Derivatives Demystified -- Contents -- Acknowledgements -- 1 The Origins and Growth of the Market -- Definitions -- Derivatives Building Blocks -- Forwards -- Futures -- Swaps -- Options -- Market Participants -- Dealers -- Hedgers -- Speculators -- Arbitrageurs -- Supporting Organizations -- Early Origins of Derivatives -- Derivatives in the USA -- Overseas Developments, Innovation and Expansion -- An Example of Recent Innovation: Weather Derivatives -- Temperature-Linked Derivatives -- The value connection -- Summary and basis risks -- The Wild Beast of Finance? -- Enter Warren Buffett -- Lessons From Recent History -- Hammersmith & Fulham Council (1988/9) -- Metallgesellschaft (1993) -- Orange County (1994) -- Barings Bank (1995) -- Long-Term Capital Management (1998) -- Enron (2001) -- Allied Irish Banks (2002) -- AIG, Merrill Lynch and Lehman Brothers (2008) -- Creative Destruction and Contagion Effects -- The Modern OTC Derivatives Market -- The Exchange-Traded Derivatives Market -- Chapter Summary -- 2 Equity and Currency Forwards -- Introduction -- Equity Forward Contract -- The Forward Price -- Establishing the fair forward price -- Components of the forward price -- The Forward Price and Arbitrage Opportunities -- Closing the gap -- The forward price and commodities -- The Forward Price and the Expected Payout -- Expected payout from a forward -- Foreign Exchange Forwards -- The forward FX rate -- Managing Currency Risk -- Profits and losses on the export deal -- Hedging with an Outright Forward FX Deal -- Showing the results in a graph -- The Forward Foreign Exchange Rate -- The Forward FX Rate and Arbitrage Opportunities -- Forward Points -- Calculating forward points -- FX Swaps -- Applications of FX Swaps -- Effects of the FX swap deal -- Chapter Summary -- 3 Forward Rate Agreements -- Introduction.

FRA Case Study: Corporate Borrower -- The FRA settlement -- Effective borrowing rate -- Results of the FRA Hedge -- The FRA hedge illustrated -- The FRA contract period -- The FRA as Two Payment Legs -- Net position with FRA hedge -- Dealing in FRAs -- The dealer's overall position -- FRA bid and ask rates -- Forward Interest Rates -- Chapter Summary -- 4 Commodity and Bond Futures -- Introduction -- The Margining System and the Clearing House -- Users of Futures Contracts -- Hedgers -- Speculators -- Arbitrageurs -- Commodity Futures -- Futures Prices and the Basis -- The basis -- US Treasury Bond Futures -- Tick size and tick value -- Bond futures profit and loss calculations -- US Treasury Bond Futures: Delivery Procedures -- Conversion or price factors -- Gilt Futures -- The Cheapest-To-Deliver (CTD) Bond -- Chapter Summary -- 5 Interest Rate and Equity Futures -- Introduction -- Eurodollar Futures -- Final settlement value -- Trading Eurodollar Futures -- Calculating trading Profits and losses -- Profits and losses in interest rate terms -- Close out before expiry -- Hedging with Interest Rate Futures -- Eurodollar futures hedge in a graph -- Interest Rate Futures Prices -- Arbitrage example -- No arbitrage relationships -- Equity Index Futures -- CME S&P 500 futures price quotation and basis -- Other major equity index futures contracts -- Applications of S&P 500 Index Futures -- Hedging with equity index futures -- FT-SE 100 Index Futures Contracts -- Trading campaign: Day 1 -- Trading campaign: Day 2 -- Trading campaign: Day 3 -- Establishing Net Profits and Losses -- Exchange delivery settlement price (EDSP) -- Single Stock Futures (SSFs) -- The future of single stock futures -- Chapter Summary -- 6 Interest Rate Swaps -- Introduction -- Interest Rate Swap Structure -- Basic Single-currency Interest Rate Swap -- Swap payment in one year.

Swap payment in two years -- The Swap as a Package of Spot and Forward Deals -- Rationale for the Swap Deal -- Swap Terminology and Swap Spreads -- Overnight index swaps -- Typical Swap Applications -- Fixing a borrowing rate -- Asset swap -- Asset-liability management (ALM) -- Switching to a fixed return -- Interest Rate Swap Variants -- Cross-Currency Interest Rate Swaps -- 1. Swap with Americo -- 2. Swap with Britco -- Net Borrowing Costs Using a Cross-Currency Swap -- The swap dealer's position -- Why does everyone win? -- Inflation Swaps -- Chapter Summary -- 7 Equity and Credit Default Swaps -- Introduction to Equity Swaps -- Equity Swap Case Study -- First swap payment -- Second swap payment -- Economic exposure -- Other Applications of Equity Swaps -- Total return equity swap -- Equity Index Swaps -- DAX equity index swap -- Hedging an Equity Index Swap -- Profit on the hedged swap -- Credit Default Swaps -- Credit Default Swap: Basic Structure -- CDS physical settlement -- CDS cash settlement -- Credit events -- Credit Default Swap Applications -- Credit Spreads -- The CDS Premium and the Credit Spread -- Cheapest-to-deliver (CTD) option -- Counterparty risk and CDS contracts -- Pricing Models for CDS Premium -- Establishing the CDS premium -- Index Credit Default Swaps -- Index CDS example -- Applications of index CDS deals -- Basket Credit Default Swaps -- FTD basket default swap -- STD basket default swap -- Chapter Summary -- 8 Fundamentals of Options -- Introduction -- Definitions -- Types of Options -- Basic Option Trading Strategies -- Intrinsic value -- Time value -- Total option value -- Long Call: Expiry Payoff Profile -- Downside and upside -- Long call and cash position compared -- Short Call: Expiry Payoff Profile -- Long Put: Expiry Payoff Profile.

Long put expiry payoff profile -- Long put versus shorting the stock -- Short Put: Expiry Payoff Profile -- Summary: Intrinsic and Time Value -- 9 Hedging with Options -- Chapter Overview -- Futures Hedge Revisited -- Results of a futures hedge -- Protective Put -- Protective put example -- Maximum loss with protective put -- Other break-even levels -- Hedging with ATM Put Option -- Covered Call Writing -- Maximum profit on the covered call -- Equity Collar -- Zero-Cost Equity Collar -- Protective PUT with a Barrier Option -- Barrier option terms -- Advantages and disadvantages -- Behaviour of Barrier Options -- Chapter Summary -- 10 Exchange-Traded Equity Options -- Introduction -- Basic Concepts -- Covered warrants -- CBOE Stock Options -- Expiry payoff profile -- Early exercise -- UK Stock Options on NYSE Liffe -- Exercise style -- Corporate actions and early exercise -- CME S&P 500 Index Options -- Option premium -- Long S&P 500 put: expiry payoff profile -- FT-SE 100 Index Options -- Chapter Summary -- 11 Currency or FX Options -- Introduction -- Users of Currency Options -- Hedging FX Exposures with Options: Case Study -- Performance of the hedge -- Graph of Hedged and Unhedged Positions -- Hedging with a Zero-Cost Collar -- Reducing Premium on FX Hedges -- Barrier option -- Pay-later option -- Instalment option -- Compound Options -- Hedging application -- Compound option structure -- Exchange-Traded Currency Options -- CME currency options -- PHLX world currency options -- Chapter Summary -- 12 Interest Rate Options -- Introduction -- OTC Interest Rate Options -- OTC Interest Rate Option Case Study -- Caplet exercise and settlement -- Hedging a Loan with a Caplet -- Results of the hedge -- Interest Rate Cap -- Pricing caplets and caps -- Interest Rate Collar -- Zero-cost collar case study.

Interest Rate Swap and Swaption -- Payer swaption -- Summary of Interest Rate Hedging Strategies -- Eurodollar Options -- Trading Eurodollar options -- Profits and losses on Eurodollar options -- Euro and Sterling Interest Rate Options -- Bond Options -- Hedging -- Zero-cost collar -- Covered call writing -- Leveraged position taking -- Exchange-Traded Bond Options -- Euro-bund options (OGBL) -- Long gilt option -- Chapter Summary -- 13 Option Valuation Concepts (1) -- Introduction -- Black-Scholes model -- The Concept of a Riskless Hedge -- A Simple Option Pricing Model -- Constructing a riskless hedge -- Purpose of the hedge -- Option Fair Value -- Extending the Binomial Model -- Dynamic hedging -- Cost of Dynamic Hedging -- The Black-Scholes Option Pricing Model -- Inputs to Black-Scholes -- Model inputs: spot price and strike price -- Model inputs: time to expiry and cost of carry -- Model input: volatility -- Historical Volatility -- Standard deviation -- Measuring and Using Historical Volatility -- Application to Black-Scholes -- Chapter Summary -- 14 Option Valuation Concepts (2) -- Introduction -- Problems with Historical Volatility -- Implied Volatility -- Applications of implied volatility -- Black-Scholes Model Assumptions -- Normal distribution -- Continuous random walk -- Dynamic hedging -- Fixed volatility -- Value of a Call Option -- Time value for an in-the-money option -- Value of a Put Option -- Equity Index and Currency Options -- Value of an FX call option -- Pricing Interest Rate Options -- Bond option pricing example -- Black model -- The Black model and interest rates -- Chapter Summary -- 15 Option Sensitivities: The 'Greeks' -- Introduction -- Delta (∆ or δ) -- Delta Behaviour -- Delta as the slope on the option price curve -- Delta as the Hedge Ratio -- Constructing the delta hedge.

The Effects of Changes in Delta.