Derivatives:

Principles and
Practice
Rangarajan K. Sundaram
Stern School of Business
New York University
New York, NY 10012

Sanjiv R. Das
Leavey School of Business
Santa Clara University
Santa Clara, CA 95053

I McGraw-Hill
I Irwin
Contents
Author Biographies xv 3.8 Futures Prices 72
3.9 Exercises 74
Preface xvi Appendix 3A Compounding Frequency 79
Acknowledgments xxi Appendix 3B Forward and Futures Prices with
Constant Interest Rates 81
Appendix 3C Rolling Over Futures Contracts 83
Chapter 1
Introduction 1 Chapter 4
1.1 Forward and Futures Contracts 5 Pricing Forwards and Futures II: Building
1.2 Options 9 - on the Foundations 85
1.3 Swaps 10
4.1 Introduction 85
1.4 Using Derivatives: Some Comments 11
4.2 From Theory to Reality 85
1.5 The Structure of this Book 14
4.3 The Implied Repo Rate 89
1.6 Exercises 15
4.4 Transactions Costs 92
4.5 Forward Prices and Future Spot Prices 92
PART ONE 4.6 Index Arbitrage 93
Futures and Forwards 17 4.7 Exercises 97
Appendix 4A Forward Prices with Convenience
Chapter 2 Yields 100
Futures Markets 19
Chapter 5
2.1 Introduction 19
Hedging with Futures and Forwards 101
2.2 The Changing Face of Futures Markets 19
2.3 The Functioning of Futures Exchanges 21 5.1 Introduction 101
2.4 The Standardization of Futures Contracts 30 5.2 A Guide to the Main Results 103
2.5 Closing Out Positions 34 5.3 The Cash Flow from a Hedged Position 104
2.6 Margin Requirements and Default Risk 36 5.4 The Case of No Basis Risk 105
2.7 Case Studies in Futures Markets 39 5.5 The Minimum-Variance Hedge Ratio 106
2.8 Exercises 53 5.6 Examples 109
Appendix 2A Futures Trading and US Regulation: 5.7 Implementation 111
A Brief History 57 5.8 Further Issues in Implementation 112
5.9 Index Futures and Changing Equity Risk 114
Chapter 3 5.10 Fixed-Income Futures and Duration-Based
Pricing Forwards and Futures I: The Basic Hedging 115
5.11 Exercises 115
Theory 60
Appendix 5A Derivation of the Optimal Tailed
3.1 Introduction 60 Hedge Ratio h** 120
3.2 Pricing Forwards by Replication 61
3.3 Examples 63 Chapter 6
3.4 Forward Pricing on Currencies and Related Interest-Rate Forwards and Futures 122
Assets 66
3.5 Forward-Rate Agreements 69 6.1 Introduction 122
3.6 Concept Check 69 6.2 Eurodollars and Libor Rates 122
3.7 The Marked-to-Market Value of a Forward 6.3 Forward-Rate Agreements 123
Contract 70 6.4 Eurodollar Futures 129

viii
 Contents ix

6.5 Treasury Bond Futures 136 Chapter 9

6.6 Treasury Note Futures 139 No-Arbitrage Restrictions on Option
6.7 Treasury Bill Futures 139 Prices 196
6.8 Duration-Based Hedging 140
6.9 Exercises 143 9.1 Introduction 196
Appendix 6A Deriving the Arbitrage-Free 9.2 Motivating Examples 196
FRA Rate 147 9.3 Notation and Other Preliminaries 198
Appendix 6B PVBP-Based Hedging Using 9.4 Maximum and Minimum Prices for
Eurodollar Futures 148 Options 199
Appendix 6C Calculating the Conversion 9.5 The Insurance Value of an Option 204
Factor 149 9.6 Option Prices and Contract Parameters 205
Appendix 6D Duration as a Sensitivity 9.7 Numerical Examples 208
Measure 150 9.8 Exercises 210
Appendix 6E The Duration of a Futures
Contract 151 Chapter 10
Early Exercise and Put-Call Parity 213
PART TWO 10.1 Introduction 213
Options 153 10.2 A Decomposition of Option Prices 213
10.3 The Optimality of Early Exercise 216
10.4 Put-Call Parity. 220
Chapter 7 10.5 Exercises 226
Options Markets 155
7.1 Introduction 155 Chapter 11
7.2 Definitions and Terminology 155 Option Pricing: An Introduction 228
7.3 Options as Financial Insurance 156
11.1 Overview 228
7.4 Naked Option Positions 158
11.2 The Binomial Model 229
7.5 Options as Views on Market Direction
11.3 Pricing by Replication in a One-Period
and Volatility 162
Binomial Model 231
7.6 Exercises 165
11.4 Comments 235
Appendix 7A Options Markets 167
11.5 Riskless Hedge Portfolios 237
11.6 Pricing Using Risk-Neutral
Chapter 8 Probabilities 238
Options: Payoffs and Trading 11.7 The One-Period Model in General
Strategies 171 Notation 242
11.8 The Delta of an Option 242
8.1 Introduction 171 11.9 An Application: Portfolio Insurance 246
8.2 Trading Strategies I: Covered Calls and 11.10 Exercises 248
Protective Puts 171 Appendix 11A Riskless Hedge Portfolios
8.3 Trading Strategies II: Spreads 174 and Option Pricing 252
8.4 Trading Strategies III: Combinations 182 Appendix 11B Risk-Neutral Probabilities
8.5 Trading Strategies IV: Other Strategies 185 and Arrow Security Prices 254
8.6 Which Strategies Are the Most Widely Appendix 11C The Risk-Neutral Probability,
Used? 189 No-Arbitrage, and Market
8.7 The Barings Case 189 Completeness 255
8.8 Exercises 192 Appendix 11D Equivalent Martingale
Appendix 8A Asymmetric Butterfly Measures 257
Spreads 195
x Contents

Chapter 12 14.10 Exercises 335

Binomial Option Pricing 259 Appendix 14A Further Properties of the
Black-Scholes Delta 338
12.1 Introduction 259 Appendix 14B Variance and Volatility Swaps 339
12.2 The Two-Period Binomial Tree 261
12.3 Pricing Two-Period European Options 262 Chapter 15
12.4 European Option Pricing in General w-Period
The Mathematics of Black-Scholes 344
Trees 269
12.5 Pricing American Options: Preliminary 15.1 Introduction 344
Comments 269 15.2 Geometric Brownian Motion Defined 344
12.6 American Puts on Non-Dividend-Paying 15.3 The Black-Scholes Formula via
Stocks 270 Replication 348
12.7 Cash Dividends in the Binomial Tree 272 15.4 The Black-Scholes Formula via Risk-Neutral
12.8 An Alternative Approach to Cash Pricing 351
Dividends 275 15.5 The Black-Scholes Formula via CAPM 353
12.9 Dividend Yields in Binomial Trees 279 15.6 Exercises 354
12.10 Exercises 282
Appendix 12A A General Representation of Chapter 16
European Option Prices 286 Options Modeling:
Beyond Black-Scholes 357
Chapter 13
16.1 Introduction 357
Implementing the Binomial Model 289
16.2 Jump-Diffusion Models 358
13.1 Introduction 289 16.3 Stochastic Volatility 368
13.2 The Lognormal Distribution 289 16.4 GARCH Models 374
13.3 Binomial Approximations of the 16.5 Other Approaches 378
Lognormal 294 16.6 Implied Binomial Trees/Local Volatility
13.4 Computer Implementation of the Binomial Models 379
Model 298 16.7 Summary 389
13.5 Exercises 303 16.8 Exercises 389
Appendix 13A Estimating Historical Appendix 16A Program Code for Jump-
Volatility 306 Diffusions 393
Appendix 16B Program Code for a Stochastic
Chapter 14 Volatility Model 394
The Black-Scholes Model 308 Appendix 16C Heuristic Comments on Option
Pricing under Stochastic
14.1 Introduction 308 Volatility 396
14.2 Option Pricing in the Black-Scholes Appendix 16D Program Code for Simulating
Setting 310 GARCH Stock Prices
14.3 Remarks on the Formula 313 Distributions 399
14.4 Working with the Formulae I: Plotting Option Appendix 16E Local Volatility Models: The Fourth
Prices 314 Period of the Example 400
14.5 Working with the Formulae II: Algebraic
Manipulation 315 Chapter 17
14.6 Dividends in the Black-Scholes Model 319
14.7 Options on Indices, Currencies,
Sensitivity Analysis: The Option
and Futures 324 "Greeks" 404
14.8 Testing the Black-Scholes Model: Implied 17.1 Introduction 404
Volatility 327 17.2 Interpreting the Greeks: A Snapshot
14.9 The VIX and Its Derivatives 332 View 404
 Contents xi

17.3 The Option Delta 408 Chapter 21

17.4 The Option Gamma 412 Convertible Bonds 519
17.5 The Option Theta 418
17.6 The Option Vega 423 21.1 Introduction 519
17.7 The Option Rho 426 21.2 Convertible Bond Terminology 519
17.8 Portfolio Greeks 429 21.3 Main Features of Convertible Bonds 520
17.9 Exercises 432 21.4 Breakeven Analysis 522
Appendix 17A Deriving the Black-Scholes 21.5 Pricing Convertibles: A First Pass 523
Option Greeks 436 21.6 Incorporating Credit Risk 530
21.7 Convertible Greeks 534
21.8 Convertible Arbitrage 542
Chapter 18 21.9 Summary 542
Exotic Options I: Path-Independent 21.10 Exercises 543
Options 440 Appendix 21A Octave Code for the Blended
18.1 Introduction 440 Discount Rate Valuation Tree 545
Appendix 21B Octave Code for the Simplified
18.2 Forward Start Options 442
Das-Sundaram Model 546
18.3 Binary Options 445
18.4 Chooser Options 450
18.5 Compound Options 453 Chapter 22
18.6 Exchange Options 458 Real Options 548
18.7 Quanta Options 460 22.1 Introduction 548
18.8 Variants on the Exchange 22.2 Preliminary Analysis and Examples 550
Option Theme 462 22.3 A Real Options "Case Study" 554
18.9 Exercises 465 22.4 Creating the State Space 560
22.5 Applications of Real Options 563
Chapter 19 22.6 Summary 564
Exotic Options II: Path-Dependent 22.7 Exercises 564
Options 470 Appendix 22A Derivation of Cash-Flow Value
in the "Waiting-to-Invest"
19.1 Path-Dependent Exotic Example 568
Options 470 _
19.2 Barrier Options 470
19.3 Asian Options 479 PART THREE
19.4 Lookback Options 485 Swaps 569
19.5 Cliquets 488
19.6 Shout Options 490 Chapter 23
19.7 Exercises 492 Interest Rate Swaps and Floating-Rate
Appendix 19A Barrier Option Pricing Products 571
Formulae 496
23.1 Introduction 571
23.2 Floating-Rate Notes 571
Chapter 20 23.3 Interest Rate Swaps 575
Value-at-Risk 498 23.4 Uses of Swaps 576
20.1 Introduction 498 23.5 Swap Payoffs 579
20.2 Value-at-Risk 498 23.6 Valuing and Pricing Swaps 582
20.3 Risk Decomposition 505 23.7 Extending the Pricing Arguments 586
20.4 Coherent Risk Measures 511 23.8 Case Study: The Procter & Gamble-Bankers
Trust "5/30" Swap 589
20.5 Exercises 515
xii Contents

23.9 Case Study: A Long-Term Capital Chapter 27

Management "Convergence Trade" 593 Estimating the Yield Curve 667
23.10 Credit Risk and Credit Exposure 596
23.11 Hedging Swaps 597 27.1 Introduction 667
23.12 Caps, Floors, and Swaptions 599 27.2 Bootstrapping 667
23.13 The Black Model for Pricing Caps, Floors, 27.3 Splines 669
and Swaptions 604 27.4 Polynomial Splines 670
23.14 Summary 609 27.5 Exponential Splines 673
23.15 Exercises 609 27.6 Implementation Issues with Splines 674
27.7 The Nelson-Siegel-Svensson Approach 674
Chapter 24 27.8 Summary 676
27.9 Exercises 676
Equity Swaps 613
Appendix 27A Bootstrapping by Matrix
24.1 Introduction 613 Inversion 680
24.2 Uses of Equity Swaps 614 Appendix 27B Implementation with Exponential
24.3 Payoffs from Equity Swaps 616 Splines 681
24.4 Valuation and Pricing of Equity Swaps 622
24.5 Summary 628 Chapter 28
24.6 Exercises 628 Modeling Term-Structure Movements 684
28.1 Introduction 684
Chapter 25 28.2 Interest-Rate Modeling versus Equity
Currency and Commodity Swaps 631 Modeling 684
25.1 Introduction 631 28.3 Arbitrage Violations: A Simple
25.2 Currency Swaps 631 Example 685
25.3 Commodity Swaps 639 28.4 A Gentle Introduction to No-Arbitrage
25.4 Summary 643 Modeling 687
25.5 Exercises 644 28.5 "No-Arbitrage" and "Equilibrium"
Models 693
28.6 Summary 697
PART FOUR 28.7 Exercises 697
Interest Rate Modeling 647
Chapter 29
Chapter 26 Factor Models of the Term Structure 700
The Term Structure of Interest Rates: 29.1 Overview 700
Concepts 649 29.2 The Black-Derman-Toy Model 701
26.1 Introduction 649 29.3 The Ho-Lee Model 710
26.2 The Yield-to-Maturity 649 29.4 One-Factor Models in Continuous Time 714
26.3 The Term Structure of Interest Rates 651 29.5 Multifactor Models 720
26.4 Discount Functions 652 29.6 Affine Factor Models 722
26.5 Zero-Coupon Rates 653 29.7 Summary 725
26.6 Forward Rates 654 29.8 Exercises 726
26.7 Yield-to-Maturity, Zero-Coupon Rates, Appendix 29A Deriving the Fundamental PDE
and Forward Rates 656 in Factor Models 729
26.8 Constructing the Yield-to-Maturity Curve:
An Empirical Illustration 657 Chapter 30
26.9 Summary 661 The Heath-Jarrow-Morton and Libor
26.10 Exercises 662 Market Models 731
Appendix 26A The Raw YTM Data 664 30.1 Overview 731
 Contents xiii

30.2 The HJM Framework: Preliminary Chapter 33

Comments 731 Reduced-Form Models of Default Risk 829
30.3 A One-Factor HJM Model 733
30.4 A Two-Factor HJM Setting 742 33.1 Introduction 829
30.5 The HJM Risk-Neutral Drifts: An Algebraic 33.2 Modeling Default I: Intensity Processes \830
Derivation 746 33.3 Modeling Default II: Recovery Rate
30.6 Libor Market Models 749 Conventions 834
30.7 Mathematical Excursion: Marting;ales 750 33.4 The Litterman-Iben Model 836
30.8 Libor Rates: Notation 751 33.5 The Duffie-Singleton Result 841
30.9 Risk-Neutral Pricing in the LMM 753 33.6 Defaultable HJM Models 843
30.10 Simulation of the Market Model 757 33.7 Ratings-Based Modeling: The JLT
30.11 Calibration 757 Model 845
30.12 Swap Market Models 758 33.8 An Application of Reduced-Form Models:
30.13 Swaptions 760 Pricing CDS 853
30.14 Summary 761 33.9 Summary 855
30.15 Exercises 761 33.10 Exercises 855
Appendix 30A Risk-Neutral Drifts Appendix 33A Duffle-Singleton
and Volatilities in HJM 765 in Discrete Time 859
Appendix 33B Derivation of the Drift-Volatility
Relationship 860
PART FIVE
Credit Risk 769 Chapter 34
Modeling Correlated Default 863
Chapter 31
Credit Derivative Products 771 34.1 Introduction 863
34.2 Examples of Correlated Default
31.1 Introduction 771 Products 863
31.2 Total Return Swaps 775 34.3 Simple Correlated Default Math 865
31.3 Credit Spread Options/Forwards 779 34.4 Structural Models Based on
31.4 Credit Default Swaps / 779 Asset Values 868
31.5 Credit-Linked Notes ' 788 34.5 Reduced-Form Models 874
31.6 Correlation Products 790 34.6 Multiperiod Correlated Default 875
31.7 Summary 797 34.7 Fast Computation of Credit Portfolio Loss
31.8 Exercises 797 Distributions without Simulation 878
Appendix 31A The CDS Big Bang 800 34.8 Copula Functions 881
34.9 Top-Down Modeling of Credit
Chapter 32 Portfolio Loss 893
Structural Models of Default Risk 802 34.10 Summary 897
34.11 Exercises 898
32.1 Introduction 802
32.2 The Merton (1974) Model 803
Bibliography B-l
32.3 Issues in Implementation 812
32.4 A Practitioner Model 817 Index 1-1
32.5 Extensions of the Merton Model 819
32.6 Evaluation of the Structural Model
Approach 820
32.7 Summary 823
32.8 Exercises 824
Appendix 32A The Delianedis-Geske
Model 826
xiv Contents

The following Web chapters are

available at www.mhhe.com/sdle:

PART SIX
Computation 901
Chapter 35
Derivative Pricing with Finite
Differencing 903
35.1 Introduction 903
35.2 Solving Differential Equations 904
35.3 A First Approach to Pricing Equity
Options 907
35.4 Implicit Finite Differencing 913
35.5 The Crank-Nicholson Scheme 917
35.6 Finite Differencing for Term-Structure
Models 919
35.7 Summary 921
35.8 Exercises 922

Chapter 36
Derivative Pricing with Monte Carlo
Simulation 923
36.1 Introduction 923
36.2 Simulating Normal Random Variables 924
36.3 Bivariate Random Variables 925
36.4 Cholesky Decomposition 925
36.5 Stochastic Processes for Equity Prices 927
36.6 ARCH Models 929
36.7 Interest-Rate Processes 930
36.8 Estimating Historical Volatility for
Equities 932
36.9 Estimating Historical Volatility for Interest
Rates 932
36.10 Path-Dependent Options 933
36.11 Variance Reduction 935
36.12 Monte Carlo for American Options 938
36.13 Summary 942
36.14 Exercises 943

Chapter 37
Using Octave 945
37.1 Some Simple Commands 945
37.2 Regression and Integration 948
37.3 Reading in Data, Sorting, and Finding 950
37.4 Equation Solving 955
37.5 Screenshots 955