Currency Derivatives: Pricing Theory, Exotic Options, Hedging Applications

Posted by Allison on 13 April 2009, 10:58

The Black-Scholes model for pricing options is well known as an influential part of the financial and investment world.  It has been successfully applied to a wide range of options, including fixed income markets, equity markets, and equity index markets.  Currency Derivatives:  Pricing Theory, Exotic Options, Hedging Applications makes the case that the Black-Scholes model has been just as influential, if not more influential, in the foreign currency derivatives market.   This book traces exactly how and why this model has been applied to currency derivatives and the tremendous knowledge that has been gained along the way. 

Currency markets well suited to derivatives

What has become quite apparent is that current markets provide an excellent arena for testing, developing, and executing a huge array of derivatives and similar financial instruments.  The Black-Scholes model forms the basis for much of this development activity, and the results are discussed extensively in Currency Derivatives:  Pricing Theory, Exotic Options, Hedging Applications.

The sheer size of this subject and the quantity of research and scientific study available on modern theories of currency derivatives presents a tremendous challenge for any single author to explain and discuss thoroughly.  Currency Derivatives:  Pricing Theory, Exotic Options, Hedging Applications deals with this challenge very nicely by bringing together a wide array of articles and published works from recognized experts in the field, creating a comprehensive volume of work for the reader's use.

David DeRosa, the editor of the book, has brought together a distinguished group of contributors and their writings, covering a range of topics from the very basics of currency derivatives to the most complex and nuanced approaches to currency derivatives.  The contributors DeRosa brings together in this book include:

  • John C. Cox
  • Jonathan E. Ingersoll, Jr.
  • Stephen A. Ross
  • Bradford Cornell
  • Marc R Reinganum
  • Mark B. Garman
  • Steven W. Kohlhagen
  • Giovanni Barone-Adesi
  • Robert F. Whaley
  • T.S. Ho
  • Richard C. Stapleton
  • Marti G. Subrahmanyam
  • Fischer Black
  • Stephen J. Taylor
  • Xinzhong Xu
  • David S. Bates
  • Philippe Jorion
  • Marc Chesney
  • Louis Scott
  • Peter Ritchken
  • Helyette Geman
  • Marc Yor
  • Cho H. Hui
  • Edmond Levy
  • Emanuel Derman
  • Piotr Karasinski
  • Jeffrey S. Wecker
  • Christopher D. Piros
  • Ajay Dravid
  • Matthew Richardson
  • Ton-sheng Sun
  • David DeRosa

As you can see, this is a huge group of contributors, all of which are recognized experts in the world of financial derivatives.  Currency Derivatives:  Pricing Theory, Exotic Options, Hedging Applications makes the excellent point that it is the work of these distinguished contributors, in coordination with the real currency market traders, who helped to develop the modern marketplace for currency derivatives.

A well designed structure of content

One of the reasons Currency Derivatives:  Pricing Theory, Exotic Options, Hedging Applications stands out is the well designed structure of the content.  It groups the topics and articles written about the topics into clear, distinct sections of focus.  The reader then has the option of moving among the different sections in whatever order they find most useful, or proceeding through the sections in the order presented by the editor.  Either way, the structure is such that the information is easy to find and use in whatever manner best suits the reader's needs.

It's well worth looking at the different sections and topics in more detail to get a clear idea of just how comprehensive the material is in this book.

Section #1 – Futures contracts and forwards contracts on the foreign currency exchange market
This section includes detailed content on all aspects of futures and forwards, including how their respective pricing interacts, the structure and nuances of their contracts, and the like.

Section #2 – Models of pricing for currency options
This section examines the specifics and structure of various pricing models and approaches, including the general process of establishing values for currency options; using a bounded exchange approach to establish values for derivatives involving foreign exchange rates; how to most efficiently analyze and approximate values for U.S. currency options; and how to successfully achieve proper hedging and valuation for U.S. currency options.

Section #3 – Models of pricing for futures currency options
This section takes a detailed look at the valuation of futures options for U.S. currency as well as effecting pricing approaches for commodity contracts.

Section #4 – Currency derivatives and implied volatility
This section provides good discussion of both the empirical evidence and the theory surrounding implied volatility smiles, especially in terms of their magnitude and their term structure.

Section #5 – Models of stochastic volatility and the jump process for foreign currency derivatives
This section examines a fairly complex topic in a very thorough manner.  It includes discussions of jump processes in stock markets as well as foreign currency exchange markets; comparisons between the random variance model and the Black-Scholes model for European currency options pricing; and examines the period 1984 – 1992 in terms of fears related to the dollar jump as well as abnormalities in the distribution trends of futures options on the currency exchange.

Section #6 – Currency options: average, barrier, and binary
This section includes detailed information about pricing barrier options, the hedging and pricing of double barrier options, the approach to pricing of European average rate currency options, and valuation of one touch double barrier binary options.

Section #7 – Equity warrants, quantos options, and special currency features
This section examines several aspects of this topic, including the advantages and disadvantages of hedging using quanto; applying Nikkei index warrants in the task of pricing contingent claims of foreign indexes; and the specifics of guaranteed exchange rate contracts and how they fit within general investments in foreign stock markets.

High level content and important information

Several critics and reviewers praise Currency Derivatives:  Pricing Theory, Exotic Options, Hedging Applications for its excellence in presenting important information and high level content relating to the general foreign currency exchange market as well as the specifics of foreign currency derivatives.  This is particularly important to foreign currency exchange traders who do not have the benefit of working with or for one of the large banks or other institutions that dominate the currency markets.  Because these large institutions have traditionally been the primary players in the currency markets, they have up until this point had a competitive edge on trading talent with the knowledge to successfully trade in foreign currency derivatives.

As more and more individual traders participate in the currency markets, it becomes more and more vital that these traders learn about the power of currency derivatives if they are to expand their expertise and achieve success.  Currency derivatives are not necessarily appropriate investment tools for everyone to embrace, of course, but by simply understanding what they are and how they work anybody can greatly expand the breadth of their trading knowledge.

Final thoughts

The currency derivatives market owes a great deal of its development and success to the trading practitioners who embraced the application of the Black-Scholes model to this extraordinarily large market.  Currency Derivatives:  Pricing Theory, Exotic Options, Hedging Applications is a comprehensive resource that very clearly discusses the Black-Scholes model and demonstrates just how important it has become to the modern currency exchange market.  The editor, David DeRosa, has assembled a terrific assortment of scientific research and articles from a distinguished line up of contributors.

The result is a wide ranging book that can serve a variety of purposes for a variety of traders.  Whether you are new to foreign currency derivatives, have never heard of them before, or are looking for better ways to trade in them successfully, Currency Derivatives:  Pricing Theory, Exotic Options, Hedging Applications contains information you will find useful.  It is a substantial volume that is a good addition to any foreign currency exchange market trader's collection of references and resources.

Direct link to this book at Amazon