Mastering Derivatives Markets A step-by-step guide to the products, applications and risks Fourth Edition FRANCESCA TAYLOR Financial Times Prentice Hall is an imprint of Harlow, England London New York Boston San Francisco Toronto Sydney Singapore Hong Kong Tokyo Seoul Taipei New Delhi Cape Town Madrid Mexico City Amsterdam Munich Paris Milan
Author's acknowledgements Publisher's acknowledgements Foreword Contributors Background and Development of the Derivatives Markets Market background Key features Uses of derivatives Range of derivatives Increasing use of the Central Counterparty Model (CCP) Risk and benchmarking Market volumes Users and uses of derivatives markets Straight Through Processing (STP) Market Fundamentals How banks generate income Three key assumptions Role and use of LIBOR. Day counts Financial maths Calculating forward rates Marking to market (MTM or M2M) Yield curves Quiz Risk - a Primer Financial risks: markets, credit, liquidity Operational risk More esoteric risks XI xiii XV xvii 1 2 2 3 4 4 5 6 7 7 9 13 14 14 16 17 19 20 24 26 27 28 31 32 32 38 40
4 Derivatives Fundamentals 45 Range of derivatives 46 What is a vanilla trade? 46 Settlement 47 Triggers 48 Liquidity and credit risk 49 Understanding the 'underlying' 49 Benchmarks 50 Fair value 50 Dealing with derivatives ^ 50 5 Basic Option Concepts 55 56 Option pricing 67 Option mechanics 68 6 Interest Rate Derivatives - Single Settlement Instruments 73 74 Single settlement interest rate derivatives 76 Financial futures contracts 77 Forward rate agreements (FRAs) \ 89 Interest rate options (IROs) 100 Quiz 109 7 Interest Rate Derivatives - OTC Multiple Settlement Instruments 111 112 Interest rate caps and floors 114 Interest rate collars 122 Interest rate swaps 128 Quiz 145 8 Benchmarking in the OTC Derivatives Markets 147 Penny Davenport, Managing Director, Markit Document Exchange and Gavan Nolan, Vice President, Credit Research, Markit Group Financial benchmarking for derivatives 148 Liquidity benchmarking for derivatives 151 Operational risk measurements for derivatives 152 Conclusion 154 9 Currency Derivatives 157 158 Over the counter currency options 160 Currency options: reduced premium strategies 184 Simple exotic structures 192
Currency swaps 194 Exchange-traded instruments 205 Quiz 208 10 The Impact of Electronic Trading on the FX Market 211 Ray McKenzie, Vice President, ICE The early years 212 FX as part of a commodity portfolio 214 First electronic dealing platforms 215 Electronic market making 215 Phases I and II ' - - ' 216 Point and click vs algo traders 218 The impact of the credit crisis on banks' FX trading 219 Phase III 220 11 Credit Derivatives 223 224 What is credit risk? 225 Styles of trading 227 The first deals 228 Range of credit derivatives 229 Credit default swaps 229 12 Central Clearing and the OTC Market 239 Bill Hodgson, Founder and CEO, The OTC Space Ltd The basics 240 Trade execution 244 Risks and mitigation 246 Getting trades into clearing 253 The business case and benefits 258 Predictions for market development 259 Terminology ^ 261 13 Equity Derivatives 265 266 Background 266 Single stocks or equity indices? 267 Stock index futures 270 Stock index options 285 Single stock options 295 Equity index swaps 299
14 Commodity Derivatives 309 310 Exchange-traded energy derivatives 316 Exchange-traded futures contracts 317 Exchange-traded energy option contracts 321 OTC or 'off-exchange' energy derivatives 330 OTC option products 331 OTC oil swaps 335 15 Carbon Derivatives and Environmental Products 341 Emilie Mazzacurati, Point Carbon, a Thomson Reuters company What are carbon markets? 342 Volumes and value 342 Overview of regulation 345 Carbon instruments 349 What drives carbon prices? 351 Trading carbon: in practice 358 Conclusion 359 16 Regulation in the Derivatives Markets 361 Eric Salomons, Associate Director, Dubai Financial Services Authority (DFSA) Why regulate the derivatives market? 362 Who regulates the derivatives market? 363 Regulatory models and objectives 364 Supervisory aims - equal access to markets 366 Market integrity 367 Market abuse and manipulation 369 The role of market surveillance 372 Efficient markets 373 Continuing regulatory challenges 376 l Glossary 379 Answers to Quizzes 394 Index 395