Dynamic Hedging Managing Vanilla and Exotic Options,9780471152804

Dynamic Hedging Managing Vanilla and Exotic Options

by
Edition: 1st
ISBN13: 9780471152804
ISBN10: 0471152803
Format: Hardcover
Pub. Date: 1997-01-14
Publisher(s): Wiley
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Summary

Written by a leading options trader and derivatives risk advisor to global banks and exchanges, this book provides a practical, real-world methodology for monitoring and managing all the risks associated with portfolio management.

Author Biography

Nassim Nicholas Taleb is the founder of Empirica Capital LLC, a hedge fund operator, and a fellow at the Courant Institute of Mathematical Sciences of New York University. He has held a variety of senior derivative trading positions in New York and London and worked as an independent floor trader in Chicago. Dr. Taleb was inducted in February 2001 in the Derivatives Strategy Hall of Fame. He received an MBA from the Wharton School and a Ph.D. from University Paris-Dauphine.

Table of Contents

Introduction Dynamic Hedging 1(8)
Principles of Real World Dynamic Hedging 1(2)
General Risk Managements 3(6)
PART I MARKETS, INSTRUMENTS, PEOPLE 9(100)
1 Introduction to the Instruments
9(29)
Derivatives
9(3)
Synthetic Securities
12(1)
Time-Dependent Linear Derivatives
13(3)
Noncontingent Time-Dependent Nonlinear Derivatives
16(1)
Options and Other Contingent Claims
16(4)
Simple Options
18(2)
Hard and Soft Optionality
20(1)
Basic Rules of Options Equivalence
20(4)
Mirror Image Rule
22(2)
American Options, Early Exercise, and Other Headaches (Advanced Topic)
24(5)
Soft American Options
24(1)
Hard American Options
25(2)
A Brief Warning about Early Exercise Tests
27(2)
Forwards, Futures, and Forward-Forwards (Advanced Topic)
29(3)
Credit
30(1)
Marks-to-Market Differences
30(1)
The Correlation between the Future and the Financing (Advanced Issue)
31(1)
Core Risk Management: Distinction between Primary and Secondary Risks
32(6)
Applying the Framework to Specific Instruments
35(3)
2 The Generalized Option
38(10)
Step 1. The Homogeneity of the Structure
38(3)
Step 2. The Type of Payoff: Continuous and Discontinuous
41(2)
Step 3. Barriers
43(1)
Step 4. Dimension of the Structure and the Number of Assets
43(2)
Step 5. Order of the Options
45(1)
Step 6. Path Dependence
46(2)
3 Market Making and Market Using
48(20)
Book Runners versus Price Takers
48(2)
Commoditized and Nonstandard Products
50(4)
Trading Risks in Commoditized Products
51(2)
Profitability
53(1)
Proprietary Departments
54(2)
Tacit Rules in Market Making
56(1)
Market Making and the Price for Immediacy
57(1)
Market Making and Autocorrelation of Price Changes
58(1)
Market Making and the Illusion of Profitability
58(2)
Adverse Selection, Signaling, and the Risk Management of Market Makers
60(2)
Value Trading versus the Greater Fool Theory
62(2)
Monkeys on a Typewriter
64(4)
The Statistical Value of Track Records
64(1)
More Modern Methods of Monitoring Traders
65(1)
The Fair Dice and the Dubins-Savage Optimal Strategy
65(1)
The ArcSine Law of the P/L
66(2)
4 Liquidity and Liquidity Holes
68(12)
Liquidity
68(1)
Liquidity Holes
69(1)
Liquidity and Risk Management
70(1)
Stop Orders and the Path of Illiquidity
70(2)
Barrier Options and the Liquidity Vacuum
72(1)
One-Way Liquidity Traps
73(1)
Holes, Black-Scholes, and the Ills of Memory
73(1)
Limits and Market Failures
74(1)
Reverse Slippage
74(1)
Liquidity and Triple Witching Hour
75(1)
Portfolio Insurance
75(2)
Liquidity and Option Pricing
77(3)
5 Arbitrage and the Arbitrageurs
80(8)
A Trader's Definition
80(1)
Mechanical versus Behavioral Stability
81(1)
The Deterministic Relationships
82(1)
Passive Arbitrage
83(1)
An Absorbing Barrier Called the "Squeeze"
84(1)
Duration of the Arbitrage
84(1)
Arbitrage and the Accounting Systems
85(1)
Other Nonmarket Forms of Arbitrage
86(1)
Arbitrage and the Variance of Returns
87(1)
6 Volatility and Correlation
88(21)
Calculating Historical Volatility and Correlation
92(3)
Centering around the Mean
92(3)
Introducing Filtering
95(2)
There Is No Such Thing as Constant Volatility and Correlation
97(4)
The Parkinson Number and the Variance Ratio Method
101(8)
PART II MEASURING OPTION RISKS The Real World and the Black-Scholes-Merton Assumptions Black-Scholes-Merton as an Almost Nonparametric Pricing System 109(164)
7 Adapting Black-Scholes-Merton: The Delta
115(17)
Characteristics of a Delta
116(1)
The Continuous Time Delta Is Not Always a Headge Ratio
116(5)
Delta as a Measure for Risk
121(2)
Confusion: Delta by the Cash or by the Forward
123(1)
Delta for Linear Instruments
123(3)
Delta for a Forward
123(2)
Delta for a Forward-Forward
125(1)
Delta for a Future
125(1)
Delta and the Barrier Options
126(1)
Delta and the Bucketing
127(1)
Delta in the Value at Risk
127(1)
Delta, Volatility, and Extreme Volatility
127(5)
8 Gamma and Shadow Gamma
132(15)
Simple Gamma
132(1)
Gamma Imperfections for a Book
133(3)
Correction for the Gamma of the Back Month
136(2)
First Adjustment
137(1)
Second Adjustment
138(1)
Shadow Gamma
138(4)
Shadow Gamma and the Skew
142(1)
GARCH Gamma
142(1)
Advanced Shadow Gamma
142(3)
Case Study in Shadow Gamma: The Syldavian Elections
145(2)
9 Vega and the Volatility Surface
147(20)
Vega and Modified Vega
147(7)
Vega and the Gamma
149(1)
The Modified Vega
150(1)
How to Compute the Simple Weightings
151(2)
Advanced Method: The Convariance Bucket Vega
153(1)
Forward Implied Volatilities
154(10)
Computing Forward Implied Volatility
154(4)
Multifactor Vega
158(6)
Volatility Surface
164(1)
The Method of Squares for Risk Management
164(3)
10 Theta and Minor Greeks
167(24)
Theta and the Modified Theta
167(4)
Modifying the Theta
167(2)
Theta for a Bet
169(1)
Theta, Interest Carry, and Self-Financing Strategies
169(1)
Shadow Theta
170(1)
Weakness of the Theta Measure
171(1)
Minor Greeks
171(10)
Rho, Modified Rho
171(3)
Omega (Option Duration)
174(4)
Alpha
178(3)
Table of Greeks
181(10)
Stealth and Health
182(1)
Convexity, Modified Convexity
183(7)
The "Double Bubble"
190(1)
11 The Greeks and Their Behavior
191(17)
The Bleed: Gamma and Delta Bleed (Holding Volatility Constant)
191(9)
Bleed with Changes in Volatility
195(1)
Going into the Expiration of a Vanilla Option
196(4)
Ddeltadvol (Stability Ratio)
200(2)
Test 1 of Stability
200(1)
Test 2 of Stability: The Asymptotic Vega Test
201(1)
Moments of an Option Position
202(2)
Ignoring Higher Greeks: The Lock Delta
204(4)
12 Fungibility, Convergence, and Stacking
208(14)
Fungibility
208(5)
Ranking of Fungibility
209(1)
Fungibility and the Term Structure of Prices: The Cash-and-Carry Line
210(2)
Fungibility and Option Arbitrage
212(1)
Changes in the Rules of the Game
212(1)
Convergence
213(4)
Mapping Convergence
215(1)
Convergence and Convexity
216(1)
Levels of Convergence Trading
216(1)
Volatility and Convergence
216(1)
Convergence and Biased Assets
216(1)
Stacking Techniques
217(5)
Other Stacking Applications
220(2)
13 Some Wrinkles of Option Markets
222(7)
Expiration Pin Risks
222(1)
Sticky Strikes
223(1)
Market Barriers
224(2)
A Currency Band: Is It a Barrier?
225(1)
The Absent Barrier
226(1)
What Flat Means
226(3)
Primary and Secondary Exposures
228(1)
14 Bucketing and Topography
229(9)
Static Straight Bucketing
229(3)
American and Path-Dependent Options
231(1)
Advanced Topic: The Forward or "Forward-Forward" Bucket
231(1)
Topography
232(6)
Strike Topography (or Static Topography)
233(2)
Dynamic Topography (Local Volatility Exposure)
235(2)
Barrier Payoff Topography
237(1)
15 Beware the Distribution
238(18)
The Tails
238(7)
Random Volatility
238(4)
Histograms from the Markets
242(3)
The Skew and Biased Assets
245(7)
Biased Assets
248(1)
Nonparallel Accounting
249(1)
Value Linked to Price
250(1)
Currencies as Assets
250(1)
Reverse Assets
251(1)
Volatility Regimes
251(1)
Correlation between Interest Rates and Carry
252(1)
More Advanced Put-Call Parity Rules
252(4)
16 Option Trading Concepts
256(17)
Initiation to Volatility Trading: Vega versus Gamma
260(2)
Soft versus Hard Deltas
262(1)
Volatility Betting
263(2)
Higher Moment Bets
264(1)
Case Study: Path Dependence of a Regular Option
265(5)
Simple Case Study: The "Worst Case" Scenario
270(3)
PART III TRADING AND HEDGING EXOTIC OPTIONS 273(142)
17 Binary Options: European Style
273(22)
European Binary Options
273(6)
Hedging with a Vanilla
275(3)
Definition of the Bet: Forward and Spot Bets
278(1)
Pricing with the Skew
279(10)
A Formal Pricing on the Skew
281(1)
The Skew Paradox
282(2)
Difference between the Binary and the Delta: The Delta Paradox Revisited
284(2)
First Hedging Consequences
286(1)
The Delta Is a Dirac Delta
286(1)
Gamma for a Bet
287(2)
Conclusion: Statistical Trading versus Dynamic Hedging
289(1)
Case Study in Binary Packages--Contingent Premium Options
290(2)
Recommended Use: Potential Devaluations
291(1)
Case Study: The Betspreads
292(3)
Avanced Case Study: Multiasset Bets
294(1)
18 Binary Options: American Style
295(17)
American Single Binary Options
295(3)
Hedging an American Binary: Fooled by the Greeks
298(1)
Case Study: National Vega Bank
298(9)
The Ravages of Time
299(4)
Understanding the Vega Convexity
303(2)
Trading Methods
305(1)
Case Study: At-Settlement American Binary Options
306(1)
Other Greeks
307(1)
American Double Binary Options
307(5)
Vegas of the Double Binary
308(1)
Other Applications of American Barriers
309(2)
Credit Risk
311(1)
19 Barrier Options (I)
312(35)
Barrier Options (Regular)
312(34)
Knock-Out Options
312(5)
Knock-In Options
317(2)
Effects of Volatility
319(2)
Adding the Drift: Complexity of the Forward Line
321(2)
Risk Reversals
323(1)
Put/Call Symmetry and the Hedging of Barrier Options
323(8)
Barrier Decomposition under Skew Environments
331(4)
The Reflection Principle
335(4)
Girsanov
339(1)
Effect of Time on Knock-Out Options
339(1)
First Exit Time and Its Risk-Neutral Expectation
340(3)
Issues in Pricing Barrier Options
343(1)
The Single Volatility Fudge
343(1)
A More Accurate Method: The Dupire-Derman-Kani Technique
344(1)
Additional Pricing Complexity: The Variance Ratios
345(1)
Exercise: Adding the Puts
346(1)
20 Barrier Options (II)
347(29)
Reverse Barrier Options
347(15)
Reverse Knock-Out Options
347(1)
Case Study: The Konck-Out Box
348(8)
Hedging Reverse Knock-Outs: A Graphical Case Study
356(6)
Double Barrier Options
362(6)
Rebate
363(1)
Exercise: Adding the Knock-In
363(1)
Alternative Barrier Options
363(1)
The Exploding Option
364(1)
Capped Index Option
365(3)
Reading a Risk Management Report
368(8)
Gaps and Gap Reports
374(2)
21 Compound, Choosers, and Higher Order Options
376(7)
Vege Convexity: The Costs of Dynamic Hedging
378(1)
Uses of Compound Options: Hedging Barrier Vega
379(1)
Chooser Options
380(2)
A Few Applications of the Higher Order Options
382(1)
22 Multiasset Options
383(20)
Choice between Assets: Rainbow Options
384(6)
Correlated and Uncorrelated Greeks
387(3)
Linear Combinations
390(5)
Basket Options
391(1)
Lognormality
391(1)
Correlation Issues
392(3)
Composite Underlying Securities
395(1)
Quantitative Case Study: Indexed Notes
395(8)
Background
396(1)
Terms of the Note
396(1)
Where Is the Underlying?
397(1)
Triangular Decomposition
398(5)
23 Minor Exotics: Lookback and Asian Options
403(12)
Lookback and Ladder Options
403(5)
The Rollover Option
404(4)
A Footnote on Basket Options: Asian Options
408(7)
PART IV MODULES 415(64)
Module A Brownian Motion on a Spreadsheet, A Tutorial
415(11)
The Classical One-Asset Random Walk
415(2)
Some Questions
417(3)
A Two-Asset Random Walk: An Introduction to the Effects of Correlation
420(4)
Extension: A Three-Asset Random Walk
424(2)
Module B Risk Neutrality Explained
426(5)
Step 1. Probabilistic Fairness, the "Fair Dice" and the Skew
426(1)
Step 2. Adding the Real World: The Risk-Neutral Argument
427(4)
The Drift
427(4)
Module C Numeraire Relativity and the Two-Country Paradox
431(7)
Extension: The Two-Country Paradox
433(5)
Conclusion
435(1)
Mathematical Note
436(1)
Conclusion
437(1)
Module D Correlation Triangles: A Graphical Case Study
438(7)
Correlation Triangle Rule
441(3)
Calculating an Implied Correlation Curve
444(1)
Module E The Value-at-Risk
445(8)
Simplified Examples
446(7)
Example 1. No Diversification
447(1)
Example 2. A Cross-Position
447(1)
Example 3. Two Possible Trades
448(5)
Module F Probabilistic Rankings in Arbitrage
453(6)
Ranking of Securities
453(4)
European Option Rules
453(1)
Calendar Rules
454(1)
Barrier and Digital Rules
454(1)
Correlation Rules
455(2)
Correlation Convexity Rules
457(1)
General Convexity Rules
458(1)
Module G Option Pricing
459(20)
Ito's Lemma Explained
459(4)
Black-Scholes Equation
463(1)
The Risk-Neutral Argument
463(1)
Stochastic Volatility Model
464(2)
Multiasset Options
466(1)
Rainbow Options
466(1)
Outperformance Options
467(1)
Spread Options
467(1)
Compound and Chooser Order Options
467(1)
Compound Options
468(1)
Chooser Options
468(1)
Barrier Options
468(9)
The Reflection Principle
469(1)
Girsanov's Theorem
469(1)
Pricing Barriers
470(7)
Numerical Stochastic Integration: A Sample
477(2)
A Mathematica TM Program
477(2)
Notes 479(11)
Bibliography 490(9)
Index 499

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