Contents
Preface ...................................................................................................................................................................................................................................................................................................................3
Introduction ........................................................................................................................................................................................................................................................................................................4
Why use derivatives? ..............................................................................................................................................................................................................................................4
How to think about derivatives..........................................................................................................................................................................................................................5
What to consider before entering into derivatives..............................................................................................................................................................................5
A bit of theory...............................................................................................................................................................................................................................................................6
What is a derivative strategy?...........................................................................................................................................................................................................................7
Derivative markets....................................................................................................................................................................................................................................................7
Documentation............................................................................................................................................................................................................................................................8
Interest rates.....................................................................................................................................................................................................................................................................................................9
The basic definitions and conventions .........................................................................................................................................................................................................9
Pricing swaps...........................................................................................................................................................................................................................................................11
Yield curves: Can identical cash flows be different?.......................................................................................................................................................................12
Yield curves and their dynamics ..................................................................................................................................................................................................................13
Risk management.......................................................................................................................................................................................................................................................................................15
Measuring uncertainty .......................................................................................................................................................................................................................................15
Yield curve risk – the classical approach ...............................................................................................................................................................................................15
Yield curve risk – the modern approach..................................................................................................................................................................................................16
Risk managing options or just speaking Greek?................................................................................................................................................................................17
Delta ...............................................................................................................................................................................................................................................................................17
Gamma .........................................................................................................................................................................................................................................................................17
Vega................................................................................................................................................................................................................................................................................18
Theta ..............................................................................................................................................................................................................................................................................18
Choosing your risk profile – interacting greeks..................................................................................................................................................................................18
Pricing options – the put-call parity ............................................................................................................................................................................................................21
Outright strategies ....................................................................................................................................................................................................................................................................................22
Where are rates going?.....................................................................................................................................................................................................................................22
Curve strategies ..........................................................................................................................................................................................................................................................................................23
Introducing relative bets....................................................................................................................................................................................................................................23
Swaps versus bonds ............................................................................................................................................................................................................................................23
Spot versus forward – hedge stability ......................................................................................................................................................................................................25
Spot versus forward – convenience of no payments......................................................................................................................................................................27
Introducing swaptions.........................................................................................................................................................................................................................................27
What determines the price of a swaption?...........................................................................................................................................................................................28
Conditional versus unconditional – using swaptions in a one-sided steepener strategy........................................................................................29
Conditional versus unconditional – using swaptions to take positions on the entire curve..................................................................................29
Conditional versus unconditional – using caps and floors to take positions on the entire curve......................................................................31
Protection: Extendable and retractable swaps ..................................................................................................................................................................................33
Constant maturity strategies.........................................................................................................................................................................................................................34