Options, Futures, and Other Derivatives with Derivagem

by Hull, John C.

• ISBN13: 9780130090560
• ISBN10: 0130090565
• Edition: 5th
• Format: Hardcover
• Copyright: 2003-01-01
• Publisher: Pearson College Div

Summary

This fifth edition book bridges the gap between the theory and practice of derivatives. It provides a unifying approach to the valuation of all derivatives--not just futures and options. It assumes that the reader has some knowledge of finance and probability and statistics. Topics covered include Determination of Forward and Futures Prices, Interest Rate Markets, Mechanics of Options Markets, and Properties of Stock Options. For individuals who work for banks and other financial institutions, as well as options traders, options analysts, risk managers, swaps traders, financial engineers, and corporate treasurers.

Table of Contents

Preface	xix
Introduction	1	(18)
Exchange-traded markets	1	(1)
Over-the-counter markets	2	(1)
Forward contracts	2	(3)
Futures contracts	5	(1)
Options	6	(4)
Types of traders	10	(4)
Other derivatives	14	(5)
Summary	15	(1)
Questions and problems	16	(1)
Assignment questions	17	(2)
Mechanics of futures markets	19	(22)
Trading futures contracts	19	(1)
Specification of the futures contract	20	(3)
Convergence of futures price to spot price	23	(1)
Operation of margins	24	(3)
Newspaper quotes	27	(4)
Keynes and Hicks	31	(1)
Delivery	31	(1)
Types of traders	32	(1)
Regulation	33	(2)
Accounting and tax	35	(1)
Forward contracts vs. futures contracts	36	(5)
Summary	37	(1)
Suggestions for further reading	38	(1)
Questions and problems	38	(2)
Assignment questions	40	(1)
Determination of forward and futures prices	41	(29)
Investment assets vs. consumption assets	41	(1)
Short selling	41	(1)
Measuring interest rates	42	(2)
Assumptions and notation	44	(1)
Forward price for an investment asset	45	(2)
Known income	47	(2)
Known yield	49	(1)
Valuing forward contracts	49	(2)
Are forward prices and futures prices equal?	51	(1)
Stock index futures	52	(3)
Forward and futures contracts on currencies	55	(3)
Futures on commodities	58	(2)
Cost of carry	60	(1)
Delivery options	60	(1)
Futures prices and the expected future spot price	61	(9)
Summary	63	(1)
Suggestions for further reading	64	(1)
Questions and problems	65	(2)
Assignment questions	67	(1)
Appendix 3A: Proof that forward and futures prices are equal when interest rates are constant	68	(2)
Hedging strategies using futures	70	(23)
Basic principles	70	(2)
Arguments for and against hedging	72	(3)
Basis risk	75	(3)
Minimum variance hedge ratio	78	(4)
Stock index futures	82	(4)
Rolling the hedge forward	86	(7)
Summary	87	(1)
Suggestions for further reading	88	(1)
Questions and problems	88	(2)
Assignment questions	90	(2)
Appendix 4A: Proof of the minimum variance hedge ratio formula	92	(1)
Interest rate markets	93	(32)
Types of rates	93	(1)
Zero rates	94	(1)
Bond pricing	94	(2)
Determining zero rates	96	(2)
Forward rates	98	(2)
Forward rate agreements	100	(2)
Theories of the term structure	102	(1)
Day count conventions	102	(1)
Quotations	103	(1)
Treasury bond futures	104	(6)
Eurodollar futures	110	(1)
The LIBOR zero curve	111	(1)
Duration	112	(4)
Duration-based hedging strategies	116	(9)
Summary	118	(1)
Suggestions for further reading	119	(1)
Questions and problems	120	(3)
Assignment questions	123	(2)
Swaps	125	(26)
Mechanics of interest rate swaps	125	(6)
The comparative-advantage argument	131	(3)
Swap quotes and LIBOR zero rates	134	(2)
Valuation of interest rate swaps	136	(4)
Currency swaps	140	(3)
Valuation of currency swaps	143	(2)
Credit risk	145	(6)
Summary	146	(1)
Suggestions for further reading	147	(1)
Questions and problems	147	(2)
Assignment questions	149	(2)
Mechanics of options markets	151	(16)
Underlying assets	151	(1)
Specification of stock options	152	(3)
Newspaper quotes	155	(2)
Trading	157	(1)
Commissions	157	(1)
Margins	158	(2)
The options clearing corporation	160	(1)
Regulation	161	(1)
Taxation	161	(1)
Warrants, executive stock options, and convertibles	162	(1)
Over-the-counter markets	163	(4)
Summary	163	(1)
Suggestions for further reading	164	(1)
Questions and problems	164	(1)
Assignment questions	165	(2)
Properties of stock options	167	(18)
Factors affecting option prices	167	(3)
Assumptions and notation	170	(1)
Upper and lower bounds for option prices	171	(3)
Put-call parity	174	(1)
Early exercise: calls on a non-dividend-paying stock	175	(2)
Early exercise: puts on a non-dividend-paying stock	177	(1)
Effect of dividends	178	(1)
Empirical research	179	(6)
Summary	180	(1)
Suggestions for further reading	181	(1)
Questions and problems	182	(1)
Assignment questions	183	(2)
Trading strategies involving options	185	(15)
Strategies involving a single option and a stock	185	(2)
Spreads	187	(7)
Combinations	194	(3)
Other payoffs	197	(3)
Summary	197	(1)
Suggestions for further reading	198	(1)
Questions and problems	198	(1)
Assignment questions	199	(1)
Introduction to binomial trees	200	(16)
A one-step binomial model	200	(3)
Risk-neutral valuation	203	(2)
Two-step binomial trees	205	(3)
A put example	208	(1)
American options	209	(1)
Delta	210	(1)
Matching volatility with u and d	211	(1)
Binomial trees in practice	212	(4)
Summary	213	(1)
Suggestions for further reading	214	(1)
Questions and problems	214	(1)
Assignment questions	215	(1)
A model of the behavior of stock prices	216	(18)
The Markov property	216	(1)
Continuous-time stochastic processes	217	(5)
The process for stock prices	222	(1)
Review of the model	223	(2)
The parameters	225	(1)
Ito's lemma	226	(1)
The lognormal property	227	(7)
Summary	228	(1)
Suggestions for further reading	229	(1)
Questions and problems	229	(1)
Assignment questions	230	(2)
Appendix 11A: Derivation of Ito's lemma	232	(2)
The Black-Scholes model	234	(33)
Lognormal property of stock prices	234	(2)
The distribution of the rate of return	236	(1)
The expected return	237	(1)
Volatility	238	(3)
Concepts underlying the Black-Scholes-Merton differential equation	241	(1)
Derivation of the Black-Scholes-Merton differential equation	242	(2)
Risk-neutral valuation	244	(2)
Black-Scholes pricing formulas	246	(2)
Cumulative normal distribution function	248	(1)
Warrants issued by a company on its own stock	249	(1)
Implied volatilities	250	(1)
The causes of volatility	251	(1)
Dividends	252	(15)
Summary	256	(1)
Suggestions for further reading	257	(1)
Questions and problems	258	(3)
Assignment questions	261	(1)
Appendix 12A: Proof of Black-Scholes-Merton formula	262	(3)
Appendix 12B: Exact procedure for calculating the values of American calls on dividend-paying stocks	265	(1)
Appendix 12C: Calculation of cumulative probability in bivariate normal distribution	266	(1)
Options on stock indices, currencies, and futures	267	(32)
Results for a stock paying a known dividend yield	267	(1)
Option pricing formulas	268	(2)
Options on stock indices	270	(6)
Currency options	276	(2)
Futures options	278	(6)
Valuation of futures options using binomial trees	284	(2)
Futures price analogy	286	(1)
Black's model for valuing futures options	287	(1)
Futures options vs. spot options	288	(11)
Summary	289	(1)
Suggestions for further reading	290	(1)
Questions and problems	291	(3)
Assignment questions	294	(1)
Appendix 13A: Derivation of differential equation satisfied by a derivative dependent on a stock providing a dividend yield	295	(2)
Appendix 13B: Derivation of differential equation satisfied by a derivative dependent on a futures price	297	(2)
The Greek letters	299	(31)
Illustration	299	(1)
Naked and covered positions	300	(1)
A stop-loss strategy	300	(2)
Delta hedging	302	(7)
Theta	309	(3)
Gamma	312	(3)
Relationship between delta, theta, and gamma	315	(1)
Vega	316	(2)
Rho	318	(1)
Hedging in practice	319	(1)
Scenario analysis	319	(1)
Portfolio insurance	320	(3)
Stock market volatility	323	(7)
Summary	323	(1)
Suggestions for further reading	324	(2)
Questions and problems	326	(1)
Assignment questions	327	(2)
Appendix 14A: Taylor series expansions and hedge parameters	329	(1)
Volatility smiles	330	(16)
Put-call parity revisited	330	(1)
Foreign currency options	331	(3)
Equity options	334	(2)
The volatility term structure and volatility surfaces	336	(1)
Greek letters	337	(1)
When a single large jump is anticipated	338	(1)
Empirical research	339	(7)
Summary	341	(1)
Suggestions for further reading	341	(2)
Questions and problems	343	(1)
Assignment questions	344	(1)
Appendix 15A: Determining implied risk-neutral distributions from volatility smiles	345	(1)
Value at risk	346	(26)
The VaR measure	346	(2)
Historical simulation	348	(2)
Model-building approach	350	(2)
Linear model	352	(4)
Quadratic model	356	(3)
Monte Carlo simulation	359	(1)
Comparison of approaches	359	(1)
Stress testing and back testing	360	(1)
Principal components analysis	360	(12)
Summary	364	(1)
Suggestions for further reading	364	(1)
Questions and problems	365	(1)
Assignment questions	366	(2)
Appendix 16A: Cash-flow mapping	368	(2)
Appendix 16B: Use of the Cornish-Fisher expansion to estimate VaR	370	(2)
Estimating volatilities and correlations	372	(20)
Estimating volatility	372	(2)
The exponentially weighted moving average model	374	(2)
The GARCH(1,1) model	376	(1)
Choosing between the models	377	(1)
Maximum likelihood methods	378	(4)
Using GARCH(1,1) to forecast future volatility	382	(3)
Correlations	385	(7)
Summary	388	(1)
Suggestions for further reading	388	(1)
Questions and problems	389	(2)
Assignment questions	391	(1)
Numerical procedures	392	(43)
Binomial trees	392	(7)
Using the binomial tree for options on indices, currencies, and futures contracts	399	(3)
Binomial model for a dividend-paying stock	402	(3)
Extensions to the basic tree approach	405	(1)
Alternative procedures for constructing trees	406	(4)
Monte Carlo simulation	410	(4)
Variance reduction procedures	414	(4)
Finite difference methods	418	(9)
Analytic approximation to American option prices	427	(8)
Summary	427	(1)
Suggestions for further reading	428	(2)
Questions and problems	430	(2)
Assignment questions	432	(1)
Appendix 18A: Analytic approximation to American option prices of MacMillan and of Barone-Adesi and Whaley	433	(2)
Exotic options	435	(21)
Packages	435	(1)
Nonstandard American options	436	(1)
Forward start options	437	(1)
Compound options	437	(1)
Chooser options	438	(1)
Barrier options	439	(2)
Binary options	441	(1)
Lookback options	441	(2)
Shout options	443	(1)
Asian options	443	(2)
Options to exchange one asset for another	445	(1)
Basket options	446	(1)
Hedging issues	447	(1)
Static options replication	447	(9)
Summary	449	(1)
Suggestions for further reading	449	(2)
Questions and problems	451	(1)
Assignment questions	452	(2)
Appendix 19A: Calculation of the first two moments of arithmetic averages and baskets	454	(2)
More on models and numerical procedures	456	(27)
The CEV model	456	(1)
The jump diffusion model	457	(1)
Stochastic volatility models	458	(2)
The IVF model	460	(1)
Path-dependent derivatives	461	(4)
Lookback options	465	(2)
Barrier options	467	(5)
Options on two correlated assets	472	(2)
Monte Carlo simulation and American options	474	(9)
Summary	478	(1)
Suggestions for further reading	479	(1)
Questions and problems	480	(1)
Assignment questions	481	(2)
Martingales and measures	483	(25)
The market price of risk	484	(3)
Several state variables	487	(1)
Martingales	488	(1)
Alternative choices for the numeraire	489	(3)
Extension to multiple independent factors	492	(1)
Applications	493	(2)
Change of numeraire	495	(2)
Quantos	497	(2)
Siegel's paradox	499	(9)
Summary	500	(1)
Suggestions for further reading	500	(1)
Questions and problems	501	(1)
Assignment questions	502	(2)
Appendix 21A: Generalizations of Ito's lemma	504	(2)
Appendix 21B: Expected excess return when there are multiple sources of uncertainty	506	(2)
Interest rate derivatives: the standard market models	508	(29)
Black's model	508	(3)
Bond options	511	(4)
Interest rate caps	515	(5)
European swap options	520	(4)
Generalizations	524	(1)
Convexity adjustments	524	(3)
Timing adjustments	527	(2)
Natural time lags	529	(1)
Hedging interest rate derivatives	530	(7)
Summary	531	(1)
Suggestions for further reading	531	(1)
Questions and problems	532	(2)
Assignment questions	534	(2)
Appendix 22A: Proof of the convexity adjustment formula	536	(1)
Interest rate derivatives: models of the short rate	537	(34)
Equilibrium models	537	(1)
One-factor equilibrium models	538	(1)
The Rendleman and Bartter model	538	(1)
The Vasicek model	539	(3)
The Cox, Ingersoll, and Ross model	542	(1)
Two-factor equilibrium models	543	(1)
No-arbitrage models	543	(1)
The Ho and Lee model	544	(2)
The Hull and White model	546	(3)
Options on coupon-bearing bonds	549	(1)
Interest rate trees	550	(2)
A general tree-building procedure	552	(11)
Nonstationary models	563	(1)
Calibration	564	(1)
Hedging using a one-factor model	565	(1)
Forward rates and futures rates	566	(5)
Summary	566	(1)
Suggestions for further reading	567	(1)
Questions and problems	568	(2)
Assignment questions	570	(1)
Interest rate derivatives: more advanced models	571	(23)
Two-factor models of the short rate	571	(3)
The Heath, Jarrow, and Morton model	574	(3)
The LIBOR market model	577	(9)
Mortgage-backed securities	586	(8)
Summary	588	(1)
Suggestions for further reading	589	(1)
Questions and problems	590	(1)
Assignment questions	591	(2)
Appendix 24A: The A(t, T), σp, and θ(t) functions in the two-factor Hull-White model	593	(1)
Swaps revisited	594	(16)
Variations on the vanilla deal	594	(1)
Compounding swaps	595	(3)
Currency swaps	598	(1)
More complex swaps	598	(3)
Equity swaps	601	(1)
Swaps with embedded options	602	(3)
Other swaps	605	(1)
Bizarre deals	605	(5)
Summary	606	(1)
Suggestions for further reading	606	(1)
Questions and problems	607	(1)
Assignment questions	607	(2)
Appendix 25A: Valuation of an equity swap between payment dates	609	(1)
Credit risk	610	(27)
Bond prices and the probability of default	610	(9)
Historical data	619	(1)
Bond prices vs. historical default experience	619	(1)
Risk-neutral vs. real-world estimates	620	(1)
Using equity prices to estimate default probabilities	621	(2)
The loss given default	623	(3)
Credit ratings migration	626	(1)
Default correlations	627	(3)
Credit value at risk	630	(7)
Summary	633	(1)
Suggestions for further reading	633	(1)
Questions and problems	634	(1)
Assignment questions	635	(1)
Appendix 26A: Manipulation of the matrices of credit rating changes	636	(1)
Credit derivatives	637	(23)
Credit default swaps	637	(7)
Total return swaps	644	(1)
Credit spread options	645	(1)
Collateralized debt obligations	646	(1)
Adjusting derivative prices for default risk	647	(5)
Convertible bonds	652	(8)
Summary	655	(1)
Suggestions for further reading	655	(1)
Questions and problems	656	(2)
Assignment questions	658	(2)
Real options	660	(18)
Capital investment appraisal	660	(1)
Extension of the risk-neutral valuation framework	661	(4)
Estimating the market price of risk	665	(1)
Application to the valuation of a new business	666	(1)
Commodity prices	667	(3)
Evaluating options in an investment opportunity	670	(8)
Summary	675	(1)
Suggestions for further reading	676	(1)
Questions and problems	676	(1)
Assignment questions	677	(1)
Insurance, weather, and energy derivatives	678	(8)
Review of pricing issues	678	(1)
Weather derivatives	679	(1)
Energy derivatives	680	(2)
Insurance derivatives	682	(4)
Summary	683	(1)
Suggestions for further reading	684	(1)
Questions and problems	684	(1)
Assignment questions	685	(1)
Derivatives mishaps and what we can learn from them	686	(11)
Lessons for all users of derivatives	686	(4)
Lessons for financial institutions	690	(3)
Lessons for nonfinancial corporations	693	(4)
Summary	694	(1)
Suggestions for further reading	695	(2)
Glossary of notation	697	(3)
Glossary of terms	700	(15)
DerivaGem software	715	(5)
Major exchanges trading futures and options	720	(2)
Table for N(x) when x ≤ 0	722	(1)
Table for N(x) when x ≥ 0	723	(2)
Author index	725	(4)
Subject index	729