ANALYSIS OF DERIVATIVES FOR THE CFA® PROGRAM Don M Chance, Ph.D., CFA Louisiana State University IMR® ASSOCIATION FOR INVESTMENT MANAGEMENT AND RESEARCH® To obtain the AIMR Product Catalog, contact: AIMR, P.O Box 3668, Charlottesville, Virginia 22903, USA Phone (001) 434-951-5499 or 800-247-8132; Fax (001) 434-951-5262; E-mail Info@aimr.org or visit AIMR's World Wide Web site at www.aimr.org to view the AIMR publications list CFA® Chartered Financial Analyst®, AIMR®, and the AIMR Logo are just a few of the trademarks· owned by the Association for Investment Management and Research® To view a list of the Association for Investment Management and Research's trademarks and the Guide for Use of AIMR's Marks, please visit our Web site at www.aimr.org ©2003 by Association for Investment Management and Research All rights reserved No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without permission of the copyright holder Requests for permission to make copies of any part of the work should be mailed to: AIMR, Permissions Department, P.O Box 3668, Charlottesville, VA 22903, USA This publication is designed to provide accurate and authoritative information in regard to the subject matter covered It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service If legal advice or other expert assistance is required, the services of a competent professional should be sought ISBN 0-935015-93-0 Cover design by Lisa Smith Printed in the United States of America by United Book Press, Inc., Baltimore, MD August 2003 ' Lt _ PREF ACE Analysis of Derivatives for the CFA® Program represents the fourth step i n a n ongoing ef fort by the Association for Investment Management and Research® (AIMR®) to produce a set of coordinated, comprehensive, and practitioner-oriented textbook readings specifi cally designed for the three levels of the Chartered Financial Analyst® Program The first step was the June 2000 publication of two volumes on fixed income analysis and portfo lio management: Fixed Income Analysis for the Chartered Financial Analyst Program and Fixed Income Readings for the Chartered Financial Analyst Program The second step was the August 2001 publication of Quantitative Methods for Investment Analysis The third step was the August 2002 publication of Analysis of Equity Investments: Valuation Giyen the favorable reception of these books and the expected favorable reception of the current book, similar textbooks in other topic areas are planned for the future This book uses a blend of theory and practice to deliver the derivatives analysis portion of the CPA Candidate Body of Knowledge (CBOK™) curriculum The CBOK is the result of an extensive job analysis conducted periodically, most recently during 2000 01 Regional job analysis panels of CPA practitioners convened in 10 cities around the world: Boston, Chicago, Hong Kong, London, Los Angeles, New York, Toronto, Seattle, Tokyo, and Zurich These and other practitioner panels specified the Global Body of Knowledge-what the investment ex pert needs to know From this, they derived the CBOK to encompass what the investment gen eralist needs to know to be effective on the job Analysis ofDerivatives for the CFA Program is a book reflecting the work of these expert panels The reader can thus be assured that the book captures current practice and reflects what the general investment practitioner needs to know about derivatives In producing this book, AIMR drew on input from numerous CPA charterholder re viewers, derivatives consultants, and AIMR professional staff members The chapters were designed to include detailed learning outcome statements at the outset, illustrative in-chapter problems with solutions, and extensive end-of-chapter questions and problems with complete solutions, all prepared with CPA candidate distance learning in mind In addition, the examples and problems reflect the global investment community Starting from a U.S.-based program of approximately 2,000 examinees each year during the 1960s and 1970s, the CPA Program has evolved into a pervasive global certification program that currently involves more than 100,000 candidates annually from more than 150 countries Through curriculum improvements such as this book, the CPA Program should continue to appeal to new candidates around the globe in future years The treatment in this volume is intended to communicate a practical risk manage ment approach to derivatives for the investment generalist Advanced concepts are included if needed by the generalist, but specialist topics are intentionally excluded The book provides a base for further specialist work if desired Unlike many alternative works, the book does not simply deliver an explanation of various derivatives instruments and positions but provides motivation for every derivatives position by explaining what the manager wants to accomplish prior to addressing the details of the position I believe CPA candidates will find this text superior to other derivatives texts for use in a distance - iii L, Preface iv learning framework The text presents difficult concepts efficiently and with a minimum of mathematical notation The presentation is academically rigorous yet based on practice and intuition Finally, in keeping with the tradition of the CFA Program, the text proceeds from tools to analysis to synthesis, with the last four chapters focusing on risk manage ment Although designed with the CFA candidate in mind, the book should have broad ap peal in the practitioner and other marketplaces AIMR Vice President Dennis McLeavey, CFA, spearheaded the effort to develop this book and the other CFA Program book projects Having someone involved in the editorial role of all the projects results in more consistent pedagogy and more even coverage across these various works than would be possible otherwise All of the authors who have worked with Dennis remark on his thoroughness, attention to detail, and commitment to the projects Dennis has a long and distinguished history of involvement with the CFA Program Before joining AIMR full time, he served on various AIMR committees On many levels, Don Chance, CFA, was the perfect individual to author this work First, Don is a CFA charterholder and is committed to the mission of the CFA Program Second, he is one of the leading derivatives experts in the world and is often quoted on derivatives topics in the media Third, and extremely valuable for this project, Don has many years of experience in preparing candidates for the CFA examinations and has first hand insight into the unique problems encountered by candidates in a distance-learning en vironment Fourth, and most important, he is an experienced author, having written numerous journal articles and textbooks The strong support of two groups should be acknowledged Peter Mackey, CFA, Chair of the Candidate Curriculum Committee, and the other members of the Executive Advisory Board of the Candidate Curriculum Committee (Alan Meder, CFA, James Bronson, CFA, and Matt Scanlan, CFA) identified the area of derivatives as one worthy of priority attention Finally, without the encouragement and support of AIMR CEO Tom Bowman and the AIMR Board of Governors, this project, intended to materially enhance the CFA Program, would not have been possible Robert R Johnson, Ph.D., CFA Senior Vice President Association for Investment Management and Research July 2003 -· · · fOREWORD When Dennis McLeavey and Bob Johnson approached me about writing a derivatives book for use in the CFA® Program, I was honored and excited Having been involved in the CFA Program for about 15 years, I would now' have the chance to be directly involved in determining what CFA charterholders should know about derivatives and how they should go about learning the material Being the risk management type, however, my first inclination is to see the down side, so I approached the project with some trepidation Having written other books and numerous (sometimes) highly technical articles on derivatives, I wondered if an introduc tory-level book on derivatives geared not toward the derivatives specialist but toward financial analysts-primarily those studying for the CFA examination-would be well received by fellow derivatives specialists Visions of book reviews by derivatives profes sionals asserting that the book is too basic and would not serve the needs of a trader or quant worried me But their observations would be correct The CFA examination is designed to train financial analysts, not traders or quants What CFA charterholders need to know about derivatives is not the same as what derivatives specialists need to know And when these groups need to know the same material, the approach to learning it is nec essarily different Also, CFA charterholders come from different backgrounds, have dif ferent technical skills, and think differently about financial problems than traders and quants A different approach is therefore needed This book is part of a formal integrated package of materials that prepares the CFA candidate for the examination This consideration is the driving force behind how the ma terial is presented Derivatives is only one part of the curriculum, but an important part My experience with CFA candidates over the years tells me that this is an area they tind among the most challenging hurdles in passing the examination Accordingly, we have gone to great lengths to elevate the quality and pedagogical features of this book As any CFA candidate knows, the Learning Outcome Statements (LOSs) identify in a concise manner the concepts that the candidate must learn Each LOS is then covered within the chapter The chapter ends with a set of items called "Key Points." There is a one-to-one correspondence between each LOS and each Key Point Although the candi date should not rely exclusively on the Key Points, they should be very useful as a concise review of the important concepts When it comes to learning derivatives, there is no substitute for working problems Accordingly, the material is liberally supported with numerical examples Each concept is illustrated not only with a numerical example but also by a subsequent detailed practice problem At the end of the chapter are approximately 20 more study problems with com plete solutions It would be virtually impossible for the candidate to say "I need more prob lems to work." The organizational structure of the book is also conducive to finding one's way around easily Each section of the book is numbered For example, consider the material in Chapter on futures markets Section is called Types of Futures Contracts Within _x Foreward vi Section are subsections called 6.1: Short-Term Interest Rate Futures Contracts, 6.2: In termediate- and Long-Term Interest Rate Futures Contracts, 6.3: Stock Index Futures Con tracts, and 6.4: Currency Futures Contracts Numbering sections provides a definitive link age among subtopics and between subtopics and the master topic The book contains bolded terms, which are defined in a glossary at the end of the book Key equations are numbered, and a list of these equations also appears at the end of the book Although the author gets most of the credit, many people participated in this project: Richard Applebach, CFA; Carl Bang, CFA; Pierre Bouvier, CFA; Robert Ernst, CFA; Darlene Halwas, CFA; Walter Haslett, CFA; Stanley Jacobs, CFA; Sandra Krueger, CFA; Robert Lamy, CFA; Erin Lorenzen, CFA; Barbara MacLeod, CFA; John Piccione, CFA; Jerald Pinto, CFA; Craig Ruff, CFA; and David Smith, CFA, provided reviews of the in dividual chapters Murli Rajan, CFA, and Sanjiv Sabherwal created the end-of-chapter problems and solutions, and both Louis James, CFA, and Greg Noronha, CFA performed detailed proofreading A special note of thanks goes to Fiona Russell and Jerry Pinto Fiona did the copy editing This has been the first time I have ever had a copyeditor who understood the sub ject, and it was a refreshing experience Jerry Pinto went over the book with a fine-toothed comb, catching items that would have required a microscope for most people I cannot imagine the quality of the book coming close to our objectives without their input Dennis McLeavey of AIMR served as the senior editor and worked closely enough with me to deserve his name on the book, but he modestly let me take all of the credit Dennis read every word many times and shaped the book into the CFA framework, mak ing sure that the concepts discussed in this book were consistent with treatments elsewhere in the curriculum If I listed everything Wanda Lauziere did on this book, I would quickly run out of space Let's just say she did everything else not covered in the above paragraphs If you ever write a book, you will know the enormous amount of work that must get done but is never obvious to the reader Wanda got things done and kept us all on schedule, while in jecting enough humor to remind me that we could all this project and have fun at the same time I jokingly tell Wanda that she could now probably pass the derivatives part of the exam Because I am now affiliated with Louisiana State University, the name of my former employer, Virginia Polytechnic Institute, does not appear formally in connection with this book The entire book was written during my time at Virginia Tech, so I want to especially thank the Pamplin College of Business of Virginia Tech for its support and encouragement of my efforts to learn more and teach more about derivatives Finally, I would like to thank my family My wife, Jan, and my daughters Kim and Ashley have always been there with great love and humor While they cannot imagine I could possibly know enough about a subject to write this much, they know I enjoy trying to convince people that I Don M Chance July 2003 �-,._ _ ABOUT THE AUTHOR Don M Chance, CFA, holds the William H Wright, Jr Endowed Chair for Financial Services at Louisiana State University He earned his CFA charter in 1986 He has extensive experience as a consultant and is widely quoted in the local, regional, and national media on matters related to derivatives, risk management, and financial markets in general Dr Chance has served as an instructor in professional training programs He is a consultant and advisor to AIMR in many capacities, including authorship of monographs on managed futures and real options, and he has spoken at many conferences of AIMR and other organizations He is the author of the university text An Introduction to Derivatives and Risk Management, 6th edition (forthcoming 2004), Essays in Derivatives (1998), and many academic and practitioner articles Dr Chance was formerly First Union Professor of Financial Risk Management at Virginia Polytechnic Institute, where he founded its student managed investment fund He holds a Ph.D in finance from Louisiana State University vii � - CONTENTS INDEX A Accounting risk, 607 608, 635 Add-on interest, 34, 635 American option(s), 62, 63, binomial model and, 1 credit risk and, 593 definition, 635 early exercise of, 92-193 on forward and futures contracts, 233 lower bounds, , 84 model risk and, 605-606 swaption and, 537, 54 1-543 Amortizing and accreting swaps, 305, 635 Analytical or variance-covariance method for estimating VAR, 578-582, Arbitrage, 9, 342 box spread and, 447 convenience yield and pricing futures contracts, 1 covered interest, 58 definition, 635 futures and options I ink, 73 one-period binomial and, 98-199 opportunity for, 7, points, pricing currency futures and, 35 pricing futures contracts and, 07, 08, 09 regulatory risk and, 606 strategies for put-call parity, 90 92 Arrears swap, 305, 635 Asset allocation with futures, 369-3 78 adjusting among classes, 370 376 preinvesting in asset class, 376-378 At the money, 64, 67, 635 B B ackwardation, 1 5, definition, 635 normal, 1 Bank for International Settlements, 1 - credit derivatives usage survey by, 604 on notional principal of global over-the counter derivatives market, 270 on swaps percentage of market, 507 Bankruptcy credit risk of forward contracts and, 592 creditor's claims and, 589 default causing, 591 managing risk and, 57 , 572 netting and, 597 remaining in business after, 595 risk governance and, 61 settlement risk and, 606 subsidiary when parent company declares, 598 Basis point value, 348, 635 Basis swap, 279, 304, 635 Bear spread, 433-436 definition, 635 profit from, 482 Beta, 356-357 definition, 635 duration versus, 357 equity portfolio and adjusting, 35R-36 , 369 market risk and, 574 measuring, 387 Binomial model, 95-2 2, 24 American options, 1 bond valuation and, 309 definition, 635 extending, 1-2 interest rate option pricing, 205-2 1 one-period, 95-200, 241 put option pricing, 204 205 two-period, 200 204, 241 vega from, 480 Binomial tree, 241 American options and, 1 definition, 635 example, 95-1 96, 200 interest rate type, 206 more than two time periods type, 205 BIS See Bank for International Settlements Black model, 233-235, 242 Black-Scholes-Merton model and, 234 bond valuation and, 309 interest rate options and appl ications of, 235-238 Black-Scholes-Merton model, 2-228, 24 , 242, 4 assumptions, 2-2 binomial model versus, 95 Black model and, 234 bond valuation and, 309 - - - -· - - cash flows in underlying effect, 224 225 estimating historical volatility, 226 227 European options and, exercise price, 220 formula, 3-2 6, 441 inputs to, 6-224 normal probability distribution, 14 risk usage, 605 606 risk-free rate, 220 21 rounding errors and, time to expiration, 222-223 underlying price, 6-220, 428 vega from, 480 volatility role, 223-224, 225-228 Bond option(s), 69-170, 635 Bond portfolio risk, managing, 347-355 bond futures versus, 349-35 government type of, -354 measuring risk, 347-349 measuring risk of bond futures and, 349 variations and problems, 354 55 Box spread, 447-449, 482-483 definition, 635 profit from, 448, 483 reasons to use, 447 value at expiration, 447, 448, 483 BPV See Basis point value Brokers definition See Futures commission merchants Bull spread, 430-433 collars and, 443 definition, 635 profit from, 482 Butterfly spread, 436 40 definition, 635 profit from, 482 sandwich spread and, 439 value at expiration illustration, 438 volatility in underlying, 439, 444 c Call(s), 5-4 adding feature i n noncallable debt, 547-550, 553 combined with puts, 440-449 covered, 422-426, 441 definition, 635 long, 422 643 - · - - -· · � - � - - - - - - - - Index 644 option and, 6, , 73 profit from buying, 48 removing feature in callable debt, 544-547, 553 short, 422 Callable bond definition, 544 swaption to sell, 544-550 Cap definition, 72, 239, 460, 635, 638 floor versus, 464 Caplet, 172, 235, 237, 239, 460-463 definition, 635 exercise rate on, 460 payoff of, 483 Capped swap, 305, 635 Carrying costs, 109, 641 Cash flow at risk, 588, 635 Cash price, 2, 635 Cash settlement, 26 definition, 635 forward contract, 591 futures contracts and, 92 options and, 161 CBOT See Chicago Board of Trade Centralized risk management, 0, 1 , 635 636 CFAR See Cash flow at risk CFTC See Commodity Futures Trading Commission Cheapest to deliver (bond), 00, 1 definition, 636 determining, 27-128 futures contract and, 349 Cherry-picking, 597, 636 Chicago Board of Trade, 83 Clearinghouse clearing firms and, 94 daily settlement, 88 definition, 636 futures exchange and, 4, 82, 85, 86, 91-92, 140 margin setting by, 87 options and, 67-168 Closeout netting, 597, 636 CMT See Constant maturity treasury CMT swap See Constant maturity swap Collar(s), 172, 429, 440-444 bull spreads versus, 443 definition, 636 interest rate, 443 profit from, 482 zero-cost, 44 , 443 Collateral and credit risk reduction, 596-597 Commodity forward(s), 37, 636 Commodity futures, 95 definition, 636 most active, 96 Commodity Futures Trading Commission, 85, 173, 354 Commodity option(s), 74, 636 Commodity swap(s), 270, 285, 506, 636 Companywide risk management definition, 635-636 Constant maturity swap, 304, 305, 636 Constant maturity treasury definition, 636 Contango, 1 5, 141 definition, 636 normal, 16 Contingent claims, 6-8, 636 Continuous time, 195 definition, 636 options pricing See Black-Scholes Merton model Convenience yield definition, 636 pricing futures contracts and, 1 1-1 Conversion factor, I 00, 636 Convexity, 574 Cost of carry, 1 definition, 636 formula for stock index futures, 30 Cost of carry model, 1 2, 1 6, 636 Covariance, 356-357 definition, 636 estimating VAR, 578-582, Covered call(s), 422-426 collar and, 441 definition, 636 profit from, 482 Covered interest arbitrage, 58, 636 Credit at risk, 598, 636 Credit derivatives, 599-604, definition, 636 insurance versus, 600 market size of, 604 types, 600-603, Credit risk, 106 collateral and reduction of, 596-597 controlling, 614 credit standards (minimum) and deriva tive product companies (enhanced) and reduction of, 597-599 current, 1 , 589 definition, 636 dimensions of, forward contracts and, 27-28, 61 63, 59 1-592, 614 Group of 30 on measurement and management of, insurance and, 599-600 limiting exposure and reduction of, 595 managing, 588 604 marking to market and reduction of, 595-596 netting and reduction of, 597 option pricing theory and, 589-591 of options, 593-595, 614 potential, 1 , 589 swaps and, 1-314, 8, 592-593, techniques for managing, 595-599 traditional notions of, 588-595 value at risk and, 598, 614 Credit spread option, 602-603, 14, 636 Credit swap(s), 600-60 , 614, 636 Credit VAR, 598, 599, 636 Credit-linked notes, 603-614, 636 Cross-product netting, 597, 636 Currency forward contracts, 36-37 pricing and valuation formulas for, 59-60 pricing and valuation of, 56 , 35 Currency forward hedge, 37 Currency futures contracts, 102-103 pricing, 35-13 Currency option(s), 165, 172-1 73, 636 Currency risk See Foreign currency risk, managing Currency swap(s), 27 , 274-278 , 5-3 6, 506 converting foreign cash receipts into domestic currency, 523-524, 552 converting loan in one currency to loan in another currency, 9-523, 55 to create and manage risk of dualcurrency bond, 525-527 credit risk and, 2, 8, 593, 595 currency options and, 65 dealers in, top, 273 definition, 636 exchange rate risk managed by using, 9-257 fixed rates on, interest rate swap versus, payments, 593 payments calculation, pricing and valuation, 294-299 types, 294 uses, 523 Current credit risk, 1 , 589, 4, 636 D Daily settlement See Marking to market Day trader, 94, 637 Dealer strategies for hedging, 470-480, 483 Dealers and legal risk, 607 Decentralized risk management, 0, 637 Deep in the money, 67, 637 Deep out of the money, 167, 637 Default risk See also Credit risk bilateral, 593 definition, 636 forward contracts and, 4, 27 future contracts and, over-the-counter instruments and, 271 swaps and, 27 , 272 Default VAR, 598, 636 Delivery, 26 definition, 637 futures contract and, 92 Delivery option, 93, 140, 637 645 Index Delta, 17-2 19, 24 , 470-47 , 484 bonds and, 574 definition, 194, 241-242, 470, 637 effect of time on, 473-474 gamma and risk of, 479 option risk sensitivity and, 473 risk and, 574, 57 risk measurement and, Delta hedge, 8, 242, 470-472, 483 definition, 637 example, 47 option over time using, 472-479 short options position example, 475-476 volatility and, 480 Delta-normal method, 582, 637 Derivative(s) classification of, definition, 2, 637 global exchanges of, life of, pricing principles of, elementary, 6-20 top dealers per Risk magazine, 29-30 transaction costs, 15, 388 types, Derivative markets criticisms of, 5-16 instruments and, 1-24 introduction, 1-2 key points, 20 measuring, 10- past and present, 8-10 purposes, 3-15 size, 10-13 types of, Derivatives dealers, 10, 637 Diff swaps, 305, 637 Discount interest, 33, 637 Discrete time, 195, 637 Diversification concentrated portfolio and, 528-530, 552 international, 530-53 , 552 Dual-currency bond, using swaps to create and manage risk of, 525-527, 552 Duration, 347-349 beta versus, 357 definition, 637 dollar-implied modified, 357, 389 fixed-rate loan and, 55 floating-rate bond and, 509-5 implied, 349 interest-rate swap and, 55 measuring, 387 modified, 355, 389 portfolio, 508 risk and, 574 swaps and, 10, Dynamic hedging, 218, 637 E e-trading, 10, 84, 85-86 futures exchanges and, 94, 95, 139 - options and, 67 EAR See Earnings at risk Earnings at risk, 588, 637 Economic exposure, 379, 637 EDPC See Enhanced derivatives products companies EFP See Exchange for physicals Electronic trading See e-trading Enhanced derivatives products companies credit risk reduction and, 597-599 definition, 637 Enterprise risk management, 1 , 637 Equitizing cash, 364-366, 637 Equity forward basis for, 30-32 definition, 30, 637 dividends effect on, 32 pricing and valuation formulas, 48-49 pricing and valuation of, 45-50 Equity market risk, managing, 343 achieving international diversification, 530-531 changing asset allocation between stocks and bonds, 532-535 creating cash out of equity, 366-369 creating equity out of cash, 361 -366 diversifying a concentrated portfolio, 528-530 insider exposure, reducing, 535-537 measuring, 356-358 portfolio, 358-361 strategies and applications, 356-369, 527-537 Equity options, 169, 637 Equity portfolios, option strategies for, 3-449 bear spreads, 433-436 box spreads, 447-449 bull spreads, 430-433 butterfly spreads, 436-440 calls, 5-4 19 collars, 440-444 combination of calls and puts, 440-449 covered calls, 422-426 money spreads, 430-440 protective puts, 426-429 puts, 19-422 standard long and short positions, 5-422 straddle, 444-447 Equity swap, 270, 28 1-285, 506 cash flow problems and, 552 changing asset allocation between stocks and bonds, 532-535, 552 credit risk and, 2, definition, 528, 637 diversification using, 528-530, 552 expiration date of, 528 features, 281-282 fixed rate on, insider exposure, reducing, 535-537 international diversification using, 530-5 , 552 payments calculation, pricing and valuation, 299-303 types of, 299, Eurodollar, 34 definition, 637 futures, 1 , 84, 98-99 pricing futures and, 24-125 time deposits, 34 European option(s), 62, 163, 239, Black model for pricing of, 233-235 B lack-Scholes-Merton model and, 3, 222 credit risk and, 593 definition, 637 lower bounds, , 84 model risk and, 605-606 Exchange for physicals, 93-94, 637 Exchange rate risk, strategies and applications for managing, 9-527 converting foreign cash receipts into domestic currency, 523-524 converting loan in one currency to loan in another currency, 9-523 currency swaps use to create and man age risk of dual-currency bond, 525-527 Exchange-traded contracts, 2, 414, 470, 588 Exercise (exercising) the option, American-style, 162 definition, 627 European style, 162 Exercise price, 6, , 6, 220 collars and, 441 definition, 637 spreads and, 430 swaptions and, 537 Exercise rate, 70, definition, 637 swaptions and, 537 Exercise value, 78, 639 Expiration date, 27 definition, 637 options, F FCMs See Futures commission merchants Fiduciary call definition, 637 as option strategy, 87-188, 90, 240 Financial futures, 95 definition, 638 most active, 96 Financial risks, 570, 572, Fixed-income forward definition, 638 pricing and valuation of, 50-5 Fixed-income portfolio, using swaps to adjust duration of, 2-5 14 Fixed-income swaps, 533 Index 646 Floating-rate loan, , 72, 288 definition, 638 for interest rate cap with, 460-464 for interest rate collar with, 466-470 for interest rate floor with, 464-466 for interest rage swaps to fixed-rate loan to, 508-5 1 , 551 managing interest rate risk on, 346-347 Floor(s), 72, 239, 464 cap versus, 464 definition, 638 Floor traders, 94, 638 Floor-based trading See Pit trading Floored swap, 305, 638 Floorlet, 172, 239, 464, 483, 638 Foreign currency risk, managing, 343 asset portfolio, foreign-market, 382-385 forward contracts and, 386 hedging and, 382-385, 390 payment, 380-382, 390 receipt, 379-380, 390 strategies and applications for, 378-385 Forward commitments, -{i Forward contract(s), 25-79 credit risk in, 27-28, 61 -Q3, 591-592, 614 currency, 36 default and, default risk and, 27 definition, 2, 3, 26, 638 delivery and settlement of, 26 feature of, important, 26 futures contract versus, 3-5, 6, 63, 82, 85, 38, 385-387 on individual bonds and bond portfolios, 33-34 on individual stocks, 30-3 on interest rates, 34-36 key points about, 64 -{i6 liquidity, 388, 39 to manage risk of foreign cash flow, 379-385 place for, pricing and valuation formulas for, 43-44 pricing and valuation of, 37 -Q I pricing options on, 228-238 process of pricing summary, 41 put-