Review of Recent Financial Books

Copyright N. N. Taleb

The Econometrics of Financial Markets by John Y. Campbell, Andrew W. Lo and A. Craig MacKinlay, Princeton University Press, Princeton, New Jersey.

Written by the "A" team of financial empiricism, it is a long awaited book. It covers many topics one could only usually find couched in the technical jargon of research papers, presented in this volume with pedagogical intentions. The language, while remaining technical, is quite accessible. It can be effortlessly read by scientific traders with standard knowledge of statistical methods or a Wall Street quant of the (nowadays rare) variety of quants who are more interested in what takes place on the planet Earth rather than what takes place inside the vaporous world of models.

The book's stated objective is the presentation of econometrics methods as applied to finance. In reality it presents the additional kicker of a review of modern financial theory seen from an empiricist's vantage point. The serious financial economist bookshelves usually includes the Ingersoll Theory of Financial Decision Making (1986, Rowman & Littlefield) and the Huang and Litzenberger Foundations for Financial Economics (1988, Prentice Hall) . These two great books are, however, getting on with age. Two other more recent books, Duffie's Dynamic Asset Pricing Theory ( 2^nd ed. 1996, Associated Press ) and Dothan's Prices in the Financial Markets ( 1990, Oxford University Press ) are not quite about financial theory as much as they are about the mathematical framework on which financial theory stands (or perhaps should stand) and present not the smallest use to a practitioner. We were left without any book presenting the results of the past few years in financial research, such as the more modern pricing kernel, the stochastic discount factor, heteroskedastic asset pricing, the widespread applications of the GMM. This book, in addition to the econometric applications (where econometric issues become indistinguishable from pure theory), fills such gap.

The book also provides discussions of the recent forays by market microstructure theory, the various results of tests of the Capital Asset Pricing Models and Arbitrage Pricing Theory (which includes a clear presentation of the theory), the Hansen-Jaganathan variance bounds, the yield curve dynamics, the estimation of the nonparametric kernel density through times series, kernel regression, ARCH methods (which includes multivariate ARCH), and other fresh topics. The authors are remarkably open minded, perhaps a sign of the evolution of finance in recent times-the result of the equity premium puzzle and the crack in the rationality hypothesis. One can find included discussions of such adventurous topics as a neural network approach to option pricing and a mention of technical analysis that is, remarkably, not condescending.

We have gone long ways from the days when orthodox finance pronounced markets efficient while, a cab ride away from the University of Chicago, floor traders (luckily unaware of the pronouncement) were lining up their pockets. Two of the authors have tested and rejected, a decade or so ago, the random walk hypothesis (a fact of which George Soros should have been aware before his condemnation of economic research). One of the authors (Lo) co-wrote a provocative paper in 1995 on option pricing with predictable returns. Yet, throughout the book, one can feel that the authors, while on the right track, would further gain by repairing to a bar in the Chicago loop and picking the brains of some local trader ( with the help of a trained translator ).

There are very few, and very minor, shortcomings in the book. First, the topics are slightly dated (the manuscript has been circulating for a few years as many researchers have been studying a smuggled copy of the draft since the early 1990s). Among the missing topics are the econometrics of regime switching processes that have recently become fashionable. Second, the topics are biased towards the (rich) contributions of the authors, which is not a serious detriment once one considers their disproportionate enrichment of financial empiricism. To conclude, this wonderful book conveys the feeling that, while Wall Street research departments may be way ahead of academia in pure derivatives pricing (and other abstractions), they, surprisingly, lag in the more relevant area of quantitative empiricism. This book should be made mandatory reading in research departments.

Interest Rate Option Models: Understanding, Analyzing and Using Models for Exotic Interest-Rate Options, by Riccardo Rebonato, Chichester, England: J. Wiley & Sons.

This is a pedagogical review book on the modelling of the yield curve dynamics with plenty of information and little of the "rigorous" mathematical smoke that pepper other recent texts. It is written in the simple language of calculus --the author, it is to note, was luckily trained as a physicist, rather than a mathematical economist (or topologist). Physicists are often taught to be down to earth (things are difficult enough as they are).

Rebonato reviews the various approaches to the yield curve. He starts with a brief principal component analysis of the matrix of Eurodollar rates, then, after a clear (but now very routine) presentation of Ito calculus, he links together the different models from Vasicek to Cox-Ingersoll-Ross. Rebonato presents the models without taking sides, which is perhaps what one would want him to do. Many of the Wall Street quants who needed a clear overview of the modelling world swear by this book. Likewise, realistic practitioners (like myself) who take a stand against the recent unjustified focus on yield curve modelling can find in it sufficient and comprehensive material to get to know what the modellers believe they know. One should not ask too much from a book: this one has no economic pretension and does not show any attempt at describing the world other than through the eyes of a person paid to work with models--not to trade or make decisions based on them. Accordingly, the book lacks in insight: Rebonato limits himself to paraphrasing the models--but he does it well.

The book somewhat can leave the reader hungry for the real opus magnus of the yield curve, a book that would provide a true intellectual understanding of the economics of interest rates. We need to start understanding the logic of yield evolutions rather than their mathematics. Where are the Irving Fishers, the John Maynard Keynes, the Holbrook Workings of today? Where are they hiding? Some of the works recently started by the behavioral finance theorists seems to be offer very promising applications to the yield curve. Should they need a review of the current models to prepare for the opus, this book will provide them with all they might need.


The Handbook of Exotic Options : Instruments, Analysis and Applications, Edited by Israel Nelken, Burr Ridge, Illinois: Irwin Professional Publisshing.

The first disappointment with this book comes from the cover. The jacket announces a "valuable software inside", which turned out to be an unusable (and not so "valuable" demo). It disallows the pricing of options at a different asset price than 50. But this is just the beginning: the editor did not do a good job at coordinating the articles. The book is just a fraction of the sum of the parts, as many of the articles, on a stand-alone basis, would be excellent. The first two chapters (otherwise well written) were quite the same one couched by two different persons. The authors were much more skilled than the editor, I might say, except for one. There is an amusing section on barrier options (in Part II supposed to cover products and applications) by Eric Berger that provides, in a display of show-off, an annoying discussion of some of the mathematical properties used for the pricing of the instruments rather than a description of the instruments themselves --such mathematical properties can be easily found in more specialized sources. It is like asking a flight attendant a depiction of Paris and getting a detailed and exhaustive description of Roissy airport.

Exotic Options : A Guide to the Second Generation Options, by Peter G. Zhang, Singapore: World Scientific Press.

In contrast with Nelken's, finally a good book on exotic options. Zhang put together a comprehensive book on their pricing and shows this to be possible to do without the measure theory twaddle. It takes the reader through the entire spectrum of products in an organized way and provides most necessary formulas as well as the intuition of their derivation (but mostly in the hypothetical Black-Scholes-Merton world). There is no other place where one can find all the pricing tools gathered together, which allows one to price an option without sneezing from the dust of the stacks of journal articles.

The book starts with a conventional review of option theory, building a framework from which all other instruments are priced. Then it goes through an exhaustive list of products broken by families. The symbols remain coherent throughout the 670 pages, which is a plus. There is only one intellectual novelty: the author attacks such issue as stochastic correlation with multi-asset options --something only timidly discussed elsewhere.

The author does a good job when he limits his role to providing a complete pricing encyclopedia. However, in chapter 35, he shows signs of taking the theory too seriously as he discusses static option replication. Zhang forgets that he is still working with strong assumptions about asset dynamics and that, accordingly, he should not step into the brackish waters of option hedging, which requires some understanding of financial markets and not just their mathematics. The remaining 35 chapters are just what one can hope for: exact, clear and useful. This is the most complete conventional option pricing book currently available.