U T D THE UNIVERSITY OF TEXAS AT DALLAS

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1 FIN 6360 Futures & Options School of Management Chris Kirby Spring 2005 U T D THE UNIVERSITY OF TEXAS AT DALLAS Overview Course Syllabus Derivative markets have experienced tremendous growth over the past 30 years, leading to a proliferation of new products, trading strategies, valuation methodologies, and risk management techniques. Many different types of firms trade derivative instruments, many of the securities that we think of as traditional assets have embedded derivative features, and the principles underlying valuation of derivatives are frequently applied in more general corporate finance and investment situations. Consequently, a good understanding of derivatives is useful in a host of applications including portfolio management, risk management, treasury finance, investment banking, corporate strategy, and sales and trading. This course provides an introduction to the core material. In the first half of the course we will cover forward, futures, and swap contracts. We begin by reviewing the contract definitions and payoff diagrams, the economic motivation for these contracts, and the markets in which they trade. Next, we develop a general approach for valuing forwards, futures, and swaps. We then use this approach to examine the implications for pricing and hedging, the relation between risk and return, and the economics behind various trading strategies. Finally, we apply our general approach to a number of specific markets including physical commodities, stock indexes, and foreign currencies. The second half of the course deals with options. We begin by reviewing the mechanics of option contracts and the structure of option prices. Then we develop a general approach for valuing options. In particular, we develop the binomial and Black-Scholes models, and illustrate methods for valuing American-style options. We use our valuation approach to examine the relation between risk and return and to evaluate a variety of hedging and trading strategies. Finally, we will discuss some advanced topics in option pricing if we have time. The lectures will emphasize problem solving and hands-on quantitative analysis. Although we will certainly develop the relevant theory, the motive for doing so is to use it for practical applications. We will work through numerous problems during class, practice problems will be distributed approximately every other week, and we will have a midterm exam and a final project. The practice problems and midterm exam will focus on implementation of the fundamental concepts and techniques developed in class. The course project will give you a chance to apply these concepts and techniques in a realistic situation by analyzing a highly publicized derivative disaster. Prerequisites The course prerequisites are FIN 6301, FIN 6310, and STAT I will assume at least a good understanding of basic ideas in finance: the time-value of money; return, risk and portfolio diversification; net present value etc. We will touch on some of these topics in class, but I expect you to refresh your memory as necessary throughout the semester. Spending time in class to review topics that are covered by more basic courses would be inefficient and, most important, would take time away from new and more interesting topics. I assume that you are in this class to learn new material and I will teach the course accordingly. Uncertainty is what makes the study of financial markets so interesting. If there were no uncertainty there would be very few job opportunities on Wall Street. Unfortunately, uncertainty also makes our task more difficult. The good 1

2 news is that you will finally understand why you had to study statistics. No serious study of derivatives and risk management can be undertaken without a basic knowledge of statistics. For this reason, I expect you to make a serious effort to refresh your memory on some essential concepts such as descriptive statistics, inference techniques and basic regression analysis. Any introductory book in statistics should help you to get up to speed. Get one and review it as necessary. A mathematical approach is necessary to avoid superficiality for many of the topics covered by this course. I will assume a good knowledge of basic algebra. Although I am not a fan of technicalities per se, I hope that by the end of the semester you will appreciate how the use of technical tools is important to make this a useful course. Reading Materials The text for the course is Options, Futures, and Other Derivatives, Fifth Edition, by John C. Hull. This is the standard industry reference for those who work in the derivatives area. You should be forewarned, however, that it is not easy material for most students. Do not be surprised if you have to go over the suggesting readings a number of times before you have a good grasp of the basic concepts. This is not a criticism of the text. It simply reflects the nature of the material. Practice Problems Practice problems will be distributed approximately every two weeks. These problems are important because they give you the chance to test your understanding of the concepts and techniques developed during the course. I will not collect these problems and they do not count towards your grade in the course. Nonetheless, I highly recommend that you work through them on a timely basis as we move through the lecture material. If you don t do this, you can easily fall behind in the course. Midterm Examination The midterm is scheduled for March 1 st. A thorough understanding of the material covered in the lectures is essential to performing well on the exam. The exam will be closed book and you will need to bring a calculator. I will provide you with a formula sheet. The exam counts for 50% of your course grade. An unexcused absence from an exam will be graded as a zero. Course Project The course project is an in-depth study of one of the derivative disasters that have been the subject of much scrutiny in the popular press. It will be done in groups of three to five students. The objective is to use the knowledge developed in the course to understand the underlying problems that led to large losses from trading derivative products. Each group will present the results of their analysis to the class. More details will be provided as we move through the class material. The project, which is due on April 26 th, counts for 50% of your course grade. Each group will have 20 minutes to present the project to the rest of the class. The presentation will count for 1/3 of you grade on the project (i.e., 1/6 of your overall course grade). Academic Honesty I expect everyone to be above reproach in all their academic activities, which includes but is not limited to projects and examinations. The use of prohibited materials or collaboration with others on the midterm will be treated as a serious case of academic dishonesty and will be dealt with in accordance with UTD policies and procedures. Requests for Additional Credit If you feel that I ve made a mistake in the grading the midterm or the course project, then you may resubmit it with a request to rectify the perceived error. The assignment or project should be returned along with a detailed written explanation of why you think you deserve additional credit. In going over the assignment or project I will focus primarily on the portion in dispute; however, I reserve the right to correct any errors that I find, regardless of whether this causes your score to go up or go down. 2

3 Contact Details Office Location: SM Office Hours: Monday, 11:00am to noon Phone: (972)

4 TENTATIVE SCHEDULE OF CLASSES Lecture Date Topic Forwards, Futures, and Swaps 1 Jan 11 Forward and Futures Markets 2 Jan 18 The Structure of Forward and Futures Prices 3 Jan 25 Fundamentals of Hedging 4 Feb 1 Managing Financial Risks 5 Feb 8 Physical Commodity Futures 6 Feb 15 Physical Commodity Futures 7 Feb 22 Swaps Mar 1 Midterm Exam Mar 8 Spring Break Options 7 Mar 15 The Structure of Option Prices 8 Mar 22 Option Valuation I 9 Mar 29 Option Valuation II 10 Apr 5 Option Trading Strategies 11 Apr 12 Common Stock Options 12 Apr 19 Real Options Apr 26 Project Presentations 4

5 READING LIST Session Suggested Readings Session 1 Forward and Futures Markets Session 2 The Structure of Forward and Futures Prices Session 3 Fundamentals of Hedging Hull, Chapters 1-2 Hull, Chapter 3 Hull, Chapter 4 Session 4 Managing Financial Risk Session 5 Physical Commodity Futures Session 6 Swaps Session 7 The Structure of Option Prices Sessions 8 &9 Option Valuation Sessions 10 Option Trading Strategies Session 11 Common Stock Options Sessions 12 Real Options Hull, Chapter 6 Hull, Chapter 7 & 8 Hull, Chapters 10 & 11 Hull, Chapter 9 Hull, Chapter 8 Hull, Chapter 28 5