Salih N. Neftci, Graduate School, CUNY, New York, and Head FAME Certificate, Switzerland
Treasures don’t come cheap…
This book is an excellent manual on tools related to four broad areas. The first
are the basic tools that are broadly applicable in all financial markets and that
form a gateway to more advanced topics. The second major category is the tools associated
in pricing, hedging and risk management of exotic options. Here there are two subcomponents;
namely, earlier exotics, such as various barriers, and their more recent relatives.
The third class is the set of techniques associated with complex volatility dynamics
and the modeling of volatility smile.
The final set of topics is made of numerical methods of modern financial engineering.
The subcomponents here are, Monte Carlo and quasi Monte Carlo methods and their
applications to pricing and hedging. Fourier transform methods in numerical analysis.
PDE methods and their applications to forward and backward Kolmogorov equations,
and, a somewhat limited discussion of tree methods.
These topics are discussed within the context of concise, FX –related pricing, hedging
and risk-management problems.
The extent of the tools provided in the book is astonishingly broad and up to date.
In fact, the only other (broadly used) major tools that are not present are perhaps
(1) A more in-depth discussion of measure change technology, (2) Characteristic
functions and Fourier transform methods other than numerical applications and (3)
The relevance of BGM type models for long term FX options. There is of course the
set of tools associated with credit analysis and derivatives that are not here,
but that is in fact appropriate. (In spite of the well known analogy between credit
default and the devaluation probability.)
Proper risk management of options books, volatility exposures and especially hedging
and risk management of exotic options portfolios will require many of the state
of the art techniques discussed in this volume. Obviously, pricing problems encountered
in dealing with these products will also be much better understood and dealt with,
by using the tools discussed here.
The audience. This book will be very useful especially for two types of potential
readers. The first are market participants with a good technical background. Experienced
traders/dealers, structurers and financial researchers, and book runners in all
instruments will find it a very useful manual to be consulted regularly. And this
is true not only in the FX sector but for interest rate, equity and commodities
as well. The only broad category that one may exclude is perhaps credit.
The second category of readers who will find this book useful and even unique in
some ways are students of Masters and beginning Ph.D. level classes in the academia.
The book will be an excellent text in technical Financial Engineering courses, or
it can be a supplement to well known textbooks such as Hull’s, in intermediate level
derivatives and risk management courses.
It must be emphasized that, although the book deals with “Foreign Exchange” as the
underlying risk, almost all the tools and motivating examples in the book apply
to interest rate and equity risk as well. In fact, Foreign Exchange is a very simple,
homogenous and liquid underlying. It does not contain any implicit options, makes
well-defined and easy-to-model “payouts” (i.e. foreign interest rates) that are
simpler to handle than dividends. Also, Foreign Exchange is not affected by corporate
actions—although Central Bank intervention could be unique in some ways-- and most
FX related instruments have relatively short expiration periods, so that the effect
of stochastic interest rates can be ignored to the first approximation.
This way FX forms an excellent medium for discussing advanced financial engineering
tools and methods. Once these tools are understood within the context of FX, they
can be extended to other more complex underlyings such as yield curve and equity.
Thus, even for those readers whose interest is ultimately in products other than
foreign exchange, the “correct” starting point to learning advanced financial engineering
methods may very well be seeing them within the context of FX markets.
An excellent example to this is the treatment and modeling of volatility smile in
the book. FX traders trade the smile routinely as vanilla products using Risk Reversals
and Butterflies. At the end, the models dealing with the volatility smile is much
easier to understand and test empirically within the Foreign Exchange context. Although
stylized facts, terminology and some of the notation used in the case of FX are
sometimes different than their counterparts in interest rates or equity, FX may
still be the “best” way of approaching modeling and calibrating issues in volatility
smile. In this sense the sequence of Chapters 2,4 and then 22 to 25 in the text
form a rather complete and up to date discussion of the volatility smile and smile
dynamics.
This is an example to another important characteristic of this text. The book is
ultimately a collection of state of the art tools and techniques to be utilized
in intermediate to advanced financial engineering tasks. Yet, this is done from
a market participant’s point of view and the reader is exposed to (1) Best market
practices, (2) Market conventions and (3) The market terminology as well. To their
credit, the authors have added several real life examples, which motivate the complex
set of tools.
A few words on the prerequisites for reading this book… It turns out that most of
the preliminary material a typical reader would need is discussed in the first 8
Chapters. However, an un-initiated reader may require a bit more background than
what is provided there. In fact, as a prerequisite it may be best if the reader
has some familiarity with most of the material in Hull’s book, and with some basics
of stochastic calculus. In particular, some earlier introduction to Ito’s Lemma,
Girsanov Theorem and Stochastic Differential Equations is something really needed.
So is some understanding of PDE methods.
In a book that attempts to discuss state of the art techniques of modern financial
engineering it is natural that there will be some missing topics. There are also
some typos, but the ones that I discovered were minor and could easily be detected
by the reader. Also given the very broad coverage of techniques and instruments,
albeit in the FX sector, advanced practitioners in each area may possibly find some
specialized aspects of the discussion on advanced techniques lacking in detail.
But, the present coverage and depth of the book is already at a surprisingly high
level.
This book will be a very useful manual for technically advanced traders, risk managers
and structurers. It is as useful for a completely different audience as well. Intermediate
and Advanced Financial Engineering classes in universities all around the world
will find it as an excellent source for learning modern tools as well as market
practices and conventions. The book also contains several real life examples and
comments. A small treasure chest... at the end.
Glyn Holton, Contingency Analysis
The literature on derivatives pricing has long been dominated by academics, but
we are now starting to see full-length books written by practitioners. Examples
are Brockhaus and James and Weber. To date, results have been outstanding. Practitioners
write with the same technical sophistication as academics, but offer practical techniques
and insights that could only be gleaned from working on a trading floor. The writing
tends to be breezy and light; skips the basics and goes straight to results. For
readers who are comfortable with the occasional stochastic integral, these practitioner
books are a goldmine.
This edited collection on foreign exchange financial engineering fits the same mold.
Editors Hakala and Wystup both work for Commerzbank. They have compiled 27 outstanding
chapters by 23 authors. They have contributed significant content themselves and
have done an excellent job promoting a uniform style of writing across all chapters.
The book offers easy reading with results that flow one after another. Sources are
cited or maybe a summary is given for how a proof might be written, and then it
is off to another result or perhaps a discussion of how some instrument is really
hedged.
The book is divided into three parts. The first contains12 chapters with practical
insights on techniques used day-to-day to manage an FX derivatives book. One chapter
covers the impact of non-trading days on derivatives pricing. Another covers components
of FX volatility—smile, skew, butterfly and reversal. There are chapters on pricing
of first- and second-generation exotics, and an entire chapter focuses on quantos.
Another chapter covers put-call parity and hedging of compound options. A chapter
explains "forward" and "backward" partial differential equations. All are sophisticated
and cutting-edge.
The second part has two chapters on using and calculating the Greeks for exotics.
Much of the focus is on efficient computation based upon homogeneity and related
techniques.
The third part contains chapters on advanced pricing models and computational techniques.
There are chapters on finite differences, variance reduction, fast Fourier transforms,
quasi-Monte Carlo methods and binomial trees. For the most part these assume basic
familiarity and delve more deeply into the respective topics. Chapters on models
cover such things as local volatility surfaces, jump-diffusion models, models for
long-dated options and other instruments, Heston's volatility model, etc.
Who is this book for? First of all, it is essential reading for anyone who prices
or trades FX derivatives. Second, it is essential reading for researchers. This
one book, in a nutshell, defines the state of the art. For the same reason, I recommend
it to financial engineers working in any of the capital markets. Finally, it will
be valuable for students who understand the theory of financial engineering, but
need to learn how it is used in practice.
Pierre Lequeux, Head of Currency Management, ABN AMRO Asset Management Ltd
Foreign exchange is without any doubt the world largest financial markets with an
estimated US$ 1.2 trillion turnover in transaction per day. Its size by far outstrip
equity and bonds markets. Features such as high liquidity, low transaction cost
and readily access to leverage make foreign exchange markets a very flexible environment
for active managers. Currency markets provides a large range of strategies and instruments
to the investor and corporate that seek to extract better value from their international
risk exposures. Amongst these instruments options have taken an increasing share
of the volume transacted throughout the last ten years. At the last triennial survey
conducted by the BIS they represented an estimated daily turnover of US$ 60 Bn against
US$ 41 bn in 1995. A significant increase of more than 38 % over the past 6 years.
The main factors behind this significant increase in turnover are without any doubt
an increased sophistication of risk reporting system and better understanding of
currency issues by the international investor. However there remains much skepticism
about the use of options and the risk attached to them due to events that have shaken
financial markets and attracted much press attention in the past. However it is
also true that many of these events are often dwarfed by other corporate failures
where option risk had not any part to play. Options are arguably not always the
most cost efficient vehicles to implement active strategies in the currency markets,
however they provide the investor with a far greater degree of flexibility whilst
addressing some of the most complex hedging scenarios. They therefore should be
considered in their own right when addressing currency risk.
This book intends to give the reader a broad view on the present developments and
research of option pricing theory. The editors Jürgen Hakala and Uwe Wystup
have managed to give the reader much more than a concise review of the option literature
by compiling works of their own and also from an impressive list of contributors.
They cover practical issues that are paramount to the market practitioner.
The first section of the book (re-) introduces the reader to the basics of options
theory: Black & Scholes equation, Greeks, volatility and term structure issues.
The editors then provide ample materials on existing products, starting from the
relatively plain vanilla barrier options to more complex structures such as forward
start and ratchet options.
The second part of the book concentrates on risk management issues and takes the
reader through the computation of option price sensitivities using homogeneity properties
of financial markets. This provides a robust answer to the use of differentiations
methods that are reputably time consuming. The authors present correlation-hedging
techniques to tackle efficiently a well-known risk feature of quanto and basket
options.
The final part takes us through the most advanced pricing techniques in option pricing
theory. It looks amongst others at the use of quasi-random number generators and
Monte-Carlo approaches to value look backs and baskets options. The authors have
good credit in reviewing in high detail the main algorithms that may be used in
the sequence generation process and also elaborating on their convergence ability.
This is surely of great help for the market practitioner. They also address extensively
two very important topics: Pricing options accounting for the volatility smile implied
by market data and valuing notoriously difficult to hedge Digital options. The editors
have managed to produce a book that will be of great use to traders, financial engineers
and risk managers.
The book is written in a refreshingly fluid and accurate style, which is an achievement
in itself as applied option theory is often a difficult topic to address. The twenty-seven
chapters of this book will contribute toward a finer knowledge of this very specialized
field as well as giving some orientation in terms of future research to the reader.
This book should be an asset to the market practitioner that have or intend to have
dealing with the foreign exchange derivatives markets.