A rigorous course on futures, options and related securities, with emphasis on arbitrage pricing and risk management.
New this year: Ryan Garino will bring some real-world perspective in two guest lectures.
Topics: Introduction to forward contracts and options. Basic strategies for hedging or speculation using forward contracts, calls and puts. Arbitrage relationship between spot prices and forward prices. More elaborate forward pricing when the underlying pays dividends, cost of carry, securities lending, and convenience yields. Applications to commodities and foreign exchange. Overview of futures markets: OTC markets versus exchanges, mark-to-market, margins, the role of clearinghouses. The use of futures in basic hedging strategies. Introduction to swaps as a natural extension of forwards and futures. Put-call parity in ideal markets as well as for hard-to-short stocks. Further basic pricing restrictions on American and European options, and analysis of the optimal exercise policy for American options. Binomial pricing of options and associated hedging strategies. Discussion of limits to arbitrage. Introduction to the Black-Merton-Scholes option pricing theory, and associated risk management techniques. Overview of option pricing applications in corporate and other settings.
Prerequisites: Finance I or equivalent. Willingness to engage in analytically involved reasoning.
Optional Recommended Text: The course materials are self-contained. Those looking for additional explanations, as well as material beyond the scope of this course, should consider Derivatives Markets, by Robert L. McDonald, Prentice Hall.
Grading: weekly assignments (40%), midterm exam (30%), final exam (30%).
Homework Groups: Problem sets should be prepared in groups of up to four people. Only a single solution set per group should be turned in. You do not have to belong to the same group for every problem set. It is also okay to complete homework individually.
Exams: The midterm and final exams will be in-class and closed-book. You should bring a calculator with the exponential function. No other computing or communication device will be allowed.