Pricing and Hedging Financial Derivatives E-Book

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Series
• Sprache: Englisch

Seitenzahl: 572

Veröffentlichungsjahr: 2014

Beschreibung

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

Leseprobe

Contents

Cover

Title Page

Copyright

Preface

Acknowledgements

Chapter 1: An Introduction to the Major Asset Classes

1.1 EQUITIES

1.2 COMMODITIES

1.3 FIXED INCOME

1.4 FOREIGN EXCHANGE

SUMMARY

Chapter 2: Derivatives: Forwards, Futures and Swaps

2.1 DERIVATIVES

2.2 FORWARD CONTRACTS

2.3 FUTURES CONTRACTS

2.4 CALCULATING IMPLIED FORWARD PRICES AND VALUING EXISTING FORWARD CONTRACTS

2.5 PRICING FUTURES CONTRACTS

2.6 SWAPS

SUMMARY

Chapter 3: Derivatives: Options and Related Strategies

3.1 CALL OPTIONS

3.2 PUT OPTIONS

3.3 BOUNDARY CONDITIONS FOR CALL AND PUT OPTIONS PRICES

3.4 PUT–CALL PARITY

3.5 SWAPTIONS

3.6 OPTIONS STRATEGIES

SUMMARY

Chapter 4: Binomial Option Pricing

4.1 ONE-PERIOD BINOMIAL TREE: REPLICATION APPROACH

4.2 RISK-NEUTRAL VALUATION

4.3 TWO-PERIOD BINOMIAL TREE: VALUING BACK DOWN THE TREE

4.4 THE BINOMIAL TREE: A GENERALIZATION

4.5 EARLY EXERCISE AND AMERICAN OPTIONS

4.6 VOLATILITY CALIBRATION

SUMMARY

Chapter 5: The Fundamentals of Option Pricing

5.1 INTRINSIC VALUE AND TIME VALUE OF AN OPTION

5.2 WHAT IS VOLATILITY AND WHY DOES IT MATTER?

5.3 MEASUREMENT OF REALIZED VOLATILITY AND CORRELATION

5.4 OPTION PRICING IN THE BLACK–SCHOLES FRAMEWORK

5.5 THE OPTION DELTA AND THE REPLICATION OF THE OPTION PAYOFF

5.6 OPTION REPLICATION

5.7 OPTION REPLICATION, RISK-NEUTRAL VALUATION AND DELTA HEDGING REVISITED

5.8 OPTIONS ON DIVIDEND PAYING ASSETS

5.9 OPTIONS ON FUTURES: THE BLACK MODEL

5.10 MONTE CARLO PRICING

5.11 OTHER PRICING TECHNIQUES

5.12 PRICING TECHNIQUES SUMMARY

5.13 THE EXCEL SPREADSHEET “OPTION REPLICATION”

SUMMARY

Chapter 6: Implied Volatility and the Greeks

6.1 IMPLIED VOLATILITY

6.2 THE GREEKS

6.3 DELTA AND ITS DYNAMICS

6.4 GAMMA AND ITS DYNAMICS

6.5 VEGA AND ITS DYNAMICS

6.6 THETA AND ITS DYNAMICS

6.7 RHO

6.8 OPTION TRADING

6.9 SOME ADDITIONAL REMARKS (IN Q&A FORMAT)

6.10 AN EXAMPLE OF THE BEHAVIOUR OF IMPLIED VOLATILITY: EUR/USD RATE AND S&P 500 IN 2010–2012

SUMMARY

Chapter 7: Volatility Smile and the Greeks of Option Strategies

7.1 THE VOLATILITY SMILE – WHY IS THE IMPLIED VOLATILITY NOT FLAT ACROSS DIFFERENT STRIKES?

7.2 THE “STICKY DELTA” AND “STICKY STRIKE” APPROACHES TO DESCRIBING VOLATILITY SMILE

7.3 THE VOLATILITY TERM STRUCTURE – WHY IS THE IMPLIED VOLATILITY NOT FLAT ACROSS DIFFERENT EXPIRIES?

7.4 THE VOLATILITY SURFACE – COMBINING SMILE AND TERM STRUCTURE

7.5 ANALYSING THE GREEKS OF COMMON OPTION STRATEGIES

7.6 SOME ADDITIONAL REMARKS ON STRADDLES, RISK REVERSALS AND BUTTERFLIES

7.7 VEGA HEDGING IS NOT JUST SIMPLY OFFSETTING OVERALL VEGA EXPOSURE

7.8 HEDGING VOLATILITY RISK: A BRIEF INTRODUCTION OF THE VANNA–VOLGA APPROACH

7.9 THE VOLATILITY SMILE – ONE STEP FURTHER

7.10 PRICING EXOTIC OPTIONS

7.11 DIFFERENT TYPES OF VOLATILITY

SUMMARY

Chapter 8: Exotic Derivatives

8.1 EXOTIC DERIVATIVES WITH FIXED PAYOFFS

8.2 OTHER COMMON EXOTIC DERIVATIVES

8.3 EUROPEAN DIGITAL OPTIONS: PRICING AND GREEKS

8.4 OTHER EXOTIC OPTIONS: PRICING AND GREEKS

SUMMARY

Chapter 9: Multi-Asset Derivatives

9.1 BASKET OPTIONS

9.2 BEST-OF AND WORST-OF OPTIONS

9.3 QUANTO DERIVATIVES

9.4 “COMPO” DERIVATIVES

SUMMARY

Chapter 10: Structured Products

10.1 DEFINITION

10.2 COMMON FEATURES

10.3 PRINCIPAL PROTECTION

10.4 THE BENEFIT TO THE ISSUER

10.5 REDEMPTION AMOUNTS AND PARTICIPATION

10.6 PRINCIPAL AT RISK: EMBEDDING A SHORT OPTION

10.7 MORE COMPLICATED PAYOFFS

10.8 AUTO-CALLABLE NOTE: PRICING AND RISK PROFILE

10.9 ONE STEP FORWARD: THE WORST-OF DIGITAL NOTE

10.10 A REAL-LIFE EXAMPLE OF STRUCTURED PRODUCT

10.11 LIQUIDITY AND EXCHANGE-TRADED NOTES (ETNs)

SUMMARY

Index

This edition first published 2014 © 2014 John Wiley & Sons, Ltd

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Library of Congress Cataloging-in-Publication Data

Marroni, Leonardo  Pricing and hedging financial derivatives : a guide for practitioners / Leonardo Marroni, Irene Perdomo.    pages cm. — (The Wiley finance series)  Includes bibliographical references and index.  ISBN 978-1-119-95371-5 (hardback) 1. Derivative securities—Prices. 2. Hedging (Finance) I. Perdomo, Irene II. Title.  HG6024.A3M367 2013  332.64′57–dc23

2013021914

A catalogue record for this book is available from the British Library.

ISBN 978-1-119-95371-5 (hardback) ISBN 978-1-119-95457-6 (ebk) ISBN 978-1-119-95458-3 (ebk)   ISBN 978-1-118-77321-5 (ebk)

Cover image: Shutterstock

Printed in Great Britain by CPI Group (UK) Ltd, Croydon, CR0 4YY

Preface

The study of derivatives is tough. The institutional and regulatory framework is evolving constantly, new products and structures are being developed daily, existing products are being refined and financial mathematicians regularly introduce new, more complicated techniques for pricing these products. Tough, but neither impossible nor inaccessible to those people who wish to learn. In fact, everybody involved in the derivatives market is caught up in a continual learning experience.

First, a word of warning. Our book is not meant to be a handbook for the derivatives market. It is light on the regulatory changes currently taking place in financial markets since this is not part of our aim. Indeed, any book written on this topic will very soon be out of date. Of course, for many, these changes are the most important developments taking place in the derivatives markets currently. We would not disagree. We just prefer someone else to write books on this.

On the other hand, our book aims to offer a practical introduction to the topic of pricing and hedging of derivatives. It is rigorous in its conclusions, although we may sometimes take a few liberties with academic rigour if it helps us to explain the intuition behind certain ideas. Where we do take poetic licence, however, we make it abundantly clear why we are doing so. Moreover, we would contend that, in recent years, had the majority of market participants had a more practical and intuitive understanding of derivative products, there would have been more respect for the risks inherent in the untrammelled expansion of the derivatives market and financial institutions may have been in less need of bail-outs.

Our book is light on complicated mathematics. We do not see the point of pages and pages of equations that we will never need again. One does not need, for example, to be able to derive the Black–Scholes pricing equation from scratch to understand the risks involved in trading and investing in derivatives and how to hedge these risks.

We hope that by the end of this book, the interested reader will have a clear understanding of the way that derivatives are priced and hedged and to be able to use this understanding in a practical manner.

Leonardo and Irene

Acknowledgements

We would like to thank the following individuals, without whose help we would not have been able to complete this project.

To Jesse McDougall and Patrick Boyle, principals of Palomar Capital Management LLP, we say a very big thank you for their patience in reviewing the entire book in such a timely fashion. Their comments were always helpful and almost all have been incorporated into the finished product. We wish them continued success with their fund, especially since one of us is an investor!

To Francesco Chiminello, we say a very big thank you for his sizeable contribution to Chapters 5 and 7. The three of us met when we worked together at Barclays Capital although we have all subsequently moved on to pastures new. We wish him well in his new role at Bloomberg. His new employer and its clients will benefit greatly from his knowledge of quantitative finance.

To Christopher Culp, Adjunct Professor of Finance at the University of Chicago's Booth School of Business, we say a big thank you for helping to review the book despite his many other commitments. As an expert in the field of derivatives and risk management, Christopher ensured that the liberties that we took with the theory in order to ease explanation were little ones. Irene also wishes to thank him again for making her time at Chicago University such a rewarding experience.

To Neil Schofield, principal of FMT Limited, a financial training company, we also say a big thank you for helping to review our book despite being halfway through writing his latest bestseller. Neil's Amazon page can be found at http://www.amazon.co.uk/Neil-C.-Schofield/e/B001IQZBC2.

To Jennie Kitchin, Vivienne Wickham, Werner Coetzee, Thomas Hyrkiel and the rest of the team at John Wiley & Sons, we say a very big thank you for their continued patience as we failed to meet all of the deadlines that we were set. They must have sighed heavily before reading every one of our e-mails in the past few months.

Finally, we would very much like to thank Troy Bowler for his significant contribution in editing the final draft. Troy is married to one of us and, as such, probably did not have much choice but to cooperate. Nevertheless, we are grateful that he was there since neither of us are native English speakers and we needed all the help we could get.

Although there were many people helping to put this book together, any mistakes are clearly our own.

Leonardo and Irene

1

An Introduction to the Major Asset Classes

This introductory, and slightly eclectic, chapter focuses on the liquid investment asset classes in which derivatives and structured products are normally developed, priced and traded, namely equities, fixed income, commodities and foreign exchange. The aim is not to describe in detail the everyday products traded in these markets but more to give a sense of the general price characteristics of these markets, e.g., how they move through time. There are many excellent product books on the market and we would recommend readers interested in the range of products available to pick up a copy of one of them; we have listed some in the References.

In this chapter, we aim to make some observations on how to model underlying asset price behaviour for each asset class.1 In order to have a real understanding of the value that can be extracted from financial derivatives, one must understand how prices behave in their composite parts. This is not a quantitative finance textbook, however, and we do not aim to be completely rigorous. Instead, in this chapter as in the others, we try to get across an intuitive (rather than an academic) understanding.2

On the way, we will also highlight some interesting features of the markets under review so that you, the reader, can feel more personal affinity with them; we think that, if your interest is tweaked, you will enjoy the book (and the chapter) much more. Many readers of this book will have experience in one or two of these asset classes but probably not all. If short on time, you could, of course, read the sections on the least familiar asset classes and skip the rest. That said, if you do have some experience but you are a little rusty, the following sections should be a good review.

1.1 EQUITIES

1.1.1 Introduction

Equities are perhaps the most familiar of the main asset classes. The shareholder capital or capital stock (or, merely, stock) of a company represents the capital paid into or invested in the business by its shareholders. Along with other assets in the firm, shareholder capital serves as security for the creditors of that company. The capital stock is divided into shares (also called equity). The company may have different types (classes) of equity, each class having distinctive ownership rules, privileges and/or prices.

Equity typically takes the form of common or preferred. Common shares typically carry voting rights, which shareholders can exercise at certain times to influence the company and its directors. Preferred shares typically do not carry voting rights but holders are legally entitled to receive their dividends before other shareholders. Since holders of preferred shares get preferential treatment, they are called preference shares in the UK.

Convertible preferred shares are preferred shares that include an option for the holder to convert them into a fixed number of common shares, usually any time after a predetermined date.

Preferred shares may sometimes have a hybrid structure, having the qualities of bonds (such as a fixed percentage dividend) and common stock voting rights.

1.1 2 Pricing equities

The price of a single stock/share/equity (the terms are interchangeable) is determined as always by the interaction of supply and demand. Factors that impact only on the single stock price are called stock-specific. These factors can include a change in CEO, new patents awarded to the company, new product development, etc. The prices of individual stocks are also influenced by factors that affect the entire equity market, however. These are market-specific. In fact, statistical analysis suggests that the majority of the variation in the prices of individual stocks usually comes about from events that impact the overall equity market, for example changes in monetary policy or the risk tolerance of investors, rather than stock-specific factors. Stocks that tend to move by more than the overall market moves are called stocks while those that move less than the market are called stocks. This is essentially a carry-over from the Capital Asset Pricing Model (CAPM), which you do not really need to know much about for the purposes of this book. High-beta stocks tend to be in cyclical sectors, such as consumer durables, property and capital equipment. Low-beta stocks tend to be non-cyclical, such as food retailers and public utilities. Another way of describing low-beta stocks is .