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Ebook Derivatives markets (3rd edition): Part 2

(BQ) Part 2 book "Derivatives markets" has contents: Financial Engineering and security design, corporate applications, the lognormal distribution, monte carlo valuation, brownian motion and itô’s lemma, the black scholes merton equation, interest rate and bond derivatives,. forwards and futures,. | PART Financial Engineering and Applications I n the preceding chapters we have focused on forwards, swaps, and options (including exotic options) as stand-alone financial claims. In the next three chapters we will see that these claims can be used as financial building blocks to create new claims, and also see that derivatives pricing theory can help us understand corporate financial policy and the valuation of investment projects. Specifically, in Chapter 15 we see how it is possible to construct and price bonds that make payments that, instead of being denominated in cash, are denominated in stocks, commodities, and different currencies. Such bonds can be structured to contain embedded options. We also see how such claims can be used for risk management and how their issuance can be motivated by tax and regulatory considerations. Chapter 16 examines some corporate contexts in which derivatives are important, including corporate financial policy, compensation options, and mergers. Chapter 17 examines real options, in which the insights from derivatives pricing are used to value investment projects. 15 F Financial Engineering and Security Design orwards, calls, puts, and common exotic options can be added to bonds or otherwise combined to create new securities. For example, many traded securities are effectively bonds with embedded options. Individual derivatives thus become building blocks—ingredients used to construct new kinds of financial products. In this chapter we will see how to assemble the ingredients to create new products. The process of constructing new instruments from these building blocks is called financial engineering. 15.1 THE MODIGLIANI-MILLER THEOREM The starting point for any discussion of modern financial engineering is the analysis of Franco Modigliani and Merton Miller (Modigliani and Miller, 1958). Before their work, financial analysts would puzzle over how to compare the values of firms with similar operating characteristics but different .