Option Pricing and Stochastic Calculus

MSO4112

Option Pricing and Stochastic Calculus

Module Handbook

Autumn/Winter term – Sept start (12 week module)

2015/16

Dr Roman Belavkin

School of Science and Technology

Information in alternative formats

This handbook can be found online at:

If you have a disability which makes navigating the website difficult and you would like to receive information in an alternative format, please contact:

Bryan Jones

Tel: 020 8411 5367

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Disclaimer

The material in this handbook is as accurate as possible at the date of production however you will be informed of any major changes in a timely manner.

Module Summary/Introduction

Introduction

This module aims to teach students to use pricing theory for derivatives, such as options, futures and forwards, using a risk-neutral probability and stochastic differential equations (SDEs). It explores discrete and continuous time models of stochastic processes with applications to pricing, such as the Black-Scholes equation for options pricing. In addition to theoretical exploration, the module introduces students to the main numerical methods, such as Monte-Carlo simulations, for modelling and solving option pricing problems.

The module teaching team

Dr Roman Belavkin (Module Leader)

Contacting the Module Leader

You can contact your module leader in the following ways:

Office Hours - Room No: TG05 Tuesday 14:00-16:00

Telephone +44(0)20 8411 6263

Web page

MyUniHub pages

It is not necessary to book an appointment to see Roman Belavkin during the above office hours you just need to drop by.

In the first instance problems should be dealt with by talking to your lecturer after the lecture. Queries concerning course content are particularly suitable for the MyUniHub Discussion Board.”

UniHelp

On the Hendon campus, UniHelp is located on the Ground Floor of the Sheppard Library

Office Hours: Monday to Friday: 08.30 – 21.30

Saturday and Sunday: 11.00 – 18.00

Learning Outcomes

On completion of this module, the successful student will be able to:

Knowledge

On completion of this module the successful student will be able to:

Formulate the main principles and assumptions of rational pricing
Define the main types of stochastic differential equations (SDE) and integrals
Reason about the main principles of application of SDE to pricing of financial assets.
Differentiate between several techniques for solving SDE

Skills

This module will call for the successful student to:

Model a specific pricing problem by an appropriate SDE

Analyse data to estimate parameters of stochastic processes used in an SDE

Obtain analytical solutions to basic SDEs

Use computer simulation to obtain numerical solutions to an SDE

Assessment Scheme

Formative assessment will consist of guided and independent activities throughout the module. Feedback will be provided on-line and in subsequent labs and seminars.

Summative assessment consists of two components selected in order to ensure students demonstrate an overall understanding of relevant concepts and techniques as well as the ability to apply and critique them in appropriate contexts.

The summative assessment components are:

Individual report (50%) students will be given data to analyse and produce a numerical solution to a pricing problem. The report (between 4-6 A4 pages) should discuss the model, calculations, results and discussion of the findings. This will address learning outcomes 5, 6, 8 (Week 11).
Two hour unseen examination (50%) assessing key concepts throughout the module. The paper will consist of a choice of questions, which will address learning outcomes 1, 2, 3, 4, 7 (Examination Period)

In order to pass this module students must achieve a grade 18 or better in each summative assessment component.

Assessment Weighting

Unseen two-hour examination, 50% of the total mark.
Coursework, 50% of the total mark as three assessed assignments.

Syllabus

Options and rational pricing

Binomial pricing

Stochastic processes and nowhere differentiable functions

Gaussian white noise and Wienner process

Continuous Markov process and the diffusion equation

Stochastic differential equations and integrals

Ito rule

The Black-Scholes theory

Reading Materials

Core Texts

Roman, S. (2012). Introduction to the mathematics of finance: Arbitrage and

option pricing. Springer.

Robert J. Elliott and P. Ekkehard Kopp (2004), Mathematics of Financial Markets. 2nd edition. Springer Finance / Springer Finance Textbooks, Springer.

Additional texts

Crack, T. F. (2014). Basic Black-Scholes: Option pricing and trading (3rd ed.). Timothy Crack.

Stratonovich, R. L. (2014). Topics in the theory of random noise (Vol. 1).

Martino Fine Books.

Bernt Oksendal (2010). Stochastic Differential Equations: An Introduction with Applications. 6th edition. Springer.

Darrell Duffie (2001). Dynamic Asset Pricing Theory. 3rd edition. Princeton Series in Finance, Princeton University Press.

Study hours outside class contact

The study hours for each credit point is 10 hours. For a 30-credit module this equates to 300 hours. Therefore, if a module has time-tabled activities i.e. lecture/seminar/lab, of 3 hours per week for a 24 week period (total of 72 hours), then the out-of-class study commitment expected of students is 228 hours in total.

Brief Guide to Web-based Module Material

The suggested textbooks and journals are available in the library. Please, refer to the Lecture plan for specific chapters in each week. Each topic is supported by lecture slides, the handouts for which are available on the module leader’s webpage:

Coursework

Details of Coursework

The aims of the coursework are to learn how to:

Estimate historical volatility of a stock and to price options using the Black-Scholes formulae.

Estimate implied volatility using options from a market.

Examine the assumptions of pricing theory by analysing real stock data.

Your work will be assessed in the classroom and based on a written report, which should include the main results and conclusions. A detailed coursework description is available at:

Deadline for Submission of Coursework

September-start modules: 15 April 2016

Sometimes deadlines from different modules will come at the same time and it is important to plan your workload to meet these deadlines.

Where to submit

Written assessed coursework must be submitted to UniHelp, Ground Floor, Sheppard Library. You should attach a coursework feedback form which will be dated and receipted. You should keep your receipt - it is for your own protection.

Do not submit hand written assessed coursework directly to your tutor, and do not submit it by email to your tutor.

Written work should normally be handed in on the campus at which the module is being taught; if for any reason you have to hand it in at another campus please point this out to UniHelp so that it can be sent to the correct campus. If, in an emergency, you have to send in written assessed work by post you must send it by recorded delivery to UniHelp, Sheppard Library, Middlesex University, The Burroughs, London NW4 4BT and keep the Post Office receipt. It will be deemed to have been submitted on the date of the postmark.

Receipts for this work and other work submitted outside opening hours can be collected from UniHelp.

Electronic Receipt of Coursework

Coursework may NOT be submitted in electronic form except where this is an explicit requirement of that assessment in the module in question. When electronic submission is a requirement, it must be done via MyUniHub never via email.

Intellectual Property

In most cases, students hold the intellectual property rights in the work they produce for assessment. There are some exceptions such as where the work is commercially-sponsored, or the aim of the module is to develop intellectual property, or where the student is sponsored or employed, or on placement. Students are asked to read the Middlesex University Policy Statement ‘Intellectual Property Rights:

Feedback to students on coursework

Students should attach a generic School Coursework Feedback form available outside Student Offices to the front of their work;
Feedback to presentation will be given and summarised during the workshop sessions

Coursework return

Coursework is not normally returned to students, so you should keep a copy of what you submit.

Teaching Plan

Week no: / Topic / Recommended reading
1 / Options and rational pricing / Chapter 1, Sec. 1.1, 1.2 (Elliott & Kopp, 2004).
Chapter 1, 2 (Roman, 2012)
Chapter 1, 3 (Crack, 2014)
2 / Binomial pricing / Chapter 1, Sec. 1.3–1.5 (Elliott & Kopp, 2004).
Chapter 5, 6 (Roman, 2012)
Chapter 6, 8, Sec, 8.3.3 (Crack, 2014)
3 / Stochastic processes and nowhere differentiable functions / Chapter 6, Sec. 6.1 (Elliott & Kopp, 2004).
Chapter 9 (Roman, 2012).
Chapter 1, Sec. 3 (Stratonovich, 2014).
4 / Gaussian white noise and Wiener process / Chapter 6, Sec. 6.2, 6.4 (Elliott & Kopp, 2004).
Chapter 10 (Roman, 2012)
5—6 / Continuous Markov process and the diffusion equation / Chapter 7 (Crack, 2014)
Chapter 4 (Stratonovich, 2014)
7 / Stochastic differential equations and integrals / Chapter 6, Sec. 6.3, 6.5 (Elliott & Kopp, 2004).
8 / Ito differentiation rule / Chapter 6, Sec. 6.4 (Elliott & Kopp, 2004).
9—10 / The Black-Scholes theory / Chapter 7, Sec. 7.6, 7.9 (Elliott & Kopp, 2004).
Chapter 10 (Roman, 2012)
Chapter 4, Sec. 4.4, Chapter 8 (Crack, 2014)
11—12 / Revision

Useful Information

The School has a student website to enrolled Science and Technology students, which provides information to support you on your programme of study, including information on the School’s Academic staff and:

UniHelp opening hours
Module Review Forms
Learning Resources: Science and Technology

Programme Handbooks

And other useful information such as

Library Catalogue

MyUniHub

Lecturers' contact details can also be found on MyUniHub, the university's online learning environment. This can be accessed from the following url: Within each module you can find 'module information' which displays contact details for the lecturer and other information about the module.

Attendance Requirements

You should attend all scheduled classes. If you do not do so, you may not be able to demonstrate that you have achieved the Learning Outcomes for the module, and you are at risk of being graded “X” in the module. The definition of the X grade is: “Fail – incomplete without good reason: may not be reassessed.” As a general guide, you need to attend at least 75% of scheduled classes in order to be able to demonstrate achievement of all Learning Outcomes. On some modules, there may be more specific attendance requirements.

Academic Dishonesty

Taking unfair advantage in assessment is considered a serious offence by the university, which will take action against any student who contravenes the regulation through negligence, foolishness or deliberate intent.

Academic dishonesty is a corrosive force in the academic life of the university; it jeopardises the quality of education and devalues the degrees and awards of the University.

The full regulations on academic dishonesty are given in the University Regulations, Section F Infringement of assessment regulations - academic misconduct.

Plagiarism

Plagiarism is one specific form of cheating.

The University Regulation Section F clearly sets out the University’s understanding of plagiarism and the regulations by which you as a student of the University are bound. The key University regulation is F2.3 which defines plagiarism as “The presentation by the student as their own work of a body of material (written, visual or oral) which is wholly or partially the work of another, either in concept or expression, or which is a direct copy.”

Work presented for assessment must be the candidate’s own, or the work of a project group as requested by the tutor. Plagiarism is the representation of another person’s published or unpublished work as the candidate’s own by unacknowledged quotation. It is not an offence if the material is acknowledged by the candidate as the work of another through the accurate use of quotation marks and the provision of detailed references and a full bibliography, although the Assessment Board will not expect work to rely heavily on direct quotations.

In addition, the University Regulations set out the process for investigating allegations of plagiarism and describes the penalties. If you are found guilty, the repercussions are very serious indeed.

You should take steps, therefore, to understand what plagiarism is, how it can be identified and how you can avoid committing it; perhaps most importantly, you should reflect and come to understand why it is to your enormous advantage never to plagiarise because it is in effect cheating yourself and your fellow students).

Full details on the Infringement of assessment regulations - Academic misconduct, can be found in the University Regulations - Section F.

Appeals

The full regulations on appeals are given in the University Regulations. Section G - Appeal regulations and procedures

Examples of all Typical/Previous Examination Papers

Please go to the University student portal website for copies of previous examination papers in all subject areas across the University.