GEORGE MICHAEL CONSTANTINIDES - Financial Derivatives: Futures, Forwards, Swaps, Options, Corporate Securities, and Credit Default Swaps (World Scientific Lecture Notes in Economics)

Financial
Derivatives

Futures, Forwards, Swaps, Options, Corporate
Securities, and Credit Default Swaps

World Scientific Lecture Notes in Economics

ISSN: 2382-6118

Series Editor: Dirk Bergemann (Yale University, USA)

Vol. 1: Financial Derivatives: Futures, Forwards, Swaps, Options, Corporate
Securities, and Credit Default Swaps

by George M. Constantinides

Forthcoming:

Lecture Notes on Econometric Models for Industrial Organization

by Matthew Shum

Cooperature Game Theory

by Adam Brandenburger

Economics of the Middle East

by Julia C. Devlin

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Library of Congress Cataloging-in-Publication Data

Constantinides, George M.

Financial derivatives : futures, forwards, swaps, options, corporate securities and credit default
swaps / by George M Constantinides (University of Chicago Booth School of Business, USA).

pages cm. -- (World scientific lecture notes in economics, ISSN 2382-6118 ; vol. 1)

Includes bibliographical references and index.

ISBN 978-9814618410 (hardcover : alk. paper)

ISBN 9789814618427 (pbk. : alk. paper)

1. Derivative securities. 2. Options (Finance) 3. Swaps (Finance) I. Title.

HG6024.A3C663 2015

332.64'57--dc23

2014041576

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To my students and colleagues from whom I learned a great deal
and who helped me build these teaching notes.

Contents

About the Author

The Leo Melamed Professor of Finance at the University of Chicagos Booth School of Business, George Constantinides is a leader of academic finance, an expert in portfolio theory, asset pricing, derivatives pricing, and capital markets behavior. Widely published and a frequent speaker and editor, he is former president of the American Finance Association and the Society for Financial Studies and member of Dimensionals Boards of Directors of the US mutual funds, among many other professional affiliations. A graduate of Oxford University in England and Indiana University, he has also visited at Harvard University.

Preface

Derivatives markets are an important and growing segment of financial markets and play an important role in the management of risk. This invaluable set of lecture notes is meant to be used in conjunction with a standard textbook on derivatives in an advanced undergraduate or MBA elective course on futures, forwards, swaps, options, corporate securities, and credit default swaps (CDS). It covers the foundations of derivatives pricing in arbitrage-free markets, develops the methodology of risk-neutral valuation, and discusses hedging and the management of risk.

I develop, critically assess, and apply theories of pricing derivatives. Topics include: Introduction to forward contracts, futures, and swaps; pricing forwards and futures; interest rate and currency swaps; introduction to options and no-arbitrage restrictions; trading strategies and slope and convexity restrictions; optimal early exercise of American options; binomial option pricing; risk-neutral valuation; the BlackScholesMerton option pricing formula; extensions of the BSM model; risk management with options; empirical evidence and time-varying volatility; the pricing and hedging of corporate securities (common stock, senior and junior bonds, callable bonds, warrants, convertible bonds, putable bonds, and CDS); and credit risk.

George M. Constantinides

Take-Away: Understand the differences between forward and futures contracts institutionally and in terms of the marking-to-market process.

Agenda

What are derivatives?

How did derivatives evolve?

Forward contracts

Example: Using forward contracts for hedging

Payoff diagram for long and short forward positions

Futures contracts

Example: Using futures contracts for hedging

Payoff diagram for long and short forward positions

Other types of derivatives

Textbook definition: A derivatives contract is a contract that derives its value from one or more underlying asset prices, reference rates, or indices.

Because future payoffs of derivatives are determined by future prices of underlying securities, we can derive relationships between the current prices of the derivative and underlying securities based on no-arbitrage arguments.

The purpose of this book is to develop and study these relationships. We also use these relationships to analyze how derivatives can be used for hedging and speculation.

These relationships are often independent of factors such as market participants risk aversion, and of some of the properties of the primitive security itself.

Derivatives are great devices to...

Perform successful risk management;

Deal with most market frictions;

Take on speculative positions;

Transfer risk from those who have it to those who want it.

But proper understanding of the risks and benefits is key to success...

1993: Metallgesellschaft losses on oil futures $1.3 billion,

1994: P&G losses on levered swaps ~$200 million,

1994: Orange County losses on int. rate deriv. ~$1.5 billion,

1995: Barings Brothers losses on short straddle on futures ~$1.3 billion,

1998: LTCM losses on convergence strategies ~$3.5 billion,