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Finance 730: Derivative Security Analysis, Fall 2022

Syllabus

Course description:

This course covers the pricing and uses of the most common derivative contracts including options, forward contracts, futures contracts, and ETFs. These contracts are actively traded in financial markets for hedging, speculation, or arbitrage purposes.

Since derivative contracts are derived from other fundamental securities, such as stocks, stock portfolios/ indices, and bonds, we must also understand the valuation of those securities, as well as the properties of their prices. We therefore talk about valuation as well as the statistical properties of stock and bond prices first.

This course emphasizes a practical understanding of trading and portfolio management. In doing so, we make use of the online trading platform Interactive Brokers (IB). Each student is given an account on IB with a 1M dollar paper money balance. You are expected to carry out specific trading assignments throughout the semester.

This course emphasizes both analytical skills as well as an understanding of financial modeling. By the end of this course, you will have a good knowledge of how these contracts work, how they are used, and how their values are determined.

Derivatives analysis is quantitative in nature. Please be prepared that mathematical and statistical analysis is used throughout this course.

The last five lectures in the course sequence cover algorithmic trading. We will use a Matlab package called IBmatlab to construct automated trading algorithms.

Learning outcomes:

Students should learn the properties, risk and theoretical valuation of derivative securities. They should learn how to trade those securities and what risk and return characterize the various types of trades. Essential to learning is doing the actual trades. By carrying out “real” trades through Interactive Brokers, students will connect real life applications to theories relating to hedging and trading derivatives. This enables a deeper understanding of the risks involved in derivatives trades. We also focus on cutting edge empirical research, including some of Professor Eraker’s own, that identifies potentially high return strategies involving derivatives.

Credits

This course meets the campus policy for 3-credit courses stated here: https://kb.wisc.edu/vesta/page.php?id=24558. You fulfill the credits by attending two lectures per week, competing the quizzes, trading assignments, problem sets and by passing the midterm and final exams.

Course Material

• Textbook (recommended): Fundamentals of futures and options markets, 9th Edition or 7th or 8th Edition); by John Hull; Pearson. This book is recommended, but not required. All classes are based on lecture slides.

Textbook Editions. Any. The book is recommended as additional reading only.

• Course website (Canvas): http://canvas.wisc.edu. Announcements, lecture notes and slides, and problem sets and solutions will be posted on the course website. Please check the course website regularly for postings. It is your responsibility to stay updated.

• Please note that neither the book nor the lecture notes/slides are intended to be a substitute for the lectures. The most efficient way to do well in this course is to attend all classes, and you are expected to do so.

Course Requirements and Grading

The grade for the class will be determined using the following weighting:

Final Paper ................................................................ 35%

Midterm...................................................................... 30%

Trading assignments................................................... 10%

Problem Sets............................................................... 15%

Online Quizzes… ......................................................... 5%

Participation… ............................................................. 5%

• The course is graded on a curve. In accordance with the Wisconsin School of Business grading policy, I expect that the average of final grade is around 3.3 with no more than 30% of students receiving ‘A’s.

• Academic Integrity: Academic Integrity is an important part of all of the classes you take at the Wisconsin School of. Students that are caught cheating for either exam or on assignments will receive a failing grade.

• McBurney Center students must submit supporting documents by the end of the first week of class if they have special exam needs and provide us with the supporting documentation provided by the McBurney Center.

Midterm and Final Exams

• You should bring a calculator to the midterm/final. No additional material or technology can be used during the exam.

• A formula sheet will be provided for the Midterm exams.

• There are no valid reasons for absence for the Midterm exam. Please note the dates and times for the exams! In the case of an unanticipated excuse (such as serious illness or injury) the student may be asked to provide documentation to corroborate why he or she is unable to take the exam.

• Re-grade policy: exams will be accepted for re-grade only if they are submitted within three days of receiving the exam. Note if an exam/project is submitted for re-grade, the entire exam will be re-graded by Professor Eraker. Requests for re-grading should be made in writing where the precise nature of the problem or the mistake is explained.

Online quizzes

• There will be 5 quizzes posted on the course website. Each of them has 10 points. Quizzes will be announced one week ahead. You should have a calculator with you when completing the quizzes. You will submit your answer through course website directly. The quizzes must be submitted by an announced deadline. The time to complete each quiz will be limited.

• The purpose of the quizzes is to make sure that you are on the right track.

• No make-up quizzes will be offered, regardless of the circumstances. You are not allowed to share offline or online quiz questions or solutions. They are for your personal use only.

Trading assignments

We will use Interactive Brokers (IB) to do simulated trading. Your simulated trading accounts will have a one million dollar balance of paper money. We will use it to do various things, including very mundane things such as placing a limit order or market order. We will also do exercises such as delta hedging options positions.

To complete the trading assignments, you will have to

i) Initiate the trade as described in the assignment, and

ii) Rebalance the trade as prices move on subsequent days

iii) Keep a log of your trades, profit and loss (P&L)

iv) Summarize the trading performance in a final report

On the completion of the assignment, you will submit a trading log.

Problem Sets and quizzes

• There will be 5 problem sets and 4 quizzes and 4 trading assignments. In addition, we might assign additional problem sets in the form of previous Midterm and/or Final exams.

• Problem sets are posted on canvas and require electronic submission.

• You are not allowed to share offline or online problem set questions or solutions. They are for your personal use only.

The tentative due dates for the problem sets and quizzes are stated on the detailed course plan below.

Class participation

Class participation is mandatory. Most classes are lecture formats, however the instructor will call on volunteers to answer questions and create dialogue regarding topics. The instructor may also cold-call on students.

Digital screen usage in class

Smart phone usage is prohibited during class. Laptops are prohibited with the exception of times during which the instructor is explicitly allowing and encouraging their use. For example, during the demonstration of IB usage, trades, students are encouraged to bring and use laptops.

Discussion sessions:

There will be discussion sections offered prior to the material on “Greeks.” This material covers calculus. Attendance is voluntary and recommended for students who have not recently taken a course in calculus.

Tentative schedule

• The specific topics covered during each lecture/week may change as the class progresses. Any significant changes will be announced in class or by e-mail. All due dates are tentative and may get pushed back in case of a delay in the schedule. Note that all assignments are scheduled to be due on Fridays.

Abbreviations: Q=Quiz, TA=Trading Assignment, PS=problem set
Week 1 (September 6-9)	Due
1. Introduction. Trading. IB
Week 2 (September 12- 16)
2. Trading continued
3. Investment theory 1	Q1/TA1
Week 3 (September 19-23)
4. Investment theory 2
5. Investment theory 3	Q2/PS1/TA2
Week 4 (September 26 – 30)
6. Futures 1.
7. Futures 2	Q3/TA3
Note: Trading assignment 3 not yet posted.
Week 5 (October 3-7)
8. Futures 3
9. Options Basics	PS2
Week 6 (October 10- 14)
10. Option Valuation 1. Binomial model
11. Option Valuation 2. Black Scholes