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Principles of Financial Engineering, 2nd Edition

Book Description

Five new chapters, numerous additions to existing chapters, and an expanded collection of questions and exercises make this Second Edition an essential part of everyone's library. Between defining swaps on its first page and presenting a case study on its last, Neftci's introduction to financial engineering shows readers how to create financial assets in static and dynamic environments. Poised among intuition, actual events, and financial mathematics, this book can be used to solve problems in risk management, taxation, regulation, and above all, pricing.

* The Second Edition presents 5 new chapters on structured product engineering, credit markets and instruments, and principle protection techniques, among other topics
* Additions, clarifications, and illustrations throughout the volume show these instruments at work instead of explaining how they should act
* The Solutions Manual enhances the text by presenting additional cases and solutions to exercises

Table of Contents

  1. Cover Image
  2. Table of Contents
  3. Title
  4. Copyright
  5. Dedication
  6. Preface
  7. Chapter 1. Introduction
    1. 1. A Unique Instrument
    2. 2. A Money Market Problem
    3. 3. A Taxation Example
    4. 4. Some Caveats for What Is to Follow
    5. 5. Trading Volatility
    6. 6. Conclusions
    7. Suggested Reading
    8. CASE STUDY: Japanese Loans and Forwards
  8. Chapter 2. An Introduction to Some Concepts and Definitions
    1. 1. Introduction
    2. 2. Markets
    3. 3. Players
    4. 4. The Mechanics of Deals
    5. 5. Market Conventions
    6. 6. Instruments
    7. 7. Positions
    8. 8. The Syndication Process
    9. 9. Conclusions
    10. Exercises
  9. Chapter 3. Cash Flow Engineering and Forward Contracts
    1. 1. Introduction
    2. 2. What Is a Synthetic?
    3. 3. Forward Contracts
    4. 4. Currency Forwards
    5. 5. Synthetics and Pricing
    6. 6. A Contractual Equation
    7. 7. Applications
    8. 8. A “Better” Synthetic
    9. 9. Futures
    10. 10. Conventions for Forwards
    11. 11. Conclusions
    12. Suggested Reading
    13. Exercises
    14. CASE STUDY: HKMA and the Hedge Funds, 1998
    15. Hedge Funds Still Bet the Currency’s Peg Goes
  10. Chapter 4. Engineering Simple Interest Rate Derivatives
    1. 1. Introduction
    2. 2. Libor and Other Benchmarks
    3. 3. Forward Loans
    4. 4. Forward Rate Agreements
    5. 5. Futures: Eurocurrency Contracts
    6. 6. Real-World Complications
    7. 7. Forward Rates and Term Structure
    8. 8. Conventions
    9. 9. A Digression: Strips
    10. 10. Conclusions
    11. Suggested Reading
    12. Exercises
  11. Chapter 5. Introduction to Swap Engineering
    1. 1. The Swap Logic
    2. 2. Applications
    3. 3. The Instrument: Swaps
    4. 4. Types of Swaps
    5. 5. Engineering Interest Rate Swaps
    6. 6. Uses of Swaps
    7. 7. Mechanics of Swapping New Issues
    8. 8. Some Conventions
    9. 9. Currency Swaps versus FX Swaps
    10. 10. Additional Terminology
    11. 11. Conclusions
    12. Suggested Reading
    13. Exercises
  12. Chapter 6. Repo Market Strategies in Financial Engineering
    1. 1. Introduction
    2. 2. What Is Repo?
    3. 3. Types of Repo
    4. 4. Equity Repos
    5. 5. Repo Market Strategies
    6. 6. Synthetics Using Repos
    7. 7. Conclusions
    8. Suggested Reading
    9. Exercises
    10. Case Study: CTD and Repo Arbitrage
  13. Chapter 7. Dynamic Replication Methods and Synthetics
    1. 1. Introduction
    2. 2. An Example
    3. 3. A Review of Static Replication
    4. 4. “Ad Hoc” Synthetics
    5. 5. Principles of Dynamic Replication
    6. 6. Some Important Conditions
    7. 7. Real-Life Complications
    8. 8. Conclusions
    9. Suggested Reading
    10. Exercises
  14. Chapter 8. Mechanics of Options
    1. 1. Introduction
    2. 2. What Is an Option?
    3. 3. Options: Definition and Notation
    4. 4. Options as Volatility Instruments
    5. 5. Tools for Options
    6. 6. The Greeks and Their Uses
    7. 7. Real-Life Complications
    8. 8. Conclusion: What Is an Option?
    9. Suggested Reading
    10. APPENDIX 8-1
    11. APPENDIX 8-2
    12. Exercises
  15. Chapter 9. Engineering Convexity Positions
    1. 1. Introduction
    2. 2. A Puzzle
    3. 3. Bond Convexity Trades
    4. 4. Sources of Convexity
    5. 5. A Special Instrument: Quantos
    6. 6. Conclusions
    7. Suggested Reading
    8. Exercises
    9. CASE STUDY: Convexity of Long Bonds, Swaps, and Arbitrage
  16. Chapter 10. Options Engineering with Applications
    1. 1. Introduction
    2. 2. Option Strategies
    3. 3. Volatility-Based Strategies
    4. 4. Exotics
    5. 5. Quoting Conventions
    6. 6. Real-World Complications
    7. 7. Conclusions
    8. Suggested Reading
    9. Exercises
  17. Chapter 11. Pricing Tools in Financial Engineering
    1. 1. Introduction
    2. 2. Summary of Pricing Approaches
    3. 3. The Framework
    4. 4. An Application
    5. 5. Implications of the Fundamental Theorem
    6. 6. Arbitrage-Free Dynamics
    7. 7. Which Pricing Method to Choose?
    8. 8. Conclusions
    9. Suggested Reading
    10. APPENDIX 11-1: Simple Economics of the Fundamental Theorem
    11. Exercises
  18. Chapter 12. Some Applications of the Fundamental Theorem
    1. 1 Introduction
    2. 2. Application 1: The Monte Carlo Approach
    3. 3. Application 2: Calibration
    4. 4. Application 3: Quantos
    5. 5. Conclusions
    6. Suggested Reading
    7. Exercises
  19. Chapter 13. Fixed-Income Engineering
    1. 1. Introduction
    2. 2. A Framework for Swaps
    3. 3. Term Structure Modeling
    4. 4. Term Structure Dynamics
    5. 5. Measure Change Technology
    6. 6. An Application
    7. 7. In-Arrears Swaps and Convexity
    8. 8. Cross-Currency Swaps
    9. 9. Differential (Quanto) Swaps
    10. 10. Conclusions
    11. Suggested Reading
    12. APPENDIX 13-1 Practical Yield Curve Calculations
    13. 1. Par Yield Curve
    14. 2. Zero-Coupon Yield Curve
    15. 3. Zero-Coupon Curve from Coupon Bonds
    16. Exercises
  20. Chapter 14. Tools for Volatility Engineering, Volatility Swaps, and Volatility Trading
    1. 1. Introduction
    2. 2. Volatility Positions
    3. 3. Invariance of Volatility Payoffs
    4. 4. Pure Volatility Positions
    5. 5. Volatility Swaps
    6. 6. Some Uses of the Contract
    7. 7. Which Volatility?
    8. 8. Conclusions
    9. Suggested Reading
    10. Exercises
  21. Chapter 15. Volatility as an Asset Class and the Smile
    1. 1. Introduction to Volatility as an Asset Class
    2. 2. Volatility as Funding
    3. 3. Smile
    4. 4. Dirac Delta Functions
    5. 5. Application to Option Payoffs
    6. 6. Breeden-Litzenberger Simplified
    7. 7. A Characterization of Option Prices as Gamma Gains
    8. 8. Introduction to the Smile
    9. 9. Preliminaries
    10. 10. A First Look at the Smile
    11. 11. What Is the Volatility Smile?
    12. 12. Smile Dynamics
    13. 13. How to Explain the Smile
    14. 14. The Relevance of the Smile
    15. 15. Trading the Smile
    16. 16. Pricing with a Smile
    17. 17. Exotic Options and the Smile
    18. 18. Conclusions
    19. Suggested Reading
    20. Exercises
  22. Chapter 16. Credit Markets: CDS Engineering
    1. 1. Introduction
    2. 2. Terminology and Definitions
    3. 3. Credit Default Swaps
    4. 4. Real-World Complications
    5. 5. CDS Analytics
    6. 6. Default Probability Arithmetic
    7. 7. Structured Credit Products
    8. 8. Total Return Swaps
    9. 9. Conclusions
    10. Suggested Reading
    11. Exercises
    12. CASE STUDY: Credit-Linked Notes
  23. Chapter 17. Essentials of Structured Product Engineering
    1. 1. Introduction
    2. 2. Purposes of Structured Products
    3. 3. Structured Fixed-Income Products
    4. 4. Some Prototypes
    5. 5. Conclusions
    6. Suggested Reading
    7. Exercises
  24. Chapter 18. Credit Indices and Their Tranches
    1. 1. Introduction
    2. 2. Credit Indices
    3. 3. Introduction to ABS and CDO
    4. 4. A Setup for Credit Indices
    5. 5. Index Arbitrage
    6. 6. Tranches: Standard and Bespoke
    7. 7. Tranche Modeling and Pricing
    8. 8. The Roll and the Implications
    9. 9. Credit versus Default Loss Distributions
    10. 10. An Important Generalization
    11. 11. New Index Markets
    12. 12. Conclusions
    13. Suggested Reading
    14. Appendix 18-1: A History of Credit Indices
    15. Exercises
  25. Chapter 19. Default Correlation Pricing and Trading
    1. 1. Introduction
    2. 2. Some History
    3. 3. Two Simple Examples
    4. 4. The Model
    5. 5. Default Correlation and Trading
    6. 6. Delta Hedging and Correlation Trading
    7. 7. Real-World Complications
    8. 8. Conclusions
    9. Suggested Reading
    10. APPENDIX 19-1: Some Basic Statistical Concepts
    11. CASE STUDY: May 2005 Volatility
  26. Chapter 20. Principal Protection Techniques
    1. 1. Introduction
    2. 2. The Classical Case
    3. 3. The CPPI
    4. 4. Modeling the CPPI Dynamics
    5. 5. An Application: CPPI and Equity Tranches
    6. 6. A Variant: The DPPI
    7. 7. Real-World Complications
    8. 8. Conclusions
    9. Suggested Reading
    10. Exercises
  27. Chapter 21. Caps/Floors and Swaptions with an Application to Mortgages
    1. 1. Introduction
    2. 2. The Mortgage Market
    3. 3. Swaptions
    4. 4. Pricing Swaptions
    5. 5. Mortgage-Based Securities
    6. 6. Caps and Floors
    7. 7. Conclusions
    8. Suggested Reading
    9. Exercises
    10. CASE STUDY: Danish Mortgage Bonds
  28. Chapter 22. Engineering of Equity Instruments: Pricing and Replication
    1. 1. Introduction
    2. 2. What Is Equity?
    3. 3. Engineering Equity Products
    4. 4. Financial Engineering of Securitization
    5. 5. Conclusions
    6. Suggested Reading
    7. Exercises
    8. CASE STUDY: VOLATILITY TRADING
  29. References
  30. Index