McDonough School of Business
Finc-556 Derivatives and Financial Markets

Instructor: Jim Bodurtha	Office: Hariri 485
Phone: 202 687-6351	Office Hours: M W  11:45am-12:50pm and by appointment

Prerequisites:  Both Financial Management modules, Finc 551 and 557. Therefore, the student must have a good understanding of discounted cash flows, present value, and future value.   Students must be able to solve linear equations.  Additionally, the student should be comfortable with statistics, differentiation, natural logs, and the natural number (e). Often, students have also taken at least one additional corporate finance, investments, real options, or fixed income course.

Description:  This course develops understanding of the basic derivative-related financial instruments (forwards, swaps, futures, at-the-money European options, collars, and participation contracts), and their use in transforming and managing risky investments and projects.

Objectives:  To provide a basic understanding of derivatives practice and use in financial markets.

To provide practical and simple investment and corporate financial management strategies using derivatives.

To allow students to apply these concepts and skills to meet investment and corporate finance objectives, using a series of examples that build to a final project.

Required Notes: The first module will be distributed in class. 
Subsequent modules are available on the MSB intranet as a hyperlink in the title of each section of in the course outline.
https://intranet.msb.edu/faculty/bodurthj/unrestricted/teaching/55610_syllabus.htm.

Required Text: You should buy any of the listed editions of the following book:

Hull, J., Options, Futures and Other Derivative Securities, 7^th edition, Upper Saddle River, N.J., Prentice Hall, 2008, ISBN 978013601586-4,
(or Hull, J., Options, Futures and Other Derivative Securities, 6^th edition, Upper Saddle River, N.J., Prentice Hall, 2006, ISBN 013149908-4,
or Hull, J., Options, Futures and Other Derivative Securities, 5^th edition, Englewood Cliffs, N.J., Prentice Hall, 2003, ISBN 013009056-5,
or Hull, J., Options, Futures and Other Derivative Securities, 4^th edition, Englewood Cliffs, N.J., Prentice Hall, 2000, ISBN 013022444-8.)

(If you prefer to purchase the book alone, the accompanying CD is not necessary.  Required class spreadsheet software is on the class web for download).

As the class-notes are in overhead form, you will need the text. The class note modules all have cross-references to the appropriate sections of the Hull book(s).  It is also recommended that you keep up with the financial press.  The FT-US and WSJ are good daily sources.  The Wall Street Journal provides discount student subscriptions on a quarterly or a semester basis (click to access) -- as does the FT for students. Weekly sources include The Economist, Barron's, Business Week, Fortune, and Forbes.

Calculation: The course will require a significant amount of calculation and/or computer spreadsheet work. Please always bring your financial calculator to class.

Grading: A series of 100 point quizzes will be given every one or two weeks throughout the module and during the assigned final exam period.  The course final project is also due at or before our final exam session. The grade weight of the final project is equal to two quizzes (2 x 100 points).   Historically, project grades have averaged 90-91 on a 100 point scale.  The final exam period quiz is equal to 1/2 of a regular quiz. (Beyond your project work, you will not have to study for this quiz.)  

As this course concerns derivatives, you earn two grading options by completing all quizzes.  You will have the option to exclude one quiz from your final grade calculation.  Should you have an excused absence for a quiz, then you must complete the quiz as additional homework to apply the drop option to the associated quiz.  Additionally, you will have the option to redo one quiz question on each quiz to earn back half of the points lost on the question.  The options are inclusive, i.e. you have both options.

The grade equation is the following: 
=IF{F>0,[(SUM(Q)-MIN(Q))+F/2]/[N-1/2],[SUM(Q)-MIN(Q)/2]/[N-1/2]} 

In Excel, the formula is the following:
=IF(Z16>0,((SUM(P16:Y16)-MIN(P16:Y16))+Z16/2)/(COUNT(P16:Y16)-1/2),(SUM(P16:Y16)-MIN(P16:Y16)/2)/(COUNT(P16:Y16)-1/2))

Q = Quiz Grades (Excel Range P16:Y16 for student in worksheet row 16, etc.)
F = Final Session Grade = 1/2 regular quiz (Excel Cell Z16 for student in row 16, etc.)
N = Number of Quizzes

Grade Weights

Grading Curve

In accordance with business school guidelines, class grades will be curved.  Past experience provides some indicative letter grade cutoffs (with no rounding up) :  100-97.5, A- 97.499-95.0, B+ 94.99-92.0, B 91.99-89.0, B- 88.99-81.0, C 80.99-60.0, and below 60.0 is an F. 

Quiz dates -
Our first quiz is during the third class, 9/8.  Current quiz dates are on Wednesdays 9/15, 9/29, and 10/13.
Our final session is in the exam period, October 18-21.

There will be no quiz make-ups.  If, for some reason - like snow, a quiz must be canceled for the entire class, then the next quiz will count as a double quiz.

Outline

Review: Time Value of Money and Interest Rates (click on title link for pdf file)

Options 7^th: 4.2-4.3 especially, 4.1-4.10, 6.1-6.2 (optional 6.3-6.4)
Options 6^th: 4.2-4.3 especially, 4.1-4.10, 6.1-6.2 (optional 6.5-6.6)
Options 5^th: pg. 42-44, 5.1-5.9, 5.13-5.15
Options 4^th: pg. 50-53, 4.1-4.9, 4.13-4.15 (optional Chapter 23-Credit Risk, esp. pp. 623-629)
    Review with required answers: Time Value of Money and Interest Rates  
   (Please focus on the first 20 pages of the handout.  Exercise 1) on page 17 is required, and 2) will
   provide extra practice.   The Raterevw.xls spreadsheet has an example of solutions.
    The appendix should help you better understand all of the concepts, but officially
    it is "optional, but highly recommended."  Prior to the quiz date, I'll be checking 
   voice- and e-mail, and will be in my office off and on.  To see background work, you
   may click to download an associated spreadsheet:  Intgrrte.xls .)
   Finally, an optional spreadsheet illustrates how to work off the benchmark Treasury
    yield curve (or term structure) to evaluate a risky project's cash flows by risk- and 
    time- adjusted DCF - Term_DCF_RP.xls.

Notation: Abbreviations and Symbols (click on title link for pdf file)

1.  Forwards

Options 6^th and 7^th:1.3, 5.3-5.7
Options 5^th: 1.3, 3.4 - 3.8  (pdf copy)
Options 4^th: 1.1, 3.1 (pp. 53-59) - 3.5

2.  Judgmental, Historical, and Regulatory Volatility (click on title link for pdf file)
          (Bloomberg HVG-color, pg 13)

Options 7^th: 13.1-13.2, 13.4, 20.1, 21.1-21.2; optional 13.3, 20.2-20.3, 21.3-21.6
Options 6^th: 13.1-13.2, 13.4, 18.1, 19.1-19.2; optional 13.3, 18.2-18.3, 19.3-19.6
Options 5^th: 12.1-12.2, 12.4, 16.1, 17.1-17.2; optional 12.3, 12.12, 16.2-16.3, 17.3-17.6
Options 4^th: 11.1-11.3, 14.1-14.2, 15.1-15.2; optional 15.3-15.7

3.  Market Benchmarked Expectations, Volatility, and Price Value @ Risk (click on title link for pdf file)

Options 7^th: 5.15, 20.1, 20.6-20.8 and 20.summary; optional Chapter 3, 20.4-20.5 and 20.9
Options 6^th: 5.15, 18.1, 18.6-18.8 and 18.summary; optional Chapter 3, 18.4-18.5 and 18.9
Options 5^th: 3.15, 16.1, 16.6-16.8 and 16.summary; optional Chapter 4, 16.4-16.5 and 16.9
Options 4^th: 3.12, 14.2, 14.7-14.9, 14.summary

5.  Option fundamentals: calls, puts, and underlying (click on title link for pdf file)

Options 6^th and 7^th: 1.5-1.7, Chapter 8
Options 5^th: 1.5-1.7, Chapter 7
Options 4^th: 1.3, 1.4, Chapter 6

6:  Option Positions and Strategies (click on title link for pdf file)

Options 7^th: Chapter 10, pp. 219-221, 230-231
Options 6^th: Chapter 10, pp. 223-225, 234-235 
Options 5^th:  Chapter 9, pp. 185-187, 194-195
Options 4^th:  Chapter 8, pp. 185-187, 194-195
Optional: Structured Bond Products (+B-C, etc.)
                 Options 7^th: 294-296 566-567, 599-602,  647-648
                 Options 6th: 298-300, 520-523, 540-541, 614
                 Options 5th: 249-250, 445-456, 511
                 Options 4th: 253-254, 469-470, 533-534, 646-648
                 Cox-Rubinstein, Option Markets, 1985, Chapter 7.3
                 Bodurtha-Valnet, “Innovation in the International Money and Bond Markets: A Source of Lower Borrowing Costs?”, 1988.

7.  Black-Scholes-Merton Model Sensitivities (click on title link for pdf file)

Chance, D., An Introduction to Derivatives, 4th ed., pp. 139-150
Cox-Rubinstein, Option Markets, 1985, 5.8, pp. 215-235
Hull, 7th edition, Chapter 12-Wiener Processes and Ito's Lemma

Additional Suggested References -
Bodurtha, J. and Courtadon G., The Pricing of Foreign Currency Options, New York, Salomon Brothers Center, New York University, 1987-4/5.
Chance, D., An Introduction to Derivatives, New York, Dryden, 1998.
Cox, J. and M. Rubinstein, Options Markets, Englewood Cliffs, N.J., Prentice-Hall, 1985, ISBN 0136382053.
Figlewski, S., W. Silber and M. Subrahmanyam, Financial Options, : From Theory to Practice, Homewood, Illinois, Business One Irwin, 1990, ISBN 1556232349.
Jarrow, R.A. and A. Rudd, Option Pricing, Homewood, Illinois, Dow Jones-Irwin, 1983, ISBN 0870943782.
Jarrow, R.A. and S. Turnbull, Derivative Securities, Cincinnati, Ohio, South-Western, 1996.
McDonald, Derivatives Markets, Boston, MA, Addison-Wesley Publishing, 2002, ISBN: 0201729601
Rubinstein, Mark, In-the-Money, http://www.in-the-money.com/body.htm, hard copy is Rubinstein on Derivatives, London, Risk Books, ISBN 1899332537.
Stoll, H. and R. Whaley, Futures and Options: Theory and Applications, Cincinnati, Ohio, South-Western, 1993, ISBN 0538801158.

Derivatives Used in Practice -
Bookstaber, R.M., Option Pricing and Investment Strategies, Chicago, Probus, 1991, ISBN 1557381453.
Burghardt, Galen, The Eurodollar Futures and Options Handbook,  New York, McGraw-Hill, 2003, ISBN 0071418555.
Gastineau, G.L., The Stock Options Manual, 3rd edition, New York, McGraw-Hill, 1988, ISBN 0070229813.
Gatheral, Jim, The Volatility Surface: A Practitioner's Guide, Hoboken, Ny Finance, 2006, 9780471792512.
Kolb, R.W., Financial Derivatives, Miami, Kolb Publishing, 1993, ISBN 1878975188.
Kolb, R.W., Understanding Futures Markets, 3rd edition, Miami, Kolb Publishing, 1991, ISBN 187897503X.
McMillan, L.G., Options as a Strategic Investment, 3rd edition, New York, New York Institute of Finance, 1993, ISBN 0136360025.
Natenberg, S., Option Volatility and Pricing: Advanced Trading Techniques, 2nd edition, Chicago, Probus, 1994, ISBN 155738486X.
Schwarz, E.W., Financial Futures: Fundamentals, Strategies and Applications, Homewood, Illinois, Irwin, 1986, ISBN 0256030057.
Siegel, D.R. and D.F. Siegel, The Futures Markets, Chicago, Probus, 1990, ISBN 1557385726.
Smith, Jr., C.W. and C.W. Smithson, The Handbook of Financial Engineering, New York, Harper & Row, 1990, ISBN 0887304486.
Risk, From Black-Scholes to Black Holes, London, Risk, 1993, ISBN 0 9516453 31.
Taleb, Nassim, Dynamic Hedging: Managing Vanilla and Exotic Options, New York, Wiley, 1997, ISBN-10 0471152803, ISBN-13  978-0471152804.
Tompkins, R.G., Options Analysis, Chicago, Probus, 1994, ISBN 1557388342.

More technical -
Ingersoll, J., Theory of Financial Decision Making, Totowa, N.J., Rowman & Littlefield, 1987, ISBN 0847673596.
Shimko, D., Finance in Continuous Time: A Primer, Miami, Kolb Publishing, 1992, ISBN 1878975072.
Wilmott, Paul, J. Dewynne and S. Howison, Option Pricing: Mathematical Models and Computation, Oxford, Oxford Financial Press, 1993,   ISBN 0952208202.

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