(continued from front flap)
Uncertainty is a hallmark of today’s global financial
marketplace. This essential guide to financial derivatives will help you unlock their vast potential for
risk management and much, much more.
JAMES A. OVERDAHL, a specialist in financial
derivatives, is the Chief Economist of the United
States Securities and Exchange Commission. He
had previously served as chief economist of the
Commodity Futures Trading Commission and has
nearly two decades of experience in senior positions
at various federal financial regulatory agencies. He
has taught economics and finance at the University
of Texas at Dallas, Georgetown University, Johns
Hopkins University, and George Washington University. Overdahl earned his PhD in economics
from Iowa State University.
The Robert W. Kolb Series in Finance is an unparalleled source of information dedicated to the most important issues in modern finance. Each book
focuses on a specific topic in the field of finance, and contains contributed
chapters from both respected academics and experienced financial professionals. As part of the Robert W. Kolb Series in Finance, Financial Derivatives aims to provide a comprehensive understanding of financial derivatives
and how you can prudently use them within the context of your underlying
business activities.
For the public at large, financial derivatives have long
been the most mysterious and least understood of all financial instruments. Through in-depth insights gleaned
from years of financial experience, the contributors
in this collection clearly explain what derivatives are
without getting bogged down by the mathematics
surrounding their pricing and valuation.
Financial Derivatives offers a broad overview of the
different types of derivatives—futures, options, swaps, and structured
products—while focusing on the principles that determine market prices.
This comprehensive resource also provides a thorough introduction to
financial derivatives and their importance to risk management in a
corporate setting. Filled with in-depth analysis and examples, Financial
Derivatives offers readers a wealth of knowledge on futures, options, swaps,
financial engineering, and structured products.
Jacket Design: Leiva-Sposato Design
FINANCIAL
DERIVATIVES
Pricing and Risk Management
FINANCIAL
DERIVATIVES
ROBERT W. KOLB is the Frank W. Considine
Chair of Applied Ethics and Professor of Finance
at Loyola University Chicago. Before this, he was
the assistant dean, Business and Society, and director, Center for Business and Society, at the University of Colorado at Boulder, and department
chairman at the University of Miami. Kolb has authored over twenty books on finance, derivatives,
and futures, as well as numerous articles in leading
finance journals.
FINANCIAL
DERIVATIVES
Kolb
Overdahl
The authors explore option strategies used to
speculate and show how the same strategies can be
employed to reduce risk. In addition, they reveal
how financial derivatives can effectively manage
interest rate risk and discuss how hedge funds use
financial derivatives.
KOLB SERIES IN FINANCE
Essential Perspectives
$95.00 USA/$114.00 CAN
As part of the Robert W. Kolb Series in Finance,
Financial Derivatives skillfully explores the contemporary world of financial derivatives. Starting
with a presumption of only a general knowledge of
undergraduate finance, this collection of essential
perspectives, written by leading figures in academics, industry, and government, provides a comprehensive understanding of financial derivatives. The
contributors provide a complete overview of the
types of financial derivatives and the markets in
which they trade. They analyze the development
and current state of derivatives markets—including
their regulation—and examine the role of derivatives in risk management. They look at the pricing
of derivatives, beginning with the fundamentals
and move on to more advanced pricing techniques,
showing how Monte Carlo methods can be applied
to price derivatives.
Robert W. Kolb, James A. Overdahl, Editors
KOLB SERIES IN FINANCE
Essential Perspectives
EAN: 9780470499108
ISBN 978-0-470-49910-8
A
t a time when our entire financial system
is under great stress, many investors point
to the misuse of derivatives as one of the
primary causes of the financial meltdown. Long
misunderstood by the general public, some financial derivatives are fairly simple—while others are
quite complicated and require considerable mathematical and statistical knowledge to fully understand. But with our financial system now undergoing unprecedented changes, there has never been
a better time to gain a firm understanding of these
instruments.
The book concludes with an examination of the
many ways derivatives can be used. While it is clear
that financial derivatives are valuable for managing risks and for providing information about the
future prices of underlying goods, they can also
be used as very sophisticated speculation tools.
(continued on back flap)
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The Robert W. Kolb Series in Finance provides a comprehensive view of the field
of finance in all of its variety and complexity. The series is projected to include
approximately 65 volumes covering all major topics and specializations in finance,
ranging from investments, to corporate finance, to financial institutions. Each volume in the Kolb Series in Finance consists of new articles especially written for the
volume.
Each Kolb Series volume is edited by a specialist in a particular area of finance, who
develops the volume outline and commissions chapters by the world’s experts in
that particular field of finance. Each volume includes an editor’s introduction and
approximately 30 articles to fully describe the current state of financial research
and practice in a particular area of finance.
The chapters in each volume are intended for practicing finance professionals,
graduate students, and advanced undergraduate students. The goal of each volume
is to encapsulate the current state of knowledge in a particular area of finance so
that the reader can quickly achieve a mastery of that special area of finance.
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FINANCIAL
DERIVATIVES
Pricing and Risk
Management
Robert W. Kolb
James A. Overdahl
The Robert W. Kolb Series in Finance
John Wiley & Sons, Inc.
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Copyright c 2010 by John Wiley & Sons, Inc. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or
transmitted in any form or by any means, electronic, mechanical, photocopying,
recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the
1976 United States Copyright Act, without either the prior written permission of the
Publisher, or authorization through payment of the appropriate per-copy fee to the
Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978)
750-8400, fax (978) 750-4470, or on the web at www.copyright.com. Requests to the
Publisher for permission should be addressed to the Permissions Department, John
Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201)
748-6008, or online at www.wiley.com/go/permissions.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used
their best efforts in preparing this book, they make no representations or warranties with
respect to the accuracy or completeness of the contents of this book and specifically
disclaim any implied warranties of merchantability or fitness for a particular purpose. No
warranty may be created or extended by sales representatives or written sales materials.
The advice and strategies contained herein may not be suitable for your situation. You
should consult with a professional where appropriate. Neither the publisher nor author
shall be liable for any loss of profit or any other commercial damages, including but not
limited to special, incidental, consequential, or other damages.
For general information on our other products and services or for technical support,
please contact our Customer Care Department within the United States at (800) 762-2974,
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Library of Congress Cataloging-in-Publication Data:
Kolb, Robert W., 1949–
Financial derivatives : pricing and risk management / Robert W. Kolb,
James A. Overdahl.
p. cm. – (The Robert W. Kolb series in finance)
Includes bibliographical references and indexes.
ISBN 978-0-470-49910-8 (cloth)
1. Derivative securities. 2. Financial engineering. I. Overdahl, James A.
II. Title.
HG6024.A3K648 2010
2009017152
332.64 57–dc22
Printed in the United States of America.
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Contents
Introduction
Acknowledgments
PART I Overview of Financial Derivatives
1
Derivative Instruments: Forwards, Futures, Options,
Swaps, and Structured Products
xxi
xxiii
1
3
G. D. Koppenhaver
2
Introduction
A Generalist’s Approach to Derivative Contracts
Forward Contracts
Futures Contracts
Swap Contracts
Option Contracts
Structured Products and an Application to Derivative Contracts
Conclusion
Endnotes
References
About the Author
3
6
7
9
11
13
16
19
19
20
20
The Derivatives Marketplace: Exchanges
and the Over-the-Counter Market
21
Sharon Brown-Hruska
Introduction
Standardization versus Customized Products: Differences
in Structure and Approach
Competition and Consolidation: Impetus for Change
Moving from Bilateral to Multilateral Risk Management
Collateral in Exchange and OTC Markets
Netting and Novation in Exchange and OTC Markets
Transparency and Information in the Exchange and
OTC Marketplaces
Conclusion
Endnotes
21
22
25
29
29
31
36
39
40
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References
About the Author
3 Speculation and Hedging
41
42
43
Greg Kuserk
Hedging Transactions
Speculation
From Hedging to Speculation
Interaction between Hedgers and Speculators
Conclusion
Endnotes
References
About the Author
4 The Social Functions of Financial Derivatives
44
48
50
52
54
54
54
55
57
Christopher L. Culp
Hedging and Risk Transfer
Price Discovery
Price Discovery, Commoditization, and Market Structure
Intertemporal Resource Allocation
Forward Contracts as Synthetic Storage
Commodity Interest Rates
Asset Finance
Commodities Lending
Project Finance
Trade Finance
Financial Asset Inventory Management
Synthetic Asset Allocation
Derivatives and Public Policy
Endnotes
Further Reading
References
About the Author
58
58
59
60
60
60
61
62
63
64
65
65
66
67
68
69
71
PART II Types of Financial Derivatives
73
5
77
Agricultural and Metallurgical Derivatives: Pricing
Joan C. Junkus
Introduction
Commodities
Seasonality in Spot and Futures Prices
Futures Pricing
Theory of Storage
Theory of Normal Backwardation
77
77
78
79
80
84
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vii
Conclusion
References
Suggested Further Reading
About the Author
85
86
86
87
Agricultural and Metallurgical Derivatives:
Speculation and Hedging
89
Joan C. Junkus
Introduction
Commodities
Derivatives
Commodity Investment Strategies
Commodity Indexes
Diversification and Inflation
Passive Investment Strategies
Active Strategies
Measuring Investment Performance
Hedging
Commodity Marketing
Risk Management
Spreads
Conclusion
References
Suggested Further Reading
About the Author
7
Equity Derivatives
89
89
90
90
90
91
91
94
94
95
95
97
99
100
100
101
101
103
Jeffrey H. Harris and L. Mick Swartz
Introduction
Stock Options
Call Options
Put Options
Stock Options on an Index
Employee Stock Options
Convertible Bonds
Warrants
Equity Futures
Single-Stock Futures
Futures on Stock Indexes
Equity Swaps
Future of Equity Derivatives
References
Further Reading
About the Authors
103
104
105
106
106
107
107
108
108
108
109
110
111
112
112
113
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8 Foreign Exchange Derivatives
115
Robert W. Kolb
Basic Pricing Principles
Purchasing Power Parity Theorem
Interest Rate Parity Theorem
Foreign Exchange Forward and Futures Contracts
Foreign Exchange Options
FX Option Pricing
Plain Vanilla Foreign Exchange Swaps
Flavored Currency Swaps
Conclusion
Endnotes
References
About the Author
9
Energy Derivatives
115
115
116
117
118
119
119
121
122
123
123
123
125
Craig Pirrong
10
Introduction
Products: An Overview
History
Petroleum Derivatives: Details
Natural Gas Derivatives: Details
Electricity Derivatives: Details
Pricing
Clearing
Recent Developments
References
About the Author
125
125
126
127
128
129
129
131
132
133
133
Interest Rate Derivatives
135
Ian Lang
Exchange-Traded (Listed) Derivatives
Over-the-Counter Derivatives
OTC Options
Rate Locks
Swaps and Swaptions
Mortgage Derivatives
Further Reading
About the Author
11
Exotic Options
135
138
138
138
139
141
142
142
143
Robert W. Kolb
Overview
Forward-Start Options
143
144
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ix
Compound Options
Chooser Options
Barrier Options
Binary Options
Lookback Options
Asian or Average Price Options
Exchange Options
Rainbow Options
Conclusion
Endnotes
References
About the Author
144
145
146
147
149
150
151
151
152
153
154
154
Event Derivatives
157
Justin Wolfers and Eric Zitzewitz
13
Types of Prediction Markets
Applications and Evidence
Accuracy of Prediction Markets
Possibilities for Arbitrage
Can Event Markets Be Manipulated Easily?
Market Design
Making Inferences from Prediction Markets
Innovative Future Applications?
Acknowledgments
Endnotes
References
About the Authors
158
160
160
164
168
168
170
173
173
174
174
176
Credit Default Swaps
177
Steven Todd
Credit Default Swaps on Corporate Debt
Credit Default Swaps on Asset-Backed Securities
Credit Default Swaps on Collateralized Debt
Obligations
The Basis
CDS Indices
Tranches of CDS Indices
Trading Strategies Using Indexes and Tranches
Market Dynamics: CDS and CDOs
Synthetic CDOs and Bespokes
Correlation
Conclusion
Endnotes
References
About the Author
177
178
180
182
182
186
188
189
189
191
196
196
197
198
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Structured Credit Products
199
Steven Todd
Asset-Backed Securities
Collateralized Debt Obligations
Commercial Mortgage-Backed Securities
Endnotes
References
About the Author
15
Executive Stock Options
202
204
208
209
210
210
211
Robert W. Kolb
16
Introduction
Basic Features of Executive Stock Options
Rationales for ESOs
Pricing of Executive Stock Options
Executive Stock Options and Incentives
Conclusion
Endnotes
References
About the Author
211
211
212
214
216
218
218
219
220
Emerging Derivative Instruments
221
Steve Swidler
Economic Derivatives
Real Estate Derivatives
The Next Frontier
Endnotes
References
Suggested Further Reading
About the Author
PART III The Structure of Derivatives Markets
and Institutions
17
The Development and Current State
of Derivatives Markets
222
224
226
228
228
229
230
231
233
Michael A. Penick
Introduction: The Situation in the 1960s
Financial Futures and Options
Foreign Markets
OTC Markets
Energy Derivatives
The Rise of Electronic Trading
Current Conditions: Consolidation and Crisis
233
234
236
237
238
240
243
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xi
Endnotes
References
About the Author
245
247
248
Derivatives Markets Intermediaries: Brokers,
Dealers, Pools, and Funds
249
James L. Carley
19
Intermediaries for Exchange-Traded Derivatives
Providers of Trade Execution Services
Providers of Money Management Services
Intermediaries for OTC Derivatives
Swap Brokers
Swap Dealers
Interdealer Brokers
Next Step: Clearinghouse(s) for Swaps
Endnotes
References
About the Author
250
251
256
257
258
258
258
259
260
261
261
Clearing and Settlement
263
James T. Moser and David Reiffen
20
Introduction
Functions of Clearinghouses
Contracts for Immediate Performance
Contracts for Deferred Performance
Clearing and Liquidity
Competition between Exchanges
Nature of the Clearing Organization
Innovation and Clearing Structure
Conclusion
Endnotes
References
About the Authors
263
263
264
265
273
275
276
278
278
279
281
282
Counterparty Credit Risk
283
James Overdahl
Measuring Counterparty Credit Risk Exposure
Presettlement versus Settlement Risk
Replacement Cost, Current Exposure, and Potential Exposure
Simulation Techniques and the Exposure Profile
Wrong-Way and Right-Way Risk
Managing Counterparty Credit Risk
Evaluating the Creditworthiness of Counterparties
Using Counterparty Credit Risk Measures in the Trade
Authorization Process
284
284
284
285
287
287
287
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Other Tools to Manage Counterparty Credit Risk
Netting
Actual Default Experience in the OTC Market
Infrastructure Improvements Aimed at Mitigating
Counterparty Credit Risk
Infrastructure and the Effectiveness of Counterparty Credit
Risk Management
Central Counterparty Clearing
Conclusion
Endnotes
References
About the Author
21
The Regulation of U.S. Commodity Futures
and Options
289
289
289
290
290
291
292
293
293
294
295
Walter L. Lukken
Tiered Regulatory Design
Statutory Exclusions for Certain OTC Derivatives
Security Futures Products
Retail Foreign Currency Fraud
Exempt Commercial Markets
CFTC Reauthorization Act of 2008
Future Legislative Reforms
Endnotes
About the Author
22
Accounting for Financial Derivatives
296
297
298
299
300
300
301
302
303
305
Ira G. Kawaller
23
Alternative Accounting Categories
Cash Flow Hedges
Fair Value Hedges
Hedges of Net Investments in Foreign Operations
Conclusion
References
About the Author
305
306
309
311
312
312
312
Derivative Scandals and Disasters
313
John E. Marthinsen
Introduction
Anatomy of Derivative-Related Failures
Investment Strategies and Exogenous Shocks behind Our Five
Derivative Fiascos
MGRM’s Strategy
LTCM’s Strategy
Amaranth’s Strategy
Barings’ and Soci´et´e G´en´erale’s Speculative Traders
313
313
315
315
316
317
318
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Lessons Learned from Derivative Scandals and Disasters
Controlling Risks Is Possible Only If They Can Be Measured
Effectively
Risk Management Systems Must Cauterize Losses Immediately
after the Initial Shocks
Creative Ways Are Needed to Supply Liquidity during
Turbulent Times
Risk Management Systems Must Control Traders and
Fund Managers
Compensation Incentives and Promotion Criteria Must
Be Scrutinized
Risk Management Systems Are Only as Strong as Their Weakest
Risk Managers
Broader Implications of Derivative Scandals and Disasters
Conclusion
Acknowledgements
Endnotes
References
Suggested Further Reading
About the Author
xiii
319
319
320
321
321
323
325
326
327
328
328
330
331
332
PART IV Pricing of Derivatives: Essential Concepts
333
24
335
No-Arbitrage Pricing
Robert A. Strong
25
Free Lunches
Theory of Put/Call Parity
Binomial Option Pricing Model
Put Pricing in the Presence of Call Options: Further Study
Binomial Put Pricing
Binomial Pricing with Asymmetric Branches
Effect of Time
Effect of Volatility
Intuition into Black-Scholes
Endnotes
References
Further Reading
About the Author
335
336
341
345
346
346
347
348
348
349
349
349
350
The Pricing of Forward and Futures Contracts
351
David Dubofsky
Cost of Carry Model
Carry Return
Commodity Futures
Convenience Yield
Delivery Options
352
354
355
356
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Interest Rate Futures and Forwards: Eurodollar Futures
and Forward Rate Agreements
Interest Rate Futures and Forwards: Treasury Bond
and Treasury Note Futures
Should Futures and Forward Prices Be the Same?
Expectations Model: An Alternative Theory for the Pricing
of Forwards and Futures
Electricity Forwards and Futures
Conclusion
Endnotes
References
About the Author
26
The Black-Scholes Option Pricing Model
358
360
362
363
364
366
367
367
369
371
A. G. Malliaris
Introduction
Brief History
Black-Scholes Formula
Assumptions of the Black-Scholes Model
Discussion of Assumptions
Ito Process
Example
Excel Application
Simple Derivation of Black-Scholes
Numerical Example
The Greeks
Delta
Gamma
Theta
Vega
Rho
Risk-Neutral Pricing
Conclusion
References
About the Author
27
The Black-Scholes Legacy: Closed-Form Option
Pricing Models
371
372
372
373
374
374
375
376
376
380
381
381
381
381
381
382
382
384
384
385
387
Ant´onio Cˆamara
Introduction
The Black-Scholes Model
First Generation of Models (One Lognormal Underlying)
Second Generation of Models (Two Lognormal Underlyings)
Third Generation of Models (One Nonlognormal
Underlying)
Fourth Generation of Models
Conclusion
387
388
392
395
397
401
402
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xv
Endnotes
References
About the Author
402
403
404
The Pricing and Valuation of Swaps
405
Gerald Gay and Anand Venkateswaran
Introduction
Illustration 1: An End User Swap Application
Framework for Pricing and Valuation
Illustration 2: A Simple Example
Steps for Swap Pricing
Obtain Market Inputs
Make Convexity Adjustments to Implied Futures Rates
Build the Zero Curve
Identify Relevant Swap Features
Price/Value the Swap
Illustration 3: Pricing an Interest Rate Swap
Illustration 4: Valuing an Existing Interest Rate Swap
Other Swaps
Currency Swaps
Illustration 5: Pricing and Valuing a Currency Swap
Commodity Swaps
Illustration 6: Pricing a Commodity Swap
Endnotes
References
About the Authors
PART V Advanced Pricing Techniques
29
Monte Carlo Techniques in Pricing
and Using Derivatives
405
406
407
409
410
410
411
413
415
415
416
416
417
417
418
419
419
420
421
422
423
425
Cara M. Marshall
30
Introduction
Pricing a Classic Black-Scholes Option
Simulation Results
Price Return
Pricing a Rainbow Option
Endnotes
References
About the Author
425
427
432
432
435
439
439
440
Valuing Derivatives Using Finite Difference
Methods
441
Craig Pirrong
Introduction
An Overview
441
441
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Basic Methods
Higher-Dimension Problems
The Pros and Cons of Finite Difference Methods
Suggested Further Reading
Endnotes
References
About the Author
31
Stochastic Processes and Models
445
449
451
451
452
452
453
455
George Chalamandaris and A. G. Malliaris
Introduction
Stochastic Processes
Definitions and Properties
Constructing the Continuous Time Model: Brownian Motion
The Ito Process and the Need for Stochastic Calculus
Basic Elements of Stochastic Calculus
Ito Integral
Ito’s Lemma
Binomial Tree: Another Way of Visualizing a
Stochastic Process
Construction of a Binomial Tree and Properties
Conclusion
Endnotes
References
Appendix: Heuristic Derivation of Ito’s Formula
About the Authors
32
Measuring and Hedging Option Price
Sensitivities
455
456
456
458
459
462
462
464
468
469
472
472
472
473
475
477
R. Brian Balyeat
Delta
Example 1
Example 2
Gamma
Example 3
Theta
Example 4
Vega
Example 5
Rho and Other Option Sensitivities
Example 6
Example 7
Hedging Delta, Gamma, and Vega
Conclusion
References
About the Author
477
479
479
484
485
487
488
491
492
493
493
494
496
498
499
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PART VI Using Financial Derivatives
501
33 Option Strategies
503
Stewart Mayhew
34
Building Blocks
Covered Calls and Protective Puts
Synthetic Positions
Bull and Bear Spreads
Cylinders
Straddles, Strangles, Strips, and Straps
Ratio Spreads
Box Spreads
Butterflies, Condors, and Seagulls
Time Strategies
Multi-Asset Strategies
Endnotes
References
About the Author
505
507
509
512
515
516
518
518
519
522
523
523
523
524
The Use of Derivatives in Financial Engineering:
Hedge Fund Applications
525
John F. Marshall and Cara M. Marshall
35
Introduction
Convertible Bond Arbitrage
Capital Structure Arbitrage
Endnotes
References
About the Authors
525
526
534
538
539
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Hedge Funds and Financial Derivatives
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Tom Nohel
Introduction
Survey of Derivative Use by Hedge Funds
Modeling Hedge Fund Risks
Description of Some Popular Hedge Fund Strategies
Convertible Arbitrage
Risk Arbitrage
Global Macro
Market Neutral/Relative Value
Volatility Trades
Correlation Trading
Credit Hedge Funds
Hedge Fund Activism
Some Unusual Derivatives Trades Made by Hedge Funds
Empty Voting
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Contents
Acquiring a Large Stake through Put Exercise
Toeholds via Contingent Contracts
Tax-Avoidance Strategies
Using Structures to Create Leverage
Conclusion
Endnotes
References
About the Author
36
Real Options and Applications in Corporate Finance
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553
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555
555
555
557
558
559
Betty Simkins and Kris Kemper
37
Introduction
A Brief History of Real Options
Distinction between Financial Options and Real Options
Types of Real Options and Examples in the Energy Industry
Option to Expand
Option to Wait
Option to Vary Production Inputs, Outputs, or Processes
Option to Abandon or Temporarily Shutdown
Hybrid Real Options
Valuing Real Options
Decision Trees
Monte Carlo Simulation
Option Pricing Models
Conclusion
Endnotes
References
About the Authors
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563
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Using Derivatives to Manage Interest Rate Risk
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Steven L. Byers
Introduction
Forward-Based Instruments
Forward Rate Agreements
Interest Rate Futures Contracts
Basis Risk
Futures Hedge Ratio
Example of Hedging with Eurodollar Futures
Hedging a Portfolio of Coupon Bonds with Interest Rate Futures
Interest Rate Swaps
Option-Based Instruments
Interest Rate Guarantees
Interest Rate Caps and Floors
Swaptions
Mortgage Securitization Risk Management Using Interest
Rate Derivatives
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CONTENTS
Conclusion
References
Suggested Further Reading
About the Author
Index
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Introduction
I
n a time in which the finance industry is under attack and our entire financial
system is under remarkable stress, financial derivatives are at the center of the
storm. For the public at large, financial derivatives have long been the most
mysterious and least understood of all financial instruments. While some financial
derivatives are fairly simple, others are admittedly quite complicated and require
considerable mathematical and statistical knowledge to understand fully.
With vast changes for our financial system in prospect, there has never been
a time in which those engaged in setting public policy and the concerned general
public have a greater need for a general understanding of financial derivatives. As
the reader of this book will learn, financial derivatives are instruments of remarkable power and very justifiable uses. However, as this text also freely acknowledges
and explains, the very power of these financial derivatives makes them subject to
accident in the hands of the incautious and also makes them effective tools for
mischief in the hands of the unscrupulous.
To contribute to an improved public understanding of these markets, Financial Derivatives explores the contemporary world of financial derivatives, starting
with a presumption of only a general knowledge of undergraduate finance. These
chapters have been written by many leading figures in academics, industry, and
government for the benefit of advanced undergraduates, graduate students, practicing finance professionals, and the general public. As such, the chapters in this
book provide a comprehensive understanding of financial derivatives. Financial
Derivatives is comprised of 37 chapters organized into six parts:
Part One, “Overview of Financial Derivatives,” provides an introduction to
and an overview of the types of financial derivatives, the markets in which they
trade, and the way that traders use derivatives, and it also offers a broader perspective addressing the question of the social function of derivatives markets. Against
that background, Part Two, “Types of Financial Derivatives,” explores the variety of
derivatives, starting with the agricultural and metallurgical derivatives that were
historically the first to be developed. This part also discusses financial derivatives
based on stock indexes, foreign currencies, energy, and interest rate instruments.
It continues by giving an overview of the variety of exotic options and a type of
exotic options known as an event derivative. Two chapters focus on credit default
swaps and structured credit products that have allegedly played a central role in
the recent crisis in financial markets. Executive compensation is always controversial, it seems, and has generated particular outrage in the current crisis, so this part
discusses executive stock options and concludes with an overview of some of the
emerging financial derivatives that are likely to become prominent in the future.
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Introduction
After having introduced the markets and types of derivatives in Parts One
and Two, Part Three turns to an examination of “The Structure of Derivatives
Markets and Institutions.” Chapter 17 analyzes the development and current state
of derivatives markets, and subsequent chapters take on issues such as a survey
of the participants in the market and the way in which transactions are fulfilled.
Fulfillment is a critical part of the market, because this issue concerns the honoring
and completion of contracts, without which no viable market can persist. Closely
related to this is the issue of counterparty credit risk—the risk that one party to the
derivatives contract might default on contractual obligations. This part also surveys
the regulation of derivatives markets, along with the principles of accounting as
they pertain to derivatives. The part concludes with a brief account of some of the
most famous derivatives disasters of recent decades.
Part Four, “The Pricing of Derivatives: Essential Concepts,” introduces the
fundamentals of determining the price of derivatives. The part begins by introducing the principle of no-arbitrage pricing. The first condition of a well-performing
market from the point of view of pricing is that prices in the market are such that
arbitrage is impossible—where arbitrage can be defined as the securing of a riskless profit without investment. With this background, the discussion turns to the
pricing of particular instruments, such as forward and futures contracts. Next the
part introduces the famous Black-Scholes option pricing model and then considers
the various ways in which this seminal model has been extended and enhanced
to apply to other derivatives. The part concludes with an analysis of the pricing of
swap contracts.
Part Five, “Advanced Pricing Techniques,” extends the pricing analysis initiated in Part Four. The chapters in this part are more technical, beginning with
showing how Monte Carlo methods can be applied to price derivatives. The discussion of Monte Carlo techniques is immediately followed by a consideration
of finite difference models, models that can be applied with great benefit when
analytical models are not available. Much of the pricing of derivatives turn on the
path that the underlying good is presumed to follow. When this path is described
statistically, the description is known as a stochastic process, an understanding of
which is necessary to more sophisticated analysis. Finally, this part explores how
option prices respond to changes in their various input values.
Part Six, “Using Financial Derivatives,” concludes the book. By this time, the
reader will be well aware that financial derivatives are very valuable for managing
risks and for providing information about the future prices of underlying goods.
Financial derivatives can also be used as tools of quite sophisticated speculation.
This part begins with an exploration of option strategies used in speculation and
shows how the same strategies can also be used to reduce risk. Next comes a
discussion of how hedge funds use financial derivatives and, more exactly, how
hedge funds use the techniques of financial engineering. Financial derivatives are
powerful tools for managing interest rate risk, as this part also explores. Chapter
36 examines real options, options based on physical assets or opportunities that
firms possess. The book concludes with a discussion of how firms can use financial
derivatives to manage their own risks.
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Acknowledgments
T
he editors would like to acknowledge the contribution of the many people
who have made this volume possible. Our first debt is to the many scholars
who shared their knowledge by writing the chapters that comprise this text.
We would like to also thank George Lobell, editor at John Wiley & Sons, Inc., for
his vision of the series in which this volume appears and his encouragement of the
series in general and this text in particular. Also at John Wiley, we would like to
offer our thanks to the editorial team of Pamela Van Giessen, William Falloon, and
Laura Walsh for their continuing support of and commitment to this project.
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