PEARSON ALWAYS LEARNING Financial Risk Manager (FRM®) Exam Part I Financial Markets and Products Fifth Custom Edition for Global Association of Risk Professionals 2015 I Association of Risk Professionals Excerpts taken from: Options, Futures, and Other Derivatives, Ninth Edition, by John C Hull Derivatives Markets, Third Edition, by Robert McDonald Excerpts taken from: -Dptions,F-Lltur-€Sr and-Other-Deriv-atjv €s,Ni~th -Edition- - - - - - - - - by John C Hull Copyright © 2015, 2012, 2009, 2006, 2003, 2000 by Pearson Education, Inc Upper Saddle River, New Jersey 07458 Derivatives Markets, Third Edition by Robert McDonald Copyright © 2012, 2005 by Pearson Education, Inc Published by Addison Wesley Boston, Massachusetts 02116 Copyright © 2015, 2014, 2013, 2012, 2011 by Pearson Learning Solutions All rights reserved This copyright covers material written expressly for this volume by the editor/s as well as the compilation itself It does not cover the individual selections herein that first appeared elsewhere Permission to reprint these has been obtained by Pearson Learning Solutions for this edition only Further reproduction by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval system, must be arranged with the individual copyright holders noted Grateful acknowledgment is made to the following sources for permission to reprint material copyrighted or controlled by them: Chapters 1, 2, and from Futures and Options (2009), by permission of The Institute for Financial Markets "Foreign Exchange Risk," by Marcia Millon Cornett and Anthony Saunders, reprinted from Financial Institutions Management: A Risk Management Approach, Eighth Edition (2011), McGraw-Hili Companies "Corporate Bonds," by Steven Mann, Adam Cohen and Frank Fabozzi, reprinted from The Handbook for Fixed Income Securities, Eighth Edition, edited by Frank Fabozzi (2012), McGraw-Hili Companies "Mortgages and Mortgage-Backed Securities," by Bruce Tuckman and Angel Serrat, reprinted from Fixed Income Securities: Tools for Today's Markets, Third Edition (2011), by permission of John Wiley & Sons, Inc "The Rating Agencies," by John B Caouette et aI., reprinted from Managing Credit Risk: The Great Challenge for Global Financial Markets, Second Edition (2008), by permission of John Wiley & Sons, Inc Learning Objectives provided by the Global Association of Risk Professionals All trademarks, service marks, registered trademarks, and registered service marks are the property of their respective owners and are used herein for identification purposes only Pearson Learning Solutions, 501 Boylston Street, Suite 900, Boston, MA 02116 A Pearson Education Company www.pearsoned.com Printed in the United States of America 10 VO 11 19 18 17 16 15 000200010271930511 JH/KE PEARSON ISBN 10: 1-323-01121-8 ISBN 13: 978-1-323-01121-8 CHAPTER AND OPTIONS MARKETS The Development of Futures Markets Lack of Adequate Storage Standardization of Quality Variation in Terms of Payment Price Dissemination The Problem of Resale Guaranteed Contract Performance Standardization of Trading Practices What Is a Futures Contract? Forwards vs Futures Equity Securities (Stocks) vs Futures 4 4 5 5 6 Futures Volume and Open Interest Requisites of a Futures Market The Uses of Futures and Options 11 Hedging Carrying of Commodity Positions Arbitrage Position-Taking 12 12 Price Discovery Speculation INTRODUCTION: FUTURES 11 11 12 12 For Your Consideration CHAPTER 12 FUTURES INDUSTRY INSTITUTIONS AND PROFESS.ONALS Development of Exchanges 17 u.s Futures The Modern Futures Exchange Exchange Organization and Administration Exchange Members The Clearinghouse or Clearing Association Operating Structure Original and Variation Margin Guaranty Deposit Clearing I?rocess Deliveries and Cash Settlement Speculators and Deliveries 18 18 19 19 20 20 20 21 22 23 24 iii -00 _ _ _ 0_ _ _ 0_ _ _ _ _ _ 0_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ Futures Commission Merchants and Introducing Brokers - - - F-utureS-Commission Me rc ha-m-s Introducing Brokers Account Executives Commodity Trading Advisors and Commodity Pool Operators Commodity Trading Advisors (CTAs) Commodity Pool Operators (CPOs) Customers Basis and Hedging 25 Long the Basis 42 25 - -Short -the Basis~- - - - - - -42 d 25 25 26 26 27 28 Customer Funds 28 For Your Consideration 28 Appendix 28 Type of Accounts CHAPTER 28 HEDGING WITH FUTURES AND OPTIONS Exchange for Physicals (EFPs) 43 Cross-Hedging 43 Hedging with Options on Futures 44 Hedging Inventory with a Long Put Position Hedging Inventory with a Short Call Position Hedging and the Option Delta For Your Consideration CHAPTER INTRODUCTION Exchange-Traded Markets 35 Electronic Markets Over-the-Counter Markets Basic Concepts 36 Cash and Futures Price Correlation 36 Futures Position as a Temporary Substitute for a Later Cash Transaction 36 Equal and Opposite Positions in Cash and Futures 37 Examples of Hedging with Futures 37 The Selling Hedge The Buying Hedge 37 38 Basis: Cash/Futures Price Relationships 39 Intertemporal Price Relationships 40 Normal, Carrying Charge or Contango Markets Inverted or Backwardation Markets Convergence An Illustration iv • Contents 42 40 40 41 41 Market Size Forward Contracts Payoffs from Forward Contracts Forward Prices and Spot Prices 44 45 46 47 51 52 53 53 54 55 55 56 Futures Contracts 56 Options 57 Types of Traders 59 Hedgers 59 Hedging Using Forward Contracts Hedging Using Options A Comparison Speculators Speculation Using Futures Speculation Using Options A Comparison 59 59 60 61 61 61 62 Arbitrageurs Dang~rs 62 _._ - - - Summary 63 64 78 Delivery 78 Cash Settlement - Types of Traders and Types of Orders 78 79 Orders CHAPTER MECHANICS OF FUTURES MARKETS Background Closing Out Positions Specification of a Futures Contract The Asset The Contract Size Delivery Arrangements Delivery Months Price Quotes Price Limits and Position Limits Convergence of Futures Price to Spot Price The Operation of Margin Accounts Daily Settlement Further Details The Clearing House and Its Members Credit Risk OTC Markets Central Counterparties Bilateral Clearing Futures Trades vs OTC Trades Market Quotes Prices Settlement Price Trading Volume and Open Interest Patterns of Futures 79 Regulation 67 68 69 Trading Irregularities 80 Accounting and Tax 80 80 81 Accounting Tax 81 Forward vs Futures Contracts 69 69 69 70 70 70 70 Profits from Forward and Futures Contracts Foreign Exchange Quotes 82 82 82 Summary CHAPTER HEDGING STRATEGIES 85 USING FUTURES 70 71 71 73 73 74 74 74 74 75 76 76 76 76 76 Basic Principles 86 Short Hedges Long Hedges 86 87 Arguments For and Against Hedging 87 87 88 Hedging and Shareholders Hedging and Competitors Hedging Can Lead to a Worse Outcome 88 89 Basis Risk 90 91 The Basis Choice of Contract 92 Cross Hedging Calculating the Minimum Variance Hedge Ratio Contents 92 • v Optimal Number of Contracts Tailing the Hedge SlC)cl( Tn-dexrulures Stock Indices Hedging an Equity Portfolio Reasons for Hedging an Equity Portfolio Changing the Beta of a Portfolio Locking in the Benefits of Stock Picking Stack and Roll 93 94 94 95 96 97 97 98 98 Summary 100 Appendix 101 Capital Asset Pricing Model 101 Duration 115 Modified Duration Bond Portf-oHos Convexity 117 Theories of the Term Structure of I nterest Rates 118 The Management of Net Interest Income Liquidity 118 119 Summary CHAPTER 120 DETERMINATION OF FORWARD AND FUTURES PRICES CHAPTER INTEREST RATES Types Of Rates Treasu ry Rates LIBOR The Fed Funds Rate Repo Rates The "Risk-Free" Rate 105 106 106 106 107 107 107 Measuring Interest Rates 107 Continuous Compounding 108 Zero Rates 109 116 111 123 Investment Assets vs Consumption Assets 124 Short Selling 124 Assumptions and Notation 125 Forward Price for an Investment Asset 126 A Generalization What If Short Sales Are Not Possible? Known Income A Generalization 126 127 128 128 Bond Pricing 109 Bond Yield Par Yield 109 110 Known Yield 129 Valuing Forward Contracts 130 110 Are Forward Prices and Futures Prices Equal? 131 Futures Prices of Stock Indices 132 Determining Treasury Zero Rates Forward Rates 111 Forward Rate Agreements 113 Valuation vi • Contents 114 Index Arbitrage 133 Forward and Futures Contracts on Currencies 133 - A Forei-g-n C-u-rrency-as-an-Ass-et Providing a Known Yield 135 Futures on Commodities 136 Income and Storage Costs Consumption Commodities Convenience Yields 136 Hedging Portfolios of Assets and Liabilities 154 136 137 Summary 154 Delivery Options 138 Futures Prices and Expected Future Spot Prices 138 CHAPTER 138 138 139 139 140 INTEREST RATE FUTURES Day Count and Quotation Conventions 143 144 Day Counts 144 Price Quotations of US Treasury Bills 145 Price Quotations of US Treasury Bonds 145 Treasury Bond Futures Quotes Conversion Factors Cheapest-to-Deliver Bond Determining the Futures Price Eurodollar Futures Forward vs Futures Interest Rates Convexity Adjustment -Duration-Basea Kedglng- -153 137 Summary 152 Strategies Using Futures The Cost of Carry Keynes and Hicks Risk and Return The Risk in a Futures Position Normal Backwardation and Contango Using Eurodollar Futures to Extend the LIBOR Zero Curve 145 147 147 148 148 149 CHAPTER 10 157 SWAPS Mechanics of Interest Rate Swaps 158 LIBOR Illustration Using the Swap to Transform a Liability Using the Swap to Transform an Asset Role of Financial Intermediary Market Makers 158 158 160 160 161 161 Day Count Issues 162 Confirmations 162 The Comparative-Advantage Argument 163 Criticism of the Argument 164 The Nature of Swap Rates 165 Determining LIBOR/Swap Zero Rates 165 Valuation of Interest Rate Swaps 166 Valuation in Terms of Bond Prices Valuation in Terms of FRAs 166 167 Term Structure Effects 168 151 152 Contents III vii Fixed-for-Fixed Currency Swaps Underlying Assets 169 JlJustr-atiOll - 169 Use of a Currency Swap to Transform Liabilities and Assets 170 Comparative Advantage 170 Valuation of Fixed-for-Fixed Currency Swaps Valuation in Terms of Bond Prices Valuation as Portfolio of Forward Contracts 171 171 172 Other Currency Swaps 173 Credit Risk 174 Central Clearing Credit Default Swaps 175 Other Types Of Swaps 175 183 18-3 183 184 Specification of Stock Options 184 Expiration Dates Strike Prices Terminology FLEX Options Other Nonstandard Products Dividends and Stock Splits Position Limits and Exercise Limits 184 184 184 Trading Market Makers Offsetting Orders 185 185 185 186 187 187 187 Variations on the Standard Interest Rate Swap Diff Swaps Equity Swaps Options Commissions 187 176 176 Margin Requirements 188 176 176 Writing Naked Options Other Rules 188 189 Commodity Swaps, Volatility Swaps, and Other Exotic Instruments 176 The Options Clearing Corporation 189 177 Exercising an Option 189 Summary CHAPTER 11 MECHANICS OF OPTIONS MARKETS Types of Options Call Options Put Options Early Exercise Option Positions viii • 175 Stock Options -I=o-r-ejgn- Curr-ency -Op-tkms Index Options Futures Options 183 Contents 179 180 180 181 181 181 Regulation 189 Taxation 190 Wash Sale Rule Constructive Sales 190 190 Warrants, Employee Stock Options, and Convertibles 190 Over-the-Counter Options Markets 191 Summary 191 CHAPTER 12 PROPERTIES OF STOCK - _ _.OPTIONS _ - " ~ ~ Factors Affecting Option Prices Stock Price and Strike Price Time to Expiration Volatility CHAPTER 195 196 Risk-Free Interest Rate Amount of Future Dividends 196 196 198 198 198 Assumptions and Notation 198 Upper and Lower Bounds for Option Prices 199 Upper Bounds Lower Bound for Calls on Non-Dividend-Paying Stocks Lower Bound for European Puts on Non-Dividend-Paying Stocks Put-Call Parity American Options 199 199 200 - Effect of Dividends Lower Bound for Calls and Puts Early Exercise Put-Call Parity Summary ~ 209 Principal-Protected Notes 210 Trading an Option and the Underlying Asset 211 Spreads 212 Bull Spreads Bear Spreads Box Spreads Butterfly Spreads Calendar Spreads Diagonal Spreads 212 213 214 215 216 217 Combinations 217 217 218 218 Straddle Strips and Straps Strangles 201 Other Payoffs 219 202 Summary 220 203 Puts on a Non-Dividend-Paying Stock 204 Bounds TRADING STRATEGIES INVOLVING OPTIONS - - Calls on a Non-Dividend-Paying Stock 202 Bounds 13 204 206 206 206 206 206 CHAPTER 14 EXOTIC OPTIONS 223 Packages 224 Perpetual American Call and Put Options 224 Nonstandard American Options 225 Gap Options 225 Forward Start Options 226 Contents • ix Cliquet Options 226 Compound Options 226 - - Chooser Options 227 Barrier Options 227 Binary Options 229 Lookback Options 229 Shout Options 231 Asian Options 231 Options to Exchange One Asset for Another 232 233 Volatility and Variance Swaps 233 Valuation of Variance Swap Valuation of a Volatility Swap The VIX Index 234 234 235 Static Options Replication 235 Summary 237 15 An ApparentA-rbiuage Short-Selling and the Lease Rate No-Arbitrage Pricing Incorporating Storage Costs Convenience Yields Summary Gold Leasing Evaluation of Gold Production 248 249 251 Electricity Natural Gas Oil Oil Distillate Spreads 251 251 253 253 Hedging Strategies 255 Basis Risk Hedging Jet Fuel with Crude Oil Weather Derivatives 255 256 256 Synthetic Commodities 257 Summary 258 239 CHAPTER 16 FOREIGN EXCHANGE RISK Introduction to Commodity Forwards Examples of Commodity Futures Prices Differences Between Commodities and Financial Assets Commodity Terminology Equilibrium Pricing of Commodity Forwards Contents 245 247 248 COMMODITY FUTURES • 244245 250 Energy Markets FORWARDS AND x 243 248 Gold Corn Options Involving Several Assets CHAPTER Pricing Commodity Forwards by Arbitrage 240 240 241 242 242 261 Introduction 262 Foreign Exchange Rates and Transactions 262 Foreign Exchange Rates Foreign Exchange Transactions 262 262 Answer: A Explanation: A market-if-touched order executes at the best available price once a trade occurs at the specified or better price A stop order executes at the best available price once a bid/offer occurs at the specified or worse price A discretionary order allows a broker to delay execution of the order to get a better price A fill-or-kill order executes the order immediately or not at all Answer: Explanation: Computing the 2-year forward swap rate starting in three years: 6.02% = [(1.045 5/(1.035 3))(1/2)J Answer: B Explanation: The forward price is computed as follows: Fo = 100 Fo x (Fo - K)e- rT = 1,050 K = 1,000 r = 0.04 T = 0.75 F = 100 x (1050 - 1000)e- o o4 *o.75 = 4852 Answer: B Explanation: The portfolio modified duration is 5.25 This is obtained by multiplying the value of each bond by the modified duration(s), then taking the sum of these products, and dividing it by the value of the total bond portfolio The change in the value of the portfolio will be -10,000,000 x 5.25 x 0.1% = -52,500 Sample Exam Answers and Explanations-Financial Markets and Products II 343 Answer: C Explanation: A strip hedge involves one-time buying of futures contracts to match the maturity of liabilities, whereas the stack and roll hedge involves multiple purchases over time A strip hedge tends to have wider bid-ask spreads due to the use of longer maturity contracts A strip hedge also tends to have lesser liquidity than a stack and roll hedge due to longer maturity contracts Both a strip hedge and stack and roll hedge would realize gains/ losses daily using futures 10 Answer: B Explanation: Futures on an asset whose price changes are most closely correlated with the asset you are looking to hedge will have the least basis risk This is determined by examining the R2 of the regressions and choosing the highest one R2 is the most applicable statistic in the above chart to determine correlation with the price of zirconium 11 Answer: B Explanation: Calculate the mortgage payment factors for the 30-year, 5% and 4% fixed rate mortgages, then calculate the mortgage payment savings = Mortgage payment factor * Principal balance Mortgage payment factor: r(1 + r)n/(l + r)n - where r = the interest rate, and n = the number of payments over the loan term 5% factor = 0.005368216; 4% factor = 0.004774153; Total monthly payment Savings = $250,000*(0.005368216 - 0.004774153) = 148.52 12 Answer: C Explanation: Cash Flows for Peck: (Inflow at the return (%) on stock index - Outflow at 5%) * Notional principal Return on stock index = (11219/10320) - = 0.0871 or 8.71% Net amount owed by the dealer to Peck EUR 1.86 million = 50 M * (0.0871 - 0.05) = 50,000,000 * 0.0371 = 13 Answer: A Explanation: For European and American call options, the maximum possible price is equal to current stock price The option price can never be higher than the stock The stock price is thus the "upper bound." For a European Put, the upper bound is the present value of strike price, while for American put, it is equal to the strike price 344 • Financial Risk Manager Part I: Financial Markets and Products 14 Answer: Explanation: The European call option is the same as an American call option since there are no dividends during the life of the options American call and put prices satisfy the inequality - K :::::; C - P :::::; - Ke- rt, thus Ke- rt - + C :::::; P :::::; K - + C, therefore: 6.86:::::; P:::::; 10 6.9 falls between 6.86 and 10 15 Answer: B Explanation: The sum of the price of an up-and-in barrier call and an up-and-out barrier call is the price of an otherwise similar European call The price of the European call is $3.52 + $1.24 = $4.76 The sum of the price of a down-and-in barrier put and a down-and-out barrier put is the price of an otherwise similar European put The price of the European put is $2.00 + $1.01 = $3.01 By put call parity, + Ke- r = P + K = er(p + - C) Hence, K = eO.02 * (3.01 + 40.96 - 4.76) = 40.00 C Sample Exam Questions-Financial Markets and Products • 345 accelerated sinking-fund provision, 291 account executives, of the FCM or IB, 25-26 accounting, futures contracts and, 80-81 accrual swaps, 176 actual commodity, actual delivery, 23-25 adjustable-rate mortgages (ARMs), 304 after-acquired clause, 285 agency loans, 304 agency securities, 307 aggregate sinking funds, 291 Allied Irish Bank, 63 Alt-A loans, 304 alternative uptick rule, 125 Altman, Edward I., 298, 321-335 A.M Best, 323, 324 American options, 57, 180, 199, 202 American Stock Exchange, 183 amortization tables, 305 amortizing swap, 176 apparent arbitrage, 244-245 arbitrage See a/so specific types defined,12 index, 133 pricing commodity forwards by, 243-248 arbitrageurs, derivatives and, 62-63 as you like it options, 227 Asian options, 231-232 asset-liability management (ALM), 154 asset-or-nothing call, 229 asset-or-nothing put, 229 assets financial, vs commodities, 241-242 foreign, 269-276 hedging portfolios of, 154 investment vs consumption, 124 sale of, 292 swaps and, 160-161 underlying, option trading and, 183-184, 211-212 assigned investors, 189 Associated Persons (APs), of the FCM or IB, 25 at the money options, 185 average price call, 231 average price put, 231 average strike call, 232 average strike put, 232 backwardation, 40-41, 78,139-140,242 BaFin, 322 Bank for International Settlements (BIS), 54-55, 158, 322 Bank of America, 269 Barclays, 54, 268 Barings Bank, 63 barrel,242 barrier options, 227-229 Basel II, 322, 330, 331, 332 basis, 36 cash/futures price relationships, 39-40 defined,39 hedging and, 42, 43 in hedging situation, 90 basis risk, 255-256 defined,90 hedging and, 89-92 basis swaps, 176 basket option, 233 bear spreads, 213-214 bearer bonds, 283 bearish calendar spreads, 217 Bermudan options, 225 bid-offer spread, 187 bilateral clearing, 74-75 binary options, 185, 229 Black, Fischer, 203 Black-Scholes-Merton formula, 225 blanket mortgage, 285 blanket sinking funds, 291 BM&F BOVESPA, 68 347 board order, 79 bond portfolios, 117 bond pricing, 109-110 valuation in terms of, 166-167 bond yield, 109-110 bonds classified by issuer type, 283 corporate See corporate bonds mortgage, 285-286 book-entry form, 283 bootstrap method, 110 Boston Options Exchange, 183 bottom straddle, 218 bottom vertical combination, 218-219 bounds call options and, 203-204 for European puts, 204-205 box spreads, 214-215 breakeven, 310 bridge financing, 297 brokerage commissions, 27 brokers, introducing, 25 buckets, 154 bull spreads, 212-213 bullish calendar spreads, 217 burnout, 313 bushel, 242 businessman's risk, 296 butterfly spreads, 215-216, 219, 220 buyer of the roll, 310 buying hedge, 38-39 buying on margin, 188 calendar spreads, 216-217 call options, 57, 180-181 call price, 289 call provisions, 289-290 calls, on non-dividend-paying stock, 202-204 Caouette, John B., 321-335 capital asset pricing model (CAPM), 101-102 capital gains, 81 capital losses, 81 capital structure, put-call parity and, 203 carry markets, 241-242 carrying charge markets, 40 cash commodity, cash settlements, 23-25,78 cash-and-carry arbitrage, 246 cash-futures basis, 39 cash-or-nothing call, 229 cash-or-nothing put, 229 cash-out refinancing, 312 CaOE Margin Manual, 189 CDS spread, 175 central counterparty (CCP), 53, 74, 80, 175 certificated stock, cheapest-to-deliver bonds, 148 348 II Index Chicago Board of Trade (CBOT), 4, 18, 23, 52, 56, 68 Chicago Board Options Exchange (CBOE), 52-53, 57, 183, 185, 186,189 Chicago Mercantile Exchange (CME), 18, 20, 52, 56, 68,132 chooser options, 227 Citigroup, 265, 266, 268, 269 Citron, Robert, 113 claw back provisions, 298 clearing house, 73 futures transactions and, 73 clearing margins, 73 clearing process, 22-23 clearinghouse clearing process, 22-23 deliveries and cash settlement, 23-25 guaranty deposit, 21-22 operating structure, 20 original and variation margin, 20-21 cliquet options, 226 closing out positions, 69 CME Group, 52, 56, 68, 145, 146 Code of Conduct Fundamentals for Rating Agencies (IOSCO), 325 collateral, 286 collateral trust bonds, 286-287 collateralized mortgage obligation (CMO), 311 combinations defined, 217 straddle, 217-218 strangles, 218-219 strips and straps, 218 commissions, options trading and, 187-188 Committee of European Banking Supervisors (CEBS), 330 commodities, futures contracts on, 136-137 Commodity Exchange Act, 25, 26, 27 commodity exchanges (COMEX), 52 commodity forwards arbitrage pricing, 243-248 corn, 250 definition of commodity, 240 energy markets, 251-254 equilibrium pricing of, 242-243 gold, 248-249 hedging strategies, 255-257 introduction, 240-242 synthetic commodities, 257-258 commodity futures forbidden, 241 prices, examples of, 240-241 Commodity Futures Trading Commission (CFTC), 7, 20, 26, 79, 189-190,241 commodity pool operators (CPOs), 27-28 commodity positions, carrying, 11-12 commodity spreads, 253 commodity swaps, 176 commodity trading advisors (CTAs), 26-27, 29 companion bonds, 311 comparative advantage, currency swaps and, 170-171 comparative-advantage argument, 163-165 competitors, hedging and, 88 compound options, 226-227 compounding swaps, 176 conditional prepayment rate (CPR), 309 confirmations, swaps and, 162-163 conforming loans, 304 constant maturity mortgage (CMM), 311 constant maturity swap (CMS swap), 176 constant maturity Treasury swap (CMT swap), 176 constant prepayment rate, 309 constant-maturity Treasury (CMT) yield, 290 constructive sales, 190 consumption assets, vs investment assets, 124 consumption commodities, 136-137 contango, 40, 78, 139-140, 242 continuous compounding, 108-109 contract performance, contract size, of futures contracts, 69-70 convenience yields, 137, 242, 247-248 convergence, 41 convergence arbitrage, 75 conversion factors, Treasury bond futures contracts, 147-148 convertible arbitrage, 60 convertible bonds (convertibles), 191 convertible debentures, 288 convexity, 117 convexity adjustment, 152 cooling degree-day, 257 corn, 250 corner the market, 80 Cornett, Marcia Millon, 261-279 corporate accounts, 29 corporate bonds alternative mechanisms to retire debt before maturity, 289-293 bond fundamentals, 283-285 corporate trustee, 282-283 credit risk and, 293-295 default rates and recovery rates, 298-299 event risk and, 295-296 high-yield bonds, 296-298 medium-term notes, 299 security for, 285-288 corporate debt maturity, 283 corporate trustee, 282-283 cost of carry, 137 coupon, 283 crack spread, 254 credit default risk, 293, 294 credit default swaps (CDS), 175 credit event binary options (CEBOs), 185 Credit Rating Agency Reform Act (2006), 330 credit risk corporate bonds and, 293-295 margins and, 74 swaps and, 174-175 credit-spread risk, 293, 295 cross-hedging, 43-44, 91, 92-94 crush spread, 254 currencies, forward and futures contracts on, 133-135 currency swaps, fixed-for-fixed, 169-173 current contract, 309 current coupon, 309 current mortgage rate, 309 curtailments, 314 Customer Information and Risk Disclosure (NFA rule 2-30), 26 customers, of FCM, 28 daily settlement, of margin accounts, 71-73 day count issues, swaps and, 162 day counts, 144-145 day traders, 19, 73, 79 debenture bonds, 287-288 debt retirement, 289-293 default loss rates, 298 default rates, corporate bonds and, 298-299 defaults, 314 deferred coupon structures, 297 deferred swaps, 176 deferred-interest bond (DIB), 284-285, 297 deliveries for futures contract, 138 futures contracts and, 23-25, 70, 78 sequence of, 24 speculators and, 24-25 delivery date, derivatives arbitrageurs and, 62-63 dangers of, 63-64 defined,52 exchange-traded markets, 52-53 forward contracts, 55-56 futures contracts, 56-57 hedges and, 59-61 options, 57-58, 59 over-the-counter markets, 53-55 speculators and, 61-62 types of traders, 59 Deutsche Bank, 268 diagonal spreads, 217 diff swaps, 176 differential, 43 direct quotes, 262 discount rates, 145 discretionary accounts, 29 discretionary orders, 79 distressed securities, 60 dividends effects of, stock options and, 206 stock options and, 185-186 Dodd-Frank Wall Street Reform and Consumer Protection Act (2010), 80, 241 Index • 349 dollar default rate, 298 dollar duration, 117 dollar rolls, 309-311 dollar value, 132 Dominion Bond Rating Services, 323, 324 DOOM options, 185 Dow Jones Industrial Average (DJX), 95, 183 Dow Jones USB index, 257-258 down-and-in call, 228 down-and-in put, 228 down-and-out call, 228 down-and-out put, 228 dual trading, 19 Dun and Bradstreet, 322 duration, of a bond, 115-117 duration matching, 154 duration-based hedge ratio, 153 duration-based hedging strategies, using futures, 153-154 earnings, 286 effective federal funds rate, 107 electricity, 251 electronic markets, 53 electronic trading, 53 emerging markets, 60 employee stock options, 191 energy markets electricity, 251 natural gas, 251-253 oil,253 oil distillate spreads, 253-254 equal and opposite transaction approach, 37 equipment trust certificates, 287 equity portfolio, hedging and, 96-97 equity stocks, vs futures contracts, 6-7 equity swaps, 176 equivalent annual interest rate, 108 Eurex,68 euro overnight index average (EONIA), 107 Eurodollar futures convexity adjustment, 152 to extend the LlBOR zero curve, 152-153 forward vs futures interest rates, 151-152 overview, 149-151 European options, 57, 180, 199 European puts, 200, 204-205 event risk, corporate bonds and, 295-296 exchange for physicals (EFPs), 43 exchange options, 232 exchange rates, interaction of interest rates, inflation, and, 276-278 exchangeable bonds, 288 exchange-traded markets, 52-53 exchange-traded options, 185-186 exercise limits, 186-187 exercise price, 57, 180 exercising an option, 189 350 Index exotic options Asian options, 231-232 barrier options, 227-229 binary options, 229 chooser options, 227 cliquet options, 226 compound options, 226-227 to exchange one asset for another, 232-233 forwards start options, 226 gap options, 225-226 hedging and, 235 involving several assets, 233 lookback options, 229-231 nonstandard American options, 225 overview, 224 packages, 224 perpetual American call and put options, 224-225 shout options, 231 static options replication, 235-237 volatility and variance swaps, 233-235 expectations theory, 118 expected spot price, 138-140 expiration date, 57,180,184,196-197 exposure, 266 extendable swaps, 176 extendible reset bonds, 297 external credit assessment institutions (ECAls), 322, 330, 331 extractive commodities, 242 Fabozzi, Frank J., 281-301 factor, of mortgage pool, 307 fallen angels, 296 federal funds rate, 107 Federal Home Loan Mortgage Corporation (FHLMC), 304 Federal National Mortgage Association (FNMA), 304 Federal Reserve, 107, 268, 290 fiduciary accounts, 29 fill-or-kill order, 79 Financial Accounting Standards Board (FASB), 80-81 first and consolidated mortgage bonds, 286 first and refunding mortgage bonds, 286 first notice day, 78 Fisher equation, 274 Fitch Group, 323, 324, 326 Fitch Ratings, 293, 322 fixed lookback call option, 230 fixed lookback put option, 230 fixed rate mortgages, 304-306 fixed-for-fixed currency swaps, 169-173 fixed-for-floating currency swaps, 173-174 fixed-price call provision, 289 fixed-rate bonds, 283 fixed-rate payer, 158 FLEX options, 185 flight to quality, 75, 119 floating lookback call, 229 floating lookback put, 229 floating-for-floating currency swaps, 173-174 floating-rate payer, 158 floor brokers, 19 force of interest, 108 Ford, Gerald, 241 foreign asset-liability positions, multicurrency, 274-276 foreign currency options, 183 foreign currency trading, 267-269 foreign exchange (FX) risk asset and liability positions, 269-276 currency trading, 267-269 integrated mini case, 278-279 interaction of interest rates, inflation, and exchange rates, 276-278 introduction, 262 rates and transactions, 262-265 sources of exposure, 265-267 foreign exchange quotes, 82 foreign exchange rates, 262, 263 foreign exchange risk exposure, 278-279 foreign exchange transactions, 262, 264 forward contracts on currencies, 133-135 vs futures contracts, 6, 81-82 payoffs from, 55-56 profits from, 82 valuation as portfolio of, 172-173 valuing, 130-131 forward exchange rate, 273 forward foreign exchange transaction, 265 forward markets for foreign exchange, 265-266 hedging with, 273-274 forward prices determining equality with futures prices, 131-132 for investment asset, 126-128 investment assets vs consumption assets, 124 known income, 128-129 known yield, 129-130 spot prices and, 56 forward rate agreements term structure effects, 168-169 valuation of interest rate swaps and, 167-168 forward rate agreements (FRA), 113-115 forward rates, 111-113 forward start options, 226 forward swaps, 176 front running, 80 Fuld, Dick, 54 funnel sinking funds, 291 future dividends, 198 futures, hedging and, 86-102 See a/so under hedging futures as substitute transaction approach, 37 futures commission merchants (FCM), 25, 78-79 account executives, 25-26 customers of, 28 introducing brokers (IB), 25 types of accounts, 28-30 futures contracts See a/so Eurodollar futures; interest rate futures on commodities, 136-137 creation of, 8, on currencies, 133-135 defining, 5-7 delivery options, 138 derivatives and, 56-57 vs equity securities (stocks), 6-7 extinguishing (offset) of, 9, 10 vs forward contracts, hedging with, 37-39 non-dollar, 20 profits from, 82 speculation using, 61 terms and trading rules, 18-19 unanticipated delivery of, 68 futures exchanges clearinghouse or clearing association, 20-23 deliveries and cash settlement, 23-25 development of, 18 members of, 19 modern, 18-19 organization and administration of, 19 futures markets accounting and tax, 80-81 background,68-69 convergence of futures price to spot price, 70-71 defining futures contract, 5-7 delivery, 78 development of, 4-5 forward vs futures contracts, 81-82 market quotes, 76-78 open interest and, 7-8, 9, 10 operation of margin accounts, 71-74 OTC markets, 74-76 price movement between cash market and, 36 regulation, 79-80 requisites of, 9-11 specifications of, 69-70 types of orders, 79 types of traders, 78-79 uses of futures and options, 11-12 futures options, 184 futures positions, hedging and, 36-37 futures prices, 68 convergence to spot price, 70-71 cost of carry, 137 determining, 148-149 determining equality with forward prices, 131-132 expected future spot prices and, 138-140 investment assets vs consumption assets, 124 patterns of, 76, 78 of stock indices, 132-133 futures trades, vs OTC trades, 75-76 futures trading, major exchanges, 335 Index II GAP management, 154 gap options, 225-226 general and refunding mortgage bonds, 286 global macro, 60 gold,248-249 gold lease rate, 136 gold mining companies, hedging by, 89 good-till-canceled order, 79 Government National Mortgage Association (GNMA), 304 government policy, futures and, 10 growth or emerging market companies, 296 guaranteed bonds, 288 guaranteed 18s, 25 guaranty deposit, 21-22 Gucci Group NV, 186 Hammersmith and Fulham, 175 heating degree-day, 257 hedge accounting, 80 hedge effectiveness, 93 hedge funds, 60 hedge ratio, 92-93, 153, 316 hedge-and-forget strategies, 86 hedgers, derivatives and, 59-61 hedging arguments for and against, 87-89 of assets and liabilities, 154 basic concepts, 36-37 basic principles, 86-87 basis and, 42, 43 basis risk, 89-92 capital asset pricing model (CAPM), 101-102 cash-futures basis, 39-40 commodity forwards and futures, 255-257 competitors and, 88 cross-hedging, 43-44, 91, 92-94 defined, 11, 36 duration-based strategies, using futures, 153-154 of equity portfolio, 96-97 exchange for physicals (EFPs), 43 exotic options and, 235 with forwards, 273-274 with futures, 37-39 by gold mining companies, 89 intertemporal price relationships, 40-42 jet fuel with crude oil, 256 leading to worse outcome, 88-89 long, 87 with long put position, 44-45 by mortgage market participants, 319 option delta and, 46 with options on futures, 44-46 risk and, 271-274 shareholders and, 87-88 short, 86-87 with short call position, 45-46 stack and roll, 98-99 352 • Index stock index futures, 94-98 tailing the hedge, 94 uses of futures and options, 11-12 using forward contracts, 59 using options, 59-60 Hicks, John, 138 high-yield bonds, 293, 296-298 holding companies, 286 Hull, John c., 51-237 18M,158 in the money options, 185 incentive fees, 27 incentive function, 312 income bonds, 284 income costs, 136 indentures, 282 independent 18s, 25 index arbitrage, 133 index options, 183-184 indirect quotes, 262 individual customer accounts, 28-29 inflation, interaction of interest rates, exchange rates, and, 276-278 initial margin, 71, 73 instantaneous forward rate, 112 Intercontinental Exchange (ICE), 68, 69 interest payment characteristics, 283-285 interest rate futures day count and quotation conventions, 144-145 duration-based hedging strategies using futures, 153-154 Eurodollar futures, 149-153 hedging portfolios of assets and liabilities, 154 treasury bond futures, 145-149 interest rate parity theorem (IRPT), 277-278 interest rate swaps illustration, 158-160 U80R (London Interbank Offered Rates), 158 market makers, 161-162 role of financial intermediary, 161 to transform a liability, 160 to transform an asset, 160-161 variations on the standard, 176 interest rates bond pricing, 109-110 convexity, 117 determining treasury zero rates, 110-111 duration, 115-117 forward rate agreements, 113-115 forward rates, 111-113 forward vs futures, 151-152 interaction of inflation, exchange rates, and, 276-278 measuring, 107-109 real,274 term structure theories of, 118-119 types of, 106-107 zero rates, 109 interest-only (10) strips, 311 International Organization of Securities Commissions (IOSCO), 325,333 International Petroleum Exchange (IPE), 21, 22 International Securities Exchange, 183, 187 International Swaps and Derivatives Association (ISDA), 162 intertemporal price relationships, 40-42 intrinsic value, of an option, 185 introducing brokers (IB), 25 inverse floaters, 113 inverted markets, 40-41, 78 investment assets vs consumption assets, 124 forward price for, 126-128 investment company accounts, 29-30 investment-grade bonds, 293 issuer default rate, 298 Jett, Joseph, 127 John Bradstreet Company, 322 joint accounts, 29 J.P Morgan Chase, 265, 269 jumbos, 304 junk bonds, 293, 296-298 junk issuers, 284-285 Kansas City Board of Trade (KCBT), 52 Kerviel, Jerome, 63 Keynes, John Maynard, 138 Kidder Peabody, 127 knock-in options, 227 knock-out options, 227 known income, 128-129 known yield, 129-130, 135 last notice day, 78 last trading day, 78 LCH.Clearnet, 175 lease rates, 242, 245 Leeson, Nick, 63 Lehman Brothers, 54, 119 level payment mortgages, 304-306 leveraged buyouts (LBO), 297 liabilities foreign, 269-276 hedging portfolios of, 154 swaps and, 160 UBOR (London Interbank Offered Rates), 106, 149, 158 UBOR zero curve, using Eurodollar futures to extend, 152-153 UBOR-in arrears swap, 176 UBOR/swap zero curve, 166 UBOR/swap zero rates, 165-166 lien, 285 limit down, 70 limit move, 70 limit order, 79 limit up, 70 liquidity, 119 liquidity preference theory, 118 locals, 78-79 lock-in effect, 314 London Interbank Offered Rate (UBOR), 106, 149, 158 long equities, 60 long futures position, 68 long hedges, 87 long position, 55, 58 long put position, hedging inventory with, 44-45 long the basis, 42 Long-Term Capital Management (LTCM), 75 lookback options, 229-231 lower bounds for calls on non-dividend-paying stocks, 199-200 for European puts on non-dividend-paying stocks, 200 Macaulay, Frederick, 115 McDonald, Robert, 239-259 maintenance and replacement funds (M&R), 292 maintenance margin, 72 maintenance of net worth clause, 295-296 make-whole call provision, 289-290 management fees, 27 margin account, 61 clearing house and its members, 73 credit risk and, 74 daily settlement, 71-73 further details, 73 margin call, 188 margins, options markets and, 188 market makers, 161-162, 187 market order, 79 market quotes, futures contracts and, 76-78 market segmentation theory, 118 market-if-touched (MIT) order, 79 market-not-held order, 79 marking to market, 71, 130 mark-to-market (MTM), 114 maturity, 57 maturity date, 6, 180 media effect, 313 medium-term notes (MTNs), 299 merger arbitrage, 60 Merton, Robert, 203 Metallgesellschaft, 99, 256, 257 minimum variance hedge ratio, 92-93 modifications, as prepayment option, 314 modified duration, 116 Monte Carlo simulation, 314-315 Moody, John, 322 Moody's Investor Service, 293, 322, 323, 324, 325, 326, 328 mortgage bonds, 285-286 mortgage guarantors, 306 mortgage options, 311 mortgage pass-through, 306 mortgage servicers, 306 Index • 353 mortgage servicing rights (MSR), 319 mortgage-backed securities calculating prepayment rates for pools, 308-309 dollar rolls, 309-311 hedge ratios, 316 mortgage pools, 307-308 other products, 311 overview, 306-307 price-rate behavior of, 318-319 specific pools and TBAs, 309 valuation and trading, 314-318 mortgages hedging requirements of selected market participants, 319 loans, 304-306 prepayment modeling, 311-314 multicurrency foreign asset-liability positions, 274-276 naked options, 188-189 Narayanan, Paul, 321-335 NASDAQ OMX, 183 Nasdaq-lOO Index (NDX), 95, 183 National Futures Association (NFA), 7,26,79-80 nationally recognized statistical rating organizations (NRSROs), 322,323,330 natural gas, 251-253 negative net exposure position, 266 negative-pledge clause, 288 net interest income, 118 net long in a currency, 266 net short in a foreign currency, 266 neutral calendar spreads, 217 New York Board of Trade (NYBOT), 27 New York Futures Exchange (NYFE), 27 New York Mercantile Exchange (NYMEX), 20, 52, 68 Nikkei 225 Index, 132 Nimmo, Robert W J., 321-335 no-arbitrage pricing, 245-247 non-agency loans, 304 non-conforming loans, 304 non-dividend-paying stocks calls on, 202-204 lower bounds for calls on, 199-200 lower bounds for European puts on, 200 puts on, 204-205 non-dollar futures contracts, 20 non-investment-grade bonds, 293 nonrefundable bonds, 289 nonspecific sinking funds, 291 nonstandard American options, 225 nonsystematic risk, 101 normal backwardation, 139-140 normal charge markets, 40 normal markets, 76 notice of intention to deliver, 68, 69 notional principal (notional), 159 NYSE Euronext, 68, 151, 183 354 III Index offer to redeem, 296 offset principle, 22-23 offsetting orders, 187 oil,253 oil distillate spreads, 253-254 omnibus accounts, 29 on-balance-sheet hedging, 271-273 open interest, 76 futures volume and, 7-8 open order, 79 open outcry system, 53 open positions, 268 option adjust spread (OAS), 317-318 option class, 184-185 option delta, hedging and, 46 option series, 185 options See a/so specific types derivatives and, 57-58, 59 on futures, hedging with, 44-46 hedging using, 59-60 speculation using, 61-62 uses of, 11-12 Options Clearing Corporation (OCC), 186, 189, 192 options markets call options, 180-181 commissions, 187-188 early exercise, 181 margin requirements, 188-189 option positions, 181-182, 183 options clearing corporation, 189 over-the-counter markets, 191 put options, 181 regulation, 189-190 specification of stock options, 184-187 taxation, 190 trading, 187 types of, 180-181 underlying assets and, 183-184 warrants, employee stock options, and convertibles, 190-191 options trading combinations, 217-219 major exchanges, 335 other payoffs, 219, 220 overview, 210 principal-protected notes, 210-211 spreads, 212-217 underlying assets and, 211-212 orders, types of, 79 original issuers, 296 original margin, 20-21 original-issue discount (010), 284 out of the money options, 185 out-trades, overhedge, 46 overnight repo, 107 over-the-counter (OTC) markets, 53-55, 74-76 over-the-counter options markets, 191 packages, 224 par yield, 110 Parisian options, 229 participating bonds, 284 partnership accounts, 29 path dependent, 314 path independent, 314 pay-in-kind (PIK) debenture, 285 payment terms, payment-in-kind (PIK) bonds, 297 perfect hedge, 86 performance fees, 27 perpetual American call and put options, 224-225 Philadelphia Stock Exchange, 183 physical commodity, 5-6 plain vanilla products, 224 planned amortization class (PAC) bonds, 311 point-in-time credit assessments, 326 poison puts, 295 Poor, Henry Varnum, 322-323 portfolio, changing beta of, 97-98 portfolio immunization, 154 position limits, 186-187 position traders, 79 position-taking, futures and, 12 positive net exposure position, 266 power of attorney accounts, 29 prepayment options curtailments, 314 defaults and modifications, 314 for mortgages, 306 refinancing, 311-313 turnover, 313-314 price, futures contracts and, 70 price discovery, 12, 251 price dissemination, price quotations of US Treasury bills, 145 of US Treasury bonds, 145 price sensitivity hedge ratio, 153 prices convergence of futures price to spot price, 70-71 mortgage-backed securities and, 318-319 primary commodities, 242 principal-only (PO) strips, 311 principal-protected notes, 210-211 principle of offset, 22-23 private-label securities, 304, 307 Promotional Material and Communication with the Public (NFA rule 2-29), 26 protective put strategy, 211 Public Holding Company Act (1940), 292 purchasing power parity (PPP), 276-277 put options, 57, 180, 181 put-call parity, 201-202, 203, 206 puts, on non-dividend-paying stock, 204-205 puttable swaps, 176 quality standardization, quanto, 132 quotes, for Treasury bonds and Treasury notes, 147 rainbow options, 233 range forward contract, 224 ratchet options, 226 rating agencies emerging trends, 332-333 globally, 322-324 growth in issues rated, 324-326 overview, 322 rating process, 326-327 ratings performance, 327-329 regulators and, 329-332 rating migration table, 293 rating transition table, 293 ratings systems, 293, 294 real interest rate, 274 real options, defined, 52 recovery rates, corporate bonds and, 299 reference entity, 175 refinancing, 311-313 refunding provisions, 289-290 registered bonds, 283 regulation of futures markets, 79-80 of options markets, 189-190 regulators, rating agencies and, 329-332 renewable commodities, 242 repo rates, 107 resale, restructuring buyouts, 297 return, risk and, 138 return on the market, 101 reverse calendar spreads, 217 reverse cash-and-carry arbitrage, 246-247 R G Dun Company, 322 risk foreign exchange See foreign exchange risk in futures position, 139 hedging and, 271-274 return and, 138 risk-free interest rates, 107, 198 rolling a futures position (rollover), 25 rolling stock, 287 Rusnak, John, 63 S&P 100 Index (OEX), 183 S&P GSCI index, 257-258 Sanio, Jochen, 322 Saunders, Anthony, 261-279 scalpers, 19, 79 Scholes, Myron, 203 second mortgage, 286 secondary commodities, 242 secondary market, 18 Index • 355 Securities and Exchange Commission (SEC), 7, 189, 292, 299 Securities Exchange Act (1934), 330 securitization, mortgages and, 306 security, for bonds, 285-288 seller's option, 23 selling hedge, 37-38 Serrat, Angel, 303-319 settlement mechanism, settlement prices, 76 Shakespeare, William, 322 shareholders, hedging and, 87-88 short call position, hedging inventory with, 45-46 short equities, 60 short futures position, 68 short hedges, 37-38, 86-87 short position, 55, 58 short sales, 127-128 short selling, 124-125 short the basis, 42, 43 short-selling, 245 shout options, 231 single monthly mortality rate, 309 sinking-fund provision, 290-292 60/40 rule, 81 Societe Generale, 63 specific grade or quality of contract, specific sinking fund, 291 specified pools, 309 speculating defined,ll uses of futures and options, 11-12 speculators deliveries and, 24-25 derivatives and, 61-62 spike payoff, 219, 220 spot contract, 55 spot foreign exchange transactions, 262 spot instrument, 5-6 spot prices convergence of futures price to, 70-71 expected, futures prices and, 138-140 forward prices and, 56 spread at origination (SATO), 312 spread duration, 293, 295 spread transaction, 73 spreads bear, 213-214 box, 214-215 bull, 212-213 butterfly, 215-216 calendar, 216-217 commodity, 253 crack,254 diagonal, 217 stack and roll, 98-99, 255 stack hedge, 255-256 Standard & Poor's 500 (S&P 500) Index, 44,95,183 356 • Index Standard & Poor's (S&P), 293, 322, 322-323, 323, 324, 326 standardization of quality, of trading practices,S static options replication, 235-237 step-up bonds, 297 step-up swap, 176 sterling overnight index average (SONIA), 107 stock index futures changing the beta of a portfolio, 97-98 defining stock index, 94 hedging an equity portfolio, 96-97 locking in the benefits of stock picking, 98 overview, 94-95 stock indices, 95-96 stock indices, futures prices of, 132-133 stock options, 183 assumptions and notation, 198-199 calls on non-dividend-paying stocks, 202-204 dividends and stock splits, 185-186 effects of dividends, 206 expiration dates, 184 factors affecting prices, 196-198 FLEX options, 185 other nonstandard products, 185 position limits and exercise limits, 186-187 put-call parity, 201-202 puts on non-dividend-paying stocks, 204-205 strike prices, 184 terminology, 184-185 upper and lower bounds for prices, 199-200 stock price, vs strike price, 196, 197 stock splits, stock options and, 185-186 stop order, 79 stop-and-limit order, 79 stop-limit order, 79 stop-loss order, 79 storage costs, 136, 241 no-arbitrage pricing incorporating, 245-247 story bonds, 296 straddle, 217-218 straddle purchase, 218 straddle write, 218 straight-coupon bonds, 283 strangles, 218-219 straps, 218, 219 strengthening of the basis, 90 strike price, 57, 180 stock options and, 184 vs stock price, 196, 197 strike reset options, 226 strip hedge, 255 strips, 127, 218, 219 structured medium-term notes, 299 subordinated debenture bonds, 288 subprime loans, 304 subsidiaries, 286 support bonds, 311 swap execution facilities (SEFs), 53 swap rates, 162 swaps See also specific types comparative-advantage argument, 163-165 confirmations, 162-163 credit risk and, 174-175 currency, 169-174 day count issues, 162 defined, 158 determining LlBOR/swap zero rates, 165-166 interest rate, mechanics of, 158-162 interest rate, valuation of, 166-168 other types of, 175-177 overview, 158 rates, nature of, 165 term structure effects, 168-169 swaptions, 176 switching a futures position, 25 synthetic commodities, 257-258 systematic risk, 101 systemic risk, 54 tailing the hedge, 94 tanker-based arbitrage, 254 Tax Relief Act (1997), 190 taxation, options trading and, 190 taxes, futures contracts and, 81 tender offers, 292-293 term repos, 107 Texas-New Mexico Power, 292 through-the-cycle credit assessments, 326 time-of-day order, 79 To Be Announced (TBAs), 309 to-arrive contracts, Tokyo Financial Exchange, 68 top straddle, 218 total return index, 95 traders, types of, 59, 78-79 trades futures vs OTC, 75-76 irregularities in, 80 trading major exchanges, 335 options markets, 187 trading practices standardization, trading volume, 76 Treasury bills, price quotations of, 145 Treasury bond futures contracts, 145-147 Treasury bonds, price quotations of, 145 treasury rates, 106 Treasury zero rates, 110-111 troy ounce, 242 trust accounts, 29 Trust Indenture Act, 282 Tuckman, Bruce, 303-319 tunnel sinking funds, 291 turnover, 313-314 UBS, 268 underlying instrument, 5-6 up-and-in call, 228 up-and-in put, 228 up-and-out call, 228 up-and-out put, 228 upper bounds, for option prices, 199 uptick rule, 125 U.S Office of Price Administration, 10 value of the roll, 310 variance swaps, 233-235 variation margin, 20-21, 72 venture-capital situations, 296 VIX volatility index, 235 volatility foreign exchange rate, FX exposure and, 266 of stock prices, 198 volatility swaps, 176-177, 233-235 Walt Disney Corporation, 299 warrants, options markets and, 190-191 wash sale rule, 190 weakening of the basis, 90 weather derivatives, 256-257 weeklys, 185 weighted-average coupon (WAC), 307 weighted-average maturity (WAM), 307 wild card play, 148 World Bank, 158 writing a covered call, 211 writing the option, 58, 181 yield curve play, 113 zero curve, 111 zero rates, 109-111 zero-coupon bonds, 284-285 zero-volatility spread, 317 Index II 357 ... delivery standards and Financial Risk Manager Exam Part I: Financial Markets and Products an efficient pricing function Because buying and selling futures contracts involve trading an item sight-unseen,... there is a short for every long It is no more difficult to take a short position in the futures markets than it is to take a long position Unlike Financial Risk Manager Exam Part I: Financial Markets. .. and equities include: • Futures markets exist to facilitate risk shifting and price discovery; the principal purpose of securities markets is to assist in capital formation • In futures trading