An Introduction to Derivative Securities, Financial Markets, and Risk Management
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An Introduction to Derivative Securities, Financial Markets, and Risk Management

Robert Jarrow, Arkadev Chatterjea

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eBook - ePub

An Introduction to Derivative Securities, Financial Markets, and Risk Management

Robert Jarrow, Arkadev Chatterjea

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About This Book

Written by two of the most distinguished finance scholars in the industry, this introductory textbook on derivatives and risk management is highly accessible in terms of the concepts as well as the mathematics.

With its economics perspective, this rewritten and streamlined second edition textbook, is closely connected to real markets, and:

Beginning at a level that is comfortable to lower division college students, the book gradually develops the content so that its lessons can be profitably used by business majors, arts, science, and engineering graduates as well as MBAs who would work in the finance industry.


  • Introduction:
    • Derivatives and Risk Management
    • Interest Rates
    • Stocks
    • Forwards and Futures
    • Options
    • Arbitrage and Trading
    • Financial Engineering and Swaps
  • Forwards and Futures:
    • Forwards and Futures Markets
    • Futures Trading
    • Futures Regulations
    • The Cost-of-Carry Model
    • The Extended Cost-of-Carry Model
    • Futures Hedging
  • Options:
    • Options Markets and Trading
    • Option Trading Strategies
    • Option Relations
    • Single-Period Binomial Model
    • Multiperiod Binomial Model
    • The Black–Scholes–Merton Model
    • Using the Black–Scholes–Merton Model
  • Interest Rate Derivatives:
    • Yields and Forward Rates
    • Interest Rate Swaps
    • Single-Period Binomial HJM Model
    • Multiperiod Binomial HJM Model
    • The HJM Libor Model
    • Risk Management Models

Readership: Undergraduate and graduate students of economics, business, arts, science and engineering, and MBAs who would work in the finance industry.Derivatives;Financial Markets;Risk Management;Arbitrage;Financial Engineering;Forwards;Futures;Call Options;Put Options;European Options;American Options;Swaps;Currency Swaps;Interest Rate Swaps;Commodity Swaps;Equity Swaps;Credit Default Swaps;Commodity Derivatives;Equity Derivatives;Index Derivatives;Interest Rate Derivatives;Commodities;Margins and Daily Settlements;Binomial Model;Black-Scholes Model;Black-Scholes-Merton Model;Delta Hedging;Gamma Hedging;Heath-Jarrow-Morton Model;Libor Model,;Forward Rate Agreements;Interest Rate Futures;Interest Rate Options;Market Manipulation;Regulation;Derivatives Exchanges00

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1 Derivatives and Risk Management

1.1 Introduction
1.2 Financial Innovation
Expanding Derivatives Markets
Two Economic Motives
1.3 Traded Derivative Securities
EXTENSION 1.1 The Influence of Regulations, Taxes, and Transaction Costs on Financial Innovation
Diverse Views on Derivatives
Applications and Uses of Derivatives
A Quest for Better Models
1.4 Defining, Measuring, and Managing Risk
1.5 The Regulator’s Classification of Risk
1.6 Portfolio Risk Management
1.7 Corporate Financial Risk Management
Risks That Businesses Face
Nonhedged Risks
Risk Management in a Blue Chip Company
1.8 Risk Management Perspectives in This Book
1.9 Summary
1.10 Cases
1.11 Questions and Problems

1.1 Introduction

The bursting of the housing price bubble, the credit crisis of 2007, the resulting losses of hundreds of billions of dollars on credit derivatives, and the failure of prominent financial institutions have forever changed the way the world views derivatives. Today derivatives are of interest not only to Wall Street but also to Main Street. Derivatives are cursed as one of the causes of the Great Recession of 2007–2009, a period of decreased economic output and high unemployment.
But what are derivatives? A derivative security or a derivative is a financial contract that derives its value from an underlying asset’s price, such as a stock or a commodity, or even from an underlying financial index like an interest rate. A derivative can both reduce risk, by providing insurance (which, in financial parlance, is referred to as hedging), and magnify risk, by speculating on future events. Derivatives provide unique and different ways of investing and managing wealth that ordinary securities do not.
Derivatives have a long and checkered past. In the 1960s, only a handful of individuals studied derivatives. No academic books covered the topic, and no college or university courses were available. Derivatives markets were small, located mostly in the US and Western Europe. Derivative users included only a limited number of traders in futures markets and on Wall Street. The options market existed as trading between professional traders (called the over-the-counter [OTC] market) with little activity. In addition, cheating charges often gave the options market disrepute. Derivatives discussion did not add sparkle to cocktail conversations, nor did it generate the allegations and condemnations that it does today. Brash young derivatives traders who drive exotic cars and move millions of dollars with the touch of a computer key didn’t exist. Although Einstein had developed the theory of relativity and astronauts had landed on the moon, no one knew how to price an option. That’s because in the 1960s, nobody cared, and derivatives were unimportant.
What a difference the following decades have made! Beginning in the early 1970s, derivatives have undergone explosive growth in the types of contracts traded and in their importance to the financial and real economy. According to the Bank for International Settlements (known as the BIS), the markets are now global and measured in trillions of dollars. Indeed, as depicted in Figure 1.1, in December 2016 the total outstanding US dollar notional value for exchange-traded derivatives was (26,172 + 41,072 =) 67,245 billion and for OTC derivatives a staggering 500,419 billion. Hundreds of academics study derivatives, and thousands of articles have been written on the topic of pricing derivatives. Colleges and universities now offer numerous derivatives courses using textbooks written on the subject. Derivatives experts are in great demand. In fact, Wall Street firms hire PhDs in mathematics, engineering, and the natural sciences to understand derivatives—these folks are admirably called “rocket scientists” (“quants” is another name). If you understand derivatives, then you know cool stuff; you are hot and possibly dangerous. Today understanding derivatives is an integral part of the knowledge needed in the risk management of financial institutions.
FIGURE 1.1: Global Derivatives Market
Source:, Table D1: Exchange-traded futures and options, by location of exchange; and, Table D5: Global OTC derivatives market.
Markets have changed to accommodate derivatives trading in three related ways: the introduction of new contracts and new exchanges, the consolidation and linking of exchanges, and the introduction of computer technology. Sometimes these changes happened with astounding quickness. For example, when twelve European nations replaced their currencies with the euro in 2002, financial markets for euro-denominated interest rate derivatives sprang up almost overnight, and in some cases, they quickly overtook the dollar-denominated market for similar interest rate derivatives.
This chapter tells the fascinating story of this expansion in derivatives trading and the controversy surrounding its growth. An understanding of the meaning of financial risk is essential in fully understanding this story. Hence a discussion of financial risk comes next, from the regulator’s, the portfolio manager’s, and the corporate financial manager’s points of view. We explain each of these unique perspectives, using them throughout the book to increase our understanding of the uses and abuses of derivatives. A summary completes the chapter.

1.2 Financial Innovation

Derivatives are at the core of financial innovation, for better or for worse. They are the innovations to which columnist David Wessel’s Wall Street Journal article titled “A Source of Our Bubble Trouble,” dated January 17, 2008, alludes:
Modern finance is, truly, as powerful and innovative as modern science. More people own homes—many of them still making their mortgage payments—because mortgages were turned into securities sold around the globe. More workers enjoy stable jobs because finance shields their employers from the ups and downs of commodity prices. More genius inventors see dreams realized because of venture capital. More consumers get better, cheaper insurance or fatter retirement checks because of Wall Street wizardry.
Expressed at a time when most of the world was in the Great Recession, this view is challenged by those who blame derivatives for the crisis. Indeed, this article goes on to say that “tens of billions of dollars of losses in new-fangled investments [in derivatives and other complex securities] at the largest US financial institutions—and the belated realization that some of those Ph.D. wielding,...

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