BFF5915 Options, Futures

and Risk Management

Week 1: Introduction
Reading: Chapter 1 (Sundaram & Das)
Should we fear derivatives by Stulz

Myself

Dr Binh Do (Chief Examiner)

Room: H4.18
Email: [email protected]
Mob: 0431 486 594
Consultation: Wednesday(1-2pm) and Thursday(4:30-5:30pm)
I take weeks 1-5 then 10-12

Co-lecturer: Andrew Zhe (weeks 6-9)

About this unit

A comprehensive introduction to derivatives

Issues covered include institutional features, pricing, hedging
Emphasis is on how derivatives can be used for hedging risk in
the process of risk management

Unit outline

Pls read it!

Contain all essential information (including my consultation

hours..)

Assessment

ASSESSMENT TASK

DUE DATE

VALUE

Pre-lecture online quizzes

1 hour prior to designated lecture

20%

Individual assignment on hedging

20 May, 2016

10%

Final Examination

During scheduled examination period

70%

TOTAL

100%

Teaching and learning approach

12 sets of lecture (2hrs) +tutorial (1hr)

Each week, you are required to complete a quiz in Moodle
before the designated lecture youve enrolled in. These quizzes
draw on prescribed reading for that lecture and are MCQ: 20% of
assessment.
Purpose: it ensures you gain the first exposure to new materials
outside the class such that class time is used to consolidate that
knowledge, go through technical issues, apply to solve problems,
discuss current relevant issues in financial markets.

First quiz results as of 7am 2nd of March

Lecture program

WEEK

BEGIN

SYLLABUS

WEEKLY ACTIVITIES

ORIENTATION WEEK 22 Feb-26 Feb

1

29 FEB

7 MAR

14 MAR

21 MAR

4 APR

11 APR

18 APR

25 APR

2 MAY

10

9 MAY

11

16 MAY

12

23 MAY

Lecture
Lecture
Lecture
Lecture

1: Introduction to derivatives
Week 1 online
2: Forwards and futures contracts
Week 2 online
3: Hedging with forwards and futures
Week 3 online
4: Pricing forwards and futures
Week 4 online
MID-SEMESTER BREAK 25 MAR-01 APR
Lecture 5: Interest rate forwards and futures
Week 5 online
Week 6 online
Lecture 6: Option markets
Lecture
Lecture
Lecture
Lecture
Lecture
Lecture

7: Option trading strategies

8: Pricing options using Black-Scholes
9: Hedging options using Black-Scholes
10: Interest rate swaps I
11: Interest rate swaps II
12: Derivative Mishaps Hull Chapter 25

quiz (not assessed)

quiz
quiz
quiz
quiz
quiz

Week 7 online quiz

Week 8 online quiz
Week 9 online quiz
Week 10 online quiz
Individual assignment due
Week 12 online quiz

Texts

Prescribed: Sundaram and Das (2016) Derivatives, Principles and

Practice, McGraw-Hill, 2nd edition (1st edition is ok)

Supplementary reading:

Hull, Treepongkaruna, Heaney, Pitt and Cowell (2011)

Fundamentals of Futures and Options Markets (Australian edition)
Chance D.M and Brooks R, (2015), An Introduction to Derivatives
and Risk Management, 10th Edition, Cengage Learning.

Resources

Multiple copies of the prescribed text and recommended texts are

held in library
Additional readings (journal articles, news articles, blogs) are
under Other Readings. Not examinable, but will be used in class
discussions.
Lecture slides are available for download on Moodle. Please print
out one copy for yourself
Tutorial questions are available at least 1 week in advance, with
suggested solutions 1 week later.
Past exam Q&A are available on Moodle around week 11.

10

Are you ready for it?

Undoubtedly the most challenging unit in finance.

Are you ready for it?

Mathematical (algebra, probability, statistics)

Complex product design

On the other hand, here is feedback on my derivative courses

By far, the most interesting, well presented and engaging of any
Monash unit I have experienced
has been one of the most challenging, but most rewarding units
I have done, and i think all the others feel about the same.

11

Lecture 1: Learning objectives

Review key concepts in finance

Introduction to derivatives market and its functions

Some preview of the courses

Should we fear derivatives?

12

Review of important concepts in finance:

risk/return trade-off

Investors invest in expectation of a return

They require a return that compensates them for the opportunity
cost (time value of money, or risk-free rate), AND for taking
certain risks

Risks that are compensated for are subject to debate and time
varying

For equity, beta risk, size, book-to-market, volatility...

For bonds, default risk, liquidity risk

The ongoing sovereign debt crisis shows government debts are not
risk-free

How do investors require return? They buy at below expected

value: S0 =E(ST )-holding cost risk premium
In general, high risk, high return. But how higher return should be
sufficiently attractive?
13

Review of important concepts in finance:

risk preference

Consider 2 investments, a deposit that earns 7% p.a, and a

stock that you expect to return either 2% or 12% with both equally
likely. Which one should you invest?

Risk averse

Risk seeking

Risk neutral

14

Review of important concepts in finance:

short selling
Short selling: process where investors sell a security that they
do not own

What purposes does it serve?

1.
Enabling price discovery improving market efficiency: if my
analysis shows that Myer (MYR) is overpriced, without short
sale, I would not be able to exploit this insight if I do not
already hold MYR

Counter-argument is people take advantage to manipulate

the market (eg rumourage) or it helps destablise already
fragile market (which led to temporary ban of short sale
amidst 2008 crisis)
2.
Hedging: Market makers need to be able to short sell to
hedge their position (eg to hedge a short put, need to sell)
- For literature on short selling, read Reed (2013) on Moodle

15

Review of important concepts in finance:

short selling

Below is cash flow schedule of a long vs short transaction,

ignoring commissions and interest income

Long
investment

Time
0

Buy stock

Short sale

Time

-100

0
Borrow & sell

100

Receive div

Pay dividend

-3

Sell stock

95

Buy back

-95

98

Cash flow

Cash flow

-100

100

-98

In reality, short sale involves loan fees which is inexpensive for

generals and expensive for specials
Show short interest reports on ASX
16

Review of important concepts in finance:

arbitrage

Consider 2 assets A1 & A2 in a world that has two possible

outcomes/states
A1=$100
A2=$50
A1=$80
A2=$40

Since A1 equivalent to 2 A2 in terms of future value, and they are

of same risk (why?) A1 should sell for 2 times A2: law of one
price

17

Review of important concepts in finance:

arbitrage

If today A1=$85 and A2=$41, what opportunity?

Short :1 unit of A1
Long: 2 units of A2
If state is up: short in A1 pays off -100, long in 2 A2 pays off 100:
zero
If state is down: short in A1 pays off -80, long in 2 A2 pays off 80:
zero
This is called arbitrage: a type of transactions in which the
investor (arbitrageur) can obtain profit without taking any risk

18

What are derivatives?

A financial contract
Whose payoff depend on (or derive from) other, more
fundamental, variables, such as

a stock price
A stock market index
an exchange rate
A commodity price
An interest rate
Or even the price of another derivative security
Or even the amount of snowfall in a skiing region
Or even the box office revenue of a movie

The underlying driving variable is commonly referred to simply as

the underlying
19

Example

Gold is not a derivative; it is a commodity with a value determined

in the gold market

But consider the following contract: on Dec 3, a buyer and seller

enter into a forward contract to trade in 100 oz of gold in 3
months (ie on March 3) at price of $900/oz

That is, the seller is undertaking to sell 100 oz in 3 months at

$900/oz while the buyer is undertaking to buy 100 oz of gold at $900

If the spot gold price on March 3 is $1000/oz, the payoff is $100

for the buyer and -$100 for the seller

Alternatively, if the spot god price on March 3 is $850, the buyer

loses $50/oz whilst the seller gains $50/oz
20

Why do people trade derivatives?

In the previous example, the buyer may be a jeweller who plans

to buy gold in the future but is concerned gold prices may rise:
hedging

Think how selling gold forward can be a hedging transaction.

Alternatively, the buyer may merely think the gold price in March
will be considerably more than $900/oz: speculation
Another, less known reason is arbitrage: the seller, for example,
may see that the forward gold price may be too high compared
to the spot price they are able to trade, (plus other
considerations), thus trying to exploit this mispricing
Yet another reason is market making: the buyer or seller is a
financial institution serving their customer, and earn a spread.

21

The roles of derivatives in our society

From the above example and discussion, we can see the roles
derivatives play in our society:
Risk management/hedging: derivatives are a tool to reduce risk,
made possible by risk sharing
Speculation: they can serve as investment vehicles to profit from
a view on the future direction of the market
Market efficiency: derivatives are channels via which arbitrage is
undertaken to reinforce Law of One Price, leading to efficient
market
Price discovery: Derivatives are a mechanism via which market
participants express their view about the future value of an asset,
otherwise not available (eg SPI futures)
1.22

Classifying derivatives

Classification 1:

Classification 2:

Forward commitments: forwards, futures, swaps

Contingent liability: options, credit default swaps, asset-backed
securities
Equity derivatives
Currency derivatives
Interest rate derivatives
Credit derivatives

Classification 3:

Exchange-traded derivatives
OTC (Over-the-Counter) derivatives
23

Major derivatives exchanges

CME Group: Chicago Mercantile Exchange (CME), Chicago Board

of Trade (CBT) and New York Mercantile Exchange (NYMEX),
collectively the largest futures markets, with contracts ranging
from energy to weather in major cities around the world
Chicago Board Option Exchange (CBOE) trades options (including
the popular S&P500 index options
Australia Stock Exchange (ASX) now the owner of Sydney Futures
Exchange (SFE) whose flagship contracts include the ASX SPI
Index Futures, 90-day BAB futures, wool futures, etc.

24

Derivatives are a huge business

...worth studying?
25

How about derivatives related disasters?

Enron
Barings Bank
Societe Generale
Orange County
National Australia Bank
And the recent GFC
...More in week 12 lecture
Paul Samuelson, one of the fathers of derivatives: we did not
know we had created a monster
Warren Buffett used to say: Derivatives are financial weapons of
destruction, carrying dangers that whilst now latent, are
potentially lethal
26

Defence of derivatives

Stulz (2004): We should not fear derivatives.

We do not fear plane because they may crash...instead make them

as safe as it makes economic sense for them to be

Shiller (2008): the main subprime solution is not to scale down

financial markets, but to expand them, democratizing finance, to
extend applications of sound financial principles to a wider
segment of society
Obama: Its power to generate wealth and expand freedom is
unmatched. ...but without a watchful eye, the market can spin out
of control
By the way, Warren Buffett does trade derivatives

27

My position statement

Derivatives are not for the faint hearted

Disasters are caused by misuse, mishandling, misunderstanding,
failure to foresee all the risks and implications, by both users and
regulators
But dont end it, mend it
We are still learning. You as future finance professionals are
fortunate enough to be observer, not victim, of several derivative
mistakes, so learn from them!
Therefore, whenever relevant, Ill go through major disasters that
are related to derivatives so we can all learn from past mistakes
and grow!

28

Next week

Introduction to forward / futures contracts and markets

29

10