Financial Engineering

Welcome to this module on Financial Engineering. The module provides an introduction to the analysis of derivatives in financial markets. You will learn the main features of the most commonly used financial derivatives, and you will understand how to use them for the management of risk.

These units explain and discuss the theoretical models that are used to analyse derivatives, and you will also see how derivatives are used in practice. You will study spreadsheet models of derivatives, analysing the performance and valuation of derivatives contracts and trading strategies, starting with the simplest options, and extending to more complex strategies and derivatives contracts. These spreadsheet models will help you to develop a deeper and stronger understanding of derivatives and how they work.

This module focuses on the conceptual and analytical aspects of derivatives. After studying this module, you will be able to understand the main characteristics of derivatives, the potential for using derivatives to manage risk, and you should be able to avoid some of the more serious misunderstandings and mistakes associated with using derivatives. The module is not a substitute for the professional expertise that can only be acquired by directly working in financial markets. But you will find that a solid grounding in the principles of derivatives will enable you to understand much better the practical aspects of derivatives investment and risk management.

The module is concerned with financial engineering as the application of statistical and mathematical methods to analyse and use derivatives in financial markets. The term ‘financial engineering’ also refers to the manipulation of the capital structure of a company to attempt to increase shareholder value. Financial engineering in relation to capital structure is studied in the CeFiMS modules Corporate Finance and Introduction to Valuation.

Learning outcomes

When you have completed your study of this module, you will be able to:

• analyse advanced derivative trading strategies for hedging and speculation
• understand the Black–Scholes–Merton model and its applications
• calculate delta and other measures of sensitivity
• discuss volatility, and strategies for trading volatility
• assess the role of credit derivatives in risk management
• apply advanced numerical techniques for valuing complex options
• construct and use spreadsheet models to analyse derivatives.

Tuition and assessment

Students are individually assigned an academic tutor for the duration of the module, with whom you can discuss academic queries at regular intervals during the study session.

You are required to complete two Assignments for this module, which will be marked by your tutor. Assignments are each worth 15% of your total mark. You will be expected to submit your first assignment by the Tuesday of Week 6, and the second assignment at the end of the module, on the Tuesday after Week 10. Assignments are submitted and feedback given online. In addition, queries and problems can be answered through the Virtual Learning Environment.

You will also sit a three-hour examination on a specified date in September/October, worth 70% of your total mark. An up-to-date timetable of examinations is published on the website in July each year.

Study resources

• Study guide: The module study guide is carefully structured to provide the main teaching, defining and exploring the main concepts and issues, locating these within current debate and introducing and linking the assigned readings.
• Key texts: Hull JC (2018) Options, Futures, and Other Derivatives. 9th Edition. Harlow UK: Pearson Education.
  Benninga S (2014) Financial Modeling. 4th Edition. Cambridge MA: The MIT Press.
• Virtual learning environment: You will have access to the VLE, a web-accessed study centre. Via the VLE, you can communicate with your assigned academic tutor, administrators and other students on the module using discussion forums. The VLE also provides access to the module Study Guide and assignments, as well as a selection of electronic journals available on the University of London Online Library.

Study calendar 2022/23

Study calendars are subject to change.

Module overview

Unit 1 Derivatives Contracts

• 1.1 Introduction
• 1.2 Forward Contracts
• 1.3 Futures Contracts
• 1.4 Options
• 1.5 Types of Traders
• 1.6A ‘Health Warning’
• 1.7 Application: Data tables
• 1.8 Conclusion
• 1.9 Solutions to Exercises

Unit 2 Properties of Stock Options

• 2.1 Introduction
• 2.2 Options
• 2.3 Stock Options
• 2.4 Warrants, Employee Stock Options and Convertibles
• 2.5 Basics of Pricing Stock Options
• 2.6 Trading Strategies Involving Options
• 2.7 Application: Profit Patterns for Options and Option Strategies
• 2.8 Conclusion
• 2.9 Solutions to Exercises

Unit 3 The Behaviour of the Stock Price and the Black–Scholes–Merton Model

• 3.1 Introduction
• 3.2 The Wiener Process
• 3.3 The Behaviour of Stock Prices
• 3.4 Itô’s Lemma
• 3.5 The Lognormal Property of Stock Prices
• 3.6 The Black–Scholes–Merton Equation and the Black–Scholes–Merton Formula
• 3.7 Application 1: Simulating a lognormal process
• 3.8 Application 2: Black–Scholes–Merton option pricing
• 3.9 Conclusion
• 3.10 Solutions to Exercises

Unit 4 Greek Letters and Trading Strategies

• 4.1 Introduction
• 4.2 Naked and Covered Positions
• 4.3 Delta Δ Hedging
• 4.4 Theta Θ
• 4.5 Gamma Γ
• 4.6 Vega v
• 4.7 Rho Ρ
• 4.8 Hedging and Portfolio Insurance
• 4.9 Application 1: Delta Hedging a Call
• 4.10 Application 2: VBA Code for Option Pricing and the Greeks
• 4.11 Conclusion
• 4.12 Solutions to Exercises

Unit 5 Volatility

• 5.1 Introduction
• 5.2 Implied Volatility
• 5.3 Volatility Smiles
• 5.4 Trading Volatility
• 5.5 Application 1: Computing implied volatility
• 5.6 Application 2: Options strategies
• 5.7 Conclusion
• 5.8 Solutions to Exercises

Unit 6 Credit Derivatives and Credit Risk

• 6.1 Introduction
• 6.2 Credit Ratings and Default Probabilities
• 6.3 Mitigation of Credit Risk and Default Correlation
• 6.4 Credit Default Swaps
• 6.5 Asset-Backed Securities and Collateralised Debt Obligations
• 6.6 Correlation and the Gaussian Copula
• 6.7 Application: Calculating Default-adjusted Expected Bond Returns
• 6.8 Conclusion
• 6.9 Solutions to Exercises

Unit 7 Further Numerical Procedures

• 7.1 Introduction
• 7.2 Binomial Trees
• 7.3 Alternative Procedures for Constructing Trees
• 7.4 Monte Carlo Simulations
• 7.5 Finite Difference Methods
• 7.6 Alternatives to Black–Scholes–Merton
• 7.7 Stochastic Volatility Models
• 7.8 American Options
• 7.9 Application 1: Binomial Trees
• 7.10 Application 2: Pricing a Simple Call Option Using Monte Carlo Methods
• 7.11 Conclusion
• 7.12 Solutions to Exercises

Unit 8 Some Exotic Options

• 8.1 Introduction
• 8.2 Exotic Options
• 8.3 Barrier, Binary and Lookback Options
• 8.4 Asian Options
• 8.5 Some Other Exotic Options
• 8.6 Weather and Energy Derivatives
• 8.7 Insurance Derivatives
• 8.8 Application 1: Asian Options
• 8.9 Application 2: Barrier Options
• 8.10 Conclusion
• 8.11 Solutions to Exercises

Module samples

• M482 Module Introduction (PDF)
• M482 Specimen Examination (PDF)
• M482 Unit 1 (PDF)

Disclaimer

Important notice regarding changes to programmes and modules