## Fundamentals of Futures and Options Markets, 8th Global Edition

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Directed primarily toward undergraduate finance students, this text also provides practical content to current and aspiring industry professionals.

Based on Hull’s *Options, Futures and Other Derivatives*, ** Fundamentals of Futures and Options Markets **presents an accessible overview of the topic without the use of calculus. Packed with numerical examples and accounts of real-life situations, this text effectively guides readers through the material while helping them prepare for the working world.

Derivatives markets have become increasingly important in the world of finance and investments. It is now essential for all finance professionals to understand how these markets work, how they can be used, and what determines prices in them. This book addresses these issues.

Derivatives are traded on exchanges and in what are termed ‘‘over-the-counter’’ (OTC) markets. The two main products trading on exchanges are futures and options. In the over-the-counter markets forwards, swaps, options, and a wide range of other derivatives transactions are agreed to. Before the crisis which started in 2007, the OTC derivatives market was relatively free from regulation. This has now changed. As we will explain, OTC market participants are now subject to rules specifying how trading must be done, how trades must be reported, and the collateral that must be provided.

This opening chapter starts by providing an introduction to futures markets and futures exchanges. It then compares exchange-traded derivatives markets with OTC derivatives markets and discusses forward contracts, which are the OTC counterpart of futures contracts. After that, it introduces options and outlines the activities of hedgers, speculators, and arbitrageurs in derivatives markets.

## CONTENTS IN BRIEF:

Preface

1. Introduction

2. Mechanics of futures markets

3. Hedging strategies using futures

4. Interest rates

5. Determination of forwarding and futures prices

6. Interest rate futures

7. Swaps

8. Securitization and the credit crisis of 2007

9. Mechanics of options markets

10. Properties of stock options

11. Trading strategies involving options

12. Introduction to binomial trees

13. Valuing stock options: the Black–Scholes–Merton model

14. Employee stock options

15. Options on stock indices and currencies

16. Futures options

17. The Greek letters

18. Binomial trees in practice

19. Volatility smiles

20. Value at risk

21. Interest rate options

22. Exotic options and other nonstandard products

23. Credit derivatives

24. Weather, energy, and insurance derivatives

25. Derivatives mishaps and what we can learn from them

Answers to quiz questions

Glossary of terms

DerivaGem software

Major exchanges trading futures and options

Tables for N(x)

Index

## About the author:

John C. Hull is a Professor of Derivatives and Risk Management at the Rotman School of Management at the University of Toronto.

He is both a very well respected researcher in the academic field of quantitative finance (see for example the Hull-White model), and also the author of (among other works) two books on financial derivatives that have become market practitioners’ standard texts: “Options, Futures, and Other Derivatives” and “Fundamentals of Futures and Options Markets”.

In 1999, he was awarded the Financial Engineer of the Year Award, by the International Association of Financial Engineers.

## Table of contents:

Preface

Chapter 1: Introduction

1.1 Futures Contracts

1.2 History of Futures Markets

1.3 The Over-the-Counter Market

1.4 Forward Contracts

1.5 Options

1.6 History of Options Markets

1.7 Types of Trader

1.8 Hedgers

1.9 Speculators

1.10 Arbitrageurs

1.11 Dangers

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Chapter 2: Mechanics of Futures Markets

2.1 Opening and Closing Futures Positions

2.2 Specification of a Futures Contract

2.3 Convergence of Futures Price to Spot Prices

2.4 The Operation of Margin Accounts

2.5 OTC Markets

2.6 Market Quotes

2.7 Delivery

2.8 Types of Trader and Types of Order

2.9 Regulation

2.10 Accounting and Tax

2.11 Forward vs. Futures Contracts

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Chapter 3: Hedging Strategies Using Futures

3.1 Basic Principles

3.2 Arguments for and Against Hedging

3.3 Basis Risk

3.4 Cross Hedging

3.5 Stock Index Futures

3.6 Stack and Roll

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Appendix: Review of Key Concepts in Statistics and the CAPM

Chapter 4: Interest Rates

4.1 Types of Rates

4.2 Measuring Interest Rates

4.3 Zero Rates

4.4 Bond Pricing

4.5 Determining Treasury Zero Rates

4.6 Forward Rates

4.7 Forward Rate Agreements

4.8 Theories of the Term Structure of Interest Rates

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Appendix: Exponential and Logarithmic Functions

Chapter 5: Determination of forwarding and Futures Prices

5.1 Investment Assets vs. Consumption Assets

5.2 Short Selling

5.3 Assumptions and Notation

5.4 Forward Price for an Investment Asset

5.5 Known Income

5.6 Known Yield

5.7 Valuing Forward Contracts

5.8 Are Forward Prices and Futures Prices Equal?

5.9 Futures Prices of Stock Indices

5.10 Forward and Futures Contracts on Currencies

5.11 Futures on Commodities

5.12 The Cost of carrying

5.13 Delivery Options

5.14 Futures Prices and the Expected Spot Prices

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Chapter 6: Interest Rate Futures

6.1 Day Count and Quotation Conventions

6.2 Treasury Bond Futures

6.3 Eurodollar Futures

6.4 Duration

6.5 Duration-Based Hedging Strategies Using Futures

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Chapter 7: Swaps

7.1 Mechanics of Interest Rate Swaps

7.2 Day Count Issues

7.3 Confirmations

7.4 The Comparative-Advantage Argument

7.5 The Nature of Swap Rates

7.6 Overnight Indexed Swaps

7.7 Valuation of Interest Rate Swaps

7.8 Estimating the Zero Curve for Discounting

7.9 Forward Rates

7.10 Valuation in Terms of Bonds

7.11 Term Structure Effects

7.12 Fixed-for-Fixed Currency Swaps

7.13 Valuation of Fixed-for-Fixed Currency Swaps

7.14 Other Currency Swaps

7.15 Credit Risk

7.16 Other Types of Swap

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Chapter 8: Securitization and the Credit Crisis of 2007

8.1 Securitization

8.2 The U.S. Housing Market

8.3 What Went Wrong?

8.4 The Aftermath

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Chapter 9: Mechanics of Options Markets

9.1 Types of Option

9.2 Option Positions

9.3 Underlying Assets

9.4 Specification of Stock Options

9.5 Trading

9.6 Commissions

9.7 Margin Requirements

9.8 The Options Clearing Corporation

9.9 Regulation

9.10 Taxation

9.11 Warrants, Employee Stock Options, and Convertibles

9.12 Over-the-Counter Options Markets

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Chapter 10: Properties of Stock Options

10.1 Factors Affecting Option Prices

10.2 Assumptions and Notation

10.3 Upper and Lower Bounds for Option Prices

10.4 Put-Call Parity

10.5 Calls on a Non-Dividend-Paying Stock

10.6 Puts on a Non-Dividend-Paying Stock

10.7 Effect of Dividends

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Chapter 11: Trading Strategies Involving Options

11.1 Principal-Protected Notes

11.2 Strategies Involving a Single Option and a Stock

11.3 Spreads

11.4 Combinations

11.5 Other Payoffs

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Chapter 12: Introduction to Binomial Trees

12.1 A One-Step Binomial Model and a No-Arbitrage Argument

12.2 Risk-Neutral Valuation

12.3 Two-Step Binomial Trees

12.4 A Put Example

12.5 American Options

12.6 Delta 300

12.7 Determining u and d

12.8 Increasing the Number of Time Steps

12.9 Using DerivaGem

12.10 Options on Other Assets

Summary

Further Reading

Quiz308

Practice Questions

Further Questions

Appendix: Derivation of the Black–Scholes–Merton Option Pricing Formula from Binomial Tree

Chapter 13: Valuing Stock Options: The Black–Scholes–Merton Model

13.1 Assumptions about How Stock Prices Evolve

13.2 Expected Return

13.3 Volatility

13.4 Estimating Volatility from Historical Data

13.5 Assumptions Underlying Black–Scholes–Merton

13.6 The Key No-Arbitrage Argument

13.7 The Black–Scholes–Merton Pricing Formulas

13.8 Risk-Neutral Valuation

13.9 Implied Volatilities

13.10 Dividends

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Appendix: The Early Exercise of American Call Options on Dividend-Paying Stocks

Chapter 14: Employee Stock Options

14.1 Contractual Arrangements

14.2 Do Options Align the Interests of Shareholders and Managers?

14.3 Accounting Issues

14.4 Valuation

14.5 Backdating Scandals

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Chapter 15: Options on Stock Indices and Currencies

15.1 Options on Stock Indices

15.2 Currency Options

15.3 Options on Stocks Paying Known Dividend Yields

15.4 Valuation of European Stock Index Options

15.5 Valuation of European Currency Options

15.6 American Options

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Chapter 16: Futures Options

16.1 Nature of Futures Options

16.2 Reasons for the Popularity of Futures Options

16.3 European Spot and Futures Options

16.4 Put-Call Parity

16.5 Bounds for Futures Options

16.6 Valuation of Futures Options Using Binomial Trees

16.7 A Futures Price as an Asset Providing a Yield

16.8 Black’s Model for Valuing Futures Options

16.9 Using Black’s Model Instead of Black–Scholes–Merton

16.10 American Futures Options vs. American Spot Options

16.11 Futures-Style Options

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Chapter 17: The Greek Letters

17.1 Illustration

17.2 Naked and Covered Positions

17.3 A Stop-Loss Strategy

17.4 Delta Hedging

17.5 Theta

17.6 Gamma

17.7 Relationship Between Delta, Theta, and Gamma

17.8 Vega

17.9 Rho

17.10 The Realities of Hedging

17.11 Scenario Analysis

17.12 Extension of Formulas

17.13 Creating Options Synthetically for Portfolio Insurance

17.14 Stock Market Volatility

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Chapter 18: Binomial Trees in Practice

18.1 The Binomial Model for a Non-Dividend-Paying Stock

18.2 Using the Binomial Tree for Options on Indices, Currencies, and Futures Contracts

18.3 The Binomial Model for a Dividend-Paying Stock

18.4 Extensions of the Basic Tree Approach

18.5 Alternative Procedure for Constructing Trees

18.6 Monte Carlo Simulation

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Chapter 19: Volatility Smiles

19.1 Foreign Currency Options

19.2 Equity Options

19.3 The Volatility Term Structure and Volatility Surfaces

19.4 When a Single Large Jump Is Anticipated

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Appendix: Why the Put Volatility Smile is the same as the Call Volatility Smile

Chapter 20: Value at Risk

20.1 The VaR Measure

20.2 Historical Simulation

20.3 Model-Building Approach

20.4 Generalization of Linear Model

20.5 Quadratic Model

20.6 Estimating Volatilities and Correlations

20.7 Comparison of Approaches

20.8 Stress Testing and Back Testing

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Chapter 21: Interest Rate Options

21.1 Exchange-Traded Interest Rate Options

21.2 Embedded Bond Options

21.3 Black’s Model

21.4 European Bond Options

21.5 Interest-Rate Caps

21.6 European Swap Options

21.7 Term Structure Models

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Chapter 22: Exotic Options and Other Nonstandard Products

22.1 Exotic Options

22.2 Agency Mortgage-Backed Securities

22.3 Nonstandard Swaps

Summary

Further Reading

Quiz

Practice Questions

Further Questions

Chapter 23: Credit Derivatives

23.1 Credit Default Swaps

23.2 Valuation of Credit Default Swaps

23.3 Total Return Swaps

23.4 CDS Forwards and Options

23.5 Credit Indices.

23.6 The Use of Fixed Coupons

23.7 Collateralized Debt Obligations

Summary

Further Reading.

Quiz

Practice Questions.

Further Questions.

Chapter 24: Weather, Energy, and Insurance Derivatives

24.1 Weather Derivatives.

24.2 Energy Derivatives.

24.3 Insurance Derivatives

Summary

Further Reading.

Quiz

Practice Questions.

Further Question

Chapter 25: Derivatives Mishaps and What We Can Learn From Them

25.1 Lessons for All Users of Derivatives

25.2 Lessons for Financial Institutions

25.3 Lessons for Nonfinancial Corporations

Summary

Further Reading.

Answers to Quiz Questions

Glossary of Terms.

DerivaGem Software

Major Exchanges Trading Futures and Options

Table for N(x) When x < 0

Table for N(x) When x > 0

Index

## Preface

I was originally persuaded to write this book by colleagues who liked my book Options, Futures, and Other Derivatives, but found the material a little too advanced for their students. Fundamentals of Futures and Options Markets cover some of the same ground as Options, Futures, and Other Derivatives, but in a way that readers who have had limited training in mathematics find easier to understand. One important difference between the two books is that there is no calculus in this book. Fundamentals are suitable for undergraduate and graduate elective courses offered by the business, economics, and other faculties. In addition, many practitioners who want to improve their understanding of futures and options markets will find the book useful.

Instructors can use this book in many different ways. Some may choose to cover only the first 12 chapters, finishing with binomial trees. There are many different sequences in which chapters 13 to 25 can be covered for those who want to do more. From Chapter 18 onward, each chapter has been designed to be independent of the others and be included in or omitted from a course without causing problems. I recommend finishing a

course with Chapter 25, which students always find interesting and entertaining.

## What’s New in This Edition?

Many changes have been made to update the material and improve the presentation. For

example:

1. The changes taking place in the way over-the-counter derivatives are traded are explained. These changes are significant and most instructors will want to talk about them in their classes.

2. Chapter 7 on swaps reflects the trend in the market toward OIS discounting. It explains how swaps can be valued using both LIBOR and OIS discounting. It is becoming increasingly important for students to understand this material.

3. New nontechnical explanations of the Black–Scholes–Merton formula are provided in Chapter 13 and an appendix to Chapter 12 outlines how the formula can be derived from binomial trees. Many users of the book have asked for these changes.

4. New material has been added on principal-protected notes (Chapter 11) reflecting their importance in the market.

5. Products such as DOOM options and CEBOs offered by the CME Group are covered (Chapter 9) because I find students enjoy learning about them.

6. The material on exotic options (Chapter 22) has been expanded to include a discussion of cliquet and Parisian options. I find students also enjoy learning about these products.

7. The material on credit derivatives (Chapter 23) has been updated and expanded. Several instructors have asked for this.

8. Value at risk is explained with an example using real data (Chapter 20). The example and accompanying spreadsheets have been improved for this edition. This makes the presentation more interesting and allows instructors to use richer assignment questions.

9. Many new end-of-chapter problems have been added.

10. The Test Bank available to adopting instructors has been expanded and improved.

## Slides

Several hundred PowerPoint slides can be downloaded from my website or Pearson’s Instructor Resource Center. Instructors adopting the book are welcome to adapt the slides to meet their own needs.

## Software

DerivaGem, Version 2.01, is included with this book. This consists of two Excel applications: the Options Calculator and the Applications Builder. The Options Calculator consists of easy-to-use software for valuing a wide range of options. The Applications Builder consists of several Excel functions from which users can build their own applications. It includes some sample applications and enables students to explore the properties of options and numerical procedures. It also allows more interesting assignments to be designed.

A version of the software’s functions compatible with Open Office for Mac and Linux users is provided. Users can now access the code for the functions underlying DerivaGem.

## End-of-Chapter Problems

At the end of each chapter (except the last) there are seven quiz questions, which students can use to provide a quick test of their understanding of the key concepts. The answers to these are given at the end of the book. In addition, there is a multitude of practice questions and further questions in the book.

## Instructors Manual

The Instructors Manual is made available online by Pearson to adopting instructors. It contains solutions to practice and further questions, notes on the teaching of each chapter and course organization, and some relevant Excel worksheets.

## Reviews about the ebook:

- Sandeep Jha:

Great clarity on the topics. Helped in hedging funds. - Victor Oliveira:

Livro indispensável para quem quer entender o mercado futuro. Infelizmente poucos leem, ou esquecem do leram.

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