Faculty of Business and Economics University of Hong Kong
Dr. T. Lin
FINA0301/2322 Derivatives Overview
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Instructor and TA Info y Instructor Information:
y Name: Dr. Tao LIN y Office: KKL 914 y Phone: 2241 5935 y Email: [email protected]
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y TA Information: y Name: Mr. Terrence Mak y Office: KKL 1026 y Phone: 2857 8310 y E-mail: [email protected]
y Course Website: Moodle y Need to check for updates and uploads prior to each class and
tutorials.
The Big Picture of The Course y What you have learned/ are concurrently learning:
y Corporate finance y Investment
y What this course is about: y the concept, the use, the pricing of derivatives.
y Goal of the course: y this course aims to provide you with a general introduction to the tools of
modern financial engineering: the construction of a financial product from other products.
y What you might learn in the future: y Fixed income securities y Mathematical finance y Risk management & financial engineering
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Topics Covered in This Course y Chapter 1 Introduction to Derivatives. y Part I: introduce basic building blocks of derivatives: forward
contracts and call and put options. Focus is on understanding of contracts and strategies (not on pricing). y Chapter 2, 3 and 4
y Part II: pricing of forwards, futures, and swaps. y Chapter 5, 6, 7, and 8
y Part III: option pricing. Chapter 9, 10, 12, 13 (Chapter 14 optional)
y Part IV: financial engineering (Optional)
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Teaching and Learning Activities y Lectures y Tutorials: Available tutorial slots will be posted on the
Moodle. Details will be available next week. y Assignments: Group based. Students should form groups of 4
to 5 people. Once the group is formed, no change is allowed. End of term peer evaluation (focus on willingness and efforts to work in the team) will be conducted. y Send in your group info to Terrence by 5pm on 2015/9/15. y One submission per group
y Self Study
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Assessment
Option 1
Class and Tutorial Performance 5%
Assignments 20%
Mid-term Examination 20%
Final Examination 55%
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� Midterm: no make up; weight shifted to final if approval for absence is obtained.
� Final: Common across all subclasses in the same semester. � Assignments: Group work encouraged. Peer Review at the end. � Cheating of any form will be disciplined according to university regulation.
Knowing Your Classmates y Number of students: 105 y Note: data collection is based on the registration information as
of 26 Aug, 2015.
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Year No. of Students
Exchange student 7
2 36
3 40
4 22
Total 105
Program No. of Students
BAA 6
A&F 18
IBGM 4
BBA(Law)&LLB 1
E&F 47
B Eng 2
BSc 9
BSc(QFin) 16
BSocSc 2
Total 105
Time Value of Money y Time value of money refers to a dollar today is different from a
dollar in the future y To compare money flows, we must convert them to the same
time point y Interest rate, compound interest, continuously compounding
interest (Appendix B) y Annual interest r compounded continuously Æ $100 investment
in year zero results in $100er after one year
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Pricing Approaches y Much of this course will focus on the pricing of a derivative
security. In general there are two approaches to price an asset (or a contract or a portfolio):
y Pricing an asset using an equilibrium model: y Determine cash flows and their risk
y Use some theory of investor’s attitude towards risk and return (e.g. CAPM).
y Pricing an asset by analogy (using no-arbitrage): y Find another asset, whose price you know, that has the same
payoffs of the asset to be priced.
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CAPM Implied Return y Find the CAPM implied expected return for Stock Z. y If the expected return deviates from the implied return, risky
abnormal return may exist. y Model specific
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Stock X Stock Y Stock Z
E(R) 10% 16% ?
beta 1 2 0.5
Definition of Arbitrage y Arbitrage is any trading strategy requiring no cash input that
has some probability of making profits, without any risk of a loss.
y Can one expect to continually earn arbitrage profits in well functioning capital markets?
y Law of No Arbitrage: a portfolio generating non negative cash flow in all states (today and in the future) and positive cash flow in some states cannot exist.
y Law of One Price: two equivalent things cannot sell for different prices.
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Assumptions y There are no market frictions (transaction costs? bid/ask spread?
margin requirements? restriction on short sales? taxes?) y Market participants entail no counterparty risk (credit risk?
collateral requirements? borrowing and lending rates difference?)
y Markets are competitive (liquidity concern? strategic trading? market manipulation?)
y Market participants prefer more wealth to less
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Cum-Dividend/Ex-Dividend Prices y A stock that pays a known dividend of dt dollars per share at
date t
Stc = the cum-dividend stock price at date t
Ste = the ex-dividend stock price at date t
y Assumptions y no arbitrage opportunities, y no differential taxation between capital gains and dividend income
y The following relation can be shown to hold St
c = Ste + dt
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No Arbitrage Argument y Suppose that St
c > Ste + dt
y sell the stock at the cum price y buy it back immediately after the dividend is paid
y reap the arbitrage profits (Stc – St
e ) – dt > 0 y Suppose that St
c < Ste + dt
y buy the stock cum-dividend y receive the dividend y sell the stock ex-dividend y reaps the arbitrage profits (St
e + dt) – Stc > 0
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No-Arbitrage Pricing Method y A synthetic contract (replicating portfolio): A portfolio
of traded assets which duplicates the cash flows and value of the contract under consideration
y Derivatives securities are by definition those for which a perfect replica can be constructed from traded securities. y Buying the replica is the same as buying the derivative. y Selling the replica is the same as hedging the derivative. y Absence of arbitrage implies the two have the same price.
y Something is worth whatever it costs to replicate it.
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To-Do List y Get the textbook if you haven’t done so.
y Required: McDonald’s “Derivatives Market” 3rd edition, available at HKU bookstore.
y Copies are reserved in the library. McDonald’s “Fundamental of Derivatives Market” or 2nd edition “Derivatives Markets” is sufficient for the course.
y Read chapter 1. y Mark your calendar for the midterm examination. (Oct 26 2015,
Monday, 7:00 – 9:00 PM). y Find your group members to work on the assignments together. y Pick up on the Math topics. y Any special request about course selection: contact FBE at
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