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Financial Engineering Lecture Notes

The document discusses evaluating the risk and expected monetary value (EMV) of testing a new product in a market using a decision tree analysis. Based on expert estimates of different testing outcomes, the analysis finds an EMV of $615,000 for launching the test with a risk of $85,000, compared to an EMV of $620,000 but higher risk of $180,000 if not testing. It is recommended to do the market test given the small reduction in EMV but substantial decrease in risk.

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Mehmet Zirek
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© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
980 views

Financial Engineering Lecture Notes

The document discusses evaluating the risk and expected monetary value (EMV) of testing a new product in a market using a decision tree analysis. Based on expert estimates of different testing outcomes, the analysis finds an EMV of $615,000 for launching the test with a risk of $85,000, compared to an EMV of $620,000 but higher risk of $180,000 if not testing. It is recommended to do the market test given the small reduction in EMV but substantial decrease in risk.

Uploaded by

Mehmet Zirek
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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UMT FACULTY OF ECONOMICS

MSc Program of Financial Engineering and


Risk Management

Financial Engineering Lecture 1


What is Financial Engineering?

Financial Engineering, is the study of applying


• Math,
• Statistics,
• Computer science,
• Economic theory, and
• Other quantitative methods to analyzing and modeling
markets
To the field of FINANCE
What is Financial Engineering?

Financial Engineers come from Quantitative Fields like


• Engineering,
• Statistics,
• Computer science,
• Math, Economics
What is Financial Engineering?

Financial Engineers work at the intersection of

• Data Science
• Finance
Modern Finance Structure
Modern Finance Structure

PRODUCTS CASH FLOWS

CREDITS
Modern Finance Structure

What makes an equity an equity is the right to vote that is conveyed in a share of
common stock. Without this right, an equity becomes more of a hybrid between an
equity and a bond.
Similarly a bond without stated maturity immediately becomes more of a hybrid
between a bond and an equity.
A country that does not have the ability to print more of its own Money may find its
currency treated as more of a hybrid between a currency and an equity.
Credit Ratings
CREDIT RATINGS OF MAJOR AGENCIES
A Recent News

NEW YORK -- January 22, 2020 Duff & Phelps, the


global advisor that protects, restores and maximizes
value for clients, today announced that a global
investor consortium led by funds managed by Stone
Point Capital and Further Global has agreed to
acquire Duff & Phelps for $4.2 billion.

The equity sellers include the Permira funds, which


will continue to hold a significant stake in the company
as part of the consortium. As part of the transaction,
the Duff & Phelps management team will maintain a
meaningful equity stake in the firm and continue to
lead the company.

The transaction is subject to customary closing


conditions and is expected to close in the second
quarter of 2020.
Example financial algorithm, namely the valuation of a European call option by Monte Carlo simulation.
We will consider a Black-Scholes-Merton (BSM) setup in which the option’s underlying risk factor
follows a geometric Brownian motion.

BLACK SHOLES MERTON MODEL MONTE CARLO ESTIMATOR

Where

• z being a standard normally distributed random PSEUDOCODE


variable.
• Initial stock index level S0 • Draw I (pseudo) random numbers z(i), i ∈ {1,
• Strike price of the European call option K 2, …, I}, from the standard normal
distribution.
• Time-to-maturity T
• Calculate all resulting index levels at maturity
• Constant, riskless short rate r ST(i) for given z(i) by BSM
• Constant volatility 𝜎 • Calculate all inner values of the option at
maturity as hT(i) = max(ST(i) – K,0).
• Estimate the option present value via the
Monte Carlo estimator
Case Study
Possible test results
(a)less than 10% of the public decided to test (we should think of dropping the idea)
(b)more than 10% of public decided to test but less than 25% of those who try
decide to buy on a second or subsequent occasion
(c)more than 10% of public decided to test and repeat purchase rate is 25% or more

Based on subjective estimates of experts:


(a) has prob. 0.5, (b) has prob. 0.25 and (c) has prob. 0.25
Test market response
(a) (b) (c)
Success (S) 0.1 0.4 1.0
Failure 0.9 0.6 0.0
Decision Tree

2
1

4
7
3
5
8
6
9
Decision Tree Analysis

2
1

4 7
3
5
8
6
9
Decision Strategy Not launched due
to negative EMV
therefore final
Decision scenarios expected monetary
1 – Drop : EMV = 0 value is
1–2 : EMV= 620,000

1 – 3 -4 –Drop : EMV =-40,000 or Launch: EMV = -70,000 0,5 0


1 – 3 -5 –Drop : EMV =-40,000 or Launch: EMV = 620,000 0,25 155,000 EMV: 615,000
1 – 3 -6 –Drop : EMV =-40,000 or Launch: EMV = 2,000,000 0,25 500,000 (655K-40K)

Risks
1-2 EMV 620,000 Risk is -180,000
1-3 EMV 615,000 Risk is -45,000-40,000 (you can also add the = - 85,000

Conclusion:
WITH LESS THAN 1% DECREASE IN YOUR EXPECTED MONETARY VALUE (615K instead of 620K)
YOU CAN DECREASE YOUR RISK SUBSTANTIALLY (-180K to -85K)
Recommended Action: TRY IN THE TEST MARKET

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