To the member page, I just uploaded a 1 hour 15 minute video tutorial “focus bag” devoted to the critical John Hull chapters. As customers have noticed, the Hull chapters are many and his text is key to Level 1 (the “big four” for Level 1 are Gujarati, Hull, Tuckman, Jorion).

This tutorial reviews, at customer request, learning spreadsheets that I built based on the Hull assignments. I hope they give you a boost in your study of derivatives. The tutorial reviews the following learning spreadsheets (if you are interested, here are the bullet point notes I made, that I wanted to make sure I mentioned):

3.a.2. Daily Margin

• Illustrates margin operations for a futures contract
• Note breach of maintenance margin triggers margin call; margin call must “top up” to initial margin (not maintenance margin)
• Volatility in margin account highlights difference between future and forward contract: daily settlement gives rise to the need for a convexity adjustment (forward price versus futures price)

3.a.3. Basis Risk

• Keep in mind that “hedge” implies two objects: (i) the future need to buy/sell a commodity and (ii) a derivative instrument. A hedge aims to offset commodity price increases (commodity buyer; airlines buys jet fuel) or decreases (commodity seller; farmer sells crops) with profit on the derivative instrument
• Basis = spot price – futures price
• Basis risk has a conceptual definition and a technical equivalent. Conceptual (Hull): uncertainty  in the basis. Technical (Geman): variance in the basis.
• Key point: the hedger is not concerned with anticipated change in basis, this is not a problem (the hedge is designed against anticipated basis change). The problem is unexpected basis weakening or strengthening.

3.a.4. Minimum Variance Hedge

• Hull’s classic example of an airline’s cross-hedge of jet fuel costs with heating oil futures contracts (we call this a “cross hedge” because jet fuel futures are not available)
• Important: minimum variance hedge = slope (beta) of the regression line

3.a.5. Compound Frequencies

• If you didn’t attend the Early Bird, mastery of compound frequencies is absolutely essential. Skipping this mundane topic creates later confusions. This spreadsheet has sixteen exercises.
• Your goal should be to become facile with (i) conversion from discrete to continuous, (ii) vice-versa, and (iii) using either/both in a bond price (PV) calculation.

3.a.5a. Bond Price

• Fundamental: pricing a bond with spot rate curve (term structure of zero rates)

3.a.5a. Bootstrapping the theoretical spot rate

• Thematic because it arises several times: bootstrapping applies a no-arbitrage idea.

3.a.6. Spot vs. Forward vs. Yield (YTM)

• This is maybe the most fundamental learning XLS in regard to the basic fixed income (Tuckman). Please try to master this!
• Compares spot rate curve (input) to discount function (i.e., set of discount factors) to implied forward rates
• Also, yield to maturity (YTM). Why does yield only required one cell (a single number) in contrast to the others which are curves/functions?

3.a.8. Cost of Carry

• It only seems like there are many cost of carry models. In this spreadsheet, I collected many of Hull’s (and McDonald’s) cost of carry examples under a single mechanic: forward price = EXP[(costs of ownership – benefits of ownership)*Time]

3.a.9. Day count convention

• I have several sheets in the learning XLS focused on interest rate futures (Hull Chapter 6), so I only here focused on the first (day count convention)

3.a.9. T-bill discount rate

• Included because T-bill pricing is not intuitive; i.e., the “discount rate” is a percentage of face value, and therefore always understates the true yield. The assigned John Hull chapter, in my opinion, is not very strong on this particular topic. If you would like a more detailed review of discount instruments (and money market math), I heartily recommend Bob Steiner’s Mastering Financial Calculations:

  Mastering Financial Calculations: A step-by-step guide to the mathematics of financial market instruments (2nd Edition) (Financial Times Prentice Hall)

3.a.11 Interest rate swap

• I warn you that the interest rate swap pricing takes time to learn; I don’t have shortcuts. Plan to spend at least a few hours on swap pricing. The silver lining is, it applies other useful building blocks; and is a good prelude to credit default swap (CDS) pricing
• Start with big picture: what’s the difference in present values between the floating and fixed legs
• Two key confusions: (i) the exercises mixes semi-annual (i.e., coupon payments) and continuous compounding (i.e., discounting LIBOR) and (ii) the floater is deceptively easy to price—we only need one cash flow!—because a floating rate coupon must price at par on settlement date.

3.a.11 Currency swap

• Essentially same, additional variables

3.a.12 Put-call parity

• I revised this for further clarity; you may tire of hearing this, but put-call parity is plank that introduces Black-Scholes. Black-Scholes can almost be grasped without math, on a conceptual basis, by way of the two equivalent “replicating” portfolios: long call + lend @ strike must equal (=) a protective put.
• In any case, this is the stepping stone into Black-Scholes-Merton, maybe the most important “invention” in recent finance, and (in cyclical fashion) subject to resurgent controversy. I just started reading Lecturing Birds on Flying by Pablo Triana; so far, an entertaining critique of quantitative finance.  He follows Taleb with a withering critique of Black-Scholes (e.g., “the model may not be needed at all,” “it is not used”). Recommended.

  Lecturing Birds on Flying: Can Mathematical Theories Destroy the Financial Markets?

Comments

1. abhishek.chhajlani 10 Aug 2009

   can you please tell me where is the video uploaded?

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