Author: Justin London
ISBN: 0-13-196259-0
Publisher: Pearson Ed

Global financial markets have seen an explosive growth in derivative products in the last two decades. There are numerous books that focus on the theory of derivatives or the mathematical foundations for valuing derivatives. However, this book by Justin London presents a practical implementation approach to building derivative valuation models, highlighting the key modeling techniques and relevant issues.

Unlike introductory books that describe derivatives, this book focuses on implementation details. Specifically, this book will be useful for practitioners who are tasked with building models and have to deal with implementation details such as calibration for the model to be useful in real life. Since different programming languages are used in the industry, the book shows implementation in Matlab, C++ and Excel.

For each type of derivative, the book explains the basic mechanics of the instrument and how it is priced. The book explains market conventions used for quoting the price and other features/ practices that make the instrument unique. The book also covers relevant design aspects in implementing  the instrument valuation, but that is not the main emphasis of the book. One salient feature of the book is that the author has included the work of other practitioners, like Stephano Galliani for credit derivatives, who have presented simple, but still comprehensive ways to understand these instruments.

The chapter on swaps and fixed income instruments covers the motivation for using the instruments as well as an overview of conventions used in these markets. Hedging calculations which demonstrate the use of these instruments are given. The chapter builds on the fixed income libraries that come along with Matlab.

Copula functions,one of the key techniques in modeling correlation dependencies of the underlying credits, are explained in detail. After a brief but clear introduction to copulas, their basic properties and classes, the book goes details the calibration of copula from market data.

Prepayment models and conventions used in MBS markets are covered before implementation of pricing using Monte Carlo simulation in c++. Also, the book shows the implementation using Matlab's fixed income toolkit are explained along with empirical and model based applications of interest rate risk and hedging. Motivations for ABS  securitization and nature of real estate cash flows are explained before the pricing of CMBS using Monte Carlo simulation.

Collateralized Debt Obligations explains the structure of CDO, different types, mechanism, and credit enhancements along with applications such as balance sheet management with CDO and reducing funding costs are explained. Distribution of default losses, CDO tranche pricing, and pricing equations are explained in detail.

The chapter on credit derivatives describes the instrument, valuation issues, and points to all relevant papers. The book address the many issues in implementing credit derivatives including hazard rate, Poisson and cox processes, hazard rate function calibration, and the credit curve construction.

Weather, energy, and power derivatives are instruments that are less commonly covered in other books, much less at an implementation level. The book not only gives an overview of the weather derivative market and contracts, but also discusses key implementation related issues such as correlations, modeling issues for temperatures like mean reversion and volatility estimation.

Energy and power derivatives starts with an introduction to electricity markets and relevant instruments such as swing options which have multiple early exercise features. Pertinent issues such as non-storability and limited transportability are discussed along with techniques such as least squares Monte Carlo for pricing.

Important modeling issues such as the estimation of stochastic processes for electricity prices are explained carefully with the implementation details. Jump diffusion models and calibration using maximum likelihood and generalized method of moments for parameter estimation are detailed.

Interest rate tree models are the fundamental building blocks for pricing derivatives. Issues in modeling interest rates are explained in reference to popular models including, Black-Derman-Toy, Hull and White, Black Karasinski, and HJM. The book further explains use of the Matlab fixed income tool box by listing the functions that are available as well as details about the parameters and how to use them.

In summary, the book is a good starting point for those interested in implementing derivative models either from scratch or using pre-built functions in Matlab. The book provides solid direction not only on implementation issues but also on the instrument and market related information.