Course Structure and Standard Syllabus Course Area: Financial Sector Policies Course Title: Financial Markets and Instruments (FMI) Objectives: This two-week course aims at providing participant with the foundation of financial instruments beyond the standard treatment of bonds and equity that are covered in our basics course. After a short review, the course takes on forwards, futures, swaps and options and moves toward combinations of these building block instruments with practical applications. Some time is devoted to relevant policy implications, notably related to the regulation of such markets, though a course devoted to financial policies is recommended for those interested in more detail. Lectures introduce the underlying theory, and workshops and case studies allow the participants to apply the techniques introduced and to test their understanding of how and why some strategies and misuse of these instruments can lead to large losses and financial instability. Participants will prepare final presentations on a set of predetermined current financial market issues. Unit 1: Introductory Lecture Lecture (3 hours) L-1 Overview of the course Financial Markets I The nature of financial markets: The allocation of resources across time and under uncertainty Financial markets and asymmetric information L-2 Financial Markets II General ways to organize financial markets Over the counter markets uses, evolution, advantages and disadvantages Exchanges call and continuous markets, automated trading without market makers, exchange consolidation Functions of financial markets Liquidity Provision Market Makers: Brokers and Dealers
2 Organization and operation of a trading desk Trading organizations: proprietary trading firms, hedge funds High-frequency trading TBD Unit 2: Basic valuation of Bonds and Stocks and Portfolios Lecture (3 hours) L-3 Valuation of fixed income securities (bonds, bond pricing, duration and convexity) and common strategies Portfolio analysis and diversification Capital Asset Pricing Model (CAPM) Bodie, Z., A. Kane, and A. Marcus, 2011, Investments and Portfolio Management, 9 th (Global) Edition (New York: McGraw Hill). Fabozzi, Frank J., 2000, Bond Pricing and Return Measures, in The Handbook of Fixed Income Securities (New York: McGraw-Hill, 6th edition), Chapter 4, pp. 51 83. Duffie and Singleton, (2003) Credit Risk: Pricing, Measurement and Management, (Princeton: Princeton University Press), Chapter 1, Unit 3: Methods for evaluating credit and counterparty risk Lecture (3 hours) L-4 Traditional, basic approaches of individual default risk New approaches to modeling portfolio credit risk and their caveats: 1. Value at Risk approach 2. Creditmetrics (credit migration approach) 3. Contingent claims approach (KMV) 4. Insurance approach (credit risk plus) Role of credit rating agencies Workshop (3 hours) W-3 Exercises: Value-at-Risk for market and credit risk
3 Allen, Linda, 2002, Credit Risk Modeling of Middle Markets, CUNY WP. http://fic.wharton.upenn.edu/fic/allenpaper.pdf Crouhy, Michael, Dan Galai, and Robert Mark, 2006, New Approaches to Measuring Credit Risk, Chapter 11 in The Essentials of Risk Management (New York: McGraw-Hill) Jorion, Philippe, 2007, Computing Value at Risk, in Value at Risk (New York: McGraw-Hill), 3 rd edition, Chapter 5 Unit 4: Futures and Forwards Lecture (3 hours) L-5 Forward contracts; futures contracts Differences between forwards and futures Standardization; unilateral reversal of positions Default risk, margin accounts, and role of CCPs Pricing forwards and futures Hedging and speculation Case Study (3 hours) W-4 A selection of cases and exercises from: Societe Générale (example of large losses in equity futures trading) GNMA (example of poor contract design with interest rate futures contract) Metallgesellshaft (example of a hedging strategy gone wrong, a market going from backwardation to contango, and basis risk) Margining procedure Korea FX futures example Latin America FX forward and carry trade example Exercises: Futures and Forwards Sundaram, Rangarajan and Sanjiv Das, 2010, McGraw-Hill) Chapters 2-5
4 Unit 5: Options basics Lecture (1.5 hours) L-6 Definition, types of option contracts, how and where options are traded Payoffs diagrams and options strategies Put-call parity Contracts with explicit or implicit options: portfolio insurance; deposit insurance. Workshop (1.5 hours) W-5 Exercises involving options strategies and pricing. Application of Hull s Derivagem (Excel-based free spreadsheet) Sundaram, Rangarajan and Sanjiv Das, 2010, McGraw-Hill) Chapters 7 8. Unit 6: Options pricing Lecture (3 hours) L-7 Variables affecting option values The binomial option pricing model The Black Scholes model Role played by volatility in options markets Volatility smiles Workshop (1.5 hours) W-6 Simulation exercises to understand the Black Scholes model (impact of changes in B-S inputs: spot price, strike price, interest rate, time, volatility) Sundaram, Rangarajan and Sanjiv Das, 2010, McGraw-Hill) Chapters 11 14. Unit 7: Swaps Lecture (3 hours) L-8 Issues related to LIBOR, OIS, benchmark risk free curve Forward rate agreements (FRA) Interest rate swaps: definitions, valuation and pricing Exchange rate swaps Dynamics of swap spreads
5 Workshop (1.5 hours) W-7 Swaps exercises (financial engineering exercises to understand swaps and their use for hedging including for central banks) Sundaram, Rangarajan and Sanjiv Das, 2010, McGraw-Hill) Chapters 23 25. Unit 8: Repo market and collateral management Lecture (1.5 hours) L-9 Definition of a repo Examples Collateral management Case study (1.5 hours) (from scratch) W-8 ECB or Fed or other CB operations in FX How to set up repo contracts Reserve management TBD Unit 9: Credit derivatives Lecture (3 hours) L-10 Credit default swaps Total-rate-of-return swaps CDS indices: itraxx and CDX and their uses in surveillance The global credit derivatives market Implications for financial stability Case Study (1.5 hours) (requires updating) W-9 The CDS fallout of the Lehman failure and AIG Bomfim, Antulio N., 2005, Understanding Credit Derivatives and Related Instruments, (San Diego: Elsevier Academic Press), Chapters 1 and 3. Stulz, René, 2010, Credit Default Swaps and the Credit Crisis, in The Journal of Economic Perspectives, Volume 24, Number 1 (Winter), pp. 73 92. http://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.24.1.73
6 Sundaram, Rangarajan and Sanjiv Das, 2010, McGraw-Hill) Chapters 31. Unit 10: Securitization and structured finance Lecture (3 hours) L-11 Funded securitization Synthetic securitization Covered bonds Structured finance CDOs and other instruments (off-balance sheet vehicles) Policy issues and applications to mortgage markets Case Study (1.5 hours) W-10 What went wrong with CDOs Positive example of securitization: small business loans in Germany; initial rise of ABCP used to securitize receivables Bowman, Louise, 2011, Can ABS Rescue Europe s Bank-Funding Market? Euromoney, March, pp. 58-63. Collins, Nathan, 2011, Fund-Starved Banks Risk Collateral Damage, Euromoney, December, pp. 61-63. Coval, Joshua, Jakub Jurek, and Erik Stafford, 2009, The Economics of Structured Finance, Journal of Economic Perspectives Vol. 23, No. 1 (Winter), pp. 3 25. http://www.aeaweb.org/issue.php?journal=jep&volume =23&issue=1 FitchRatings, 2008, ABCs of U.S. Covered Bond. Unit 11: Motivation and current issues for regulation of securities markets and derivatives Lecture (3 hours) L-12 Case study (1.5 hours) (requires updating) Objectives and key areas of securities regulation Regulation of OTC derivatives (trade repositories and CCPs) Regulation and oversight of rating agencies Regulation of hedge funds W-11 Case 1: Bear Stearns (inability to rollover repos, counterparty risk) Case 2: LTCM (pitfalls of leverage and OTC derivatives)
7 Acharya, Viral V., Thomas F. Cooley, Matthew Richardson, and Ingo Walter, 2011, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance, (New York: Wiley). Blinder, Alan, 2010, It s Broke, Let s Fix It: Rethinking Financial Regulation, International Journal of Central Banking, Vol. 6, No. 4, December. http://www.ijcb.org/journal/ijcb10q4a13.pdf Unit 12: Concluding lecture Lecture (1.5 hours) L-13 Summary and recap of the course Notes: Wherever possible, country examples will be provided. Older cases will be upgraded to more recent examples where relevant data can be obtained. Depth of material will depend on regional absorptive capacity, satisfaction of prerequisites, and current applicable issues. A typical 2-week course corresponds to 57 contact hours with participants (including the opening and closing sessions). This syllabus represents a total of 30 hours of teaching, and 19.5 hours of workshops. The difference will be the time allocated to the preparation and delivery of participants presentations. Prerequisites The course is targeted to (junior to senior) officials working in Ministries of Finance and Central Banks. Participants should have an advanced degree in economics or equivalent experience. Participants are strongly encouraged to do the e-learning module on Financial Market Analysis (FMAx) prior to the start of the course. Performance Evaluation: Two multiple-choice tests will be given, one at the beginning and one at the end of the course. Performance in these tests will be recorded in participants evaluations.