Principles of Financial Engineering

3rd Edition - November 26, 2014
Authors: Robert Kosowski, Salih N. Neftci
Language: English
Hardback ISBN:
9 7 8 - 0 - 1 2 - 3 8 6 9 6 8 - 5
eBook ISBN:
9 7 8 - 0 - 1 2 - 3 8 7 0 0 7 - 0

Principles of Financial Engineering, Third Edition, is a highly acclaimed text on the fast-paced and complex subject of financial engineering. This updated edition describes… Read more

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Principles of Financial Engineering, Third Edition, is a highly acclaimed text on the fast-paced and complex subject of financial engineering. This updated edition describes the "engineering" elements of financial engineering instead of the mathematics underlying it. It shows how to use financial tools to accomplish a goal rather than describing the tools themselves. It lays emphasis on the engineering aspects of derivatives (how to create them) rather than their pricing (how they act) in relation to other instruments, the financial markets, and financial market practices.

This volume explains ways to create financial tools and how the tools work together to achieve specific goals. Applications are illustrated using real-world examples. It presents three new chapters on financial engineering in topics ranging from commodity markets to financial engineering applications in hedge fund strategies, correlation swaps, structural models of default, capital structure arbitrage, contingent convertibles, and how to incorporate counterparty risk into derivatives pricing. Poised midway between intuition, actual events, and financial mathematics, this book can be used to solve problems in risk management, taxation, regulation, and above all, pricing. A solutions manual enhances the text by presenting additional cases and solutions to exercises.

This latest edition of Principles of Financial Engineering is ideal for financial engineers, quantitative analysts in banks and investment houses, and other financial industry professionals. It is also highly recommended to graduate students in financial engineering and financial mathematics programs.

Cover image
Title page
Table of Contents
Copyright
Dedication
Preface to the Third Edition
Chapter 1. Introduction
1.1 A Unique Instrument
1.2 A Money Market Problem
1.3 A Taxation Example
1.4 Some Caveats for What Is to Follow
1.5 Trading Volatility
1.6 Conclusions
Suggested Reading
Exercises
Chapter 2. Institutional Aspects of Derivative Markets
2.1 Introduction
2.2 Markets
2.3 Players
2.4 The Mechanics of Deals
2.5 Market Conventions
2.6 Instruments
2.7 Positions
2.8 The Syndication Process
2.9 Conclusions
Suggested Reading
Exercises
Chapter 3. Cash Flow Engineering, Interest Rate Forwards and Futures
3.1 Introduction
3.2 What Is a Synthetic?
3.3 Engineering Simple Interest Rate Derivatives
3.4 LIBOR and Other Benchmarks
3.5 Fixed Income Market Conventions
3.6 A Contractual Equation
3.7 Forward Rate Agreements
3.8 Fixed Income Risk Measures: Duration, Convexity and Value-at-Risk
3.9 Futures: Eurocurrency Contracts
3.10 Real-World Complications
3.11 Forward Rates and Term Structure
3.12 Conventions
3.13 A Digression: Strips
3.14 Conclusions
Suggested Reading
Appendix—Calculating the Yield Curve
Exercises
Chapter 4. Introduction to Interest-Rate Swap Engineering
4.1 The Swap Logic
4.2 Applications
4.3 The Instrument: Swaps
4.4 Types of Swaps
4.5 Engineering Interest-Rate Swaps
4.6 Uses of Swaps
4.7 Mechanics of Swapping New Issues
4.8 Some Conventions
4.9 Additional Terminology
4.10 Conclusions
Suggested Reading
Exercises
Chapter 5. Repo Market Strategies in Financial Engineering
5.1 Introduction
5.2 Repo Details
5.3 Types of Repo
5.4 Equity Repos
5.5 Repo Market Strategies
5.6 Synthetics Using Repos
5.7 Differences Between Repo Markets and the Impact of the GFC
5.8 Conclusions
Suggested Reading
Exercises
Chapter 6. Cash Flow Engineering in Foreign Exchange Markets
6.1 Introduction
6.2 Currency Forwards
6.3 Synthetics and Pricing
6.4 A Contractual Equation
6.5 Applications
6.6 Conventions for FX Forward and Futures
6.7 Swap Engineering in FX Markets
6.8 Currency Swaps Versus FX Swaps
6.9 Mechanics of Swapping New Issues
6.10 Conclusions
Suggested Reading
Exercises
Chapter 7. Cash Flow Engineering and Alternative Classes (Commodities and Hedge Funds)
7.1 Introduction
7.2 Parameters of a Futures Contract
7.3 The Term Structure of Commodity Futures Prices
7.4 Swap Engineering for Commodities
7.5 The Hedge Fund Industry
7.6 Conclusions
Suggested Reading
Exercises
Chapter 8. Dynamic Replication Methods and Synthetics Engineering
8.1 Introduction
8.2 An Example
8.3 A Review of Static Replication
8.4 “Ad Hoc” Synthetics
8.5 Principles of Dynamic Replication
8.6 Some Important Conditions
8.7 Real-Life Complications
8.8 Conclusions
Suggested Reading
Exercises
Chapter 9. Mechanics of Options
9.1 Introduction
9.2 What is an Option?
9.3 Options: Definition and Notation
9.4 Options as Volatility Instruments
9.5 Tools for Options
9.6 The Greeks and Their Uses
9.7 Real-Life Complications
9.8 Conclusion: What is an Option?
Suggested Reading
Appendix 9.1
Appendix 9.2
Exercises
Chapter 10. Engineering Convexity Positions
10.1 Introduction
10.2 A Puzzle
10.3 Bond Convexity Trades
10.4 Sources of Convexity
10.5 A Special Instrument: Quantos
10.6 Conclusions
Suggested Reading
Exercises
Chapter 11. Options Engineering with Applications
11.1 Introduction
11.2 Option Strategies
11.3 Volatility-Based Strategies
11.4 Exotics
11.5 Quoting Conventions
11.6 Real-World Complications
11.7 Conclusions
Suggested Reading
Exercises
Chapter 12. Pricing Tools in Financial Engineering
12.1 Introduction
12.2 Summary of Pricing Approaches
12.3 The Framework
12.4 An Application
12.5 Implications of the Fundamental Theorem
12.6 Arbitrage-Free Dynamics
12.7 Which Pricing Method to Choose?
12.8 Conclusions
Suggested Reading
Appendix 12.1 Simple Economics of the Fundamental Theorem
Exercises
Chapter 13. Some Applications of the Fundamental Theorem
13.1 Introduction
13.2 Application 1: The Monte Carlo Approach
13.3 Application 2: Calibration
13.4 Application 3: Quantos
13.5 Conclusions
Suggested Reading
Exercises
Chapter 14. Fixed Income Engineering
14.1 Introduction
14.2 A Framework for Swaps
14.3 Term Structure Modeling
14.4 Term Structure Dynamics
14.5 Measure Change Technology
14.6 An Application
14.7 In-Arrears Swaps and Convexity
14.8 Cross-Currency Swaps
14.9 Differential (Quanto) Swaps
14.10 Conclusions
Suggested Reading
Exercises
Chapter 15. Tools for Volatility Engineering, Volatility Swaps, and Volatility Trading
15.1 Introduction
15.2 Volatility Positions
15.3 Invariance of Volatility Payoffs
15.4 Pure Volatility Positions
15.5 Variance Swaps
15.6 Real-World Example of Variance Contract
15.7 Volatility and Variance Swaps Before and After the GFC—The Role of Convexity Adjustments?
15.8 Which Volatility?
15.9 Conclusions
Suggested Reading
Exercises
Chapter 16. Correlation as an Asset Class and the Smile
16.1 Introduction to Correlation as an Asset Class
16.2 Volatility as Funding
16.3 Smile
16.4 Dirac Delta Functions
16.5 Application to Option Payoffs
16.6 Breeden–Litzenberger Simplified
16.7 A Characterization of Option Prices as Gamma Gains
16.8 Introduction to the Smile
16.9 Preliminaries
16.10 A First Look at the Smile
16.11 What Is the Volatility Smile?
16.12 Smile Dynamics
16.13 How to Explain the Smile
16.14 The Relevance of the Smile
16.15 Trading the Smile
16.16 Pricing with a Smile
16.17 Exotic Options and the Smile
16.18 Conclusions
Suggested Reading
Exercises
Chapter 17. Caps/Floors and Swaptions with an Application to Mortgages
17.1 Introduction
17.2 The Mortgage Market
17.3 Swaptions
17.4 Pricing Swaptions
17.5 Mortgage-Based Securities
17.6 Caps and Floors
17.7 Conclusions
Suggested Reading
Exercises
Chapter 18. Credit Markets: CDS Engineering
18.1 Introduction
18.2 Terminology and Definitions
18.3 Credit Default Swaps
18.4 Real-World Complications
18.5 CDS Analytics
18.6 Default Probability Arithmetic
18.7 Pricing Single-Name CDS
18.8 Comparing CDS to TRS and EDS
18.9 Sovereign CDS
18.10 Conclusions
Suggested Reading
Exercises
Chapter 19. Engineering of Equity Instruments and Structural Models of Default
19.1 Introduction
19.2 What Is Equity?
19.3 Equity as the Discounted Value of Future Cash Flows
19.4 Equity as an Option on the Assets of the Firm
19.5 Capital Structure Arbitrage
19.6 Engineering Equity Products
19.7 Conclusions
Suggested Reading
Exercises
Chapter 20. Essentials of Structured Product Engineering
20.1 Introduction
20.2 Purposes of Structured Products
20.3 Structured Fixed-Income Products
20.4 Some Prototypes
20.5 Conclusions
Suggested Reading
Exercises
Chapter 21. Securitization, ABSs, CDOs, and Credit Structured Products
21.1 Introduction
21.2 Financial Engineering of Securitization
21.3 ABSs Versus CDOs
21.4 A Setup for Credit Indices
21.5 Index Arbitrage
21.6 Tranches: Standard and Bespoke
21.7 Tranche Modeling and Pricing
21.8 The Roll and the Implications
21.9 Regulation, Credit Risk Management, and Tranche Pricing
21.10 New Index Markets
21.11 Structured Credit Products
21.12 Conclusions
Suggested Reading
Exercises
Chapter 22. Default Correlation Pricing and Trading
22.1 Introduction
22.2 Two Simple Examples
22.3 Standard Tranche Valuation Model
22.4 Default Correlation and Trading
22.5 Delta Hedging and Correlation Trading
22.6 Real-World Complications
22.7 Default Correlation Case Study: May 2005
22.8 Conclusions
Suggested Reading
Appendix 22.1 Some Basic Statistical Concepts
Exercises
Chapter 23. Principal Protection Techniques
23.1 Introduction
23.2 The Classical Case
23.3 The CPPI
23.4 Modeling the CPPI Dynamics
23.5 An Application: CPPI and Equity Tranches
23.6 Differences Between CPDO and CPPI
23.7 A Variant: The DPPI
23.8 Application of CPPI in the Insurance Sector: ICPPI
23.9 Real-World Complications
23.10 Conclusions
Suggested Reading
Exercises
Chapter 24. Counterparty Risk, Multiple Curves, CVA, DVA, and FVA
24.1 Introduction
24.2 Counterparty Risk
24.3 Credit Valuation Adjustment
24.4 Debit Valuation Adjustment
24.5 Bilateral Counterparty Risk
24.6 Hedging Counterparty Risk
24.7 Funding Valuation Adjustment
24.8 CVA Desk
24.9 Choice of the Discount Rate and Multiple Curves
24.10 Conclusions
Suggested Reading
Exercises
References
Index

Robert Kosowski

Robert Kosowski is Associate Professor in the Finance Group of Imperial College Business School, Imperial College London, and Director of the Risk Management Lab and Centre for Hedge Fund Research. Robert is an associate member of the Oxford-Man Institute of Quantitative Finance at Oxford University and a member of AIMA's research committee. His research interests include asset management, asset pricing, and financial econometrics with a focus on hedge and mutual funds, performance measurement, asset allocation, business cycles, and derivative trading strategies.

Robert's research has been featured in "The Financial Times" and "The Wall Street Journal" and was awarded the European Finance Association 2007 Best Paper Award, an INQUIRE UK 2008 best paper award, an INQUIRE Europe 2009/10 and 2012/13 best paper award, and the British Academy's mid-career fellowship (2011-2012). Robert's research has been published in top peer-reviewed finance journals such as "The Journal of Finance," "The Journal of Financial Economics" and the "Review of Financial Studies."

Prior to joining Imperial College London Robert was an Assistant Professor of Finance at INSEAD, where he taught in the MBA, Executive Education, and Ph.D. programs. Robert was a visiting scholar at the UCSD Economics Department (2000) and the International Monetary Fund (2008). At Imperial Robert teaches in the MSc Finance. He won teaching prizes at Imperial College Business School in 2009 and 2014.

Robert holds a BA (First Class Honours) and MA in Economics from Trinity College, Cambridge University, and a MSc in Economics and Ph.D. from the London School of Economics. He has consulted for private and public sector organizations and has worked for Goldman Sachs, the Boston Consulting Group, and Deutsche Bank. His policy related advisory work includes: Specialist Adviser to UK House of Lords (2009-2010) and Expert Technical Consultant (International Monetary Fund, USA, 2008).

Affiliations and expertise

Associate Professor of Finance and Director of the Risk Management Lab and Centre for Hedge Fund Research, Imperial College, London, UK

Salih N. Neftci

Professor Neftci completed his Ph.D. at the University of Minnesota and was head of the FAME Certificate program in Switzerland. He taught at the Graduate School, City University of New York; ICMA Centre, University of Reading; and at the University of Lausanne. He was also a Visiting Professor in the Finance Department at Hong Kong University of Science and Technology. Known his books and articles, he was a regular columnist for CBN daily, the most influential financial newspaper in China. Salih Neftci was already suffering from gliosarcoma, a malignant brain cancer, while writing the second edition. It published just 5 months before his death on April 15, 2009.

Affiliations and expertise

Late of the Global Finance Master’s Program, New School for Social Research, New York, NY, USA

Life Sciences

Physical Sciences & Engineering

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