Principles of Financial Engineering, 3rd Edition

Principles of Financial Engineering, 3rd Edition

by Robert Kosowski, Salih N. Neftci
Released November 2014
Publisher(s): Academic Press
ISBN: 9780123870070

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Book description

Principles of Financial Engineering, Third Edition, is a highly acclaimed text on the fast-paced and complex subject of financial engineering. This updated edition describes the "engineering" elements of financial engineering instead of the mathematics underlying it. It shows how to use financial tools to accomplish a goal rather than describing the tools themselves. It lays emphasis on the engineering aspects of derivatives (how to create them) rather than their pricing (how they act) in relation to other instruments, the financial markets, and financial market practices.

This volume explains ways to create financial tools and how the tools work together to achieve specific goals. Applications are illustrated using real-world examples. It presents three new chapters on financial engineering in topics ranging from commodity markets to financial engineering applications in hedge fund strategies, correlation swaps, structural models of default, capital structure arbitrage, contingent convertibles, and how to incorporate counterparty risk into derivatives pricing. Poised midway between intuition, actual events, and financial mathematics, this book can be used to solve problems in risk management, taxation, regulation, and above all, pricing. A solutions manual enhances the text by presenting additional cases and solutions to exercises.

This latest edition of Principles of Financial Engineering is ideal for financial engineers, quantitative analysts in banks and investment houses, and other financial industry professionals. It is also highly recommended to graduate students in financial engineering and financial mathematics programs.

  • The Third Edition presents three new chapters on financial engineering in commodity markets, financial engineering applications in hedge fund strategies, correlation swaps, structural models of default, capital structure arbitrage, contingent convertibles and how to incorporate counterparty risk into derivatives pricing, 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. Title page
  3. Table of Contents
  4. Copyright
  5. Dedication
  6. Preface to the Third Edition
  7. Chapter 1. Introduction
    1. 1.1 A Unique Instrument
    2. 1.2 A Money Market Problem
    3. 1.3 A Taxation Example
    4. 1.4 Some Caveats for What Is to Follow
    5. 1.5 Trading Volatility
    6. 1.6 Conclusions
    7. Suggested Reading
    8. Exercises
  8. Chapter 2. Institutional Aspects of Derivative Markets
    1. 2.1 Introduction
    2. 2.2 Markets
    3. 2.3 Players
    4. 2.4 The Mechanics of Deals
    5. 2.5 Market Conventions
    6. 2.6 Instruments
    7. 2.7 Positions
    8. 2.8 The Syndication Process
    9. 2.9 Conclusions
    10. Suggested Reading
    11. Exercises
  9. Chapter 3. Cash Flow Engineering, Interest Rate Forwards and Futures
    1. 3.1 Introduction
    2. 3.2 What Is a Synthetic?
    3. 3.3 Engineering Simple Interest Rate Derivatives
    4. 3.4 LIBOR and Other Benchmarks
    5. 3.5 Fixed Income Market Conventions
    6. 3.6 A Contractual Equation
    7. 3.7 Forward Rate Agreements
    8. 3.8 Fixed Income Risk Measures: Duration, Convexity and Value-at-Risk
    9. 3.9 Futures: Eurocurrency Contracts
    10. 3.10 Real-World Complications
    11. 3.11 Forward Rates and Term Structure
    12. 3.12 Conventions
    13. 3.13 A Digression: Strips
    14. 3.14 Conclusions
    15. Suggested Reading
    16. Appendix—Calculating the Yield Curve
    17. Exercises
  10. Chapter 4. Introduction to Interest-Rate Swap Engineering
    1. 4.1 The Swap Logic
    2. 4.2 Applications
    3. 4.3 The Instrument: Swaps
    4. 4.4 Types of Swaps
    5. 4.5 Engineering Interest-Rate Swaps
    6. 4.6 Uses of Swaps
    7. 4.7 Mechanics of Swapping New Issues
    8. 4.8 Some Conventions
    9. 4.9 Additional Terminology
    10. 4.10 Conclusions
    11. Suggested Reading
    12. Exercises
  11. Chapter 5. Repo Market Strategies in Financial Engineering
    1. 5.1 Introduction
    2. 5.2 Repo Details
    3. 5.3 Types of Repo
    4. 5.4 Equity Repos
    5. 5.5 Repo Market Strategies
    6. 5.6 Synthetics Using Repos
    7. 5.7 Differences Between Repo Markets and the Impact of the GFC
    8. 5.8 Conclusions
    9. Suggested Reading
    10. Exercises
  12. Chapter 6. Cash Flow Engineering in Foreign Exchange Markets
    1. 6.1 Introduction
    2. 6.2 Currency Forwards
    3. 6.3 Synthetics and Pricing
    4. 6.4 A Contractual Equation
    5. 6.5 Applications
    6. 6.6 Conventions for FX Forward and Futures
    7. 6.7 Swap Engineering in FX Markets
    8. 6.8 Currency Swaps Versus FX Swaps
    9. 6.9 Mechanics of Swapping New Issues
    10. 6.10 Conclusions
    11. Suggested Reading
    12. Exercises
  13. Chapter 7. Cash Flow Engineering and Alternative Classes (Commodities and Hedge Funds)
    1. 7.1 Introduction
    2. 7.2 Parameters of a Futures Contract
    3. 7.3 The Term Structure of Commodity Futures Prices
    4. 7.4 Swap Engineering for Commodities
    5. 7.5 The Hedge Fund Industry
    6. 7.6 Conclusions
    7. Suggested Reading
    8. Exercises
  14. Chapter 8. Dynamic Replication Methods and Synthetics Engineering
    1. 8.1 Introduction
    2. 8.2 An Example
    3. 8.3 A Review of Static Replication
    4. 8.4 “Ad Hoc” Synthetics
    5. 8.5 Principles of Dynamic Replication
    6. 8.6 Some Important Conditions
    7. 8.7 Real-Life Complications
    8. 8.8 Conclusions
    9. Suggested Reading
    10. Exercises
  15. Chapter 9. Mechanics of Options
    1. 9.1 Introduction
    2. 9.2 What is an Option?
    3. 9.3 Options: Definition and Notation
    4. 9.4 Options as Volatility Instruments
    5. 9.5 Tools for Options
    6. 9.6 The Greeks and Their Uses
    7. 9.7 Real-Life Complications
    8. 9.8 Conclusion: What is an Option?
    9. Suggested Reading
    10. Appendix 9.1
    11. Appendix 9.2
    12. Exercises
  16. Chapter 10. Engineering Convexity Positions
    1. 10.1 Introduction
    2. 10.2 A Puzzle
    3. 10.3 Bond Convexity Trades
    4. 10.4 Sources of Convexity
    5. 10.5 A Special Instrument: Quantos
    6. 10.6 Conclusions
    7. Suggested Reading
    8. Exercises
  17. Chapter 11. Options Engineering with Applications
    1. 11.1 Introduction
    2. 11.2 Option Strategies
    3. 11.3 Volatility-Based Strategies
    4. 11.4 Exotics
    5. 11.5 Quoting Conventions
    6. 11.6 Real-World Complications
    7. 11.7 Conclusions
    8. Suggested Reading
    9. Exercises
  18. Chapter 12. Pricing Tools in Financial Engineering
    1. 12.1 Introduction
    2. 12.2 Summary of Pricing Approaches
    3. 12.3 The Framework
    4. 12.4 An Application
    5. 12.5 Implications of the Fundamental Theorem
    6. 12.6 Arbitrage-Free Dynamics
    7. 12.7 Which Pricing Method to Choose?
    8. 12.8 Conclusions
    9. Suggested Reading
    10. Appendix 12.1 Simple Economics of the Fundamental Theorem
    11. Exercises
  19. Chapter 13. Some Applications of the Fundamental Theorem
    1. 13.1 Introduction
    2. 13.2 Application 1: The Monte Carlo Approach
    3. 13.3 Application 2: Calibration
    4. 13.4 Application 3: Quantos
    5. 13.5 Conclusions
    6. Suggested Reading
    7. Exercises
  20. Chapter 14. Fixed Income Engineering
    1. 14.1 Introduction
    2. 14.2 A Framework for Swaps
    3. 14.3 Term Structure Modeling
    4. 14.4 Term Structure Dynamics
    5. 14.5 Measure Change Technology
    6. 14.6 An Application
    7. 14.7 In-Arrears Swaps and Convexity
    8. 14.8 Cross-Currency Swaps
    9. 14.9 Differential (Quanto) Swaps
    10. 14.10 Conclusions
    11. Suggested Reading
    12. Exercises
  21. Chapter 15. Tools for Volatility Engineering, Volatility Swaps, and Volatility Trading
    1. 15.1 Introduction
    2. 15.2 Volatility Positions
    3. 15.3 Invariance of Volatility Payoffs
    4. 15.4 Pure Volatility Positions
    5. 15.5 Variance Swaps
    6. 15.6 Real-World Example of Variance Contract
    7. 15.7 Volatility and Variance Swaps Before and After the GFC—The Role of Convexity Adjustments?
    8. 15.8 Which Volatility?
    9. 15.9 Conclusions
    10. Suggested Reading
    11. Exercises
  22. Chapter 16. Correlation as an Asset Class and the Smile
    1. 16.1 Introduction to Correlation as an Asset Class
    2. 16.2 Volatility as Funding
    3. 16.3 Smile
    4. 16.4 Dirac Delta Functions
    5. 16.5 Application to Option Payoffs
    6. 16.6 Breeden–Litzenberger Simplified
    7. 16.7 A Characterization of Option Prices as Gamma Gains
    8. 16.8 Introduction to the Smile
    9. 16.9 Preliminaries
    10. 16.10 A First Look at the Smile
    11. 16.11 What Is the Volatility Smile?
    12. 16.12 Smile Dynamics
    13. 16.13 How to Explain the Smile
    14. 16.14 The Relevance of the Smile
    15. 16.15 Trading the Smile
    16. 16.16 Pricing with a Smile
    17. 16.17 Exotic Options and the Smile
    18. 16.18 Conclusions
    19. Suggested Reading
    20. Exercises
  23. Chapter 17. Caps/Floors and Swaptions with an Application to Mortgages
    1. 17.1 Introduction
    2. 17.2 The Mortgage Market
    3. 17.3 Swaptions
    4. 17.4 Pricing Swaptions
    5. 17.5 Mortgage-Based Securities
    6. 17.6 Caps and Floors
    7. 17.7 Conclusions
    8. Suggested Reading
    9. Exercises
  24. Chapter 18. Credit Markets: CDS Engineering
    1. 18.1 Introduction
    2. 18.2 Terminology and Definitions
    3. 18.3 Credit Default Swaps
    4. 18.4 Real-World Complications
    5. 18.5 CDS Analytics
    6. 18.6 Default Probability Arithmetic
    7. 18.7 Pricing Single-Name CDS
    8. 18.8 Comparing CDS to TRS and EDS
    9. 18.9 Sovereign CDS
    10. 18.10 Conclusions
    11. Suggested Reading
    12. Exercises
  25. Chapter 19. Engineering of Equity Instruments and Structural Models of Default
    1. 19.1 Introduction
    2. 19.2 What Is Equity?
    3. 19.3 Equity as the Discounted Value of Future Cash Flows
    4. 19.4 Equity as an Option on the Assets of the Firm
    5. 19.5 Capital Structure Arbitrage
    6. 19.6 Engineering Equity Products
    7. 19.7 Conclusions
    8. Suggested Reading
    9. Exercises
  26. Chapter 20. Essentials of Structured Product Engineering
    1. 20.1 Introduction
    2. 20.2 Purposes of Structured Products
    3. 20.3 Structured Fixed-Income Products
    4. 20.4 Some Prototypes
    5. 20.5 Conclusions
    6. Suggested Reading
    7. Exercises
  27. Chapter 21. Securitization, ABSs, CDOs, and Credit Structured Products
    1. 21.1 Introduction
    2. 21.2 Financial Engineering of Securitization
    3. 21.3 ABSs Versus CDOs
    4. 21.4 A Setup for Credit Indices
    5. 21.5 Index Arbitrage
    6. 21.6 Tranches: Standard and Bespoke
    7. 21.7 Tranche Modeling and Pricing
    8. 21.8 The Roll and the Implications
    9. 21.9 Regulation, Credit Risk Management, and Tranche Pricing
    10. 21.10 New Index Markets
    11. 21.11 Structured Credit Products
    12. 21.12 Conclusions
    13. Suggested Reading
    14. Exercises
  28. Chapter 22. Default Correlation Pricing and Trading
    1. 22.1 Introduction
    2. 22.2 Two Simple Examples
    3. 22.3 Standard Tranche Valuation Model
    4. 22.4 Default Correlation and Trading
    5. 22.5 Delta Hedging and Correlation Trading
    6. 22.6 Real-World Complications
    7. 22.7 Default Correlation Case Study: May 2005
    8. 22.8 Conclusions
    9. Suggested Reading
    10. Appendix 22.1 Some Basic Statistical Concepts
    11. Exercises
  29. Chapter 23. Principal Protection Techniques
    1. 23.1 Introduction
    2. 23.2 The Classical Case
    3. 23.3 The CPPI
    4. 23.4 Modeling the CPPI Dynamics
    5. 23.5 An Application: CPPI and Equity Tranches
    6. 23.6 Differences Between CPDO and CPPI
    7. 23.7 A Variant: The DPPI
    8. 23.8 Application of CPPI in the Insurance Sector: ICPPI
    9. 23.9 Real-World Complications
    10. 23.10 Conclusions
    11. Suggested Reading
    12. Exercises
  30. Chapter 24. Counterparty Risk, Multiple Curves, CVA, DVA, and FVA
    1. 24.1 Introduction
    2. 24.2 Counterparty Risk
    3. 24.3 Credit Valuation Adjustment
    4. 24.4 Debit Valuation Adjustment
    5. 24.5 Bilateral Counterparty Risk
    6. 24.6 Hedging Counterparty Risk
    7. 24.7 Funding Valuation Adjustment
    8. 24.8 CVA Desk
    9. 24.9 Choice of the Discount Rate and Multiple Curves
    10. 24.10 Conclusions
    11. Suggested Reading
    12. Exercises
  31. References
  32. Index

Product information

  • Title: Principles of Financial Engineering, 3rd Edition
  • Author(s): Robert Kosowski, Salih N. Neftci
  • Release date: November 2014
  • Publisher(s): Academic Press
  • ISBN: 9780123870070