Equity Derivatives Explained

Equity Derivatives Explained

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 978 1137 32733 8 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

Equity Derivatives Explained Mohamed Bouzoubaa

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 1988. First published 2014 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, 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 10010. 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 978-1-137-33553-1 ISBN 978-1-137-33554-8 (ebook) DOI 10.1057/9781137335548 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.

To my parents and family And special thanks to Lamia

vii Contents List of Figures ix 1 Fundamentals 1 1.1 Stock Markets and Indices 1 1.2 Interest Rates and Dividends 2 1.3 Short Selling and Borrowing 8 1.4 Volatility Concepts 10 2 Inside the World of Equity Derivatives 14 2.1 The Sell Side 14 2.2 The Buy Side 19 3 Forwards, Futures and Swaps 22 3.1 Futures Markets 22 3.2 Forward Contracts 26 3.3 Equity Swaps 29 3.4 Dividend Swaps 35 4 Pricing Vanilla Options 38 4.1 European Calls and Puts 38 4.2 Hedging Cost Principle 43 4.3 Pricing Vanillas 45 4.4 American Options 49 4.5 Asian Options 52 5 Risk Management Tools 54 5.1 All About the Greeks 54 5.2 Greeks Closed Relationships 68 5.3 Choosing the Right Model 71 6 Strategies Built around Vanillas 73 6.1 Equity Hedging the Traditional Way 73 6.2 Vertical Spreads 77 6.3 Bear Put Spread 79 6.4 Collars and Three-Ways 81 6.5 Butterfly and Condor Spreads 83 6.6 Straddles and Strangles 86

viii Contents 7 Yield Enhancement Solutions 89 7.1 Equity Structured Notes 89 7.2 Playing with Volatility 91 7.3 Equity Dispersion Derivatives 93 7.4 Dynamic Indices 94 Index 97

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 12 1.6: Term structure of volatility 13 2.1: Communication scheme between the sell side front office and the buy side when a reverse enquiry takes place 18 3.1: Margin call mechanism 24 3.2: Terms of a one-year forward contract 26 3.3: Payoff patterns from long and short forward positions 27 3.4: Cash flows exchanged in a three-month bullet equity swap 30 3.5: Financing and execution of the purchase of shares by a bank on behalf of the client 33 3.6: Exchanged cash flows during the life of a swap 33 3.7: Outcomes of an equity swap 34 3.8: Diagram of an equity swap transaction 35 3.9: Dividend swaps mechanism 37 4.1: Moneyness of European call and put options 39 4.2: Payoff of a long ATM call position and payoff of a short OTM call position 39 4.3: Comparison of profits from long positions in a European call and a forward contract with identical strikes at 110% 40 4.4: 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% 41 4.5: Comparison of profits from long positions in a European put and a forward contract with identical strikes 42 4.6: Terms of a two-year European put option 43 4.7: Log-normal distribution 45

x List of Figures 4.8: Cumulative probability up to the standardized normal value 46 4.9: Price of a one-year European call struck at 100% with respect to the underlying spot price 47 4.10: Price of a one-year European put with strike at 100% with respect to the underlying spot price 47 5.1: Price of a forward contract with respect to the underlying stock s price 55 5.2: Impact of time on the delta of a European call 56 5.3: Effects of volatility on the delta of a European call 57 5.4: Delta of a European put option with respect to the underlying stock s price for different maturities 58 5.5: Gamma of a European option with respect to the underlying stock s price for different maturities 61 5.6: Vega of a European put option with respect to the underlying stock s price for different maturities 63 5.7: Theta of a European call option with respect to the underlying stock s price for different maturities 65 5.8: Theta of a European put option with respect to the underlying stock s price for different maturities 65 5.9: Rho of a European call option with respect to the underlying stock s price for different maturities 67 5.10: Rho of a European put option with respect to the underlying stock s price for different maturities 67 6.1: Profit graph from a short covered call position 74 6.2: Profit graph associated with a protective put strategy 76 6.3: Payoff and profit of a call spread strategy 78 6.4: Bearish put spread versus vanilla put 80 6.5: 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%. 82 6.6: Profit at maturity from adding a three-way with strikes at 60%/80%/130% to a stock portfolio 83 6.7: Payoff and profit of a short butterfly spread strategy 84 6.8: Payoff and profit of a short condor spread strategy 85 6.9: Payoff and profit of a long straddle strategy 87 6.10: Payoff and profit of a long strangle strategy 88 7.1: Composition and payoff of a three-year equity structure note based on S&P 500 index 90