Explaining Derivatives and the Complex Securities at the Heart of the Financial Crisis

Equities Staff |

Robert Jarrow Publishes an Accessible Introduction to the Complex Securities at the Heart of the Financial Crisis

An Introduction to Derivative Securities, Financial Markets, and Risk Management
by Robert A. Jarrow and Arkadev Chatterjea

The cover is the first clue: this is not your usual derivatives textbook. Two eager commodities traders — a rabbit, bearing acorns, and a squirrel, bearing carrots — face off across the front of a new introductory text by Robert Jarrow and Arkadev Chatterjea ’91, PhD ’93.

“Look at the covers of the other texts in the field,” says Jarrow, the Ronald P. and Susan E Lynch Professor of Investment Management and professor of finance at Johnson. On the tomes he pulls from his shelves — some bearing his name — are towering skyscrapers, maps of the world, mathematical graphics, and dense rows of securities quotes. “They are designed to intimidate!” he says, with a laugh. “For an introductory book, why scare them off?”

Virtually all derivatives textbooks before this have been written for aspiring financial engineers, with emphasis on mathematics at the expense of context. Jarrow, one of the world’s top experts on the securities valuation and risk, and Chatterjea, a Cornell PhD in economics and Jarrow’s former student, set out to write a very different kind of book, one accessible to advanced undergraduates and first-year MBA students, but with enough depth to be useful to investment practitioners.

An Introduction to Derivative Securities, Financial Markets, and Risk Management still contains plenty of Greek-letter equations, but it also includes a rich leavening of history, current events, and practical explanations of how markets work and how businesses use derivatives to manage risks. The book’s treatment of forward sales and futures, for example, touches on their origins in ancient India, Greece, and Rome, the formalization of such markets in medieval Europe and Edo-period Japan, and the 19th-century development of the modern futures contract at the Chicago Board of Trade.

The authors stress how the evolution of derivatives was driven by the price and supply assurance needs of farmers, grain merchants, and purchasers of bulk commodities. They also convey a fundamental principle of securities valuation: To find a complex asset’s value, find a way to replicate its cash flows using a combination of simpler, more easily valued instruments. This principle underlies all the valuation and risk-management models explained in the book. Among these are cost-of-carry models for futures and forwards, the famous Black-Scholes-Merton optionpricing model, the industry-standard Heath-Jarrow-Morton models for valuation of interest-rate derivatives, and Value-at-Risk and scenario analysis.

Robert_Jarrow.jpgWhy write a book like this? Jarrow argues that the abuse of high-risk financial instruments that led to the recent crisis has led to a simplistic view of all derivatives by the general public. To most people, the term connotes the exotic securities — collateralized debt obligations (CDOs), synthetic CDOs, credit-default swaps, and so on — that brought the global financial system to its knees. Even a distinguished Cornell colleague told him, "Derivatives destroyed the world!"

“The general public’s perception that derivatives are evil obscures the crucial role they play in helping businesses manage risk,” says Jarrow. The term actually encompasses all securities whose values are derived from one or more underlying assets. These include options to sell or buy stocks or other assets, forward-sale contracts (most often for commodities), futures contracts (on commodities, stocks, bonds, and other assets), index investments, swaps, and more. Non-specialists need to understand these financial instruments, their practical uses, and how they can be abused. Most of the abuses today’s regulators confront are variations on those their counterparts faced several centuries ago in Amsterdam or London, says Chatterjea, albeit with additional complexity, scale, and speed.

Public understanding of derivatives is particularly important as governments consider how to regulate risk in the financial sector. Poorly designed regulatory measures can often end up creating more-complex problems. For example, usury laws — legal restrictions on the charging of interest — led the legendary 19th century financier Russell Sage to develop “synthetic loans,” securities that combine stock shares and options to provide cash flows equivalent to loans, to get around them. Of course, more complex securities are less transparent, and reduced transparency can obscure excessive risk.

”This book is intended to be as much about managing risk as it is about derivatives,” Jarrow says. To this subject he brings not only his work as a theorist — he is the co-developer of some of the most widely used valuation models in finance — but also his experience as a practitioner. In addition to his Johnson responsibilities, he also serves as managing director for research of Kamakura Corp., a leading global provider of risk management software, information, and consulting. In this role, he is regularly exposed to the day-to-day concerns of investment managers and CFOs. “Good risk management comes not only from good models, but from a solid understanding of their uses and limitations,” Jarrow emphasizes.

All in all, An Introduction to Derivative Securities, Financial Markets, and Risk Management is a unique, readable, and frequently entertaining primer. It is also the product of a remarkable, 15-year intercontinental collaboration — and longer friendship — between its co-authors. Starting in 1997, when the book was conceived over a meal at a now-defunct Elmira Road restaurant, the two traded ideas and manuscripts between Ithaca and the universities where Chatterjea has been based , which have included the University of Colorado, Indiana University, the Indian Institute of Management Calcutta, and the Kenan-Flagler Business School at the University of North Carolina.

Chatterjea also has returned regularly to Cornell for visiting appointments, summer teaching, and consultations with his co-author. Jarrow credits Chatterjea — who has considerable experience teaching undergraduates and introductory courses — with setting the book’s accessible, readable tone. Chatterjea, in turn, says that collaboration with one of the world’s preeminent finance scholars is what ensured its intellectual rigor. The combination is likely to command the attention of generations of business students to come.

By John E. Young

Cornell Enterprise Fall 2013


Originally published in Cornell Enterprise, the magazine of the Samuel Curtis Johnson Graduate School of Management, Fall 2013. Reprinted with permission.


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