Table of Contents Preface Acknowledgments About the Author Part One: Introduction to Forwards, Futures, and Options Chapter 1: Forwards and Futures Introduction 1.1 Forward contract characteristics 1.2 Long forward payoff 1.3 Long forward P&L 1.4 Short forward payoff 1.5 Short forward P&L 1.6 Long forward P&L diagram 1.7 Short forward P&L diagram 1.8 Forwards are zero-sum games 1.9 Counterparty credit risk 1.10 Futures contracts Key Points Chapter 2: Call Options Introduction 2.1 Call option characteristics 2.2 Long call payoff 2.3 Long call P&L 2.4 Short call payoff 2.5 Short call P&L 2.6 Long call P&L diagram 2.7 Short call P&L diagram 2.8 Call options are zero-sum games 2.9 Call option moneyness 2.10 Exercising a call option early 2.11 Comparison of call options and forwards/futures Key Points Chapter 3: Put Options Introduction 3.1 Put option characteristics 3.2 Long put payoff 3.3 Long put P&L 3.4 Short put payoff 3.5 Short put P&L 3.6 Long put P&L diagram 3.7 Short put P&L diagram 3.8 Put options are zero-sum games 3.9 Put option moneyness 3.10 Exercising a put option early 3.11 Comparison of put options, call options, and forwards Key Points Part Two: Pricing and Valuation Chapter 4: Useful Quantitative Concepts Introduction 4.1 Compounding conventions 4.2 Calculating future value and present value 4.3 Identifying continuously compounded interest rates 4.4 Volatility and historical standard deviation 4.5 Interpretation of standard deviation 4.6 Annualized standard deviation 4.7 The standard normal cumulative distribution function 4.8 The z-score Key Points Chapter 5: Introduction to Pricing and Valuation Introduction 5.1 The concepts of price and value of a forward contract 5.2 The concepts of price and value of an option 5.3 Comparison of price and value concepts for forwards and options 5.4 Forward value 5.5 Forward price 5.6 Option value: The Black-Scholes model 5.7 Calculating the Black-Scholes model 5.8 Black-Scholes model assumptions 5.9 Implied volatility Key Points Chapter 6: Understanding Pricing and Valuation Introduction 6.1 Review of payoff, price, and value equations 6.2 Value as the present value of expected payoff 6.3 Risk-neutral valuation 6.4 Probability and expected value concepts 6.5 Understanding the Black-Scholes equation for call value 6.6 Understanding the Black-Scholes equation for put value 6.7 Understanding the equation for forward value 6.8 Understanding the equation for forward price Key Points Chapter 7: The Binomial Option Pricing Model Introduction 7.1 Modeling discrete points in time 7.2 Introduction to the one-period binomial option pricing model 7.3 Option valuation, one-period binomial option pricing model 7.4 Two-period binomial option pricing model, European-style option 7.5 Two-period binomial model, American-style option 7.6 Multi-period binomial option pricing models Key Points Part Three: The Greeks Chapter 8: Introduction to the Greeks Introduction 8.1 Definitions of the Greeks 8.2 Characteristics of the Greeks 8.3 Equations for the Greeks 8.4 Calculating the Greeks 8.5 Interpreting the Greeks 8.6 The accuracy of the Greeks Key Points Chapter 9: Understanding Delta and Gamma Introduction 9.1 Describing sensitivity using Delta and Gamma 9.2 Understanding Delta 9.3 Delta across the underlying asset price 9.4 Understanding Gamma 9.5 Gamma across the underlying asset price Key Points Chapter 10: Understanding Vega, Rho, and Theta Introduction 10.1 Describing sensitivity using Vega, Rho, and Theta 10.2 Understanding Vega 10.3 Understanding Rho 10.4 Understanding Theta Key Points Part Four: Trading Strategies Chapter 11: Price and Volatility Trading Strategies Introduction 11.1 Price and volatility views 11.2 Relating price and volatility views to Delta and Vega 11.3 Using forwards, calls, and puts to monetize views 11.4 Introduction to straddles 11.5 Delta and Vega characteristics of long and short straddles 11.6 The ATM DNS strike price 11.7 Straddle: numerical example 11.8 P&L diagrams for long and short straddles 11.9 Breakeven points for long and short straddles 11.10 Introduction to strangles 11.11 P&L diagrams for long and short strangles 11.12 Breakeven points for long and short strangles 11.13 Summary of simple price and volatility trading strategies Key Points Chapter 12: Synthetic, Protective, and Yield-Enhancing Trading Strategies Introduction 12.1 Introduction to put-call parity and synthetic positions 12.2 P&L diagrams of synthetic positions 12.3 Synthetic positions premiums and ATMF 12.4 The Greeks of synthetic positions 12.5 Option arbitrage 12.6 Protective puts 12.7 Covered calls 12.8 Collars Key Points Chapter 13: Spread Trading Strategies Introduction 13.1 Bull and bear spreads using calls 13.2 Bull and bear spreads using puts 13.3 Risk reversals 13.4 Butterfly spreads 13.5 Condor spreads Key Points Part Five: Swaps Chapter 14: Interest Rate Swaps Introduction 14.1 Interest rate swap characteristics 14.2 Interest rate swap cash flows 14.3 Calculating interest rate swap cash flows 14.4 How interest rate swaps can transform cash flows Key Points Chapter 15: Credit Default Swaps, Cross-Currency Swaps, and Other Swaps Introduction 15.1 Credit default swap characteristics 15.2 Key determinants of the credit default swap spread 15.3 Cross-currency swap characteristics 15.4 Transforming cash flows using a cross-currency swap 15.5 Other swap varieties Key Points Appendix: Solutions to Knowledge Check Questions A.1 Chapter 1: Forwards and Futures A.2 Chapter 2: Call Options A.3 Chapter 3: Put Options A.4 Chapter 4: Useful Quantitative Concepts A.5 Chapter 5: Introduction to Pricing and Valuation A.6 Chapter 6: Understanding Pricing and Valuation A.7 Chapter 7: The Binomial Option Pricing Model A.8 Chapter 8: Introduction to the Greeks A.9 Chapter 9: Understanding Delta and Gamma A.10 Chapter 10: Understanding Vega, Rho, and Theta A.11 Chapter 11: Price and Volatility Trading Strategies A.12 Chapter 12: Synthetic, Protective, and Yield-Enhancing Trading Strategies A.13 Chapter 13: Spread Trading Strategies A.14 Chapter 14: Interest Rate Swaps A.15 Chapter 15: Credit Default Swaps, Cross-Currency Swaps, and Other Swaps Index End User License Agreement List of Illustrations Chapter 1: Forwards and Futures Figure 1.1 Forward contract cash flows Figure 1.2 Forward contract cash flows example Figure 1.3 Forward contract cash flows example Figure 1.4 Long forward payoff example Figure 1.5 Long forward P&L example Figure 1.6 Short forward payoff example Figure 1.7 Short forward P&L example Figure 1.8 Long forward P&L diagram Figure 1.9 Long forward P&L diagram Figure 1.10 Short forward P&L diagram Figure 1.11 Short forward P&L diagram Figure 1.12 Forward contract as a zero-sum game Chapter 2: Call Options Figure 2.1 European-style call option cash flows Figure 2.2 European-style call option cash flows example Figure 2.3 Long call P&L diagram Figure 2.4 Long call P&L diagram example Figure 2.5 Short call P&L diagram Figure 2.6 Short call P&L diagram Figure 2.7 Call option as a zero-sum game Chapter 3: Put Options Figure 3.1 European-style put option cash flows Figure 3.2 European-style put option cash flows example Figure 3.3 Long put P&L diagram Figure 3.4 Long put P&L diagram example Figure 3.5 Short put P&L diagram Figure 3.6 Short put P&L diagram example Figure 3.7 Put option as a zero-sum game Chapter 4: Useful Quantitative Concepts Figure 4.1 Growth of an investment that receives 5% over one year Figure 4.2 Growth of an investment that receives 2.5% for two six-month periods Figure 4.3 Probability of return above or below the average return Figure 4.4 Probability of return within one standard deviation of the average return Figure 4.5 Probability of return within two standard deviations of the average return Figure 4.6 Probability of return within three standard deviations of the average return Chapter 5: Introduction to Pricing and Valuation Figure 5.1 Volatility term structure example Figure 5.2 Volatility smile example Figure 5.3 Volatility skew example Figure 5.4 Volatility surface example Chapter 7: The Binomial Option Pricing Model Figure 7.1 Discrete points in time in one-, two-, three-, and four-period models Figure 7.2 Characteristics of the underlying asset, one-period binomial model Figure 7.3 Underlying asset example, one-period binomial model Figure 7.4 Characteristics of a call option, one-period binomial model Figure 7.5 Call option example, one-period binomial model Figure 7.6 Cost and payoffs associated with a portfolio consisting of α of the underlying asset and a short call Figure 7.7 Cost and payoffs example associated with a portfolio consisting of α of the underlying asset and a short call Figure 7.8 Underlying asset example, two-period binomial model Figure 7.9 European-style put option example, two-period binomial model Figure 7.10 Midpoint node valuation, European-style put option example, twoperiod binomial model Figure 7.11 Option valuation, European-style put option example, two-period binomial model Figure 7.12 Option valuation, American-style put option example, two-period binomial model Chapter 9: Understanding Delta and Gamma Figure 9.1 Delta across the underlying asset price for long and short calls and puts Figure 9.2 Gamma across the underlying asset price for long and short calls and puts Chapter 10: Understanding Vega, Rho, and Theta Figure 10.1 The symmetrical sensitivity of forward positions Figure 10.2 The asymmetrical sensitivity of long calls and puts Figure 10.3 The asymmetrical sensitivity of short calls and puts Figure 10.4 Examples of long call and put values across time to expiration Chapter 11: Price and Volatility Trading Strategies Figure 11.1 Long and short straddles' P&L diagrams Figure 11.2 Long and short strangles' P&L diagrams Chapter 12: Synthetic, Protective, and Yield-Enhancing Trading Strategies Figure 12.1 P&L diagrams for long and short synthetic forwards Figure 12.2 P&L diagrams for long and short synthetic calls Figure 12.3 P&L diagrams for long and short synthetic puts Figure 12.4 P&L diagram for a collar Chapter 13: Spread Trading Strategies Figure 13.1 P&L diagrams for bull and bear spreads using calls Figure 13.2 P&L diagrams for bull and bear spreads using puts Figure 13.3 P&L diagram for a risk reversal Figure 13.4 P&L diagrams for long and short butterfly spreads Figure 13.5 P&L diagrams for long and short condor spreads Chapter 14: Interest Rate Swaps Figure 14.1 The exchange of fixed rate for floating rate in an interest rate swap Figure 14.2 Floating rate borrower Figure 14.3 Transformation of floating rate borrowing into fixed rate borrowing Figure 14.4 Floating rate lender Figure 14.5 Transformation of floating rate lending into fixed rate lending Figure 14.6 Fixed rate borrower Figure 14.7 Transformation of fixed rate borrowing into floating rate borrowing Figure 14.8 Fixed rate lender Figure 14.9 Transformation of a fixed rate lending into floating rate lending Chapter 15: Credit Default Swaps, Cross-Currency Swaps, and Other Swaps Figure 15.1 GBP borrower Figure 15.2 Transformation of GBP borrowing into EUR borrowing: detailed cash flows Figure 15.3 Transformation of GBP borrowing into EUR borrowing: net cash flows List of Tables Chapter 2: Call Options Table 2.1 Call option exercise decision and long call payoff Table 2.2 Call option exercise decision and long call payoff and P&L Table 2.3 Call option exercise decision and short call payoff Table 2.4 Call option exercise decision and short call payoff and P&L Table 2.5 Long and short call P&L and net P&L Table 2.6 Call option moneyness and long and short call payoff Table 2.7 Comparison of forwards/futures and call option positions Chapter 3: Put Options Table 3.1 Put option exercise decision and long put payoff Table 3.2 Put option exercise decision and long put payoff and P&L Table 3.3 Put option exercise decision and short put payoff Rho sensitivity of synthetic short forward Theta value Vega when a liability when an asset why Delta is constant why Gamma is zero why Rho is negative Why theta is positive why Vega is zero zero payoff point Short Gamma short interest rate swap and LIBOR definition motivation using to transform fixed to floating rate borrowing using to transform floating to fixed rate lending Short position butterfly call option condor forward contract put option straddle strangle Short put and bear spreads using puts and bull spreads using puts and covered calls and price views and risk reversals and short straddles and short strangles and volatility views as a selling counterparty as a trading strategy Black-Scholes model breakeven point comparison with long call comparison with long forward comparison with long put comparison with short call comparison with short forward definition Delta Gamma Greeks loss range nature of obligation negative payoff range P&L diagram P&L payoff profit range Rho sensitivity of synthetic short put Theta Vega why Delta is positive why Gamma is negative why Rho is positive why Theta is either positive or negative why Vega is negative zero payoff range Short Rho Short straddle and long butterfly spreads and price views and short calls and short puts and the strike price and volatility views as a trading strategy at-the-money Delta-neutral-straddle (ATM DNS) breakeven points cash flows definition Delta how formed P&L diagram sensitivity of Vega when exactly Delta neutral why broadly Delta neutral why Vega is negative Short strangle and long condor spreads and price views and short butterfly spreads and short calls and short condor spreads and short puts and the strike price and volatility views as a trading strategy breakeven points definition how formed P&L diagram sensitivity of Short Theta Short Vega and volatility bearish views Single-stock futures contracts Spark spread swap Standard deviation and average return and the normal distribution assumption and variance annualized as a measure of risk calculation historical standard deviation implied volatility interpretation sample standard deviation population standard deviation Standard normal cumulative distribution function and NORM.S.DIST( ) and probability of returns above a given return and probability of returns below a given return and the Z-score assumptions definition inputs N( ) output STDEV.S( ) Straddles at-the-money Delta-neutral-straddle (ATM DNS) breakeven points cash flows comparison to strangles definition Delta characteristics long straddle P&L diagrams short straddle Vega characteristics why broadly Delta neutral Strangles breakeven points comparison to straddles definition long strangle P&L diagrams short strangle Strike price and the Black-Scholes model definition versus call price Swap commodity swap crack spread swap credit default swap cross-currency swap definition equity swap equity-for-equity swap interest rate swap spark spread swap Synthetic long call and option arbitrage and protective puts and put-call parity Greeks how formed P&L diagram relationship with traded long call Synthetic long forward and at-the-money forward (ATMF) and option arbitrage and put-call parity Greeks how formed P&L diagram relationship with traded long forward when zero premium Synthetic long put and option arbitrage and put-call parity Greeks how formed P&L diagram relationship with traded long put Synthetic positions and at-the-money forward (ATMF) and option arbitrage and put-call parity Greeks how formed P&L diagrams premiums synthetic long call synthetic long forward synthetic long put synthetic short call synthetic short forward synthetic short put Synthetic short call and option arbitrage and put-call parity Greeks how formed P&L diagram relationship with traded short call Synthetic short forward and option arbitrage and put-call parity Greeks how formed P&L diagram and at-the-money forward (ATMF) relationship with traded short forward when zero premium Synthetic short put and covered calls and option arbitrage and put-call parity Greeks how formed P&L diagram relationship with traded short put Tenor Theta and decay and purchasing counterparties and selling counterparties and the level of interest rates and the time to expiration as a measure of sensitivity calculation definition equation interpretation of long forward long call long put long Theta optionality value effect present value effect short call short forward short put short Theta source of sensitivity Theta neutral when a put is deep-in-the-money (deep-ITM) when a put is near-the-money why it is not a measure of risk Theta neutral TIBOR Time value of money future value present value when rates are continuously compounded when rates are not continuously compounded Time value Tokyo interbank Offered Rate See TIBOR Trading strategies and price views and volatility views bear spreads using calls bear spreads using puts bear spreads bull spreads using calls bull spreads using puts bull spreads butterfly spreads collars condors spreads covered calls dividend option arbitrage long butterfly spreads long call long condor spreads long forward long put long straddle long strangle monetizing price and volatility views option arbitrage protective puts risk reversals short butterfly spreads short call short condor spreads short forward short put short straddle short strangle spread strategies straddles strangles synthetic long call synthetic long forward synthetic long put synthetic short call synthetic short forward synthetic short put when price bearish and volatility bearish when price bearish and volatility bullish when price bearish and volatility neutral when price bullish and volatility bearish when price bullish and volatility bullish when price bullish and volatility neutral when price neutral and volatility bearish when price neutral and volatility bullish when price neutral and volatility neutral Two-period binomial option pricing model American-style options European-style options Upfront reconciling payments Value as the present value of expected payoff at forward initiation at option initiation comparison of value concept for forwards and options definition long call long forward long put post-contract initiation relationship between long and short position value short call short forward short put Variance Vega across the underlying asset price and the underlying asset volatility and volatility views as a measure of risk as a measure of sensitivity calculation definition equation interpretation of long call long forward long put long Vega relationship between call and put Vega short call short forward short put short Vega source of sensitivity Vega neutral Vega neutral and volatility neutral views Volatility definition historical standard deviation implied volatility Volatility bearish and short calls and short puts and short straddles and short strangles and Vega definition Volatility bullish and long calls and long puts and long straddles and long strangles and Vega definition Volatility neutral and long forwards and short forwards and Vega definition Volatility skew and implied volatility definition interpretation of Volatility smile and implied volatility definition interpretation of Volatility surface and implied volatility definition interpretation of Volatility term structure and implied volatility definition interpretation of Volatility views and long calls and long forwards and long puts and long straddles and long strangles and price views and short calls and short forwards and short puts and short straddles and short strangles and Vega definition monetization volatility bearish volatility bullish volatility neutral Zero-sum game attribute call option definition forward contract put option Z-score WILEY END USER LICENSE AGREEMENT Go to www.wiley.com/go/eula to access Wiley's ebook EULA ... committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding Derivatives Essentials An Introduction to Forwards,. .. 9: Understanding Delta and Gamma Table 9.1 Describing sensitivity using Delta and Gamma Table 9.2 Delta and Gamma of forwards and options Table 9.3 Example of Delta and Gamma for long and short... and short put payoff and P&L Table 3.5 Long and short put P&L and net P&L Table 3.6 Put option moneyness and long and short put payoff Table 3.7 Comparison of forwards /futures, call option, and