Pricing and Hedging Financial Derivatives: A Guide for Practitioners

by Leonardo Marroni, Irene Perdomo

Overview

The only guide focusing entirely on practical approaches to pricing and hedging derivatives

One valuable lesson of the financial crisis was that derivatives and risk practitioners don't really understand the products they're dealing with. Written by a practitioner for practitioners, this book delivers the kind of knowledge and skills traders and finance professionals need to fully understand derivatives and price and hedge them effectively. Most derivatives books are written by academics and are long on theory and short on the day-to-day realities of derivatives trading. Of the few practical guides available, very few of those cover pricing and hedging—two critical topics for traders. What matters to practitioners is what happens on the trading floor—information only seasoned practitioners such as authors Marroni and Perdomo can impart.

• Lays out proven derivatives pricing and hedging strategies and techniques for equities, FX, fixed income and commodities, as well as multi-assets and cross-assets
• Provides expert guidance on the development of structured products, supplemented with a range of practical examples
• Packed with real-life examples covering everything from option payout with delta hedging, to Monte Carlo procedures to common structured products payoffs
• The Companion Website features all of the examples from the book in Excel complete with source code

Product Details

ISBN-13:	9781119954583
Publisher:	Wiley
Publication date:	06/19/2014
Series:	The Wiley Finance Series
Sold by:	JOHN WILEY & SONS
Format:	eBook
Pages:	272
File size:	3 MB

About the Author

Leonardo Marroni (London, UK) is an Asset Manager at GLG Partners. He joined the EM team in January 2010 from Barclays Capital where he was working in the Commodity Investor Structuring team responsible for product development and execution of commodity investment derivatives. Before joining Barclays Capital, Leonardo was working in the Equity Structured Product Trading team at Banca Caboto in London where he was responsible for structuring and trading algorithmic products. Prior to this, Leonardo was part of the Interest Rates Derivatives Trading team at Banca Caboto in Milan. Leonardo graduated in Economics from Bocconi University, Milan.

Irene Perdomo (London, UK) is an Associate Vice President at Barclays Capital. She has worked in banking for three years and her current role is in commodities structuring. Irene has an MBA from IESE Business School which included an exchange trip with the University of Chicago Booth. Her background is in Computer Science Engineering where she had overall experience of six years working in South America and India.

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Table of Contents

Preface ix

Acknowledgements xi

1 An Introduction to the Major Asset Classes 1

1.1 Equities 1

1.2 Commodities 5

1.3 Fixed Income 12

1.4 Foreign Exchange 15

Summary 17

2 Derivatives: Forwards, Futures and Swaps 19

2.1 Derivatives 19

2.2 Forward Contracts 20

2.3 Futures Contracts 24

2.4 Calculating Implied Forward Prices and Valuing Existing Forward Contracts 26

2.5 Pricing Futures Contracts 34

2.6 Swaps 35

Summary 49

3 Derivatives: Options and Related Strategies 51

3.1 Call Options 51

3.2 Put Options 55

3.3 Boundary Conditions for Call and Put Options Prices 58

3.4 Put–Call Parity 61

3.5 Swaptions 63

3.6 Options Strategies 64

Summary 76

4 Binomial Option Pricing 77

4.1 One-Period Binomial Tree: Replication Approach 77

4.2 Risk-Neutral Valuation 83

4.3 Two-Period Binomial Tree: Valuing Back Down the Tree 85

4.4 The Binomial Tree: A Generalization 89

4.5 Early Exercise and American Options 90

4.6 Volatility Calibration 90

Summary 92

5 The Fundamentals of Option Pricing 93

5.1 Intrinsic Value and Time Value of an Option 93

5.2 What is Volatility and Why Does it Matter? 95

5.3 Measurement of Realized Volatility and Correlation 97

5.4 Option Pricing in the Black–Scholes Framework 99

5.5 The Option Delta and the Replication of the Option Payoff 100

5.6 Option Replication 102

5.7 Option Replication, Risk-Neutral Valuation and Delta Hedging Revisited 104

5.8 Options on Dividend Paying Assets 106

5.9 Options on Futures: The Black Model 107

5.10 Monte Carlo Pricing 108

5.11 Other Pricing Techniques 112

5.12 Pricing Techniques Summary 113

5.13 The Excel Spreadsheet “Option Replication” 114

Summary 117

6 Implied Volatility and the Greeks 121

6.1 Implied Volatility 121

6.2 The Greeks 123

6.3 Delta and its Dynamics 123

6.4 Gamma and its Dynamics 127

6.5 Vega and its Dynamics 132

6.6 Theta and its Dynamics 136

6.7 Rho 142

6.8 Option Trading 143

6.9 Some Additional Remarks (in Q&A Format) 146

6.10 An Example of the Behaviour of Implied Volatility: EUR/USD Rate and S&P 500 in 2010–2012 147

Summary 148

7 Volatility Smile and the Greeks of Option Strategies 151

7.1 The Volatility Smile – Why is the Implied Volatility Not Flat Across Different Strikes? 151

7.2 The “Sticky Delta” and “Sticky Strike” Approaches to Describing Volatility Smile 153

7.3 The Volatility Term Structure – Why is the Implied Volatility Not Flat Across Different Expiries? 155

7.4 The Volatility Surface – Combining Smile and Term Structure 156

7.5 Analysing the Greeks of Common Option Strategies 158

7.6 Some Additional Remarks on Straddles, Risk Reversals and Butterflies 170

7.7 Vega Hedging is Not Just Simply Offsetting Overall Vega Exposure 171

7.8 Hedging Volatility Risk: A Brief Introduction of the Vanna–Volga Approach 172

7.9 The Volatility Smile – One Step Further 173

7.10 Pricing Exotic Options 178

7.11 Different Types of Volatility 179

Summary 184

8 Exotic Derivatives 185

8.1 Exotic Derivatives with Fixed Payoffs 185

8.2 Other Common Exotic Derivatives 188

8.3 European Digital Options: Pricing and Greeks 191

8.4 Other Exotic Options: Pricing and Greeks 200

Summary 208

9 Multi-Asset Derivatives 209

9.1 Basket Options 209

9.2 Best-of and Worst-of Options 211

9.3 Quanto Derivatives 222

9.4 “Compo” Derivatives 225

Summary 227

10 Structured Products 229

10.1 Definition 229

10.2 Common Features 229

10.3 Principal Protection 230

10.4 The Benefit to the Issuer 231

10.5 Redemption Amounts and Participation 232

10.6 Principal at Risk: Embedding a Short Option 234

10.7 More Complicated Payoffs 235

10.8 Auto-Callable Note: Pricing and Risk Profile 238

10.9 One Step Forward: The Worst-of Digital Note 240

10.10 A Real-Life Example of Structured Product 241

10.11 Liquidity and Exchange-Traded Notes (ETNs) 242

Summary 243

Index 245