Essays in Derivatives

DON M. CHANCE holds the William H. Wright Jr. Endowed Chair for Financial Services at the E. J. Ourso College of Business Administration at Louisiana State University. He was formerly the First Union Professor of Financial Risk Management at the Pamplin College of Business at Virginia Tech. Prior to his academic career, Chance worked for a large southeastern bank. Professor Chance has had numerous articles published in academic and practitioner journals, is often quoted in the media, and has an extensive consulting practice. He holds a PhD in finance from LSU and is a CFA charterholder.

• Preface to the New Edition xiiiPreface to the First Edition xvSECTION ONE Derivatives and Their Markets 1ESSAY 1 The Structure of Derivative Markets 3ESSAY 2 A Brief History of Derivatives 7ESSAY 3 Why Derivatives? 15ESSAY 4 Forward Contracts and Futures Contracts 25ESSAY 5 Options 29ESSAY 6 Swaps 33ESSAY 7 Types of Risks 37SECTION TWO The Basic Instruments 41ESSAY 8 Interest Rate Derivatives: FRAs and Options 43ESSAY 9 Interest Rate Derivatives: Swaps 49ESSAY 10 Currency Swaps 53ESSAY 11 Structured Notes 57ESSAY 12 Securitized Instruments 61ESSAY 13 Equity Swaps 67ESSAY 14 Equity-Linked Debt 71ESSAY 15 Commodity Swaps 75ESSAY 16 American versus European Options 79ESSAY 17 Swaptions 83ESSAY 18 Credit Derivatives 89ESSAY 19 Volatility Derivatives 95ESSAY 20 Weather and Environmental Derivatives 99SECTION THREE Derivative Pricing 103ESSAY 21 Forward and Futures Pricing 105ESSAY 22 Put-Call Parity for European Options on Assets 111ESSAY 23 Put-Call Parity for American Options on Assets 115ESSAY 24 Call Options as Insurance and Margin 119ESSAY 25 A Nontechnical Introduction to Brownian Motion 123ESSAY 26 Building a Model of Brownian Motion in the Stock Market 129ESSAY 27 Option Pricing: The Black-Scholes-Merton Model 133ESSAY 28 Option Pricing: The Binomial Model 139ESSAY 29 Option Pricing: Numerical Methods 143ESSAY 30 Dynamic Option Replication 147ESSAY 31 Risk-Neutral Pricing of Derivatives: I 153ESSAY 32 Risk-Neutral Pricing of Derivatives: II 159ESSAY 33 It’s All Greek to Me 165ESSAY 34 Implied Volatility 169ESSAY 35 American Call Option Pricing 175ESSAY 36 American Put Option Pricing 181ESSAY 37 Swap Pricing 185SECTION FOUR Derivative Strategies 191ESSAY 38 Asset Allocation with Derivatives 193ESSAY 39 Protective Puts and Portfolio Insurance 197ESSAY 40 Misconceptions about Covered Call Writing 201ESSAY 41 Hedge Funds and Other Privately Managed Accounts 205ESSAY 42 Spreads, Collars, and Prepaid Forwards 209ESSAY 43 Box Spreads 213SECTION FIVE Exotic Instruments 217ESSAY 44 Barrier Options 219ESSAY 45 Straddles and Chooser Options 223ESSAY 46 Compound and Installment Options 227ESSAY 47 Digital Options 231ESSAY 48 Geographic Options 235ESSAY 49 Multi-Asset Options 239ESSAY 50 Range Forwards and Break Forwards 243ESSAY 51 Lookback Options 249ESSAY 52 Deferred Start and Contingent Premium Options 253SECTION SIX Fixed Income Securities and Derivatives 257ESSAY 53 Duration 259ESSAY 54 Limitations of Duration and the Concept of Convexity 263ESSAY 55 The Term Structure of Interest Rates 269ESSAY 56 Theories of the Term Structure: I 273ESSAY 57 Theories of the Term Structure: II 279ESSAY 58 Simple Models of the Term Structure: Vasicek and Cox-Ingersoll-Ross 285ESSAY 59 No-Arbitrage Models of the Term Structure: Ho-Lee and Heath-Jarrow-Morton 291ESSAY 60 Tree Pricing of Bonds and Interest Rate Derivatives: I 297ESSAY 61 Tree Pricing of Bonds and Interest Rate Derivatives: II 301ESSAY 62 Tree Pricing of Bonds and Interest Rate Derivatives: III 307ESSAY 63 Tree Pricing of Bonds and Interest Rate Derivatives: IV 313ESSAY 64 Tree Pricing of Bonds and Interest Rate Derivatives: V 319SECTION SEVEN Other Topics and Issues 325ESSAY 65 Stock Options 327ESSAY 66 Value at Risk 335ESSAY 67 Stock as an Option 341ESSAY 68 The Credit Risk of Derivatives 345ESSAY 69 Operational Risk 349ESSAY 70 Risk Management in an Organization 355ESSAY 71 Accounting and Disclosure of Derivatives 361ESSAY 72 Worst Practices in Derivatives 367ESSAY 73 Best Practices in Derivatives 375Recommended Reading 379Answers to End-of-Essay Questions 381