(Futures and Options)

UNIVERSITY OF CALIFORNIA

IRVINE, CALIFORNIA 92717-3125

The last twenty years have witnessed an explosion in the growth of
financial products known as *derivative* instruments. These are
products,
such as futures, forwards, swaps and options, that are traded in
relation to more basic underlying instruments, such as stocks, bonds,
commodities and currencies. Because derivative products offer low
transaction costs and new profit patterns, they have become essential
tools for hedging, speculating and controlling financial risks.
Options are also important
because they offer a structure to evaluate residual claims such as
common stocks, and can be applied to many areas of corporate finance.

The purpose of this course is to provide students a working knowledge of derivative markets. The following contracts will be examined:

This course will show how to use and price these instruments. The fair price of futures and forwards can be found in relation to that of the underlying asset, through aForwardcontracts are agreements to buy or sell an asset on a defined date at a fixed price, and are traded on Over-The-Counter markets.

Futurescontracts perform a similar function, but instead are traded on exchanges.

Swapsare agreements between two companies to exchange cash flows in the future according to a prearranged formula.

Optioncontracts give the buyer the right, but not the obligation, to buy (or sell) an asset on or before a defined date at a fixed price. Therefore, options are much more flexible instruments than forward contracts; the issue with options is whether their cost fairly reflects future profits.

**Course Materials:**

The required text is

John Hull, *Options, Futures and Other Derivative Securities,*
Prentice-Hall, 1993.

Since the text is quite complete and up-to-date, additional materials consist mainly of descriptions of recent developments and applications of derivatives. I would also encourage students to take a subscription to Futures magazine, which covers trends in futures, options and other derivatives products. Subscriptions, costing about $40, can be ordered at (800) 635-3931.

**Prerequisites:**

For the regular MBA program:
GSM 209B (Investments), and therefore GSM 209A (Corporate Finance) and GSM
201A (Statistics).
Students should be prepared to the fact that the
course will need to build on mathematical and statistical concepts
developed in core statistics and finance courses. The objective, however,
is not to master theory for its own sake, but rather to learn how to best
use derivative products.
The case package contains a 3-page summary
of statistics for finance, over which you should go very carefully.
If you have problems comprehending any of the material, your background
may be deficient for this course, and you should come see me before
taking the class for credit.

** Requirements:**

The final grade will be approximately based on:

- classroom performance 5%Assignments consist of problem sets, to be solved individually. There will be two computer assignments.

- assignments 15%

- midterm 30%

- final 50%

- The first assignment focuses on a time-series of currency futures prices over 1985-1993, and analyzes the efficacy of cross-hedging and of technical analysis. A spreadsheet can be used for this assignment.

- The second assignment makes use of OPTSIM, a commercial software package for pricing options, running under Windows. The purpose of the assignment is to detect mispriced options, and to hedge an option position using dynamic hedging.

Topic and *readings*

1. Introduction -- *Ch. 1 Read 1, 2 (Jorion notes)*

Using futures -- *Ch. 2 *

2. Futures and forwards -- *Ch. 3 Exercise 1 *

Interest rate futures -- * Read 3, 4 (Jorion notes)*

3. Interest rate futures -- *Ch. 4 Exercise 2 *

Hedging and speculating * Read 8 (Jorion and Roisenberg)*

4. Review -- * Assignment 3 *

Swap contracts -- *Ch. 5 *

5. *** MIDTERM *** -- * Exercise 3b *

Option contracts -- *Ch. 6 *

6. Arbitrage conditions -- *Ch. 7 Exercise 4*

Behavior of stock prices -- *Ch. 9 *

7. Binomial option pricing *Ch. 14 Exercise 5*

Black-Scholes pricing -- *Ch. 10 *

Options on SI, FX futures -- *Ch. 11 *

8. Hedging -- *Ch. 13 Exercise 6,7*

Portfolio Insurance

9. Using options -- * Exercise 8 *

Option trading strategies -- *Ch. 8 *

10. Review -- * Assignment 9*

Numerical procedures -- * Ch. 14 *

Exotics, credit risk -- * Ch. 16,18 *

** Professor's Material:**

1. The Function of Derivative Securities

2. Notes: Review of Statistics for Finance

3. Notes: A General Framework for Risk Management

4. Notes: Institutional Aspects of Derivatives in the United States

** Assignments:**

Assignment 3: Hedging and Speculating with Futures

Assignment 9: Pricing and Hedging Options

Notes on OPTSIM program

** Supplementary Readings:**

1. *Beleaguered Giant: Derivatives...* Wall Street Journal,
August 25, 1994.

2. *Beauty in the Beast.* Economist, May 14, 1994.

3. *Derivatives Survey.* Financial Times, November 16, 1994.

4. *Fill that Gap.* Euromoney, August 1994.

5. Jorion and Roisenberg, *Synthetic International Diversification.*
Journal of Portfolio Management (Winter 1993): 65-73.

6. *Futures on the March.* Futures Magazine, August 1994.

7. *Investing in Managed Futures.* Futures Magazine, July 1993.

Read my recent book on the Orange County disaster,

Big Bets Gone Bad:
Derivatives and Bankruptcy in Orange County,

published by Academic Press (September 1995).

The book explains the role of derivatives in the $1.7 billion loss
suffered by the Orange County Investment Pool in December 1994.

Read the solution to these "derivatives" disasters,

Value at Risk: The New Benchmark for Controlling Market Risk,

published by Irwin Professional (July 1996).

The book explains how to use Value at Risk to control financial risks.
Reporting one single number might have saved Orange County!