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Please carefully study the following illustration to convince yourself that the arguments hold.  The basic concepts described here will not only help your understanding of valuation and arbitrage involving stock index futures, but will also be shown in class to underlie more advanced strategies used in industry including portable alpha and enhanced indexing.

Assume that you are in a world with the following current market conditions:

S (a stock or stock index) = \$100; L (Libor) = 6%; d (div yield) = 2%; and you have a 1 year (360-day) investment horizon. Thus, based on this information, we know that the one-year futures price should be:

F = S*[1 + (L - d)*(T-t)/360]

F = 100*[1 + (.06 - .02)*360/360] = 104

Now, consider the following two investment strategies, which I argue are equivalent or that you would be indifferent between choosing:

1. Invest \$100 in the stock, or

2. Invest \$100 in a money market account and go long one futures based on that stock (at 104).  (This is sometimes referred to as a fully collateralized futures position.)

Scenario A:

Suppose that after 1 year the stock is now at \$120. Your ending wealth from each of the two strategies are:

1. Wealth = 120 + .02*100 = 122 (stock value plus dividends received)

2. Wealth = 100*(1+.06) + (120 - 104) = 106 + 16 = 122 (money market investment plus gain on the futures)

Therefore, both strategies produce the same terminal wealth.

Scenario B:

Suppose that after 1 year the stock is now at \$80. Your ending wealth from each of the two strategies are:

1. Wealth = 80 + .02*100 = 82 (stock value plus dividends received)

2. Wealth = 100*(1+.06) + (80 - 104) = 106 - 24 = 82 (money market investment plus loss on futures)

Again, both strategies produce the identical ending wealth.

Welcome all to FI 8200 "Derivative Markets"!

I hope that you will find this course to be a superb and one of your most beneficial experiences at GSU.  I am looking forward to seeing each of you at the first class on January 10.  As a reminder, our class meets at 5:30pm in Room 1215 of the Buckhead Center.

Please do the following prior to the first day of class:

(2) The textbook is optional, but if you want to get one the ISBN number is 978-1-4051-5049-1.  Note that any used/older edition will also work fine.

(3) Go to www.cmegroup.com, shade "Education" and click on the Education Home link.  This will take you to www.cmegroup.com/education.html and you will see a set of tutorials/presentations that provide a nice introduction to derivatives, exchanges, and futures.  At a minimum please take a few minutes to watch the following video group at:

(i) Managing Risk at CME Group - How it All Works (there are about 8 chapter videos, each only about 1-2 minutes long).
http://www.cmegroup.com/education/managing-risk-cme-group-how-it-works.html

(ii) And then at futuresfundamentals.cmegroup.com/, go quickly through the various links under "Get the Basics", "See the Impact", and "Explore the Marketplace".

(4) Important: Please begin to build a spread sheet that will compute duration and modified duration.  Along these lines, you should also go ahead and begin working on Assignment No. 1. I will send it to you via a separate email with instructions.  Note that I will attempt to post all homework exercises under "Assignments" on the course website.  For more information on this, I will send you an email with a couple of short articles attached that provide an excellent primer on calculating duration with examples.

As you have time, please also:

(5) Give a quick review to the assigned chapters for the first day of class and begin reading articles 2 and 3 that are posted under the Syllabus/Readings link.

(6) Here is a brief summary of what we will discuss at our first lecture:

We will begin by developing a working definition of a derivative, and then consider a number of common derivative structures as well as identify their market venue (both OTC and exchange-traded instruments).  We will look at some recently released statistics regarding global market size, including breakdowns according to product and instrument type, and maturity.

In our inspection of the various types of derivatives, we will see that basically all derivatives can be viewed as one or a combination of two basic building blocks: the futures/forward contract and the option contract.

To illustrate both types of contracts, we will review two case studies.  In the first, we will review an early case study regarding the use of financial futures for hedging--the Salomon Bros/Merrill Lynch underwriting of IBM's first public debt offering.  This event is sometimes credited with being the true motivating birth of the financial futures markets. In the second case study, we will look a structured debt security. Using basic financial engineering techniques, we will identify and value embedded options in the product and show how the overall security was priced from a yield perspective.

We will subsequently explore the "why" of financial risk management in which we examine the various channels through which financial risk management can potentially enhance shareholder value.  We will discuss how and under what conditions hedging can reduce financial distress and related business disruption costs, reduce under-investment incentives and adverse selection problems, and reduce taxes.

See all at our first class and please do not hesitate to call me or stop by at any time!

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