P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton

Index

Accounting for financial derivatives, Bid-ask spread, 53, 59, 136, 138, 183, 185, 305–312 189, 273, 274, 276, 278, 279, 351 Agricultural derivatives. See Commodities Binary options, 147–149 Alternating direction implicit (ADI) Binomial option pricing model, 14, 106, method, 450, 451 341–349, 387, 425, 426, 445, 482 Amaranth Advisors, 314, 317–321, 324, 326, Binomial tree model, 468–472 327 Black-Scholes option pricing model American options, 105, 106, 144, 145, 212, assumptions, 373, 374, 384 214, 216, 442, 443, 448, 451, 493, 505, and convertible bond arbitrage, 527, 528, 563, 584 531 Analytical pricing models, 425, 426. See also derivation of, 376, 378–380 Black-Scholes option pricing model example, 375, 376 Arbitrage Excel spreadsheet application, 376, 377 arbitrageurs, 50 executive stock options, 214 capital structure arbitrage, 534–538 exotic options, 145, 152 cash-and-carry, 80, 81, 352–354, 356, 358, and finite difference methods, 441, 442 361, 363, 364, 389 foreign exchange options, 119, 122 convertible bond arbitrage, 526–534 formula, 372, 373 and cost of carry model, 351. See also Cost Greeks, 381, 382. See also Greeks, the of carry history of, 236, 372 credit default swaps (CDS), 189 interest rate options, 135 defined, 335 Ito process, 374, 375, 384 event derivatives, 164–168 numerical example, 380, 381 no-arbitrage principle, 335, 336, 351 and option price sensitivities. See Option reverse cash-and-carry, 80, 81, 352–354, price sensitivities 356, 366 overview, 348, 349, 371, 372, 384, 388–392 Asian options (averagehttp://www.pbookshop.com price options), 150, and pricing models generally, 425, 426 151, 449 publication of, 236 Asset-backed securities (ABS), 142, 177–180, purpose of, 14 182, 187, 188, 201–204 real options, 569, 570 Asset-based financing, 57, 61–65 risk-neutral pricing, 382, 383 and stochastic processes, 466, 467 Backwardation COPYRIGHTEDand MATERIAL volatility, 106 commodities, 77, 82, 84, 85, 92–95, Bootstrapping, 413, 534 129–131, 316, 420 Box spreads, 518, 519 and convenience yield, 84, 85, 95 Brownian motion, 373, 387–389, 394, 395, inverted market, 61 397, 399, 442, 443, 458–465, 467, 564 normal backwardation, 77, 80, 84, 85, 363, Bull spreads, 512, 513, 515 364, 366 Butterfly spreads, 519–521 Barings Bank, 314, 318, 320–327 Barrier options, 146, 147, 442, 443, 445, 449 Calendar spreads, 50, 100, 317, 318, 522 Basis risk, 45–47, 182, 224–228, 316, 317, 578, Call options, 13–16, 83, 95, 97, 105–108, 143, 579 144, 152, 315, 341–348, 531, 532. See also Bear spreads, 512–515 Binomial option pricing model; Option Bespokes, 191, 192 price sensitivities

591 P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton

592 Index

Capital budgeting, 59, 559, 560, 569, 570 Collateral return, 92, 95 Capital structure arbitrage, 534–538, 551 Collateralized bond obligations (CBO), 180, Caps and floors, 201, 584, 585 204, 205, 208 Carry market. See Contango Collateralized debt obligations (CDOs), Cash flow hedges, 305–309 177, 180–182, 188–189, 204–208, 544, Cash-and-carry arbitrage, 80, 81, 352–354, 551, 552, 555 356, 358, 361, 363, 364, 389 Collateralized mortgage obligations Cash-or-nothing call, 148, 149 (CMOs), 142, 199 Central counterparty (CCP) clearing, 22, Commercial mortgage-backed securities 28–31, 33–36, 39, 40, 259, 291, 292 (CMBS), 142, 177, 187, 199–201, 204, CFTC Reauthorization Act of 2008, 296, 208–209 299–301 Commercial risk, 3, 4, 6–10, 12, 15, 19, 21 Chooser options, 145 Commodities Clearing active investment strategies, 89, 94, 100 anonymity, 265 agricultural, 78, 79, 90, 221, 233, 234, 236, central clearinghouse, 259, 260, 276–278, 295, 296, 301, 302 283 background, 233, 234 central counterparty (CCP) clearing, 22, commodity marketing, 95–97 28–31, 33, 34, 36, 39, 40, 259, 291, 292 derivatives, 90 clearing choice, 277, 278 diversification, 91, 95, 100 clearing members, 35, 36, 40, 136, 250, energy. See Energy derivatives 254, 264, 266, 268–270, 272–274, 276, exchange-traded funds (ETFs), 93, 106 277, 283 exchange-traded notes (ETNs), 93, 94 clearinghouse, functions of, 10, exempt commodities, 300 263–273 futures contracts, 90, 96, 97 clearinghouse ownership, 269 futures prices, 77, 79–85 credit default swaps, 28, 31, 35, 244 gold, 80, 81 energy derivatives, 131, 132 hedge ratio, 97–99 exchanges, 23, 28, 29 hedging, 89, 95–100 innovation, effect of, 278 indexes, 90–92, 94 and liquidity, 273–275 as inflation hedge, 89, 91, 95, 100, 125 margin payments, 269–273, 276 as inputs in manufacturing, 91 over-the-counter products, 22, 24, 25, interest rates, 60, 61 27–29, 37, 39, 132, 240, 263, 297, 298 investment performance, 52, 89, 94, 95 overview, 263, 278, 279 lending, 62, 63 proposed changes, 275–278 markets, 233, 234, 236 regulation, 296, 297 metallurgical, 89, 90. See also Gold swaps, 259, 260 mutual funds, 94 Closed-form option pricinghttp://www.pbookshop.com models overview, 89, 90 Black-Scholes. See Black-Scholes option passive investment strategy, 89, 91–94, pricing model 100 classification of, 389, 402 price indexes, 89, 90 and explicit integration, 443 pricing, 351. See also Cost of carry; one lognormal underlying (first Expectations pricing model generation), 392–394, 402 risk management, 97–99 one nonlognormal underlying (third seasonal price behavior, 77–79, 90 generation), 397–402 speculation, 89, 92, 93, 100 overview, 387, 388, 402 spot prices, 77 two lognormal underlyings (second spreads, 89, 99–100 generation), 395–397, 402 swaps, 406, 419, 420 two underlyings, one is nonlognormal theory of normal backwardation, 77, 80, (fourth generation), 401, 402 84, 85. See also Backwardation Close-out netting agreements, 283, 289. theory of storage, 77, 80–85 See also Netting trading volume, 90 Collars, 140, 505, 514, 515, 549, 584–585 types of, 89 Collateral, 29–31 weather, impact of on prices, 90 Collateral agreements, 283 Commoditization, 59, 278 P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton

INDEX 593

Commodity Exchange Act (CEA), 11, 232, hedgers, 189 250, 253, 256, 257, 295–299, 301, 302 home equity loan (HEL) market, 179 Commodity Futures Modernization Act indices, 182–189 (CFMA), 26, 28, 108, 295–301 market growth, 177, 178 Commodity Futures Trading Commission overview, 17, 18, 177, 238 (CFTC), 250, 251, 253–257, 295–301 reference entity (obligation), 177 Commodity interest rates, 60, 61 residential mortgage-backed securities Commodity pool operators (CPOs), 250, (RMBS), 177, 204 251, 255–257 settlement, 177–185 Commodity trading advisors (CTAs), 94, special-purpose vehicle (SPV), 189, 190 250, 251, 255–257 speculators, 189 Compensation, 211–218, 314, 315, 323, 324, spread, 182, 189, 192–196 328 synthetic collateralized debt obligations, Compound options, 144, 145 177, 180, 182, 186, 189–192 Contango, 61, 79, 82, 92, 93, 129, 130, 316, trading strategies, 188, 189 364, 366 tranches, 177–181, 186–195 Convenience yield, 61, 80–85, 95, 130, 351, Credit hedge funds, 551, 552 356, 357, 365, 366 Credit risk, 5, 6, 17, 19, 29–31, 46, 201, 527, Convertible bonds (converts), 103, 107, 530 526–534, 545, 549, 551 Cross-hedging, 51, 52, 222–224, 226 Convexity, 137, 141, 194, 410–413, 486, 581, Crude oil. See Energy derivatives 587 Currency swaps, 237, 406, 417–419 Corporate debt, 177, 178 Current exposure, 284, 285 Corporate finance, 525, 560, 561 Current replacement cost, 284, 285 Corporate indices, 183–185 Customized products, 23–25 Correlation trading, 191–196, 551 Cylinders, 505, 515 Cost of carry, 60, 99, 129, 130, 351–354, 358, 360, 363–366 Day traders, 49, 50 Counterparty risk, 21, 22, 24, 30, 32, 34, 112, Decision trees, 560 136, 183, 190, 201, 223, 254, 260, 263, Delta (), 140, 189, 194, 195, 381, 448, 265–269, 273, 283–292, 320, 328, 363. 477–486, 490, 492, 496–498, 503, See also Clearing 531–534, 549 Covered calls, 336, 337, 504, 507, 508, 512, Depository Trust Clearing Corporation 514 (DTCC), 24, 25, 33, 35, 275–277 Crack spreads, 50, 127, 128, 131, 239 Derivative contracts, generally, 3, 4, 6–16, Crank-Nicolson method, 441, 445–449 541–543 Credit default swaps (CDS) arbitrage opportunities, 189 Economic derivatives, 221–224, 228 asset-backed securitieshttp://www.pbookshop.com (ABS), 177–180, Electricity. See Energy derivatives 182, 187, 188 Electronic trading, 24–26, 105, 128, 148, 160, basis, 182 161, 168, 171, 235, 239–244, 297, 298, 300 bespokes, 191, 192 Emerging derivative instruments, 221–228 and capital structure arbitrage, 537, 538 Employee stock options, 107 centralized clearing, 259, 260 Empty voting, 552, 553 collateralized bond obligations (CBO), Energy derivatives 180, 204, 205, 208 background, 238–240 collateralized debt obligations (CDOs), backwardation, 130 177, 180–182, 188, 189, 544 basis contracts, 126 commercial mortgage-backed securities clearing, 131, 132, 297 (CMBS), 177 crude oil, 46, 51, 53, 61, 125–131 and convertible bond arbitrage, 530–533 electricity, 125, 127, 129–131, 364–366 corporate debt, 177, 178 electronic trading, 128 corporate indices, 183–185 energy products, 125, 126 correlation, 187, 189, 191–196 exchanges, 125–128 counterparty credit risk management, 289 futures contracts, 125, 127–129 future trends, 196, 238 history of, 126, 127 and hedge funds, 541, 543, 544 index swaps, 128 P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton

594 Index

Energy derivatives (Continued ) Exotic options legislative proposals, 132 Asian options (average price options), natural gas, 125–131, 239, 246, 317, 318, 150, 151 561, 562, 565–568 barrier options, 146, 147 options on futures contracts, 126 binary options, 147–149 overview, 125 chooser options, 145 petroleum and petroleum derivatives, compound options, 144, 145 125–128, 131, 238–240, 561, 563, 564, exchange options, 151 568 finite difference valuation methods, 445, pricing, 129–131 449. See also Finite difference valuation and regulatory reform, 301, 302 methods and speculation, 132, 133 foreign exchange, 122 spread trading, 127, 128 forward-start options, 144 swaps, 126, 128, 129 lookback options, 149, 150 swaptions, 126, 129 overview, 143, 144, 152, 153 trading volume, 127–129 rainbow options, 151, 152 vanilla forward contracts, 126 valuation of, 435–439, 441, 449 Energy industry, real option examples, Expectations pricing model, 351, 363, 364, 561–568 366 Equity derivatives, 103–112, 273 Explicit integration, 441, 443–446 Eurodollar futures contracts, 13, 48, 58, 59, Explicit method, 441, 443–449, 451 136, 137, 226, 234–238, 241, 243, 358–360, 363, 411–413, 577, 580, 581, 601 Failures and disasters in derivatives, European options, 105, 106, 144, 152, 177, 313–327 212, 214, 336, 339, 371, 388, 402, 443, Fair value hedges, 305, 309–311 448, 503, 505, 584 Financial Accounting Standard No. 133 Event derivatives (FAS 133), 305, 307–311 accuracy of prediction markets, 160–164 Financial engineering arbitrage opportunities, 164–168 capital structure arbitrage, 534–538 future applications, 173 convertible bond arbitrage, 526–533 inferences from prediction markets, exotic options, 144. See also Exotic options 170–173 overview, 525, 526 Iowa Electronic Market, 148, 160, 161, Financial futures, 3, 27, 28, 51, 234–237, 241, 168, 171 243 market design, 168–170 Financial options, 561, 570 market manipulation, 168 Finite difference valuation methods markets, 148, 149, 160 advantages and disadvantages of, 451 overview, 157, 158 alternating direction implicit (ADI) Policy Analysis Markethttp://www.pbookshop.com (PAM), 148, 157, method, 450, 451 168, 173 basic methods, 445–449 types of prediction markets, 158, 159 binomial model, 445 Exchanges and closed-form models, 443 clearing and clearinghouses. See Clearing Crank-Nicolson method, 441, 445, 446, competition and consolidation, 25–29 448, 449 equity derivatives, 112 explicit method, 441, 443–447, 449, 451 intermediaries for exchange-traded Feynman-Kac theorem, 443 derivatives, 250–257 higher-dimension problems, 449–451 markets for derivatives, 233–245 implicit method, 441, 445–449 mergers of, 112 integration method, 442 overview, 21 Martingale methods, 441–443 regulation, 250–257, 295–302 Monte Carlo integration, 442, 443 standardization, 22, 23 and Monte Carlo simulation, 451 and technology, 25–27 and numerical integration methods, 451 transparency, 36, 37 overview, 441–445 Exchange-traded funds (EFTs), 93, 299 partial differential equation (PDE) Exchange-traded notes (ETNs), 93, 94 approach, 441, 443, 445, 450 Executive stock options (ESOs), 211–218 resources, 451, 452 P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton

INDEX 595

splitting methods, 450, 451 forward contracts compared, 10, 11, 362, trinomial method, 445, 447 363 valuation grid, 444–446, 448 interest rate futures contracts, 577, 578 Flavored currency swaps, 121, 122 overview, 9–11 Foreign currency fraud, 299 pricing. See Forward and futures Foreign exchange derivatives contracts, pricing background, 235 social benefits, 60, 61 forward contracts, 117, 118 standardized, 23, 577, 578 futures contracts, 117, 118 trading volume, 103, 104 interest rate parity theorem (IRPT), 73, Futures hedge ratio, 97–99, 579–581 116, 117, 121 options, 118, 119 Gamma (), 137, 140, 194, 195, 381, 401, 448, overview, 115, 122, 221 484–487, 490, 492, 496–498, 532, 533 pricing, 115–117 Geopolitical risk. See Event derivatives purchasing power parity theorem Global macro strategy, 545, 549, 550 (PPPT), 73, 115–117 Gold, 62, 63, 80, 81, 92, 93, 98, 99, 351, 355, swaps, 119–122 366 Forward and futures contracts, pricing Greeks, the, 137, 140, 141, 189, 194, 195, 381, and backwardation in oil futures, 130 382, 401, 442, 445, 448, 451, 477–498, carry cost, 80, 354–356 503, 531–534, 549 carry return, 354, 355 cash-and-carry arbitrage, 80, 81, 352–354, Hedge accounting, 305–312 356, 358, 361, 363, 364, 389 Hedge funds commodity futures, 351, 355, 356, 363, capital structure arbitrage, 534–538, 551 364, 366 contingent contracts, use of, 553, 554 convenience yield, 351, 356, 357, 366 convertible bond arbitrage, 526–533, 545, cost of carry pricing model, 60, 129, 548, 549, 551 351–363, 366 correlation trading, 551 delivery options, 357, 358 credit hedge funds, 551, 552 electricity, 129, 364–366 derivatives, use of, 544–547 expectations model, 351, 363, 364, 366 empty voting, 552, 553 futures and forward price differentials, equity swap contracts, use of, 110, 111 362, 363 global macro strategy, 545, 549, 550 interest rate futures and forwards, growth of, 541, 542 358–361 leverage and use of structures, 555 overview, 351–352, 366 long-short equity strategy, 550 reverse cash-and-carry, 80, 81, 352–354, market-neutral strategies, 545, 549, 550 356, 366 merger arbitrage, 549 Forward contracts, 7–11,http://www.pbookshop.com 16, 60, 63, 64, 117, offshore funds, 554 118, 362, 363. See also Forward and overview, 541–543, 555 futures contracts, pricing performance, 547, 548 Forward rate agreements (FRAs), 8–9, 13, put options, 553 136, 297, 358–360, 410, 575–578, 584 regulation, 541, 544, 547 Fraud, 37, 217, 256, 257, 295, 299–301, 322 relative value strategy, 550, 551 Fundamental traders, 48, 49 risk arbitrage, 549 Futures commission merchants (FCMs), and shareholder activism, 552–554 235, 250–255, 258, 272, 297, 299 strategies, 548–552 Futures contracts tax-avoidance strategies, 554 background, 233–236 trends, 551, 552 clearing, 265–273. See also Clearing volatility strategies, 550, 551 commodities, 90 Hedging delivery options, 357, 358 basis risk, 45–47 equity futures, 108, 109 commodities, 89, 95–100 Eurodollar, 13, 48, 58, 59, 136, 137, 226, credit default swaps, 189. See also Credit 234–238, 241, 243, 358–360, 363, default swaps (CDS) 411–413, 577, 580, 581, 601 cross-hedging, 51, 52, 222–224, 226 foreign exchange derivatives, 117, 118 defined, 43 P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton

596 Index

Hedging (Continued ) over-the-counter derivatives, 138–142 equity swaps, 110, 111 overview, 135 foreign exchange futures and forwards, plain vanilla, 135 118 swaptions, 139–141, 586 forward rate agreements, 577. See also Interest rate guarantees, 584 Forward rate agreements (FRAs) Interest rate parity theorem (IRPT), 73, 116, impact of on market, 54 117, 121 interest rate risk, 58, 580, 581. See also Interest rate risk Interest rate derivatives basis risk, 578, 579 option price sensitivities, 496–498 caps and floors, 201, 584, 585 overview, 44–47 and convertible bond arbitrage, 527, 529, real estate derivatives, 224–228 530 and risk transfer, 58 coupon bonds portfolio, hedging with speculators, interaction with, 43, 52–54, interest rate futures, 581, 582 363, 364 and credit risk, 17, 19, 201 Home equity loans (HELs), 179, 185, 188, and financial engineering, 525, 527, 529, 202–204 530 Human capital, 221 and floating rate mortgages, 43 Hybrid instruments, 298 forward rate agreements, 9, 575–577 Hybrid real options, 562, 568 forward-based instruments for managing risk, 575–583 Implicit method, 441, 442, 445–449 futures hedge ratio, 579–581 Index contracts, 158–160, 171, 252 hedging, 46, 58, 580, 581. See also Interest Indexes rate derivatives Big Mac index, 116 hedging with Eurodollar futures, 58 commodities, 37, 38, 89–95, 100, 132, interest rate futures contracts, 577, 578 244 interest rate guarantees, 584 Consumer Price Index (CPI), 222, 223 mortgage securitization risk credit default swaps, 22, 177, 182–191, management, 586–588 194, 195 option-based products for managing, Herfindahl index, 208 575, 583–588 index swaps, 128, 129 overview, 4, 575 macroeconomic, 221–223, 227 swaptions, 586 narrow-based security index, 298 International Swaps and Derivatives real estate, 224–226, 228 Association (ISDA) stocks, 46, 51, 60, 106–110, 112, 226, background, 24, 178 235–238, 241, 364, 578 Credit Support Annex (CSA), 30 Inflation Credit Support Documents, 34 commodities as inflationhttp://www.pbookshop.com hedge, 89, 91, Master Agreements, 17, 24, 32, 34, 139, 95, 100, 125 407 Consumer Price Index (CPI) as measure pay-as-you-go (PAYGO or PAUG) of, 222, 223 template for credit default swaps, emerging derivative instruments, 221, 179–182, 185, 188, 192 222 Introducing brokers (IBs), 250, 255 futures, 160, 221–223 Iowa Electronic Market (IEM), 148, 160, 161, and speculation, 48, 118 168, 171 Information asymmetries, 39, 61, 83, 325 Ito integral, 462–464 Information market, 157. See also Event Ito process, 374–376, 384, 455, 459–467, 470, derivatives 473 Interdealer brokers, 258, 259, 283 Ito’s lemma, 382, 395, 464–468, 473, 474 Interest rate derivatives background, 235 Lease rate, 62, 63, 80, 81, 355 exchange-traded, 135–137 Liquidity, 11, 21, 104, 105, 111, 136, 273, 274, interest rate swaps, 58, 119–121, 236–238, 288, 289, 316, 317, 325 405–417, 582, 583 Long-Term Capital Management (LTCM), mortgage derivatives, 141, 142. See also 314, 316, 317, 319–321, 327 Mortgages Lookback options, 149, 150, 449 P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton

INDEX 597

Macroeconomic indexes, 221–223 Novation, 32, 33, 35, 288, 290, 291 Margin payments, 269–273, 276 Numeric pricing models, 425, 426. See also Market intermediaries, 249–260 Binomial option pricing model; Finite Market-neutral strategies, 545, 549, 550 difference valuation methods Markets for derivatives Numerical integration methods, 451 agricultural futures, 233, 234, 236. See also Commodities Offshore hedge funds, 554 background, 233–236 Oil and petroleum products. See Energy commodities, 233, 234, 236 derivatives and electronic trading, 240–243 Option contracts. See also Call options; Put energy derivatives, 238–240 options exchanges, 233–245 clearing, 271, 272. See also Clearing financial crisis of 2008, effect of, 244, 245 foreign exchange options, 118, 119 foreign currency, 235 forward contracts, relationship to, 16 foreign markets, 236, 237 OTC interest rate derivatives, 138 futures contracts, 234 overview, 13–16 livestock futures, 234 pricing. See Black-Scholes option pricing mergers and consolidation of exchanges, model; Closed-form option pricing 243, 244 models options, 235 trading volume, 103, 104 over-the-counter markets, 234, 235, Option price sensitivities, 141, 381, 382, 237–240, 242, 244, 245 477–498 Markov process, 456, 457, 459, 461, 469, 470 Option to abandon or temporarily Mark-to-market process, 23, 29, 30, 37, 191, shutdown, 562, 566–568 252, 253, 269–271, 284, 287, 288, 362 Option to expand, 562, 563 Martingale methods, 441–443, 456, 458, 459, Option to vary production inputs, outputs, 471 or processes, 562, 564–566 Merger arbitrage, 549 Option to wait, 562–564 Metallgesellschaft AG, 314–316, 319, Option trading strategies 325–327 albatross, 520 Metallurgical derivatives. See bear spreads, 512–515 Commodities; Gold box spreads, 518, 519 Money management services, 256, 257 bull spreads, 512, 513, 515 Monte Carlo simulation, 285, 425–439, butterfly spreads, 519–521 441–443, 451, 569 call backspreads, 518 Mortgages Christmas tree, 518 credit default swaps, 177–179 condors, 520 derivatives, 141, 142 covered calls, 507, 508 floating rate, 43 http://www.pbookshop.comcylinders, 515 home equity loans (HELs), 179, 185, 188, dispersion trading, 523 202–204 European versus American options, interest rate caps and floors, 584, 585 505 mortgage securitization, 141, 142, 203, iron butterfly, 521 208, 209, 586–588 long/short spreads, 523 mortgage-backed securities (MBS), 199, multi-asset strategies, 523 200 overview, 503–505 residential, 177, 179, 199, 201, 202, 584 payoff tables, 505–514, 516–521 Mutual funds, 94, 109, 253, 256, 544–546 protective puts, 508, 509 put backspreads, 518 National Futures Association, Inc. (NFA), ratio spreads, 518 250, 251, 255–257 seagulls, 521, 522 Natural gas. See Energy derivatives straddles, 516–518, 520–522 Netting, 29, 31–36, 39, 121, 283, 289, 291, 410 strangles, 516, 517 No-arbitrage principle, 14, 106, 335–349, straps, 517 387, 425, 445, 482 strips, 517 Normal backwardation, 77, 80, 84, 85, 363, synthetic positions, 509–512, 515, 523 364, 366 time strategies, 522 P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton

598 Index

Options Clearing Corporation (OCC), 28, equilibrium models, 365, 366, 391, 392 111, 273, 275–277, 289 exotic options, 144, 152 Over-the-counter (OTC) market foreign exchange derivatives, 115–119 clearing and clearinghouses. See Clearing foreign exchange options, 119 competition and consolidation, 25–29 forward and futures contracts. See conventional bilateral swaps, 298 Forward and futures contracts, pricing counterparty credit risk. See Monte Carlo simulation. See Monte Carlo Counterparty risk simulation default statistics, 289, 290 no-arbitrage principle. See No-arbitrage energy derivatives, 126 principle foreign exchange forward market, 117, numeric models, 425, 426 118 option price sensitivities. See Option information asymmetries, 36–40 price sensitivities interest rate derivatives, 138–142 price discovery as social function of intermediaries for OTC derivatives, derivatives, 57–59 250–260 reduced form (intensity) models, 195, ISDA Master Agreements, 17, 24, 32, 34, 196, 366 139, 407 seasonality in commodities prices, 78, 79 netting and novation, 3, 31, 32, 34–36 simulation models, 425, 426 overview, 21, 22, 234, 235, 237–240, 242 single-stock futures, 109 regulation of, 26, 27, 37, 244, 245, 297, 298, stochastic models. See Stochastic 300–302 processes and models and standardization, 22–25 stock options, 105 swaps, 139, 140. See also Swaps structural models, 195, 196 swaptions, 139, 140. See also Swaptions swaps. See Swaps, pricing and valuation transparency, 36–38 and theory of normal backwardation, 77, 80, 84, 85, 363, 364, 366 Partial differential equation (PDE), 441, 443, theory of storage. See Theory of storage 445, 450 Private placements, 526, 527, 549 Pay-as-you-go template for credit default Project finance, 63, 64 swaps, 179–182, 185, 188, 192 Protective puts, 504, 508, 509, 514 Payoff tables, 505–514, 516–521 Psi, 494, 495, 498 Petroleum. See Energy derivatives Purchasing power parity theorem (PPPT), Plain vanilla foreign exchange swaps, 73, 115–117 119–121 Put backspreads, 518 Plain vanilla interest rate derivatives, 135 Put options, 13–16, 106, 345–348, 553 Plain vanilla options, 74, 119, 120, 143, 145, Put/call parity, 16, 336–341, 346, 348, 371, 146, 149, 150, 152, 428–433 380, 381, 398, 480–481, 484, 491, 504, Plain vanilla swaps, 59,http://www.pbookshop.com 119–122, 529, 530 509 Policy Analysis Market (PAM), 148, 157, 168, 173 Quanto notes, 122, 153 Prediction markets, 157. See also Event derivatives Rainbow options, 151, 152, 435–439 Price discovery as social function of Rate locks, 138–139, 586, 587 derivatives, 57–59 Ratio spreads, 505, 518 Price risk, 19, 316 Real estate derivatives, 221, 222, 224–228 Pricing Real options analytical models, 425, 426 and corporate finance, 560, 561 Black-Scholes option pricing model. See defined, 559 Black-Scholes option pricing model energy industry examples, 561–568 capital asset pricing model (CAPM), 85, financial options distinguished, 561 391 hybrid real options, 562, 568 closed-form option pricing models. See option to abandon or temporarily Closed-form option pricing models shutdown, 562, 566–568 commodity futures, 79–85 option to expand, 562, 563 econometric model, 366 option to vary production inputs, energy derivatives, 129–131, 364–366 outputs, or processes, 562, 564–566 P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton

INDEX 599

option to wait, 562–564 Security futures products (SFPs), 298, 299 overview, 559, 560, 570 Self-regulatory organizations (SROs), pharmaceutical industry, 560, 570 249–250, 255, 257–258 timing option, 563 Settlement, 177–185, 236, 284. See also types of, 562–568 Clearing; Counterparty risk valuation, 568–570 Shareholder activism, 552–554 Regulation and regulatory agencies Sharpe ratio, 66, 545, 546 commodity futures and options (U.S.), Simulation models, 425, 426. See also Monte 295–302 Carlo simulation equity derivatives, 111, 112 Single-stock futures, 108, 109 exchange-traded derivatives, 250, 251, Social functions of derivatives, 57–67 253–257 Societ´ eG´ en´ erale,´ 314, 318, 320–327 future legislative reforms, 301, 302 Special-purpose vehicle (SPV), 189, 190, 200 hedge funds, 541, 544, 547 Speculation, 43, 44, 48–54, 89, 92, 93, 100, Relative value strategy, 550, 551 118, 189, 363, 364 Residential mortgage-backed securities Splitting methods, 450, 451 (RMBS), 177, 204 Spot return, 92 Reverse cash-and-carry arbitrage, 80, 81, Spread traders, 50 352–354, 356, 366 Spreads, 89, 99, 100, 182, 189, 192–196, Rho, 382, 493–496, 498 512–515, 518–521, 523 Risk arbitrage, 549 Stack-and-roll hedges, 316 Risk management Standardized products, 22, 23, 577, 578 bilateral to multilateral, 29–36 Stochastic processes and models commodities, 97–99 binomial tree model, 468–472 compensation and promotion criteria, Brownian motion (Wiener process), 314, 315, 323–325, 328 458–465, 467 control of traders and fund managers, definitions and properties, 456–458 321–323 and finite difference methods, 449, 450 equity derivatives, 103, 104 Ito integral, 462–464 and ethical behavior, 324, 325 Ito process, 374–376, 384, 459–467, 470, failures and disasters, examples of and 473 lessons learned, 313–328 Ito’s lemma (formula), 382, 395, 464–468, and financial engineering, 526 473, 474 hedging, 43, 50–52, 58. See also Hedging overview, 455, 456, 472 and innovation, 67 stochastic calculus, 426, 455, 458–468 internal controls, 326 Stock indexes, 106, 107, 109, 236 and liquidity access, 321 Stock options, 103–108, 211–218, 236. losses, restricting, 320, 321 See also American options; European managers, role of, 325,http://www.pbookshop.com 326, 328 options measuring risk, 319, 320 trading strategies. See Option trading net positions, monitoring, 322, 323 strategies overview, 3, 4, 19, 327, 328 Storage, theory of. See Theory of storage and portfolio theory, 103 Straddles, 66, 505, 516–518, 520–523, 548 separation of duties, 322 Strangles, 66, 505, 516, 517, 521 and speculation, 50–52 Straps, 517 Risk premium, 5, 6, 84, 85, 92, 94, 363, 364, Stress tests, 319, 328 366, 396 Strips, 517 Roll return, 92–95 Structured credit products asset-backed securities (ABS), 201–204 Scalpers, 25, 52, 53 collateralized debt obligations (CDOs), Scandals. See Failures and disasters in 204–208 derivatives collateralized mortgage obligations Seagulls, 505, 521, 522 (CMOs), 199 Seasonal price behavior, 77–79, 130, 131 commercial mortgage-backed securities Securities and Exchange Commission (CMBS), 208, 209 (SEC), 108, 110–112, 236, 250, 251, 256, and credit default swaps. See Credit 259, 260, 298, 299, 301, 544 default swaps (CDS) P1: OTA/XYZ P2: ABC ind JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton

600 Index

Structured credit products (Continued ) Theory of storage, 77, 80–85, 130, 131, 363. mortgage-backed securities (MBS), 199, See also Cost of carry 200 Theta (θ), 381, 486–491, 496, 498 overview, 199–201 Trade finance, 64, 65 special-purpose vehicles (SPVs), 200 Trading strategies tranches, 199, 206, 207 credit default swaps, 188, 189 Structured products, 3, 16–19, 66 options. See Option trading strategies Swaps Trading volume brokers, 258, 259 commodities, 90 centralized clearing for, 259, 260 energy derivatives, 127–129 CIRCUS swap, 122 equity derivatives, 103, 104, 108, 111, 112 counterparty credit risk, 283–292. See also foreign exchange forwards, 117 Counterparty risk foreign exchange futures, 117, 118 currency annuity swap, 122 foreign markets, 104, 236, 237 currency basis swap, 122 futures contracts, 21, 103, 104 dealers, 64, 237, 238, 258, 259, 285, 406, historical background, 233–235 407, 420, 529, 530, 532, 533 interest rate derivatives, 135, 136 Eligible Contract Participants, 11 option contracts, 21, 103, 104 equity swaps, 110, 111 Tranches, 17, 177–181, 186–195, 199, 206, flavored currency swaps, 121, 122 207 interest rate derivatives, 139 Transparency, 1, 21, 22, 36–38, 59, 115, 214, interest rate swaps. See Interest rate 259, 278, 328, 578 derivatives Trinomial option pricing model, 445, 447 overview, 11–13, 237 plain vanilla foreign exchange swaps, Underinvestment problems, 57, 61–62, 65 119–121 Unwinding positions, 186, 263, 268, as portfolio of different maturity forward 274–276, 550 contracts, 13 U.S. Treasury bonds, 74, 137, 139, 236, 237, pricing. See Swaps, pricing and valuation 241, 357, 358, 360, 361, 534 Swaps, pricing and valuation U.S. Treasury notes, 137, 235, 242, 243, 358, commodity swaps, 406, 419, 420 360, 361 currency swaps, 406, 417–419 framework for, 407–409 Valuation. See also Pricing interest rate swap, example, 406, 407 finite difference methods. See Finite interest rate swaps, 406–417 difference valuation methods ISDA Master Agreement, 17, 24, 32, 34, grid, 444–446, 448 139, 407 real options, 568–570 overview, 13, 405, 406 Value at risk (VaR), 319, 320, 328 steps for, 410–417 http://www.pbookshop.comVariance swaps, 66, 551 Swaptions, 126, 129, 139–141, 586 Vega, 141, 381, 491–493, 496–498 Synthetic asset allocation, 57, 65–67 Volatility derivatives, 66 Synthetic collateralized debt obligations, Volatility smile, 166, 451 177, 180, 182, 186, 189–192 Volatility strategies, 550, 551 Synthetic positions, 182, 509–512, 515, 523 Synthetic storage, 60 Warrants, 103, 108 Wiener process, 375, 389, 395, 398, 455, Tax-avoidance strategies, 554 457–459, 461, 463, 465. See also Technical traders, 48, 49 Brownian motion Theory of normal backwardation, 77, 80, 84, 85, 363, 364, 366 Zero curve, 410–415, 419