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Risk-Transfer Tools and

Topics Made Easy
Second Edition

DON M. CHANCE, Ph.D., CFA

Louisiana State University

WILEY
John Wiley & Sons, Inc.
Preface to the New Eitiomi KI
Preface to the Hrat Eitiomi MV

Derivatives ami! Tito* iVlarkets H

ESSAY 1
The Structure of Derivative Markets 3

ESSAY 2
A Brief History of Derivatives 7

ESSAYS

ESSAY 4
Forward Contracts and Futures Contracts 25

ESSAY 5
29

ESSAYS
Swaps 33

ESSAY 7
Types of Risks 37
Vi CONTENTS

SECTION TOO
The Basic tottramenrts 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 B7

ESSAY 14
Equity-Linked Debt 71

ESSAY 15
Commodity Swaps 75

ESSAY I I
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
Contents Vii

SECTION THRE
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 Pricino: The Black-Scholes-Merton Model 133

ESSAY 28
Option Pricing: The Binomial Model

ESSAY 29
Option Pricing: Numerical Methods

ESSAY 30
Dynamic Option Replication 147

ESSAY 31
Risk-Neutral Pricing of Derivatives: n 153

ESSAY 32
Risk-Neutral Pricing of Derivatives: ID 159

ESSAY 33
irs All Greek to Me 165
Viil CONTENTS

ESSAY 34
Implied Volatility 169

ESSAY 35
American Call Option Pricing 175

ESSAY 36
American Put Option Pricing 181

ESSAY 37
Swap Pricing 185

ESSAY 38
Asset Allocation with Derivatives

ESSAY 39
Protective Puts and Portfolio Insurance 197

ESSAY 40
Misconceptions about Covered Call Writing 201

ESSAY 41
Hedge Funds and Other Privately n/ianaged Accounts 205

ESSAY 42
Spreads, Collars, and Prepaid Forwards 209

ESSAY 43
Box Spreads 213

Exotic tagtrmneiiti 217

ESSAY 44
Barrier Options 219
Contents ix

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 SIH
Hcome Securities ami ieoivatives 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
IK CONTENTS

ESSAY 57
Theories of the Term Structure: 1 279

ESSAY 58
Simple Models of the Term Structure: Vasicek aid
Cox-lngersoll-Boss 285

ESSAY 59
No-Arbitrage Models of the Term Structure: Mo-D.ee and
Heath-Jarrow-Morton 291

ESSAY 60
Tree Pricing of Bonds and Interest Rate Derivatives: D 297

ESSAY 61
Tree Pricing of Bonds and Interest Rate Derivatives: 1 301

ESSAY 62
Tree Pricing of Bonds and Interest Bate Derivatives: I 307

ESSAY 63
Tree Pricing of BtmtBs and Interest Bate Derivatives: IV 313

ESSAY 64
Tree Pricing of Bonds araJ Dnterest Bate Derivatives: V 319

SECTION. SEVEN ~. Y _, ,^,.,__ _ _ „_

Other Topics mi Issues
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
Contents xj

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

RecommeraJeiJ
Answers to End-olHEs$ay Questions 3811