Lahore University of Management Sciences

FINN 453 Financial Derivatives

Spring 2017


Instructor Ferhana Ahmad
Room No. 314
Office Hours TBD
Email ferhana.ahmad@lums.edu.pk
Telephone +92 42 3560 8044
Secretary/TA TBA
TA Office Hours TBD
Course URL (if any) suraj.lums.edu.pk

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 Yes
Open for Student Category Juniors/Seniors
Close for Student Category 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

COURSE OBJECTIVES

n To provide a comprehensive analysis on the properties of derivative instruments.
n To offer a theoretical framework within which all derivatives can be analyzed and valued.
n 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.

Learning Outcomes
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At the end of this course, participants should be able to:

n Outline the structure and operation of derivatives markets.
n Demonstrate the pricing of swaps, forwards, futures and options.
n Implement and evaluate hedging, arbitrage and speculative trading strategies using derivatives.
n 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 Course Learning Objectives Course Assessment Item
Goal 1 Effective Written and Oral The course provides an opportunity to students Written: Assignments, Quizzes
Communication to write and deliver effectively the knowledge
of Financial Derivatives Oral: Presentation and CP
Goal 3 Analytical Thinking and Problem Solving The course equips students with problem
Skills solving techniques in Derivatives market. It Assignments, Quizzes, and Exams
enables students to analytically think on
hedging the risk involved in the financial market
using derivatives
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Goal 4 Application of Information Technology NA NA

Goal 5 Teamwork in Diverse and Multicultural The course forces students to learn in
Environments teamwork. The discussion on assignments and Assignments
lecture notes will help them in working in
diverse environmets.
Goal 7 (a) Discipline Specific Knowledge Students will learn Financial Derivatives
and Understanding traded in the financial markets. This the Quizzes, Assignments, and Exams
first course where they are going to learn
specifications, valuation and hedging
techniques of financial derivatives market.
This will help them learning key
instruments in the financial industry.
Goal 7 (b) Understanding the science Students will learn Financial derivatives. They
behind the decision-making process will be given examples from the real market Assignments
derivatives markets to understand the process
of the market

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:
n You may have up to 3 absences during the course without losing any attendance points.
n You are advised to be on time in sessions. Late arrival by 5 minutes will mark you absent for the session.
n Absent from class on medical leave/ tours on behalf of LUMS or any other personal or professional reasons will mark you absent for the
session unless approved by OAS.
n Use of mobile phones in the class or bringing food in class will mark you absent for the session.
n Marks will be deducted at a rate of 1% per class missed after 3 absences mentioned in the first point.


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.

Examination Detail

Yes/No: Yes
Midterm
Combine Separate:
Exam
Duration: 1 hour 15 min
Preferred Date:
 Lahore University of Management Sciences
Exam Specifications: Closed books & closed notes

Yes/No: Yes
Combine Separate:
Final Exam
Duration: 2 hours
Exam Specifications: Closed books & closed notes


COURSE OVERVIEW
Recommended Objectives/
Session Topics
Readings Application
n Define a derivative and distinguish between
exchange traded and over the counter derivatives
Derivative Markets and John Hull n Define Forward/Future contracts, option and
Instruments Chapter 1 swaps and compare their characteristics

1, 2 n Describe the purpose and criticism of derivative
markets

n Explain arbitrage and the role it plays in

promoting market efficiency

n Explain trading in futures contracts

n Specifications of the futures contract

n Distinguish between margin in future market and
security market
Mechanics of Futures John Hull
Markets Chapter 2
n Describe price limits and the process of marking
to market, and calculate and interpret the margin
3, 4, 5 balance

n Describe how a future contract can be

terminated at or prior to termination

n Describe the characteristics of various types of

future contracts

n Forward contracts Vs Futures contracts

n Measuring Interest rates (Discrete and
continuous compounding)
6 ,7, 8, 9
Valuation of Forward John Hull
n Forward price for an investment asset

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Chapter 4 & 5 n Valuing forward contracts
and Futures Prices
n Are forward prices and futures prices equal?

n Stock Index futures

n Forward and futures contract on currency

n Futures on commodity

n Adding cost of carry

n Delivery options

n Futures prices and the expected spot price


Hedging strategies John and Hull n Explain the basic principles of hedging
using futures Chapter 3
10 n Arguments for and against hedging

n Cross hedging

n Measuring interest rate

Interest rate futures John Hull n Forward rates
Chapter 6
n Forward rate arguments

11,12
n Day count and quotation conventions

n Treasury bond futures

n Eurodollar futures


n Mechanics of interest rate swaps

n The nature of swap rates
John Hull
Chapter 7 n Determining the LIBOR/swap zero rates
13--14 Swaps
n Valuation of interest rate swaps

n Currency swaps and valuation of currency swaps

n Other types of swaps


15 Mid Term n Mid Term

16
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n Types of Options

Introduction to Option John Hull n Option positions
Markets and Contracts Chapter 8
n Identify the types of options in terms of the
underlying instruments

n Margins

n Over the counter markets

n Factors affecting option prices

Properties of Stock John Hull n Upper and lower bounds of options
Options
Chapter 9 n 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.

n Early exercise: Call and puts on a non-dividend
paying stock
17,18

n Effects of dividends

n Synthetic options

n Calculate and interpret the prices of synthetic call
option, synthetic put option, synthetic bond, and
synthetic underlying stock

n Explain why investor would want to create such
instruments.

n Strategies involving a single option and a stock

Trading Strategies John Hull n Spreads
involving options Chapter 10
19
n Combinations

n Other payoffs

n A one-step binomial model and a no arbitrage
argument
20 Binomial Models John Hull
Chapter 11 n Risk neutral evaluation

n Two step binomial trees
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n Two step binomial trees

n American options

n Finding Delta

n Lognormal property of stock prices

The Black-Scholes- John Hull n The distribution of the rate of return
Merton Model Chapter 13
n The expected return

21
n Volatility

n The idea underlying the Black-Scholes-Merton
model

n Black-Scholes pricing formulae


n Options on stock indices
John and Hull
Options on Stock Chapter 15 n Currency options
Indices and Currencies
22 n Valuation of European stock index options

n Valuation of European currency options

n American Options


n Nature of Future Options
Futures Options
John Hull n European spot and futures options
Chapter 16
n Put-Call parity
23
n Bounds for futures options

n Valuation of futures options using binomial
model
n Black's model for valuing futures options


n Explain and evaluate the Greeks

24-25 The Greeks n Explain the delta of an option and demonstrate
John Hull how it is used in dynamic hedging

Chapter 17 n Explain the gamma effect on the options delta
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and how can gamma effect a delta hedge

n Demonstrate the historical volatility and implied

volatility methods for estimating the future
volatility of the underlying asset

Exotic Options Students will be given a brief introduction of some exotic
John Hull options including
Chapter 24
n Barrier options

26
n Binary options

n Lookback options

n Asian options



Interest Rate John Hull An overview of the options on interest rates
Derivatives Chapter 28
27 n Bond Options

n Interest rate caps and floors


28 Presentation/Review

Textbook(s)/Supplementary Readings

n Hull, John, 2011, 7th Edition, Fundamentals of Futures and Options Markets(Prentice Hall)
th
n Hull, John, 7 Edition, Options Futures and other Derivatives (Text Book)