Instructor: Professor Stanley R. Pliska, Room 2333 University Hall, 996-7170, srpliska@uic.edu, web: www.uic.edu/~srpliska

Office Hours:  make appointment by email or at end of class (3:30-4:30 Tuesdays and Thursdays usually convenient)

Prerequisite: FIN 510 Investments or permission of instructor

Text: Fundamentals of Futures and Options Markets (sixth edition) by John Hull, Prentice Hall, 2008

Overview: The aim is to study the basic principles about how futures and options function, how they are used for risk mangement and speculation, and how they are valued (i.e., priced) via arbitrage pricing theory. Hence this class will be useful for students who want to get jobs in the futures and options industry, who want to get corporate or banking jobs in the area of risk management, and who want to trade futures and options (either speculatively or to manage risks of personal portfolios). Due to the nature of the subject, this class will be very quantitative. There will not be much calculus, but students will find some mathematics on most every page of the text.

Teaching Method: Use will be made by the instructor of the Power Point overhead slides that have been prepared by the author of the text. For maximum note-taking efficiency, it is recommended that students bring printed versions of these slides to class. These can be downloaded from the author's Web site which is http://www.mgmt.utoronto.ca/~hull and can be accessed directly by clicking here. Time at the beginning of most classes will be devoted to the end-of-chapter "Quiz" problems as well as additional, selected "Questions and Problems" corresponding to the chapter that was covered during the preceding class. Hence students are urged to study these problems prior to class and to bring questions to class. Note that answers to most of the problems and exercises in the text will be held on reserve in the library. There will be about nine homework assignments, each consisting of a single problem; the lowest score will not count toward your overall homework grade (so you can skip one assignment). Also, these problems will be announced orally in the class session before they are due, so this is one reason why regular attendance is a good idea. Tentatively, we will use one class time in early October for a field trip to the electronic trading classroom at the Chicago Mercantile Exchange.

Grade: Quiz 1 (30%); Quiz 2 (30%); computer project (10%); homework (30%)

1. August 28 Chapter 1: Introduction and overview
2. August 30 Chapter 2: Mechanics of futures and forward markets
3. September 4 Chapter 3: Hedging strategies using futures
4. September 6 Chapter 3: The minimum variance hedge; hedging with stock index futures
5. September 11 Chapter 4: Interest rates
6. September 13 Chapter 5: Determination of forward and futures prices
7. September 18 Chapter 5: Futures on commodities; cost of carry
8. September 20 Chapter 6: Interest rate futures
9. September 25 Chapter 6: Duration based hedging strategies
10. September 27 Chapter 7: Interest rate swaps
11. October 2 Electronic trading field trip to the CME (tentative date)
12. October 4 Chapter 7: Valuation of interest rate swaps (skip pages 168-174 on currency swaps)
13. October 9 Review chapters 1-7. Chapter 8: Mechanics of options markets
14. October 11 Quiz 1 (open book and notes; covers chapters 1-7; bring a calculator)
15. October 16 Chapter 9: Properties of stock options
16. October 18 Chapter 9: Put-call parity, early exercise of American options
17. October 23 Chapter 10: Trading strategies involving options
18. October 25 Chapter 10: Spreads and Combinations
19. October 30 Chapter 11: Introduction to binomial trees
20. November 1 Chapter 11: Two-period binomial trees
21. November 6 Chapter 12: Valuing stock options: the Black-Scholes formula
22. November 8 Chapter 12: Implied volatilities
23. November 13 Chapter 13: Options on stock indices and currencies
24. November 15 Chapter 14: Futures Options
25. November 20 Chapter 15: The Greek letters
26. November 27 Chapter 15: Hedging with the Greek letters
27. November 29 Review chapters 8-15; discuss computer project (note chapters 16 and 17)
28. December 4 Quiz 2 (open book and notes; covers chapters 8-15; bring a calculator)
29. December 6 Review quiz and Wrap-up; Computer Project Due

For a sample (Word document) of a recent midterm, click here.

Due Thursday, December 6: Assignment based mostly upon DerivaGem Software which comes with our text or can be downloaded from author's web page. Submit your results using computer printouts wherever possible; make sure they are carefully labeled with the problem number, your name(s), etc. It is OK to work in small groups of two or at most three, in which case the group should hand in just one document.

1. Using the monthly prices (disregard interest rate data) on the Excel file which can be downloaded by clicking here, estimate the annual volatilities of
1. Allstate stock and
2. the S&P 500 index.
2. Consider a three-month put with a strike price $50. The price of the underlying stock, which does not pay a dividend, is $45, and its volatility is 35%. The riskless interest rate is 3%.
1. Compute the analytic (Black-Scholes) price of this put assuming it is European.Also, specify the delta, gamma, vega, theta, and rho.
2. Compute the binomial price of this put assuming it is European, for each of the following number of tree steps: 2, 5, 10, 20, 50, 100, 200.
3. Compute the binomial price of this put assuming it is American, using 200 tree steps.
4. For the analytic European case, print out three plots with the horizontal axis equal to the stock price (ranging from 10 to 80) and the vertical axis equal to the (i) put price, (ii) delta, (iii) gamma.
5. For the analytic European case, print out a graph showing the put price versus the volatility, with the scale on the horizontal axis ranging from 10% to 80%
3. To learn about the volatility smile, pick out a stock that has lots of traded options. Pick a maturity for which at least five calls (each with a different strike) are traded.
1. Clip out the little bit from the WSJ or a similar publication that shows your choices. Present a table listing all the strikes and the corresponding prices. Make sure you have at least five strikes, with the current stock price (say what this is) somewhere near the middle. Include any details about dividend payments. What is the expiration date for your calls? Are they American or European.
2. Using an interest rate of 3% and the binomial model with 100 tree steps, compute the implied volatility for each strike, and add this to your table.
3. Draw a graph showing the implied volatility as a function of the strike price.
4. To learn about when early exercise of an American call might be optimal, in this problem you are to make up numbers for each of the two cases below in order to demonstrate that the price of an American call can be strictly greater than the price of an otherwise identical European call. Specifically, show the American "tree" price is strictly greater than the corresponding European "tree" price, as calculated by the computer program with 100 tree steps. For each case, the two options should be identical except that one is European and the other is American. Print out the pages showing the computed results.
1. a call on a stock that pays a discrete dividend
2. a call on a currency (see page 267 of the text)
5. For each of the following two cases, pick out an option from the Wall Street Journal or a similar publication, clip out the little bit showing the option price and price of the underlying, and compute the implied volatility using an interest rate of 3% (and, if you use a binomial tree, use 100 tree steps). For each case provide a computer printout with the little bit from the WSJ taped or pasted to it.
1. option on a stock index
2. option on a futures price