(continued from front flap) $95.00 USA/$114.00 CAN KOLB SERIES IN FINANCEThe authors explore option strategies used to Essential Perspectives Overdahl Kolb FINANCIALspeculate and show how the same strategies can beemployed to reduce risk. In addition, they revealhow ﬁnancial derivatives can effectively manageinterest rate risk and discuss how hedge funds use FINANCIAL DERIVATIVESﬁnancial derivatives.Uncertainty is a hallmark of today’s global ﬁnancialmarketplace. This essential guide to ﬁnancial de-rivatives will help you unlock their vast potential for The Robert W. Kolb Series in Finance is an unparalleled source of informa- tion dedicated to the most important issues in modern ﬁnance. Each book DERIVATIVES A t a time when our entire ﬁnancial system is under great stress, many investors point to the misuse of derivatives as one of the Pricing and Risk Managementrisk management and much, much more. focuses on a speciﬁc topic in the ﬁeld of ﬁnance, and contains contributed primary causes of the ﬁnancial meltdown. LongROBERT W. KOLB is the Frank W. Considine misunderstood by the general public, some ﬁnan- chapters from both respected academics and experienced ﬁnancial profes-Chair of Applied Ethics and Professor of Finance cial derivatives are fairly simple—while others are sionals. As part of the Robert W. Kolb Series in Finance, Financial Deriva- DERIVATIVES FINANCIALat Loyola University Chicago. Before this, he was quite complicated and require considerable math-the assistant dean, Business and Society, and direc- tives aims to provide a comprehensive understanding of ﬁnancial derivatives ematical and statistical knowledge to fully under-tor, Center for Business and Society, at the Uni- and how you can prudently use them within the context of your underlying stand. But with our ﬁnancial system now undergo-versity of Colorado at Boulder, and department business activities. ing unprecedented changes, there has never beenchairman at the University of Miami. Kolb has au- a better time to gain a ﬁrm understanding of thesethored over twenty books on ﬁnance, derivatives, For the public at large, ﬁnancial derivatives have long instruments.and futures, as well as numerous articles in leading been the most mysterious and least understood of all ﬁ-ﬁnance journals. As part of the Robert W. Kolb Series in Finance, nancial instruments. Through in-depth insights gleaned Financial Derivatives skillfully explores the con-JAMES A. OVERDAHL, a specialist in ﬁnancial from years of ﬁnancial experience, the contributors temporary world of ﬁnancial derivatives. Startingderivatives, is the Chief Economist of the United in this collection clearly explain what derivatives are with a presumption of only a general knowledge ofStates Securities and Exchange Commission. He without getting bogged down by the mathematics undergraduate ﬁnance, this collection of essentialhad previously served as chief economist of the surrounding their pricing and valuation. perspectives, written by leading ﬁgures in academ-Commodity Futures Trading Commission and has ics, industry, and government, provides a compre-nearly two decades of experience in senior positions Financial Derivatives offers a broad overview of the hensive understanding of ﬁnancial derivatives. Theat various federal ﬁnancial regulatory agencies. He different types of derivatives—futures, options, swaps, and structured contributors provide a complete overview of thehas taught economics and ﬁnance at the University types of ﬁnancial derivatives and the markets in products—while focusing on the principles that determine market prices.of Texas at Dallas, Georgetown University, Johns which they trade. They analyze the developmentHopkins University, and George Washington Uni- This comprehensive resource also provides a thorough introduction to and current state of derivatives markets—includingversity. Overdahl earned his PhD in economics financial derivatives and their importance to risk management in a their regulation—and examine the role of deriva-from Iowa State University. corporate setting. Filled with in-depth analysis and examples, Financial tives in risk management. They look at the pricing Derivatives offers readers a wealth of knowledge on futures, options, swaps, of derivatives, beginning with the fundamentals ﬁnancial engineering, and structured products. and move on to more advanced pricing techniques, showing how Monte Carlo methods can be applied to price derivatives. The book concludes with an examination of theJacket Design: Leiva-Sposato Design many ways derivatives can be used. While it is clear Robert W. Kolb, James A. Overdahl, Editors that ﬁnancial derivatives are valuable for manag- ing risks and for providing information about the future prices of underlying goods, they can also be used as very sophisticated speculation tools. KOLB SERIES IN FINANCE Essential Perspectives (continued on back flap) EAN: 9780470499108 ISBN 978-0-470-49910-8
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P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton FINANCIAL DERIVATIVES
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton The Robert W. Kolb Series in Finance provides a comprehensive view of the ﬁeld of ﬁnance in all of its variety and complexity. The series is projected to include approximately 65 volumes covering all major topics and specializations in ﬁnance, ranging from investments, to corporate ﬁnance, to ﬁnancial institutions. Each vol- ume in the Kolb Series in Finance consists of new articles especially written for the volume. Each Kolb Series volume is edited by a specialist in a particular area of ﬁnance, who develops the volume outline and commissions chapters by the world’s experts in that particular ﬁeld of ﬁnance. Each volume includes an editor’s introduction and approximately 30 articles to fully describe the current state of ﬁnancial research and practice in a particular area of ﬁnance. The chapters in each volume are intended for practicing ﬁnance professionals, graduate students, and advanced undergraduate students. The goal of each volume is to encapsulate the current state of knowledge in a particular area of ﬁnance so that the reader can quickly achieve a mastery of that special area of ﬁnance.
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton FINANCIAL DERIVATIVES Pricing and Risk Management Robert W. Kolb James A. Overdahl The Robert W. Kolb Series in Finance John Wiley & Sons, Inc.
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton Copyright c 2010 by John Wiley & Sons, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and speciﬁcally disclaim any implied warranties of merchantability or ﬁtness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of proﬁt or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Kolb, Robert W., 1949– Financial derivatives : pricing and risk management / Robert W. Kolb, James A. Overdahl. p. cm. – (The Robert W. Kolb series in ﬁnance) Includes bibliographical references and indexes. ISBN 978-0-470-49910-8 (cloth) 1. Derivative securities. 2. Financial engineering. I. Overdahl, James A. II. Title. HG6024.A3K648 2010 332.64 57–dc22 2009017152 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton Contents Introduction xxi Acknowledgments xxiii PART I Overview of Financial Derivatives 1 1 Derivative Instruments: Forwards, Futures, Options, Swaps, and Structured Products 3 G. D. Koppenhaver Introduction 3 A Generalist’s Approach to Derivative Contracts 6 Forward Contracts 7 Futures Contracts 9 Swap Contracts 11 Option Contracts 13 Structured Products and an Application to Derivative Contracts 16 Conclusion 19 Endnotes 19 References 20 About the Author 20 2 The Derivatives Marketplace: Exchanges and the Over-the-Counter Market 21 Sharon Brown-Hruska Introduction 21 Standardization versus Customized Products: Differences in Structure and Approach 22 Competition and Consolidation: Impetus for Change 25 Moving from Bilateral to Multilateral Risk Management 29 Collateral in Exchange and OTC Markets 29 Netting and Novation in Exchange and OTC Markets 31 Transparency and Information in the Exchange and OTC Marketplaces 36 Conclusion 39 Endnotes 40 v
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton vi Contents References 41 About the Author 42 3 Speculation and Hedging 43 Greg Kuserk Hedging Transactions 44 Speculation 48 From Hedging to Speculation 50 Interaction between Hedgers and Speculators 52 Conclusion 54 Endnotes 54 References 54 About the Author 55 4 The Social Functions of Financial Derivatives 57 Christopher L. Culp Hedging and Risk Transfer 58 Price Discovery 58 Price Discovery, Commoditization, and Market Structure 59 Intertemporal Resource Allocation 60 Forward Contracts as Synthetic Storage 60 Commodity Interest Rates 60 Asset Finance 61 Commodities Lending 62 Project Finance 63 Trade Finance 64 Financial Asset Inventory Management 65 Synthetic Asset Allocation 65 Derivatives and Public Policy 66 Endnotes 67 Further Reading 68 References 69 About the Author 71 PART II Types of Financial Derivatives 73 5 Agricultural and Metallurgical Derivatives: Pricing 77 Joan C. Junkus Introduction 77 Commodities 77 Seasonality in Spot and Futures Prices 78 Futures Pricing 79 Theory of Storage 80 Theory of Normal Backwardation 84
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton CONTENTS vii Conclusion 85 References 86 Suggested Further Reading 86 About the Author 87 6 Agricultural and Metallurgical Derivatives: Speculation and Hedging 89 Joan C. Junkus Introduction 89 Commodities 89 Derivatives 90 Commodity Investment Strategies 90 Commodity Indexes 90 Diversiﬁcation and Inﬂation 91 Passive Investment Strategies 91 Active Strategies 94 Measuring Investment Performance 94 Hedging 95 Commodity Marketing 95 Risk Management 97 Spreads 99 Conclusion 100 References 100 Suggested Further Reading 101 About the Author 101 7 Equity Derivatives 103 Jeffrey H. Harris and L. Mick Swartz Introduction 103 Stock Options 104 Call Options 105 Put Options 106 Stock Options on an Index 106 Employee Stock Options 107 Convertible Bonds 107 Warrants 108 Equity Futures 108 Single-Stock Futures 108 Futures on Stock Indexes 109 Equity Swaps 110 Future of Equity Derivatives 111 References 112 Further Reading 112 About the Authors 113
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton viii Contents 8 Foreign Exchange Derivatives 115 Robert W. Kolb Basic Pricing Principles 115 Purchasing Power Parity Theorem 115 Interest Rate Parity Theorem 116 Foreign Exchange Forward and Futures Contracts 117 Foreign Exchange Options 118 FX Option Pricing 119 Plain Vanilla Foreign Exchange Swaps 119 Flavored Currency Swaps 121 Conclusion 122 Endnotes 123 References 123 About the Author 123 9 Energy Derivatives 125 Craig Pirrong Introduction 125 Products: An Overview 125 History 126 Petroleum Derivatives: Details 127 Natural Gas Derivatives: Details 128 Electricity Derivatives: Details 129 Pricing 129 Clearing 131 Recent Developments 132 References 133 About the Author 133 10 Interest Rate Derivatives 135 Ian Lang Exchange-Traded (Listed) Derivatives 135 Over-the-Counter Derivatives 138 OTC Options 138 Rate Locks 138 Swaps and Swaptions 139 Mortgage Derivatives 141 Further Reading 142 About the Author 142 11 Exotic Options 143 Robert W. Kolb Overview 143 Forward-Start Options 144
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton CONTENTS ix Compound Options 144 Chooser Options 145 Barrier Options 146 Binary Options 147 Lookback Options 149 Asian or Average Price Options 150 Exchange Options 151 Rainbow Options 151 Conclusion 152 Endnotes 153 References 154 About the Author 154 12 Event Derivatives 157 Justin Wolfers and Eric Zitzewitz Types of Prediction Markets 158 Applications and Evidence 160 Accuracy of Prediction Markets 160 Possibilities for Arbitrage 164 Can Event Markets Be Manipulated Easily? 168 Market Design 168 Making Inferences from Prediction Markets 170 Innovative Future Applications? 173 Acknowledgments 173 Endnotes 174 References 174 About the Authors 176 13 Credit Default Swaps 177 Steven Todd Credit Default Swaps on Corporate Debt 177 Credit Default Swaps on Asset-Backed Securities 178 Credit Default Swaps on Collateralized Debt Obligations 180 The Basis 182 CDS Indices 182 Tranches of CDS Indices 186 Trading Strategies Using Indexes and Tranches 188 Market Dynamics: CDS and CDOs 189 Synthetic CDOs and Bespokes 189 Correlation 191 Conclusion 196 Endnotes 196 References 197 About the Author 198
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton x Contents 14 Structured Credit Products 199 Steven Todd Asset-Backed Securities 202 Collateralized Debt Obligations 204 Commercial Mortgage-Backed Securities 208 Endnotes 209 References 210 About the Author 210 15 Executive Stock Options 211 Robert W. Kolb Introduction 211 Basic Features of Executive Stock Options 211 Rationales for ESOs 212 Pricing of Executive Stock Options 214 Executive Stock Options and Incentives 216 Conclusion 218 Endnotes 218 References 219 About the Author 220 16 Emerging Derivative Instruments 221 Steve Swidler Economic Derivatives 222 Real Estate Derivatives 224 The Next Frontier 226 Endnotes 228 References 228 Suggested Further Reading 229 About the Author 230 PART III The Structure of Derivatives Markets and Institutions 231 17 The Development and Current State of Derivatives Markets 233 Michael A. Penick Introduction: The Situation in the 1960s 233 Financial Futures and Options 234 Foreign Markets 236 OTC Markets 237 Energy Derivatives 238 The Rise of Electronic Trading 240 Current Conditions: Consolidation and Crisis 243
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton CONTENTS xi Endnotes 245 References 247 About the Author 248 18 Derivatives Markets Intermediaries: Brokers, Dealers, Pools, and Funds 249 James L. Carley Intermediaries for Exchange-Traded Derivatives 250 Providers of Trade Execution Services 251 Providers of Money Management Services 256 Intermediaries for OTC Derivatives 257 Swap Brokers 258 Swap Dealers 258 Interdealer Brokers 258 Next Step: Clearinghouse(s) for Swaps 259 Endnotes 260 References 261 About the Author 261 19 Clearing and Settlement 263 James T. Moser and David Reiffen Introduction 263 Functions of Clearinghouses 263 Contracts for Immediate Performance 264 Contracts for Deferred Performance 265 Clearing and Liquidity 273 Competition between Exchanges 275 Nature of the Clearing Organization 276 Innovation and Clearing Structure 278 Conclusion 278 Endnotes 279 References 281 About the Authors 282 20 Counterparty Credit Risk 283 James Overdahl Measuring Counterparty Credit Risk Exposure 284 Presettlement versus Settlement Risk 284 Replacement Cost, Current Exposure, and Potential Exposure 284 Simulation Techniques and the Exposure Proﬁle 285 Wrong-Way and Right-Way Risk 287 Managing Counterparty Credit Risk 287 Evaluating the Creditworthiness of Counterparties 287 Using Counterparty Credit Risk Measures in the Trade Authorization Process 288
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton xii Contents Other Tools to Manage Counterparty Credit Risk 289 Netting 289 Actual Default Experience in the OTC Market 289 Infrastructure Improvements Aimed at Mitigating Counterparty Credit Risk 290 Infrastructure and the Effectiveness of Counterparty Credit Risk Management 290 Central Counterparty Clearing 291 Conclusion 292 Endnotes 293 References 293 About the Author 294 21 The Regulation of U.S. Commodity Futures and Options 295 Walter L. Lukken Tiered Regulatory Design 296 Statutory Exclusions for Certain OTC Derivatives 297 Security Futures Products 298 Retail Foreign Currency Fraud 299 Exempt Commercial Markets 300 CFTC Reauthorization Act of 2008 300 Future Legislative Reforms 301 Endnotes 302 About the Author 303 22 Accounting for Financial Derivatives 305 Ira G. Kawaller Alternative Accounting Categories 305 Cash Flow Hedges 306 Fair Value Hedges 309 Hedges of Net Investments in Foreign Operations 311 Conclusion 312 References 312 About the Author 312 23 Derivative Scandals and Disasters 313 John E. Marthinsen Introduction 313 Anatomy of Derivative-Related Failures 313 Investment Strategies and Exogenous Shocks behind Our Five Derivative Fiascos 315 MGRM’s Strategy 315 LTCM’s Strategy 316 Amaranth’s Strategy 317 Barings’ and Soci´t´ G´n´rale’s Speculative Traders ee e e 318
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton CONTENTS xiii Lessons Learned from Derivative Scandals and Disasters 319 Controlling Risks Is Possible Only If They Can Be Measured Effectively 319 Risk Management Systems Must Cauterize Losses Immediately after the Initial Shocks 320 Creative Ways Are Needed to Supply Liquidity during Turbulent Times 321 Risk Management Systems Must Control Traders and Fund Managers 321 Compensation Incentives and Promotion Criteria Must Be Scrutinized 323 Risk Management Systems Are Only as Strong as Their Weakest Risk Managers 325 Broader Implications of Derivative Scandals and Disasters 326 Conclusion 327 Acknowledgements 328 Endnotes 328 References 330 Suggested Further Reading 331 About the Author 332 PART IV Pricing of Derivatives: Essential Concepts 333 24 No-Arbitrage Pricing 335 Robert A. Strong Free Lunches 335 Theory of Put/Call Parity 336 Binomial Option Pricing Model 341 Put Pricing in the Presence of Call Options: Further Study 345 Binomial Put Pricing 346 Binomial Pricing with Asymmetric Branches 346 Effect of Time 347 Effect of Volatility 348 Intuition into Black-Scholes 348 Endnotes 349 References 349 Further Reading 349 About the Author 350 25 The Pricing of Forward and Futures Contracts 351 David Dubofsky Cost of Carry Model 352 Carry Return 354 Commodity Futures 355 Convenience Yield 356 Delivery Options 357
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton xiv Contents Interest Rate Futures and Forwards: Eurodollar Futures and Forward Rate Agreements 358 Interest Rate Futures and Forwards: Treasury Bond and Treasury Note Futures 360 Should Futures and Forward Prices Be the Same? 362 Expectations Model: An Alternative Theory for the Pricing of Forwards and Futures 363 Electricity Forwards and Futures 364 Conclusion 366 Endnotes 367 References 367 About the Author 369 26 The Black-Scholes Option Pricing Model 371 A. G. Malliaris Introduction 371 Brief History 372 Black-Scholes Formula 372 Assumptions of the Black-Scholes Model 373 Discussion of Assumptions 374 Ito Process 374 Example 375 Excel Application 376 Simple Derivation of Black-Scholes 376 Numerical Example 380 The Greeks 381 Delta 381 Gamma 381 Theta 381 Vega 381 Rho 382 Risk-Neutral Pricing 382 Conclusion 384 References 384 About the Author 385 27 The Black-Scholes Legacy: Closed-Form Option Pricing Models 387 Ant´ nio Cˆ mara o a Introduction 387 The Black-Scholes Model 388 First Generation of Models (One Lognormal Underlying) 392 Second Generation of Models (Two Lognormal Underlyings) 395 Third Generation of Models (One Nonlognormal Underlying) 397 Fourth Generation of Models 401 Conclusion 402
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton CONTENTS xv Endnotes 402 References 403 About the Author 404 28 The Pricing and Valuation of Swaps 405 Gerald Gay and Anand Venkateswaran Introduction 405 Illustration 1: An End User Swap Application 406 Framework for Pricing and Valuation 407 Illustration 2: A Simple Example 409 Steps for Swap Pricing 410 Obtain Market Inputs 410 Make Convexity Adjustments to Implied Futures Rates 411 Build the Zero Curve 413 Identify Relevant Swap Features 415 Price/Value the Swap 415 Illustration 3: Pricing an Interest Rate Swap 416 Illustration 4: Valuing an Existing Interest Rate Swap 416 Other Swaps 417 Currency Swaps 417 Illustration 5: Pricing and Valuing a Currency Swap 418 Commodity Swaps 419 Illustration 6: Pricing a Commodity Swap 419 Endnotes 420 References 421 About the Authors 422 PART V Advanced Pricing Techniques 423 29 Monte Carlo Techniques in Pricing and Using Derivatives 425 Cara M. Marshall Introduction 425 Pricing a Classic Black-Scholes Option 427 Simulation Results 432 Price Return 432 Pricing a Rainbow Option 435 Endnotes 439 References 439 About the Author 440 30 Valuing Derivatives Using Finite Difference Methods 441 Craig Pirrong Introduction 441 An Overview 441
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton xvi Contents Basic Methods 445 Higher-Dimension Problems 449 The Pros and Cons of Finite Difference Methods 451 Suggested Further Reading 451 Endnotes 452 References 452 About the Author 453 31 Stochastic Processes and Models 455 George Chalamandaris and A. G. Malliaris Introduction 455 Stochastic Processes 456 Deﬁnitions and Properties 456 Constructing the Continuous Time Model: Brownian Motion 458 The Ito Process and the Need for Stochastic Calculus 459 Basic Elements of Stochastic Calculus 462 Ito Integral 462 Ito’s Lemma 464 Binomial Tree: Another Way of Visualizing a Stochastic Process 468 Construction of a Binomial Tree and Properties 469 Conclusion 472 Endnotes 472 References 472 Appendix: Heuristic Derivation of Ito’s Formula 473 About the Authors 475 32 Measuring and Hedging Option Price Sensitivities 477 R. Brian Balyeat Delta 477 Example 1 479 Example 2 479 Gamma 484 Example 3 485 Theta 487 Example 4 488 Vega 491 Example 5 492 Rho and Other Option Sensitivities 493 Example 6 493 Example 7 494 Hedging Delta, Gamma, and Vega 496 Conclusion 498 References 499 About the Author 499
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton CONTENTS xvii PART VI Using Financial Derivatives 501 33 Option Strategies 503 Stewart Mayhew Building Blocks 505 Covered Calls and Protective Puts 507 Synthetic Positions 509 Bull and Bear Spreads 512 Cylinders 515 Straddles, Strangles, Strips, and Straps 516 Ratio Spreads 518 Box Spreads 518 Butterﬂies, Condors, and Seagulls 519 Time Strategies 522 Multi-Asset Strategies 523 Endnotes 523 References 523 About the Author 524 34 The Use of Derivatives in Financial Engineering: Hedge Fund Applications 525 John F. Marshall and Cara M. Marshall Introduction 525 Convertible Bond Arbitrage 526 Capital Structure Arbitrage 534 Endnotes 538 References 539 About the Authors 539 35 Hedge Funds and Financial Derivatives 541 Tom Nohel Introduction 541 Survey of Derivative Use by Hedge Funds 544 Modeling Hedge Fund Risks 547 Description of Some Popular Hedge Fund Strategies 548 Convertible Arbitrage 548 Risk Arbitrage 549 Global Macro 549 Market Neutral/Relative Value 550 Volatility Trades 550 Correlation Trading 551 Credit Hedge Funds 551 Hedge Fund Activism 552 Some Unusual Derivatives Trades Made by Hedge Funds 552 Empty Voting 552
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton xviii Contents Acquiring a Large Stake through Put Exercise 553 Toeholds via Contingent Contracts 553 Tax-Avoidance Strategies 554 Using Structures to Create Leverage 555 Conclusion 555 Endnotes 555 References 557 About the Author 558 36 Real Options and Applications in Corporate Finance 559 Betty Simkins and Kris Kemper Introduction 559 A Brief History of Real Options 560 Distinction between Financial Options and Real Options 561 Types of Real Options and Examples in the Energy Industry 561 Option to Expand 563 Option to Wait 563 Option to Vary Production Inputs, Outputs, or Processes 564 Option to Abandon or Temporarily Shutdown 566 Hybrid Real Options 568 Valuing Real Options 568 Decision Trees 569 Monte Carlo Simulation 569 Option Pricing Models 569 Conclusion 570 Endnotes 570 References 572 About the Authors 573 37 Using Derivatives to Manage Interest Rate Risk 575 Steven L. Byers Introduction 575 Forward-Based Instruments 575 Forward Rate Agreements 575 Interest Rate Futures Contracts 577 Basis Risk 578 Futures Hedge Ratio 579 Example of Hedging with Eurodollar Futures 580 Hedging a Portfolio of Coupon Bonds with Interest Rate Futures 581 Interest Rate Swaps 582 Option-Based Instruments 583 Interest Rate Guarantees 584 Interest Rate Caps and Floors 584 Swaptions 586 Mortgage Securitization Risk Management Using Interest Rate Derivatives 586
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton CONTENTS xix Conclusion 588 References 588 Suggested Further Reading 589 About the Author 589 Index 591
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P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton Introduction I n a time in which the ﬁnance industry is under attack and our entire ﬁnancial system is under remarkable stress, ﬁnancial derivatives are at the center of the storm. For the public at large, ﬁnancial derivatives have long been the most mysterious and least understood of all ﬁnancial instruments. While some ﬁnancial derivatives are fairly simple, others are admittedly quite complicated and require considerable mathematical and statistical knowledge to understand fully. With vast changes for our ﬁnancial system in prospect, there has never been a time in which those engaged in setting public policy and the concerned general public have a greater need for a general understanding of ﬁnancial derivatives. As the reader of this book will learn, ﬁnancial derivatives are instruments of remark- able power and very justiﬁable uses. However, as this text also freely acknowledges and explains, the very power of these ﬁnancial derivatives makes them subject to accident in the hands of the incautious and also makes them effective tools for mischief in the hands of the unscrupulous. To contribute to an improved public understanding of these markets, Finan- cial Derivatives explores the contemporary world of ﬁnancial derivatives, starting with a presumption of only a general knowledge of undergraduate ﬁnance. These chapters have been written by many leading ﬁgures in academics, industry, and government for the beneﬁt of advanced undergraduates, graduate students, prac- ticing ﬁnance professionals, and the general public. As such, the chapters in this book provide a comprehensive understanding of ﬁnancial derivatives. Financial Derivatives is comprised of 37 chapters organized into six parts: Part One, “Overview of Financial Derivatives,” provides an introduction to and an overview of the types of ﬁnancial derivatives, the markets in which they trade, and the way that traders use derivatives, and it also offers a broader perspec- tive addressing the question of the social function of derivatives markets. Against that background, Part Two, “Types of Financial Derivatives,” explores the variety of derivatives, starting with the agricultural and metallurgical derivatives that were historically the ﬁrst to be developed. This part also discusses ﬁnancial derivatives based on stock indexes, foreign currencies, energy, and interest rate instruments. It continues by giving an overview of the variety of exotic options and a type of exotic options known as an event derivative. Two chapters focus on credit default swaps and structured credit products that have allegedly played a central role in the recent crisis in ﬁnancial markets. Executive compensation is always controver- sial, it seems, and has generated particular outrage in the current crisis, so this part discusses executive stock options and concludes with an overview of some of the emerging ﬁnancial derivatives that are likely to become prominent in the future. xxi
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton xxii Introduction After having introduced the markets and types of derivatives in Parts One and Two, Part Three turns to an examination of “The Structure of Derivatives Markets and Institutions.” Chapter 17 analyzes the development and current state of derivatives markets, and subsequent chapters take on issues such as a survey of the participants in the market and the way in which transactions are fulﬁlled. Fulﬁllment is a critical part of the market, because this issue concerns the honoring and completion of contracts, without which no viable market can persist. Closely related to this is the issue of counterparty credit risk—the risk that one party to the derivatives contract might default on contractual obligations. This part also surveys the regulation of derivatives markets, along with the principles of accounting as they pertain to derivatives. The part concludes with a brief account of some of the most famous derivatives disasters of recent decades. Part Four, “The Pricing of Derivatives: Essential Concepts,” introduces the fundamentals of determining the price of derivatives. The part begins by introduc- ing the principle of no-arbitrage pricing. The ﬁrst condition of a well-performing market from the point of view of pricing is that prices in the market are such that arbitrage is impossible—where arbitrage can be deﬁned as the securing of a risk- less proﬁt without investment. With this background, the discussion turns to the pricing of particular instruments, such as forward and futures contracts. Next the part introduces the famous Black-Scholes option pricing model and then considers the various ways in which this seminal model has been extended and enhanced to apply to other derivatives. The part concludes with an analysis of the pricing of swap contracts. Part Five, “Advanced Pricing Techniques,” extends the pricing analysis ini- tiated in Part Four. The chapters in this part are more technical, beginning with showing how Monte Carlo methods can be applied to price derivatives. The dis- cussion of Monte Carlo techniques is immediately followed by a consideration of ﬁnite difference models, models that can be applied with great beneﬁt when analytical models are not available. Much of the pricing of derivatives turn on the path that the underlying good is presumed to follow. When this path is described statistically, the description is known as a stochastic process, an understanding of which is necessary to more sophisticated analysis. Finally, this part explores how option prices respond to changes in their various input values. Part Six, “Using Financial Derivatives,” concludes the book. By this time, the reader will be well aware that ﬁnancial derivatives are very valuable for managing risks and for providing information about the future prices of underlying goods. Financial derivatives can also be used as tools of quite sophisticated speculation. This part begins with an exploration of option strategies used in speculation and shows how the same strategies can also be used to reduce risk. Next comes a discussion of how hedge funds use ﬁnancial derivatives and, more exactly, how hedge funds use the techniques of ﬁnancial engineering. Financial derivatives are powerful tools for managing interest rate risk, as this part also explores. Chapter 36 examines real options, options based on physical assets or opportunities that ﬁrms possess. The book concludes with a discussion of how ﬁrms can use ﬁnancial derivatives to manage their own risks.
P1: OTA/XYZ P2: ABCfm JWBT151-Kolb September 10, 2009 8:40 Printer Name: Hamilton Acknowledgments T he editors would like to acknowledge the contribution of the many people who have made this volume possible. Our ﬁrst debt is to the many scholars who shared their knowledge by writing the chapters that comprise this text. We would like to also thank George Lobell, editor at John Wiley & Sons, Inc., for his vision of the series in which this volume appears and his encouragement of the series in general and this text in particular. Also at John Wiley, we would like to offer our thanks to the editorial team of Pamela Van Giessen, William Falloon, and Laura Walsh for their continuing support of and commitment to this project. xxiii
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P1: OTA/XYZ P2: ABCc01 JWBT151-Kolb September 10, 2009 8:42 Printer Name: Hamilton PART I Overview of Financial Derivatives art One consists of four introductory chapters intended to open the world of P ﬁnancial derivatives to the reader. In Chapter 1, “Derivative Instruments: Forwards, Futures, Options, Swaps, and Structured Products,” Gary D. Koppenhaver takes a generalist approach to forwards, futures, swaps, and op- tions. He approaches these instruments from the point of view of their suitability to address a single problem: managing ﬁnancial risk. Through this approach, he shows that these instruments obey common principles and are closely related from a conceptual point of view. Koppenhaver strives to emphasize the connec- tions among these different types of derivatives in order to demystify derivatives in general. One of the largest differences among derivatives turns on the manner in which they are traded—on exchanges or in the more informal and less structured over- the-counter market? Sharon Brown-Hruska contrasts these two models for trad- ing derivatives in Chapter 2, “The Derivatives Marketplace: Exchanges and the Over-the-Counter Market.” In light of the ﬁnancial crisis, many legislators are pressing to reduce or eliminate the over-the-counter market, which is actually much larger than the market for exchange-traded derivatives. However, many be- lieve that trading derivatives on exchanges make them more transparent, easier to regulate, and less likely to lead to derivatives disasters. From the point of view of derivatives, we might think of speculation as trading derivatives in a manner that increases the investor’s risk in order to pursue proﬁt. Hedging by contrast is trading derivatives in order to reduce a preexisting risk. In Chapter 3, “Speculation and Hedging,” Gregory Kuserk shows how hedging and speculation differ but also explains how one might think of hedging and speculating as two sides of the same coin, with the relationship between the two activities being much closer than is generally recognized. The editors of this volume believe that Chapter 4 by Christopher L. Culp, “The Social Function of Financial Derivatives,” is one of the most important in the entire volume. As discussed in the introduction to this book, there is a recurring impulse to eliminate derivatives markets through legislative action. Culp shows how derivatives markets serve society in a variety of ways, some of which are quite obvious and others of which are more sophisticated. 1
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P1: OTA/XYZ P2: ABCc01 JWBT151-Kolb September 10, 2009 8:42 Printer Name: Hamilton CHAPTER 1 Derivative Instruments Forwards, Futures, Options, Swaps, and Structured Products G. D. KOPPENHAVER Professor and Chair, Department of Finance, Insurance and Law, Illinois State University INTRODUCTION The evolution of ideas in ﬁnance usually is driven by circumstances in ﬁnancial markets. In the early 1980s, at the inception of cash-settled ﬁnancial futures con- tracts, the term derivatives was most often associated with ﬁnancial rocket science. Esoteric derivative contracts, especially on ﬁnancial instruments, faced a public relations probem on Main Street. By the mid-1990s, the term derivatives carried a negative connotation that conservative ﬁrms avoided. High-proﬁle derivative mar- ket losses by nonﬁnancial ﬁrms, such as Metallgesellschaft AG, Procter & Gamble Co., and Orange County, California, caused boards of directors to look askance at derivatives positions.1 In the early 2000s, however, derivatives and their use are a real part of a discussion of business tactics. While it is still the case that derivatives contracts are a powerful tool that could damage proﬁtability if used incorrectly, the discussion today does not focus on why derivative contracts are used but how and which derivative contracts to use. The goal of this chapter is to take a generalist approach to closely related in- struments designed to deal with a single problem: managing ﬁnancial risk.2 In the chapter, forwards, futures, swaps, and options are not treated as unique in- struments that require specialized expertise. Rather the connection between each class of derivative contracts is emphasized to demystify derivatives in general. As off–balance sheet items, each is an unfunded contingent obligation of contract counterparties. Later in the chapter, the discussion returns full circle to consider the creation of funded obligations with derivative contracts, called structured prod- ucts. Structured products are ﬁnancial instruments that combine cash assets and/or derivative contracts to offer a risk/reward proﬁle that is not otherwise available or is already offered but at a relatively high cost. The repackaging of off–balance sheet credit derivatives into an on–balance sheet claim is shown through a structured investment vehicle example. Uncertainty is a hallmark of today’s global ﬁnancial marketplace. Unexpected movements in exchange rates, commodity prices, and interest rates affect 3
P1: OTA/XYZ P2: ABCc01 JWBT151-Kolb September 10, 2009 8:42 Printer Name: Hamilton 4 Overview of Financial Derivatives earnings and the ability to repay claims on assets. Great cost efﬁciency, state-of- the-art production techniques, and superior management are not enough to ensure ﬁrm proﬁtability over the long run in an uncertain environment. Risk management is based on the idea that ﬁnancial price and quantity risks are an ever-increasing challenge to decision making. In responding to uncertainty, decision makers can act to avoid, mitigate, transfer, or retain a commercial risk. Because entities are in business to bear some commercial risk to reap the expected rewards, the mitigation or transfer of unwanted risk and the retention of acceptable risk is usually the out- come of decision making. Examples of risk mitigation activities include forecasting uncertain events and making decisions that affect on–balance sheet transactions to manage risk. The transfer of unwanted risk with derivative contracts, however, is a nonintrusive, inexpensive alternative, which helps explain the popularity of derivatives contracting. Consider Exhibits 1.1 through 1.4 as part of the historical record of volatility in ﬁnancial markets. Exhibit 1.1 illustrates the monthly percentage change in the Japanese yen/U.S. dollar exchange rate following the breakdown of the Bretton Woods Agreement in the early 1970s. The subsequent exchange rate volatility helped create a successful Japanese yen futures contract in Chicago. In Exhibit 1.2, the monthly percentage change in a measure of the spot market in petroleum is illustrated. While signiﬁcant spikes in price occur around embargos or conﬂict in the Middle East, price volatility has not lessened over time for this important input to world economies. U.S. interest rates are also a source of uncertainty. The change in Federal Reserve operating procedures in the late 1970s temporarily increased volatility, but signiﬁcant uncertainty in Treasury yields has remained over time. Monthly 8 6 4 2 % Change 0 –2 –4 –6 –8 –10 1 3 5 7 9 1 3 5 7 9 91 93 95 97 99 01 03 05 /7 /7 /7 /7 /7 /8 /8 /8 /8 /8 / / / / / / / / Fe b Fe b Fe b Fe b Fe b Fe b Fe b Fe b Fe b Feb Feb Feb Feb Feb Feb Feb Feb Feb Exhibit 1.1 Percent Change in Yen/U.S. $ Exchange Rate
P1: OTA/XYZ P2: ABCc01 JWBT151-Kolb September 10, 2009 8:42 Printer Name: Hamilton DERIVATIVE INSTRUMENTS 5 Spot Market, Monthly 60 50 40 30 20 % Change 10 0 –10 –20 –30 –40 /7 1 /7 3 /7 5 /7 7 /7 9 /8 1 /8 3 85 /87 /89 /91 /93 /95 /97 /99 /01 /03 /05 b b b b b b b b/ b b b b b b b b b b Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Exhibit 1.2 Percent Change in West Texas Oil Prices Exhibit 1.4 illustrates the past history of default risk premiums. Most recently, a sharp spike in default risk premiums occurred at the end of the stock market technology bubble in the early 2000s. Across all graphs, it should be clear that uncertainty in economically important markets is not decreasing over time and that the effectiveness of forecasting changes in prices, rates, or spreads as a method to mitigate the uncertainty is not likely to be high. Constant Maturity, Monthly 1.50 1.00 0.50 Percentage Points 0.00 –0.50 –1.00 –1.50 1 3 5 7 9 1 3 5 7 9 1 3 5 7 9 1 3 5 b /7 b /7 b /7 b /7 b /7 b /8 b /8 b/8 b/8 b/8 b/9 b/9 b/9 b/9 b/9 b/0 b/0 b/0 Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Fe Exhibit 1.3 Change in 5-Year Treasury Yield
P1: OTA/XYZ P2: ABCc01 JWBT151-Kolb September 10, 2009 8:42 Printer Name: Hamilton 6 Overview of Financial Derivatives Baa Over Aaa Corporate Yields, Monthly 0.8 0.6 0.4 Percentage Points 0.2 0 –0.2 –0.4 –0.6 1 3 5 7 9 1 3 5 7 9 1 3 5 7 9 1 3 5 n /7 n/7 n/7 n/7 n/7 n/8 n/8 n/8 n/8 n/8 n/9 n/9 n/9 n/9 n/9 n/0 n/0 n/0 Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Ja Exhibit 1.4 Credit Risk Premium Change A GENERALIST’S APPROACH TO DERIVATIVE CONTRACTS What are derivative contracts? A derivative contract is a delayed delivery agree- ment whose value depends on or is derived from the value of another, underlying transaction. The underlying transaction may be from a market for immediate de- livery (spot or cash market) or from another derivative market. A key point of the deﬁnition is that delivery of the underlying is delayed until sometime in the future. Economic conditions will not remain static over time; changing economic conditions can make the delayed delivery contract more or less valuable to the initial contract counterparties. Because the contract obligations do not become real until a future date, derivative contract positions are unfunded today, are carried off the balance sheet, and the ﬁnancial requirements for initiating a derivative contract are just sufﬁcient for a future performance guarantee of counterparty obligations. Before beginning a discussion of contract types, it is helpful to depict the proﬁles of the commercial risks being managed with derivative contracts. The ﬁrst step in any risk management plan is to accurately assess the exposure facing the decision maker. Consider Exhibit 1.5, which plots the expected change in the value of a ﬁrm, ∆V, as a function of the unexpected change in a ﬁnancial price, ∆P. The price could be for a ﬁrm output or for a ﬁrm input. The dashed line indicates that as the price increases (∆P > 0) unexpectedly, the value of the ﬁrm falls. The speciﬁc relationship is consistent with many conditions, such as an unexpected rise in input cost, a loss of signiﬁcant market share as output prices unexpectedly rise, or even a rise in the price of a ﬁxed income asset due to an unexpected decline in yields. The key is simply that the unexpected price rise causes the expected value of the enterprise to fall.