Derivatives & Risk Management

Cover
About the Author
Contents
Preface
	Organization of the Book
	Features of the book
	The Teaching and Learning Package
	Acknowledgements
Chapter 1: Introduction
	1.1 What Are Derivatives?
	1.2 Derivatives Markets
	1.3 Forward Contracts
	1.4 Futures Contracts
	1.5 Options Contracts
	1.6 Swap Contracts
	1.7 Uses of Derivatives
	1.8 What Is Risk?
		1.8.1 Operating or Business Risk
		1.8.2 Event Risk
		1.8.3 Price Risk
	1.9 Risk Management
	1.10 A Brief History of Risk Management
	1.11 Implications for Hedging
	1.12 Upside and Downside Risks
	1.13 Commodity Price Risk
		1.13.1 Volatility
		1.13.2 Liquidity
	1.14 Interest Rate Risk
		1.14.1 Deregulation and Interest Rate as a Tool for Developing Monetary Policy
		1.14.2 Floating Rate Loans
		1.14.3 Interest Rates and Inflation
		1.14.4 Components of Interest Rate Risk
	1.15 Currency Risk
	1.16 Approaches to Risk Management
	1.17 Risks in Derivatives Trading
	Chapter Summary
	Review Questions
	Problems
	Case Study
Chapter 2: The Derivatives Market in India
	2.1 The International Derivatives Market
	2.2 Derivatives in India
	2.3 Operations of Derivatives Exchanges
	2.4 The Trading System
		2.4.1 Types of Orders
		2.4.2 Order-matching Rules
		2.4.3 Order Conditions
	2.5 The Clearing and Settlement System
		2.5.1 The Members of the Clearing House
		2.5.2 The Clearing Mechanism
		2.5.3 Margin and Margin Accounts
		2.5.4 The Settlement System
		2.5.5 Risk Management
	2.6 The Trading Process
	2.7 Online Trading
	2.8 The OTC Derivatives Market
	2.9 The Regulation of Derivatives Trading in India
	Chapter Summary
	Review Questions
Chapter 3: Interest rates
	3.1 What Is Interest rate?
	3.2 Simple and Compound Interest Rates
	3.3 Future Value and Present Value
		3.3.1 Present Value
	3.4 Effective Interest Rates for Different Compounding Periods
		3.4.1 Present Value for Different Compounding Periods
		3.4.2 Relation Between Rate Under Continuous Compounding and Rate Under Compounding for m Periods
	3.5 Risk-free Interest Rate
		3.5.1 Interest Rate Risk
		3.5.2 Default Risk
		3.5.3 Call Risk
		3.5.4 Liquidity Risk
	3.6 Risk-free Rates
		3.6.1 Government Security
		3.6.2 Interbank Rates
		3.6.3 Repurchase Agreement Rate (Repo Rate)
	3.7 Interest Rate Risk and Forward Rates
	3.8 Term Structure of Interest Rates
		3.8.1 Implied Forward Rates
		3.8.2 Why Implied Forward Rates?
		3.8.3 Calculating Implied Forward Rate from Coupon Bonds
	Chapter Summary
	Review Questions
	Problems
	Case Study
Chapter 4: Forward Contracts
	4.1 What is a Forward Contract?
	4.2 The Purpose of Forward Contracts
	4.3 A dvantages of Forward Contracts
	4.4 Problems with Forward Contracts
		4.4.1 Parties with Matching Needs
		4.4.2 Non-performance
		4.4.3 Non-transferability
	4.5 The Pricing of Commodity Forward Contracts
	4.6 Currency Forward Contracts
		4.6.1 The Operation of the Currency Forward Market
		4.6.2 Characteristics of Currency Forward Contracts
		4.6.3 The Pricing of Currency Forward Contracts
		4.6.4 Covered Interest Arbitrage
		4.6.5 Rolling Over Currency Forward Contracts
	4.7 Interest Rate Forwards
		4.7.1 Mechanics of FRAs
		4.7.2 The FRA Payment Amount
		4.7.3 An Alternative View of an FRA and the Settlement Amount
		4.7.4 Uses of FRAs
	4.8 Non-deliverable Forwards
	Chapter Summary
	Review Questions
	Problems
	Case Study
Chapter 5: Futures Contracts
	5.1 What Is a Futures Contract?
	5.2 Futures Contracts Versus Forward Contracts
		5.2.1 Negotiability
		5.2.2 Standardization
		5.2.3 Liquidity
		5.2.4 Performance
		5.2.5 Cash Needs
		5.2.6 Ability to Reduce Losses
	5.3 Participants in Futures Markets
		5.3.1 Hedgers
		5.3.3 Arbitragers
	5.4 Specifications of Futures Contracts
		5.4.1 The Underlying Asset
		5.4.2 The Contract Size
		5.4.3 Delivery Arrangements: Location
		5.4.4 Delivery Arrangements: Alternative Grade
		5.4.5 Delivery Month
		5.4.6 Delivery Notification
		5.4.7 Daily Price Movement Limits
		5.4.8 Position Limits
	5.5 Closing out the Positions
	5.6 Arbitrage Between the Futures Market and the Spot Market
	5.7 Performance of Contracts
	5.8 The Clearinghouse
	5.9 Margins and Marking-to-Market
	5.10 Price Quotes
	5.11 Settlement Price
	5.12 Open Interest
	5.13 The Pattern of Prices
	5.14 The Relation Between Futures Price and Spot Price
	5.15 Delivery
	5.16 Cash Settlement
	5.17 Types of Orders
		5.17.1 Market Orders
		5.17.2 Limit Orders
		5.17.3 Stop Orders
		5.17.4 Stop–Limit Orders
		5.17.5 Other Orders
	5.18 How to Trade in Futures?
	5.19 pricing of Futures Contracts
	Chapter Summary
	Review Questions
	Problems
	Case Study
Chapter 6: Hedging Strategies Using Futures
	6.1 The Principles of Hedging
	6.2 Long Hedges
	6.3 Short Hedges
	6.4 Should Hedging be Undertaken?
	6.5 Risks in Hedging
	6.6 Basis Risk
	6.7 Factors Affecting Basis Risk
	6.8 The Hedge Ratio
	6.9 Static and Dynamic Hedging
	6.10 Strip Hedges and Stack Rolling Hedges
	6.11 Losses from Hedging Using Futures
	Chapter Summary
	Review Questions
	Problems
	Case Study
Chapter 7: Single Stock Futures and Stock Index Futures
	7.1 Single Stock Futures
	7.2 What Is a Stock Futures Contract?
	7.3 Hedging Using Single Stock Futures
		7.3.1 What Type of Hedging is Appropriate?
		7.3.2 Which Instrument to Use?
		7.3.3 How Many Contracts to Use?
		7.3.4 When to Take an Open Position?
		7.3.5 When to Close the Position?
		7.3.6 Risks in Hedging Using Single Stock Futures
	7.4 Speculation Using Stock Futures
	7.5 Pricing of Single Stock Futures Contracts
	7.6 Single Stock Futures and Arbitrage
	7.7 Using Stock Futures for Insurance Purposes
	7.8 Using Stock Futures for Investment Purposes
	7.9 Stock Indexes
	7.10 Stock Index Futures
	7.11 Stock Index Futures Contracts Traded on the BSE and the NSE
	7.12 How do Index Futures Work?
	7.13 Pricing of Index Futures Contracts
	7.14 Speculation Using Index Futures
	7.15 Portfolio Insurance Using Index Futures
	7.16 Index Arbitrage
	7.17 Program Trading
	7.18 Hedging the Value of a Portfolio of Shares Using Index Futures
	7.19 Adjusting Equity Portfolio Beta Using Index Futures
	7.20 Issues in Using Index Futures
	Chapter Summary
	Review Questions
	Problems
	Case Study
Chapter 8: Interest Rate Futures
	8.1 The Impact of Interest Rate Risk and the Need for Hedging
	8.2 Interest Rate Futures in India
	8.3 Contract Specification
	8.4 Conversion Factor
	8.5 Cheapest-to-deliver Bonds
	8.6 The Pricing of Bond Futures
	8.7 Uses of Long-term Interest Rate Futures
		8.7.1 Directional Trading Directional trading is more
		8.7.2 Arbitrage It was seen that
		8.7.3 Calendar-spread Trading
		8.7.4 Hedging
		8.7.5 Fixed Income Portfolio Management
		8.7.6 Changing a Fixed Income Loan to a Floating-rate Loan
	8.8 Short-term Interest Rate Futures
	8.9 P ricing of T-bill Futures Contracts
	8.10 Hedging Using Bill Futures Contracts
	8.11 Uses of Short-term Interest Rate Futures Contracts
		8.11.1 Hedging Borrowing Costs
		8.11.2 Hedging an Investment Yield
		8.11.3 Hedging a Floating-rate Loan or Strip Hedging
		8.11.4 Directional Trades
		8.11.5 Spread Trades
		8.11.6 Arbitrage Transactions
		8.11.7 Adjusting the Duration of the Portfolio
		8.11.8 Cross-hedging
	8.12 Cautions in Using Interest Rate Futures
	Chapter Summary
	Review Questions
	Problems
	Case Study
Chapter 9: Currency Futures
	9.1 What Are Currency Futures?
	9.2 The Specifications of Exchange-traded Currency Futures Contracts
	9.3 The Pricing of Currency Futures
	9.4 Hedging with Currency Futures
	9.5 Basis Risk While Using Currency Futures
	9.6 Speculation Using Currency Futures
	9.7 Arbitraging with Currency Futures Contracts
	Chapter Summary
	Review Questions
	Problems
	Case Study
Chapter 10: Swaps
	10.1 What Are Swaps?
	10.2 Types of Swaps
	10.3 Terminologies in Swaps
	10.4 Interest Rate Swaps
	10.5 Swap Rates
	10.6 Rationale for Swap Arrangements
	10.7 Swap with Intermediaries
	10.8 Forward Swaps
	10.9 Swaptions
	10.10 Uses of Interest Rate Swaps
	10.11 Valuation of Interest Rate Swaps
	10.12 Currency Swaps
		10.12.1 Differences Between an Interest Rate Swap and a Currency Swap
		10.12.2 Basic Structure of Currency Swaps
	10.13 Currency Risk in Currency Swaps
	10.14 Comparative Advantages of Currency Swaps
	10.15 Uses of Currency Swaps
	10.16 The Valuation of a Currency Swap
	10.17 Equity Swaps
	10.18 The Valuation of an Equity Swap
	10.19 Commodity Swaps
	10.20 Risks While Entering into Interest Rate Swaps
	Chapter Summary
	Review Questions
	Problems
	Case Study
Chapter 11: Fundamentals of Options
	11.1 Options Issued by Corporations
		11.1.1 Warrants
		11.1.2 Employee Stock Options
		11.1.3 Convertible Bonds
		11.1.4 Callable Bonds
		11.1.5 Put Bonds
		11.1.6 Rights
	11.2 Options Contracts Between Private Parties
	11.3 Exchange-traded Options
	11.4 Options Contracts: An Example
	11.5 What Is an Options Contract?
	11.6 Options Terminologies
		11.6.1 The Underlying Asset
		11.6.2 Call and Put Options
		11.6.3 The Option Premium
		11.6.4 Exercising Options
		11.6.5 The Exercise Price or the Strike Price
		11.6.6 The Exercise Date or the Strike Date
		11.6.7 American and European Options
		11.6.8 Buyers and Writers of Options
		11.6.9 The Contract Size
		11.6.10 In-the-money, At-the-money and Out-of-money Options
	11.7 Exchange-traded and OTC Options: A Comparison
		11.7.1 Guarantee of Performance in Exchange-traded Options
		11.7.2 Margin Requirements
		11.7.3 Margin Calculation
		11.7.4 Standardization of Contracts
		11.7.5 Exercise Dates
		11.7.6 Exercise Prices
		11.7.7 Options Classes and Options Series
	11.8 Trading of Options
		11.8.1 Types of Orders
		11.8.2 Offsetting Orders
	11.9 Price Quotes
	11.10 Protection Against Corporate Actions
	Chapter Summary
	Review Questions
	Problems
	Case Study
Chapter 12: Call and Put Options
	12.1 What are Call Options?
	12.2 The Terminal Value of a Call Option
	12.3 Gains and Losses from Purchasing Call Options
	12.4 Value of a Call Option Before Maturity
	12.5 Minimum and Maximum Values of a Call
	12.6 When to Exercise an American Call Option
	12.7 From a Call Option Writer’s Point of View
		12.7.1 The Terminal Value of a Written Call
		12.7.2 Gains and Losses for a Call Writer
	12.8 Comparison Between the Gains Made by a Call Buyer and a Call Writer
	12.9 When to Buy and When to Write a Call Option?
	12.10 Put Options
		12.10.1 What Are Put Options?
		12.10.2 Rationale for Put Options
	12.11 The Terminal Value of a Put Option
	12.12 Gains and Losses from Purchasing Put Options
	12.13 Value of a Put Option Before Maturity
	12.14 Minimum and Maximum Values of Put
	12.15 When to Exercise a Put Option
	12.16 From a Put Option Writer’s Point of View
		12.16.1 The Terminal Value of a Written Put
		12.16.2 Gains and Losses for a Put Writer
	12.17 Comparison Between the Gains Made by a Put Buyer and a Put Writer
	12.18 When to Buy and When to Write a Put Option
	12.19 Comparison Between Calls and Puts
	Chapter Summary
	Review Questions
	Problems
	Case Study
Chapter 13: Combinations of Options: Trading Strategies
	13.1 Naked or Uncovered Positions
		13.1.1 Naked Long Stock Positions
		13.1.2 Naked Short Stock Positions
		13.1.3 Naked Bought Calls
		13.1.4 Naked Written Calls
		13.1.5 Naked Bought Puts
		13.1.6 Naked Written Puts
	13.2 Hedge or Covered Positions
		13.2.1 Covered Call Writing
		13.2.2 Reverse Hedges
		13.2.3 Protective Puts
		13.2.4 Short Stocks and Short Puts
		13.2.5 Partial Hedges
		13.2.6 Summary of Hedged Positions
	13.3 Spread Positions
		13.3.1 Money Spread Using Calls
		13.3.2 Money Spreads Using Puts
		13.3.3 Box Spreads
		13.3.4 Butterfly Spreads
		13.3.5 Calendar Spreads
		13.3.6 Iron Condor Spreads
	13.4 Combinations of Puts and Calls
		13.4.1 Straddles
		13.4.2 Strips
		13.4.3 Straps
		13.4.4 Strangles
		13.4.5 Other Pay-offs
		13.5 Losses from Options Trading
	Chapter Summary
	Review Questions
	Problems
	Case Study
Chapter 14: Put–Call Parity
	14.1 Risk-free Security
	14.2 Strategies Using Options, a Risk-free Security and Underlying Assets
		14.2.1 Combination of Call Options and Risk-free Securities
		14.2.2 Combination of Long Stocks and Long Puts
	14.3 The Put–Call Relationship
	14.4 Put–Call Arbitrage
	14.5 Creation of Synthetic Securities
		14.5.1 Creation of Synthetic Puts
		14.5.2 The Written Put Strategy
		14.5.3 The Bought Call Strategy
		14.5.4 The Written Call Strategy
		14.5.5 The Strategy of Investing at a Risk-free Rate
		14.5.6 The Strategy for Borrowing at a Risk-free Rate
		14.5.7 Cautions in Creating Synthetic Positions
	14.6 Put–Call Parity for Dividend-paying Stocks: European Options
	14.7 Put–Call Parity for American Options
		14.7.1 Early Exercise of American Call Options: Non-dividend-paying Stock
		14.7.2 Early Exercise of Call Options: Dividend-paying Stock
		14.7.3 Early Exercise of Put Options: Non-dividend-paying Stock
		14.7.4 Put–Call Parity for American Options When Dividends Are Not Paid
		14.7.5 Put–Call Parity for American Options When Dividends Are Paid
	14.8 Implications of Put–Call Parity
	14.9 Put–Call parity and Regulatory Arbitrage
	Chapter Summary
	Review Questions
	Problems
	Case Study
Chapter 15: The Binomial Options Pricing Model
	15.1 The Binomial Options Pricing Model for Call Options
	15.2 The Binomial Options Pricing Model for Put Options
	15.3 The Relation Between the Hedge Ratios for Call and Put Options
	15.4 The No-arbitrage Pricing Argument
	15.5 The Derivation of the Binomial Options Pricing Model
	15.6 The Single-period Binomial Options Pricing Model
	15.7 The Two-period Binomial Options Pricing Model
	15.8 The Multi-period Binomial Options Pricing Model
	15.9 The Determination of u and d
	15.10 The Valuation of a European Call Paying a Given Dividend Amount
	15.11 The Valuation of an American Call Paying a Given Dividend Amount
	15.12 The Binomial Put Options Pricing Model
	Chapter Summary
	Review Questions
	Problems
	Case Study
Chapter 16: The Black–Scholes Options Pricing Model
	16.1 The History of Options Pricing Research
	16.2 Stock Price Behaviour
		16.2.1 Lognormal Distribution
		16.2.2 The Valuation of Options
	16.3 The Assumptions in the Black–Scholes Options Pricing Model
	16.4 The Black–Scholes Model for Pricing Call Options
	16.5 The Black–Scholes Model for Pricing Put Options
	16.6 Determinants of Options Prices
		16.6.1 The Current Price of the Underlying Asset
		16.6.2 The Exercise Price
		16.6.3 The Time to Expiration
		16.6.4 Volatility of the Underlying Asset
		16.6.5 The Risk-free Rate
	16.7 The Options Pricing Model for Securities that Pay Known Dividends
	16.8 Volatility
	16.9 Implied Volatility
	16.10 Volatility Smile
	Chapter Summary
	Review Questions
	Problems
	Case Study
Chapter 17: Currency Options, Interest Rate Options and Options on Futures
	17.1 Currency options
	17.2 Interest Rate Options
		17.2.1 Bond Options
		17.2.2 Embedded Bond Options
		17.2.3 Interest Rate Options
	17.3 Interest Rate Caps, Floors and Collars
		17.3.1 Interest Rate Caps
		17.3.2 Interest Rate Floors
		17.3.3 Interest Rate Collars
	17.4 Pricing Interest Rate Options
	17.5 Valuing an Interest Rate Cap or Floor
	17.6 Options on Futures or Futures Options
		17.6.1 Model for Valuing Options on Futures Contracts
	Chapter Summary
	Review Questions
	Problems
	Case Study
Chapter 18: Greeks in Options
	18.1 Risks in Options Trading
	18.2 Characteristics of Options Hedging
		18.2.1 The Naked Position
		18.2.2 The Covered Position
		18.2.3 Hedging Through the Cap
	18.3 Greeks in Options Hedging
	18.4 Delta
		18.4.1 The Use of Futures in Delta Hedging
		18.4.2 The Delta of a Portfolio
	18.5 Gamma
		18.5.1 Making a Portfolio Gamma-neutral
		18.5.2 Calculating Gamma
	18.6 Theta
	18.7 The Relationship Between Delta, Gamma and Theta
	18.8 Vega
	18.9 Rho
	18.10 Creating Portfolio Insurance Using Synthetic Puts
	18.11 Hedging Options positions in practice
	Chapter Summary
	Review Questions
	Problems
	Case Study
Chapter 19: Exotic Options
	19.1 Differences Between Plain Vanilla Options and Exotic Options
	19.2 Asian Options
	19.3 Barrier Options
		19.3.1 Down-and-out Options
		19.3.2 Down-and-in Options
		19.3.3 Up-and-in Barrier Options
	19.4 Chooser Options
	19.5 Compound Options
	19.6 Digital or Binary Options
	19.7 Exchange Options
	19.8 Basket Options
	19.9 Bermudan Options
	19.10 Cliquet/Ratchet Options
	19.11 Coupe Options
	19.12 Extendible Options
	19.13 Hawaiian Options
	19.14 Instalment Options
	19.15 Israeli Options
	19.16 Parisian Options
	19.17 Passport Options
	19.18 Rainbow Options
	19.19 Russian Options
	19.20 Shout Options
	19.21 Spread Options
	19.22 Quanto Options
	19.23 Forward Start Options
	19.24 Edokko Options or Tokyo Options
	19.25 Lookback Options
	19.26 Extreme Spread Options
	19.27 Mountain Range Options
	Chapter Summary
	Review Questions
Chapter 20: Credit Derivatives
	20.1 An Introduction to Credit Derivatives
	20.2 Credit Risk
	20.3 What Are Credit Derivatives?
	20.4 Basic Credit Derivatives Structures
	20.5 Credit Default Swaps
		20.5.1 Credit Events
		20.5.2 Contingent Payments
		20.5.3 Notional Value
		20.5.4 Protection Buyers
		20.5.5 Protection Sellers
		20.5.6 Premium
		20.5.7 The Tenure
		20.5.8 The Threshold Risk
		20.5.9 The Settlement
	20.6 An Example of a CDS
	20.7 Counterparty Risk and Synthetic Lending
	20.8 Contingent Credit Swaps
	20.9 Dynamic Credit Swaps
	20.10 Total Return Swaps
	20.11 Credit Options
	20.12 Credit-linked Notes
	20.13 Credit Derivatives Versus Financial Guarantee Products
	Chapter Summary
	Review Questions
Glossary
Bibliography
	Credit Derivatives
	Forwards and Futures
	Options
	Risk Management
	Swaps
Index