||Dr Kevin Campbell
||The module will be delivered by means of Lectures, Problem-Solving sessions and Drop-in sessions. There will be two hours of weekly Lectures, a one hour weekly Problem-Solving session and a one hour weekly Drop-in session.
||Assessment will comprise a one hour multiple choice test (30 per cent of the module grade) and a final examination (70 per cent of the module grade) of two hours duration. The multiple choice test and the final exam will contain both numerical and discursive questions and will enable students to demonstrate their knowledge of both derivatives theory and the application of this theory to solve practical problems in risk management and related fields.
The module provides an understanding of the uses and the valuation of the main derivative financial instruments: futures, swaps and options. It covers the trading mechanisms used on derivative markets and explains the fundamental principles underlying the pricing of derivative instruments and their use in portfolio management. Particular attention is paid to the practicalities of using derivative instruments for risk management purposes. The module also provides an introduction to the working of the foreign exchange market and the instruments traded thereon. Related institutional aspects are introduced where necessary. Upon completion of the module students will have met learning outcomes from levels I, II and III of the CFA®Program Candidate Body of Knowledge in respect of Derivatives.
Knowledge and understanding of:
- Define a derivative and differentiate between exchange-traded and over-the-counter derivatives.
- Discuss the purposes and criticisms of derivative markets.
- Explain the concept of arbitrage and its in determining prices and in promoting market efficiency.
- Define futures and forward contracts.
- Define the terms futures price, long position and short position, open interest, price limit, and position limit.
- Explain how futures and forwards can be used by hedgers and speculators.
- Describe how marking to market and margin accounts work.
- Explain the difference between futures and forward contracts.
- Describe how futures and forwards can be used in risk management.
- Outline the main arguments in favour of and against hedging.
- Explain the concept of basis risk, how cross hedging works and calculate the minimum variance hedge ratio.
- Describe how to use stock index futures to hedge an equity portfolio.
- Explain the differences between investment and consumption assets.
- Describe the mechanics of short selling.
- Calculate forward prices for investment assets with and without income.
- Calculate the value of a forward contract.
- Explain the pricing of futures contracts on commodities. Show the difference between pricing futures on investment and consumption commodities.
- Discuss the concept of convenience yield and the cost of carry model.
- Explain the relation between futures prices and expected spot prices.
- Define a swap contract and explain how the swap market works.
- Show how interest rate swaps may be used to transform a liability or an asset.
- Describe the role of a financial intermediary in a swap.
- Discuss the comparative advantage argument in favour of interest rate swaps and explain why it is flawed.
- Perform valuation of an interest rate swap.
- Explain how to use currency swaps and the comparative advantage argument.
- Perform valuation of a currency swap.
- Explain the credit risk problem in the case of swaps and describe other types of swaps.
- Understand the organisation of the foreign exchange market.
- Understand the difference between the spot and forward foreign exchange markets.
- Discuss the concepts of foreign exchange risk and cross exchange rates.
- Explain how triangular arbitrage works in foreign exchange markets.
- Explain the law of one price and purchasing power parity.
- Describe interest rate parity and the main reasons for deviations from interest rate parity.
- Define the basic characteristics of equity option (put and call) contracts.
- Explain the differences between purchasing and writing option contracts.
- Define the terms European option, American option, moneyness, payoff, intrinsic value and time value.
- Describe how options can be used for speculating on price changes and for hedging price risk.
- Explain how option payoffs are determined.
- Identify the minimum and maximum values of European options and American options.
- Describe the relationship between options that differ only by exercise price.
- Explain how option prices are affected by the time to expiration, the price of the underlying instrument, volatility and the market rate of interest.
- Explain the relationship between American options and European options in terms of the lower bounds on option prices and the possibility of early exercise.
- Explain the use of a variety of option trading strategies such as short straddles and long butterflies
- Apply option hedging techniques to simple situations.
- Determine the value at expiration, the profit, the maximum profit and loss, the breakeven price at expiration, and the general shape of the graph of the strategies of buying and selling calls and buying and selling puts, and explain each strategy’s characteristics.
- Determine the value at expiration, the profit, the maximum profit and loss, the breakeven price at expiration, and the general shape of the graph of the straddle strategy, strips and straps, strangles, the bull spread strategy, the bear spread strategy, the butterfly spread strategy, the collar strategy, and explain each strategy’s characteristics.
- Determine the value at expiration, the profit, the maximum profit and loss, the breakeven price at expiration, and the general shape of the graph of the covered call strategy and the protective put strategy, and explain each strategy’s characteristics.
- Understand how synthetic securities may be created how they may be used.
- Understand the derivation of and apply the put-call parity theorem.
- Calculate the fair value of a call option contract using the simple binomial option pricing model.
- Explain the assumptions underlying the Black–Scholes–Merton option pricing model and their limitations.
- Calculate the fair value of an option contract using the Black–Scholes–Merton option pricing model.
- Explain how an option price is affected by each of the input values (the option ‘Greeks’).
- Explain how the Black-Scholes–Merton option price is affected by the payment of dividends.
- Explain the delta of an option and demonstrate how it is used in dynamic hedging.
- Understand the difference between historical volatility and implied volatility.
The above learning outcomes encompass learning outcomes from levels I, II and III of the CFA® Program Candidate Body of Knowledge.
- numeracy, through the manipulation and of financial data and the application of pricing models
- methodical working through planning and prioritisation
- effective listening
- effective time management and the ability to work under pressure
- the ability to analyse information and solve structured problems
- the ability to identify arguments and think critically
Division: Accounting & Finance
This module information is representative of what is included in the module in a given year. Details of actual reading, lectures and coursework may vary year to year and will be available at the beginning of the semester.