Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options(The Wiley Finance Series)

Derivatives are everywhere in the modern world and it is important for everyone in banking, investment and finance to have a good understanding of the subject. Derivatives Demystified provides a step-by-step guide to the subject, enabling the reader to have a solid, working understanding of key derivative products. Adopting a highly accessible approach, the author explains derivative products in straightforward terms and without the complex mathematics that underlie the subject, focusing on practical applications, case studies and examples of how the products are used to solve real-world problems. Derivatives Demystified follows a sequence that is designed to show that, although there are many applications of derivatives, there are only a small number of basic building blocks, namely forwards and futures, swaps and options. The book shows how each building block is applied to different markets and to the solution of various risk management and trading problems. This new edition will be fully revised to reflect the many changes the derivatives markets have seen over the last three years.  New material will include a comprehensive history of derivatives, leading up to their use and abuse in the current credit crisis.  It will also feature new chapters on regulation and control of derivatives, commodity derivatives, credit derivatives and structured products and new derivative markets including inflation linked and insurance linked products.  Derivatives Demystified is essential reading for everyone who operates in the financial markets or within the corporate environment who requires a good understanding of these important financial instruments.

Table of Contents:
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

About the Author :
ANDREW M. CHISHOLM MA MBA PhD is a Visiting Fellow at the International Capital Market Association (ICMA) Centre at the University of Reading in England. He has designed, developed and taught programmes in derivatives and finance for more than 25 years. In that time, he has worked with many of the largest financial institutions around the world, teaching corporate financiers, traders, sales and marketing staff, risk managers, analysts, fund managers, operations and technology professionals. He has worked extensively on seminars at senior management level as well as training programmes designed to introduce new graduate and MBA entrants to the securities industry. He was formerly Head of Professional Development for Europe at JP Morgan and is the author of An Introduction to International Capital Markets, the second edition of which was published by John Wiley and Sons in 2009.