An Introduction to Derivatives and Risk Management, 7th edition

Don M. Chance and Robert Brooks

Table of Contents

Preface
Chapter 1
Introduction
Derivative Markets and Instruments
Options
Forward Contracts
Futures Contracts
Swaps and Other Derivatives
The Underlying Asset
Important Concepts in Financial and Derivative Markets
Risk Preference
Short Selling
Repurchase Agreements
Return and Risk
Market Efficiency and Theoretical Fair Value
Fundamental Linkages between Spot and Derivative Markets
Arbitrage and the Law of One Price
The Storage Mechanism: Spreading Consumption across Time
Delivery and Settlement
The Role of Derivative Markets
Risk Management
Price Discovery
Operational Advantages
Market Efficiency
Criticisms of Derivative Markets
Misuses of Derivatives
Derivatives and Your Career
Sources of Information on Derivatives
Book Overview
Organization of the Book
Key Features of the Book
Specific New Features of the Seventh Edition
Use of the Book
Summary
Key Terms
Further Reading
Questions and Problems
PART I
Options
Chapter 2
Structure of Options Markets
Development of Options Markets
Call Options
Put Options
Over-the-Counter Options Market
Organized Options Trading
Listing Requirements
Contract Size
Exercise Prices
Expiration Dates
Position and Exercise Limits
Options Exchanges and Trading Activity
Option Traders
Market Maker
Floor Broker
Order Book Official
Other Option Trading Systems
Off-Floor Option Traders
Cost and Profitability of Exchange Membership
Mechanics of Trading
Placing an Opening Order
Role of the Clearinghouse
Placing an Offsetting Order
Exercising an Option
Option Price Quotations
Types of Options
Stock Options
Index Options
Currency Options
Other Types of Options
Real Options
Transaction Costs in Option Trading
 Floor Trading and Clearing Fees
Commissions
Bid-Ask Spread
Other Transaction Costs
Regulation of Options Markets
Summary
Key Terms
Further Reading
Questions and Problems
Appendix 2.A: Margin Requirements
Margin Requirements on Stock Transactions
Margin Requirements on Option Purchases
Margin Requirements on the Uncovered Sale of Options
Margin Requirements on Covered Calls
Questions and Problem
Appendix 2.B: Taxation of Option Transactions
Taxation of Long Call Transactions
Taxation of Short Call Transactions
Taxation of Long Put Transactions
Taxation of Short Put Transactions
Taxation of Non-Equity Options
Wash and Constructive Sales
Questions and Problems
Chapter 3
Principles of Option Pricing
Basic Notation and Terminology
Principles of Call Option Pricing
Minimum Value of a Call
Maximum Value of a Call
Value of a Call at Expiration
Effect of Time to Expiration
Effect of Exercise Price
Lower Bound of a European Call
American Call Versus European Call
Early Exercise of American Calls on Dividend-Paying Stocks
Effect of Interest Rates
Effect of Stock Volatility
Principles of Put Option Pricing
Minimum Value of a Put
 Maximum Value of a Put
Value of a Put at Expiration
Effect of Time to Expiration
The Effect of Exercise Price
Lower Bound of a European Put
American Put Versus European Put
Early Exercise of American Puts
Put-Call Parity
Effect of Interest Rates
Effect of Stock Volatility
Summary
Key Terms
Further Reading
Questions and Problems
Appendix 3: The Dynamics of Option Boundary Conditions: A Learning Exercise

Chapter 4
Option Pricing Models: The Binomial Model
One-Period Binomial Model
Illustrative Example
Hedge Portfolio
Overpriced Call
Underpriced Call
Two-Period Binomial Model
Illustrative Example
Hedge Portfolio
Mispriced Call in the Two-Period World
Extensions of the Binomial Model
Pricing Put Options
American Puts and Early Exercise
Dividends, European Calls, American Calls, and Early Exercise
Extending the Binomial Model to n Periods
Behavior of the Binomial Model for Large n and Fixed Option Life
Alternative Specifications of the Binomial Model
Advantages of the Binomial Model
SOFTWARE DEMONSTRATION 4.1
Calculating the Binomial Price with the Excel Spreadsheet BSMbin7e.xls
Summary
Key Terms
Further Reading
Questions and Problems

Chapter 5
Option Pricing Models: The Black-Scholes-Merton Model
Origins of the Black-Scholes-Merton Formula
Black-Scholes-Merton Model as the Limit of the Binomial Model
Assumptions of the Black-Scholes-Merton Model
Stock Prices Behave Randomly and Evolve According to a Lognormal Distribution
Risk-Free Rate and Volatility of the Log Return on the Stock are Constant
Throughout the Option’s Life
No Taxes or Transaction Costs
Stock Pays No Dividends
Options Are European
A Nobel Formula
Digression on Using the Normal Distribution
Numerical Example
SOFTWARE DEMONSTRATION 5.1
Calculating the Black-Scholes-Merton Price with the Excel Spreadsheet
BSMbin7e.xls
Characteristics of the Black-Scholes-Merton Formula
Variables in the Black-Scholes-Merton Model
Stock Price
Exercise Price
Risk-Free Rate
Volatility or Standard Deviation
Time to Expiration
Black-Scholes-Merton Model When the Stock Pays Dividends
Known Discrete Dividends
Known Continuous Dividend Yield
Black-Scholes-Merton Model and Some Insights into American Call Options
Estimating the Volatility
Historical Volatility
Implied Volatility
SOFTWARE DEMONSTRATION 5.2
Calculating the Historical Volatility with the Excel Spreadsheet Hisv7e.xls
Put Option Pricing Models
Managing the Risk of Options
Summary
Key Terms
Further Reading
Questions and Problems
Appendix 5.A: A Shortcut to the Calculation of Implied Volatility
Appendix 5.B: The BSMbwin7e.exe Windows Software

Chapter 6
Basic Option Strategies
Terminology and Notation
Profit Equations
Different Holding Periods
Assumptions
Stock Transactions
Buy Stock
Sell Short Stock
Call Option Transactions
Buy a Call
Write a Call
Put Option Transactions
Buy a Put
Write a Put
Calls and Stock: The Covered Call
Some General Considerations with Covered Calls
Puts and Stock: The Protective Put
Synthetic Puts and Calls
SOFTWARE DEMONSTRATION 6.1
Analyzing Option Strategies with the Excel Spreadsheet Stratlyz7e.xls
Summary
Key Terms
Questions and Problems

Chapter 7
Advanced Option Strategies
Option Spreads: Basic Concepts
Why Investors Use Option Spreads
Notation
Money Spreads
Bull Spreads
Bear Spreads
A Note about Call Bear Spreads and Put Bull Spreads
 Collars
Butterfly Spreads
Calendar Spreads
Time Value Decay
Ratio Spreads
Straddles
Box Spreads
Summary
Key Terms
Further Reading
Questions and Problems

PART II
Forwards, Futures, and Swaps
Chapter 8
The Structure of Forward and Futures Markets
Development of Forward and Futures Markets
Chicago Futures Markets
Development of Financial Futures
Development of Options on Futures Markets
Parallel Development of Over-the-Counter Markets
Over-the-Counter Forward Market
Organized Futures Trading
Contract Development
Contract Terms and Conditions
Delivery Terms
Daily Price Limits and Trading Halts
Other Exchange Responsibilities
Futures Exchanges
Futures Traders
General Classes of Futures Traders
Classification by Trading Strategy
Classification by Trading Style
Off-Floor Futures Traders
Costs and Profitability of Exchange Membership
Forward Market Traders
Mechanics of Futures Trading
Placing an Order
Role of the Clearinghouse
 Daily Settlement
Delivery and Cash Settlement
Futures Price Quotations
Types of Futures Contracts
Agricultural Commodities
Natural Resources
Miscellaneous Commodities
Foreign Currencies
Federal Funds and Eurodollars
Treasury Notes and Bonds
Swap Futures
Equities
Managed Funds
Hedge Funds
Options on Futures
Transaction Costs in Forward and Futures Trading
Commissions
Bid-Ask Spread
Delivery Costs
Regulation of Futures and Forward Markets
Summary
Key Terms
Further Reading
Questions and Problems
Appendix 8: Taxation of Futures Transactions in the United States
Questions and Problems

Chapter 9
Principles of Pricing Forwards, Futures, and Options on Futures
Generic Carry Arbitrage
Concept of Price versus Value
Value of a Forward Contract
Price of a Forward Contract
Value of a Futures Contract
Price of a Futures Contract
Forward versus Futures Prices
Carry Arbitrage When Underlying Generates Cash Flows
Stock Indices and Dividends
Foreign Currencies and Foreign Interest Rates: Interest Rate Parity
 Commodities and Storage Costs
Pricing Models and Risk Premiums
Spot Prices, Risk Premiums, and Carry Arbitrage for Generic Assets
Forward/Futures Pricing Revisited
Futures Prices and Risk Premia
Put-Call-Forward/Futures Parity
Pricing Options on Futures
Intrinsic Value of an American Option on Futures
Lower Bound of a European Option on Futures
Put-Call Parity of Options on Futures
Early Exercise of Call and Put Options on Futures
Black Futures Option Pricing Model
Summary
Key Terms
Further Reading
Questions and Problems

Chapter 10
Futures Arbitrage Strategies
Short-Term Interest Rate Arbitrage
Carry Arbitrage and the Implied Repo Rate
Federal Funds Futures Carry Arbitrage and the Implied Repo Rate
Eurodollar Arbitrage
Intermediate- and Long-Term Interest Rate Arbitrage
Determining the Cheapest-to-Deliver Bond on the Treasury Bond Futures Contract
Delivery Options
Implied Repo, Carry Arbitrage and Treasury Bond Futures
SOFTWARE DEMONSTRATION 10.1
Identifying the Cheapest-to-Deliver Bond with the Excel Spreadsheet CTD7e.xls
Treasury Bond Futures Spreads and the Implied Repo Rate
Stock Index Arbitrage
Foreign Exchange Arbitrage
Summary
Key Terms
Further Reading
Questions and Problems
Appendix 10: Determining the CBOT Treasury Bond Conversion Factor
SOFTWARE DEMONSTRATION 10.2
Determining the CBOT Conversion Factor with the Excel Spreadsheet CF7e.xls
Chapter 11
Forward and Futures Hedging, Spread, and Target Strategies
Why Hedge?
Hedging Concepts
Short Hedge and Long Hedge
The Basis
Some Risks of Hedging
Contract Choice
Margin Requirements and Marking to Market
Determination of the Hedge Ratio
Minimum Variance Hedge Ratio
Price Sensitivity Hedge Ratio
Stock Index Futures Hedging
Hedging Strategies
Foreign Currency Hedges
Intermediate- and Long-Term Interest Rate Hedges
Spread Strategies
Intramarket Spreads
Intermarket Spreads
Target Strategies
Target Duration with Bond Futures
Alpha Capture
Target Beta with Stock Index Futures
Tactical Asset Allocation Using Stock and Bond Futures
Summary
Key Terms
Further Reading
Questions and Problems
Appendix 11: Taxation of Hedging

Chapter 12
Swaps
Interest Rate Swaps
Structure of a Typical Interest Rate Swap
Pricing and Valuation of Interest Rate Swaps
Interest Rate Swap Strategies
Currency Swaps
Structure of a Typical Currency Swap
 Pricing and Valuation of Currency Swaps
Currency Swap Strategies
Equity Swaps
Structure of a Typical Equity Swap
Pricing and Valuation of Equity Swaps
Equity Swap Strategies
Some Final Words about Swaps
Summary
Key Terms
Further Reading
Questions and Problems

PART III
Advanced Topics
Chapter 13
Interest Rate Forwards and Options
Forward Rate Agreements
Structure and Use of a Typical FRA
Pricing and Valuation of FRAs
Applications of FRAs
Interest Rate Options
Structure and Use of a Typical Interest Rate Option
Pricing and Valuation of Interest Rate Options
Interest Rate Option Strategies
Interest Rate Caps, Floors, and Collars
Interest Rate Options, FRAs, and Swaps
Interest Rate Swaptions and Forward Swaps
Structure of a Typical Interest Rate Swaption
Equivalence of Swaptions and Options on Bonds
Pricing Swaptions
Forward Swaps
Applications of Swaptions and Forward Swaps
Summary
Key Terms
Further Reading
Questions and Problems

Chapter 14
Advanced Derivatives and Strategies
Advanced Equity Derivatives and Strategies
Portfolio Insurance
Equity Forwards
Equity Warrants
Equity-Linked Debt
Advanced Interest Rate Derivatives
Structured Notes
Mortgage-Backed Securities
Exotic Options
Digital and Chooser Options
Path-Dependent Options
Other Exotic Options
Some Unusual Derivatives
Electricity Derivatives
Weather Derivatives
Summary
Key Terms
Further Reading
Questions and Problems
Appendix 14: Monte Carlo Simulation

Chapter 15
Financial Risk Management Techniques and Applications
Why Practice Risk Management?
Impetus for Risk Management
Benefits of Risk Management
Managing Market Risk
Delta Hedging
Gamma Hedging
Vega Hedging
Value at Risk (VAR)
A Comprehensive Calculation of VAR
Benefits and Criticisms of VAR
Extensions of VAR
Managing Credit Risk
Credit Risk as an Option
Credit Risk of Derivatives
Netting
Credit Derivatives
Other Types of Risks
Summary
Key Terms
Further Reading
Questions and Problems

Chapter 16
Managing Risk in an Organization
The Structure of the Risk Management Industry
End Users
Dealers
Other Participants in the Risk Management Industry
Organizing the Risk Management Function in a Company
Risk Management Accounting
Fair Value Hedges
Cash Flow Hedges
Foreign Investment Hedges
Speculation
Some Problems in the Application of FAS 133
Disclosure
Avoiding Derivatives Losses
Metallgesellschaft: To Hedge or Not to Hedge?
Orange County, California: Playing the Odds
Barings PLC: How One Man Blew Up a Bank
Procter & Gamble: Going Up in Suds
Risk Management Industry Standards
Responsibilities of Senior Management
Summary
Key Terms
Further Reading
Questions and Problems
Appendix A
List of Formulas
Appendix B
References
Glossary
Index