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Demystifying Exotic Products: Interest Rates, Equities and Foreign Exchange

Demystifying Exotic Products: Interest Rates, Equities and Foreign Exchange

Chia Tan

ISBN: 978-0-470-68788-8 January 2010 272 Pages




In recent times, derivatives have been inaccurately labelled the financial weapons of mass destruction responsible for the worst financial crisis in recent history. Inherently complex and perilous for the ill-informed investment professional they can however also be gainfully harnessed.

This book is a practical guide to the complexities of exotic products written in simple terms based on the premise that derivatives are not homogenous, and not necessarily dangerous.

By exploring common themes behind the construction of various structured products in interest rates, equities and foreign exchange, and investigating the economic environment that promoted the explosive growth of these products, this book will help readers make sense of their relevance in this period of economic uncertainty. Subsequently, by explaining exotic products with simple mathematics, it will aid readers in understanding their potential use in certain investment strategies whilst having a firm control over risk.

Exotic products need not be inaccessible. By understanding the products available investors can make informed decisions ensuring features are consistent with their investment objectives and risk preferences. Author Chia Chiang Tan takes readers through the risks and rewards of each product, illustrating when products can damage investment strategies and how to avoid them, leading to suitable, profitable investments.

Ultimately, this book will provide practitioners with an understanding of derivatives, enabling them to determine for themselves which products will fit their investment strategy, and how to use them based on the economic environment and inherent risks.





1 Derivatives in their Golden Days (1994 to 2007).

1.1 Uses of Derivatives.

1.2 Structured Notes.

2 Themes in Constructing Exotic Products.

2.1 Principal Protection.

2.2 Upside-Only Participation.

2.3 Protected Selling of Optionality for Yield.

2.4 Betting Against the Forward Curve.

2.5 Diversification.

2.6 Some Considerations in Hedging.

3 Basics of Derivatives.

3.1 The Forward Contract.

3.2 The Plain Vanilla Option.

3.3 No-Arbitrage Pricing.

3.4 The Black–Scholes Model.

3.5 The Volatility Surface.

3.6 Correlation.

3.7 Modelling Considerations.

4 Barriers.

4.1 Digitals.

4.2 Knockouts and Reverse Knockouts.

4.3 One-Touches and No-Touches.

4.4 Double Barriers and More.

5 Quantoes.

5.1 Some Motivation.

5.2 Multi-Currency Products.

5.3 Non-Deliverable Products.

5.4 Self-Quantoes (Auto-Quantoes).

5.5 Quantoes.

6 Swaps, Constant Maturity Swaps and Spreads.

6.1 The Swap.

6.2 Natural Payment Time and the Libor-in-Arrears.

6.3 The Swaption.

6.4 The Constant Maturity Swap.

6.5 Spread between Two CMS Rates.

6.6 Callable CMS.

7 Range Accruals.

7.1 Motivation.

7.2 Single Reference Accruals.

7.3 Multiple Reference Accruals.

8 Early Termination.

8.1 The Mindset of a Benchmark Investor.

8.2 Callables.

8.3 Triggers (Autocalls).

8.4 The Target Redemption Note.

8.5 Puttables.

8.6 Early Termination and Contingent Cashflows.

9 Pathwise Accumulators.

9.1 The One-Way Floater.

9.2 Skylines.

9.3 Snowballs.

10 Power Reverse Dual Currencies.

10.1 The Carry Trade.

10.2 Long-Dated Foreign Exchange.

10.3 Normal PRDCs.

10.4 The Redemption Strike.

10.5 Chooser PRDCs.

11 Baskets and Hybrids.

11.1 Baskets and the Benign Effect of Averaging.

11.2 Hybrid Baskets.

11.3 “Best of” Products and Hybrids.

11.4 Hybrids and Conditional Coupons.

11.5 Multiplying Assets.

12 Some Exotic Equity Products.

12.1 A Historical Perspective.

12.2 The Cliquet.

12.3 The Himalaya.

12.4 The Altiplano.

12.5 The Atlas.

12.6 The Everest.

12.7 Principal Protection or Lack Thereof.

13 Volatility and Correlation Products.

13.1 Variance and Volatility Swaps.

13.2 Options on Variance Swaps.

13.3 Correlation Swaps.

14 Fund Derivatives.

14.1 Fund Derivatives Products.

14.2 Constant Proportion Portfolio Insurance.

14.3 The Ideal Underlying Fund.

15 The Products Post-2008.

15.1 The Products Likely to Survive the Credit Crunch.

15.2 Incorporating Some Lessons Learned.

15.3 Credit Considerations.

Some Final Thoughts.