Options, Futures, and Other Derivatives, Global Edition

Cover
......Page 1
Title Page......Page 4
Copyright Page......Page 5
Contents in Brief......Page 7
Contents......Page 8
List of Business Snapshots......Page 18
List of Technical Notes......Page 19
Preface......Page 20
Chapter 1.Introduction......Page 24
1.1 Exchange-traded markets......Page 25
1.2 Over-the-counter markets......Page 26
1.3 Forward contracts......Page 29
1.5 Options......Page 31
1.7 Hedgers......Page 34
1.8 Speculators......Page 37
1.9 Arbitrageurs......Page 39
1.10 Dangers......Page 40
Summary......Page 41
Practice questions......Page 42
Further questions......Page 44
2.1 Background......Page 47
2.2 Specification of a futures contract
......Page 49
2.3 Convergence of futures price to spot price......Page 51
2.4 The operation of margin accounts......Page 52
2.5 OTC markets......Page 55
2.6 Market quotes......Page 58
2.7 Delivery......Page 61
2.8 Types of traders and types of orders......Page 62
2.9 Regulation......Page 63
2.10 Accounting and tax......Page 64
Summary......Page 67
Practice questions......Page 68
Further questions......Page 70
3.1 Basic principles......Page 72
3.2 Arguments for and against hedging......Page 74
3.3 Basis risk......Page 77
3.4 Cross hedging......Page 81
3.5 Stock index futures......Page 85
3.6 Stack and roll......Page 91
Further reading......Page 93
Practice questions......Page 94
Further questions......Page 96
Appendix: Capital asset pricing model......Page 98
4.1 Types of rates......Page 100
4.2 Measuring interest rates......Page 102
4.4 Bond pricing......Page 105
4.5 Determining Treasury zero rates......Page 107
4.6 Forward rates......Page 109
4.7 Forward rate agreements......Page 111
4.8 Duration......Page 114
4.9 Convexity......Page 118
4.10 Theories of the term structure of interest rates......Page 119
Summary......Page 121
Practice questions......Page 122
Further questions......Page 125
5.1 Investment assets vs. consumption assets......Page 127
5.2 Short selling......Page 128
5.3 Assumptions and notation......Page 129
5.4 Forward price for an investment asset......Page 130
5.5 Known income......Page 133
5.7 Valuing forward contracts......Page 135
5.8 Are forward prices and futures prices equal?......Page 137
5.9 Futures prices of stock indices......Page 138
5.10 Forward and futures contracts on currencies......Page 140
5.11 Futures on commodities......Page 143
5.12 The cost of carry......Page 146
5.14 Futures prices and expected future spot prices......Page 147
Summary......Page 149
Practice questions......Page 151
Further questions......Page 153
6.1 Day count and quotation conventions......Page 155
6.2 Treasury bond futures......Page 158
6.3 Eurodollar futures......Page 163
6.4 Duration-based hedging strategies using futures......Page 168
Summary......Page 170
Practice questions......Page 171
Further questions......Page 173
Chapter 7.Swaps......Page 175
7.1 Mechanics of interest rate swaps......Page 176
7.2 Day count issues......Page 181
7.4 The comparative-advantage argument......Page 182
7.5 The nature of swap rates......Page 186
7.7 Valuation of interest rate swaps......Page 187
7.9 Fixed-for-fixed currency swaps
......Page 191
7.10 Valuation of fixed-for-fixed currency swaps
......Page 195
7.11 Other currency swaps......Page 198
7.12 Credit risk......Page 199
7.13 Other types of swaps
......Page 201
Summary......Page 203
Practice questions......Page 204
Further questions......Page 206
8.1 Securitization......Page 208
8.2 The US housing market......Page 212
8.3 What went wrong?......Page 216
8.4 The aftermath......Page 218
Summary......Page 219
Further reading......Page 220
Further questions......Page 221
9.1 The risk-free rate......Page 223
9.2 The OIS rate......Page 225
9.3 Valuing swaps and FRAs with OIS discounting......Page 228
9.4 OIS vs. LIBOR: Which is correct?......Page 229
9.5 Credit risk: CVA and DVA......Page 230
9.6 Funding costs......Page 232
Summary......Page 233
Practice questions......Page 234
Further questions......Page 235
10.1 Types of options......Page 236
10.2 Option positions......Page 238
10.3 Underlying assets......Page 240
10.4 Specification of stock options
......Page 241
10.6 Commissions......Page 246
10.7 Margin requirements......Page 247
10.8 The options clearing corporation......Page 249
10.10 Taxation......Page 250
10.12 Over-the-counter options markets......Page 252
Summary......Page 253
Practice questions......Page 254
Further questions......Page 255
11.1 Factors affecting option prices
......Page 257
11.3 Upper and lower bounds for option prices......Page 261
11.4 Put–call parity......Page 264
11.5 Calls on a non-dividend-paying stock......Page 268
11.6 Puts on a non-dividend-paying stock......Page 269
11.7 Effect of dividends
......Page 272
Summary......Page 273
Practice questions......Page 274
Further questions......Page 276
12.1 Principal-protected notes......Page 277
12.2 Trading an option and the underlying asset......Page 279
12.3 Spreads......Page 281
12.4 Combinations......Page 289
12.5 Other payoffs
......Page 292
Summary......Page 293
Practice questions......Page 294
Further questions......Page 295
13.1 A one-step binomial model and a no-arbitrage argument......Page 297
13.2 Risk-neutral valuation......Page 301
13.3 Two-step binomial trees......Page 303
13.4 A put example......Page 306
13.5 American options......Page 307
13.6 Delta......Page 308
13.7 Matching volatility with u and d......Page 309
13.9 Increasing the number of steps......Page 311
13.10 Using DerivaGem......Page 312
13.11 Options on other assets......Page 313
Summary......Page 316
Further reading......Page 317
Practice questions......Page 318
Further questions......Page 319
Appendix: Derivation of the Black–Scholes–Merton option-pricing formula from a binomial tree......Page 321
14.1 The Markov property......Page 325
14.2 Continuous-time stochastic processes......Page 326
14.3 The process for a stock price......Page 331
14.4 The parameters......Page 334
14.5 Correlated processes......Page 335
14.6 Itô’s lemma
......Page 336
14.7 The lognormal property......Page 337
Summary......Page 338
Practice questions......Page 339
Further questions......Page 340
Appendix: Derivation of Itô’s lemma 
......Page 342
Chapter 15.The Black–Scholes–Merton model......Page 344
15.1 Lognormal property of stock prices......Page 345
15.2 The distribution of the rate of return......Page 346
15.3 The expected return......Page 347
15.4 Volatility......Page 348
15.5 The idea underlying the Black–Scholes–Merton differential equation
......Page 352
15.6 Derivation of the Black–Scholes–Merton differential equation
......Page 354
15.7 Risk-neutral valuation......Page 357
15.8 Black–Scholes–Merton pricing formulas......Page 358
15.9 Cumulative normal distribution function......Page 361
15.10 Warrants and employee stock options......Page 362
15.11 Implied volatilities......Page 364
15.12 Dividends......Page 366
Summary......Page 369
Further reading......Page 370
Practice questions......Page 371
Further questions......Page 373
Appendix: Proof of Black–Scholes–Merton formula using risk-neutral valuation......Page 375
16.1 Contractual arrangements......Page 377
16.2 Do options align the interests of shareholders and managers?......Page 379
16.3 Accounting issues......Page 380
16.4 Valuation......Page 381
16.5 Backdating scandals......Page 386
Summary......Page 387
Practice questions......Page 388
Further questions......Page 389
17.1 Options on stock indices......Page 390
17.2 Currency options......Page 392
17.3 Options on stocks paying known dividend yields......Page 395
17.4 Valuation of European stock index options......Page 397
17.5 Valuation of European currency options......Page 400
17.6 American options......Page 401
Further reading......Page 402
Practice questions......Page 403
Further questions......Page 405
18.1 Nature of futures options......Page 406
18.3 European spot and futures options......Page 409
18.4 Put–call parity......Page 410
18.5 Bounds for futures options......Page 411
18.6 Valuation of futures options using binomial trees......Page 412
18.7 Drift of a futures price in a risk-neutral world......Page 414
18.8 Black’s model for valuing futures options......Page 415
18.10 Futures-style options......Page 417
Summary......Page 418
Practice questions......Page 419
Further questions......Page 420
19.1 Illustration......Page 422
19.3 A stop-loss strategy......Page 423
19.4 Delta hedging......Page 425
19.5 Theta......Page 432
19.6 Gamma......Page 434
19.7 Relationship between delta, theta, and gamma......Page 437
19.8 Vega......Page 438
19.9 Rho......Page 440
19.10 The realities of hedging......Page 441
19.12 Extension of formulas......Page 442
19.13 Portfolio insurance......Page 445
Summary......Page 447
Practice questions......Page 449
Further questions......Page 451
Appendix: Taylor series expansions and hedge parameters......Page 453
20.1 Why the volatility smile is the same for calls and puts......Page 454
20.2 Foreign currency options......Page 456
20.3 Equity options......Page 459
20.4 Alternative ways of characterizing the volatility smile......Page 460
20.5 The volatility term structure and volatility surfaces......Page 461
20.6 Greek letters......Page 462
20.8 When a single large jump is anticipated......Page 463
Summary......Page 465
Practice questions......Page 466
Further questions......Page 468
Appendix: Determining implied risk-neutral distributions from volatility smiles......Page 470
21.1 Binomial trees......Page 473
21.2 Using the binomial tree for options on indices, currencies, and futures contracts......Page 481
21.3 Binomial model for a dividend-paying stock......Page 483
21.4 Alternative procedures for constructing trees......Page 488
21.5 Time-dependent parameters......Page 491
21.6 Monte Carlo simulation......Page 492
21.7 Variance reduction procedures......Page 498
21.8 Finite difference methods
......Page 501
Summary......Page 511
Further reading......Page 512
Practice questions......Page 513
Further questions......Page 515
22.1 The VaR measure......Page 517
22.2 Historical simulation......Page 520
22.3 Model-building approach......Page 524
22.4 The linear model......Page 527
22.5 The quadratic model......Page 532
22.6 Monte Carlo simulation......Page 534
22.7 Comparison of approaches......Page 535
22.9 Principal components analysis......Page 536
Further reading......Page 540
Practice questions......Page 541
Further questions......Page 542
23.1 Estimating volatility......Page 544
23.2 The exponentially weighted moving average model......Page 546
23.3 The GARCH (1,1) model......Page 548
23.4 Choosing between the models......Page 549
23.5 Maximum likelihood methods......Page 550
23.6 Using GARCH (1,1) to forecast future volatility......Page 555
23.7 Correlations......Page 558
23.8 Application of EWMA to four-index example......Page 561
Practice questions......Page 563
Further questions......Page 565
24.1 Credit ratings......Page 567
24.2 Historical default probabilities......Page 568
24.3 Recovery rates......Page 569
24.4 Estimating default probabilities from bond yield spreads......Page 570
24.5 Comparison of default probability estimates......Page 573
24.6 Using equity prices to estimate default probabilities......Page 576
24.7 Credit risk in derivatives transactions......Page 578
24.8 Default correlation......Page 584
24.9 Credit VaR......Page 587
Further reading......Page 590
Practice questions......Page 591
Further questions......Page 592
Chapter 25.Credit derivatives......Page 594
25.1 Credit default swaps......Page 595
25.2 Valuation of credit default swaps......Page 598
25.3 Credit indices......Page 602
25.4 The use of ?xed coupons......Page 603
25.7 Total return swaps......Page 604
25.8 Collateralized debt obligations......Page 606
25.10 Valuation of a synthetic CDO......Page 608
25.11 Alternatives to the standard market model......Page 615
Further reading......Page 617
Practice questions......Page 618
Further questions......Page 619
26.1 Packages......Page 621
26.2 Perpetual American call and put options......Page 622
26.3 Nonstandard American options......Page 623
26.4 Gap options......Page 624
26.7 Compound options......Page 625
26.8 Chooser options......Page 626
26.9 Barrier options......Page 627
26.10 Binary options......Page 629
26.11 Lookback options......Page 630
26.13 Asian options......Page 632
26.14 Options to exchange one asset for another......Page 634
26.15 Options involving several assets......Page 635
26.16 Volatility and variance swaps......Page 636
26.17 Static options replication......Page 639
Summary......Page 641
Practice questions......Page 642
Further questions......Page 644
Chapter 27.More on models and numerical procedures
......Page 647
27.1 Alternatives to Black–Scholes–Merton......Page 648
27.2 Stochastic volatility models......Page 653
27.3 The IVF model......Page 655
27.4 Convertible bonds......Page 656
27.5 Path-dependent derivatives......Page 659
27.6 Barrier options......Page 663
27.7 Options on two correlated assets......Page 666
27.8 Monte Carlo simulation and American options......Page 669
Summary......Page 673
Further reading......Page 674
Practice questions......Page 675
Further questions......Page 676
Chapter 28.Martingales and measures......Page 678
28.1 The market price of risk......Page 679
28.2 Several state variables......Page 682
28.3 Martingales......Page 683
28.4 Alternative choices for the numeraire......Page 684
28.5 Extension to several factors......Page 688
28.6 Black’s model revisited......Page 689
28.7 Option to exchange one asset for another......Page 690
28.8 Change of numeraire......Page 691
Summary......Page 692
Practice questions......Page 693
Further questions......Page 695
29.1 Bond options......Page 696
29.2 Interest rate caps and ?oors......Page 701
29.3 European swap options......Page 707
29.5 Hedging interest rate derivatives......Page 711
Summary......Page 712
Practice questions......Page 713
Further questions......Page 715
30.1 Convexity adjustments......Page 716
30.2 Timing adjustments......Page 720
30.3 Quantos......Page 722
Practice questions......Page 725
Further questions......Page 727
Appendix: Proof of the convexity adjustment formula......Page 728
31.1 Background......Page 729
31.2 Equilibrium models......Page 730
31.3 No-arbitrage models......Page 737
31.4 Options on bonds......Page 742
31.5 Volatility structures......Page 743
31.6 Interest rate trees
......Page 744
31.7 A general tree-building procedure......Page 746
31.8 Calibration......Page 755
31.9 Hedging using a one-factor model......Page 757
Further reading......Page 758
Practice questions......Page 759
Further questions......Page 761
32.1 The Heath, Jarrow, and Morton model......Page 763
32.2 The LIBOR market model......Page 766
32.3 Handling multiple zero curves......Page 776
32.4 Agency mortgage-backed securities......Page 778
Summary......Page 780
Practice questions......Page 781
Further questions......Page 782
33.1 Variations on the vanilla deal......Page 783
33.2 Compounding swaps......Page 785
33.3 Currency swaps......Page 786
33.4 More complex swaps......Page 787
33.5 Equity swaps......Page 790
33.6 Swaps with embedded options......Page 792
33.7 Other swaps......Page 794
Summary......Page 795
Practice questions......Page 796
Further questions......Page 797
34.1 Agricultural commodities......Page 798
34.2 Metals......Page 799
34.3 Energy products......Page 800
34.4 Modeling commodity prices......Page 802
34.5 Weather derivatives......Page 808
34.7 Pricing weather and insurance derivatives......Page 809
34.8 How an energy producer can hedge risks......Page 811
Further reading......Page 812
Practice questions......Page 813
Further questions......Page 814
35.1 Capital investment appraisal......Page 815
35.2 Extension of the risk-neutral valuation framework......Page 816
35.3 Estimating the market price of risk......Page 818
35.5 Evaluating options in an investment opportunity......Page 819
Further reading......Page 826
Further questions......Page 827
36.1 Lessons for all users of derivatives......Page 829
36.2 Lessons for financial institutions
......Page 833
36.3 Lessons for nonfinancial corporations
......Page 838
Further reading......Page 840
DerivaGem software......Page 863
Major exchanges trading futures and options......Page 868
Tables for N(x)......Page 869
Author index......Page 871
Subject index......Page 875