Lahore University of Management Sciences. FINN 453 Financial Derivatives Spring Semester 2017

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1 Instructor Ferhana Ahmad Room No. 314 Office Hours TBA Telephone Secretary/TA Sec: Bilal Alvi/ TA: TBA TA Office Hours TBA Course URL (if any) FINN 453 Financial Derivatives Spring Semester 2017 COURSE BASICS Credit Hours 3 Lecture(s) Nbr of Lec(s) Per Week 2 Duration 1 hour 15 min Recitation/Lab (per week) Nbr of Lec(s) Per Week Duration Tutorial (per week) Nbr of Lec(s) Per Week Duration COURSE DISTRIBUTION Core Elective Open for Student Category Close for Student Category Yes Juniors/Seniors Freshman/Sophomore COURSE DESCRIPTION The course is designed to provide an introduction, evaluation and pricing of the most important financial derivative instruments, namely forwards, futures, options and swaps. The course equips students with essential tools to be applied to value these derivatives and hedging the associated financial market exposures. In particular, the course emphasizes the importance of the general principal of pricing derivatives using no arbitrage arguments. Furthermore, the course also provides an introduction to the principal models that underpin modern financial theory and practice the Black Scholes model and its generalization. The course also examines the pricing of options, their uses and their risk characteristics. The group/individual assignment (projects) also help students to understand the basics behind actual trading in futures by taking positions in a futures market and keeping margin accounts. The students also learn to develop trading option strategies during the course. COURSE PREREQUISITE(S) FINN 200 Intermediate Finance COURSE OBJECTIVES To provide a comprehensive analysis on the properties of derivative instruments. To offer a theoretical framework within which all derivatives can be analyzed and valued. To provide practical and simple investment and corporate financial management strategies using derivatives in a manner this will allow students to apply these concepts and skills.

2 LEARNING OUTCOMES At the end of this course, participants should be able to: Outline the structure and operation of derivatives markets. Demonstrate the pricing of swaps, forwards, futures and options. Implement and evaluate hedging, arbitrage and speculative trading strategies using derivatives. Construct simple options trading strategies. UNDERGRADUATE PROGRAM LEARNING GOALS & OBJECTIVES General Learning Goals & Objectives Goal 1 Effective Written and Oral Communication Objective: Students will demonstrate effective writing and oral communication skills Goal 2 Ethical Understanding and Reasoning Objective: Students will demonstrate that they are able to identify and address ethical issues in an organizational context. Goal 3 Analytical Thinking and Problem Solving Skills Objective: Students will demonstrate that they are able to identify key problems and generate viable solutions. Goal 4 Application of Information Technology Objective: Students will demonstrate that they are able to use current technologies in business and management context. Goal 5 Teamwork in Diverse and Multicultural Environments Objective: Students will demonstrate that they are able to work effectively in diverse environments. Goal 6 Understanding Organizational Ecosystems Objective: Students will demonstrate that they have an understanding of Economic, Political, Regulatory, Legal, Technological, and Social environment of organizations. Major Specific Learning Goals & Objectives Goal 7 (a) Discipline Specific Knowledge and Understanding Objective: Students will demonstrate knowledge of key business disciplines and how they interact including application to real world situations (Including subject knowledge). Goal 7 (b) Understanding the science behind the decision making process (for MGS Majors) Objective: Students will demonstrate ability to analyze a business problem, design and apply appropriate decision support tools, interpret results and make meaningful recommendations to support the decision maker Indicate below how the course learning objectives specifically relate to any program learning goals and objectives. PROGRAM LEARNING GOALS AND OBJECTIVES Goal 1 Effective Written and Oral Communication Goal 3 Analytical Thinking and Problem Solving Skills Goal 4 Application of Information Technology COURSE LEARNING OBJECTIVES The course provides an opportunity to students to write and deliver effectively the knowledge of Financial Derivatives The course equips students with problem solving techniques in Derivatives market. It enables students to analytically think on hedging the risk involved in the financial market using derivatives NA COURSE ASSESSMENT ITEM Written: Assignments, Quizzes Oral: Presentation and CP Assignments, Quizzes, and Exams NA

3 Goal 5 Teamwork in Diverse and Multicultural Environments The course forces students to learn in teamwork. The discussion on assignments and lecture notes will help them in working in diverse environments. Assignments Goal 7 (a) Discipline Specific Knowledge and Understanding Goal 7 (b) Understanding the science behind the decision making process Students will learn Financial Derivatives traded in the financial markets. This the first course where they are going to learn specifications, valuation and hedging techniques of financial derivatives market. This will help those learning key instruments in the financial industry. Students will learn Financial derivatives. They will be given examples from the real market derivatives markets to understand the process of the market Quizzes, Assignments, and Exams Assignments GRADING BREAKUP AND POLICY Assignments and Project: 20% There will be at least 4 assignments and a project. The deadlines of the assignments and project will be announced along with the assignments, no extension will be given in any case. Quiz(s): 15% There will be at least 4 quizzes during the course sessions. The quizzes can be both announced and unannounced. N 1 policy will only be applicable if there are more than 4 quizzes. Class Participation and Attendance: 10% Attendance policy: Students are advised to be on time in lecture sessions. Being away from the class for more than 5 minutes gets you marked Late for the session. Two late markings are equal to one Absent marking. Marks will be deducted at a rate of 1% per class missed. No compensation will be given for the lectures missed without prior approval. Midterm Examination: 25% Final Examination: 30% The examinations will be closed book/closed notes. No re make of exams will be allowed unless approved by OAS and instructor for university competitions.

4 EXAMINATION DETAIL Midterm Exam Yes/No: Yes Combine Separate: Duration: 1 hour 30 min Preferred Date: Exam Specifications: Closed books & closed notes Final Exam Yes/No: Yes Combine Separate: Duration: 2 hours Exam Specifications: Closed books & closed notes COURSE OVERVIEW SESSION 1, 2 TOPICS Derivative Markets and Instruments RECOMMENDED READINGS Chapter 1 OBJECTIVES/ APPLICATION Define a derivative and distinguish between exchange traded and over the counter derivatives Define Forward/Future contracts, option and swaps and compare their characteristics Describe the purpose and criticism of derivative markets Explain arbitrage and the role it plays in promoting market efficiency 3, 4, 5 6,7, 8, 9 Mechanics of Futures Markets Valuation of Forward and Futures Prices Chapter 2 Chapter 4 & 5 Explain trading in futures contracts Specifications of the futures contract Distinguish between margin in future market and security market Describe price limits and the process of marking to market, and calculate and interpret the margin balance Describe how a future contract can be terminated at or prior to termination Describe the characteristics of various types of future contracts Forward contracts Vs Futures contracts Measuring Interest rates (Discrete and continuous compounding) Forward price for an investment asset Valuing forward contracts Are forward prices and futures prices equal? Stock Index futures Forward and futures contract on currency Futures on commodity Adding cost of carry Delivery options Futures prices and the expected spot price

5 10 Hedging strategies using futures 11, Interest rate futures Swaps John and Hull Chapter 3 Chapter 6 Chapter 7 15 Mid Term Explain the basic principles of hedging Arguments for and against hedging Cross hedging Measuring interest rate Forward rates Forward rate arguments Day count and quotation conventions Treasury bond futures Eurodollar futures Mechanics of interest rate swaps The nature of swap rates Determining the LIBOR/swap zero rates Valuation of interest rate swaps Currency swaps and valuation of currency swaps Other types of swaps 16 17, Introduction to Option Markets and Contracts Properties of Stock Options Trading Strategies involving options Binomial Models Chapter 8 Chapter 9 Chapter 10 Chapter 11 Types of Options Option positions Identify the types of options in terms of the underlying instruments Margins Over the counter markets Factors affecting option prices Upper and lower bounds of options Put Call Parity : Explain put call parity for European options and explain how put call parity is related to arbitrage and construction of synthetic options. Early exercise: Call and puts on a non dividend paying stock Effects of dividends Synthetic options Calculate and interpret the prices of synthetic call option, synthetic put option, synthetic bond, and synthetic underlying stock Explain why investor would want to create such instruments. Strategies involving a single option and a stock Spreads Combinations Other payoffs A one step binomial model and a no arbitrage argument Risk neutral evaluation Two step binomial trees Two step binomial trees American options

6 21 The Black Scholes Merton Model Options on Stock Indices and Currencies Futures Options The Greeks Exotic Options Interest Rate Derivatives 28 Review of the course Chapter 13 John and Hull Chapter 15 Chapter 16 Chapter 17 Chapter 24 Chapter 28 Finding Delta Lognormal property of stock prices The distribution of the rate of return The expected return Volatility The idea underlying the Black Scholes Merton model Black Scholes pricing formulae Options on stock indices Currency options Valuation of European stock index options Valuation of European currency options American Options Nature of Future Options European spot and futures options Put Call parity Bounds for futures options Valuation of futures options using binomial model Black's model for valuing futures options Explain and evaluate the Greeks Explain the delta of an option and demonstrate how it is used in dynamic hedging Explain the gamma effect on the options delta and how can gamma effect a delta hedge Demonstrate the historical volatility and implied volatility methods for estimating the future volatility of the underlying asset Students will be given a brief introduction of some exotic options including Barrier options Binary options Lookback options Asian options An overview of the options on interest rates Bond Options Interest rate caps and floors TEXTBOOK(S)/SUPPLEMENTARY READINGS Hull, John, 2011, 7th Edition, Fundamentals of Futures and Options Markets(Prentice Hall) Hull, John, 7 th Edition, Options Futures and other Derivatives (Text Book)