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Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options, Second Edition

Book Description

Derivatives are everywhere in the modern world and it is important for everyone in banking, investment and finance to have a good understanding of the subject. Derivatives Demystified provides a step-by-step guide to the subject, enabling the reader to have a solid, working understanding of key derivative products.

Adopting a highly accessible approach, the author explains derivative products in straightforward terms and without the complex mathematics that underlie the subject, focusing on practical applications, case studies and examples of how the products are used to solve real-world problems. Derivatives Demystified follows a sequence that is designed to show that, although there are many applications of derivatives, there are only a small number of basic building blocks, namely forwards and futures, swaps and options. The book shows how each building block is applied to different markets and to the solution of various risk management and trading problems.

This new edition will be fully revised to reflect the many changes the derivatives markets have seen over the last three years. New material will include a comprehensive history of derivatives, leading up to their use and abuse in the current credit crisis. It will also feature new chapters on regulation and control of derivatives, commodity derivatives, credit derivatives and structured products and new derivative markets including inflation linked and insurance linked products.

Derivatives Demystified is essential reading for everyone who operates in the financial markets or within the corporate environment who requires a good understanding of these important financial instruments.

Table of Contents

  1. Title Page
  2. Copyright Page
  3. Dedication
  4. Epigraph
  5. Acknowledgements
  6. Chapter 1 - The Origins and Growth of the Market
    1. DEFINITIONS
    2. DERIVATIVES BUILDING BLOCKS
    3. MARKET PARTICIPANTS
    4. SUPPORTING ORGANIZATIONS
    5. EARLY ORIGINS OF DERIVATIVES
    6. DERIVATIVES IN THE USA
    7. OVERSEAS DEVELOPMENTS, INNOVATION AND EXPANSION
    8. AN EXAMPLE OF RECENT INNOVATION: WEATHER DERIVATIVES
    9. TEMPERATURE-LINKED DERIVATIVES
    10. THE WILD BEAST OF FINANCE?
    11. LESSONS FROM RECENT HISTORY
    12. CREATIVE DESTRUCTION AND CONTAGION EFFECTS
    13. THE MODERN OTC DERIVATIVES MARKET
    14. THE EXCHANGE-TRADED DERIVATIVES MARKET
    15. CHAPTER SUMMARY
  7. Chapter 2 - Equity and Currency Forwards
    1. INTRODUCTION
    2. EQUITY FORWARD CONTRACT
    3. THE FORWARD PRICE
    4. THE FORWARD PRICE AND ARBITRAGE OPPORTUNITIES
    5. THE FORWARD PRICE AND THE EXPECTED PAYOUT
    6. FOREIGN EXCHANGE FORWARDS
    7. MANAGING CURRENCY RISK
    8. HEDGING WITH AN OUTRIGHT FORWARD FX DEAL
    9. THE FORWARD FOREIGN EXCHANGE RATE
    10. THE FORWARD FX RATE AND ARBITRAGE OPPORTUNITIES
    11. FORWARD POINTS
    12. FX SWAPS
    13. APPLICATIONS OF FX SWAPS
    14. CHAPTER SUMMARY
  8. Chapter 3 - Forward Rate Agreements
    1. INTRODUCTION
    2. FRA CASE STUDY: CORPORATE BORROWER
    3. RESULTS OF THE FRA HEDGE
    4. THE FRA AS TWO PAYMENT LEGS
    5. DEALING IN FRAs
    6. FORWARD INTEREST RATES
    7. CHAPTER SUMMARY
  9. Chapter 4 - Commodity and Bond Futures
    1. INTRODUCTION
    2. THE MARGINING SYSTEM AND THE CLEARING HOUSE
    3. USERS OF FUTURES CONTRACTS
    4. COMMODITY FUTURES
    5. FUTURES PRICES AND THE BASIS
    6. US TREASURY BOND FUTURES
    7. US TREASURY BOND FUTURES: DELIVERY PROCEDURES
    8. GILT FUTURES
    9. THE CHEAPEST-TO-DELIVER (CTD) BOND
    10. CHAPTER SUMMARY
  10. Chapter 5 - Interest Rate and Equity Futures
    1. INTRODUCTION
    2. EURODOLLAR FUTURES
    3. TRADING EURODOLLAR FUTURES
    4. HEDGING WITH INTEREST RATE FUTURES
    5. INTEREST RATE FUTURES PRICES
    6. EQUITY INDEX FUTURES
    7. APPLICATIONS OF S&P 500 INDEX FUTURES
    8. FT-SE 100 INDEX FUTURES CONTRACTS
    9. ESTABLISHING NET PROFITS AND LOSSES
    10. SINGLE STOCK FUTURES (SSFs)
    11. CHAPTER SUMMARY
  11. Chapter 6 - Interest Rate Swaps
    1. INTRODUCTION
    2. INTEREST RATE SWAP STRUCTURE
    3. BASIC SINGLE-CURRENCY INTEREST RATE SWAP
    4. THE SWAP AS A PACKAGE OF SPOT AND FORWARD DEALS
    5. RATIONALE FOR THE SWAP DEAL
    6. SWAP TERMINOLOGY AND SWAP SPREADS
    7. TYPICAL SWAP APPLICATIONS
    8. INTEREST RATE SWAP VARIANTS
    9. CROSS-CURRENCY INTEREST RATE SWAPS
    10. NET BORROWING COSTS USING A CROSS-CURRENCY SWAP
    11. INFLATION SWAPS
    12. CHAPTER SUMMARY
  12. Chapter 7 - Equity and Credit Default Swaps
    1. INTRODUCTION TO EQUITY SWAPS
    2. EQUITY SWAP CASE STUDY
    3. OTHER APPLICATIONS OF EQUITY SWAPS
    4. EQUITY INDEX SWAPS
    5. HEDGING AN EQUITY INDEX SWAP
    6. CREDIT DEFAULT SWAPS
    7. CREDIT DEFAULT SWAP: BASIC STRUCTURE
    8. CREDIT DEFAULT SWAP APPLICATIONS
    9. CREDIT SPREADS
    10. THE CDS PREMIUM AND THE CREDIT SPREAD
    11. PRICING MODELS FOR CDS PREMIUM
    12. INDEX CREDIT DEFAULT SWAPS
    13. BASKET CREDIT DEFAULT SWAPS
    14. CHAPTER SUMMARY
  13. Chapter 8 - Fundamentals of Options
    1. INTRODUCTION
    2. DEFINITIONS
    3. TYPES OF OPTIONS
    4. BASIC OPTION TRADING STRATEGIES
    5. LONG CALL: EXPIRY PAYOFF PROFILE
    6. SHORT CALL: EXPIRY PAYOFF PROFILE
    7. LONG PUT: EXPIRY PAYOFF PROFILE
    8. SHORT PUT: EXPIRY PAYOFF PROFILE
    9. SUMMARY: INTRINSIC AND TIME VALUE
  14. Chapter 9 - Hedging with Options
    1. CHAPTER OVERVIEW
    2. FUTURES HEDGE REVISITED
    3. PROTECTIVE PUT
    4. HEDGING WITH ATM PUT OPTION
    5. COVERED CALL WRITING
    6. EQUITY COLLAR
    7. ZERO-COST EQUITY COLLAR
    8. PROTECTIVE PUT WITH A BARRIER OPTION
    9. BEHAVIOUR OF BARRIER OPTIONS
    10. CHAPTER SUMMARY
  15. Chapter 10 - Exchange-Traded Equity Options
    1. INTRODUCTION
    2. BASIC CONCEPTS
    3. CBOE STOCK OPTIONS
    4. UK STOCK OPTIONS ON NYSE LIFFE
    5. CME S&P 500 INDEX OPTIONS
    6. FT-SE 100 INDEX OPTIONS
    7. CHAPTER SUMMARY
  16. Chapter 11 - Currency or FX Options
    1. INTRODUCTION
    2. USERS OF CURRENCY OPTIONS
    3. HEDGING FX EXPOSURES WITH OPTIONS: CASE STUDY
    4. GRAPH OF HEDGED AND UNHEDGED POSITIONS
    5. HEDGING WITH A ZERO-COST COLLAR
    6. REDUCING PREMIUM ON FX HEDGES
    7. COMPOUND OPTIONS
    8. EXCHANGE-TRADED CURRENCY OPTIONS
    9. CHAPTER SUMMARY
  17. Chapter 12 - Interest Rate Options
    1. INTRODUCTION
    2. OTC INTEREST RATE OPTIONS
    3. OTC INTEREST RATE OPTION CASE STUDY
    4. HEDGING A LOAN WITH A CAPLET
    5. INTEREST RATE CAP
    6. INTEREST RATE COLLAR
    7. INTEREST RATE SWAP AND SWAPTION
    8. SUMMARY OF INTEREST RATE HEDGING STRATEGIES
    9. EURODOLLAR OPTIONS
    10. EURO AND STERLING INTEREST RATE OPTIONS
    11. BOND OPTIONS
    12. EXCHANGE-TRADED BOND OPTIONS
    13. CHAPTER SUMMARY
  18. Chapter 13 - Option Valuation Concepts (1)
    1. INTRODUCTION
    2. THE CONCEPT OF A RISKLESS HEDGE
    3. A SIMPLE OPTION PRICING MODEL
    4. OPTION FAIR VALUE
    5. EXTENDING THE BINOMIAL MODEL
    6. COST OF DYNAMIC HEDGING
    7. THE BLACK-SCHOLES OPTION PRICING MODEL
    8. HISTORICAL VOLATILITY
    9. MEASURING AND USING HISTORICAL VOLATILITY
    10. CHAPTER SUMMARY
  19. Chapter 14 - Option Valuation Concepts (2)
    1. INTRODUCTION
    2. PROBLEMS WITH HISTORICAL VOLATILITY
    3. IMPLIED VOLATILITY
    4. BLACK-SCHOLES MODEL ASSUMPTIONS
    5. VALUE OF A CALL OPTION
    6. VALUE OF A PUT OPTION
    7. EQUITY INDEX AND CURRENCY OPTIONS
    8. PRICING INTEREST RATE OPTIONS
    9. CHAPTER SUMMARY
  20. Chapter 15 - Option Sensitivities: The ‘Greeks’
    1. INTRODUCTION
    2. DELTA (D OR d)
    3. DELTA BEHAVIOUR
    4. DELTA AS THE HEDGE RATIO
    5. THE EFFECTS OF CHANGES IN DELTA
    6. READJUSTING THE DELTA HEDGE
    7. GAMMA (G OR g)
    8. GAMMA AND THE SPOT PRICE OF THE UNDERLYING
    9. GAMMA AND TIME TO EXPIRY
    10. THETA (T)
    11. VEGA OR KAPPA (κ )
    12. RHO (p)
    13. SUMMARY OF GREEKS
    14. CHAPTER SUMMARY
  21. Chapter 16 - Option Trading Strategies (1)
    1. INTRODUCTION
    2. BULL SPREAD
    3. BULL POSITION WITH DIGITAL OPTIONS
    4. SPOT PRICE AND CON VALUE
    5. BEAR SPREAD
    6. THE GREEKS FOR THE BEAR SPREAD
    7. PUT OR BEAR RATIO SPREAD
    8. LONG STRADDLE
    9. LONG STRADDLE CURRENT PAYOFF PROFILE
    10. POTENTIAL RISKS WITH A LONG STRADDLE
    11. CHAPTER SUMMARY
  22. Chapter 17 - Option Trading Strategies (2)
    1. INTRODUCTION
    2. CHOOSER OPTION
    3. SHORT STRADDLE
    4. SHORT STRADDLE CURRENT PAYOFF PROFILE
    5. POTENTIAL PROFITS WITH A SHORT STRADDLE
    6. MANAGING THE RISK ON A SHORT STRADDLE
    7. SHORT STRANGLE
    8. NEW WAYS OF TRADING VOLATILITY
    9. CALENDAR OR TIME SPREAD
    10. CHAPTER SUMMARY
  23. Chapter 18 - Convertible and Exchangeable Bonds
    1. INTRODUCTION
    2. INVESTORS IN CONVERTIBLE BONDS
    3. ISSUERS OF CONVERTIBLE BONDS
    4. CB MEASURES OF VALUE
    5. CONVERSION PREMIUM AND PARITY
    6. OTHER FACTORS AFFECTING CB VALUE
    7. CONVERTIBLE ARBITRAGE
    8. CONVERTIBLE ARBITRAGE EXAMPLE
    9. PROFITS AND RISKS WITH THE CB ARBITRAGE TRADE
    10. MANDATORILY CONVERTIBLES AND EXCHANGEABLES
    11. STRUCTURING A MANDATORILY EXCHANGEABLE (ME) BOND
    12. CHAPTER SUMMARY
  24. Chapter 19 - Structured Securities
    1. INTRODUCTION
    2. CAPITAL PROTECTION EQUITY-LINKED NOTES
    3. EXPIRY VALUE OF 100% CAPITAL PROTECTION NOTES
    4. 100% PARTICIPATION EQUITY-LINKED NOTES
    5. CAPPED PARTICIPATION EQUITY-LINKED NOTES
    6. AVERAGE PRICE NOTES
    7. LOCKING IN INTERIM GAINS: CLIQUET OPTIONS
    8. SECURITIZATION AND CDOs
    9. THE BASIC CDO STRUCTURE
    10. RATIONALE FOR SECURITIZATION
    11. SYNTHETIC CDOs
    12. CHAPTER SUMMARY
  25. Chapter 20 - Clearing, Settlement and Operational Risk
    1. INTRODUCTION
    2. RISK MANAGEMENT IN GENERAL
    3. SETTLEMENT OF EXCHANGE-TRADED DERIVATIVES
    4. MAJOR CLEARING HOUSES
    5. CONFIRMATION AND SETTLEMENT OF OTC DEALS
    6. CONTROLLING COUNTERPARTY RISK ON OTC DERIVATIVES
    7. OPERATIONAL RISK
    8. BEST PRACTICE IN OPERATIONAL RISK MANAGEMENT
    9. CHAPTER SUMMARY
  26. Appendix A - Financial Calculations
  27. Appendix B - Exotic Options
  28. Appendix C - Glossary of Terms
  29. Index