# Derivatives and Risk Management

**by**Srivastava, Rajiv

2nd

### 9780198089155

0198089155

Paperback

6/24/2014

Oxford University Press

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## Author Biography

Rajiv Srivastava,

*Indian Institute of Foreign Trade, New Delhi*

**Rajiv Srivastava**is presently Professor, Financial Management, Derivatives and Risk Management, Security Analysis and Portfolio Management, and International Financial and Forex Management, at Indian Institute of Foreign Trade, New Delhi. Prof Srivastava has 35 years of experience in working with reputed organizations such as the State Bank of India, Rajasthan Breweries, CMC Ltd and Flex Industries Ltd. He is the co-author of

*Financial Management 2/e*(OUP, 2010).

## Table of Contents

Introduction

Credit Derivative

Types of Credit Risk

Credit Default Swaps

Cash flows, Settlement and Applications

Valuation of CDS - Merton Model

Total Return Swap

Features, Differences with CDS

Securitisation

Structured Credit Derivatives

Credit Linked Notes

Collateralised Debt Obligations

21. Corporate securities and derivatives

Introduction

Equity as Call option

Agency Cost of Debt

Debt as Options

Subordinated debt

Callable and Puttable Bonds

Convertible Bonds

Warrants

22. Real Options

Introduction

Kinds of Real Options

Differences in Financial and Real Options

Option to Delay

Evaluating Timing Decision with DCF

Valuing Option to Delay by Binomial Method

Discounted Cash Flow and Binomial Option Valuation

Using Black Scholes Model for Investment Timing

Option to Expand

DCF Valuation

Value Option to Expand by Binomial Method

Value Option to Expand by Black Scholes Model

Option to Abandon

DCF Valuation

Valuing Put Option using Binomial Method

Value of Put Option using Black Scholes Model

23. Weather and energy derivatives

Introduction

Weather Derivatives

Temperature

Rain

Energy Derivatives

Oil

Electricity

Natural Gas

24. Accounting for Derivatives

Introduction

Accounting Definition of Derivatives

Types of Financial Instruments

Fair Value

Fair Value Measurement

Hedge Accounting

Types of Hedges

Fair Value Hedge

Cash Flow Hedge

Steps for Hedge Accounting

Hedged Item

Hedging Instruments

Hedging Relationship

Accounting For Derivatives

Derivatives Held for Trading

Derivatives as Fair Value Hedge

Derivatives as Cash Flow Hedge

Conclusion

25. Derivatives Disasters

Introduction

The Cases

Metallgesellschaft AG

LTCM

Barings PLC

Sumitomo

Procter and Gamble

Learnings

Index

**Preface**

**Derivatives-An Introduction**

**Introduction to Risk**

**Managing Risk**

**Types of Business Risks**

**Price Risk**

**Exchange Rate Risk**

**Interest Rate Risk**

**Derivatives**

**Principle of Hedging**

**Derivative Products**

**Classification of Derivatives**

**Participants in Derivative Markets**

**Hedgers**

**Speculators**

**Arbitrageurs**

**Steps for Hedge Accounting**

**Hedged Item**

**Hedging Instruments**

**Hedging Relationship**

**Functions of Derivative Markets**

**Misuses and Criticism of Derivatives**

**2. Forwards and Futures**

**Introduction**

**Forward Contract**

**Features of Forward Contract**

**Settlement of Forward Contract**

**Futures Contract**

**Specifications of Futures Contract**

**Open Interest**

**Differences between Forward and Futures Contracts**

**Margins**

**Marking to Market**

**Pricing of Forward/Futures Contract**

**Cash-and-carry Arbitrage**

**Reverse Cash-and-carry Arbitrage**

**Pricing Investment Asset**

**Pricing Consumption Asset**

**Value of a forward contract**

**Convergence**

**Relationship Between forward and Futures Price**

**Relationship of futures price and future spot price**

**Expectancy Model of Futures Pricing**

**Types of Futures**

**Commodity Futures**

**Introduction**

**Benefits of Commodity Futures**

**Commodity Futures and Economy**

**Differences - Commodity and Financial Futures**

**Futures Contracts on Commodities**

**Hedging with Commodity Futures**

**Long and Short Positions**

**Short Hedge**

**Long Hedge**

**Perfect and Imperfect Hedge**

**Basis and Basis Risk**

**Hedge Ratio**

**Hedging for Changes in Volume**

**Speculation with Commodity Futures**

**Spread Strategies with Futures**

**Hedging for Gross Profit Margin**

**Stock and Index Futures**

**Introduction**

**Index Futures**

**Forward Contracts on Stocks**

**Futures Contracts on Indices and Individual Stocks**

**Features and Specifications**

**Margining System**

**Pricing Stock and Index Futures**

**Applications of Index Futures**

**Hedging Through Index Futures**

**Hedging Existing Portfolio**

**Hedge Ratio**

**Hedging Short Position**

**Insulate Against Market Risk**

**Controlling Risk of Stock Portfolio**

**Speculation with Futures**

**Arbitrage with Futures**

**Other Applications of Index Futures**

**Currency Forwards and Futures**

**Introduction**

**Foreign Exchange Preliminaries**

**Foreign Exchange Risk**

**Foreign Exchange Markets and Rates**

**Bid Rate vs. Ask Rate**

**Spot Rate vs. Forward Rate**

**Forward Premium/Discount**

**Currency Forwards**

**Foreign Exchange Transactions**

**Spot Transaction, Forward Transaction, Swap Transaction**

**Outright Forward vs Swap**

**Arbitrage and Foreign Exchange Rates**

**Hedging Through Forward Contracts**

**Hedging Receivables**

**Hedging Payables**

**Cost of Forward Hedge**

**Speculation with Forward Contracts**

**Arbitrage with Forward Contract**

**Non Deliverable Forward (NDF)**

**Evolution and Growth of NDF**

**Features of NDF**

**How NDF Works**

**NDF and Interest Rate Parity**

**Are NDFs Desirable**

**Currency Futures**

**Contract Specifications**

**Pricing Currency Futures**

**Hedging Through Currency Futures**

**Speculation with Currency Futures**

**Arbitrage with Currency Futures**

**Interest Rate and Forwards**

**Introduction**

**Interest Rate Markets**

**Repo and Reverse Repo Transactions**

**Treasury Rate**

**Interbank Transactions**

**Term Structure of Interest Rates (Yield Curve)**

**Treasury Zeros and YTMs**

**Bootstrapping Method**

**Continuous Compounding**

**Forward Rate Agreements (FRAs)**

**FRA - The Product, Borrower's FRA, Investor's FRA, Settlement of FRA**

**Pricing FRA**

**Hedging with FRAs**

**Hedging Against Rising Interest Rates**

**Hedging Against Falling Interest Rates**

**Speculation with FRAs**

**Arbitrage with FRAs**

**Interest Rate Futures**

**Introduction**

**Short term interest rate futures**

**Treasury Bills**

**Interest Rate Futures on T-bills**

**Futures Contracts on T-bills**

**Pricing of T-bills and Price Quotation on T-Bill Futures**

**Futures Contract on T-bills in India**

**Hedging with T-Bill Futures**

**Hedging Against Falling Yields (Long Hedge)**

**Hedging Against Rising Interest Rates (Short Hedge)**

**Speculation with T-Bill Futures**

**Arbitrage with T-Bill Futures**

**Implied Repo Rate**

**Pricing of T-Bill Futures**

**Euro Dollar Futures**

**Euro Dollars**

**Futures Contracts on Euro Dollars**

**Pricing of and Hedging with Euro Dollar Futures**

**TREASURY BOND FUTURES**

**Treasury Bonds**

**Pricing Treasury Bonds**

**Futures Contract on Treasury Bonds**

**Pricing of Treasury Bond Futures**

**Conversion Factor**

**Cheapest to Deliver Bond**

**Hedging Principle, Duration and Modified Duration**

**Optimal Hedge Ratio: Duration Based Hedging**

**Interest Rate Futures in India**

**Interest Rate and Currency Swaps**

**Introduction**

**Interest Rate Swaps**

**Features of Swap**

**Need for Swap Intermediary**

**Applications of Swaps**

**Transforming Nature of Liabilities**

**Transforming Nature of Assets**

**Hedging with Swaps**

**Reducing Cost of Funds**

**Rationale for Swaps - The Comparative Advantage**

**Types of Interest Rate Swaps**

**Fixed to Floating, Floating to Fixed, Basis Swap**

**Currency Swaps**

**Hedging Against Exchange Rate Risk with Currency Swap**

**Reducing Cost of Funds with Currency Swap**

**Distinguishing Features of Currency Swap**

**Valuation of Swap**

**Valuing Interest Rate Swap**

**Swap as pair of bonds**

**Swap as series of forward contracts**

**Swap Quotes and Initial Pricing**

**Counter party Risk and Swaps**

**Valuing Currency Swap**

**Other Swaps**

**Commodity Swaps**

**Equity Swaps**

**Options-Basics**

**Introduction**

**Terminology of options**

**Call option**

**Put Option**

**Moneyness of Options**

**In-the-money, At-the-money and Out-of-the-money options**

**Types of Options**

**Nature of Exercise**

**Nature of Markets**

**Nature of Underlying Asset**

**Understanding Options Quotations**

**Trading and Settlement**

**Assignment**

**Options Other than Stocks/Indices**

**Differences between Options and Forwards/Futures**

**Option Pricing - Basics**

**Introduction**

**Intrinsic Value and Time Value**

**BOUNDARY CONDITIONS FOR OPTION PRICING**

**Call Option**

**Put Option**

**ARBITRAGE BASED RELATIONSHIP OF OPTION PRICING**

**PUT CALL PARITY**

**Put Call Parity for European Options**

**Put Call Parity for American Options**

**Option Pricing - Binomial Model**

**Introduction**

**Binomial Option Pricing Model**

**Risk Neutral Valuation**

**Equivalent Portfolio Approach**

**Binomial Model for Put Pricing**

**Multi-period Binomial Model**

**Valuing American Options**

**Valuing American Call**

**Valuing American Put**

**Binomial Model for Valuing Options On Dividend Paying Stocks**

**Putting Binomial Model In Practice**

**Binomial Model for Currency Options**

**Binomial Model for Index Options**

**Monte Carlo Simulation**

**Options - Black scholes Model**

**Introduction**

**Factors Affecting Option Prices**

**Spot Price**

**Exercise Price**

**Time to Maturity**

**Volatility**

**Interest Rates**

**Dividend**

**Black Scholes Option Pricing Model**

**Lognormal distribution**

**Mean and Standard Deviations**

**Applying Black Scholes Model**

**Assumptions of Black Scholes Model**

**Interpreting Black Scholes Model**

**Put Pricing Using BSM**

**Merton Model for Valuing Options on Dividend Paying Stock**

**Valuing Options on Indices**

**Valuing Options on Currencies**

**Pseudo American Option Pricing**

**Black Scholes American Option Pricing for Single Dividend**

**Volatility - Measurement**

**Implied Volatility**

**Options Greeks-Sensitivities**

**Introduction**

**Delta and Delta Hedging**

**Computing Delta**

**Meaning of and Limits on Values of Delta**

**Assumption of Linearity**

**Behaviour of Delta**

**Delta and Time to Maturity**

**Additivity of Delta**

**Deltas of Other Derivatives**

**Delta Hedging**

**Delta Neutrality**

**Theta**

**Computing Theta**

**Meaning of Theta**

**Theta and Time**

**Theta for put option**

**Portfolio Theta**

**Gamma and Gamma Neutrality**

**Computing Gamma**

**Behaviour of Gamma with Spot Price and Time**

**Portfolio Gamma**

**Gamma Neutrality**

**Other Greeks**

**Vega**

**Volatility and value at Risk**

**Introduction**

**Measures of Risk**

**VOLATILITY**

**Exponential Weighted Moving Average Method**

**Correlation and Covariance**

**GARCH (1,1) Model**

**Volatility Index**

**Computing VIX**

**VALUE AT RISK**

**Introduction**

**Definition and Meaning of VaR**

**Decisions on VaR**

**Methods of Calculating VaR**

**Historical Simulation**

**Limitations of VaR**

**Stress Testing**

**15. Hedging with Options**

**Introduction**

**HEDGING STRATEGIES WITH OPTIONS**

**Hedging with Stock Options**

**Hedging Long Position in Stock**

**Hedging Short Position in Stock**

**Hedging Portfolios with Index Options**

**Hedging Long Position in Portfolio**

**Hedging Short Position in Portfolio**

**Hedging with Currency Options**

**Hedging Receivables**

**Hedging Payables**

**Range Forward- Zero cost structures**

**16. Options trading strategies**

**Introduction**

**INCOME GENERATION WITH OPTIONS**

**Naked Call**

**Writing Covered Call**

**Writing Put**

**OPTION TRADING STRATEGIES**

**Straddle - Long and Short**

**Strangle - Long and Short**

**Straps and Strips**

**Bull Spread**

**Bear Spread**

**Butterfly Spread**

**Condor Spread**

**Calendar Spreads**

**Diagonal Spread**

**Box Spread**

**Factor Affecting Spreads**

**SYNTHETIC POSITIONS**

**Synthetic Long Position**

**Synthetic Short Position**

**Other Synthetic Positions**

**17. Exotic Options**

**Introduction**

**Forward Start Option**

**Binary Option**

**Chooser Option**

**Shout Option**

**Exchange Option**

**Gap Option**

**Pay Later Option**

**Compound Option**

**Path Dependent Options**

**Barrier Options**

**Asian Options**

**Look-back Option**

**Other Exotic Options**

**18. Interest rate options**

**Introduction**

**Interest Rate Option**

**Cap**

**Hedging with Cap**

**Valuation of Cap**

**Floor**

**Valuation of Floor**

**Collar**

**Options on Bonds**

**Valuation of Options on Bonds**

**19. Options on futures and swaps**

**Introduction**

**Options on Futures**

**Payoff**

**Put Call Parity for Futures Options**

**Binomial Model for Futures Options**

**Valuation of Futures Options - Black's Model**

**Options on Swaps - Swaptions**

**Payoff**

**Option on Bonds and Swaptions**

**Valuation of Swaptions**

**20. Credit risk, securitization, and Credit Derivatives**

**Introduction**

**Credit Risk**

**Introduction**

**Probability of Default**

**Recovery Rates**

**Default Rates**

**Transition Rates**

**Credit Value at Risk**

**Credit Derivatives**

**Introduction**

**Credit Derivative**

**Types of Credit Risk**

**Credit Default Swaps**

**Cash flows, Settlement and Applications**

**Valuation of CDS - Merton Model**

**Total Return Swap**

**Features, Differences with CDS**

**Securitisation**

**Structured Credit Derivatives**

**Credit Linked Notes**

**Collateralised Debt Obligations**

**21. Corporate securities and derivatives**

**Introduction**

**Equity as Call option**

**Agency Cost of Debt**

**Debt as Options**

**Subordinated debt**

**Callable and Puttable Bonds**

**Convertible Bonds**

**Warrants**

**22. Real Options**

**Introduction**

**Kinds of Real Options**

**Differences in Financial and Real Options**

**Option to Delay**

**Evaluating Timing Decision with DCF**

**Valuing Option to Delay by Binomial Method**

**Discounted Cash Flow and Binomial Option Valuation**

**Using Black Scholes Model for Investment Timing**

**Option to Expand**

**DCF Valuation**

**Value Option to Expand by Binomial Method**

**Value Option to Expand by Black Scholes Model**

**Option to Abandon**

**DCF Valuation**

**Valuing Put Option using Binomial Method**

**Value of Put Option using Black Scholes Model**

**23. Weather and energy derivatives**

**Introduction**

**Weather Derivatives**

**Temperature**

**Rain**

**Energy Derivatives**

**Oil**

**Electricity**

**Natural Gas**

**24. Accounting for Derivatives**

**Introduction**

**Accounting Definition of Derivatives**

**Types of Financial Instruments**

**Fair Value**

**Fair Value Measurement**

**Hedge Accounting**

**Types of Hedges**

**Fair Value Hedge**

**Cash Flow Hedge**

**Steps for Hedge Accounting**

**Hedged Item**

**Hedging Instruments**

**Hedging Relationship**

**Accounting For Derivatives**

**Derivatives Held for Trading**

**Derivatives as Fair Value Hedge**

**Derivatives as Cash Flow Hedge**

**Conclusion**

**25. Derivatives Disasters**

**Introduction**

**The Cases**

**Metallgesellschaft AG**

**LTCM**

**Barings PLC**

**Sumitomo**

**Procter and Gamble**

**Learnings**

**Index**