financial derivatives pricing and risk management

(continued from front flap) Uncertainty is a hallmark of today’s global financial marketplace This essential guide to financial derivatives will help you unlock their vast potential for risk management and much, much more JAMES A OVERDAHL, a specialist in financial derivatives, is the Chief Economist of the United States Securities and Exchange Commission He had previously served as chief economist of the Commodity Futures Trading Commission and has nearly two decades of experience in senior positions at various federal financial regulatory agencies He has taught economics and finance at the University of Texas at Dallas, Georgetown University, Johns Hopkins University, and George Washington University Overdahl earned his PhD in economics from Iowa State University The Robert W Kolb Series in Finance is an unparalleled source of information dedicated to the most important issues in modern finance Each book focuses on a specific topic in the field of finance, and contains contributed chapters from both respected academics and experienced financial professionals As part of the Robert W Kolb Series in Finance, Financial Derivatives aims to provide a comprehensive understanding of financial derivatives and how you can prudently use them within the context of your underlying business activities For the public at large, financial derivatives have long been the most mysterious and least understood of all financial instruments Through in-depth insights gleaned from years of financial experience, the contributors in this collection clearly explain what derivatives are without getting bogged down by the mathematics surrounding their pricing and valuation Financial Derivatives offers a broad overview of the different types of derivatives—futures, options, swaps, and structured products—while focusing on the principles that determine market prices This comprehensive resource also provides a thorough introduction to financial derivatives and their importance to risk management in a corporate setting Filled with in-depth analysis and examples, Financial Derivatives offers readers a wealth of knowledge on futures, options, swaps, financial engineering, and structured products Jacket Design: Leiva-Sposato Design FINANCIAL DERIVATIVES Pricing and Risk Management FINANCIAL DERIVATIVES ROBERT W KOLB is the Frank W Considine Chair of Applied Ethics and Professor of Finance at Loyola University Chicago Before this, he was the assistant dean, Business and Society, and director, Center for Business and Society, at the University of Colorado at Boulder, and department chairman at the University of Miami Kolb has authored over twenty books on finance, derivatives, and futures, as well as numerous articles in leading finance journals FINANCIAL DERIVATIVES Kolb Overdahl The authors explore option strategies used to speculate and show how the same strategies can be employed to reduce risk In addition, they reveal how financial derivatives can effectively manage interest rate risk and discuss how hedge funds use financial derivatives KOLB SERIES IN FINANCE Essential Perspectives $95.00 USA/$114.00 CAN As part of the Robert W Kolb Series in Finance, Financial Derivatives skillfully explores the contemporary world of financial derivatives Starting with a presumption of only a general knowledge of undergraduate finance, this collection of essential perspectives, written by leading figures in academics, industry, and government, provides a comprehensive understanding of financial derivatives The contributors provide a complete overview of the types of financial derivatives and the markets in which they trade They analyze the development and current state of derivatives markets—including their regulation—and examine the role of derivatives in risk management They look at the pricing of derivatives, beginning with the fundamentals and move on to more advanced pricing techniques, showing how Monte Carlo methods can be applied to price derivatives Robert W Kolb, James A Overdahl, Editors KOLB SERIES IN FINANCE Essential Perspectives EAN: 9780470499108 ISBN 978-0-470-49910-8 A t a time when our entire financial system is under great stress, many investors point to the misuse of derivatives as one of the primary causes of the financial meltdown Long misunderstood by the general public, some financial derivatives are fairly simple—while others are quite complicated and require considerable mathematical and statistical knowledge to fully understand But with our financial system now undergoing unprecedented changes, there has never been a better time to gain a firm understanding of these instruments The book concludes with an examination of the many ways derivatives can be used While it is clear that financial derivatives are valuable for managing risks and for providing information about the future prices of underlying goods, they can also be used as very sophisticated speculation tools (continued on back flap) P1: OTA/XYZ P2: ABC fm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton FINANCIAL DERIVATIVES P1: OTA/XYZ P2: ABC fm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton The Robert W Kolb Series in Finance provides a comprehensive view of the field of finance in all of its variety and complexity The series is projected to include approximately 65 volumes covering all major topics and specializations in finance, ranging from investments, to corporate finance, to financial institutions Each volume in the Kolb Series in Finance consists of new articles especially written for the volume Each Kolb Series volume is edited by a specialist in a particular area of finance, who develops the volume outline and commissions chapters by the world’s experts in that particular field of finance Each volume includes an editor’s introduction and approximately 30 articles to fully describe the current state of financial research and practice in a particular area of finance The chapters in each volume are intended for practicing finance professionals, graduate students, and advanced undergraduate students The goal of each volume is to encapsulate the current state of knowledge in a particular area of finance so that the reader can quickly achieve a mastery of that special area of finance P1: OTA/XYZ P2: ABC fm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton FINANCIAL DERIVATIVES Pricing and Risk Management Robert W Kolb James A Overdahl The Robert W Kolb Series in Finance John Wiley & Sons, Inc P1: OTA/XYZ P2: ABC fm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton Copyright c 2010 by John Wiley & Sons, Inc All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 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strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002 Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books For more information about Wiley products, visit our web site at www.wiley.com Library of Congress Cataloging-in-Publication Data: Kolb, Robert W., 1949– Financial derivatives : pricing and risk management / Robert W Kolb, James A Overdahl p cm – (The Robert W Kolb series in finance) Includes bibliographical references and indexes ISBN 978-0-470-49910-8 (cloth) Derivative securities Financial engineering I Overdahl, James A II Title HG6024.A3K648 2010 2009017152 332.64 57–dc22 Printed in the United States of America 10 P1: OTA/XYZ P2: ABC fm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton Contents Introduction Acknowledgments PART I Overview of Financial Derivatives Derivative Instruments: Forwards, Futures, Options, Swaps, and Structured Products xxi xxiii G D Koppenhaver Introduction A Generalist’s Approach to Derivative Contracts Forward Contracts Futures Contracts Swap Contracts Option Contracts Structured Products and an Application to Derivative Contracts Conclusion Endnotes References About the Author 11 13 16 19 19 20 20 The Derivatives Marketplace: Exchanges and the Over-the-Counter Market 21 Sharon Brown-Hruska Introduction Standardization versus Customized Products: Differences in Structure and Approach Competition and Consolidation: Impetus for Change Moving from Bilateral to Multilateral Risk Management Collateral in Exchange and OTC Markets Netting and Novation in Exchange and OTC Markets Transparency and Information in the Exchange and OTC Marketplaces Conclusion Endnotes 21 22 25 29 29 31 36 39 40 v P1: OTA/XYZ P2: ABC fm JWBT151-Kolb September 10, 2009 8:40 vi Printer Name: Hamilton Contents References About the Author Speculation and Hedging 41 42 43 Greg Kuserk Hedging Transactions Speculation From Hedging to Speculation Interaction between Hedgers and Speculators Conclusion Endnotes References About the Author The Social Functions of Financial Derivatives 44 48 50 52 54 54 54 55 57 Christopher L Culp Hedging and Risk Transfer Price Discovery Price Discovery, Commoditization, and Market Structure Intertemporal Resource Allocation Forward Contracts as Synthetic Storage Commodity Interest Rates Asset Finance Commodities Lending Project Finance Trade Finance Financial Asset Inventory Management Synthetic Asset Allocation Derivatives and Public Policy Endnotes Further Reading References About the Author 58 58 59 60 60 60 61 62 63 64 65 65 66 67 68 69 71 PART II Types of Financial Derivatives 73 77 Agricultural and Metallurgical Derivatives: Pricing Joan C Junkus Introduction Commodities Seasonality in Spot and Futures Prices Futures Pricing Theory of Storage Theory of Normal Backwardation 77 77 78 79 80 84 P1: OTA/XYZ P2: ABC fm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton CONTENTS vii Conclusion References Suggested Further Reading About the Author 85 86 86 87 Agricultural and Metallurgical Derivatives: Speculation and Hedging 89 Joan C Junkus Introduction Commodities Derivatives Commodity Investment Strategies Commodity Indexes Diversification and Inflation Passive Investment Strategies Active Strategies Measuring Investment Performance Hedging Commodity Marketing Risk Management Spreads Conclusion References Suggested Further Reading About the Author Equity Derivatives 89 89 90 90 90 91 91 94 94 95 95 97 99 100 100 101 101 103 Jeffrey H Harris and L Mick Swartz Introduction Stock Options Call Options Put Options Stock Options on an Index Employee Stock Options Convertible Bonds Warrants Equity Futures Single-Stock Futures Futures on Stock Indexes Equity Swaps Future of Equity Derivatives References Further Reading About the Authors 103 104 105 106 106 107 107 108 108 108 109 110 111 112 112 113 P1: OTA/XYZ P2: ABC fm JWBT151-Kolb September 10, 2009 8:40 viii Printer Name: Hamilton Contents Foreign Exchange Derivatives 115 Robert W Kolb Basic Pricing Principles Purchasing Power Parity Theorem Interest Rate Parity Theorem Foreign Exchange Forward and Futures Contracts Foreign Exchange Options FX Option Pricing Plain Vanilla Foreign Exchange Swaps Flavored Currency Swaps Conclusion Endnotes References About the Author Energy Derivatives 115 115 116 117 118 119 119 121 122 123 123 123 125 Craig Pirrong 10 Introduction Products: An Overview History Petroleum Derivatives: Details Natural Gas Derivatives: Details Electricity Derivatives: Details Pricing Clearing Recent Developments References About the Author 125 125 126 127 128 129 129 131 132 133 133 Interest Rate Derivatives 135 Ian Lang Exchange-Traded (Listed) Derivatives Over-the-Counter Derivatives OTC Options Rate Locks Swaps and Swaptions Mortgage Derivatives Further Reading About the Author 11 Exotic Options 135 138 138 138 139 141 142 142 143 Robert W Kolb Overview Forward-Start Options 143 144 P1: OTA/XYZ P2: ABC fm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton CONTENTS 12 ix Compound Options Chooser Options Barrier Options Binary Options Lookback Options Asian or Average Price Options Exchange Options Rainbow Options Conclusion Endnotes References About the Author 144 145 146 147 149 150 151 151 152 153 154 154 Event Derivatives 157 Justin Wolfers and Eric Zitzewitz 13 Types of Prediction Markets Applications and Evidence Accuracy of Prediction Markets Possibilities for Arbitrage Can Event Markets Be Manipulated Easily? Market Design Making Inferences from Prediction Markets Innovative Future Applications? Acknowledgments Endnotes References About the Authors 158 160 160 164 168 168 170 173 173 174 174 176 Credit Default Swaps 177 Steven Todd Credit Default Swaps on Corporate Debt Credit Default Swaps on Asset-Backed Securities Credit Default Swaps on Collateralized Debt Obligations The Basis CDS Indices Tranches of CDS Indices Trading Strategies Using Indexes and Tranches Market Dynamics: CDS and CDOs Synthetic CDOs and Bespokes Correlation Conclusion Endnotes References About the Author 177 178 180 182 182 186 188 189 189 191 196 196 197 198 P1: OTA/XYZ P2: ABC c37 JWBT151-Kolb September 10, 2009 586 8:57 Printer Name: Hamilton Using Financial Derivatives Swaptions A swaption is an option to enter into an interest rate swap on some future date Swaptions often are used to hedge against future borrowings There are two primary types of swaptions: payer’s swaptions and receiver’s swaptions A payer’s swaption gives buyers the right to pay the fixed rate on the swap, thus protecting them from raising rates The receiver’s swaption gives buyers the right to receive the fixed rate, thus protecting them from falling rates Swaptions are very similar to other options, but in this case, the underlying instrument is an interest rate swap The expiry date is the date upon which the swaption may be exercised into the underlying swap, while the strike price is the fixed rate of the underlying swap European swaptions can be exercised into the underlying swap or cash settled solely on the expiry date of the swaption American swaptions are also available, and they come in two varieties The first is a variable swaption, where the underlying swap has a fixed tenor, no matter when the swaption is exercised The second is a wasting swaption, where the underlying swap has a fixed maturity date, so the tenor of the underlying swap becomes shorter the later the swap is exercised To illustrate the use of swaptions, consider the next situation Caribou Research, Inc knows it will finance a project by borrowing a lump sum of money in one year for three years by accessing its line of credit at Telluride Bank Its line of credit is at a floating rate of LIBOR + 0.65 percent Caribou Research faces the risk that interest rates may fluctuate over the next four years, so it prefers to borrow fixed It considers two approaches First, it can pay the fixed rate on a three-year swap (deferred one year) at a rate of percent In this case, the company locks in a fixed rate of percent regardless of market rates in one year If rates rise to percent, the company effectively borrows at percent under the swap If rates fall to percent, Caribou Research still borrows at percent and cannot benefit from the lower spot rates The second approach is to buy a one-year payer’s swaption into a three-year percent swaption for a swaption premium of 0.25 percent per year Now if rates rise to percent, Caribou Research exercises the swaption to fix at percent If rates fall to percent, Caribou Research allows the option to expire worthless, and it borrows at percent The swaption allows the company to benefit from the falling rates whereas the deferred swap does not Mortgage Securitization Risk Management Using Interest Rate Derivatives Mortgages are traditionally very illiquid assets However, through the securitization process, mortgages are transformed into standardized instruments that are normally highly liquid Mortgage lenders securitize mortgages by placing the loans in a trust and then securities representing shares of assets (mortgages) in the trust are sold to investors The proceeds from the sale of these securities provide funding to purchase more loans and repeat the securitization process Throughout the securitization process, lenders face interest rate risk, prepayment risk, and fallout For purposes of this discussion, the pipeline extends from the rate lock to sale in to the secondary market, typically a period lasting between 60 to 90 days Before a mortgage closes, falling interest rates can result in applicants withdrawing their loan applications; this is known as fallout Interest rates falling after the closing can result P1: OTA/XYZ P2: ABC c37 JWBT151-Kolb September 10, 2009 8:57 Printer Name: Hamilton USING DERIVATIVES TO MANAGE INTEREST RATE RISK 587 in the homeowners prepaying and refinancing In both instances, the mortgages drop out of the pipeline Conversely, if interest rates rise before or after closing, homeowners will be more likely to stay in their current mortgage, and the number of mortgages in the pipeline remains the same However, each mortgage will be worth less than par, and the lender cannot realize the full value from the sale of the paper Clearly, interest rate risk directly generates challenges to pipeline managers, because both falling and rising interest rates can each have negative implications To manage these risks, pipeline managers use interest rate futures and options on futures to create an effective hedging strategy The hedging manager must take into account the direct risk of changing interest rates on the value of the portfolio and the indirect risk of fallout Besides changing interest rates, fallout also varies depending on the characteristics of the loans in the pipeline, such as loan type, purpose, source, and even which part of the country it comes from Fallout can vary dramatically from branch to branch within the same lending institution Therefore, hedging managers must estimate the level of fallout in their pipelines This requires them to have enough quantitative resources to make reasonably good estimates of the likely effects of interest rate changes on fallout Let us look for a moment at how fallout affects a hedging strategy In a rising rate environment, fallout can generate a significant increase in the potential loss of value in a mortgage lender’s pipeline As rates rise, loan values decline In addition, the number of loans that close increases (i.e., as the rate locks gain in value to the consumer, fallout decreases) For this reason, lenders have to change their projections regarding the number of loans that will exit the other end of the pipeline and adjust the amount of the assets to be hedged This phenomenon is known as negative convexity, and it is a critically important source of risk for mortgage lenders Basically, the lender’s pipeline produces more loans at the worst possible time, and vice versa When rates fall, fallout increases, and all the good loans that the lender thought it had locked in are not completed All of this risk arises from one simple source: the put options that lenders offer to prospective borrowers For this reason, using interest rate futures alone to hedge are not sufficient Options on interest rate futures are a key element in hedging pipeline risk The more interest rate sensitivity in the lender’s pipeline, the more the lender will need to use options to hedge the potential fluctuations in pipeline value Since lenders write a put when they offer the rate lock, they will tend to use puts, rather than calls, to offset that exposure Let us assume a pipeline manager has a $40 million portfolio After a thorough analysis of the mortgage portfolio, she decides to use forwards and futures to hedge part, but not all, of that pipeline, since she knows that some percentage of the loan commitments will drop out before closing Additionally, she would use options on futures to hedge a portion of that exposure As an example, the hedging strategy shown in Exhibit 37.2 is devised The manager estimates that $30 million in loans will close; $16 million for which she knows when they will close, and $14 million for which she does not know the exact time when they will close Many pipeline managers would hedge this exposure by simply selling forward their expected closing volume, either for cash or mortgage-backed securities An alternative approach is to sell an equivalent amount of Treasury futures As rates go up, the value of the short positions will rise and offset the losses on the loans in the pipeline In any case, the manager uses a combination of forwards (for the portion of the portfolio she knows the date they P1: OTA/XYZ P2: ABC c37 JWBT151-Kolb September 10, 2009 588 8:57 Printer Name: Hamilton Using Financial Derivatives Exhibit 37.2 Hedging Strategy for a $40 Million Loan Portfolio Amount Likely Outcome Hedging Tool $16 million $14 million $8 million $2 million Loans will close Loans will close, unsure when Might close Will not close Forwards Futures Options on futures No hedge will be closed) and futures (for the portion of the portfolio for which she knows the loans will close but not exactly when) She also estimates that $2 million worth of the loans will not close for some reason or another and chooses not hedge this portion For the uncertain portion of the portfolio (due to potential fallout), suppose that the manager buys put options on futures to cover $8 million of the pipeline If Treasury prices fall over the next few weeks or months and rates rise, those loans are likely to close, so she exercises the puts, which give her the right to sell Treasury futures at the price she fixed at the time of purchase This allows the manager to lock in the futures at that price and install the hedge The main expense—the hedge cost—is the premium paid to purchase the puts Now let us look at the opposite scenario If Treasury prices rally and rates drop, the fallout ratio is going to rise, so the $8 million of loans that were covered with the put options drop out of the pipeline Now there is no need for the hedge, so the manager decides against exercising the options, and they expire worthless This hedging strategy exposes the manager to some loss, but the loss is limited to the premiums paid to purchase the options Remember that if she had gone directly into the futures instead of using the options, the fallout would have required her to liquidate the hedge at a higher price than when purchased, and that would have been much more costly than the lost premiums The third scenario is that interest rates not move at all In this case, the manager buys the coverage by exercising the put options In other words, she ends up with the same hedge profile as in the first scenario The difference is that she loses the options premium and gains the peace of mind that comes from knowing that the hedging strategy is going to work in both rising and falling interest environments CONCLUSION Interest rate derivatives come in a wide variety of standardized forms They can be easily tailored to specific interest rate risk management needs of the user This chapter has presented an overview of the types of instruments available and examples of their usefulness in managing interest rate risk REFERENCES Bierwag, G O 1987 Duration Analysis: Managing Interest Rate Risk Cambridge, MA: Ballinger Publishing Kolb, R W., and J A Overdahl 2007 Futures, Options, and Swaps London: Blackwell Publishing P1: OTA/XYZ P2: ABC c37 JWBT151-Kolb September 10, 2009 8:57 Printer Name: Hamilton USING DERIVATIVES TO MANAGE INTEREST RATE RISK 589 SUGGESTED FURTHER READING Cornyn, A., R Klein, and J Lederman 1997 Controlling & Managing Interest-Rate Risk New York: New York Institute of Finance James, T 2006 Interest Rate Derivatives: A Practical Guide to Applications, Pricing and Modeling London: Risk Books Obazee, P O 1997 Interest Rate Derivatives: Analysis, Valuation and Market Applications New York: McGraw-Hill Fabozzi, F J 2002 The Handbook of Financial Instruments Hoboken, NJ: John Wiley & Sons Kolb, R W Kolb, and J A Overdahl 2007 Futures, Options, and Swaps London: Blackwell Publishing Hull, J 2008 Options, Futures, and Other Derivatives Upper Saddle River, NJ: Prentice-Hall Maginn, J L., D L Tuttle, J E Pinto, and D W McLeavey 2007 Managing Investment Portfolios: A Dynamic Process Hoboken, NJ: John Wiley & Sons Jorion, P 2007 Financial Risk Manager Handbook Hoboken, NJ: John Wiley & Sons ABOUT THE AUTHOR Steven Byers is currently an academic fellow at the U.S Securities and Exchange Commission He earned an International MBA from the University of Denver in 1992, a PhD in economics from Colorado State University in 1999, and a MSc in mathematical trading and finance from City University in London in 1998 Previously, Dr Byers was the chief economist at the Public Company Accounting Oversight Board, where he led multiple fraud detection modeling projects and performed regulatory cost-benefit analysis Prior to that, he worked at the Comptroller of the Currency in the Risk Analysis Division and at the Commodity Futures Trading Commission He has authored published articles in peer-reviewed journals on topics related to general equilibrium modeling, regional economic modeling, and interest rate forecasting P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton Index Accounting for financial derivatives, 305–312 Agricultural derivatives See Commodities Alternating direction implicit (ADI) method, 450, 451 Amaranth Advisors, 314, 317–321, 324, 326, 327 American options, 105, 106, 144, 145, 212, 214, 216, 442, 443, 448, 451, 493, 505, 563, 584 Analytical pricing models, 425, 426 See also Black-Scholes option pricing model Arbitrage arbitrageurs, 50 capital structure arbitrage, 534–538 cash-and-carry, 80, 81, 352–354, 356, 358, 361, 363, 364, 389 convertible bond arbitrage, 526–534 and cost of carry model, 351 See also Cost of carry credit default swaps (CDS), 189 defined, 335 event derivatives, 164–168 no-arbitrage principle, 335, 336, 351 reverse cash-and-carry, 80, 81, 352–354, 356, 366 Asian options (average price options), 150, 151, 449 Asset-backed securities (ABS), 142, 177–180, 182, 187, 188, 201–204 Asset-based financing, 57, 61–65 Backwardation commodities, 77, 82, 84, 85, 92–95, 129–131, 316, 420 and convenience yield, 84, 85, 95 inverted market, 61 normal backwardation, 77, 80, 84, 85, 363, 364, 366 Barings Bank, 314, 318, 320–327 Barrier options, 146, 147, 442, 443, 445, 449 Basis risk, 45–47, 182, 224–228, 316, 317, 578, 579 Bear spreads, 512–515 Bespokes, 191, 192 Bid-ask spread, 53, 59, 136, 138, 183, 185, 189, 273, 274, 276, 278, 279, 351 Binary options, 147–149 Binomial option pricing model, 14, 106, 341–349, 387, 425, 426, 445, 482 Binomial tree model, 468–472 Black-Scholes option pricing model assumptions, 373, 374, 384 and convertible bond arbitrage, 527, 528, 531 derivation of, 376, 378–380 example, 375, 376 Excel spreadsheet application, 376, 377 executive stock options, 214 exotic options, 145, 152 and finite difference methods, 441, 442 foreign exchange options, 119, 122 formula, 372, 373 Greeks, 381, 382 See also Greeks, the history of, 236, 372 interest rate options, 135 Ito process, 374, 375, 384 numerical example, 380, 381 and option price sensitivities See Option price sensitivities overview, 348, 349, 371, 372, 384, 388–392 and pricing models generally, 425, 426 publication of, 236 purpose of, 14 real options, 569, 570 risk-neutral pricing, 382, 383 and stochastic processes, 466, 467 and volatility, 106 Bootstrapping, 413, 534 Box spreads, 518, 519 Brownian motion, 373, 387–389, 394, 395, 397, 399, 442, 443, 458–465, 467, 564 Bull spreads, 512, 513, 515 Butterfly spreads, 519–521 Calendar spreads, 50, 100, 317, 318, 522 Call options, 13–16, 83, 95, 97, 105–108, 143, 144, 152, 315, 341–348, 531, 532 See also Binomial option pricing model; Option price sensitivities 591 P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 8:40 592 Capital budgeting, 59, 559, 560, 569, 570 Capital structure arbitrage, 534–538, 551 Caps and floors, 201, 584, 585 Carry market See Contango Cash flow hedges, 305–309 Cash-and-carry arbitrage, 80, 81, 352–354, 356, 358, 361, 363, 364, 389 Cash-or-nothing call, 148, 149 Central counterparty (CCP) clearing, 22, 28–31, 33–36, 39, 40, 259, 291, 292 CFTC Reauthorization Act of 2008, 296, 299–301 Chooser options, 145 Clearing anonymity, 265 central clearinghouse, 259, 260, 276–278, 283 central counterparty (CCP) clearing, 22, 28–31, 33, 34, 36, 39, 40, 259, 291, 292 clearing choice, 277, 278 clearing members, 35, 36, 40, 136, 250, 254, 264, 266, 268–270, 272–274, 276, 277, 283 clearinghouse, functions of, 10, 263–273 clearinghouse ownership, 269 credit default swaps, 28, 31, 35, 244 energy derivatives, 131, 132 exchanges, 23, 28, 29 innovation, effect of, 278 and liquidity, 273–275 margin payments, 269–273, 276 over-the-counter products, 22, 24, 25, 27–29, 37, 39, 132, 240, 263, 297, 298 overview, 263, 278, 279 proposed changes, 275–278 regulation, 296, 297 swaps, 259, 260 Closed-form option pricing models Black-Scholes See Black-Scholes option pricing model classification of, 389, 402 and explicit integration, 443 one lognormal underlying (first generation), 392–394, 402 one nonlognormal underlying (third generation), 397–402 overview, 387, 388, 402 two lognormal underlyings (second generation), 395–397, 402 two underlyings, one is nonlognormal (fourth generation), 401, 402 Close-out netting agreements, 283, 289 See also Netting Collars, 140, 505, 514, 515, 549, 584–585 Collateral, 29–31 Collateral agreements, 283 Printer Name: Hamilton Index Collateral return, 92, 95 Collateralized bond obligations (CBO), 180, 204, 205, 208 Collateralized debt obligations (CDOs), 177, 180–182, 188–189, 204–208, 544, 551, 552, 555 Collateralized mortgage obligations (CMOs), 142, 199 Commercial mortgage-backed securities (CMBS), 142, 177, 187, 199–201, 204, 208–209 Commercial risk, 3, 4, 6–10, 12, 15, 19, 21 Commodities active investment strategies, 89, 94, 100 agricultural, 78, 79, 90, 221, 233, 234, 236, 295, 296, 301, 302 background, 233, 234 commodity marketing, 95–97 derivatives, 90 diversification, 91, 95, 100 energy See Energy derivatives exchange-traded funds (ETFs), 93, 106 exchange-traded notes (ETNs), 93, 94 exempt commodities, 300 futures contracts, 90, 96, 97 futures prices, 77, 79–85 gold, 80, 81 hedge ratio, 97–99 hedging, 89, 95–100 indexes, 90–92, 94 as inflation hedge, 89, 91, 95, 100, 125 as inputs in manufacturing, 91 interest rates, 60, 61 investment performance, 52, 89, 94, 95 lending, 62, 63 markets, 233, 234, 236 metallurgical, 89, 90 See also Gold mutual funds, 94 overview, 89, 90 passive investment strategy, 89, 91–94, 100 price indexes, 89, 90 pricing, 351 See also Cost of carry; Expectations pricing model risk management, 97–99 seasonal price behavior, 77–79, 90 speculation, 89, 92, 93, 100 spot prices, 77 spreads, 89, 99–100 swaps, 406, 419, 420 theory of normal backwardation, 77, 80, 84, 85 See also Backwardation theory of storage, 77, 80–85 trading volume, 90 types of, 89 weather, impact of on prices, 90 Commoditization, 59, 278 P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton INDEX Commodity Exchange Act (CEA), 11, 232, 250, 253, 256, 257, 295–299, 301, 302 Commodity Futures Modernization Act (CFMA), 26, 28, 108, 295–301 Commodity Futures Trading Commission (CFTC), 250, 251, 253–257, 295–301 Commodity interest rates, 60, 61 Commodity pool operators (CPOs), 250, 251, 255–257 Commodity trading advisors (CTAs), 94, 250, 251, 255–257 Compensation, 211–218, 314, 315, 323, 324, 328 Compound options, 144, 145 Contango, 61, 79, 82, 92, 93, 129, 130, 316, 364, 366 Convenience yield, 61, 80–85, 95, 130, 351, 356, 357, 365, 366 Convertible bonds (converts), 103, 107, 526–534, 545, 549, 551 Convexity, 137, 141, 194, 410–413, 486, 581, 587 Corporate debt, 177, 178 Corporate finance, 525, 560, 561 Corporate indices, 183–185 Correlation trading, 191–196, 551 Cost of carry, 60, 99, 129, 130, 351–354, 358, 360, 363–366 Counterparty risk, 21, 22, 24, 30, 32, 34, 112, 136, 183, 190, 201, 223, 254, 260, 263, 265–269, 273, 283–292, 320, 328, 363 See also Clearing Covered calls, 336, 337, 504, 507, 508, 512, 514 Crack spreads, 50, 127, 128, 131, 239 Crank-Nicolson method, 441, 445–449 Credit default swaps (CDS) arbitrage opportunities, 189 asset-backed securities (ABS), 177–180, 182, 187, 188 basis, 182 bespokes, 191, 192 and capital structure arbitrage, 537, 538 centralized clearing, 259, 260 collateralized bond obligations (CBO), 180, 204, 205, 208 collateralized debt obligations (CDOs), 177, 180–182, 188, 189, 544 commercial mortgage-backed securities (CMBS), 177 and convertible bond arbitrage, 530–533 corporate debt, 177, 178 corporate indices, 183–185 correlation, 187, 189, 191–196 counterparty credit risk management, 289 future trends, 196, 238 and hedge funds, 541, 543, 544 593 hedgers, 189 home equity loan (HEL) market, 179 indices, 182–189 market growth, 177, 178 overview, 17, 18, 177, 238 reference entity (obligation), 177 residential mortgage-backed securities (RMBS), 177, 204 settlement, 177–185 special-purpose vehicle (SPV), 189, 190 speculators, 189 spread, 182, 189, 192–196 synthetic collateralized debt obligations, 177, 180, 182, 186, 189–192 trading strategies, 188, 189 tranches, 177–181, 186–195 Credit hedge funds, 551, 552 Credit risk, 5, 6, 17, 19, 29–31, 46, 201, 527, 530 Cross-hedging, 51, 52, 222–224, 226 Crude oil See Energy derivatives Currency swaps, 237, 406, 417–419 Current exposure, 284, 285 Current replacement cost, 284, 285 Customized products, 23–25 Cylinders, 505, 515 Day traders, 49, 50 Decision trees, 560 Delta ( ), 140, 189, 194, 195, 381, 448, 477–486, 490, 492, 496–498, 503, 531–534, 549 Depository Trust Clearing Corporation (DTCC), 24, 25, 33, 35, 275–277 Derivative contracts, generally, 3, 4, 6–16, 541–543 Economic derivatives, 221–224, 228 Electricity See Energy derivatives Electronic trading, 24–26, 105, 128, 148, 160, 161, 168, 171, 235, 239–244, 297, 298, 300 Emerging derivative instruments, 221–228 Employee stock options, 107 Empty voting, 552, 553 Energy derivatives background, 238–240 backwardation, 130 basis contracts, 126 clearing, 131, 132, 297 crude oil, 46, 51, 53, 61, 125–131 electricity, 125, 127, 129–131, 364–366 electronic trading, 128 energy products, 125, 126 exchanges, 125–128 futures contracts, 125, 127–129 history of, 126, 127 index swaps, 128 P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 594 8:40 Printer Name: Hamilton Index Energy derivatives (Continued ) legislative proposals, 132 natural gas, 125–131, 239, 246, 317, 318, 561, 562, 565–568 options on futures contracts, 126 overview, 125 petroleum and petroleum derivatives, 125–128, 131, 238–240, 561, 563, 564, 568 pricing, 129–131 and regulatory reform, 301, 302 and speculation, 132, 133 spread trading, 127, 128 swaps, 126, 128, 129 swaptions, 126, 129 trading volume, 127–129 vanilla forward contracts, 126 Energy industry, real option examples, 561–568 Equity derivatives, 103–112, 273 Eurodollar futures contracts, 13, 48, 58, 59, 136, 137, 226, 234–238, 241, 243, 358–360, 363, 411–413, 577, 580, 581, 601 European options, 105, 106, 144, 152, 177, 212, 214, 336, 339, 371, 388, 402, 443, 448, 503, 505, 584 Event derivatives accuracy of prediction markets, 160–164 arbitrage opportunities, 164–168 future applications, 173 inferences from prediction markets, 170–173 Iowa Electronic Market, 148, 160, 161, 168, 171 market design, 168–170 market manipulation, 168 markets, 148, 149, 160 overview, 157, 158 Policy Analysis Market (PAM), 148, 157, 168, 173 types of prediction markets, 158, 159 Exchanges clearing and clearinghouses See Clearing competition and consolidation, 25–29 equity derivatives, 112 intermediaries for exchange-traded derivatives, 250–257 markets for derivatives, 233–245 mergers of, 112 overview, 21 regulation, 250–257, 295–302 standardization, 22, 23 and technology, 25–27 transparency, 36, 37 Exchange-traded funds (EFTs), 93, 299 Exchange-traded notes (ETNs), 93, 94 Executive stock options (ESOs), 211–218 Exotic options Asian options (average price options), 150, 151 barrier options, 146, 147 binary options, 147–149 chooser options, 145 compound options, 144, 145 exchange options, 151 finite difference valuation methods, 445, 449 See also Finite difference valuation methods foreign exchange, 122 forward-start options, 144 lookback options, 149, 150 overview, 143, 144, 152, 153 rainbow options, 151, 152 valuation of, 435–439, 441, 449 Expectations pricing model, 351, 363, 364, 366 Explicit integration, 441, 443–446 Explicit method, 441, 443–449, 451 Failures and disasters in derivatives, 313–327 Fair value hedges, 305, 309–311 Financial Accounting Standard No 133 (FAS 133), 305, 307–311 Financial engineering capital structure arbitrage, 534–538 convertible bond arbitrage, 526–533 exotic options, 144 See also Exotic options overview, 525, 526 Financial futures, 3, 27, 28, 51, 234–237, 241, 243 Financial options, 561, 570 Finite difference valuation methods advantages and disadvantages of, 451 alternating direction implicit (ADI) method, 450, 451 basic methods, 445–449 binomial model, 445 and closed-form models, 443 Crank-Nicolson method, 441, 445, 446, 448, 449 explicit method, 441, 443–447, 449, 451 Feynman-Kac theorem, 443 higher-dimension problems, 449–451 implicit method, 441, 445–449 integration method, 442 Martingale methods, 441–443 Monte Carlo integration, 442, 443 and Monte Carlo simulation, 451 and numerical integration methods, 451 overview, 441–445 partial differential equation (PDE) approach, 441, 443, 445, 450 resources, 451, 452 P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton INDEX splitting methods, 450, 451 trinomial method, 445, 447 valuation grid, 444–446, 448 Flavored currency swaps, 121, 122 Foreign currency fraud, 299 Foreign exchange derivatives background, 235 forward contracts, 117, 118 futures contracts, 117, 118 interest rate parity theorem (IRPT), 73, 116, 117, 121 options, 118, 119 overview, 115, 122, 221 pricing, 115–117 purchasing power parity theorem (PPPT), 73, 115–117 swaps, 119–122 Forward and futures contracts, pricing and backwardation in oil futures, 130 carry cost, 80, 354–356 carry return, 354, 355 cash-and-carry arbitrage, 80, 81, 352–354, 356, 358, 361, 363, 364, 389 commodity futures, 351, 355, 356, 363, 364, 366 convenience yield, 351, 356, 357, 366 cost of carry pricing model, 60, 129, 351–363, 366 delivery options, 357, 358 electricity, 129, 364–366 expectations model, 351, 363, 364, 366 futures and forward price differentials, 362, 363 interest rate futures and forwards, 358–361 overview, 351–352, 366 reverse cash-and-carry, 80, 81, 352–354, 356, 366 Forward contracts, 7–11, 16, 60, 63, 64, 117, 118, 362, 363 See also Forward and futures contracts, pricing Forward rate agreements (FRAs), 8–9, 13, 136, 297, 358–360, 410, 575–578, 584 Fraud, 37, 217, 256, 257, 295, 299–301, 322 Fundamental traders, 48, 49 Futures commission merchants (FCMs), 235, 250–255, 258, 272, 297, 299 Futures contracts background, 233–236 clearing, 265–273 See also Clearing commodities, 90 delivery options, 357, 358 equity futures, 108, 109 Eurodollar, 13, 48, 58, 59, 136, 137, 226, 234–238, 241, 243, 358–360, 363, 411–413, 577, 580, 581, 601 foreign exchange derivatives, 117, 118 595 forward contracts compared, 10, 11, 362, 363 interest rate futures contracts, 577, 578 overview, 9–11 pricing See Forward and futures contracts, pricing social benefits, 60, 61 standardized, 23, 577, 578 trading volume, 103, 104 Futures hedge ratio, 97–99, 579–581 Gamma ( ), 137, 140, 194, 195, 381, 401, 448, 484–487, 490, 492, 496–498, 532, 533 Geopolitical risk See Event derivatives Global macro strategy, 545, 549, 550 Gold, 62, 63, 80, 81, 92, 93, 98, 99, 351, 355, 366 Greeks, the, 137, 140, 141, 189, 194, 195, 381, 382, 401, 442, 445, 448, 451, 477–498, 503, 531–534, 549 Hedge accounting, 305–312 Hedge funds capital structure arbitrage, 534–538, 551 contingent contracts, use of, 553, 554 convertible bond arbitrage, 526–533, 545, 548, 549, 551 correlation trading, 551 credit hedge funds, 551, 552 derivatives, use of, 544–547 empty voting, 552, 553 equity swap contracts, use of, 110, 111 global macro strategy, 545, 549, 550 growth of, 541, 542 leverage and use of structures, 555 long-short equity strategy, 550 market-neutral strategies, 545, 549, 550 merger arbitrage, 549 offshore funds, 554 overview, 541–543, 555 performance, 547, 548 put options, 553 regulation, 541, 544, 547 relative value strategy, 550, 551 risk arbitrage, 549 and shareholder activism, 552–554 strategies, 548–552 tax-avoidance strategies, 554 trends, 551, 552 volatility strategies, 550, 551 Hedging basis risk, 45–47 commodities, 89, 95–100 credit default swaps, 189 See also Credit default swaps (CDS) cross-hedging, 51, 52, 222–224, 226 defined, 43 P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 8:40 596 Printer Name: Hamilton Index Hedging (Continued ) equity swaps, 110, 111 foreign exchange futures and forwards, 118 forward rate agreements, 577 See also Forward rate agreements (FRAs) impact of on market, 54 interest rate risk, 58, 580, 581 See also Interest rate derivatives option price sensitivities, 496–498 overview, 44–47 real estate derivatives, 224–228 and risk transfer, 58 speculators, interaction with, 43, 52–54, 363, 364 Home equity loans (HELs), 179, 185, 188, 202–204 Human capital, 221 Hybrid instruments, 298 Hybrid real options, 562, 568 Implicit method, 441, 442, 445–449 Index contracts, 158–160, 171, 252 Indexes Big Mac index, 116 commodities, 37, 38, 89–95, 100, 132, 244 Consumer Price Index (CPI), 222, 223 credit default swaps, 22, 177, 182–191, 194, 195 Herfindahl index, 208 index swaps, 128, 129 macroeconomic, 221–223, 227 narrow-based security index, 298 real estate, 224–226, 228 stocks, 46, 51, 60, 106–110, 112, 226, 235–238, 241, 364, 578 Inflation commodities as inflation hedge, 89, 91, 95, 100, 125 Consumer Price Index (CPI) as measure of, 222, 223 emerging derivative instruments, 221, 222 futures, 160, 221–223 and speculation, 48, 118 Information asymmetries, 39, 61, 83, 325 Information market, 157 See also Event derivatives Interdealer brokers, 258, 259, 283 Interest rate derivatives background, 235 exchange-traded, 135–137 interest rate swaps, 58, 119–121, 236–238, 405–417, 582, 583 mortgage derivatives, 141, 142 See also Mortgages over-the-counter derivatives, 138–142 overview, 135 plain vanilla, 135 swaptions, 139–141, 586 Interest rate guarantees, 584 Interest rate parity theorem (IRPT), 73, 116, 117, 121 Interest rate risk basis risk, 578, 579 caps and floors, 201, 584, 585 and convertible bond arbitrage, 527, 529, 530 coupon bonds portfolio, hedging with interest rate futures, 581, 582 and credit risk, 17, 19, 201 and financial engineering, 525, 527, 529, 530 and floating rate mortgages, 43 forward rate agreements, 9, 575–577 forward-based instruments for managing risk, 575–583 futures hedge ratio, 579–581 hedging, 46, 58, 580, 581 See also Interest rate derivatives hedging with Eurodollar futures, 58 interest rate futures contracts, 577, 578 interest rate guarantees, 584 mortgage securitization risk management, 586–588 option-based products for managing, 575, 583–588 overview, 4, 575 swaptions, 586 International Swaps and Derivatives Association (ISDA) background, 24, 178 Credit Support Annex (CSA), 30 Credit Support Documents, 34 Master Agreements, 17, 24, 32, 34, 139, 407 pay-as-you-go (PAYGO or PAUG) template for credit default swaps, 179–182, 185, 188, 192 Introducing brokers (IBs), 250, 255 Iowa Electronic Market (IEM), 148, 160, 161, 168, 171 Ito integral, 462–464 Ito process, 374–376, 384, 455, 459–467, 470, 473 Ito’s lemma, 382, 395, 464–468, 473, 474 Lease rate, 62, 63, 80, 81, 355 Liquidity, 11, 21, 104, 105, 111, 136, 273, 274, 288, 289, 316, 317, 325 Long-Term Capital Management (LTCM), 314, 316, 317, 319–321, 327 Lookback options, 149, 150, 449 P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton INDEX Macroeconomic indexes, 221–223 Margin payments, 269–273, 276 Market intermediaries, 249–260 Market-neutral strategies, 545, 549, 550 Markets for derivatives agricultural futures, 233, 234, 236 See also Commodities background, 233–236 commodities, 233, 234, 236 and electronic trading, 240–243 energy derivatives, 238–240 exchanges, 233–245 financial crisis of 2008, effect of, 244, 245 foreign currency, 235 foreign markets, 236, 237 futures contracts, 234 livestock futures, 234 mergers and consolidation of exchanges, 243, 244 options, 235 over-the-counter markets, 234, 235, 237–240, 242, 244, 245 Markov process, 456, 457, 459, 461, 469, 470 Mark-to-market process, 23, 29, 30, 37, 191, 252, 253, 269–271, 284, 287, 288, 362 Martingale methods, 441–443, 456, 458, 459, 471 Merger arbitrage, 549 Metallgesellschaft AG, 314–316, 319, 325–327 Metallurgical derivatives See Commodities; Gold Money management services, 256, 257 Monte Carlo simulation, 285, 425–439, 441–443, 451, 569 Mortgages credit default swaps, 177–179 derivatives, 141, 142 floating rate, 43 home equity loans (HELs), 179, 185, 188, 202–204 interest rate caps and floors, 584, 585 mortgage securitization, 141, 142, 203, 208, 209, 586–588 mortgage-backed securities (MBS), 199, 200 residential, 177, 179, 199, 201, 202, 584 Mutual funds, 94, 109, 253, 256, 544–546 National Futures Association, Inc (NFA), 250, 251, 255–257 Natural gas See Energy derivatives Netting, 29, 31–36, 39, 121, 283, 289, 291, 410 No-arbitrage principle, 14, 106, 335–349, 387, 425, 445, 482 Normal backwardation, 77, 80, 84, 85, 363, 364, 366 597 Novation, 32, 33, 35, 288, 290, 291 Numeric pricing models, 425, 426 See also Binomial option pricing model; Finite difference valuation methods Numerical integration methods, 451 Offshore hedge funds, 554 Oil and petroleum products See Energy derivatives Option contracts See also Call options; Put options clearing, 271, 272 See also Clearing foreign exchange options, 118, 119 forward contracts, relationship to, 16 OTC interest rate derivatives, 138 overview, 13–16 pricing See Black-Scholes option pricing model; Closed-form option pricing models trading volume, 103, 104 Option price sensitivities, 141, 381, 382, 477–498 Option to abandon or temporarily shutdown, 562, 566–568 Option to expand, 562, 563 Option to vary production inputs, outputs, or processes, 562, 564–566 Option to wait, 562–564 Option trading strategies albatross, 520 bear spreads, 512–515 box spreads, 518, 519 bull spreads, 512, 513, 515 butterfly spreads, 519–521 call backspreads, 518 Christmas tree, 518 condors, 520 covered calls, 507, 508 cylinders, 515 dispersion trading, 523 European versus American options, 505 iron butterfly, 521 long/short spreads, 523 multi-asset strategies, 523 overview, 503–505 payoff tables, 505–514, 516–521 protective puts, 508, 509 put backspreads, 518 ratio spreads, 518 seagulls, 521, 522 straddles, 516–518, 520–522 strangles, 516, 517 straps, 517 strips, 517 synthetic positions, 509–512, 515, 523 time strategies, 522 P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 598 8:40 Printer Name: Hamilton Index Options Clearing Corporation (OCC), 28, 111, 273, 275–277, 289 Over-the-counter (OTC) market clearing and clearinghouses See Clearing competition and consolidation, 25–29 conventional bilateral swaps, 298 counterparty credit risk See Counterparty risk default statistics, 289, 290 energy derivatives, 126 foreign exchange forward market, 117, 118 information asymmetries, 36–40 interest rate derivatives, 138–142 intermediaries for OTC derivatives, 250–260 ISDA Master Agreements, 17, 24, 32, 34, 139, 407 netting and novation, 3, 31, 32, 34–36 overview, 21, 22, 234, 235, 237–240, 242 regulation of, 26, 27, 37, 244, 245, 297, 298, 300–302 and standardization, 22–25 swaps, 139, 140 See also Swaps swaptions, 139, 140 See also Swaptions transparency, 36–38 Partial differential equation (PDE), 441, 443, 445, 450 Pay-as-you-go template for credit default swaps, 179–182, 185, 188, 192 Payoff tables, 505–514, 516–521 Petroleum See Energy derivatives Plain vanilla foreign exchange swaps, 119–121 Plain vanilla interest rate derivatives, 135 Plain vanilla options, 74, 119, 120, 143, 145, 146, 149, 150, 152, 428–433 Plain vanilla swaps, 59, 119–122, 529, 530 Policy Analysis Market (PAM), 148, 157, 168, 173 Prediction markets, 157 See also Event derivatives Price discovery as social function of derivatives, 57–59 Price risk, 19, 316 Pricing analytical models, 425, 426 Black-Scholes option pricing model See Black-Scholes option pricing model capital asset pricing model (CAPM), 85, 391 closed-form option pricing models See Closed-form option pricing models commodity futures, 79–85 econometric model, 366 energy derivatives, 129–131, 364–366 equilibrium models, 365, 366, 391, 392 exotic options, 144, 152 foreign exchange derivatives, 115–119 foreign exchange options, 119 forward and futures contracts See Forward and futures contracts, pricing Monte Carlo simulation See Monte Carlo simulation no-arbitrage principle See No-arbitrage principle numeric models, 425, 426 option price sensitivities See Option price sensitivities price discovery as social function of derivatives, 57–59 reduced form (intensity) models, 195, 196, 366 seasonality in commodities prices, 78, 79 simulation models, 425, 426 single-stock futures, 109 stochastic models See Stochastic processes and models stock options, 105 structural models, 195, 196 swaps See Swaps, pricing and valuation and theory of normal backwardation, 77, 80, 84, 85, 363, 364, 366 theory of storage See Theory of storage Private placements, 526, 527, 549 Project finance, 63, 64 Protective puts, 504, 508, 509, 514 Psi, 494, 495, 498 Purchasing power parity theorem (PPPT), 73, 115–117 Put backspreads, 518 Put options, 13–16, 106, 345–348, 553 Put/call parity, 16, 336–341, 346, 348, 371, 380, 381, 398, 480–481, 484, 491, 504, 509 Quanto notes, 122, 153 Rainbow options, 151, 152, 435–439 Rate locks, 138–139, 586, 587 Ratio spreads, 505, 518 Real estate derivatives, 221, 222, 224–228 Real options and corporate finance, 560, 561 defined, 559 energy industry examples, 561–568 financial options distinguished, 561 hybrid real options, 562, 568 option to abandon or temporarily shutdown, 562, 566–568 option to expand, 562, 563 option to vary production inputs, outputs, or processes, 562, 564–566 P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton INDEX option to wait, 562–564 overview, 559, 560, 570 pharmaceutical industry, 560, 570 timing option, 563 types of, 562–568 valuation, 568–570 Regulation and regulatory agencies commodity futures and options (U.S.), 295–302 equity derivatives, 111, 112 exchange-traded derivatives, 250, 251, 253–257 future legislative reforms, 301, 302 hedge funds, 541, 544, 547 Relative value strategy, 550, 551 Residential mortgage-backed securities (RMBS), 177, 204 Reverse cash-and-carry arbitrage, 80, 81, 352–354, 356, 366 Rho, 382, 493–496, 498 Risk arbitrage, 549 Risk management bilateral to multilateral, 29–36 commodities, 97–99 compensation and promotion criteria, 314, 315, 323–325, 328 control of traders and fund managers, 321–323 equity derivatives, 103, 104 and ethical behavior, 324, 325 failures and disasters, examples of and lessons learned, 313–328 and financial engineering, 526 hedging, 43, 50–52, 58 See also Hedging and innovation, 67 internal controls, 326 and liquidity access, 321 losses, restricting, 320, 321 managers, role of, 325, 326, 328 measuring risk, 319, 320 net positions, monitoring, 322, 323 overview, 3, 4, 19, 327, 328 and portfolio theory, 103 separation of duties, 322 and speculation, 50–52 Risk premium, 5, 6, 84, 85, 92, 94, 363, 364, 366, 396 Roll return, 92–95 Scalpers, 25, 52, 53 Scandals See Failures and disasters in derivatives Seagulls, 505, 521, 522 Seasonal price behavior, 77–79, 130, 131 Securities and Exchange Commission (SEC), 108, 110–112, 236, 250, 251, 256, 259, 260, 298, 299, 301, 544 599 Security futures products (SFPs), 298, 299 Self-regulatory organizations (SROs), 249–250, 255, 257–258 Settlement, 177–185, 236, 284 See also Clearing; Counterparty risk Shareholder activism, 552–554 Sharpe ratio, 66, 545, 546 Simulation models, 425, 426 See also Monte Carlo simulation Single-stock futures, 108, 109 Social functions of derivatives, 57–67 Soci´et´e G´en´erale, 314, 318, 320–327 Special-purpose vehicle (SPV), 189, 190, 200 Speculation, 43, 44, 48–54, 89, 92, 93, 100, 118, 189, 363, 364 Splitting methods, 450, 451 Spot return, 92 Spread traders, 50 Spreads, 89, 99, 100, 182, 189, 192–196, 512–515, 518–521, 523 Stack-and-roll hedges, 316 Standardized products, 22, 23, 577, 578 Stochastic processes and models binomial tree model, 468–472 Brownian motion (Wiener process), 458–465, 467 definitions and properties, 456–458 and finite difference methods, 449, 450 Ito integral, 462–464 Ito process, 374–376, 384, 459–467, 470, 473 Ito’s lemma (formula), 382, 395, 464–468, 473, 474 overview, 455, 456, 472 stochastic calculus, 426, 455, 458–468 Stock indexes, 106, 107, 109, 236 Stock options, 103–108, 211–218, 236 See also American options; European options trading strategies See Option trading strategies Storage, theory of See Theory of storage Straddles, 66, 505, 516–518, 520–523, 548 Strangles, 66, 505, 516, 517, 521 Straps, 517 Stress tests, 319, 328 Strips, 517 Structured credit products asset-backed securities (ABS), 201–204 collateralized debt obligations (CDOs), 204–208 collateralized mortgage obligations (CMOs), 199 commercial mortgage-backed securities (CMBS), 208, 209 and credit default swaps See Credit default swaps (CDS) P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 600 8:40 Printer Name: Hamilton Index Structured credit products (Continued ) mortgage-backed securities (MBS), 199, 200 overview, 199–201 special-purpose vehicles (SPVs), 200 tranches, 199, 206, 207 Structured products, 3, 16–19, 66 Swaps brokers, 258, 259 centralized clearing for, 259, 260 CIRCUS swap, 122 counterparty credit risk, 283–292 See also Counterparty risk currency annuity swap, 122 currency basis swap, 122 dealers, 64, 237, 238, 258, 259, 285, 406, 407, 420, 529, 530, 532, 533 Eligible Contract Participants, 11 equity swaps, 110, 111 flavored currency swaps, 121, 122 interest rate derivatives, 139 interest rate swaps See Interest rate derivatives overview, 11–13, 237 plain vanilla foreign exchange swaps, 119–121 as portfolio of different maturity forward contracts, 13 pricing See Swaps, pricing and valuation Swaps, pricing and valuation commodity swaps, 406, 419, 420 currency swaps, 406, 417–419 framework for, 407–409 interest rate swap, example, 406, 407 interest rate swaps, 406–417 ISDA Master Agreement, 17, 24, 32, 34, 139, 407 overview, 13, 405, 406 steps for, 410–417 Swaptions, 126, 129, 139–141, 586 Synthetic asset allocation, 57, 65–67 Synthetic collateralized debt obligations, 177, 180, 182, 186, 189–192 Synthetic positions, 182, 509–512, 515, 523 Synthetic storage, 60 Tax-avoidance strategies, 554 Technical traders, 48, 49 Theory of normal backwardation, 77, 80, 84, 85, 363, 364, 366 Theory of storage, 77, 80–85, 130, 131, 363 See also Cost of carry Theta (θ ), 381, 486–491, 496, 498 Trade finance, 64, 65 Trading strategies credit default swaps, 188, 189 options See Option trading strategies Trading volume commodities, 90 energy derivatives, 127–129 equity derivatives, 103, 104, 108, 111, 112 foreign exchange forwards, 117 foreign exchange futures, 117, 118 foreign markets, 104, 236, 237 futures contracts, 21, 103, 104 historical background, 233–235 interest rate derivatives, 135, 136 option contracts, 21, 103, 104 Tranches, 17, 177–181, 186–195, 199, 206, 207 Transparency, 1, 21, 22, 36–38, 59, 115, 214, 259, 278, 328, 578 Trinomial option pricing model, 445, 447 Underinvestment problems, 57, 61–62, 65 Unwinding positions, 186, 263, 268, 274–276, 550 U.S Treasury bonds, 74, 137, 139, 236, 237, 241, 357, 358, 360, 361, 534 U.S Treasury notes, 137, 235, 242, 243, 358, 360, 361 Valuation See also Pricing finite difference methods See Finite difference valuation methods grid, 444–446, 448 real options, 568–570 Value at risk (VaR), 319, 320, 328 Variance swaps, 66, 551 Vega, 141, 381, 491–493, 496–498 Volatility derivatives, 66 Volatility smile, 166, 451 Volatility strategies, 550, 551 Warrants, 103, 108 Wiener process, 375, 389, 395, 398, 455, 457–459, 461, 463, 465 See also Brownian motion Zero curve, 410–415, 419 (continued from front flap) Uncertainty is a hallmark of today’s global financial marketplace This essential guide to financial derivatives will help you unlock their vast potential for risk management and much, much more JAMES A OVERDAHL, a specialist in financial derivatives, is the Chief Economist of the United States Securities and Exchange Commission He had previously served as chief economist of the Commodity Futures Trading Commission and has nearly two decades of experience in senior positions at various federal financial regulatory agencies He has taught economics and finance at the University of Texas at Dallas, Georgetown University, Johns Hopkins University, and George Washington University Overdahl earned his PhD in economics from Iowa State University The Robert W Kolb Series in Finance is an unparalleled source of information dedicated to the most important issues in modern finance Each book focuses on a specific topic in the field of finance, and contains contributed chapters from both respected academics and experienced financial professionals As part of the Robert W Kolb Series in Finance, Financial Derivatives aims to provide a comprehensive understanding of financial derivatives and how you can prudently use them within the context of your underlying business activities For the public at large, financial derivatives have long been the most mysterious and least understood of all financial instruments Through in-depth insights gleaned from years of financial experience, the contributors in this collection clearly explain what derivatives are without getting bogged down by the mathematics surrounding their pricing and valuation Financial Derivatives offers a broad overview of the different types of derivatives—futures, options, swaps, and structured products—while focusing on the principles that determine market prices This comprehensive resource also provides a thorough introduction to financial derivatives and their importance to risk management in a corporate setting Filled with in-depth analysis and examples, Financial Derivatives offers readers a wealth of knowledge on futures, options, swaps, financial engineering, and structured products Jacket Design: Leiva-Sposato Design FINANCIAL DERIVATIVES Pricing and Risk Management FINANCIAL DERIVATIVES ROBERT W KOLB is the Frank W Considine Chair of Applied Ethics and Professor of Finance at Loyola University Chicago Before this, he was the assistant dean, Business and Society, and director, Center for Business and Society, at the University of Colorado at Boulder, and department chairman at the University of Miami Kolb has authored over twenty books on finance, derivatives, and futures, as well as numerous articles in leading finance journals FINANCIAL DERIVATIVES Kolb Overdahl The authors explore option strategies used to speculate and show how the same strategies can be employed to reduce risk In addition, they reveal how financial derivatives can effectively manage interest rate risk and discuss how hedge funds use financial derivatives KOLB SERIES IN FINANCE Essential Perspectives $95.00 USA/$114.00 CAN As part of the Robert W Kolb Series in Finance, Financial Derivatives skillfully explores the contemporary world of financial derivatives Starting with a presumption of only a general knowledge of undergraduate finance, this collection of essential perspectives, written by leading figures in academics, industry, and government, provides a comprehensive understanding of financial derivatives The contributors provide a complete overview of the types of financial derivatives and the markets in which they trade They analyze the development and current state of derivatives markets—including their regulation—and examine the role of derivatives in risk management They look at the pricing of derivatives, beginning with the fundamentals and move on to more advanced pricing techniques, showing how Monte Carlo methods can be applied to price derivatives Robert W Kolb, James A Overdahl, Editors KOLB SERIES IN FINANCE Essential Perspectives EAN: 9780470499108 ISBN 978-0-470-49910-8 A t a time when our entire financial system is under great stress, many investors point to the misuse of derivatives as one of the primary causes of the financial meltdown Long misunderstood by the general public, some financial derivatives are fairly simple—while others are quite complicated and require considerable mathematical and statistical knowledge to fully understand But with our financial system now undergoing unprecedented changes, there has never been a better time to gain a firm understanding of these instruments The book concludes with an examination of the many ways derivatives can be used While it is clear that financial derivatives are valuable for managing risks and for providing information about the future prices of underlying goods, they can also be used as very sophisticated speculation tools (continued on back flap) ... understanding of financial derivatives Financial Derivatives is comprised of 37 chapters organized into six parts: Part One, “Overview of Financial Derivatives, ” provides an introduction to and. .. financial derivatives in particular Joan C Junkus provides the analysis of agricultural and metallurgical derivatives in Chapters and 6, “Agricultural and Metallurgical Derivatives: Pricing, ” and “Agricultural... Risk Management Systems Must Control Traders and Fund Managers Compensation Incentives and Promotion Criteria Must Be Scrutinized Risk Management Systems Are Only as Strong as Their Weakest Risk