The Financial Times Handbook of Financial Engineering: Using Derivatives to Manage Risk (Financial Times Series)

769 Pages·2013·18.164 MB·English

by  Lawrence Galitz

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Whether you are an experienced hedge fund manager or new to the world of • Forward rates and FRAs
Lawrence Galitz is a director and founder gf Financial Times
finance, this comprehensive handbook explores all the issues you really need to • Financial futures
of ACF Consultants, a leading provider of
know about minimising financial risk and putting the techniques into practice. i
financial markets training to major investment • Swaps (including pricing and valuing)
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banks, central banks, investment institutions The Financial Times Handbook of Financial Engineering is an introduction to handbook • Options (including basics and pricing,
and corporations around the world. He is also the devices used in managing financial risk. It explains the theory behind each e volatility and portfolios)
a director of Acumen Technologies, which instrument and shows you how they are applied, priced and hedged. All
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produces eLearning and learning management applications are illustrated with fully-worked examples.
solutions. In these roles he has developed an r • Credit derivatives, CDS pricing and credit
Through its clear and informative style, this fully updated third edition:
international reputation both as a dynamic and i indices
exceptionally gifted instructor, and also as a • Explains what financial engineering is and discusses the nature of risk n of • Applications for financial engineering
Using derivatives to
writer of great clarity. His innovative blended
• Gives you a clear overview of the cash markets • Managing currency risk
learning techniques, integrating eLearning g
and simulation with instructor-led training, • Examines forward exchange rates, FRAs and financial futures manage risk • How to manage interest-rate risk
create a highly motivating, multi-faceted • Explores swaps, options and exotics financial • Managing equity, commodity and credit risk
learning experience.
• Tells you how to manage all types of financial risk (including currency, • Structured products
interest-rate, equity, commodity and credit risk)
Lawrence Galitz has a PhD in banking and third
finance and has extensive experience of • Adds four new chapters on credit derivatives and structured products
edition
consulting for a wide range of clients in the • Introduces new topics like LIBOR-OIS discounting, SEFs, central counterparties,
global financial markets. collateralisation, finite-difference pricing, the ISDA CDS pricing model, and
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Visit our website at Lawrence Galitz
www.pearson-books.com
Visit our website at
Cover image © Getty Images www.pearson-books.com
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FINANCIAL TIMES HANDBOOK
OF FINANCIAL ENGINEERING
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FINANCIAL TIMES HANDBOOK OF
FINANCIAL ENGINEERING
Using Derivatives to Manage Risk
3rd edition
Lawrence Galitz
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PEARSON EDUCATION LIMITED
Edinburgh Gate
Harlow CM20 2JE
United Kingdom
Tel: [phone]
Web: www.pearson.com/uk
First published 1993 (print)
Second edition published 1994 (print)
Third edition published (print and electronic)
© Lawrence Galitz 1993, 1994, 2013 (print and electronic)
The right of Lawrence Galitz to be identified as author of this work has been asserted by him in
accordance with the Copyright, Designs and Patents Act 1988.
Pearson Education is not responsible for the content of third-party internet sites.
ISBN: 978-0-273-74240-1 (print)
978-0-273-74241-8 (PDF)
978-0-273-74242-5 (ePub)
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Contains public sector information licensed under the Open Government Licence (OGL) v1.0. www.
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The Financial Times. With a worldwide network of highly respected journalists, The Financial
Times provides global business news, insightful opinion and expert analysis of business, finance and
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Print edition typeset in 10/13pt ITC Century Light by 30
Print edition printed and bound by Ashford Colour Press Ltd, Gosport
NOTE THAT ANY PAGE CROSS-REFERENCES REFER TO THE PRINT EDITION
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To Valerie
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CONTENTS
About the author xii
Acknowledgements xiii
Publisher’s acknowledgments xiv
Preface to the second edition xv
Preface to the third edition xvi
PART I: TOOLS
1 Introduction 3
1.1 Forty years of evolution 4
1.2 What is financial engineering? 5
1.3 The nature of risk 6
1.4 Financial engineering and risk 8
1.5 Layout of this book 11
2 The cash markets 13
2.1 Overview of financial markets 14
2.2 The foreign exchange market 15
2.3 The money markets 17
2.4 The bond markets 18
2.5 The equities markets 19
2.6 The commodities markets 22
2.7 Cash instruments versus derivatives 22
2.8 Capital adequacy requirements 23
3 Forward rates 27
3.1 Forward exchange rates 28
3.2 Forward interest rates 31
3.3 Do forward rates predict future spot rates? 35
3.4 Spot and forward rates in practice 36
4 FRAs 39
4.1 What is an FRA? 40
4.2 Definitions 41
4.3 Terminology 43
4.4 The settlement process 44
4.5 Hedging with FRAs 46
4.6 Pricing FRAs 47
4.7 Behaviour of FRA rates 53
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CONTENTS vii
5 Financial futures 57
5.1 A brief history of futures markets 58
5.2 What is a financial future? 61
5.3 Futures trading – from pits to screens 62
5.4 Buying and selling 64
5.5 The clearing mechanism 64
5.6 Futures margins 66
5.7 Physical delivery versus cash settlement 70
5.8 Futures and cash markets compared 72
5.9 The advantages of futures 72
6 Short-term interest rate futures 75
6.1 Definitions 76
6.2 STIR contracts pricing 79
6.3 Basis 83
6.4 Convergence 85
6.5 Behaviour of futures prices 87
6.6 Basic hedging example 91
6.7 Short-term futures contracts compared 93
6.8 Comparisons of futures and FRAs 96
6.9 Spread positions 97
7 Bond and stock index futures 103
7.1 Definition of bond futures contracts 104
7.2 The cheapest-to-deliver bond 108
7.3 Cash-and-carry pricing for bond futures 113
7.4 The implied repo rate 119
7.5 The delivery mechanism 121
7.6 Basic hedging with bond futures 125
7.7 Stock indices and stock index futures 128
7.8 Definition of stock index futures contracts 128
7.9 Advantages of using stock index futures 130
7.10 Cash-and-carry pricing for stock index futures 131
7.11 Stock index futures prices in practice 134
7.12 Turning cash into share portfolios and share portfolios into cash 136
8 Swaps 143
8.1 Definition of interest rate and cross-currency swaps 144
8.2 Development of the swap market 145
8.3 Interest rate swaps 147
8.4 Non-standard interest rate swaps 150
8.5 Overnight indexed swaps 154
8.6 Cross-currency swaps 157
8.7 Basic applications for swaps 159
8.8 Asset swaps 162
8.9 CMS and CMT swaps 164
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viii CONTENTS
8.10 Inflation swaps 165
8.11 Equity and dividend swaps 167
8.12 Commodity swaps 170
8.13 Volatility and variance swaps 171
8.14 Exotic swaps 173
8.15 ISDA documentation 174
8.16 Changes in market infrastructure after the credit crisis 176
9 Pricing and valuing swaps 181
9.1 Principles of swap valuation and pricing 182
9.2 Discount factors and the discount function 183
9.3 Calculating discount factors from swap and forward rates 187
9.4 Generating the discount function 191
9.5 Relationship between zero, swap and forward rates 196
9.6 Valuation and pricing of interest rate swaps 199
9.7 Valuation and pricing of currency swaps 208
9.8 Cancelling a swap 212
9.9 Hedging swaps with futures 213
9.10 The convexity correction 216
9.11 Credit risk of swaps 217
9.12 Collateralised vs. non-collateralised swaps 221
9.13 LIBOR-OIS discounting 223
10 Options – basics and pricing 235
10.1 Why options are different 237
10.2 Definitions 240
10.3 Options terminology 243
10.4 Value and profit profiles at maturity 247
10.5 Pricing options 251
10.6 The behaviour of financial prices 255
10.7 The Black–Scholes model 262
10.8 The binomial approach 271
10.9 The Monte Carlo approach 281
10.10 Finite difference methods 283
11 Options – volatility and the Greeks 291
11.1 Volatility 292
11.2 Volatility smiles and skews 296
11.3 The VIX 305
11.4 Value profiles prior to maturity 306
11.5 How options behave – the Greeks 314
11.6 Delta hedging 326
12 Options – from building blocks to portfolios 337
12.1 The building block approach 338
12.2 Option spreads – vertical, horizontal and diagonal 342
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CONTENTS ix
12.3 Volatility structures 350
12.4 Range structures 357
12.5 Arbitrage structures 363
13 Options – interest rate and exotic options 367
13.1 Why interest rate options are different 368
13.2 Caps, floors and collars 369
13.3 Swaptions 373
13.4 Cancellable and extendible swaps 376
13.5 Pricing interest rate options 378
13.6 Compound options 385
13.7 Exotic options 387
13.8 Path-dependent options 387
13.9 Digital options 397
13.10 Multivariate options 398
13.11 Other exotic options 400
13.12 Pricing exotic options 401
13.13 Price comparisons between exotic options 406
13.14 Embedded options 411
14 Introducing credit derivatives 415
14.1 Development of the credit derivatives market 416
14.2 Motivations for using credit derivatives 419
14.3 Introducing credit default swaps (CDS) 420
14.4 Market conventions 423
14.5 Credit events and determination committees 426
14.6 Capital structure, recovery rates, reference and
deliverable obligations 429
14.7 Settlement methods and auctions 432
14.8 Other aspects of CDS 439
15 CDS pricing and credit indices 447
15.1 A simple CDS pricing model 448
15.2 Obtaining default probabilities 450
15.3 Developing a multi-period framework 451
15.4 The ISDA CDS Standard Model 452
15.5 Bootstrapping default probabilities 455
15.6 Calculating up-front payments 459
15.7 Mark-to-market and CDS valuation 463
15.8 PV01 and SDV01 465
15.9 How credit indices developed 467
15.10 The CDX and iTraxx credit indices 468
15.11 Market quotations and statistics 473
15.12 Other credit indices 475
15.13 Index tranches 477
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