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INSTRUCTION DIVISION

II SEMESTER 2015-16

Course Handout Part II Date: 12-01--2016

In addition to Part-I (General Handout for all courses appended to the timetable) this portion gives further specific details regarding the
course.

Course No. : FIN F311


Course Title : Derivatives & Risk Management
Instructor-in-charge : Niranjan Swain (niranjanswain@hyderabad.bits-pilani.ac.in)

The Merriam-Webster dictionary defines a derivative in the field of chemistry as a substance that can be made from another substance.
Derivatives in finance work on the same principle Derivatives are specific types of instruments that derive their value over time from the
performance of an underlying asset: e.g equities, bonds, commodities. Derivatives are used to manage risk arising between assets and
liabilities. For example, derivatives are often used to hedge unrewarded risks in the pension scheme (such as interest rates) providing
schemes with greater flexibility around asset allocation.

1. Scope & Objective:

This course aims at introducing students to the fundamentals of derivatives and mechanics of derivative market. The course covers pricing
and the variables affecting derivative price. Students are exposed to various types of risks namely Market Risk, Credit Risk, Operational
Risk, Liquidity risk & Model Risk and techniques /tools to manage these risks. It also provides an exposure to understand and analyze risk
of using derivative in general and in specific scenarios through case studies.
3. Text book:
John C. Hull & Basu Sankarshan, Options, Futures and Other Derivatives, 8th Edition, Pearson Education.

4. Reference books:

R1. Derivatives, by Rangarajan Sundaram, Sanjiv Das, McGraw Hill, 1st edition

R2. Risk Management and Financial Institutions, John Hull.

R3. Futures, Options and Other Derivatives by John C Hull, 7th Edition

5. Course Plan:

Reference to
Lecture
Learning Objectives Topics to be Covered Text Book
No.
(TB)
1-5 Understanding of various risks and Types of risks price risk, interest rate risk, Ch.1
derivatives products, markets, participants exchange rate risk, etc.
and structure Exchange Rate Mechanisms: PPP and Interest Rate
Parity (Fixed Exchange Rate Regime and Floating
Exchange Rate Regime)
Derivatives Product, Participants and Functions.
Types of derivatives: Exchange Traded and Over-
the-Counter Derivatives.
OTC vs. Exchange-Traded Derivatives. (Benefits of
an Exchange-Traded and Clearing House
Guaranteed Model)
Cost and Benefits of Derivatives
Derivative markets in India
6 -13 Understanding how the value of forward Forward Markets and Contracts - Delivery and Ch.2
contract is determined at initiation, during Settlement of a Forward Contract, Default Risk and
life of the contract, and at expiration; Forward Contracts, Termination of Forward
Calculate and interpret the price and value Contract.
of forward contract on equity stock, fixed- Types of Forward Contracts Forward Contracts on
income security, currency and a forward Individual Stocks, Stock Portfolios and Stock
rate agreement (FRA); Indices.
Evaluate credit risk in a forward contract, Bond and Interest Rate Forward Contracts.
and explain how market value is a measure Currency Forward Contracts.
of exposure to a party in a forward contract. Pricing and Valuation of Equity, Fixed-Income and
Interest Rate Forward Contracts.
Case Study: Liability Management at General Motor.
Objectives: To understand how large industrial organization (GM) approached the management of its debt portfolio; provides
opportunities to analyze the policy decisions made by the organization and the means by which these policies were
implemented; and introduces students to address the sensitivity and feasibility of managing interest rate exposure in the context
of an industrial organization. It also illustrates the large gap between liability management policy and execution and the fine line
between managing interest rate exposure and speculating on interest rate movements.
14-19 Understand why the futures price must Brief history and features of futures markets. Ch.2 - 5.
converge to the spot price at expiration; Futures Trading
Determine value of futures contracts; The Clearinghouse, Margins and Price Limits.
Understand as to why forward and futures Delivery and cash settlement
price differ; Distinction between futures and forwards contracts
Understand the relation between futures Types of Futures Contracts: Short-term interest rate
prices and expected spot prices; and futures contracts, Intermediate and long-term
appreciate the difficulties in pricing short- interest rate futures contracts, Stock Index Futures
term futures contracts Contracts and Currency Contracts.
Pricing and Valuation of futures contracts
Case study of Bearings Bank
20-25 Understanding Option Markets and Basic characteristics of options. Ch. 9 -12
Contracts Variants, Payoffs, Pricing and Structure of Global Options Markets.
Hedging strategy Types of Options and Option Payoffs.
Principles of Option Pricing.
Option Combinations Hedging with Options.
Distinction between futures and options.
Case Study: Porsche Exposed
Objectives: The case is intended to provide a contemporary debate over the use of financial derivatives (in this case foreign
currency option) as a method for the management of the economic exposure (also called operating exposure) experienced by
Porsche as result of its global sales. Porsche serves aa an excellent focal point for the debate given that it produces in only one
currency environment, the euro zone, and then exports product globally. In addition, the decision-making of senior management
is also questioned because the firm has continued to be highly controversial in its attitudes and practices related to financial
reporting, and the associated practices of management towards shareholders relations and corporate governance as a whole.

Case Study: Enron Corporations Weather Derivatives.


Objectives: Expose students to the cutting edge of financial innovation; to illustrate use of options to reduce business risk; to
challenge the students to value option when the Black-Scholes model cannot be used and simulation can be readily employed;
and to experience the perspective of top management in risk-management activities.
26-30 Understanding the distinction between Characteristics of Swap Contracts, Ch. 6-8.
pricing and valuation of swaps; Structure of Swap Global Swap Markets
Understanding interest rate swaps to a Types of Swaps Currency Swap and Interest Rate
series of off-market forward rate Swap, Equity Swaps.
agreements (FRAs) and a plain vanilla swap Pricing and Valuation of Swaps
to a combination of an interest rate call and Pricing and Valuation of Off-Market Swaps.
an put option. Characteristics of Swaptions, Swaption Payoffs and
Calculate and interpret the fixed rate on a Pricing and Valuation of Swaptions.
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
31-35 Understand structure and features Credit Risk, Securitization and Credit Derivatives: Ch.20
(reference entity, credit events, settlement Mechanisms of and Market for Credit Derivatives,
method, CDs spread) of credit default Pricing, Valuation, and Risk Management
swaps (CDS);
Compare CDS, total return swaps, asset
swaps, and credit spread option;
Identify uses of CDS (such as hedging
exposure to credit risk, enabling action on a
negative credit view, engaging in arbitrage
between markets); and
Understanding relationship between CDS
spread, expected spread payments, and
expected default losses.

36-40 Case Study: Foreign Exchange Hedging Strategies at GM- Competitive Exposure.
Objectives: Explore how competitive exposures arise for multinational firms, how they can be measured and managed, and the
economic consequences of competitive exposures.

Case Study: Foreign Exchange Hedging Strategies at GM- Transactional and Transnational Exposures.
Objectives: This case explores the hedging policies of a global corporation and provides a detailed account of the specific issues
GM faces from its exposure to the Canadian Dollar and Argentinean Peso. Students will experience analyzing GMs exposure to
two currencies, in the context of deciding whether GMs exposure to each currency justifies a deviation from its standard hedging
policies.

Case Study: Hedging Currency Risk at American Institute for Foreign Study (AIFS).
Objectives: This case provides an introduction to how currency mismatch creates exposure, why companies hedge those
exposures and how they hedge those exposures. The case will enable students to identify the sources of exposures to exchange
rate fluctuate and why companies choose to manage these risks; consider the use of different instruments in hedging foreign
exchange exposures; evaluate different hedging strategies in the presence of volume uncertainty; and consider what outcomes
should be hedged against.
6. Evaluation Scheme:

EC Components Duration Weight age Date, Time & Venue Nature of


No. (%) Component
1 Assignments 20 TBA OB
26/2, 1.00 - 2.00 PM
2 Test-I 1 Hour 20 CB / OB
12/4, 1.00 - 2.00 PM
3 Test-II 1 Hour 20 CB / OB
4 Comprehensive 3 hrs 40 06/05 FN CB

7. Chamber Consultation Hour: To be announced in the class.

8. Notice: All notices will be displayed on Economics & Finance Notice Board.

9. Assignment: A group of 3 students needs to select a topic in the area of financial market (Derivative and Risk Management) and submit
the Title of topic, Objective, Expected Deliverables, Methodology and Data Collection by Jan 30, 2016.