Derivatives

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• Foreword xviiPreface xixAcknowledgments xxiAbout the CFA Institute Investment Series xxiiiChapter 1 Derivative Markets and Instruments 1Learning Outcomes 11. Derivatives: Introduction, Definitions, and Uses 12. The Structure of Derivative Markets 52.1. Exchange-Traded Derivatives Markets 62.2. Over-the-Counter Derivatives Markets 83. Types of Derivatives: Introduction, Forward Contracts 103.1. Forward Commitments 104. Types of Derivatives: Futures 145. Types of Derivatives: Swaps 186. Contingent Claims: Options 226.1. Options 227. Contingent Claims: Credit Derivatives 308. Types of Derivatives: Asset-Backed Securities and Hybrids 338.1. Hybrids 359. Derivatives Underlyings 369.1. Equities 369.2. Fixed-Income Instruments and Interest Rates 369.3. Currencies 379.4. Commodities 379.5. Credit 379.6. Other 3710. The Purposes and Benefits of Derivatives 3910.1. Risk Allocation, Transfer, and Management 4010.2. Information Discovery 4110.3. Operational Advantages 4110.4. Market Efficiency 4211. Criticisms and Misuses of Derivatives 4211.1. Speculation and Gambling 4311.2. Destabilization and Systemic Risk 4312. Elementary Principles of Derivative Pricing 4512.1. Storage 4612.2. Arbitrage 47Summary 52Problems 54Chapter 2 Basics of Derivative Pricing and Valuation 61Learning Outcomes 611. Introduction 622. Basic Derivative Concepts, Pricing the Underlying 622.1. Basic Derivative Concepts 622.2. Pricing the Underlying 643. The Principle of Arbitrage 683.1. The (In)Frequency of Arbitrage Opportunities 693.2. Arbitrage and Derivatives 693.3. Arbitrage and Replication 703.4. Risk Aversion, Risk Neutrality, and Arbitrage-Free Pricing 713.5. Limits to Arbitrage 724. Pricing and Valuation of Forward Contracts: Pricing vs. Valuation; Expiration; Initiation 744.1. Pricing and Valuation of Forward Commitments 755. Pricing and Valuation of Forward Contracts: Between Initiation and Expiration; Forward Rate Agreements 795.1. A Word about Forward Contracts on Interest Rates 806. Pricing and Valuation of Futures Contracts 827. Pricing and Valuation of Swap Contracts 848. Pricing and Valuation of Options 878.1. European Option Pricing 889. Lower Limits for Prices of European Options 9410. Put–Call Parity, Put–Call–Forward Parity 9710.1. Put–Call–Forward Parity 10111. Binomial Valuation of Options 10312. American Option Pricing 107Summary 110Problems 111Chapter 3 Pricing and Valuation of Forward Commitments 117Learning Outcomes 1171. Introduction to Pricing and Valuation of Forward Commitments 1171.1. Principles of Arbitrage-Free Pricing and Valuation of Forward Commitments 1181.2. Pricing and Valuing Generic Forward and Futures Contracts 1192. Carry Arbitrage 1242.1. Carry Arbitrage Model When There Are No Underlying Cash Flows 1242.2. Carry Arbitrage Model When Underlying Has Cash Flows 1313. Pricing Equity Forwards and Futures 1353.1. Equity Forward and Futures Contracts 1353.2. Interest Rate Forward and Futures Contracts 1384. Pricing Fixed-Income Forward and Futures Contracts 1474.1. Comparing Forward and Futures Contracts 1535. Pricing and Valuing Swap Contracts 1545.1. Interest Rate Swap Contracts 1566. Pricing and Valuing Currency Swap Contracts 1637. Pricing and Valuing Equity Swap Contracts 171Summary 176Problems 179Chapter 4 Valuation of Contingent Claims 187Learning Outcomes 1871. Introduction and Principles of a No- Arbitrage Approach to Valuation 1881.1. Principles of a No- Arbitrage Approach to Valuation 1882. Binomial Option Valuation Model 1903. One- Period Binomial Model 1924. Binomial Model: Two- Period (Call Options) 1995. Binomial Model: Two- Period (Put Options) 2036. Binomial Model: Two- Period (Role of Dividends & Comprehensive Example) 2077. Interest Rate Options & Multiperiod Model 2137.1. Multiperiod Model 2158. Black–Scholes–Merton (BSM) Option Valuation Model, Introduction and Assumptions of the BSM Model 2168.1. Introductory Material 2168.2. Assumptions of the BSM Model 2169. BSM Model: Components 21810. BSM Model: Carry Benefits and Applications 22211. Black Option Valuation Model and European Options on Futures 22611.1. European Options on Futures 22612. Interest Rate Options 22813. Swaptions 23214. Option Greeks and Implied Volatility: Delta 23414.1. Delta 23515. Gamma 23816. Theta 24117. Vega 24218. Rho 24319. Implied Volatility 244Summary 247Problems 249Chapter 5 Credit Default Swaps 255Learning Outcomes 2551. Introduction 2552. Basic Definitions and Concepts 2552.1. Types of CDS 2573. Important Features of CDS Markets and Instruments, Credit and Succession Events, and Settlement Proposals 2583.1. Credit and Succession Events 2603.2. Settlement Protocols 2613.3. CDS Index Products 2623.4. Market Characteristics 2644. Basics of Valuation and Pricing 2654.1. Basic Pricing Concepts 2654.2. The Credit Curve and CDS Pricing Conventions 2684.3. CDS Pricing Conventions 2694.4. Valuation Changes in CDS during Their Lives 2704.5. Monetizing Gains and Losses 2715. Applications of CDS 2725.1. Managing Credit Exposures 2736. Valuation Differences and Basis Trading 277Summary 279Problems 280Chapter 6 Introduction to Commodities and Commodity Derivatives 285Learning Outcomes 2851. Introduction 2852. Commodity Sectors 2862.1. Commodity Sectors 2883. Life Cycle of Commodities 2903.1. Energy 2913.2. Industrial/Precious Metals 2923.3. Livestock 2943.4. Grains 2953.5. Softs 2954. Valuation of Commodities 2965. Commodities Futures Markets: Participants 2985.1. Futures Market Participants 2986. Commodity Spot and Futures Pricing 3027. Theories of Futures Returns 3067.1. Theories of Futures Returns 3068. Components of Futures Returns 3139. Contango, Backwardation, and the Roll Return 31710. Commodity Swaps 32010.1. Total Return Swap 32210.2. Basis Swap 32310.3. Variance Swaps and Volatility Swaps 32311. Commodity Indexes 32411.1. S&p Gsci 32711.2. Bloomberg Commodity Index 32711.3. Deutsche Bank Liquid Commodity Index 32711.4. Thomson Reuters/CoreCommodity CRB Index 32711.5. Rogers International Commodity Index 32811.6. Rebalancing Frequency 32811.7. Commodity Index Summary 328Summary 329References 331Problems 331Chapter 7 Currency Management: An Introduction 339Learning Outcomes 3391. Introduction 3402. Review of Foreign Exchange Concepts 3402.1. Spot Markets 3412.2. Forward Markets 3432.3. FX Swap Markets 3462.4. Currency Options 3473. Currency Risk and Portfolio Risk and Return 3473.1. Return Decomposition 3473.2. Volatility Decomposition 3504. Strategic Decisions in Currency Management: Overview 3534.1. The Investment Policy Statement 3544.2. The Portfolio Optimization Problem 3544.3. Choice of Currency Exposures 3565. Strategic Decisions in Currency Management: Spectrum of Currency Risk Management Strategies 3595.1. Passive Hedging 3595.2. Discretionary Hedging 3595.3. Active Currency Management 3605.4. Currency Overlay 3606. Strategic Decisions in Currency Management: Formulating a Currency Management Program 3637. Active Currency Management: Based on Economic Fundamentals, Technical Analysis, and the Carry Trade 3657.1. Active Currency Management Based on Economic Fundamentals 3657.2. Active Currency Management Based on Technical Analysis 3677.3. Active Currency Management Based on the Carry Trade 3688. Active Currency Management: Based on Volatility Trading 3709. Currency Management Tools: Forward Contracts, FX Swaps, and Currency Options 3759.1. Forward Contracts 3769.2. Currency Options 38310. Currency Management Strategies 38510.1. Over- /Under- Hedging Using Forward Contracts 38610.2. Protective Put Using OTM Options 38710.3. Risk Reversal (or Collar) 38710.4. Put Spread 38810.5. Seagull Spread 38810.6. Exotic Options 38910.7. Section Summary 39011. Hedging Multiple Foreign Currencies 39311.1. Cross Hedges and Macro Hedges 39311.2. Minimum- Variance Hedge Ratio 39711.3. Basis Risk 39712. Currency Management Tools and Strategies: A Summary 40013. Currency Management for Emerging Market Currencies 40413.1. Special Considerations in Managing Emerging Market Currency Exposures 40413.2. Non- Deliverable Forwards 406Summary 407References 409Problems 410Chapter 8 Options Strategies 421Learning Outcomes 4211. Introduction 4222. Position Equivalencies 4222.1. Synthetic Forward Position 4232.2. Synthetic Put and Call 4263. Covered Calls and Protective Puts 4283.1. Investment Objectives of Covered Calls 4284. Investment Objectives of Protective Puts 4364.1. Loss Protection/Upside Preservation 4374.2. Profit and Loss at Expiration 4395. Equivalence to Long Asset/Short Forward Position 4415.1. Writing Puts 4426. Risk Reduction Using Covered Calls and Protective Puts 4446.1. Covered Calls 4456.2. Protective Puts 4456.3. Buying Calls and Writing Puts on a Short Position 4457. Spreads and Combinations 4487.1. Bull Spreads and Bear Spreads 4488. Straddle 4578.1. Collars 4608.2. Calendar Spread 4639. Implied Volatility and Volatility Skew 46510. Investment Objectives and Strategy Selection 46910.1. The Necessity of Setting an Objective 46910.2. Criteria for Identifying Appropriate Option Strategies 47011. Uses of Options in Portfolio Management 47211.1. Covered Call Writing 47211.2. Put Writing 47411.3. Long Straddle 47511.4. Collar 47811.5. Calendar Spread 47812. Hedging an Expected Increase in Equity Market Volatility 48012.1. Establishing or Modifying Equity Risk Exposure 482Summary 485Problems 487Chapter 9 Swaps, Forwards, and Futures Strategies 493Learning Outcomes 4931. Managing Interest Rate Risk with Swaps 4931.1. Changing Risk Exposures with Swaps, Futures, and Forwards 4942. Managing Interest Rate Risk with Forwards, Futures, and Fixed- Income Futures 4982.1. Fixed- Income Futures 5003. Managing Currency Exposure 5063.1. Currency Swaps 5063.2. Currency Forwards and Futures 5104. Managing Equity Risk 5114.1. Equity Swaps 5114.2. Equity Forwards and Futures 5134.3. Cash Equitization 5165. Volatility Derivatives: Futures and Options 5175.1. Volatility Futures and Options 5186. Volatility Derivatives: Variance Swaps 5207. Using Derivatives to Manage Equity Exposure and Tracking Error 5237.1. Cash Equitization 5248. Using Derivatives in Asset Allocation 5258.1. Changing Allocations between Asset Classes Using Futures 5258.2. Rebalancing an Asset Allocation Using Futures 5288.3. Changing Allocations between Asset Classes Using Swaps 5299. Using Derivatives to Infer Market Expectations 5319.1. Using Fed Funds Futures to Infer the Expected Average Federal Funds Rate 5319.2. Inferring Market Expectations 533Summary 534Problems 535Chapter 10 Introduction to Risk Management 543Learning Outcomes 5431. Introduction 5432. The Risk Management Process 5453. The Risk Management Framework 5474. Risk Governance − An Enterprise View 5544.1. An Enterprise View of Risk Governance 5545. Risk Tolerance 5566. Risk Budgeting 5587. Identification of Risk − Financial and Non- Financial Risk 5617.1. Financial Risks 5617.2. Non- Financial Risks 5638. Identification of Risk − Interactions Between Risks 5679. Measuring and Modifying Risk − Drivers and Metrics 5719.1. Drivers 5719.2. Metrics 57210. Methods of Risk Modification − Prevention, Avoidance, and Acceptance 57610.1. Risk Prevention and Avoidance 57710.2. Risk Acceptance: Self- Insurance and Diversification 57811. Methods of Risk Modification − Transfer, Shifting, Choosing a Method for Modifying 57911.1. Risk Shifting 58111.2. How to Choose Which Method for Modifying Risk 583Summary 585Problems 587Chapter 11 Measuring and Managing Market Risk 591Learning Outcomes 5911. Introduction 5921.1. Understanding Value at Risk 5922. Estimating VaR 5963. The Parametric Method of VaR Estimation 5984. The Historical Simulation Method of VaR Estimation 6025. The Monte Carlo Simulation Method of VaR Estimation 6056. Advantages and Limitations of VaR and Extensions of VaR 6086.1. Advantages of VaR 6086.2. Limitations of VaR 6096.3. Extensions of VaR 6117. Other Key Risk Measures − Sensitivity Risk Measures; Sensitivity Risk Measures 6137.1. Sensitivity Risk Measures 6148. Scenario Risk Measures 6188.1. Historical Scenarios 6188.2. Hypothetical Scenarios 6209. Sensitivity and Scenario Risk Measures and VaR 6239.1. Advantages and Limitations of Sensitivity Risk Measures and Scenario Risk Measures 62410. Using Constraints in Market Risk Management 62710.1. Risk Budgeting 62810.2. Position Limits 62910.3. Scenario Limits 62910.4. Stop- Loss Limits 63010.5. Risk Measures and Capital Allocation 63011. Applications of Risk Measures 63211.1. Market Participants and the Different Risk Measures They Use 63212. Pension Funds and Insurers 63712.1. Insurers 639Summary 641Reference 643Problems 643Chapter 12 Risk Management for Individuals 651Learning Outcomes 6511. Introduction 6522. Human Capital, Financial Capital, and Economic Net Worth 6522.1. Human Capital 6532.2. Financial Capital 6562.3. Economic Net Worth 6613. A Framework for Individual Risk Management 6613.1. The Risk Management Strategy for Individuals 6613.2. Financial Stages of Life 6624. The Individual Balance Sheet 6654.1. Traditional Balance Sheet 6654.2. Economic (Holistic) Balance Sheet 6664.3. Changes in Economic Net Worth 6685. Individual Risk Exposures 6715.1. Earnings Risk 6715.2. Premature Death Risk 6725.3. Longevity Risk 6735.4. Property Risk 6745.5. Liability Risk 6745.6. Health Risk 6756. Life Insurance: Uses, Types, and Elements 6766.1. Life Insurance 6777. Life Insurance: Pricing, Policy Cost Comparison, and Determining Amount Needed 6807.1. Mortality Expectations 6807.2. Calculation of the Net Premium and Gross Premium 6827.3. Cash Values and Policy Reserves 6847.4. Consumer Comparisons of Life Insurance Costs 6857.5. How Much Life Insurance Does One Need? 6878. Other Types of Insurance 6888.1. Property Insurance 6908.2. Health/Medical Insurance 6928.3. Liability Insurance 6938.4. Other Types of Insurance 6939. Annuities: Types, Structure, and Classification 6949.1. Parties to an Annuity Contract 6949.2. Classification of Annuities 69510. Annuities: Advantages and Disadvantages of Fixed and Variable Annuities 69810.1. Volatility of Benefit Amount 69810.2. Flexibility 69910.3. Future Market Expectations 69910.4. Fees 70010.5. Inflation Concerns 70010.6. Payout Methods 70010.7. Annuity Benefit Taxation 70110.8. Appropriateness of Annuities 70111. Risk Management Implementation: Determining the Optimal Strategy and Case Analysis 70311.1. Determining the Optimal Risk Management Strategy 70311.2. Analyzing an Insurance Program 70512. The Effect of Human Capital on Asset Allocation and Risk Reduction 71212.1. Asset Allocation and Risk Reduction 716Summary 718References 720Problems 720Chapter 13 Case Study in Risk Management: Private Wealth 727Learning Outcomes 7271. Introduction and Case Background 7271.1. Background of Eurolandia 7281.2. The Schmitt Family in Their Early Career Stage 730Summary 772Problems 773Chapter 14 Integrated Cases in Risk Management: Institutional 777Learning Outcomes 7771. Introduction 7772. Financial Risks Faced by Institutional Investors 778References 831Glossary 833About the Editors and Authors 845Index 849