College of Business Management

FINANCIAL DERIVATIVES
FALL COURSE OUTLINE
Course Code: FIN509
Total Credit hours: 45
Duration: 26 sessions

1. Overall aims of course

Introducing key concepts and techniques underlying financial derivatives. The main concepts examined
include various derivative instruments, interest rate swaps, put-call parity, types of spreads, binomial trees
and option trading strategies.

2. Intended learning outcomes of course (ILOs)

Intended learning outcomes of course (ILOs)

a) Knowledge and understanding:

Students should be able to understand:

 various major types of derivatives including forward, futures and options

 the implications of known income and known yield

 mechanism of interest rate swaps

 market terminologies
 put call parity
 early exercise: calls on non-dividend paying stock
 early exercise: puts on non-dividend paying stock
 types of spreads
 one step binomial model and no arbitrage argument
 b) Intellectual skills:
Students should be able to:
• distinguish between:
• forward and future contracts

• call and put options and

• American and European options

• determine forward price of an investment and consumption asset

• distinguish between hedgers, speculators and arbitrageurs

• discuss the nature of nature of swap rates

• determine the value of interest rate and currency swaps

• assess credit risk

• relate to option positions

• appreciate assets underlying options

• highlight factors affecting option prices

• relate to strategies involving single option and a stock

• understand
• relate to stock and option combinations
• explain two step binomial trees
• realize the lognormal property of stock prices
• explain distribution of rate of return and expected return volatility

c) Professional and practical skills

After completion of the course, the students should be able to:

 appreciate various derivative instruments available

 relate to various techniques applied in option trading
 professionally apply the concepts learnt in this course as finance or asset managers

d) General and transferable skills

Whatever learned in the course can be applied in:

 asset allocation amongst various financial derivatives

 management of personal and client investment portfolios using various option trading strategies

3. Course Contents:

Session Topics/Contents, Intended Learning Outcomes and Methodology

1&2 Introduction
 Ways derivatives are used
 Forward prices and payoffs
 Future contracts
 Payoffs to buyer and sellers of call options
 Payoffs to buyers and seller of put options
 American vs European Options
 Types of trades with illustrative examples
Intended Learning Outcomes
 Appreciate the size of global derivatives market
 Understand various major types of derivatives including forward, futures and options
Methodology
 Lecture on Chapter 1 and overview of Pakistan Mercantile Exchange (PMEX)
 Reinforcement of concepts through:
o problem solving
o Class discussion on derivatives market in Pakistan
3&4 Mechanics of Futures Markets
 Difference between forward and future contracts
 Margins
 Types of Orders
 Open Interest
Intended Learning Outcomes
 To understand the terminology used in the futures market
 To distinguish between forwards and futures
Methodology
 Lecture on Chapter 2
 Problem solving
 Class discussion on future contracts on PMEX
5&6 Hedging Strategies Using Futures
 Long and Short Hedges
 Basis Risk
 Optimal Hedge Ratio
Intended Learning Outcomes
 To recognize issues associated with construction of hedging strategies
 To understand dynamic hedging strategies
Methodology
 Lecture on Chapter 3
 Problem Solving
7&8 Determination of Forward and Future Prices •
 Risk Aversion
 Short selling
 Notation for valuing future and forward contracts
 Identification of arbitrage opportunity
 Forward prices when an investment asset provides a known dollar income
 Forward prices when an investment asset provides a known yield
 Forward vs futures prices
Intended Learning Outcomes
 Distinguish between investment and consumption assets
 Understand short selling
Methodology
  Lecture on Chapter 5
 Review of Handout on Regulations Governing Cash Settled Futures on KSE
 Problem Solving
9 & 10 Swaps
 Nature of swaps
 An example of a “plain vanilla” interest rate swap
 Typical uses of an interest rate swap
 The comparative advantage argument
 The swap when a financial institution is involved
 Currency swaps and its typical uses
 Credit risk
Intended Learning Outcomes
 Explain the mechanism of interest rate swaps
 Discuss the nature of nature of swap rates
 Determine the value of interest rate and currency swaps
 Entail credit risk
Methodology
 Lecture on Chapter 7
 Problem Solving
11, 12 Article Presentation
& 13  Role of Financial Derivatives in Global Financial Turmoil or
 Any topic related to practical application of concepts taught in the course in local and
global financial derivative markets
Intended Learning Outcomes
 To enable students to assess the risk profile of financial derivatives and to relate
concepts taught in the course with their practical applications
 To reinforce presentation skills
Methodology
 Recent articles or research papers to be sourced from various journals and publications
14 & 15 Mechanics of Option Markets
 Long call vs short call
 Long put vs short put
 Assets underlying exchange-traded options
 Specification of exchange-traded options
 Dividends & stock splits
 Market makers
 Margins
 Warrants
 Convertible bonds
Intended Learning Outcomes
 Understand various types of options
 Relate to option positions
 Appreciate assets underlying options
 Relate to market terminologies
Methodology
 Lecture on Chapter 9
 Problem solving
16 & 17 Properties of Stock Options
 Effect of variables on option pricing
 American vs European options
  An arbitrage opportunity in calls
 An arbitrage opportunity in puts
 Put call parity
 Reasons for not exercising a call early (no dividends)
 Should puts be exercised early?
 Highlight factors affecting option prices
Intended Learning Outcomes
 Understand put call parity
 Early exercise: calls on non-dividend paying stock
 Early exercise: puts on non-dividend paying stock
Methodology
 Lecture on Chapter 10
 Problem solving
18 & 19 Trading Strategies Involving Options •
 Bull spread using calls and puts
 Bear spread using calls and puts
 Box spread
 Butterfly spread using calls and puts
 A straddle combination
 A strip and strap
 A strangle combination
Intended Learning Outcomes
 Relate to strategies involving single option and a stock
 Understand types of spreads
 Relate to stock and option combinations
Methodology
 Lecture on Chapter 11
 Problem Solving
 Class discussion on circumstances when various trading strategies should be used
20 & 21 Binomial Trees•
 Setting up a riskless portfolio
 Valuing the portfolio
 Valuing the option
 p as a Probability
 Risk-neutral valuation
 Valuing the option using risk-neutral valuation
 Irrelevance of stock’s expected return
 What happens when an option is American
Intended Learning Outcomes
 Understand a one step binomial model and no arbitrage argument
 Explain two step binomial trees
 Discuss American options
Methodology
 Lecture on Chapter 12
 Problem Solving
23 The Black – Scholes – Merton Model
 The lognormal property and distribution
 Continuously compounded return
 Mutual fund returns
 Estimating volatility from historical data
 Nature of volatility
  The concepts underlying Black-Scholes
 Applying risk-neutral valuation
 Valuing a forward contract with risk-neutral valuation
Intended Learning Outcomes
 Realize the lognormal property of stock prices
 Explain distribution of rate of return and expected return volatility
 Understand the Black-Scholes-Merton Differential Equation
Methodology
 Lecture on relevant extracts from CFA Notes
 Class discussion on hedging using Black Scholes Model
24 Presentation on Derivatives Market in Pakistan by an Industry Expert
Intended Learning Outcomes
 Gain awareness of the financial derivatives traded in Pakistan
 Appreciate the volume and performance of derivatives market in Pakistan
 Realize the pros and cons of trading in the local derivatives market
Methodology
 Students to be examined on the information obtained in this session
25 & 26 Term Report to be prepared on any topic related Financial Derivatives
Intended Learning Outcomes
 Relate theory with practical applications across the globe
 Familiarize with contemporary issues facing the local and international derivatives
market
 Understand the risks inherent in misuse of derivatives

4. Teaching and learning methods

52%
Lectures:

Practical training /laboratory: NA

Seminar/Workshop: NA
Class activity: 48%

5. Student assessment methods

Scheduled
Assessment methods ….. to access Weight age
week
1 Quizzes Knowledge and understanding 3, 6, 9
15%
Term Report and Professional skills, Knowledge
2 15 & 16 10%
Presentation and understanding
 Knowledge, Intellectual and
3 Article Presentation 9 5%
analytical skills
4 1st Mid Term test Knowledge and understanding 6 15%

5 2nd Mid Term test Professional skills 11 15%

6 Final exam Professional skills 16 40%

Total 100%
Rubrics for Marking Marking Quizzes, Mid-term and Final Exams (which together carry
85% weightage in the Grade)

SKILLS A B C D&F
Comprehension Always understands Frequently Usually Unsatisfactory
and Analysis the theoretical comprehends the understands the knowledge of key
(20%) concept and is able to theoretical key concepts concepts. Inadequate
relate it to practical concepts. taught in the understanding of
applications. Able to course. Familiar financial derivatives
Thorough understand with various and the related
understanding of various types of types of financial concepts covered in
various types of financial derivatives but the course.
financial derivatives derivatives. sometimes faces Generally unable to
including forwards, Demonstrates difficulty in analyze data due to
futures, swaps and good analytical interpreting weak concepts.
options. Firm grip skills. theory.
on the properties and
mechanics of markets
for various
instruments.
Demonstrates
excellent analytical
skills.

Problem Always finds a Frequently seeks Usually finds Rarely seeks out
Solving (60%) number of ways to out solution to the solution to the other ways to solve
solve the problem on problem, and problem, but the problem and
own initiative. rarely needs occasionally frequently needs
support or needs support or support and
Always solves the guidance. guidance. guidance.
paper in a neat and
logical manner with Frequently solves Sometimes skips Usually skips the
the relevant formula, the paper in a the steps steps required for
proper working and neat and logical required for working out a
required formats (if manner with the working out a problem. Most of the
any). relevant formula, problem. At time does not adhere
proper working times also does to the required
and required not follow the formats (if any).
SKILLS A B C D&F
formats (if any). required formats
(if any).

Rubrics for Marking Term Project and Personal Management (which together carry 15%
weightage in the Grade)

Delivery of Fully comprehends To a large extent To some extent Does not

Term the requirements of the understands the understands the understand the
Project (7%) term report and is able requirements of the requirements of the requirements of
to add value to the term report and is report. Some of the the project. The
topic through able to present information presented content of the
extensive research and relevant in the report may be report is irrelevant
analysis. Delivers information. irrelevant, redundant and not current.
hard/soft copy of the Delivers hard/soft or non-current. Poor and delayed
report as per the copy of the report Submits hard/soft delivery of the
guidelines in a neat, as per the copy of the report but report.
professional and guidelines on time. does not ensure
timely manner. adherence to
guidelines.
Presentation Excellent Good presentation Fair presentation of Poor
Skills (8%) presentation of the of the article the article which is presentation of
article which is which is current current. Faces the article which
current and adds value and interesting. difficulty in is current.
to the knowledge of Good presentation presenting term Unable to present
the class. of the term project project findings term project
Excellent findings before the before the class. findings before the
presentation of the class. class.
term project findings
before the class.

6. Recommended Texts:

Textbook: Options, Futures and Other Derivatives by John C. Hull (8th Edition)

Handouts: SBP – Financial Derivative Business Regulations

Overview of Pakistan Mercantile Exchange
Regulations governing Cash Settled Futures on KSE

Reference Material: Investment Analysis and Portfolio Management by Prasanna Chandra

Modern Investment Theory by Robert A. Haugen.
CFA Notes