An Introduction to Derivatives and Risk Management (with Stock-Trak Coupon)

by Chance, Don M.; Brooks, Roberts

• ISBN13: 9780324321395
• ISBN10: 0324321392
• Edition: 7th
• Format: Hardcover
• Copyright: 2006-09-21
• Publisher: South-Western College Pub

Summary

You'll find detailed but flexible coverage of options, futures, forwards, swaps, and risk management as well as a solid introduction to pricing, trading, and strategy in AN INTRODUCTION TO DERIVATIVES AND RISK MANAGEMENT. A collection of figures illustrate links between puts, calls, stocks, risk-free bonds, futures, options, forwards, Black-Scholes call/put pricing, etc. Included with your purchase is a StockTrack Coupon.

Table of Contents

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
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
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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