Academic journal article Journal of Risk and Insurance

An Introduction to Derivatives and Risk Management

Academic journal article Journal of Risk and Insurance

An Introduction to Derivatives and Risk Management

Article excerpt

An Introduction to Derivatives and Risk Management, 5th ed., by Don M. Chance, 2001, Fort Worth, Texas: Harcourt College Publishers.

Don Chance's textbook provides readers with a thorough initiation into the world of derivative securities. The book discusses options, forwards, futures, swaps, and related derivative instruments, their markets, and some applications. The book's importance has grown with the popularity of derivative contracts in recent years. As recent derivatives debacles illustrate, it is important for anyone in business to be conversant with the terminology in this area. This book helps fill the void in this area by providing a solid introduction to derivative securities and their uses.

The title of the current edition of the text (now in its 5th edition) includes the added-on phrase "and Risk Management." But the traditional concept of risk management is only loosely integrated in the book. Indeed, while the title of the text has changed, the structure of the text is virtually the same as the 4th edition, suggesting that no significant progress has been made to more formally link the area of derivatives and traditional risk management. While risk management concepts may be automatically embedded in any presentation of the subject (e.g., derivatives can be used as hedging instruments, or protective puts are essentially insurance on the value of a portfolio), this book is more directly an exposition on derivatives. The presentation of the book is fairly straightforward. Case studies, vignettes, and other supplemental stories (such as "Derivatives in Practice") are kept to a minimum. After an introductory chapter that provides a foundation for some of the tools employed throughout the book (including arbitrage and short selling), the text is organized into three separate sections. The first part contains six chapters on options. It is interesting that Chance (and many other authors) begins the book with options rather than futures contracts, even though futures contracts have a longer history and are more similar to other financial transactions (i.e., futures have performance demands on both of the contracting parties).

Chapter 2 provides an overview of the options markets, including a description of contract specifications and an introduction to trading on options exchanges. Chapters 3 through 5 carefully develop the pricing of option contracts, starting with fundamental principles, working through the binomial pricing model, and ending with a presentation of the Black-Scholes model. Chapters 6 and 7 discuss basic and advanced strategies of options, including both speculative and hedging strategies. One advantage of this text relative to other books on derivatives is that when the author discusses option strategies, he allows the time horizon of the investor to vary, while other authors too often assume that the user holds the position until the expiration date of the option.

The second part of the text contains four chapters on forward and futures contracts. As with the options section of the book, the presentation of forward-based contracts begins with a discussion of the contract details, futures exchanges, and regulation (Chapter 8). Chapter 9 then presents issues in pricing forward-based contracts, including the cost of carry approach and the risk premium hypothesis. Chapters 10 and 11 then discuss basic and advanced strategies using futures contracts.

The third part of the text contains five chapters on miscellaneous topics. Chapter 12 looks at a specific kind of option contract where the underlying security in the option is a futures contract (futures options). Chapter 13 discusses foreign currency derivatives. Given the increasing emphasis on the globalization of business, this chapter presents some of the common strategies used to hedge the currency risk of organizations. Chapter 14 looks at interest rate risk, another specific application of derivatives. For organizations exposed to fluctuations in interest rates, this chapter discusses interest rate derivatives including caps and floors, forward rate agreements, swaps, and related instruments. …

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