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

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  • Edition: 7th
  • Format: Hardcover
  • Copyright: 2006-09-21
  • Publisher: South-Western College Pub
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Supplemental Materials

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  • The New copy of this book will include any supplemental materials advertised. Please check the title of the book to determine if it should include any access cards, study guides, lab manuals, CDs, etc.


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

Prefacep. xiii
Introductionp. 1
Derivative Markets and Instrumentsp. 2
Optionsp. 2
Forward Contractsp. 3
Futures Contractsp. 3
Swaps and Other Derivativesp. 4
The Underlying Assetp. 4
Important Concepts in Financial and Derivative Marketsp. 5
Risk Preferencep. 5
Short Sellingp. 5
Repurchase Agreementsp. 6
Return and Riskp. 6
Market Efficiency and Theoretical Fair Valuep. 8
Fundamental Linkages between Spot and Derivative Marketsp. 9
Arbitrage and the Law of One Pricep. 10
The Storage Mechanism: Spreading Consumption across Timep. 11
Delivery and Settlementp. 11
The Role of Derivative Marketsp. 12
Risk Managementp. 12
Price Discoveryp. 12
Operational Advantagesp. 13
Market Efficiencyp. 13
Criticisms of Derivative Marketsp. 13
Misuses of Derivativesp. 14
Derivatives and Your Careerp. 14
Sources of Information on Derivativesp. 15
Book Overviewp. 15
Organization of the Bookp. 15
Key Features of the Bookp. 16
Specific New Features of the Seventh Editionp. 17
Use of the Bookp. 17
Summaryp. 18
Key Termsp. 18
Further Readingp. 19
Questions and Problemsp. 19
Optionsp. 21
Structure of Options Marketsp. 22
Development of Options Marketsp. 23
Call Optionsp. 24
Put Optionsp. 24
Over-the-Counter Options Marketp. 25
Organized Options Tradingp. 26
Listing Requirementsp. 27
Contract Sizep. 27
Exercise Pricesp. 28
Expiration Datesp. 28
Position and Exercise Limitsp. 29
Options Exchanges and Trading Activityp. 29
Option Tradersp. 30
Market Makerp. 31
Floor Brokerp. 31
Order Book Officialp. 32
Other Option Trading Systemsp. 32
Off-Floor Option Tradersp. 33
Cost and Profitability of Exchange Membershipp. 33
Mechanics of Tradingp. 34
Placing an Opening Orderp. 34
Role of the Clearinghousep. 34
Placing an Offsetting Orderp. 36
Exercising an Optionp. 37
Option Price Quotationsp. 37
Types of Optionsp. 40
Stock Optionsp. 40
Index Optionsp. 40
Currency Optionsp. 41
Other Types of Optionsp. 41
Real Optionsp. 42
Transaction Costs in Option Tradingp. 43
Floor Trading and Clearing Feesp. 43
Commissionsp. 43
Bid-Ask Spreadp. 43
Other Transaction Costsp. 44
Regulation of Options Marketsp. 44
Summaryp. 46
Key Termsp. 46
Further Readingp. 46
Questions and Problemsp. 47
Margin Requirementsp. 48
Margin Requirements on Stock Transactionsp. 48
Margin Requirements on Option Purchasesp. 48
Margin Requirements on the Uncovered Sale of Optionsp. 48
Margin Requirements on Covered Callsp. 49
Questions and Problemp. 49
Taxation of Option Transactionsp. 50
Taxation of Long Call Transactionsp. 50
Taxation of Short Call Transactionsp. 50
Taxation of Long Put Transactionsp. 51
Taxation of Short Put Transactionsp. 51
Taxation of Non-Equity Optionsp. 51
Wash and Constructive Salesp. 52
Questions and Problemsp. 52
Principles of Option Pricingp. 54
Basic Notation and Terminologyp. 55
Principles of Call Option Pricingp. 57
Minimum Value of a Callp. 57
Maximum Value of a Callp. 59
Value of a Call at Expirationp. 59
Effect of Time to Expirationp. 60
Effect of Exercise Pricep. 62
Lower Bound of a European Callp. 65
American Call Versus European Callp. 67
Early Exercise of American Calls on Dividend-Paying Stocksp. 69
Effect of Interest Ratesp. 69
Effect of Stock Volatilityp. 70
Principles of Put Option Pricingp. 70
Minimum Value of a Putp. 71
Maximum Value of a Putp. 72
Value of a Put at Expirationp. 72
Effect of Time to Expirationp. 73
The Effect of Exercise Pricep. 75
Lower Bound of a European Putp. 76
American Put Versus European Putp. 79
Early Exercise of American Putsp. 79
Put-Call Parityp. 79
Effect of Interest Ratesp. 82
Effect of Stock Volatilityp. 83
Summaryp. 84
Key Termsp. 86
Further Readingp. 86
Questions and Problemsp. 87
The Dynamics of Option Boundary Conditions: A Learning Exercisep. 90
Option Pricing Models: The Binomial Modelp. 92
One-Period Binomial Modelp. 93
Illustrative Examplep. 96
Hedge Portfoliop. 97
Overpriced Callp. 98
Underpriced Callp. 100
Two-Period Binomial Modelp. 100
Illustrative Examplep. 102
Hedge Portfoliop. 103
Mispriced Call in the Two-Period Worldp. 105
Extensions of the Binomial Modelp. 106
Pricing Put Optionsp. 106
American Puts and Early Exercisep. 108
Dividends, European Calls, American Calls, and Early Exercisep. 108
Extending the Binomial Model to n Periodsp. 113
Behavior of the Binomial Model for Large n and Fixed Option Lifep. 115
Alternative Specifications of the Binomial Modelp. 117
Advantages of the Binomial Modelp. 119
Calculating the Binomial Price with the Excel Spreadsheet BSMbin7e.xlsp. 120
Summaryp. 121
Key Termsp. 122
Further Readingp. 122
Questions and Problemsp. 123
Option Pricing Models: The Black-Scholes-Merton Modelp. 125
Origins of the Black-Scholes-Merton Formulap. 125
Black-Scholes-Merton Model as the Limit of the Binomial Modelp. 126
Assumptions of the Black-Scholes-Merton Modelp. 128
Stock Prices Behave Randomly and Evolve According to a Lognormal Distributionp. 128
Risk-Free Rate and Volatility of the Log Return on the Stock are Constant Throughout the Option's Lifep. 131
No Taxes or Transaction Costsp. 132
Stock Pays No Dividendsp. 133
Options Are Europeanp. 133
A Nobel Formulap. 133
Digression on Using the Normal Distributionp. 134
Numerical Examplep. 135
Calculating the Black-Scholes-Merton Price with the Excel Spreadsheet BSMbin7e.xlsp. 137
Characteristics of the Black-Scholes-Merton Formulap. 138
Variables in the Black-Scholes-Merton Modelp. 141
Stock Pricep. 142
Exercise Pricep. 145
Risk-Free Ratep. 146
Volatility or Standard Deviationp. 147
Time to Expirationp. 149
Black-Scholes-Merton Model When the Stock Pays Dividendsp. 151
Known Discrete Dividendsp. 151
Known Continuous Dividend Yieldp. 151
Black-Scholes-Merton Model and Some Insights into American Call Optionsp. 153
Estimating the Volatilityp. 154
Historical Volatilityp. 155
Implied Volatilityp. 155
Calculating the Historical Volatility with the Excel Spreadsheet Hisv7e.xlsp. 157
Put Option Pricing Modelsp. 163
Managing the Risk of Optionsp. 166
Summaryp. 171
Key Termsp. 172
Further Readingp. 172
Questions and Problemsp. 174
A Shortcut to the Calculation of Implied Volatilityp. 177
The BSMbwin7e.exe Windows Softwarep. 179
Basic Option Strategiesp. 181
Terminology and Notationp. 182
Profit Equationsp. 182
Different Holding Periodsp. 184
Assumptionsp. 184
Stock Transactionsp. 185
Buy Stockp. 185
Sell Short Stockp. 185
Call Option Transactionsp. 187
Buy a Callp. 187
Write a Callp. 191
Put Option Transactionsp. 193
Buy a Putp. 193
Write a Putp. 196
Calls and Stock: The Covered Callp. 199
Some General Considerations with Covered Callsp. 203
Puts and Stock: The Protective Putp. 204
Synthetic Puts and Callsp. 208
Analyzing Option Strategies with the Excel Spreadsheet Stratlyz7e.xlsp. 211
Summaryp. 215
Key Termsp. 215
Questions and Problemsp. 215
Advanced Option Strategiesp. 218
Option Spreads: Basic Conceptsp. 219
Why Investors Use Option Spreadsp. 219
Notationp. 220
Money Spreadsp. 221
Bull Spreadsp. 221
Bear Spreadsp. 224
A Note about Call Bear Spreads and Put Bull Spreadsp. 226
Collarsp. 226
Butterfly Spreadsp. 230
Calendar Spreadsp. 234
Time Value Decayp. 236
Ratio Spreadsp. 238
Straddlesp. 239
Box Spreadsp. 244
Summaryp. 246
Key Termsp. 246
Further Readingp. 247
Questions and Problemsp. 247
Forwards, Futures, and Swapsp. 251
The Structure of Forward and Futures Marketsp. 252
Development of Forward and Futures Marketsp. 253
Chicago Futures Marketsp. 253
Development of Financial Futuresp. 254
Development of Options on Futures Marketsp. 255
Parallel Development of Over-the-Counter Marketsp. 256
Over-the-Counter Forward Marketp. 256
Organized Futures Tradingp. 257
Contract Developmentp. 258
Contract Terms and Conditionsp. 258
Delivery Termsp. 259
Daily Price Limits and Trading Haltsp. 259
Other Exchange Responsibilitiesp. 260
Futures Exchangesp. 260
Futures Tradersp. 262
General Classes of Futures Tradersp. 262
Classification by Trading Strategyp. 262
Classification by Trading Stylep. 263
Off-Floor Futures Tradersp. 264
Costs and Profitability of Exchange Membershipp. 264
Forward Market Tradersp. 265
Mechanics of Futures Tradingp. 265
Placing an Orderp. 265
Role of the Clearinghousep. 266
Daily Settlementp. 267
Delivery and Cash Settlementp. 269
Futures Price Quotationsp. 271
Types of Futures Contractsp. 271
Agricultural Commoditiesp. 272
Natural Resourcesp. 272
Miscellaneous Commoditiesp. 272
Foreign Currenciesp. 272
Federal Funds and Eurodollarsp. 273
Treasury Notes and Bondsp. 273
Swap Futuresp. 273
Equitiesp. 273
Managed Fundsp. 275
Hedge Fundsp. 276
Options on Futuresp. 276
Transaction Costs in Forward and Futures Tradingp. 277
Commissionsp. 277
Bid-Ask Spreadp. 277
Delivery Costsp. 277
Regulation of Futures and Forward Marketsp. 278
Summaryp. 279
Key Termsp. 279
Further Readingp. 280
Questions and Problemsp. 280
Taxation of Futures Transactions in the United Statesp. 282
Questions and Problemsp. 283
Principles of Pricing Forwards, Futures, and Options on Futuresp. 284
Generic Carry Arbitragep. 285
Concept of Price versus Valuep. 285
Value of a Forward Contractp. 286
Price of a Forward Contractp. 288
Value of a Futures Contractp. 288
Price of a Futures Contractp. 289
Forward versus Futures Pricesp. 290
Carry Arbitrage When Underlying Generates Cash Flowsp. 292
Stock Indices and Dividendsp. 292
Foreign Currencies and Foreign Interest Rates: Interest Rate Parityp. 295
Commodities and Storage Costsp. 297
Pricing Models and Risk Premiumsp. 298
Spot Prices, Risk Premiums, and Carry Arbitrage for Generic Assetsp. 298
Forward/Futures Pricing Revisitedp. 299
Futures Prices and Risk Premiap. 305
Put-Call-Forward/Futures Parityp. 309
Pricing Options on Futuresp. 311
Intrinsic Value of an American Option on Futuresp. 311
Lower Bound of a European Option on Futuresp. 312
Put-Call Parity of Options on Futuresp. 314
Early Exercise of Call and Put Options on Futuresp. 315
Black Futures Option Pricing Modelp. 317
Summaryp. 319
Key Termsp. 321
Further Readingp. 321
Questions and Problemsp. 322
Futures Arbitrage Strategiesp. 325
Short-Term Interest Rate Arbitragep. 326
Carry Arbitrage and the Implied Repo Ratep. 326
Federal Funds Futures Carry Arbitrage and the Implied Repo Ratep. 327
Eurodollar Arbitragep. 329
Intermediate- and Long-Term Interest Rate Arbitragep. 330
Determining the Cheapest-to-Deliver Bond on the Treasury Bond Futures Contractp. 332
Delivery Optionsp. 334
Implied Repo, Carry Arbitrage and Treasury Bond Futuresp. 337
Identifying the Cheapest-to-Deliver Bond with the Excel Spreadsheet CTD7e.xlsp. 338
Treasury Bond Futures Spreads and the Implied Repo Ratep. 340
Stock Index Arbitragep. 341
Foreign Exchange Arbitragep. 345
Summaryp. 346
Key Termsp. 347
Further Readingp. 348
Questions and Problemsp. 348
Determining the CBOT Treasury Bond Conversion Factorp. 351
Determining the CBOT Conversion Factor with the Excel Spreadsheet CF7e.xlsp. 352
Forward and Futures Hedging, Spread, and Target Strategiesp. 353
Why Hedge?p. 354
Hedging Conceptsp. 355
Short Hedge and Long Hedgep. 355
The Basisp. 356
Some Risks of Hedgingp. 360
Contract Choicep. 361
Margin Requirements and Marking to Marketp. 364
Determination of the Hedge Ratiop. 365
Minimum Variance Hedge Ratiop. 365
Price Sensitivity Hedge Ratiop. 367
Stock Index Futures Hedgingp. 370
Hedging Strategiesp. 371
Foreign Currency Hedgesp. 371
Intermediate- and Long-Term Interest Rate Hedgesp. 373
Spread Strategiesp. 382
Intramarket Spreadsp. 383
Intermarket Spreadsp. 386
Target Strategiesp. 388
Target Duration with Bond Futuresp. 388
Alpha Capturep. 391
Target Beta with Stock Index Futuresp. 393
Tactical Asset Allocation Using Stock and Bond Futuresp. 394
Summaryp. 398
Key Termsp. 399
Further Readingp. 399
Questions and Problemsp. 400
Taxation of Hedgingp. 404
Swapsp. 405
Interest Rate Swapsp. 408
Structure of a Typical Interest Rate Swapp. 408
Pricing and Valuation of Interest Rate Swapsp. 410
Interest Rate Swap Strategiesp. 416
Currency Swapsp. 420
Structure of a Typical Currency Swapp. 421
Pricing and Valuation of Currency Swapsp. 423
Currency Swap Strategiesp. 428
Equity Swapsp. 430
Structure of a Typical Equity Swapp. 431
Pricing and Valuation of Equity Swapsp. 432
Equity Swap Strategiesp. 436
Some Final Words about Swapsp. 437
Summaryp. 438
Key Termsp. 439
Further Readingp. 439
Questions and Problemsp. 439
Advanced Topicsp. 443
Interest Rate Forwards and Optionsp. 444
Forward Rate Agreementsp. 445
Structure and Use of a Typical FRAp. 446
Pricing and Valuation of FRAsp. 448
Applications of FRAsp. 450
Interest Rate Optionsp. 453
Structure and Use of a Typical Interest Rate Optionp. 454
Pricing and Valuation of Interest Rate Optionsp. 455
Interest Rate Option Strategiesp. 457
Interest Rate Caps, Floors, and Collarsp. 461
Interest Rate Options, FRAs, and Swapsp. 466
Interest Rate Swaptions and Forward Swapsp. 467
Structure of a Typical Interest Rate Swaptionp. 468
Equivalence of Swaptions and Options on Bondsp. 471
Pricing Swaptionsp. 471
Forward Swapsp. 472
Applications of Swaptions and Forward Swapsp. 473
Summaryp. 475
Key Termsp. 475
Further Readingp. 476
Questions and Problemsp. 476
Advanced Derivatives and Strategiesp. 480
Advanced Equity Derivatives and Strategiesp. 481
Portfolio Insurancep. 481
Equity Forwardsp. 487
Equity Warrantsp. 490
Equity-Linked Debtp. 491
Advanced Interest Rate Derivativesp. 491
Structured Notesp. 492
Mortgage-Backed Securitiesp. 493
Exotic Optionsp. 498
Digital and Chooser Optionsp. 499
Path-Dependent Optionsp. 502
Other Exotic Optionsp. 508
Some Unusual Derivativesp. 509
Electricity Derivativesp. 509
Weather Derivativesp. 509
Summaryp. 511
Key Termsp. 511
Further Readingp. 512
Questions and Problemsp. 513
Monte Carlo Simulationp. 516
Financial Risk Management Techniques and Applicationsp. 518
Why Practice Risk Management?p. 519
Impetus for Risk Managementp. 519
Benefits of Risk Managementp. 520
Managing Market Riskp. 521
Delta Hedgingp. 523
Gamma Hedgingp. 524
Vega Hedgingp. 527
Value at Risk (VAR)p. 528
A Comprehensive Calculation of VARp. 534
Benefits and Criticisms of VARp. 536
Extensions of VARp. 537
Managing Credit Riskp. 538
Credit Risk as an Optionp. 539
Credit Risk of Derivativesp. 541
Nettingp. 544
Credit Derivativesp. 545
Other Types of Risksp. 551
Summaryp. 555
Key Termsp. 555
Further Readingp. 556
Questions and Problemsp. 556
Managing Risk in an Organizationp. 559
The Structure of the Risk Management Industryp. 560
End Usersp. 560
Dealersp. 560
Other Participants in the Risk Management Industryp. 561
Organizing the Risk Management Function in a Companyp. 561
Risk Management Accountingp. 566
Fair Value Hedgesp. 567
Cash Flow Hedgesp. 568
Foreign Investment Hedgesp. 570
Speculationp. 570
Some Problems in the Application of FAS 133p. 570
Disclosurep. 571
Avoiding Derivatives Lossesp. 571
Metallgesellschaft: To Hedge or Not to Hedge?p. 571
Orange County, California: Playing the Oddsp. 574
Barings PLC: How One Man Blew Up a Bankp. 576
Procter & Gamble: Going Up in Sudsp. 578
Risk Management Industry Standardsp. 579
Responsibilities of Senior Managementp. 579
Summaryp. 585
Key Termsp. 586
Further Readingp. 586
Questions and Problemsp. 587
List of Formulasp. 589
Referencesp. 598
Glossaryp. 619
Indexp. 641
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