An Introduction to Derivatives and Risk Management, 7 th edition Don M. Chance and Robert Brooks Table of Contents Preface Chapter 1 Introduction Derivative Markets and Instruments Options Forward Contracts Futures Contracts Swaps and Other Derivatives The Underlying Asset Important Concepts in Financial and Derivative Markets Risk Preference Short Selling Repurchase Agreements Return and Risk Market Efficiency and Theoretical Fair Value Fundamental Linkages between Spot and Derivative Markets Arbitrage and the Law of One Price The Storage Mechanism: Spreading Consumption across Time Delivery and Settlement The Role of Derivative Markets Risk Management Price Discovery Operational Advantages Market Efficiency Criticisms of Derivative Markets Misuses of Derivatives Derivatives and Your Career Sources of Information on Derivatives Book Overview Organization of the Book Key Features of the Book Specific New Features of the Seventh Edition Use of the Book
PART I Options Chapter 2 Structure of Options Markets Development of Options Markets Call Options Put Options Over-the-Counter Options Market Organized Options Trading Listing Requirements Contract Size Exercise Prices Expiration Dates Position and Exercise Limits Options Exchanges and Trading Activity Option Traders Market Maker Floor Broker Order Book Official Other Option Trading Systems Off-Floor Option Traders Cost and Profitability of Exchange Membership Mechanics of Trading Placing an Opening Order Role of the Clearinghouse Placing an Offsetting Order Exercising an Option Option Price Quotations Types of Options Stock Options Index Options Currency Options Other Types of Options Real Options Transaction Costs in Option Trading
Floor Trading and Clearing Fees Commissions Bid-Ask Spread Other Transaction Costs Regulation of Options Markets Appendix 2.A: Margin Requirements Margin Requirements on Stock Transactions Margin Requirements on Option Purchases Margin Requirements on the Uncovered Sale of Options Margin Requirements on Covered Calls Questions and Problem Appendix 2.B: Taxation of Option Transactions Taxation of Long Call Transactions Taxation of Short Call Transactions Taxation of Long Put Transactions Taxation of Short Put Transactions Taxation of Non-Equity Options Wash and Constructive Sales Chapter 3 Principles of Option Pricing Basic Notation and Terminology Principles of Call Option Pricing Minimum Value of a Call Maximum Value of a Call Value of a Call at Expiration Effect of Time to Expiration Effect of Exercise Price Lower Bound of a European Call American Call Versus European Call Early Exercise of American Calls on Dividend-Paying Stocks Effect of Interest Rates Effect of Stock Volatility Principles of Put Option Pricing Minimum Value of a Put
Maximum Value of a Put Value of a Put at Expiration Effect of Time to Expiration The Effect of Exercise Price Lower Bound of a European Put American Put Versus European Put Early Exercise of American Puts Put-Call Parity Effect of Interest Rates Effect of Stock Volatility Appendix 3: The Dynamics of Option Boundary Conditions: A Learning Exercise Chapter 4 Option Pricing Models: The Binomial Model One-Period Binomial Model Illustrative Example Hedge Portfolio Overpriced Call Underpriced Call Two-Period Binomial Model Illustrative Example Hedge Portfolio Mispriced Call in the Two-Period World Extensions of the Binomial Model Pricing Put Options American Puts and Early Exercise Dividends, European Calls, American Calls, and Early Exercise Extending the Binomial Model to n Periods Behavior of the Binomial Model for Large n and Fixed Option Life Alternative Specifications of the Binomial Model Advantages of the Binomial Model SOFTWARE DEMONSTRATION 4.1 Calculating the Binomial Price with the Excel Spreadsheet BSMbin7e.xls
Chapter 5 Option Pricing Models: The Black-Scholes-Merton Model Origins of the Black-Scholes-Merton Formula Black-Scholes-Merton Model as the Limit of the Binomial Model Assumptions of the Black-Scholes-Merton Model Stock Prices Behave Randomly and Evolve According to a Lognormal Distribution Risk-Free Rate and Volatility of the Log Return on the Stock are Constant Throughout the Option s Life No Taxes or Transaction Costs Stock Pays No Dividends Options Are European A Nobel Formula Digression on Using the Normal Distribution Numerical Example SOFTWARE DEMONSTRATION 5.1 Calculating the Black-Scholes-Merton Price with the Excel Spreadsheet BSMbin7e.xls Characteristics of the Black-Scholes-Merton Formula Variables in the Black-Scholes-Merton Model Stock Price Exercise Price Risk-Free Rate Volatility or Standard Deviation Time to Expiration Black-Scholes-Merton Model When the Stock Pays Dividends Known Discrete Dividends Known Continuous Dividend Yield Black-Scholes-Merton Model and Some Insights into American Call Options Estimating the Volatility Historical Volatility Implied Volatility SOFTWARE DEMONSTRATION 5.2 Calculating the Historical Volatility with the Excel Spreadsheet Hisv7e.xls Put Option Pricing Models Managing the Risk of Options
Appendix 5.A: A Shortcut to the Calculation of Implied Volatility Appendix 5.B: The BSMbwin7e.exe Windows Software Chapter 6 Basic Option Strategies Terminology and Notation Profit Equations Different Holding Periods Assumptions Stock Transactions Buy Stock Sell Short Stock Call Option Transactions Buy a Call Write a Call Put Option Transactions Buy a Put Write a Put Calls and Stock: The Covered Call Some General Considerations with Covered Calls Puts and Stock: The Protective Put Synthetic Puts and Calls SOFTWARE DEMONSTRATION 6.1 Analyzing Option Strategies with the Excel Spreadsheet Stratlyz7e.xls Chapter 7 Advanced Option Strategies Option Spreads: Basic Concepts Why Investors Use Option Spreads Notation Money Spreads Bull Spreads Bear Spreads A Note about Call Bear Spreads and Put Bull Spreads
Collars Butterfly Spreads Calendar Spreads Time Value Decay Ratio Spreads Straddles Box Spreads PART II Forwards, Futures, and Swaps Chapter 8 The Structure of Forward and Futures Markets Development of Forward and Futures Markets Chicago Futures Markets Development of Financial Futures Development of Options on Futures Markets Parallel Development of Over-the-Counter Markets Over-the-Counter Forward Market Organized Futures Trading Contract Development Contract Terms and Conditions Delivery Terms Daily Price Limits and Trading Halts Other Exchange Responsibilities Futures Exchanges Futures Traders General Classes of Futures Traders Classification by Trading Strategy Classification by Trading Style Off-Floor Futures Traders Costs and Profitability of Exchange Membership Forward Market Traders Mechanics of Futures Trading Placing an Order Role of the Clearinghouse
Daily Settlement Delivery and Cash Settlement Futures Price Quotations Types of Futures Contracts Agricultural Commodities Natural Resources Miscellaneous Commodities Foreign Currencies Federal Funds and Eurodollars Treasury Notes and Bonds Swap Futures Equities Managed Funds Hedge Funds Options on Futures Transaction Costs in Forward and Futures Trading Commissions Bid-Ask Spread Delivery Costs Regulation of Futures and Forward Markets Appendix 8: Taxation of Futures Transactions in the United States Chapter 9 Principles of Pricing Forwards, Futures, and Options on Futures Generic Carry Arbitrage Concept of Price versus Value Value of a Forward Contract Price of a Forward Contract Value of a Futures Contract Price of a Futures Contract Forward versus Futures Prices Carry Arbitrage When Underlying Generates Cash Flows Stock Indices and Dividends Foreign Currencies and Foreign Interest Rates: Interest Rate Parity
Commodities and Storage Costs Pricing Models and Risk Premiums Spot Prices, Risk Premiums, and Carry Arbitrage for Generic Assets Forward/Futures Pricing Revisited Futures Prices and Risk Premia Put-Call-Forward/Futures Parity Pricing Options on Futures Intrinsic Value of an American Option on Futures Lower Bound of a European Option on Futures Put-Call Parity of Options on Futures Early Exercise of Call and Put Options on Futures Black Futures Option Pricing Model Chapter 10 Futures Arbitrage Strategies Short-Term Interest Rate Arbitrage Carry Arbitrage and the Implied Repo Rate Federal Funds Futures Carry Arbitrage and the Implied Repo Rate Eurodollar Arbitrage Intermediate- and Long-Term Interest Rate Arbitrage Determining the Cheapest-to-Deliver Bond on the Treasury Bond Futures Contract Delivery Options Implied Repo, Carry Arbitrage and Treasury Bond Futures SOFTWARE DEMONSTRATION 10.1 Identifying the Cheapest-to-Deliver Bond with the Excel Spreadsheet CTD7e.xls Treasury Bond Futures Spreads and the Implied Repo Rate Stock Index Arbitrage Foreign Exchange Arbitrage Appendix 10: Determining the CBOT Treasury Bond Conversion Factor SOFTWARE DEMONSTRATION 10.2 Determining the CBOT Conversion Factor with the Excel Spreadsheet CF7e.xls
Chapter 11 Forward and Futures Hedging, Spread, and Target Strategies Why Hedge? Hedging Concepts Short Hedge and Long Hedge The Basis Some Risks of Hedging Contract Choice Margin Requirements and Marking to Market Determination of the Hedge Ratio Minimum Variance Hedge Ratio Price Sensitivity Hedge Ratio Stock Index Futures Hedging Hedging Strategies Foreign Currency Hedges Intermediate- and Long-Term Interest Rate Hedges Spread Strategies Intramarket Spreads Intermarket Spreads Target Strategies Target Duration with Bond Futures Alpha Capture Target Beta with Stock Index Futures Tactical Asset Allocation Using Stock and Bond Futures Appendix 11: Taxation of Hedging Chapter 12 Swaps Interest Rate Swaps Currency Swaps Structure of a Typical Interest Rate Swap Pricing and Valuation of Interest Rate Swaps Interest Rate Swap Strategies Structure of a Typical Currency Swap
Pricing and Valuation of Currency Swaps Currency Swap Strategies Equity Swaps Structure of a Typical Equity Swap Pricing and Valuation of Equity Swaps Equity Swap Strategies Some Final Words about Swaps PART III Advanced Topics Chapter 13 Interest Rate Forwards and Options Forward Rate Agreements Structure and Use of a Typical FRA Pricing and Valuation of FRAs Applications of FRAs Interest Rate Options Structure and Use of a Typical Interest Rate Option Pricing and Valuation of Interest Rate Options Interest Rate Option Strategies Interest Rate Caps, Floors, and Collars Interest Rate Options, FRAs, and Swaps Interest Rate Swaptions and Forward Swaps Structure of a Typical Interest Rate Swaption Equivalence of Swaptions and Options on Bonds Pricing Swaptions Forward Swaps Applications of Swaptions and Forward Swaps Chapter 14 Advanced Derivatives and Strategies
Advanced Equity Derivatives and Strategies Portfolio Insurance Equity Forwards Equity Warrants Equity-Linked Debt Advanced Interest Rate Derivatives Structured Notes Mortgage-Backed Securities Exotic Options Digital and Chooser Options Path-Dependent Options Other Exotic Options Some Unusual Derivatives Electricity Derivatives Weather Derivatives Appendix 14: Monte Carlo Simulation Chapter 15 Financial Risk Management Techniques and Applications Why Practice Risk Management? Impetus for Risk Management Benefits of Risk Management Managing Market Risk Delta Hedging Gamma Hedging Vega Hedging Value at Risk (VAR) A Comprehensive Calculation of VAR Benefits and Criticisms of VAR Extensions of VAR Managing Credit Risk Credit Risk as an Option Credit Risk of Derivatives Netting Credit Derivatives
Other Types of Risks Chapter 16 Managing Risk in an Organization The Structure of the Risk Management Industry End Users Dealers Other Participants in the Risk Management Industry Organizing the Risk Management Function in a Company Risk Management Accounting Fair Value Hedges Cash Flow Hedges Foreign Investment Hedges Speculation Some Problems in the Application of FAS 133 Disclosure Avoiding Derivatives Losses Metallgesellschaft: To Hedge or Not to Hedge? Orange County, California: Playing the Odds Barings PLC: How One Man Blew Up a Bank Procter & Gamble: Going Up in Suds Risk Management Industry Standards Responsibilities of Senior Management Appendix A List of Formulas Appendix B References Glossary Index