Essays in Derivatives

ESSAYS IN DERIVATIVES SECOND EDITION Derivatives can be a painfully difficult subject to master, usually requiring a steep learning curve. As Don Chance points out, "many legal pads are used up, sometimes frustratingly, in working through some of the principles covered in technical derivatives books." This book is different. In the updated second edition of Chance's well-received Essays in Derivatives, the author once again keeps derivatives simple enough for the beginner, but offers enough in-depth information to satisfy the more experienced investor. This book provides up-to-date and detailed coverage of various financial products related to derivatives in several key areas: derivatives and their markets, the basic instruments, derivative pricing, derivative strategies, exotic instruments, and fixed income securities and derivatives. Chance begins with the basics, defining what a derivative is, outlining four common types--forward contracts, futures contracts, options, and swaps--and explaining the kinds of situations in which one type might be used and preferred over another. From there, he gradually moves on to more complex topics--all presented in the same accessible, down-to-earth style and nontechnical language. Since the first edition of this book was published in 1998, the derivatives business has become vastly more sophisticated. Recognizing this, the author has eliminated outdated material and, in addition to revising almost every chapter in the book, has added many completely new chapters, covering subjects that include why derivatives are used, forward and futures pricing, operational risk, volatility derivatives, weather derivatives, good and bad practices, and other new topics. In addition, the end of each chapter includes practice questions that allow you to test how much of the material has been retained. Answers are provided at the end of the book. The material in Essays in Derivatives will appeal to individuals at all levels of expertise. Beginners will find these essays particularly useful in gaining a fundamental grasp of the subject, and experts will appreciate the simple manner in which such seemingly complicated subjects can be presented. Both will agree: a basic understanding of derivatives need not be hard . . . and can even be enjoyable.

Preface to the New Edition xiii
Preface to the First Edition xv
SECTION ONE Derivatives and Their Markets 1
ESSAY 1 The Structure of Derivative Markets 3
ESSAY 2 A Brief History of Derivatives 7
ESSAY 3 Why Derivatives? 15
ESSAY 4 Forward Contracts and Futures Contracts 25
ESSAY 5 Options 29
ESSAY 6 Swaps 33
ESSAY 7 Types of Risks 37
SECTION TWO The Basic Instruments 41
ESSAY 8 Interest Rate Derivatives: FRAs and Options 43
ESSAY 9 Interest Rate Derivatives: Swaps 49
ESSAY 10 Currency Swaps 53
ESSAY 11 Structured Notes 57
ESSAY 12 Securitized Instruments 61
ESSAY 13 Equity Swaps 67
ESSAY 14 Equity-Linked Debt 71
ESSAY 15 Commodity Swaps 75
ESSAY 16 American versus European Options 79
ESSAY 17 Swaptions 83
ESSAY 18 Credit Derivatives 89
ESSAY 19 Volatility Derivatives 95
ESSAY 20 Weather and Environmental Derivatives 99
SECTION THREE Derivative Pricing 103
ESSAY 21 Forward and Futures Pricing 105
ESSAY 22 Put-Call Parity for European Options on Assets 111
ESSAY 23 Put-Call Parity for American Options on Assets 115
ESSAY 24 Call Options as Insurance and Margin 119
ESSAY 25 A Nontechnical Introduction to Brownian Motion 123
ESSAY 26 Building a Model of Brownian Motion in the Stock Market 129
ESSAY 27 Option Pricing: The Black-Scholes-Merton Model 133
ESSAY 28 Option Pricing: The Binomial Model 139
ESSAY 29 Option Pricing: Numerical Methods 143
ESSAY 30 Dynamic Option Replication 147
ESSAY 31 Risk-Neutral Pricing of Derivatives: I 153
ESSAY 32 Risk-Neutral Pricing of Derivatives: II 159
ESSAY 33 It's All Greek to Me 165
ESSAY 34 Implied Volatility 169
ESSAY 35 American Call Option Pricing 175
ESSAY 36 American Put Option Pricing 181
ESSAY 37 Swap Pricing 185
SECTION FOUR Derivative Strategies 191
ESSAY 38 Asset Allocation with Derivatives 193
ESSAY 39 Protective Puts and Portfolio Insurance 197
ESSAY 40 Misconceptions about Covered Call Writing 201
ESSAY 41 Hedge Funds and Other Privately Managed Accounts 205
ESSAY 42 Spreads, Collars, and Prepaid Forwards 209
ESSAY 43 Box Spreads 213
SECTION FIVE Exotic Instruments 217
ESSAY 44 Barrier Options 219
ESSAY 45 Straddles and Chooser Options 223
ESSAY 46 Compound and Installment Options 227
ESSAY 47 Digital Options 231
ESSAY 48 Geographic Options 235
ESSAY 49 Multi-Asset Options 239
ESSAY 50 Range Forwards and Break Forwards 243
ESSAY 51 Lookback Options 249
ESSAY 52 Deferred Start and Contingent Premium Options 253
SECTION SIX Fixed Income Securities and Derivatives 257
ESSAY 53 Duration 259
ESSAY 54 Limitations of Duration and the Concept of Convexity 263
ESSAY 55 The Term Structure of Interest Rates 269
ESSAY 56 Theories of the Term Structure: I 273
ESSAY 57 Theories of the Term Structure: II 279
ESSAY 58 Simple Models of the Term Structure: Vasicek and Cox-Ingersoll-Ross 285
ESSAY 59 No-Arbitrage Models of the Term Structure: Ho-Lee and Heath-Jarrow-Morton 291
ESSAY 60 Tree Pricing of Bonds and Interest Rate Derivatives: I 297
ESSAY 61 Tree Pricing of Bonds and Interest Rate Derivatives: II 301
ESSAY 62 Tree Pricing of Bonds and Interest Rate Derivatives: III 307
ESSAY 63 Tree Pricing of Bonds and Interest Rate Derivatives: IV 313
ESSAY 64 Tree Pricing of Bonds and Interest Rate Derivatives: V 319
SECTION SEVEN Other Topics and Issues 325
ESSAY 65 Stock Options 327
ESSAY 66 Value at Risk 335
ESSAY 67 Stock as an Option 341
ESSAY 68 The Credit Risk of Derivatives 345
ESSAY 69 Operational Risk 349
ESSAY 70 Risk Management in an Organization 355
ESSAY 71 Accounting and Disclosure of Derivatives 361
ESSAY 72 Worst Practices in Derivatives 367
ESSAY 73 Best Practices in Derivatives 375
Recommended Reading 379
Answers to End-of-Essay Questions 381