Derivatives Essentials

A clear, practical guide to working effectively with derivative securities products

Derivatives Essentials is an accessible, yet detailed guide to derivative securities. With an emphasis on mechanisms over formulas, this book promotes a greater understanding of the topic in a straightforward manner, using plain-English explanations. Mathematics are included, but the focus is on comprehension and the issues that matter most to practitioners--including the rights and obligations, terms and conventions, opportunities and exposures, trading, motivation, sensitivities, pricing, and valuation of each product. Coverage includes forwards, futures, options, swaps, and related products and trading strategies, with practical examples that demonstrate each concept in action. The companion website provides Excel files that illustrate pricing, valuation, sensitivities, and strategies discussed in the book, and practice and assessment questions for each chapter allow you to reinforce your learning and gauge the depth of your understanding.

Derivative securities are a complex topic with many "moving parts," but practitioners must possess a full working knowledge of these products to use them effectively. This book promotes a truly internalized understanding rather than rote memorization or strict quantitation, with clear explanations and true-to-life examples.
* Understand the concepts behind derivative securities
* Delve into the nature, pricing, and offset of sensitivities
* Learn how different products are priced and valued
* Examine trading strategies and practical examples for each product

Pricing and valuation is important, but understanding the fundamental nature of each product is critical--it gives you the power to wield them more effectively, and exploit their natural behaviors to achieve both short- and long-term market goals. Derivatives Essentials provides the clarity and practical perspective you need to master the effective use of derivative securities products.

Preface xiii
Acknowledgements xvii
About the Author xix
Part One Introduction to Forwards, Futures, and Options
Chapter 1 Forwards and Futures 3
1. 1 Forward contract characteristics 3
1. 2 Long forward payoff 6
1. 3 Long forward P&L 8
1. 4 Short forward payoff 9
1. 5 Short forward P&L 10
1. 6 Long forward P&L diagram 12
1. 7 Short forward P&L diagram 13
1. 8 Forwards are zero-sum games 15
1. 9 Counterparty credit risk 17
1. 10 Futures contracts 19
Chapter 2 Call Options 22
2. 1 Call option characteristics 22
2. 2 Long call payoff 25
2. 3 Long call P&L 27
2. 4 Short call payoff 29
2. 5 Short call P&L 30
2. 6 Long call P&L diagram 32
2. 7 Short call P&L diagram 33
2. 8 Call options are zero-sum games 35
2. 9 Call option moneyness 37
2. 10 Exercising a call option early 38
2. 11 Comparison of call options and forwards/futures 40
Chapter 3 Put Options 44
3. 1 Put option characteristics 44
3. 2 Long put payoff 47
3. 3 Long put P&L 49
3. 4 Short put payoff 50
3. 5 Short put P&L 52
3. 6 Long put P&L diagram 53
3. 7 Short put P&L diagram 55
3. 8 Put options are zero-sum games 57
3. 9 Put option moneyness 58
3. 10 Exercising a put option early 59
3. 11 Comparison of put options, call options, and forwards/futures 60
Part Two Pricing and Valuation
Chapter 4 Useful Quantitative Concepts 65
4. 1 Compounding conventions 66
4. 2 Calculating future value and present value 68
4. 3 Identifying continuously compounded interest rates 71
4. 4 Volatility and historical standard deviation 72
4. 5 Interpretation of standard deviation 77
4. 6 Annualized standard deviation 80
4. 7 The standard normal cumulative distribution function 81
4. 8 The z-score 83
Chapter 5 Introduction to Pricing and Valuation 86
5. 1 The concepts of price and value of a forward contract 87
5. 2 The concepts of price and value of an option 88
5. 3 Comparison of price and value concepts for forwards and options 90
5. 4 Forward value 91
5. 5 Forward price 92
5. 6 Option value: The Black-Scholes model 94
5. 7 Calculating the Black-Scholes model 96
5. 8 Black-Scholes model assumptions 98
5. 9 Implied volatility 99
Chapter 6 Understanding Pricing and Valuation 105
6. 1 Review of payoff, price, and value equations 106
6. 2 Value as the present value of expected payoff 108
6. 3 Risk-neutral valuation 109
6. 4 Probability and expected value concepts 112
6. 5 Understanding the Black-Scholes equation for call value 117
6. 6 Understanding the Black-Scholes equation for put value 120
6. 7 Understanding the equation for forward value 122
6. 8 Understanding the equation for forward price 123
Chapter 7 The Binomial Option Pricing Model 126
7. 1 Modeling discrete points in time 126
7. 2 Introduction to the one-period binomial option pricing model 127
7. 3 Option valuation, one-period binomial option pricing model 131
7. 4 Two-period binomial option pricing model, European-style option 135
7. 5 Two-period binomial model, American-style option 138
7. 6 Multi-period binomial option pricing models 140
Part Three The Greeks
Chapter 8 Introduction to the Greeks 145
8. 1 Definitions of the Greeks 146
8. 2 Characteristics of the Greeks 146
8. 3 Equations for the Greeks 149
8. 4 Calculating the Greeks 151
8. 5 Interpreting the Greeks 153
8. 6 The accuracy of the Greeks 156
Chapter 9 Understanding Delta and Gamma 158
9. 1 Describing sensitivity using Delta and Gamma 158
9. 2 Understanding Delta 161
9. 3 Delta across the underlying asset price 162
9. 4 Understanding Gamma 166
9. 5 Gamma across the underlying asset price 167
Chapter 10 Understanding Vega, Rho, and Theta 171
10. 1 Describing sensitivity using Vega, Rho, and Theta 171
10. 2 Understanding Vega 174
10. 3 Understanding Rho 177
10. 4 Understanding Theta 178
Part Four Trading Strategies
Chapter 11 Price and Volatility Trading Strategies 189
11. 1 Price and volatility views 189
11. 2 Relating price and volatility views to Delta and Vega 191
11. 3 Using forwards, calls, and puts to monetize views 193
11. 4 Introduction to straddles 194
11. 5 Delta and Vega characteristics of long and short straddles 195
11. 6 The ATM DNS strike price 196
11. 7 Straddle: numerical example 197
11. 8 P&L diagrams for long and short straddles 199
11. 9 Breakeven points for long and short straddles 199
11. 10 Introduction to strangles 201
11. 11 P&L diagrams for long and short strangles 202
11. 12 Breakeven points for long and short strangles 202
11. 13 Summary of simple price and volatility trading strategies 204
Chapter 12 Synthetic, Protective, and Yield-Enhancing Trading Strategies 206
12. 1 Introduction to put-call parity and synthetic positions 207
12. 2 P&L diagrams of synthetic positions 208
12. 3 Synthetic positions premiums and ATMF 212
12. 4 The Greeks of synthetic positions 214
12. 5 Option arbitrage 215
12. 6 Protective puts 217
12. 7 Covered calls 218
12. 8 Collars 219
Chapter 13 Spread Trading Strategies 223
13. 1 Bull and bear spreads using calls 223
13. 2 Bull and bear spreads using puts 226
13. 3 Risk reversals 229
13. 4 Butterfly spreads 232
13. 5 Condor spreads 236
Part Five Swaps
Chapter 14 Interest Rate Swaps 243
14. 1 Interest rate swap characteristics 243
14. 2 Interest rate swap cash flows 246
14. 3 Calculating interest rate swap cash flows 249
14. 4 How interest rate swaps can transform cash flows 256
Chapter 15 Credit Default Swaps, Cross-Currency Swaps, and Other Swaps 264
15. 1 Credit default swap characteristics 264
15. 2 Key determinants of the credit default swap spread 267
15. 3 Cross-currency swap characteristics 270
15. 4 Transforming cash flows using a cross-currency swap 270
15. 5 Other swap varieties 273
Appendix: Solutions to Knowledge Check Questions 275
Index 301