MGFC30H -- Introduction to Derivatives Markets

Instructor: Prof. Jason Z. Wei Jan. – Apr., 2019

Office: IC 372 L01: WE 11am-1pm, IC 204
Office hrs: MO 4:00-5:00pm, WE 5:00-6:30pm L02: WE 3pm-5pm, IC200
Phone: 416-287-7332 Email: wei@utsc.utoronto.ca

COURSE DESCRIPTIONS

Derivatives, as a class of financial securities, have become an integral part of modern

finance. Nowadays, introductory and intermediate-level courses on futures and options are
standard offerings in most business schools. Meantime, the demand for finance professionals
with a sound understanding of derivative products and markets has been increasing, especially on
Wall Street and Bay Street. Financial institutions (e.g., banks) and institutional investors (e.g.,
pension funds) regularly deal with the trading, valuation, and accounting of derivative securities.
The co-op terms of many UTSC BBA students involve duties related to derivatives, especially for
the placements with banks, CPPIB and Ontario Teachers’ Pension Plan.

This course covers the fundamentals of futures and options, with four main objectives.
First, it introduces students to the basic valuation models such as the cost-of-carry model and the
Black-Scholes model. Just as the discount cash flow framework allows us to value bonds and
stocks (by discounting coupons and dividends), the basic valuation models introduced in this
course allow us to arrive at an intrinsic value for a derivative security. Second, we demonstrate
how derivative securities can be used to enrich investment strategies and enhance risk
management (e.g., portfolio insurance). Third, the course exposes students to the most recent
developments in the derivatives market, and identifies trends that will likely shape the future of
the derivatives industry. Fourth, the course enlightens students with the practical aspect of the
derivatives markets. Through real-time trading of derivative securities via the Rotman Portfolio
Manager (RPM), students will be able to apply their classroom knowledge to real-world
investing. By the end of the course, students will have mastered the basic knowledge and skills
necessary to pursue an entry level career in the derivatives industry or pursue advanced studies of
the subject.

The co-requisite is MGFC10 (Intermediate Finance) and hence the prerequisites are
identical to those of MGFC10. Those who have taken RSM435H (Futures and Options Markets)
on St. George Campus or MGT438H from UTM are not allowed to take this course.

Management, 1265 Military Trail, Toronto, ON, M1C 1A4, Canada

www.utsc.utoronto.ca/mgmt 1
REQUIRED TEXTBOOK:

Fundamentals of Futures and Options Markets, 9th Edition, by John Hull (Pearson, 2017). ISBN-
10: 0-13-408324-5, or ISBN-13: 978-0-13-408324-7.

PERFORMANCE EVALUATION:
Attendance: 3%
Assignments (3): 12%
Simulation: 10%
Report: 6%
Portfolio: 4%
Bonus: 2%
Mid-term exam: 25% (Date: Feb. 27 - Temporary)
Final exam: 50%

The following notes apply to the above evaluation scheme. First, no late assignments will
be accepted for marking since the solutions are posted right after the deadline.

Second, although only three assignments are to be handed in for marking, one extra
assignment will be given for practice. Only Assignments 1, 3 and 4 are for marking. Assignment
2 is for practice only. Students do not have the option of handing in any three of the four
assignments. You must hand in Assignments 1, 3 and 4.

Third, for those who fail to write the midterm exam, the midterm weight (25%) will be
added to the final exam (75% in total). There will be no makeup midterm exam.

Fourth, to encourage continuous efforts and to reward significant improvement in

performance throughout the course, the midterm exam weight will be partially shifted to the final
exam should the final exam turn out to be better than the midterm. The bigger the improvement,
the larger the amount of shift in weight. If the percentage improvement is larger than 30%, then
all the midterm weight of 25% will be shifted to the final. Specifically, let “m” and “f” stand for
the midterm and final marks respectively in percentage and suppose f > m. Then the amount of
shift = [min(f – m, 0.30)/0.30] 3/2 × 25%. For instance, if the final is 82% and the midterm is 61%,
then the shift is [0.21/0.30]3/2 × 25% = 14.64%. In this case, the midterm is worth 10.36% and the
final is worth 64.64%. To continue the example, if the final is 86% or higher, then the entire
midterm weight is shifted to the final.

Finally, the purpose of assigning 3% of the course weight to attendance is to discourage

students from skipping classes. Past experiences indicate time and again that the consequence of
missing classes is far more detrimental than students would like to believe. Barring unforeseen,
extraordinary events, students should attend each and every lecture. Attendance will be taken at
least three times throughout the term, with dates to be randomized. Each absence will result in a
loss of 1%, and the total penalty will be capped at 3%. For instance, if attendance is taken four
times in the term, and a student is absent at each attendance check, then he/she will lose 3%. On
the other hand, if attendance is taken five times, and a student is present at the first three

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attendance checks and only absent at the last two checks, then he/she will still lose 2%. In other
words, I count the total number of absences.

Given the limited lecturing hours, it is very difficult to cover in detail all the relevant
topics in class. To better utilize the classroom time, students are encouraged to come prepared for
each lecture by reading ahead. Active learning in the form of pre-class reading and in-class
questioning is extremely beneficial. Class participation is encouraged.

SELF-STUDY AND REVIEW

Aside from reading ahead, students are also encouraged to review each lecture right after
the class and clear away all the questions before the next lecture. The benefits are enormous. To
facilitate this process, end-of-chapter questions will be assigned to each topic, in addition to the
many in-class numerical examples. Full solution keys are provided for all assigned questions.
Students are encouraged to fully utilize the office hours offered by the TA and the instructor.

COMMUNICATIONS AND COURSE MATERIAL DISTRIBUTIONS

All of the study materials including assignments and important announcements will be
posted on the portal. Students are encouraged to frequently check the postings.

SIMULATION — RPM INVESTMENT CHALLENGE

The ultimate purpose of the simulation is to introduce realism in learning. A group of no-
more-than six students will perform the task of setting up and managing a derivatives portfolio
(students may also form smaller groups as they wish, but the minimum size should be two).
Through trading derivatives on formal exchanges, students are expected to learn and appreciate
the workings of the derivatives markets, and to apply their knowledge and wisdom in the
investment world. The investment vehicle will be the Rotman Portfolio Manager (RPM). Please
visit http://rpm.rotman.utoronto.ca for details. Please also download the RPM advanced user
guide:
http://financelab.rotman.utoronto.ca/documents/RPM_Students_Advanced_User_Guide.pdf. Be
sure to read it before the simulation starts. For a quick-start guide, please download:
http://financelab.rotman.utoronto.ca/documents/RPM_Students_Quick_Start_Guide.pdf. (The
two files are also available on the portal.) There are a 15 minute-long Quick Start Tutorial video
for first-time users and a 60 minute-long full video explaining the software features.

The investment game will start on January 28, 2019 (Monday) and end on March 29,
2019 (Friday), for a duration of nine weeks. Each account will be endowed with $1,000,000Cdn
fake money, and participants will have access to stocks (North American as well as
international), options, futures, futures options, bonds, and currencies. In this simulation,
students are required to trade only derivatives: options, futures and options on futures.

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 There will be two training sessions offered by the Finance Trading Lab, one on Monday,
January 21 and the other on Wednesday, January 23. The two sessions are identical and run from
5:30pm to 6:30pm. Students may choose the session at their convenience. The training session is
essential since it will teach you the basics of derivatives trading and prepare you for the start of
simulation on January 28. Everyone should attend regardless of your group size. We will take
attendance and a 1% bonus will be offered to those who are present. For your convenience, the
Finance Trading Lab has created a resource page: http://guides.library.utoronto.ca/MGFC30.

Overall Instructions and Requirements

Each group will maintain a trading account with an initial endowment of $1,000,000Cdn.
Students are allowed to trade derivatives only. The position limit is 50%, meaning that you
cannot invest more than 50% of your capital in a single security. All groups will be subject to the
same investment restrictions set out by RPM. Specifically, transaction costs are $2/contract for
futures and options. The borrowing and lending rates are, respectively, 0.5% above and 0.5%
below the overnight LIBOR rate.

To register your account, follow these steps:

1. Download and install the software from http://rpm.rotman.utoronto.ca/
2. Form your group and submit your group membership to me, with each member’s
name, student number, email, and phone number (deadline is January 22).
3. Register your group account on the following webpage:
http://rpm.rotman.utoronto.ca/. The Class Code is MGFC30_2019s, and the Class
Password is “hedgefund.” Please don’t register more than one account per group.

Note: no adjustment will be made to group membership once finalized on January 22.
You must make up your mind beforehand. This is especially important for those who want me to
assign you to a group (i.e., I form a group for you). Please indicate your preference (if any)
beforehand. Do not come back to me and ask for group re-assignment after the January 22
deadline.

You will be evaluated based on two items: a written report (6%) and the ending portfolio
value (4%). Clearly, more weight is placed on the report, since students are not supposed to be
overly concerned about the portfolio value. The written report should be no more than six pages
long (excluding tables, figures, etc), double-spaced, and in regular sized fonts. There is no
specific format required for the report. However, a good report will clearly stipulate the
investment objective and corresponding strategies; discuss the implementation of the strategies;
justify the strategies with respect to the assessment of the market conditions (e.g., gold price
movements); provide insights gained from the simulation; and so on. A group may in the end lose
a lot of money, but if it can clearly justify its objectives and strategies and implement meaningful
trades, then the group can still get a high mark on the report. In other words, in the end, it is the
experience and learning that count. The report is due on the last day of lecture.

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 To make the simulation more exciting, 4% is assigned to the portfolio value. Here, the
objective is very simple: get the highest return possible. The evaluation is purely based on
portfolio value, regardless of the strategies. The 4% is to be awarded to the best performing
portfolio, but I do have my own bar set for this, and it is going to be subject to my sole discretion.
For instance, if the best performing portfolio in our class earns only a 7% return, then I will be
very hesitant to give 4% to this group. Notice that I do not set an absolute bar. This is in the
students’ interest, because I am not prepared to give a zero to any group.

Finally, to reward superior performance, a 2% bonus will be handed out if the ending
portfolio is above $4,000,000. For instance, if a group gets a perfect mark on the report, and has
an ending portfolio value of $4,500,000, then it will receive 12% from the simulation. Note: the
bonus is handed out ONLY WHEN the portfolio value is above $4,000,000. In other words, you
won’t get it or a fraction of the bonus if your ending portfolio value is, e.g., $3,950,000.

The following are specific requirements:

1) Complete account registration and make at least one transaction by the end of
January 29. Failure to do so will lead to a loss of 1%, regardless of the final
portfolio performance.
2) Make at least five (5) transactions by the end of week 4 (i.e., February 22). Failure
to do so will lead to a loss of 1%, regardless of the final portfolio performance.
3) Make at least 12 transactions by the end of week 6 (i.e., March 8). Failure to do so
will lead to a loss of 1%, regardless of the final portfolio performance. (Therefore,
you may actually lose 3% toward your total course grade if you fail to meet all of
the three requirements.)
4) Execute a minimum of 20 transactions by the end of the simulation. When/if this
condition is not met, the group will receive a zero for the simulation even if
the group has met requirements 1) to 3).

Several caveats are in order:

 Portfolio performance will be based solely on the closing value at the end of the
simulation. The history of portfolio performance does not matter as far as the 4%
is concerned. But the history will matter for your report. For instance, if your
portfolio has been doing well until the last week when a big mistake makes a
devastating blow to your portfolio, I still consider that you have done well overall.
 Please do not exercise options since you will end up with a stock position, but you
are not allowed to trade stocks in this simulation. You should sell the options if
you want to close the position.

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Several popular resources for stock analysis and trading strategies:
 http://www.barchart.com
 http://www.marketwatch.com
 http://www.bnn.ca/
Enjoy and good luck!!!

Resolution of Team Work Conflict

Once in a while, I receive complaints from students that certain of their group members are not
shouldering their share and hence not contributing enough to the group. In all cases, I leave the
resolution to the group, for managing group dynamics is part of the learning. To facilitate a
successful resolution in case of dispute, I have borrowed the idea of Peer Evaluation from a
colleague. Please see the Peer Evaluation Form at the end of this course outline. Of course, only
those groups that have an issue with uneven workload (perceived or real) may consider filling out
the form. Note: the form is valid only with signatures from all members of the group.

Academic Support
The Department of Management, in collaboration with the UTSC library, will be providing
academic research support in the IC Building. To refine your research skills or to learn more
about various scholarly resources, please contact the Librarian for Management and Economics
students. 

Stephanie Perpick
Librarian, Department of Management IC368
416-208-2987
Stephanie.perpick@utoronto.ca
Office hours by appointment

The English Language Development Centre (ELDC) helps students develop the critical thinking,
vocabulary and academic communication skills essential for achieving academic and professional
success. Personalized support includes: RWE (for academic writing); Communication Cafés
(oral); Discussion Skill-Building Cafés; Vocabulary Cafés; seminars/workshops; personal ELD
consultations; drop-in sessions. http://ctl.utsc.utoronto.ca/eld/

The Writing Centre (TWC) offers invaluable services to students (learn to become a better
writer!) and offers many different kinds of help: drop-in sessions, individual consultations,
workshops, clinics, and online writing handouts. http://ctl.utsc.utoronto.ca/twc/

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Academic Misconduct
Students should note that copying, plagiarizing, or other forms of academic misconduct will not
be tolerated. Any student caught engaging in such activities will be subject to academic discipline
ranging from a mark of zero on the assignment, test or examination to dismissal from the
university as outlined in the academic handbook. Any student abetting or otherwise assisting in
such misconduct will also be subject to academic penalties.

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 PLANNED COURSE SCHEDULE

Topic Date Chapter

I. INTRODUCTION Jan 9 1
− Introduction
− Risk versus financial engineering

II. FORWARDS AND FUTURES Jan 16, 23, 30 2, 3, 4, 5, 6

− Definitions
− Purpose of Futures Markets
− Structure and Specification of Futures Contracts
− Operation of Margins
− Forward and Futures Price Determination
− Interest Rate Futures
− Hedging with Futures

III. OPTION TRADING STRATEGIES AND

PROPERTIES OF STOCK OPTIONS Feb 6, 13 9, 10, 11
− Basics
− Trading Strategies
− Factors Affecting Option Prices
− Bounds for Option Prices
− Early Exercise of American Options

Mid-Term Exam Feb 27

IV. BINOMIAL TREES Mar 6 12, 18

− One Period Binomial Tree
− Two-Period Binomial Tree
− Multi-Period Binomial Tree
− Binomial Tree for Options on
− Indexes, Currencies and Futures
− Binomial Tree for a Dividend Paying Stock

V. THE BLACK-SCHOLES MODEL Mar 13, 20 13, 15, 16

− History 17
− Review of Probability Theory
− Modelling Stock Price
− The Black-Scholes Model

VI. EXOTIC AND INNOVATIVE OPTIONS Mar 27 22, 23, 24

− Range-forward contract
− Chooser option
− Barrier option
− Look-back option
− Shout option
− Asian option
− Option to exchange one asset for another
− Innovative swaps
− Credit derivatives
− Weather derivatives

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VII. APPLICATIONS AND REVIEW Apr 3

Detailed Outline and Pages of Text Corresponding to Each topic

Topic Pages

I. INTRODUCTION 1-19
− Introduction
− Risk versus financial engineering

Quiz: 1.1, 1.2, 1.3, 1.4, 1.6.

II. FORWARDS AND FUTURES

− Definitions 1-7
− Purpose of Futures Markets
− Structure and Specification of Futures Contracts 24-27
− Operation of Margins 29-35, 217-218
− Forward and Futures Price Determination
• Preliminaries 81-91
• Cost of Carry Model 127
• Forward on a Security without Cash Income 107-112
• Forward on a Security with Known Cash 113-118
• Stock Index Futures 63-69, 118-120
• Forward and Futures on Currencies 121-124
• Futures on Commodities 124-127
• Futures Price as a Predictor of Future Spot Price 118, 128-130
− Interest Rate Futures
• Preliminaries 81-92
• Forward Rate Agreement (FRA) 95-97
• Treasury Bill Futures (Not in book)
• Day Count Conventions 136-138
• Treasury Bond Futures 139-143
− Hedging with Futures
• General Issues 49-55
• Optimal Hedge Ratio 60-62

Quiz: 2.1, 2.5, 3.1, 3.3, 3.5, 4.1, 4.5, 4.7, 5.2, 5.5, 5.6, 5.7, 6.1, 6.2.

III. OPTION TRADING STRATEGIES AND

PROPERTIES OF STOCK OPTIONS
− Basics 202-215
− Trading Strategies
• single option holdings 249-253
• straddle 261-262
• strip 262-263
• strap 262-263
• strangle 263-264
• bull spread 253-255
• bear spread 255-256

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 • butterfly spread 258-259
− Factors Affecting Option Prices 227-230
− Bounds for Option Prices 232-239
− Early Exercise of American Options
• without dividends 239-243
• with dividends 243-245

Quiz: 9.1, 9.4, 9.6, 10.1, 10.2, 10.3, 10.4, 10.5, 10.6, 11.2, 11.3, 11.6.

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 Detailed Outline and Pages of Text Corresponding to Each topic

Topic Pages

IV. BINOMIAL TREES

− One Period Binomial Tree 268-274
− Two-Period Binomial Tree 274-281
− Multi-Period Binomial Tree 281-282, 391-398
− Binomial Tree for Options on 398-401
Indexes, Currencies and Futures
− Binomial Tree for a Dividend Paying Stock 401-404

Quiz: 12.1, 12.3, 12.5, 18.2, 18.3.

V. THE BLACK-SCHOLES MODEL

− History 293
− Review of Probability Theory (Not in book)
− Modelling Stock Price
• Black-Scholes assumption of returns 294-296
• expected return 297-298
• estimating volatility 298-301
• The Black-Scholes Model
• assumptions 301-302
• model 304-306
• Black-Scholes model with dividends 309-311
• options on stock indexes 328-331, 333-
335
• options on currencies 331
• futures options 344-348, 350-354
• delta and delta hedging 359-364
• insurance with traded put options (Not in book)
• insurance with synthetic put options 382-385
• insurance with index futures 383-384

Quiz: 13.2, 13.4, 13.5, 13.6, 15.1, 15.2, 15.6, 16.3, 17.1, 17.2, 17.3, 17.7.

VI. EXOTIC AND INNOVATIVE OPTIONS

− Range-forward contract 332-333
− Chooser option 480
− Barrier option 480-482
− Look-back option 482
− Shout option 482-483
− Asian option 483
− Option to exchange one asset for another 483
− Innovative swaps 485-491 (only
casual read)
− Credit derivatives 496-500, 505-
507
− Weather derivatives 515-520

Quiz: 22.1, 22.3, 24.1, 24.2.

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VII. APPLICATIONS AND REVIEW 1-598 : -)

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 Peer Evaluation Form for Workload/Credit Redistribution

This form is to facilitate a negotiated settlement among group members when dispute arises
concerning relative workload and contribution. It is modelled after similar forms used in some
other Management courses.

It is recommended that the group meets as soon as some members are perceived/believed to
shirk. Very often, the meeting itself with frank discussions can clear the issue (e.g., the perceived
shirking may simply be due to some misunderstanding/miscommunications or special personal
circumstances). At any rate, if all members agree that the workload is not evenly distributed, then
the form may be signed with credit redistribution. Each group member is endowed with 100
points and the redistribution will lead to a re-scaling of the group grade. All members must sign
the form in order for it to be effective.

To illustrate, suppose there are five members in the group and the group receives 80% on the
project. Further suppose that Member A in the group agrees to receive only 70% of the group
grade since he/she failed to contribute enough. In this case, A’s mark will be (0.7)80% = 56%,
while that for other four members will be (430/4)80% = 86%. To avoid an adjusted mark
exceeding 100%, the scaled-up mark will in general be max{100%, G(100n–S)/(n-m)}, where G
is the group project grade, n is the group size and S is the total points among the m shirking
members. To illustrate further, suppose the group receives 90% on the project and suppose A
agrees to lose 20 points and B agrees to lose 30 points, then the marks for A and B will be (0.8)
(90%) = 72% and (0.7)(90%) = 63%, while the mark for the remaining three members will be
max{100%, 90%(500–150)/(5–2)}=max{100%, 105%} =100%.

Name Points Signature

Total points 

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