Derivatives Demystified

Acknowledgements xix

1 The Origins and Growth of the Market 1

Definitions 1

Derivatives Building Blocks 1

Market Participants 3

Supporting Organizations 4

Early Origins of Derivatives 5

Derivatives in the USA 6

Overseas Developments, Innovation and Expansion 7

An Example of Recent Innovation: Weather Derivatives 7

Temperature-Linked Derivatives 8

The Wild Beast of Finance? 9

Lessons from Recent History 10

Creative Destruction and Contagion Effects 13

The Modern OTC Derivatives Market 13

The Exchange-Traded Derivatives Market 15

Chapter Summary 15

2 Equity and Currency Forwards 17

Introduction 17

Equity Forward Contract 17

The Forward Price 18

The Forward Price and Arbitrage Opportunities 19

The Forward Price and the Expected Payout 20

Foreign Exchange Forwards 21

Managing Currency Risk 22

Hedging with an Outright Forward FX Deal 23

The Forward Foreign Exchange Rate 24

The Forward FX Rate and Arbitrage Opportunities 25

Forward Points 26

FX Swaps 27

Applications of FX Swaps 28

Chapter Summary 28

3 Forward Rate Agreements 31

Introduction 31

FRA Case Study: Corporate Borrower 31

Results of the FRA Hedge 33

The FRA as Two Payment Legs 34

Dealing in FRAs 36

Forward Interest Rates 37

Chapter Summary 37

4 Commodity and Bond Futures 39

Introduction 39

The Margining System and the Clearing House 39

Users of Futures Contracts 40

Commodity Futures 41

Futures Prices and the Basis 42

US Treasury Bond Futures 43

US Treasury Bond Futures: Delivery Procedures 44

Gilt Futures 45

The Cheapest-To-Deliver (CTD) Bond 45

Chapter Summary 46

5 Interest Rate and Equity Futures 47

Introduction 47

Eurodollar Futures 47

Trading Eurodollar Futures 48

Hedging with Interest Rate Futures 50

Interest Rate Futures Prices 50

Equity Index Futures 52

Applications of S&P 500 Index Futures 53

FT-SE 100 Index Futures Contracts 54

Establishing Net Profits and Losses 55

Single Stock Futures (SSFs) 56

Chapter Summary 57

6 Interest Rate Swaps 59

Introduction 59

Interest Rate Swap Structure 59

Basic Single-Currency Interest Rate Swap 60

The Swap as a Package of Spot and Forward Deals 61

Rationale for the Swap Deal 62

Swap Terminology and Swap Spreads 62

Typical Swap Applications 63

Interest Rate Swap Variants 64

Cross-Currency Interest Rate Swaps 65

Net Borrowing Costs Using a Cross-Currency Swap 66

Inflation Swaps 67

Chapter Summary 68

7 Equity and Credit Default Swaps 69

Introduction to Equity Swaps 69

Equity Swap Case Study 69

Other Applications of Equity Swaps 71

Equity Index Swaps 73

Hedging an Equity Index Swap 74

Credit Default Swaps 75

Credit Default Swap: Basic Structure 76

Credit Default Swap Applications 77

Credit Spreads 78

The CDS Premium and the Credit Spread 78

Pricing Models for CDS Premium 80

Index Credit Default Swaps 80

Basket Credit Default Swaps 81

Chapter Summary 82

8 Fundamentals of Options 83

Introduction 83

Definitions 83

Types of Options 83

Basic Option Trading Strategies 84

Long Call: Expiry Payoff Profile 85

Short Call: Expiry Payoff Profile 87

Long Put: Expiry Payoff Profile 88

Short Put: Expiry Payoff Profile 90

Summary: Intrinsic and Time Value 90

9 Hedging with Options 93

Chapter Overview 93

Futures Hedge Revisited 93

Protective Put 93

Hedging with ATM Put Option 96

Covered Call Writing 97

Equity Collar 98

Zero-Cost Equity Collar 99

Protective PUT with a Barrier Option 100

Behaviour of Barrier Options 101

Chapter Summary 102

10 Exchange-Traded Equity Options 103

Introduction 103

Basic Concepts 103

CBOE Stock Options 104

UK Stock Options on NYSE Liffe 106

CME S&P 500 Index Options 107

FT-SE 100 Index Options 109

Chapter Summary 109

11 Currency or FX Options 111

Introduction 111

Users of Currency Options 111

Hedging FX Exposures with Options: Case Study 112

Graph of Hedged and Unhedged Positions 113

Hedging with a Zero-Cost Collar 114

Reducing Premium on FX Hedges 115

Compound Options 116

Exchange-Traded Currency Options 117

Chapter Summary 118

12 Interest Rate Options 119

Introduction 119

OTC Interest Rate Options 119

OTC Interest Rate Option Case Study 120

Hedging a Loan with a Caplet 121

Interest Rate Cap 123

Interest Rate Collar 123

Interest Rate Swap and Swaption 124

Summary of Interest Rate Hedging Strategies 125

Eurodollar Options 126

Euro and Sterling Interest Rate Options 127

Bond Options 127

Exchange-Traded Bond Options 128

Chapter Summary 130

13 Option Valuation Concepts (1) 131

Introduction 131

The Concept of a Riskless Hedge 132

A Simple Option Pricing Model 132

Option Fair Value 134

Extending the Binomial Model 134

Cost of Dynamic Hedging 135

The Black-Scholes Option Pricing Model 136

Historical Volatility 137

Measuring and Using Historical Volatility 139

Chapter Summary 140

14 Option Valuation Concepts (2) 141

Introduction 141

Problems with Historical Volatility 141

Implied Volatility 142

Black-Scholes Model Assumptions 143

Value of a Call Option 143

Value of a Put Option 144

Equity Index and Currency Options 145

Pricing Interest Rate Options 146

Chapter Summary 148

15 Option Sensitivities: The ‘Greeks’ 149

Introduction 149

Delta (Δ or δ) 149

Delta Behaviour 150

Delta as the Hedge Ratio 151

The Effects of Changes in Delta 152

Readjusting the Delta Hedge 153

Gamma (Γ or γ) 153

Gamma and the Spot Price of the Underlying 154

Gamma and Time to Expiry 155

Theta (Θ) 156

Vega or Kappa (κ) 157

Rho (ρ) 158

Summary of Greeks 159

Chapter Summary 160

16 Option Trading Strategies (1) 161

Introduction 161

Bull Spread 161

Bull Position with Digital Options 162

Spot Price and Con Value 163

Bear Spread 164

The Greeks for the Bear Spread 165

Put or Bear Ratio Spread 166

Long Straddle 167

Long Straddle Current Payoff Profile 168

Potential Risks with a Long Straddle 169

Chapter Summary 170

17 Option Trading Strategies (2) 171

Introduction 171

Chooser Option 171

Short Straddle 172

Short Straddle Current Payoff Profile 172

Potential Profits with a Short Straddle 175

Managing the Risk on a Short Straddle 175

Short Strangle 177

New Ways of Trading Volatility 177

Calendar or Time Spread 178

Chapter Summary 179

18 Convertible and Exchangeable Bonds 181

Introduction 181

Investors in Convertible Bonds 181

Issuers of Convertible Bonds 182

CB Measures of Value 183

Conversion Premium and Parity 184

Other Factors Affecting CB Value 185

Convertible Arbitrage 186

Convertible Arbitrage Example 186

Profits and Risks with the CB Arbitrage Trade 187

Mandatorily Convertibles and Exchangeables 188

Structuring a Mandatorily Exchangeable (ME) Bond 189

Chapter Summary 190

19 Structured Securities 193

Introduction 193

Capital Protection Equity-Linked Notes 193

Expiry Value of 100% Capital Protection Notes 195

100% Participation Equity-Linked Notes 196

Capped Participation Equity-Linked Notes 197

Average Price Notes 199

Locking in Interim Gains: Cliquet Options 200

Securitization and CDOs 201

The Basic CDO Structure 202

Rationale for Securitization 203

Synthetic CDOs 203

Chapter Summary 205

20 Clearing, Settlement and Operational Risk 207

Introduction 207

Risk Management in General 207

Settlement of Exchange-Traded Derivatives 208

Major Clearing Houses 209

Confirmation and Settlement of OTC Deals 210

Controlling Counterparty Risk on OTC Derivatives 211

Operational Risk 211

Best Practice in Operational Risk Management 213

Chapter Summary 213

Appendix A: Financial Calculations 215

Appendix B: Exotic Options 235

Appendix C: Glossary of Terms 239

Index 255