Chapter 1:Introduction 1
1.1 Futures Contracts 1
1.2 History of Futures Markets 2
1.3 The Over-the-Counter Market 3
1.4 Forward Contracts 5
1.5 Options Contracts 6
1.6 History of Options Markets 8
1.7 Types of Traders 9
1.8 Hedgers 9
1.9 Speculators 11
1.10 Arbitrageurs 14
1.11 Dangers 15
Summary 15
Further Reading 16
Quiz 16
Questions and Problems 17
Assignment Questions 18
Chapter 2:Mechanics of Futures Markets 21
2.1 Opening and Closing Futures Positions 21
2.2 The Specification of a Futures Contract 22
2.3 Convergence of Futures Price to Spot Price 25
2.4 The Operation of Margins 26
2.5 Newspaper Quotes 31
2.6 Delivery 35
2.7 Types of Traders and Types of Orders 36
2.8 Regulation 37
2.9 Accounting and Tax 38
2.10 Forward vs. Futures Contracts 40
Summary 42
Further Reading 43
Quiz 44
Questions and Problems 44
Assignment Questions 45
Chapter 3:Hedging Strategies Using Futures 47
3.1 Basic Principles 47
3.2 Arguments for and against Hedging 50
3.3 Basis Risk 53
3.4 Cross Hedging 58
3.5 Stock Index Futures 61
3.6 Rolling the Hedge Forward 68
Summary 69
Further Reading 70
Quiz 71
Questions and Problems 71
Assignment Questions 72
Appendix:Proof of the Minimum Variance Hedge Ratio Formula 74
Chapter 4:Interest Rates 75
4.1 Types of Rates 75
4.2 Measuring Interest Rates 77
4.3 Zero Rates 80
4.4 Bond Pricing 80
4.5 Determining Treasury Zero Rates 82
4.6 Forward Rates 84
4.7 Forward-Rate Agreements 86
4.8 Theories of the Term Structure 89
Summary 90
Further Reading 90
Quiz 90
Questions and Problems 91
Assignment Questions 92
Appendix:Exponential and Logarithm Functions 94
Chapter 5:Determination of Forward and Futures Prices 97
5.1 Investment Assets vs.Consumption Assets 97
5.2 Short Selling 97
5.3 Assumptions and Notation 99
5.4 Forward Price for an Investment Asset 99
5.5 Known Income 102
5.6 Known Yield 105
5.7 Valuing Forward Contracts 105
5.8 Are Forward Prices and Futures Prices Equal? 107
5.9 Futures Prices of Stock Indices 108
5.10 Forward and Futures Contracts on Currencies 110
5.11 Futures on Commodities 114
5.12 The Cost of Carry 117
5.13 Delivery Options 118
5.14 Futures Prices and the Expected Spot Prices 118
Summary 120
Further Reading 121
Quiz 122
Questions and Problems 122
Assignment Questions 124
Appendix:Proof that Forward and Futures Prices Are Equal When Interest Rates Are Constant 125
Chapter 6:Interest Rate Futures 127
6.1 Day Count Conventions 127
6.2 Quotations for Treasury Bonds and Bills 128
6.3 Treasury Bond Futures 131
6.4 Eurodollar Futures 135
6.5 Duration 138
6.6 Duration-Based Hedging Strategies 142
Summary 146
Further Reading 147
Quiz 147
Questions and Problems 148
Assignment Questions 149
Chapter 7:Swaps 151
7.1 Mechanics of Interest Rate Swaps 151
7.2 Day Count Issues 158
7.3 Confirmations 158
7.4 The Comparative-Advantage Argument 159
7.5 The Nature of Swap Rates 162
7.6 Determining LIBOR/Swap Zero Rates 163
7.7 Valuation of Interest Rate Swaps 164
7.8 Currency Swaps 168
7.9 Valuation of Currency Swaps 172
7.10 Credit Risk 174
Summary 176
Further Reading 177
Quiz 177
Questions and Problems 178
Assignment Questions 180
Chapter 8:Mechanics of Options Markets 181
8.1 Types of Options 181
8.2 Option Positions 184
8.3 The Underlying Assets 186
8.4 Specification of Stock Options 187
8.5 Newspaper Quotes 191
8.6 Trading 191
8.7 Commissions 193
8.8 Margins 194
8.9 The Options Clearing Corporation 196
8.10 Regulation 197
8.11 Taxation 197
8.12Warrants,Executive Stock Options,and Convertibles 198
8.13 Over-the-Counter Markets 199
Summary 201
Further Reading 201
Quiz 202
Questions and Problems 202
Assignment Questions 203
Chapter 9:Properties of Stock Options 205
9.1 Factors Affecting Option Prices 205
9.2 Assumptions and Notation 209
9.3 Upper and Lower Bounds for Option Prices 209
9.4 Put-Call Parity 213
9.5 Early Exercise:Calls on a Non-Dividend-Paying Stock 216
9.6 Early Exercise:Puts on a Non-Dividend-Paying Stock 217
9.7 Effect of Dividends 219
Summary 220
Further Reading 221
Quiz 221
Questions and Problems 222
Assignment Questions 223
Chapter 10:Trading Strategies Involving Options 225
10.1 Strategies Involving a Single Option and a Stock 225
10.2 Spreads 227
10.3 Combinations 236
10.4 Other Payoffs 239
Summary 239
Further Reading 240
Quiz 240
Questions and Problems 240
Assignment Questions 241
Chapter 11:Introduction to Binomial Trees 243
11.1 A One-Step Binomial Model 243
11.2 Risk-Neutral Valuation 246
11.3 Two-Step Binomial Trees 249
11.4 A Put Example 251
11.5 American Options 252
11.6 Delta 253
11.7 Determining u and d 254
11.8 Increasing the Number of Time Steps 255
11.9 Options on Other Assets 256
Summary 259
Further Reading 260
Quiz 260
Questions and Problems 261
Assignment Questions 262
Chapter 12:Valuing Stock Options:The Black-Scholes Model 263
12.1Assumptions about How Stock Prices Evolve 263
12.2 Expected Return 266
12.3 Volatility 267
12.4 Estimating Volatility from Historical Data 268
12.5 Assumptions Underlying Black-Scholes 271
12.6 The Black-Scholes/Merton Analysis 272
12.7 Risk-Neutral Valuation 275
12.8 Implied Volatilities 276
12.9 Dividends 277
Summary 279
Further Reading 280
Quiz 281
Questions and Problems 281
Assignment Questions 283
Appendix:The Early Exercise of American Call Options on Dividend-Paying Stocks 284
Chapter 13:Options on Stock Indices and Currencies 287
13.1 A Simple Rule 287
13.2 Pricing Formulas 289
13.3 Binomial Trees 289
13.4 Options on Stock Indices 290
13.5 Currency Options 296
Summary 298
Further Reading 299
Quiz 299
Questions and Problems 300
Assignment Questions 301
Chapter 14:Futures Options 303
14.1 Nature of Futures Options 303
14.2 Quotes 304
14.3 Reasons for the Popularity of Futures Options 305
14.4 Put-Call Parity 308
14.5 Bounds for Futures Options 309
14.6 Valuation of Futures Options Using Binomial Trees 310
14.7 A Futures Price as an Asset Providing a Yield 312
14.8 Black's Model for Valuing Futures Options 312
14.9 Futures Options vs.Spot Options 313
Summary 314
Further Reading 314
Quiz 315
Questions and Problems 315
Assignment Questions 316
Chapter 15:The Greek Letters 317
15.1 Illustration 317
15.2 Naked and Covered Positions 318
15.3 A Stop-Loss Strategy 318
15.4 Delta Hedging 320
15.5 Theta 329
15.6 Gamma 331
15.7 Relationship between Delta,Theta,and Gamma 334
15.8 Vega 335
15.9 Rho 337
15.10 The Realities of Hedging 338
15.11 Scenario Analysis 339
15.12Creating Options Synthetically for Portfolio Insurance 340
15.13 Stock Market Volatility 342
Summary 343
Further Reading 344
Quiz 344
Questions and Problems 345
Assignment Questions 347
Chapter 16:Valuation Using Binomial Trees 349
16.1 The Binomial Model for a Non-Dividend-Paying Stock 349
16.2 Using the Binomial Tree for Options on Indices,Currencies,and Futures Contracts 356
16.3 The Binomial Model for a Dividend-Paying Stock 359
16.4 Extensions of the Basic Tree Approach 362
16.5 Alternative Procedure for Constructing Trees 363
16.6 Monte Carlo Simulation 366
Summary 367
Further Reading 368
Quiz 368
Questions and Problems 368
Assignment Questions 369
Chapter 17:Volatility Smiles 371
17.1 Put-Call Parity Revisited 371
17.2 Foreign Currency Options 372
17.3 Equity Options 376
17.4 The Volatility Term Structure and Volatility Surfaces 377
17.5 When a Single Large Jump Is Anticipated 379
Summary 381
Further Reading 381
Quiz 382
Questions and Problems 382
Assignment Questions 383
Chapter 18:Value at Risk 385
18.1 The VaR Measure 385
18.2 Historical Simulation 388
18.3 Model-Building Approach 389
18.4 Linear Model 393
18.5 Quadratic Model 396
18.6 Estimating Volatilities and Correlations 398
18.7 Comparison of Approaches 402
18.8 Stress Testing and Back Testing 403
Summary 403
Further Reading 404
Quiz 405
Questions and Problems 405
Assignment Questions 407
Appendix:Cash-Flow Mapping 409
Chapter 19: Interest Rate Options 411
19.1 Exchange-Traded Interest Rate Options 411
19.2 Embedded Bond Options 413
19.3 Black's Model 413
19.4 European Bond Options 415
19.5 Interest Rate Caps 417
19.6 European Swap Options 423
19.7 Term Structure Models 426
Summary 427
Further Reading 427
Quiz 428
Questions and Problems 428
Assignment Questions 429
Chapter 20: Exotic Options and Other Nonstandard Products 431
20.1 Exotic Options 431
20.2 Mortgage-Backed Securities 437
20.3 Nonstandard Swaps 438
Summary 444
Further Reading 445
Quiz 446
Questions and Problems 447
Assignment Questions 448
Chapter 21:Credit Derivatives 449
21.1 Credit Default Swaps 449
21.2 Total Return Swaps 456
21.3 CDS Forwards and Options 458
21.4 Collateralized Debt Obligations 459
Summary 460
Further Reading 461
Quiz 461
Questions and Problems 461
Assignment Questions 462
Chapter 22:Weather,Energy,and Insurance Derivatives 465
22.1 Weather Derivatives 465
22.2 Energy Derivatives 466
22.3 Insurance Derivatives 469
Summary 470
Further Reading 471
Quiz 471
Questions and Problems 472
Assignment Question 472
Chapter 23:Derivatives Mishaps and What We Can Learn from Them 473
23.1 Lessons for All Users of Derivatives 473
23.2 Lessons for Financial Institutions 477
23.3 Lessons for Nonfinancial Corporations 481
Summary 482
Further Reading 482
Answers to Quiz Questions 485
Chapter 1 485
Chapter 2 486
Chapter 3 486
Chapter 4 487
Chapter 5 489
Chapter 6 489
Chapter 7 490
Chapter 8 492
Chapter 9 494
Chapter 10 494
Chapter 11 495
Chapter 12 497
Chapter 13 498
Chapter 14 500
Chapter 15 500
Chapter 16 501
Chapter 17 503
Chapter 18 503
Chapter 19 505
Chapter 20 505
Chapter 21 506
Chapter 22 507
Glossary of Terms 509
Major Exchanges Trading Futures and Options 525
Table for N(x)When x≤0 526
Table for N(x)When x≥0 527