Financial Derivatives: Markets and Applications

Contents
Preface
About the Book
New to This Edition
About the Author
Acknowledgments
Chapter 1 Derivatives: Introduction and Overview
	Introduction
	1.1 What are Derivative Instruments?
	1.2 Common Derivative Instruments
	1.3 Evolution of Derivative Instruments
		1.3.1 Forward Contracts
		1.3.2 The Need for Futures Contracts
		1.3.3 The Need for Options
		1.3.4 The Advent of Swaps
	1.4 OTC versus Exchange-Traded Derivatives
	1.5 The Main Players in Derivative Markets
	1.6 Commodity versus Financial Derivatives
	1.7 Types of Risks
	1.8 Overview of Global Trading in Derivatives
	SUMMARY
		KEY TERMS
		End-of-Chapter Questions
Chapter 2 Derivative Markets and Trading
	Introduction
	2.1 Trading Methods
		2.1.1 Open-Outcry or Auction Methods
		2.1.2 Order Routing/Trade Execution
		2.1.3 Computerized/Screen-Based Trading
		2.1.4 Open-Outcry versus Computerized Systems
	2.2 The Role of a Derivatives Clearinghouse
	2.3 Derivatives Trading in Malaysia
		2.3.1 Bursa Malaysia Derivatives
		2.3.2 The Regulation of Derivatives in Malaysia
		2.3.3 Trading Performance of Derivatives in Malaysia
	2.4 Hong Kong Exchanges and Clearing
		2.4.1 Market Crash and Reform
		2.4.2 The Regulatory Framework for Derivatives
		2.4.3 Trading Performance of Hong Kong Derivatives
			2.4.3.1 HKEX Futures Contr
			2.4.3.2 HKEX Option Contracts
	2.5 Derivatives in Singapore
		2.5.1 SGX — Trading Performance
	2.6 Derivatives in Thailand
		2.6.1 Financial Crisis and Derivative Markets
		2.6.2 Trading Performance of Thailand Derivatives
			2.6.2.1 TFEX Futures Contracts
			2.6.2.2 TFEX Option Contracts
	2.7 Relative Trading Performance of the Four Derivatives Exchanges
	SUMMARY
		KEY TERMS
		End-of-Chapter Questions
Chapter 3 Forward and Futures Markets: Pricing and Analysis
	Introduction
	3.1 Forward Contracts
	3.2 Futures Contracts
		3.2.1 Multiple Coincidence of Needs
		3.2.2 Potential for Price Squeeze/Unfair Price
		3.2.3 Counterparty/Default Risk
	3.3 Mechanics of Futures Trading
	3.4 Margining and Marking-to-Market
	3.5 Forwards, Futures: Zero-Sum Game
	3.6 Futures Markets — The Main Players
		3.6.1 Hedgers
		3.6.2 Arbitrageurs
		3.6.3 Speculators
	3.7 Determination of Futures Prices
	3.8 Issues in Futures Trading
		3.8.1 The Convergence Property
		3.8.2 Basis and Basis Risk
		3.8.3 Cross-Hedging
		3.8.4 Leverage and Transaction Costs
		3.8.5 Margins and Leverage Factor
		3.8.6 Contango and Normal Backwardation
		3.8.7 Open Interest and Trading Volume
	3.9 Types of Orders
		3.9.1 Price-Related Orders
		3.9.2 Execution-Related Orders
		3.9.3 Time-Related Orders
	SUMMARY
		KEY TERMS
		End-of-Chapter Quest
	Appendix
		The Crude Palm Oil Futures Contract
		Pricing CPO Futures Contracts
		CPO Pricing: An illustration
		CPO Futures Contracts: Applications
Chapter 4 Stock Index Futures Contracts: Analysis and Applications
	Introduction
	4.1 Why Use SIF Contracts?
		4.1.1 Diversification Benefits
		4.1.2 Lower Transaction Cost
		4.1.3 Provides Leverage
		4.1.4 Market Exposure and Stock Selection
		4.1.5 Hedging, Portfolio Insurance, and Risk Management
	4.2 Index Construction and Types of Indexes
		4.2.1 An Equally Weighted Index
		4.2.2 Capitalization Weighted Index
		4.2.3 Geometrically Weighted Index
	4.3 FBM KLCI Futures, Contract Specifications
	4.4 SIF Trading — The Main Players
	4.5 The Pricing of SIF Contracts
		4.5.1 Using the Cost of Carry Model: An Example
		4.5.2 Dividend Yields and Dividend Payment Patterns
	4.6 Applications of SIF Contracts
		4.6.1 Index Arbitrage
		4.6.2 Hedging
		4.6.3 Creating Synthetic Position (Replication)
		4.6.4 Speculating with SIF Contracts
		4.6.5 Spread Trading
	4.7 SIF in Thailand
		4.7.1 Index Arbitrage with SET 50 Index Futures Contracts
			4.7.1.1 Cash and Carry Arbitrage
			4.7.1.2 Reverse Cash and Carry Arbitrage
		4.7.2 Hedging with SET 50 Index Futures Contract
		4.7.3 Speculating with SET 50 Index Futures Contracts
			4.7.3.1 Speculative Position: Bullish Expectation
			4.7.3.2 Speculative Position: Bearish Expectation
		4.7.4 The Congruence in Strategies Amongst Contracts
	4.8 SIF Contracts and Portfolio Management
		4.8.1 Adjusting Portfolio Betas with SIF Contracts
		4.8.2 Adjusting Asset Allocation
	4.9 Issues in SIF Pricing
	4.10 Issues in SIF Trading
		4.10.1 Volatility of Underlying Stock Market
		4.10.2 Volume Migration from Spot to SIF
		4.10.3 Lead–Lag Relationships in Returns and Volatility
		4.10.4 Patterns in Intraday Trading and Volatility
		4.10.5 Intermarket Spread Trading
	4.11 Growth and Trading Performance of the FBM KLCI and the SET 50 Index Futures Contracts
	4.12 Single Stock Futures
		4.12.1 SSFs in Malaysia
		4.12.2 SSF in Thailand
		4.12.3 SSF — Trading Mechanics
		4.12.4 Why Use SSF Contracts?
		4.12.5 Pricing a SSF Contract
		4.12.6 SSF — Applications
	SUMMARY
		KEY TERMS
		End-of-Chapter Questions
Chapter 5 Interest Rate Futures Contracts and Currency Futures Contracts
	Introduction
	5.1 Interest Rate Futures Contracts
	5.2 What is Interest Rate Risk?
	5.3 Bond Pricing, Yields, and Interest Rate Risk
		5.3.1 Bond Yield and Yield Curves
		5.3.2 Interest Rate Change, Bond Yields, and Duration
	5.4 The 3-Month KLIBOR Futures Contract
	5.5 Contract Specifications — 3-Month KLIBOR and 3-Month BIBOR Futures
		5.5.1 Pricing IRF Contracts
	5.6 Determining the Equilibrium Price: The Implied Forward Rate
	5.7 3-Month IRF: Applications
		5.7.1 Locking in the Cost of Borrowing
		5.7.2 Hedging: Protecting Interest Income/Revenue
		5.7.3 Speculating on Interest Rate Movements
		5.7.4 Arbitraging with IRF
		5.7.5 The Reverse Cash and Carry Arbitrage
	5.8 Singapore Exchange’s IRF Contract: The 10-Year Mini Japanese Government Bond Futures Contract
		5.8.1 SGX Mini JGB Futures: Applications
		5.8.2 Speculating on Interest Rate Movements
		5.8.3 Arbitraging with SGX Mini JGB Futures
	5.9 Determinants of IRF Prices
	5.10 Contract Performance
	5.11 Currency Forward and Futures Contracts
	5.12 The HKEX’s US$/CNH Currency Futures Contract
		5.12.1 Currency Futures — Applications for Hedging, Speculation, and Arbitrage
		5.12.2 Speculating with Currency Futures
		5.12.3 Arbitraging with Currency Futures
	SUMMARY
		KEY TERMS
		End-of-Chapter Questions
	Appendix
		Why Interest Rate Risk Matters
		Managing Interest Rate Risk
		Basic Gap Analysis — An Illustration
		The Maturity Bucket Approach
		Maturity Bucket Approach: An Illustration
		Hedging the Interest Rate Risk
		Analysis of the Hedged 1-Month Position
		Analysis of the Hedged 3-Month Position
		Simplified Bank Balance Sheet
Chapter 6 Introduction to Options
	What Are Options?
	6.1 Calls and Puts
	6.2 Payoffs to Investing in Stocks versus Options
		6.2.1 Stock versus Option Positions
		6.2.2 Forward/Futures versus Option Positions
	6.3 Expectations and Option Positions
	6.4 Options: Uses and Applications
	6.5 Option Moneyness
		6.5.1 Option Valuation
		6.5.2 Time Decay and Options
	SUMMARY
		KEY TERMS
		End-of-Chapter Questions
Chapter 7 Equity, Equity Index, and Currency Options
	Introduction
	7.1 Trading Option Contracts
	7.2 Option Premiums and Underlying Asset Price
	7.3 American-Style Options and Early Exercise
	7.4 Intermediation and Margining
	7.5 Option Classes and Series
	7.6 Malaysia’s FBM KLCI Options: Contract Specifications
	7.7 Stock Options Traded on Hong Kong’s HKEX
	7.8 Stock Index Options in Thailand — The SET 50 Index Options
		7.8.1 SET 50 Index Options: Applications
			7.8.1.1 Hedging Equity Exposure with SET 50 Index Options
			7.8.1.2 Speculating with SET 50 Index Options
			7.8.1.3 Arbitrage Strategy — Arbitraging with Index Options
	7.9 Currency Options
		7.9.1 Applications with Currency Options
			7.9.1.1 Hedging Exchange Rate Risk with Currency Options
			7.9.1.2 Speculating with Currency Options
			7.9.1.3 Arbitraging with Currency Options
	SUMMARY
		KEY TERMS
		End-of-Chapter Questions
	Appendix
		Singapore — The SGX Nikkei 225 Stock Index Option Contracts
		SGX Nikkei 225 Index Options: Applications
		Arbitrage Strategy
Chapter 8 Option Strategies and Payoffs
	Introduction
	8.1 Uncovered/Naked Positions
	8.2 Hedge Strategies
		8.2.1 Hedging a Long Stock Position (Portfolio Insurance)
		8.2.2 Hedging a Short Stock Position
		8.2.3 Conversion Strategy (Locking-in a Fixed Value of Underlying Asset)
	8.3 Spread Strategies
		8.3.1 A Bull Call Spread: Illustration
		8.3.2 A Bull Put Spread
		8.3.3 A Bear Call Spread
		8.3.4 Bear Put Spread
	8.4 Combination Strategies
		8.4.1 Straddle Strategy
		8.4.2 Long Straddle: Illustration
		8.4.3 Short Straddle: Illustration
		8.4.4 Strangle Strategy
		8.4.5 Long Strangle: Illustration
		8.4.6 Short Strangle Strategy
	8.5 Covered Call Strategy
	8.6 Butterfly, Condor, Ratio, and Box Spreads
	8.7 Summary of Strategies by Market Outlook
	SUMMARY
		KEY TERMS
		End-of-Chapter Questions
Chapter 9 Option Pricing
	Introduction
	9.1 Asset Valuation in Finance
	9.2 The Binomial Option Pricing Model
		9.2.1 Binomial Option Pricing: Probabilities and Volatility
		9.2.2 Volatility and BOPM Option Value
		9.2.3 Pricing Put Options with BOPM
	9.3 The Black–Scholes Option Pricing Model
		9.3.1 The Underlying Logic of BSOPM
		9.3.2 Underlying Assumptions of the BSOPM
		9.3.3 Pricing Put Options
	9.4 Determinants of Option Prices
	9.5 Illustration of Price Dynamics — Changing Call and Put Values
	9.6 Issues in Option Pricing
	9.7 Implied Volatility
	9.8 Valuing Equity Index Options
		9.8.1 Pricing Stock Index Options
		9.8.2 Valuing Call Options on Stock Index Futures
	9.9 Valuing Currency Options
	SUMMARY
		KEY TERMS
		End-of-Chapter Questions
	Appendix 1
		Option Greeks and Comparative Statics
		Option Greeks — Dynamics
		Option Deltas and Gammas
		Estimating Sensitivity: Comparative Statics
		Comparative Statics: Illustration
		Option Greeks and Trading/Investment Strategies
		Trading Volatility
		Position Deltas and Gammas
	Appendix II
		(1) A Multiperiod Binomial Model
		(2) Pricing American-Style Options
			Compound Option Approach
			Analytical Approximation Approach
		(3) Other Stock/Index Option Models
			Comparison of Models
Chapter 10 Replication, Synthetics, and Arbitrage
	Introduction
	10.1 Replication and Synthetics
		10.1.1 A Synthetic Long Stock Position
		10.1.2 A Synthetic Short Stock Position
		10.1.3 A Synthetic Long Call Position
		10.1.4 A Synthetic Short Call Position
		10.1.5 A Synthetic Long Put Position
		10.1.6 A Synthetic Short Put Position
	10.2 Put–Call Parity and Arbitrage
		10.2.1 Put–Call Parity and Arbitrage: Illustration
		10.2.2 Mispricing and Arbitrage: Another Illustration
		10.2.3 Determining Arbitrage Strategy
	10.3 Put–Call Parity, Conversion, and Delta Neutral Trading
	10.4 Put–Call Parity — Empirical Evidence
	SUMMARY
		KEY TERMS
		End-of-Chapter Questions
Chapter 11 Options in Corporate Finance and Real Options
	Introduction
	11.1 Levered Equity: An Options Approach
		11.1.1 Payoff to Levered Equity
		11.1.2 Payoff to Debt
		11.1.3 Payoff Profile and Incentive Effects
	11.2 A Rights Issue
	11.3 The Value of Underwriting a Securities Issue
	11.4 Securities with Option-Like Features
	11.5 Real Options and Capital Budgeting
	11.6 Exotic Options
		11.6.1 Barrier Options
		11.6.2 Forward Start Options
		11.6.3 Binary Options
		11.6.4 Asian Options
		11.6.5 Other Structured Products
		11.6.6 Structured Warrants
	SUMMARY
		KEY TERMS
		End-of-Chapter Questions
	Appendix
		Pricing Convertible Bonds and ICULS1
		Value of Convertible at Maturity/at Exercise
		Payoff Profile to ICULS
Chapter 12 Interest Rate Swaps, Credit, and Other Derivatives
	Introduction
	12.1 Interest Rate Swaps
		12.1.1 Why Use IRS?
	12.2 IRS — Applications
		12.2.1 Arbitrage Using IRS
		12.2.2 Hedging Interest Rate Risk with IRS
		12.2.3 Hedging Duration Gaps
		12.2.4 Speculating with IRS
		12.2.5 Duration Gaps and Interest Rate Expectation
	12.3 Pricing IRS
	12.4 Currency Swaps
		12.4.1 Illustration: A Currency Swap
		12.4.2 Arbitraging Credit Spreads with Currency Swaps
		12.4.3 Illustration: Using a Currency Swap to Arbitrage
	12.5 Nondeliverable Forward Contracts
		12.5.1 Why NDFs?
		12.5.2 NDF — Applications
	12.6 Forward Rate Agreement
	12.7 Credit Derivatives
	12.8 Credit Swaps
		12.8.1 A Credit Default Swap
		12.8.2 A Loan Portfolio Swap
		12.8.3 A Total Return Swap
	12.9 Credit Options
		12.9.1 Illustration: Use of Credit Options Call Options on Credit Risk Premiums — for Bond Issuers
		12.9.2 Put Options on Credit Risk Premiums — for Investors of Bond/ Debt Instruments
	12.10 Credit-Linked Notes
	12.11 Contract for Difference
		12.11.1 Illustration: Mechanics of a CFD
	SUMMARY
		KEY TERMS
		End-of-Chapter Questions
Chapter 13 Derivative Instruments and Islamic Finance
	Introduction
	13.1 Necessary Features for Islamic Financial Instruments
	13.2 Islamic Finance Instruments with Features of Derivative Instruments
		13.2.1 Ba’i Salam
		13.2.2 Istisna and Joa’la Contracts
		13.2.3 The Istijrar Contract
	13.3 The Ba'i Al-Urbun
	13.4 The Bai bil-Wafa and Bai bil-Istighlal Contracts
	13.5 The Islamic Profit Rate Swap
		13.5.1 Mechanics of the IPRS
	13.6 Islamic Structured Products
		13.6.1 Examples of Structured Products Offered by Islamic Banks
		13.6.2 Risks Associated with Structured Products
		13.6.3 Islamic Structured Products — Challenges
	13.7 Sukuk with Embedded Options
	13.8 Shariah Views on the Trading of Currency and Shariah-Compliant Tools for Managing Currency Risk
	13.9 Islamic View of Current-Day Derivative Instruments
		13.9.1 Opinions on Futures Contracts
		13.9.2 Opinions on Option Contracts
	13.10 The Need for Harmonization
	SUMMARY
		KEY TERMS
		End-of-Chapter Questions
Answers to Select End-of-Chapter Questions
	Chapter 1
	Chapter 2
	Chapter 3
	Chapter 4
	Chapter 5
	Chapter 6
	Chapter 7
	Chapter 8
	Chapter 9
	Chapter 10
	Chapter 11
	Chapter 12
	Chapter 13
References and Further Reading
Formulas
Index