ØKB3103 Financial Instruments

Contents and structure

The course will describe the functioning of modern derivative markets and how derivates can be used to manage financial risk. The emphasis is on forward/futures and options and how they can be utilised in different risk management strategies. Other topics that are covered are continuous compounding, bootstrapping, swaps, credit derivatives and the pricing of forward/futures, options and credit default swaps.

Learning Outcome

Knowledge

The student:

• Is  able to give an account of the differences between forward and futures contracts
• Is  able to give an account of long/short positions in futures and the closing of these, contract specification, mark-to-market, the margin account system, the principles governing delivery, convergence and the main categories of participants in the futures market
• Is  able to give an account of  different risk management strategies which uses futures, cross hedging, hedging a stock portfolio with index futures and how to roll a futures hedge forward
• Is  able to give an account of  the determination of forward/futures prices, convenience yield and cost of carry
• Is  able to give an account of  the LIBOR market and eurodollar futures, interest rate swaps and FRAs
• Is  able to give an account of  the main ideas behind securitisation and possible incentive problems
• Is  able to give an account of  the organisation of the option markets and the main characteristics of different options
• Is  able to give an account of  option parities, pay-off functions and the classical option trading strategies
• Is  able to give an account of  the principles of risk-neutral valuation
• Is  able to give an account of  delta-hedging of a short call and also how the other ¿greeks¿ describes different risk-dimensions of option strategies
• Is  able to give an account of  volatility-smiles
• Is  able to give an account of  credit derivatives and how the CDS-spread is determined

Skills

The student:

• Knows how to do continuous compounding, NPV, FV and internal rate of return (by interpolation)
• Knows how to calculate theoretical value, yield, duration, par yield and forward rates with continuous compounding
• Knows how to do bootstrapping of interest rates to estimate the yield curve
• Knows how to develop hedging strategies with forwards/futures, incl. hedging of LIBOR loans with Eurodollar futures
• Knows how to calculate the value of simple interest rate swaps and FRAs
• Knows how to formulate simple arbitrage arguments for forwards/futures
• Knows how to illustrate option trading strategies in price/profit diagrams
• Knows how to calculate an option price by drawing binomial trees
• Knows how to calculate option prices with different versions of the Black-Scholes option pricing formula
• Knows how to use software and spreadsheets to calculate option prices
• Knows how to valuate a simple CDS

General Competence

The student :

• Has acquired a certain respect and caution for the risk associated with derivatives 
• Has acquired an understanding of derivatives immense efficiency as a tool for building hedging strategies, but also the vast risk exposure that might follow if used improperly
• Has acquired a strong conviction that derivatives one does not fully understand one better avoid.

Entry requirements

None

Recommended previous knowledge

BØA204 Investments and financing or similar

Teaching methods

Lectures and problem solving.

Compulsory learning activities

Hand-in assignments

Assessment

Written exam,5 hour, 100%

Grade Scale A-F