Structured Derivatives Handbook

Author: Mihai Mateu
Publisher:
Publish Date: 2000-08-01
Features: Do you want to learn about the clever and practical financial trading tools used by fund managers who battle in financial markets? This book is a practical financial tools manual. It provides a detailed introduction to the construction, pricing, and corresponding combinations of numerous over-the-counter or structured derivative instruments, as well as their applications in investment management. The financial derivatives covered in the book include: interest rate and foreign exchange forward contracts, interest rate caps and floors, swap options, bond options, currency options, stock options, and a series of "second-generation" derivatives such as barrier options, backward options, digital options, average rate options, and cross-index basis notes, among others. This book is written for practitioners involved in investment management, hence it places greater emphasis on practicality. It is particularly useful for fund managers, bankers, investment firms, and cash-rich companies operating in international financial markets. For financial operations researchers and students, it will help enhance or deepen their understanding of this field.
Chapter 1: Introduction
In the past two decades, corporate borrowers and institutional investors have faced a fundamentally transformed financial environment. Unprecedented technological advancements, globalization of competition in financial products and factors, and the twin external forces of financial market deregulation and integration have led to significant changes in the financial landscape. In every aspect, the current financial environment is riskier than two decades ago, with the certainty of past financial markets replaced by the frequent volatility of today's markets. Neither borrowers nor investors can ignore the risks brought by unpredictable interest and exchange rate fluctuations. In response to the increasing volatility, the financial market has designed various financial instruments and strategies to hedge market risks. These risk-management products, more commonly referred to as derivatives, dominate the international financial market in many ways. For example, a substantial proportion of European bond issues are driven by swaps, and asset swaps are an integral part of fixed-income investments. The role of derivatives in risk management is just one aspect of their utility. In recent years, derivatives have been increasingly used for speculation in various financial and commodity markets. For instance, derivatives provide a more convenient way to establish chain-trading derivative positions while reducing the need for operations in the cash market. Derivatives are also increasingly being incorporated into conventional investment portfolios to assume certain risks and gain access to regulated or restricted markets. In these cases, derivatives are embedded within conventional asset and liability products. The characteristics of risk and return can be altered by exploiting market anomalies or expressing views that differ from those of the market. The role of derivatives in creating structured assets and liabilities is a significant theme in today's financial market, and the growing trend of structured products represents a major new application of derivatives. The purpose of this book is to provide investors with the tools to create structured products.
The Economic Context of Derivatives Development
In the 1950s, Western countries, after experiencing prolonged periods of price stability, faced an unexpected and unprecedented rise in prices. One precursor to this price instability was the Great Depression of the 1930s, during which countries adopted competitive devaluations and trade protectionism to protect their economies. At the end of World War II, international economic policy was primarily based on two considerations: facilitating the reconstruction of the war-torn economies of European countries and preventing the competitive devaluations and trade protectionism that had occurred in the 1930s. To achieve these goals, the Bretton Woods System, a fixed exchange rate system, was established in 1944 at a ski resort in New Hampshire through the Bretton Woods Agreement. Under this system, member countries were obligated to maintain the convertibility of their currencies and keep their exchange rates fixed, with only the possibility of appreciation or depreciation if there was clear evidence of fundamental economic imbalances, meaning the establishment of a new fixed parity. Convertibility seemed to be a good idea rather than a realistic goal, as only the United States allowed for complete capital mobility among major economic powers. From the perspective of maintaining fixed exchange rates, the Bretton Woods System was successful, with only fixed currency parities changing occasionally and to a much smaller extent compared to the 1970s. In reality, until the Bretton Woods System began to collapse gradually in the late 1960s, there were only two market trends: the decline in the value of the pound, with two major devaluations in 1948 and 1967; and the appreciation of the Deutsche Mark due to the recovery of the German economy and the decline in U.S. trade competitiveness. The Bretton Woods System, which provided greater stability for the post-war world, began to collapse in 1968. The Bretton Woods System operated under the Gold Exchange Standard, under which the United States guaranteed that it could exchange gold for dollars at any time through what was known as the "gold window," fixing the price of gold at $35 per ounce. Other countries pegged their currencies to the U.S. dollar, with only the possibility of devaluation or appreciation to maintain economic balance. In 1968, an unofficial free gold market began to operate, excluding central banks, which effectively led to a dual price of gold and made the official gold price unrealistic. On August 15, 1973, with President Nixon's announcement of the closure of the "gold window," the Bretton Woods System ultimately collapsed, and the Smithsonian Agreement, which attempted to repair the system, failed within 12 months. The end of the fixed exchange rate system under the Bretton Woods System in 1973 caused a major shock to the post-war stable financial market. One of the main reasons for the failure of the Bretton Woods System was the rising inflation. Contrary to the deflationary concerns of the participating countries at the time of the Bretton Woods conference, the 1950s and 1960s saw a world-wide acceleration in inflation, initially at a slower pace but becoming quite rapid starting in 1967. Therefore, controlling inflation became a crucial policy for major industrialized countries.