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Course objectives
The module provides an understanding of the uses and the
valuation of the main derivative financial instruments:
forward, futures, swaps and options. It covers the trading
mechanisms used on derivative markets and explains the
fundamental principles underlying the pricing of derivative
instruments and their use in portfolio management.
Particular attention is paid to the practicalities of using
derivative instruments for risk management purposes. The
module also provides an introduction to the working of the
foreign exchange market and the instruments traded thereon.
Related institutional aspects are introduced where necessary.
Learning Outcomes
Define a derivative and differentiate between exchange-traded and over-thecounter derivatives.
Discuss the purposes and criticisms of derivative markets.
Explain the concept of arbitrage and the role it plays in determining prices and
in promoting market efficiency.
Define futures and forward contracts.
Define the terms futures price, long position and short position, open interest,
price limit, and position limit.
Explain how futures and forwards can be used by hedgers and speculators.
Describe how marking to market and margin accounts work.
Explain the difference between futures and forward contracts.
Describe how futures and forwards can be used in risk management.
Outline the main arguments in favour of and against hedging.
Explain the concept of basis risk.
Explain how cross hedging works and calculate the minimum variance hedge
ratio.
Describe how to use stock index futures to hedge an equity portfolio.
Explain the differences between investment and consumption assets.
Describe the mechanics of short selling.
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Learning Outcomes
Calculate forward prices for investment assets with and without income.
Calculate the value of a forward contract.
Explain the pricing of futures contracts on commodities. Show the difference
between pricing futures on investment and consumption commodities.
Discuss the concept of convenience yield and the cost of carry model.
Explain the relation between futures prices and expected spot prices.
Define a swap contract and explain how the swap market works.
Show how interest rate swaps may be used to transform a liability or an asset.
Describe the role of a financial intermediary in a swap.
Explain how to use currency swaps and the comparative advantage argument.
Perform valuation of a currency swap.
Understand the organisation of the foreign exchange market.
Understand the difference between the spot and forward foreign exchange
markets.
Discuss the concepts of foreign exchange risk
Describe interest rate parity and the main reasons for deviations from interest
rate parity.
Learning Outcomes
Define the basic characteristics of equity option (put and call) contracts.
Explain the differences between purchasing and writing option contracts.
Define the terms European option, American option, moneyness, payoff,
intrinsic value and time value.
Describe how options can be used for speculating on price changes and for
hedging price risk.
Explain how option payoffs are determined.
Identify the minimum and maximum values of European options and
American options.
Describe the relationship between options that differ only by exercise price.
Explain how option prices are affected by the time to expiration, the price of
the underlying instrument, volatility and the market rate of interest.
Explain the relationship between American options and European options in
terms of the lower bounds on option prices and the possibility of early
exercise.
Explain the use of a variety of option trading strategies such as short straddles
and long butterflies
Apply hedging techniques to simple situations.
Learning Outcomes
Determine the value at expiration, the profit, the maximum profit and loss, the
breakeven price at expiration, and the general shape of the graph of the strategies
of buying and selling calls and buying and selling puts, and explain each strategys
characteristics.
Determine the value at expiration, the profit, the maximum profit and loss, the
breakeven price at expiration, and the general shape of the graph of the straddle
strategy, strips and straps, strangles, the bull spread strategy, the bear spread
strategy, the butterfly spread strategy, the collar strategy, and explain each
strategys characteristics.
Determine the value at expiration, the profit, the maximum profit and loss, the
breakeven price at expiration, and the general shape of the graph of the covered
call strategy and the protective put strategy, and explain each strategys
characteristics.
Understand how synthetic securities may be created how they may be used.
Understand and apply the put-call parity theorem.
Calculate the fair value of a call option contract using the simple binomial option
pricing model.
Explain the assumptions underlying the BlackScholesMerton option pricing
model and their limitations.
Calculate the fair value of a call option contract using the BlackScholesMerton
option pricing model.
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Readings
Required textbooks
Options, Futures and other Derivatives, Hull, 8e, 2012 (Chapter 1, 2, 3,
5, 7, 9, 10, 11, 12, 14).
Recommended textbooks:
CFA curriculum on derivatives, 2009-2011
An Introduction to Derivatives and Risk management, Chance and
Brooks, 7e, 2008
Assessment
The module will be assessed as follows:
A test will take place on the 9th class. The test will have a multiple
choice format, will be based on all materials covered in the forward
and futures topic, and will account for 30 per cent of the marks.
Or A 10,000-word assignment for each group of 5-10 students.
The final examination, accounting for 60 per cent of the marks, will
take place on 23rd October (tentative). The final exam will contain both
detailed numerical questions and descriptive/discursive questions in
multiple choice format or short question format based on course
materials (textbook chapters, class handouts, lectures and seminars).
Class schedule
Topic
Reading
Hull Chapter 1, 2
Hull Chapter 5
Hull Chapter 3
Swaps
Hull Chapter 7
Introduction to options
Hull Chapter 9
Hull Chapter 11
Hull Chapter 10
Hedging (continued) & Properties of stock options
Hull Chapter 12:
Options Valuation I: The binomial option pricing Model
12.1-12.8
Options Valuation II: The Black-Scholes-Merton Model
Hull Chapter 14
option pricing model and its Applications
Seminars
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CFA
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The company
Financial risk
Information/
Data
Indentify risk
Measure risk
Execute
Risk Mgmt.
Transactions
Derivatives
Non-Derivatives
Identify appropriate
transactions
Price transactions
Execute transactions
Identify
source of
uncertainty
Determine
Market
Price or
Value
Attractively
Priced
Execute
transaction
Select
Appropriate
model
Compare
Determine
Model
Price or
Value
Not Attractively
Priced
Seek
Alternative
Transaction
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Liquidity risk
Taxes
Credit risk
Legal
Regulations
Commodity
Prices
Nonfinancial risk
The company
Financial risk
Equity
Prices
Settlement
Model
Operations
Interest
rates
Exchange
rates
Market risk is the risk associated with interest rate, exchange rates, stock prices, and commodity prices.
Sovereign risk is a form of credit risk in which the borrower is the government of a sovereign nation.
Political risk is associated with changes in the political environment.
Other risks such as ESG risk (the risk to a companys market valuation resulting from environmental,
social, and governance factors) performance netting risk, settlement netting risk.
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Measuring risk
Measuring risk often takes the form of standard deviations, betas,
and probabilities of default.
Measuring market risk: Assets volatility represented by the Greek
letter sigma, beta measures sensitivity to market movements for a
stock portfolio, duration, convexity, gamma, theta.
Value at risk: is an estimate of the loss that we expect to exceeded
with a given level of probability over a specified time period. Three
standardized methods for calculating CAR are the analytical or
variance-covariance method, the historical method, and the Monte
Carlo simulation method.
Measuring credit risk: credit VAR
Measuring nonfinancial risk is difficult. Some of these risk could be
thought of as more suitable for insurance than measurement and
hedging. Basel II banking regulation has created real advantages for
banks that can credibility measure their operational risks.
Managing risk
Two professional organization are devoted to risk management: The
Global Association of Risk Professional (GARP) and the professional
Risk Managers International Association (PRMIA)
Managing market risk: risk budgeting is a new approach to risk
management, which is the process of establishing policies to allocate
the finite resource of risk capacity to business units that must assume
exposure in order to generate return.
Managing credit risk: setting exposure limits for individual
counterparties, exchanging cash values that reflect mark-to-market
level, posting collateral, netting, setting minimum credit, using specialpurpose vehicles that have higher credit ratings than the companies
that own them, and using credit derivatives.
Performance evaluation: measure performance against risk assumed
and budgeted (risk-adjusted performance) in a portfolio context: the
Sharpe ratio, risk-adjusted return on capital, return over maximum
drawdown, and the Sortino ratio.
Allocating capital across business units: measure such allocating capital
include nominal position limits, VAR-based position limits, maximum
loss limits, internal capital requirements, and regulatory capital
requirements.
Introduction to Derivatives
Mai Thu Hien
Faculty of Banking and Finance
Foreign Trade University
Email: maithuhien712@yahoo.com
Web: http://web.ftu.edu.vn/maithuhien/
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Derivatives contracts
A derivative contract is a financial instrument with a return that
is obtained from or derived from the return of another asset:
futures, forwards, swaps, options, exotics
Derivatives contracts are created on and traded in two distinct
but related types of markets: exchange traded and over the
counter
Exchange-traded contracts have standard terms and features
and are traded on an organized derivatives trading facility.
Over-the-counter contracts are any transactions created by
two parties anywhere else.
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Source: Bank for International Settlements. Chart shows total principal amounts for
OTC market and value of underlying assets for exchange market
Options, Futures, and Other Derivatives, 8th Edition, Copyright John C. Hull 2012
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Derivatives contracts
Exchange-traded derivatives
contracts
Traded in the exchange
Have standardized terms (have
public and standardized
transactions)
Default-risk free
Daily settlement or marking to
market (refers to the
procedure that the gains and
losses on each partys position
are credited and charged on a
daily basis)
Over-the-counter derivatives
contracts
Traded off the exchange
through dealers
Do not have standard terms
(have a private and
customized transaction)
Default risk exists (subject to
the possibility that the other
party will default)
Settlement at expiration of
the contract
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Derivatives contracts
Derivatives contracts can be classified into two general
categories: forward commitments and contingent claims.
A forward commitment is a contract in which the two
parties enter into an agreement to engage in a transaction
at a later date at a price established at the start. Three
types of forward commitments are forward contracts,
futures contracts and swaps.
A contingent claim is a derivative contract with a payoff
dependent on the occurence of a future event. We
generally refer to this type of derivatives as option.
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Derivatives
Contingent claims
Exchangetraded
Over-thecounter
Options
Forward commitments
Exchangetraded
Over-thecounter
Futures
Forward
Swaps
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Types of Traders
Hedgers trade to cover an open position to avoid risk (i.e.
they are risk averse)
Arbitragers trade to make a riskless profit by exploiting forex
anomalies (i.e. they are risk neutral)
Speculators risk bearers who take decisions involving open
positions to make profits if expectations are correct
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Forward contract
A forward contract is an agreement between two parties in which
one party, the buyer, agrees to buy from the other party, the
seller, an asset at a future date at a price established at the start of
contract (i.e., it is the delivery price that would make the contract
worth exactly zero)
The forward price may be different for contracts of different
maturities (as shown by the table)
The parties to the transaction specify the forward contracts terms
and conditions. In this sense, the contract is said to be customized.
Each party is subject to the possibility that the other party will
default.
The holder of a long forward contract (the long) is obligated to
take delivery of the underlying asset and pay the forward price at
expiration. The holder of a short forward contract is obligated to
deliver the underlying asset and accept payment of the forward
price at expiration.
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Terminology
The party that has agreed to buy has what is termed a
long position
The party that has agreed to sell has what is termed a
short position
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Profit (Payoff)
Price of
underlying
at maturity ST
Long Position
Price of
underlying
at maturity ST
Short Position
Payoff = ST - K
Payoff = K - ST
(K = delivery price = forward price at time contract is entered into)
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Example (page 5)
On May 24, 2010 the treasurer of a corporation enters
into a long forward contract to buy 1 million in six
months at an exchange rate of 1.4422
This obligates the corporation to pay $1,442,200 for 1
million on November 24, 2010
What are the possible outcomes? (ST = 1.5 and ST =
1.35)
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Options
A call option is an option to buy a certain asset by a
certain date for a certain price (the strike price)
A put option is an option to sell a certain asset by a
certain date for a certain price (the strike price)
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Google Call Option Prices (June 15, 2010; Stock Price is bid
497.07, offer 497.25); See Table 1.2 page 8; Source: CBOE
Strike
Price
Jul 2010
Bid
Jul 2010
Offer
Sep 2010
Bid
Sep 2010
Offer
Dec 2010
Bid
Dec 2010
Offer
460
43.30
44.00
51.90
53.90
63.40
64.80
480
28.60
29.00
39.70
40.40
50.80
52.30
500
17.00
17.40
28.30
29.30
40.60
41.30
520
9.00
9.30
19.10
19.90
31.40
32.00
540
4.20
4.40
12.70
13.00
23.10
24.00
560
1.75
2.10
7.40
8.40
16.80
17.70
Price of a
December
call option to
buy 100
shares at
strike price of
USD520
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Google Put Option Prices (June 15, 2010; Stock Price is bid 497.07,
offer 497.25); See Table 1.3 page 9; Source: CBOE
Strike
Price
Jul 2010
Bid
Jul 2010
Offer
Sep 2010
Bid
Sep 2010
Offer
Dec 2010
Bid
Dec 2010
Offer
460
6.30
6.60
15.70
16.20
26.00
27.30
480
11.30
11.70
22.20
22.70
33.30
35.00
500
19.50
20.00
30.90
32.60
42.20
43.00
520
31.60
33.90
41.80
43.60
52.80
54.50
540
46.30
47.20
54.90
56.10
64.90
66.20
560
64.30
66.70
70.00
71.30
78.60
80.00
Price of a
September
put option to
buy 100
shares at
strike price of
USD480
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Options vs Futures/Forwards
A futures/forward contract gives the holder the obligation
to buy or sell at a certain price
An option gives the holder the right to buy or sell at a
certain price
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Arbitrage Example
A stock price is quoted as 100 in London and $140 in
New York
The current exchange rate is 1.4300
What is the arbitrage opportunity?
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Dangers
Traders can switch from being hedgers to speculators or
from being arbitrageurs to speculators
It is important to set up controls to ensure that trades are
using derivatives in for their intended purpose
Soc Gen (see Business Snapshot 1.3 on page 17) is an
example of what can go wrong
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Long/Short Equities
Convertible Arbitrage
Distressed Securities
Emerging Markets
Global macro
Merger Arbitrage
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