Derivatives Essentials: An Introduction to Forwards, Futures, Options and Swaps

Praise for Derivatives Essentials

"Derivatives have become critically important hedging and trading vehicles in the Financial Services marketplace, and understanding these complex instruments and markets is thus of paramount importance for industry professionals. Aron′s book provides robust and fulsome coverage of Derivatives. Most importantly, the book provides well balanced viewpoints and insights first, balanced between the academic (′theoretical′) and practitioner (′real–world′) perspectives, and second, balanced between qualitative concepts (the ′why′) and quantitative formulas (the ′numbers′). Possessing such a well–balanced understanding of Derivatives is a critical skill set for industry professionals, and I thus recommend this book."
Robert J. Chersi, retired CFO, Fidelity Investments – Financial Services and UBS Wealth Management

"In the thirty years I′ve worked in risk management on Wall Street, Derivatives Essentials is by far the most comprehensive and understandable book I′ve read about the complex world of derivative products and strategies. Anyone who needs to understand and communicate about topics such as derivative pricing, valuation and risk sensitivities or ′Greeks,′ should have Derivatives Essentials within reach on their book shelf!"
Michael Leibrock, Managing Director – Credit and Systemic Risk, The Depository Trust and Clearing Corporation

"Derivatives Essentials is a comprehensive guide that covers all of the important topics on derivative securities. As an experienced educator, Dr. Gottesman has the ability to simplify many complex concepts for students, but this text also provides experienced practitioners with a deeper understanding of the same concepts as well. This is a must–have text and desk–reference for students and practitioners alike!"
Christopher Lo, Senior Portfolio Manager, Columbia Threadneedle Investments

Preface

Acknowledgements

About the Author

Part One: Introduction to Forwards, Futures, and Options

Chapter 1: Forwards and Futures

Introduction

1.1 Forward contract characteristics

1.2 Long forward payoff

1.3 Long forward P&L

1.4 Short forward payoff

1.6 Short forward P&L

1.7 Long forward P&L diagram

1.8 Short forward P&L diagram

1.9 Forwards are zero–sum games

1.10 Counterparty credit risk

1.11 Futures contracts

Chapter 2: Call Options

Introduction

2.1 Call option characteristics

2.2 Long call payoff

2.3 Long call P&L

2.4 Short call payoff

2.5 Short call P&L

2.6 Long call P&L diagram

2.7 Short call P&L diagram

2.8 Call options are zero–sum games

2.9 Call option moneyness

2.10 Exercising a call option early

2.11 Comparison of call options and forwards/futures

Chapter 3: Put Options

Introduction

3.1 Put option characteristics

3.2 Long put payoff

3.3 Long put P&L

3.4 Short put payoff

3.5 Short put P&L

3.6 Long put P&L diagram

3.7 Short put P&L diagram

3.8 Put options are zero–sum games

3.9 Put option moneyness

3.10 Exercising a put option early

3.11 Comparison of put options, call options and forwards/futures

Part Two: Pricing and Valuation

Chapter 4: Useful Quantitative Concepts

Introduction

4.1 Compounding conventions

4.2 Calculating future value and present value

4.3 Identifying continuously compounded interest rates

4.4 Volatility and historical standard deviation

4.5 Interpretation of standard deviation

4.6 Annualized standard deviation

4.7 The standard normal cumulative distribution function

4.8 The z–score

Chapter 5: Introduction to Pricing and Valuation

Introduction

5.1 The concepts of price and value by a forward contract

5.2 The concepts of price and value by an option

5.3 Comparison of price and value concepts for forwards and options

5.4 Forward value

5.5 Forward price

5.6 Option value: The Black–Scholes model

5.7 Calculating the Black–Scholes model

5.8 Black–Scholes model assumptions

5.9 Implied volatility

Chapter 6: Understanding Pricing and Valuation

Introduction

6.1 Review of payoff, price, and value equations

6.2 Value as the present value of expected payoff

6.3 Risk–neutral valuation

6.4 Probability and expected value concepts

6.5 Understanding the Black–Scholes equation for call value

6.6 Understanding the Black–Scholes equation for put value

6.7 Understanding the equation for forward value

6.8 Understanding the equation for forward price

Chapter 7: The Binomial Option Pricing Model

Introduction

7.1 Modeling discrete points in time

7.2 Introduction to the one–period binomial option pricing model

7.3 Option valuation, one–period binomial option pricing model

7.4 Two–period binomial option pricing model, European–style option

7.5 Two–period binomial model, American–style option

7.6 Multi–period binomial option pricing models

Part Three: The Greeks

Chapter 8: Introduction to the Greeks

Introduction

8.1 Definitions of the Greeks

8.2 Characteristics of the Greeks

8.3 Equations for the Greeks

8.4 Calculating the Greeks

8.5 Interpreting the Greeks

8.6 The accuracy of the Greeks

Chapter 9: Understanding Delta and Gamma

Introduction

9.1 Describing sensitivity using Delta and Gamma

9.2 Understanding Delta

9.3 Delta across the underlying asset price

9.4 Understanding Gamma

9.5 Gamma across the underlying asset price

Chapter 10: Understanding Vega, Rho, and Theta

Introduction

10.1 Describing sensitivity using Vega, Rho, and Theta

10.2 Understanding Vega

10.3 Understanding Rho

10.4 Understanding Theta

Part Four: Trading Strategies

Chapter 11: Price and Volatility Trading Strategies

Introduction

11.1 Price and volatility views

11.2 Relating price and volatility views to Delta and Vega

11.3 Using forwards, calls, and puts to monetize views

11.4 Introduction to straddles

11.5 Delta and Vega characteristics of long and short straddles

11.6 The ATM DNS strike price

11.7 Straddle: numerical example

11.8 P&L diagrams for long and short straddles

11.9 Breakeven points for long and short straddles

11.10 Introduction to strangles

11.11 P&L diagrams for long and short strangles

11.12 Breakeven points for long and short strangles

11.13 Summary of simple price and volatility trading strategies

Chapter 12: Synthetic, Protective, and Yield–Enhancing Trading Strategies

Introduction

12.1 Introduction to put–call parity and synthetic positions

12.2 P&L diagrams of synthetic positions

12.3 Synthetic positions premiums and ATMF

12.4 The Greeks of synthetic positions

12.5 Option arbitrage

12.6 Protective puts

12.7 Covered calls

12.8 Collars

Chapter 13: Spread Trading Strategies

Introduction

13.1 Bull and bear spreads using calls

13.2 Bull and bear spreads using puts

13.3 Risk reversals

13.4 Butterfly spreads

13.5 Condor spreads

Part Five: Swaps

Chapter 14: Interest Rate Swaps

Introduction

14.1 Interest rate swap characteristics

14.2 Interest rate swap cash flows

14.3 Calculating interest rate swap cash flows

14.4 How interest rate swaps can transform cash flows

Chapter 15: Credit Default Swaps, Cross–Currency Swaps, and Other Swaps

Introduction

15.1 Credit default swap characteristics

15.2 Key determinants of the credit default swap spread

15.3 Cross–currency swap characteristics

15.4 Transforming cash flows using a cross–currency swap

15.5 Other swap varieties

Appendix: Solutions to Knowledge Check Questions

Index

ARON GOTTESMAN is professor of finance and the chair of the department of finance and economics at the Lubin School of Business at Pace University. He teaches courses on derivative securities, financial markets, and asset management, and presents corporate workshops on derivative securities to bulge bracket financial institutions.