Principles of Financial Engineering, Second Edition

Five new chapters, numerous additions to existing chapters, and an expanded collection of questions and exercises make this Second Edition an essential part of everyone's library. Between defining swaps on its first page and presenting a case study on its last, Neftci's introduction to financial engineering shows readers how to create financial assets in static and dynamic environments. Poised among intuition, actual events, and financial mathematics, this book can be used to solve problems in risk management, taxation, regulation, and above all, pricing. * The Second Edition presents 5 new chapters on structured product engineering, credit markets and instruments, and principle protection techniques, among other topics * Additions, clarifications, and illustrations throughout the volume show these instruments at work instead of explaining how they should act * The Solutions Manual enhances the text by presenting additional cases and solutions to exercises Front Cover......Page 1 Principles of Financial Engineering......Page 4 Copyright Page......Page 5 Dedication......Page 6 Table of Contents......Page 8 Preface......Page 16 1. A Unique Instrument......Page 18 2. A Money Market Problem......Page 25 3. A Taxation Example......Page 28 4. Some Caveats for What Is to Follow......Page 31 5. Trading Volatility......Page 32 6. Conclusions......Page 35 Suggested Reading......Page 36 Case Study......Page 37 2. Markets......Page 40 4. The Mechanics of Deals......Page 44 5. Market Conventions......Page 47 7. Positions......Page 54 8. The Syndication Process......Page 58 Appendix 2-1: The Hedge Fund Industry......Page 59 Exercises......Page 63 2. What Is a Synthetic?......Page 64 3. Forward Contracts......Page 68 4. Currency Forwards......Page 71 6. A Contractual Equation......Page 76 7. Applications......Page 77 8. A “Better” Synthetic......Page 83 9. Futures......Page 87 10. Conventions for Forwards......Page 92 11. Conclusions......Page 93 Suggested Reading......Page 94 Exercises......Page 95 Case Study......Page 97 1. Introduction......Page 100 2. Libor and Other Benchmarks......Page 101 3. Forward Loans......Page 102 4. Forward Rate Agreements......Page 109 5. Futures: Eurocurrency Contracts......Page 113 6. Real-World Complications......Page 117 7. Forward Rates and Term Structure......Page 119 8. Conventions......Page 120 9. A Digression: Strips......Page 121 Suggested Reading......Page 122 Exercises......Page 123 1. The Swap Logic......Page 126 2. Applications......Page 129 3. The Instrument: Swaps......Page 134 4. Types of Swaps......Page 137 5. Engineering Interest Rate Swaps......Page 146 6. Uses of Swaps......Page 154 7. Mechanics of Swapping New Issues......Page 159 9. Currency Swaps versus FX Swaps......Page 165 10. Additional Terminology......Page 167 Suggested Reading......Page 168 Exercises......Page 169 1. Introduction......Page 174 2. What Is Repo?......Page 175 3. Types of Repo......Page 177 5. Repo Market Strategies......Page 182 6. Synthetics Using Repos......Page 188 Suggested Reading......Page 190 Exercises......Page 191 Case Study......Page 192 1. Introduction......Page 194 3. A Review of Static Replication......Page 195 4. “Ad Hoc” Synthetics......Page 200 5. Principles of Dynamic Replication......Page 203 6. Some Important Conditions......Page 214 7. Real-Life Complications......Page 215 Suggested Reading......Page 217 Exercises......Page 218 1. Introduction......Page 220 2. What Is an Option?......Page 221 3. Options: Definition and Notation......Page 222 4. Options as Volatility Instruments......Page 228 5. Tools for Options......Page 238 6. The Greeks and Their Uses......Page 245 7. Real-Life Complications......Page 257 Suggested Reading......Page 258 Appendix 8-1......Page 259 Appendix 8-2......Page 261 Exercises......Page 263 1. Introduction......Page 266 3. Bond Convexity Trades......Page 267 4. Sources of Convexity......Page 279 5. A Special Instrument: Quantos......Page 284 Suggested Reading......Page 289 Exercises......Page 290 Case Study......Page 292 1. Introduction......Page 294 2. Option Strategies......Page 297 3. Volatility-Based Strategies......Page 308 4. Exotics......Page 313 5. Quoting Conventions......Page 324 6. Real-World Complications......Page 326 Suggested Reading......Page 327 Exercises......Page 328 1. Introduction......Page 332 2. Summary of Pricing Approaches......Page 333 3. The Framework......Page 334 4. An Application......Page 339 5. Implications of the Fundamental Theorem......Page 345 6. Arbitrage-Free Dynamics......Page 351 7. Which Pricing Method to Choose?......Page 355 Suggested Reading......Page 356 Appendix 11-1......Page 357 Exercises......Page 359 1. Introduction......Page 362 2. Application 1: The Monte Carlo Approach......Page 363 3. Application 2: Calibration......Page 371 4. Application 3: Quantos......Page 380 Suggested Reading......Page 387 Exercises......Page 388 1. Introduction......Page 390 2. A Framework for Swaps......Page 391 3. Term Structure Modeling......Page 400 4. Term Structure Dynamics......Page 402 5. Measure Change Technology......Page 411 6. An Application......Page 416 7. In-Arrears Swaps and Convexity......Page 421 8. Cross-Currency Swaps......Page 425 10. Conclusions......Page 426 Suggested Reading......Page 427 Appendix 13-1: Practical Yield Curve Calculations......Page 428 Exercises......Page 431 1. Introduction......Page 432 2. Volatility Positions......Page 433 3. Invariance of Volatility Payoffs......Page 434 4. Pure Volatility Positions......Page 441 5. Volatility Swaps......Page 444 6. Some Uses of the Contract......Page 449 7. Which Volatility?......Page 450 8. Conclusions......Page 451 Suggested Reading......Page 452 Exercises......Page 453 1. Introduction to Volatility as an Asset Class......Page 456 2. Volatility as Funding......Page 457 4. Dirac Delta Functions......Page 459 5. Application to Option Payoffs......Page 461 6. Breeden-Litzenberger Simplified......Page 463 7. A Characterization of Option Prices as Gamma Gains......Page 467 8. Introduction to the Smile......Page 468 9. Preliminaries......Page 469 10. A First Look at the Smile......Page 470 11. What Is the Volatility Smile?......Page 471 13. How to Explain the Smile......Page 479 14. The Relevance of the Smile......Page 486 16. Pricing with a Smile......Page 487 17. Exotic Options and the Smile......Page 488 Suggested Reading......Page 492 Exercises......Page 493 1. Introduction......Page 496 2. Terminology and Definitions......Page 497 3. Credit Default Swaps......Page 499 4. Real-World Complications......Page 509 5. CDS Analytics......Page 511 6. Default Probability Arithmetic......Page 512 7. Structured Credit Products......Page 517 8. Total Return Swaps......Page 521 Suggested Reading......Page 522 Exercises......Page 524 Case Study......Page 527 1. Introduction......Page 530 2. Purposes of Structured Products......Page 531 3. Structured Fixed-Income Products......Page 543 4. Some Prototypes......Page 550 5. Conclusions......Page 560 Suggested Reading......Page 561 Exercises......Page 562 2. Credit Indices......Page 564 3. Introduction to ABS and CDO......Page 565 4. A Setup for Credit Indices......Page 567 5. Index Arbitrage......Page 570 6. Tranches: Standard and Bespoke......Page 572 7. Tranche Modeling and Pricing......Page 573 8. The Roll and the Implications......Page 577 9. Credit versus Default Loss Distributions......Page 579 10. An Important Generalization......Page 580 11. New Index Markets......Page 583 Suggested Reading......Page 585 Appendix 18-1......Page 586 Exercises......Page 587 1. Introduction......Page 588 3. Two Simple Examples......Page 589 4. The Model......Page 592 5. Default Correlation and Trading......Page 596 6. Delta Hedging and Correlation Trading......Page 597 7. Real-World Complications......Page 602 Suggested Reading......Page 604 Appendix 19–1......Page 605 Exercises......Page 607 Case Study......Page 608 1. Introduction......Page 612 2. The Classical Case......Page 613 3. The CPPI......Page 614 4. Modeling the CPPI Dynamics......Page 616 5. An Application: CPPI and Equity Tranches......Page 618 6. A Variant: The DPPI......Page 621 7. Real-World Complications......Page 622 Suggested Reading......Page 623 Exercises......Page 624 1. Introduction......Page 628 2. The Mortgage Market......Page 629 3. Swaptions......Page 635 4. Pricing Swaptions......Page 637 5. Mortgage-Based Securities......Page 642 6. Caps and Floors......Page 643 Suggested Reading......Page 648 Exercises......Page 649 Case Study......Page 651 1. Introduction......Page 654 2. What Is Equity?......Page 655 3. Engineering Equity Products......Page 661 4. Financial Engineering of Securitization......Page 671 Suggested Reading......Page 674 Exercises......Page 675 Case Study......Page 676 References......Page 680 Index......Page 684 Five new chapters, numerous additions to existing chapters, and an expanded collection of questions and exercises make this Second Edition an essential part of everyone's library. Between defining swaps on its first page and presenting a case study on its last, Salih Neftci's introduction to financial engineering shows readers how to create financial assets in static and dynamic environments. Poised among intuition, actual events, and financial mathematics, this book can be used to solve problems in risk management, taxation, regulation, and above all, pricing.

* The Second Edition presents 5 new chapters on structured product engineering, credit markets and instruments, and principle protection techniques, among other topics
* Additions, clarifications, and illustrations throughout the volume show these instruments at work instead of explaining how they should act
* The Solutions Manual enhances the text by presenting additional cases and solutions to exercises An introduction to financial engineering, this title offers clear links between intuition and underlying mathematics and a mixture of market insights and mathematical materials. It forms the basis of practical risk management useful for learning about practical elements of financial engineering "This second edition of the highly acclaimed text that explains financial engineering in Dr Neftci's trademark clear and practical style is completely updated to keep pace with this fast-changing world, including new material on all the important topics."--BOOK JACKET