A course in derivative securities. Introduction to theory and computation. (Q2565574)

This book contains a practical introduction to the mathematics of financial engineering. It can serve as an excellent bridge between the introductory books on derivative securities and those that provide advanced mathematical treatments. Although there is no detailed introductory information about financial markets and basic derivative instruments, the book presents a very wide spectrum of the problems and methods concerned with pricing and hedging derivatives in a quite accessible way. The theory of pricing and hedging is developed under the assumption that the market is frictionless (no transactions costs, no margin requirements, no restrictions on short selling). Only binomial and Brownian motion models are considered -- jump processes are omitted. The book uses almost exclusively the probabilistic/martingale approach. One can agree with the author's opinion that such approach is easier for students, especially if they are not advanced in mathematics. The results that appear in the book tend to be stated rather than proven. Nevertheless, the concepts are developed in a logical manner and are intuitively explained. The book is divided into three parts. The first one (Chapters 1--5) introduces the basic notions and methods of option pricing. Chapter 1 briefly reviews fundamental concepts (longs, shorts, calls, puts, compounded interest) and after that describes the martingale (change of numeraire) method for valuing derivative securities, starting from a one-period binomial model and then extending to the models with a continuum of states. Chapter 2 introduces the concepts of a Brownian motion, quadratic variation, and Itô processes. After that, Itô's formula is introduced and explained, and its applications most frequently used in the book are presented. The mathematics of this chapter is essential for all the considerations in the remainder of the book. In Chapter 3, the author studies the value of European digital and share digital options, and standard European puts and calls under the Black-Scholes assumptions. The option ``Greeks'' and implied volatilities are also discussed, and methods of their calculations are presented. Chapter 4 deals with the problem of estimating and modeling the volatility. In the case of a changing volatility, GARCH and Stochastic Volatility models are briefly described. Chapter 5 introduces two principal numerical methods for valuing derivative securities: Monte Carlo and binomial models. Part two (Chapters 6--10) contains more advanced material on option pricing. Chapter 6 shows how to apply the Black-Scholes formula to value currency options and options on foreign assets. Currency forwards and futures, quanto forwards and return swaps are also discussed. Chapter 7 presents three important generalizations of the Black-Scholes formula: Margrabe's formula for an option to exchange one asset for another, Black's formulas for options on forward and futures contract, and Merton's formulas for calls and puts in the absence of a constant risk-free rate. In Chapter 8, some exotic options are analyzed in the Black-Scholes framework. The considered examples include: forward-start options, compound options, American calls with discrete dividends, chooser options, options on the max or min, barrier options, lookbacks, basket options, spread options, and Asian options. Chapter 9 is a continuation of Chapter 5 and presents more advanced applications of Monte Carlo and binomial models to the pricing of the exotic options for which closed-form solutions do not exist: basket options, spread options, discretely-sampled lookback options, and Asian options. Chapter 10 deals with the estimation of derivative values by numerically solving the corresponding partial differential equation, using finite difference methods. Only derivatives written on a single underlying asset are considered, but a way of generalization is indicated. The last part (Chapters 11--16) is devoted to fixed income derivatives, i.e. the derivatives that can be viewed as written on bonds or on interest rates. In Chapter 11, some basic concepts (the yield curve, LIBOR, swap, yield to maturity, duration, convexity) are explained. Then, principal components and hedging principal components in the context of the yield curve are discussed. Chapter 12 introduces caps, floors and swaptions which are the most important fixed income derivatives, and explains the ``market model'' approach to their valuation. The considerations in Chapter 13 are the continuation of those from Chapter 12 and analyze one of the earliest model of term structure proposed by Vasicek and some of its extensions. Chapter 14 contains a very brief survey of other important approaches to term structure modeling (Ho-Lee, Black-Derman-Toy, Black-Karasinski, Cox-Ingersoll-Ross, Heath-Jarrow-Morton). At the end of each chapter exercises (problems) are given. They are mostly of calculation nature and designed for practicing the presented concepts on. A very attractive feature of the book is that nearly all of the described formulas and procedures are implemented in Excel VBA and the corresponding programs are in the text. An introduction to the programming in VBA appears as Appendix A. The other of the appendices gives a concise review of miscellaneous facts about continuous-time models. The book by Kerry Back combines in an elegant and reader-friendly way the conceptual, technical, and practical aspects of pricing derivative securities. Thus, it can be strongly recommended not only to be used for a course but also for those wishing to train themselves in this field.