BITS PILANI- K.K.

BIRLA GOA CAMPUS

First Semester – 2019-20
Course -Handout

Date: 02/08/2019

Course Title :Derivatives and Risk Management

Instructor in Charge : Dr. Sukumar .V Instructor: Rammohan Menon

Course Objectives:

The objective of this course is to familiarize the students with the various instruments
available for risk management. It covers rather simpler instruments such as options, futures,
swaps, and credit derivatives. Besides discussing the pricing of these instruments and
hedging principles the course would also aim at introduction of some complex instruments
such as options on futures and swaps etc. The course has the following objectives:

✓ To understand the role of financial risk management as well as the techniques available for
its measurement in financial and non-financial corporations.

✓ To review the set of financial instruments available in modern financial markets as well as
the strategies that a firm or and an individual can use to optimize the management of the
risks.

Lecturing
As a general rule, most of the lectures will introduce new concepts and theory. The
objective is to make it as participative and dynamic as possible. Therefore, students are
encouraged to intervene with clarifying and constructive questions or remarks anytime
during the lecture. The material covered in every lecture is contained in the recommended
readings. The specific material is mentioned opportunely in the course schedule. Due to the
obvious time constraint, class slides will only cover the main aspects of every topic. A
successful preparation for the exam requires reading the corresponding material and
working on the suggested problems (if any) after every session.

Text Book
John C. Hull & Sankarshan Basu,- Options, Futures and Other Derivatives, 9th Edition,
Pearson Education.

R1. Risk Management and Financial Institutions, John Hull.

Online Resources
Recommended periodicals and newspapers:Economist, Wall Street Journal, Financial Times
(FT) and Business Week. (Most of the web editions are free, though online-registration
might be needed). Recommended web sites for news: Yahoo! Finance, CNN Money, Smart
Money, Money Control, Economic Times and Mint. Recommended web sites for data: NSE,
MCX, NCDEX and if possible Bloomberg and Thomason Reuters.

Suggested problems
Some lectures may include a suggested set of problems from the recommended readings.
These problems are designed to help you understand and digest the course material and
serve as a self-guide of your progress and as preparation for the final exam. Students are
encouraged to work regularly on the suggested problems .

Course contents
Lecture Learning Objectives Topics to be Covered Chapter
Numbe in the
r Text
Book
Understanding of various risks and Introduction to Risk:
derivatives products, markets, Financial Risk
participants and structure.
Introduction to Derivatives:
Evolution of the forex markets. Spots Products, Classification, Participants,
and Forwards
Function, Uses and Misuses.
Dynamics of the bid-ask spread One
way and two quotations. Interest rates:
Measuring interest rates, Day count Ch 1,2&
Interest rate parity conditions. Zero rates, Bond pricing, Determining 4 of TB,
Purchasing power parity conditions. Treasury zero rates, Duration,
1 to 8 Convexity, Measurement and relevance .
of convexity. structure of interest rates,
yield analysis.

Exchange Rate Mechanism:

Foreign Exchange Markets, and Rates,
Determination of bid and ask rate,
spreads. Spot and forward rate.
Conditions for Interest Rate Parity (IRP),
Conditions required for Purchasing
Power Parity (PPP).
Understanding how the value of
forward contract is determined at
initiation, during life of the contract,
and at expiration.
Calculate and interpret the price and
9 to 13 value of forward contract on equity Mechanics of future markets. Ch2,5
stock, fixed-income security, Forward Markets and Contracts, of TB
currency and a forward rate Determination of forward and future
 agreement (FRA).
Evaluate credit risk in a forward
contract, and explain how market
value is a measure of exposure to a
party in a forward contract.
prices, Equity, Fixed-Income and
Interest Rate Forward Contracts,
Evaluating credit risk in a forward
contracts.

Hedging Strategies Using Futures:

Basic Principles, Arguments for and Ch 3 & 6
Understand why the futures price against hedging, Basis Risk, Cross of TB
must converge to the spot price at hedging. Hedging Gross profit and
expiration. Determine value of volume.
futures contracts.
Interest Rate Futures:
Basics, Treasury bond futures,
Understand as to why forward and
Eurodollar futures, Short-term interest
futures price differ.
rate futures contracts, Intermediate
and long-term interest rate futures
Understand the relation between
contracts.
14 to futures prices and expected spot
18 prices; and appreciate the difficulties
Stock and Index Futures:
in pricing short-term futures Trading of Index Futures, Pricing,
contracts. Hedging, Speculation, and Arbitrage
with Index Futures.

Commodity Futures
Hedging, Speculation, Arbitrage with
commodity futures, Pricing of forward
and futures, Normal Backwardation&
Convergence -

Understanding Option Markets and Options:

Contracts – Variants, Payoffs, Pricing Basics of call and put options, the Ch 10
19 to and Hedging strategy. payoffs, Intrinsic value and time value, and 11
27
American and European options, At the of TB
▪ General shape of the graph of the
straddle strategy. money, out of money and in the money
options, Bounds to option pricing,
▪ Strips and straps, strangles, the bull Arbitrage based price limits, Put call
spread strategy. parity.
Properties of stock option Ch.11
▪ The bear spread strategy. Options on stock indices and currencies Ch 17 of
TB
▪ The butterfly spread strategy.
Option Pricing: Binomial Option Pricing
▪ The collar strategy. model, Risk Neutral valuation, Black
▪ Scholes option pricing model and
▪ assumptions, Interpretation of Black
 Scholes model.

Option Trading Strategies: Ch 12 of

Straddle, Strangle, Strips and strap TB
Butterfly, Bull and Bear spread,
Calendar spread, Box spread, ,
Synthesizing with options.

Understanding the distinction

between pricing and valuation of
swaps.

Understanding interest rate swaps to

a series of off-market forward rate Swaps: Forward Rate Agreement,
agreements (FRAs) and a plain vanilla Currency Swaps, Interest Rate Swaps, Ch 7 of
swap to a combination of an interest Applications of swaps, Cancellation, TB
28 to rate call and a put option. Pricing of Swaps – Interest Rate &
31 Currency Swap, Valuation of swap.
Calculate and interpret the fixed rate
on a plain vanilla interest rate swap
and the market value of the swap
during its life.
Calculate and interpret the fixed
rate, if applicable, and the foreign
notional principal for a given
domestic notional principal on a
currency swap, and estimate the
market values of currency swaps
during their lives.

Explain and interpret the

characteristics and use of swaptions,
and calculate the payoffs and cash
flows of an interest rate swaption.
Understand structure and features Credit Risk:
(reference entity, credit events, Credit ratings, Historical default
settlement method, CDs spread) of probabilities, estimating default Ch 24 of
32 to
credit default swaps (CDS). probabilities from bond prices, Using TB
35
equity prices to estimate default
Compare CDS, total return swaps, probabilities, Credit risk in derivatives
asset swaps, and credit spread transactions.
 option. Credit Derivatives:
Credit default swaps, Valuation of credit Ch 25 of
Identify uses of CDS (such as hedging default swaps, CDS forwards and TB
exposure to credit risk, enabling options, Total return swaps,
action on a negative credit view, Collateralized debt obligations, and
engaging in arbitrage between Valuation of a synthetic CDO.
markets), and Understanding
relationship between CDS spread, .
expected spread payments, and
expected default losses.
39-37 Estimation of risks The Greek Letters Ch.19
38-40 Taxonomy of Financial Risk Different types of risk: Relevant
Market, Credit, Operational & Liquidity Sections
Risk of R1

Measures of Financial Risk Value-at-Risk & Expected Tail Loss

The above plan is tentative and subject to change.

Elements in grading of the students’ performance in the course will be based on the
following criteria:

Activity Percentage

1. Case study/assignment 20%

2 .Quizes 10% (2 surprise quizzes of equal marks)
3 .Mid Term Exam 30%
4. Term End Exam 40%

Total 100%

Activity 1 and 2 are open book work and will be conducted in the class room. No re-test will
be conducted

Examination questions will be a mixture of theory as well as problems to test the

understanding and application of the concepts

Rammohan Menon