Durbin - All About Derivatives

All About DERIVATIVES

FULLY REVISED SECOND EDITION

MICHAEL DURBIN

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To the splendor of Mom and the memory of Dad

Chapter 1
Derivatives in a Nutshell

Chapter 2
The Forward Contract

Chapter 3
The Futures Contract

Chapter 4
The Swap Contract

Chapter 5
The Option Contract

Chapter 6
Credit Derivatives

Chapter 7
Using Derivatives to Manage Risk

Chapter 8
Pricing Forwards and Futures

Chapter 9
Pricing Swaps

Chapter 10
Pricing Options

Chapter 11
Hedging a Derivatives Position

Chapter 12
Derivatives and the 2008 Financial Meltdown

The public perception of financial derivatives has certainly changed since the publication of the first edition of All About Derivatives. More people are curious about them, asking questions about them, and wanting to know more than ever just what these seemingly bizarre financial instruments are all about.

Nearly everyone, it seems, knows that derivatives played a role in the 2008 global financial crisiseven if they cant begin to say how. What many people dont know is that the derivatives that got us into all that trouble were credit derivatives, a relatively new type of derivative bearing almost no resemblance to the traditional stock, interest rate, and currency derivatives that have been used extensively for many decades. And they were traded in the overthe-counter (OTC) market, a free-for-all venue that lackedat the timethe trade standardization and clearing features of the listed or exchange markets where derivatives have historically traded. Traditional derivatives are price guarantees used to protect against (or wager on) future price changes. Credit derivatives guarantee not the price of something, but rather the ability of borrowers of moneysay, holders of mortgagesto repay their loans. Those are very different things.

Alas, they are all considered derivatives, and theres not much we can do about that. We can, however, make a modest effort to understand the distinction. An entirely new chapter, , Derivatives and the 2008 Financial Meltdown, is devoted to explaining the role of the credit default swap (CDS) during that painful economic period. This chapter also explains the much-publicized collateralized debt obligation (CDO), which is technically not a derivative security but can beand wascreated synthetically using credit default swaps.

In addition, every bit of the first edition was reviewed to make sure it is still relevant to whats going on today with derivatives, and to clean up a few errors (some rather embarrassing) the author failed to catch the first time around. Any errors that might have slipped into this one will be noted at www.michaelpdurbin.com .

I once had a college professor who would mark papers with BGO! wherever he caught a student wasting the readers time on a blinding glimpse of the obvious. He would certainly mark this page as such, because it is indeed obvious how indebted I am to the many readers who took the time to e-mail me with comments, suggestions, and errors after reading the first edition of