Chapter1 Introduction 1
Derivative Markets and Instruments 2
Options 2
Forward Contracts 3
Futures Contracts 3
Options on futures 4
Swaps and Other Derivatives 4
The Underlying Asset 5
Some Important Concepts in Financial and Derivative Markets 5
Risk Preference 5
Short Selling 5
Return and Risk 6
Market Efficiency and Theoretical Fair Value 6
Fundamental Linkages between Spot and Derivative Markets 8
Arbitrage and the Law of One Price 8
The Storage Mechanism:Spreading Consumption across Time 9
Delivery and Settlement 10
The Role of Derivative Markets 10
Risk Management 10
Price Discovery 11
Operational Advantages 11
Market Efficiency 12
Criticisms of Derivative Markets 12
Misuses of Derivatives 12
Derivatives and Your Career 13
Sources of Information on Derivatives 14
Summary 14
Further Reading 14
Questions and Problems 15
PART ⅠOptions 17
Chapter2 The Structure of Options Markets 18
The Development of Options Markets 19
Call Options 20
Put Options 21
The Over-the-Counter Options Market 21
Organized Options Trading 23
Listing Requirements 23
Contract Size 23
Exercise Prices 24
Expiration Dates 24
Position and Exercise Limitw 25
Options Exchanges and Trading Activity 26
Option Traders 27
The Market Maker 27
The Floor Broker 28
The Order Book Official 28
Other Option Trading Systems 28
Off-Floor Option Traders 29
The Mechanics of Trading 29
Placing an Opening Order 29
The Role of the Clearinghouse 30
Placing an Offsetting Order 31
Exercising an Option 32
Option Price Quotations 33
Types of Options 34
Stock Options 34
Index Options 35
Currency Options 36
Other Types of Traded Options 36
Real Options 37
Transaction Costs in Option Trading 38
Floor Trading and Clearing Fees 38
Commissions 38
Bid-Ask Spread 39
Other Trnsaction Costs 39
The Regulation of Options Markets 40
Summary 41
Further Reading 41
Questions and Problems 41
Appendix2:Margin Requirements 43
Chapter3 Prciples of Option Pricing 45
Basic Notation and Terminology 46
Principles of Call Option Pricing 47
The Minimum Value of a Call 47
The Maximum Value of a Call 49
The Value of a Call at Expiration 49
The Effect of Time to Expiration 49
The Effect of Exercise Price 52
The Lower Bound of a European Call 55
American Call Versus European Call 58
The Early Exercise of American Calls on Dividend-Paying Stocks 59
The Effect of Inrerest Rates 60
The Effect of Stock Volatility 60
Principles of Put Option Pricing 61
The MInimum Value of a Put 61
The Maximum Value of a Put 62
The Value of a Put at Expiration 63
The Effect of Time to Expiration 64
The Effect of Exercise Price 65
The Lower Bound of a European Put 67
American Put Versus European Put 70
The Early Exercise of American Puts 70
Put-Call Parity 70
The Effect of Interest Rates 73
The Effect of Stock Volatility 74
Summary 75
Further Reading 76
Questions and Problems 77
Appendix 3:The Dynamics of Option Boundary Conditions:A Learning Exercise 80
Chapter4 Option Pricing Models:The Binomial Model 81
The One-Period Binomial Model 82
An Illustrative Example 85
A Hedge Portfolio 86
An Overpriced Call 87
An Underpriced Call 87
The Two-Period Binomial Model 88
An Illustrative Example 91
A Hedge Portfolio 92
A Mispriced Call in the Two-Period World 94
Extensions of the Binomial Model 95
Pricing Put Options 95
American Puts and Early Exercise 97
Dividends,European Calls,American Calls,and Early Exercise 98
Extending the Binomial Model to n Periods 103
The Behavior of the Binomial Model for a Large n and a Fixed Option Life 105
Alternative Specifications of the Binomial Model 106
SOFTWARE DEMONsTRATIoN 4.1 109
Calculating the Binomial Price with the Excel Spreadsheet:bsbin3.xls 109
Summary 109
Further Reading 110
Questions and Problems 110
Chapter5 Option Pricing Models:The Black-Scholes Model 112
The Black-Scholes Model as the Limit of the Binomial Model 113
The Assumptions of the Model 114
Stock Prices Behaue Randomly and Evolve According to a Lognormal Distribution 115
The Risk-Free Rate and Volatility of the Log Return on the Stock Are Constant throughout the Option's Life 118
There Are No Taxes or Transaction Costs 119
The Stok Pays No Dividends 119
The Options Are European 120
A Nobel Formula 120
A Numerical Example 121
SOFTWARE DEMONSTRATION 5.1 122
Calculating the Black-Scholes Price with the Excel Spreadsheet:bsbin3.xls 122
Characteristics of the Black-Scholes Formula 122
The Variables in the Black-Scholes Model 126
The Stock Price 126
The Exercise Price 131
The Risk-Free Rate 132
The Volatility or Standard Deviation 134
The Time to Expiration 136
The Black-Scholes Model When the Stock Pays Dividends 138
Known Discrete Dividends 138
Known Continuous Dividend Yield 139
The Black-Scholes Model and Some Insights into American Call Options 141
Estimating the Volatility 142
Historical Volatility 142
SOFTWARE DEMONsTRATION 5.2 143
Calculating the Historical Volatility with the Excel Spreadsheet:hisv2.xls 143
Implied Volatility 143
Put Option Pricing Models 147
Managing the Risk of Options 150
Summary 155
Further Reading 156
Questions and Problems 157
Appendix 5:The BSBWIN2.2 Windows Software 160
Chapter6 Basic Option Strategies 161
Terminology and Notation 162
The Profit Equations 162
Different Holding Periods 164
Assumptions 165
Stock Transactions 165
Buy Stock 165
Sell Short Stock 165
Call Option Transactions 166
Buv a Call 166
Write a Call 170
Put Option Transactions 173
Buy a Put 173
Write a Put 175
Calls and Stock:The Covered Call 178
Some General Considerations with Covered Calls 183
Puts and Stock:The Protective Put 184
Synthetic Puts and Calls 187
SOFTWARE DEMONSTRATION 6.1 190
Analyzing Option Strategies with the Excel Spreadsheet:stratlyz3.xls 190
Summary 190
Questions and Problems 191
PART ⅡForwards,Futures,and Swaps 193
Chapter7 The Structure of Forward and Futures Marketa 194
The Development of Forward and Futures Markets 195
Chicago Futures Markets 195
The Development of Financial Futures 196
The Development of Options on Futures Markets 197
The Parallel Development of Over-the-Counter Markets 198
The Over-the-Counter Forward Market 198
Organized Futures Trading 199
Contract Development 199
Contract Terms and Conditions 200
Delivery Terms 201
Daily Price Limits and Trading Halts 201
Other Exchange Responsibilities 202
Futures Exchanges 202
Futures Traders 204
General Classes of Futures Traders 204
Classification by Trading Strategy 204
Classification by Trading Style 204
Off-Floor Futures Traders 206
Forward Market Traders 206
The Mechanics of Futures Trading 206
Placing an Order 207
The Role of the Clearinghouse 207
Daily Settlement 208
Delivery and Cash Settlement 211
Futures Price Quotations 212
Types of Futures Contracts 213
Agricultural Commodities 213
Natural Resources 213
Miscellaneous Commodities 214
Foreign Currencies 214
Treasury Bills and Eurodollars 214
Treasury Notes and Bouds 214
Equities 215
Managed Funds 215
Hedge Funds 217
Options on Futures 218
Transaction Costs in Forward and Futures Trading 218
Commissions 218
Bid-Ask Spread 218
Delivery Costs 219
The Regulation of Futures and Forward Markets 219
Summary 220
Further Reading 221
Questions and Problems 221
Chapter8 Principles of Pricing Forwards,Futures,and Options on Futures 223
Properties of Forward and Futures Prices 224
The Concept of Price versus Value 224
The Value of a Forward Contract 224
The Value of a Futures Contract 226
Forward versus Futures Prices 228
A Forward and Futures Pricing Model 230
SpotPrices,RiskPremiums,and the Cost of Carry for Generic Assets 230
The Theoretical Fair Price 232
Futures Prices and Risk Premia 237
Forward and Futures Pricing When the Underlying Generates Cash Flows 240
Another Look at Valuation of Forward Contracts 243
Pricing Foreign Currency Forward and Futures Contracts:Interest Rate Parity 244
Prices of Futures Contracts of Different Expirations 246
Put-Call-Forward/Futures Parity 247
Pricing Options on Futures 248
The Intrinsic Value of an American Option on Futures 249
The Lower Bound of a European Option on Futures 249
Put-Call Parity of Options on Futures 251
Early Exercise of Call and Put Options on Futures 252
The Black Option on Futures Pricing Model 253
Summary 257
Further Reading 258
Questions and Problems 259
Chapter9 Forward and Futures Hedging Strategies 260
Hedging Concepts 261
Short Hedge and Long Hedge 261
The Basis 261
Some Risks of Hedging 264
Contract Choice 265
Margin Requirements and Marking to Market 267
Determination of the Hedge Ratio 269
Minimum Variance Hedge Ratio 269
Price Sensitivity Hedge Ratio 271
Stock Index Futures Hedging 273
Tailing the Hedge 274
Hedging Strategies 274
Foreign Currency Hedges 275
Intermediate-and Long-Term Interest Rate Hedges 277
Stock Market Hedges 280
Summary 284
Further Reading 285
Questions and Problems 285
Appendix9:Derivation of the Hedge Ratio 288
Minimum Variance Hedge Ratio 288
Price Sensitivity Hedge Ratio 288
Chapter10 Swaps 290
Interest Rate Swaps 292
The Structure of a Typical Interest Rate Swap 292
The Pricing and Valuation of Interest Rate Swaps 295
Interest Rate Swap Strategies 301
Currency Swaps 303
The Structure of a Typical Currency Swap 303
The Pricing and Valuation of Currency Swaps 305
Currency Swap Strategies 309
Equity Swaps 312
The Structure of a Typical Equity Swap 313
Pricing and Valuation of Equity Swaps 314
Equity Swap Strategies 318
Some Final Words about Swaps 320
Summary 321
Further Reading 321
Questions and Problems 322
PART ⅢAdvanced Topics 325
Chapter11 Interest Rate Forwards and Options 326
Forward Rate Agreements 327
The Structure and Use of a Typical FRA 327
The Pricing and Valuation of FRAs 329
Applications of FRAs 331
Interest Rate Options 333
The Structure and Use of a Typical Interest Rate Option 334
Pricing and Valuation of Interest Rate Options 335
Interest Rate Option Strategies 336
Interest Rate Caps,Floors,and Collars 341
Interest Rate Options,FRAs,and Swaps 347
Summary 348
Further Reading 348
Questions and Problems 349
Chapter12 Financial Risk Management Techniques and Applications 352
Why Practice Risk Management? 353
The Impetus for Risk Management 353
The Benefits of Risk Management 353
Managing Market Risk 355
Delta Hedging 356
Gamma Hedging 358
Vega Hedging 360
Value at Risk (VAR) 362
Benefits and Criticisms of VAR 368
Managing Credit Risk 369
Option Pricing Theory and Credit Risk 369
The Credit Risk of Derivatives 371
Netting 374
Credit Derivatives 376
Other Types of Risks 378
Summary 382
Further Reading 382
Questions and Problems 383
Appendix 12:Monte Carlo Simulation 385
Chapter13 Managing Risk in an Organization 388
The Structure of the Risk Management Industry 389
End Users 389
Dealers 390
Other Participants in the Risk Management Industry 391
Organizing the Risk Management Function in a Company 392
Risk Management Accounting 395
Fair Value Hedges 396
Cash Flow Hedges 397
Foreign Investment Hedges 399
Speculation 399
Some Problems in the Application of FAS 133 399
Disclosure 400
Risk Management Industry Standards 400
Responsibilities of Senior Management 406
Summary 407
Further Reading 407
Questions and Problems 408