Table of Contents
Preface vii
About the Author ix
Part I Introduction 1
Part II Traded Assets and Liabilities 5
Chapter 1 Primary Assets 9
1.1 Market Types 9
1.2 Asset Types 10
1.2.1 Physical Commodities 10
1.2.2 Financial Securities 11
1.3 Buying on Margin 15
1.4 Short Selling 16
1.5 Asset Risks 16
Chapter 2 Derivatives 19
2.1 The Four Basic Derivatives 19
2.1.1 Forwards 20
2.1.2 Futures 20
2.1.3 European Puts 21
2.1.4 European Calls 21
2.2 Notable Derivatives 22
2.2.1 Repurchase Agreements (Repos) 22
2.2.2 Swaps 23
2.2.3 Swaptions 25
2.2.4 Bonds with Embedded Options 26
2.2.5 Inverse Floaters 26
2.2.6 Asset Backed Securities 27
Part III Modeling Risks 29
Chapter 3 Market Risk (Equities, FX, Commodities) 35
3.1 Set up 35
3.2 Results 40
3.3 Pricing 42
3.4 Synthetic Construction 43
3.5 Bubbles 44
Chapter 4 Market Risk (Interest Rates) 47
4.1 Set up 47
4.2 Results 49
4.3 Pricing 50
4.4 Synthetic Construction 51
4.5 Bubbles 51
Chapter 5 Credit Risk 53
5.1 Set up 53
5.2 Results 56
5.3 Pricing 56
5.4 Synthetic Construction 57
5.5 Bubbles 58
Chapter 6 Liquidity Risk 59
6.1 Temporary Quantity Impact, on the Price 59
6.1.1 Set up 60
6.1.2 Results 64
6.1.3 Pricing and Synthetic Construction 64
6.2 Permanent Quantity Impact on the Price 66
6.2.1 Market Manipulation 66
6.2.2 Pricing and Hedging Derivatives 67
6.2.3 Conclusion 68
Chapter 7 Operational Risk 69
7.1 Management and Accounting Controls 69
7.2 Risk Management 69
Chapter 8 Trading Constraints 71
5.1 Set up 71
5.2 Results 74
8.3 Pricing and Synthetic Construction 75
8.4 Bubbles 76
Part IV Optimizing Risk 77
Chapter 9 Individuals 81
9.1 Set up 81
9.2 Objective 81
9.2.1 The Expected Utility Hypothesis 82
9.2.2 Risk Aversion 83
9.2.3 The Risk Management Problem 84
9.3 Solution 84
9.3.1 Finding Arbitrage Opportunities 85
0.3.2 Risk Optimized Portfolios 86
9.1 Complications 87
Chapter 10 Firms 89
10.1 Set up 89
10.2 Objective 89
10.3 Solution 90
10.4 Complications 91
Chapter 11 Banks 93
11.1 Set up 93
11.2 Objective 93
11.2.1 Regulatory Risk Measures 94
11.2.2 The Constrained Optimization Problem 95
11.3 Solution 96
11.4 Complications 97
Part V Managing Risks 99
Chapter 12 Diversification 103
12.1 The Basic Idea 103
12.2 Portfolio Risk Minimization 104
12.3 Conclusion 105
Chapter 13 Static Hedging 107
13.1 Risk Reduction 107
13.1.1 Portfolio Insurance 107
13.1.2 Floating Rate Loans 108
13.2 Cost of Carry 108
13.3 Put Call Parity 109
13.1 Coupon Bonds 110
13.4.1 Default-free 110
13.4.2 Risky 112
11.3.5 Inverse Floaters 112
13.6 Interest Rate Swaps 113
Chapter 14 Dynamic Hedging 115
14 1 Set up 115
14.2 Complete Markets 116
14.2.1 Taylor Series Expansion 117
14.2.2 Delta $ (∂C/∂S) Hedging 118
11.2.1 Gamma (∂2C/∂S2) Hedging 119
14.2.1 Vega (∂C/∂σ) Hedging 120
14.3 Incomplete Markets 123
14.3.1 Super- and Sub- Replication 124
14.3.2 Valuation and Hedging 127
Part VI Case Studies 127
Chapter 15 Penn Square Bank (1982) 133
15.1 Summary 133
15.2 The Trading Strategy 135
15.2.1 Oil and Gas Partnerships 135
15.2.2 Oil and Gas Mortgage Loans 136
15.2.3 Market Risk 137
15.2.4 Credit Risk 137
15.2.5 Liquidity Risk 138
15.2.0 Operational Risk 138
15.3 Conclusion 139
Chapter 16 Metallgesellschaft (1993) 141
10.1 Summary 141
10.2 The Trading Strategy 143
16.2.1 Market Risk 144
16.2.2 Credit Risk 144
16.2.3 Liquidity Risk 144
16.2.4 Operational Risk 145
16.3 Conclusion 145
Chapter 17 Orange County (1994) 147
17.1 Summary 147
17.2 The Trading Strategy 149
17.2.1 Long-term Coupon Bonds 149
17.2.2 Inverse Floaters 150
17.2.3 Leveraging via Reverse Repurchase Agreements 150
17.2.4 Market Risk 152
17.2.5 Credit Risk 152
17.2.6 Liquidity Risk 152
17.2.7 Operational Risk 152
17.3 Conclusion 153
Chapter 18 Barings Bank (1995) 155
18.1 Summary 155
18.2 The Trading Strategy 156
18.2.1 Naked Futures 156
18.2.2 Option Straddles 158
18.2.3 Market Risk 159
18.2.4 Credit Risk 159
18.2.5 Liquidity Risk 159
18.2.6 Operational Risk 160
18.3 Conclusion 160
Chapter 19 Long Term Capital Management (1998) 161
19.1 Summary 161
19.2 The Trading Strategy 162
19.2.1 Step 1 (The Spread Trade) 163
19.2.2 Step 2 (The Leveraging) 163
19.2.3 Step 3 (Diversification) 164
19.2.4 Market Risk 165
19.2.5 Credit Risk 165
19.2.6 Liquidity Risk 165
19.2.7 Operational Risk 165
19.3 Conclusion 165
Chapter 20 The Credit Crisis (2007) 167
20.1 Summary 167
20.1.1 The Ponzi Scheme 167
20.1.2 The Collapse 169
20.2 The Trading Strategy 169
20.2.1 Buying ABS and CDOs 169
20.2.2 Buying CDS 170
20.2.3 Selling CDS 171
20.3 Conclusion 171
Chapter 21 Washington Mutual (2008) 173
21.1 Summary 173
21.2 The Trading Strategy 175
21.2.1 Option ARMs 175
21.2.2 Market Risk 176
21.2.3 Credit Risk 176
21.2.4 Liquidity Risk 176
21.2.5 Operational Risk 176
21.3 Conclusion 176
Bibliography 179
Index 185
