# Introduction Chapter 1 Financial Engineering

Pages: 31 (4088 words) Published: July 29, 2013
Financial Engineering
Xingguo Luo http://mypage.zju.edu.cn/xingguo
College of Economics and Academy of Financial Research Zhejiang University (ZJU)

Chapter 1: Introduction
Lecture 1: Feb 28, 2013

Xingguo Luo (ZJU)

Financial Engineering (2013)

Lecture 1: Feb 28, 2013

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Outline

Outline

Course Introduction
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Course description Learning outcomes Candidate topics Assessment A unique instrument A money market problem A taxation example Trading volatility

Introduction
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Financial Engineering (2013)

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Course introduction

Course description
This is one of elective courses for undergraduate students The course introduces methods that use ﬁnancial instruments and ﬁnancial engineering strategies in solving practical problems The engineering dimension of the topics under consideration is emphasized. Simple graphs and elementary mathematics are employed The course does not discuss the details of ﬁnancial instruments and its pricing The purpose of this course is to help students ﬁnd their interests and to provide insights for them to learn more advanced topics or work in ﬁnancial industry

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Financial Engineering (2013)

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Course introduction

Course learning outcomes

Understand popular ﬁnancial instruments from conceptual and engineering perspectives Be able to analyze features of practical ﬁnancial instruments Develop skills in designing ﬁnancial products

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Financial Engineering (2013)

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Course introduction

Candidate topics
Forward contracts Cash ﬂow engineering Swap engineering Repo Synthetics Options Fixed-income engineering Volatility trading CDS Structured product engineering

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Financial Engineering (2013)

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Course introduction

Assessment

Individual class contribution, 10% Assignments, 20% Midterm project, 30% Final exam, 40% Total, 100%

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Financial Engineering (2013)

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Chapter 1: Introduction

A unique instrument

1. A unique instrument
There is a unique ﬁnancial instrument that has the same property as the integer zero in ﬁnance. Consider the forward Libor loan: t0 , t1 and t2 are some speciﬁc dates and initial time is t0 . At t1 , we borrow USD100, at the going interest rate of time t1 , called the Libor and denoted by the symbol Lt1 . We pay the interest and the principal back at time t2 . The loan has no default risk and is for a period of δ units of time. Note that the contract is written at t0 , but starts at the future date t1 . The value of Lt1 will also be determined at t1 . What is the value of this forward contract for the time interval, t ∈ [t0 , t1 ]?

Xingguo Luo (ZJU)

Financial Engineering (2013)

Lecture 1: Feb 28, 2013

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Chapter 1: Introduction

A unique instrument

Forward Libor loan

1 100 Interest and Principal paid

t0

t1
2Lt d100
1

t2

2 100 Contract initiation

FIGURE 1-1
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Chapter 1: Introduction

A unique instrument

We calculate time t1 value of the cash ﬂows that will be exchanged at time t2 by discounting them with the proper discount rate: PVt = Lt1 δ100 100 + . (1 + Lt1 δ) (1 + Lt1 δ) (1)

Collecting the terms in the numerator, PVt (1 + Lt1 δ)100 , (1 + Lt1 δ) = 100. = (2) (3)

We don’t need to know Lt1 Regardless of what happens to interest rate expectations and market volatility, the value of the contract is always zero for any t ∈ [t0 , t1 ] Given any instrument at time t, we can add (or subtract) the Libor loan to it, and the value of the original instrument will not change for all t ∈ [t0 , t1 ] Xingguo Luo (ZJU) Financial Engineering (2013) Lecture 1: Feb 28, 2013 9 / 45...