Introduction | p. 1 |

Introduction | p. 1 |

Types of Derivatives | p. 3 |

Options | p. 3 |

Futures Contracts | p. 3 |

Swaps | p. 4 |

Product Characteristies | p. 4 |

Participants in the Derivatives World | p. 5 |

Hedging | p. 5 |

Speculation | p. 5 |

Arbitrage | p. 6 |

Uses of Derivatives | p. 7 |

Risk Management | p. 7 |

Income Generation | p. 8 |

Financial Engineering | p. 8 |

Effective Study of Derivatives | p. 9 |

Appendix | p. 11 |

A Review of Statistical Principles Useful in the Study of Derivatives | p. 11 |

Basic Principles Of Stock Options | p. 15 |

What Options Are and Where They Come From | p. 16 |

Call Options | p. 16 |

Put Options | p. 17 |

Where Options Come From | p. 18 |

Opening and Closing Transactions | p. 18 |

The Role of the Options Clearing Corporation | p. 21 |

Why Options Are a Good Idea | p. 21 |

Portfolio Risk Management | p. 22 |

Risk Transfer | p. 22 |

Financial Leverage | p. 23 |

Income Generation | p. 23 |

Where and How Options Trade | p. 23 |

Exchanges | p. 23 |

Over-the-Counter Options | p. 24 |

Other Listed Options | p. 25 |

Trading Mechanics | p. 26 |

The Option Premium | p. 29 |

Intrinsic Value and Time Value | p. 29 |

Option Price Quotations | p. 29 |

Profits and Losses with Options | p. 31 |

Understanding the Exercise of an Option | p. 31 |

Profit and Loss Diagrams | p. 33 |

Buying a Call Option | p. 33 |

Writing a Call Option | p. 34 |

Buying a Put Option | p. 35 |

Writing a Put Option | p. 36 |

A Note on Margin Requirements | p. 37 |

Basic Option Strategies: Covered Calls And Protective Puts | p. 41 |

Using Options as a Hedge | p. 41 |

Protective Puts | p. 42 |

Using Calls to Hedge a Short Position | p. 47 |

Writing Covered Calls to Protect Against Market Downturns | p. 50 |

Using Options to Generate Income | p. 52 |

Writing Calls to Generate Income | p. 52 |

Writing Puts to Generate Income | p. 55 |

Profit and Loss Diagrams with Seasoned Stock Positions | p. 58 |

Adding a Put to an Existing Stock Position | p. 58 |

Writing a Call Against an Existing Stock Position | p. 59 |

Improving on the Market | p. 60 |

Writing Calls to Improve on the Market | p. 60 |

Writing Puts to Improve on the Market | p. 61 |

Option Combinations and Spreads | p. 66 |

Combinations | p. 66 |

Spreads | p. 73 |

Types of Spreads | p. 73 |

Nonstandard Spreads | p. 83 |

Other Strategies | p. 85 |

Margin Considerations | p. 87 |

Evaluating Spreads | p. 90 |

Option Pricing | p. 97 |

A Brief History of Options Pricing | p. 98 |

The Early Work | p. 98 |

The Middle Years | p. 99 |

The Present | p. 99 |

Arbitrage and Option Pricing | p. 100 |

Free Lunches | p. 100 |

The Theory of Put/Call Parity | p. 101 |

The Binomial Option Pricing Model | p. 107 |

Put Pricing in the Presence of Call Options: Further Study | p. 112 |

Binomial Put Pricing | p. 113 |

Binomial Pricing with Asymmetric Branches | p. 114 |

The Effect of Time | p. 115 |

The Effect of Volatility | p. 116 |

Intuition into Black-Scholes | p. 118 |

Continuous Time and Multiple Periods | p. 118 |

Option Pricing and the Roll of Dice | p. 119 |

Appendix | p. 126 |

Multi-Period Binomial Option Pricing | p. 126 |

Option Pricing with Continuous Compounding | p. 126 |

Risk Neutrality and Implied Branch Probabilities | p. 127 |

Extension of Two Periods | p. 128 |

Recombining Binomial Trees | p. 131 |

Another Example | p. 131 |

Binomial Pricing with Lognormal Returns | p. 132 |

Multiperiod Binomial Put Pricing | p. 134 |

Exploiting Arbitrage | p. 136 |

American vs. European Option Pricing | p. 137 |

The Black-Scholes Option Pricing Model | p. 139 |

The Black-Scholes Option Pricing Model | p. 140 |

The Model | p. 140 |

Development and Assumptions of the Model | p. 140 |

Determinants of the Option Premium | p. 141 |

Assumptions of the Black-Scholes Model | p. 143 |

Intuition Into the Black-Scholes Model | p. 147 |

Calculating Black-Scholes Prices from Historical Data | p. 149 |

Call Values | p. 149 |

Implied Volatility | p. 153 |

Calculating Implied Volatility | p. 153 |

An Implied Volatility Heuristic | p. 154 |

Historical Versus Implied Volatility | p. 154 |

Pricing in Volatility Units | p. 156 |

Volatility Smiles | p. 158 |

Using Black-Scholes to Solve for the Put Premium | p. 162 |

Problems Using the Black-Scholes Model | p. 162 |

Option Greeks | p. 167 |

The Principal Option Pricing Derivatives | p. 167 |

Delta | p. 167 |

Measure of Option Sensitivity | p. 168 |

Hedge Ratio | p. 169 |

Likelihood of Becoming in-the-Money | p. 169 |

Theta | p. 170 |

Gamma | p. 171 |

Sign Relationships | p. 172 |

Other Derivatives | p. 173 |

Vega | p. 173 |

Rho | p. 174 |

The Greeks of Vega | p. 175 |

Others | p. 175 |

Position Derivatives | p. 175 |

An Example | p. 175 |

Caveats About Position Derivatives | p. 175 |

Delta Neutrality | p. 176 |

Calculating Delta Hedge Ratios | p. 177 |

Why Delta Neutrality Matters | p. 177 |

Two Markets: Directional and Speed | p. 179 |

Directional Market | p. 179 |

Speed Market | p. 179 |

Combining Directional and Speed Markets | p. 179 |

Dynamic Hedging | p. 180 |

Minimizing the Cost of Delta Adjustments | p. 181 |

Position Risk | p. 182 |

Fundamentals Of The Futures Market | p. 190 |

The Concept of Futures Contracts | p. 191 |

The Futures Promise | p. 191 |

Why We Have Futures Contracts | p. 194 |

Ensuring the Promise Is Kept | p. 195 |

Market Mechanics | p. 196 |

Types of Orders | p. 196 |

Ambience of the Marketplace | p. 198 |

Creation of a Contract | p. 200 |

Market Participants | p. 201 |

Hedgers | p. 201 |

Processors | p. 202 |

Speculators | p. 204 |

Scalpers | p. 205 |

The Clearing Process | p. 206 |

Matching Trades | p. 206 |

Accounting Supervision | p. 208 |

Intramarket Settlement | p. 211 |

Settlement Prices | p. 212 |

Delivery | p. 212 |

Principles of Futures Contract Pricing | p. 213 |

The Expectations Hypothesis | p. 213 |

Normal Backwardation | p. 214 |

A Full Carrying Charge Market | p. 215 |

Reconciling the Three Theories | p. 217 |

Spreading with Commodity Futures | p. 217 |

Intercommodity Spreads | p. 217 |

Intermarket Spreads | p. 218 |

Intracommodity Spreads | p. 218 |

Why Spread in the First Place? | p. 219 |

Stock Index Futures | p. 223 |

Stock Indexes and Their Futures Contracts | p. 223 |

Stock Indexes | p. 224 |

Stock Index Futures Contracts | p. 227 |

The SandP 500 Stock Index Futures Contract | p. 227 |

Pricing of Stock Index Futures | p. 228 |

Basis Convergence | p. 232 |

Use of Stock Index Futures | p. 232 |

Speculation | p. 232 |

Spreading | p. 233 |

Arbitrage | p. 233 |

Anticipation of Stock Purchase or Sale | p. 234 |

Hedging | p. 234 |

Hedging with Stock Index Futures | p. 235 |

Systematic and Unsystematic Risk | p. 235 |

The Need to Hedge | p. 236 |

The Hedge Ratio | p. 236 |

Hedging in Retrospect | p. 239 |

Adjusting Market Risk | p. 241 |

Foreign Exchange Futures | p. 245 |

Foreign Exchange Risk | p. 246 |

FX Risk and Interest Rates | p. 247 |

The Concept of Exposure | p. 248 |

Accounting Exposure | p. 248 |

Economic Exposure | p. 248 |

FX Risk from a Business Perspective | p. 249 |

FX Risk from an Investment Perspective | p. 251 |

Forward Rates | p. 252 |

Purchasing Power Parity | p. 253 |

Interest Rate Parity | p. 254 |

Foreign Currency Futures | p. 256 |

Pricing of Foreign Exchange Futures Contracts | p. 256 |

Dealing with the Risk | p. 258 |

Dealing with the Exposure | p. 258 |

A Business Example | p. 258 |

An Investment Example | p. 260 |

Key Issues in Foreign Exchange Risk Management | p. 261 |

Fundamentals Of Interest Rate Futures | p. 265 |

Interest Rate Futures | p. 266 |

Treasury Bills, Eurodollars, and Their Futures Contracts | p. 266 |

Characteristics of U.S. Treasury Bills | p. 266 |

The Treasury Bill Futures Contract | p. 268 |

Characteristics of Eurodollars | p. 269 |

The Eurodollar Futures Contract | p. 269 |

Speculating with T-Bill Futures | p. 271 |

Hedging with T-Bill Futures | p. 272 |

Treasury Bonds and Their Futures Contracts | p. 273 |

Characteristics of U.S. Treasury Bonds | p. 273 |

Pricing of Treasury Bonds | p. 274 |

The Treasury Bond Futures Contract | p. 275 |

Dealing with Coupon Differences | p. 275 |

The Matter of Accrued Interest | p. 278 |

Delivery Procedures | p. 279 |

The Invoice Price | p. 280 |

Cheapest to Deliver | p. 281 |

Pricing Interest Rate Futures Contracts | p. 282 |

Arbitrage with T-Bill Futures | p. 285 |

Delivery Options | p. 286 |

Spreading with Interest Rate Futures | p. 287 |

TED Spread | p. 287 |

The NOB Spread | p. 289 |

Other Spreads with Financial Futures | p. 290 |

Futures Contracts And Portfolio Management | p. 294 |

The Concept of Immunization | p. 295 |

Bond Risks | p. 295 |

Duration Matching | p. 296 |

Bank Immunization | p. 298 |

Duration Shifting | p. 301 |

Hedging with Interest Rate Futures | p. 303 |

Increasing Duration with Futures | p. 304 |

Disadvantages of Immunizing | p. 306 |

Altering Asset Allocation with Futures | p. 308 |

Tactical Changes | p. 308 |

Initial Situation | p. 309 |

Bond Adjustment | p. 310 |

Stock Adjustment | p. 310 |

Neutralizing Cash | p. 311 |

Swaps And Interest Rate Options | p. 315 |

Interest Rate Swaps | p. 316 |

Immunizing with Interest Rate Swaps | p. 322 |

Exploiting Comparative Advantage in the Credit Market | p. 324 |

Foreign Currency Swaps | p. 325 |

Circus Swap | p. 329 |

Swap Variations | p. 329 |

Interest Rate Options | p. 330 |

Interest Rate Cap | p. 330 |

Interest Rate Floor | p. 332 |

Calculating Cap and Floor Payoffs | p. 333 |

Interest Rate Collar | p. 334 |

Swaption | p. 334 |

Swap Pricing | p. 340 |

Intuition Into Swap Pricing | p. 340 |

Swaps as a Pair of Bonds | p. 341 |

Swaps as a Series of Forward Contracts | p. 341 |

Swaps as a Pair of Option Contracts | p. 342 |

Solving for the Swap Price | p. 342 |

The Role of the Forward Curve for LIBOR | p. 343 |

Implied Forward Rates | p. 344 |

Initial Condition Pricing | p. 346 |

Quoting the Swap Price | p. 348 |

Counterparty Risk Implications | p. 349 |

Valuing an Off-Market Swap | p. 350 |

Hedging the Swap | p. 351 |

Hedging Against a Parallel Shift in the Yield Curve | p. 352 |

Hedging Against Any Shift in the Yield Curve | p. 353 |

Tailing the Hedge | p. 355 |

Pricing a Currency Swap | p. 356 |

Other Derivative Assets | p. 361 |

Futures Options | p. 361 |

Characteristics | p. 362 |

Speculating with Futures Options | p. 365 |

Spreading with Futures Options | p. 365 |

Basis Risk with Spreads | p. 365 |

Hedging with Futures Options | p. 366 |

Speculators and Hedging | p. 367 |

Early Exercise of Futures Options | p. 368 |

Pricing Futures Options | p. 368 |

Disposing of Valuable Options | p. 369 |

Futures Option Deltas | p. 370 |

Implied Volatility | p. 370 |

Warrants | p. 370 |

Characteristics | p. 371 |

Pricing | p. 371 |

Hedging with Stock Warrants | p. 373 |

Other Derivative Assets | p. 374 |

Characteristics | p. 375 |

A Note on the Pricing of Foreign Currency Options | p. 375 |

When-Issued Stock | p. 376 |

Common Stock Trading on a When-Issued Basis | p. 377 |

Financial Engineering And Risk Management | p. 381 |

Financial Engineering | p. 382 |

Engineering an Option | p. 383 |

Gamma Risk | p. 388 |

Risk Management | p. 390 |

Managing Company Risk | p. 391 |

A Case Study | p. 392 |

Managing Market Risk | p. 395 |

Contemporary Issues | p. 401 |

Long-Term Capital Management | p. 402 |

Value at Risk | p. 403 |

VAR Calculation | p. 405 |

New Product Development | p. 406 |

Weather Derivatives | p. 406 |

Telecom Capacity | p. 409 |

Rental Caps | p. 409 |

Equity Swaps | p. 410 |

Program Trading | p. 411 |

Implementation | p. 412 |

The Open Outcry and Specialist Systems | p. 413 |

FAS 133 | p. 414 |

Requirements | p. 414 |

Criticism | p. 415 |

Implications | p. 416 |

Glossary | p. 419 |

Self Test Answers | p. 435 |

Index | p. 440 |

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