FUNDAMENTALS OF FUTURES AND OPTIONS MARKETS

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1 SEVENTH EDITION FUNDAMENTALS OF FUTURES AND OPTIONS MARKETS GLOBAL EDITION John C. Hull / Maple Financial Group Professor of Derivatives and Risk Management Joseph L. Rotman School of Management University of Toronto Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo

2 CONTENTS IN BRIEF Business snapshots xv Preface xvii 1. Introduction 1 2. Mechanics of futures markets Hedging strategies using futures / Interest rates Determination of forward and futures prices Interest rate futures Swaps Securitization and the credit crisis of Mechanics of options markets Properties of stock options." Trading strategies involving options Introduction to binomial trees Valuing stock options: The Black-Scholes-Merton model Derivatives markets in developing countries Options on stock indices and currencies Futures options The Greek letters Binomial trees in practice Volatility smiles ( Value at risk Interest rate options Exotic options and other nonstandard products Credit derivatives Weather, energy, and insurance derivatives Derivatives mishaps and what we can learn from them 525 Answers to quiz questions 537 Glossary of terms 561 DerivaGem software 579 Major exchanges trading futures and options 585 Tables for N(x) 586 Index 589

3 Contents Business Snapshots Preface Chapter 1: Introduction Futures Contracts History of Futures Markets The Over-the-Counter Market Forward Contracts Options History of Options Markets Types of Traders! Hedgers Speculators Arbitrageurs Dangers 16 Summary 16 Further Reading 18 Quiz 18 Practice Questions 18 Further Questions 19 Chapter 2: Mechanics of Futures Markets Opening and Closing Futures Positions Specification of a Futures Contract Convergence of Futures Price to Spot Price The Operation of Margins OTC Markets Newspaper Quotes Delivery Types of Trader and Types of Order Regulation Accounting and Tax Forward vs. Futures Contracts 40 Summary 42 Further Reading 43 Quiz 43 Practice Questions 43 Further Questions 44 xv xvii vii

4 Vlll Contents Chapter 3: Hedging Strategies Using Futures Basic Principles Arguments for and against Hedging Basis Risk Cross Hedging Stock Index Futures Rolling the Hedge Forward 67 Summary 68 Further Reading.^ 69 Quiz ".'...:.'.: 70 Practice Questions 71 Further Questions 72 Appendix: Review of Key Concepts in Statistics and the CAPM 74 Chapter 4: Interest Rates Types of Rates Measuring Interest Rates Zero Rates Bond Pricing Determining Treasury Zero Rates Forward Rates Forward Rate Agreements Theories of the Term Structure of Interest Rates '. 93 Summary 95 Further Reading 96 Quiz 96 Practice Questions 97 Further Questions 98 Appendix: Exponential and Logarithmic Functions 100 Chapter 5: Determination of Forward and Futures Prices Investment Assets vs. Consumption Assets Short Selling Assumptions and Notation Forward Price for an Investment Asset Known Income Known Yield Ill 5.7 Valuing Forward Contracts Ill 5.8 Are Forward Prices and Futures Prices Equal? Futures Prices of Stock Indices Forward and Futures Contracts on Currencies Futures on Commodities The Cost of Carry ^ Delivery Options Futures Prices and the Expected Spot Prices 124 Summary 126 Further Reading 127 Quiz 128

5 Contents ix Practice Questions 128 Further Questions 130 Chapter 6: Interest Rate Futures Day Count and Quotation Conventions Treasury Bond Futures Eurodollar Futures Duration Duration-Based Hedging Strategies Using Futures 147 Summary 151 Further Reading 152 Quiz 152 Practice Questions 153 Further Questions 154 Chapter 7: Swaps Mechanics of Interest Rate Swaps Day Count Issues Confirmations " The Comparative-Advantage Argument The Nature of Swap Rates." Determining LIBOR/Swap Zero Rates > Valuation of Interest Rate Swaps Currency Swaps Valuation of Currency Swaps Credit Risk Other Types of Swap 182 Summary 184 Further Reading 185 Quiz 185 Practice Questions 186 Further Questions 188 Chapter 8: Securitization and the Credit Crisis of Securitization The U.S. Housing Market What Went Wrong? Avoiding Future Crises 198 Summary 201 Further Reading 202 Quiz 202 Practice Questions 203 _ Further Questions 203 Chapter 9: Mechanics of Options Markets Types of Option Option Positions Underlying Assets Specification of Stock Options Trading Commissions 216

6 X Contents 9.7 Margins The Options Clearing Corporation Regulation Taxation Warrants, Employee Stock Options, and Convertibles Over-the-Counter Markets 222 Summary 222 Further Reading 223 Quiz ; 223 Practice Questions "!...:.r..~. 224 Further Questions 225 Chapter 10: Properties of Stock Options Factors Affecting Option Prices Assumptions and Notation : Upper and Lower Bounds for Option Prices Put-Call Parity Calls on a Non-Dividend-Paying Stock Puts on a Non-Dividend-Paying Stock Effect of Dividends : 243 Summary 244 Further Reading 245 Quiz 245 Practice Questions 246 Further Questions 247 Chapter 11: Trading Strategies Involving Options Strategies Involving a Single Option and a Stock Spreads Combinations Other Payoffs 263 Summary 263 Further Reading 264 Quiz 264 Practice Questions 264 Further Questions 265 Chapter 12: Introduction to Binomial Trees A One-Step Binomial Model and a No-Arbitrage Argument Risk-Neutral Valuation Two-Step Binomial Trees A Put Example American Options Delta Determining u and d Increasing the Number of Time Steps Options on Other Assets 281 Summary 286 Further Reading 286 Quiz 286

7 Contents xi Practice Questions 287 Further Questions 288 Chapter 13: Valuing Stock Options: The Black-Scholes-Merton Model Assumptions about How Stock Prices Evolve Expected Return Volatility Estimating Volatility from Historical Data Assumptions Underlying Black-Scholes-Merton The Key No-Arbitrage Argument The Black-Scholes-Merton Pricing "Formulas Risk-Neutral Valuation Implied Volatilities Dividends Valuing Employee Stock Options 306 Summary 310 Further Reading 311 Quiz 311 Practice Questions 312 Further Questions.' 313 Appendix: The Early Exercise of American Call Options on Dividend-Paying Stocks 315 Chapter 14: Derivatives Markets in Developing Countries China's Markets India's Markets Other Developing Countries 320 Summary 320 Further Reading 321 Chapter 15: Options on Stock Indices and Currencies Options on Stock Indices Currency Options Options on Stocks Paying Known Dividend Yields Valuation of European Stock Index Options Valuation of European Currency Options American Options 334 Summary 335 Further Reading 335 Quiz...: 336 Practice Questions 336 Further Questions 338 Chapter 16: Futures Options Nature of Futures Options Reasons for the Popularity of Futures Options European Spot and Futures Options Put-Call Parity Bounds for Futures Options Valuation of Futures Options Using Binomial Trees A Futures Price as an Asset Providing a Yield 347

8 xii Contents 16.8 Black's Model for Valuing Futures Options Using Black's Model Instead of Black-Scholes-Merton American Futures Options vs. American Spot Options Futures-Style Options 349 Summary 350 Further Reading 351 Quiz 351 Practice Questions 351 Further Questions Chapter 17: The Greek Letters...!...: Illustration Naked and Covered Positions A Stop-Loss Strategy Delta Hedging Theta Gamma Relationship Between Delta, Theta, and Gamma Vega Rho The Realities of Hedging Scenario Analysis Extensions of Formulas Creating Options Synthetically for Portfolio Insurance Stock Market Volatility 380 Summary 381 Further Reading 382 Quiz 382 Practice Questions 383 Further Questions 385 Chapter 18: Binomial Trees in Practice The Binomial Model for a Non-Dividend-Paying Stock Using the Binomial Tree for Options on Indices, Currencies, and Futures Contracts The Binomial Model for a Dividend-Paying Stock Extensions of the Basic Tree Approach Alternative Procedure for Constructing Trees Monte Carlo Simulation Summary : 405 Further Reading 406 Quiz 406 Practice Questions 406 Further Questions 407 Chapter 19: Volatility Smiles Foreign Currency Options Equity Options The Volatility Term Structure and Volatility Surfaces When a Single Large Jump Is Anticipated 416

9 Contents xiii Summary 417 Further Reading 418 Quiz 419 Practice Questions 419 Further Questions 420 Appendix: Why the Put Volatility Smile is the Same as the Call Volatility Smile 422 Chapter 20: Value at Risk The VaR Measure Historical Simulation \...:..; Model-Building Approach Generalization of Linear Model Quadratic Model Estimating Volatilities and Correlations Comparison of Approaches Stress Testing and Back Testing : 449 Summary 449 Further Reading 450 Quiz : 451 Practice Questions 452 Further Questions 453 Appendix: Cash-Flow Mapping 455 Chapter 21: Interest Rate Options Exchange-Traded Interest Rate Options Embedded Bond Options Black's Model European Bond Options Interest Rate Caps European Swap Options Term Structure Models 472 Summary 473 Further Reading 474 Quiz Practice Questions 475 Further Questions 476 Chapter 22: Exotic Options and Other Nonstandard Products Exotic Options Agency Mortgage-Backed Securities Nonstandard Swaps 485 Summary 492 Further Reading 492 Quiz 493 Practice Questions 493 Further Questions 494 Chapter 23: Credit Derivatives Credit Default Swaps Determining CDS Spreads 502

10 xiv Contents 23.3 Total Return Swaps CDS Forwards and Options Collateralized Debt Obligations 509 Summary 513 Further Reading 513 Quiz 514 Practice Questions 514 Further Questions 515 Chapter 24: Weather, Energy, and Insurance Derivatives Weather Derivatives..';...; Energy Derivatives Insurance Derivatives : 521 Summary 522 Further Reading 523 Quiz : 523 Practice Questions 524 Further Question 524 Chapter 25: Derivatives Mishaps and What We Can Learn From Them Lessons for All Users of Derivatives Lessons for Financial Institutions Lessons for Nonfinancial Corporations 534 Summary 535 Further Reading 536 Answers to Quiz Questions 537 Glossary of Terms 561 DerivaGem Software 579 The Options Calculator 580 The Applications Builder 583 Major Exchanges Trading Futures and Options 585 Table for N(x) When x < Table for N(x) When x > Index \ 589

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