Equity Derivatives Explained

Transcription

1 Equity Derivatives Explained

2 Financial Engineering Explained About the series Financial Engineering Explained is a series of concise, practical guides to modern finance, focusing on key, technical areas of risk management and asset pricing. Written for practitioners, researchers and students, the series discusses a range of topics in a non-mathematical but highly intuitive way. Each self-contained volume is dedicated to a specific topic and offers a thorough introduction with all the necessary depth, but without too much technical ballast. Where applicable, theory is illustrated with real world examples, with special attention to the numerical implementation. Series Editor: Wim Schoutens, Department of Mathematics, Catholic University of Leuven. Series Advisory Board: Peter Carr, Executive Director, NYU Mathematical Finance; Global Head of Market Modeling, Morgan Stanley. Ernst Eberlein, Department of Mathematical Stochastics, University of Freiburg. Matthias Scherer, Chair of Mathematical Finance, Technische Universität München. Titles in the series: Equity Derivatives Explained, Mohamed Bouzoubaa Forthcoming titles: Smile Pricing Explained, Peter Austing The Greeks and Hedging Explained, Peter Leoni Interest Rates Explained Volume 1, Jörg Kienitz Interest Rates Explained Volume 2, Jörg Kienitz Dependence Modeling Explained, Matthias Scherer and Jan-Frederik Mai Submissions: Wim Schoutens wim@shoutens.be Financial Engineering Explained series Series Standing Order ISBN You can receive future titles in this series as they are published by placing a standing order. Please contact your bookseller or, in case of difficulty, write to us at the address below with your name and address, the title of the series and the ISBN quoted above. Customer Services Department, Macmillan Distribution Ltd, Houndmills, Basingstoke, Hampshire RG21 6XS, England

3 Equity Derivatives Explained Mohamed Bouzoubaa

4 Mohamed Bouzoubaa 2014 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6 10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act First published 2014 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number , of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin s Press LLC, 175 Fifth Avenue, New York, NY Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave and Macmillan are registered trademarks in the United States, the United Kingdom, Europe and other countries ISBN ISBN (ebook) DOI / This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress.

5 To my parents and family And special thanks to Lamia

6 vii Contents List of Figures ix 1 Fundamentals Stock Markets and Indices Interest Rates and Dividends Short Selling and Borrowing Volatility Concepts 10 2 Inside the World of Equity Derivatives The Sell Side The Buy Side 19 3 Forwards, Futures and Swaps Futures Markets Forward Contracts Equity Swaps Dividend Swaps 35 4 Pricing Vanilla Options European Calls and Puts Hedging Cost Principle Pricing Vanillas American Options Asian Options 52 5 Risk Management Tools All About the Greeks Greeks Closed Relationships Choosing the Right Model 71 6 Strategies Built around Vanillas Equity Hedging the Traditional Way Vertical Spreads Bear Put Spread Collars and Three-Ways Butterfly and Condor Spreads Straddles and Strangles 86

7 viii Contents 7 Yield Enhancement Solutions Equity Structured Notes Playing with Volatility Equity Dispersion Derivatives Dynamic Indices 94 Index 97

8 ix List of Figures 1.1: AUD denominated upward-sloping yield curve 5 1.2: Downward-sloping curve 5 1.3: Humped yield curve 5 1.4: Short selling scheme 8 1.5: Implied volatility skew versus flat volatility graph : Term structure of volatility : Communication scheme between the sell side front office and the buy side when a reverse enquiry takes place : Margin call mechanism : Terms of a one-year forward contract : Payoff patterns from long and short forward positions : Cash flows exchanged in a three-month bullet equity swap : Financing and execution of the purchase of shares by a bank on behalf of the client : Exchanged cash flows during the life of a swap : Outcomes of an equity swap : Diagram of an equity swap transaction : Dividend swaps mechanism : Moneyness of European call and put options : Payoff of a long ATM call position and payoff of a short OTM call position : Comparison of profits from long positions in a European call and a forward contract with identical strikes at 110% : Payoff of a long position in a European put with strike at 100% and from a short position in a European put with strike at 110% : Comparison of profits from long positions in a European put and a forward contract with identical strikes : Terms of a two-year European put option : Log-normal distribution 45

9 x List of Figures 4.8: Cumulative probability up to the standardized normal value : Price of a one-year European call struck at 100% with respect to the underlying spot price : Price of a one-year European put with strike at 100% with respect to the underlying spot price : Price of a forward contract with respect to the underlying stock s price : Impact of time on the delta of a European call : Effects of volatility on the delta of a European call : Delta of a European put option with respect to the underlying stock s price for different maturities : Gamma of a European option with respect to the underlying stock s price for different maturities : Vega of a European put option with respect to the underlying stock s price for different maturities : Theta of a European call option with respect to the underlying stock s price for different maturities : Theta of a European put option with respect to the underlying stock s price for different maturities : Rho of a European call option with respect to the underlying stock s price for different maturities : Rho of a European put option with respect to the underlying stock s price for different maturities : Profit graph from a short covered call position : Profit graph associated with a protective put strategy : Payoff and profit of a call spread strategy : Bearish put spread versus vanilla put : Profit at maturity from an equity collar composed of a long position in the underlying stock and a zero-cost short risk-reversal position with strikes at 80% and 120% : Profit at maturity from adding a three-way with strikes at 60%/80%/130% to a stock portfolio : Payoff and profit of a short butterfly spread strategy : Payoff and profit of a short condor spread strategy : Payoff and profit of a long straddle strategy : Payoff and profit of a long strangle strategy : Composition and payoff of a three-year equity structure note based on S&P 500 index 90