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Financial Derivatives Term 3, 2015-16

Faculty: Professor Shashidhar Murthy, Contact: shashidhar.murthy@iimb.ernet.in

Objective: The course deals with the building blocks of Financial Derivatives Futures (and Forwards),
Options and Swaps. The types of underlying assets considered will be equities, currencies, (and some
commodities). On completing this course, students should have developed a good understanding of
these derivative contracts, be proficient in the no-arbitrage pricing methodology (and risk-neutral
approach) that underlies derivative pricing, and have an exposure to related quantitative techniques.

The course assumes a basic understanding of mathematics, statistics, and applications. While one does
not have to be an expert in mathematics, we will rely on quantitative reasoning a lot. The course does
not require pre-requisites other than Corporate Finance, QM-I, and QM-II.

Text: Options and Other Derivatives; John C. Hull and Sankarshan Basu; 8th Edition; Pearson Education

Handouts: Relevant handouts for every part of the course will be posted on Moodle in due course and
will be required reading (except as mentioned).

Evaluation:
Mid-Term & End-Term Exams: Each exam has 40% weight. Format: some MCQs, numerical
problems, some short discussion questions.
Group Homework: Weight = 20%. Groups (of 3-4 students each; to be decided at the start of
the term) will submit 1 assignment per group. There will be 2 such assignments.

Attendance Policy: There is a minimum of 15 sessions out of 20 that you must attend. Your final grade
point will drop by 0.2 for every class in excess of 5 that you do not attend. All material covered in class
sessions is relevant to the exams.

Session wise plan (1.5 hour sessions) and Reading from Text
1. 1ntroduction to Futures & Options, Chapter 1 (1 session)
- Cash/Spot versus Forward Contracts; Introduction to Options; Payoff and Profit Profiles
- Hedgers and Speculators; Leverage
- The Economic Role of Futures and Options, and Reasons for Growth of Derivative Markets

2. Mechanics of Futures Markets, Chapter 2 (1 session)

- Futures Exchanges; OTC Markets; Types of Underlying Assets
- Contract Specifications, Standardization, Multiple Deliverable Grades

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- Delivery vs Cash Settlement

- Margins and Marking-to-Market; The Clearinghouse
- Arbitrage and Spot-Futures Convergence at Expiration
- Forward Contracts versus Futures Contracts
- Indian Markets

3. Pricing Futures, Chapter 5, (2.5 sessions)

- Perfect Markets Assumptions; Short-Selling
- Pricing Forwards on a Security that pays No Income, pays a Known Income, or pays a Known
Dividend Yield
- The Value of a Forward Contract
- Forward Contracts on Commodities, Investment Assets, Consumption Assets
- Cost of Carry
- Forward Prices versus Futures Prices
- Risk and Futures Prices; Backwardation and Contango
- Synthetic Securities; Quasi-Arbitrage
- Imperfect Markets; Risks Inherent in Arbitrage

4 Mechanics of Options Markets, Chapter 9 (1 session)

- Options Exchanges; OTC Markets; Types of Underlying Assets
- Types of options; Contract Specifications
- Options positions
- Margins; Clearing
- Warrants; ESOPs; Converibles
- Indian Markets

5. No-arbitrage Restrictions on Option Prices, and Options Strategies, Chapter 10 & 11 (2

sessions)
- Pricing Bounds
- Put-Call parity
- Simple trading strategies using options: Covered Calls, Protective Puts
- Spreads and Combinations

6. The Binomial Option Pricing Model, Chapter 12 (2.5 sessions)

- Replicating & Hedge Portfolios
- Risk-neutral valuation
- Incorporating Dividends
- American options & Early Exercise
- Calibration

7. The Black-Scholes Option Pricing Model, Chapters 13 & 14, (2.5 sessions)
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- Introduction to Stochastic Calculus & Itos Lemma; Risk-neutral Valuation

- The Log-normal Stock Price Distribution
- The Black-Scholes Hedge Portfolio Strategy
- The Black-Scholes Formula & Properties
- American Options

8. Stock Index & Currency Options, Chapter 16 (1 session)

- Contract Specs
- Stock Index Options Pricing
- Currency options pricing

9. Hedging using Futures and Options, Chapter 3 (2.5 sessions)

- Arguments for hedging; Futures vs. Options in Hedging; Ex-post Regret
- Basis Risk; The Minimum Variance Hedge Ratio; Estimating the Hedge Ratio
- Hedging With Index Futures and Options; Portfolio Insurance; Changing Beta
- Market Timing & Stock Picking

10. Option Greeks, and Volatility, Chapters 18 & 19 (1 session)

- Greeks of options (based on the Black-Scholes formula)
- Uses in hedging strategies
- Estimation of volatility
- Implied volatility & Volatility smiles

11. More Binomial Trees, Chapter 20 (1 session)

- Trees for indices and currencies
- Trees for dividend-paying stocks

12. Swaps, Chapter 7 (2 sessions)

- Comparative Advantage
- An introduction to interest rate swaps
- Plain Vanilla Currency Swaps