Back of the Envelope

Observations on the Theory and Empirics of Mathematical Finance

Baxter & Rennie (BR): Overview

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Let’s start with a very brief overview of the way BR’s book is structured.

BR begin with a warning to beginners to not to treat pricing derivative securities with a statistical mindset – why using the law of large numbers can be dangerous to one’s financial health. Then it goes the Shreve’s way of intuiting the basic probabilisitc ideas in the subject (martingales, change of measures etc.) using the two-period Binomial Asset Pricing Model (BAPM). While Shreve has an entire volume devoted to it, this being a much more concise text, covers the ground quickly. BR then move to establishing the main ideas in continuous time, when they also introduce Ito calculus and derivatives pricing in the Black-Scholes-Merton world.

After giving a very brief overview of the basic financial instruments across asset classes, they spend the majority of the remaining time in the book on illustrating the application of the main techniques to pricing interest rate derivatives. They conclude the book by giving a flavour of the more advanced models and formalizing the link between the existence of equivalent martingale measures and ability to hedge.

We’ll try and take up a more detailed topic-by-topic look at the book next.

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Written by Vineet

August 19, 2010 at 6:17 am

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