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Five new chapters, numerous additions to existing chapters, and an expanded collection of questions and exercises make this Second Edition an essential part of everyone's library. Between defining swaps on its first page and presenting a case study on its last, Neftci's introduction to financial engineering shows readers how to create financial assets in static and dynamic environments. Poised among intuition, actual events, and financial mathematics, this book can be used to solve problems in risk management, taxation, regulation, and above all, pricing.
* The Second Edition presents 5 new chapters on structured product engineering, credit markets and instruments, and principle protection techniques, among other topics
* Additions, clarifications, and illustrations throughout the volume show these instruments at work instead of explaining how they should act
* The Solutions Manual enhances the text by presenting additional cases and solutions to exercises
Summary: Deeply satsifying and friendly overview with a long shelf life
Professor Neftci's Second Edition of Principles of Financial Engineering brilliantly seizes the high ground in clarity and authority. He promotes a "way of solving problems using financial securities and their derivatives" and absolutely succeeds in sharing the thinking process of a financial engineer.
The book's essence is to illustrate the financial engineer's modus operandi: the deconstruction of a complex instrument into its synthetic equivalent, a replicating portfolio of simpler building block instruments, that mimics the instrument's economics (cash flows and risk). By the end, you will see financial instruments as combinations of basic positions.
His favor to the reader is heavy use of cash flow diagrams. Initially, I thought these would be tedious; but I soon become convinced these are extremely useful frameworks.
For example, take a credit default swap (CDS). Neftci "solves" for the CDS cash flows sequence by combining the cash flows (literally combining cash flow diagrams) of three other instruments, so we can see exactly how a bond is synthetically replicated:
* Long risky bond = Short CDS (sell protection) + make default-free LIBOR-based money market deposit + receive-fixed in an interest rate swap, or
* Short CDS = Long a risky bond + borrow at money market rate + pay-fixed in an interest rate swap
So, the "replicated" short CDS position (selling protection) works as follows. Funds to purchase the risky bond are borrowed at LIBOR floating; coupons are received from the bond. Most of the risky bond coupon goes to pay the fixed-rate on the interest rate swap. The received LIBOR coupon on the swap exactly funds the interest rate on the borrowed funds. Which leaves the remainder of the risky bond coupon; i.e., the swap spread. And, under this simple model, the credit spread over the swap rate should equal the CDS premium.
My favorite parts of the book:
Chapter 2 is useful review of market conventions; e.g., different yields
Chapter 4 put swaps at the center of financial engineering: he shows how swaps are a "the equivalent of zero in finance" and how a swap can be deconstructed from virtually any cash instrument.
His approach perfectly lends itself to viewing options as volatility instruments (Chapter 8). Not new per se, but it finds an intuitive explanation under his method: a delta-neutral portfolio consists of a long (funded) call plus a short position in the underlying stock (of delta units), such that any volatility produces a profit. The long call is long volatility.
Chapter 10 reviews exotic options, but as you'd expect, exotics are brilliantly displayed with their synthetic equivalents; e.g., a binary call is replicated by a long call plus a short call with higher strike price.
Theory on risk neutral probabilities with applications
Entire chapter on volatility positions (i.e., portfolios that isolate on volatility as the risk factor)
Additional material (from the first edition) on credit markets, CDS, structured products, credit indices and correlation pricing
Finally, the other rare achievement of this book is that it adresses several levels of proficiency. There is something for everbody, from the beginner to the advanced engineer. Few finance books actually pull this off.
Summary: If you have one book at work, this one should be it
I've read of few books about financial products and their application, but this one is by far the best. The author's intent is to share his knowledge, rather than show it off. This title has served as a very helpful starting point quite a few times, especially when I have to get something done in a hurry.
I bought a number of copies over the years to give them to colleagues - especially those new to the financial industry. The explanations and derivations can be followed by mortals - the author does not leave out big chunks of the explanation using the old "as it can EASILY be shown". Instead, he tells the whole story to build a solid understanding of the subject matter.
Summary: great resource
Does anyone know if there is an errata available for the recent second edition yet? Neftcis' website has a preprint errata from 2004.
Summary: great book
Prof. Neftci gave one of our mandatory course - Financial Engineering, in HEC Lausanne. This book is the reference book for this course. His lecture is great, a lot of jokes and funny stories as well as insights about financial engineering. However, I find out that the book is even better than his lecture.
Summary: Simply a must own for anyone with any use for Quant Finance
Neftci is one of those rare authors who can begin at the begining, explain his major point and logic without excessive jargon or short-cuts, and do so without sacrificing depth and substance.
In a field were the readable texts are for MBAs or elementary practioneers or for the initiated members of the priesthood, here is one of a few handful of authors (Wilmott and Joshi as well) that are both clear and serious, rigorous and accessible, insightful and a plerasure to read.
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