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.
Contents:
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
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
1.4Defining, Measuring, and Managing Risk
1.5The Regulatorâs Classification of Risk
1.6Portfolio Risk Management
1.7Corporate Financial Risk Management
Risks That Businesses Face
Nonhedged Risks
Risk Management in a Blue Chip Company
1.8Risk Management Perspectives in This Book
1.9Summary
1.10Cases
1.11Questions 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 2007â2009, 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 assetâs 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 didnât exist. Although Einstein had developed the theory of relativity and astronauts had landed on the moon, no one knew how to price an option. Thatâs 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 derivativesâthese folks are admirably called ârocket scientistsâ (âquantsâ 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.
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 regulatorâs, the portfolio managerâs, and the corporate financial managerâs 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 Wesselâs Wall Street Journal article titled âA Source of Our Bubble Trouble,â dated January 17, 2008, alludes:
Modern finance is, truly, as powerful and innovative as modern science. More people own homesâmany of them still making their mortgage paymentsâbecause 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 âtens of billions of dollars of losses in new-fangled investments [in derivatives and other complex securities] at the largest US financial institutionsâand the belated realization that some of those Ph.D. wielding,...