"Richard Flavell has a strong theoretical perspective on swaps with considerable practical experience in the actual trading of these instruments. This rare combination makes this welcome updated second edition a useful reference work for market practitioners." -Satyajit Das, author of Swaps and Financial Derivatives Library and Traders and Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives

Fully revised and updated from the first edition, Swaps and Other Derivatives, Second Edition, provides a practical explanation of the pricing and evaluation of swaps and interest rate derivatives.

Based on the author's extensive experience in derivatives and risk management, working as a financial engineer, consultant and trainer for a wide range of institutions across the world this book discusses in detail how many of the wide range of swaps and other derivatives, such as yield curve, index amortisers, inflation-linked, cross-market, volatility, diff and quanto diffs, are priced and hedged. It also describes the modelling of interest rate curves, and the derivation of implied discount factors from both interest rate swap curves, and cross-currency adjusted curves.

There are detailed sections on the risk management of swap and option portfolios using both traditional approaches and also Value-at-Risk. Techniques are provided for the construction of dynamic and robust hedges, using ideas drawn from mathematical programming.

This second edition has expanded sections on the credit derivatives market - its mechanics, how credit default swaps may be priced and hedged, and how default probabilities may be derived from a market strip. It also prices complex swaps with embedded options, such as range accruals, Bermudan swaptions and target accrual redemption notes, by constructing detailed numerical models such as interest rate trees and LIBOR-based simulation. There is also increased discussion around the modelling of volatility smiles and surfaces.

The book is accompanied by a CD-ROM where all the models are replicated, enabling readers to implement the models in practice with the minimum of effort.

RICHARD FLAVELL has spent over twenty years working as a financial engineer, consultant and trainer, specialising in complex derivatives and risk management. He spent seven years as Director of Financial Engineering at Lombard Risk, where he was responsible for the mathematical development and implementation of models in its varied pricing and risk systems. He is currently Chairman of Lucidate, a company which specialises in the provision of consultancy and training to financial institutions.

Inhalt

Preface ix

List of Worksheets (see the accompanying CD) xv

List of Abbreviations xxv

1 Swaps and Other Derivatives 1

1.1 Introduction 1

1.2 Applications of swaps 3

1.3 An overview of the swap market 6

1.4 The evolution of the swap market 8

1.5 Conclusion 10

2 Short-term Interest Rate Swaps 13

Objective 13

2.1 Discounting, the time value of money and other matters 13

2.2 Forward rate agreements (FRAs) and interest rate futures 19

2.3 Short-term swaps 24

2.4 Convexity bias in futures 29

2.5 Forward valuing a swap 31

3 Generic Interest Rate Swaps 33

Objective 33

3.1 Generic interest rate swaps 33

3.2 Pricing through comparative advantage 37

3.3 The relative pricing of generic IRSs 40

3.4 The relationship between the bond and swap markets 43

3.5 Implying a discount function 50

3.6 Building a blended curve 56

4 The Pricing and Valuation of Non-generic Swaps 59

Objective 59

4.1 The pricing of simple non-generic swaps: forward starts 59

4.2 Rollercoasters 64

4.3 Pricing of simple non-generic swaps: a more complex example 66

4.4 Forward valuing as an alternative to discountingrevisited 68

4.5 Swap valuation 69

5 Asset Packaging 73

Objective 73

5.1 Creation and pricing of a par asset swap 74

5.2 Creation and pricing of a par maturity asset swap 77

5.3 Discounting, embedded loans and forward valuing 78

5.4 Further extensions to asset packaging 78

6 Credit Derivatives 79

Background and objective 79

6.1 Total return swaps 80

6.2 Credit default swaps 82

6.3 Pricing and hedging of generic CDSs 88

6.4 Modelling a CDS 92

6.5 Pricing and valuing non-generic CDSs 96

6.6 Basket and portfolio CDSs 97

6.7 Credit exposure under swaps 99

6.8 Appendix: An outline of the credit modelling of portfolios 102

7 More Complex Swaps 107

Objective 107

7.1 Simple mismatch swaps 107

7.2 Average rate swaps 108

7.3 Compound swaps 109

7.4 Yield curve swaps 110

7.5 Convexity effects of swaps 112

7.6 Appendix: Measuring the convexity effect 115

7.6.1 Two approaches to measuring the convexity effect 115

7.6.2 A general mismatch swap 120

7.6.3 Yield curve swaps 123

8 Cross-market and Other Market Swaps 127

Objective 127

8.1 Overnight indexed swaps 127

8.2 Cross-market basis swaps 130

8.3 Equity and commodity swaps 135

8.3.1Commodity swaps 138

8.4 Longevity swaps 140

8.5 Inflation swaps 141

8.6 Volatility swaps 151

9 Cross-currency Swaps 159

Objective 159

9.1 Floatingfloating cross-currency swaps 159

9.2 Pricing and hedging of CCBSs 161

9.3 CCBSs and discounting 166

9.4 Fixedfloating cross-currency swaps 169

9.5 Floatingfloating swaps continued 171

9.6 Fixedfixed cross-currency swaps 174

9.7 Cross-currency swap valuation 177

9.8 Dual-currency swaps 179

9.9 Cross-currency equity swaps 182

9.10 Conclusion 183

9.11 Appendix: Quanto adjustments 183

10 OTC Options 187

Objective 187

10.1 Introduction 187

10.2 The Black option-pricing model 188

10.3 Interest rate volatility 190

10.4 Par and forward volatilities 199

10.5 Caps, floors and collars 201

10.6 Digital options 210

10.7 Embedded structures 211

10.8 Swaptions 214

10.9 Structures with embedded swaptions 220