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Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options, 2nd Edition

ISBN: 978-0-470-74937-1
288 pages
August 2010
Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options, 2nd Edition (0470749377) cover image
Derivatives are everywhere in the modern world and it is important for everyone in banking, investment and finance to have a good understanding of the subject. Derivatives Demystified provides a step-by-step guide to the subject, enabling the reader to have a solid, working understanding of key derivative products.

Adopting a highly accessible approach, the author explains derivative products in straightforward terms and without the complex mathematics that underlie the subject, focusing on practical applications, case studies and examples of how the products are used to solve real-world problems. Derivatives Demystified follows a sequence that is designed to show that, although there are many applications of derivatives, there are only a small number of basic building blocks, namely forwards and futures, swaps and options. The book shows how each building block is applied to different markets and to the solution of various risk management and trading problems.

This new edition will be fully revised to reflect the many changes the derivatives markets have seen over the last three years.  New material will include a comprehensive history of derivatives, leading up to their use and abuse in the current credit crisis.  It will also feature new chapters on regulation and control of derivatives, commodity derivatives, credit derivatives and structured products and new derivative markets including inflation linked and insurance linked products. 

Derivatives Demystified is essential reading for everyone who operates in the financial markets or within the corporate environment who requires a good understanding of these important financial instruments.

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Acknowledgements.

1. The Origins and Growth of the Market.

Definitions.

Derivatives Building Blocks.

Market Participants.

Supporting Organizations.

Early Origins of Derivatives.

Derivatives in the USA.

Overseas Developments, Innovation and Expansion.

An Example of Recent Innovation: Weather Derivatives.

Temperature-Linked Derivatives.

The Wild Beast of Finance?

Lessons from Recent History.

Creative Destruction and Contagion Effects.

The Modern OTC Derivatives Market.

The Exchange-Traded Derivatives Market.

Chapter Summary.

2. Equity and Currency Forwards.

Introduction.

Equity Forward Contract.

The Forward Price.

The Forward Price and Arbitrage Opportunities.

The Forward Price and the Expected Payout.

Foreign Exchange Forwards.

Managing Currency Risk.

Hedging with an Outright Forward FX Deal.

The Forward Foreign Exchange Rate.

The Forward FX Rate and Arbitrage Opportunities.

Forward Points.

FX Swaps.

Applications of FX Swaps.

Chapter Summary.

3. Forward Rate Agreements.

Introduction.

FRA Case Study: Corporate Borrower.

Results of the FRA Hedge.

The FRA as Two Payment Legs.

Dealing in FRAs.

Forward Interest Rates.

Chapter Summary.

4. Commodity and Bond Futures.

Introduction.

The Margining System and the Clearing House.

Users of Futures Contracts.

Commodity Futures.

Futures Prices and the Basis.

US Treasury Bond Futures.

US Treasury Bond Futures: Delivery Procedures.

Gilt and Euro-Bund Futures.

The Cheapest-to-Deliver (CTD) Bond.

Chapter Summary.

5. Interest Rate and Equity Futures.

Introduction.

Eurodollar Futures.

Trading Eurodollar Futures.

Hedging with Interest Rate Futures.

Interest Rate Futures Prices.

Equity Index Futures.

Applications of S&P 500 Index Futures.

FT-SE 100 Index Futures Contracts.

Establishing Net Profits and Losses.

Single Stock Futures (SSFs).

Chapter Summary.

6. Interest Rate Swaps.

Introduction.

Interest Rate Swap Structure.

Basic Single-Currency Interest Rate Swap.

The Swap as a Package of Spot and Forward Deals.

Rationale for the Swap Deal.

Swap Terminology and Swap Spreads.

Typical Swap Applications.

Interest Rate Swap Variants.

Cross-Currency Interest Rate Swaps.

Net Borrowing Costs using a Cross-Currency Swap.

Inflation Swaps.

Chapter Summary.

7. Equity and Credit Default Swaps.

Introduction to Equity Swaps.

Equity Swap Case Study.

Other Applications of Equity Swaps.

Equity Index Swaps.

Hedging an Equity Index Swap.

Credit Default Swaps.

Credit Default Swap: Basic Structure.

Credit Default Swap Applications.

Credit Spreads.

The CDS Premium and the Credit Spread.

Pricing Models for CDS Premium.

Index Credit Default Swaps.

Basket Credit Default Swaps.

Chapter Summary.

8. Fundamentals of Options.

Introduction.

Definitions.

Types of Options.

Basic Option Trading Strategies.

Long Call: Expiry Payoff Profile.

Short Call: Expiry Payoff Profile.

Long Put: Expiry Payoff Profile.

Short Put: Expiry Payoff Profile.

Summary: Intrinsic and Time Value.

9. Hedging with Options.

Chapter Overview.

Futures Hedge Revisited.

Protective Put.

Hedging with ATM Put Option.

Covered Call Writing.

Equity Collar.

Zero-Cost Equity Collar.

Protective Put with a Barrier Option.

Behaviour of Barrier Options.

Chapter Summary.

10 Exchange-Traded Equity Options.

Introduction.

Basic Concepts.

CBOE Stock Options.

UK Stock Options on NYSE Liffe.

CME S&P 500 Index Options.

FT-SE 100 Index Options.

Chapter Summary.

11. Currency or FX Options.

Introduction.

Users of Currency Options.

Hedging FX Exposures with Options: Case Study.

Graph Of Hedged And Unhedged Positions.

Hedging with a Zero-Cost Collar.

Reducing Premium on FX Hedges.

Compound Options.

Exchange-Traded Currency Options.

Chapter Summary.

12. Interest Rate Options.

Introduction.

OTC Interest Rate Options.

OTC Interest Rate Option Case Study.

Hedging a Loan with a Caplet.

Interest Rate Cap.

Interest Rate Collar.

Interest Rate Swap and Swaption.

Summary of Interest Rate Hedging Strategies.

Eurodollar Options.

Euro and Sterling Interest Rate Options.

Bond Options.

Exchange-Traded Bond Options.

Chapter Summary.

13. Option Valuation Concepts (1).

Introduction.

The Concept of a Riskless Hedge.

A Simple Option Pricing Model.

Option Fair Value.

Extending the Binomial Model.

Cost of Dynamic Hedging.

The Black-Scholes Option Pricing Model.

Historical Volatility.

Measuring and Using Volatility.

Chapter Summary.

14. Option Valuation Concepts (2).

Introduction.

Problems with Historical Volatility.

Implied Volatility.

Black-Scholes Model Assumptions.

Value of a Call Option.

Value of a Put Option.

Equity Index and Currency Options.

Pricing Interest Rate Options.

Chapter Summary.

15. Option Sensitivities: The 'Greeks'.

Introduction.

Delta (Δ or δ).

Delta Behaviour.

Delta as the Hedge Ratio.

The Effects of Changes in Delta.

Readjusting the Delta Hedge.

Gamma (Γ or γ).

Gamma and the Spot Price of the Underlying.

Gamma and Time to Expiry.

Theta (θ).

Vega or Kappa (κ).

Rho (ρ).

Summary of Greeks.

Chapter Summary.

16. Option Trading Strategies (1).

Introduction.

Bull Spread.

Bull Position with Digital Options.

Spot Price and CON Value.

Bear Spread.

The Greeks for the Bear Spread.

Put or Bear Ratio Spread.

Long Straddle.

Long Straddle Current Payoff Profile.

Potential Risks with a Long Straddle.

Chapter Summary.

17. Option Trading Strategies (2).

Introduction.

Chooser Option.

Short Straddle.

Short Straddle Current Payoff Profile.

Potential Profits with a Short Straddle.

Managing the Risk on a Short Straddle.

Short Strangle.

New Ways of Trading Volatility.

Calendar or Time Spread.

Chapter Summary.

18. Convertible and Exchangeable Bonds.

Introduction.

Investors in Convertible Bonds.

Issuers of Convertible Bonds.

CB Measures of Value.

Conversion Premium and Parity.

Other Factors Affecting CB Values.

Convertible Arbitrage.

Convertible Arbitrage Example.

Profits and Risks with the CB Arbitrage Trade.

Mandatorily Convertibles and Exchangeables.

Structuring a Mandatorily Exchangeable (ME) Bond.

Chapter Summary.

19. Structured Securities.

Introduction.

Capital Protection Equity-Linked Notes.

Expiry Value of 100% Capital Protection Notes.

100% Participation Equity-Linked Notes.

Capped Participation Equity-Linked Notes.

Average Price Notes.

Locking in Interim Gains: Cliquet Options.

Securitization and CDOs.

The Basic CDO Structure.

Rationale for Securitization.

Synthetic CDOs.

Chapter Summary.

20. Clearing, Settlement and Operational Risk.

Introduction.

Risk Management in General.

Settlement of Exchange-Traded Derivatives.

Major Clearing Houses.

Confirmation and Settlement of OTC Deals.

Controlling Counterparty Risk on OTC Derivatives.

Operational Risk.

Best Practice in Operational Risk Management.

Chapter Summary.

Appendix A: Financial Calculations.

Appendix B: Exotic Options.

Appendix C: Glossary of Terms.

Index.

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