## Wednesday, December 22, 2010

All About Derivatives (McGraw-Hill, 2011, a fully revised second edition) is a curious book, and I don’t say that unkindly. It’s just odd that in a book in the “All About” series, touted as “the easy way to get started,” you find such a lengthy discussion of options pricing. But then Michael Durbin is, among other things, a financial technology consultant specializing in high-frequency trading of financial derivatives, and he has helped numerous Wall Street firms develop derivative pricing and trading systems.

The structure of this book is straightforward. After an overview chapter, the author devotes a chapter each to forwards, futures, swaps, options, and credit derivatives. He then looks at using derivatives to manage risk, pricing the various derivatives, hedging a derivatives position, and derivatives and the 2008 financial meltdown. In three appendices he investigates interest, swap conventions, and binominal option pricing.

Even though this book would be a fine introduction to the subject of derivatives, it often goes beyond the elementary. For instance, Durbin points out the subtle pricing differences between warrants and options. Moreover, the book is laced with interesting tidbits. I didn’t know, for example, that Enron issued a series of credit-sensitive notes in 1998 that offered a coupon rate inversely tied to its credit rating.

For options traders who want to delve a little more deeply into pricing models, Durbin offers a gentle account in the text, coupled with a more mathematical description in an appendix. He explains why Black-Scholes cannot be used to determine the value of every type of option. Yes, it was meant to apply to European-style options, and there are other choices for American-style call options. But, he writes, “for American puts, Black-Scholes is simply not a choice. You must use a binomial tree method because an analytical method for pricing an American put option simply does not exist. An analytical solution is one in which you plug factors into a function and get a result. A nonanalytical method is more of a brute-force or trial-and-error approach, which the tree method really is.” It seems that the absence of an analytical solution to pricing American-style puts is an example of a “free boundary” problem. “These things,” Durbin continues, “are hard, like trying to predict precisely where water will flow when poured from a bucket onto a flat surface.” (p. 172)

All About Derivatives is a survey of a world that nearly everybody caught a glimpse of after 2008, but Durbin gives it structure and some mathematical clarity. It is a how-it-works book, not a how-to book. The trader in search of a quick buck will be disappointed. I was not.