FINANCIALDERIVATIVES

Pricing and RiskManagement

Robert W. KolbJames A. Overdahl

The Robert W. Kolb Series in Finance

WILEYJohn Wiley & Sons, Inc.

Contents

Introduction xxiiAcknowledgments xxiv

PART I Overview of Financial Derivatives 1

1 Derivative Instruments: Forwards, Futures, Options,Swaps, and Structured Products 3G. D. Koppenhaver

Introduction 3A Generalist's Approach to Derivative Contracts 6

Forward Contracts 7Futures Contracts 9Swap Contracts 11Option Contracts 13

Structured Products and an Application to Derivative Contracts 16Conclusion 19Endnotes 19References 20About the Author 20

2 The Derivatives Marketplace: Exchangesand the Over-the-Counter Market 21Sharon Brown-Hruska

Introduction 21Standardization versus Customized Products: Differencesin Structure and Approach 22Competition and Consolidation: Impetus for Change 25Moving from Bilateral to Multilateral Risk Management 29

Collateral in Exchange and OTC Markets 29Netting and Novation in Exchange and OTC Markets 31

Transparency and Information in the Exchange andOTC Marketplaces 36Conclusion 39Endnotes 40

viii Contents

References 41About the Author 42

3 Speculation and Hedging 43Greg Kuserk

Hedging Transactions 44Speculation 48From Hedging to Speculation 50Interaction between Hedgers and Speculators 52Conclusion 54Endnotes 54References 54About the Author 55

4 The Social Functions of Financial Derivatives 57Christopher L. Culp

Hedging and Risk Transfer 58Price Discovery 58

Price Discovery, Commoditization, and Market Structure 59Intertemporal Resource Allocation 60

Forward Contracts as Synthetic Storage 60Commodity Interest Rates 60

Asset Finance 61Commodities Lending 62Project Finance 63Trade Finance 64Financial Asset Inventory Management 65

Synthetic Asset Allocation 65Derivatives and Public Policy 66

Endnotes 67Further Reading 68References 69About the Author 71

PART II Types of Financial Derivatives 73

5 Agricultural and Metallurgical Derivatives: Pricing 77Joan C. Junkus

Introduction 77Commodities 77Seasonality in Spot and Futures Prices 78Futures Pricing 79

Theory of Storage 80Theory of Normal Backwardation 84

CONTENTS ix

Conclusion 85References 86Suggested Further Reading 86About the Author 87

Agricultural and Metallurgical Derivatives:Speculation and Hedging 89Joan C. Junkus

Introduction 89Commodities 89Derivatives 90Commodity Investment Strategies 90

Commodity Indexes 90Diversification and Inflation 91Passive Investment Strategies 91Active Strategies 94Measuring Investment Performance 94

Hedging 95Commodity Marketing 95Risk Management 97

Spreads 99Conclusion 100References 100Suggested Further Reading 101About the Author 101

7 Equity Derivatives 103Jeffrey H. Harris and L. Mick Szvartz

Introduction 103Stock Options 104

Call Options 105Put Options 106Stock Options on an Index 106Employee Stock Options 107Convertible Bonds 107Warrants 108

Equity Futures 108Single-Stock Futures . 108Futures on Stock Indexes 109

Equity Swaps 110Future of Equity Derivatives 111References 112Further Reading 112About the Authors 113

x Contents

8 Foreign Exchange Derivatives 115Robert W. Kolb

Basic Pricing Principles 115Purchasing Power Parity Theorem 115Interest Rate Parity Theorem 116

Foreign Exchange Forward and Futures Contracts 117Foreign Exchange Options 118FX Option Pricing 119Plain Vanilla Foreign Exchange Swaps 119Flavored Currency Swaps 121Conclusion 122Endnotes 123References 123About the Author 123

9 Energy Derivatives 125Craig Pirrong

Introduction 125Products: An Overview 125History 126Petroleum Derivatives: Details 127Natural Gas Derivatives: Details 128Electricity Derivatives: Details 129Pricing 129Clearing 131Recent Developments 132References 133About the Author 133

10 Interest Rate Derivatives 135Ian Lang

Exchange-Traded (Listed) Derivatives 135Over-the-Counter Derivatives 138

OTC Options 138Rate Locks 138Swaps and Swaptions 139Mortgage Derivatives ' 141

Further Reading 142About the Author 142

11 Exotic Options 143Robert W. Kolb

Overview 143Forward-Start Options 144

CONTENTS xi

Compound Options 144Chooser Options 145Barrier Options 146Binary Options 147Lookback Options 149Asian or Average Price Options 150Exchange Options 151Rainbow Options 151Conclusion 152Endnotes 153References 154About the Author 154

12 Event Derivatives 157Justin Wolfers and Eric Zitzewitz

Types of Prediction Markets 158Applications and Evidence 160Accuracy of Prediction Markets 160Possibilities for Arbitrage 164Can Event Markets Be Manipulated Easily? 168Market Design 168Making Inferences from Prediction Markets 170Innovative Future Applications? 173Acknowledgments 173Endnotes 174References 174About the Authors 176

13 Credit Default Swaps 177Steven Todd

Credit Default Swaps on Corporate Debt 177Credit Default Swaps on Asset-Backed Securities 178Credit Default Swaps on Collateralized DebtObligations 180The Basis 182CDS Indices . 182Tranches of CDS Indices 186Trading Strategies Using Indexes and Tranches 188Market Dynamics: CDS and CDOs 189Synthetic CDOs and Bespokes 189Correlation _ 191Conclusion 196Endnotes 196References 197About the Author 198

xii Contents

14 Structured Credit Products 199Steven Todd

Asset-Backed Securities 202Collateralized Debt Obligations 204Commercial Mortgage-Backed Securities 208Endnotes 209References 210About the Author 210

15 Executive Stock Options 211Robert W. Kolb

Introduction 211Basic Features of Executive Stock Options 211

Rationales for ESOs 212Pricing of Executive Stock Options 214Executive Stock Options and Incentives 216

Conclusion 218Endnotes 218References 219About the Author 220

16 Emerging Derivative Instruments 221Steve Swidler

Economic Derivatives 222Real Estate Derivatives 224The Next Frontier 226Endnotes 228References 228Suggested Further Reading 229About the Author 230

PART III The Structure of Derivatives Marketsand Institutions 231

17 The Development and Current Stateof Derivatives Markets 233Michael A. Penick

Introduction: The Situation in the 1960s 233Financial Futures and Options 234Foreign Markets 236OTC Markets 237Energy Derivatives 238The Rise of Electronic Trading 240Current Conditions: Consolidation and Crisis 243

CONTENTS xiii

Endnotes 245References 247About the Author 248

18 Derivatives Markets Intermediaries: Brokers,Dealers, Pools, and Funds 249James L. Carley

Intermediaries for Exchange-Traded Derivatives 250Providers of Trade Execution Services 251Providers of Money Management Services 256

Intermediaries for OTC Derivatives 257Swap Brokers 258Swap Dealers 258Interdealer Brokers 258Next Step: Clearinghouse(s) for Swaps 259

Endnotes 260References 261About the Author 261

19 Clearing and Settlement 263James T. Moser and David Reiffen

Introduction 263Functions of Clearinghouses 263

Contracts for Immediate Performance 264Contracts for Deferred Performance 265

Clearing and Liquidity 273Competition between Exchanges 275

Nature of the Clearing Organization 276Innovation and Clearing Structure 278

Conclusion 278Endnotes 279References 281About the Authors 282

20 Counterparty Credit Risk 283James Overdahl

Measuring Counterparty Credit Risk Exposure 284Presettlement versus Settlement Risk 284Replacement Cost, Current Exposure, and Potential Exposure 284Simulation Techniques and the Exposure Profile 285Wrong-Way and Right-Way Risk 287

Managing Counterparty Credit Risk 287Evaluating the Creditworthiness of Counterparties 287Using Counterparty Credit Risk Measures in the TradeAuthorization Process 288

xiv Contents

Other Tools to Manage Counterparty Credit RiskNettingActual Default Experience in the OTC Market

Infrastructure Improvements Aimed at MitigatingCounterparty Credit Risk

Infrastructure and the Effectiveness of Counterparty CreditRisk ManagementCentral Counterparty Clearing

ConclusionEndnotesReferencesAbout the Author

289289289

290

290292292293293294

21 The Regulation of U.S. Commodity Futuresand Options 295Walter L. Lukken

Tiered Regulatory Design 296Statutory Exclusions for Certain OTC Derivatives 297Security Futures Products 298Retail Foreign Currency Fraud 299Exempt Commercial Markets 300CFTC Reauthorization Act of 2008 300Future Legislative Reforms 301Endnotes 302About the Author 303

22 Accounting for Financial Derivatives 305Ira G. Kawaller

Alternative Accounting Categories 305Cash Flow Hedges 306Fair Value Hedges 309Hedges of Net Investments in Foreign Operations ..,_ 322

Conclusion 312References 312About the Author 312

23 Derivative Scandals and Disasters 313John E. Marthinsen

IntroductionAnatomy of Derivative-Related FailuresInvestment Strategies and Exogenous Shocks behind Our FiveDerivative Fiascos

MGRM's StrategyLTCM's StrategyAmaranth's StrategyBarings' and Societe Generale's Speculative Traders

313313

315315316317318

CONTENTS XV

Lessons Learned from Derivative Scandals and Disasters 319Controlling Risks Is Possible Only If They Can Be MeasuredEffectively 319Risk Management Systems Must Cauterize Losses Immediatelyafter the Initial Shocks 320Creative Ways Are Needed to Supply Liquidity duringTurbulent Times 321Risk Management Systems Must Control Traders andFund Managers 321Compensation Incentives and Promotion Criteria MustBe Scrutinized 323Risk Management Systems Are Only as Strong as Their WeakestRisk Managers 325

Broader Implications of Derivative Scandals and Disasters 326Conclusion 327Acknowledgements 328Endnotes 328References 330Suggested Further Reading 331About the Author 332

PART IV Pricing of Derivatives: Essential Concepts 333

24 No-Arbitrage Pricing 335Robert A. Strong

Free Lunches 335Theory of Put/Call Parity 336Binomial Option'Pricing Model 341Put Pricing in the Presence of Call Options: Further Study 345Binomial Put Pricing 346Binomial Pricing with Asymmetric Branches 346Effect of Time 347Effect of Volatility 348Intuition into Black-Scholes 348Endnotes 349References 349Further Reading 349About the Author 350

25 The Pricing of Forward and Futures Contracts 351David Dubofsky

Cost of Carry Model 352Carry Return 354Commodity Futures 355Convenience Yield 356Delivery Options 357

xvi Contents

• Interest Rate Futures and Forwards: Eurodollar Futuresand Forward Rate Agreements 358Interest Rate Futures and Forwards: Treasury Bondand Treasury Note Futures 360Should Futures and Forward Prices Be the Same? 362Expectations Model: An Alternative Theory for the Pricingof Forwards and Futures 363Electricity Forwards and Futures 364Conclusion > 366Endnotes 367References 367About the Author 369

26 The Black-Scholes Option Pricing Model 371A. G. Malliaris

Introduction 371Brief History 372Black-Scholes Formula 372Assumptions of the Black-Scholes Model 373Discussion of Assumptions 374Ito Process 374Example 375Excel Application 376Simple Derivation of Black-Scholes 376Numerical Example 380The Greeks 381

Delta 381Gamma ' 381Theta 381Vega 381Rho 382

Risk-Neutral Pricing 382Conclusion 384References 384About the Author 385

27 The Black-Scholes Legacy: Closed-Form OptionPricing Models 387Antonio Camara

Introduction t̂ 387The Black-Scholes Model 388First Generation of Models (One Lognormal Underlying) 392Second Generation of Models (Two Lognormal Underlyings) 395Third Generation of Models (One NonlognormalUnderlying) 397Fourth Generation of Models 401Conclusion 402

CONTENTS xvii

Endnotes 402References 403About the Author 404

28 The Pricing and Valuation of Swaps 405Gerald Gay and Anand Venkateswaran

Introduction 405Illustration 1: An End User Swap Application 406

Framework for Pricing and Valuation 407Illustration 2: A Simple Example 409

Steps for Swap Pricing 410Obtain Market Inputs 410Make Convexity Adjustments to Implied Futures Rates 411Build the Zero Curve 413Identify Relevant Swap Features 415Price/Value the Swap 415Illustration 3: Pricing an Interest Rate Swap 416Illustration 4: Valuing an Existing Interest Rate Swap 416

Other Swaps 417Currency Swaps 417Illustration 5: Pricing and Valuing a Currency Swap 418Commodity Swaps 419Illustration 6: Pricing a Commodity Swap 419

Endnotes 420References 421About the Authors 422

PART V Advanced Pricing Techniques 423

29 Monte Carlo Techniques in Pricingand Using Derivatives 425Cara M. Marshall

Introduction 425Pricing a Classic Black-Scholes Option 427

Simulation Results 432Price Return 432

Pricing a Rainbow Option 435Endnotes 439References . 439About the Author 440

30 Valuing Derivatives Using Finite DifferenceMethods 441Craig Pirrong

Introduction 441An Overview 441

xviii Contents

Basic Methods 445Higher-Dimension Problems 449The Pros and Cons of Finite Difference Methods 451Suggested Further Reading 451Endnotes 452References 452About the Author 453

31 Stochastic Processes and Models 455George Chalamandaris and A. G. Malliaris

IntroductionStochastic Processes

Definitions and PropertiesConstructing the Continuous Time Model: Brownian MotionThe Ito Process and the Need for Stochastic Calculus

Basic Elements of Stochastic CalculusIto IntegralIto's Lemma

Binomial Tree: Another Way of Visualizing aStochastic Process

Construction of a Binomial Tree and PropertiesConclusionEndnotesReferencesAppendix: Heuristic Derivation of Ito's FormulaAbout the Authors

455456456458459462462464

468469472472472473475

32 Measuring and Hedging Option PriceSensitivities 477R. Brian Balyeat

Delta 477Example 1 479Example 2 479

Gamma 484Example 3 485

Theta S 487Example 4 ^ 488

Vega 491Example 5 492

Rho and Other Option Sensitivities 493Example 6 493Example 7 494

Hedging Delta, Gamma, and Vega 496Conclusion 498References 499About the Author 499

CONTENTS xix

PART VI Using Financial Derivatives 501

33 Option Strategies 503Stewart Mayhew

Building Blocks 505Covered Calls and Protective Puts 507Synthetic Positions 509Bull and Bear Spreads 512Cylinders 515Straddles, Strangles, Strips, and Straps 516Ratio Spreads 518Box Spreads 518Butterflies, Condors, and Seagulls 519Time Strategies 522Multi-Asset Strategies 523Endnotes 523References 523About the Author 524

34 The Use of Derivatives in Financial Engineering:Hedge Fund Applications 525John F. Marshall and Cara M. Marshall

Introduction 525Convertible Bond Arbitrage 526Capital Structure Arbitrage 534Endnotes 538References 539About the Authors 539

35 Hedge Funds and Financial Derivatives 541Tom Nohel

Introduction 541Survey of Derivative Use by Hedge Funds 544Modeling Hedge Fund Risks 547Description of Some Popular Hedge Fund Strategies 548

Convertible Arbitrage 548Risk Arbitrage 549Global Macro 549Market Neutral/Relative Value 550Volatility Trades . 550Correlation Trading 551Credit Hedge Funds 551Hedge Fund Activism 552

Some Unusual Derivatives Trades Made by Hedge Funds 552Empty Voting 552

xx Contents

Acquiring a Large Stake through Put Exercise 553Toeholds via Contingent Contracts 553Tax-Avoidance Strategies 554Using Structures to Create Leverage 555

Conclusion 555Endnotes 555References 557About the Author 558

36 Real Options and Applications in Corporate Finance 559Betty Simkins and Kris Kemper

Introduction 559A Brief History of Real Options 560Distinction between Financial Options and Real Options 561Types of Real Options and Examples in the Energy Industry 561

Option to Expand 563Option to Wait 563Option to Vary Production Inputs, Outputs, or Processes 564Option to Abandon or Temporarily Shutdown 566Hybrid Real Options 568

Valuing Real Options 568Decision Trees 569Monte Carlo Simulation 569Option Pricing Models 569

Conclusion 570Endnotes 570References 572About the Authors 573

37 Using Derivatives to Manage Interest Rate Risk 575Steven L. Byers

Introduction 575Forward-Based Instruments 575

Forward Rate Agreements 575Interest Rate Futures Contracts 577Basis Risk 578Futures Hedge Ratio 579Example of Hedging with Eurodollar Futures 580Hedging a Portfolio of Coupon Bonds with Interest Rate Futures 581Interest Rate Swaps 582

Option-Based Instruments 583Interest Rate Guarantees 584Interest Rate Caps and Floors 584Swaptions 586Mortgage Securitization Risk Management Using InterestRate Derivatives 586

CONTENTS xxi

Conclusion 588References 588Suggested Further Reading 589About the Author 589

Index 591