Derivatives Markets and Analysis

Book Preface

In 1973, the Chicago Board of Trade formed the Chicago Board Options Exchange (CBOE). The CBOE was the first organized option exchange for the trading of options. Just as the Chicago Board of Trade had served to increase the popularity of futures, the CBOE helped to increase the trading of options by making the contracts more marketable. Since the creation of the CBOE, organized stock exchanges in the United States, most of the organized futures exchanges, and many security exchanges outside the United States also began offering markets for the trading of options. As the number of exchanges offering options increased, so did the number of securities and instruments with options written on them. Today, option contracts exist not only on stocks but also on currencies, indexes, futures contracts, and debt and interest rate-sensitive securities. There is also a large over-the-counter option market in currency, debt, and interest-sensitive securities and products in the United States and a growing over-the-counter option market outside the United States. Just as impressive as the growth in options trading has been the growth in the futures market. Today, there are futures contracts on commodities, equity indexes, currencies, bonds, and interest rates, as well as such hybrid contracts as swaps. Options, futures, and swaps are derivatives—securities that derive their values from the underlying asset. Derivatives are used by institutional investors, portfolio managers, and corporations for speculation and hedging, as well as financial engineering in creating structured currency, equity, and debt positions.

Over the past 50 years, the investment industry has seen not only the proliferation of derivative securities and markets, but also academic contributions to the study of derivatives: The Black-Scholes Option Pricing Model, index arbitrage, financial engineering, and dynamic portfolio insurance. The growth in the derivative markets and the academic contributions together point out the challenges in mastering an understanding and developing a knowledge of derivatives. The purpose of this text is to provide professionals and finance students with an exposition on derivatives that will take them from the basic concepts, strategies, and fundamentals to a more detailed understanding of the markets, advanced strategies, and models.

Derivative Markets and Analysis is the last in a three-part series on securities from Bloomberg Press’s Financial Series. The first, Debt Markets and Analysis, covered fixed-income securities, and the second, Equity Markets and Analysis, focused on stock and stock portfolios. This book covers subjects presented in many derivative texts: futures and forward markets, the carrying-cost model for pricing futures, option strategies, the Black-Scholes and Binomial Option Pricing models, futures options, and swaps.

Today, many practitioners manage their securities and portfolios using a Bloomberg terminal. Bloomberg is a computer information and retrieval system providing access to financial and economic data, news, and analytics. Bloomberg terminals are common on most trading floors and are becoming more common in universities where they are used for research, teaching, and managing student investment funds. Given this widespread use of the Bloomberg system, the text also provides guides for using Bloomberg data and analytical functions for the topics covered in each chapter. There are also supplemental appendices with detailed descriptions of the Bloomberg system and a listing of many of the analytical functions that can be applied to investment analysis.

It is my hope that the synthesis of fundamental and advanced topics with Bloomberg information and analytics will provide professionals and students of finance not only with a better foundation in understanding the complexities and subtleties of derivatives, but also with the ability to apply that understanding to real-world investment decisions—to grasp how “it is done on the street.” It is also my hope that the integration of Bloomberg with derivative concepts and theories enhances the readers’ intellectual depth and understanding of finance. Finance and economics professors frequently require that students explain a theory, strategy, or idea mathematically, graphically, and intuitively. By so doing, students’ depth of understanding, as well as retention, of the theory and idea is often enhanced. It has been my experience in using Bloomberg in my derivatives classes that it too enhances a student’s depth and knowledge of derivatives.

The book is designed for professors offering a one-semester derivatives course. The Bloomberg material is presented at the end of each chapter, allowing the material to be presented separately. The book is also written for professionals in the investment industry. For professionals, the text can be used as an instructional source and as a guide on how to apply Bloomberg to derivative markets and analysis, as well as a review of fundamental derivative concepts and theories.