Financial Risk Management and Derivative Instruments

275 Pages·2021·5.602 MB·English

by  Michael Dempsey

Financial Risk Management and Derivative
Instruments
Financial Risk Management and Derivative Instruments offers an introduction
to the riskiness of stock markets and the application of derivative instruments
in managing exposureto suchrisk. Structuredin two parts,the firstpartoffers
an introduction to stock market and bond market risk as encountered by
investors seeking investment growth. The second part of the text introduces
the financial derivative instruments that provide for either a reduced exposure
(hedging) or an increased exposure (speculation) to market risk. The funda-
mental aspects of the futures and options derivative markets and the tools of
the Black-Scholes model are examined.
The text sets the topics in their global context, referencing financial shocks
such as Brexit and the Covid-19 pandemic. An accessible writing style is sup-
ported by pedagogical features such as key insights boxes, progressive illus-
trative examples and end-of-chapter tutorials. The book is supplemented by
PowerPoint slidesdesigned to assistpresentationof thetext materialas wellas
providing a coherent summary of the lectures.
This textbook provides an ideal text for introductory courses to derivative
instruments and financial risk management for either undergraduate, masters
or MBA students.
Michael Dempsey is Professor of Finance at Ton Duc Thang University in Ho
Chi Minh City, Vietnam, having previously been Professor of Finance and
Head of Finance at RMIT University, Melbourne, Australia.
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Financial Risk Management and Derivative Instruments
Michael Dempsey
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Financial Risk Management and
Derivative Instruments
Michael Dempsey
Firstpublished2021
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LibraryofCongressCataloging-in-PublicationData
Names:Dempsey,Michael,1951-author.
Title:Financialriskmanagementandderivativeinstruments/Michael
Dempsey.
Description:MiltonPark,Abingdon,Oxon;NewYork,NY:Routledge,
2021.|Series:Routledgeadvancedtextineconomicsandfinance|Includes
bibliographicalreferencesandindex.|
Identifiers:LCCN2020053241(print)|LCCN2020053242(ebook)|ISBN
9780367676643(hardback)|ISBN9780367674793(paperback)|ISBN
9781003132240(ebook)
Subjects:LCSH:Financialriskmanagement.|Financialfutures.|Derivative
securities.
Classification:LCCHD61.D462021 (print)|LCCHD61 (ebook)|DDC
332.64/5–dc23
LCrecordavailableathttps://lccn.loc.gov/2020053241
LCebookrecordavailableathttps://lccn.loc.gov/2020053242
ISBN:978-0-367-67664-3(hbk)
ISBN:978-0-367-67479-3(pbk)
ISBN:978-1-003-13224-0(ebk)
TypesetinSabon
byTaylor&FrancisBooks
To family and friends
It is never too late to know that it is never too late
Emily Dempsey

Contents
List of figures xi
List of tables xii
Illustrative examples xiii
About the author xvi
Introduction 1
PARTA
Markets and uncertainty 3
1 Stock market risk: Fundamentals and behaviour 5
1.1 Introduction 6
1.2 The riskiness of stock markets 6
1.3 The concept of fundamental value 8
1.4 The concept of a required rate of return 10
1.5 Time for reflection: What has been revealed? 12
2 Financial leverage and risk 15
2.1 Introduction 16
2.2 Financial leverage 17
2.3 Modigliani and Miller propositions 19
2.4 Debt, firm profitability, and valuation 20
2.5 Debt, the markets and the economy: Hyman Minsky 24
2.6 Debt and the global financial crisis 25
2.7 Time for reflection: What has been revealed? 28
3 Bond market risk: Interest Rates 31
3.1 Introduction 32
viii Contents
3.2 Implications of interest rates for bonds 32
3.3 The duration of bonds and sensitivity to interest rates 36
3.4 Interest rates, inflation and economic stimulation 40
3.5 Interrogating bonds: expectations for interest rates 42
3.6 Time for reflection: What has been revealed? 45
4 The nature of growth 48
4.1 Introduction 49
4.2 The normal distribution 50
4.3 Co-variance, correlation and expected return and variance for
a portfolio of assets 55
4.4 Continuously-compounding growth 61
4.5 Market predictions allowing normally distributed
outcomes 65
4.6 Continuouslycompoundinggrowthratesovermanyperiods 68
4.7 Time for reflection: What has been revealed? 75
PARTB
Derivative instruments and financial engineering 85
5 Interest rate futures (forwards) 87
5.1 Introduction 88
5.2 Interest rate swaps 88
5.3 Banks and the incentive to facilitate interest rate swaps 92
5.4 Hedginginterestrateswithan“overthecounter”forwardrate
agreement (FRA) 94
5.5 Hedging and speculation with Treasury bond futures 96
5.6 Hedging and speculation with interest rate futures 98
5.7 Time for reflection: What has been revealed? 102
6 Futures contracts: Hedging/speculating on currency risk 106
6.1 Introduction 107
6.2 Futures (forward contracts) 107
6.3 Institutionalized futures markets 109
6.4 Futures and leveraged speculation 110
6.5 The futures price in relation to the current spot price 111
6.6 Hedging currency risk 114
6.7 Hedging and “regret” 115
6.8 Time for reflection: What has been revealed? 116
Contents ix
7 Options contracts: Hedging/speculating on currency risk 119
7.1 Introduction 120
7.2 The nature of options trading 120
7.3 Options and foreign currencies 122
7.4 Price discovery: intrinsic and time value 129
7.5 Speculating on foreign exchange 130
7.6 Hedging corporate foreign exchange exposure 132
7.7 Time for reflection: What has been revealed? 136
8 The Black-Scholes model 139
8.1 Introduction 140
8.2 The principle of risk neutrality 141
8.3 Derivation of the Black-Scholes formula 146
8.4 Put–Call parity 156
8.5 TheBlack-Scholesformulaappliedtoeither(i)anindexwitha
continuousdividendyieldor(ii)acurrencywithaninterestrate 157
8.6 The Black-Scholes model in practice 159
8.7 Time for reflection: What has been revealed? 163
9 Trading index futures 167
9.1 Introduction 168
9.2 Futures trading platforms 168
9.3 Equity Index Basis 171
9.4 Trading Strategies 173
9.5 Time for reflection: What has been revealed? 176
10 Option strategies 179
10.1 Introduction 180
10.2 The options markets 180
10.3 Changing prices of options (inputs to the Black-Scholes
model) 181
10.4 Options trading strategies 182
10.5 Time for reflection: What has been revealed? 197
11 Option pricing: The Greeks 200
11.1 Introduction 201
11.2 The Greeks 201
11.3 The Greeks in combination 209
11.4 Time for reflection: What has been revealed? 210