Principles of Financial Engineering, Second Edition

Front Cover......Page 1
Principles of Financial Engineering......Page 4
Copyright Page......Page 5
Dedication......Page 6
Table of Contents......Page 8
Preface......Page 16
1. A Unique Instrument......Page 18
2. A Money Market Problem......Page 25
3. A Taxation Example......Page 28
4. Some Caveats for What Is to Follow......Page 31
5. Trading Volatility......Page 32
6. Conclusions......Page 35
Suggested Reading......Page 36
Case Study......Page 37
2. Markets......Page 40
4. The Mechanics of Deals......Page 44
5. Market Conventions......Page 47
7. Positions......Page 54
8. The Syndication Process......Page 58
Appendix 2-1: The Hedge Fund Industry......Page 59
Exercises......Page 63
2. What Is a Synthetic?......Page 64
3. Forward Contracts......Page 68
4. Currency Forwards......Page 71
6. A Contractual Equation......Page 76
7. Applications......Page 77
8. A “Better” Synthetic......Page 83
9. Futures......Page 87
10. Conventions for Forwards......Page 92
11. Conclusions......Page 93
Suggested Reading......Page 94
Exercises......Page 95
Case Study......Page 97
1. Introduction......Page 100
2. Libor and Other Benchmarks......Page 101
3. Forward Loans......Page 102
4. Forward Rate Agreements......Page 109
5. Futures: Eurocurrency Contracts......Page 113
6. Real-World Complications......Page 117
7. Forward Rates and Term Structure......Page 119
8. Conventions......Page 120
9. A Digression: Strips......Page 121
Suggested Reading......Page 122
Exercises......Page 123
1. The Swap Logic......Page 126
2. Applications......Page 129
3. The Instrument: Swaps......Page 134
4. Types of Swaps......Page 137
5. Engineering Interest Rate Swaps......Page 146
6. Uses of Swaps......Page 154
7. Mechanics of Swapping New Issues......Page 159
9. Currency Swaps versus FX Swaps......Page 165
10. Additional Terminology......Page 167
Suggested Reading......Page 168
Exercises......Page 169
1. Introduction......Page 174
2. What Is Repo?......Page 175
3. Types of Repo......Page 177
5. Repo Market Strategies......Page 182
6. Synthetics Using Repos......Page 188
Suggested Reading......Page 190
Exercises......Page 191
Case Study......Page 192
1. Introduction......Page 194
3. A Review of Static Replication......Page 195
4. “Ad Hoc” Synthetics......Page 200
5. Principles of Dynamic Replication......Page 203
6. Some Important Conditions......Page 214
7. Real-Life Complications......Page 215
Suggested Reading......Page 217
Exercises......Page 218
1. Introduction......Page 220
2. What Is an Option?......Page 221
3. Options: Definition and Notation......Page 222
4. Options as Volatility Instruments......Page 228
5. Tools for Options......Page 238
6. The Greeks and Their Uses......Page 245
7. Real-Life Complications......Page 257
Suggested Reading......Page 258
Appendix 8-1......Page 259
Appendix 8-2......Page 261
Exercises......Page 263
1. Introduction......Page 266
3. Bond Convexity Trades......Page 267
4. Sources of Convexity......Page 279
5. A Special Instrument: Quantos......Page 284
Suggested Reading......Page 289
Exercises......Page 290
Case Study......Page 292
1. Introduction......Page 294
2. Option Strategies......Page 297
3. Volatility-Based Strategies......Page 308
4. Exotics......Page 313
5. Quoting Conventions......Page 324
6. Real-World Complications......Page 326
Suggested Reading......Page 327
Exercises......Page 328
1. Introduction......Page 332
2. Summary of Pricing Approaches......Page 333
3. The Framework......Page 334
4. An Application......Page 339
5. Implications of the Fundamental Theorem......Page 345
6. Arbitrage-Free Dynamics......Page 351
7. Which Pricing Method to Choose?......Page 355
Suggested Reading......Page 356
Appendix 11-1......Page 357
Exercises......Page 359
1. Introduction......Page 362
2. Application 1: The Monte Carlo Approach......Page 363
3. Application 2: Calibration......Page 371
4. Application 3: Quantos......Page 380
Suggested Reading......Page 387
Exercises......Page 388
1. Introduction......Page 390
2. A Framework for Swaps......Page 391
3. Term Structure Modeling......Page 400
4. Term Structure Dynamics......Page 402
5. Measure Change Technology......Page 411
6. An Application......Page 416
7. In-Arrears Swaps and Convexity......Page 421
8. Cross-Currency Swaps......Page 425
10. Conclusions......Page 426
Suggested Reading......Page 427
Appendix 13-1: Practical Yield Curve Calculations......Page 428
Exercises......Page 431
1. Introduction......Page 432
2. Volatility Positions......Page 433
3. Invariance of Volatility Payoffs......Page 434
4. Pure Volatility Positions......Page 441
5. Volatility Swaps......Page 444
6. Some Uses of the Contract......Page 449
7. Which Volatility?......Page 450
8. Conclusions......Page 451
Suggested Reading......Page 452
Exercises......Page 453
1. Introduction to Volatility as an Asset Class......Page 456
2. Volatility as Funding......Page 457
4. Dirac Delta Functions......Page 459
5. Application to Option Payoffs......Page 461
6. Breeden-Litzenberger Simplified......Page 463
7. A Characterization of Option Prices as Gamma Gains......Page 467
8. Introduction to the Smile......Page 468
9. Preliminaries......Page 469
10. A First Look at the Smile......Page 470
11. What Is the Volatility Smile?......Page 471
13. How to Explain the Smile......Page 479
14. The Relevance of the Smile......Page 486
16. Pricing with a Smile......Page 487
17. Exotic Options and the Smile......Page 488
Suggested Reading......Page 492
Exercises......Page 493
1. Introduction......Page 496
2. Terminology and Definitions......Page 497
3. Credit Default Swaps......Page 499
4. Real-World Complications......Page 509
5. CDS Analytics......Page 511
6. Default Probability Arithmetic......Page 512
7. Structured Credit Products......Page 517
8. Total Return Swaps......Page 521
Suggested Reading......Page 522
Exercises......Page 524
Case Study......Page 527
1. Introduction......Page 530
2. Purposes of Structured Products......Page 531
3. Structured Fixed-Income Products......Page 543
4. Some Prototypes......Page 550
5. Conclusions......Page 560
Suggested Reading......Page 561
Exercises......Page 562
2. Credit Indices......Page 564
3. Introduction to ABS and CDO......Page 565
4. A Setup for Credit Indices......Page 567
5. Index Arbitrage......Page 570
6. Tranches: Standard and Bespoke......Page 572
7. Tranche Modeling and Pricing......Page 573
8. The Roll and the Implications......Page 577
9. Credit versus Default Loss Distributions......Page 579
10. An Important Generalization......Page 580
11. New Index Markets......Page 583
Suggested Reading......Page 585
Appendix 18-1......Page 586
Exercises......Page 587
1. Introduction......Page 588
3. Two Simple Examples......Page 589
4. The Model......Page 592
5. Default Correlation and Trading......Page 596
6. Delta Hedging and Correlation Trading......Page 597
7. Real-World Complications......Page 602
Suggested Reading......Page 604
Appendix 19–1......Page 605
Exercises......Page 607
Case Study......Page 608
1. Introduction......Page 612
2. The Classical Case......Page 613
3. The CPPI......Page 614
4. Modeling the CPPI Dynamics......Page 616
5. An Application: CPPI and Equity Tranches......Page 618
6. A Variant: The DPPI......Page 621
7. Real-World Complications......Page 622
Suggested Reading......Page 623
Exercises......Page 624
1. Introduction......Page 628
2. The Mortgage Market......Page 629
3. Swaptions......Page 635
4. Pricing Swaptions......Page 637
5. Mortgage-Based Securities......Page 642
6. Caps and Floors......Page 643
Suggested Reading......Page 648
Exercises......Page 649
Case Study......Page 651
1. Introduction......Page 654
2. What Is Equity?......Page 655
3. Engineering Equity Products......Page 661
4. Financial Engineering of Securitization......Page 671
Suggested Reading......Page 674
Exercises......Page 675
Case Study......Page 676
References......Page 680
Index......Page 684