FINANCIAL MARKETS ECONOMICS

This course covers forwards, futures, swaps, and options. By the end of the course, students will have good knowledge of how these products work, how they are used, how they are priced, and how financial institutions hedge their risks when they trade the products.

Base knowledge of financial mathematics

Students will understand how derivatives markets work. For example: – how derivative traders generate liquidity, volatility, and profits/losses; – how derivative prices get determined reflecting information, news, investor behavior, etc. They will also understand: – the role of various market participants, including dealers, brokers, arbitrageurs, buy-side traders (institutions) and retail investors; – different order types, such as market versus limit orders, stop orders, etc.

The course starts by introducing the markets for futures, forward, and option contracts and by explaining the activities of hedgers, speculators, and arbitrageurs (Chapter 1). Then Chapter 2 explains the functioning of futures markets and discusses how long and short futures positions are used for hedging. Chapter 3 covers basis risk, hedge ratios, the use of stock index futures, and how to roll a hedge forward. After dealing with calculations involving interest rates, Chapter 4 includes a discussion of forward rates, FRAs, and theories of the term structure. The relationship between forward/futures prices and spot prices is proved in Chapter 5 by using simple arbitrage arguments. Chapter 7 covers the nature of swaps and how they are valued. Chapter 10 provides information on how options markets work. Chapter 11 outlines a number of relationships between a stock option price and the underlying stock price that do not involve any assumptions about the volatility of the stock’s price. Chapter 12 covers various ways in which traders can form portfolios of calls and puts to get interesting payoff patterns. Chapter 13 discusses simple one- and two-step binomial trees. It enables some of the key concepts in option valuation to be introduced. Material on the use of binomial trees for index options, currency options, and futures options is included in this chapter. Chapter15 covers a great deal of important material: the log-normality of stock prices, the calculation of volatility from historical data, risk-neutral valuation, the Black-Scholes-Merton option pricing formulas, implied volatilities, and the impact of dividends. Chapter 17 deals with options on stock indices and currencies. It shows how the Black-Scholes-Merton formulas can be modified to provide valuations of European call and put options on a stock paying a known dividend yield (stock indices and currencies are analogous to stocks paying known dividend yields). Chapter 18 deals with futures options. It is closely related to the previous chapter. The key point is that a futures price behaves like a stock paying a dividend yield at the risk-free rate. Chapter 19 covers the way in which traders working for financial institutions and market makers on the floor of an exchange hedge portfolio of derivatives.

HULL, John C., “Options, Futures, and Other Derivatives”, Pearson, April 2021 (11th ed.). HULL, John C., “Options, Futures, and Other Derivatives - Solutions Manual”, Pearson, April 2021 (11th ed.). ADDITIONAL RESOURCES HULL, John C., “Technical Notes”, instructor’s web page.

The material discussed in class follows the same order of the textbook. End-of-chapter problems are divided into two group: “Practice Questions” and “Further Questions”. Solutions to the Practice Questions are in “Options, Futures, and Other Derivatives - Solutions Manual”. Some problems are discussed in class, some others are just signaled to students. Sometimes, the instructor uses the PowerPoint slides available on John Hull’s web pages.

The assessment method is based on a futures challenge and two written exams.

The criterion rewards the students’ performance in the exams.