The only guide focusing entirely on practical approaches to pricing and hedging derivatives One valuable lesson of the financial crisis was that derivatives and risk practitioners don't really understand the products they're dealing with. Written by a practitioner for practitioners, this book delivers the kind of knowledge and skills traders and finance professionals need to fully understand derivatives and price and hedge them effectively. Most derivatives books are written by academics and are long on theory and short on the day-to-day realities of derivatives trading. Of the few practical guides available, very few of those cover pricing and hedging-two critical topics for traders. What matters to practitioners is what happens on the trading floor-information only seasoned practitioners such as authors Marroni and Perdomo can impart. Lays out proven derivatives pricing and hedging strategies and techniques for equities, FX, fixed income and commodities, as well as multi-assets and cross-assets Provides expert guidance on the development of structured products, supplemented with a range of practical examples Packed with real-life examples covering everything from option payout with delta hedging, to Monte Carlo procedures to common structured products payoffs The Companion Website features all of the examples from the book in Excel complete with source code
Preface ix Acknowledgements xi 1 An Introduction to the Major Asset Classes 1 1.1 Equities 1 1.1.1 Introduction 1 1.1.2 Pricing equities 2 1.1.3 Fundamental analysis 2 1.1.4 Technical analysis 3 1.1.5 Quantitative analysis 3 1.1.6 The equity risk premium and the pre-FOMC announcement drift 5 1.2 Commodities 5 1.2.1 Introduction 5 1.2.2 Hedging 6 1.2.3 Backwardation and contango 7 1.2.4 Investment in commodities 9 1.2.5 Commodity fundamentals 10 1.2.6 Super-cycles in commodity prices 11 1.2.7 Future regulation 12 1.3 Fixed Income 12 1.3.1 Introduction 12 1.3.2 Credit risk 13 1.3.3 The empirical pattern of yield curve moves 13 1.3.4 Modelling interest rate movements 14 1.3.5 Modelling the risks of default 14 1.4 Foreign Exchange 15 1.4.1 Introduction 15 1.4.2 How foreign exchange rates are quoted 16 Summary 17 2 Derivatives: Forwards, Futures and Swaps 19 2.1 Derivatives 19 2.2 Forward Contracts 20 2.2.1 Definition 20 2.2.2 Payoffs of forward contracts 21 2.2.3 Forward price versus delivery price 23 2.3 Futures Contracts 24 2.4 Calculating Implied Forward Prices and Valuing Existing Forward Contracts 26 2.4.1 Calculating implied forward prices on equities 26 2.4.2 Calculating implied forward prices on foreign exchange rates 29 2.4.3 Calculating implied forward prices on commodities 31 2.4.4 Valuing existing forward contracts 34 2.5 Pricing Futures Contracts 34 2.6 Swaps 35 2.6.1 Introduction 35 2.6.2 Interest rate swaps 36 2.6.3 Commodity swaps 41 2.6.4 Commodity swap valuation 44 2.6.5 Commodity swaps with variable notional and price 46 2.6.6 Currency swaps 46 2.6.7 Equity swaps 48 Summary 49 3 Derivatives: Options and Related Strategies 51 3.1 Call Options 51 3.1.1 Definition 51 3.1.2 Examples 52 3.1.3 Scenario analysis for the S&P 500 Index call option 53 3.2 Put Options 55 3.2.1 Definition 55 3.2.2 Examples 55 3.2.3 Scenario analysis for put options 56 3.3 Boundary Conditions for Call and Put Options Prices 58 3.3.1 Introduction and basic notation 58 3.3.2 A call option cannot be worth more than the price of the underlying asset 59 3.3.3 The price of a put option cannot be higher than the present value of the strike price, K 60 3.3.4 Lower boundaries for call options on non-dividend paying stocks 60 3.3.5 Lower boundaries for put options on non-dividend paying stocks 61 3.4 Put--Call Parity 61 3.5 Swaptions 63 3.6 Options Strategies 64 3.6.1 Introduction to option strategies 64 3.6.2 Option spreads 65 3.6.3 Directional strategies using vertical spreads 65 3.6.4 Risk reversal and collars 69 3.6.5 Volatility strategies with puts and calls 70 Summary 76 4 Binomial Option Pricing 77 4.1 One-Period Binomial Tree: Replication Approach 77 4.2 Risk-Neutral Valuation 83 4.2.1 Introduction to risk-neutral valuation 83 4.2.2 An alternative way to think of the option price 84 4.2.3 Risk-neutral probabilities 85 4.3 Two-Period Binomial Tree: Valuing Back Down the Tree 85 4.4 The Binomial Tree: A Generalization 89 4.5 Early Exercise and American Options 90 4.6 Volatility Calibration 90 Summary 92 5 The Fundamentals of Option Pricing 93 5.1 Intrinsic Value and Time Value of an Option 93 5.1.1 Introduction and definitions 93 5.1.2 Jensen's inequality 94 5.1.3 Time value of an option 95 5.2 What is Volatility and Why Does it Matter? 95 5.3 Measurement of Realized Volatility and Correlation 97 5.4 Option Pricing in the Black--Scholes Framework 99 5.5 The Option Delta and the Replication of the Option Payoff 100 5.6 Option Replication 102 5.7 Option Replication, Risk-Neutral Valuation and Delta Hedging Revisited 104 5.8 Options on Dividend Paying Assets 106 5.9 Options on Futures: The Black Model 107 5.10 Monte Carlo Pricing 108 5.10.1 Introduction to the Monte Carlo technique 108 5.10.2 Generation of a Monte Carlo path 110 5.11 Other Pricing Techniques 112 5.11.1 Partial differential equation 112 5.11.2 Binomial/trinomial tree pricing 113
