Preface | p. xiii |

Introduction | p. 1 |

Derivative Markets and Instruments | p. 2 |

Options | p. 2 |

Forward Contracts | p. 3 |

Futures Contracts | p. 3 |

Swaps and Other Derivatives | p. 4 |

The Underlying Asset | p. 4 |

Important Concepts in Financial and Derivative Markets | p. 5 |

Risk Preference | p. 5 |

Short Selling | p. 5 |

Repurchase Agreements | p. 6 |

Return and Risk | p. 6 |

Market Efficiency and Theoretical Fair Value | p. 8 |

Fundamental Linkages between Spot and Derivative Markets | p. 9 |

Arbitrage and the Law of One Price | p. 10 |

The Storage Mechanism: Spreading Consumption across Time | p. 11 |

Delivery and Settlement | p. 11 |

The Role of Derivative Markets | p. 12 |

Risk Management | p. 12 |

Price Discovery | p. 12 |

Operational Advantages | p. 13 |

Market Efficiency | p. 13 |

Criticisms of Derivative Markets | p. 13 |

Misuses of Derivatives | p. 14 |

Derivatives and Your Career | p. 14 |

Sources of Information on Derivatives | p. 15 |

Book Overview | p. 15 |

Organization of the Book | p. 15 |

Key Features of the Book | p. 16 |

Specific New Features of the Seventh Edition | p. 17 |

Use of the Book | p. 17 |

Summary | p. 18 |

Key Terms | p. 18 |

Further Reading | p. 19 |

Questions and Problems | p. 19 |

Options | p. 21 |

Structure of Options Markets | p. 22 |

Development of Options Markets | p. 23 |

Call Options | p. 24 |

Put Options | p. 24 |

Over-the-Counter Options Market | p. 25 |

Organized Options Trading | p. 26 |

Listing Requirements | p. 27 |

Contract Size | p. 27 |

Exercise Prices | p. 28 |

Expiration Dates | p. 28 |

Position and Exercise Limits | p. 29 |

Options Exchanges and Trading Activity | p. 29 |

Option Traders | p. 30 |

Market Maker | p. 31 |

Floor Broker | p. 31 |

Order Book Official | p. 32 |

Other Option Trading Systems | p. 32 |

Off-Floor Option Traders | p. 33 |

Cost and Profitability of Exchange Membership | p. 33 |

Mechanics of Trading | p. 34 |

Placing an Opening Order | p. 34 |

Role of the Clearinghouse | p. 34 |

Placing an Offsetting Order | p. 36 |

Exercising an Option | p. 37 |

Option Price Quotations | p. 37 |

Types of Options | p. 40 |

Stock Options | p. 40 |

Index Options | p. 40 |

Currency Options | p. 41 |

Other Types of Options | p. 41 |

Real Options | p. 42 |

Transaction Costs in Option Trading | p. 43 |

Floor Trading and Clearing Fees | p. 43 |

Commissions | p. 43 |

Bid-Ask Spread | p. 43 |

Other Transaction Costs | p. 44 |

Regulation of Options Markets | p. 44 |

Summary | p. 46 |

Key Terms | p. 46 |

Further Reading | p. 46 |

Questions and Problems | p. 47 |

Margin Requirements | p. 48 |

Margin Requirements on Stock Transactions | p. 48 |

Margin Requirements on Option Purchases | p. 48 |

Margin Requirements on the Uncovered Sale of Options | p. 48 |

Margin Requirements on Covered Calls | p. 49 |

Questions and Problem | p. 49 |

Taxation of Option Transactions | p. 50 |

Taxation of Long Call Transactions | p. 50 |

Taxation of Short Call Transactions | p. 50 |

Taxation of Long Put Transactions | p. 51 |

Taxation of Short Put Transactions | p. 51 |

Taxation of Non-Equity Options | p. 51 |

Wash and Constructive Sales | p. 52 |

Questions and Problems | p. 52 |

Principles of Option Pricing | p. 54 |

Basic Notation and Terminology | p. 55 |

Principles of Call Option Pricing | p. 57 |

Minimum Value of a Call | p. 57 |

Maximum Value of a Call | p. 59 |

Value of a Call at Expiration | p. 59 |

Effect of Time to Expiration | p. 60 |

Effect of Exercise Price | p. 62 |

Lower Bound of a European Call | p. 65 |

American Call Versus European Call | p. 67 |

Early Exercise of American Calls on Dividend-Paying Stocks | p. 69 |

Effect of Interest Rates | p. 69 |

Effect of Stock Volatility | p. 70 |

Principles of Put Option Pricing | p. 70 |

Minimum Value of a Put | p. 71 |

Maximum Value of a Put | p. 72 |

Value of a Put at Expiration | p. 72 |

Effect of Time to Expiration | p. 73 |

The Effect of Exercise Price | p. 75 |

Lower Bound of a European Put | p. 76 |

American Put Versus European Put | p. 79 |

Early Exercise of American Puts | p. 79 |

Put-Call Parity | p. 79 |

Effect of Interest Rates | p. 82 |

Effect of Stock Volatility | p. 83 |

Summary | p. 84 |

Key Terms | p. 86 |

Further Reading | p. 86 |

Questions and Problems | p. 87 |

The Dynamics of Option Boundary Conditions: A Learning Exercise | p. 90 |

Option Pricing Models: The Binomial Model | p. 92 |

One-Period Binomial Model | p. 93 |

Illustrative Example | p. 96 |

Hedge Portfolio | p. 97 |

Overpriced Call | p. 98 |

Underpriced Call | p. 100 |

Two-Period Binomial Model | p. 100 |

Illustrative Example | p. 102 |

Hedge Portfolio | p. 103 |

Mispriced Call in the Two-Period World | p. 105 |

Extensions of the Binomial Model | p. 106 |

Pricing Put Options | p. 106 |

American Puts and Early Exercise | p. 108 |

Dividends, European Calls, American Calls, and Early Exercise | p. 108 |

Extending the Binomial Model to n Periods | p. 113 |

Behavior of the Binomial Model for Large n and Fixed Option Life | p. 115 |

Alternative Specifications of the Binomial Model | p. 117 |

Advantages of the Binomial Model | p. 119 |

| |

Calculating the Binomial Price with the Excel Spreadsheet BSMbin7e.xls | p. 120 |

Summary | p. 121 |

Key Terms | p. 122 |

Further Reading | p. 122 |

Questions and Problems | p. 123 |

Option Pricing Models: The Black-Scholes-Merton Model | p. 125 |

Origins of the Black-Scholes-Merton Formula | p. 125 |

Black-Scholes-Merton Model as the Limit of the Binomial Model | p. 126 |

Assumptions of the Black-Scholes-Merton Model | p. 128 |

Stock Prices Behave Randomly and Evolve According to a Lognormal Distribution | p. 128 |

Risk-Free Rate and Volatility of the Log Return on the Stock are Constant Throughout the Option's Life | p. 131 |

No Taxes or Transaction Costs | p. 132 |

Stock Pays No Dividends | p. 133 |

Options Are European | p. 133 |

A Nobel Formula | p. 133 |

Digression on Using the Normal Distribution | p. 134 |

Numerical Example | p. 135 |

| |

Calculating the Black-Scholes-Merton Price with the Excel Spreadsheet BSMbin7e.xls | p. 137 |

Characteristics of the Black-Scholes-Merton Formula | p. 138 |

Variables in the Black-Scholes-Merton Model | p. 141 |

Stock Price | p. 142 |

Exercise Price | p. 145 |

Risk-Free Rate | p. 146 |

Volatility or Standard Deviation | p. 147 |

Time to Expiration | p. 149 |

Black-Scholes-Merton Model When the Stock Pays Dividends | p. 151 |

Known Discrete Dividends | p. 151 |

Known Continuous Dividend Yield | p. 151 |

Black-Scholes-Merton Model and Some Insights into American Call Options | p. 153 |

Estimating the Volatility | p. 154 |

Historical Volatility | p. 155 |

Implied Volatility | p. 155 |

| |

Calculating the Historical Volatility with the Excel Spreadsheet Hisv7e.xls | p. 157 |

Put Option Pricing Models | p. 163 |

Managing the Risk of Options | p. 166 |

Summary | p. 171 |

Key Terms | p. 172 |

Further Reading | p. 172 |

Questions and Problems | p. 174 |

A Shortcut to the Calculation of Implied Volatility | p. 177 |

The BSMbwin7e.exe Windows Software | p. 179 |

Basic Option Strategies | p. 181 |

Terminology and Notation | p. 182 |

Profit Equations | p. 182 |

Different Holding Periods | p. 184 |

Assumptions | p. 184 |

Stock Transactions | p. 185 |

Buy Stock | p. 185 |

Sell Short Stock | p. 185 |

Call Option Transactions | p. 187 |

Buy a Call | p. 187 |

Write a Call | p. 191 |

Put Option Transactions | p. 193 |

Buy a Put | p. 193 |

Write a Put | p. 196 |

Calls and Stock: The Covered Call | p. 199 |

Some General Considerations with Covered Calls | p. 203 |

Puts and Stock: The Protective Put | p. 204 |

Synthetic Puts and Calls | p. 208 |

| |

Analyzing Option Strategies with the Excel Spreadsheet Stratlyz7e.xls | p. 211 |

Summary | p. 215 |

Key Terms | p. 215 |

Questions and Problems | p. 215 |

Advanced Option Strategies | p. 218 |

Option Spreads: Basic Concepts | p. 219 |

Why Investors Use Option Spreads | p. 219 |

Notation | p. 220 |

Money Spreads | p. 221 |

Bull Spreads | p. 221 |

Bear Spreads | p. 224 |

A Note about Call Bear Spreads and Put Bull Spreads | p. 226 |

Collars | p. 226 |

Butterfly Spreads | p. 230 |

Calendar Spreads | p. 234 |

Time Value Decay | p. 236 |

Ratio Spreads | p. 238 |

Straddles | p. 239 |

Box Spreads | p. 244 |

Summary | p. 246 |

Key Terms | p. 246 |

Further Reading | p. 247 |

Questions and Problems | p. 247 |

Forwards, Futures, and Swaps | p. 251 |

The Structure of Forward and Futures Markets | p. 252 |

Development of Forward and Futures Markets | p. 253 |

Chicago Futures Markets | p. 253 |

Development of Financial Futures | p. 254 |

Development of Options on Futures Markets | p. 255 |

Parallel Development of Over-the-Counter Markets | p. 256 |

Over-the-Counter Forward Market | p. 256 |

Organized Futures Trading | p. 257 |

Contract Development | p. 258 |

Contract Terms and Conditions | p. 258 |

Delivery Terms | p. 259 |

Daily Price Limits and Trading Halts | p. 259 |

Other Exchange Responsibilities | p. 260 |

Futures Exchanges | p. 260 |

Futures Traders | p. 262 |

General Classes of Futures Traders | p. 262 |

Classification by Trading Strategy | p. 262 |

Classification by Trading Style | p. 263 |

Off-Floor Futures Traders | p. 264 |

Costs and Profitability of Exchange Membership | p. 264 |

Forward Market Traders | p. 265 |

Mechanics of Futures Trading | p. 265 |

Placing an Order | p. 265 |

Role of the Clearinghouse | p. 266 |

Daily Settlement | p. 267 |

Delivery and Cash Settlement | p. 269 |

Futures Price Quotations | p. 271 |

Types of Futures Contracts | p. 271 |

Agricultural Commodities | p. 272 |

Natural Resources | p. 272 |

Miscellaneous Commodities | p. 272 |

Foreign Currencies | p. 272 |

Federal Funds and Eurodollars | p. 273 |

Treasury Notes and Bonds | p. 273 |

Swap Futures | p. 273 |

Equities | p. 273 |

Managed Funds | p. 275 |

Hedge Funds | p. 276 |

Options on Futures | p. 276 |

Transaction Costs in Forward and Futures Trading | p. 277 |

Commissions | p. 277 |

Bid-Ask Spread | p. 277 |

Delivery Costs | p. 277 |

Regulation of Futures and Forward Markets | p. 278 |

Summary | p. 279 |

Key Terms | p. 279 |

Further Reading | p. 280 |

Questions and Problems | p. 280 |

Taxation of Futures Transactions in the United States | p. 282 |

Questions and Problems | p. 283 |

Principles of Pricing Forwards, Futures, and Options on Futures | p. 284 |

Generic Carry Arbitrage | p. 285 |

Concept of Price versus Value | p. 285 |

Value of a Forward Contract | p. 286 |

Price of a Forward Contract | p. 288 |

Value of a Futures Contract | p. 288 |

Price of a Futures Contract | p. 289 |

Forward versus Futures Prices | p. 290 |

Carry Arbitrage When Underlying Generates Cash Flows | p. 292 |

Stock Indices and Dividends | p. 292 |

Foreign Currencies and Foreign Interest Rates: Interest Rate Parity | p. 295 |

Commodities and Storage Costs | p. 297 |

Pricing Models and Risk Premiums | p. 298 |

Spot Prices, Risk Premiums, and Carry Arbitrage for Generic Assets | p. 298 |

Forward/Futures Pricing Revisited | p. 299 |

Futures Prices and Risk Premia | p. 305 |

Put-Call-Forward/Futures Parity | p. 309 |

Pricing Options on Futures | p. 311 |

Intrinsic Value of an American Option on Futures | p. 311 |

Lower Bound of a European Option on Futures | p. 312 |

Put-Call Parity of Options on Futures | p. 314 |

Early Exercise of Call and Put Options on Futures | p. 315 |

Black Futures Option Pricing Model | p. 317 |

Summary | p. 319 |

Key Terms | p. 321 |

Further Reading | p. 321 |

Questions and Problems | p. 322 |

Futures Arbitrage Strategies | p. 325 |

Short-Term Interest Rate Arbitrage | p. 326 |

Carry Arbitrage and the Implied Repo Rate | p. 326 |

Federal Funds Futures Carry Arbitrage and the Implied Repo Rate | p. 327 |

Eurodollar Arbitrage | p. 329 |

Intermediate- and Long-Term Interest Rate Arbitrage | p. 330 |

Determining the Cheapest-to-Deliver Bond on the Treasury Bond Futures Contract | p. 332 |

Delivery Options | p. 334 |

Implied Repo, Carry Arbitrage and Treasury Bond Futures | p. 337 |

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Identifying the Cheapest-to-Deliver Bond with the Excel Spreadsheet CTD7e.xls | p. 338 |

Treasury Bond Futures Spreads and the Implied Repo Rate | p. 340 |

Stock Index Arbitrage | p. 341 |

Foreign Exchange Arbitrage | p. 345 |

Summary | p. 346 |

Key Terms | p. 347 |

Further Reading | p. 348 |

Questions and Problems | p. 348 |

Determining the CBOT Treasury Bond Conversion Factor | p. 351 |

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Determining the CBOT Conversion Factor with the Excel Spreadsheet CF7e.xls | p. 352 |

Forward and Futures Hedging, Spread, and Target Strategies | p. 353 |

Why Hedge? | p. 354 |

Hedging Concepts | p. 355 |

Short Hedge and Long Hedge | p. 355 |

The Basis | p. 356 |

Some Risks of Hedging | p. 360 |

Contract Choice | p. 361 |

Margin Requirements and Marking to Market | p. 364 |

Determination of the Hedge Ratio | p. 365 |

Minimum Variance Hedge Ratio | p. 365 |

Price Sensitivity Hedge Ratio | p. 367 |

Stock Index Futures Hedging | p. 370 |

Hedging Strategies | p. 371 |

Foreign Currency Hedges | p. 371 |

Intermediate- and Long-Term Interest Rate Hedges | p. 373 |

Spread Strategies | p. 382 |

Intramarket Spreads | p. 383 |

Intermarket Spreads | p. 386 |

Target Strategies | p. 388 |

Target Duration with Bond Futures | p. 388 |

Alpha Capture | p. 391 |

Target Beta with Stock Index Futures | p. 393 |

Tactical Asset Allocation Using Stock and Bond Futures | p. 394 |

Summary | p. 398 |

Key Terms | p. 399 |

Further Reading | p. 399 |

Questions and Problems | p. 400 |

Taxation of Hedging | p. 404 |

Swaps | p. 405 |

Interest Rate Swaps | p. 408 |

Structure of a Typical Interest Rate Swap | p. 408 |

Pricing and Valuation of Interest Rate Swaps | p. 410 |

Interest Rate Swap Strategies | p. 416 |

Currency Swaps | p. 420 |

Structure of a Typical Currency Swap | p. 421 |

Pricing and Valuation of Currency Swaps | p. 423 |

Currency Swap Strategies | p. 428 |

Equity Swaps | p. 430 |

Structure of a Typical Equity Swap | p. 431 |

Pricing and Valuation of Equity Swaps | p. 432 |

Equity Swap Strategies | p. 436 |

Some Final Words about Swaps | p. 437 |

Summary | p. 438 |

Key Terms | p. 439 |

Further Reading | p. 439 |

Questions and Problems | p. 439 |

Advanced Topics | p. 443 |

Interest Rate Forwards and Options | p. 444 |

Forward Rate Agreements | p. 445 |

Structure and Use of a Typical FRA | p. 446 |

Pricing and Valuation of FRAs | p. 448 |

Applications of FRAs | p. 450 |

Interest Rate Options | p. 453 |

Structure and Use of a Typical Interest Rate Option | p. 454 |

Pricing and Valuation of Interest Rate Options | p. 455 |

Interest Rate Option Strategies | p. 457 |

Interest Rate Caps, Floors, and Collars | p. 461 |

Interest Rate Options, FRAs, and Swaps | p. 466 |

Interest Rate Swaptions and Forward Swaps | p. 467 |

Structure of a Typical Interest Rate Swaption | p. 468 |

Equivalence of Swaptions and Options on Bonds | p. 471 |

Pricing Swaptions | p. 471 |

Forward Swaps | p. 472 |

Applications of Swaptions and Forward Swaps | p. 473 |

Summary | p. 475 |

Key Terms | p. 475 |

Further Reading | p. 476 |

Questions and Problems | p. 476 |

Advanced Derivatives and Strategies | p. 480 |

Advanced Equity Derivatives and Strategies | p. 481 |

Portfolio Insurance | p. 481 |

Equity Forwards | p. 487 |

Equity Warrants | p. 490 |

Equity-Linked Debt | p. 491 |

Advanced Interest Rate Derivatives | p. 491 |

Structured Notes | p. 492 |

Mortgage-Backed Securities | p. 493 |

Exotic Options | p. 498 |

Digital and Chooser Options | p. 499 |

Path-Dependent Options | p. 502 |

Other Exotic Options | p. 508 |

Some Unusual Derivatives | p. 509 |

Electricity Derivatives | p. 509 |

Weather Derivatives | p. 509 |

Summary | p. 511 |

Key Terms | p. 511 |

Further Reading | p. 512 |

Questions and Problems | p. 513 |

Monte Carlo Simulation | p. 516 |

Financial Risk Management Techniques and Applications | p. 518 |

Why Practice Risk Management? | p. 519 |

Impetus for Risk Management | p. 519 |

Benefits of Risk Management | p. 520 |

Managing Market Risk | p. 521 |

Delta Hedging | p. 523 |

Gamma Hedging | p. 524 |

Vega Hedging | p. 527 |

Value at Risk (VAR) | p. 528 |

A Comprehensive Calculation of VAR | p. 534 |

Benefits and Criticisms of VAR | p. 536 |

Extensions of VAR | p. 537 |

Managing Credit Risk | p. 538 |

Credit Risk as an Option | p. 539 |

Credit Risk of Derivatives | p. 541 |

Netting | p. 544 |

Credit Derivatives | p. 545 |

Other Types of Risks | p. 551 |

Summary | p. 555 |

Key Terms | p. 555 |

Further Reading | p. 556 |

Questions and Problems | p. 556 |

Managing Risk in an Organization | p. 559 |

The Structure of the Risk Management Industry | p. 560 |

End Users | p. 560 |

Dealers | p. 560 |

Other Participants in the Risk Management Industry | p. 561 |

Organizing the Risk Management Function in a Company | p. 561 |

Risk Management Accounting | p. 566 |

Fair Value Hedges | p. 567 |

Cash Flow Hedges | p. 568 |

Foreign Investment Hedges | p. 570 |

Speculation | p. 570 |

Some Problems in the Application of FAS 133 | p. 570 |

Disclosure | p. 571 |

Avoiding Derivatives Losses | p. 571 |

Metallgesellschaft: To Hedge or Not to Hedge? | p. 571 |

Orange County, California: Playing the Odds | p. 574 |

Barings PLC: How One Man Blew Up a Bank | p. 576 |

Procter & Gamble: Going Up in Suds | p. 578 |

Risk Management Industry Standards | p. 579 |

Responsibilities of Senior Management | p. 579 |

Summary | p. 585 |

Key Terms | p. 586 |

Further Reading | p. 586 |

Questions and Problems | p. 587 |

List of Formulas | p. 589 |

References | p. 598 |

Glossary | p. 619 |

Index | p. 641 |

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