Derivatives Essentials An Introduction to Forwards, Futures, Options and Swaps Wiley Finance Series

Derivatives Essentials is an accessible, yet detailed guide to derivative securities. With an emphasis on mechanisms over formulas, this book promotes a greater understanding of the topic in a straightforward manner, using plain-English explanations. Mathematics are included, but the focus is on comprehension and the issues that matter most to practitioners?including the rights and obligations, terms and conventions, opportunities and exposures, trading, motivation, sensitivities, pricing, and valuation of each product. Coverage includes forwards, futures, options, swaps, and related products and trading strategies, with practical examples that demonstrate each concept in action. The companion website provides Excel files that illustrate pricing, valuation, sensitivities, and strategies discussed in the book, and practice and assessment questions for each chapter allow you to reinforce your learning and gauge the depth of your understanding.

Derivative securities are a complex topic with many "moving parts," but practitioners must possess a full working knowledge of these products to use them effectively. This book promotes a truly internalized understanding rather than rote memorization or strict quantitation, with clear explanations and true-to-life examples.

• Understand the concepts behind derivative securities
• Delve into the nature, pricing, and offset of sensitivities
• Learn how different products are priced and valued
• Examine trading strategies and practical examples for each product

Pricing and valuation is important, but understanding the fundamental nature of each product is critical?it gives you the power to wield them more effectively, and exploit their natural behaviors to achieve both short- and long-term market goals. Derivatives Essentials provides the clarity and practical perspective you need to master the effective use of derivative securities products.

Preface xiii

Acknowledgements xvii

About the Author xix

Part One Introduction to Forwards, Futures, and Options

Chapter 1 Forwards and Futures 3

1.1 Forward contract characteristics 3

1.2 Long forward payoff 6

1.3 Long forward P&L 8

1.4 Short forward payoff 9

1.5 Short forward P&L 10

1.6 Long forward P&L diagram 12

1.7 Short forward P&L diagram 13

1.8 Forwards are zero-sum games 15

1.9 Counterparty credit risk 17

1.10 Futures contracts 19

Chapter 2 Call Options 22

2.1 Call option characteristics 22

2.2 Long call payoff 25

2.3 Long call P&L 27

2.4 Short call payoff 29

2.5 Short call P&L 30

2.6 Long call P&L diagram 32

2.7 Short call P&L diagram 33

2.8 Call options are zero-sum games 35

2.9 Call option moneyness 37

2.10 Exercising a call option early 38

2.11 Comparison of call options and forwards/futures 40

Chapter 3 Put Options 44

3.1 Put option characteristics 44

3.2 Long put payoff 47

3.3 Long put P&L 49

3.4 Short put payoff 50

3.5 Short put P&L 52

3.6 Long put P&L diagram 53

3.7 Short put P&L diagram 55

3.8 Put options are zero-sum games 57

3.9 Put option moneyness 58

3.10 Exercising a put option early 59

3.11 Comparison of put options, call options, and forwards/futures 60

Part Two Pricing and Valuation

Chapter 4 Useful Quantitative Concepts 65

4.1 Compounding conventions 66

4.2 Calculating future value and present value 68

4.3 Identifying continuously compounded interest rates 71

4.4 Volatility and historical standard deviation 72

4.5 Interpretation of standard deviation 77

4.6 Annualized standard deviation 80

4.7 The standard normal cumulative distribution function 81

4.8 The z-score 83

Chapter 5 Introduction to Pricing and Valuation 86

5.1 The concepts of price and value of a forward contract 87

5.2 The concepts of price and value of an option 88

5.3 Comparison of price and value concepts for forwards and options 90

5.4 Forward value 91

5.5 Forward price 92

5.6 Option value: The Black-Scholes model 94

5.7 Calculating the Black-Scholes model 96

5.8 Black-Scholes model assumptions 98

5.9 Implied volatility 99

Chapter 6 Understanding Pricing and Valuation 105

6.1 Review of payoff, price, and value equations 106

6.2 Value as the present value of expected payoff 108

6.3 Risk-neutral valuation 109

6.4 Probability and expected value concepts 112

6.5 Understanding the Black-Scholes equation for call value 117

6.6 Understanding the Black-Scholes equation for put value 120

6.7 Understanding the equation for forward value 122

6.8 Understanding the equation for forward price 123

Chapter 7 The Binomial Option Pricing Model 126

7.1 Modeling discrete points in time 126

7.2 Introduction to the one-period binomial option pricing model 127

7.3 Option valuation, one-period binomial option pricing model 131

7.4 Two-period binomial option pricing model, European-style option 135

7.5 Two-period binomial model, American-style option 138

7.6 Multi-period binomial option pricing models 140

Part Three The Greeks

Chapter 8 Introduction to the Greeks 145

8.1 Definitions of the Greeks 146

8.2 Characteristics of the Greeks 146

8.3 Equations for the Greeks 149

8.4 Calculating the Greeks 151

8.5 Interpreting the Greeks 153

8.6 The accuracy of the Greeks 156

Chapter 9 Understanding Delta and Gamma 158

9.1 Describing sensitivity using Delta and Gamma 158

9.2 Understanding Delta 161

9.3 Delta across the underlying asset price 162

9.4 Understanding Gamma 166

9.5 Gamma across the underlying asset price 167

Chapter 10 Understanding Vega, Rho, and Theta 171

10.1 Describing sensitivity using Vega, Rho, and Theta 171

10.2 Understanding Vega 174

10.3 Understanding Rho 177

10.4 Understanding Theta 178

Part Four Trading Strategies

Chapter 11 Price and Volatility Trading Strategies 189

11.1 Price and volatility views 189

11.2 Relating price and volatility views to Delta and Vega 191

11.3 Using forwards, calls, and puts to monetize views 193

11.4 Introduction to straddles 194

11.5 Delta and Vega characteristics of long and short straddles 195

11.6 The ATM DNS strike price 196

11.7 Straddle: numerical example 197

11.8 P&L diagrams for long and short straddles 199

11.9 Breakeven points for long and short straddles 199

11.10 Introduction to strangles 201

11.11 P&L diagrams for long and short strangles 202

11.12 Breakeven points for long and short strangles 202

11.13 Summary of simple price and volatility trading strategies 204

Chapter 12 Synthetic, Protective, and Yield-Enhancing Trading Strategies 206

12.1 Introduction to put-call parity and synthetic positions 207

12.2 P&L diagrams of synthetic positions 208

12.3 Synthetic positions premiums and ATMF 212

12.4 The Greeks of synthetic positions 214

12.5 Option arbitrage 215

12.6 Protective puts 217

12.7 Covered calls 218

12.8 Collars 219

Chapter 13 Spread Trading Strategies 223

13.1 Bull and bear spreads using calls 223

13.2 Bull and bear spreads using puts 226

13.3 Risk reversals 229

13.4 Butterfly spreads 232

13.5 Condor spreads 236

Part Five Swaps

Chapter 14 Interest Rate Swaps 243

14.1 Interest rate swap characteristics 243

14.2 Interest rate swap cash flows 246

14.3 Calculating interest rate swap cash flows 249

14.4 How interest rate swaps can transform cash flows 256

Chapter 15 Credit Default Swaps, Cross-Currency Swaps, and Other Swaps 264

15.1 Credit default swap characteristics 264

15.2 Key determinants of the credit default swap spread 267

15.3 Cross-currency swap characteristics 270

15.4 Transforming cash flows using a cross-currency swap 270

15.5 Other swap varieties 273

Appendix: Solutions to Knowledge Check Questions 275

Index 301

ARON GOTTESMAN is professor of finance and the chair of the department of finance and economics at the Lubin School of Business at Pace University. He teaches courses on derivative securities, financial markets, and asset management, and presents corporate workshops on derivative securities to bulge bracket financial institutions.