Financial

Third Edition

ROBERT W. KOLBJAMES A. OVERDAHL

John Wiley & Sons, Inc.

derivatives

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F inanc ia lderivatives

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John Wiley & Sons

Founded in 1807, John Wiley & Sons is the oldest independent publishingcompany in the United States. With offices in North America, Europe, Aus-tralia and Asia, Wiley is globally committed to developing and marketingprint and electronic products and services for our customers professionaland personal knowledge and understanding.

The Wiley Finance series contains books written specifically for financeand investment professionals as well as sophisticated individual investorsand their financial advisors. Book topics range from portfolio managementto e-commerce, risk management, financial engineering, valuation and fi-nancial instrument analysis, as well as much more.

For a list of available titles, please visit our Web site at www.WileyFinance.com.

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Financial

Third Edition

ROBERT W. KOLBJAMES A. OVERDAHL

John Wiley & Sons, Inc.

derivatives

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Copyright 2003 by Robert W. Kolb and James A. Overdahl. 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 inany form or by any means, electronic, mechanical, photocopying, recording, scanning, orotherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization throughpayment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-750-4470, or on the web atwww.copyright.com. Requests to the Publisher for permission should be addressed to thePermissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030,201-748-6011, fax 201-748-6008, e-mail: permcoordinator

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

The views expressed by the author (Overdahl) are his own and do not necessarily reflect theviews of the Commodity Futures Trading Commission or its staff.

For general information on our other products and services, or technical support, pleasecontact our Customer Care Department within the United States at 800-762-2974, outside theUnited States at 317-572-3993 or fax 317-572-4002.

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ISBN 0-471-23232-7

Printed in the United States of America.

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http://www.copyright.com

To my splendid Lori, an original who is anythingbut derivative.

R.W.K.

To Janis, who is consistently above fair value.J.A.O.

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preface

Financial Derivatives introduces the broad range of markets for financialderivatives. A financial derivative is a financial instrument based on an-other more elementary financial instrument. The value of the financial de-rivative depends on, or derives from, the more basic instrument. Usually, thebase instrument is a cash market financial instrument, such as a bond or ashare of stock.

Introductory in nature, this book is designed to supplement a widerange of college and university finance and economics classes. Every efforthas been made to reduce the mathematical demands placed on the student,while still developing a broad understanding of trading, pricing, and riskmanagement applications of financial derivatives.

The text has two principal goals. First, the book offers a broad overviewof the different types of financial derivatives (futures, options, options on fu-tures, and swaps), while focusing on the principles that determine marketprices. These instruments are the basic building blocks of all more compli-cated risk management positions. Second, the text presents financial deriva-tives as tools for risk management, not as instruments of speculation. Whilefinancial derivatives are unsurpassed as tools for speculation, the book em-phasizes the application of financial derivatives as risk management tools ina corporate setting. This approach is consistent with todays emergence of fi-nancial institutions and corporations as dominant forces in markets forfinancial derivatives.

This edition of Financial Derivatives includes three new chapters de-scribing the applications of financial derivatives to risk management. Thesenew chapters reflect an increased emphasis on exploring how financial deriv-atives are applied to managing financial risks. These new chaptersChapter3 (Risk Management with Futures Contracts), Chapter 5 (Risk Managementwith Options Contracts), and Chapter 7 (Risk Management with Swaps)in-clude several new applied examples. These application chapters follow thechapters describing futures (Chapter 2), options (Chapter 4), and the marketswaps (Chapter 6). Chapter 1 (Introduction), surveys the major types of fi-nancial derivatives and their basic applications. The chapter discusses threetypes of financial derivativesfutures, options, and swaps. It then considers

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viii PREFACE

financial engineeringthe application of financial derivatives to manage risk.The chapter concludes with a discussion of the markets for financial deriva-tives and brief comments on the social function of financial derivatives.

Chapter 2 (Futures) explores the futures markets in the United Statesand the contracts traded on them. Futures markets have a reputation forbeing incredibly risky. To a large extent, this reputation is justified, but fu-tures contracts may also be used to manage many different kinds of risks.The chapter begins by explaining how a futures exchange is organized andhow it helps to promote liquidity to attract greater trading volume. Chapter2 focuses on the principles of futures pricing. Applications of futures con-tracts for risk management are explored in Chapter 3.

The second basic type of financial derivative, the option contract, is thesubject of Chapter 4 (Options). Options markets are very diverse and havetheir own particular jargon. As a consequence, understanding options re-quires a grasp of the institutional details and terminology employed in themarket. Chapter 4 begins with a discussion of the institutional backgroundof options markets, including the kinds of contracts traded and the pricequotations for various options. However, the chapter focuses principally onthe valuation of options. For a potential speculator in options, these pricingrelationships are of the greatest importance, as they are for a trader whowants to use options to manage risk.

Applications of options for risk management are explored in Chapter 5.In addition to showing how option contracts can be used in risk manage-ment, Chapter 5 shows how the option pricing model can be used to guiderisk management decisions. The chapter emphasizes the role of option sen-sitivity measures (i.e., The Greeks) in portfolio management.

Compared to futures or options, swap contracts are a recent innova-tion. A swap is an agreement between two parties, called counterparties, toexchange sets of cash flows over a period in the future. For example, PartyA might agree to pay a fixed rate of interest on $1 million each year for fiveyears to Party B. In return, Party B might pay a floating rate of interest on$1 million each year for five years. The cash flows that the counterpartiesmake are can be tied to the value of debt instruments, to the value of foreigncurrencies, the value of equities or commodities, or the credit characteristicsof a reference asset. This gives rise to five basic kinds of swaps: interest rateswaps, currency swaps, equity swaps, commodity swaps, and credit swaps.Chapter 6 (The Swaps Market) provides a basic introduction to the swapsmarket, a market that has grown incredibly over the last decade. Today, theswaps market has begun to dwarf other derivatives markets, as well as secu-rities markets, including the stock and bond markets. New to this editionstreatment of swaps is a section on counterparty credit risk. Also, applied ex-amples of swaps pricing have been added.

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Applications of swaps for risk management are explored in Chapter 7.New to this edition are sections on duration gap management, uses of eq-uity swaps, and swap portfolio management. This last section describes theconcepts of value at risk (VaR) and stress testing and their role in managingthe risk of a derivatives portfolio.

Chapter 8 (Financial Engineering and Structured Products) shows howforwards, futures, options, and swaps are building blocks that can be com-bined by the financial engineer to create new instruments that have highlyspecialized and desirable risk and return characteristics. While the financialengineer cannot create instruments that violate the wellestablished tradeoffsbetween risk and return, it is possible to develop positions with risk and re-turn profiles that fit a specific situation almost exactly. The chapter also ex-amines some of the high-profile derivatives debacles of the past decade. Newto this edition are descriptions of the Metallgesellschaft and Long-Term Capi-tal Management debacles.

As always, in creating a book of this type, authors incur many debts. Allof the material in the text has been tested in the classroom and revised inlight of that teaching experience. For their patience with different versions ofthe text, we want to thank our students at the University of Miami and JohnsHopkins University. Shantaram Hegde of the University of Connecticut readthe entire text of the first edition and made many useful suggestions. Fortheir work on the previous edition, We would like to thank Kateri Davis,Andrea Coens, and Sandy Schroeder. We would also like to thank the manyprofessors who made suggestions for improving this new edition.

ROBERT W. KOLBJAMES A. OVERDAHL

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contents

CHAPTER 1Introduction 1

CHAPTER 2Futures 23

CHAPTER 3Risk Management with Futures Contracts 69

CHAPTER 4Options 96

CHAPTER 5Risk Management with Options Contracts 140

CHAPTER 6The Swaps Market 166

CHAPTER 7Risk Management with Swaps 199

CHAPTER 8Financial Engineering and Structured Products 224

APPENDIX 271

QUESTIONS AND PROBLEMS WITH ANSWERS 273

NOTES 305

INDEX 313

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1

CHAPTER 1Introduction

By now the headlines are familiar: Gibson Greetings Loses $19.7 Million inDerivatives . . . Procter and Gamble Takes $157 Million Hit on Deriva-tives . . . Metallgesellschaft Derivatives Losses Put at $1.3 billion . . . De-rivatives Losses Bankrupt Barings. Such popular press accounts could easilylead us to conclude that derivatives were not only involved in these losses, butwere responsible for them as well. Over the past few years, derivatives have be-come inviting targets for criticism. They have become demonizedthe Dwordthe junk bonds of the New Millennium. But what are they?

Actually, there is not an easy definition. Economists, accountants,lawyers, and government regulators have all struggled to develop a precisedefinition. Imprecision in the use of the term, moreover, is more than just asemantic problem. It also is a real problem for firms that must operate in aregulatory environment where the meaning of the term often depends onwhich regulator is using it.

Although there are several competing definitions, we define a derivativeas a contract that derives most of its value from some underlying asset, ref-erence rate, or index. As our definition implies, a derivative must be basedon at least one underlying. An underlying is the asset, reference rate, orindex from which a derivative inherits its principal source of value. Fallingwithin our definition are several different types of derivatives, includingcommodity derivatives and financial derivatives. A commodity derivative isa derivative contract specifying a commodity or commodity index as the un-derlying. For example, a crude oil forward contract specifies the price,quantity, and date of a future exchange of the grade of crude oil that under-lies the forward contract. Because crude oil is a commodity, a crude oil for-ward contract would be a commodity derivative. A financial derivative, thefocus of this book, is a derivative contract specifying a financial instrument,interest rate, foreign exchange rate, or financial index as the underlying. Forexample, a call option on IBM stock gives its owner the right to buy theIBM shares that underlie the option at a predetermined price. In this sense,

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