Options, futures, and other derivatives [Tenth edition] 9789352866595, 9789353063016, 9780134472089, 013447208X, 9352866592

Table of contents :
Cover......Page 1
About Pearson......Page 2
Title Page ......Page 4
Copyright Page......Page 5
Detication Page ......Page 6
CONTENTS IN BRIEF......Page 7
Contents......Page 8
BUSINESS SNAPSHOTS......Page 19
TECHNICAL NOTES......Page 20
What’s New in the Tenth Edition?......Page 21
Instructor Resources......Page 22
Acknowledgments......Page 23
About the Author......Page 24
About the Adapter......Page 25
Chapter 1 - Introduction......Page 26
1.1 EXCHANGE-TRADED MARKETS......Page 27
1.2 OVER-THE-COUNTER MARKETS......Page 28
1.3 FORWARD CONTRACTS......Page 31
1.5 OPTIONS......Page 33
1.6 TYPES OF TRADERS......Page 36
1.7 HEDGERS......Page 37
1.8 SPECULATORS......Page 39
1.9 ARBITRAGEURS......Page 41
1.10 OVERVIEW OF THE INDIAN DERIVATIVES MARKET......Page 42
1.11 DANGERS......Page 50
SUMMARY......Page 52
Practice Questions......Page 53
Further Questions......Page 55
2.1 BACKGROUND......Page 57
2.2 SPECIFICATION OF A FUTURES CONTRACT......Page 62
2.4 THE OPERATION OF MARGIN ACCOUNTS......Page 67
2.5 OTC MARKETS......Page 71
2.6 NEWSPAPER QUOTES......Page 74
2.7 DELIVERY......Page 76
2.8 TYPES OF TRADERS AND TYPES OF ORDERS......Page 78
2.9 REGULATION......Page 79
2.10 ACCOUNTING AND TAX......Page 80
2.11 FORWARD vs. FUTURES CONTRACTS......Page 82
SUMMARY......Page 83
FURTHER READING......Page 84
Practice Questions......Page 85
Further Questions......Page 86
3.1 BASIC PRINCIPLES......Page 89
3.2 ARGUMENTS FOR AND AGAINST HEDGING......Page 91
3.3 BASIS RISK......Page 94
3.4 CROSS HEDGING......Page 98
3.5 STOCK INDEX FUTURES......Page 102
3.6 STACK AND ROLL......Page 109
SUMMARY......Page 111
FURTHER READING......Page 112
Practice Questions......Page 113
Further Questions......Page 114
APPENDIX : CAPITAL ASSET PRICING MODEL......Page 117
4.1 TYPES OF RATES......Page 119
4.2 SWAP RATES......Page 124
4.3 THE RISK-FREE RATE......Page 125
4.4 MEASURING INTEREST RATES......Page 126
4.6 BOND PRICING......Page 129
4.7 DETERMINING ZERO RATES......Page 131
4.8 FORWARD RATES......Page 134
4.9 FORWARD RATE AGREEMENTS......Page 136
4.10 DURATION......Page 139
4.11 CONVEXITY......Page 143
4.12 THEORIES OF THE TERM STRUCTURE OF INTEREST RATES......Page 144
SUMMARY......Page 146
Practice Questions......Page 148
Further Questions......Page 150
5.1 INVESTMENT ASSETS vs. CONSUMPTION ASSETS......Page 153
5.2 SHORT SELLING......Page 154
5.3 ASSUMPTIONS AND NOTATION......Page 155
5.4 FORWARD PRICE FOR AN INVESTMENT ASSET......Page 156
5.5 KNOWN INCOME......Page 160
5.7 VALUING FORWARD CONTRACTS......Page 162
5.8 ARE FORWARD PRICES AND FUTURES PRICES EQUAL?......Page 165
5.9 FUTURES PRICES OF STOCK INDICES......Page 166
5.10 FORWARD AND FUTURES CONTRACTS ON CURRENCIES......Page 167
5.11 FUTURES ON COMMODITIES......Page 171
5.12 THE COST OF CARRY......Page 174
5.14 FUTURES PRICES AND EXPECTED FUTURE SPOT PRICES......Page 175
SUMMARY......Page 178
Practice Questions......Page 179
Further Questions......Page 181
6.1 DAY COUNT AND QUOTATION CONVENTIONS......Page 183
6.2 TREASURY BOND FUTURES......Page 186
6.3 EURODOLLAR FUTURES......Page 192
6.4 DURATION-BASED HEDGING STRATEGIES USING FUTURES......Page 198
6.5 HEDGING PORTFOLIOS OF ASSETS AND LIABILITIES......Page 199
SUMMARY......Page 200
Practice Questions......Page 201
Further Questions......Page 203
Chapter 7 - Swaps......Page 205
7.1 MECHANICS OF INTEREST RATE SWAPS......Page 208
7.2 DAY COUNT ISSUES......Page 213
7.3 CONFIRMATIONS......Page 214
7.4 THE COMPARATIVE-ADVANTAGE ARGUMENT......Page 215
7.5 VALUATION OF INTEREST RATE SWAPS......Page 219
7.6 HOW THE VALUE CHANGES THROUGH TIME......Page 221
7.7 FIXED-FOR-FIXED CURRENCY SWAPS......Page 222
7.8 VALUATION OF FIXED-FOR-FIXED CURRENCY SWAPS......Page 225
7.9 OTHER CURRENCY SWAPS......Page 227
7.10 CREDIT RISK......Page 228
7.12 OTHER TYPES OF SWAPS......Page 229
SUMMARY......Page 231
Practice Questions......Page 232
Further Questions......Page 235
8.1 SECURITIZATION......Page 237
8.2 THE U.S. HOUSING MARKET......Page 241
8.3 WHAT WENT WRONG?......Page 245
8.4 THE AFTERMATH......Page 247
8.5 IMPACT OF THE CRISIS IN INDIA......Page 248
SUMMARY......Page 249
Practice Questions......Page 250
Further Questions......Page 251
9.1 CVA AND DVA......Page 252
9.2 FVA AND MVA......Page 255
9.3 KVA......Page 258
9.4 CALCULATION ISSUES......Page 259
FURTHER READING......Page 260
Further Questions......Page 261
10.1 TYPES OF OPTIONS......Page 262
10.2 OPTION POSITIONS......Page 264
10.3 UNDERLYING ASSETS......Page 267
10.4 SPECIFICATION OF STOCK OPTIONS......Page 268
10.5 TRADING......Page 272
10.6 COMMISSIONS......Page 274
10.7 MARGIN REQUIREMENTS......Page 275
10.8 THE OPTIONS CLEARING CORPORATION......Page 277
10.10 TAXATION......Page 278
10.11 WARRANTS, EMPLOYEE STOCK OPTIONS, AND CONVERTIBLES......Page 279
10.12 OVER-THE-COUNTER OPTIONS MARKETS......Page 280
SUMMARY......Page 281
Practice Questions......Page 282
Further Questions......Page 284
11.1 FACTORS AFFECTING OPTION PRICES......Page 286
11.2 ASSUMPTIONS AND NOTATION......Page 290
11.3 UPPER AND LOWER BOUNDS FOR OPTION PRICES......Page 291
11.4 PUT–CALL PARITY......Page 293
11.5 CALLS ON A NON-DIVIDEND-PAYING STOCK......Page 296
11.6 PUTS ON A NON-DIVIDEND-PAYING STOCK......Page 299
11.7 EFFECT OF DIVIDENDS......Page 301
SUMMARY......Page 302
Practice Questions......Page 303
Further Questions......Page 305
12.1 PRINCIPAL-PROTECTED NOTES......Page 307
12.2 TRADING AN OPTION AND THE UNDERLYING ASSET......Page 309
12.3 SPREADS......Page 311
12.4 COMBINATIONS......Page 319
12.5 OTHER PAYOFFS......Page 322
SUMMARY......Page 323
Practice Questions......Page 324
Further Questions......Page 325
13.1 A ONE-STEP BINOMIAL MODEL AND A NO-ARBITRAGE ARGUMENT......Page 327
13.2 RISK-NEUTRAL VALUATION......Page 331
13.3 TWO-STEP BINOMIAL TREES......Page 333
13.4 A PUT EXAMPLE......Page 336
13.5 AMERICAN OPTIONS......Page 337
13.6 DELTA......Page 338
13.7 MATCHING VOLATILITY WITH u AND d......Page 339
13.9 INCREASING THE NUMBER OF STEPS......Page 341
13.10 USING DerivaGem......Page 342
13.11 OPTIONS ON OTHER ASSETS......Page 343
SUMMARY......Page 346
FURTHER READING......Page 347
Practice Questions......Page 348
Further Questions......Page 349
APPENDIX : DERIVATION OF THE BLACK–SCHOLES–MERTON OPTION-PRICING FORMULA FROM A BINOMIAL TREE......Page 351
14.1 THE MARKOV PROPERTY......Page 355
14.2 CONTINUOUS-TIME STOCHASTIC PROCESSES......Page 356
14.3 THE PROCESS FOR A STOCK PRICE......Page 361
14.4 THE PARAMETERS......Page 364
14.5 CORRELATED PROCESSES......Page 365
14.6 ITO ’S LEMMA......Page 366
14.7 THE LOGNORMAL PROPERTY......Page 367
SUMMARY......Page 368
Practice Questions......Page 369
Further Questions......Page 370
APPENDIX : A NONRIGOROUS DERIVATION OF ITO  ’S LEMMA......Page 372
Chapter 15 - The Black–Scholes–Merton Model......Page 374
15.1 LOGNORMAL PROPERTY OF STOCK PRICES......Page 375
15.2 THE DISTRIBUTION OF THE RATE OF RETURN......Page 376
15.3 THE EXPECTED RETURN......Page 377
15.4 VOLATILITY......Page 378
15.5 THE IDEA UNDERLYING THE BLACK–SCHOLES–MERTON DIFFERENTIAL EQUATION......Page 382
15.6 DERIVATION OF THE BLACK–SCHOLES–MERTON DIFFERENTIAL EQUATION......Page 384
15.7 RISK-NEUTRAL VALUATION......Page 387
15.8 BLACK–SCHOLES–MERTON PRICING FORMULAS......Page 388
15.9 CUMULATIVE NORMAL DISTRIBUTION FUNCTION......Page 391
15.10 WARRANTS AND EMPLOYEE STOCK OPTIONS......Page 392
15.11 IMPLIED VOLATILITIES......Page 394
15.12 DIVIDENDS......Page 396
SUMMARY......Page 399
FURTHER READING......Page 400
Practice Questions......Page 401
Further Questions......Page 403
APPENDIX : PROOF OF THE BLACK–SCHOLES–MERTON FORMULA USING RISK-NEUTRAL VALUATION......Page 405
16.1 CONTRACTUAL ARRANGEMENTS......Page 408
16.2 DO OPTIONS ALIGN THE INTERESTS OF SHAREHOLDERS AND MANAGERS?......Page 410
16.3 ACCOUNTING ISSUES......Page 411
16.4 VALUATION......Page 412
16.5 BACKDATING SCANDALS......Page 417
Practice Questions......Page 418
Further Questions......Page 419
17.1 OPTIONS ON STOCK INDICES......Page 421
17.2 CURRENCY OPTIONS......Page 423
17.3 OPTIONS ON STOCKS PAYING KNOWN DIVIDEND YIELDS......Page 426
17.4 VALUATION OF EUROPEAN STOCK INDEX OPTIONS......Page 428
17.5 VALUATION OF EUROPEAN CURRENCY OPTIONS......Page 431
17.6 AMERICAN OPTIONS......Page 432
FURTHER READING......Page 433
Practice Questions......Page 434
Further Questions......Page 436
18.1 NATURE OF FUTURES OPTIONS......Page 437
18.3 EUROPEAN SPOT AND FUTURES OPTIONS......Page 440
18.4 PUT–CALL PARITY......Page 441
18.5 BOUNDS FOR FUTURES OPTIONS......Page 442
18.6 DRIFT OF A FUTURES PRICE IN A RISK-NEUTRAL WORLD......Page 443
18.7 BLACK’S MODEL FOR VALUING FUTURES OPTIONS......Page 444
18.8 USING BLACK’S MODEL INSTEAD OF BLACK–SCHOLES–MERTON......Page 445
18.9 VALUATION OF FUTURES OPTIONS USING BINOMIAL TREES......Page 446
18.10 AMERICAN FUTURES OPTIONS vs. AMERICAN SPOT OPTIONS......Page 448
SUMMARY......Page 449
Practice Questions......Page 450
Further Questions......Page 452
19.1 ILLUSTRATION......Page 453
19.2 NAKED AND COVERED POSITIONS......Page 454
19.3 GREEK LETTER CALCULATION......Page 456
19.4 DELTA HEDGING......Page 457
19.5 THETA......Page 463
19.6 GAMMA......Page 465
19.7 RELATIONSHIP BETWEEN DELTA, THETA, AND GAMMA......Page 469
19.8 VEGA......Page 470
19.9 RHO......Page 472
19.11 THE REALITIES OF HEDGING......Page 473
19.12 SCENARIO ANALYSIS......Page 474
19.13 EXTENSION OF FORMULAS......Page 475
19.14 PORTFOLIO INSURANCE......Page 477
19.15 STOCK MARKET VOLATILITY......Page 479
SUMMARY......Page 480
Practice Questions......Page 482
APPENDIX : TAYLOR SERIES EXPANSIONS AND GREEK LETTERS......Page 486
20.1 WHY THE VOLATILITY SMILE IS THE SAME FOR CALLS AND PUTS......Page 487
20.2 FOREIGN CURRENCY OPTIONS......Page 489
20.3 EQUITY OPTIONS......Page 492
20.5 THE VOLATILITY TERM STRUCTURE AND VOLATILITY SURFACES......Page 494
20.7 THE ROLE OF THE MODEL......Page 496
20.8 WHEN A SINGLE LARGE JUMP IS ANTICIPATED......Page 497
SUMMARY......Page 498
FURTHER READING......Page 499
Practice Questions......Page 500
Further Questions......Page 501
APPENDIX : DETERMINING IMPLIED RISK-NEUTRAL DISTRIBUTIONS FROM VOLATILITY SMILES......Page 503
21.1 BINOMIAL TREES......Page 506
21.2 USING THE BINOMIAL TREE FOR OPTIONS ON INDICES, CURRENCIES, AND FUTURES CONTRACTS......Page 514
21.3 BINOMIAL MODEL FOR A DIVIDEND-PAYING STOCK......Page 516
21.4 ALTERNATIVE PROCEDURES FOR CONSTRUCTING TREES......Page 521
21.5 TIME-DEPENDENT PARAMETERS......Page 524
21.6 MONTE CARLO SIMULATION......Page 525
21.7 VARIANCE REDUCTION PROCEDURES......Page 531
21.8 FINITE DIFFERENCE METHODS......Page 534
SUMMARY......Page 544
FURTHER READING......Page 545
Practice Questions......Page 546
Further Questions......Page 548
Chapter 22 - Value at Risk and Expected Shortfall......Page 550
22.1 THE VaR AND ES MEASURES......Page 551
22.2 HISTORICAL SIMULATION......Page 552
22.3 MODEL-BUILDING APPROACH......Page 558
22.4 THE LINEAR MODEL......Page 561
22.5 THE QUADRATIC MODEL......Page 566
22.6 MONTE CARLO SIMULATION......Page 569
22.9 PRINCIPAL COMPONENTS ANALYSIS......Page 570
SUMMARY......Page 574
FURTHER READING......Page 575
Practice Questions......Page 576
Further Questions......Page 577
23.1 ESTIMATING VOLATILITY......Page 579
23.2 THE EXPONENTIALLY WEIGHTED MOVING AVERAGE MODEL......Page 581
23.3 THE GARCH(1,1) MODEL......Page 583
23.4 CHOOSING BETWEEN THE MODELS......Page 584
23.5 MAXIMUM LIKELIHOOD METHODS......Page 585
23.6 USING GARCH(1,1) TO FORECAST FUTURE VOLATILITY......Page 590
23.7 CORRELATIONS......Page 593
23.8 APPLICATION OF EWMA TO FOUR-INDEX EXAMPLE......Page 596
Practice Questions......Page 598
Further Questions......Page 600
24.1 CREDIT RATINGS......Page 602
24.2 HISTORICAL DEFAULT PROBABILITIES......Page 603
24.3 RECOVERY RATES......Page 604
24.4 ESTIMATING DEFAULT PROBABILITIES FROM BOND YIELD SPREADS......Page 605
24.5 COMPARISON OF DEFAULT PROBABILITY ESTIMATES......Page 608
24.6 USING EQUITY PRICES TO ESTIMATE DEFAULT PROBABILITIES......Page 611
24.7 CREDIT RISK IN DERIVATIVES TRANSACTIONS......Page 613
24.8 DEFAULT CORRELATION......Page 619
24.9 CREDIT VaR......Page 622
SUMMARY......Page 625
Practice Questions......Page 626
Further Questions......Page 628
Chapter 25 - Credit Derivatives......Page 630
25.1 CREDIT DEFAULT SWAPS......Page 631
25.2 VALUATION OF CREDIT DEFAULT SWAPS......Page 635
25.3 CREDIT INDICES......Page 638
25.4 THE USE OF FIXED COUPONS......Page 639
25.5 CDS FORWARDS AND OPTIONS......Page 640
25.7 TOTAL RETURN SWAPS......Page 641
25.8 COLLATERALIZED DEBT OBLIGATIONS......Page 642
25.9 ROLE OF CORRELATION IN A BASKET CDS AND CDO......Page 644
25.10 VALUATION OF A SYNTHETIC CDO......Page 645
25.11 ALTERNATIVES TO THE STANDARD MARKET MODEL......Page 652
FURTHER READING......Page 654
Practice Questions......Page 655
Further Questions......Page 656
26.1 PACKAGES......Page 658
26.2 PERPETUAL AMERICAN CALL AND PUT OPTIONS......Page 659
26.3 NONSTANDARD AMERICAN OPTIONS......Page 660
26.4 GAP OPTIONS......Page 661
26.7 COMPOUND OPTIONS......Page 662
26.8 CHOOSER OPTIONS......Page 663
26.9 BARRIER OPTIONS......Page 664
26.10 BINARY OPTIONS......Page 666
26.11 LOOKBACK OPTIONS......Page 667
26.12 SHOUT OPTIONS......Page 669
26.13 ASIAN OPTIONS......Page 670
26.14 OPTIONS TO EXCHANGE ONE ASSET FOR ANOTHER......Page 671
26.15 OPTIONS INVOLVING SEVERAL ASSETS......Page 672
26.16 VOLATILITY AND VARIANCE SWAPS......Page 673
26.17 STATIC OPTIONS REPLICATION......Page 677
FURTHER READING......Page 680
Practice Questions......Page 681
Further Questions......Page 683
Chapter 27 - More on Models and Numerical Procedures......Page 685
27.1 ALTERNATIVES TO BLACK–SCHOLES–MERTON......Page 686
27.2 STOCHASTIC VOLATILITY MODELS......Page 691
27.3 THE IVF MODEL......Page 693
27.4 CONVERTIBLE BONDS......Page 695
27.5 PATH-DEPENDENT DERIVATIVES......Page 697
27.6 BARRIER OPTIONS......Page 700
27.7 OPTIONS ON TWO CORRELATED ASSETS......Page 703
27.8 MONTE CARLO SIMULATION AND AMERICAN OPTIONS......Page 705
SUMMARY......Page 709
FURTHER READING......Page 710
Practice Questions......Page 711
Further Questions......Page 713
Chapter 28 - Martingales and Measures......Page 715
28.1 THE MARKET PRICE OF RISK......Page 716
28.2 SEVERAL STATE VARIABLES......Page 719
28.3 MARTINGALES......Page 720
28.4 ALTERNATIVE CHOICES FOR THE NUMERAIRE......Page 721
28.5 EXTENSION TO SEVERAL FACTORS......Page 724
28.6 BLACK’S MODEL REVISITED......Page 725
28.7 OPTION TO EXCHANGE ONE ASSET FOR ANOTHER......Page 726
28.8 CHANGE OF NUMERAIRE......Page 727
SUMMARY......Page 729
Practice Questions......Page 730
Further Questions......Page 731
29.1 BOND OPTIONS......Page 733
29.2 INTEREST RATE CAPS AND FLOORS......Page 738
29.3 EUROPEAN SWAP OPTIONS......Page 744
29.4 HEDGING INTEREST RATE DERIVATIVES......Page 748
SUMMARY......Page 749
Practice Questions......Page 750
Further Questions......Page 751
30.1 CONVEXITY ADJUSTMENTS......Page 753
30.2 TIMING ADJUSTMENTS......Page 757
30.3 QUANTOS......Page 759
Practice Questions......Page 762
Further Questions......Page 764
APPENDIX : PROOF OF THE CONVEXITY ADJUSTMENT FORMULA......Page 765
31.1 BACKGROUND......Page 766
31.2 ONE-FACTOR MODELS......Page 768
31.3 REAL-WORLD VS. RISK-NEUTRAL PROCESSES......Page 773
31.4 ESTIMATING PARAMETERS......Page 774
31.5 MORE SOPHISTICATED MODELS......Page 775
Practice Questions......Page 776
Further Questions......Page 777
32.1 EXTENSIONS OF EQUILIBRIUM MODELS......Page 779
32.2 OPTIONS ON BONDS......Page 783
32.3 VOLATILITY STRUCTURES......Page 784
32.4 INTEREST RATE TREES......Page 785
32.5 A GENERAL TREE-BUILDING PROCEDURE......Page 787
32.6 CALIBRATION......Page 796
32.7 HEDGING USING A ONE-FACTOR MODEL......Page 798
Practice Questions......Page 799
Further Questions......Page 800
33.1 THE HEATH, JARROW, AND MORTON MODEL......Page 802
33.2 THE LIBOR MARKET MODEL......Page 805
33.3 HANDLING MULTIPLE ZERO CURVES......Page 815
33.4 AGENCY MORTGAGE-BACKED SECURITIES......Page 816
SUMMARY......Page 818
Practice Questions......Page 819
Further Questions......Page 820
34.1 VARIATIONS ON THE VANILLA DEAL......Page 821
34.2 COMPOUNDING SWAPS......Page 823
34.3 CURRENCY SWAPS......Page 824
34.4 MORE COMPLEX SWAPS......Page 825
34.5 EQUITY SWAPS......Page 828
34.6 SWAPS WITH EMBEDDED OPTIONS......Page 829
34.7 OTHER SWAPS......Page 832
SUMMARY......Page 833
Further Questions......Page 834
Chapter 35 - Energy and Commodity Derivatives......Page 836
35.2 METALS......Page 837
35.3 ENERGY PRODUCTS......Page 838
35.4 MODELING COMMODITY PRICES......Page 840
35.5 WEATHER DERIVATIVES......Page 846
35.6 INSURANCE DERIVATIVES......Page 847
35.7 PRICING WEATHER AND INSURANCE DERIVATIVES......Page 849
35.8 HOW AN ENERGY PRODUCER CAN HEDGE RISKS......Page 850
FURTHER READING......Page 851
Practice Questions......Page 852
Further Questions......Page 853
36.1 CAPITAL INVESTMENT APPRAISAL......Page 854
36.2 EXTENSION OF THE RISK-NEUTRAL VALUATION FRAMEWORK......Page 855
36.3 ESTIMATING THE MARKET PRICE OF RISK......Page 857
36.5 EVALUATING OPTIONS IN AN INVESTMENT OPPORTUNITY......Page 858
FURTHER READING......Page 865
Further Questions......Page 866
37.1 LESSONS FOR ALL USERS OF DERIVATIVES......Page 868
37.2 LESSONS FOR FINANCIAL INSTITUTIONS......Page 872
37.3 LESSONS FOR NONFINANCIAL CORPORATIONS......Page 879
FURTHER READING......Page 881
Glossary of Terms......Page 882
DerivaGem Software......Page 905
Major Exchanges Trading Futures and Options......Page 910
Table for N (x) When x ≤ 0......Page 911
Author Index......Page 914
Subject Index......Page 918