Kellogg Graduate School of Management
Northwestern University
Finance 467, Derivatives Markets II
Winter, 2008
Prof. Robert McDonald
| Office | Andersen 4-208 |
| Office hours | before class or by appt. |
| Phone | 847-491-8344 |
| Fax | 847-491-5719 |
| r-mcdonald@northwestern.edu | |
This course is a follow-up to Derivatives Markets I, Finance 465. Familiarity with the material in that course is a prerequisite; in particular, I assume familiarity with the Black-Scholes model and working knowledge of binomial pricing. I also assume very good facility with Excel, and we will do some VBA programming (Appendix D in my text is a VBA tutorial).
The material in this course is more mathematical than in the average course at Kellogg. We will use calculus in class, though I will not expect you to do sophisticated mathematical derivations on exams. (Ryan (2003) might suffice for those needing a calculus refresher.) I do presuppose that you are interested in being able to read “advanced practitioner” literature, such as Risk magazine, and technical reports published by the investment banks.
We will make extensive use of Excel (Office 97 or later) and Visual Basic for Applications (VBA), Excel’s built-in macro language. An introduction to VBA is in the case packet. If you’re not familiar with VBA, you should work through the VBA tutorial, which is an appendix in the book and is also on the web. The spreadsheet OptAll2.xls is included with the second edition of my book.
For the course project we have several data sources:
These may be handed in as group assignments, with a maximum of four to a group. See the “Honor Code” and “Written Assignments” notes below. I drop the low homework grade.
This will be three brief (30-minute or less) in-class quizzes, on these dates:
The purpose of these quizzes is to encourage you to keep up with the material. I drop the low quiz grade.
March 18. This will be in-class and will cover the entire class.
Due Friday, March 14. The final project will give you the opportunity to apply the tools of the course to a practical problem. We will discuss this more in class. This may be handed in as a group project. The grade will reflect the number of participants (i.e. I expect a better project from a larger group.) You must have a bibliography, and citations in the paper to your research references.
You should discuss your project with me before you begin in-depth work.
I expect you to bring namecards to class and to display them. I will reward thoughtful comments and contributions that enlighten others or me. This grade is determined entirely by the quality of your participation, not its quantity. Here are things that will count as class participation:
Your grade will be determined by the following formula:
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where XQ is the participation grade, XPS the problem set grade (low grade dropped), XJ the project grade, XQ the quiz grade (low grade dropped), and XF the final.
In addition to the usual expectations created by the honor code, there are four aspects I want to interpret and emphasize for this class:
Failure to adhere to these standards is a potential violation of the honor code and may be deemed plagiarism.
Except in unusual and pre-approved circumstances, assignments are to be submitted on paper, not electronically. Prinouts of spreadsheets must be clearly documented, indicating the formulas and calculations. Unless I explicity state otherwise, there is no need to turn in pages of random numbers.
E-mail is the best way to get in touch with me. I ask that you please not send attachments without a good reason to do so.
The following is a tentative outline of the course. If you miss a class, it is your responsibility to check with someone to find out what happened.
A “*” after a reading means that the material is available in the case packet.
Chicago Board Options Exchange (2003, link), Heston (1993, link), Bakshi et al. (1997, link), Duffie et al. (2000, link), Coval and Shumway (2001, link),
Fleming and Garbade (2002, link)*,
Bakshi, G., Cao, C., and Chen, Z., 1997, “Empirical Performance of Alternative Option Pricing Models,” Journal of Finance, 52(5), 2003–49.
Bakshi, G. and Kapadia, N., 2003, “Delta-hedged Gains and the Negative Market Volatility Risk Premium,” Review of Financial Studies, 16(2), 527–566.
Baubonis, C., Gastineau, G., and Purcell, D., 1993, “The Banker’s Guide to Equity-Linked Certificates of Deposit,” Journal of Derivatives, 1(2), 87–95.
Black, F., Derman, E., and Toy, W., 1990, “A One-Factor Model of Interest Rates and Its Application to Treasury Bond Options,” Financial Analysts Journal, 46(1), 33–39.
Bodie, Z. and Crane, D., 1999, “The Design and Production of New Retirement Savings Products,” Journal of Portfolio Management, 25(2), 77–82.
Broadie, M. and Glasserman, P., 1997, “Pricing American Style Securities by Simulation,” Journal of Economic Dynamics and Control, 21, 1323–1352.
Campbell, J., Lettau, M., Malkiel, B., and Xu, Y., 2001, “Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk,” Journal of Finance, 56(1), 1–43.
Campbell, J. Y., Lo, A. W., and MacKinlay, A. C., 1997, The Econometrics of Financial Markets, Princeton University Press, Princeton, NJ.
Campbell, J. Y. and Taksler, G. B., 2003, “Equity Volatility and Corporate Bond Yields,” Journal of Finance, 58(6), 2321 – 2350.
Chicago Board Options Exchange, 2003, VIX: CBOE Volatility Index, Technical report, Chicago Board Options Exchange.
Coval, J. D. and Shumway, T., 2001, “Expected Option Returns,” Journal of Finance, 56(3), 983–1009.
Duffie, D., Pan, J., and Singleton, K., 2000, “Transform Analysis and Asset Pricing for Affine Jump-Diffusions,” Econometrica, 68(6), 1343–1376.
Fleming, M. J. and Garbade, K. D., 2002, “When the Back Office Moved to the Front Burner: Settlement Fails in the Treasury Market After 9/11,” FRBNY Economic Policy Review, 8(2), 35–57.
Fleming, M. J. and Garbade, K. D., 2003, “The Repurchase Agreement Refined: GCF Repo,” Current Issues in Economics and Finance, 9(6), 1–7.
Geman, H., 2005, Commodities and Commodity Derivatives, John Wiley & Sons, Chichester, England.
Glasserman, P., 2004, Monte Carlo Methods in Financial Engineering, number 53 in Applications of Mathematics, Springer-Verlag, New York.
Hakannson, N. H., 1976, “The Purchasing Power Fund: A New Kind of Financial Intermediary,” Financial Analysts Journal, 32(6), 49–59.
Heston, S. L., 1993, “A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bonds and Currency Options,” Review of Financial Studies, 6(2), 327–343.
Hull, J. C., 2003, Options, Futures, and Other Derivatives, Prentice-Hall, Upper Saddle River, NJ, 5th edition.
Jackson, M. and Staunton, M., 2001, Advanced Modelling in Finance Using Excel and VBA, John Wiley & Sons, Ltd., Chichester, England.
Joshi, M. S., 2003, The Concepts and Practice of Mathematical Finance, Cambridge University Press, Cambridge, UK.
London, J., 2007, Modeling Derivatives Applications in Matlab, C++ and Excel, FT Press.
Longstaff, F. A. and Schwartz, E. S., 2001, “Valuing American Options by Simulation: A Least Squares Approach,” Review of Financial Studies, 14(1), 113–147.
Lowenstein, R., 2000, When Genius Failed: The Rise and Fall of Long-Term Capital Management, Random House, New York.
McDonald, R. L., 2006, Derivatives Markets, Addison Wesley, Boston, MA, 2nd edition.
Merton, R. C., 1995, “Financial Innovation and the Financial System,” in S. Mason, R. Merton, A. Perold, and P. Tufano, (eds.) “Cases in Financial Engineering: Applied Studies of Financial Innovation,” pp. 1–42, Prentice-Hall, Englewood Cliffs, New Jersey.
Meulbroek, L. K., 2002, “Designing an Option Plan that Rewards Relative Performance: Indexed Options Revisited,” Harvard Business School working paper 02-022.
Neftci, S. N., 2000, An Introduction to the Mathematics of Financial Derivatives, Academic Press, San Diego, CA, 2nd edition.
Pearson, N. D., 2002, Risk Budgeting: Portfolio Problem Solving with Value-at-Risk, John Wiley & Sons, Inc.
Ryan, M., 2003, Calculus for Dummies, Wiley Publishing, Inc.
Schwartz, E. S. and Moon, M., 2000, “Rational Valuation of Internet Companies,” Financial Analysts Journal, 56(3), 62–75.
Schwartz, E. S. and Moon, M., 2001, “Rational Pricing of Internet Companies Revisited,” The Financial Review, 36(4), 7–25.
Srivastava, S., 1999, “Value at Risk Analysis of a Leveraged Swap,” Journal of Risk, 1(2).
Surdell, S. M., 1999, “Towards an Econnomically Rational Definition of Constructive Sales Under Section 1259,” Derivatives, 4(3).
Wilmott, P., 1998, Derivatives: The Theory and Practice of Financial Engineering, John Wiley & Sons, Chichester, England.