BAF4111: Financial Markets & Derivatives - Comprehensive Course Syllabus and Study Guide

Course Overview and Rationale

• Course Code: BAF4111

• Course Title: Financial Markets & Derivatives

• Pre-Requisite: SOB 2031

• Background and Rationale:

  • This course is designed as an essential curriculum for professionals participating in risk management, trading, hedge funds, treasury management, and financial corporate strategy.

  • It is equally critical for those involved in the regulatory supervision of financial institutions.

  • The course equips students with practical and theoretical skills across various financial sectors: the money market, bond market, foreign exchange market, stock market, and derivative markets.

  • It provides the analytical framework necessary to comprehend the forces determining the prices of both financial and real assets.

  • Students will develop a system of tools to understand the simultaneous determination of interest rates, bond prices, international capital flows, and exchange rates.

  • The curriculum demonstrates the application of financial derivatives—including futures, options, and swaps—as tools for firms to hedge against diverse risks.

Course Aim and Objectives

• Primary Aim: To provide students with in-depth knowledge regarding the most recent techniques for risk identification, measurement, and management.

• Learning Objectives: By the conclusion of the course, students should be able to:

  • Explain the fundamental role and structure of the financial system along with its various constituent institutions.

  • Discuss relevant economic and financial theories pertaining to markets and institutions.

  • Explain and interpret the general features and mechanics of basic derivative securities.

  • Determine the pricing of derivatives using advanced models, specifically the Binomial model and the Black-Scholes model.

  • Assess the strategic use of financial derivatives in the context of risk management and various trading environments.

  • Devise comprehensive hedging strategies using various derivative instruments.

The Money Market

• Description and Role: Understanding the function of money markets in providing short-term liquidity.

• Supply and Demand: Analysis of the factors driving the supply and demand sides of money.

• Targets in the Money Market:

  • Operating targets.

  • Intermediate targets.

  • Ultimate targets.

• Money Creation Mechanics:

  • The specific role of commercial banks in the process of money creation.

  • The role of the general public in the money creation cycle.

• Regulatory Oversight: The specific role and influence of the Bank of Zambia within the Money Market.

The Bond Market

• Description and Role: Exploration of the bond market's function in long-term debt financing.

• Interest Rates and Bond Prices: Detailed analysis of the inverse relationship between market interest rates and the price of bonds.

• Rate Distinctions:

  • The difference between interest rates and the actual rates of return.

  • The distinction between nominal interest rates and real interest rates (inflation-adjusted).

• Market Structure: The functional differences between primary bond markets (new issues) and secondary bond markets (trading of existing debt).

• Price Determinants: Identification of the economic forces and macroeconomic indicators that determine bond pricing.

Credit, Foreign Exchange, and International Capital Flows

• Systemic Relationships: Examining the interconnectedness between interest rates, international capital flows, exchange rates, and the Balance of Payments ($BOP$).

• Business Cycles: Impact of economic cycles on the volatility and pricing of interest rates, bonds, and short-term exchange rates.

• Case Study - Banking Risk: Practical analysis of how a bank implements hedging strategies to protect against an increase in the rate of interest.

Exchange Rate Regimes and the FX Market

• Classification of Regimes:

  • Fixed Exchange Rates.

  • Floating Exchange Rates.

  • Managed Float Exchange Rates (often referred to as a "dirty float").

  • Pegged Exchange Rates.

• Currency Dynamics:

  • Mechanics and triggers of speculative attacks on a national currency.

  • Identification of the long-run determinants that influence floating exchange rates.

The Stock Market

• Equity Issuance: The process of Initial Public Offerings ($IPOs$) and the role of investment banks in the underwriting of securities.

• Secondary Trading: Structure and operation of secondary stock markets for equity liquidity.

• Evaluation Techniques: Methods used by portfolio investors to evaluate stocks, including fundamental and technical considerations.

The Derivatives Market: Foundations and Pricing

• Definition: Comprehensive definition of what derivatives are and their role as contracts derived from underlying assets.

• Main Types of Derivatives: Overview of forwards, futures, swaps, and options.

• Trading Rationales: Discussion on why entities trade derivatives, focusing on hedging, speculation, and arbitrage.

• Derivative Pricing Theory: Fundamental principles governing how derivative contracts are valued in the marketplace.

Forwards, Futures, and Swaps

• Market Structures: Analysis of the institutional framework for forward and futures markets.

• Operational Mechanics:

  • The process of "Marking to Market."

  • The role and calculation of margins (initial and maintenance).

• Valuation:

  • Techniques for valuing forward contracts.

  • Determination of the forward price versus the futures price.

• Strategizing: Hedging and speculating using futures contracts.

• Case Studies:

  • How foreign corporations hedge against movements in the value of the Dollar ($USD$).

  • How two corporations execute an interest rate swap to exchange fixed-rate payments for variable-rate payments.

Option Markets and Valuation Models

• Market Dynamics: The structure of the market for options and the nature of option payoffs (calls versus puts).

• Pricing Factors: Identification of variables affecting option prices (asset price, strike price, time to expiration, volatility, and risk-free rate).

• Theoretical Constraints:

  • No-arbitrage restrictions.

  • The Put-Call Parity relationship.

• Exercise Styles: Discussion on the early exercise of American options compared to European options.

• Trading and Hedging:

  • Strategic trading involving options.

  • Hedging and speculating with commodity option contracts.

• Advanced Valuation Techniques:

  • The Binomial Model.

  • The Black-Scholes Model.

  • Monte-Carlo Simulation methods.

  • Volatility estimation and the concept of Implied Volatility.

• Risk Metric: Introduction to Value-at-Risk ($VaR$).

Hedging and the "Greeks"

• Risk Measures (The Greeks):

  • Delta: Sensitivity to the price of the underlying asset.

  • Gamma: Sensitivity of Delta to the price of the underlying asset.

  • Vega: Sensitivity to volatility.

  • Theta: Sensitivity to the passage of time (time decay).

  • Rho: Sensitivity to interest rates.

• Hedging Principles:

  • The basic principle of Delta-hedging.

  • Managing asset mismatch, maturity mismatch, and basis risk.

  • Minimum-variance hedging techniques.

  • Delta-Gamma hedging strategies using options to create more robust market-neutral positions.

Special Topics in Financial Engineering

• Financial Engineering: The design and construction of innovative financial instruments and processes.

• Exotic Options: Non-standard option contracts (e.g., Asian, Barrier, or Lookback options).

• Employee Stock Options ($ESOs$): Principles and implications of using options as corporate compensation.

Method of Delivery and Assessment Structure

• Delivery Methods: Full-time, distance learning, evening sessions, weekend sessions, and e-learning platforms.

• Assessment Components:

  • Continuous Assessment (40% Total):

    • $2$ Assignments: $10\%$ contribution to total grade.

    • $2$ Tests: $30\%$ contribution to total grade.

  • Final Examination (60% Total):

    • $1$ Final Examination: $60\%$ contribution to total grade.

Prescribed Reading List

1. Hull, John C. (2011). Options, Futures and Other Derivatives, 8th edition, N.J: Prentice Hall.

2. Glen Arnold (2012). Modern Financial Markets and Institutions: a Practical Perspective, Harlow: Pearson.

3. Stephen Cecchetti and Kermit Schoenholtz (2015). Money, Banking, and Financial Markets, 4th edition, McGraw Hill/Irwin.

Recommended Reading List

1. Buckle, M. and J. Thompson (2004). The UK Financial System: Theory and Practice, 4th ed., Manchester: Manchester University Press.

2. Brealey, R. A., Myers, S. C., and Marcus, A. J. (2008). Fundamentals of Corporate Finance, 6th edition, McGraw Hill.

3. Arnold, G. (2008). Corporate Financial Management, 4th edition, FT Prentice Hall.

4. Watson, D. and Head, A. (2009). Corporate Finance: Principles and Practice, 5th edition, FT Prentice Hall.