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Financial Derivatives: Pricing and Risk Management

Robert Kolb (Editor), James A. Overdahl (Editor)
ISBN: 978-0-470-49910-8
600 pages
November 2009
Financial Derivatives: Pricing and Risk Management  (0470499109) cover image

Essential insights on the various aspects of financial derivatives

If you want to understand derivatives without getting bogged down by the mathematics surrounding their pricing and valuation, Financial Derivatives is the book for you. Through in-depth insights gleaned from years of financial experience, Robert Kolb and James Overdahl clearly explain what derivatives are and how you can prudently use them within the context of your underlying business activities.

Financial Derivatives introduces you to the wide range of markets for financial derivatives. This invaluable guide 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 helpful tables and charts, Financial Derivatives offers a wealth of knowledge on futures, options, swaps, financial engineering, and structured products.

  • Discusses what derivatives are and how you can prudently implement them within the context of your underlying business activities
  • Provides thorough coverage of financial derivatives and their role in risk management
  • Explores financial derivatives without getting bogged down by the mathematics surrounding their pricing and valuation

This informative guide will help you unlock the incredible potential of financial derivatives.

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Part I: Overview of Financial Derivatives.

Chapter One: Derivative Instruments: Forwards, Futures, Options, Swaps, and Structured Products.

Introduction.

A Generalist's Approach to Derivative Contracts.

Structured Products and an Application to Derivative Contracts.

Conclusion.

Endnotes.

References.

About the Author.

Chapter Two: The Derivatives Marketplace: Exchanges and the Over-the-Counter Market.

Introduction.

Standardization vs. Customized Products: Differences in Structure and Approach.

Competition and Consolidation: Impetus for Change.

Moving from Bilateral to Multilateral Risk Management.

Transparency and Information in the Exchange and OTC Marketplaces.

Conclusion.

Endnotes.

References.

About the Author.

Chapter Three: Speculation and Hedging.

Hedging Transactions.

Speculation.

From Hedging to Speculation.

The Interaction between Hedgers and Speculators.

Conclusion.

Endnotes.

References.

About the Author.

Chapter Four: The Social Functions of Financial Derivatives.

Hedging and Risk Transfer.

Price Discovery.

Intertemporal Resource Allocation.

Asset Finance.

Synthetic Asset Allocation.

Endnotes.

References.

About the Author.

Part II: Types of Financial Derivatives.

Chapter Five: Agricultural and Metallurgical Derivatives: Pricing.

Introduction.

Commodities.

Seasonality in Spot and Futures Prices.

Futures Pricing.

Conclusion.

References.

Suggested Further Reading.

About the Author.

Chapter Six: Agricultural and Metallurgical Derivatives: Speculation and Hedging.

Introduction.

Commodities.

Derivatives.

Commodity Investment Strategies.

Hedging.

Spreads.

Conclusion.

References.

Suggested Further Reading.

About the Author.

Chapter Seven: Equity Derivatives.

Introduction.

Stock Options.

Equity Futures.

Equity Swaps.

The Future of Equity Derivatives.

References.

About the Authors.

Chapter Eight: Foreign Exchange Derivatives.

Basic Pricing Principles.

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.

Chapter Nine: Energy Derivatives.

Introduction.

Products: An Overview.

History.

Petroleum Derivatives: Details.

Natural Gas Derivatives: Details.

Electricity Derivatives: Details.

Pricing.

Clearing.

Recent Developments.

References.

About the Author.

Chapter Ten: Interest Rate Derivatives.

Exchange Traded (Listed) Derivatives.

Over the Counter Derivatives.

Further Reading.

About the Author.

Chapter Eleven: Exotic Options.

Overview.

Forward-Start Options.

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.

Chapter Twelve: Event Derivatives.

Types of Prediction Markets.

Applications and Evidence.

Accuracy of Prediction Markets.

Possibilities for Arbitrage.

Can Event Markets Be Easily Manipulated?

Market Design.

Making Inferences from Prediction Markets.

Innovative Future Applications?

Acknowledgements.

Endnotes.

References.

About the Author.

Chapter Thirteen: Credit Default Swaps.

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.

Chapter Fourteen: Structured Credit Products.

ABS.

CDOs.

CMBS.

Endnotes.

References.

About the Author.

Chapter Fifteen: Executive Stock Options.

Introduction.

Basic Features of Executive Stock Options (ESOs).

Conclusion.

Endnotes.

References.

About the Author.

Chapter Sixteen: Emerging Derivative Instruments.

Economic Derivatives.

Real Estate Derivatives.

The Next Frontier.

Endnotes.

References.

Suggested Further Reading.

About the Author.

Part III: The Structure of Derivatives Markets and Institutions.

Chapter Seventeen: The Development and Current State of Derivatives Markets.

Introduction: The Situation in the 1960s.

Financial Futures and Options.

Foreign Markets.

OTC Markets.

Energy Derivatives.

The Rise of Electronic Trading.

Current Conditions: Consolidation and Crisis.

Endnotes.

References.

About the Author.

Chapter Eighteen: Derivatives Markets Intermediaries: Brokers, Dealers, Pools, and Funds.

Intermediaries for Exchange-traded Derivatives.

Intermediaries for OTC Derivatives.

Endnotes.

References.

About the Author.

Chapter Nineteen: Clearing and Settlement.

Introduction.

The Functions of Clearinghouses.

Clearing and Liquidity.

Competition Between Exchanges.

Conclusion.

Endnotes.

References.

About the Authors.

Chapter Twenty: Counterparty Credit Risk.

Measuring Counterparty Credit Risk Exposure.

Managing Counterparty Credit Risk.

Infrastructure Improvements Aimed at Mitigating Counterparty Credit Risk.

Conclusion.

Endnotes.

References.

About the Author.

Chapter Twenty One: The Regulation of U.S. Commodity Futures and Options.

Tiered Regulatory Design.

Statutory Exclusions for Certain OTC Derivatives.

Security Futures Products (SFPs).

Retail Foreign Currency Fraud.

Exempt Commercial Markets.

CFTC Reauthorization Act of 2008.

Future Legislative Reforms.

Endnotes.

About the Author.

Chapter Twenty Two: Accounting for Financial Derivatives.

Alternative Accounting Categories.

Conclusion.

References.

About the Author.

Chapter Twenty Three: Derivative Scandals and Disasters.

Introduction.

Anatomy of Derivative-Related Failures.

Investment Strategies and Exogenous Shocks behind Our Five Derivative Fiascos.

Lessons Learned from Derivative Scandals and Disasters.

Broader Implications of Derivative Scandals and Disasters.

Conclusion.

Acknowledgements.

Endnotes.

References.

Suggested Further Reading.

About the Author.

Part IV: Pricing of Derivatives: Essential Concepts.

Chapter Twenty Four: No-Arbitrage Pricing.

Free Lunches.

The Theory of Put/Call Parity.

The Binomial Option Pricing Model.

Put Pricing in the Presence of Call Options: Further Study.

Binomial Put Pricing.

Binomial Pricing with Asymmetric Branches.

The Effect of Time.

The Effect of Volatility.

Intuition Into Black-Scholes.

Endnotes.

References.

Further Reading.

About the Author.

Chapter Twenty Five: The Pricing of Forward and Futures Contracts.

The cost of carry model.

The Carry Return.

Commodity Futures.

The Convenience Yield.

Delivery Options.

Interest rate futures and forwards: Eurodollar futures and Forward Rate Agreements.

Interest rate futures and forwards: Treasury Bond and Treasury Note futures.

Should futures and forward prices be the same?

The Expectations Model: An alternative theory for the pricing of forwards and futures.

Electricity Forwards and Futures.

Conclusion.

Endnotes.

References.

About the Author.

Chapter Twenty Six: The Black-Scholes Option Pricing Model.

Introduction.

Brief history.

The Black-Scholes Formula.

Assumptions of the Black-Scholes Model.

Discussion of Assumptions.

Itô Process.

An Example.

An Excel Application.

Simple Derivation of Black-Scholes.

A Numerical Example.

The Greeks.

Risk-neutral Pricing.

Conclusion.

References.

About the Author.

Chapter Twenty Seven: The Black-Scholes Legacy: Closed-Form Option Pricing Models.

Introduction.

The Black-Scholes Model.

First Generation of Models (One lognormal underlying).

Second Generation of Models (Two lognormal underlyings).

Third Generation of Models (One non-longnormal underlying).

Fourth Generatino of Models.

Conclusion.

References.

About the Author.

Chapter Twenty Eight: The Pricing and Valuation of Swaps.

Introduction.

A framework for pricing and valuation.

Steps for swap pricing.

Other swaps.

Endnotes.

References.

About the Authors.

Part V: Advanced Pricing Techniques.

Chapter Twenty Nine: Monte Carlo Techniques in Pricing and Using Derivatives.

Monte Carlo Simulation in the Pricing of Derivatives.

Pricing a Classic Black-Scholes Option.

Pricing a Rainbow Option.

Endnotes.

References.

About the Author.

Chapter Thirty: Valuing Derivatives Using Finite Difference Models.

Introduction.

An Overview.

Basic Models.

Higher Dimension Problems.

The Pros and Cons of Finite Difference Models.

Suggested Further Reading.

References.

About the Author.

Chapter Thirty One: Stochastic Processes and Models.

Introduction.

Stochastic Processes.

Basic Elements of Stochastic Calculus.

Binomial Tree – Another Way of Visualizing a Stochastic Process.

Conclusion.

References.

Appendix: Heuristic Derivation of Ito’s Formula.

About the Authors.

Chapter Thirty Two: Measuring and Hedging Option Price Sensitivities.

Delta.

Gamma.

Theta.

Vega.

Rho and Other Option Sensitivities.

Hedging Delta, Gamma, and Vega.

Conclusion.

References.

About the Author.

Part VI: Using Financial Derivatives.

Chapter Thirty Three: Option Strategies.

Building Blocks.

Covered Calls and Protective Puts.

Synthetic Positions.

Bull and Bear Spreads.

Cylinders.

Straddles, Strangles, Strips, and Straps.

Ratio Spreads.

Box Spreads.

Butterflies, Condors, and Seagulls.

Time Strategies.

Multi-Asset Strategies.

References.

About the Author.

Chapter Thirty Four: The Use of Derivatives in Financial Engineering: Hedge Fund Applications.

Queens College The Use of Derivatives in Financial Engineering: Hedge Fund Applications.

Convertible Bond Arbitrage.

Capital Structure Arbitrage.

Endnotes.

References.

About the Authors.

Chapter Thirty Five: Hedge Funds and Financial Derivatives.

Introduction.

A Survey of Derivative Use by Hedge Funds.

Modeling Hedge Fund Risks.

Description of Some Popular Hedge Fund Strategies.

Some Unusual Derivatives Trades Made by Hedge Funds.

Conclusion.

Endnotes.

References.

About the Author.

Chapter Thirty Six: Real Options and Applications in Corporate Finance.

Introduction.

A Brief History of Real Options.

Distinction Between Financial Options and Real Options.

Types of Real Options and Examples in the Energy Industry.

Valuing Real Options.

Conclusion.

Endnotes.

References.

About the Authors.

Chapter Thirty Seven: Using Derivatives to Manage Interest Rate Risk.

Introduction.

Forward-Based Instruments.

Option-Based Instruments.

Conclusion.

Suggested Further Reading.

About the Author.

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