Derivatives. Pirie Wendy L.

>

      Wendy L. Pirie

      Derivatives

DERIVATIVES

Wendy L. Pirie, CFA

      Cover image: © AvDe/Shutterstock

      Cover design: Wiley

      Copyright © 2017 by CFA Institute. All rights reserved.

      Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

      Published simultaneously in Canada.

      No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, [phone], fax [phone], or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, [phone], fax [phone], or online at http://www.wiley.com/go/permissions.

      Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

      For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at [phone], outside the United States at [phone] or fax [phone].

      Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com.

      Library of Congress Cataloging-in-Publication Data

      Names: Pinto, Jerald E., author. | Pirie, Wendy L., author.

      Title: Derivatives / Jerald E. Pinto, CFA, Wendy L. Pirie, CFA.

      Description: Hoboken, New Jersey: John Wiley & Sons, Inc., [2017] | Series: CFA Institute investment series | Includes index. |

      Identifiers: LCCN 2017005397 (print) | LCCN 2017016281 (ebook) | ISBN 9781119381747 (pdf) | ISBN 9781119381761 (epub) | ISBN 9781119381815 (cloth)

      Subjects: LCSH: Derivative securities.

      Classification: LCC HG6024.A3 (ebook) | LCC HG6024.A3 P535 2017 (print) | DDC 332.64/57 – dc23

      LC record available at https://lccn.loc.gov/2017005397

      FOREWORD

      Since the breakthrough introduction of the Black–Scholes–Merton options pricing model in 1973, the field of financial derivatives has evolved into an extensive and highly scientific body of theoretical knowledge alongside a vast and vibrant market where economic producers, investors, finance professionals, and government regulators all interact to seek financial gains, manage risk, or promote price discovery. It is hard to imagine how even the most thoughtful and diligent practitioners can come to terms with such a broad and complex topic – until they read this book.

      CFA Institute has compiled into a single book those parts of its curriculum that address this critically important topic. And it is apparent from reading this book that CFA Institute attracted preeminent scholars to develop its derivatives curriculum.

      This book has several important virtues:

      1. It is detailed, comprehensive, and exceptionally accessible.

      2. It is efficiently organized in its coverage of topics.

      3. It makes effective use of visualization with diagrams of transactions and strategy payoffs.

      4. It includes numerous practice problems along with well-explained solutions.

      5. And finally, unlike many academic textbooks, its focus is more practical than theoretical, although it does provide more-than-adequate treatment of the relevant theory.

      The book begins by addressing the basics of derivatives, including definitions of the various types of derivatives and descriptions of the markets in which they trade.

      It goes on to address the purpose of derivatives and the benefits they impart to society, including risk transfer, price discovery, and operational efficiency. It also discusses how derivatives can be misused to enable excessive speculation and how derivatives could contribute to the destabilization of financial markets.

      The book provides comprehensive treatment of pricing and valuation with discussions of the law of one price, risk neutrality, the Black–Scholes–Merton options pricing model, and the binomial model. It also covers the pricing of futures and forward contracts as well as swaps.

      The book then shifts to applications of derivatives. It discusses how derivatives can be used to create synthetic cash and equity positions along with several other positions. It relies heavily on numerical examples to illustrate these equivalencies.

      It offers a comprehensive treatment of risk management with discussions of market risk, credit risk, liquidity risk, operational risk, and model risk, among others. It describes how to measure risk and, more importantly, how to manage it with the application of forward and futures contracts, swaps, and options.

      This summary of topics is intended to provide a flavor of the book’s contents. The contents of this book are far broader and deeper than I describe in this foreword.

      Those who practice finance, as well as those who teach it, in my view, owe a huge debt of gratitude to CFA Institute – first, for assembling this extraordinary body of knowledge in its curriculum and, second, for organizing this knowledge with such cohesion and clarity. Anyone who wishes to acquire a solid knowledge of derivatives or to refresh and expand what they have learned about derivatives previously should certainly read this book.

Mark Kritzman

      PREFACE

      We are pleased to bring you Derivatives. The content was developed in partnership by a team of distinguished academics and practitioners, chosen for their acknowledged expertise in the field, and guided by CFA Institute. It is written specifically with the investment practitioner in mind and is replete with examples and practice problems that reinforce the learning outcomes and demonstrate real-world applicability.

      The CFA Program Curriculum, from which the content of this book was drawn, is subjected to a rigorous review process to ensure that it is:

      • Faithful to the findings of our ongoing industry practice analysis

      • Valuable to members, employers, and investors

      • Globally relevant

      • Generalist (as opposed to specialist) in nature

      • Replete with sufficient examples and practice opportunities

      • Pedagogically sound

      The accompanying workbook is a useful reference that provides Learning Outcome Statements, which describe exactly