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Derivatives and Risk Management

Book Description

Through the incorporation of real-life examples from Indian organizations, Derivatives and Risk Management provides cutting-edge material comprising new and unique study tools and fresh, thought-provoking content. The organization of the text is designed to conceptually link a firm's actions to its value as determined in the derivatives market. It addresses the specific needs of Indian students and managers by successfully blending the best global derivatives and risk management practices with an in-depth coverage of the Indian environment.

Table of Contents

  1. Cover
  2. Title Page
  3. About the Authors
  4. Brief Contents
  5. Contents
  6. Preface
  7. PART 1 – BASIC PRINCIPLES OF DERIVATIVES
    1. 1. Risk Management with Derivatives
      1. 1.1 Introduction
      2. 1.2 Market Risk and Economic Stability
      3. 1.3 Types of Risks and Risk Management Practices of Firms
        1. 1.3.1 Types of risks
        2. 1.3.2 Operating risk
        3. 1.3.3 Financial risk
        4. 1.3.4 Systems risk
        5. 1.3.5 Event risk
        6. 1.3.6 Active and passive hedging strategies
      4. 1.4 Benefits of Hedging
      5. 1.5 Hedging Tools
      6. 1.6 Trading in Derivatives
      7. 1.7 Derivative Instruments as Investments
      8. 1.8 Scope and Limitations
      9. Chapter Summary
      10. Key Terms
      11. Discussion Questions
      12. Case for Analysis
      13. Suggested Readings
    2. 2. Derivative Markets
      1. 2.1 Introduction
      2. 2.2 Development of Derivative Markets
      3. 2.3 Derivative Markets in India
        1. 2.3.1 Economic impact of derivative markets
        2. 2.3.2 Commodity derivatives
        3. 2.3.3 Equity derivatives
        4. 2.3.4 Interest-rate derivatives
        5. 2.3.5 Currency derivatives
      4. 2.4 Derivative Market Structure
        1. 2.4.1 Exchange-traded derivative market
        2. 2.4.2 OTC derivative market
      5. 2.5 Derivative Segments in Markets
        1. 2.5.1 National Stock Exchange (NSE)
        2. 2.5.2 Multi-commodity exchange
        3. 2.5.3 Chicago mercantile exchange
      6. 2.6 Trading Functions and Mechanism
        1. 2.6.1 Derivative trading mechanism in an exchange
        2. 2.6.2 OTC derivatives trading mechanism
      7. 2.7 Clearing Mechanism in Derivative Markets
        1. 2.7.1 Exchange-traded clearing facility
        2. 2.7.2 Clearing of derivative trades in OTC markets
      8. 2.8 Risk Mitigation in the Derivative Market
        1. 2.8.1 Counterparty risk
        2. 2.8.2 Operational risk
        3. 2.8.3 Legal risk
        4. 2.8.4 Liquidity risk
        5. 2.8.5 Systemic risk
      9. 2.9 Desired Derivative Market Characteristics
      10. 2.10 Effectiveness of Derivative Exchange
        1. 2.10.1 Product innovation
        2. 2.10.2 Technological innovation
      11. Chapter Summary
      12. Key Terms
      13. Discussion Questions
      14. Case for Analysis
      15. Net-Wise Exercises
      16. Suggested Readings
    3. 3. Derivative Market Regulation in India
      1. 3.1 Introduction
      2. 3.2 Commodity Derivative Market Regulation
        1. 3.2.1 Participants in indian commodity derivative markets
        2. 3.2.2 Derivative market regulation
        3. 3.2.3 Eligibility criteria for commodity derivative contracts
        4. 3.2.4 Trading system
        5. 3.2.5 Margin requirements
      3. 3.3 Securities Derivative Market Regulation
        1. 3.3.1 Participants in the indian equity derivative market
        2. 3.3.2 Derivative market regulation
        3. 3.3.3 Eligibility criteria for introducing derivative contracts on stocks
        4. 3.3.4 Trading system
        5. 3.3.5 Margin system
      4. 3.4 Interest-Rate Derivative Market Regulation
        1. 3.4.1 Derivative market participants in india
        2. 3.4.2 Derivative market regulation
        3. 3.4.3 Eligibility criteria
        4. 3.4.4 Risk management
      5. 3.5 Currency Derivative Market Regulation
        1. 3.5.1 Participants in the indian derivative market
        2. 3.5.2 Derivative market regulation
      6. 3.6 Structured Credit Derivatives Market Regulation
        1. 3.6.1 Participants in the indian derivative market
        2. 3.6.2 Derivative market regulation
      7. Chapter Summary
      8. Key Terms
      9. Discussion Questions
      10. Suggested Readings
    4. 4. Forward and Futures Instruments
      1. 4.1 Introduction
      2. 4.2 Forward Instruments
      3. 4.3 Forward Rate Agreements (FRAs)
      4. 4.4 Futures Instruments
        1. 4.4.1 Commodity futures
        2. 4.4.2 Security futures
        3. 4.4.3 Currency futures
        4. 4.4.4 Interest rate futures
      5. 4.5 Differences Between Forward and Futures Contracts
      6. 4.6 Futures Instruments for Asset Allocation—Security Futures
      7. 4.7 Futures as Portfolio Insurance—Index Futures
      8. 4.8 Price Discovery in the Futures Market
      9. Chapter Summary
      10. Key Terms
      11. Discussion Questions
      12. Problems
      13. Case for Analysis
      14. Net-Wise Exercises
      15. Suggested Readings
    5. 5. Swap Instruments
      1. 5.1 Introduction
      2. 5.2 Swaps
      3. 5.3 Vanilla Swaps
      4. 5.4 Amortizing Swap
      5. 5.5 Forward Swap
      6. 5.6 Basis Swap
      7. 5.7 Constant Maturity Swap
      8. 5.8 Yield Curve Swap
      9. 5.9 Rate Differential Swap
      10. 5.10 Corridor Swap
      11. 5.11 Uses of Swap Instruments
      12. Chapter Summary
      13. Key Terms
      14. Discussion Questions
      15. Problems
      16. Case for Analysis
    6. 6. Option Instruments
      1. 6.1 Introduction
      2. 6.2 Features of Option Instruments
      3. 6.3 Index Options
      4. 6.4 Currency Options
      5. 6.5 Interest Rate Options
        1. 6.5.1 Intrinsic and time value of interest rate option contracts
        2. 6.5.2 Interest rate caps
        3. 6.5.3 Interest rate floors
      6. 6.6 Swaptions
      7. Chapter Summary
      8. Key Terms
      9. Discussion Questions
      10. Problems
      11. Case for Analysis
      12. Net-Wise Exercises
      13. 7. Derivative Option Strategies
      14. 7.1 Introduction
      15. 7.2 Synthetic Position
        1. 7.2.1 Synthetic treasury bill
        2. 7.2.2 Synthetic portfolio using futures
        3. 7.2.3 Synthetic long position in a security using options
        4. 7.2.4 Synthetic put option
        5. 7.2.5 Synthetic call option
      16. 7.3 Covered Position
        1. 7.3.1 Covered call option
        2. 7.3.2 Covered put option
      17. 7.4 Spread
        1. 7.4.1 Bull spread using call options
        2. 7.4.2 Bull spread using put options
        3. 7.4.3 Bear spread using call options
        4. 7.4.4 Bear spread using put options
      18. 7.5 Combo
        1. 7.5.1 Long combo
        2. 7.5.2 Short combo
      19. 7.6 Straddle
        1. 7.6.1 Long straddle
        2. 7.6.2 Short straddle
      20. 7.7 Strangle
        1. 7.7.1 Long strangle
        2. 7.7.2 Short strangle
      21. 7.8 Butterfly
        1. 7.8.1 Long butterfly
        2. 7.8.2 Short butterfly
      22. 7.9 Condor
        1. 7.9.1 Long condor
        2. 7.9.2 Short condor
      23. 7.10 Strips
        1. 7.10.1 Long call strip
        2. 7.10.2 Long put strip
      24. 7.11 Strap
      25. 7.12 Collar
      26. 7.13 Calendar Spread
      27. Chapter Summary
      28. Key Terms
      29. Discussion Questions
      30. Problems
      31. Case for Analysis
      32. Net-Wise Exercises
      33. Suggested Readings
  8. PART 2 – APPLICATION OF DERIVATIVE PRODUCTS
    1. 8. Commodity Market Derivative Instruments
      1. 8.1 Introduction
      2. 8.2 Product Category
        1. 8.2.1 Bullion products
        2. 8.2.2 Metal products
        3. 8.2.3 Agro products
        4. 8.2.4 Energy products
        5. 8.2.5 Polymer products
        6. 8.2.6 Weather carbon credits
      3. 8.3 Contract Specifications
        1. 8.3.1 Tick size
        2. 8.3.2 Daily price limit
        3. 8.3.3 Margin system
        4. 8.3.4 Sales tax
        5. 8.3.5 Contract expiry
        6. 8.3.6 Tender and delivery period
        7. 8.3.7 Delivery logic
        8. 8.3.8 Determination of closing price
        9. 8.3.9 Commission and other charges
      4. 8.4 Risk-Reducing Strategies Using Commodity Futures
        1. 8.4.1 Spread positions
        2. 8.4.2 Spread contracts
        3. 8.4.3 Cross hedging
      5. 8.5 Commodity Options
        1. 8.5.1 Call option hedge
        2. 8.5.2 Put option hedge
        3. 8.5.3 Long combo hedge
      6. 8.6 Commodity Swaps
        1. 8.6.1 Energy swap hedges
        2. 8.6.2 Agro swap hedges
      7. Chapter Summary
      8. Key Terms
      9. Discussion Questions
      10. Problems
      11. Case for Analysis
      12. Net-Wise Exercises
      13. Appendix
      14. Suggested Readings
    2. 9. Equity Market Derivative Instruments
      1. 9.1 Introduction
      2. 9.2 Derivative Contracts
      3. 9.3 Margin System in Equity Derivative Segment
        1. 9.3.1 Initial margins
        2. 9.3.2 Mark-to-market margins
        3. 9.3.3 Margin calls
      4. 9.4 Hedging versus Speculation Using Equity Derivatives
      5. 9.5 Security Hedge versus Portfolio Hedge
      6. 9.6 Performance of a Hedged Portfolio
      7. 9.7 Security Hedge Using Futures
        1. 9.7.1 Tailing the hedge
      8. 9.8 Portfolio Hedging Using Futures
      9. 9.9 Security Hedge Using Options
      10. 9.10 Portfolio Hedge Using Options
      11. 9.11 Options on Futures
      12. 9.12 Employee Stock Option Schemes (ESOS)
      13. 9.13 Warrants
      14. 9.14 Convertibles
      15. 9.15 Derivatives in Mutual Fund Portfolios
      16. Chapter Summary
      17. Key Terms
      18. Discussion Questions
      19. Problems
      20. Case for Analysis
      21. Net-Wise Exercises
      22. Suggested Readings
    3. 10. Interest Rate Derivative Instruments
      1. 10.1 Introduction
      2. 10.2 Interest Rate Derivative Products
      3. 10.3 Interest Rate Categories
      4. 10.4 Zero-Coupon Yield Curve
      5. 10.5 Term Structure of Interest Rates
        1. 10.5.1 Theories explaining term structure of interest rates
        2. 10.5.2 Interpreting the yield curve
        3. 10.5.3 Normal yield curve
        4. 10.5.4 Upward yield curve
        5. 10.5.5 Humped yield curve
        6. 10.5.6 Flat yield curve
        7. 10.5.7 Downward-sloping yield curve
      6. 10.6 Trading in Forward Rate Agreements
      7. 10.7 Speculation in Interest Rate Derivatives
      8. 10.8 Hedging Using Interest Rate Derivatives
      9. 10.9 Cheapest-to-Deliver Bonds
      10. 10.10 Trading Strategies Using Interest Rate Futures
        1. 10.10.1 Riding the yield curve
        2. 10.10.2 Spread strategy
        3. 10.10.3 TED spreads
      11. 10.11 Trading Strategies Using Interest Rate Options
      12. 10.12 Trading in Interest Rate Swaps
        1. 10.12.1 Comparative advantage swap
        2. 10.12.2 Synthetic swap spread
      13. 10.13 Interest Rate Strips
      14. Chapter Summary
      15. Key Terms
      16. Discussion Questions
      17. Problems
      18. Case for Analysis
      19. Net-Wise Exercises
      20. Suggested Readings
    4. 11. Currency Derivative Instruments
      1. 11.1 Introduction
      2. 11.2 Exchange Rate Quotations
        1. 11.2.1 Cross-currency rates
        2. 11.2.2 Effective exchange rates
      3. 11.3 Currency Derivative Products
        1. 11.3.1 Foreign exchange forwards
        2. 11.3.2 Foreign-currency rupee swap
        3. 11.3.3 Foreign-currency rupee options
        4. 11.3.4 Cross-currency options
        5. 11.3.5 Cross-currency swaps
        6. 11.3.6 Indian currency trading platforms
      4. 11.4 Determinants of Foreign-Exchange Rate
      5. 11.5 Economic Theorems of Exchange Rate ­Determination
      6. 11.6 Speculation in Currency Derivatives
        1. 11.6.1 Speculating with spreads
      7. 11.7 Hedging with Currency Derivatives
      8. 11.8 Hedging Transaction Exposure
      9. 11.8.1 Measuring exposure
      10. 11.9 Currency Forwards
        1. 11.9.1 Synthetic Agreements for Forward Exchange (SAFE)
        2. 11.9.2 Break forward contract
        3. 11.9.3 Participating forward contracts
        4. 11.9.4 Range forward contracts
      11. 11.10 Currency Futures
      12. 11.11 Currency Options
      13. 11.12 Currency Swaps
      14. Chapter Summary
      15. Key Terms
      16. Discussion Questions
      17. Problems
      18. Case for Analysis
      19. Net-Wise Exercises
      20. Suggested Readings
  9. PART 3 – ADDITIONAL DERIVATIVE PRODUCTS
    1. 12. Credit Derivative Instruments
      1. 12.1 Introduction
      2. 12.2 Credit Risk
      3. 12.3 Measurement of Credit Risk
      4. 12.4 Capital Requirement for Credit Risk
      5. 12.5 Credit Ratings
      6. 12.6 Credit Derivatives
      7. 12.7 Structured Credit Instruments
        1. 12.7.1 Credit linked notes
        2. 12.7.2 Collateralized debt obligations
        3. 12.7.3 Cash versus synthetic CDOs
        4. 12.7.4 Credit Default Swap (CDS)
        5. 12.7.5 Total return swap
        6. 12.7.6 Constant-maturity swap
        7. 12.7.7 Credit options
        8. 12.7.8 Credit spread (price) put options
        9. 12.7.9 Credit spread (price) call options
      8. 12.8 Trading Strategies of Credit Derivatives
      9. 12.9 Risk Associated with Credit Derivatives
      10. Chapter Summary
      11. Key Terms
      12. Discussion Questions
      13. Problems
      14. Case for Analysis
      15. Net-Wise Exercises
      16. Suggested Readings
    2. 13. Real Options
      1. 13.1 Introduction
      2. 13.2 Characteristics of Real Options
        1. 13.2.1 Underlying asset
        2. 13.2.2 Uncertainty in the asset price value
        3. 13.2.3 Exercise price
        4. 13.2.4 Option expiry duration
        5. 13.2.5 Risk-free rate
        6. 13.2.6 Cost of delay
      3. 13.3 Corporate Capital Budgeting Applications
        1. 13.3.1 Expansion option
        2. 13.3.2 Project abandonment
      4. 13.4 Research and Development Application
      5. 13.5 Property Development Application
      6. 13.6 Portfolio of Real Options
      7. 13.7 Practical Considerations
      8. Chapter Summary
      9. Key Terms
      10. Discussion Questions
      11. Problems
      12. Net-Wise Exercise
      13. Suggested Readings
    3. 14. Exotic Options
      1. 14.1 Introduction
      2. 14.2 Asian Options
      3. 14.3 Binary Options
      4. 14.4 Look Back Options
      5. 14.5 Barrier Options
        1. 14.5.1 Knock-out barrier options
        2. 14.5.2 Knock-in barrier options
      6. 14.6 Chooser Options
      7. 14.7 Compound Options
        1. 14.7.1 Compound option: call on call
        2. 14.7.2 Compound option: put on put
        3. 14.7.3 Compound option: call on put
        4. 14.7.4 Compound option: put on call
      8. 14.8 Contingent Premium Options
        1. 14.8.1 Contingent cap
      9. 14.9 Deferred Strike Options
      10. 14.10 Rainbow Option
        1. 14.10.1 Best-of-assets rainbow option
        2. 14.10.2 Worst-of-assets rainbow options
        3. 14.10.3 Basket rainbow option
        4. 14.10.4 Quanto
        5. 14.10.5 Spread rainbow option
      11. 14.11 LEAPS (Long-Term Equity Anticipation Securities)
      12. Chapter Summary
      13. Key Terms
      14. Discussion Questions
      15. Problems
      16. Case for Analysis
      17. Net-Wise Exercises
      18. Suggested Readings
  10. PART 4 – PRICING DERIVATIVE PRODUCTS
    1. 15. Pricing Futures
      1. 15.1 Introduction
      2. 15.2 Principles of Pricing Futures
        1. 15.2.1 Expectation hypothesis
        2. 15.2.2 Backwardation principle
        3. 15.2.3 Cost of carrying the underlying asset
      3. 15.3 Cost of Carry Model
      4. 15.4 Pricing Commodity Futures
      5. 15.5 Pricing Equity Futures
      6. 15.6 Pricing Interest-Rate Futures
      7. 15.7 Pricing Forward-Rate Agreement (FRA)
      8. 15.8 Pricing Foreign Exchange Rate Futures
      9. 15.9 Forward and Futures Prices
      10. Chapter Summary
      11. Key Terms
      12. Discussion Questions
      13. Problems
      14. Suggested Readings
    2. 16. Pricing Options
      1. 16.1 Introduction
      2. 16.2 Rational Boundaries of Option Contracts
        1. 16.2.1 European call option lower bound value
        2. 16.2.2 European call option upper bound value
        3. 16.2.3 European put option lower bound value
        4. 16.2.4 European put option upper bound value
        5. 16.2.5 American call option lower bound value
        6. 16.2.6 American call option upper bound value
        7. 16.2.7 American put option lower bound value
        8. 16.2.8 American put option upper bound value
      3. 16.3 Variations in the Basic Structure of Options
        1. 16.3.1 Value of options with different expiry dates
        2. 16.3.2 Values of options with different strike prices
        3. 16.3.3 Value of options with different underlying asset spot prices
        4. 16.3.4 Option values when the underlying asset pays dividend
      4. 16.4 Binomial Option Pricing Model
        1. 16.4.1 Continuous dividend payments from underlying assets
        2. 16.4.2 European put option
        3. 16.4.3 American options
      5. 16.5 Black-Scholes Model
        1. 16.5.1 Adjustment for expected dividend inflow
      6. 16.6 Pricing Option on Futures
      7. 16.7 Put-call Parity Relationship
        1. 16.7.1 Put-call parity in european options
        2. 16.7.2 Put-call parity with dividend inflow
        3. 16.7.3 Put-call parity relationship of american options
      8. 16.8 Comparison of Black-Scholes with Binomial Valuations
      9. 16.9 Implied Volatilities
      10. 16.10 Criticism on Option-Pricing Models
      11. Chapter Summary
      12. Key Terms
      13. Discussion Questions
      14. Problems
      15. Suggested Readings
    3. 17. Pricing Swaps
      1. 17.1 Introduction
      2. 17.2 Pricing and Valuing Interest-Rate Swaps
        1. 17.2.1 Plain vanilla interest-rate swap as a zero-cost collar
        2. 17.2.2 Fixed-for-floating interest-rate swap
      3. 17.3 Pricing and Valuing Equity Swap
        1. 17.3.1 Determining the fixed-percentage swap rate
        2. 17.3.2 Computation of spread on floating interest rate
      4. 17.4 Pricing and Valuing Currency Swap
        1. 17.4.1 Fixed-for-fixed currency swap
      5. 17.5 Pricing and Valuing Commodity Swap
      6. 17.6 Swaptions
      7. 17.7 Pricing and Valuing Credit Default Swaps
      8. Chapter Summary
      9. Key Terms
      10. Discussion Questions
      11. Problems
      12. Suggested Readings
  11. PART 5 – DERIVATIVE RISK MANAGEMENT
    1. 18. Market Risk
      1. 18.1 Introduction
      2. 18.2 Risk Management
      3. 18.3 VaR Measure
        1. 18.3.1 Nifty total return index
        2. 18.3.2 Commodity index
      4. 18.4 Approaches to Quantification of VaR
        1. 18.4.1 Historical method
        2. 18.4.2 The variance–covariance approach
        3. 18.4.3 Delta normal valuation
        4. 18.4.4 Delta gamma valuation
        5. 18.4.5 Historical simulation approach
        6. 18.4.6 Monte carlo VaR
        7. 18.4.7 Extreme value theory and VaR
      5. 18.5 Sub-Elements of VaR
        1. 18.5.1 Marginal VaR
        2. 18.5.2 Incremental VaR
        3. 18.5.3 Component VaR
        4. 18.5.4 Conditional VaR
        5. 18.5.5 Accounting for skewness and kurtosis with the cornish–fisher expansion
      6. 18.6 Evaluation of VaR
        1. 18.6.1 Ability to capture the risks of options and option-like ­instruments
        2. 18.6.2 Ease of implementation
        3. 18.6.3 Reliability of the results
        4. 18.6.4 Flexibility in incorporating alternative assumptions
      7. Chapter Summary
      8. Key Terms
      9. Discussion Questions
      10. Problems
      11. Net-Wise Exercise
      12. Suggested Readings
    2. 19. Measuring Risk Characteristics of Derivative Instruments
      1. 19.1 Introduction
      2. 19.2 Derivative Greeks
      3. 19.3 Delta Hedging
        1. 19.3.1 Call option delta sensitivity
        2. 19.3.2 Put option delta sensitivity
        3. 19.3.3 Delta neutrality
      4. 19.4 Gamma Hedging
        1. 19.4.1 Call and put option gamma sensitivity
      5. 19.5 Delta–Gamma Hedging
      6. 19.6 Vega Hedging
        1. 19.6.1 Vega sensitivity
      7. 19.7 Delta–Gamma–Vega Hedging
      8. 19.8 Theta Hedging
        1. 19.8.1 Call option theta sensitivity
        2. 19.8.2 Put option theta sensitivity
      9. 19.9 Delta, Gamma, Vega, Theta Hedging
      10. 19.10 Rho Hedging
        1. 19.10.1 Call option sensitivity of rho values
        2. 19.10.2 Put option sensitivity to rho values
      11. 19.11 Delta, Vega, Rho Hedging
      12. 19.12 Derivative Instruments Risk Management
      13. Chapter Summary
      14. Key Terms
      15. Discussion Questions
      16. Problems
      17. Case for Analysis
      18. Net-Wise Exercises
      19. Suggested Readings
    3. 20. Derivative Hedge Accounting
      1. 20.1 Introduction
      2. 20.2 Accounting for Derivative Margin Payments
        1. 20.2.1 Margin accounting when trades are offset
        2. 20.2.2 Margin accounting when trades are physically delivered
      3. 20.3 Accounting Standards for Derivative ­Transactions
        1. 20.3.1 International accounting standards board
        2. 20.3.2 Financial accounting standards board
      4. 20.4 Effectiveness of Hedge Accounting
      5. 20.5 Hedge Accounting
      6. 20.6 Hedge Accounting Models
        1. 20.6.1 Fair-value hedge accounting
        2. 20.6.2 Cash-flow hedge
        3. 20.6.3 Net-investment hedge
      7. 20.7 Accounting for Derivative Instruments (ICAI Directive)
      8. 20.8 Hedge Trade Life Cycle Accounting
      9. 20.9 Taxation of Derivative Gains (Losses)
      10. 20.10 IFRS and Derivative Accounting
      11. Chapter Summary
      12. Key Terms
      13. Discussion Questions
      14. Net-Wise Exercises
      15. Suggested Readings
  12. Glossary
  13. Index
  14. Copyright