Principles of Financial Engineering, 3rd Edition

 
Principles of Financial Engineering, 3rd Edition,Robert Kosowski,Salih Neftci,ISBN9780123869685
 
 
 

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Academic Press

9780123869685

9780123870070

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Bestselling author updates this highly acclaimed text on the fast-paced and complex subject of financial engineering

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Key Features

  • The Third Edition presents three new chapters on financial engineering in commodity markets, 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, among other topics.

  • Additions, clarifications, and illustrations throughout the volume show these instruments at work instead of explaining how they should act

  • The solutions manual enhances the text by presenting additional cases and solutions to exercises

Description

Three new chapters, numerous additions to existing chapters, and an expanded collection of questions and exercises make this third edition of Principles of Financial Engineering essential reading. Between defining swaps on its first page and presenting a case study on its last, Robert Kosowski and Salih Neftci's introduction to financial engineering shows readers how to create financial assets in static and dynamic environments. Poised among intuition, actual events, and financial mathematics, this book can be used to solve problems in risk management, taxation, regulation, and above all, pricing.

Readership

financial engineers, quantitative analysts in banks and investment houses, and other financial industry professionals; graduate students in financial engineering and financial mathematics programs.

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 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.

Affiliations and Expertise

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

View additional works by Salih N. Neftci

Principles of Financial Engineering, 3rd Edition

  • 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

Quotes and reviews

"This text has quickly become a modern classic of financial engineering, as broad in coverage as it is deep in content, and the addition of Kosowski brings another dimension of academic rigor and practical relevance to Neftci's impressive pedagogical legacy." --Andrew W. Lo, MIT Sloan School of Management

"I’m delighted that this classical text has been updated by Professor Kosowski to reflect financial engineering post-crisis. This timely combination of timeless principles and recent revelations makes for an irresistible read." --Peter Carr, Morgan Stanley and New York University

 
 
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