Hedging Instruments and Risk Management How to Use Derivatives to Control Financial Risk in Any Market

by Cusatis, Patrick; Thomas, Martin

• ISBN13: 9780071443128
• ISBN10: 0071443126
• Edition: 1st
• Format: Hardcover
• Copyright: 2005-02-11
• Publisher: McGraw-Hill Education

Summary

Books on complex hedging instruments are often more confusingthan the instruments themselves.Hedging Instruments &Risk Managementbrings clarity to the topic, giving moneymanagers the straightforward knowledge they need to employhedging tools and techniques in four key marketsequity,currency, fixed income, and mortgage. Using real-world dataand examples, this high-level book shows practitioners how todevelop a common set of mathematical and statistical tools forhedging in various markets and then outlines several hedgingstrategies with the historical performance of each.

Author Biography

Patrick Cusatis (State College, PA) is a professor of finance at Penn State University. Martin Thomas (State College, PA) is principal of financial services consulting firm Penn Data Mining.

Table of Contents

List of Exhibits	xiii
Preface	xxi
Introduction	1	(8)
A Systematic Approach to Hedging	2	(1)
Mathematical and Statistical Concepts	2	(1)
Hedging Tools	3	(1)
Hedging Strategies	4	(1)
Identifying Risk Tolerance	4	(1)
Hedging Efficiency	5	(1)
Hedging Applications	5	(2)
Summary	7	(2)
The Time Value of Money	9	(12)
Introduction	9	(1)
Future Value	10	(1)
Present Value	10	(1)
Annuities	11	(2)
Compounding Periods	13	(1)
Effective Annual Rates of Interest	14	(1)
Continuous Compounding	14	(2)
Amortized Loans	16	(3)
Summary	19	(2)
Statistical Review	21	(22)
Random Variables	21	(1)
Mean and Variance	22	(1)
The Normal Distribution	23	(2)
Sampling and Statistical Inference	25	(3)
Confidence Intervals and Hypothesis Testing	28	(2)
Covariance and Correlation	30	(4)
Linear Regression	34	(2)
Coefficient of Determination	36	(2)
Inference About the Regression Model	38	(2)
Summary	40	(1)
References	41	(2)
Fixed-Income Mathematics	43	(32)
Bond Pricing	44	(1)
Present Value of Bonds	44	(2)
Full-Coupon Bonds	46	(2)
Zero-Coupon Bonds	48	(2)
Computation of Yield	50	(1)
Price Volatility	51	(1)
The Price/Yield Relationship	52	(3)
Duration	55	(1)
Macaulay's Duration	56	(2)
Effect of Cash Flows on Duration	58	(4)
Portfolio Duration	62	(1)
Relationship Between Duration and Maturity	63	(1)
Relationship Between Duration and Coupon	63	(1)
Relationship Between Duration and Yield	64	(1)
Modified Duration	65	(2)
Convexity	67	(4)
Negative Convexity	71	(1)
Summary	72	(1)
References	73	(2)
Term Structure of Interest Rates	75	(22)
U.S. Treasury Securities and the Yield Curve	75	(4)
The Term Structure of Interest Rates	79	(1)
Implied Zero-Coupon Yields	80	(2)
The Pure Expectations Hypothesis	82	(1)
Implied Forward Rates	83	(2)
The Swap Yield Curve	85	(1)
The Short End of the Swap Yield Curve	86	(1)
The Middle Area of the Swap Curve	87	(1)
Convexity Adjustment	88	(3)
The Long End of the Swap Yield Curve	91	(2)
Construction of the Swap Zero-Coupon Curve	93	(2)
Summary	95	(1)
References	96	(1)
Futures Contracts	97	(36)
Futures Payoff Profile	98	(2)
Hedging and Speculating Examples	100	(3)
Long Hedge Example	100	(1)
Short Hedge Example	101	(1)
Speculating Example	102	(1)
Marking-to-Market and Margins	103	(1)
Delivery Options	104	(1)
The Cost-of-Carry Relationship	105	(1)
Basis	106	(1)
Futures Contracts	107	(1)
Metals Futures	107	(1)
Energy Futures	108	(1)
Agricultural Futures	108	(3)
Currency Futures	111	(1)
Currency Futures Valuation	112	(1)
Interest Rate Futures	113	(1)
U.S. Treasury Note and Bond Futures	114	(1)
Conversion Factors	114	(4)
Calculating Cheapest-to-Deliver	118	(1)
Interest Rate Futures Valuation	119	(2)
Duration	121	(1)
The Eurodollar Futures Contract	122	(1)
Municipal Futures	122	(2)
Duration	124	(2)
Municipal to Treasury Basis	126	(1)
Swap Futures	127	(2)
Equity Futures	129	(1)
Equity Futures Valuation	129	(2)
Summary	131	(1)
References	131	(2)
Swaps	133	(34)
Vanilla Interest Rate Swaps	134	(1)
Swap Quotes	134	(1)
Swap Payments	135	(1)
Hedging Examples	136	(2)
Short Hedge Example	136	(1)
Long Hedge Example	137	(1)
Swap Valuation	138	(4)
Term Structure of Interest Rates	142	(1)
At-Market Swap	143	(2)
Duration of a Swap	145	(5)
Cost of Carry	150	(1)
Forward-Delivery Interest Rate Swaps	150	(1)
Municipal Swaps	151	(3)
Currency Swaps	154	(2)
Pricing of Currency Swaps	156	(3)
Equity Swaps	159	(2)
Basis Swaps and Credit Default Swaps	161	(3)
Total Rate of Return Swaps	164	(1)
Summary	165	(1)
References	165	(2)
Options	167	(40)
The Options Market	167	(1)
Exchange-Traded Options	168	(1)
Over-the-Counter Options	169	(1)
Embedded Options	169	(1)
Call Options	170	(2)
Put Options	172	(4)
Gross and Net Payoffs	176	(1)
Exercise Provisions	176	(1)
Option Strategies	177	(1)
Covered Call	177	(1)
Protective Put (Synthetic Call)	177	(1)
Synthetic Put (Reverse Hedge)	178	(1)
Option Collar	179	(2)
Put-Call Parity	181	(2)
Option Valuation	183	(1)
Lower and Upper Bound Values for American Options	184	(1)
Binomial Option Pricing	184	(7)
Measuring Option Volatility with a Binomial Model	191	(1)
Black-Scholes Option Pricing Model	192	(1)
Measuring Option Volatility with Black-Scholes	193	(2)
Interest Rate Options	195	(1)
Bond Options	195	(1)
Bond Option Valuation	196	(1)
Interest Rate Caps and Floors	196	(2)
Cap and Floor Valuation	198	(2)
Swaptions	200	(1)
Valuation	201	(1)
Futures Options	202	(1)
Valuation	203	(2)
Summary	205	(1)
References	205	(2)
Commodities	207	(22)
The Commodity Derivatives Market	208	(1)
Historic Commodity Data	208	(4)
Techniques for Hedging Commodity Risk	212	(1)
Commodity Futures Hedge	213	(3)
Carrying Costs with Commodity Futures Contracts	216	(1)
Cross-Market Commodity Hedging with Futures	217	(2)
Stability of Futures Hedge Ratios	219	(1)
Commodity Hedging with Swaps	220	(2)
Commodity Hedging with Options	222	(3)
Comparison of Hedging Alternatives	225	(1)
Summary	226	(1)
References	226	(3)
Currencies	229	(24)
The Foreign Exchange Market	230	(1)
Historic Currency Data	231	(3)
Techniques for Hedging Transaction Exposure	234	(1)
Currency Futures Hedge	235	(1)
Carrying Costs with Currency Futures Contracts	236	(2)
Rolling the Hedge Forward	238	(2)
Currency Forward Hedge	240	(2)
Carrying Costs with Currency Forward Contracts	242	(2)
Hedging Transaction Exposure with Swaps	244	(2)
Hedging Transaction Exposure with Options	246	(4)
Comparison of Hedging Alternatives	250	(1)
Summary	251	(1)
References	252	(1)
Equities	253	(20)
Stock Market Risks	254	(1)
Market Risk	255	(2)
Hedging with Equity Index Futures	257	(3)
Futures Hedge Performance	260	(1)
Tailing the Hedge	261	(2)
Equity Futures Cost-of-Carry	263	(1)
Equity Swaps	264	(2)
Hedging with Equity Index Options	266	(3)
Adjusting Delta	269	(1)
Comparison of Hedging Alternatives	270	(1)
Summary	270	(1)
References	271	(2)
Municipal Bonds	273	(32)
Municipal Basis	274	(1)
Hedging Municipal Market Risk: Perfect Capital Markets	275	(2)
Hedging Municipal Market Risk: Shifts in Basis	277	(1)
Level Change in Basis	278	(1)
Historic Change in Basis	278	(3)
Ex Ante Optimal Hedge Ratio	281	(1)
Historic Municipal Bond and Hedge Data	282	(3)
Historic Hedge Efficiency	285	(5)
Stability of Hedge Ratios	290	(1)
Cost-of-Carry	290	(2)
Callable bonds	292	(5)
Issuer Hedging Strategies	297	(1)
Variable-Rate Exposure	297	(1)
Hedging the Value of an Embedded Call Option	298	(1)
Advance Refunding	299	(1)
Forward-Delivery Bonds	299	(1)
Forward-Delivery Swap	300	(1)
Selling a Swaption	300	(2)
Selling an Option	302	(1)
Comparison of Hedging Alternatives	302	(1)
Summary	303	(1)
References	303	(2)
Corporate Bonds	305	(30)
Credit Risk	306	(2)
Corporate Spreads	308	(1)
Option-Adjusted Spread	309	(1)
Hedging Corporate Bond Market Risk: Static Capital Markets	310	(2)
Hedging Corporate Bond Market Risk: Volatile Capital Markets	312	(1)
Historic Change in Spread	312	(2)
Ex Ante Optimal Hedge Ratio	314	(2)
Historic Corporate Bond and Hedge Data	316	(2)
Hedging Example: One Corporate Bond	318	(4)
Libor Swap Structure	322	(1)
Basis Swaps	323	(1)
Credit Default Swaps	324	(1)
Hedging Example: Corporate Bond Portfolio	324	(2)
Hedging Callable Bonds	326	(2)
Puttable Bonds	328	(1)
Cost-of-Carry	328	(1)
Issuer Strategies	329	(1)
Forward-Delivery Bonds	330	(1)
Forward-Delivery Swap	330	(1)
Selling a Swaption	330	(2)
Comparison of Hedging Alternatives	332	(1)
Summary	332	(1)
References	333	(2)
Mortgages	335	(16)
The Mortgage Market	335	(3)
Prepayment Risk	338	(1)
Collateralized Mortgage Obligations	339	(1)
Historic Mortgage Data	340	(1)
Risks of Investing in Mortgages	341	(1)
Mortgage Pipeline Risk	342	(1)
Retained Interests in Mortgages	343	(1)
Hedging Mortgage Price Risk with U.S. Treasury Note Futures	343	(3)
Hedging Mortgage Pipeline Risk with Options	346	(2)
Summary	348	(1)
References	349	(2)
Summary of Notation	351
Index