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Derivatives and Risk Management

Name: Derivatives and Risk Management
Author: Sundaram Janakiramanan
ISBN: 9788131755143

by Sundaram Janakiramanan

February 2011

Beginner to intermediate

536 pages

22h 7m

English

Pearson India

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Cover
Title Page
Contents
About the Author
Dedication
Preface
1 - Introduction
Learning Objectives1.1 - What are Derivatives?1.2 - Derivatives Markets1.3 - Forward Contracts1.4 - Futures Contracts1.5 - Options Contracts1.6 - Swap Contracts1.7 - Uses of Derivatives1.8 - What is Risk?1.8.1 - Operating or Business Risk1.8.2 - Event Risk1.8.3 - Price Risk1.9 - Risk Management1.10 - A Brief History of Risk Management1.11 - Implications for Hedging1.12 - Upside and Downside Risks1.13 - Commodity Price Risk1.13.1 - Volatility1.13.2 - Liquidity1.14 - Interest Rate Risk1.14.1 - Deregulation and Interest Rate as a Tool for Developing Monetary Policy1.14.2 - Floating Rate Loans1.14.3 - Interest Rates and Inflation1.14.4 - Components of Interest Rate Risk1.15 - Currency Risk1.16 - Approaches to Risk Management1.17 - Risks in Derivatives TradingChapter SummaryReview QuestionsProblemsCase Study
2 - The Derivatives Market in India
Learning Objectives2.1 - The International Derivatives Market2.2 - Derivatives in India2.3 - Operations of Derivatives Exchanges2.4 - The Trading System2.4.1 - Types of Orders2.4.2 - Order-matching Rules2.4.3 - Order Conditions2.5 - The Clearing and Settlement System2.5.1 - The Members of the Clearing House2.5.2 - The Clearing Mechanism2.5.3 - Margin and Margin Accounts2.5.4 - The Settlement System2.5.5 - Risk Management2.6 - The Trading Process2.7 - Online Trading2.8 - The OTC Derivatives Market2.9 - The Regulation of Derivatives Trading in IndiaChapter SummaryReview QuestionsExhibit 2.1
3 - Interest Rates
Learning Objectives3.1 - What is Interest Rate?3.2 - Simple and Compound Interest Rates3.3 - Future Value and Present Value3.3.1 - Present Value3.4 - Effective Interest Rates for Different Compounding Periods3.4.1 - Present Value for Different Compounding Periods3.4.2 - Relation between Rate under Continuous Compounding and Rate under Compounding for m Periods3.5 - Risk-free Interest Rate3.5.1 - Interest Rate Risk3.5.2 - Default Risk3.5.3 - Call Risk3.5.4 - Liquidity Risk3.6 - Risk-free Rates3.6.1 - Government Security3.6.2 - Interbank Rates3.6.3 - Repurchase Agreement Rate (Repo Rate)3.7 - Interest Rate Risk and Forward Rates3.8 - Term Structure of Interest Rates3.8.1 - Implied Forward Rates3.8.2 - Why Implied Forward Rates?3.8.3 - Calculating Implied Forward Rate from Coupon BondsChapter SummaryReview QuestionsProblemsCase Study
4 - Forward Contracts
Learning Objectives4.1 - What is a Forward Contract?4.2 - The Purpose of Forward Contracts4.3 - Advantages of Forward Contracts4.4 - Problems with Forward Contracts4.4.1 - Parties with Matching Needs4.4.2 - Non-performance4.4.3 - Non-transferability4.5 - The Pricing of Commodity Forward Contracts4.6 - Currency Forward Contracts4.6.1 - The Operation of the Currency Forward Market4.6.2 - Characteristics of Currency Forward Contracts4.6.3 - The Pricing of Currency Forward Contracts4.6.4 - Covered Interest Arbitrage4.6.5 - Rolling over Currency Forward Contracts4.7 - Interest Rate Forwards4.7.1 - Mechanics of FRAs4.7.2 - The FRA Payment Amount4.7.3 - An Alternative View of an FRA and the Settlement Amount4.7.4 - Uses of FRAs4.8 - Non-deliverable ForwardsChapter SummaryReview QuestionsProblemsCase Study

5 - Futures Contracts
Learning Objectives5.1 - What is a Futures Contract?5.2 - Futures Contracts Versus Forward Contracts5.2.1 - Negotiability5.2.2 - Standardization5.2.3 - Liquidity5.2.4 - Performance5.2.5 - Cash Needs5.2.6 - Ability to Reduce Losses5.3 - Participants in Futures Markets5.3.1 - Hedgers5.3.2 - Speculators5.3.3 - Arbitragers5.4 - Specifications of Futures Contracts5.4.1 - The Underlying Asset5.4.2 - The Contract Size5.4.3 - Delivery Arrangements: Location5.4.4 - Delivery Arrangements: Alternative Grade5.4.5 - Delivery Month5.4.6 - Delivery Notification5.4.7 - Daily Price Movement Limits5.4.8 - Position Limits5.5 - Closing out the Positions5.6 - Arbitrage between the Futures Market and the Spot Market5.7 - Performance of Contracts5.8 - The Clearinghouse5.9 - Margins and Marking-to-Market5.10 - Price Quotes5.11 - Settlement Price5.12 - Open Interest5.13 - The Pattern of Prices5.14 - The Relation between Futures Price and Spot Price5.15 - Delivery5.16 - Cash Settlement5.17 - Types of Orders5.17.1 - Market Orders5.17.2 - Limit Orders5.17.3 - Stop Orders5.17.4 - Stop–Limit Orders5.17.5 - Other Orders5.18 - How to Trade in Futures?5.19 - Pricing of Futures ContractsChapter SummaryReview QuestionsProblemsCase Study
6 - Hedging Strategies Using Futures
Learning Objectives6.1 - The Principles of Hedging6.2 - Long Hedges6.3 - Short Hedges6.4 - Should Hedging be Undertaken?6.5 - Risks in Hedging6.6 - Basis Risk6.7 - Factors Affecting Basis Risk6.8 - The Hedge Ratio6.9 - Static and Dynamic Hedging6.10 - Strip Hedges and Stack Rolling Hedges6.11 - Losses from Hedging Using FuturesChapter SummaryReview QuestionsProblemsCase Study
7 - Single Stock Futures and Stock Index Futures
Learning Objectives7.1 - Single Stock Futures7.2 - What is a Stock Futures Contract?7.3 - Hedging Using Single Stock Futures7.3.1 - What Type of Hedging is Appropriate?7.3.2 - Which Instrument to Use?7.3.3 - How Many Contracts to Use?7.3.4 - When to Take an Open Position?7.3.5 - When to Close the Position?7.3.6 - Risks in Hedging Using Single Stock Futures7.4 - Speculation Using Stock Futures7.5 - Pricing of Single Stock Futures Contracts7.6 - Single Stock Futures and Arbitrage7.7 - Using Stock Futures for Insurance Purposes7.8 - Using Stock Futures for Investment Purposes7.9 - Stock Indexes7.10 - Stock Index Futures7.11 - Stock Index Futures Contracts Traded on the BSE and the NSE7.12 - How do Index Futures Work?7.13 - Pricing of Index Futures Contracts7.14 - Speculation Using Index Futures7.15 - Portfolio Insurance Using Index Futures7.16 - Index Arbitrage7.17 - Program Trading7.18 - Hedging the Value of a Portfolio of Shares Using Index Futures7.19 - Adjusting Equity Portfolio Beta Using Index Futures7.20 - Issues in Using Index FuturesChapter SummaryReview QuestionsProblemsCase Study
8 - Interest Rate Futures
Learning Objectives8.1 - The Impact of Interest Rate Risk and the Need for Hedging8.2 - Interest Rate Futures in India8.3 - Contract Specification8.4 - Conversion Factor8.5 - Cheapest-to-deliver Bonds8.6 - The Pricing of Bond Futures8.7 - Uses of Long-term Interest Rate Futures8.7.1 - Directional Trading8.7.2 - Arbitrage8.7.3 - Calendar-spread Trading8.7.4 - Hedging8.7.5 - Fixed Income Portfolio Management8.7.6 - Changing a Fixed Income Loan to a Floating-rate Loan8.8 - Short-term Interest Rate Futures8.9 - Pricing of T-bill Futures Contracts8.10 - Hedging Using Bill Futures Contracts8.11 - Uses of Short-term Interest Rate Futures Contracts8.11.1 - Hedging Borrowing Costs8.11.2 - Hedging an Investment Yield8.11.3 - Hedging a Floating-rate Loan or Strip Hedging8.11.4 - Directional Trades8.11.5 - Spread Trades8.11.6 - Arbitrage Transactions8.11.7 - Adjusting the Duration of the Portfolio8.11.8 - Cross-hedging8.12 - Cautions in Using Interest Rate FuturesChapter SummaryReview QuestionsProblemsCase Study
9 - Currency Futures
Learning Objectives9.1 - What are Currency Futures?9.2 - The Specifications of Exchange-traded Currency Futures Contracts9.3 - The Pricing of Currency Futures9.4 - Hedging with Currency Futures9.5 - Basis Risk While Using Currency Futures9.6 - Speculation Using Currency Futures9.7 - Arbitraging with Currency Futures ContractsChapter SummaryReview QuestionsProblemsCase Study
10 - Swaps
Learning Objectives10.1 - What are Swaps?10.2 - Types of Swaps10.3 - Terminologies in Swaps10.4 - Interest Rate Swaps10.5 - Swap Rates10.6 - Rationale for Swap Arrangements10.7 - Swap with Intermediaries10.8 - Forward Swaps10.9 - Swaptions10.10 - Uses of Interest Rate Swaps10.11 - Valuation of Interest Rate Swaps10.12 - Currency Swaps10.12.1 - Differences between an Interest Rate Swap and a Currency Swap10.12.2 - Basic Structure of Currency Swaps10.13 - Currency Risk in Currency Swaps10.14 - Comparative Advantages of Currency Swaps10.15 - Uses of Currency Swaps10.16 - The Valuation of a Currency Swap10.17 - Equity Swaps10.18 - The Valuation of an Equity Swap10.19 - Commodity Swaps10.20 - Risks While Entering into Interest Rate SwapsChapter SummaryReview QuestionsProblemsCase Study
11 - Fundamentals of Options
Learning Objectives11.1 - Options Issued by Corporations11.1.1 - Warrants11.1.2 - Employee Stock Options11.1.3 - Convertible Bonds11.1.4 - Callable Bonds11.1.5 - Put Bonds11.1.6 - Rights11.2 - Options Contracts between Private Parties11.3 - Exchange-traded Options11.4 - Options Contracts: An Example11.5 - What is an Options Contract?11.6 - Options Terminologies11.6.1 - The Underlying Asset11.6.2 - Call and Put Options11.6.3 - The Option Premium11.6.4 - Exercising Options11.6.5 - The Exercise Price or the Strike Price11.6.6 - The Exercise Date or the Strike Date11.6.7 - American and European Options11.6.8 - Buyers and Writers of Options11.6.9 - The Contract Size11.6.10 - In-the-money, At-the-money and Out-of-money Options11.7 - Exchange-traded and OTC Options: A Comparison11.7.1 - Guarantee of Performance in Exchange-traded Options11.7.2 - Margin Requirements11.7.3 - Margin Calculation11.7.4 - Standardization of Contracts11.7.5 - Exercise Dates11.7.6 - Exercise Prices11.7.7 - Options Classes and Options Series11.8 - Trading of Options11.8.1 - Types of Orders11.8.2 - Offsetting Orders11.9 - Price Quotes11.10 - Protection Against Corporate ActionsChapter SummaryReview QuestionsProblemsCase Study
12 - Call and Put Options
Learning Objectives12.1 - What are Call Options?12.2 - The Terminal Value of a Call Option12.3 - Gains and Losses from Purchasing Call Options12.4 - Value of a Call Option Before Maturity12.5 - Minimum and Maximum Values of a Call12.6 - When to Exercise an American Call Option12.7 - From a Call Option Writer's Point of View12.7.1 - The Terminal Value of a Written Call12.7.2 - Gains and Losses for a Call Writer12.8 - Comparison between the Gains Made by a Call Buyer and a Call Writer12.9 - When to Buy and When to Write a Call Option?12.10 - Put Options12.10.1 - What are Put Options?12.10.2 - Rationale for Put Options12.11 - The Terminal Value of a Put Option12.12 - Gains and Losses from Purchasing Put Options12.13 - Value of a Put Option Before Maturity12.14 - Minimum and Maximum Values of Put12.15 - When to Exercise a Put Option12.16 - From a Put Option Writer's Point of View12.16.1 - The Terminal Value of a Written Put12.16.2 - Gains and Losses for a Put Writer12.17 - Comparison between the Gains Made by a Put Buyer and a Put Writer12.18 - When to Buy and When to Write a Put Option12.19 - Comparison between Calls and PutsChapter SummaryReview QuestionsProblemsCase Study
13 - Combinations of Options: Trading Strategies
Learning Objectives13.1 - Naked or Uncovered Positions13.1.1 - Naked Long Stock Positions13.1.2 - Naked Short Stock Positions13.1.3 - Naked Bought Calls13.1.4 - Naked Written Calls13.1.5 - Naked Bought Puts13.1.6 - Naked Written Puts13.2 - Hedge or Covered Positions13.2.1 - Covered Call Writing13.2.2 - Reverse Hedges13.2.3 - Protective Puts13.2.4 - Short Stocks and Short Puts13.2.5 - Partial Hedges13.2.6 - Summary of Hedged Positions13.3 - Spread Positions13.3.1 - Money Spread Using Calls13.3.2 - Money Spreads Using Puts13.3.3 - Box Spreads13.3.4 - Butterfly Spreads13.3.5 - Calendar Spreads13.3.6 - Iron Condor Spreads13.4 - Combinations of Puts and Calls13.4.1 - Straddles13.4.2 - Strips13.4.3 - Straps13.4.4 - Strangles13.4.5 - Other Pay-offs13.5 - Losses from Options TradingChapter SummaryReview QuestionsProblemsCase Study
14 - Put–Call Parity
Learning Objectives14.1 - Risk-free Security14.2 - Strategies Using Options, a Risk-free Security and Underlying Assets14.2.1 - Combination of Call Options and Risk-free Securities14.2.2 - Combination of Long Stocks and Long Puts14.3 - The Put–Call Relationship14.4 - Put–Call Arbitrage14.5 - Creation of Synthetic Securities14.5.1 - Creation of Synthetic Puts14.5.2 - The Written Put Strategy14.5.3 - The Bought Call Strategy14.5.4 - The Written Call Strategy14.5.5 - The Strategy of Investing at a Risk-free Rate14.5.6 - The Strategy for Borrowing at a Risk-free Rate14.5.7 - Cautions in Creating Synthetic Positions14.6 - Put–Call Parity for Dividend-paying Stocks: European Options14.7 - Put–Call Parity for American Options14.7.1 - Early Exercise of American Call Options: Non-dividend-paying Stock14.7.2 - Early Exercise of Call Options: Dividend-paying Stock14.7.3 - Early Exercise of Put Options: Non-dividend-paying Stock14.7.4 - Put–Call Parity for American Options When Dividends are Not Paid14.7.5 - Put–Call Parity for American Options When Dividends are Paid14.8 - Implications of Put–Call Parity14.9 - Put–Call Parity and Regulatory ArbitrageChapter SummaryReview QuestionsProblemsCase Study
15 - The Binomial Options Pricing Model
Learning Objectives15.1 - The Binomial Options Pricing Model for Call Options15.2 - The Binomial Options Pricing Model for Put Options15.3 - The Relation between the Hedge Ratios for Call and Put Options15.4 - The No-arbitrage Pricing Argument15.5 - The Derivation of the Binomial Options Pricing Model15.6 - The Single-period Binomial Options Pricing Model15.7 - The Two-period Binomial Options Pricing Model15.8 - The Multi-period Binomial Options Pricing Model15.9 - The Determination of u and d15.10 - The Valuation of a European Call Paying a Given Dividend Amount15.11 - The Valuation of an American Call Paying a Given Dividend Amount15.12 - The Binomial Put Options Pricing ModelChapter SummaryReview QuestionsProblemsCase Study
16 - The Black–Scholes Options Pricing Model
Learning Objectives16.1 - The History of Options Pricing Research16.2 - Stock Price Behaviour16.2.1 - Lognormal Distribution16.2.2 - The Valuation of Options16.3 - The Assumptions in the Black–Scholes Options Pricing Model16.4 - The Black–Scholes Model for Pricing Call Options16.5 - The Black–Scholes Model for Pricing Put Options16.6 - Determinants of Options Prices16.6.1 - The Current Price of the Underlying Asset16.6.2 - The Exercise Price16.6.3 - The Time to Expiration16.6.4 - Volatility of the Underlying Asset16.6.5 - The Risk-free Rate16.7 - The Options Pricing Model for Securities that Pay Known Dividends16.8 - Volatility16.9 - Implied Volatility16.10 - Volatility SmileChapter SummaryReview QuestionsProblemsCase Study
17 - Currency Options, Interest Rate Options and Options on Futures
Learning Objectives17.1 - Currency Options17.2 - Interest Rate Options17.2.1 - Bond Options17.2.2 - Embedded Bond Options17.2.3 - Interest Rate Options17.3 - Interest Rate Caps, Floors and Collars17.3.1 - Interest Rate Caps17.3.2 - Interest Rate Floors17.3.3 - Interest Rate Collars17.4 - Pricing Interest Rate Options17.5 - Valuing an Interest Rate Cap or Floor17.6 - Options on Futures or Futures Options17.6.1 - Model for Valuing Options on Futures ContractsChapter SummaryReview QuestionsProblemsCase Study
18 - Greeks in Options
Learning Objectives18.1 - Risks in Options Trading18.2 - Characteristics of Options Hedging18.2.1 - The Naked Position18.2.2 - The Covered Position18.2.3 - Hedging Through the Cap18.3 - Greeks in Options Hedging18.4 - Delta18.4.1 - The Use of Futures in Delta Hedging18.4.2 - The Delta of a Portfolio18.5 - Gamma18.5.1 - Making a Portfolio Gamma-neutral18.5.2 - Calculating Gamma18.6 - Theta18.7 - The Relationship between Delta, Gamma and Theta18.8 - Vega18.9 - Rho18.10 - Creating Portfolio Insurance Using Synthetic Puts18.11 - Hedging Options Positions in PracticeChapter SummaryReview QuestionsProblemsCase Study
19 - Exotic Options
Learning Objectives19.1 - Differences between Plain Vanilla Options and Exotic Options19.2 - Asian Options19.3 - Barrier Options19.3.1 - Down-and-out Options19.3.2 - Down-and-in Options19.3.3 - Up-and-in Barrier Options19.3.4 - Up-and-out Barrier Options19.4 - Chooser Options19.5 - Compound Options19.6 - Digital or Binary Options19.7 - Exchange Options19.8 - Basket Options19.9 - Bermudan Options19.10 - Cliquet/Ratchet Options19.11 - Coupe Options19.12 - Extendible Options19.13 - Hawaiian Options19.14 - Instalment Options19.15 - Israeli Options19.16 - Parisian Options19.17 - Passport Options19.18 - Rainbow Options19.19 - Russian Options19.20 - Shout Options19.21 - Spread Options19.22 - Quanto Options19.23 - Forward Start Options19.24 - Edokko Options or Tokyo Options19.25 - Lookback Options19.26 - Extreme Spread Options19.27 - Mountain Range OptionsChapter SummaryReview Questions
20 - Credit Derivatives
Learning Objectives20.1 - An Introduction to Credit Derivatives20.2 - Credit Risk20.3 - What are Credit Derivatives?20.4 - Basic Credit Derivatives Structures20.5 - Credit Default Swaps20.5.1 - Credit Events20.5.2 - Contingent Payments20.5.3 - Notional Value20.5.4 - Protection Buyers20.5.5 - Protection Sellers20.5.6 - Premium20.5.7 - The Tenure20.5.8 - The Threshold Risk20.5.9 - The Settlement20.6 - An Example of a CDS20.7 - Counterparty Risk and Synthetic Lending20.8 - Contingent Credit Swaps20.9 - Dynamic Credit Swaps20.10 - Total Return Swaps20.11 - Credit Options20.12 - Credit-linked Notes20.13 - Credit Derivatives Versus Financial Guarantee Products
Notes
Chapter 2
Chapter 4
Chapter 5
Chapter 9
Chapter 20
Bibliography
Glossary
Acknowledgements
Copyright

Content preview from Derivatives and Risk Management

1 Introduction

LEARNING OBJECTIVES

After completing this chapter, you will be able to answer the following questions:

What are derivatives and what are the main uses of derivatives?
What are forwards, futures, options, and swaps?
What are risks and how do they affect businesses?
What are commodity price risks, interest rate risks, and currency risks?
Why is it important to manage risks?
What is meant by hedging?
What are the approaches to risk management?

BOX 1.1 Caution While Using Derivatives

While dealing with derivatives, a number of points are to be kept in mind. First, a derivative contract is based on a zero-sum game, which means that for every person who makes money from derivatives, there must be one loser. Second, many derivative ...

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Derivatives and Risk Management

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