The Value of Uncertainty: Dealing with Risk in the Equity Derivatives Market Hardcover – 16 Jan 2013
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"In his timely book, George Kaye, a Cambridge-trained physicist with over a dozen years of experience as a quantitative analyst at leading investment banks in the City of London, covers a wide variety of topics in the context of equity option pricing and risk management. He presents a broad and thorough survey of the relevant mathematical methods, and shows how they can be used in practice. Both students of the subject and seasoned market practitioners will greatly benefit from reading this book. I recommend it to the readers without reservations."-- Alexander Lipton, Bank of America Merrill Lynch and Imperial College London
"Model valuation used to inhabit the boring corner of derivatives pricing. After the valuation debacles of the last few years, it has moved firmly to centre stage, and now captures the attention of regulators, practitioners and CEOs as it never did before. And so it should, as it goes to the very heart of the question: What is the value of a derivative product? With this book, George Kaye makes a timely and well-informed contribution to the debate. One of the strengths of the book is to be found in the author's ability to deal with the nittygritty details of modelling while keeping the big picture constantly in sharp focus. This volume provides a useful contribution to the debate, and a treasure trove of insights on derivatives pricing and hedging." --Riccardo Rebonato, Global Head of Interest Rates and FX Analytics, PIMCO and, Visiting Lecturer, Mathematical Finance, Oxford University
From the Inside Flap
The Value of Uncertainty begins by tracing the growth in the equity derivative markets prior to the events of September 2008, and demonstrates how exotic derivatives formed a significant component of that growth. It goes on to show that, with this growth, the mere decision of whether to use one model versus another became a significant contributor to valuation uncertainty. The book then focuses on equity derivative models, charting, step by step, how key assumptions on the dynamics of stocks impact on the value of exotics. The presentation is technical, but always maintains a strong focus on intuition and practical applicability to the current market.See all Product description
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The technical details within each chapter are rather limited with derivations rendered to exercises in the end of each chapter with solutions provided in the end of the book. This structure of the book makes it easy to use as either a reference book, if one needs to study the impact of a particular factor (dividend, credit, etc) on the valuation and risk, or a study book, if one wants to learn modelling for equity derivatives working through exercises.
In particular, I like the following features of the book. The chapter on dividends provides the common approach to dividend modelling in the industry. The impact of discrete and proportional dividends is studied in depth. The chapter on the stochastic volatility applies the local stochastic volatility model to investigate the impact of vol-of-vol and correlation on various volatility products. The chapter on credit illustrate the impact of state-dependent intensity on the value of a convertible bond, which I found new for myself.
The chapter on the interest rate risk is very insightful. The key point by studying the impact of any factor on value and risk of a particular product is to differentiate between two cases: first, bumping the magnitude of the factor and leaving remaining model parameters to be the same (in particular, the local volatility) and, second, bumping the magnitude of the factor and re-calibrating the model (local volatility) to input implied volatility surface. As neatly illustrated in this chapter, the impact of stochastic interest rates in the above mentioned cases turns out to be different. This is a crucial approach that, by analysing the impact of a particular model factor, we need to differentiate between un-calibrated and calibrated models. The author is trying to emphasize this approach and provide corresponding analysis throughout the book.
To summarize, I could only wish that this book would have been available when I started in equity derivatives - it could have saved me a lot of time figuring out those small details that make equity derivatives so challenging. I think that this book can be beneficial for:
1) new comers to equity derivatives industry to learn about industry-wide models and how these models are applied;
2) people in the industry (in particular quants, structurers, risk and model validations) to systematize and test their experience and knowledge;
3) researches in the field of quant finance to learn industry-base approach to equity modelling and risk management
The author combines a solid mathematical background with a "hands-on" knowledge of market dynamics and equity products. The material is clearly exposed and should be useful to readers with different levels of experience.
Each chapter focus on a different source of risk (jumps, default, stochastic rates, stochastic vol, etc...), discusses how to model it (typically via extensions of local-volatility model) and analyzes the implications on pricing structured products. The book is a solid reference source on the main models covered - in addition it provides intuition on the dynamics of complex structured products which will be valuable for the more experience reader.
Though quants and model validators are the obvious target audience, this book will be useful to anyone who wants to understand why model choices matter (traders, risk managers). I thoroughly recommend it!