Volatility and Correlation: The Perfect Hedger and the Fox Hardcover - 2004 - 2nd Edition

From the rear cover

The new edition of Volatility and Correlation has been thoroughly updated and expanded with over 80% new or reworked material, reflecting the changes and developments that have taken place in the field. The new and updated material includes: empirical and theoretical analysis of the smile dynamics; examination of the perfect-replication model in relation to exotic options; treatment of additional important models, namely, Variance Gamma, displaced diffusion, CEV, stochastic volatility for interest-rate smiles and equity/FX options; questioning of the informational efficiency of markets in commonly-used calibration and hedging practices.

The book is split into four sections. Part I deals with a deterministic-volatility Black world (no smiles), and sets out the author's 'philosophical' approach to option pricing. Part II deals with smiles in the equity and FX worlds. Beginning with a review of relevant empirical information about smiles, this part provides coverage of local-stochastic-volatility, general-stochastic-volatility, jump-diffusion and Variance-Gamma processes. Part II concludes with an important chapter that discusses if and to what extent one can dispense with an explicit specification of a process-based model, and can directly prescribe the dynamics of the smile surface. Part III focuses on interest rates, and part IV extends the setting used for the deterministic-volatility LIBOR market model in order to account for interest-rate smiles in a financially-motivated and computationally-tractable manner. In this final part the author deals, in increasing levels of complexity, with CEV processes, with diffusive stochastic volatility and with Markov-chain processes.

Covering FX, equity and interest-rate products, Volatility and Correlation is a blend of theoretical and practical material and is designed for traders, risk managers, financial professionals and students.

'The second edition is even more comprehensive than the first, and ideally suited to quantitatively oriented traders and risk managers. Rebonato has a knack for distilling the essence from a wide range of complex option pricing models.' Darrell Duffie, Stanford University, USA

'The author has greatly extended the first edition of this book, whose main merit remains its courage to deal with relevant issues for practitioners. Rather than concentrating on fictional problems stemming from the need to give financial ground to one's favourite theories, the author moves from problems posed by the market. At times a colloquial stance is privileged over mathematical rigor and formalism, allowing a larger public to benefit from this book.' Damiano Brigo, Head of Credit Models, Banca IMI, author of Interest Rate Models: Theory and Practice.

'This book is about equity, FX and interest-rate option pricing at its best. It combines rigorous theory with practical knowledge of markets and models. Riccardo Rebonato uses his technical mastery to make the theory clear, and his wealth of experience to give insights into applications. Whatever your level of knowledge of these markets, you will learn from him.' Ian Cooper, Professor of Finance, London Business School

'In this book, Riccardo Rebonato discloses his invaluable expertise, shedding light over the gloomy path of modern model selection for pricing and hedging derivatives. Both practitioners and academics will benefit from his teachings and advice.' Fabio Mercurio, Head of Financial Models, Banca IMI, Milan, Italy

From the jacket flap

Volatility and Correlation in the Pricing of Equity, FX and Interest-Rate Options is split into three sections. In the first, an introduction is presented to the complex concepts of correlation and volatility encountered in equity/FX and interest-rate option pricing, aimed at providing practitioners with a better informed choice when deciding which models to utilise. This first part also highlights the fundamental conceptual difference between interest-rate volatility on the one hand, and of FX and equity volatility on the other. The author then moves on to the problem of smiles, with considerable emphasis placed on option pricing when markets are incomplete. This second part focuses on the need for end users to take an approach, at the same time practical and theoretically sound, when it comes to implementing the various models which can account for smiles. To this effect, many existing models are reviewed and several new, original approaches are presented. The author points out that the temptation of being seduced by the elegance of mathematical models must be tempered by the need to look at the financial mechanisms driving the dynamics of the specific derivative product. The analysis of the third part deals with the role of volatility and correlation in the context of interest-rate models. In particular, it covers in detail practical and powerful calibration techniques to caplet volatilities and correlation surfaces of the state-of-the-art BGM approach, and suggests criteria to choose the functional form for the all-important instantaneous volatility functions.