Derivative-security

Jorion gives a good text book account of the Orange County debacle, concluding that this was a gross but purely human error, and not a failure of the financial system or the derivatives market.

The first part of the book introduces the problem quickly then proceeds to give the reader a crash course in risk management theory, explaining among other things the concept of Value-at-Risk (VaR). Many types of derivatives are described and their proper use explained. We are given a manager's working knowlege of finance.

Jorion then moves to the Orange County debacle proper and his conclusion is frighteningly simple: the financial managers of Orange County, entrusted with billions, did not know what they were doing. They were ignorant of what we learned in the first few chapters. They were amateur money managers playing roulette.

The book is still topical. The Basel II banking agreements mandate strict capital reserve requirements for a variety of risks, such as market and liquidity risk, so that understanding the concept of VaR is more important than ever. Most importantly however, Basel II requires preparation and reserves for operation risk, which most often has to do with the people side of finance rather than the mathematical vality of the models used. Jorion's book is thus also a good introduction to the human side of risk.

Readable account of the Orange County financial blow-up. Particularly interesting is the description of Robert Citron, the hapless college dropout who controlled billions of dollars of public money. Also fascinating are the prescient comments of the obscure accountant who ran against unbeatable Citron in the election prior to the disaster. Jorion manages to educate the reader, in a very painless way, about the institutions of the bond market (such as repos).

On the minus side, the book is not particularly well documented (in terms of, for example, the graphs and the sources of the data) and some chapters seem suspiciously like lecture notes, hastily adapted to a book format. Still, an enjoyable trip to the dark side of financial market.

This book tells the story of a 1.4 billion$ financial loss by the Orange County municipality.
The author explains very clearly what happened.
The municipality, through its treasurer, speculated that interest rates would stay the same or fall. Into the bargain, he leveraged his position with a factor 3. The means for the speculation were repos on bonds.

When the interest rates went through the roof (from 5,25% to 8% = + 52%), the value of the collateral (the bonds) for his position fell (with a factor 3). He got a margin call, but couldn't pay it. The biggest part of the investment (held by FBCS) was liquidated with a phenomenal loss. Only Merrill Lynch didn't cover their position.

The author gives excellent explanations on some very specialized investments like reverse floaters and other high tech financial operations of which the value can only calculated by partial integrals.

Food for investment bankers.

This book is one more in the long line of books that takes an author's training in a field of science or engineering and then tries to export it wholesale into understanding the markets. I've seen it done with engineers using the principles of signal processing and torque, physicists using -- believe it or not -- general relativity, so I guess I should not be surprised someone would pull out the really big guns of modern physics. It may be fun for the author's fellow physicists, but speaking as a finance professional with a Ph.D. and nearly twenty years on Wall Street, there are a lot of other places I would be going to understand and implement contingent claim theory before I would invest the time or money in this book.

Although I am not specialized in the field of financial analysis, I believe that it is important and useful to quantitatively describe financial phenomena. Therefore, this new theory and new method will certainly contribute to the establishment of a standard model of financial analysis. I hope the publication of this book will help people to understand, improve and apply the theory, introduced from modern theoretical physics by the author, for practical application in financial analysis.

The recognition of patterns in natural systems is the most significant step towards the full understanding of the dynamics of such systems. In the context of financial markets, the degree to which one appreciates these dynamics is the degree to which one is profitable. Beliefs-Preferences Gauge Symmetry Group and Replication of Contingent Claims in a General Market Environment not only identifies the key concepts in the understanding of the financial markets, but also lays out a rich display of tools and applications with which to analyze financial phenomena.

From the book's outset, the emphasis is on the role and formulation of mathematical symmetries, which govern the evolution of quantities such as derivative payoffs or prices in the marketplace. The key concept is summarized in the words of the author when he conjectures that, "the absence of some type of arbitrage opportunity in the marketplace indicates the presence of a certain inherent symmetry." From this powerful observation, he proceeds to formulate the active degrees of freedom in the market (i.e. the market participants) and the symmetric implications of this statement. The identification of arbitrage opportunities, that is, the practical application of this observation, comes straight from basing oneself in this non-varying quality of the market and seeing where deviations exist. As such, Dr. Kholodnyi's book is a gift to financial practitioners. Only when one knows what the market should be doing can one appreciate the instances when the market is behaving in an unusual fashion.

Considered in a wider sense, the tools laid out in this text demonstrate the power of the symmetry principle. Physicists have long been accustomed to using gauged symmetries in the analysis of high-energy phenomena. By using the same techniques to understand an area as applied as the financial markets, Beliefs-Preferences Gauge Symmetry Group and Replication of Contingent Claims in a General Market Environment heralds the dawn of potential new technologies for such disparate areas of science as quantum mechanics and biological systems.

As these techniques mature in the sense of becoming widely available financial tools, Dr. Kholodnyi's book will become the standard text for a rigorous analysis of financial phenomena. The text requires a strong mathematical background and some familiarity with mathematical rigor. However, since rigor leads to reliability, the viability of any financial strategies will ultimately depend on the understanding of the tools laid out so cleanly in this text.

Zhang's Barings Bankruptcy presents a workable, though at times dry treatment of the Barings debacle and financial derivatives. Despite what the web page blurb says, this book only speculates at what caused the Barings bankruptcy. Zhang hints at certain things, but does not give us any real facts beyond what made the headlines throughout the world.

At first glance, the book is organized fairly well. Starting with the fall of the bank in early 1995, the first three chapters of the book give some interesting background on the Barings family and merchant bank. We also learn that at one point, the Barings family was considered to be one of the six great powers of Europe. In part two of the book, readers who are unfamiliar with exotic financial instruments received a thorough and comprehensive introduction to options, futures, and other exotic derivatives. Throughout the explanations Zhang employs vivid analogies and clever examples to get his point across. In part three of the book, Zhang makes a weak though well substantiated attempt to implicate the Japanese economy as the real culprit and devotes nearly a whole chapter to explaining the state of the Japanese economy at the time of the bankruptcy. Zhang gives us a brief history lesson of the Japanese political economy and Japanese financial markets, and a snapshot of Japanese economic and financial activity in and around the first two months of 1995.

Zhang agrees with such financial scholars as Jorion, author of Big Bets Gone Bad, that the people who wield these exotic derivative products are often more dangerous than the products themselves. Here, just as in the case of Robert L. Citron's key role in the Orange county bankruptcy and the rocket scientists at the helm of Long Term Capital Management's financial collapse, this line of reasoning may very well be true.

If you're going to be introduced to Derivatives pricing and Quantitative finance in continuous time, you need some basics in probability theory, an elementary introduction to stochastic calculus and you need "bjork". It tells you the equation and how to understand it.

It's the best source for a complete understanding of the basics of arbitrage free pricing in continuous time; whether it's in complete or incomplete markets.

The best feature of this book is how the author invariably provides an "intuitive interpretation or explanation" to convey critical concepts. {Things like market price of risk in the context of interest rate modelling, change of measure etc...}

Why I rated the book 4 instead of 5?
I will not forgive "Tomas bjork" not to have covered the Libor Market Model; it's "THE" model and therefore should be covered in great details by any book of this calibre. A new edition of this book with the libor market model is needed.
Having said that, the coverage he gives to the popular short rate models is worth every read!

Guy,
Msc Financial Engineering at ISMA Center, Reading - UK.

It is a good book to read as an introduction to the field. The author is successful in conveying the intuition behind the models instead of striving for complete mathematical rigor. I recommend this book if you want to quickly get acquainted with derivatives pricing but are a bit afraid of the higher math seen in other books.

The central text for IOE 552(financial Engineering I) at the University of Michigan. Halfway through the course and I really understand the application of Ito's Lemma and the Feynman-Kac stochastic representation theorem. This book has just the right mixture of narative story telling, and mathematical rigor. The derivations are accessible to those with a semester of advanced calculus and a semester of probability. Over and over, Bjork shows that the secret of success in Financial Engineering is "RAIL" which stands for the "Relentless Application of Ito's Lemma".

The book provides good reference information with regard to the basic price/yield equations, but John Martin gives short shrift to any discussion of the finance theory behind them. It is not just an academic issue since many instruments will trade a premium or discount to the prices implied by the basic equations.

Go with the classic: Options, Futures, and Other Derivatives (5th Edition) -- by John C. Hull.

I agree with the Mr. Phillips about this book merely presenting the basic valuation equations, but I think that is the beauty of this book. Notice the title made a reference to this book beeing intended for 'non-quants'. However this book still provide 'quants' a valuable reference guide when one needs to brush up on the mechanics of a given derivative valuation.

This book is written from a risk-management practitioner point of view and as such it goes in great length in not just showing the different valuation models, which include most of the models in practice, but also the working mechanism of the specific securities market, and the associated exchange and clearing house settlement procedure. The key strong point of this book is that the author wrote every section of the book with conciseness and to the point. Each instrument's characteristics are presented, the associated equations are explained, and the spreadsheet models are shown in detail (included with the accompanying disk). After reading the book one is left with the feeling that finance is really this simple, involving setting the appropiate model to go with the relevant parameters,

One point regarding the editing: it was simply a great pleasure to browse this book. The clean layout of the book, the consistent sequence of presentation of the materials for all the instruments, and the detailed explaination of each of every equation (all the equations all the cells are shown) allows the reader to follow and comprehend the material with ease.

The contents of the books: market mechanism, valuation and model of interest rate forward, foreign exchange forward, equity forward, interest rate swap (the author is really an expert in these types of intruments, showing models of single-rate bond valuation method, simple offset valuation method, zero-coupon yields bootstrapping, zero-coupon yields: forward rate reinvestment, futures strip swap pricing, forward rate offset valuation method, zero-coupon valuation method), cross-currency swaps, equity swaps, equity options, interest rate options, currency options. The disk includes major valuation models of all the derivatives.(most requires just Excel 4.0 version)

Update: Since this book was published over a year ago, many other fine derivatives books have been published. However its straightforward simplicity still makes it a valuable part of a risk manager's personal library. One minor objection even at [...]its list price it is still priced a tad [...] for an introductory/intermediate level textbook. Anyone more quantitative-oriented, might want to check Cuthbertson's Financial Engineering and Risk Management. Comes with software and real life application examples.