Principles of Financial Engineering This page intentionally left blank Principles of Financial Engineering Third Edition Robert L Kosowski Oxford-Man Institute of Quantitative Finance Oxford University Salih N Neftci Department of Finance Imperial College Business School Imperial College London, UK AMSTERDAM • BOSTON • HEIDELBERG • LONDON NEW YORK • OXFORD • PARIS • SAN DIEGO SAN FRANCISCO • SINGAPORE • SYDNEY • TOKYO Academic Press is an imprint of Elsevier Academic Press is an imprint of Elsevier 32 Jamestown Road, London NW1 7BY, UK 525 B Street, Suite 1800, San Diego, CA 92101-4495, USA 225 Wyman Street, Waltham, MA 02451, USA The Boulevard, Langford Lane, Kidlington, Oxford OX5 1GB, UK First published 2004 Second edition 2008 Third edition 2015 Copyright r 2015, 2008 and 2004 Elsevier Inc All rights reserved No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information storage and retrieval system, without permission in writing from the publisher Details on how to seek permission, further information about the Publisher’s permissions policies and our arrangements with organizations such as the Copyright Clearance Center and the Copyright Licensing Agency, can be found at our website: www.elsevier.com/permissions This book and the individual contributions contained in it are protected under copyright by the Publisher (other than as may be noted herein) Notices Knowledge and best practice in this field are constantly changing As new research and experience broaden our understanding, changes in research methods, professional practices, or medical treatment may become necessary Practitioners and researchers must always rely on their own experience and knowledge in evaluating and using any information, methods, compounds, or experiments described herein In using such information or methods they should be mindful of their own safety and the safety of others, including parties for whom they have a professional responsibility To the fullest extent of the law, neither the Publisher nor the authors, contributors, or editors, assume any liability for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions, or ideas contained in the material herein ISBN: 978-0-12-386968-5 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data A catalog record for this book is available from the Library of Congress For information on all Academic Press publications visit our website at http://store.elsevier.com Typeset by MPS Limited, Chennai, India www.adi-mps.com Printed and bound in the United States Dedicated to Salih Neftci and my family This page intentionally left blank Contents Preface to the Third Edition xvii CHAPTER Introduction 1.1 A Unique Instrument 1.2 A Money Market Problem 10 1.3 A Taxation Example .13 1.4 Some Caveats for What Is to Follow .17 1.5 Trading Volatility .18 1.6 Conclusions .22 Suggested Reading 22 Exercises 22 CHAPTER Institutional Aspects of Derivative Markets 25 2.1 Introduction .26 2.2 Markets .26 2.3 Players .35 2.4 The Mechanics of Deals 36 2.5 Market Conventions 39 2.6 Instruments 41 2.7 Positions 41 2.8 The Syndication Process 50 2.9 Conclusions .51 Suggested Reading 51 Exercises 51 CHAPTER 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 Cash Flow Engineering, Interest Rate Forwards and Futures 53 Introduction .54 What Is a Synthetic? .55 Engineering Simple Interest Rate Derivatives .59 LIBOR and Other Benchmarks 63 Fixed Income Market Conventions 64 A Contractual Equation 70 Forward Rate Agreements 79 Fixed Income Risk Measures: Duration, Convexity and Value-at-Risk 83 Futures: Eurocurrency Contracts 89 vii viii Contents 3.10 Real-World Complications 95 3.11 Forward Rates and Term Structure 96 3.12 Conventions 98 3.13 A Digression: Strips .99 3.14 Conclusions 99 Suggested Reading 100 Appendix—Calculating the Yield Curve .100 Exercises .103 CHAPTER Introduction to Interest-Rate Swap Engineering 107 4.1 The Swap Logic 108 4.2 Applications 111 4.3 The Instrument: Swaps 115 4.4 Types of Swaps 117 4.5 Engineering Interest-Rate Swaps 124 4.6 Uses of Swaps .133 4.7 Mechanics of Swapping New Issues 140 4.8 Some Conventions 144 4.9 Additional Terminology .145 4.10 Conclusions 145 Suggested Reading 145 Exercises .146 CHAPTER Repo Market Strategies in Financial Engineering 149 5.1 Introduction 150 5.2 Repo Details 151 5.3 Types of Repo .154 5.4 Equity Repos 160 5.5 Repo Market Strategies 161 5.6 Synthetics Using Repos 168 5.7 Differences Between Repo Markets and the Impact of the GFC 170 5.8 Conclusions 170 Suggested Reading 171 Exercises .171 CHAPTER 6.1 6.2 6.3 6.4 Cash Flow Engineering in Foreign Exchange Markets 175 Introduction 176 Currency Forwards 178 Synthetics and Pricing 183 A Contractual Equation 184 Contents ix 6.5 Applications 185 6.6 Conventions for FX Forward and Futures 191 6.7 Swap Engineering in FX Markets 194 6.8 Currency Swaps Versus FX Swaps 198 6.9 Mechanics of Swapping New Issues 204 6.10 Conclusions 206 Suggested Reading 207 Exercises .207 CHAPTER Cash Flow Engineering and Alternative Classes (Commodities and Hedge Funds) 211 7.1 Introduction 212 7.2 Parameters of a Futures Contract 212 7.3 The Term Structure of Commodity Futures Prices .215 7.4 Swap Engineering for Commodities 221 7.5 The Hedge Fund Industry .228 7.6 Conclusions 233 Suggested Reading 234 Exercises .234 CHAPTER Dynamic Replication Methods and Synthetics Engineering 237 8.1 Introduction 238 8.2 An Example 238 8.3 A Review of Static Replication 239 8.4 “Ad Hoc” Synthetics .245 8.5 Principles of Dynamic Replication 248 8.6 Some Important Conditions 261 8.7 Real-Life Complications .262 8.8 Conclusions 263 Suggested Reading 264 Exercises .264 CHAPTER 9.1 9.2 9.3 9.4 9.5 9.6 Mechanics of Options 267 Introduction 268 What Is an Option? .269 Options: Definition and Notation 271 Options as Volatility Instruments 277 Tools for Options 289 The Greeks and Their Uses 296 .. .Principles of Financial Engineering This page intentionally left blank Principles of Financial Engineering Third Edition Robert L Kosowski Oxford-Man Institute of Quantitative... emphasized Like Salih, I learned a great deal from technically oriented market practitioners who, over the years, have taken my courses The deep knowledge and the professionalism of these brilliant... Initially we place ourselves at time t0 The following deal is struck with a bank At time t1 we borrow 100 US dollars (USD100), at the going interest rate of time t1, called the LIBOR and denoted by