WTW 354

FINANCIAL ENGINEERING
STUDY GUIDE 2024 (Semester 1)

Contents
1 ORGANISATIONAL COMPONENT 1
1.1 CLASS ATTENDANCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 DEPARTMENTAL INFORMATION . . . . . . . . . . . . . . . . . . . . . 1
1.2.1 Admittance to the module . . . . . . . . . . . . . . . . . . . . . . . 1
1.2.2 Test and exam arrangements . . . . . . . . . . . . . . . . . . . . . . 1
1.2.3 Disciplinary cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.3 ORGANISATION OF THE MODULE . . . . . . . . . . . . . . . . . . . . 2
1.3.1 Lecturer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.3.2 Assessment and Grading . . . . . . . . . . . . . . . . . . . . . . . . 2
1.4 Final Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.4.1 About the Excel Exam . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.4.2 Semester Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.4.3 Class Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.4.4 Practical Test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.4.5 Semester mark composition . . . . . . . . . . . . . . . . . . . . . . 3
1.4.6 Examination Admission . . . . . . . . . . . . . . . . . . . . . . . . 3
1.4.7 Final mark composition . . . . . . . . . . . . . . . . . . . . . . . . 3
1.4.8 Exemption Procedures . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.4.9 Supplementary Examination . . . . . . . . . . . . . . . . . . . . . . 3
1.4.10 Lecture Classes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.4.11 Tutorial Classes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.4.12 Textbooks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.4.13 Recommended Textbook: . . . . . . . . . . . . . . . . . . . . . . . . 4
1.4.14 Calculators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.4.15 Learning Hours . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.5 GENERAL LEARNING OUTCOMES . . . . . . . . . . . . . . . . . . . . 5

2 Module Structure and Content 6

3 MODULE CONTENTS 6
3.1 STUDY THEME : MEAN - VARIANCE PORTFOLIO THEORY . . . . . 6
3.2 STUDY THEME : MARKET EQUILIBRIUM MODELS . . . . . . . . . . 8
3.3 STUDY THEME : MODELS OF ASSET RETURNS . . . . . . . . . . . . 8
3.4 STUDY THEME : UTILITY THEORY AND SOME GENERAL PRIN-
CIPLES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
3.5 STUDY THEME : MEASURES OF INVESTMENT RISK . . . . . . . . . 12
3.6 STUDY THEME : EFFICIENT MARKET HYPOTHESIS . . . . . . . . . 12
3.7 STUDY THEME : Stochastic interest rate of return models . . . . . . . . 13

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1 ORGANISATIONAL COMPONENT
1.1 CLASS ATTENDANCE
Class attendance for this module is compulsory. The study guide is nothing else but a
GUIDE. Important issues such as specific learning outcomes will only be communicated
in class. All the exercises and problems that have to be mastered for the tutorial and
practical sessions will be given during the lectures. Students should take note of the
following: The order of the lectures will not necessarily be in the same order as set out in
the Module Contents section of this guide. It is the student’s responsibility to make sure
that she/he knows exactly what material has been covered in class.

1.2 DEPARTMENTAL INFORMATION

1.2.1 Admittance to the module
The prerequisites for WTW 354 are a pass mark for WTW 218, WTW 211 and WST
211.

1.2.2 Test and exam arrangements

The exam/test instructions on the UP webpage must be followed meticulously.

Material for tests: Material for tests will be announced in class and will be published
on the web notice board of this module.
Unless otherwise indicated, class tests will include the material covered up to the
Friday directly preceding the test.

Absence from tests: The lecturer must be notified of absence from any test due to
illness within three days of the date of the test.
Satisfactory proof of the reason for absence must be supplied. In the case of a
medical certificate being presented, illness during the actual time of the test must
be clearly indicated. In such cases of satisfactory proof and only in such cases an
additional test has to be written at the end of the semester (Date to be confirmed).
No other extraordinary tests will be granted.
In the case of exams, the relevant faculty administration should be informed of
absence.

Enquiries concerning tests: All queries concerning the grading of a specific test must
be finalised within 3 (three) days after receipt of the graded test. After three days
it is assumed that all marks are final and correct and no further discussion will be
entered into.

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1.2.3 Disciplinary cases
The policy of the Department of Mathematics and Applied Mathematics is without excep-
tion to refer all cases where a suspicion of irregularity exists to the disciplinary committee
of the university.

1.3 ORGANISATION OF THE MODULE

1.3.1 Lecturer
Lecturer Office Tel. Email
Dr AJ van Zyl 2-26 012 420 2784 gusti.vanzyl@up.ac.za
Dr van Zyl is also the Module Coordinator.

1.3.2 Assessment and Grading

Evaluation will take the form of regular class tests, quizzes, two Semester Tests and a
Final Examination ( Paper 1 Written & Paper 2 Lab). A Final Excel Exam will be
written in the Computer Laboratory.
Upon return of your class tests, practical test and semester tests, please keep them
safely as they are your only proof that you have indeed written the tests.

1.4 Final Examination

Apart from a written exam there will be an hour practical Excel Exam in the Laboratory.
The arrangement for this will be availed in due course.

1.4.1 About the Excel Exam

If if you fail to follow instructions about uploading and saving your files, it is your fault.
For example, forgetting to name your files.

1.4.2 Semester Tests

Dates of the semester tests will be made available in the Timetable section of the UP
Student Portal. The Semester Tests will exclude the Lab Excel component.

1.4.3 Class Tests

Class Tests will be written either in class or during the Practical Sessions. They will cover
both the theory and the problems.

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1.4.4 Practical Test
A Practical Test will be done on computers in the Computer Laboratory whenever it
happens and feasible.

1.4.5 Semester mark composition

Semester Test 1 35%
Semester Test 2 35%
Class Tests, Practical Tests, Assignments 30%.

1.4.6 Examination Admission

In order to be admitted to the exam, you must obtain a Semester Mark of at least 40%.

1.4.7 Final mark composition

Semester mark 50%
Examination mark 50%
The Examination has the Written Part, Paper 1, (70%) and the Excel Laboratory Part,
Paper 2, (30%).
To pass the module a student must obtain a final mark of at least 50% and a sub-minimum
of 40% in the examination.

1.4.8 Exemption Procedures

An independent external examiner decides which candidates are recommended for ex-
emptions, based on both the WTW 354 and WTW 364 examination papers using an
equal weighting for each module in the same calender year. Only candidates who obtain
semester marks of at least 60% in both semesters (WTW 354 and WTW 364) will be
considered. In addition students should also have included WST 322 and IAS 221 in their
degree.
No Supplementary, Sick or any other Special Examination marks may be used for exemp-
tion purposes.

1.4.9 Supplementary Examination

1) Subject to other Faculty Regulations a student may be admitted to a supplementary
examination, in cases where
a) In all other cases, a student may be admitted to a supplementary exam in
a module when a final mark between 40% and 49% has been obtained AND
either the exam mark or the semester mark is above 50%; or
b) a pass mark has been obtained, but the required sub-minimum in the exami-
nation has not been obtained.

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 2) Subject to other Faculty regulations, a student must obtain a Final Mark of at least
50% in order to pass an Supplementary Examination. The semester or year mark
is not taken into account and the Supplementary Mark is the final mark.

3) The highest Final Mark that may be awarded to a student in the Supplementary
Examination is 50%.

4) If you write a Sick Exam you will not be offered a Supplementary Exam.

1.4.10 Lecture Classes

Tuesday 09:30 – 10:20 EMB 4-151

Friday 09:30 – 10:20 EMB 4-151

1.4.11 Tutorial Classes

Wednesday 14:30 – 16:00 Law building 1-54

Thursday 08:30 – 10:00 EMS 4-150
The Tutorial Worksheets will be given, well before the tutorial, on clickUP.
You are expected to

• prepare the theoretical part thoroughly before the tutorial class

• do all the exercises for the tutorial class beforehand and use the Tutorial Class to
sort out any problems.

1.4.12 Textbooks
Class notes will be provided on all topics. The prescribed textbook is the following
however it does not cover all the themes.

1.4.13 Recommended Textbook:

• Investment Science, by D. G. Luenberger. Oxford University Press, ISBN 0-19-
510809-4.

Supplementary Textbooks:

– Modern Portfolio Theory and Investment Analysis, by EJ Elton, MJ Gruber,

SJ Brown and WN Goetzmann, 6th Edition, John Wiley, 2003
– Financial Economics: with applications to investments, insurance and pen-
sions, H H Panjer (Ed), The Actuarial Foundation, 1998.
– Beninga S. Principles of Finance with Excel. Oxford University Press (2005)

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1.4.14 Calculators
During the Semester Tests, class tests and the exam, only non-programmable pocket
calculators may be used.

1.4.15 Learning Hours

This module carries a weight of 18 credits, indicating that on average a students should
spend some 180 hours to master the required skills (including time for preparation for
tests and examinations). This means that on average you should devote some 12 hours
of study time per week to this module. The scheduled contact time is 3 21 hours per week,
which means that another 8 21 hours per week of own study time should be devoted to the
module.

1. 3. General
i. Announcements
The study guide does not necessarily contain all the information. Impor-
tant announcements may be made during lectures and will be posted on
the notice board.
ii. Calculators and / or Computers
• Only non-programmable calculators may be used. It will be announced
before each Test and Examination whether or not you are permitted
to use a calculator.
• Programming: Programs implementing numerical algorithms may be
written during the Practicals/Tests in Excel.
• There is a Practical Excel Exam done in labs for at least an hour.
iii. Announcements and ClickUP
All important information will appear on clickUP. It is your responsibility
to be aware of any announcements that are made on clickUP or during
lectures and tutorial (practical) classes, also when you are absent.

1.5 GENERAL LEARNING OUTCOMES

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

(i) Describe and discuss the assumptions of mean-variance portfolio theory and its prin-
cipal results.

(ii) Describe asset pricing models, discussing the principal results and assumptions and
limitations of such models.

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 (iii) Describe and discuss the properties of single and multifactor models of asset returns.
(iv) Describe and discuss the application of utility theory to financial problems
(v) Discuss the general principles of risk neutral pricing
(vi) Discuss the advantages and disadvantages of different measures of investment risk.
(vii) Discuss the various forms of the Efficient Markets Hypothesis and discuss the evi-
dence for and against the hypothesis.
(viii) Demonstrate a knowledge and understanding of simple stochastic models.

2 Module Structure and Content

The subject matter for the course is divided into four themes:
1 . Asset valuations. 13 lectures
– Mean-Variance Portfolio Theory. 6 lectures
– Asset pricing models [Market equilibrium models, e.g., CAPM]. 3 Lectures
– Single and multifactor models for investment returns. 4 lectures
2 . Theories of Financial Market behaviour. 9 lectures
– Rational choice theory [Utility theory and properties]. 3 lectures
– Stochastic Dominance. 2 lectures
– Rational Expectation theory [Efficient Markets Hypothesis]. 2 lectures
– Behavioural Economics. 2 lectures
3 . Measures of investment risk. 3 lectures
4 . Stochastic interest rate models. 3 lectures
[Note: The order of study is as it is except Theme 2, the last three bullets will be done
in the last weeks of the semester.]

3 MODULE CONTENTS
3.1 STUDY THEME : MEAN - VARIANCE PORTFOLIO THE-
ORY
When making an investment the initial outlay is known, but the amount to be returned
is uncertain. This uncertainty is treated by mean-variance analysis. The objective of
Theme 1 is to describe and discuss the assumptions of mean-variance portfolio theory.
Number of Lectures: 6

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1.1 Fundamental concepts
Asset and portfolio return.
Define and discuss random variables, expected values, variance and covariance.

Source: Investment Science, D G Luenberger Sections 6.1, 6.2 and 6.3.

Problems: Class notes.

1.2 Portfolio mean and variance

Mean return and variance of portfolio return.
Diversification.
The feasible set.
Markowitz model.
The two - fund theorem.
The one - fund theorem.

Source: Luenberger sections 6.4 - 6.10.

Problems: Luenberger p 170 # 1, 3, 5,7,8,10 and additional exercises.
Learning outcomes : After completion of this unit you should be able to

1. Describe and discuss the assumptions of mean-variance portfolio theory.

2. Discuss the conditions under which application of mean-variance portfolio the-
ory leads to the selection of an optimum portfolio.
3. Calculate the expected return and risk of a portfolio of risky assets, given the
expected return, variance and covariance of returns of the individual assets,
using mean-variance portfolio theory.
4. Calculate the minimum variance point and another fund on the minimum vari-
ance set.
5. Determine the one fund of the one fund theorem.
6. Explain the benefits of diversification using mean-variance portfolio theory.
7. Explain what is meant by: feasible set, efficient frontier, optimum portfolio, in
the context of mean-variance portfolio theory.

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3.2 STUDY THEME : MARKET EQUILIBRIUM MODELS
The objective of this theme is to describe equilibrium models, such as the capital as-
set pricing model, discussing the principal results, assumptions and limitations of such
models.
Number of lectures: 3

1. Source: Luenberger sections 7.1 - 7.8

Problems: Luenberger p 193 # 1,2,3, 6 and additional exercises.

Learning outcomes : After completion of this unit you should be able to

(a) Describe the assumptions and the principal results of the Sharpe-Lintner-Moss
Capital Asset Pricing Model (CAPM).
(b) Discuss the limitations of the basic CAPM and some of the attempts that have
been made to develop the theory to overcome these limitations.
(c) Perform calculations using the CAPM.

3.3 STUDY THEME : MODELS OF ASSET RETURNS

1. In our previous themes we looked at how mean - variance portfolio theory can be
used to determine the efficient frontier. From this the investor can choose his/her
optimal portfolio. Unfortunately, this approach can be difficult to implement since
the parameters are not readily available. Subsequent research has been directed at
developing means of simplifying the implementation process.

The objective of theme 3 is to describe and discuss the properties of single and
multi-factor models of asset returns and to show how it simplifies the covariance
structure.

Number of lectures: 4

Source: Luenberger Chapter 8.

Problems: Luenberger p 224 # 1, 2,4 6. Other problems may be given in class.

Learning outcomes : After completion of this unit you should be able to

(a) Discuss the single index model of asset returns.

(b) Discuss the multifactor model of asset returns.

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(c) Discuss the concepts of diversifiable and non-diversifiable risk.
(d) Discuss the assumptions, principal results and limitations of the Arbitrage
Pricing Theory model (APT).

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3.4 STUDY THEME : UTILITY THEORY AND SOME GEN-
ERAL PRINCIPLES
Number of lectures: 9
Source: Luenberger Chapter 9 and class notes.
Learning outcomes: After completion of this unit you should be able to

1. Explain the meaning of the term utility function.

2. Explain the axioms underlying utility theory and the expected utility theorem.

3. Explain how the following economic characteristics of investors can be expressed

mathematically by a utility function

• Non-satiation
• Risk-aversion
• Risk-neutral
• Risk-seeking
• declining or increasing absolute risk-aversion

4. Perform calculations using commonly used utility functions to compare investment

opportunities.

5. State conditions for absolute dominance and for first and second order dominance.

6. Analyse simple insurance problems in terms of utility theory.

7. Discuss the key findings in behavioural finance.

• Describe the main features of Kahneman and Tversky’s prospect theory cri-
tique of expected utility theory.
• Explain what is meant by “framing”, “heuristics” and “bias” in the context
of financial markets and describe the following features of behaviour in such
markets:
(a) the herd instinct
(b) anchoring and adjustment
(c) self-serving bias
(d) loss aversion
(e) confirmation bias
(f) availability bias
(g) familiarity bias.

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 • Describe the Bernartzi and Thaler solution to the equity premium puzzle.

8. Illustrate that the mean-variance approach used in the Markowitz portfolio problem
can be linked to the expected utility approach by using a quadratic utility function.

9. Discuss linearity of pricing.

10. Discuss the portfolio choice problem and solve problems related to this.

11. Discuss Log-optimal pricing and solve related problems.

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3.5 STUDY THEME : MEASURES OF INVESTMENT RISK
In Financial Economics, it is often assumed that the key factors influencing investment
decisions are ”risk” and ”return”. In practice, return is almost always measured as the
expected investment return. However, there are many possible ways to measure risk, of
which variance is just one, each of which corresponds to a different utility function.
Number of lectures: 3
Source: Source: Class notes and Transactions of the Faculty of Actuaries, Vol 39.
Learning outcomes: After completion of this unit you should be able to

1. Define the following measures of investment risk:

• variance of return
• downside semi-variance of return
• shortfall probabilities
• Value at Risk (VaR)/Tail VaR

2. Describe how the risk measures listed in (a) above are related to the form of an
investor’s utility function.
3. Perform calculations using the risk measures listed above to compare investment
opportunities.
4. Explain how the distribution of returns and the thickness of tails will influence the
assessment of risk.
5. Describe how insurance companies help to reduce or remove risk.
6. Explain what is meant by the terms “ moral hazard” and “adverse selection”.

3.6 STUDY THEME : EFFICIENT MARKET HYPOTHESIS

Number of lectures: 2.
Source: Class notes
Learning outcomes: After completion of this unit you should be able to

1. Discuss the three forms of the Efficient Markets Hypothesis and their consequences
for investment management.
2. Describe briefly the evidence for or against each form of the Efficient Markets Hy-
pothesis.

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3.7 STUDY THEME : Stochastic interest rate of return models
Number of lectures: 3
Source: Class notes and Transactions of the Faculty of Actuaries, Vol 39.
Learning outcomes: After completion of this unit you should be able to

• Show an understanding of simple stochastic models for investment returns.

– Describe the concept of a stochastic investment return model and the funda-
mental distinction between this and a deterministic model.
– Derive algebraically, for the model in which the annual rates of return are inde-
pendently and identically distributed and for other simple models, expressions
for the mean value and the variance of the accumulated amount of a single
premium.
– Derive algebraically, for the model in which the annual rates of return are
independently and identically distributed, recursive relationships which permit
the evaluation of the mean value and the variance of the accumulated amount
of an annual premium.
– Derive analytically, for the model in which each year the random variable (1+r)
has an independent log-normal distribution, the distribution functions for the
accumulated amount of a single premium and for the present value of a sum
due at a given specified future time.
– Apply the above results to the calculation of the probability that a simple
sequence of payments will accumulate to given amount at a specific future
time.

References of the study content: Institute and Faculty of Actuaries subject CM2 (2019).

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