An Introduction to Derivatives and Risk Management

641 Pages·2015·37.909 MB·English

by  Don M. Chance, Roberts Brooks

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don M. chance & robert Brooks
04969_cvr_ptg01_hires.indd 1 SE/Chance, An Introduction to Derivatives and Risk Management 10th Edition ISBN-13: 978-1-305-10496-9 ©2016 23/10/14 4:34 PM
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An Introduction
to Derivatives and
Risk Management
Louisiana State University
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AnIntroductiontoDerivativesandRisk ©2016,2013CengageLearning
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Print Number: 01 Print Year: 2014
Brief Contents
Preface xv
CHAPTER 1 Introduction 1
CHAPTER 2 Structure of Derivatives Markets 26
PART I Options 69
CHAPTER 3 Principles of Option Pricing 70
CHAPTER 4 Option Pricing Models: The Binomial Model 109
CHAPTER 5 Option Pricing Models: The Black Scholes Merton Model 143
CHAPTER 6 Basic Option Strategies 202
CHAPTER 7 Advanced Option Strategies 239
PART II Forwards, Futures, and Swaps 273
CHAPTER 8 Principles of Pricing Forwards, Futures, and Options on
Futures 274
CHAPTER 9 Futures Arbitrage Strategies 316
CHAPTER 10 Forward and Futures Hedging, Spread, and Target
Strategies 343
CHAPTER 11 Swaps 395
PART III Advanced Topics 437
CHAPTER 12 Interest Rate Forwards and Options 438
CHAPTER 13 Advanced Derivatives and Strategies 475
CHAPTER 14 Financial Risk Management Techniques and Applications 516
CHAPTER 15 Managing Risk in an Organization 559
Appendix A Solutions to Concept Checks A-1
(Thiscontentisalsoavailableonthetextbookcompanionsite.)
Appendix B References B-1
(Thiscontentisavailableonthetextbookcompanionsiteonly.)
Appendix C List of Symbols C-1
(Thiscontentisavailableonthetextbookcompanionsiteonly.)
Appendix D List of Important Formulas D-1
(Thiscontentisavailableonthetextbookcompanionsiteonly.)
Glossary G-1
Index I-1
iii
Contents
Preface .......................................................................xv
CHAPTER 1
Introduction.................................................................. 1
1-1 DerivativeMarketsandInstruments 4
1-1a DerivativesMarkets 4
1-1b Options 4
1-1c ForwardContracts 4
1-1d Futures Contracts 5
1-1e Swaps 5
1-2 TheUnderlying Asset 5
1-3 ImportantConceptsinFinancialandDerivativeMarkets 6
1-3a Presuppositions forFinancialMarkets 6
1-3b RiskPreference 6
1-3c ShortSelling 7
1-3d RepurchaseAgreements 8
1-3e ReturnandRisk 8
1-3f MarketEfficiency andTheoreticalFairValue 10
MakingtheConnection
RiskandReturnandArbitrage 11
1-4 FundamentalLinkagesbetweenSpotandDerivativeMarkets 12
1-4a ArbitrageandtheLawofOnePrice 12
1-4b TheStorageMechanism:SpreadingConsumptionacrossTime 13
1-4c DeliveryandSettlement 13
1-5 RoleofDerivativeMarkets 14
1-5a RiskManagement 14
1-5b PriceDiscovery 14
MakingtheConnection
JetFuelRiskManagementatSouthwestAirlines 15
1-5c OperationalAdvantages 15
1-5d MarketEfficiency 16
1-6 CriticismsofDerivativeMarkets 16
1-7 MisusesofDerivatives 17
1-8 DerivativesandEthics 17
1-9 DerivativesandYourCareer 19
1-10 SourcesofInformationonDerivatives 19
1-11 BookOverview 20
1-11a OrganizationoftheBook 20
1-11b KeyFeatures oftheBook 20
1-11c SpecificNewFeaturesoftheTenthEdition 22
1-11d UseoftheBook 22
iv
Contents v
Summary 23
KeyTerms 23
FurtherReading 23
ConceptChecks 24
QuestionsandProblems 24
CHAPTER 2
Structure of Derivatives Markets .............................................. 26
2-1 TypesofDerivatives 26
2-1a Options 26
2-1b ForwardContracts 28
2-1c Futures Contracts 29
2-1d Swaps 30
2-1e OtherTypesofDerivatives 30
2-2 OriginsandDevelopmentofDerivativesMarkets 31
2-2a EvolutionofCommodityDerivatives 32
2-2b IntroductionandEvolutionofFinancial Derivatives 33
2-2c DevelopmentoftheOver-the-CounterDerivativesMarkets 35
MakingtheConnection
CollegeFootballOptions 36
2-3 Exchange-ListedDerivativesTrading 37
2-3a DerivativesExchanges 37
2-3b Standardization ofContracts 39
2-3c Physical versusElectronicTrading 42
2-3d Mechanics ofTrading 43
2-3e OpeningandClosingOrders 43
2-3f Expiration andExerciseProcedures 44
2-4 Over-the-CounterDerivativesTrading 46
2-4a OpeningandEarlyTerminationOrders 49
2-4b Expiration andExerciseProcedures 51
2-5 ClearingandSettlement 51
2-5a RoleoftheClearinghouse 52
2-5b Daily Settlement 53
MakingtheConnection
HowClearinghousesReduceCreditRisk 54
2-6 MarketParticipants 58
2-7 TransactionCosts 60
2-7a FloorTradingandClearingFees 60
2-7b Commissions 60
2-7c Bid–AskSpreads 61
2-7d DeliveryCosts 61
2-7e OtherTransactionCosts 61
2-8 Taxes 62
2-9 RegulationofDerivativesMarkets 62
Summary 65
KeyTerms 65
FurtherReading 65
ConceptChecks 66
QuestionsandProblems 67
vi Contents
PART I Options
CHAPTER 3
Principles of Option Pricing.................................................. 70
3-1 BasicNotation andTerminology 71
3-2 PrinciplesofCallOption Pricing 73
3-2a MinimumValueofaCall 73
3-2b MaximumValueofaCall 75
3-2c ValueofaCallatExpiration 75
3-2d EffectofTimetoExpiration 76
3-2e EffectofExercisePrice 78
3-2f LowerBoundofaEuropeanCall 81
MakingtheConnection
AsynchronousClosingPricesandApparentBoundaryConditionViolations 83
3-2g AmericanCallversusEuropeanCall 84
3-2h Early ExerciseofAmericanCallsonDividend-PayingStocks 85
3-2i EffectofInterestRates 86
3-2j EffectofStockVolatility 86
TakingRiskinLife
DrugEffectiveness 87
3-3 PrinciplesofPutOptionPricing 88
3-3a MinimumValueofaPut 88
3-3b MaximumValueofaPut 89
3-3c ValueofaPutatExpiration 90
3-3d EffectofTimetoExpiration 91
3-3e TheEffectofExercisePrice 92
3-3f LowerBoundofaEuropeanPut 94
3-3g AmericanPutversusEuropeanPut 96
3-3h Early ExerciseofAmericanPuts 96
3-3i Put–CallParity 96
MakingtheConnection
Put–CallParityArbitrage 100
3-3j EffectofInterestRates 101
3-3k EffectofStockVolatility 101
Summary 101
KeyTerms 103
FurtherReading 103
ConceptChecks 103
QuestionsandProblems 104
Appendix 3:DynamicsofOptionBoundaryConditions:ALearning Exercise 107
CHAPTER 4
Option Pricing Models: The Binomial Model ................................. 109
4-1 One-PeriodBinomialModel 109
4-1a IllustrativeExample 113
4-1b HedgePortfolio 114
4-1c OverpricedCall 115
4-1d UnderpricedCall 115
4-2 Two-Period BinomialModel 116
4-2a IllustrativeExample 118
4-2b HedgePortfolio 118
Contents vii
MakingtheConnection
BinomialOptionPricing,RiskPremiums,andProbabilities 119
4-2c MispricedCallintheTwo-PeriodWorld 122
4-3 ExtensionsoftheBinomialModel 123
4-3a PricingPutOptions 123
4-3b AmericanPutsandEarlyExercise 125
4-3c Dividends,EuropeanCalls,AmericanCalls,andEarlyExercise 126
4-3d ForeignCurrencyOptions 130
4-3e IllustrativeExample 130
4-3f ExtendingtheBinomialModeltonPeriods 131
4-3g BehavioroftheBinomialModelforLargenandFixedOptionLife 133
4-3h AlternativeSpecifications oftheBinomialModel 135
4-3i Advantages oftheBinomialModel 137
MakingtheConnection
UsesoftheBinomialOptionPricingFrameworkinPractice 137
SoftwareDemonstration4.1
Calculating theBinomialPricewiththeExcelSpreadsheet
BlackScholesMertonBinomial10e.xlsm 138
Summary 139
KeyTerms 140
FurtherReading 140
ConceptChecks 140
QuestionsandProblems 141
CHAPTER 5
Option Pricing Models: The Black Scholes Merton Model..................... 143
5-1 OriginsoftheBlack Scholes MertonFormula 143
5-2 Black Scholes MertonModelastheLimitoftheBinomialModel 144
MakingtheConnection
Logarithms,Exponentials,andFinance 146
5-3 AssumptionsoftheBlack Scholes MertonModel 147
5-3a StockPricesBehaveRandomlyandEvolveAccordingtoaLognormal
Distribution 147
5-3b Risk-FreeRateandVolatility oftheLogReturnontheStockAreConstant
throughouttheOption’sLife 150
5-3c NoTaxesorTransactionCosts 151
5-3d StockPaysNoDividends 151
5-3e OptionsAreEuropean 151
5-4 ANobelFormula 151
5-4a DigressiononUsingtheNormalDistribution 152
5-4b Numerical Example 154
5-4c Characteristics oftheBlack–Scholes–MertonFormula 155
SoftwareDemonstration5.1
Calculating theBlack-Scholes-MertonPricewiththeExcelSpreadsheet
BlackScholesMerton Binomial10e.xlsm 157
5-5 VariablesintheBlack Scholes MertonModel 159
5-5a StockPrice 160
5-5b ExercisePrice 162
5-5c Risk-FreeRate 164
5-5d Volatility (orStandardDeviation) 164
5-5e TimetoExpiration 167
viii Contents
5-6 Black Scholes MertonModelWhentheStockPaysDividends 169
5-6a KnownDiscreteDividends 169
5-6b KnownContinuousDividendYield 169
5-6c Black–Scholes–MertonModelandCurrencyOptions 171
5-7 Black Scholes MertonModelandSomeInsightsintoAmericanCallOptions 171
5-7a EstimatingtheVolatility 173
5-7b HistoricalVolatility 173
5-7c ImpliedVolatility 175
SoftwareDemonstration5.2
CalculatingtheHistoricalVolatilitywiththeExcelSpreadsheet
HistoricalVolatility10e.xlsm 176
MakingtheConnection
Smiles,Smirks,andSurfaces 181
TakingRiskinLife
CancerClusters 183
5-8 PutOptionPricingModels 185
5-9 ManagingtheRiskofOptions 187
5-9a WhentheBlack–Scholes–MertonModelMay andMayNotHold 192
Summary 193
KeyTerms 195
FurtherReading 195
ConceptChecks 196
QuestionsandProblems 196
Appendix 5:AShortcuttotheCalculation ofImpliedVolatility 200
CHAPTER 6
Basic Option Strategies...................................................... 202
6-1 TerminologyandNotation 203
6-1a ProfitEquations 203
6-1b DifferentHoldingPeriods 204
6-1c Assumptions 205
6-2 StockTransactions 206
6-2a Buy Stock 206
6-2b ShortSellStock 206
6-3 CallOption Transactions 207
6-3a Buy aCall 207
6-3b WriteaCall 211
6-4 PutOptionTransactions 214
6-4a Buy aPut 214
6-4b WriteaPut 217
6-5 CallsandStock:TheCoveredCall 220
6-5a SomeGeneralConsiderations withCoveredCalls 223
MakingtheConnection
AlphaandCoveredCalls 224
6-6 PutsandStock:TheProtectivePut 225
MakingtheConnection
UsingtheBlack–Scholes–MertonModeltoAnalyzetheAttractivenessofaStrategy 228
6-7 SyntheticPutsandCalls 229
SoftwareDemonstration6.1
AnalyzingOption StrategieswiththeExcelSpreadsheet
OptionStrategyAnalyzer10e.xlsm 232
Contents ix
Summary 235
KeyTerms 235
FurtherReading 235
ConceptChecks 236
QuestionsandProblems 236
CHAPTER 7
Advanced Option Strategies ................................................. 239
7-1 OptionSpreads:BasicConcepts 239
7-1a Why InvestorsUseOptionSpreads 240
7-1b Notation 240
7-2 MoneySpreads 241
7-2a BullSpreads 241
MakingtheConnection
SpreadsandOptionMarginRequirements 244
7-2b BearSpreads 245
7-2c ANoteaboutCallBearSpreads andPutBullSpreads 247
7-2d Collars 247
7-2e Butterfly Spreads 250
MakingtheConnection
DesigningaCollarforanInvestmentPortfolio 251
7-3 CalendarSpreads 255
7-3a TimeValueDecay 256
7-4 RatioSpreads 258
7-5 Straddles 260
7-5a ChoiceofHoldingPeriod 262
7-5b ApplicationsofStraddles 263
7-5c ShortStraddle 264
Taking RiskinLife
FalsePositives 264
7-6 BoxSpreads 265
Summary 268
KeyTerms 268
FurtherReading 268
ConceptChecks 269
QuestionsandProblems 269
PART II Forwards, Futures, and Swaps
CHAPTER 8
Principles of Pricing Forwards, Futures, and Options on Futures .............. 274
8-1 GenericCarryArbitrage 275
8-1a ConceptofPriceversusValue 275
8-1b ValueofaForwardContract 276
8-1c PriceofaForwardContract 278
8-1d ValueofaFutures Contract 278
MakingtheConnection
WhenForwardandFuturesContractsAretheSame 279
8-1e PriceofaFutures Contract 280
8-1f ForwardversusFuturesPrices 281