BIRLA INSTITUTE OF TECHNOLOGY AND SCIENCE, PILANI

INSTRUCTION DIVISION
FIRST SEMESTER 2019-20
Course Handout Part II
Date: 31/07/2019
In addition to Part-I (General Handout for all courses appended to the timetable) this portion gives further
specific details regarding the course.

Course No. : ECON F354 / FIN F311

Course Title : Derivatives & Risk Management
Instructor-in-charge : ARUN KUMAR VAISH

1. Scope & Objective:

The objective of this course is to provide students an introductory level familiarity with a particular
type of financial instruments known as DERIVATIVES. To achieve the stated objectives the course
provides a detailed description on the structure (read, design) and utility (read, relevance) of the most
common and popular financial derivatives namely, Options, Futures, and Swaps. The scope of the
course entails acquainting students with the mechanics of trading and settlement of derivative
instruments in the financial markets and their function as insurance products for hedging financial
risk.
No understanding about financial instruments or their derivatives is complete without a thorough
grasp over interest rate concepts and hence the course also includes discussion on topics such as time
value of money, term structure of interest rates and their role in valuation of bonds, computation of
yield and forward interest rates, estimating bond-price volatility, and the role of bond duration and
convexity in mitigating interest rate risks.
The topics covered in the course will, at an introductory level, enable participants to learn about
common risks prevalent in the financial markets and how to manage its impact on investment
exposure by using derivatives. Discussion on valuation of financial derivatives and a brief
introduction to creating synthetic investment positions by combining derivatives prepares students
for advanced level courses such as Financial Engineering and Financial Risk Analytics and
Management. The course concludes with a survey of selective topics of contemporary interest to risk
management industry such as forecasting volatility, estimating value-at-risk, etc. The topics covered
in the course will also assist students in preparing for competitive professional international
certifications such as Financial Risk Manager (FRM) and Chartered Financial Analyst (CFA).

Prerequisites: This is an elementary course on Derivatives and Risk Management and does not
assume any prior knowledge of Financial Markets, Instruments and Derivatives. However,
familiarity of basic economic theory such as law of supply and demand, utility maximization
principle, compounding and discounting of cash flows, etc. are desirable. The course is not
mathematically rigorous and a first-year course on elementary linear algebra, calculus, probability,
and differential equations will be sufficient to grasp the contents of the course. It is expected that
students have technical know-how of MS excel as it will be used to demonstrate required
computations, wherever required, and for carrying out take-home assignments.

3. Text book:
Hull, John C., and Basu, Sankarshan (2016). Options, Futures, and Other Derivatives, 10th Edition. Pearson
Education Inc.

1. Reference books:

R1. David A. Dubrofsky and Thomos W. Miller, Jr., Deivatives Valuation and Risk Management,

Oxford Unversity Press.

R2. David G. Luenberger, Investment Science, Oxford University Press
Lecture Learning Objectives Topics to be Covered Learning Outcomes Reading
No. and Reference
Date
0 Orientation:  Importance of this course to the
 Course introduction and Overview participants for fulfilling career -NA-
discussion on the hand-out. aspirations related to this course.
 Brief orientation of the  Familiarity of the course instructor
participants and their with course participants and their
expectations from the course. expectations from this course.
1 -4 Introduction:  Exchange-traded markets vs.  Fundamental distinction between Ch. 1
 Introduction to Financial Over-the-counter markets. underlying instruments and (selective
Markets and financial  Introduction to common derivatives of those instruments. topics:
instruments. financial instruments such as  Different types of derivatives and follow
 Role of intermediaries in stocks and bonds, and their how they differ from each other, classroom
modern-day finance. role in financial markets. e.g. Difference between Options discussion)
 What are derivatives and their  Basics of derivatives and the and Futures. Difference between + Class
relation with traditional concept of the underlying call option and put option. notes
financial instruments? instrument.  The first principles of asset
 Philosophy of asset valuation.  Distinction between valuation, which will enable
 Types of traders in financial investment, hedging, and students to learn the universal
markets. speculation. convention followed for asset
 Role of arbitrageurs in financial valuation.
markets.

5-8 Basic Tenet: An introduction to:  Understand the inherent relation Class notes
 Introduction to types of risks  Risk and to estimate risk. between risk and return and
present in the financial  What is return? How to importance of risk in asset
markets. estimate return on stocks? valuation.
 What is return on investment  Historical analysis of financial  Common types of risks that
and how is it calculated? instruments from their risk- investors encounter in financial
 How derivatives are used in return profiles. markets.
managing downside risk?  Basic understanding of using
derivatives for hedging downside
risk.
9-15 Futures and Forwards  Specification of a futures  Identify futures contract on stock Ch 2 and 3 +
 Introduction to Futures contract. exchange and read and interpret Class notes
 How Futures are traded on  Trading of futures contract on online quotes on futures.
stock exchange? stock exchange.  Place trading orders on Futures.
 Clearing and settlement of  Margin requirements and  Importance and implications of
Futures contract. marking-to-market futures margin requirements for initiating
 Risk management strategies position. a futures contract and role of
using futures.  Expiration of futures contract maintenance margin in sustaining
 Anticipation based strategies and rollover. the contract.
using futures.  Basic trading strategies using  The concept of Marking-to-Market
 Forwards contract futures contract. (MTM) an open position in futures
 Valuation of Futures and  Hedging stock risk using contract as stock prices fluctuate
Forwards. futures contract. real-time.
 Law of convergence and  Identification of variables that
valuation of futures contract. affect intra-and-inter-day prices of
 Forwards vs Futures futures contract.
 Cost of carry and its implication Role of interest rates,

on futures valuation. transportation costs, storage costs
 Short selling and intra-day on prices of futures.
trading of futures.  Fundamental difference between
 Speculation using futures futures and forwards.
contract.  Application of time value of money
 Forwards on non-financial for valuing futures and forward
assets (commodities). contracts.
 Stock index futures.  Risk management using futures
contract.
Lecture Learning Objectives Topics to be Covered Learning Outcomes Reading
No. and Reference
Date
16-20 Options: Introduction,  Types of options.  Distinction between long on Ch 10, 11
Trading, Strategies  Options positions and basic options and short on options. (selective
 Introduction to options. pay-off diagrams.  Draw pay-off diagrams of different topics:
 Options trading mechanism.  Specification of options and options based strategies. follow
 Clearing and settlement of interpretation of options  Interpretation of price of an option classroom
options. quotes. as function of intrinsic value and discussion)
 Difference between long on  Market mechanics of options time value. and 12 +
options and short on options. trading, clearing, and  Impact of moneyness of an option Class notes
 Basic options pay-off diagrams. settlement. on its value and utility for hedging
 Identify important variables  Factors affecting options the underlying.
that impact options prices. prices.  Creating hedging strategies using
 Creating and utilizing options  Stock position protection using options.
strategies for risk management options.  Creating speculative strategies
and speculation.  Creating strategies, using options.
21-25 Option Greeks and Valuation  Introduction to option Greeks:  Basics of option Greeks and their Ch. 11
 The Greek letters and their Delta, Theta, Gamma, Vega, different types. (selective
estimation. Rho.  Differentiate between At-the- topics), 19,
 Moneyness of an option and  Moneyness and delta hedging. money, In-the-money, and Out-of- 13, 15 +
option Greeks.  One-step binomial model and a the-money options. Class notes
 Hedging the underlying using no-arbitrage argument.  Utilize information on options
options Greeks.  Risk-neutral valuation. Greeks to formulate hedging
 Relations between option  Two-step binomial trees strategies.
Greeks and volatility smiles  Binomial model: Simulation  Identify mispricing of options using
 Put-call Parity and option example. Put-Call parity.
valuation.  Put-call parity and no-arbitrage  Learn the theory of risk-neutral
 Binomial model of option condition.. valuation and use Binomial and B-
pricing.  Inputs to Black-Scholes-Merton S-M model to price options using
 Black-Scholes-Merton (B-S-M) option pricing model. data from the stock exchange.
option pricing model.  Estimation of call and put  Learn the impact of dividends on
prices using B-S-M model. option prices.

26-32 Fixed Income Instruments and  Features of fixed income  Role of interest rates in pricing Ch. 4 +5 +
their Derivatives instruments. securities. class notes
 Interest rate basics.  Bond yield calculation.  Relate fluctuations in interest
 Interest rates and their role in  Pricing plain-vanilla bond. rates with macroeconomic
bond valuation, yield-to-  Yield curve analysis. scenario.
maturity and yield-to-call .  Bond price volatility.  Factors affecting bond yields and
 Day count convention and its  Forward rates of interest. the term structure of interest
role in calculating clean and  Strips markets. rates.
dirty price of bond.  Overview of interest rate  Estimating bond duration and
 Zero coupon bonds. derivatives. convexity.
 Estimating forward interest  Hedging using interest rate  Bond portfolio management
rates. futures. strategies.
 Treasury STRIPS and FRAs.  Trading strategies using  Importance of STRIPS and their
 Duration, modified duration interest rate options. relation with forward interest
and bond price volatility.  Currency derivative rates.
 Convexity. instruments.  Futures and options on interest
 Bond portfolio immunization.  Determinants of foreign- bearing instruments and their use
exchange rate in hedging interest rate risk.
Lecture Learning Objectives Topics to be Covered Learning Outcomes Reading
No. and Reference
Date
33-36 Swaps and their applications  Mechanics of swaps.  Why firms undertake swaps Ch. 7 + class
 Comparative-advantage contract for exchanging one cash- notes
 Need for swaps in modern day argument. flow with another?
finance.  The nature of swap rates.  How swap contracts are designed
 Different types of swaps.  Determining the LIBOR / swap and what purpose they satisfy?
 Swaps and cash flow zero rates.  Role of financial intermediaries in
engineering.  Valuation of interest rate a swap contract.
 Role of financial institutions in swaps.  Distinction between different
a swap contract.  Cross-currency swaps. types of swaps.
 Valuation of swap.  Commodity swaps.  Valuation of swap contracts and
 Risk management using swaps. their role in financial risk
management.
37-42 Contemporary topics related to  Volatility smiles and smirks.  Relation between moneyness of Ch. 20
risk quantification and  Measures of VaR. an option with volatility smile. (selective
management  Stress testing and back testing.  How information on historical topics), Ch.
 Principal component analysis. price movement is utilized for 22 (selective
 Estimation of implied volatility  Volatility estimation and estimating value-at-risk using topics), 23
from option prices. forecasting using exponentially different models. (selective
 Volatility smiles and smirks. weighted moving average and  How information on value-at-risk topics) +
 Value-at-Risk (V-a-R) generalized autoregressive is used for portfolio risk Class notes
estimation and its utility in conditional heteroscedasticity management.
portfolio hedging. (GARCH) models.  The latent nature of volatility and
 Estimating volatilities and  Using GARCH (1, 1) to forecast how it is estimated using EWMA
correlations future volatility. and GARCH approaches.
 Types of GARCH models and
forecasting volatility using GARCH
models.

6. Evaluation Scheme - (Course. is of 200 marks

EC Component Duration Weight-age Date, Time & Venue Nature of

No. Component
1. Mid-Semester 90 min. 30% As per timetable Open book
Announced (1 buffer
2. Surprize Quizzes- 25 min. 30% and no make-up) Closed book
{best 2 out of 3}

3. Comprehensive 180 min. 40% As per timetable Closed book

7. Chamber Consultation Hour: 1200 hrs-1300 hrs - Wednesday

8. Notice: All notices will be displayed on Economics & Finance Notice Board.

Instructor-In-Charge