which businesses and individuals raise money, as well as how money is allocated to projects while considering the risk factors associated with them. Finance Theory Group Summer School 'Frictions in Firms and Markets” June 26-29, 2019. CALL FOR APPLICATIONS. Following the success of previous summer schools, the Finance Theory Group (FTG), in conjunction with the Rodney L. White Center for Financial Research at the University of Pennsylvania’s Wharton School, is seeking applications and nominations for participation in the FTG’s. Finance Applications of Game Theory 3 (1989) has argued that the reason for the delay was the boldness of the assumption that all investors have the same beliefs about the means and variances of all assets. Sharpe (1964) and Lintner (1965) showed that in equilibrium Eri = rf + βi(ErM – rF).

History: Q versus P[edit]

There are two separate branches of finance that require advanced quantitative techniques: derivatives pricing, and risk and portfolio management. One of the main differences is that they use different probabilities, namely the risk-neutral probability (or arbitrage-pricing probability), denoted by 'Q', and the actual (or actuarial) probability, denoted by 'P'.

Finance Theory And Applications

Derivatives pricing: the Q world[edit]

The goal of derivatives pricing is to determine the fair price of a given security in terms of more liquid securities whose price is determined by the law of supply and demand. The meaning of 'fair' depends, of course, on whether one considers buying or selling the security. Examples of securities being priced are plain vanilla and exotic options, convertible bonds, etc.

Once a fair price has been determined, the sell-side trader can make a market on the security. Therefore, derivatives pricing is a complex 'extrapolation' exercise to define the current market value of a security, which is then used by the sell-side community. Quantitative derivatives pricing was initiated by Louis Bachelier in The Theory of Speculation ('Théorie de la spéculation', published 1900), with the introduction of the most basic and most influential of processes, the Brownian motion, and its applications to the pricing of options.^[3][4] The Brownian motion is derived using the Langevin equation and the discrete random walk.^[5] Bachelier modeled the time series of changes in the logarithm of stock prices as a random walk in which the short-term changes had a finite variance. This causes longer-term changes to follow a Gaussian distribution.^[6]

The theory remained dormant until Fischer Black and Myron Scholes, along with fundamental contributions by Robert C. Merton, applied the second most influential process, the geometric Brownian motion, to option pricing. For this M. Scholes and R. Merton were awarded the 1997 Nobel Memorial Prize in Economic Sciences. Black was ineligible for the prize because of his death in 1995.^[7]

The next important step was the fundamental theorem of asset pricing by Harrison and Pliska (1981), according to which the suitably normalized current price P₀ of a security is arbitrage-free, and thus truly fair, only if there exists a stochastic processP_t with constant expected value which describes its future evolution:^[8]

A process satisfying (1) is called a 'martingale'. A martingale does not reward risk. Thus the probability of the normalized security price process is called 'risk-neutral' and is typically denoted by the blackboard font letter '${\displaystyle \mathbb{Q}}$'.

The relationship (1) must hold for all times t: therefore the processes used for derivatives pricing are naturally set in continuous time.

The quants who operate in the Q world of derivatives pricing are specialists with deep knowledge of the specific products they model.

Securities are priced individually, and thus the problems in the Q world are low-dimensional in nature.Calibration is one of the main challenges of the Q world: once a continuous-time parametric process has been calibrated to a set of traded securities through a relationship such as (1), a similar relationship is used to define the price of new derivatives.

The main quantitative tools necessary to handle continuous-time Q-processes are Itō's stochastic calculus, simulation and partial differential equations (PDE's).

Risk and portfolio management: the P world[edit]

Risk and portfolio management aims at modeling the statistically derived probability distribution of the market prices of all the securities at a given future investment horizon.
This 'real' probability distribution of the market prices is typically denoted by the blackboard font letter '${\displaystyle \mathbb{P}}$', as opposed to the 'risk-neutral' probability '${\displaystyle \mathbb{Q}}$' used in derivatives pricing. Based on the P distribution, the buy-side community takes decisions on which securities to purchase in order to improve the prospective profit-and-loss profile of their positions considered as a portfolio.

For their pioneering work, Markowitz and Sharpe, along with Merton Miller, shared the 1990 Nobel Memorial Prize in Economic Sciences, for the first time ever awarded for a work in finance.

The portfolio-selection work of Markowitz and Sharpe introduced mathematics to investment management. With time, the mathematics has become more sophisticated. Thanks to Robert Merton and Paul Samuelson, one-period models were replaced by continuous time, Brownian-motion models, and the quadratic utility function implicit in mean–variance optimization was replaced by more general increasing, concave utility functions.^[9] Furthermore, in more recent years the focus shifted toward estimation risk, i.e., the dangers of incorrectly assuming that advanced time series analysis alone can provide completely accurate estimates of the market parameters.^[10]

Much effort has gone into the study of financial markets and how prices vary with time. Charles Dow, one of the founders of Dow Jones & Company and The Wall Street Journal, enunciated a set of ideas on the subject which are now called Dow Theory. This is the basis of the so-called technical analysis method of attempting to predict future changes. One of the tenets of 'technical analysis' is that market trends give an indication of the future, at least in the short term. The claims of the technical analysts are disputed by many academics.

Criticism[edit]

Over the years, increasingly sophisticated mathematical models and derivative pricing strategies have been developed, but their credibility was damaged by the financial crisis of 2007–2010.Contemporary practice of mathematical finance has been subjected to criticism from figures within the field notably by Paul Wilmott, and by Nassim Nicholas Taleb, in his book The Black Swan.^[11] Taleb claims that the prices of financial assets cannot be characterized by the simple models currently in use, rendering much of current practice at best irrelevant, and, at worst, dangerously misleading. Wilmott and Emanuel Derman published the Financial Modelers' Manifesto in January 2009^[12] which addresses some of the most serious concerns.Bodies such as the Institute for New Economic Thinking are now attempting to develop new theories and methods.^[13]

In general, modeling the changes by distributions with finite variance is, increasingly, said to be inappropriate.^[14] In the 1960s it was discovered by Benoit Mandelbrot that changes in prices do not follow a Gaussian distribution, but are rather modeled better by Lévy alpha-stable distributions.^[15] The scale of change, or volatility, depends on the length of the time interval to a power a bit more than 1/2. Large changes up or down are more likely than what one would calculate using a Gaussian distribution with an estimated standard deviation. But the problem is that it does not solve the problem as it makes parametrization much harder and risk control less reliable.^[11] See also Variance gamma process#Option pricing.

Mathematical finance articles[edit]

See also Outline of finance: § Financial mathematics; § Mathematical tools; § Derivatives pricing.

Mathematical tools[edit]

• Copulas, including Gaussian
• Mathematical optimization
• Numerical analysis
• Partial differential equations
  • Numerical partial differential equations
• Probability distributions
• Stochastic calculus
• Volatility

Derivatives pricing[edit]

• The Brownian model of financial markets
• Rational pricing assumptions
  • Arbitrage-free pricing
• Valuation adjustments
• Swap valuation
• Options
  • Put–call parity (Arbitrage relationships for options)
  • Intrinsic value, Time value
  • Pricing models
    • Binomial options model
    • Implied volatility, Volatility smile
    • Stochastic volatility
      • Heston model
    • Trinomial tree
  • Pricing of American options
• Interest rate derivatives
  • Black model
  • Short-rate models
  • Forward rate-based models
    • LIBOR market model (Brace–Gatarek–Musiela Model, BGM)
    • Heath–Jarrow–Morton Model (HJM)

Portfolio modelling[edit]

See also[edit]

• Derivative (finance), list of derivatives topics

Notes[edit]

1. ^Johnson, Tim (September 2009). 'What is financial mathematics?'. +Plus Magazine. Retrieved 28 March 2014.
2. ^'Quantitative Finance'. About.com. Retrieved 28 March 2014.
3. ^E., Shreve, Steven (2004). Stochastic calculus for finance. New York: Springer. ISBN9780387401003. OCLC53289874.
4. ^Stephen., Blyth (2013). Introduction to Quantitative Finance. Oxford University Press, USA. p. 157. ISBN9780199666591. OCLC868286679.
5. ^B., Schmidt, Anatoly (2005). Quantitative finance for physicists : an introduction. San Diego, Calif.: Elsevier Academic Press. ISBN9780080492209. OCLC57743436.
6. ^Bachelir, Louis. 'The Theory of Speculation'. Retrieved 28 March 2014.
7. ^Lindbeck, Assar. 'The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1969-2007'. Nobel Prize. Retrieved 28 March 2014.
8. ^Brown, Angus (1 Dec 2008). 'A risky business: How to price derivatives'. Price+ Magazine. Retrieved 28 March 2014.
9. ^Karatzas, Ioannis; Shreve, Steve (1998). Methods of Mathematical Finance. Secaucus, NJ, USA: Springer-Verlag New York, Incorporated. ISBN9780387948393.
10. ^Meucci, Attilio (2005). Risk and Asset Allocation. Springer. ISBN9783642009648.
11. ^ ^abTaleb, Nassim Nicholas (2007). The Black Swan: The Impact of the Highly Improbable. Random House Trade. ISBN978-1-4000-6351-2.
12. ^'Financial Modelers' Manifesto'. Paul Wilmott's Blog. January 8, 2009. Retrieved June 1, 2012.
13. ^Gillian Tett (April 15, 2010). 'Mathematicians must get out of their ivory towers'. Financial Times.
14. ^Svetlozar T. Rachev; Frank J. Fabozzi; Christian Menn (2005). Fat-Tailed and Skewed Asset Return Distributions: Implications for Risk Management, Portfolio Selection, and Option Pricing. John Wiley and Sons. ISBN978-0471718864.
15. ^B. Mandelbrot, 'The variation of certain Speculative Prices', The Journal of Business 1963

References[edit]

Game Theory Finance Applications

• Harold Markowitz, 'Portfolio Selection', The Journal of Finance, 7, 1952, pp. 77–91
• William F. Sharpe, Investments, Prentice-Hall, 1985
• Attilio Meucci, P versus Q: Differences and Commonalities between the Two Areas of Quantitative Finance, GARP Risk Professional, February 2011, pp. 41–44
• Nicole El Karoui, The Future of Financial Mathematics, ParisTech Review, September 2013

Finance Theory And Application Ch 4 Quiz