Elementary Financial Derivatives

A Guide to Trading and Valuation with Applications

Jana Sacks

• Publisher: Wiley
• Year: 2015
• Print ISBN: 9781119076759
• eBook ISBN: 9781119077312
• Edition: 1
• Topic: Business
• Subtopic: Financial Engineering
• Index: Business

A step-by-step approach to the mathematical financial theory and quantitative methods needed to implement and apply state-of-the-art valuation techniques

Written as an accessible and appealing introduction to financial derivatives, Elementary Financial Derivatives: A Guide to Trading and Valuation with Applications provides the necessary techniques for teaching and learning complex valuation techniques. Filling the current gap in financial engineering literature, the book emphasizes an easy-to-understand approach to the methods and applications of complex concepts without focusing on the underlying statistical and mathematical theories.

Organized into three comprehensive sections, the book discusses the essential topics of the derivatives market with sections on options, swaps, and financial engineering concepts applied primarily, but not exclusively, to the futures market. Providing a better understanding of how to assess risk exposure, the book also includes:

• A wide range of real-world applications and examples detailing the theoretical concepts discussed throughout
• Numerous homework problems, highlighted equations, and Microsoft^® Office Excel^® modules for valuation
• Pedagogical elements such as solved case studies, select answers to problems, and key terms and concepts to aid comprehension of the presented material
• A companion website that contains an Instructor's Solutions Manual, sample lecture PowerPoint^® slides, and related Excel files and data sets

Elementary Financial Derivatives: A Guide to Trading and Valuation with Applications is an excellent introductory textbook for upper-undergraduate courses in financial derivatives, quantitative finance, mathematical finance, and financial engineering. The book is also a valuable resource for practitioners in quantitative finance, industry professionals who lack technical knowledge of pricing options, and readers preparing for the CFA exam.

Jana Sacks, PhD, is Associate Professor in the Department of Accounting and Finance at St. John Fisher College in Rochester, New York. A member of The American Finance Association, the National Association of Corporate Directors, and the International Atlantic Economic Society, Dr. Sack's research interests include risk management, credit derivatives, pricing, hedging, and structured finance.

1
Derivative Instruments: Concepts and Definitions

1.1 Key Derivative Instruments Definitions

Forwards and Futures

A forward contract is a contract between two parties. It states that one of the two parties is to buy something from the other at a later date at a price agreed upon today.

A futures contract is also a contract between two parties. One party is bound to buy something from the other at a later date at a price agreed upon today, subject to a daily settlement of gains and losses and guaranteed against the risk that either party might default.

Swaps

A swap is a contract in which two parties agree to exchange a series of cash flows at predetermined dates over a period of time.

Options

Options are contracts made between two parties that give one party, the buyer, the right to buy or sell an asset from or to the other party, the seller, at a later date and price agreed upon today.

Positions

All derivative contracts have essentially two basic positions: long and short. Long position refers to buying, whereas short position refers to selling. The exact positions, rights, and obligations stemming from them differ for different types of financial derivatives.

1.2 The Role, Risks, and Benefits of Derivatives Markets

Derivative instruments are securities that derive their value from an underlying asset. They offer investors global diversification in financial instruments and currencies, and promise to generate returns that are superior to traditional investments. Investors in derivatives can profit from changes in interest rates and equity markets around the world, currency exchange rate shifts, and changes in global supply and demand for various types of commodities such as precious and industrial metals, oil, and grains.

There are two widely recognized benefits of derivative instruments: price discovery and risk management.

Price Discovery

How do we determine prices? Prices depend on a continuous flow of information from around the world and require the highest possible degree of transparency. A broad range of various elements constantly have an impact on supply and demand for assets. Information flow concerning political situations, climatic and environmental conditions, debt situation, and societal behavioral patterns constantly impacts the price of a commodity, such as wheat, soybeans, and oil. This process is known as price discovery.

Futures markets in particular are a useful tool to help discover prices. Futures markets are considered a primary means for determining the spot price of an asset. The futures market is more active than the spot market; hence, information taken from it is often considered more reliable. Futures markets' underlying assets can be geographically quite dispersed and hence have more than one spot price in existence. The price of the contract with the shortest time to expiration often serves as a proxy for the underlying spot price of an asset.

Options are also relevant in price discovery, mostly in the way the market participants view markets' volatility. If investors think that the markets will be volatile, the option premiums (i.e., their purchase prices) will spike higher.

Risk Management

Companies and investors today use derivatives as tools in their strategies designed to enable them to manage risk exposures more effectively. Risk management is about both hedging and speculation. At times, investors want to increase their risk exposure to gain greater expected return. At other times, investors will want to protect themselves from undesirable risk exposure. Risk management has a very important purpose for the derivatives market. It is essentially the process of recognizing the desired level of risk, detecting the actual level of risk, and altering the actual to equal the desired.

Derivative securities represent additional risks to investors. Many of those risks are heightened by investors perhaps not fully understanding the proper use of said instruments. For example, options offer the potential for vast gains and losses. While the potential for gain is appealing, their complexity makes them suitable for only sophisticated investors with a high degree of risk tolerance.

Professional traders and money managers can use derivatives effectively. They are aware and trained to work with risk exposures stemming from (1) expiration time of the instrument, (2) market timing, (3) market direction, (4) market volatility, and (5) transaction costs.

Derivative instruments have expiration dates. As each day passes, the expiration date approaches and investors lose more and more “time value”. In the case of options, that alone makes an option's value decrease. In order to make money with most derivatives, investors need to accurately predict the direction in which the ...

Table of contents

• Cover
• Title Page
• Copyright
• Dedication
• Preface
• Acknowledgments
• Table of Figures
• About the Companion Websites
• Chapter 1: Derivative Instruments: Concepts and Definitions
• Chapter 2: Forwards And Futures
• Chapter 3: Swaps
• Chapter 4: Options
• Literature
• Index
• End User License Agreement