Description
Book SynopsisThe 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.
Table of ContentsPreface ix
Acknowledgements xi
1 An Introduction to the Major Asset Classes 1
1.1 Equities 1
1.2 Commodities 5
1.3 Fixed Income 12
1.4 Foreign Exchange 15
Summary 17
2 Derivatives: Forwards, Futures and Swaps 19
2.1 Derivatives 19
2.2 Forward Contracts 20
2.3 Futures Contracts 24
2.4 Calculating Implied Forward Prices and Valuing Existing Forward Contracts 26
2.5 Pricing Futures Contracts 34
2.6 Swaps 35
Summary 49
3 Derivatives: Options and Related Strategies 51
3.1 Call Options 51
3.2 Put Options 55
3.3 Boundary Conditions for Call and Put Options Prices 58
3.4 Put–Call Parity 61
3.5 Swaptions 63
3.6 Options Strategies 64
Summary 76
4 Binomial Option Pricing 77
4.1 One-Period Binomial Tree: Replication Approach 77
4.2 Risk-Neutral Valuation 83
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
5.2 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
5.11 Other Pricing Techniques 112
5.12 Pricing Techniques Summary 113
5.13 The Excel Spreadsheet “Option Replication” 114
Summary 117
6 Implied Volatility and the Greeks 121
6.1 Implied Volatility 121
6.2 The Greeks 123
6.3 Delta and its Dynamics 123
6.4 Gamma and its Dynamics 127
6.5 Vega and its Dynamics 132
6.6 Theta and its Dynamics 136
6.7 Rho 142
6.8 Option Trading 143
6.9 Some Additional Remarks (in Q&A Format) 146
6.10 An Example of the Behaviour of Implied Volatility: EUR/USD Rate and S&P 500 in 2010–2012 147
Summary 148
7 Volatility Smile and the Greeks of Option Strategies 151
7.1 The Volatility Smile – Why is the Implied Volatility Not Flat Across Different Strikes? 151
7.2 The “Sticky Delta” and “Sticky Strike” Approaches to Describing Volatility Smile 153
7.3 The Volatility Term Structure – Why is the Implied Volatility Not Flat Across Different Expiries? 155
7.4 The Volatility Surface – Combining Smile and Term Structure 156
7.5 Analysing the Greeks of Common Option Strategies 158
7.6 Some Additional Remarks on Straddles, Risk Reversals and Butterflies 170
7.7 Vega Hedging is Not Just Simply Offsetting Overall Vega Exposure 171
7.8 Hedging Volatility Risk: A Brief Introduction of the Vanna–Volga Approach 172
7.9 The Volatility Smile – One Step Further 173
7.10 Pricing Exotic Options 178
7.11 Different Types of Volatility 179
Summary 184
8 Exotic Derivatives 185
8.1 Exotic Derivatives with Fixed Payoffs 185
8.2 Other Common Exotic Derivatives 188
8.3 European Digital Options: Pricing and Greeks 191
8.4 Other Exotic Options: Pricing and Greeks 200
Summary 208
9 Multi-Asset Derivatives 209
9.1 Basket Options 209
9.2 Best-of and Worst-of Options 211
9.3 Quanto Derivatives 222
9.4 “Compo” Derivatives 225
Summary 227
10 Structured Products 229
10.1 Definition 229
10.2 Common Features 229
10.3 Principal Protection 230
10.4 The Benefit to the Issuer 231
10.5 Redemption Amounts and Participation 232
10.6 Principal at Risk: Embedding a Short Option 234
10.7 More Complicated Payoffs 235
10.8 Auto-Callable Note: Pricing and Risk Profile 238
10.9 One Step Forward: The Worst-of Digital Note 240
10.10 A Real-Life Example of Structured Product 241
10.11 Liquidity and Exchange-Traded Notes (ETNs) 242
Summary 243
Index 245
