PRINTED BY. Aldo Cavazos . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. create Course _Derivados Financiers Professor _E, Dante Suérez Itesm Universidad TECVirtual FINANCEPRINTED BY. Aldo Cavazos . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. ua create httpy/create.megrawehill.com Copyroh 201263 The MeGua Hil Cmgoria ne Alighs fezerved Printed nthe Unted Sater ef Ameica Except Fermi unde te United Staves Copyright et 1975 pet of this publeaton mey bs epeduced or ebute in any form fr byanyiears or serecina catbac or erieval sys shuren permiton afte publi Neseey-l foc publeaon by the never Fs course Teint ely perborate fsck mates nstuctorsetin copyright of thse sens] mater SSaN-n0 1121784186 ISBN: grenr2t78et6sPRINTED BY: Aldo Cavazos , Pisting Tor personal private use only No part ofthis book may be eproduced ar wansmied without publish Prior ermisson. Viottrs willbe prosecute. Contents 1.Preface 1 2ilnizoduction 7 43. Fomme Markets. 72 4.Pricing Forwards snd Futures I: The Basic Theory 64 S.Heedging with Futures and Forwards. 3 6.Options Markets 111 7.Options: PayofTs and Trading Strategies 127 8.Oplion Pricing: An Tulroduction 152 9. The Black-Scholes Model 108 10. Value-at-Risk 220 11.Conwventble Bonds. 241 12.Real Options 270 13. Equity Swaps 291 14.Curreney and Commodity Swaps 309 15. Credit Derivative Products 325, 16.Bibliography 356 17. Subject Index. 264PRINTED BY: Aldo Cavazos , Pisting Tor personal private use only No part ofthis book may be eproduced ar wansmied without publish Prior ermisson. Viottrs willbe prosecute. Credits 1 Preface: Chapter rom Derivatives: Pneples nd Practice by Sundaram, Das, 2011 1 2. Introduction: Chapter 1 from Derivatives: Precples and Practice by Sundar, Bas. 2011 7 3. Forums Markers’ Chapter? fram Devatee Pace and Practiem by Snadinae, Ba 2015 4.Pricing Forwards and Futures I: Tae Basic Teory: Chopte3 fom Dervates:Praciles and racic by Sundaram, Di, 2077 64 5. Hodging with Fumes nel Farwarel: Chapters fam Delatlne Prepac and Prats hy Sundaram, as, 2011 Bb 6. Options Markt Chapter 7 fam Deviate Pennie and Dari by Sundaram, ee. 2071 119 7. Options: Payofls and Trading Strategies: Chapter 8 from Derivaves:Princples and Practice by Sundovam, Das, ‘oT 127 8. Option Pricing: An Tnrosiuction: Chapter 1 fram Derivatives Princes and Practice by Sundaram, Daz,2011 152 9. The Black-Scholes Madel: Chapter 1 rom Derivative: rincplesand Practice by Sundaram, Des 2011184 10. ValuseateRisk: Chapter 20 fc Dervctivs Pines cd Proctcby Sundaram, Bes, 2011 220 11.Convertbls Bands: Chapter 2 fam Derletve: rnp: and Pretee by Sundaram Dat, 2011 241 12. Real Options: Chapter22 rom Derivatives Pricpls and Preece ty Sundraim, Das,2011 270 13. Laquity Swaps: Chapte24 ram Derivatives Principles and Practice by Sundaram Das.20"1 251 14. Cusrency and Commodity Swaps: Chapter 25 fan Dena: Pitnphes ond Prative by Sundaram Das, 2017 309 15. Credit Dervative Products: Chapters fom Denwatwes Princes and Practice by Sundaram, Das 2017825 16.Bibliograpay: Chopter rom Derivatives Pincipes an Practice by Sunsaram Das, 2011 355 17. Subject Index: Chapter fram Devtvatues:Princplesand Practice by Sundaram, Das 201) 368PRINTED BY. Aldo Cavazos . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. Dematves ences and Pactce Preface ‘Tae two of us have worked together academically for more then s quarter cemury, first a5 sgzaduatestuden's,andthenas university fecuty. Given ow close collaborsion, ur common esenre? and teaching sfleresis inthe Held oF derivatives, and the Iequent pecagngieal discussions we have Lad on the subject, this book was perhaps inevitable, The final product grow out of many sources. Aboct three-fourths of the book came from notes developed by Raghu for his derivatives course at New York University ax well 1s for cther aeademic courses and professional training programs at Credit Suisse, ICICI ‘Bank, the International Monetary Fund (IME), Inveseo-Grest Wall, 2. Mogan, Merrill Lynch, the Indian School of Business (SB), the Insitute for Financial Management and Rescarch (FMR), and New York University, among other instrutions. Other parts grew out of academic courses and professional taining programs tsught by Sanjiv at Harvard University, Sante Clara University, the University of Califoraia at Berkeley, the ISB, the TEMP, the IME. and Citibank, among others. Some chapters were developed specifically for this hook, ax wore most ofthe ond-af-chapter exercises. ‘The discussion below provides an overview cf the book, emphasizing some ofits special features. We provide too our suggestions for vasious Gerivatives courses that may be carved ‘ut of the bk An Overview of the Contents ‘Tae mam body of tns books drded mo soxparts. Parts I~S cover respecavely, fuses and forwards; options; and swaps. Part 4 examines term-structure modeling and the pricing of interest-rate dexvatives, while Part Sis concezuod with credit derivatives and the modeling of credit risk Par 6 discusses computational issues. A deusiled description of the book's contents is provided in Section ILS; here, we confine ourselves to a brief overview of cach pat. Part 1 examines forward and futures contracts, The wpics covered in this span include the structure and characteristics of futures marks; the pricing of Forwards and futures: Ineiging with forwards and funares, in peice novion oF minim uariance hedaing andits implementation; and inteest-rate-dependent forwards and futures, such as forward rte agreements or FRA, eurodellar futures, and Treasury frures contacts Part 2, the lengthisst portion af the hook, is conccmed mainly with options. We begin with 2 discussion of option payoff, the role of volatility, and the use of options in incor. poring into ponfoliv specie views ou urhel disvclion and/or volallity. Thee we (urs ‘our attention to the pricing of options contacts. The binomis! and Blsck-Scholes models fare developed in detail, and several generalizarions of these models are examined. Prom pricing, we move 1 Reaping ang a discussion of he option “greeks,” measures of aption, sensitivity to changes in the market environment. Rounding ofT the pricing and hedging material, two chapiers dseuss a wide range of "exoti” options and their betavior The remainder of Part 2 focuses on special topics: portfolio measures of risk such as ‘Value-at-Risk und the notion ofrisk budgeting, the pricing and hedging of convertible bonds, and study of “real” optiors, optionalities embedded within investment projects. art3 ofthe book looks t swaps, The uses aad prising ef interes! sate swaps are coveced in detail, as are equity swaps, currency swaps, and commodity swaps. (Other insruments bearng the “swans” moniker are covered elseniere in the book. Variance and volatilityPRINTED BY. Aldo Cavazos . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. Denuadasrinanceres Peace i ‘swaps are prosentad in the chaptar on Black-Scholes, and credit-default snaps and toxal- return awape are examined inthe chapter on erodit-derivative products) Also included in Part 3 is a presentation of eaps, floors, and sweptions, ind of the “murket model” used to pice these instrumen's Part 4 deals with iierestvate modeling. We begin with different nodoas of ie yisld ‘curv, the esimation of the yield curve fom market dit, and the challenges involved in ‘modeling movements inthe yield curve. We then work our way through factor models of the yield curve, including soversl well-known models suchas Ho-Leo, Black-Derman-Toy, \Vasicek, Cor-Ingersoll-Koss, and otues. A final chapter presents te Heati-Jarrow-Morion. framework, and aso that ofthe Libor and Swap Market Models Part § deals with croditsisk and credit desivatives. An opening chapter provides a taxonomy of products and their characteristics. The remaining chapters are concerned with rmodcling crodit risk. Stucural models sro covered in one chapter, reduced-form models inthe next, and comelsted-defuult modeling in the third Parté,cvsilableorline athtsp: //srea-xhe.con/a41, looks t comnnationa seuss. Finite-cifarencing and Monte-Carlo methocs ae discussed here. final chapier provides A nutorsl em then of Aetna fies safwareakn to Nath, chat we use far lnsraive ‘purposes throughout the book Background Knowledge 1 would be inaccurate to say that tis book docs not pre-suppese aay kuowledge on the pat ofthe reader, bu itis true that it does not pre-suppose much. A basic knowledge of ‘nanciel markets, instruments, and variables (cauities, bonds, interest rates, exchange rates, etc) will obviously heln—indeed, ie almost essential. So ton will a degree of analytic prepacedaess (for example, Famliaity with logs aud expouenss, compouading, preset ‘value eomputations busi satites and probahi'y, the normal distribution, end so on). But ‘beyond this, ot muck is required. The book is largely self-contained. The use of vanced (Grom the standpoint of an MBA course) mathematical tools, such as stochastic calculus, is -keptto a minimum, and where such concepts are intreuced, they are often deviations fom the ruin urvatve dha may be awided isu desired, What Is Different about This Book? [thas bees our experience thatthe overwhelming majrity of radents in derivatives courses {20 0n to become ters, ercalors of structured prnducts, or cther users of derivatives, for ‘whom a decp conosptual, rither shan solely mathematical, understanding of products nd odes is required. Happily, Uwe Geld of derivatives lends iiself Wo suc an ea: while it is one of the most mathematicaly-sophisticated areas of finance, it is also possible, perhaps more so than in any other area of nance, to explain the fundamental principles “underlying dervatves pricing and risk-menagement in simple-to-urdersnd ard relatively rnon-mathematical terms. Our baok loaks to orate precisely such a blended approach, one tats formal and rigorous, yet intuitive and accessible. ‘To this purpose, a great deal of our effort throughout this book is spent on explaining ‘what lies behind the formal mathematics of pricing and hedging. How are forward prices determined? Why does the Black-Scholes formula have the form does? What isthe option ‘pammaand whyisitofsvch importance to a der? The option theta? Whi dotermstructaze ‘models take the approach they do? In parieulsr, what are che subteties and pitfells in ‘mod:lingrerm-structure movements? How may equity prices be used to extract default iskPRINTED BY. Aldo Cavazos . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. Dematves ences and Pactce walt nfo ‘of companies? Debt prices? How daca default eorrelstion matter in the pricing of polio ‘crsd.tinstruments? Why does itmattor inthis way’? inall ofthese eaves and others throughout the bock, we use verbal and pictorial expositions, and sometimes simple mathematical ‘models, to explain the underlying principles before proceeding to a formal analysis. "Nou® of tis should be taken to imply tha: ous presentations ave iafocmal or matheanati- cally incomplete, Rutitis ue that we eschew te use of unnecessary mishemmties. Where diserewe-ilme setings can convey the behavior of a model beter than cominuousime set= tings, we esertfo such a framework Where pictur cando the work ofa thousand (or even ‘aundred) words, we use a picture, And we evo the presentation ot “black box" ormulae to the maximum extent possible. In the few eases where deriving the prices of some deriva tives would eequize the use of edvancod mathematic, we spend eos explaining ituitively the form and behavior ofthe pricing formula. ‘To supplement the intuitive nd formal presentations, wemake extensive use cfmumerical ‘examples for illustrative purposes. To exabie comparability, the mumetical examples are often builtaround «common partmetriatior. For example, inthe chapter on ntion greeks, ‘ahaseline set of parameter values is Chosen, andthe behavior of each greek is Mustrated tising departies fm these hase Tnaddition, the book presents several fll-enati: case studies, including some ofthe most Gayfamous decivatives disasters in history. These include Amaranth, Barings, Long-Term (Capital Management (LTCM), Metallgecellschaf, Procter & Gamble, and others. These are supplomanted by other ease saudiesanlable on this hook’s wchsito, including Ashanti, Sumitomo, the Son-of-Doss tax shelters, ané American Intercational Group (AIG). Finally, since the bes: way to leun the theory of desivatives priciug and hedging is by working through exercises, the book offers a large number of end-of-chapter problems. ‘These problems are of thee ypes. Some are conceptual, mostly simed at ensuring tne besic definitions have been understood but cecasionclly also involving algebraic manipulations. ‘Tae second group comprise numerical exereses, problems that cane solved with calcu lator or a spreadsheet. The last group are programming questions, questions that challenge the students to write code to implement specific models. Possible Course Outlines Figo 1 closer the Ingival Rew af chapters in the hole The honk cam he nod at the ‘undergraduate and MBA levels asthe tex: fora fast couree in derivatives; for s second (or advanced) course in derivatives; fora “topies” couse in derivatives (asa follow uptoa frst ‘course, and fora fixed-income andlor eredit derivatives course; among others. Wedeseribe below our suggested sclection of chaptor for cach of those A fist course in decivatives typically vovers forwards and futures, basic uplious material, and peraps interest rate swaps. Such acourse couldbe built around Chaprers 1-4 on fsrures markets and forwerd and furures pricing; Chapters 7-14 on options payoffs and tmading strategies, no-aitrage resrieions end pit-cll pasty, nd the binomial and Black ‘models; Chapters 17-19 on option greeks and exotie options; and Chapter 23 on sate swaps and othe Doating-rate oduct, “Assecond course, focused primrily on interest-rsteand crdit-tisk modeling, could begin witha review of basic option pricing (Chapters 11-14), move on ‘oan examinstior of more ‘complex pricing models (Chapter 1), then cover interest-rate modeling (Chapters 26-30) and lnally credit derivatives and crodit-risk modeling (Chapters 31-34). ‘A“‘opies” course following te fist course could begin again with review of basic op- tion prising (Chapters | 1-14) folowed by an examination of mone complex pricing modelsPRINTED BY: Aldo Cavazos , Piting Is Tor penonal private use only No part ofthis book may be eproduced ar wansmied without publishers Prior ermisson. Viottrs willbe prosecute. Denuadasrinanceres tas FIGURE 1 ‘The Flow of te Book, vorviow 2a ForwarouFires Peeing } | laomstanresorst +} aM Futures. Hosging Set ¥ | se |, 7 ‘Advarood O3tcos Option Sonsitaty eet estat eed | >| eer Seaeenetn |< Conmedty Supa intrest Fates BH Terma Model mae Fr Finite Diferencng «| ens Cc Devatnes| (Chapter 16), This could be followed by Value-at-Risk and risk budgeting (Chapter 20); ‘convertible honds (Chapter 21); real options (Chapter 22); and interest-me, equity, and ‘currency swaps (Chapters 23~25), with the final pat of the course covering either an into . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. Dematves ences and Pactce ve He Finally, & coum on fxod-inaome derivatives can he structured around baie forward pricing (Chapter 3); interant-rate futures and forwarde (Chapter 6); basic option pricing and the Black Scholes model (Chepters 1 and 14); inerest rate svaps, caps, floors, aad swep- tions, andthe Diack model (Chapter 23); andthe yield curve and term-sructure modeling (Chapters 26-30). A Final Comment Tais book hss been several years inthe msking and hss undergone several revisions in that time, Meanwhile the derivatives morket has itself been changing atan explosive pace. The fSnazcial crisis tht erupted in 2008 will almost surely esul in altecing majer components of the derivatives market, partiewary in the case of over.the-eounter derivatives. Thus, itis posible that some ofthe products we have deseribad could vanish from the market in a few {year ce the way these products are traded could Fundamertally change. But the principles {governing the valuation and rsk-management ofthese predicts are more permancrt, end lis duve principles, rather Gan solely Gi Uetals of tae products (benselves, Gil we have ‘tied to communicate in tis book. We hve enjoyed writing this book. We hope the reader finds the fnal product as enjoyanl.PRINTED BY: Aldo Cavazos , Pisting Tor personal private use only No part ofthis book may be eproduced ar wansmied without publish Prior ermisson. Viottrs willbe prosecute.PRINTED BY. Aldo Cavazos . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. Dematves ences and Pactce Chapter Introduction ‘The world derivatives marketisa hugecme. The Bark for International Scilements estimates that by December 2008, the volume of derivatives outstanding worldwide, measured in terms of notional outstanding, was 8 stagzering $592 milion. The gross market value of these derivatives was a more modest, but still respectable, 332.9 willion. By way of comparison, the gross domestic product in 3007 ofthe United Staies, the world’s largest eoonomy, was “only” about $13.8 tilion. ‘Notonly i the market immense; it bas also been growing a furious pace. The notional amountoutstanding in derivatives contacts worldwide increased more than sevenfoldin the nine years ending December 2007, doubling in us the last vo years ofthat span (Tables L.1 and 1.2) The global financial erisis that erupted in 2008 took its tall on the market, bu: at the end of December 2008, the aotional outstanding was roughly the same as ai the end ‘of December 2007, and the gross market value ofthese derivatives was more than 130% hisher. “The growth has been truly widespread, There are now thriving derivatives exchanges not ‘only inthe talitional developed econamies of Nosth Amerie, Fumpe, and lagen, hit also jn Brazil, China. Inia, lal, Korea, Mexica, and Singapore, smang many othor countrics. ‘A survey by the International Swaps und Derivatives Associntion (ISDA) in 2003 found that 92% of the world’s SOD largest companies use der-vasives to maange ssk of vacious form, especially inteest rate risk (92%) and currency tsk (85%), but, to c lesser extent, also commodity tsk (25%) and equity risk (128). Firms in over 90% of the counties represented inthe sample used derivatives. ‘Malchiay—and Gucligg tne prowl es becu the pace of inmovalien i Uae aurbel ‘Traditional derivatives were writen on commodity prices, bur begining with foreign cur- rency and otber financial denvatives i the 1970s, new forms of denvatives have beem ntro- ducad almost continuousy. Today, derivatives contracts reference a wide range aF underlying instrumen's including equity prices, commodity prices, exchange rates, interest rates, bond ices, index levels, and ereditrisk. Derivativeshavealsobeen introduced, with varying sac- ‘cess rites, on more exotic underlying variables such as market volailty electricity prices, temperature levels, broadband newsprint, and natural extastrophies, among many others. “This i an impressive picture. Yetderivtives have also bee the txrget of Here criticism, 1 2003, Warren Bullet, pechaps the world’s most successful investor, labeled ther, “nan cis] weapons of mass destuction” Derivatives—especislly credit derivatives—have been ‘widely blamed for snshling, ora lecstexaceshating, the global nancial makes criss that ‘began in late 2007. Victims of derivatives (mis-)use over the decades include such promi- nent names ax the esnturiesold British institution Barings Rank, the German industrial ‘conglomerate Metallgosellacha?t AG, the Fapancse trading ponethouse Sumitomo, andthe ‘jant US insurance company, American Intemational Group (AIG),PRINTED BY: Aldo Cavazos , Pisting Tor personal private use only No part ofthis book may be eproduced ar wansmied without publish Prior ermisson. Viottrs willbe prosecute. Denuadasrinanceres 2 Chapter! tnmdesin TABLE 1.1 BIS Estimate of World Dervis Matkat Sie: 2006-2008 Notional Amounts Outstanding (Gross Market Values End 2006 End 2007 End 2008 End 2005 End 2007 End 2008 Total contracts 4148 © 5960592087 us 339 Foreign exchange contracts 4030 56.200 49-813 39 Forwards and forex swaps 199 2911 M6 05 7 ‘Currency swaps 108 143 W706 16 Options 96 127 108 02 06 Interest rate contracts wis 39314878 184 Forward-rate agreements 266 393 oo 02 Interest rate swap 3096 3281 42 166 Options S700 S13 06 7 Equity-tinked contracts Bs 65 (Os uw Forwards and swaps 22 1 02 03 Options 63 49 oF os Commodity contracts 90 44 OF 10 Gold 06 04 a 00 ‘Other commodities Ba 40 06 09 Forwards and swaps 56 25 ‘options 28 Le. Credit default swaps S79 419 os 87 ‘Single-name instruments 179 322 24 16 16 37 Mult-name istzuments 108 256 16. 00 00 20 Unallocated 397 n2 m7 090 00 a8 Some Dek mt Stem Swe ‘Wht ir adevivative? What are the different types of derivatives? What are the benefits of derivatives that have fueled their growth? The risks that have le to disasters” How is the valuc of & derwvative determined” How are the risks ina derivative measured? How com these risks he managed (oF hedged)? These and other questions are the foces of this book. We describe and analyze a wide mnge of derivative securities. By combining the ‘analyieal deserptons with aumerial examples, exercises, and case studies, we present an introduction to the world of derivatives that is at once formal and rigorous yet seecssible and intuitive. The rest ofthis chapter elaborates and lays the foundation forthe book. What Are Derivatives? A derivative security's a financial security whose payof¥deperdson (ot derives from)ather, ‘more firementl, viribles such a8 a sthek price, an exchange rate, a carimodity price, fn interest eate—or even the price af another derivative security. The underlying deving variable is commonly referred toas simply the underlying. ‘The simplestkind of der:vative—and historically the oldest form, dating bc thousands, of years—is a forward contract. A forward contract s one in which two partis (commonly refered to a8 the evunterpuriies in the sransactinn) ageee to the terms of a trae to be ‘consummated on a specified date in tho future, For example, on December 3, a buyer and seller may enter inco a forward contract to trade in 100 oz of gold in three months (ie.,on ‘March 3) ata price of 8600/0. In tis ease, the seler is undertaking to sll 100 2 i threePRINTED BY: Aldo Cavazos , Pisting Tor personal private use only No part ofthis book may be eproduced ar wansmied without publish Prior ermisson. Viottrs willbe prosecute. Dewwatves Petes and Practice Chapter immdueton 3 TABLE 1.2. BIS Ewimates of World Derivatives Mast Stas: 1098-2008 Notional Amounts Outstanding Dec 1998 Dec. 2000 Dec 2002 Dec 2004 Dex. 2007 Dec. 2008 ‘Total contracts 303 95.20 T2579 596.0 592.0 Foreign exchangecontracts 180 15.7 18493 S62 49.8. Forwards and forex swaps 121 10. 107, 1302 26 (Currency swaps 23 32 45 a2 M3 az Options 37 23 32 6 127105 Interest rate contracts 7 wy 90S 814187 Forward-ate agyeernents a8 128 0K 303 Icterestrate swaps 71 1806 3096 ©3281 Options 7 oat 513 Equity linked contracts 23 4a 6s Forwards and swaps os og 16 Optom 19 36 43 Commodity contracts 09 14 4a Gold 03 04 04 (Other commodities os 1 4.0 Forwards and swaps oa os 25 (Gptons uz us Le Credit default swaps 64 ais Single-narve instruments a 254 ‘Mul-rame instruments 13 161 Unallocated 104 123 1s 259 n2 Sur: ek rine Se cn HS ie i ad. ‘months at a price of $900/o7 while the buyer is undertaking to bay 100 or of pol in three months at S900i02. ‘One common motivation for entering ino a forward eortret isthe elimination of exsh- ‘ow uncertainty from a Future transaction. La our example, ifthe bayer anticipates a nved {or 100.07 oF gold in threa months ands worried shew price Frictions aver thet peri, ‘any uncertainty about the cash outly required can be removed by entering into a forward ‘contact. Similarly, ifthe seller expects to be offloading 100 or of gold in three months ‘and is concerned about peices that might prevail atthe end of thet horizon, cntsring into a ‘onward contrac: locks inthe Price recived for thet Fture sal, I sor, forward evairacts ny be used bo Fede cashellow risk associated wil fue ‘marke: commitments. Forward contracts are commonly used by importers and exporters ‘worried about exchange-rate uerustioms, investors and borrowers worried about interest- ‘ate fuctuntions, commodity producers and buyers worried abour commodity price huem- ators, and soon, A slightly more complex example ofa deivative isan option. Asin. forward, a option ‘contact too spocifics the terms of a furur trade, but while a forward commits both partis to the trade, inn option, one party fo the contract retains the ight to enforce or opt out of the coolenst. I iis the buyer who has this right, the option is called a eal! option if the sale, a put eption. ‘The key difference between a forward and an option is thst while s forward contract is an instrument for heding, an option provides « form of financial inaurance. Consider, forPRINTED BY. Aldo Cavazos . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. Denuadasrinanceres 4 Chapter tnmdesin ccxarple, a call option on gold in which the huyer has the right t9 hay gold from the asllor ata price of (54y) $000i07 in thos months" time, If the pris of gold fa thees mosths ie syeacer than $900/oz (for example, itis $930/02), then the buyer will exercise the right in the contract and buy the gold for the cantract price of $900. Ilowever, ifthe price in three ‘mouths is ess than $900/07 (e.g. is $880/oz) the buyer can choose to opt vutof the coutiast and, if necessary, buy the gold directly inthe market atthe cheaper price of SHNO/o Thus, holding call option effectively provides the buyer wih protection (“insurance”) ‘against an mrease in the price above tat specified inthe contract even wale slowing the bbuyerto take full advantage of pice decreases. Since tis the seller wit takes the other side of the contract whenever the buyer deeidas to enforce i, it isthe seller who provides this, insurance tothe buyer. la exchange lor providing this protection, the seer will ckare the buyer an up-front fee called the call option premium. ‘Analogously, a zur option provides the seller with insurance against « decrease in the rice. For instance, consider « put option on gold in which the seller has the risat 10 sell foldto the buyer at $900. Ifthe price of gol falls helow $500/er, the seller can exercise the right in the put and sell the gold for $900/0z, but ifthe pre of god rises to more than '$001Ve, them the sell en elec to et tho apo and sel the godt the higher markt price. Holding the put insures the seller against fll:n the price below $900/0z. The buyer provides this incurance and will chazpe an up-front fee, the put premium, for providing this (Options ofr am altemative to forwards for investors concerned about fusure price Fac tuations. Unlike forwards, there is an up-front cost of buying an option (Vz. tke option preauiumn) but, compensating for this, there is ao coupulsion to exercise sf dolig $0 would resul in los. Forwards and options are two of the most ccmmon and important forms of derivatives. tr many ways, Hey are the building blocks of the dervazves landscape. Macy other forms of derivatives exist, some whieh are simple varanls of these sirctures, clhers much more ‘complex or “exotic” (a favorite term inthe derivatives azca for describing something that s not run-of-the-mill or “plain vanilla”), We elaborate on tis Ister inthis chapter and in the rest o the book. But fis, we present a brief disoussion on the differen eriteria that may be used to classify derivatives. Classifying Derivatives A popstar way tn claeify derivatives i tn group them according tn the merging, For txample, an equi derivative is one whose underlying i an equy peice or sock index level a currency oc FX ahor fo fereign exchenge) derive is oae whose underlying is an eichange eis; end soon. Mach of the worlds derivatives radeon jus few common tuderyings. Table 1. shown het inten ote derivatives (derivatives dined on intrest fale oro ieesate- salve sures clas bam) wocoun or alu ball es racket vale ofthe derivatives macket,wita smaller shares being taken by cuency, equi, cornmedy, end rein darian, "While thete ae the most common underyings, derivatives m,n principle, e defined cn ust ahoutany underlying variable Ton asubsantl chur of te growth in dtiatives tmathts i the fist years ofthe 2000s came rom rei derivlines(etvaives dependent on the codt rise of specifed underlying ents), x eaegory of derivatives tha: didnot ven exist in 1990, As noted eater inthis chap, derivatives have also been introduced ‘amber of exaic underlying variables including elececty prices, temperate levels, broadband, newsprint, and mavketvolaiiy Derivaves ean differ srealy in the mame in which they depend onthe undeving, ranging for very simple dependenciesta very complex ones. Nonetheless mostderivativesPRINTED BY. Aldo Cavazos . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. Dematves ences and Pactce Chapter! imraducton 5 fall into ane of two clstox: thoss that involve a enmamioment to a given trade or exchange ‘of cash flows in the future and those in which one party has the cplian to enforee or opt cout ofthe trade or exchange. Incuded in the former class ue derivative securities such as forwards, futures, and saps; derivatives in th latter eless are called eprions ‘Forwards and options hive akesdy been defloed above. Futures contracts are similar to forward contracts excep: that they are traded cn organized exchanges; we discuss the differences more precisely below. Swaps are contracts in whlch the partes commit to mmu?- ‘ple exchanges of cash flows in the futuro, with th cash flaws to be cxckanged calculated ‘under rales specified mn the contract; thus, swaps are Like forwards except wath multiple ‘wansactions to whieh the partis cori. ‘Tables 1.1 and 1.2 use both ofthese schemes of classification, rst breaking down the ‘world derivatives matke: by underlying and then into forwards, swaps, and options. The breakdown reveals some intersting variations. For example, while swaps account forthe ‘area bulk (roughly 80%) of inerest-r:e dervssives, options constitute over 75% of equity derivatives Athiedolassitioation of derivatives ointerestis into over-the-counter (OTC) ar exchange- ‘rade! deevaives. Ovorshe-sonnterdasivatvescommacts an rade hilatemaly etwoen fn ‘counterparties who deal direcly with each othe In such transactions, each pasty takes the credit risk ofthe otser (Le. the risk thatthe other courterparty my default ox the contra). Tivexchange-traded contracts, the partes deal though an organizedexchange, andthe identity ‘of the counterparty is unully not known. Forwands and swaps are OTC: contracts, while futares are exchange traded. Options can be both OTC and exchange traded. 1.1 Forward and Futures Contracts A forward contact is an apreamanthetwoon two paris to made ina spocified quantity of ‘a specified good at a specified price on a specified date inthe fetue. The following basic teeminclogy is used when discussing these contacts + "The buyerin the forward contracts said to have a long postion in the contrac: the seller is suid 10 have a short pesiion. +The good specifedin the contracts calledthe underying assetor, simply, teumderlying. +The date specified inthe contracton which he trade will tke place is called the marurity date of ie vous, + The pre specitied in the contmet forthe trade i ealled the delivery price in te contract. ‘This is the prov at which delivery will be mado by the sller end accepted by the buyes. ‘We will define the important conacpt af «forward price shory. For the mement, we nate Ua du Forward pric is ela (, bul is wot Uae sete concep a, Une delivery pric ‘The underiying ina forward contract may be any commodiy or financial asset. Forward ccontracs may be siriten on foreign currencies, bonds, equities, or indices, or paysic ‘commodities sh as ofl, gold or weet. Forward sontraets also exist om such nderlyings as interest ries or velaility which eaanot be delivered physically (se, for example, the forward-ratecagreements or FRAsdescsibed in Chapt 6, orl forward contracts on market volatility known as variance and volatility swaps, described in Chsper 14); in such cases, the contracts are settled in cash with one side making s payment io the otter based on rules Specified inthe contret. Cash se:tlement is also eommenly used for those underlyings for wich physical delivery is dificul, such as equity indices ‘As has been discussed, «primary motive for entering into forward contracts hedzing: using a forward contract results i lacking-in a prize today for a Future market transaction,PRINTED BY. Aldo Cavazos . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. Denuadasrinanceres 5 Chapter tnmesicn sand this ciminatas cash-flow uncertainty from she transaction. Forsign euraney forward, for example, enable exporters to convert the payments rossived in foreign currency into Ihom: currency at fixed rate. Inerestzate forwaris such as FRAAs enable frms to lock-in an interest rate today fora fotar borrowing ot investment. Commodity forwards such as, ‘arwards on oll enable users ofol te lock-in prises at whieh future pucisses ate cade and refiners of oto loce-in a price at which fate sales are made. Forwant contacts can also be used Zorspeculaion, that i, without an undeslylag expo sure alvady existing. An investor who fools thatthe price of somo underlying is Hikly to amcrease can speculate on this view by entermg mo a long forward contract on that under- lying. I°pricas do go up as anticipated, the investor can buy te asset at the lockec-in price on the forward coutact and sell at the higher price, making a profi. Similarly, an investor ‘wishing to speculate om falling prices can use s short forward contract for this purpose. Key Characteristics of Forward Contracts Fourcharstersis of forward contmots deserve special emphasis because these are exactly the dimensions along whieh forwards and fares die: + Fist, a forward contact isa bilateral contrac: That is, the terms of the contract are ‘negotiated directly by the seller and the buyer. + Second asa consequence, a forward contract is customizable. Thal i, the terms of the comet (marity dare, quality or grade ofthe nlrlying asset, ot) ean be “one tothe needs atthe hiyer and sell + Thin, these is possible default risk for hath partis. Fach party takes the risk tha the toh my fil o perfor on Ee wor + vourth nether party can walk away untletealy from the contractor transter its rights ‘and obligations inthe contmet unilaterally to athied party. ‘We return to these characteristics when discussing futures contracts Payoffs from Forward Contracts ‘Tae payor ftom 3 forward contract is the profit or loss made by the two partos to the contact. Consider an example. Suppose a buyer and seller enter mo a forward contract ‘on astock with a delivery price of F = 100. Let Sy denete the price of the stock on the maturity date T. Tae, on date 7, + The long position is buying for F = 100 an asset worth S;. So the payofT to the long, position is; — 100, Thelong position mukesuruftif'S, > 106, hut hye iS; < 100. +The short postion is selling for F = 100 an asset worth 8. So the payailto the stort position is 100~Sy. The short positiomekes aproitif Sy = 100, butloses if S> > 100, or example: + IS; = 110, den the long is buying for 100 an asset worth 110, so gains 10, ut the short is selling for 100 an asset worch 110, so Toses 10. + If; = 90, the long is buying for 100 an esset worth only 90, so loses 10, while the short is selling for 100 an asset worth only 90, 20 gains 10. ‘Table 1.3 describes the payoff to the two sides for some other values of J. Teo points fahout these pays should be noted. Fist, forwarcs (like all derivatives) are zen-um instruments: tne profits made by the loag come atthe expense of th short, and vie versa ‘Tae sum of the payoffs of the long and short is always zero. This is unsurprising. Except when the delivery price F exactly coincides withthe time-T price 5, of the underlying, a forward coatraet involves aa off-market tmade (ie, 0 trade at a different price tun thePRINTED BY. Aldo Cavazos . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. Dematves ences and Pactce Chapter imation 7 TABLE 1.3 The “This able dscbes he payato te long and shor pestons Es onthe maturity date F ota forward contract with a devery price of 100. 5; —— Ste pice a the underlying asset on date T. Time-T Price 5+ Payoff to Lona Payot to short 70 10 +30 30 =20 +20 90 “10 #10 prevail ack pre) In ay earl Ue, Une beet ued is easly eu 0 the loss raken by the other. Second as Figure 1.1 ilastates, fronds are “near” derisive. Every $1 increase the price §; of the underlyingat date 7 inreases the pay ofthe long position by $1 snd reduces the payols ofthe shot position by SL Linas isa consequeaee of commiting to the trade specified in the contract. n contrast, swe will ee options, whichare characterized by their “optonaliry” concerning the trade, are findsmentallynon‘inear instruments, nd this makes their valuation nd risk management much ticket. What Is the “Forward Price”? ‘By convention, neither party pays anything to cater into s forward comract. 0 ihe delivery ice inthe conracissetsothat the contract has zero value to both parties. This “breakeven” Aelivery price isealied the rsd price FIGURE 1.1 ‘Te Hgurestons theo nun short postions onwards Ar “Linear” onthe matusty date 7 ofa forwaed contact with delivery Deslvaves rico F as the time-T priv > of the undeciying assetPRINTED BY. Aldo Cavazos . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. Denuadasrinanceres 8 Chapter! tnmesin Te the forward price a well-defined eorcept? That in isi chvious that there ia only oma breakeven delivery price? At fit glance, it appears not. Certainly, itis true that i the delivery price is set very high, the short will expect to profit from the contract end the ong, to lose; tat is, the contact will have postive value :0 the short and negative value to the loug, Sunilaiy if the price is set tov low, the conuast will have postive value to the long, (wna l expect to prfit from having access tothe asset at an excessively low price) end ‘negative value tothe sheet. But I is no: obvious bat between these exizemes, where is oaly ‘one possible breakeven delivery price at which both parties will epre the contacthas zero value, Inhutiely, appears that such idiosynerati factors as nsk-aversion and ourlooks ccongerning the macket ought to mater In Chapte: 3, ve examine tis issue. We show thet under fatty general conditions, the forward price is in fact, 8 well-defined concept and that regardless of attudes to risk and other factors, everyone must agree on the breakeven delivery price. Possible violations of these conditions and their consequences for the pricing theory are examined in Chapter 4. ‘Tae principal assumption we male there, and threuglnoat this book, is that markets do not peritarkitrage. The no-arhitrage assumption is just the minimal requirement thatidentical ssots er ashes asst must faa domes prions Futures Markets A fitures contracts, in sven, farward contact that is taded on an organized exchange. [Dut while futures and forwards are functionally similar (Le, they serve the same economic. purpose), the involvement of the exchange results in some important diferences between, thei, Fist, in 2 futures contract, buyers and sellers deal hough the futures exchange, aot lett, Buyers submit buy orders to the exehange, sellers submit sell orders, nd these are matched vis the exchange. The counierparies are unbkely to know each others ‘densities Second because buyers and sellers do not meet, futures contracts aust be slandardized ‘Standardization coves the sot of possible delivery dates and delivery locations, the size of fone contract, ard the quality or grade of the underiving that may be delivered under the contact, ands one of the most important functions performed by the exchenge. ‘Thi, counterparties are not exposed to eav ethers default risk. Rather, the exchange interposes itself between buyer and seller and guarantees performance on the contracts. (This is nenessary bonus the counterparties have na way a gaging each other's credit isk.) Thus, each party to 2 futures trenssction is exposed only tothe defeult risk of the ‘exchange. In well nun futures exchanges, this riscis gexerlly very ow. Fourth, an investor may, al any time, elose out ar reverse a furs position. Closing, ‘out involves taking an apposite positon to the original one. For exumpic, if che investor ‘as ndially long 10 Cutures wontracts in yo for delivery in March, clesiny ul involves taking short positions in 10 furures contracts for delivery in March. These positions are netted agains exc: other, and as fi as tre exchange is concerned the investor has no net ‘obligations remaining. Ff, having guaranteed performance on the futures eantaes, the exchange must put sefequards in place to easui it aot called upon te honor its guarante: too offen. That is, itmust ensure thatthe partes to the comtact do 2ot default in the first place. For this purpose, 2 system based on the use of “margin accounts” (ea, ‘performance bonds”) are ‘commenly used. ‘Table 1.4 sumuatizes these maia diferences between futures and forwards. The insti= tutional features of futures markets are designed to enhance the integrity and liquidity of the market, thereby making it more atcsve to participants. Hevwever, they also Fave eco ‘nomic consequences. For example, futures priees—the breakeven delivery prices for futuresPRINTED BY. Aldo Cavazos . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. Dematves ences and Pactce Chapter induction 9 TABLE 1.4 eee Giterion Futures Forwards Forvardsand Faures -Suyersller interaction Via exchange Direct Contract tems Standardized Can be taiored Unilateral reversal Possible Not possible Defaults bome by Exchange Individual partes Default controled by Margin accounts Collateral ‘contmcts are typically close to, but do nat quite coincide wit, forward prises because of these ullfereuces, es Chapter 3 discusses. 1.2 Options An eplion’ a financial security that gives the buyer the right (put not the obligation) to buy ‘or soll a specified asst ata specified priee on or before a specified date. Tn dealing with ‘options, we adopt the following terminology: ‘+ Buyer = Holder = Long Postion: The buyer ofthe option, also called the holder ofthe option, is said to have along position inthe option, + Seller — Writer — Short Postion: The eller ofthe option, also called ‘option, is said to have a short position in the option. + The wel specified in Gee option contrac i calle the underlying asset or simply Wie iter of re uaderising. + The price specified in the contract is called the strike price or the exerve price of the option, +The late specified in the contract ix called the maturity date the expination dato the option, We differemtiate between options aloag two fundemeatal dimcasions: *+ Calis vs. Puts I the option provides the holder with the ight to lute underiying asset atthe specified strike price, we eal ita call option. I she option provides the holder with the right to sell the underlying atthe specified sake price, iis aput option, + American vs. Ruropean If the right i the option can be exercised at any time on or ‘ure the maturity date itis called an American-wtye (or simply, Amerioan) option. IF the sight can be availed of only on the maturity date, i is called @ Eurupeanstyle (ot simply, European) option. American options are generally more valuable than otherwise ‘dential European ores. ‘Traditions call and pat options, whether European or American, are refered to as plain ‘vant (or just vanila) options. Options thae aie rom plain vanilla options any way are ctlled exotic options. Reemadsn options are an example: in a Rermudén cption, exercise i allowed on any one 07a set of specified dates. Nor quite as vluable as American options, Wich may be exercised at any time, they are more Valuable than European options, which may be excrcsed only at maturity. (Options cam be written on any esse, though financial options are the most common. ‘Options on equities, equity indices, and Toreign currencies are aded oth inthe over-Tie- ‘counter mazket zndon exchanges. Options on inverest rates come in many forms. Exchange- ‘traded interest-rate options include opsions on bond futures (.c., the option is writen on fa futures contrast tha, in turn, is written on an underlying bond). n the everthe-courter ‘market, popular interest-rate options include cups and floors, which are options writenPRINTED BY. Aldo Cavazos . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. Denuadasrinanceres 10 Chapter nace directly on Lond Intarhank Offered Rates (“Libor”) rates, and swaptions, which are ‘options on interest ate swaps. In addition to options que options, many financial secures are sold with embedded options A commen example is a caliable bord. A callable bond is a head issued by a corporstion or other eatiy that muy be purchased back bythe issuing eatiy under specified cconditionsat fixed price. Thus, nesllable bonds combination of astraight nnd an acl ‘option that gives the isulng entity the sight to buy back (or “call” de bond under speciiied conditions ata fixed price. A mare complex example is a comvernble Bond. A convertible bbondisa bond issued by a company ths: may be converted, st the holders option, mo shares ‘of equi of the issuing company. Convertible bonds in the United States are usualy also callable, so both the issuer and the buyer of the bond hold optioas. Embedded optioas are also present in more mundane securities, Inthe United States, for example, mortgages may be prepeid at any time, usually without penalty at the morigage-bolder’s option. As ciscussed earlier inthis chepter, an option is «form of financial insurance. Since an option comes witharight but notan obigation, the helder ofthe option wll exercite it only iffitis in his interest todo so. Thus, the option protets the holder against ownside risk, bat Dowie Fl upside potential in oxchamge for providing this insurance, the yar of Pe op tion makes sn up-front payment tothe writer called the option price or the opticn premium. 1.3. Swaps ‘A swap ta tater! contract between two counterparties that calls tor period exchanges ‘of cash flows on specified daies and oaleulated using specified rules, The swap eontmct specifies (a) the dates (say, 7, Ts,.-., Jz) on which cash Lows will be exchanged and () the rules according to which che eash flows due ftom each counterparty on these dstes, ‘recalculated. Importantly the frequeney of payments forthe two counterpartiesneed not be the same. For example, one counterparty could be requized to make semiannual payments, while the other makes quareriy payments. ‘Swaps ate differentiated by the underlying mackets to which payments on one o: both legsareFinked (The “leg” nf a sp refers to tho cash Flow pd hy = commrerpamy Tha, euch swap hat two les.) The langest chunk ofthe swaps market is occupied by intoreet rate swags in which eoch leg of the swap is ied to a specific interest-rate index. For example, fo log may be ted 1 a loating interest ate such as Libor, while ths other log may specify afixed interest-rate (¢g., 8%). Other imporant exzegories of swaps include: + Currency swaps, in whieh the two legs ofthe swaps are linked to payments in diferent curtencies. For example, the swap may require the exchange of US dollar (USD) payments calculated on the bass ofthe USD-Libor rate for Euro payments calculated besed on a Feel mers + Rguity swaps, in which one log (or both logs) of the swap is linked to an equity price oF cquity index. er ccample, the swap may cal fr the exchange of annval returns on the ‘SAP 500 equity indes for interest payments computed using a xed intesest sae. + Commodity svcps, in which one leg of the swap is linked to a commodity price. For ‘example, te swap may cll for an exchange ofthe price of ol (observed onthe payment dates) egainsta fixed dollar amount * Cros linked swaps (especially credit cefelt swaps) in which one Ie of the swap is linked to occurrence of a credit evert (e.g. default) on a specified reference entity Uses of Swaps ‘Swans are among the mast versatile of financial instruments with new uses heing discov ered (vented?) almost every dey. A principal source of swap utility is tha: swaps enablePRINTED BY. Aldo Cavazos . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. Dematves ences and Pactce Chapter tonmdacion 1 ‘converting the exposure to ome marct ina exposure to another market. Consider, forex ample, a three-year equity swap in which + One counterparty pays the returns on the S&P S00) on a given netiona principal P. +The other eounterrarty pays a fixed rate of interest on the same principal P In such a swap, the first counterparty inthis swap is exchanging equity-market retumns for interest-rate returns over this three-year horizon. An equity-fird manager who enters this swap is converting his equity returns into Fxed-inoome returns though the swap. The second counteparty & doing the opposite exchange. A fixed-income manages who takes this side ofthe swap is comvering his fixed-income exposure into equity exposure. Tr similar vein, an interest rate swap thet involves (say) the exchange of Libor for a {xed rate of interest enables converting Joaling-rate interest exposure to Axed sates and vioe versa: a currency swap that requites the exchange of (ay) USD payments hased on USD4t hor fr Japanese yon (IPY) payments based on IPY. Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. Denuadasrinanceres 12 Chapter maui 2. Use futures, It can entr into a shor: Futures contract and commit to sling the euroe at fine price. 3. Use options. ft can buy a put option contract that gives ft the right to sell the euros reoeved ata specified suk price, ‘Tokeep things simple, we ignore "basisrisk” issues, ie. possible mismatcheseoncemning the delivery dates ofthe futures and options contracts, and the date the company will receive the money, [fhe company éecidesto go with futures, it will use the euro futures contractsavailableon the Chisago Mercantile Exchange (CME), Like all futures contracts, these are standardized ceonLaats. One Futures eumtrat ells forthe short position ta deliver 125,000 euros. Taha Ue ealire exposure of 25 snllioa euros, Ge company mus Lberefore lke a srl pesitiva in 200 March futures voutra's. Finally, suppose thet en Decetaber 13, dhe futures price (USD/EUR) for March expiry is 1.0328; this is the xed exchange rete the compary can lock nif at decides to use the futures contact. Inthe eompary decides to use options, will use the euro aptions contract evasianle on the Philadelphia Exchange (PHLX).One options contrat on the PHLX calls fr the delivery (0 62,500 euros, soto cover the full emourt of 25 million curos,atotsl of 400 contracs with ‘March expiry must be used. A final decision the compaay must mske concerns tie choice of strike price. Suppose thatthe company has decided to use a srike price (USDVEUR) of 1103 and that a put option with @ sike of 1.03 and March expiry costs USD1,056.25 per ‘contact. Then, if tae company decides to use options, the total uty recuired is USD (400 x 1,056.25) = USD422,500.00 ‘Dillusrate the impact of the different akernatives, we vonsider two ossbie exchange rates (U/SD/EUR}in March: (a) 0.9928 and (b) 0728, The folowing table surmmerizes the ‘USD cesta low in March from each ofthe tive alternatives, Note thatthe opioas cash Dow docs not include the intial cash outlay of USD 422,500. The payoffs are obtained in the ‘obvious way. For example, under the do-nothing wiemative ifthe spotrate of $0.9928/euro ‘were to prevail, the cashflow thst results is 25 million x 0.9928 = $24.82 million. Alternative $0.9928/0uro $1.9728/euro Da nerhing 2482 rion 26.42 milion Futures contract 25.82 millon 25.82 milion Put option 25.75 milion 26.82 milion ‘There er thoe important criteria under which wie may compare the altmatves 1. Cashflow uncerianty. This is maximal foe the do-nothing altecaative, intermediate for the option contact, and least forthe futures coatract. 2. Upsoat cast. The do-nothing and Futures contrast alternatives cost nothing, However, ‘ete isan up-front cost of $422,500 for entering into the option contract. 3. xercise-ime regret. With an option contract, exerese-time outcomes ae guarantzed 10 ‘be faverale(HFthe USII/EUR exchange rte is greater than the strike rae, the option $8 allowed to lapse; otherwise its exeresed). With the othe two alternatives, this is not the case: + Inthe do-noihing case, a “Tavorable” spot price movement (ce. the high USDEUR cexchangerat of 1.0728) isbenefcial, tan “unfevoratle” spot price movement (the Tow USD/FUR exchange rate of 0.9928) hurtsPRINTED BY. Aldo Cavazos . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. Dematves ences and Pactce Chapter tonne 13 TABLE 1S a es se ne ee ikem c= ar tis ica Be cy ce # + lu the futwes contac, the igh spot exchange tate urs (e cannot take advantage of it because the delivery price is locked-in); however, the low spot exchenge rate eaves us off for having locked in higher rate ‘Table 1 summarizes this comparison. The key point thet emerges here is that there is no outcome that is dominant, i, that is beter in all eireumstances. Doing nothing is sometimes better than using futures or options but sometimes not (Inasense,deing aathing ‘ig ukin to hating on a faverable movement in procs, inthis ease, om the TSDYEUR mate increasing, Like all speculation, this bet can ge wrong.) Using futures provides cash-flow ‘poniol, but the ex post eutvome may aot always look goud. For iastauce, if te exchauge ‘ate moves to$1,0728/eura, the company is worse off forhaving hedged using ftures—end iis useful to keep in mind here that regardless of our ex ante intentions, we are almost abays judged inthis world on ox post outcomes. Usirg options provides protection but involves a substantial up-front cost ‘hat may not be recouped by the gains from exerising the option —and thats fully lost the opton lspses unexercised. Derivatives in Speculation ‘he preceding example dealt watn hedging: the reduction of cash-ow uncetsinty from a prior market commitment. Derivative securities ean also be used to speculate ie, to make profits by aking views on maiket direction. ‘Suppo, for exzmple, that an investor believes tha the aparese yen (PY) willppreciate significantly with zespoc: to the US dolla: (USD) over the neat tree months. The investor ‘can spevulste on this belief using derivatives inst least two ways: 1. By taking 2 long posilion in JPY fuures deliverable in nev mal 2. By buying a all option on JPY with aa expiry dat in three months. (CThore is also the third alternative of buying the JPY in the spot market today and holding ‘tor three months, hut this seategy docs not involve the use of derivatives.) Tn heth eases, le investor mikes uiouey {Fis belie is vindicaled, aa Use yea appaccia ee expected, ‘With the futures contrac, the investor has locked-in price forthe future purchase of yen; any merease in price of Yen ener his locked-in rate results fm a pratt. With the call option, the invester has the rightto uy yen ata fixed price, vz. the strike price inthe contact. Any increase in the price of yen above this strike resulls in exerwse-time profits forthe invesior However, there are costs to both strategies. la the case ofthe futures, the cost is thet the anticipated appreciation muy fil tobe zealize; ifthe price of JPY instead falls, tho futures ‘contact leads to a loss, since it obligates the investor to buy yen atthe higher locked-in pice. In the case of options, the up-front premium paid i lst if tre yen depreciates and the option lapses unexereised; but even i the option is exereised, the profits al exercise time ‘may no: be sufisent to make up the cos ofthe premium. Thus, once again, there is no one hese" way to use derivatives t exploit a market view.PRINTED BY. Aldo Cavazos . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. Denuadasrinanceres 14 Chapter tact 1.5 The Structure of this Book ‘Tae main body of this book is divided into five (anequal) parts with a sixth technics! part supplementing the mater Part 1 ofthe hook (Chapters 2-6) deals with Tuures and forwards. Chapter 2 diseusses futures markets and their institutional features. Caapters 3 and 4 deal with the pricing of futures and forward contracts. Chapter 3 develops ‘he pricing theory, while Chapter 4Iooks atthe empirical performance of the theary and discuses extensions of the basic theory (Chapter Sis concemed with hedging strategies in futures and forward marcets, in partcelr the development and implementation of miniasem-variance hedging strategies in tuations in which 2 pesfect hedge is impossible because of @ mismatch betwoea the sak being Ihedged and the available futures or forvard contracts. Chapter 6 looks ata spevial class of futures and forward contracts —thoze defined on interest rates or bood prices, a category ‘that includes some of the most suocessful coniacis ever introduced, including eucodollar futures and Tressury futures Part2, which deals mainly with options, isthe ‘ongest segment ofthe hook, crmprising (Chapters 7-22. Chaptors 7 and 8 cover preliminary material, including the role of volatility and a discussion of commonly used “trading stategis.” Chapters 9-16 are concerned ‘with option priving, beginning with no-arbitrage sesrietions on these pres (Chapter 9) and pus-call parity and rested results (Chapter 10). Chapter 11 then provides a gentle Inzeduction wo option pricing and is key coneeps (such as the ogton dela and esk-neuial Pricing) Building on this foundstion, Chspters 12 and 13 develop the binomial model of option pricing, winle Chapters 14 and 19 present the Black-Scholes model. Chapter 16 discusses several generalizations of the basi hincrnil/Black-Seholes approach inelading jump-dilfusions, stochastic volaility/GARCH-based models, and local volatility madels. ‘Moving from pricing to the management of optioa risk, Chapter 17 looks atthe “option saeeis,” measures of option seasitvity to changes in market conditions, Chapters 18 and 19 move this diseussicn heyond the realm of pain vanillaoptions. Chapter ISeximines arange ‘of “path-indeneneient” exotic options, while Chapter 19 stues “path-dependent” exotics ‘Theremainder of Part2iooks at special topics. The measurement portfolio risk andthe eancep of Vist-Risk (oe Hak) atl risk-budgeting arc intrducedin Chapter 70, Convert= ‘le sonds and theic pricing and hedging are the subject of Chapter 21, Finally, Chapter 22, examines the field of ‘real options” optionalities ersbedded within investment projects. Port 3 of the book (Chapters 23 25) examines swaps. Chapter 23 looks at interest mute sways, which constitute the great bulk the swaps market, The workhorse of the interest ra sap ork, the plain vanilla xed-or-fouting swap, is examined in desl, ws are soveral others. This chapter also inroduces caps, floors, and swaptions, and presents the so-called “market model” commonly used to value these instruments. Chapter 24 moves fn to equity sweps, them uses, pricing, and hedging, while Caper 25 completes the sa ‘material with a discussion of currency and comma swaps. As we noted in the Preface, ‘athe: products that hea the “swaps” moniker are discussed elsewiere inthe book: volatility and variance swapsare discussed inthe chapter on the Black-Scholes model, andtoxl return ‘swaps and credit default swaps are discussed in the chapter on credit derivative products. art 4 of the book (Chapters 25-30) deals with interestrate modeling. Chepters 26 ancl 27 deal with the yield eurve and its construction (i.e, estimation from the dats). Chap tee 28 provides a geatleinteoductioa te term-steucture modeling aad its complications znd discusses te diferent clases of temn-stracture models, Chapter 29 presents several well- known “facter models” of interest rates. Te begins witha detailed presentation of two well- kkaown members of the “norarbitrage” class of tenmstructure models from the 1980s andPRINTED BY. Aldo Cavazos . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. Dematves ences and Pactce Chapter! tonnducioe 1S cxrly 1990s, namely the medals of Ho and Te (1986) and Black, Derman, snd Tay (1992) “Ther, it develops one-factor and multifactor models of interest fates, including, a apocial cases, the models of Vasicee and Cox-Ingersoll-Ross, among others. Finally, it presents the important result of Duffie and Kan (1996) on “affine” term-stucture models. Build ing on this background, Chapter 30 develops the two classes of models that have formed the backbome for mach of the maxleling of interest-rate risk in practice: the framework of Heath-Jartow-Morton and that of the Libor and Swap Mazket models. Part Sof the book (Chapters 31-34) deals with credi-risk modeling and credit deriva ‘aves. Chapter 31 mtreduces the many classes of credit denvatives snd discusses thei uses. ‘Chapters 32 and 33 deal with credit risk measurement. Chapter 32 deals the class of mod cls that comprise the “structural” approach to creditisk extraction, while Chapter 33 does likewise for the “‘redueed-form” approach. The structural and reduced-form approaches are ‘concerned with extracting information sbout the defsultrisk of am individual entity from the market prices of traded securities issued by ths: entity. Chapter 34 discusses the modeling of correlated default, of modeling default risk at the portfolio level rather than atthe level ofthe individual entity. art 6, the final pst af she honk, deals with ermputationsl mothods, Chapter 35 laoks at the method of fnite-differencing, and Chapter 36 describes Monte-Carlo methods. An introduction to the programming laaguage Octave, a freeware version of Marlab that we use throughout the book for illustrative purses, may be found in Chapter 37 Case Studles ‘Tae book provides amumber of ll-ength casestudies, These studiesinclude therise and fll ofthe GNMA-CDR futures contract, the frst interest-rate futures centract tobe introduced fon a futures exchange: the Procier & Ciamble-Hankers Trust scandal af the 1990s: and the sagas of Amacanth, Rarings, LTCM, and Metallgesellechaft, major derivatives disasters all Shorter eaar studies are alan scattered throught the book, especially to assist in highlighting specife points. In addition, the wehsite of this hook (wwwmbhe.comisdl<) contzins a numter of other case studies including the stores ofthe Ashanti Gold hedge that {iled, Oronge County's 1994 baniruptey, Suniiomo Corporsion's huge eopper losses he ‘SonoF-Boss tax schemes, and the AIG debacle of 2008, among others, 1.6 Exercises 1. Whatis «derivative secwity? 2. Give an example ofa security that is not derivative, 3. Can a darivaive acerity he the underlying for another darivative security? Its, give sus example, Lak, explain why al 4. Derivatives may be used for both hedging and insurance. What isthe difference in these ‘wo motives? 5. Define arsed eonirac Explain at what time cash lows ae generated for this contret. How is sottlement deteemincd? 3. Explain who bears defbult risk in a forward contrac, ‘What risk is boing mauagod by wading derivatives on exchanges?” ‘Explain the difference botwomn a forvanl contact and an option. What isthe diference between value and payolT inthe context of derivative securities?PRINTED BY. Aldo Cavazos . Pitng Is for parsnal private use only No part ofthis book may be eproduced ar tansmited without publishers Prior ermisson. Viottrs willbe prosecute. Denuadasrinanceres 16 Chapter! tnwaducton 10, What i: a short postion in forward contre? Draw the payoff diagram for a short postion ata forward prize of $103 i the possible ange ofthe underlying stock price ie $50-150, 11, Forward prices may be derived using the notion of absence of atbiuage, and market celliciency is not necessary. What isthe difference beoween these two concepts? 12, Suppose you are holding a stock position and wish to hedge it. What forward contact ‘would you use, a long or z short? What opion contact might you use? Compare the forward versus the option on the following three criteria: (a) uncertainty of hedged ‘sition cashflow, (b) up-frot cash flow, and (c) maturity time regret. 13. Wht derivatives srategy might you implement if you expeoted a bullish rend in stole prices? Would your sumegy be different if you also forcest thatthe vouility of stook. prices will dp? 14, What are the underlyings in the following derivative contacts? (@) A life insurance contract, () A home mortgage (©) Employee stock options. @ Arte leckcina home loan. 15, Assume you have s portfolio that consins stocks tht traci the market index. You now ‘want fo change this portfolio to be 20% in commodities und only 80% in the manket ‘index. How would you use decvatves to implement your strategy? 16. Tn the previous question, hw ds yous implement the same trading idea without using, futures contacts? 17. You uy a furs contract on the S&P $00, Is the correlsion with the S&P 510 indox positive ornegative? Ifthe nominal value of the cortractis $100,000 and you arerequized ‘tw post $10,000 as margin, how much leverage do you Lave?