Derivatives Markets The Pearson Series in Finance Bekaert/Hodrick Hull International Financial Management Fundamentals of Futures and Options Markets Berk/DeMarzo Hull Corporate Finance* Options, Futures, and Other Derivatives Berk/DeMarzo Keown Corporate Finance: The Core* Personal Finance: Turning Money into Wealth* Berk/DeMarzo/Harford Keown/Martin/Petty Fundamentals of Corporate Finance* Foundations of Finance: The Logic and Practice of Financial Management* Brooks Financial Management: Core Concepts* Kim/Nofsinger Corporate Governance Copeland/Weston/Shastri Financial Theory and Corporate Policy Madura Personal Finance* Dorfman/Cather Introduction to Risk Management and Insurance Marthinsen Risk Takers: Uses and Abuses of Financial Derivatives Eiteman/Stonehill/Moffett Multinational Business Finance McDonald Derivatives Markets Fabozzi Bond Markets: Analysis and Strategies McDonald Fundamentals of Derivatives Markets Fabozzi/Modigliani Capital Markets: Institutions and Instruments Mishkin/Eakins Financial Markets and Institutions Fabozzi/Modigliani/Jones Foundations of Financial Markets and Institutions Moffett/Stonehill/Eiteman Fundamentals of Multinational Finance Finkler Financial Management for Public, Health, and Nofsinger Not-for-Profit Organizations Psychology of Investing Frasca Ormiston/Fraser Personal Finance Understanding Financial Statements Gitman/Joehnk/Smart Pennacchi Fundamentals of Investing* Theory of Asset Pricing Gitman/Zutter Rejda Principles of Managerial Finance* Principles of Risk Management and Insurance Gitman/Zutter Seiler Principles of Managerial Finance—Brief Edition* Performing Financial Studies: A Methodological Cookbook Haugen The Inefficient Stock Market: What Pays Off and Why Solnik/McLeavey Global Investments Haugen The New Finance: Overreaction, Complexity, and Stretcher/Michael Uniqueness Cases in Financial Management Holden Titman/Keown/Martin Excel Modeling in Corporate Finance Financial Management: Principles and Applications* Holden Titman/Martin Excel Modeling in Investments Valuation: The Art and Science of Corporate Investment Decisions Hughes/MacDonald International Banking: Text and Cases Weston/Mitchel/Mulherin Takeovers, Restructuring, and Corporate Governance * denotes MyFinanceLab titles Log onto www.myfinancelab.com to learn more Derivatives Markets THIRD EDITION Robert L. McDonald Northwestern University Kellogg School of Management Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo Editor in Chief: Donna Battista Cover Designer: Bruce Kenselaar Acquisitions Editor: Katie Rowland Creative Director: Jayne Conte Editorial Project Manager: Jill Kolongowski Cover Art: Shutterstock/Pokaz Editorial Assistant: Elissa Senra-Sargent Media Director: Susan Schoenberg Director of Marketing: Maggie Moylan Media Project Manager: Lisa Rinaldi Marketing Manager: Jami Minard Supplements Editors: Kathryn Dinovo, Alison Eusden Director of Production: Erin Gregg Full-Service Project Management: Cypress Graphics, Senior Managing Editor: Nancy Fenton Windfall Software Production Project Manager: Carla Thompson Printer/Binder: Edwards Brothers Senior Manufacturing Buyer: Carol Melville Cover Printer: Lehigh-Phoenix Color/Hagerstown Text Designer: Gina Hagen Kolenda Text Font: Times Roman Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on the appropriate page within text. 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ISBN-13: 978-0-321-54308-0 (hardcover) ISBN-10: 0-321-54308-4 (hardcover) 1. Derivative securities. I. Title. HG6024.A3M394 2013 332.6457—dc23 2012029875 10987654321 ISBN 10: 0-321-54308-4 ISBN 13: 978-0-321-54308-0 For Irene, Claire, David, and Henry This page intentionally left blank Brief Contents Preface xxi 1 Introduction to Derivatives 1 PART ONE Insurance, Hedging, and Simple Strategies 23 2 An Introduction to Forwards and Options 25 3 Insurance, Collars, and Other Strategies 61 4 Introduction to Risk Management 89 PART TWO Forwards, Futures, and Swaps 123 5 Financial Forwards and Futures 125 6 Commodity Forwards and Futures 163 7 Interest Rate Forwards and Futures 195 8 Swaps 233 PART THREE Options 263 9 Parity and Other Option Relationships 265 10 Binomial Option Pricing: Basic Concepts 293 11 Binomial Option Pricing: Selected Topics 323 12 The Black-Scholes Formula 349 13 Market-Making and Delta-Hedging 381 14 Exotic Options: I 409 vii viii Brief Contents PART FOUR Financial Engineering and Applications 435 15 Financial Engineering and Security Design 437 16 Corporate Applications 469 17 Real Options 509 PART FIVE Advanced Pricing Theory and Applications 543 18 The Lognormal Distribution 545 19 Monte Carlo Valuation 573 20 Brownian Motion and Ito’sˆ Lemma 603 21 The Black-Scholes-Merton Equation 627 22 Risk-Neutral and Martingale Pricing 649 23 Exotic Options: II 683 24 Volatility 717 25 Interest Rate and Bond Derivatives 751 26 Value at Risk 789 27 Credit Risk 815 Appendix A The Greek Alphabet 851 Appendix B Continuous Compounding 853 Appendix C Jensen’s Inequality 859 Appendix D An Introduction to Visual Basic for Applications 863 Glossary 883 References 897 Index 915 Contents Preface xxi PART ONE Insurance, Hedging, and Simple Chapter 1 Strategies 23 Introduction to Derivatives 1 1.1 What Is a Derivative? 2 Chapter 2 1.2 An Overview of Financial Markets 2 An Introduction to Forwards and Trading of Financial Assets 2 Options 25 Measures of Market Size and Activity 4 2.1 Forward Contracts 25 Stock and Bond Markets 5 The Payoff on a Forward Contract 29 Derivatives Markets 6 Graphing the Payoff on a Forward 1.3 The Role of Financial Markets 9 Contract 30 Financial Markets and the Averages 9 Comparing a Forward and Outright Risk-Sharing 10 Purchase 30 1.4 The Uses of Derivatives 11 Zero-Coupon Bonds in Payoff and Profit Uses of Derivatives 11 Diagrams 33 Perspectives on Derivatives 13 Cash Settlement Versus Delivery 34 Financial Engineering and Security Credit Risk 34 Design 14 2.2 Call Options 35 1.5 Buying and Short-Selling Financial Option Terminology 35 Assets 14 Payoff and Profit for a Purchased Call Transaction Costs and the Bid-Ask Option 36 Spread 14 Payoff and Profit for a Written Call Ways to Buy or Sell 15 Option 38 Short-Selling 16 2.3 Put Options 41 The Lease Rate of an Asset 18 Payoff and Profit for a Purchased Put Risk and Scarcity in Short-Selling 18 Option 41 Chapter Summary 20 Payoff and Profit for a Written Put Further Reading 20 Option 42 Problems 20 The “Moneyness” of an Option 44 ix x Contents 2.4 Summary of Forward and Option Chapter 4 Positions 45 Introduction to Risk Management 89 Positions Long with Respect to the 4.1 Basic Risk Management: The Producer’s Index