Theory of Financial Risk and Derivative Pricing

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Risk control and derivative pricing have become of major concern to financial institutions, and there is a real need for adequate statistical tools to measure and anticipate the amplitude of the potential moves of the financial markets. Summarising recent theoretical developments in the field, this second edition has been substantially expanded. Additional chapters now cover stochastic processes, Monte-Carlo methods, Black-Scholes theory, the theory of the yield curve, and Minority Game. There are discussions on aspects of data analysis, financial products, non-linear correlations, and herding, feedback and agent based models. This book has become a classic reference for graduate students and researchers working in econophysics and mathematical finance, and for quantitative analysts working on risk management, derivative pricing and quantitative trading strategies.

Theory of Financial Risk and Derivative Pricing Review

`Econophysics' (the application of techniques developed in the physical sciences to economic, business and financial problems) has emerged as a newly active field of interdisciplinary research. `Theory of Financial Risks' (written by two of the pioneers of this field) highlights very clearly the contribution that physicists can make to quantitative finance.From the outset the point of view of the book is one of empirical observation (of the statistical properties of asset price dynamics) followed by the development of theories attempting to explain these results and enabling quantitative predictions to be made. This philosophy is reflected in the structure of the book. After a brief account of relevant mathematical concepts from probability theory the statistics of empirical financial data is analysed in detail. A key result from this analysis is the observation that the correlation matrix (measuring the correlation in asset price movements between pairs of assets) is dominated by measurement noise (which, as the authors observe, has serious consequences for the construction of optimal portfolios). Chapter 3 begins the core theme of the book with a discussion of measures of risk and the construction of optimal portfolios. A central result of this chapter is that minimisation of the variance of a portfolio may actually increase its Value-at-Risk.The theme of improved measures of risk continues in chapters 4 and 5 which focus on futures and options. A new theory for measuring the risk in derivative pricing is presented. In the appropriate limit (continuous-time, Gaussian statistics) this model reproduces the central results of the Black-Scholes model - namely that one can construct a portfolio of options and assets such that the residual risk is identically equal to zero. However as the book has constantly highlighted, these market conditions are simply not observed in practice. Moreover the new theory presented allows one to calculate the residual risk which exists under more general and realistic market conditions (allowing the development of improved trading strategies). In summary this book highlights very clearly many of the inadequacies of current financial theories and presents a number of new approaches, based upon concepts developed in statistical physics, to overcome these problems. It is to be recommended to both students of finance as well as to professional analysts as a good example of how an interdisciplinary approach to financial engineering may yield improved measures of risk. Help other customers find the most helpful reviews� Was this review helpful to you?�Yes No Report abuse | PermalinkComment Comment

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