Derivatives Demystified
A Step-by-Step Guide to Forwards, Futures,Swaps and Options
Andrew M. Chisholm
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Derivatives Demystified
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Derivatives Demystified
A Step-by-Step Guide to Forwards, Futures,Swaps and Options
Andrew M. Chisholm
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Library of Congress Cataloging-in-Publication Data
Chisholm, Andrew, 1952Derivatives demystified : a step-by-step guide to forwards, futures, swaps & options / Andrew M. Chisholm.
p. cm.Includes bibliographical references and index.ISBN 0-470-09382-X (alk. paper)1. Derivative securities. I. Title.HG6024.A3C487 2004332.6457dc22 2004002791
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
ISBN 0-470-09382-X
Typeset in 10/12pt Times by TechBooks, New Delhi, IndiaPrinted and bound in Great Britain by MPG Limited, Bodmin, CornwallThis book is printed on acid-free paper responsibly manufactured from sustainable forestryin which at least two trees are planted for each one used for paper production.
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Contents
Preface xiii
1 The Market Background 1Derivatives building blocks 1Market participants 2Origins and development of derivatives 3The modern OTC derivatives market 6Exchange-traded futures and options 8Chapter summary 9
2 Equity and Currency Forwards 11Introduction 11The forward price 11
Components of the forward price 13Forward price and expected payout 14
Foreign exchange forwards 15Managing currency risk 16Hedging with FX forwards 17The forward FX rate 18Forward points 20FX swaps 20Applications of FX swaps 21Chapter summary 21
3 Forward Rate Agreements 23Introduction 23FRA application: corporate borrower 23
Results of the FRA hedge 24FRA payment dates and settlement 25The FRA as two payment legs 26
Dealing in FRAs 28Forward interest rates 29Chapter summary 29
viii Contents
4 Commodity and Bond Futures 31Introduction 31Commodity futures 32
Futures prices and the basis 33Bond futures 34
Gilt and Euro bund futures 36The cheapest-to-deliver 37Chapter summary 38
5 Interest Rate and Equity Futures 39Introduction 39Interest rate futures 39
Trading interest rate futures 40Hedging with interest rate futures 41Interest rate futures prices 42
Equity index futures 43The margining system 44Single stock futures 46Chapter summary 47
6 Interest Rate Swaps 49Introduction 49Sterling interest rate swap 49
Hedging with interest rate swaps 50Dollar interest rate swap 52Summary of IRS applications 53Swap rates and credit risk 54Cross-currency swaps 55
Gains from cross-currency swap 56Chapter summary 58
7 Equity and Credit Default Swaps 59Equity swaps 59Monetizing corporate cross-holdings 59Other applications of equity swaps 60Equity index swaps 62
Hedging equity swaps 63Credit default swaps 64
Credit default swap premium 65Chapter summary 66
8 Fundamentals of Options 69Introduction 69Call option: intrinsic and time value 70
Long call expiry payoff 71Short call expiry payoff 72
Contents ix
Put option: intrinsic and time value 73Long put expiry payoff 74Short put expiry payoff 75
Chapter summary 76
9 Hedging with Options 77Introduction 77Forward hedge revisited 77Protective put 79Payoff profile of protective put 80
Changing the put strike 82Equity collar 82
Zero-cost equity collar 84Collars and forwards 84Protective put with barrier option 86Covered call writing (buywrite) 88Chapter summary 89
10 Exchange-Traded Equity Options 91Introduction 91UK stock options on LIFFE 92Stock options: call expiry payoff 93US-listed stock options 94CME options on S&P 500 R index futures 95FT-SE 100 index options 97Expiry payoff of FT-SE 100 call 98Exercising FT-SE 100 index options 99Chapter summary 99
11 Currency Options 101Introduction 101Currency options and forwards 101Results from the option hedge 102Zero-cost collar 104Reducing premium on FX hedges 105Compound options 106Exchange-traded currency options 107
Hedging with exchange-traded options 108FX covered call writing 109Chapter summary 111
12 Interest Rate Options 113Introduction 113OTC interest rate options 113
Hedging with interest rate calls 115Caps, floors and collars 116
x Contents
Swaptions 117Eurodollar options 119Euro and sterling interest rate options 120Bond options 121
Exchange-traded bond options 121Bund and gilt bond options 122
Chapter summary 123
13 Option Valuation Concepts 125Introduction 125The concept of expected payout 125Inputs to the BlackScholes model 127Historical volatility 128Implied volatility 131Share price simulations 132Value of a call and put option 133Pricing currency options 136Pricing interest rate options 137Chapter summary 138
14 Option Sensitivities: The Greeks 141Introduction 141Delta 141Gamma 144
Delta, gamma and expiry 146Theta 147Vega 148Rho 149Signs of the Greeks 150Chapter summary 150
15 Managing Trading Risks on Options 153Introduction 153Delta risk on a short call 153Delta hedging and gamma 155Profit from a short call position 156Chasing the delta 157Practical constraints on hedging 158Chapter summary 159
16 Option Trading Strategies 161Introduction 161Bull spread 161Bull position with digital options 162Bear spread 164Put or bear ratio spread 166Long straddle 167
Contents xi
Chooser option 169Short straddle 170Managing the gamma risk
