DERIVATIVE MARKETS
Module Aims
This module aims to:

develop students’ ability to master the knowledge and understanding at an advanced level of the
nature and uses of financial derivatives;

provide students with the opportunity to develop the ability to critically understand academic
literature relating to derivative financial instruments;

provide students with the ability to critically review this specialised complex area of knowledge
with a view to undertaking the study of risk management and a dissertation in the field of
financial engineering.
Learning Outcomes of the Module
At the conclusion of the module you should:

have an advanced knowledge and critical understanding of the main derivative financial
instruments, their uses and their differences;

have understood the roles of arbitrage, speculation and hedging derivative financial markets,
including the complexity and interactions inherent in these roles;

have used highly specialized and advanced technical and academic skills to analyze the pricing
of different derivative instruments;

have explored, understood and appreciated the complexity and contradictions of the current
academic literature and its implications for professional practice, and be able to identify open
questions for their own research;

have demonstrated the ability to learn and work independently in this area, exercising critical
judgement and discrimination in the resolution of complex problematic situations;

have practised problem solving and analytical skills in a complex specialised context.
In addition, you will have had the opportunity to develop the following key skills:
 Written Communication - e.g. by completing a formative assignment and through summative
assessment.
 Interpersonal Communication - e.g. by using e-mail to communicate with other students and class
leaders; discussing prepared material in classes with both the class leader and other students in the
group.
 Oral Presentation - e.g. by explaining the answers to class questions to other students and the class
leader, in general, by actively participating in discussion during classes.
 Teamwork - e.g. by working in teams in preparing work for classes.
 Planning, Organisation and Time Management - e.g. by working in teams; preparing for classes;
observing the strict assignment deadlines; downloading before the relevant lectures any OHPs;
revising relevant material before lectures; preparing for examinations.
 Problem Solving and Analysis - e.g. by applying the necessary analytical and quantitative skills, as
well as the ability to manipulate concepts in Derivative Markets, in answering class questions and
undertaking assessed work.
 Initiative - e.g. by organising teamwork; searching relevant literature and information in
preparation of the formative essay.
 Numeracy - e.g. by applying core mathematical and statistical skills to answer a range of class and
examination questions.
 Computer Literacy and Information Retrieval - e.g. by word-processing formative assignments;
accessing, and downloading teaching material from DUO; using e-mail to communicate with the
class leader and other students; undertaking bibliographical search and information retrieval for
classes and summative work.
Delivery Mechanisms
The module is delivered by:

16 hours of lectures (a short revision session might be provided nearer the final exam)

4 classes
Classes provide a structured program of work designed to reinforce knowledge and encourage
independent study. Many classes are tutorials covering problems. All students are expected to
prepare answers to all questions for each tutorial and to be prepared to enter into discussion of the
issues. The member of staff in charge of the tutorial will take a lead, but students are expected to
make major contributions.
Summative Assessment
Students are to be assessed by one unseen 2 hour examination.
Module Outline and Reading
(additional reading will be provided in lectures)
Text Books
Recommended for purchase
Hull, J.C. (2008), Options Futures and Other Derivatives, 7th edition, Prentice Hall.
Students may find it beneficial to consult some of the following textbooks:
Baxter, M. and A. Rennie (1996), Financial Calculus: An Introduction to Derivative Pricing,
Cambridge University Press.
Brandimarte, P. (2006), Numerical Methods in Finance and Economics: A MATLAB-based
Introduction, 2nd edition, Wiley. Dixit, A. and R. Pindyck (1994), Investment Under Uncertainty,
Princeton.
Jarrow, R. and S. Turnbull (2000), Derivative Securities, 2nd edition, South-Western College
Publishing, Thomson Learning.
Lamberton, D. (2007), Introduction to Stochastic Calculus Applied to Finance, 2nd Edition, Chapman
& Hall.
McDonald, Robert (2006), Derivative Markets, 2nd edition, Pearson International Edition.
Neftci, N., (2000). An Introduction to the Mathematics of Financial Derivatives, 2nd edition, Salih
Academic Press.
Stulz, R.M. (2003), Risk Management & Derivatives, South-Western College Publishing, Thomson
Learning.
Tuckman, (2002), Fixed Income Securities, 2nd edition, Wiley.
Watsham, T. and K. Parramore (1997), Quantitative Methods in Finance, 2nd edition, Thomson
Learning.
Essential reading is identified below. Additional references will be provided during the course. You
should also undertake your own search for additional relevant literature and follow up relevant
references contained in the literature identified below. It should be noted that each topic does not
necessarily correspond to a single lecture.
MODULE OUTLINE
1. Introduction to derivative markets and a review of financial mathematics:
Motivation for the existence of derivative markets and economic functions of derivative contracts
and markets, and a review of key mathematical concepts.
Suggested reading: Hull, chapter 1 Jarrow and Turnbull, chapter 1 Neftci, chapter 3 and 5 Watsham
and Parramore, chapters 3 and 4 McDonald, chapter 1 and appendix B
2. Forward Contracts: Spot and forward rates, specification, the pricing framework, the value of
forward contracts, currency forwards and covered interest rate arbitrage.
Suggested reading: Hull, chapter 2 Jarrow and Turnbull, chapters 1 and 2 McDonald, chapters 1 and
5 Stulz, chapter 5
3. Futures Markets: Specification, margin accounts, stock index futures, and interest rate futures,
short selling, cost of carry, hedging.
Suggested reading: Hull, chapters 3 and 5 Jarrow and Turnbull, chapter 2 McDonald, chapters 5 and
6 Neftci, chapter 1
4. Interest Rates - Fixed Income Theory: Characteristics and risks of debt securities, money market
securities, floating rate securities, riskless term structure of interest rates, duration and convexity, risk
of default.
Suggested reading: Hull, chapter 4 Jarrow and Turnbull, chapter 13 McDonald, chapter 7 Tuckman,
chapters 2 and 3
5. Swaps: Interest rate swaps, converting asset and liability, risk management, comparative
advantage, the value of a swap and currency swaps, introduction of the interest rate derivatives,
forward rate agreements, short- and long-term interest rate futures, interest rate caplets, caps,
floorlets, floors and collars.
Suggested reading: 8 Hull, chapters 7 and 30 Jarrow and Turnbull, chapter 14 McDonald, chapter 8
Tuckman, chapter 18
6. Introduction to option contracts: Introduction, definitions, properties, trading strategies.
Suggested reading: Hull, chapters 8, 9, 10 McDonald, chapter 9
7. Binomial pricing & stochastic calculus for options contracts: Introduction to the binomial
pricing model, multi-period binomial trees, risk-neutral valuation/pricing, models of the behaviour of
stock prices, Markov property and continuous time stochastic processes, Itô's lemma. Suggested
reading: Hull, chapters 11 and 12 McDonald, chapters 10, 11 Lamberton, (all chapters contain useful
material) Neftci (all chapters contain useful material)
8. The Black-Scholes-Merton Model and the pricing of options written on different underlying
assets: Introduction of the Black-Scholes-Merton formula, derivation of the Black-Scholes
differential equation & option pricing formula, historical and implied volatility, options on stock
indices, currencies and futures contracts, multiperiod binomial trees and their convergence to the
Black-Scholes-Merton model.
Suggested reading: Hull, chapters 12, 13, 15 McDonald, chapters 12, 20, 21, 23 Neftci, chapter 13
Black, F. and M. Scholes (1973), “The pricing of options and corporate liabilities”, Journal of
Political Economy 81, pp.637-654 Merton, R. C. (1973), “Theory of rational option pricing”, Bell
Journal of Economics and Management Science 4, pp. 141-183.
9. The Greek Letters and Risk Management: Explanation of the 2007 crisis, investigation of risks
in option positions, the mathematics and properties of Greek letters, relations between Greek letters,
different schemes of volatility estimation, hedging in practice.
Suggested reading: Hull, chapter 17 McDonald, chapters 13, 23
10. Volatility Smiles and Smirks, Extensions of the Black-Scholes-Merton Model and Empirical
Evidence: Examination of the volatility term structure & of volatility surfaces, extensions &
empirical evidence on the Black-Scholes-Merton Model (e.g. the jump diffusion model, constant
elasticity of variance, stochastic volatility, implied volatility function/regression models).
Suggested reading: Hull, chapters 18, 26 McDonald, chapter 23 Cox and Ross (1976) “The valuation
of option for alternative stochastic processes”, Journal of Financial Economics 3, pp. 145-166.
Merton (1976) “Option pricing when underlying stock returns are discontinuous”, Journal of
Financial Economics 3, pp. 125-144. Heston (1993) “A close form solution for options with
stochastic volatility with applications to bonds and currency options”, Review of Financial Studies 6,
pp. 327-343. Bakshi, Cao and Chen (1997) “Empirical Performance of Alternative Option Pricing
Models”, Journal of Finance 52, pp. 2003-2049. Dumas, Flemming and Whaley (1998) “Implied
Volatility Functions: Empirical Tests”, Journal of Finance 6, pp. 2059 – 2106.