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Pricing and Hedging Financial Derivatives. A Guide for Practitioners. The Wiley Finance Series

  • ID: 2330821
  • Book
  • 264 Pages
  • John Wiley and Sons Ltd
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Pricing and Hedging Financial Derivatives: A Guide for Practitioners attempts to explain the insights required in the pricing and hedging of the most common derivative products and aims to educate and inform the many rather than the few. Targeted at the practitioner rather than the academic, this book contains many worked examples to help develop an understanding of key concepts and tools.

The book begins with a descriptive examination of the main asset classes, the main derivative products and the most common option strategies. It then moves on to the fundamentals of option pricing, the Greeks, implied volatility, the volatility smile, exotic derivatives (digitals, barriers, Asian options) and multi–asset derivatives. Along the way, the authors spend time explaining the concepts of replication and risk–neutral valuation with numerous examples that help develop an intuitive grasp of derivative pricing. The book concludes with a chapter on structured products because these, unlike derivative products, may be accessible to investors.

A website accompanies the book ([external URL] and contains a number of practical example excel spreadsheets.

The book will provide investment professionals, whether new to the world of finance or seasoned, with the toolkit required to understand derivatives and approach them with confidence.

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Preface ix

Acknowledgements xi

1 An Introduction to the Major Asset Classes 1

1.1 Equities 1

1.2 Commodities 5

1.3 Fixed Income 12

1.4 Foreign Exchange 15

Summary 17

2 Derivatives: Forwards, Futures and Swaps 19

2.1 Derivatives 19

2.2 Forward Contracts 20

2.3 Futures Contracts 24

2.4 Calculating Implied Forward Prices and Valuing Existing Forward Contracts 26

2.5 Pricing Futures Contracts 34

2.6 Swaps 35

Summary 49

3 Derivatives: Options and Related Strategies 51

3.1 Call Options 51

3.2 Put Options 55

3.3 Boundary Conditions for Call and Put Options Prices 58

3.4 Put Call Parity 61

3.5 Swaptions 63

3.6 Options Strategies 64

Summary 76

4 Binomial Option Pricing 77

4.1 One–Period Binomial Tree: Replication Approach 77

4.2 Risk–Neutral Valuation 83

4.3 Two–Period Binomial Tree: Valuing Back Down the Tree 85

4.4 The Binomial Tree: A Generalization 89

4.5 Early Exercise and American Options 90

4.6 Volatility Calibration 90

Summary 92

5 The Fundamentals of Option Pricing 93

5.1 Intrinsic Value and Time Value of an Option 93

5.2 What is Volatility and Why Does it Matter? 95

5.3 Measurement of Realized Volatility and Correlation 97

5.4 Option Pricing in the Black Scholes Framework 99

5.5 The Option Delta and the Replication of the Option Payoff 100

5.6 Option Replication 102

5.7 Option Replication, Risk–Neutral Valuation and Delta Hedging Revisited 104

5.8 Options on Dividend Paying Assets 106

5.9 Options on Futures: The Black Model 107

5.10 Monte Carlo Pricing 108

5.11 Other Pricing Techniques 112

5.12 Pricing Techniques Summary 113

5.13 The Excel Spreadsheet Option Replication 114

Summary 117

6 Implied Volatility and the Greeks 121

6.1 Implied Volatility 121

6.2 The Greeks 123

6.3 Delta and its Dynamics 123

6.4 Gamma and its Dynamics 127

6.5 Vega and its Dynamics 132

6.6 Theta and its Dynamics 136

6.7 Rho 142

6.8 Option Trading 143

6.9 Some Additional Remarks (in Q&A Format) 146

6.10 An Example of the Behaviour of Implied Volatility: EUR/USD Rate and S&P 500 in 2010 2012 147

Summary 148

7 Volatility Smile and the Greeks of Option Strategies 151

7.1 The Volatility Smile Why is the Implied Volatility Not Flat Across Different Strikes? 151

7.2 The Sticky Delta and Sticky Strike Approaches to Describing Volatility Smile 153

7.3 The Volatility Term Structure Why is the Implied Volatility Not Flat Across Different Expiries? 155

7.4 The Volatility Surface Combining Smile and Term Structure 156

7.5 Analysing the Greeks of Common Option Strategies 158

7.6 Some Additional Remarks on Straddles, Risk Reversals and Butterflies 170

7.7 Vega Hedging is Not Just Simply Offsetting Overall Vega Exposure 171

7.8 Hedging Volatility Risk: A Brief Introduction of the Vanna Volga Approach 172

7.9 The Volatility Smile One Step Further 173

7.10 Pricing Exotic Options 178

7.11 Different Types of Volatility 179

Summary 184

8 Exotic Derivatives 185

8.1 Exotic Derivatives with Fixed Payoffs 185

8.2 Other Common Exotic Derivatives 188

8.3 European Digital Options: Pricing and Greeks 191

8.4 Other Exotic Options: Pricing and Greeks 200

Summary 208

9 Multi–Asset Derivatives 209

9.1 Basket Options 209

9.2 Best–of and Worst–of Options 211

9.3 Quanto Derivatives 222

9.4 Compo Derivatives 225

Summary 227

10 Structured Products 229

10.1 Definition 229

10.2 Common Features 229

10.3 Principal Protection 230

10.4 The Benefit to the Issuer 231

10.5 Redemption Amounts and Participation 232

10.6 Principal at Risk: Embedding a Short Option 234

10.7 More Complicated Payoffs 235

10.8 Auto–Callable Note: Pricing and Risk Profile 238

10.9 One Step Forward: The Worst–of Digital Note 240

10.10 A Real–Life Example of Structured Product 241

10.11 Liquidity and Exchange–Traded Notes (ETNs) 242

Summary 243

Index 245

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Leonardo Marroni
Irene Perdomo
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