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.