6 of 6 people found the following review helpful:
4.0 out of 5 stars
Excellent book for the newcomer to options pricing/analysis, July 22, 2001
This book is a good general overview of options pricing for those who do not have a strong mathematical background. It emphasizes the practical aspects of the subject and the author endeavors to be as concrete as possible. There is accompanying software with the book, but since I have written my own software for options pricing I did not use it and cannot attest to its utility or reliability.
The first chapter defines the call and put option, and gives a short history of the options markets. The author discusses taxation of option transactions briefly, which is not usually found in books on options.
In chapter 2, the author discusses options payoffs from using various options strategies. The important principle of arbitrage is discussed, and the assumption of no transaction costs is made throughout the chapter. The author gives a good example of how small differences in price can persist in actual markets, thus showing how transaction costs can effect option pricing. Option combinations, such as straddles, strangles, bull, bear, box, butterfly, spreads, and condors. All of these are summarized nicely in table form. The important area of portfolio insurance is treated with brief discussions on mimicking portfolios and synthetic instruments. Helpful references are given that study the cost of portfolio insurance.
In chapter 3, the author considers the factors that contribute to the pricing of an option using the principle of arbitrage. Complete financial markets are assumed, and the goal is to find how these assumptions can be used to put bounds on option prices. The chapter could be viewed as an elementary exercise in the mathematical formalism of optimization with constraints, but the arguments are mostly qualitative. The effect of interest rates on option prices is also considered in this chapter. Here, the principle of arbitrage is employed to show the price of a put must fall as interest rates rise, while call option prices increase with higher interest rates. Also, the author begins an attempt to show how stock prices influence option prices, and he shows that the riskier the underlying stock, the greater the value of an option.
Then in chapter 4, the author takes up issues of a more mathematical nature, wherein he uses the single-period and multi-period binomial models to price European options. These are used to derive the famous Black-Scholes option pricing model. The author's approach is very practical as he discusses various methods of using historical data to estimate the stock's standard deviation. He cites the Crash of 1987 as an example of why one should use current data to estimate the volatility. This motivates the development of other techniques, such as implied volatility, for estimating the standard deviation.
The 'Greeks', called option sensitivity measures by the author, are discussed in chapter 5. He does use partial differential calculus, but motivates it well, so readers without the mathematical preparation can follow the presentation. It is shown how to combine options with the underlying stock or into portfolios, one can construct positions with the desired risk exposure.
The more difficult job of pricing American options is dealt with in chapter 6, the Black pseudo-American call option pricing model being treated first. The binomial model is applied to American options with various kinds of dividends.
In chapter 7, the author considers options on stock indices, foreign currency, and futures. The Merton model leads off the discussion, and both European and American options are treated in the chapter.
Then in chapter 8, the techniques developed in the book are applied to corporate securities. It is an interesting discussion, and the author gives straightforward examples to illustrate various corporate financing strategies. It should prepare the reader for more advanced reading on the subject.
The last chapter is the most interesting of all as it deals with exotic options. The author considers nine types of exotic options, namely forward-start, compound, chooser, barrier, binary, loopback, average price, exchange, and rainbow options, all of these studied as European options. Closed-form solutions for these types of options are given and numerical examples are given. Several helpful references are given at the end of the chapter. The author gives an interesting real-world example of the use of chooser options, namely the case of hedging with a chooser option on the Mexican peso before the NAFTA agreement in 1993.
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