Principles of Financial Engineering PDF
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Principles of Financial Engineering This pageintentionallyleftblank Principles of Financial Engineering Third Edition Robert L. Kosowski Oxford-Man Institute of Quantitative Finance Oxford University Salih N. Neftci Department of Finance Imperial College Business School Imperial College London, UK AMSTERDAM(cid:129)BOSTON(cid:129)HEIDELBERG(cid:129)LONDON NEWYORK(cid:129)OXFORD(cid:129)PARIS(cid:129)SANDIEGO SANFRANCISCO(cid:129)SINGAPORE(cid:129)SYDNEY(cid:129)TOKYO AcademicPressisanimprintofElsevier AcademicPressisanimprintofElsevier 32JamestownRoad,LondonNW17BY,UK 525BStreet,Suite1800,SanDiego,CA92101-4495,USA 225WymanStreet,Waltham,MA02451,USA TheBoulevard,LangfordLane,Kidlington,OxfordOX51GB,UK Firstpublished2004 Secondedition2008 Thirdedition2015 Copyrightr2015,2008and2004ElsevierInc.Allrightsreserved. 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This pageintentionallyleftblank Contents Preface tothe ThirdEdition..............................................................................................................xvii CHAPTER 1 Introduction ................................................................................1 1.1 A Unique Instrument..................................................................................................2 1.2 A Money Market Problem........................................................................................10 1.3 A Taxation Example.................................................................................................13 1.4 Some Caveats for What Isto Follow.......................................................................17 1.5 Trading Volatility.....................................................................................................18 1.6 Conclusions...............................................................................................................22 Suggested Reading...........................................................................................................22 Exercises...........................................................................................................................22 CHAPTER 2 Institutional Aspects of Derivative Markets..................................25 2.1 Introduction...............................................................................................................26 2.2 Markets.....................................................................................................................26 2.3 Players.......................................................................................................................35 2.4 TheMechanics ofDeals...........................................................................................36 2.5 Market Conventions..................................................................................................39 2.6 Instruments................................................................................................................41 2.7 Positions....................................................................................................................41 2.8 TheSyndication Process...........................................................................................50 2.9 Conclusions...............................................................................................................51 Suggested Reading...........................................................................................................51 Exercises...........................................................................................................................51 CHAPTER 3 Cash Flow Engineering, Interest Rate Forwards and Futures .........53 3.1 Introduction...............................................................................................................54 3.2 What Is aSynthetic?.................................................................................................55 3.3 Engineering Simple Interest Rate Derivatives.........................................................59 3.4 LIBORand Other Benchmarks................................................................................63 3.5 Fixed Income Market Conventions..........................................................................64 3.6 A Contractual Equation............................................................................................70 3.7 Forward Rate Agreements........................................................................................79 3.8 Fixed Income Risk Measures: Duration,Convexity and Value-at-Risk.................83 3.9 Futures: Eurocurrency Contracts..............................................................................89 vii viii Contents 3.10 Real-WorldComplications.....................................................................................95 3.11 Forward Rates and Term Structure........................................................................96 3.12 Conventions............................................................................................................98 3.13 ADigression: Strips...............................................................................................99 3.14 Conclusions.............................................................................................................99 Suggested Reading.........................................................................................................100 Appendix—Calculating the Yield Curve.......................................................................100 Exercises.........................................................................................................................103 CHAPTER 4 Introduction to Interest-Rate Swap Engineering........................107 4.1 The Swap Logic....................................................................................................108 4.2 Applications..........................................................................................................111 4.3 The Instrument: Swaps.........................................................................................115 4.4 Types ofSwaps.....................................................................................................117 4.5 Engineering Interest-Rate Swaps.........................................................................124 4.6 Uses ofSwaps.......................................................................................................133 4.7 Mechanics ofSwapping New Issues....................................................................140 4.8 Some Conventions................................................................................................144 4.9 AdditionalTerminology.......................................................................................145 4.10 Conclusions...........................................................................................................145 Suggested Reading.........................................................................................................145 Exercises.........................................................................................................................146 CHAPTER 5 Repo Market Strategies in Financial Engineering....................... 149 5.1 Introduction.............................................................................................................150 5.2 Repo Details............................................................................................................151 5.3 Types ofRepo.........................................................................................................154 5.4 Equity Repos...........................................................................................................160 5.5 Repo Market Strategies..........................................................................................161 5.6 Synthetics Using Repos..........................................................................................168 5.7 Differences Between Repo Marketsand the Impact of the GFC..........................170 5.8 Conclusions.............................................................................................................170 Suggested Reading.........................................................................................................171 Exercises.........................................................................................................................171 CHAPTER 6 Cash Flow Engineering in Foreign Exchange Markets................. 175 6.1 Introduction.............................................................................................................176 6.2 Currency Forwards.................................................................................................178 6.3 Synthetics and Pricing............................................................................................183 6.4 AContractual Equation..........................................................................................184 Contents ix 6.5 Applications..........................................................................................................185 6.6 Conventions for FXForward and Futures...........................................................191 6.7 Swap Engineeringin FXMarkets........................................................................194 6.8 Currency Swaps Versus FXSwaps......................................................................198 6.9 MechanicsofSwapping New Issues....................................................................204 6.10 Conclusions...........................................................................................................206 Suggested Reading.........................................................................................................207 Exercises.........................................................................................................................207 CHAPTER 7 Cash Flow Engineering and Alternative Classes (Commodities and Hedge Funds)............................................... 211 7.1 Introduction.............................................................................................................212 7.2 Parameters of aFuturesContract...........................................................................212 7.3 TheTerm Structure of CommodityFuturesPrices...............................................215 7.4 Swap Engineeringfor Commodities......................................................................221 7.5 TheHedgeFundIndustry.......................................................................................228 7.6 Conclusions.............................................................................................................233 Suggested Reading.........................................................................................................234 Exercises.........................................................................................................................234 CHAPTER 8 Dynamic Replication Methods and Synthetics Engineering.........237 8.1 Introduction.............................................................................................................238 8.2 An Example............................................................................................................238 8.3 A Review ofStatic Replication..............................................................................239 8.4 “Ad Hoc”Synthetics...............................................................................................245 8.5 Principles of Dynamic Replication........................................................................248 8.6 Some Important Conditions....................................................................................261 8.7 Real-Life Complications.........................................................................................262 8.8 Conclusions.............................................................................................................263 Suggested Reading.........................................................................................................264 Exercises.........................................................................................................................264 CHAPTER 9 Mechanics of Options.............................................................. 267 9.1 Introduction.............................................................................................................268 9.2 What Is anOption?.................................................................................................269 9.3 Options:Definition and Notation...........................................................................271 9.4 Options asVolatilityInstruments...........................................................................277 9.5 Tools for Options....................................................................................................289 9.6 TheGreeks andTheirUses....................................................................................296
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