A Preview of Future Topics in Finance 4366

This week in Finance 4366, we introduced and described the nature of financial derivatives and motivated their study with examples of forwards, futures, and options. Derivatives are so named because they derive their values from one or more underlying assets. Underlying assets typically involve traded financial assets such as stocks, bonds, currencies, or other derivatives, but derivatives can derive value from pretty much anything. For example, the Chicago Mercantile Exchange (CME) offers exchange-traded weather futures and options contracts (see “Market Futures: Introduction To Weather Derivatives“). There are also so-called “prediction” markets, in which derivatives based upon the outcome of political events are actively traded (see “Prediction Market“).

Besides introducing financial derivatives and discussing various institutional aspects of markets where they are traded, we also considered various properties of forward and option contracts, since virtually all financial derivatives feature isomorphic payoffs to either or both schemes. For example, a futures contract is simply an exchange-traded version of a forward contract. Similarly, since swaps involve exchanges between counterparties of payment streams over time, these instruments essentially represent a series of forward contracts. In the option space, besides traded stock options, many corporate securities feature “embedded” options; e.g., a convertible bond represents a combination of a non-convertible bond plus a call option on company stock. Similarly, when a company invests, so-called “real” options to expand or abandon the investment in the future are often present.

Perhaps the most important (pre-Midterm 1) idea that we’ll introduce is the concept of a so-called “arbitrage-free” price for a financial derivative. While details will follow, the basic idea is to replicate the payoffs on a forward or option by forming a portfolio comprising the underlying asset and a riskless bond. This portfolio is called the “replicating” portfolio since, by design, it replicates the payoffs on the forward or option. Since the forward or option and its replicating portfolio produce the same payoffs, then they must also have the same value. However, suppose the replicating portfolio (forward or option) is more expensive than the forward or option (replicating portfolio). If this occurs, then one can earn a riskless arbitrage profit by simply selling the replicating portfolio (forward or option) and buying the forward or option (replicating portfolio). However, competition will ensure that opportunities for riskless arbitrage profits vanish quickly. Thus, the forward or option will be priced such that one cannot earn arbitrage profit from playing this game.

Kids Explain Futures Trading

For a non-technical introduction to forward and futures contracts, it’s hard to beat the following video tutorial on this topic (apologies if an ad appears on the front-end of this video :-():

Finance 4366 Grades on Canvas

Here is a “heads-up” about the Finance 4366 grade book on Canvas.  There, you will find grade averages that reflect 1) attendance/participation grades for the first four class meetings, 2) two quiz grades and a student survey completion grade which counts as a quiz grade, and 3) problem set 1.  Thus, your current (Monday, January 29) course numeric grade in Finance 4366 is based on the following equation:

(1) Current Course Numeric Grade = (.10(Attendance and Participation) +.10(Quizzes) +.20(Problem Sets))/.4

Note that equation (1) is a special case of the final course numeric grade equation (equation (2) below) which also appears in the “Grade Determination” section of the course syllabus:

(2) Final Course Numeric Grade =.10(Attendance and Participation) +.10(Quizzes) +.20(Problem Sets) + Max{.20(Midterm Exam 1) +.20(Midterm Exam 2) +.20(Final Exam), .20(Midterm Exam 1) +.40(Final Exam), .20(Midterm Exam 2) +.40(Final Exam)}

My goal going forward is for the Finance 4366 grade book to dynamically incorporate new grade information on a timely basis for each student, consistent with the final course numeric grade equation.  For example, after midterm 1 grading is complete, equation (3) will be used to determine your numeric course grade:

(3) Course Numeric Grade after Midterm 1 = (.10(Attendance and Participation) +.10(Quizzes) +.20(Problem Sets) +.20(Midterm 1))/.6

After midterm 2 grades are recorded, equation (4) will be used to determine your numeric course grade then:

(4) Course Numeric Grade after Midterm 2 = (.10(Attendance and Participation) +.10(Quizzes) +.20(Problem Sets) +.20(Midterm 1) +.20(Midterm 2))/.8

After the spring semester and the final exam period are over, all Finance 4366-related grades will have been collected, and I will use equation 2 above to calculate your final course numeric grade.  At that time, your final course letter grade will be based on the following schedule (which appears in the “Grade Determination” section of the course syllabus):

A 93-100% C 73-77%
A- 90-93% C- 70-73%
B+ 87-90% D+ 67-70%
B 83-87% D 63-67%
B- 80-83% D- 60-63%
C+ 77-80% F <60%

 

Problem Set 2 helpful hints

Problem Set 2 is available from the course website at http://fin4366.garven.com/spring2024/ps2.pdf; its due date is Tuesday, January 30.

Problem Set 2 consists of two problems. The first problem requires calculating expected value, standard deviation, and correlation, and using this information as inputs into determining expected returns and standard deviations for 2-asset portfolios. The second problem involves using the standard normal probability distribution to calculate the probabilities of earning various levels of return by investing in risky securities and portfolios; see pp. 13-19 of the http://fin4366.garven.com/spring2024/lecture4.pdf lecture note for coverage of that topic.

Z Table Extra Credit Assignment (due at the start of class on Tuesday, January 30)

Here’s an extra credit opportunity for Finance 4366. Working on your own (i.e., this is not a group project; I will only give credit for spreadsheets that are uniquely your own), build your own “z” table in Excel (patterned after the table at http://fin4366.garven.com/stdnormal.pdf); the top row should have values ranging from 0.00 to 0.09, and the first column should have z values ranging from -3.0 to +3.0, in increments of 0.1).

Conveniently, Excel has the standard normal distribution function built right in; e.g., if you type “=normsdist(z)”, Excel returns the probability associated with whatever z value you provide. If you type “=normsdist(0)”, .5 is returned, since half of the area under the curve lies to the left of the expected value E(z) = 0. Similarly, if you type “=normsdist(1)”, then .8413 is returned because 84.13% of the area under the curve lies to the left of z = 1. Perhaps you recall from your QBA course that 68.26% of the area under the curve lies between z = -1; this “confidence interval” of +/- 1 standard deviation away from the mean (E(z)=0) is calculated in Excel with the following code: “=normsdist(1)-normsdist(-1)”, and so forth.

The grade you earn on this extra credit assignment will replace your lowest quiz grade; that is if your lowest quiz grade is lower than your extra credit grade. The deadline is the start of class on Tuesday, January 30.

You can turn your spreadsheet for this extra credit assignment in at the link labeled “Z Table Extra Credit Assignment” under the Assignment tab on Canvas.

Gamma Iota Sigma Chapter Meeting

Gamma Iota Sigma (GIS) is an international collegiate professional fraternity established in 1966 at the Ohio State University in Columbus, Ohio. Baylor University’s Alpha Pi chapter of GIS was founded in 2001. GIS aims to promote, encourage, and sustain student interest in insurance, risk management, and actuarial science as professions. Additionally, it seeks to enhance the moral and scholastic achievements of chapter members while fostering interaction between Baylor University and the business community through research activities, scholarship, and networking opportunities.

Join us for the inaugural chapter meeting of the Spring 2024 semester on Thursday, January 25, from 6:30 to 7:30 pm in Foster 322. We look forward to your participation!