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