Financial Engineering and Arbitrage in the Financial Markets -- Contents -- Introduction -- 1 Purpose and Structure of Financial Markets -- 1.1 Overview of Financial Markets -- 1.2 Risk Sharing -- 1.3 Transactional Structure of Financial Markets -- 1.4 Arbitrage: Pure Versus Relative Value -- 1.5 Financial Institutions: Transforming Intermediaries vs Broker-Dealers -- 1.6 Primary (Issuance) and Secondary (Resale) Markets -- 1.7 Market Players: Hedgers vs Speculators -- 1.8 Preview of the Book -- PART I RELATIVE VALUE BUILDING BLOCKS -- 2 Spot Markets -- 2.1 Bonds and Annual Bond Math -- 2.1.1 Zero-Coupon Bond -- 2.1.2 Coupon Bond -- 2.1.3 Amortizing Bond -- 2.1.4 Floating Rate Bond -- 2.2 Intra-Year Compounding and Day-Count -- 2.2.1 Intra-Year Compounding -- 2.2.2 Day-Count -- 2.2.3 Accrued Interest -- 2.3 Term Structure of Interest Rates and the Discount Factor Bootstrap -- 2.3.1 Term Structure -- 2.3.2 Discount Factor Bootstrap -- 2.3.3 Valuation of an Arbitrary Bond -- 2.4 Interest Rate Risk: Duration and Convexity -- 2.4.1 Duration -- 2.4.2 Portfolio Duration -- 2.4.3 Convexity -- 2.4.4 Other Risk Measures -- 2.5 Equity, Commodity, and Currency Math -- 2.5.1 Equities -- 2.5.2 Currencies -- 2.6 Short Selling -- 2.6.1 Buying on Margin -- 2.6.2 Short Selling in a Margin Account -- 2.6.3 Short Selling of Bonds -- 3 Futures Markets -- 3.1 Fundamentals of Futures and Forwards -- 3.2 Futures Mechanics -- 3.2.1 Physical Commodity Futures -- 3.2.2 Interest Rate Futures -- 3.2.3 Stock Index Futures -- 3.2.4 Currency Futures and Forwards -- 3.3 Cash-and-Carry Arbitrage -- 3.3.1 Commodities -- 3.3.2 Stock Indexes -- 3.3.3 Currencies -- 3.4 Futures Not Subject to Cash-and-Carry -- 3.5 Yield Curve Construction with Interest Rate Futures -- 3.5.1 Certainty Equivalence of Eurodollar Futures -- 3.5.2 Forward Rate Agreements -- 3.5.3 Building Spot Zeros.

3.5.4 Recovering the Forwards -- 3.5.5 Including Repo Rates in the Calculation of the Forwards -- 4 Swap Markets -- 4.1 Fundamentals of Swaps -- 4.1.1 The Dual Nature of Swaps -- 4.1.2 Implication for Pricing and Hedging -- 4.2 Interest Rate Swaps -- 4.2.1 Definition of an Interest Rate Swap -- 4.2.2 Valuation of Interest Rate Swaps -- 4.2.3 Hedging of Interest Rate Swaps -- 4.3 Cross-Currency Swaps -- 4.3.1 Definition of a Fixed-for-Fixed Cross-Currency Swap -- 4.3.2 Valuation and Settlement of Cross-Currency Swaps -- 4.3.3 Cross-Currency Swaps as Packages of Off-Market FX Forwards -- 4.3.4 Multicurrency and Combination Cross-Currency Swaps -- 4.4 Equity, Commodity, and Exotic Swaps -- 4.4.1 Equity Swaps -- 4.4.2 Commodity Swaps -- 4.4.3 Volatility Swaps -- 4.4.4 Index Principal Swaps -- 5 Options on Prices and Hedge-Based Valuation -- 5.1 Call and Put Payoffs at Expiry -- 5.2 Composite Payoffs at Expiry -- 5.2.1 Straddles and Strangles -- 5.2.2 Spreads and Combinations -- 5.3 Option Values Prior to Expiry -- 5.4 Options and Forwards, Risk Sharing and Put-Call Parity -- 5.5 Currency Options -- 5.6 Binomial Option Pricing -- 5.6.1 One-Step Examples -- 5.7 Black-Scholes Model and Extensions -- 5.7.1 Black-Scholes with No Dividends -- 5.7.2 Dividends -- 5.7.3 Options on Currency Rates -- 5.7.4 Black-Scholes Delta, Gamma, and Vega -- 5.8 Residual Risk of Options: Gamma, Vega, and Volatility -- 5.8.1 Implied Volatility -- 5.8.2 Volatility Smiles and Skews -- 5.9 A Real-Life Option Pricing Exercise -- 5.9.1 Consistency Checks: Put-Call Parity, Black-Scholes, and Binomial -- 6 Options on Non-Price Variables -- 6.1 Black Models For Bond Price Options, Caps/Floors, and European Swaptions -- 6.1.1 Options on Bond Prices -- 6.1.2 Cap and Floor Definitions -- 6.1.3 Relationship of Caps and Floors to FRAs and Swaps -- 6.1.4 A Cap Application.

6.1.5 Pricing of Caps and Floors -- 6.1.6 European Swaption Definitions -- 6.1.7 Options to Cancel Swaps -- 6.1.8 Relationship of Swaptions to Forward Swaps -- 6.1.9 Pricing of European Swaptions -- 6.1.10 Limitations of the Black Model -- 6.2 Convexity-Adjusted Models For Libor Forwards, Quantos, and Constant Maturity Swaps -- 6.2.1 Convexity Adjustment for Eurodollar Futures -- 6.2.2 Convexity Adjustment for CMS Options -- 6.2.3 Quanto Adjustments -- 6.3 Arbitrage-Free Interest Rate Models -- 6.3.1 Short Rate Models -- 6.3.2 Trinomial Trees and Calibration -- 6.3.3 The Heath-Jarrow-Morton Model and the LIBOR Market Model -- 6.3.4 Bermudan Swaptions and Multifactor Models -- 6.4 Exotic Interest Rate Options -- 6.4.1 Periodic Caps -- 6.4.2 Digitals and Ranges -- 7 Default Risk and Credit Derivatives -- 7.1 Credit Default Swaps -- 7.1.1 Credit Default Swap -- 7.1.2 No Arbitrage: CDS vs Corporate Bond Spread -- 7.1.3 Bundled Single-Name Credit Derivatives -- 7.2 A Constant Default Probability Model -- 7.3 A Deterministic Credit Migration Model -- 7.4 A Poisson Model of Single Issuer Default -- 7.4.1 Poisson Distribution -- 7.4.2 A Single Issuer Default Model -- 7.4.3 Pricing a Credit Default Swap in a Single Issuer Default Model -- 7.5 The Default Correlation of the Reference Issuer and the Protection Seller -- PART II CASH FLOW ENGINEERING -- 8 Structured Finance -- 8.1 A Simple Classification of Structured Notes -- 8.2 Interest Rate and Yield Curve-Based Structured Products -- 8.2.1 An Inverse Floater -- 8.2.2 A Leveraged Inverse Floater -- 8.2.3 A Capped Floater -- 8.2.4 A Callable -- 8.2.5 A Range Floater -- 8.2.6 An Index Principal Swap -- 8.3 Asset Class-Linked Notes -- 8.3.1 Principal-Protected Equity-Linked Notes -- 8.3.2 A (Rainbow) Multi-Asset-Linked Note -- 8.3.3 Principal-At-Risk Notes and Commodity-Tracking ETNs.

8.4 Insurance Risk Structured Products -- 9 Mortgage-Backed Securities -- 9.1 Mortgage Financing Basics -- 9.2 Prepayment Risk -- 9.3 Mortgage Pass-Through Securities -- 9.4 Collateralized Mortgage Obligations -- 9.4.1 Sequential-Pay CMO -- 9.4.2 Planned Amortization Class CMO -- 9.4.3 Interest-only (IO) and Principal-only (PO) Classes -- 9.5 Multiclass and Non-Vanilla CMOs -- 9.5.1 A Multiclass PAC Structure with a PAC I/O and a Floater/Inverse Coupon Split -- 9.5.2 Non-Accelerating Senior and Accrual Tranches in Sequential CMOs -- 10 Collateralized Debt Obligations and Basket Credit Derivatives -- 10.1 Collateralized Debt Obligations -- 10.1.1 Cash CDO -- 10.1.2 Synthetic CDO -- 10.2 Basket Credit Derivatives -- 10.2.1 First-to-Default Basket -- 10.2.2 Nth-to-Default Basket, Arbitrage Conditions, and Hedging -- 10.2.3 Hedging of Basket Derivatives -- 10.3 Copulas and the Modeling of Default Correlation -- 10.3.1 A Gaussian Copula -- 10.3.2 General Copula Models -- 10.4 Synthetic CDO Tranche Pricing and Loss Analysis -- 10.4.1 Synthetic CDO Revisited -- 10.4.2 Synthetic CDO Pricing and Expected Loss -- 10.4.3 Synthetic CDO - Loss Rates, Ratings and the Crisis of 2008 -- 10.5 Credit Derivative Indexes -- PART III THE PLAYERS -- 11 Individual Investors: A Survey of Modern Investment Theory -- 11.1 A Brief History of Investment Thought -- 11.2 Free Cash Flow Valuation of Companies -- 11.2.1 Free Cash Flow Definitions -- 11.2.2 Growth and the Discounting of the Cash Flows -- 11.2.3 Terminal Multiple Models of Cash Flow Discounting -- 11.3 The Modern Portfolio Theory and the CAPM -- 11.3.1 Diversification and the Efficient Frontier -- 11.3.2 Two-Fund Separation -- 11.3.3 Systematic Risk and the CAPM -- 11.3.4 Using the CAPM as a Stock Screen to Discover Alpha -- 11.4 Multifactor Index Models -- 11.4.1 The Fama-French Three-Factor Model.

11.4.2 The Carhart Fourth Factor: the Momentum -- 11.4.3 International Index Factors -- 11.5 Fundamental Indexing -- 11.5.1 A Brief History of Fundamental Indexing -- 11.5.2 Fundamental Indexing and Rebalancing -- 11.5.3 Tactical Asset Allocation -- 11.5.4 Fundamentally Indexed US Funds -- 12 Hedge Funds: Alpha, Beta, and Strategy Indexes -- 12.1 Hedge Fund Strategies -- 12.1.1 Relative Asset Value Funds -- 12.1.2 Relative Corporate/Credit Structure -- 12.1.3 Theoretical Relative Value -- 12.1.4 Statistical Relative Value Arbitrage -- 12.2 Portable Alpha and Market-Neutral Plays -- 12.3 Hedge Fund Replication and Strategy Indexes -- 13 Banks: Asset-Liability Management -- 13.1 Bank Balance Sheets and Income Statements -- 13.2 Interest-Sensitive Gap Management -- 13.3 Duration Gap Management -- 13.4 Value at Risk -- 14 Private Equity, Pension, and Sovereign Funds -- 14.1 Private Equity -- 14.1.1 Investment in Private Equity - Limited Partnership Funds -- 14.1.2 Leverage Buyouts -- 14.1.3 Private Equity Lending - Mezzanine Capital and Distressed Loans -- 14.1.4 Other Forms of Private Equity - PIPEs -- 14.1.5 Venture Capital -- 14.1.6 Exit Strategies - IPOs and Secondary Sales -- 14.2 Risk Allocation for Pension Funds and Sovereign Funds -- 14.2.1 Defined Benefit Pension Funds and Endowments -- 14.2.2 The Risk Budget Allocation Process -- Acknowledgment -- References -- Index.