Undergraduate study in Economics,

Management, Finance and the Social Sciences

Derivatives and
risk management

J. Danielsson and R. Rahi

FN3206
2024
Derivatives and risk management
J. Danielsson and R. Rahi
FN3206
2024

Undergraduate study in
Economics, Management,
Finance and the Social Sciences

This subject guide is for a 300 course offered as part of the University of London’s
undergraduate study in Economics, Management, Finance and the Social
Sciences. This is equivalent to Level 6 within the Framework for Higher Education
Qualifications in England, Wales and Northern Ireland (FHEQ).
For more information see: london.ac.uk
This guide was prepared for the University of London by:
Dr Jon Danielsson, Reader in Finance, Co-Director, Systemic Risk Centre, Department
of Finance, London School of Economics; and Dr Rohit Rahi, Associate Professor of
Finance, Department of Finance, London School of Economics.
This is one of a series of subject guides published by the University. We regret that
due to pressure of work the authors are unable to enter into any correspondence
relating to, or arising from, the guide. If you have any comments on this subject
guide, please communicate these through the discussion forum on the virtual
learning environment.

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Published by: University of London

© University of London 2024

The University of London asserts copyright over all material in this subject guide
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 Contents

Contents

1.1 What is a subject guide?.................................................................................... i

1.2 Introduction to the subject area....................................................................... i
1.3 Syllabus............................................................................................................. i
1.4 Aims of the course............................................................................................ ii
1.5 Learning outcomes for the course.................................................................... ii
1.6 Employability outcomes................................................................................... ii
1.7 Overview of learning resources....................................................................... ii
1.7.1 The subject guide..................................................................................................ii
1.7.2 Essential reading..................................................................................................iii
1.7.3 Further reading....................................................................................................iii
1.7.4 Online study resources..........................................................................................iv
1.8 Examination advice...........................................................................................v
1.9 References cited...............................................................................................vi

C
 Introduction

Chapter 1 Introduction

1.1 What is a subject guide?

FN3206 has two parts: the first for derivatives and the second for risk
management.
The PDFs provide comprehensive notes for FN3206. The material is
in thematic order, so the chapters are not equal in length and do not
correspond to lectures. You should read them at the appropriate pace to
keep up with your lectures.

1.2 Introduction to the subject area

Derivatives focuses on financial derivatives, with a particular emphasis
on equity derivatives (e.g. standard call and put options, exotic options),
futures and forward contracts, and interest rate derivatives (e.g. swaps,
caps and floors, swaptions). This part of the course systematically
addresses three basic questions: How do these products work (i.e., what
are their payoffs)? How can they be used, for hedging purposes or as part
of trading strategies? And above all, how are they priced? The course
emphasises a small number of powerful ideas: absence of arbitrage,
replication and risk-neutral pricing. It covers discrete-time models (mainly
binomial trees) and the Black-Scholes model.
Risk management focuses on quantitative methods for forecasting
financial risk and emphasises theoretical concepts of financial risk,
time-series methods for modelling the stochastic process of asset prices,
and techniques for evaluating the quality of forecasts with backtesting.
This part of the course combines finance, statistics, statistical and
programming. We do not expect you to have programmed before, but you
should have a solid understanding of statistical techniques and financial
markets.

1.3 Syllabus
The course is divided into two parts: (I) Derivatives; and (II) Risk
management.
(I) Derivatives
Topics include the binomial model, Black-Scholes, the Greeks, exotic
options, forwards and futures, fixed income basics and interest rate
options.
The content is covered in Chapters 1–9 and Appendices A–D.
(II) Risk management
Topics include properties of prices and returns on markets, the stylised
facts of returns, univariate and multivariate volatility models, concepts
of market risk, implementation of risk forecasting, backtesting of risk
forecasts, risk for derivatives, endogenous risk and financial regulations.
The content is covered in Chapters 10–19.

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FN3206 Derivatives and risk management

1.4 Aims of the course

This course has two main aims, and these directly relate to the major
themes that will be emphasised throughout this subject guide. The course
aims to:
• provide a comprehensive introduction to options, forwards and
futures, and other financial derivatives
• provide a toolkit for understanding a range of models used for market
risk forecasting in the financial industry and key issues in using these
models.

1.5 Learning outcomes for the course

By the end of the course, you should be able to:
• develop an understanding of the fundamental theorem of asset pricing
(FTAP)
• understand the connection between absence of arbitrage, replication,
and risk-neutral pricing
• price a range of derivatives using binomial trees
• have a good understanding of the Black-Scholes formula
• appreciate the importance of the Greeks in risk management
• value forwards and futures
• understand the yield curve and value interest rate derivatives
• identify the time-series properties of financial asset prices and returns
• understand univariate and multivariate volatility models
• define and compare different risk measures: volatility, value-at-risk
(VaR) and expected shortfall
• implement and backtest risk models
• use Monte Carlo methods for risk in derivatives and bonds
• understand endogenous risk
• appreciate market risk regulations.

1.6 Employability outcomes

Below are the three most relevant skill outcomes for students undertaking
this course which you can convey to future prospective employers:
1. Decision making
2. Complex problem solving
3. Creativity and innovation

1.7 Overview of learning resources

1.7.1 The subject guide
Multiple-choice questions accompany each chapter. These questions are
designed to test your basic understanding of the content of that chapter.
You will also find exercises near the end of Chapters 3–9. You should
attempt each exercise before you cover it in class. This will ensure that
you get the most out of class discussion.

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 Introduction

The risk management part of the course is very empirical, which means
you have to implement the various methods in the computer. The things
we do in this course are too complicated to execute in Excel, and we need
to use specialised software. We have opted for R, a widely used free and
open-source language that is specially designed for statistics. It comes
with a useful front-end interface, RStudio. You can find details about
its practical implementation on the R Risk notebook, including code for
implementing the methods, data vendors, description of how to put them
in practice, the various issues arising from practical implementations and
sample data sufficient for implementing all methods in the course.

1.7.2 Essential reading

Detailed reading references in this subject guide refer to the editions of the
set textbooks listed below. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the virtual learning environment (VLE) regularly for updated guidance on
readings.
For derivatives, there is no required text, but this is an excellent reference
(and the industry standard):
Hull, J.C. Options, futures and other derivatives. (London: Pearson, 2021) 11th
edition [ISBN 9781292410654].
In addition, you may find the following book useful (somewhat less
technical than Hull):
McDonald, R.L. Derivatives markets. (London: Pearson, 2013) 3rd edition
[ISBN 9780321543080].
Risk management is based on the following textbook:
Danielsson, J. Financial Risk Forecasting. (London: Wiley Finance, 2011)
[ISBN 9780470669433].
In this book, you can find more details on the techniques discussed below.
The content here is a subset of the book. We omit many of the technical
details here and refer you to the book for more in-depth analysis.
We also provide various materials to aid in learning, all listed on the R
Risk Notebook. That includes sample computer code, sample data, lecture
slides and assignments. Much of this material is continually updated.
What might be particularly useful for this course is an online notebook,
which you can find on the R Risk notebook, which contains details on
how to implement the various techniques in this course, along with the
computer code to do it and sample data.

1.7.3 Further reading

Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the VLE and University of London
Online Library (see below).
Other useful texts for this course include:
Christoffersen, P. Elements of financial risk management. (London: Academic
Press, 2011) 2nd edition [ISBN 9780128102350].
McNeil, A.J., R. Frey and P. Embrechts Quantitative risk management: Concepts,
techniques and tools. (Princeton: Princeton University Press, 2011) 2nd

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FN3206 Derivatives and risk management

edition [ISBN 9780691166278].

Tsay, R.S. Analysis of financial time series. (London: Wiley, 2011) 3rd edition
[ISBN 9780470414354].
Unless otherwise stated, all websites in this subject guide were accessed in
May 2024. We cannot guarantee, however, that they will stay current and
you may need to perform an internet search to find the relevant pages.

1.7.4 Online study resources

In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal.
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave
on your application form. You have probably already logged in to the
Student Portal in order to register! As soon as you registered, you will
automatically have been granted access to the VLE, Online Library and
your fully functional University of London email account.
If you have forgotten these login details, please click on the ‘Forgot
password’ link on the login page.

The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
• Course materials: Subject guides and other course materials
available for download. In some courses, the content of the subject
guide is transferred into the VLE and additional resources and
activities are integrated with the text.
• Readings: Direct links, wherever possible, to Essential readings in
the Online Library, including journal articles and ebooks.
• Video content: Including introductions to courses and topics within
courses, interviews, lessons and debates.
• Screencasts: Videos of PowerPoint presentations, animated podcasts
and on-screen worked examples.
• External material: Links out to carefully selected third-party
resources.
• Self-test activities: Multiple-choice, numerical and algebraic
quizzes to check your understanding.
• Collaborative activities: Work with fellow students to build a body
of knowledge.
• Discussion forums: A space where you can share your thoughts
and questions with fellow students. Many forums will be supported by
a ‘course moderator’, a subject expert employed by LSE to facilitate the
discussion and clarify difficult topics.
• Past examination papers: We provide up to three years of past
examinations alongside Examiners’ commentaries that provide
guidance on how to approach the questions.
• Study skills: Expert advice on getting started with your studies,
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 Introduction

preparing for examinations and developing your digital literacy skills.

Note: Attempt activities and Test your knowledge and understanding
questions and discuss them on the discussion forums.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.

Making use of the Online Library

The Online Library contains a huge array of journal articles and other
resources to help you read widely and extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login.
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please use the online help pages or contact the Online
Library team using the ‘Chat with us’ function.

1.8 Examination advice

Assessment is via a three-hour written examination at the end of
the course. The exam will consist of two parts, derivatives and risk
management. You will find a sample exam paper on the VLE.
The following points apply to the derivatives part of the exam:
1. The questions on the exam will be similar to those in the end-of-
chapter exercises or in the sample exam.
2. You could be asked short essay-type questions that are directly out of
the lecture notes.
3. You will not be asked for values of the standard normal CDF (for
example, to calculate Black-Scholes prices) that require the use of
statistical tables. No statistical tables will be provided.
4. You do not need to memorise the following formulas:
a. Black-Scholes formula
b. The Greeks (except for delta)
c. Swap rate formulas
5. If at any point in the exam you feel that anything is unclear, please
make any additional assumptions that you feel are necessary and state
them clearly. However, you may lose points if you make unnecessary
assumptions.
The following points apply to the risk management part of the exam:
1. The questions on the exam will be similar to those in the sample exam.
2. You could be asked to provide short explanations on a particular
technique or problem.
3. You might be asked to do numerical calculations, and will be provided
with statistical tables on the relevant distributions.
4. You might be required to do short model derivations.

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FN3206 Derivatives and risk management

5. If at any point in the exam you feel that anything is unclear, please
make any additional assumptions that you feel are necessary and state
them clearly. However, you may lose points if you make unnecessary
assumptions.

1.9 References cited

The data for the graphs in the subject guide is taken from the following
four databases.
• Dimson, E., P.R. Marsh and M. Staunton Credit Suisse Global Investment
Returns Sourcebook 2016. (Zurich: Credit Suisse, 2016).
• Unicorn Data Services ‘Financial data from around the world’
• Bloomberg
• Global Financial Data

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