Elementary Financial Derivatives A Guide to Trading and Valuation with Applications

A step-by-step approach to the mathematical financial theory and quantitative methods needed to implement and apply state-of-the-art valuation techniques

Written as an accessible and appealing introduction to financial derivatives, Elementary Financial Derivatives: A Guide to Trading and Valuation with Applications provides the necessary techniques for teaching and learning complex valuation techniques. Filling the current gap in financial engineering literature, the book emphasizes an easy-to-understand approach to the methods and applications of complex concepts without focusing on the underlying statistical and mathematical theories.

Organized into three comprehensive sections, the book discusses the essential topics of the derivatives market with sections on options, swaps, and financial engineering concepts applied primarily, but not exclusively, to the futures market. Providing a better understanding of how to assess risk exposure, the book also includes:

• A wide range of real-world applications and examples detailing the theoretical concepts discussed throughout
• Numerous homework problems, highlighted equations, and Microsoft^® Office Excel^® modules for valuation
• Pedagogical elements such as solved case studies, select answers to problems, and key terms and concepts to aid comprehension of the presented material
• A companion website that contains an Instructor?s Solutions Manual, sample lecture PowerPoint^® slides, and related Excel files and data sets

Elementary Financial Derivatives: A Guide to Trading and Valuation with Applications is an excellent introductory textbook for upper-undergraduate courses in financial derivatives, quantitative finance, mathematical finance, and financial engineering. The book is also a valuable resource for practitioners in quantitative finance, industry professionals who lack technical knowledge of pricing options, and readers preparing for the CFA exam.

Jana Sacks, PhD, is Associate Professor in the Department of Accounting and Finance at St. John Fisher College in Rochester, New York. A member of The American Finance Association, the National Association of Corporate Directors, and the International Atlantic Economic Society, Dr. Sack?s research interests include risk management, credit derivatives, pricing, hedging, and structured finance.

Preface xi

Acknowledgments xiii

Table of Figures xv

About the Companion Websites xix

1 DERIVATIVE INSTRUMENTS: CONCEPTS AND DEFINITIONS 1

1.1 Key Derivative Instruments Definitions, 1

1.2 The Role, Risks, and Benefits of Derivatives Markets, 2

1.3 Arbitrage, 4

Case Study 1.3-1, 4

Problems, 5

1.4 Miscellaneous, 5

Problems, 7

2 FORWARDS AND FUTURES 9

2.1 Futures Fundamentals, 9

2.1.1 Futures Margin Account and Marking to Market, 17

Case Study 2.1.1-1, 19

Problems, 21

2.1.2 Futures Hedging, 21

Case Study 2.1.2-1, 23

Problems, 26

2.2 Forward Rate Agreements, 27

Case Study 2.2-1, 27

Case Study 2.2-2, 29

Case Study 2.2-3, 34

Case Study 2.2-4, 37

Problems, 38

2.3 Currency Forwards, 40

Case Study 2.3-1, 41

Case Study 2.3-2, 47

Problems, 53

3 SWAPS 55

3.1 Swaps Fundamentals, 55

3.1.1 Interest Rate Swap, 57

Case Study 3.1.1-1, 58

Case study 3.1.1-2, 65

Case Study 3.1.1-3, 68

Problems, 69

3.2 Equity, Currency, and FX Swaps, 69

3.2.1 Equity Swaps, 69

Case Study 3.2.1-1, 72

Case Study 3.2.1-2, 74

Case Study 3.2.1-3, 75

Case Study 3.2.1-4, 77

Case Study 3.2.1-5, 77

Problems, 78

3.2.2 Currency/FX Swap, 80

Case Study 3.2.2-1, 83

Case Study 3.2.2-2, 86

Problems, 89

3.3 Other Yield Curve-Dependent Swaps, 89

3.3.1 Basic Swap, 89

Case Study 3.3.1-1, 91

Case Study 3.3.1-2, 93

Problems, 95

3.3.2 Credit Default Swap, 96

Case Study 3.3.2-1, 105

Problems, 106

4 OPTIONS 107

4.1 Options Fundamentals, 107

4.1.1 Basic Information, 107

4.1.2 Options Trading Strategies, 115

Case Study 4.1.2-1, 121

Case Study 4.1.2-2, 123

Problems, 124

4.2 Pricing, 126

4.2.1 Binomial Tree Option Pricing Model, 126

Case Study 4.2.1-1, 131

Case Study 4.2.1-2, 134

Problems, 135

Case Study 4.2.1-3, 141

Case Study 4.2.1-4, 145

Case Study 4.2.1-5, 149

Problems, 151

4.2.2 Black–Scholes Formula, 153

Case Study 4.2.2-1, 156

Case Study 4.2.2-2, 159

Case Study 4.2.2-3, 160

Case Study 4.2.2-4, 164

Problems, 165

4.3 Greeks, 166

4.3.1 Delta, 166

Case Study 4.3-1, 168

Case Study 4.3-2, 169

4.3.2 Gamma, 170

4.3.3 Rho, 171

Case Study 4.3-3, 172

4.3.4 Vega, 173

Case Study 4.3-4, 174

4.3.5 Theta, 175

Case Study 4.3-5, 176

Problems, 177

4.4 Volatility, 178

4.4.1 Delta Hedging, 178

Case Study 4.4.1-1, 180

4.4.2 Greek Neutrality, 182

Case Study 4.4.2-1, 182

Case Study 4.4.2-2, 184

Case Study 4.4.2-3, 186

4.4.3 Implied Volatility, 187

Case Study 4.4.3-1, 187

Problems, 188

4.5 Exotics, 189

4.5.1 Asian Options, 189

4.5.2 Barrier Option, 189

4.5.3 Basket Options, 190

4.5.4 Binary Options, 190

4.5.5 Chooser Options, 191

4.5.6 Forward Start Options, 192

4.5.7 Look-back Options, 192

Problems, 192

Literature 195

Index 199

Jana Sacks, PhD, is Assistant Professor in the Department of Accounting and Finance at St. John Fisher College in Rochester, New York. A member of The American Finance Association, the National Association of Corporate Directors, and the International Atlantic Economic Society, Dr. Sack’s research interests include risk management, credit derivatives, pricing, hedging, and structured finance.