An Introduction to Derivatives and Risk Management

Front Cover......Page 1
Title Page......Page 4
Copyright......Page 5
Contents......Page 7
Preface......Page 19
CHAPTER 1 Introduction......Page 24
Options......Page 25
Futures Contracts......Page 26
The Underlying Asset......Page 27
Short Selling......Page 28
Repurchase Agreements......Page 29
Return and Risk......Page 30
Market Efficiency and Theoretical Fair Value......Page 31
Making the Connection Risk and Return and Arbitrage......Page 32
Arbitrage and the Law of One Price......Page 33
The Storage Mechanism: Spreading Consumption across Time......Page 34
Risk Management......Page 35
Price Discovery......Page 36
Criticisms of Derivative Markets......Page 37
Derivatives and Your Career......Page 38
Organization of the Book......Page 39
Key Features of the Book......Page 40
Specific New Features of the Eighth Edition......Page 41
Key Terms......Page 42
Questions and Problems......Page 43
PART I: Options......Page 46
Development of Options Markets......Page 47
Put Options......Page 49
Over-the-Counter Options Market......Page 50
Organized Options Trading......Page 51
Options Exchanges and Trading Activity......Page 54
Option Traders......Page 55
Mechanics of Trading......Page 59
Making the Connection Reading Option Price Quotations......Page 63
Types of Options......Page 65
Transaction Costs in Option Trading......Page 68
Regulation of Options Markets......Page 69
Making the Connection Suspicious Put Option Trading and Bear Stearns & Co., Inc. Implosion......Page 70
Key Terms......Page 71
Questions and Problems......Page 72
Appendix 2.A: Margin Requirements......Page 74
Appendix 2.B: Taxation of Option Transactions......Page 76
CHAPTER 3 Principles of Option Pricing......Page 80
Basic Notation and Terminology......Page 81
Principles of Call Option Pricing......Page 83
Making the Connection Asynchronous Closing Prices and Apparent Boundary Condition Violations......Page 93
Principles of Put Option Pricing......Page 97
Making the Connection Put-Call Parity Arbitrage......Page 110
Summary......Page 111
Further Reading......Page 112
Questions and Problems......Page 113
Appendix 3: Dynamics of Option Boundary Conditions: A Learning Exercise......Page 116
One-Period Binomial Model......Page 118
Two-Period Binomial Model......Page 124
Making the Connection Binomial Option Pricing, Risk Premiums, and Probabilities......Page 125
Extensions of the Binomial Model......Page 132
Making the Connection Uses of the Binomial Option Pricing Framework in Practice......Page 145
Software Demonstration 4.1 Calculating the Binomial Price with the Excel Spreadsheet BSMbin8e.xls......Page 146
Further Reading......Page 147
Questions and Problems......Page 148
Origins of the Black-Scholes-Merton Formula......Page 150
Black-Scholes-Merton Model as the Limit of the Binomial Model......Page 151
Making the Connection Logarithms, Exponentials, and Finance......Page 153
Assumptions of the Black-Scholes-Merton Model......Page 154
A Nobel Formula......Page 158
Software Demonstration 5.1 Calculating the Black-Scholes-Merton Price with the Excel Spreadsheet BSMbin8e.xls......Page 163
Variables in the Black-Scholes-Merton Model......Page 167
Black-Scholes-Merton Model When the Stock Pays Dividends......Page 175
Black-Scholes-Merton Model and Some Insights into American Call Options......Page 179
Software Demonstration 5.2 Calculating the Historical Volatility with the Excel Spreadsheet Hisv8e.xls......Page 183
Making the Connection Smiles, Smirks, and Surfaces......Page 188
Put Option Pricing Models......Page 191
Managing the Risk of Options......Page 193
Summary......Page 198
Further Reading......Page 199
Questions and Problems......Page 200
Appendix 5: A Shortcut to the Calculation of Implied Volatility......Page 203
CHAPTER 6 Basic Option Strategies......Page 206
Terminology and Notation......Page 207
Stock Transactions......Page 210
Call Option Transactions......Page 212
Put Option Transactions......Page 218
Calls and Stock: The Covered Call......Page 224
Making the Connection Alpha and Covered Calls......Page 229
Puts and Stock: The Protective Put......Page 230
Making the Connection Using the Black-Scholes-Merton Model to Analyze the Attractiveness of a Strategy......Page 233
Synthetic Puts and Calls......Page 234
Software Demonstration 6.1 Analyzing Option Strategies with the Excel Spreadsheet Stratlyz8e.xls......Page 237
Summary......Page 240
Questions and Problems......Page 241
Option Spreads: Basic Concepts......Page 244
Money Spreads......Page 246
Making the Connection Spreads and Option Margin Requirements......Page 250
Making the Connection Designing a Collar for an Investment Portfolio......Page 256
Calendar Spreads......Page 260
Ratio Spreads......Page 264
Straddles......Page 265
Box Spreads......Page 269
Further Reading......Page 272
Questions and Problems......Page 273
PART II: Forwards, Futures, and Swaps......Page 276
CHAPTER 8 The Structure of Forward and Futures Markets......Page 277
Development of Forward and Futures Markets......Page 278
Organized Futures Trading......Page 282
Futures Traders......Page 287
Mechanics of Futures Trading......Page 290
Making the Connection How Clearinghouses Reduce Credit Risk......Page 292
Futures Price Quotations......Page 297
Types of Futures Contracts......Page 298
Making the Connection Reading Futures Price Quotations......Page 301
Transaction Costs in Forward and Futures Trading......Page 303
Regulation of Futures and Forward Markets......Page 304
Summary......Page 305
Further Reading......Page 306
Questions and Problems......Page 307
Appendix 8: Taxation of Futures Transactions in the United States......Page 309
CHAPTER 9 Principles of Pricing Forwards, Futures, and Options on Futures......Page 310
Generic Carry Arbitrage......Page 311
Making the Connection When Forward and Futures Contracts Are the Same......Page 315
Carry Arbitrage When Underlying Generates Cash Flows......Page 318
Pricing Models and Risk Premiums......Page 323
Pricing Options on Futures......Page 336
Summary......Page 344
Key Terms......Page 346
Questions and Problems......Page 347
Short-Term Interest Rate Arbitrage......Page 350
Intermediate- and Long-Term Interest Rate Arbitrage......Page 355
Software Demonstration 10.1 Identifying the Cheapest-to-Deliver Bond with the Excel Spreadsheet CTD8e.xls......Page 363
Treasury Bond Futures Spreads and the Implied Repo Rate......Page 365
Stock Index Arbitrage......Page 366
Foreign Exchange Arbitrage......Page 370
Making the Connection Currency-Hedged Cross-Border Index Arbitrage......Page 371
Concept Checks......Page 373
Questions and Problems......Page 374
Appendix 10: Determining the CBOT Treasury Bond Conversion Factor......Page 376
Software Demonstration 10.2 Determining the CBOT Conversion Factor with the Excel Spreadsheet CF8e.xls......Page 377
CHAPTER 11 Forward and Futures Hedging, Spread, and Target Strategies......Page 378
Why Hedge?......Page 379
Hedging Concepts......Page 380
Determination of the Hedge Ratio......Page 390
Hedging Strategies......Page 395
Making the Connection Hedging Contingent Foreign Currency Risk......Page 399
Spread Strategies......Page 407
Target Strategies......Page 414
Summary......Page 424
Concept Checks......Page 425
Questions and Problems......Page 426
Appendix 11: Taxation of Hedging......Page 429
CHAPTER 12 Swaps......Page 430
Interest Rate Swaps......Page 432
Making the Connection LIBOR and the British Bankers Association......Page 440
Currency Swaps......Page 446
Making the Connection Valuing a Currency Swap as a Series of Currency Forward Contracts......Page 453
Equity Swaps......Page 456
Some Final Words about Swaps......Page 463
Summary......Page 464
Concept Checks......Page 465
Questions and Problems......Page 466
PART III: Advanced Topics......Page 470
CHAPTER 13 Interest Rate Forwards and Options......Page 471
Forward Rate Agreements......Page 472
Interest Rate Options......Page 479
Interest Rate Swaptions and Forward Swaps......Page 494
Making the Connection Binomial Pricing of Interest Rate Options......Page 495
Key Terms......Page 502
Questions and Problems......Page 503
Advanced Equity Derivatives and Strategies......Page 506
Making the Connection Portfolio Insurance in a Crashing Market......Page 514
Advanced Interest Rate Derivatives......Page 517
Exotic Options......Page 524
Some Unusual Derivatives......Page 535
Summary......Page 537
Further Reading......Page 538
Questions and Problems......Page 539
Appendix 14: Monte Carlo Simulation......Page 542
Why Practice Risk Management?......Page 544
Managing Market Risk......Page 547
Managing Credit Risk......Page 564
Making the Connection What Derivatives Tell Us About Bonds......Page 569
Making the Connection Unfunded Synthetic CDOs......Page 577
Other Types of Risks......Page 578
Further Reading......Page 582
Questions and Problems......Page 583
The Structure of the Risk Management Industry......Page 586
Organizing the Risk Management Function in a Company......Page 588
Making the Connection Professional Organizations in Risk Management: GARP and PRMIA......Page 589
Risk Management Accounting......Page 593
Risk Management Industry Standards......Page 604
Responsibilities of Senior Management......Page 605
Further Reading......Page 607
Questions and Problems......Page 608
Appendix A: List of Formulas......Page 611
Appendix B: References......Page 617
Appendix C: Solutions to Concept Checks......Page 631
Glossary......Page 643
Index......Page 666