## Principles of Financial Engineering (Google eBook)Five new chapters, numerous additions to existing chapters, and an expanded collection of questions and exercises make this Second Edition an essential part of everyone's library. Between defining swaps on its first page and presenting a case study on its last, 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. * The Second Edition presents 5 new chapters on structured product engineering, credit markets and instruments, and principle protection techniques, 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 |

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### Contents

FixedIncome Engineering | 373 |

2 A Framework for Swaps | 374 |

3 Term Structure Modeling | 383 |

4 Term Structure Dynamics | 385 |

5 Measure Change Technology | 394 |

6 An Application | 399 |

7 InArrears Swaps and Convexity | 404 |

8 CrossCurrency Swaps | 408 |

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60 | |

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70 | |

10 Conventions for Forwards | 75 |

11 Conclusions | 76 |

Suggested Reading | 77 |

Exercises | 78 |

HKMA and the Hedge Funds 1998 | 80 |

Engineering Simple Interest Rate Derivatives | 83 |

2 Libor and Other Benchmarks | 84 |

3 Forward Loans | 85 |

4 Forward Rate Agreements | 92 |

Eurocurrency Contracts | 96 |

6 RealWorld Complications | 100 |

7 Forward Rates and Term Structure | 102 |

8 Conventions | 103 |

Strips | 104 |

10 Conclusions | 105 |

Exercises | 106 |

Introduction to Swap Engineering | 109 |

2 Applications | 112 |

Swaps | 117 |

4 Types of Swaps | 120 |

5 Engineering Interest Rate Swaps | 129 |

6 Uses of Swaps | 137 |

7 Mechanics of Swapping New Issues | 142 |

8 Some Conventions | 148 |

10 Additional Terminology | 150 |

11 Conclusions | 151 |

Exercises | 152 |

Repo Market Strategies in Financial Engineering | 157 |

2 What Is Repo? | 158 |

3 Types of Repo | 160 |

4 Equity Repos | 165 |

6 Synthetics Using Repos | 171 |

7 Conclusions | 173 |

Exercises | 174 |

CTD and Repo Arbitrage | 175 |

Dynamic Replication Methods and Synthetics | 177 |

2 An Example | 178 |

4 Ad HocSynthetics | 183 |

5 Principles of Dynamic Replication | 186 |

6 Some Important Conditions | 197 |

7 RealLife Complications | 198 |

8 Conclusions | 200 |

Exercises | 201 |

Mechanics of Options | 203 |

2 What Is an Option? | 204 |

Definition and Notation | 205 |

4 Options as Volatility Instruments | 211 |

5 Tools for Options | 221 |

6 The Greeks and Their Uses | 228 |

7 RealLife Complications | 240 |

What Is an Option? | 241 |

APPENDIX 81 | 242 |

APPENDIX 82 | 244 |

Exercises | 246 |

Engineering Convexity Positions | 249 |

2 A Puzzle | 250 |

4 Sources of Convexity | 262 |

Quantos | 267 |

6 Conclusions | 272 |

Exercises | 273 |

Convexity of Long Bonds Swaps and Arbitrage | 275 |

Options Engineering with Applications | 277 |

2 Option Strategies | 280 |

3 VolatilityBased Strategies | 291 |

4 Exotics | 296 |

5 Quoting Conventions | 307 |

6 RealWorld Complications | 309 |

7 Conclusions | 310 |

Exercises | 311 |

Pricing Tools in Financial Engineering | 315 |

2 Summary of Pricing Approaches | 316 |

3 The Framework | 317 |

4 An Application | 322 |

5 Implications of the Fundamental Theorem | 328 |

6 ArbitrageFree Dynamics | 334 |

7 Which Pricing Method to Choose? | 338 |

8 Conclusions | 339 |

Simple Economics of the Fundamental Theorem | 340 |

Exercises | 342 |

Some Applications of the Fundamental Theorem | 345 |

The Monte Carlo Approach | 346 |

Calibration | 354 |

Quantos | 363 |

5 Conclusions | 370 |

Exercises | 371 |

9 Differential Quanto Swaps | 409 |

Suggested Reading | 410 |

Practical Yield Curve Calculations | 411 |

Exercises | 414 |

Tools for Volatility Engineering Volatility Swaps and Volatility Trading | 415 |

2 Volatility Positions | 416 |

3 Invariance of Volatility Payoffs | 417 |

4 Pure Volatility Positions | 424 |

5 Volatility Swaps | 427 |

6 Some Uses of the Contract | 432 |

7 Which Volatility? | 433 |

8 Conclusions | 434 |

Suggested Reading | 435 |

Exercises | 436 |

Volatility as an Asset Class and the Smile | 439 |

2 Volatility as Funding | 440 |

3 Smile | 442 |

5 Application to Option Payoffs | 444 |

6 BreedenLitzenberger Simplified | 446 |

7 A Characterization of Option Prices as Gamma Gains | 450 |

8 Introduction to the Smile | 451 |

9 Preliminaries | 452 |

10 A First Look at the Smile | 453 |

11 What Is the Volatility Smile? | 454 |

13 How to Explain the Smile | 462 |

14 The Relevance of the Smile | 469 |

15 Trading the Smile | 470 |

17 Exotic Options and the Smile | 471 |

18 Conclusions | 475 |

Exercises | 476 |

Credit Markets CDS Engineering | 479 |

2 Terminology and Definitions | 480 |

3 Credit Default Swaps | 482 |

4 RealWorld Complications | 492 |

5 CDS Analytics | 494 |

6 Default Probability Arithmetic | 495 |

7 Structured Credit Products | 500 |

8 Total Return Swaps | 504 |

9 Conclusions | 505 |

Exercises | 507 |

CreditLinked Notes | 510 |

Essentials of Structured Product Engineering | 513 |

2 Purposes of Structured Products | 514 |

3 Structured FixedIncome Products | 526 |

4 Some Prototypes | 533 |

5 Conclusions | 543 |

Suggested Reading | 544 |

Exercises | 545 |

Credit Indices and Their Tranches | 547 |

3 Introduction to ABS and CDO | 548 |

4 A Setup for Credit Indices | 550 |

5 Index Arbitrage | 553 |

Standard and Bespoke | 555 |

7 Tranche Modeling and Pricing | 556 |

8 The Roll and the Implications | 560 |

9 Credit versus Default Loss Distributions | 562 |

10 An Important Generalization | 563 |

11 New Index Markets | 566 |

12 Conclusions | 568 |

A History of Credit Indices | 569 |

Exercises | 570 |

Default Correlation Pricing and Trading | 571 |

2 Some History | 572 |

4 The Model | 575 |

5 Default Correlation and Trading | 579 |

6 Delta Hedging and Correlation Trading | 580 |

7 RealWorld Complications | 585 |

8 Conclusions | 587 |

Some Basic Statistical Concepts | 588 |

Exercises | 590 |

May 2005 Volatility | 591 |

Principal Protection Techniques | 595 |

2 The Classical Case | 596 |

3 The CPPI | 597 |

4 Modeling the CPPI Dynamics | 599 |

CPPI and Equity Tranches | 601 |

The DPPI | 604 |

7 RealWorld Complications | 605 |

8 Conclusions | 606 |

Exercises | 607 |

CapsFloors and Swaptions with an Application to Mortgages | 611 |

2 The Mortgage Market | 612 |

3 Swaptions | 618 |

4 Pricing Swaptions | 620 |

5 MortgageBased Securities | 625 |

6 Caps and Floors | 626 |

7 Conclusions | 631 |

Exercises | 632 |

Danish Mortgage Bonds | 634 |

Engineering of Equity Instruments Pricing and Replication | 637 |

2 What Is Equity? | 638 |

3 Engineering Equity Products | 644 |

4 Financial Engineering of Securitization | 654 |

5 Conclusions | 657 |

Exercises | 658 |

Volatility Trading | 659 |

663 | |

667 | |

### Common terms and phrases

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