An introduction to derivative pricing

Preface

Notoriously, works of mathematical finance can be precise and can be comprehensible. Sadly, as Dr Johnson might have put it, the ones which are precise are not necessarily comprehensible, and those comprehensible are not necessarily precise.

But both are needed. The mathematics of finance is not easy, and much market practice is based on a soft understanding of what is actually going on. This is usually enough for experienced practitioners to price existing contracts, but often insufficient for innovative new products. Novices, managers and regulators can be left to stumble around in literature which is ill-suited to their need for a clear explanation of the basic principles. Such `seat of the pants' practices are more suited to the pioneering days of an industry, rather than the mature $15 trillion market which the derivatives business has become.

On the academic side, effort is too often expended on finding precise answers to the wrong questions. When working in isolation from the market, the temptation is to find analytic answers for their own sake with no reference to the concerns of practitioners. In particular, the importance of hedging both as a justification for the price and as an important end in itself is often underplayed. Scholars need to be aware of such financial issues, if only because some of the very best work has arisen in answering the questions of industry rather than academe.

Chapter two develops the idea of hedging and pricing by arbitrage in the discrete time setting of binary trees. The key probabilistic concepts of conditional expectation, martingales, change of measure, and representation are all introduced in this simple framework, accompanied by illustrative, and illustrated, examples.

Chapter three repeats all the work of its predecessor in the continuous time setting. The Brownian motion process is brought out as well as the It\^o calculus needed to manipulate it, culminating in a derivation of the Black-Scholes formula.

Chapter four runs through a variety of actual financial instruments, such as dividend paying equities, currencies and coupon paying bonds, and adapts the Black-Scholes approach to each in turn. A general pattern of the distinction between tradable and non-tradable quantities leads to the definition the market price of risk, as well as a warning not to take that name too seriously. A section on quanto products provides a showcase of examples.

Chapter five is about the interest rate market. In spirit, a market of bonds is much like a market of stocks, but the richness of this market makes it more than just a special case of Black-Scholes. Market models are discussed with a joint short-rate/HJM approach, which lies within the general continuous framework set up in chapter three. One section details a few of the many possible interest rate contracts, including swaps, caps/floors and swaptions. This is a substantial chapter reflecting the depth of financial and technical knowledge that has to be introduced in an understandable way. The aim is to tell one basic story of the market, which all approaches can slot into.

Chapter six concludes with some technical results about larger and more general models, including multiple stock n-factor models, stochastic numeraires, and foreign exchange interest-rate models. The running link between the existence of equivalent martingale measures and the ability to price and hedge is finally formalised.

A short bibliography, complete answers to the (small) number of exercises, a full glossary of technical terms and an index are in the appendices.

A reader is not expected to have any particular prior body of knowledge, except for some (classical) differential calculus and experience with symbolic notation. Some basic probability definitions are contained in the glossary, whereas more advanced readers will find technical asides in the text from time to time.

**Martin Baxter**

**Andrew Rennie**

*Cambridge and London, June 1996*

Return to book page