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Principles of Financial Engineering, 2nd Edition by Salih N. Neftci

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CHAPTER 3

Cash Flow Engineering and Forward Contracts

1. Introduction

All financial instruments can be visualized as bundles of cash flows. They are designed so that market participants can trade cash flows that have different characteristics and different risks. This chapter uses forwards and futures to discuss how cash flows can be replicated and then repackaged to create synthetic instruments.

It is easiest to determine replication strategies for linear instruments. We show that this can be further developed into an analytical methodology to create synthetic equivalents of complicated instruments as well. This analytical method will be summarized by a (contractual) equation. After plugging in the right instruments, the equation will yield ...

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