By Phelim P. Boyle (Editor), Feidhilm Boyle (Editor)

This name units out to equip the lay reader with a transparent and thorough clarification of monetary derivatives and the way they paintings. It good points an advent to the complete realm of derivatives, applying quite a number genuine existence examples to supply a vast outlook at the material that is worldwide in standpoint. It additionally offers a lucid conceptual historical past to derivatives via keeping off unecessary technical information.

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Extra resources for Derivatives : The Tools That Changed Finance

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However, for this result to be true, there must be no taxes or bankruptcies. In the real world of course, we do have taxes and firms can (and sometimes do) go under. It is very common in financial economics to make simplifying assumptions like these. We know that the precise conditions required for the Miller– Modigliani law are not found in the real world, but the result does provide a useful benchmark. 5 ARBITRAGE AND TRANSACTION COSTS The no-arbitrage result stems from the insight that two identical items should trade for the same price.

We will construct the replicating portfolio that will eventually lead us to the current price of the option. The replicating portfolio that mimics the option’s payoff needs to be adjusted to reflect changes in the asset price over time and we will need to keep track of its composition over time. To track the composition of the replicating portfolio we need to make some assumptions about how the asset price changes. The numerical example that follows illustrates the nature of the assumptions we use.

One very painful way would be to use what is known as a trial-and-error method. Under this method, which we do not recommend, we would construct a portfolio by guessing how much to put in the asset and the bond and then calculate the value of this portfolio after one year. We would check whether or not the value of the portfolio corresponds to the payoff under the option contract. 2 Payoffs on call option at maturity 20 0 Current time End of one year It is most unlikely that we would guess correctly and so, under this method, we would go back and guess again until we eventually find the portfolio that exactly matches the payoff of the call option.

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