Financial Derivatives

Futures, Forwards, Swaps, Options, Corporate Securities, and Credit Default Swaps

George M Constantinides

• Publisher: WSPC
• Year: 2014
• eBook ISBN: 9789814618441
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Derivatives markets are an important and growing segment of financial markets and play an important role in the management of risk.

This invaluable set of lecture notes is meant to be used in conjunction with a standard textbook on derivatives in an advanced undergraduate or MBA elective course on futures, forwards, swaps, options, corporate securities, and credit default swaps. It covers the foundations of derivatives pricing in arbitrage-free markets, develops the methodology of risk-neutral valuation, and discusses hedging and the management of risk.

Contents:

• Introduction to Forward and Futures Contracts
• Pricing Forwards and Futures
• Interest Rate and Currency Swaps
• Introduction to Options and No-Arbitrage Restrictions
• Trading Strategies and Slope and Convexity Restrictions
• Optimal Early Exercise of American Options
• Binomial Option Pricing
• Using the Binomial Model
• The Black–Scholes–Merton Option Pricing Formula
• Options on Futures
• Risk Management
• Empirical Evidence and Fixes
• Corporate Securities and Credit Risk

Readership: Advanced undergraduates and postgraduate students of finance along with MBA students taking an elective on derivatives and risk management in finance.
Key Features:

• Develops the theory of arbitrage-free derivatives pricing
• Covers a broad set of derivatives including futures, forwards, swaps, options, corporate securities, and credit default swaps
• Discusses hedging and risk management

Chapter 1

Introduction to Forward
and Futures Contracts

Take-Away: Understand the differences between forward and futures contracts institutionally and in terms of the marking-to-market process.

Agenda

• What are derivatives?

• How did derivatives evolve?

• Forward contracts

• Example: Using forward contracts for hedging

• Payoff diagram for long and short forward positions

• Futures contracts

• Example: Using futures contracts for hedging

• Payoff diagram for long and short forward positions

• Other types of derivatives

What are Derivatives?

• “Textbook” definition: A derivatives contract is a contract that derives its value from one or more underlying asset prices, reference rates, or indices.

• Because future payoffs of derivatives are determined by future prices of underlying securities, we can derive relationships between the current prices of the derivative and underlying securities based on no-arbitrage arguments.

• The purpose of this book is to develop and study these relationships. We also use these relationships to analyze how derivatives can be used for hedging and speculation.

• These relationships are often independent of factors such as market participants’ risk aversion, and of some of the properties of the primitive security itself.

• Derivatives are great devices to . . .

Perform successful risk management;

Deal with most market frictions;

Take on speculative positions;

Transfer risk from those who have it to those who want it.

• But proper understanding of the risks and benefits is key to success . . .

1993: Metallgesellschaft losses on oil futures $1.3 billion,

1994: P&G losses on levered swaps ~$200 million,

1994: Orange County losses on int. rate deriv. ~$1.5 billion,

1995: Barings Brothers losses on short straddle on futures ~$1.3 billion,

1998: LTCM losses on convergence strategies ~$3.5 billion,

2006: Amaranth losses on gas futures ~$500 million,

2008: Soc. Gen. losses on equity futures ~$7 billion,

2007–2009 credit crisis: CDSs (credit default swaps) and CDOs (collateralized debt obligations).

How Did Derivatives Evolve?

• Ancient Greek philosopher, Thales, obtained the right to lease the olive oil presses at fixed prices during the harvest.

• Medieval fairs in the 1400s and 1500s involved extensive use of forward contracts on grain and other goods.

• Futures on rice traded in Osaka in the 1700s.

• Options traded in Amsterdam in the 1700s.

• Futures on grains traded in Chicago in 1848 (CBOT).

• Options on equity listed on the CBOT in the 1930s.

• Financial futures traded in Chicago by the 1970s.

Forward Contracts

• A forward contract is an agreement between two parties to buy (sell) something at a pre-specified price on a pre-specified date:

The party agreeing to buy the good in the future is said to buy a forward, and has a long position.

The party agreeing to sell the good in the future is said to sell a forward, and has a short position.

• Contract specification:

Amount and quality of good to be delivered;

Delivery price (K);

Time of delivery (T);

Location of delivery.

• The net number of outstanding contracts is always zero:

# Long Positions − # Short Positions = 0.

• Forward contracts are...

Table of contents

• Cover
• Halftitle
• Series Editor
• Title Page
• Copyright Page
• Dedication
• Contents
• About the Author
• Preface
• Chapter 1 Introduction to Forward and Futures Contracts
• Chapter 2 Pricing Forwards and Futures
• Chapter 3 Interest Rate and Currency Swaps
• Chapter 4 Introduction to Options and No-Arbitrage Restrictions
• Chapter 5 Trading Strategies and Slope and Convexity Restrictions
• Chapter 6 Optimal Early Exercise of American Options
• Chapter 7 Binomial Option Pricing
• Chapter 8 Using the Binomial Model
• Chapter 9 The Black–Scholes–Merton Option Pricing Formula
• Chapter 10 Options on Futures
• Chapter 11 Risk Management
• Chapter 12 Empirical Evidence and Fixes
• Chapter 13 Corporate Securities and Credit Risk