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: tlin@hku.hk

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y TA Information: y Name: Mr. Terrence Mak y Office: KKL 1026 y Phone: 2857 8310 y E-mail: tmch@hku.hk

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

ugenquiry@fbe.hku.hk.

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