whole is worth the sum of its parts. Even the most complex structured bond, credit arbitrage strategy or hedge trade can be broken down into its component parts, and if we understand the elemental components, we can then value the whole as the sum of its parts. We can quantify the risk that is hedged and the risk that is left as the residual exposure. If we learn to view all financial trades and securities as engineered packages of building blocks, then we can analyze in which structures some parts may be cheap and some may be rich. It is this relative value arbitrage principle that drives all modern trading and investment. This book is an easy-to-understand guide to the complex world of today's financial markets teaching you what money and capital markets are about through a sequence of arbitrage-based numerical illustrations and exercises enriched with institutional detail. Filled with insights and real life examples from the trading floor, it is essential reading for anyone starting out in trading. Using a unique structural approach to teaching the mechanics of financial markets, the book dissects markets into their common building blocks: spot (cash), forward/futures, and contingent (options) transactions. After explaining how each of these is valued and settled, it exploits the structural uniformity across all markets to introduce the difficult subjects of financially engineered products and complex derivatives. The book avoids stochastic calculus in favour of numeric cash flow calculations, present value tables, and diagrams, explaining options, swaps and credit derivatives without any use of differential equations.
Introduction xi 1 Purpose and Structure of Financial Markets 1 1.1 Overview of Financial Markets 1 1.2 Risk Sharing 2 1.3 Transactional Structure of Financial Markets 6 1.4 Arbitrage: Pure Versus Relative Value 8 1.5 Financial Institutions: Transforming Intermediaries vs Broker-Dealers 12 1.6 Primary (Issuance) and Secondary (Resale) Markets 13 1.7 Market Players: Hedgers vs Speculators 15 1.8 Preview of the Book 18 PART I RELATIVE VALUE BUILDING BLOCKS 2 Spot Markets 23 2.1 Bonds and Annual Bond Math 23 2.1.1 Zero-Coupon Bond 23 2.1.2 Coupon Bond 25 2.1.3 Amortizing Bond 27 2.1.4 Floating Rate Bond 28 2.2 Intra-Year Compounding and Day-Count 30 2.2.1 Intra-Year Compounding 30 2.2.2 Day-Count 31 2.2.3 Accrued Interest 33 2.3 Term Structure of Interest Rates and the Discount Factor Bootstrap 34 2.3.1 Term Structure 34 2.3.2 Discount Factor Bootstrap 36 2.3.3 Valuation of an Arbitrary Bond 36 2.4 Interest Rate Risk: Duration and Convexity 39 2.4.1 Duration 41 2.4.2 Portfolio Duration 44 2.4.3 Convexity 45 2.4.4 Other Risk Measures 46 2.5 Equity, Commodity, and Currency Math 47 2.5.1 Equities 48 2.5.2 Currencies 49 2.6 Short Selling 51 2.6.1 Buying on Margin 52 2.6.2 Short Selling in a Margin Account 53 2.6.3 Short Selling of Bonds 54 3 Futures Markets 57 3.1 Fundamentals of Futures and Forwards 57 3.2 Futures Mechanics 59 3.2.1 Physical Commodity Futures 59 3.2.2 Interest Rate Futures 62 3.2.3 Stock Index Futures 69 3.2.4 Currency Futures and Forwards 70 3.3 Cash-and-Carry Arbitrage 73 3.3.1 Commodities 74 3.3.2 Stock Indexes 76 3.3.3 Currencies 79 3.4 Futures Not Subject to Cash-and-Carry 81 3.5 Yield Curve Construction with Interest Rate Futures 84 3.5.1 Certainty Equivalence of Eurodollar Futures 85 3.5.2 Forward Rate Agreements 86 3.5.3 Building Spot Zeros 88 3.5.4 Recovering the Forwards 91 3.5.5 Including Repo Rates in the Calculation of the Forwards 93 4 Swap Markets 95 4.1 Fundamentals of Swaps 95 4.1.1 The Dual Nature of Swaps 96 4.1.2 Implication for Pricing and Hedging 96 4.2 Interest Rate Swaps 97 4.2.1 Definition of an Interest Rate Swap 97 4.2.2 Valuation of Interest Rate Swaps 99 4.2.3 Hedging of Interest Rate Swaps 101 4.3 Cross-Currency Swaps 105 4.3.1 Definition of a Fixed-for-Fixed Cross-Currency Swap 105 4.3.2 Valuation and Settlement of Cross-Currency Swaps 107 4.3.3 Cross-Currency Swaps as Packages of Off-Market FX Forwards 109 4.3.4 Multicurrency and Combination Cross-Currency Swaps 110 4.4 Equity, Commodity, and Exotic Swaps 112 4.4.1 Equity Swaps 112 4.4.2 Commodity Swaps 114 4.4.3 Volatility Swaps 115 4.4.4 Index Principal Swaps 116 5 Options on Prices and Hedge-Based Valuation 119 5.1 Call and Put Payoffs at Expiry 120 5.2 Composite Payoffs at Expiry 122 5.2.1 Straddles and Strangles 122 5.2.2 Spreads and Combinations 123 5.3 Option Values Prior to Expiry 126 5.4 Options and Forwards, Risk Sharing and Put-Call Parity 127 5.5 Currency Options 128 5.6 Binomial Option Pricing 129 5.6.1 One-Step Examples 129 5.7 Black-Scholes Model and Extensions 141 5.7.1 Black-Scholes with No Dividends 141 5.7.2 Dividends 142 5.7.3 Options on Currency Rates 143 5.7.4 Black-Scholes Delta, Gamma, and Vega 144 5.8 Residual Risk of Options: Gamma, Vega, and Volatility 145 5.8.1 Implied Volatility 147 5.8.2 Volatility Smiles and Skews 148 5.9 A Real-Life Option Pricing Exercise 150 5.9.1 Consistency Checks: Put-Call Parity, Black-Scholes, and Binomial 150 6 Options on Non-Price Variables 155 6.1 Black Models For Bond Price Options, Caps/Floors, and European Swaptions 156 6.1.1 Options on Bond Prices 156 6.1.2 Cap and Floor Definitions 158 6.1.3 Relationship of Caps and Floors to FRAs and Swaps 159 6.1.4 A Cap Application 160 6.1.5 Pricing of Caps and Floors 163 6.1.6 European Swaption Definitions 164 6.1.7 Options to Cancel Swaps 165 6.1.8 Relationship of Swaptions to Forward Swaps 165 6.1.9 Pricing of European Swaptions 167 6.1.10 Limitations of the Black Model 168 6.2 Convexity-Adjusted Models For Libor Forwards, Quantos, a
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