Preface xiii
Scope of this Book xiii
The Readership xiii
About the Author xiv
Acknowledgments xiv
1 Foreign Exchange Options 1
1.1 A journey through the history of options 1
1.2 Technical issues for vanilla options 2
1.2.1 Value 4
1.2.2 A note on the forward 4
1.2.3 Greeks 5
1.2.4 Identities 6
1.2.5 Homogeneity based relationships 7
1.2.6 Quotation 8
1.2.7 Strike in terms of delta 10
1.2.8 Volatility in terms of delta 11
1.2.9 Volatility and delta for a given strike 11
1.2.10 Greeks in terms of deltas 12
1.3 Volatility 15
1.3.1 Historic volatility 15
1.3.2 Historic correlation 18
1.3.3 Volatility smile 19
1.3.4 At-the-money volatility interpolation 25
1.3.5 Volatility smile conventions 25
1.3.6 At-the-money definition 26
1.3.7 Interpolation of the volatility on maturity pillars 26
1.3.8 Interpolation of the volatility spread between maturity pillars 26
1.3.9 Volatility sources 27
1.3.10 Volatility cones 27
1.3.11 Stochastic volatility 28
1.3.12 Exercises 291.4 Basic strategies containing vanilla options 29
1.4.1 Call and put spread 30
1.4.2 Risk reversal 31
1.4.3 Risk reversal flip 33
1.4.4 Straddle 33
1.4.5 Strangle 35
1.4.6 Butterfly 36
1.4.7 Seagull 38
1.4.8 Exercises 39
1.5 First generation exotics 39
1.5.1 Barrier options 40
1.5.2 Digital options, touch options and rebates 49
1.5.3 Compound and instalment 58
1.5.4 Asian options 69
1.5.5 Lookback options 77
1.5.6 Forward start, ratchet and cliquet options 84
1.5.7 Power options 86
1.5.8 Quanto options 93
1.5.9 Exercises 96
1.6 Second generation exotics 101
1.6.1 Corridors 101
1.6.2 Faders 103
1.6.3 Exotic barrier options 105
1.6.4 Pay-later options 116
1.6.5 Step up and step down options 118
1.6.6 Spread and exchange options 119
1.6.7 Baskets 121
1.6.8 Best-of and worst-of options 126
1.6.9 Options and forwards on the harmonic average 131
1.6.10 Variance and volatility swaps 132
1.6.11 Exercises 135
2 Structured Products 139
2.1 Forward products 139
2.1.1 Outright forward 141
2.1.2 Participating forward 142
2.1.3 Fade-in forward 142
2.1.4 Knock-out forward 143
2.1.5 Shark forward 144
2.1.6 Fader shark forward 147
2.1.7 Butterfly forward 149
2.1.8 Range forward 151
2.1.9 Range accrual forward 153
2.1.10 Accumulative forward 156
2.1.11 Boomerang forward 161
2.1.12 Amortizing forward 162
2.1.13 Auto-renewal forward 1632.1.14 Double shark forward 164
2.1.15 Forward start chooser forward 165
2.1.16 Free style forward 165
2.1.17 Boosted spot/forward 165
2.1.18 Time option 166
2.1.19 Exercises 167
2.2 Series of strategies 170
2.2.1 Shark forward series 170
2.2.2 Collar extra series 172
2.2.3 Exercises 173
2.3 Deposits and loans 174
2.3.1 Dual currency deposit/loan 175
2.3.2 Performance linked deposits 177
2.3.3 Tunnel deposit/loan 179
2.3.4 Corridor deposit/loan 181
2.3.5 Turbo deposit/loan 184
2.3.6 Tower deposit/loan 185
2.3.7 Exercises 187
2.4 Interest rate and cross currency swaps 190
2.4.1 Cross currency swap 191
2.4.2 Hanseatic swap 192
2.4.3 Turbo cross currency swap 193
2.4.4 Buffered cross currency swap 196
2.4.5 Flip swap 196
2.4.6 Corridor swap 198
2.4.7 Double-no-touch linked swap 200
2.4.8 Range reset swap 202
2.4.9 Exercises 202
2.5 Participation notes 203
2.5.1 Gold participation note 204
2.5.2 Basket-linked note 206
2.5.3 Issuer swap 207
2.5.4 Moving strike turbo spot unlimited 207
2.6 Hybrid FX products 208
3 Practical Matters 211
3.1 The traders’ rule of thumb 211
3.1.1 Cost of vanna and volga 211
3.1.2 Observations 214
3.1.3 Consistency check 214
3.1.4 Abbreviations for first generation exotics 216
3.1.5 Adjustment factor 217
3.1.6 Volatility for risk reversals, butterflies and theoretical value 218
3.1.7 Pricing barrier options 218
3.1.8 Pricing double barrier options 219
3.1.9 Pricing double-no-touch options 219
3.1.10 Pricing european style options 2193.1.11 No-touch probability 219
3.1.12 The cost of trading and its implication on the market price
of one-touch options 220
3.1.13 Example 220
3.1.14 Further applications 222
3.1.15 Exercises 222
3.2 Bid–ask spreads 222
3.2.1 One touch spreads 223
3.2.2 Vanilla spreads 223
3.2.3 Spreads for first generation exotics 223
3.2.4 Minimal bid–ask spread 224
3.2.5 Bid–ask prices 224
3.2.6 Exercises 224
3.3 Settlement 224
3.3.1 The Black-Scholes model for the actual spot 226
3.3.2 Cash settlement 226
3.3.3 Delivery settlement 227
3.3.4 Options with deferred delivery 227
3.3.5 Exercises 228
3.4 On the cost of delayed fixing announcements 228
3.4.1 The currency fixing of the European Central Bank 229
3.4.2 Model and payoff 230
3.4.3 Analysis procedure 230
3.4.4 Error estimation 231
3.4.5 Analysis of EUR-USD 234
3.4.6 Conclusion 236
4 Hedge Accounting under IAS 39 237
4.1 Introduction 237
4.2 Financial instruments 238
4.2.1 Overview 238
4.2.2 General definition 240
4.2.3 Financial assets 240
4.2.4 Financial liabilities 240
4.2.5 Offsetting of financial assets and financial liabilities 241
4.2.6 Equity instruments 242
4.2.7 Compound financial instruments 242
4.2.8 Derivatives 243
4.2.9 Embedded derivatives 245
4.2.10 Classification of financial instruments 247
4.3 Evaluation of financial instruments 250
4.3.1 Initial recognition 250
4.3.2 Initial measurement 251
4.3.3 Subsequent measurement 252
4.3.4 Derecognition 255
4.4 Hedge accounting 257
4.4.1 Overview 257
4.4.2 Types of hedges 2584.4.3 Basic requirements 260
4.4.4 Stopping hedge accounting 264
4.5 Methods for testing hedge effectiveness 265
4.5.1 Fair value hedge 265
4.5.2 Cash flow hedge 270
4.6 Testing for effectiveness – a case study of the forward plus 272
4.6.1 Simulation of exchange rates 273
4.6.2 Calculation of the forward plus value 273
4.6.3 Calculation of the forward rates 277
4.6.4 Calculation of the forecast transaction’s value 278
4.6.5 Dollar-offset ratio – prospective test for effectiveness 279
4.6.6 Variance reduction measure – prospective test for effectiveness 280
4.6.7 Regression analysis – prospective test for effectiveness 280
4.6.8 Result 282
4.6.9 Retrospective test for effectiveness 283
4.7 Conclusion 289
4.8 Relevant original sources for accounting standards 291
4.9 Exercises 291
5 Foreign Exchange Markets 293
5.1 A tour through the market 293
5.1.1 Statement by GFI group (Fenics), 25 October 2005 293
5.1.2 Interview with ICY software, 14 October 2005 294
5.1.3 Interview with Bloomberg, 12 October 2005 296
5.1.4 Interview with Murex, 8 November 2005 300
5.1.5 Interview with SuperDerivatives, 17 October 2005 303
5.1.6 Interview with Lucht Probst Associates, 27 February 2006 307
5.2 Software and system requirements 309
5.2.1 Fenics 309
5.2.2 Position keeping 309
5.2.3 Pricing 310
5.2.4 Straight through processing 310
5.2.5 Disclaimers 310
5.3 Trading and sales 310
5.3.1 Proprietary trading 311
5.3.2 Sales-driven trading 311
5.3.3 Inter bank sales 311
5.3.4 Branch sales 311
5.3.5 Institutional sales 311
5.3.6 Corporate sales 311
5.3.7 Private banking 312
5.3.8 Listed FX options 312
5.3.9 Trading floor joke 312