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PRINCIPLES OF FINANCIAL ENGINEERING

Second Edition

Salih N. Neftci
Global Finance Program New School for Social Research New York, New York and Department of Finance Hong Kong University of Science and Technology Hong Kong and ICMA Centre University of Reading Reading, UK

AMSTERDAM • BOSTON • HEIDELBERG • LONDON NEW YORK • OXFORD • PARIS • SAN DIEGO SAN FRANCISCO • SINGAPORE • SYDNEY •TOKYO Academic Press is an imprint of Elsevier

Academic Press is an imprint of Elsevier 30 Corporate Drive, Suite 400, Burlington, MA 01803, USA 525 B Street, Suite 1900, San Diego, California 92101-4495, USA 84 Theobald’s Road, London WC1X 8RR, UK Copyright c 2008, Elsevier Inc. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means,electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without permission in writing from the publisher. Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone: (+44) 1865 843830, fax: (+44) 1865 853333, E-mail: permissions@elsevier.com. You may also complete your request online via the Elsevierhomepage (http://www.elsevier.com), by selecting “Support & Contact” then “Copyright and Permission” and then “Obtaining Permissions.” Library of Congress Cataloging-in-Publication Data Application submitted. British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. ISBN: 978-0-12-373574-4 For information on all Academic Presspublications, visit our Web site at: http://www.books.elsevier.com Printed in Canada 08 09 10 9 8 7 6 5 4 3 2 1

Contents
Preface
xv

CHAPTER 1 Introduction

1

1. A Unique Instrument 1 2. A Money Market Problem 8 3. A Taxation Example 11 4. Some Caveats for What Is to Follow 5. Trading Volatility 15 6. Conclusions 18 Suggested Reading 19 Case Study 20

14

CHAPTER 2 An Introduction to SomeConcepts and Definitions
1. Introduction 23 2. Markets 23 3. Players 27 4. The Mechanics of Deals 27 5. Market Conventions 30 6. Instruments 37 7. Positions 37 8. The Syndication Process 41 9. Conclusions 42 Suggested Reading 42 Appendix 2-1: The Hedge Fund Industry Exercises 46

23

42

CHAPTER 3 Cash Flow Engineering and Forward Contracts
1. 2. 3. 4. 5. 6. 7. Introduction 47 What Is aSynthetic? 47 Forward Contracts 51 Currency Forwards 54 Synthetics and Pricing 59 A Contractual Equation 59 Applications 60

47

vii

viii

Contents

8. A “Better” Synthetic 66 9. Futures 70 10. Conventions for Forwards 11. Conclusions 76 Suggested Reading 77 Exercises 78 Case Study 80

75

CHAPTER 4 Engineering Simple Interest Rate Derivatives
1. Introduction 83 2. Libor and OtherBenchmarks 84 3. Forward Loans 85 4. Forward Rate Agreements 92 5. Futures: Eurocurrency Contracts 96 6. Real-World Complications 100 7. Forward Rates and Term Structure 102 8. Conventions 103 9. A Digression: Strips 104 10. Conclusions 105 Suggested Reading 105 Exercises 106

83

CHAPTER 5 Introduction to Swap Engineering
1. The Swap Logic 109 2. Applications 112 3. The Instrument: Swaps 1174. Types of Swaps 120 5. Engineering Interest Rate Swaps 129 6. Uses of Swaps 137 7. Mechanics of Swapping New Issues 142 8. Some Conventions 148 9. Currency Swaps versus FX Swaps 148 10. Additional Terminology 150 11. Conclusions 151 Suggested Reading 151 Exercises 152

109

CHAPTER 6 Repo Market Strategies in Financial Engineering
1. Introduction 157 2. What Is Repo? 158 3. Types of Repo160 4. Equity Repos 165 5. Repo Market Strategies 165 6. Synthetics Using Repos 171 7. Conclusions 173 Suggested Reading 173 Exercises 174 Case Study 175

157

Contents

ix

CHAPTER 7 Dynamic Replication Methods and Synthetics
1. Introduction 177 2. An Example 178 3. A Review of Static Replication 178 4. “Ad Hoc” Synthetics 183 5. Principles of Dynamic Replication 186 6. Some Important...
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