Lecture notes in Analytical Finance I & II
Jan R. M. Röman
Department of Mathematics and Physics
Mälardalen University, SwedenThis lecture notes was used the first time in the course
Analytical Finance I at themaster program, Analytical Finance at Mälardalen University 2004. The aim is to
cover most essential parts of probability theory and the stochastic processes needed to
study arbitrage theory in continuous time.
First we will give a short introduction to pricing via arbitrage and the central limit
theorem. Then a number of different binomial models are discussed. Binomial models
are important, both for the understanding and since they are widely used to calculate
the price and Greeks for a number of different derivatives. The reason is that they are
general and can handle all kinds of derivatives, e.g., European, Bermudan and
American options. We also discuss the numerical approach of the binomial models,
finite element methods and Monte-Carlo simulations.
Then, an introduction to probability theory and stochastic integration is given. After
this introduction we are ready to study partial differential equations and the solution
of the Black-Scholes equation. A number of generalizations to Black-Scholes are
given, such as stochastic volatility and time dependent parameters. We also discuss a
number of analytical approximations for American options and why we can't use
Black-Scholes PDE on American options with early exercise.
A short introduction to Poisson processes is also given. Then we study diffusion
processes, Martingale representation and Girsanov theorem. Before we end up with a
general guide to pricing via Black-Scholes we give an introduction to exotic options
wheatear derivatives and volatility models.
This course is followed by Analytical Finance II where we will go into the fix income
market where the interest rates and bond prices are given by stochastic processes.