Financial Engineering and Arbitrage in the Financial Markets is an easy-to-understand guide to the complex world of today’s financial markets teaching you what money and capital markets are about through a sequence of arbitrage-based numerical illustrations and exercises enriched with institutional detail. Filled with insights and real life examples from the trading floor, it is essential reading for anyone starting out in trading. Using a unique structural approach to teaching the mechanics of financial markets, the book dissects markets into their common building blocks: spot (cash), forward/futures, and contingent (options) transactions. After explaining how each of these is valued and settled, it exploits the structural uniformity across all markets to introduce the difficult subjects of financially engineered products and complex derivatives.
Introduction:
The improvement is in the presentation. The method of the original book was to present the difficult subjects of arbitrage, derivative pricing, and financial engineering in terms of numbers – cash flow discounting, binomial trees, tables, and diagrams – rather than differential equations. This book follows that appealing formula. All examples are worked out numerically, but they are now enhanced with flow diagrams, and are connected across the markets and chapters. Another big improvement, hopefully, is the division of the book into three parts, each offering a different perspective. If you watched three boys play with Lego, you would want to know the types of blocks (colors, the number of pegs, etc.) they are playing with, what they are building with them (a robot or a fire station), and why each boy is playing. The three parts of this book are just like that: Part I is the basic spot, futures, swap, and option transactions as building blocks; Part II illustrates examples of engineering those building blocks into CDOs or mortgage-backed securities (MBSs); and Part III relates to the players: individuals, banks, hedge funds, and private equity.
The main premise is that all financial markets are organized in the same way. All have spot (cash) transactions, forward/futures transactions and options, as well as complex swap arrangements combining all three. If you master the spot-futures cash-and-carry trade in one market (stock index arbitrage), then you can easily grasp it in another (currency-covered interest parity). If you master how delta or vega risk is hedged in equity markets, then you are likely to understand the same process in commodities or interest rates. Building a fire station with red Lego blocks is similar to building a space ship with green and blue blocks. Instead of focusing on the purpose of individual financial markets, the book focuses on the common structure. What we are building is an arbitrage or a relative value trade to profit from the real or perceived mispricing of risk. The blocks we use have the same shape, only a different color.
The building clusters in all structured products and strategies are: spot and futures trading mechanics, spot-futures linkages, option pricing, option linkages to futures, and spot, swaps, and their decomposition into bonds and forwards. The improvements in Part I consist of new chapters and easier-to-follow number and flow diagram presentations. The options discussion is split into two: options on price variables (equities, currencies, etc.) and options on non-price variables (interest rates). In the latter, we don’t model prices directly – instead we model rates, derive the prices from the rates, then we price derivatives. The part includes a new chapter on credit derivatives. Part II introduces financial cash flow engineering. In addition to a survey of the perennially popular structured products, the mortgage section is substantially clearer and more complete; and the CDO section is entirely new.
The analogy between prepayment and credit risk tranching should be very hard to miss. Part III is completely new and is mostly concerned with “why”. Chapter 11, taking an individual investor perspective, is a repository of all-you-need-to-know about modern portfolio theory and its morph into statistical arbitrage methods, as well as fundamental equity valuation methods. Chapter 12 scratches the surface of hedge fund strategies and the new area of strategy indexes as a beta way of getting the alpha. Chapter 13 looks at the traditional asset-liability management for banks, which in many cases is still more useful than the newer voluminously analyzed VaR methods. Chapter 14 focuses mainly on private equity, but it also looks at liability/politics, constrained pension funds, endowments, and sovereign funds. While Part III does not answer all the whys, it hopefully illustrates the main motivations and quantitative techniques pursued by the key players in the financial markets.
Contents:
- Purpose and Structure of Financial Markets
- Spot Markets
- Futures Markets
- Swap Markets
- Options on Prices and Hedge-Based Valuation
- Options on Non-Price Variables
- Default Risk and Credit Derivatives
- Structured Finance
- Mortgage-Backed Securities
- Collateralized Debt Obligations and Basket Credit Derivatives
- Individual Investors: A Survey of Modern Investment Theory
- Hedge Funds: Alpha, Beta, and Strategy Indexes
- Banks: Asset-Liability Management
- Private Equity, Pension, and Sovereign Funds