Introduction to Financial

Engineering

Prof. Shijie Deng

Georgia Institute of Technology
Financial Engineering
◼ History of financial engineering
◼ Concepts were born in the end of 1960’s
◼ Rapid growth from the 1980’s through 2007
◼ Pricing and hedging
◼ Corporate governance and executive compensation

◼ Merger and acquisition

◼ Themes of financial engineering

◼ Quantitative and systematic modeling
◼ Innovation and creativity
Financial Engineering:
Interdisciplinary Nature
Finance

Financial
engineering
Information Quantitative
technology tools and
engineering
principles
 Two Fundamental Concepts
◼ Replication
◼ Pricing financial instruments
◼ Managing market-traded risks
◼ Diversification
◼ Determining cost of capital
◼ Managing assets and portfolios
Course Organization and Contents
◼ Cash flow streams
◼ Deterministic cash flow streams
◼ Single-period random cash flow
◼ General cash flow models
◼ Financial engineering principles in asset valuation,
investment and risk management
◼ Discounted cash flow analysis
◼ Equilibrium pricing
◼ No arbitrage pricing
◼ Portfolio management
 Contents and Applications
◼ Markets, trading and investment
◼ Financial markets: fixed income, equity, and derivatives
◼ Security price dynamics
◼ Free-Lunch principle
◼ Arbitrage
◼ Risk aversion
◼ Classical financial engineering applications
◼ Pricing
◼ Hedging
◼ Risk assessment and management
◼ Portfolio management
 Contents and Applications
◼ Emerging applications in finance
◼ Quantitative trading and Robo-advisors: machine learning
◼ FinTech applications
◼ Cryptocurrencies
◼ Peer-to-peer lending
◼ Implementation tools
◼ Python packages: Anaconda distribution
Deterministic Cash Flow
Streams
The Basic Theory of Interest
 2.1 Principal and Interest
◼ Principal:
◼ Original investment in a bank account.
◼ Interest: how is it paid?
◼ Simple Interest
◼ Compound Interest
◼ Yearly Compounding
◼ Compounding at Various Intervals
◼ Continuous Compounding
◼ Interest: other forms of appearance
◼ Debt
◼ Money Markets
 2.1 Principal and Interest
◼ Simple Interest
If an amount A is left in an account at simple
interest r, the total value after n years is:
V = (1 + rn) A
If the proportional rule holds for fractional years,
then after any time t (year-based), the account
value is:
V = (1 + rt ) A
 2.1 Principal and Interest
Fig. 2.1 Simple and compound interest.
◼ Compound Interest Simple interest leads to linear growth over
Under yearly compounding, time, whereas compound interest leads to
geometric growth.
if an amount A is left in an
account at compound
interest r, the total value
after n years is:
V = (1 + r ) n A
 2.1 Principal and Interest
◼ Compounding at Various Intervals
If an amount A is left in an account at interest rate
r per year, under m times compounding, the total
amount after 1 year is:
V = [1 + (r / m)]m A
◼ Nominal rate: r
◼ Effective interest rate: r 

1 + r = [1 + (r / m)]m
 2.1 Principal and Interest
◼ Continuous Compounding Fig. 2.2 Exponential growth curve;
continuous compounding growth.
If an amount A is left in an
account at interest rate r per
year, compounded m times a
year, the total amount after time
t (year-based) is:
V = [1 + (r / m)]mt A
Dividing a year into smaller and
smaller periods leads to the idea
of continuous compounding:
lim[1 + (r / m)]mt A = e rt A
m →
Principal and Interest: Other Forms
◼ Debt
◼ A single investment in bank account grows over
time due to interest compounding.
◼ The same mechanism works for debt.

◼ If one borrows money from the bank at an

interest rate r and make no payments to the
bank, then the debt increases according to the
same formulas.
Principal and Interest: Other Forms
◼ Money Markets
◼ There are many
different interest rates at
work each day.
◼ Different rates apply to
different circumstances,
different user classes,
and different periods.
◼ Most rates are
established by the
forces of supply and
demand in broad
markets to which they
apply.
 2.2 Present Value
◼ Present Value
Consider two equivalent situations:
(1) You will receive $110 in 1 year
(2) You receive $100 now and deposit it in a bank
account for 1 year at 10% interest.
The $110 to be received in 1 year has a present value of
$100.

In general, $1 to be received a year in the future has a

present value of $1/(1+r), where r is the interest rate.
 2.2 Present Value
◼ Present value of future obligations
Suppose you have an obligation to pay someone $100 in exactly 1
year, the money you would need now in order to cover the
obligation is $100/(1+r), which is the present value of the
obligation.

◼ Discounting and discount factor

◼ Discounting: the process of evaluating future obligation as an equivalent
present value.
◼ Discount factor: the factor by which the future value must be discounted.
 2.3 Present and Future
Values of Cashflow Streams
◼ The Ideal Bank
◼ It applies the same rate of interest to both deposits and loans.
◼ It has no service charges or transactions fees.
◼ Its interest rate applies equally to any size of principal.
◼ Separate transactions in an account are completely additive in their effect on future balances.
Note: It does not imply that interest rates for all transactions are identical.

◼ Constant Ideal Bank

If an ideal bank has an interest rate that is independent of the length time for
which it applies, and that interest is compounded according to normal rules, it is
a constant ideal bank.

The constant ideal bank is the reference point used to describe the outside
financial market.
 2.3 Present and Future Values of
Cashflow Streams
◼ Given a cash flow stream ( x0 , x1 , , xn ) and interest rate
r each period,
◼ At the end of period n, the future value of the cashflow stream
is: n −1
FV = x0 (1 + r ) + x1 (1 + r )
n
+ + xn
◼ At current time 0, the present value of this cashflow stream is:

PV = x0 + x1 (1 + r ) −1 + x2 (1 + r ) −2 + xn (1 + r ) − n

◼ The present value and the future value are related by:
PV = FV (1 + r ) − n
 2.3 Present and Future Values
◼ PV under Frequent/Continuous Compounding
Suppose that r is the nominal annual interest rate and
interest is compounded at m equally spaced periods per
year. Suppose that cash flows occur initially and at the end
of each period for a total of n periods, forming a
stream ( x0 , x1 , , xn ) . Then we have:
n
xk
PV = 
k = 0 [1 + ( r / m)]
k

Suppose that r is compounded continuously and cash

flows occur at times t0 , t1 , , tn . Then we have:
n
PV =  x(tk )e− rtk
k =0
 2.3 Present Value Equivalence
◼ Main Theorem on Present Value
The cash flow streams x = ( x0 , x1 , , xn ) and
y = ( y0 , y1 , , yn ) are equivalent for a constant ideal
bank with interest rate r if and only if the present values
of the two streams, evaluated at the bank’s interest rate,
are equal.

Note: This result is important because it implies that

present value is the only number needed to characterize a
cash flow stream when an ideal bank is available.
 2.4 Internal Rate of Return
◼ Internal Rate of Return
Let ( x0 , x1 , x2 , , xn ) be a cash flow stream. Then the
internal rate of return of this stream is a number r
satisfying the equation
−1 −2 −n
0 = x0 + x1 (1 + r ) + x2 (1 + r ) + + xn (1 + r )
Equivalently, it is a number r satisfying 1/(1+r)=c,
where c satisfies the polynomial equation
0 = x0 + x1c + x2 c 2 + + xn c n
 2.4 Internal Rate of Return
◼ Existence of the positive root
Main theory of internal rate of return:
Suppose the cash flow stream ( x0 , x1 , , xn ) has
x0  0 and xk  0 for all k, k=1,2,…,n, with at least one
term being strictly positive. Then there is a unique positive
root to the equation
0 = x0 + x1c + x2 c 2 + + xn c n .
Furthermore, if  nk =0 xk  0 , then the corresponding
internal rate of return r=(1/c)-1 is positive.
 2.5 Evaluation Criteria
◼ Net Present Value
◼ The higher the present value, the more desirable the
alternative.
◼ To be worthy of consideration, the cash flow stream
associated with an investment must have a positive net
present value.

◼ Internal Rate of Return

◼ The higher the internal rate of return, the more desirable the
investment.
◼ To be worthy of consideration, the internal rate of return
should be greater than the prevailing interest rate.
 2.5 Evaluation Criteria
◼ Example 2.4 (When to cut a tree)
Suppose that you have the opportunity to plant trees that later can
be sold for lumber. This project requires an initial outlay of money
in order to purchase and plant the seedlings. No other cash flow
occurs until the trees are harvested. However, you have a choice as
to when to harvest: after 1 year or after 2 years. We assume that the
cash flow streams associated with these two alternatives are:
(a) (-1,2) cut early
(b) (-1,0,3) cut later
 2.5 Evaluation Criteria
◼ Example 2.4 (Continued)
Criterion: Net Present Value (NPV)
(a) NPV=-1+2/1.1=0.82
(b) NPV=-1+3/(1.1)^2=1.48
According to NPV criterion, it is best to cut later.

Criterion: Internal Rate of Return

(a) -1+2c=0
(b) -1+3c^2=0
As usual, c=1/(1+r). These have the following solutions:
(a) r=1.0
(b) r=3^(1/2)-1=0.732
According to internal rate of return criterion, it is best to cut early.
 2.5 Evaluation Criteria
◼ Discussion of the Criteria
◼ Net present value is simplest to compute; it does not
have the ambiguity associated with the several
possible roots of the internal rate of return equation.
◼ Net present value can be broken into component
pieces, unlike internal rate of return.
◼ Internal rate of return has the advantage that it
depends only on the properties of the cash flow
stream, and not on the prevailing interest rate (which
in practice may not be easily defined).
 2.5 Evaluation Criteria
◼ Discussion of the Criteria
Suppose that the proceeds of the first harvest are used to plant
additional trees. Under plans (a) and (b):
(a) Cut early, the business can be doubled every year;
(b) Cut later, the business can be tripled every 2 years which is
equivalent to increasing by a factor of 3 every year.

The yearly growth rates of these two plans, factors of 2 and 3 ,

respectively, are each equal to 1 plus the internal rates of return of
the plans. So in this situation, it makes sense to select the project
with the largest internal rate of return in order to get the greatest
growth of capital.
 2.5 Evaluation Criteria
◼ Discussion of the Criteria
On the other hand, suppose that this investment is a one-
time opportunity and cannot be repeated. Here the net
present value method is the appropriate criterion since it
compares the investment with what could be obtained
through normal channels (which offer the prevailing rate
of interest).
 2.5 Evaluation Criteria
◼ Discussion of the Criteria
It is widely agreed that, over-all, the best criterion is that
based on net present value.

There are many other factors that influence a good

present value analysis.
(1) The selection of the interest rate to be used in the
calculation;
(2) Present value by itself does not reveal much about the
rate of return.
 2.6 Applications and Extensions
◼ Example 2.6
 2.6 Applications and Extensions
◼ Example 2.6 (Continued)
 2.6 Applications and Extensions
◼ Example 2.7
 2.6 Applications and Extensions
◼ Example 2.7 (Continued)
2.6 Applications and Extensions
◼ Example 2.8
 2.6 Applications and Extensions
◼ Example 2.8 (Continued)
 2.6 Applications and Extensions
◼ Example 2.9
 2.6 Applications and Extensions
◼ Example 2.9 (Continued)
 2.6 Applications and Extensions
◼ Inflation Rate f
◼ Prices 1 year from now will on average be equal to
today’s prices multiplied by (1+f).
◼ The value of a dollar next year in terms of the
purchasing power of today’s dollar is 1/(1+f).
◼ Inflation rate f, real interest rate r0 and nominal
interest rate r satisfy:
1+ r
1 + r0 =
1+ f
We can solve for r0 as:
r− f
r0 = (2.5)
1+ f
 2.6 Applications and Extensions
◼ Example 2.10
 2.6 Applications and Extensions
◼ Example 2.10 (Continued)