Economics 200E

Financial Derivatives and Financial Engineering
Fall 2004, Professor George Tauchen

http://www.econ.duke.edu/~get/browse/courses/200/fall04/200f04.htm

Professor Tauchen, 224 Social Science

Office Hours: 10 AM - 11:00AM, Tuesday and Thursday

NEWS: Course news on line revise.htm

PROJECTS: Assignments.  See also the rules for formattaing documents turned in for grade and the policy on submitting revisions of graded projects.

HANDOUTS: Most, but not all of the materials handed out in class.  Many are in .pdf format, which can be viewed and printed using Adobe Acrobat Reader

Outlines from previous years:    2001 2002 2003

Background: The course will use tools and techniques developed in Economics 105 (or 149), Economics 110 (or 154), 157 (or 158), and Statistics 110 to study models of financial derivatives. A financial derivative, such as a stock option, is a security whose returns are contractually related to the returns of another security or group of securities. Although stock options have been traded for hundreds of years, the general use of derivatives has grown dramatically since the early 1970s. Indeed, the volume of trading on organized options markets has, at times, exceeded that of the New York Stock Exchange. The types of traded derivatives has now expanded to include a vast array of financial instruments including options on broad stock market indexes, futures on stock indexes, futures on U.S. Treasury securities, fixed for variable interest rate swaps, and even more exotic options. A completely satisfactory theory of option valuation was not developed until the early 1970s. Since that time, the theory has been extended and refined to include complex exotic derivatives.

Procedures: This course is a seminar course that requires substantial student involvement with the material and the numerical work. It is not a traditional lecture/exam type course. In the first half of the course, I will give lectures on the various models and techniques available for derivatives pricing. Students will develop and execute numerical work on research projects during this portion of the course. In the second half of the course, students will give presentations to the group on the results of their research projects. Thus, only students who are interested in learning in this intensive hands-on manner should register for the course. Students expecting a course on financial engineering taught in the traditional lecture format should not register for the course.

Objectives: Students will learn to implement the essential tools and techniques of derivatives pricing including the Black-Scholes formula for basic options, the Cox-Ingersoll-Ross model for fixed income analysis, and the binomial model for more complex derivatives. Extensive use will be made of spreadsheets and computer software packages, and perhaps interactive mathematical packages as sophisticated as MATLAB. Students will be expected to prepare and document at least four projects, with two of the projects summarized in a formal extensive research paper. Students will also be expected to give presentations of work in progress and to participate in in-class workshop presentations of work in progress. Expectations are high in terms of level of student participation and involvement with the course material.

Topics: Futures, both financial and commodity; European and American call and put options; Black-Scholes valuation; binomial models; term structure of interest rates; fixed income securities; interest rate and currency swaps.

Prerequisites: Economics 105 (or 149), Economics 110 (or 154), Statistics (STA 103 is preferred); Economics 157, 158, or 181 are helpful and may be taken concurrently; or permission of the instructor. Additional courseware in mathematics or computer science is helpful but not essential.

Grade: The final grade is based on four projects, the final research paper, which together count 80  percent; attendance, classroom interest, and general level of enthusiasm count the remaining 20 percent. The final paper is a full-length research paper developed from two of the earlier projects.

Warnings: Finance, and in particular financial engineering, is inherently a technical and analytical field. The 1997 Nobel Prize in Economics was awarded to two finance professors for the derivation of a complicated, but very widely used formula for pricing derivative securities. (The derivation of the formula involved the solution of a complicated partial differential equation!) We will study aspects of that formula (not the partial differential equation) in this course. Be forewarned about the nature of the subject matter, the prerequisites, and the level of student involvement expected.

Books and Reading Materials (* denotes required):

NOTE: There are two several books by John C. Hull. The book, Options, Futures... is the main text for the course. Other books such as Introduction... or Fundamentals of ... provide a more intuitive overview of the material. The books are excellent and well worth owning. I own Introduction ... . If not available in the bookstore, any of these books is quickly available from amazon.com. The book by Jorion is a very readable, lively, and interesting account of the Orange County CA debacle. You should be reading it over the course of the semester.

*(Hull): Hull, John C., Options, Futures, and other Derivatives, Fifth Edition, Prentice Hall, 2002.

(Hull, Introduction): Hull, John C., Fundamentals of Futures and Options Markets, Fourth Edition Prentice Hall, 2001.

(Jorion): Jorion, Philippe, Big Bets Gone Bad: Derivatives and Bankruptcy in Orange County, Academic Press, 1995.

(Stoll and Whaley): Stoll, Hans R. and Robert E. Whaley, Futures and Options: Theory and Applications, South-Western Publishers, 1992.

*Course handouts: I will distribute handouts on more technical material.

Computer Resources: Students may do the computations in whatever language or package they prefer to use. Here are some possibilities:

DerivaGem: This package is on a diskette that comes with the Hull books.

MATLAB is a general-purpose matrix language that has an extensive finance module. Instructions: (possibly out of date): It is available on acpub via telnet to godzilla.acpub.duke.edu. Type matlab at the prompt and use the password iamastudent. At the matlab prompt type help finance to see what is available (there is a lot).

The Student Edition of MATLAB is a small version of matlab for the PC. It lacks all statistical features and does not have the finance toolkit, but it can come in handy.

General Finance Books and other Reading Materials:

(Bodie, Kane, and Marcus): Bodie, Zvi, Alex Kane, and Alan J. Marcus, Investments, Hardcover Edition, Irwin/McGraw Hill, 2003, or earlier. (T his book is used in most sections of Economics 157 at Duke.)

(Elton and Gruber): Elton, Edwin J. and Martin J. Gruber, Modern Portfolio Theory and Investment Analysis, Sixth Edition, John Wiley and Sons, 2002. (Used in some Duke finance courses.)

(Malkiel): Malkiel, Burton G., A Random Walk Down Wall Street, W. W. Norton & Company, Inc., any edition is fine.

(Sharpe): Sharpe, William F. , Gordon J. Alexander, and Jeffrey V. Bailey, Investments, Prentice Hall, Sixth Edition, 2002 (earlier edition is fine)..

The Wall Street Journal (Students are encouraged to subscribe to the Journal and keep abreast of daily events in the financial markets.)

The Economist, excellent weekly news magazine covering economic and financial topics with a strong focus on international affairs.

Web Resources: There are many excellent Web pages in the areas of finance and financial markets. Here are some good starting points:

http://finance.yahoo.com Excellent sources for historical financial data and current options data.

http://www.afajof.org/: Journal of Finance home page.

http://www.cob.ohio-state.edu/~fin/journal/jofsites.htm#edres links to many other useful finance related materials on the web prepared by the Journal of Finance.

http://www.duke.edu/~charvey This site is the web page of Cam Harvey, Professor of Finance, Fuqua School of Business, Duke University. It is among the top ten rated web pages in finance.

 http://nber.org National Bureau of Economic Research. Links to many useful economics web sites along with useful historical statistics.

http://www.econ-datalinks.org Web site of the Business and Economic Statistics Section of the ASA. It contains links to many useful data sources for economics and business.

http://www.finweb.com This site is a comprehensive set of links to many useful sites in finance.

http://www.jpmorgan.com This site is the J. P. Morgan site. Nearly all major investment banks and financial firms have useful web sites.

http://www.nyse.com
http://www.cbot.com
http://www.cme.com
http://www.cboe.com
These are the web sites of the New York Stock Exchange, the Chicago Board of Trade, the Chicago Mercantile Exchange, and the Chicago Board Options Exchange.   Most other major exchanges have useful web sites as well.

http://screening.nasdaq.com/heatmaps/heatmap_100.asp  Fascinating heat map of the NASDQ 100.

Course Outline (*Denotes Required)

Overview of Derivative Securities

*Hull: Chapter 1

Hull-Introduction Chapter 1

Stoll and Whaley: Chapters 1, 2

Jorian's Web Case Study of the Orange County CA Disaster

Futures Markets

*Hull: Chapters 2, 3, 4, 5

Hull-Introduction: Chapters 2, 3, 4

Stoll and Whaley: Chapters 3, 4, 5, 6, 7, 8

Basic Mechanics of Options Markets

*Hull: Chapters 7, 8, 9

Hull-Introduction: Chapters 7, 8, 9

Stoll and Whaley: Chapter 10

Option Valuation: Black-Scholes and Binomial Trees

*Hull: Chapters 10, 11, 12, 13, 14, 15 , 18

Hull-Introduction: Chapters 10, 11, 12, 13, 14, 15, 17

Stoll and Whaley: Chapters 11, 12, 13, 14

Exotics

*Hull: Chapter 19

Hull-Introduction: Chapters 19, 20

Stoll and Whaley: Chapter 16

General Valuation Methods

*Hull: Chapters 20, 21(as time permits)

Hull-Introduction: Chapter 11 (revisited)

Stoll and Whaley: Chapter 11 (revisited)

Fixed Income Analysis

*Hull: Chapters 5 (revisited), 22, 23, (and possibly some of 24)

Hull-Introduction: Chapters 5, 18

Stoll and Whaley: Chapter 15

*Jorian's Web Case Study of the Orange County CA Disaster

Value at Risk

*Hull: Chapter 16 (as time permits)

Hull-Introduction: Chapter 16

Swaps

*Hull: Chapter 6 (as time permits)

Hull-Introduction: Chapter 6