Sacks - Elementary financial derivatives : a guide to trading and valuation with applications

Copyright 2016 by John Wiley & Sons, Inc. All rights reserved

Published by John Wiley & Sons, Inc., Hoboken, New Jersey

Published simultaneously in Canada

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Library of Congress Cataloging-in-Publication Data

Sacks, Jana.

Elementary financial derivatives : a guide to trading and valuation with applications / Jana Sacks, Ph.D.

pages cm

Includes bibliographical references and index.

ISBN 978-1-119-07675-9 (hardback)

1. Derivative securities. I. Title.

HG6024.A3.S2297 2015

332.6457dc23

2015024277

ISBN: 9781119076759

To Jonathan

This book is written to be an easy-to-understand introductory textbook featuring hands-on application of presented theoretical concepts. The intention of the book is to introduce the subject of financial derivatives in an accessible and appealing way. The readers will be learning by doing. In the academic environment, the book is intended to be a textbook for an introductory course in financial derivatives.

The purpose of this book is essentially its focus on simplicity. Financial derivatives are often regarded as financial instruments that are just too complex to comprehend and individual investors tend to shy away. At the same time, market professionals state that financial derivatives trades now constitute about 40% of the overall alternative asset markets. This book offers explanations of complex concepts in the simplest possible form with hands-on applications through problems, case studies, and Microsoft Office Excel-based modules for valuation.

The book covers all the essential parts of the derivatives market. Aside from a section on options, it features sections on swaps and financial engineering concepts applied primarily, but not exclusively, to the futures markets.

The target audience is anyone who is interested in learning about financial derivatives in a relatively short time, such as individuals preparing for the CFA exam. I envision the readership anywhere from business school studentsonline and in-classto individual investors interested in trading options using online trading accounts. After reading this book, investors will be able to better understand and assess their risk exposure and decide whether it is indeed one they are prepared to take.

The material in this book is organized into three parts: forwards and futures, swaps, and options. There is an Instructor's Manual available on the book's companion website hosted by John Wiley & Sons, which includes all solutions to end-of-chapter problems. Instructors may also obtain PowerPoint slides from the website.

Jana Sacks

There are a number of people I would like to thank for their encouragement, advice, and suggestions. I would like to thank my academic colleagues at St. John Fisher College; my mentorsrecognizing the late Dr. Salih Neftci in particular; industry practitionersKatrina Bell and Ira Jersey; and my research assistantsGarrett MacDonald and Daniela Stefanovski.

I would also like to extend my special thanks to my wonderful family including my canine writing companionsMoses and Buddy.

Long Position with Futures Price of $100

Short Position with Futures Price of $100

Limit Terminology

Margin Terminology

Long Futures Replication

Short Bond Cash Flows: Borrower

Long Bond Cash Flows: Lender

Cash Flow Diagram for Forward Loan

Replication of a Forward Loan

Deposit

Short Two-Period Bond

Forward Loan

FRA Float Against Fix Cash Flows

Floating Rate Deposit

Fixed Rate Loan

EUR/USD Currency Forward

Long USD Bond

Short EUR Bond

Spot Transaction of Purchasing USD Against EUR

Spot Purchase of EUR

Long EUR-Denominated Bond

Forward Contract: Selling EUR Against USD

Long USD-Denominated Zero-Coupon Bond

Spot Purchase of CHF Against TWD

Spot Purchase of USD Against TWD

Spot Purchase of CHF Against USD

List of Ways to Terminate a Swap

Interest Rate Swap Cash Inflows and Outflows

IRS: Fixed Payer at 6% Against 10-Year LiborCounterparty A

IRS: 10-Year Libor Payer Against 6% FixedCounterparty B

Equity Swap: Floating Against Floating

Counterparty A: Cash Flows

Counterparty B: Cash Flows

Firm A's Cash Flows

Firm B's Cash Flows

FX Swap: Purchase EUR, Pay USD

Financial Engineering of Basis Swap

Financial Engineering of Credit Default Swap

Long Position in a Defaultable Bond

Default-Free Floating Rate Loan

Cash Flows from Combining Defaultable Bond with Default-Free Loan

IRS: Pay Fixed, Receive Float

CDS Spread

Long Call Option Payoff Function at Expiration Time

Short Call Option Payoff Function at Expiration, X = $50, C = $4.30

Long Put Option Payoff Function at Expiration Time

Short Put Option Payoff Function at Expiration Time

Protective Put

Covered Call

Bull Spread

Bear Spread

Call Butterfly Spread, Underlying GM

Put Butterfly Spread, Underlying JCI

Condor

Long Straddle

Short Straddle

Long Strangle

Short Strangle

One-Period Binomial Tree

One-period Asset Price Binomial Tree

The Current Call Option Price is the Probability-weighed Present Value of the Future Call Prices

One Period Binomial Tree for a Call Option

Overvalued Call

Undervalued Call

Stock Price Two-Period Binomial Tree

Call Price Tree

Put Price Tree

Hedge Ratio Tree