Reviews
North American Actuarial Journal
Apr 2003, by Cox, Samuel H
> Original article available in pdf format (read)
This is a fascinating account of the tools that changed finance, and itshould not be confused with one of the steady stream of new quantitative
texts on options, futures, or swaps that is currently available. The authors
state in the preface, the "aim is to explain in simple terms what derivatives
are and, in some respects, they are no more complicated than insurance."
In following through on this aim, they have created a unique and valuable
addition to the large and growing financial derivatives literature.
The Boyles tell the story of the tools (primarily options) superbly well, but
they also tell it with the novice or general reader in mind. This makes the
book accessible to readers with no advanced mathematics or finance
prerequisites. Interesting illustrations (often using insurance) and accounts
of the contributions of famous people are included; and, because Phelim
Boyle is one of the early contributors to development of these tools, he
has continued to work in the field and knows many of the other
contributors. This gives the text an authenticity and uniqueness of a first-
hand account
Although the book is written for a general audience, experts in finance will
enjoy it because the Boyles have included the history of the tools and the
examples are very well done. The frequent use of insurance to illustrate
derivatives is a good idea and I know of no other texts that uses this
analogy so well. And while insurance does not play an important role in
most textbooks on derivatives, Phelim Boyle is a famous actuary, so we
should not be surprised to see insurance play such a prominent role in this
text. In short, three primary qualities make this book unique and valuable:
it is accessible, one of the authors a major contributor to the field, and it
uses insurance to illustrate option concepts.
The first chapter introduces forward contracts, options, and swaps. It
explains hedging, speculation, and leverage. Examples include a weather
deal between Enron and Gorney & Barrow, a U.K. chain of wine bars, the
Barings Bank collapse in 1995, and the Long-Term Capital Management
failure in 1998.
The second chapter describes markets and products such as digital
options, straddles, look-back options, American options, Asian options, and
European options. The California electrical power market crisis of 2000 is
presented in detail, with an emphasis on the role of forward contracts (or
their prohibition) and price caps.
Chapter three explains the crucial role that the no-arbitrage principle
plays in pricing derivatives. The example of betting on a tennis match is
used to introduce the principle, and the U.S. presidential election of 2000
is used to illustrate the importance of clear language in defining the
outcome of a contest. Of course this is as important in insurance
contracts as it is in derivative contracts.
Chapter four introduces pricing by replication. Here, for the first time, the
authors write about a model-the binary one-period asset price model. The
first equations appear in this chapter as well. Interesting asides (how
Polya's study of random walks was motivated by an experience during a
walk in the woods near Zurich), clear illustrations, and simple numerical
examples make chapter four easy and fun.
Chapter five is, perhaps, the most interesting of the entire book. It
provides an excellent history of option pricing, from Bachelier's 1900
doctoral thesis to the more famous Nobel-winning work of Black, Scholes,
and Merton in 1973. The explanation of the Black-Scholes-Merton formula
is intuitive, requiring no advanced mathematics.
Chapters six and seven describe, respectively, how firms hedge and how
investors use derivatives. Again, the authors provide interesting, real-world
examples, including hedging by gold producers, insuring annuity options,
portfolio insurance, and employee stock options.
Chapter eight covers three disasters in which derivatives played a role:
Barings Bank, Long-Term Capital Holding, and Orange County. I have used
these examples for several years in a seminar of actuarial science for
graduate students, yet I found the treatment here appealing.
Chapter nine is important. It covers credit risk, credit derivatives, and
hedging default risk. Actuaries have been involved in credit risk a long
time, and the surety field is an example in which actuaries have developed
explicit credit risk insurance. But credit risk has an important role in a much
broader context. For example, pension plans and insurance companies can
(and do) expose themselves to credit risk when they buy insurance or
reinsurance, when they buy risky bonds, or when they open a swap
agreement. Actuaries include credit risk, perhaps implicitly in margins, when
they model these plans and companies.
Chapter nine shows how important credit risk management has become and
how very broadly credit derivatives may be applied. This is something for
actuaries to note-the actuarial tool kit applies to credit risk management in
a very broad context, beyond traditional actuarial practice areas.
Chapter 10 describes the numerical methods of solving equations for
option prices. The computational methods have become feasible with the
availability of cheap, fast computers. The ideas of Bachelier, Black,
Scholes, Merton, and others form the intellectual basis of modern financial
derivatives. However, without effective numerical techniques, these ideas
cannot be applied. A big part of the story tells how these techniques
allowed the ideas to be applied, resulting in flourishing markets for a wide
variety of derivatives. Chapter 10 explains three of these methods.
The first is the discrete time binomial tree method which, according to the
authors, was first used by Bill Sharpe. The second is the finite difference
method, which originated in applied mathematics, physics, and engineering
(where it is still important). The Monte Carlo method is the third method.
Like the finite difference method, it has roots in physics.
Phelim Boyle played a role in bringing both the finite difference method and
the Monte Carlo method to finance, and this book offers a first-hand
account of this actuary's important contributions to finance. But Phelim
Boyles' contributions to finance go well beyond this. The profession should
be proud of his work in finance, a field that was not a traditional actuarial
practice area at the time. Indeed, he is one of the relatively few actuaries
who have made substantial contributions to finance.
I would recommend this book to anyone, beginner or expert, who is
interested in finance. Since it requires no advanced mathematics or
finance background, it is very appropriate for self-study. Although I have
not yet used it as a textbook, I intend to try it in our next offering of
Financial Engineering I. This book will fit our course well, because it gives
students the key tools for the study of derivatives in an interesting,
simple, and accurate story. We would use the book to provide background
and motivation for a detailed, mathematical study of products and
methods. The book does not have exercises, however, and this is its only
weakness as a textbook.
Derivatives: The Tools that Changed Finance is full of interesting historical
details and enlightening examples. Actuaries will appreciate the frequent
use of insurance examples to illustrate financial concepts (life insurance is
used in the explanation of credit risk, for example). In summary, the Boyles
write well, their book is technically accessible, and it is affordable. If you
have been meaning to find out what derivatives are all about or learn
about the history of derivatives, then I strongly recommend this book.
Samuel H. Cox, F.S.A., M.A.A.A., Ph.D.
Bowles Chair of Actuarial Science
Georgia State University
Department of Risk Management & Insurance
The North American Actuarial Journal (NAAJ) is the premier publication of
the Society of Actuaries as its only refereed journal. In addition to the
Society membership, it serves the international, scientific, academic,
business and governmental communities, making it the most widely
distributed actuarial journal.
 | John Hull | |
| Harvard Business School | |
| Journal of Finance | |
| Swiss Derivatives Review | |
| The Actuary Magazine Review | |
| North American Actuarial Journal |
North American Actuarial Journal
Apr 2003, by Cox, Samuel H
> Original article available in pdf format (read)
This is a fascinating account of the tools that changed finance, and it
texts on options, futures, or swaps that is currently available. The authors
state in the preface, the "aim is to explain in simple terms what derivatives
are and, in some respects, they are no more complicated than insurance."
In following through on this aim, they have created a unique and valuable
addition to the large and growing financial derivatives literature.
The Boyles tell the story of the tools (primarily options) superbly well, but
they also tell it with the novice or general reader in mind. This makes the
book accessible to readers with no advanced mathematics or finance
prerequisites. Interesting illustrations (often using insurance) and accounts
of the contributions of famous people are included; and, because Phelim
Boyle is one of the early contributors to development of these tools, he
has continued to work in the field and knows many of the other
contributors. This gives the text an authenticity and uniqueness of a first-
hand account
Although the book is written for a general audience, experts in finance will
enjoy it because the Boyles have included the history of the tools and the
examples are very well done. The frequent use of insurance to illustrate
derivatives is a good idea and I know of no other texts that uses this
analogy so well. And while insurance does not play an important role in
most textbooks on derivatives, Phelim Boyle is a famous actuary, so we
should not be surprised to see insurance play such a prominent role in this
text. In short, three primary qualities make this book unique and valuable:
it is accessible, one of the authors a major contributor to the field, and it
uses insurance to illustrate option concepts.
The first chapter introduces forward contracts, options, and swaps. It
explains hedging, speculation, and leverage. Examples include a weather
deal between Enron and Gorney & Barrow, a U.K. chain of wine bars, the
Barings Bank collapse in 1995, and the Long-Term Capital Management
failure in 1998.
The second chapter describes markets and products such as digital
options, straddles, look-back options, American options, Asian options, and
European options. The California electrical power market crisis of 2000 is
presented in detail, with an emphasis on the role of forward contracts (or
their prohibition) and price caps.
Chapter three explains the crucial role that the no-arbitrage principle
plays in pricing derivatives. The example of betting on a tennis match is
used to introduce the principle, and the U.S. presidential election of 2000
is used to illustrate the importance of clear language in defining the
outcome of a contest. Of course this is as important in insurance
contracts as it is in derivative contracts.
Chapter four introduces pricing by replication. Here, for the first time, the
authors write about a model-the binary one-period asset price model. The
first equations appear in this chapter as well. Interesting asides (how
Polya's study of random walks was motivated by an experience during a
walk in the woods near Zurich), clear illustrations, and simple numerical
examples make chapter four easy and fun.
Chapter five is, perhaps, the most interesting of the entire book. It
provides an excellent history of option pricing, from Bachelier's 1900
doctoral thesis to the more famous Nobel-winning work of Black, Scholes,
and Merton in 1973. The explanation of the Black-Scholes-Merton formula
is intuitive, requiring no advanced mathematics.
Chapters six and seven describe, respectively, how firms hedge and how
investors use derivatives. Again, the authors provide interesting, real-world
examples, including hedging by gold producers, insuring annuity options,
portfolio insurance, and employee stock options.
Chapter eight covers three disasters in which derivatives played a role:
Barings Bank, Long-Term Capital Holding, and Orange County. I have used
these examples for several years in a seminar of actuarial science for
graduate students, yet I found the treatment here appealing.
Chapter nine is important. It covers credit risk, credit derivatives, and
hedging default risk. Actuaries have been involved in credit risk a long
time, and the surety field is an example in which actuaries have developed
explicit credit risk insurance. But credit risk has an important role in a much
broader context. For example, pension plans and insurance companies can
(and do) expose themselves to credit risk when they buy insurance or
reinsurance, when they buy risky bonds, or when they open a swap
agreement. Actuaries include credit risk, perhaps implicitly in margins, when
they model these plans and companies.
Chapter nine shows how important credit risk management has become and
how very broadly credit derivatives may be applied. This is something for
actuaries to note-the actuarial tool kit applies to credit risk management in
a very broad context, beyond traditional actuarial practice areas.
Chapter 10 describes the numerical methods of solving equations for
option prices. The computational methods have become feasible with the
availability of cheap, fast computers. The ideas of Bachelier, Black,
Scholes, Merton, and others form the intellectual basis of modern financial
derivatives. However, without effective numerical techniques, these ideas
cannot be applied. A big part of the story tells how these techniques
allowed the ideas to be applied, resulting in flourishing markets for a wide
variety of derivatives. Chapter 10 explains three of these methods.
The first is the discrete time binomial tree method which, according to the
authors, was first used by Bill Sharpe. The second is the finite difference
method, which originated in applied mathematics, physics, and engineering
(where it is still important). The Monte Carlo method is the third method.
Like the finite difference method, it has roots in physics.
Phelim Boyle played a role in bringing both the finite difference method and
the Monte Carlo method to finance, and this book offers a first-hand
account of this actuary's important contributions to finance. But Phelim
Boyles' contributions to finance go well beyond this. The profession should
be proud of his work in finance, a field that was not a traditional actuarial
practice area at the time. Indeed, he is one of the relatively few actuaries
who have made substantial contributions to finance.
I would recommend this book to anyone, beginner or expert, who is
interested in finance. Since it requires no advanced mathematics or
finance background, it is very appropriate for self-study. Although I have
not yet used it as a textbook, I intend to try it in our next offering of
Financial Engineering I. This book will fit our course well, because it gives
students the key tools for the study of derivatives in an interesting,
simple, and accurate story. We would use the book to provide background
and motivation for a detailed, mathematical study of products and
methods. The book does not have exercises, however, and this is its only
weakness as a textbook.
Derivatives: The Tools that Changed Finance is full of interesting historical
details and enlightening examples. Actuaries will appreciate the frequent
use of insurance examples to illustrate financial concepts (life insurance is
used in the explanation of credit risk, for example). In summary, the Boyles
write well, their book is technically accessible, and it is affordable. If you
have been meaning to find out what derivatives are all about or learn
about the history of derivatives, then I strongly recommend this book.
Samuel H. Cox, F.S.A., M.A.A.A., Ph.D.
Bowles Chair of Actuarial Science
Georgia State University
Department of Risk Management & Insurance
The North American Actuarial Journal (NAAJ) is the premier publication of
the Society of Actuaries as its only refereed journal. In addition to the
Society membership, it serves the international, scientific, academic,
business and governmental communities, making it the most widely
distributed actuarial journal.
info@thederivativesbook.com
Derivatives: The Tools That Changed Finance
| The North American Actuarial Journal (NAAJ) is the premier publication of the Society of Actuaries as its only refereed journal. In addition to the Society membership, it serves the international, scientific, academic, business and governmental communities, making it the most widely distributed actuarial journal. |
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