Post Graduate Programme in Management

2014-15
TERM: V
TITLE OF THE COURSE: OPTION, FUTURES AND OTHER DERIVATIVES
CREDITS: 4

COURSE: Elective Course

No. of Section: 2

Instructor:
Email:
Tel. NumberFaculty Block and Room No.
Prof. Hariprasad B. hariprasad@iimidr.ac.in519 A-107

COURSE DESCRIPTION
The derivative instruments are very effective tools for altering the risk of an
organization or portfolio of securities. These instruments may be used to reduce the
cost of implementing various investment strategies adopted by institutional investors.
Over the past three decades, the use of financial derivatives to manage risk has evolved
from an exotic practice to a commonplace occurrence. This revolution mandates all
financial managers to acquire a working knowledge of these important risk management
instruments.

COURSE OBJECTIVES
The objective of this course is to introduce participants to different types of
derivatives, their practical application and valuation. Emphasis will be placed on three
aspects of derivatives the nature of their payoffs, how they are priced and how they
can be used for hedging and speculative purposes. The course is quantitative in nature,
but not at the cost of the underlying economic intuition. The focus will be on the
concepts rather than procedures of trading in the market. Upon completion of this
course, the participant would be able to think logically and systematically about most
financial instruments traded in the market. The course will improve upon participants
ability to understand

the payoffs of derivative securities and how to use them for hedging

the basic principles and models in pricing and valuing them.

PEDAGOGY/TEACHING METHOD
Instruction will be in a lecture-cum-discussion mode. Cases will be used wherever
necessary. Class would be divided into groups and the groups are assigned
problems/exercises for each class which they have submit in hand written form at the
beginning of the class. The groups may be called at random to present their solution.

EVALUATION
Quizzes
CP and assignments
Mid-term examination
End-term examination
Total

Weightage
30%
15%
25%
30%
100%

SCHEDULE OF SESSIONS
Module I

Introduction and futures markets

Module Objective
To provide brief introduction to various types of plain-vanilla financial and commodity
derivatives and discuss in detail about features of forward and futures markets,
valuation of these derivative instruments alongwith how to use them to hedge the
exposures present in the main line of business.
Sessions and Objective
Session 1: Introduction
Objective: In this session, we take a first look at forward, futures, and options markets
and provide an overview of how they are used by hedgers, speculators and arbitragers.
Reading: Chapter 1, Introduction (JCH)
Case: Indian Shipping Limited
Session 2: Mechanics of Futures Markets
Objective: In this session, we take a look at the kind of futures products available in
India, their contract details, Indian regulations, and the credit risk issues arising out of
them.
Reading: Chapter 2, Mechanics of Futures Markets (JCH)
Session 3: Hedging Strategies Using Futures
Objective: In this session, we discuss the reasons for hedging the exposures, identifying
the appropriate position to be taken, tailing the hedge alongwith merits of the stripping
and strapping strategies to hedge multi-period exposures.
Reading: Chapter 3, Hedging Strategies Using Futures (JCH)
Case: Intimated in due course
Session 4: Hedging Strategies Using Futures (Contd.)
Objective: In this session, we consider, we discuss the issues in hedging a stock or a
stock portfolio using the stock index futures.
Reading: Chapter 3, Hedging Strategies Using Futures (JCH)

Session 5: Pricing the futures and forward contracts

Objective: In this session, we examine how forward and futures prices are related to the
spot prices of the underlying and derive some important general results on their
relationship to examine the relationship between futures prices and spot prices for
contracts on stock indices, currencies, and commodities.
Reading: Chapter 5, Determination of Forward and Futures Prices (JCH)
Session 6: Valuation of futures and forward contracts
Objective: To explain the process of valuing the forward and futures contracts when the
underlying market variables changes in value.
Reading: Chapter 5, Determination of Forward and Futures Prices (JCH)

Module II

Financial Options

Module Objective
To introduce the participants to mechanics of options markets, trading strategies
involving option prices and the properties of option prices.
Sessions and Objective
Session 7: Mechanics of Options Markets
Objective:To explain how the options markets are organized, the terminology used, how
the contracts are traded, how margin requirements are set, regulation and taxation.
Reading: Chapter 9, Mechanics of Options Markets (JCH)
Session 8: Trading Strategies Involving Stock Options
Objective: To explain the payoff profiles of trading strategies involving a combination of
single option and stock, spread trading strategies and the combination strategies such as
straddle, strangle, strip and strap using current market prices
Reading: Chapter 11, Trading Strategies Involving Options (JCH)
Session 9: Structured solutions involving forex options
Objective: To understand different types of structures for hedging foreign currency
exposures originating from export and import transactions such as Seagull, participatory
forward, fader, TARN, barrier options and digitals.
Reading: Intimated in due course
Session 10: Properties of Stock Option Prices
Objective: To explain the impact of various market factors on stock option prices and to
use the arbitrage arguments to derive the put-call parity relationship apart from
examining whether the American options should be exercised early
Reading: Chapter 10, Properties of Stock Options (JCH)

Module III

Advanced topics in Options

Module Objective
To introduce participants to various models of option valuation and how to use options
to manage the risk arising out of option portfolios
Sessions and Objective
Session 11: Option Valuation using Binomial model
Objective: To explain the nature of no-arbitrage arguments used to value European
options and to explain the binomial tree numerical procedure for valuing American
options and other derivatives in the risk-neutral world.
Reading: Chapter 12, Introduction to Binomial Trees (JCH)
Session 12: Option Valuation using Black-Scholes-Merton Model
Objective: In this session, we cover the Mertons approach to derive the close-form
solution to Black-Scholes-Merton model using the risk-neutral valuation approach and
extend it to deal with European call and put options on dividend-paying stocks.
Reading: Chapter 12: Valuing Stock Options: The Black-Scholes Model (JH)
Session 13: Options on Stock Indices and Currencies
Objective: To explain the properties of currency and stock index options and how to
value them using the binomial model and BSOPM.
Reading: Chapter 13, Options on Stock Indices and Currencies (JH)
Session 14: The Greeks
Objective: To explain alternative strategies used by financial institutions to hedge the
OTC option exposures using the standardized ETC option products.
Reading: Chapter 15, The Greek Letters (JH)
Session 15: Scenario analysis and portfolio insurance
Objective: To explain the realities of hedging and need for scenario analysis leading the
discussion of insuring a stock portfolio by creating put options synthetically.
Reading: Chapter 15, The Greek Letters (JH)

Module IV

Interest rate derivatives

Module Objective
To introduce participants to the interest rate markets and explain how to price and use
various derivative instruments to hedge the interest rate exposures.
Sessions and Objective
Session 16: Interest rates
Objective: To discuss the fundamental issues concerned with the way interest rates are
measured and analyzed and to explain the interlinkages between money market and
currency market thereby laying the ground for discussion about interest rate derivative
products
Reading: Chapter 4, Interest Rates (JCH)
Session 17: Forward rate agreements and plain-vanilla interest rate swaps
Objective: To understand how to hedge interest rate exposures using forward rate
agreements, estimate their payoffs and how value them leading to the discussion about
interest rate swaps to hedge multi-period interest rate exposures.
Reading: Chapter 7, Swaps (JCH)
Session 18: Interest rate swaps and currency swaps
Objective: To explain how to price and value interest rate swaps and currency swaps
alongwith discussion about non-standard swaps such as coupon only swaps, constant
maturity swaps, curve steepeners and curve flatteners
Reading: Chapter 7, Swaps (JCH)
Session 19: Interest rate options
Objective: To explain how to estimate the payoffs of interest rate options and how to
use structures such as interest rate cap, collar, Seagull, KO cap and KIKOs to hedge the
interest rate exposures
Reading: Chapter 19, Interest Rate Options (JH)
Session 20: Interest rate futures
Objective: To explain how to use Eurodollar futures and bond futures to hedge a
companys exposure to interest rate movements.
Reading: Chapter 6, Interest rate futures (JCH)

Additional Readings
1.
2.

3.

John C. Hull and S. Basu, Options, Futures and Other Derivatives (8th edition),
Pearson Education 2013 (JCH)
Don M. Chance and Robert Brooks, Introduction to Derivatives and Risk
Management (9th edition), Cengage Learning, 2012 (CB). Participants may also
like to make use this book as it is more elementary and has far more detail on the
basics than JCH.
John C. Hull, Fundamentals of Futures and Options Markets, 7th edition, Pearson
Education, 2011 (JH) discusses the concepts at preliminary to understand the
topics in Module III and module IV.

****