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Lahore University of Management Sciences

Finn 222 – Introduction to Mathematics of Finance


Spring 2019
Instructor Ferhana Ahmad
Room No. 314 – SDSB building
Office Hours Tuesday, Thursday: 1500-1630 (other times by appointment)
Email ferhana.ahmad@lums.edu.pk, ferhanaahmad@gmail.com
Telephone 042 3560 8044
Secretary/TA Sharha Mumtaz/Azka Waseem & Ali Jalaludin
TA Office Hours TBA
Course URL (if any) suraj.lums.edu.pk

COURSE BASICS
Credit Hours 3
Lecture(s) Nbr of Lec(s) Per Week 2 Duration 1.25 hours
Recitation/Lab (per week) Nbr of Lec(s) Per Week Duration
Tutorial (per week) Nbr of Lec(s) Per Week Duration

COURSE DISTRIBUTION
Core No
Elective Yes
Open for Student Category Open for all
Close for Student Category None

COURSE DESCRIPTION

With the recent developments in Finance over the past decade, the usefulness of Mathematical tools in Finance has become
significant than ever. The course provides an introduction to mathematics of finance and is ideal for developing an understanding
and knowledge of basic mathematical finance that a student requires throughout his or her academic and professional career. It
introduces the vocabulary of mathematics of finance that helps developing the understanding of financial instrument at large. The
course serves as the basis for higher studies in finance, quantitative finance, computational finance, financial engineering, financial
economics, economics, insurance, actuarial sciences or any similar field. The course will broaden your horizon of finance and
financial industry. Not only that the course is essential for the undergraduate and graduate studies in finance but also plays an
important role in the student’s performance in their professional careers.

The course covers topics including basics of calculus, time value of money, theory of interest, probability, normal random variables
and probability, arbitrage theorem, random walks and Brownian motion.

COURSE PREREQUISITE(S)

 Principles of Finance
Calculus I

COURSE LEARNING OBJECTIVES


Lahore University of Management Sciences
The course helps students to get over their fear of mathematics as a student enrolled in SDSB. The course will

 develop the vocabulary of mathematics of finance


 familiarize students with basic mathematical tools that are used in finance
 introduce students to probability theory required in finance
 introduce students with the concepts of randomness in finance
 prepare students to take advanced courses in finance and quantitative finance

LEARNING OUTCOMES
Upon completion of the course, students will be able to;

 apply basic mathematical concepts used in finance


 implement the learnt theory of interest rates in other courses and in their professional lives
 apply the randomness concepts in finance and probability
 model randomness using Brownian motion
 simulate a simple random walk
 simulate stock prices as random processes

UNDERGRADUATE PROGRAM LEARNING GOALS & OBJECTIVES


General Learning Goals & Objectives
Goal 1 –Effective Written and Oral Communication
Objective: Students will demonstrate effective writing and oral communication skills
Goal 2 –Ethical Understanding and Reasoning
Objective: Students will demonstrate that they are able to identify and address ethical issues in an
organizational context.
Goal 3 – Analytical Thinking and Problem Solving Skills
Objective: Students will demonstrate that they are able to identify key problems and generate viable
solutions.
Goal 4 – Application of Information Technology
Objective: Students will demonstrate that they are able to use current technologies in business and
management context.
Goal 5 – Teamwork in Diverse and Multicultural Environments
Objective: Students will demonstrate that they are able to work effectively in diverse environments.
Goal 6 – Understanding Organizational Ecosystems
Objective: Students will demonstrate that they have an understanding of Economic, Political,
Regulatory, Legal, Technological, and Social environment of organizations.

Major Specific Learning Goals & Objectives


Goal 7 (a) – Discipline Specific Knowledge and Understanding
Objective: Students will demonstrate knowledge of key business disciplines and how they interact
including application to real world situations (Including subject knowledge).
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Goal 7 (b) – Understanding the “science” behind the decision-making process (for MGS Majors)
Objective: Students will demonstrate ability to analyze a business problem, design and apply
appropriate decision-support tools, interpret results and make meaningful recommendations to support
the decision-maker

Indicate below how the course learning objectives specifically relate to any program learning goals and
objectives.

PROGRAM LEARNING GOALS AND COURSE LEARNING OBJECTIVES COURSE ASSESSMENT ITEM
OBJECTIVES
Goal 1 –Effective Written and Oral The course provides an opportunity to Written: Assignments, Quizzes
Communication students to write and deliver effectively Oral: CP
the mathematical nature problems arising
in Finance.
Goal 2 –Ethical Understanding and
Reasoning
Goal 3 – Analytical Thinking and Problem The course equips students with basic Assignments, Quizzes, Exams
Solving Skills problem solving techniques in Finance
using quantitative methods. It enables
students to analytically think a problem
and solve it using the problem solving
techniques they're learning throughout
the course
Goal 4 – Application of Information Students will simulate stock prices using Class work and Assignments
Technology Excel
Goal 5 – Teamwork in Diverse and The course forces students to learn in Assignments and Projects
Multicultural Environments teamwork. The discussion on assignments
and lecture notes will help them in
working in diverse environments
Goal 6 – Understanding Organizational NA
Ecosystems
Goal 7 (a) – Discipline Specific Knowledge Students will learn quantitative skills in Quizzes, Assignments, Project, and
and Understanding finance that they can apply and model the Exams
real world financial situations/problems
Goal 7 (b) – Understanding the “science” This is a basic course in mathematics of
behind the decision-making process finance. Students will learn tools that may Assignments, Quizzes, and Exams
help them in future if they opt for
Quantitative finance career in designing
and solving a problem in finance using
quantitative skills.

GRADING BREAKUP AND POLICY

Assignments: 15% There will be around 4-5 assignments during the semester. Students are advised to submit the assignments
before the deadline. Late submissions will not be entertained. No make-up assignments will be given! There will be one excel based
assignment for module 4 of the course.

Quizzes: 20% There will be around 4-6 announced & unannounced quizzes in class. The N-1 policy will be applicable only when the
number of quizzes exceeds 4. No make-up quizzes will be conducted.
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Please note that no late submission for assignments or project will be entertained. Missed deadlines mark zero for the instrument. Please also
note that there is no make-up quizzes or assignments in case of absence (even if it is approved by OSA). There is no grade for attendance,
however being absent from class will reflect in reduced CP and other instrument grades.

Class Participation: 5%

Class rules:

 You are advised to be on time in sessions. There will be no class participation for students arriving late in the session. There is zero-
minute tolerance policy for late arrivals.
 Use of mobile phones, bringing food, or creating disturbance in the class will mark you absent for the session.
 In case of any absences, even if approved from OSA, the CP for the session will be zero.
 Students are required to bring calculator and basic stationary in the sessions for class works.
 Students are advised not to miss a lecture session for topics taught in the sessions are interlinked and missing a session means less to no
learning in the following sessions (or in the course).

Midterm Examination: 30%

Final Examination: 30%

The exams are closed book/closed notes. Cheat sheets are not allowed! No re-take or compensations (mean) of exams will be allowed
unless approved by OSA and instructor beforehand for university competitions or otherwise.

EXAMINATION DETAIL

Yes/No: YES
Combine Separate:
Midterm
Duration: 1 hour 15 minutes
Exam
Preferred Date:
Exam Specifications:

Yes/No: YES
Combine Separate:
Final Exam Duration: 2 hours
Exam Specifications:
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COURSE OVERVIEW
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The course outlines are subject to change

WEEK/
RECOMMENDED
LECTURE/ TOPICS SESSION OBJECTIVE(S)
READINGS
MODULE

Basics of Calculus
The module is based on the revision of the basic mathematics and calculus concepts that students have already learnt in Further
mathematics or Calculus I. The module prepares students to look at finance from mathematical side. The module reviews the real
number system, vectors and array, polynomial and series concepts along with functions, their derivatives and integration.

 Students will revise the


Thomas’ Calculus (Review) concepts of limits &
continuity, derivatives and
Ch: 3 (Differentiation) (3.1, 3.2, integration
3.5 (chain rule))
Ch: 4 (Optimization) (4.1, 4.3,  They’ll apply the concepts on
4.4) (maxima and minima finding maxima and minima –
Calculus Ch5: (Integration) the first step towards
5.4(Fundamental theorem of optimization
1-3
calculus)

 Students will learn the


sequences, series and sums
Thomas’ Calculus
4-5 Calculus Ch:11 (746-748, 761-765,794-  Application of series to
795,800,805-808) present value
computations
 Taylor Series expansion
Students will learn
 functions of multiple variables
Thomas’ Calculus  how to take derivatives of a
multivariate function
Ch:14 (965-966, 14.2,14.3,14.4)  how to interpret the
Partial Derivatives derivatives
6
Mean Value optimization  the application of partial
derivatives in Lagrangian
optimization (Overview of
Mean Variance optimization
problem)
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(Overview)
Zill & Cullen Students will learn first order
differential equations and their
Chapter 1.1 (pages 2-5) solutions using integrating factors
Introduction to first order differential Chapter 2 (2.2,2.3,2.4) and separation of variables
Session equations
28 Differential equations are an
moved integral part of financial
here modeling. The session will
prepare students to think about
analytical solutions, if any, of the
financial instruments and
modeling of the financial
instruments.

Finance
The module is based on the basic concepts in finance and interest rate theory. The students learn the core concepts in finance such
as time value of money and rate of return. They will learn the mathematics behind the interest rate compounding and measuring
the rates in discrete and continuous times.

Principles of Managerial Finance Time value of money concepts


Time value of money 13th Edition Chapter 5 (Finn 100 will be given and discussed with
readings) students to emphasize the need
to mathematical concepts to
7
Paul Wilmott introduces model interest rates and other
Quantitative Finance financial instruments
Second Edition Chapter 1 (1.6)

Kavin J Hasting Students will learn


Theory of interest rates Ch: 1 (1.1,1.2,1.3 & 1.6)  Rate of return and
present value
8  Compound interest
 Annuities
 Measuring rate of return
 Continuous time interest
Students will be given the
J Robert Buchanan concept of arbitrage in finance.
Arbitrage Pages (81-84) They will be provided with
Kevin J Hastings (5.1.2) example of taking advantage of
9
arbitrage and how pricing is
Students are advised to bring mostly based on no arbitrage
examples of arbitrage for class arguments
discussion
Students will learn to price
Pricing of Financial Instruments using Class Notes futures and options contract
10
Arbitrage arguments using arbitrage arguments

Probability Theory
Randomness is a core concept in finance, especially when we model the financial securities and instruments. It provides the
analytical tools to solve practical problems in the complex and rapidly evolving world of today's financial industry. Due to the
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randomness involved in the financial industry, we work in a probabilistic way. The module provides the essential concepts that are
required for defining and understanding the modeling of a Brownian motion.

Students will learn the concepts


Grimmett & Stirzekar in probability theory from a
Probability theory mathematical side. The will learn
Random experiments, random variable, Chapter 2 (2.1 (25-29), 32)  What constitutes a random
events, sample space experiment
11
 What is a random variable
 What we mean by events
 How do we define sample
space

In this session, they will learn


Grimmett & Stirzekar  The concepts required to
Algebra, Sigma algebra, filtration, define probability space
measure, probability measure, probability Chapter 1: (Pages 1-14)  Concepts such as algebra,
space sigma algebra, filtration will
12-13 be introduced to students
 Measure will be defined as a
function
 Probability measure and
probability space will be
defined

Expectations, conditional expectations, Grimmett & Stirzekar Expectations, conditional


14-15 independence Ch: 3 (3.1,3.2,3.3,3.7) expectations and independent
Ch:4 (4.1,4.2,4.3,4.6) events will defined using
mathematical definitions
Normal distribution has an
essential role in the theory of
Normal distribution, mean variance and J Robert Buchanan randomness in finance. The
moment generating function Chapter 3 distribution function, mean,
Log-normal distribution variance and moment generating
function of a normal distribution
will be discussed in the sessions.
16-17 The usage of moment generating
function in finding moments will
be discussed. By the end of the
sessions, students will be
comfortable will the concepts
that are required in stochastic
calculus.

Randomness concepts in Finance


The module on randomness concepts in finance provides the basics of quantitative and computational finance. The module starts
with discussion of a random walk, the pattern the stocks follow in reality are discussed for comparison. Brownian motion is defined
and its properties are discussed as the basic ingredient of the mathematics of finance and stochastic calculus. The modeling of
financial instruments is all based on the concept and modeling of randomness. The students will learn those basic concepts in the
module
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Students will learn
J Robert Buchman  the concept or randomness
18 Random Walk Chapter 5  random walk and its properties
 how to formulate a random
walk
Brownian motion will be defined
J Robert Buchman as
Chapter 5  as a continuous time limit of a
random walk
19 Brownian motion  as a random variable from a
normal distribution
 Alternative definition of a
Brownian motion

 Students will learn different


properties of Brownian
J Robert Buchman motion such as scaling, time
20-21 Properties of Brownian motion Chapter 5 inversion, time reversal
 The will learn to show
whether a process is a
Brownian motion or not
 We model stock prices as a
Geometric Brownian motion and its geometric Brownian motion,
22 properties Lecture Notes in this session students will
learn the properties of a
geometric Brownian motion
- Students will learn martingales
Martingale and Markov process Ubbo F Wiersema and will show that Brownian
Pages (31- 37) motion is a martingale
23
- Students will learn the Markov
property and will show that the
BM is Markov
- Students will price stock prices
Stock prices as a lognormal process Reading Provided as a lognormal process
24-25 Richard Ivey School of Business - Simulation of stock prices will
Modeling Stock Prices be done on Excel

Students will learn the


Options, John Hull - Applications of modeling
Pricing options using Monte Carlo Chapter 8 randomness
26-27
Simulation - Monte Carlo simulation for
pricing an option (Overview,
application, Excel)

28 Moved in Module 1

TEXTBOOK(S)/SUPPLEMENTARY READINGS
Lahore University of Management Sciences
1. J Robert Buchanan. An Undergraduate Introduction to Financial Mathematics, World Scientific Publishing Company, 3rd
Edition, [ISBN 9789814407441] (Finance and Randomness)
2. Kevin J. Hastings. Introduction to Financial Mathematics, Chapman and Hall, 2015. [ISBN 9781498723909] (Finance and
Randomness)
3. Geoffrey R Grimmett and David R Stirzekar, Probability and Random Processes, Oxford University Press, 3 rd Edition, 2001.
[ISBN-13: 978-0198572220] (Probability Theory)
4. George B Thomas, Maurice D Weir, Joel Hass and Franke R Giordano, Thomas’ Calculus, 11 th Edition, Addison Wesley,
2004. [ISBN 9780321185587] (Calculus review)
5. Dennis G Zill and Micheal R Cullen, Differential Equations with Boundary Conditions, 7th Edition, Cengage Learning, 2009.
[ASIN: B008UB1WJE] (Introduction to Differential Equations Overview)