Course Category

Futures and Forward Contracts (Sessions I, II, and III)

Nature of Futures Contracts

• What is a futures contract?
• (a) Confusion over terms ''commodities'' and ''futures''
• (b) Contracts for future purchase and sale
• Forward contracts versus futures
• Comparison to trading ''cash market'' securities
• (a) Securities buyers/sellers versus futures longs/shorts
• (b) Comparative cash flows cash versus futures positions
• (c) Different meaning of margin
• Role of the clearinghouse in futures trading

Characteristics of Futures Contracts

• Standardized contract specifications
• Daily settlement
• Margins
• (a) Futures margins, initial and maintenance
• (b) Comparison to securities margins

Types of Futures Contracts

• ''Traditional'' commodities
• (a) Precious metals - gold, silver, and platinum
• (b) Grains - wheat, soybeans, corn
• (c) Energy - crude oil, heating oil, natural gas
• (d) Others - cattle, lumber, cotton, coffee
• Financial futures
• (a) Interest rate - t-bond, t-note, Eurodollar
• (b) Stock index - S&P 500, NASDAQ 100, DJIA
• (c) Currencies - Yen, Sterling, Peso
• Characteristics of interest rate futures contracts
• (a) Contract specifications
• (b) Conversion factors - t-bonds and bunds
• (c) Cash settlement - Eurodollars
• Characteristics of index futures contracts
• (a) Contract specifications
• (b) Index points and cash values
• (c) Cash settlement

Futures (Forward) Pricing - Cost of Carry

• Generalized carry models
• (a) Intuition
• (b) Where it applies
• (c) Where it breaks down
• Carry considerations
• (a) Storage
• (b) Insurance
• (c) Interest
• (d) Income - interest or dividends
• Application to pricing ''traditional'' commodities
• (a) Negative carry - normal markets
• (b) Inverted markets
• (c) The role of expectations
• Application to pricing financial futures
• (a) Positive versus negative carry
• (b) Income yield versus opportunity cost of capital

Hedging with Futures Contracts

• Review of fundamentals of hedging
• (a) Concept
• (b) Risk and return of hedged positions
• (c) Simple applications
• Hedging with financial futures
• (a) Hedge ratios - duration or beta
• (b) Basis - cash minus futures
• (c) Dealing with margin finance risk - tailing a hedge

Futures Contracts: Other Risk Management Applications

• Index arbitrage
• Portfolio management

Options (Sessions III, IV, and V)

Options Pricing

• Brief review of option basics
• (a) Types of options and contract specifications
• (b) Static (intrinsic value/value at exercise) gains, losses and break-even considerations
• (c) Profit/loss diagrams
• Basic properties and boundary conditions of call and put values
• (a) Minimum and maximum values
• (b) Effect of interest rates on call and put option values
• (c) Effect of volatility on call and put option values
• (d) Early exercise considerations

Option Pricing Dynamics

• The ''Greeks''
• (a) Delta, Gamma, Theta and Vega
• (b) Definitions
• (c) Mathematical derivations and graphical manifestations
• (d) Trading and hedging applications
• Black-Scholes Model - Implied Volatility
• (a) Historical volatility into B-S = B-S price
• (b) Market price of option into B-S = implied volatility
• (c) B-S assumes all have same volatility
• (d) Actually all differ - volatility smile
• Black-Scholes Model - volatility smile versus the volatility curve
• (a) Term structure of volatility
• (b) Market experience

Introduction to Arbitrage Pricing Relationships

• Synthetic positions
• Arbitrage trading strategies
• (a) Conversions
• (b) Reverse conversions (reversals)
• Put/call parity
• Using conversions, reversal and box spreads
• (a) The options market as a bank
• (b) Locking in mispricings with synthetic positions

Black-Scholes Option Pricing Model

• Black- Scholes - limiting case of binomial model
• (a) The formula
• (b) What the formula means
• (c) Computing an option price
• A generalized option pricing formula
• (a) Adjustments for cash flows on the underlying instrument
• (b) Options on dividend paying stocks
• Bond and foreign exchange options
• Options on futures

Options: Binomial Pricing Models

• Binomial trees
• (a) Nodes
• (b) Intervals
• (c) Centering proposition
• Two step process
• (a) Project stock prices to expiration, determine intrinsic values
• (b) Step back process to find option value
• Flexible versus standard binomial tress
• Mathematics of binomial trees
• (a) General considerations
• (b) One period pricing/arbitrage relationships
• (c) Two period pricing/arbitrage relationships
• (d) Multi period model
• Determination of ''Greeks'' on binomial trees

Swaps (Sessions VI and VII)

Swaps: Introduction

• Brief history of swaps market
• Growth of market - flexibility and variety of applications
• Managing exposures and monetizing market views
• (a) Lower financing costs
• (b) Fixing interest expense of floating rate debt
• (c) Portfolio management/asset allocation
• (d) Accessing markets
• (e) Accessing securities
• (f) Tailored solutions

Review of Swap Basics

• Structure of swap contracts and transactions
• Diagrammatic analysis
• (a) Box diagram
• (b) Cash flow diagrams
• All-in-cost
• (a) Simple presentations - too simplistic
• (b) Money market adjustments
• (c) Other considerations - more later

Pricing Swaps

• Equating present values
• (a) What does that really mean?
• (b) Fixed versus floating coupon
• (c) Floating versus floating coupon
• Methodology
• (a) Zero coupon swap curve
• (b) Swap coupon
• (c) Formulas
• (d) Reality
• Terminating a swap before term/pricing off-market swaps
• (a) Difference between present value of payments
• (b) Methodology
• (c) Up-front payments versus adjustment to floating leg
• Forward swaps

Types of Swaps

• Interest rate swaps
• Currency swaps
• Commodity swaps
• Equity swaps
• Credit swaps

Beyond Plain Vanilla Interest Rate Swaps

• Variations in notional amounts and coupons
• (a) Basis swaps
• (b) Zero coupon swaps
• (c) Amortizing swaps
• (d) Accreting swaps
• (e) Rollercoaster swaps
• Yield curve swaps
• Applications
• (a) Fixing interest expense of floating rate debt
• (b) Lower financing costs
• (c) Matching assets and liabilities
• (d) Speculating on rate movements
• (e) Speculating on yield curve shifts

Equity Swaps

• Equity swap contracts
• (a) Basic structure
• (b) Underlying index
• (c) Swap coupon
• (d) Settlement frequency
• (e) Comparison to interest rate swaps
• Variations in equity swaps
• (a) Combinations of indices - rainbow swaps
• (b) Swap for best of two (or more) indices
• (c) Total return swaps
• (d) Quanto swaps
• (e) Individual equities or specific portfolios
• Applications - asset allocation and hedging
• (a) Diversifying concentrated portfolios
• (b) Modifying asset class weightings: equity versus debt
• (c) Modifying asset class weightings

Currency Swaps

• Interest rate swaps with legs in different currencies
• Notional principal - exchange of or lack thereof
• (a) Initiation
• (b) Termination
• (c) Both
• (d) Neither
• Service payments
• (a) Fixed for floating
• (b) Floating for fixed
• (c) Fixed for fixed
• (d) Floating for floating
• (e) Zero coupon
• Applications
• (a) Hedging foreign exchange exposures
• (b) Reducing interest rates on borrowings
• (c) Speculation on exchange rate movements
• (d) Speculation on relative interest rate movements

Structured (Compound) Swap Solutions

• Financial engineering
• (a) Lego/building block approach
• (b) Box and cash flow diagrams
• (c) Reverse engineer from desired result to basic components
• Applications

Exotic Options (Sessions VII and VIII)

Exotic Options: Cap and Floor Contracts

• Contract specifications
• (a) Notional amount of underlying
• (b) Strike price
• (c) Tenor/maturity
• (d) Settlement frequency
• Comparison to simple puts and calls
• Other valuation considerations
• (a) Volatility
• (b) Interest rates
• (c) Forward prices
• Cap/floor premium
• Diagramming positions
• (a) Profit/loss profiles of caps and floors
• (b) Exposure profiles - cap/floor with underlying position

Exotic Options: Combinations of Caps and/or Floors

• Collars
• Corridors
• Zero cost hedges

Exotic Options: Put-Call Parity

Other Types of Exotic Options

• General Considerations
• Types of Exotic Options
• (a) Binary or digital options
• (b) Barrier or knock-in and knock-out options
• (c) Look-back and modified look-back options
• (d) Other types of exotic options
• Pricing exotic options with binomial models