Stochastic Finance in Continuous Time, ISEG, 2024-2025

Stochastic Finance in Continuous Time
ISEG, 2024-2025
(Final(?) update with corrections of the slides on 26 September 2024)

The course is part of the Mestrado em Mathematical Finance, Lisbon School of Economics & Management (Instituto Superior de Economia e Gestão, ISEG), Universidade de Lisboa.
The object of this course is to provide an introduction to arbitrage theory in continuous time and in particular to pricing and hedging theory for financial derivatives. Aims and objectives include the following.

Understanding the notions of: arbitrage portfolio, self-financing portfolio, risk-neutral measure, static or dynamics hedging, market completeness;
Deriving: the Black-Scholes model as well as it standard extensions to include dividends or currency derivatives;
Use the change of numeraire technique to simplify pricing expressions;
Distinguish between futures and forward contracts and prices;
Apply basic notions of Stochastic Optimal Control, in particular, concerning their use under a particular control function to maximize a value function.

Literature

The course is based on T. Björk, Arbitrage Theory in Continuous Time. The link leads to the 4th, expanded, edition of the book, but the slides (see below) are based on the 3rd edition as the reference text. Try to find a second hand copy. The 2nd edition can mostly be used as well.
The slides that have been produced by Tomas Björk in 2017 will be used as the main vehicle of the course, with chapters from the (3rd edition of the) book as background material (also the 2nd Edition will do for most purposes). Be aware of (rather minor) differences in notation between slides and book.
During the course, annotated slides will incrementally be uploaded. As time passes by you find the annotated slides of Lecture 1, annotated slides of Lecture 2, annotated slides of Lecture 3, annotated slides of Lecture 4, annotated slides of Lecture 5, annotated slides of Lecture 6, annotated slides of Lecture 7, annotated slides of Lecture 8, annotated slides of Lecture 9, and a (sketch) proof of the Verification theorem for the HJB equation.
Have a look at the file containing only(!) the exercises of the 3rd Edition.
We will sometimes use some additional exercises in the tutorials.
Other, very different, topics in Mathematical Finance for further studying after the course are treated in the video lectures by Lech Grzelak. Recommended!

Prerequisites

Basic concepts of probability and measure theory, for instance at the level of the Appendices A and B of the book by Tomas Björk.

Examination

Written exam, planned as officially scheduled for 19 December 2024. You (students) are allowed to bring up to 4 pages (A4 format, written in normal print) with your own notes with you.

People

Lectures by Peter Spreij.
Assistance and tutorials by Henrique Guerreiro.

General schedule

Lectures during three weeks in September 2024, in the mornings of September 11, 12, 13, 16, 17, 19, 20, 23, 26. Tutorials are spread over Mondays in September and October of the Fall semester, and planned for September 9, 16, 23, 30 and October 7, 14, 21. See the timetable for details. This timetable is part of the overview site, which contains further administrative information.

Planned programme of 2024-2025
(may be updated during the course; )

0

No lecture, only a refresher tutorial (9 Sep 2024) on Itô calculus and related topics. Among them Wiener process, filtrations, martingales, Itô isometry, Itô formula, simple SDEs, Feynman-Kac formula. Make Exercises (from the 3rd Edition) 4.1, 4.3, 4.8, 5.1, 5.5, 5.9, and 5.8 if there is sufficient time left.

1
11 Sep 2024, F1 002
Lecture: Main topics are Portfolio dynamics, self financing strategies and arbitrage pricing; Slides 42-97; related material from the book in Sections 6.1, 6.2, 7.1-7.5.
Tutorial (16 Sep 2024): Exercises 7.1, 7.2, 7.3, 7.4, 7.5, 7.6; and give an example of a (very simple) derivative where the approach of slides 63-66 fails. How to remedy this? Is the Black-Scholes PDE also valid in this example?

2
12 Sep 2024, F1 002
Lecture: Main topics are Completeness, hedging, parity relations and the Greeks; Slides 98-127; background in the book in Chapters 8,9.
Tutorial (16 Sep 2024): Exercises 8.2, 8.3.
Tutorial (23 Sep 2024): 9.1, 9.5, 9.10. In order to compute the Delta and Gamma for a European call (or put), show first that $s\phi(d_1)-Ke^{-r(T-t)}\phi(d_2) = 0$, where $\phi$ denotes the density of the standard normal distribution. Then it becomes easier to compute the Delta and Gamma.

3
13 Sep 2024, F1 002
Lecture: Main topic is the mathematical background of the martingale approach to arbitrage theory; Slides 128-168. Recap of probability theory based on Sections B.1, B.5, B.6, C.3 and Theorem A.52. The `dynamic' version of all this (use of processes, filtrations, martingales) in Sections 11.1-11.5.
Tutorial: No particular exercises for this theoretical part.

4
16 Sep 2024, F1 102
Lecture: Main topic is The martingale approach to arbitrage theory, application of the theory; Slides 169-205. These are based on (a light version of) Sections 10.3-10.6 and Chapter 12. Take good notice of the summary Section 10.7.
Tutorial (23 Sep 2024): Additional exercises 2, 3, 4 (and, only if there is enough time left, 5).

5
17 Sep 2024, F1 102
Lecture: Main topics are dividends, forwards and futures; Slides 206-248, based on Sections 16.2 (we skip Section 16.1), 16.3.1; Sections 7.6 and 29.1, 29.2 of the book.
Tutorial (30 Sep 2024): Exercises 7.8 (very easy), 7.9, 16.2, 16.4 (slide 221), 16.5 (slide 222), 16.6, 16.8 (only if there is enough time), 16.9.
Tutorial (7 Oct 2024): 29.1, and (if there is enough time left) 29.2, 29.3.

6
19 Sep 2024, F1 002
Lecture: Main topics are currency derivatives and change of numeraire; Slides 249-288, based on Sections 17.1, 17.3, 17.4 and (most of) Sections 26.1-26.5.
Tutorial (7 Oct 2024): Exercises 17.1, 17.2, 17.3, 17.5 (if there is sufficient time).
Tutorial (14 Oct 2024): Additional exercises 8, 9 , 10, 11.

7
20 Sep 2024, F1 002
Lecture: Main topic is incomplete markets and; Slides 289-320, based on Sections 15.1, 15.2.
Tutorial (14 Oct 2024): Exercises 15.1, 15.3 (for a univariate model), 15.4.

8
23 Sep 2024, F1 004
Lecture: Main topic is the introduction to stochastic control theory, dynamic programming; Slides 321 - 347, based on Sections 19.1 - 19.5;
Tutorial (21 Oct 2024): Exercises 19.1, 19.5, 19.6 (if there is enough time), 19.8.

9
26 Sep 2024, F1 104
Lecture: Main topics are the application of stochastic control theory and the martingale approach to optimal investment; Slides 348-385, based on Sections 19.5-19.7, 20.1-20.4 and 20.7.
Tutorial (21 Oct 2024): Exercises 20.1, 20.2 and (if there is enough time) 20.3.

Planned schedule of the tutorials
(may be updated during the course; )

1
9 Sep 2024, F2 105
Refresher tutorial on Itô calculus and related topics. Among them Wiener process, filtrations, martingales, Itô isometry, Itô formula, simple SDEs, Feynman-Kac formula. Background on Slides 2-40 and Chapters 4,5. Make Exercises (from the 3rd Edition) 4.1, 4.3, 4.8, 5.1, 5.5, 5.9, and 5.8 if there is sufficient time left.

2
16 Sep 2024, F2 105 Exercises 7.1, 7.2, 7.3, 7.4, 7.5, 7.6, 8.2, 8.3. Also give an example of a (very simple) derivative where the approach of slides 63-66 fails. How to remedy this? Is the Black-Scholes PDE also valid in this example?

3
23 Sep 2024, F2 105
Exercises 9.1, 9.5, 9.10. In order to compute the Delta and Gamma for a European call (or put), show first that $s\phi(d_1)-Ke^{-r(T-t)}\phi(d_2) = 0$, where $\phi$ denotes the density of the standard normal distribution. Then it becomes easier to compute the Delta and Gamma. Extra exercises 2, 3, 4 (and, only if there is enough time left, 5).

4
30 Sep 2024, F2 105
Exerices 7.8 (very easy), 7.9, 16.2, 16.4 (slide 221), 16.5 (slide 222), 16.6, 16.8 (only if there is enough time), 16.9.

5
7 Oct 2024, F2 105
Exercises 17.1, 17.2, 17.3, 17.5 (if there is sufficient time), 29.1, and (if there is enough time left) 29.2, 29.3;

6
14 Oct 2024, F2 105
Exercises 15.1, 15.3 (for a univariate model), 15.4 and Additional exercises 8, 9 , 10, 11.

7
21 Oct 2024, F2 105
Exercises 19.1, 19.5, 19.6 (if there is enough time), 19.8, 20.1, 20.2 and (if there is enough time) 20.3.

Links

Departamento de Matemática do ISEG, Universidade de Lisboa
Mestrado em Mathematical Finance, Lisbon School of Economics & Management (ISEG), Universidade de Lisboa

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