Table Of ContentPrinciples of Financial
Engineering
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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
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Contents
Preface tothe ThirdEdition..............................................................................................................xvii
CHAPTER 1 Introduction ................................................................................1
1.1 A Unique Instrument..................................................................................................2
1.2 A Money Market Problem........................................................................................10
1.3 A Taxation Example.................................................................................................13
1.4 Some Caveats for What Isto Follow.......................................................................17
1.5 Trading Volatility.....................................................................................................18
1.6 Conclusions...............................................................................................................22
Suggested Reading...........................................................................................................22
Exercises...........................................................................................................................22
CHAPTER 2 Institutional Aspects of Derivative Markets..................................25
2.1 Introduction...............................................................................................................26
2.2 Markets.....................................................................................................................26
2.3 Players.......................................................................................................................35
2.4 TheMechanics ofDeals...........................................................................................36
2.5 Market Conventions..................................................................................................39
2.6 Instruments................................................................................................................41
2.7 Positions....................................................................................................................41
2.8 TheSyndication Process...........................................................................................50
2.9 Conclusions...............................................................................................................51
Suggested Reading...........................................................................................................51
Exercises...........................................................................................................................51
CHAPTER 3 Cash Flow Engineering, Interest Rate Forwards and Futures .........53
3.1 Introduction...............................................................................................................54
3.2 What Is aSynthetic?.................................................................................................55
3.3 Engineering Simple Interest Rate Derivatives.........................................................59
3.4 LIBORand Other Benchmarks................................................................................63
3.5 Fixed Income Market Conventions..........................................................................64
3.6 A Contractual Equation............................................................................................70
3.7 Forward Rate Agreements........................................................................................79
3.8 Fixed Income Risk Measures: Duration,Convexity and Value-at-Risk.................83
3.9 Futures: Eurocurrency Contracts..............................................................................89
vii
viii Contents
3.10 Real-WorldComplications.....................................................................................95
3.11 Forward Rates and Term Structure........................................................................96
3.12 Conventions............................................................................................................98
3.13 ADigression: Strips...............................................................................................99
3.14 Conclusions.............................................................................................................99
Suggested Reading.........................................................................................................100
Appendix—Calculating the Yield Curve.......................................................................100
Exercises.........................................................................................................................103
CHAPTER 4 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 ofSwaps.....................................................................................................117
4.5 Engineering Interest-Rate Swaps.........................................................................124
4.6 Uses ofSwaps.......................................................................................................133
4.7 Mechanics ofSwapping New Issues....................................................................140
4.8 Some Conventions................................................................................................144
4.9 AdditionalTerminology.......................................................................................145
4.10 Conclusions...........................................................................................................145
Suggested Reading.........................................................................................................145
Exercises.........................................................................................................................146
CHAPTER 5 Repo Market Strategies in Financial Engineering....................... 149
5.1 Introduction.............................................................................................................150
5.2 Repo Details............................................................................................................151
5.3 Types ofRepo.........................................................................................................154
5.4 Equity Repos...........................................................................................................160
5.5 Repo Market Strategies..........................................................................................161
5.6 Synthetics Using Repos..........................................................................................168
5.7 Differences Between Repo Marketsand the Impact of the GFC..........................170
5.8 Conclusions.............................................................................................................170
Suggested Reading.........................................................................................................171
Exercises.........................................................................................................................171
CHAPTER 6 Cash Flow Engineering in Foreign Exchange Markets................. 175
6.1 Introduction.............................................................................................................176
6.2 Currency Forwards.................................................................................................178
6.3 Synthetics and Pricing............................................................................................183
6.4 AContractual Equation..........................................................................................184
Contents ix
6.5 Applications..........................................................................................................185
6.6 Conventions for FXForward and Futures...........................................................191
6.7 Swap Engineeringin FXMarkets........................................................................194
6.8 Currency Swaps Versus FXSwaps......................................................................198
6.9 MechanicsofSwapping New Issues....................................................................204
6.10 Conclusions...........................................................................................................206
Suggested Reading.........................................................................................................207
Exercises.........................................................................................................................207
CHAPTER 7 Cash Flow Engineering and Alternative Classes
(Commodities and Hedge Funds)............................................... 211
7.1 Introduction.............................................................................................................212
7.2 Parameters of aFuturesContract...........................................................................212
7.3 TheTerm Structure of CommodityFuturesPrices...............................................215
7.4 Swap Engineeringfor Commodities......................................................................221
7.5 TheHedgeFundIndustry.......................................................................................228
7.6 Conclusions.............................................................................................................233
Suggested Reading.........................................................................................................234
Exercises.........................................................................................................................234
CHAPTER 8 Dynamic Replication Methods and Synthetics Engineering.........237
8.1 Introduction.............................................................................................................238
8.2 An Example............................................................................................................238
8.3 A Review ofStatic 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 Mechanics of Options.............................................................. 267
9.1 Introduction.............................................................................................................268
9.2 What Is anOption?.................................................................................................269
9.3 Options:Definition and Notation...........................................................................271
9.4 Options asVolatilityInstruments...........................................................................277
9.5 Tools for Options....................................................................................................289
9.6 TheGreeks andTheirUses....................................................................................296
