Derivatives: The Tools that Changed Finance doc

Derivatives THE TOOLS THAT CHANGED FINANCE Derivatives THE TOOLS THAT CHANGED FINANCE Phelim Boyle & Feidhlim Boyle Several people have helped us in connection with this book and it has ben- efited from their comments and their suggestions. Even when we did not follow their advice on a particular point, we were forced to think about how we could do a better job of explaining the issue. These individuals are not responsible for any remaining errors – we are. Junichi Imai provided excellent technical assistance throughout the pro- ject. Darko Lakota and Sahar Kfir read earlier drafts and made many thoughtful suggestions. Peter Christoffersen and Dietmar Leisen gave use- ful comments on how firms use derivatives. Gladys Yam helped with the proof reading and Lochlann Boyle made suggestions on the syntax. Geoff Chaplin critiqued our discussion of credit risk. Hans Buhlman, Yuri Kabanov and Philippe Artzner provided several historical details. A number of individuals shared their ideas and experiences with us. These include Sheen Kassouf, Case Sprenkle, Ed Thorp, Mark Rubinstein, Farshid Jamshidian, David Heath, Richard Rendleman, Britt Barter and Tom Ho. Jeremy Evnine gave us a first-hand account of what it was like to be in the trenches during the stock market crash of October 1987. The authors are extremely grateful to Amy Aldous for taking care of so many details associated with this work in her usual efficient manner. Bill Falloon initially conceived the idea for this book. We would like to thank Martin Llewellyn, our editor at Risk books, for all his hard work on this project. Feidhlim Boyle would like to thank his dad for the opportunity to work with him on this project. He credits his own interest in and knowledge of derivatives to his father’s influence. Feidhlim did much of the early research on the book but during the later stages, when he was a full time MBA student at Cornell, he did not have as much time for the book as he would have liked. He is indebted to Jim Doak and Professor Charles M. C. Lee whose knowledge of investments contributed to greatly to his under- standing of markets. On a personal note, Feidhlim is deeply grateful to Roben Stikeman for all her support and encouragement during the research and writing process. Phelim Boyle’s ideas on derivatives have been shaped by discussion over the years with his students, colleagues and individuals in the investment community. The list is too long to name every person individually. However, he would like to single out Leif Andersen, George Blazenko, Mark Broadie, Ren-Raw Chen, Piet de Jong, Baoyan Ding, David Downie, v Acknowledgements David Emanuel, Paul Glasserman, Yann d’Halluin, Houben Huang , Lee Ann Janissen, Sok Hoon Lau, Inmoo Lee, Dawei Li, Sheldon Lin, Chonghui Liu, Jennifer Mao, Jennifer Page, Dave Pooley, Eric Reiner, Yisong Tian, Vishwanath Tirupattur, Stuart Turnbull, Ton Vorst, Tan Wang, Hailang Yang, Dehui Yu and Robert Zvan. He is particularly fortunate to work with and learn so much from Ken Seng Tan and Weidong Tian. Phelim is grate- ful to his colleagues at the University of Waterloo especially David Carter, Peter Forsyth, Andrew Heunis, Adam Kolkiewicz, Don McLeish, Bill Scott, Ranjini Sivakumar and Ken Vetzal. Phelim Boyle’s greatest debt is to his wife Mary Hardy. She provided sage counsel, strong support and warm encouragement throughout the project. DERIVATIVES vi Acknowledgements v Authors ix Preface xi 1 Introduction 1 2 Markets and Products 15 3 Why there are No Free Lunches 37 4 Pricing by Replication 49 5 The Quest for the Option Formula 71 6 How Firms Hedge 95 7 How Investors use Derivatives 115 8 Disasters: Divine Results Racked by Human Recklessness 135 9 Credit Risk 155 10 Financial Engineering: Some Tools of the Trade 177 Further Reading 191 Bibliography 193 Index 199 vii Contents [...]... its exposure to the Enron shares for the two-year period Swap terminology We now describe some of the terms associated with swaps The duration of the swap contract is called the tenor of the swap In the above example the tenor is two years The two parties to the contract are called the counterparties, following the example, the counterparties are the pension plan and the investment bank The sequence of... has favoured the person holding the long position because they can buy the asset for less than its market value However, if the price of the asset falls during the life of the contract, the asset will be less than the contract price at the delivery date In this case fortune has favoured the person holding the short position because they can sell the asset for more than its market value The parties have... electricity We take the existence of the steady supply of power for granted, the price we pay is an average price based on the usage for the month The total consumption for a given region is the sum of the usage by the households and industries in that region This consumption varies considerably by time of day, by the season of the year and also with the vagaries of the weather The total consumption... price 3 DERIVATIVES The price to be paid for the asset is termed the delivery price or the contract price This price is fixed at inception and does not change over the term of the contract In contrast, the price of the underlying asset will change as time passes If the price of the asset rises a lot over the term of the contract, the asset will be worth more than the contract price at the delivery date... painting or a rare bottle of Chateau Margaux The terms of the option contract specify the underlying asset, the duration of the contract and the price to be paid for the asset In option jargon, the fixed price agreed upon for buying the asset, is called the exercise price or the strike price The act of buying or selling the asset is known as exercising the option The simplest type of option is a “European”... The sequence of fixed payments is called the fixed leg of the swap and the sequence of variable payments is called the variable leg of the swap In a commodity swap the payments on one leg of the swap may be based on the market price of the commodity Sometimes the swap is based on the actual delivery of the underlying commodity Cominco, the largest zinc producer in the world, is based in British Columbia,... level, then the location needs to specified For example, the traded weather options on the Chicago Mercantile Exchange use the temperature readings at O’Hare Airport as a basis for their Chicago contract Power providers and energy utilities have considerable exposure to the vagaries of the weather If the summer is very hot consumers will turn up the air conditioning and if the winters are very cold there... OTC derivatives are only guaranteed by the issuer Thus, the investor is subject to credit (default) risk The longer the term, the higher is the risk that one of the parties will default Firms and countries that seem strong today may be in default in the future Steve Ross has noted that the largest stock markets in the world 100 years ago were in Russia, Austria and the UK.9 DERIVATIVES AND DISASTERS Inordinate... parties have agreed in advance to exchange the asset for the contract price at a fixed rate in the future However, when the delivery date arrives, one of the parties will show a profit on the contract and the other will show a loss We will explain later how the contract (delivery) price is determined at the outset so that when the forward contract is set up, the terms of the contract are fair to both parties... amount equal to the change in the market value of its Enron shares In return, the plan receives the agreed fixed dollar amount every month; after two years the swap expires The pension plan still owns its Enron shares The two parties go their separate ways During this two-year period the bank receives the same returns that it would have received had it owned the Enron common shares The pension plan . Derivatives THE TOOLS THAT CHANGED FINANCE Derivatives THE TOOLS THAT CHANGED FINANCE Phelim Boyle & Feidhlim Boyle Several. technical audi- ences. They describe the details of the underlying models and tend to focus on the mathematical models and the technical details. The second group