Faculty
Professor Richard J. Rendleman
Objectives
This course will provide an introduction to options, futures, swaps and credit derivatives and the applications of these securities to the management of stock portfolios, fixed-income portfolios and other financial and business risks. Emphasis will be placed on real-world applications of theoretical (or conceptual) material developed in class and using the theory of derivatives pricing and risk management to better understand 1) the role of derivatives markets in our financial system, 2) derivatives trading, and 3) some of the root causes of the recent financial crisis. Although the pricing of derivative securities and the applications of such securities to portfolio and risk management is mathematical by nature, most of the math in the course will be algebra-based.
Specific topics include: no-arbitrage-based option pricing relationships; the binomial and Black-Scholes option pricing models; option investing from a risk-return perspective; using option pricing models in portfolio management; futures and forward markets, pricing and hedging; an introduction to interest rate futures, interest rate swaps and credit derivatives; value-at-risk (VaR); risk-equivalence accounting for derivatives. The course will incorporate lectures and student discussions in covering the various topics. Students will be required to prepare several application-based projects as a basis for class discussion.
The course should be useful to students interested in portfolio management, derivatives trading, risk management, management consulting, executive compensation, commercial banking, investment banking, industry finance or any other field involving financial decision-making.
Requirements
Materials
John C. Hull, Options, Futures and Other Derivatives, seventh edition, Prentice Hall, 2009. ISBN 978-0-13-601586-4.
This book can be purchased at Wheelock Books and the Dartmouth Bookstore. Alternatively, an online version, available for $83.08, can be purchased from CourseSmart at http://www.coursesmart.com/9780136015901, but this version can only be viewed on a computer.Richard J. Rendleman, Jr., Applied Derivatives: Options, Futures and Swaps, revised edition 2008, in course packet. The first edition was published by Blackwell Publishers in 2002. Do not purchase the 2002 edition. The revised edition is not available for purchase.Additional readings, including PowerPoint lecture notes, will be available on the course website.
Tuck Honor Code
Students are not allowed to use old lecture notes, tests, test solutions, homework solutions, project solutions or any other material from prior classes that I have taught at Tuck, UNC, or the Helsinki School of Economics that have not been made available to all members of the class. Use of such materials in connection with this class will be considered a violation of the Honor Code.
Homework
A number of optional homework problems have been assigned for each class session. These problems should not be turned in. Solutions for Q&P from the Rendleman text are available online. Solutions for Q&P from the Hull text are available in the Feldberg library. You should try to do each problem before looking at the solutions, since these problems are representative of the types of questions you can expect to see on the final exam.
Projects
Five group projects will be assigned during the term and must be turned in at the beginning of class on the day they are assigned. Each project can count up to 10 percent of your course grade using the "H-Credit" system explained in "PROJECT GRADING.pdf" contained in the GENERAL DOCUMENTS section of the course folder. The projects may be done individually or in a group that does not exceed three students. You should keep a copy of each project and bring it to class for reference during class discussion.
Computer Usage in Class
Computer usage in class is strictly prohibited, unless I have assigned a specific computer-related project for a particular class. In such cases, students will be notified in advance to bring their computers to class.
Cell Phones and Other Communications Devices
The use of cell phones and other communications devices in class for any reason other than to stay in touch with family due to a potentially impending emergency is strictly prohibited.
E-mail
Whenever you send me e-mail, please put "FOM:" as the first four characters in the subject line.
Grading
Projects 0-50%
Five group projects will be assigned during the term and must be turned in at the beginning of class on the day they are assigned. Each project has the potential to give you a grade of H (100) for up to 10 percent of your course grade. Projects may be done individually or in a group that does not exceed three students. More detail on group projects and the "H-Credit" grading system is provided in "PROJECT GRADING.pdf" contained in the GENERAL DOCUMENTS section of the course folder.
Class Participation 10%
Final Exam 40-90%
(Don't panic about the 90%. See the final exam section of the "PROJECT GRADING.pdf" document.) The final exam will be a closed book (and closed notes) take-home exam. I will provide a set of formula sheets approximately one week from the end of the term that you can use when taking the final exam. The exam will be comprehensive (covering the entire term), and you will have four hours to complete the exam during the exam week.
Most of the more challenging questions and problems from the Rendleman text came from old exams and are representative of questions of average to above-average difficulty that you can expect to see.
Schedule
Thursday, 1/08/09
Options Background and Overview
Rendleman, Chapter 1, Introduction to Option Markets, sections 1.1 – 1.5.
Optional: Rendleman, Review Q&P 1-14 and do Q&P 7, 9, 12-14.
Optional: Hull, Chapter 8, Mechanics of Option Markets, and Chapter 1, Introduction, sections 1.2, 1.5, 1.7 (options section only) and 1.8 (options section only).
Friday, 1/09/09
Common Option Investment Strategies
Rendleman, Chapter 1, Introduction to Option Markets, section 1.6 – end.
Hull, Chapter 10.
Note: The Hull text uses continuous compounding of interest throughout. To review continuous interest, read Hull chapter 4, section 4.2 and Rendleman chapter 4 appendix. Later, we will study continuous interest in more detail in connection with the binomial model.
Optional: Rendleman, Do Q&P 15-23. (All are old exam questions.)
Optional: Hull, Review Q&P 2-4, 6-10, 12-14.
Wednesday, 01/14/2009
No-Arbitrage Based Pricing Relationships
Rendleman, Chapter 2, Put-Call Parity and Other Pricing Restrictions.
Hull, Chapter 9, Properties of Stock Options.
Optional: Rendleman, Do Q&P 1-14. (Most of these questions were from old exams.)
Optional: Hull, Do Q&P 4-5, 8, 13, 20.
Wednesday, 01/14/2009
Project 1 due, Testing the Put-Call Parity Equation
Instructions in course folder.
This is a relatively straightforward project and should not take much time to complete. It should be noted, however, that the remaining projects will require a significantly greater time commitment.
Thursday, 01/15/2009
Introduction to the Binomial Option-Pricing Model
Rendleman, Chapter 3, An Introduction to the Binomial Option Pricing Model, sections 3.1 and 3.2.
Optional: Rendleman, Do Q&P 1-6, 12, 13. (Almost all are old exam questions. If you only have a limited amount of time, make sure you do question 13.)
Thursday, 01/22/2009
Advanced Binomial Pricing and Introduction to the Black-Scholes Model
Rendleman, Chapter 4, Advanced Binomial Option Pricing.
Optional: Rendleman, Do Q&P 1-7, 9, 11. Although the binomial course software can help you to solve problems 6, 7, 9 and 11, you should try to do the problems by hand (or in a clean Excel worksheet) and then use the software as a check. (Note that problems 6, 7 and 11 were old exam questions and some of problems 1-5 may have come from old exams.)
Friday, 01/23/2009
Expected Returns from Options and Option-Related Investment Strategies
Rendleman, Chapter 8, Option Investing from a Risk–Return Perspective, sections 8.1 and 8.2.
Optional: Rendleman, Do Q&P 3, 5, 6.
Friday, 01/23/2009
Project 2 due, Option Expected Returns
Instructions in course folder.
Wednesday, 01/28/2009
Practical Issues Associated with Binomial and Black-Scholes Based Option Replication
Rendleman, Chapter 5, Practical Issues Associated with Binomial and Black–Scholes-Based Option Replication.
Hull, Chapter 17, The Greek Letters, section 17.1 and "Dynamic Aspects of Delta Hedging" in Section 17.4. Note that in Tables 17.2 and 17.3, the heading "Cumulative cost including interest" would be better described as "Total amount borrowed including interest."
Optional: Rendleman, Do Q&P 1.
Thursday, 01/29/2009
Introduction to Options-Based Portfolio Risk Management (the “Greeks”)
Rendleman, Chapter 6, The Black–Scholes Model: Using and Interpreting the “Greeks.”
Optional: Rendleman, Do Q&P 1-11. (All of these questions were from old exams.)
Hull, Chapter 17, The Greek Letters, skip section 17.12. Note that in Tables 17.2 and 17.3, the heading "Cumulative cost including interest" would be better described as "Total amount borrowed including interest."
Optional: Hull, Do Q&P 7, 20, 23
Wednesday, 02/04/2009
Optimal Arbitrage-Based Option Portfolio Selection Using Linear Programming (Part 1)
Rendleman, Chapter 7, Options Arbitrage, focusing mainly on the material starting in section 7.1, subsection “Picking the best options to buy and sell in ‘riskless’ arbitrage,” and going through the end of the chapter.
Wednesday, 02/04/2009
Project 3 due, Optimal Option Portfolio Selection Using Linear Programming
Instructions in course folder.
Thursday, 02/05/2009
Introduction to Futures and Forward Markets
Rendleman, Chapter 12, Introduction to Futures, Forward, and Swap Markets.
Hull, Chapter 2.
Optional: Rendleman, Do Q&P 1-7. (All of these questions were from old exams.)
Optional: Hull, Q&P 3-5, 7, 8, 11, 12, 17-19, 23.
Wednesday, 02/11/2009
Futures Pricing
Rendleman, Chapter 13, Futures Pricing.
Hull, Chapter 5, Determination of Forward and Futures Prices.
Optional: Rendleman, Do Q&P 1-6, 8, 9
Optional: Hull, Q&P 2-4, 6-15.
Thursday, 02/12/2009
Hedging with Futures
Rendleman, Chapter 14, Hedging with Futures.
Hull, Chapter 3, Hedging Strategies Using Futures.
Optional: Rendleman, Do Q&P 1-6 (unit-based hedging only). (All of these questions were from old exams.)
Optional: Hull, Chapter 2, Do Q&P 24 and 25.
Optional: Hull, Chapter 3, Do Q&P 1, 2, 4, 6-8, 10, 13-18, 20-22.
Wednesday, 02/18/2009
Interest Rate Futures
Rendleman, Chapter 15, sections 15.3 and 15.4.
Hull, Chapter 6, Interest Rate Futures, sections 6.1-6.3.
Optional: Hull, Q&P 3, 4, 10-13.
Wednesday, 02/18/2009
Project 4 due, Hedging Stock Portfolios with Index Futures.
Instructions in course folder.
Thursday, 02/19/2009
Interest Rate Swaps
Rendleman, Chapter 16, Interest Rate Swaps, sections 5.1-5.3.
Note, I have totally re-written the swaps material since my original book was published. Now, chapter 5 of my fixed income book has been substitued for chapter 16. That's why the sections are numbered 5.1-5.3 rather than 16.1-16.3.
Hull, Chapter 7, Swaps, sections 7.1, 7.2, 7.4-7.6.
Optional: Rendleman, Q&P 1. (This question was from on old exam.)
Optional: Hull, Q&P 1, 3, 4.
Wednesday, 02/25/2009
Credit Derivatives, CDOs and the ABX.HE Index
Hull, Chapter 23, Credit Derivatives, sections 23.1-23.9.
Note that we will focus primarily on the descriptive material from these sections. You will not be responsible for the valuation of credit default swaps in section 23.2.
Optional: Hull, Q&P 1-5.
Commentary: Credit Default Swaps Are Good For You
Forbes, October 20, 2008, by Stephen Figlewski and Roy C. Smith
The ABX: How do the Markets Price Subprime Mortgage Risk?
BIS Quarterly Review, September 2008, by Ingo Fender and Martin Scheicher
Thursday, 02/26/2009
Value at Risk (VaR)
Hull, Chapter 20, Value at Risk, sections 20.1-20.8.
Optional: Hull, Chapter 20, Q&P 1, 3, 4, 8, 9.
Go over the VaR project in the "VaR PROJECT folder." You do not need to "do" the project, but make sure you are familiar with it before class. I will go over the solution as part of my lecture.
Wednesday, 03/04/2009
Risk-Equivalence Accounting for Derivatives
We will examine the concept of risk-equivalence accounting, using the 2007 annual report of AIG as an example of current accounting practice.
Optional: Behind AIG's Fall, Risk Models Failed to Pass Real-World Test, WSJ, October 31, 2008
Wednesday, 03/04/2009
Project 5 due, Accounting for Derivatives Positions at AIG.
Instructions in course folder. Links to copyright reading material below.
AIG 2007 Annual Report
Obviously, I do not expect you to read the entire report, but having it in electronic form will make it easy to perform keyword searches.
Behind AIG's Fall, Risk Models Failed to Pass Real-World Test
WSJ, November 3, 2008, By Carrick Mollenkamp, Serena Ng, Liam Pleven and Randall Smith
Thursday, 03/05/2009
To be announced
To be announced
Wednesday, 03/11/2009
Final Exam due to Tuck 309C at 5 pm
Final Exam due to Tuck 309C at 5 pm
