WHAT IS NEW IN THE THIRD EDITION
The reader familiar with the previous editions will find the same overall plan, but will
discover many changes. Some are small, some are major. In general:
Many examples have been updated.
. There are numerous changes to streamline and clarify exposition.
. There are connections throughout to events during the financial crisis and to the Dodd-
Frank financial reform act.
. New boxes cover Bernie Madoff, Mexico’s oil hedge, oil arbitrage, LIBOR during
the financial crisis, Islamic finance, Bank capital, Google and compensation options,
Abacus and Magnetar, and other topics.
Several chapters have also been extensively revised:
. Chapter 1 has a new discussion of clearing and the organization and measurement of
markets.
. The chapter on commodities, Chapter 6, has been reorganized. There is a new introductory
discussion and overview of differences between commodities and financial
assets, a discussion of commodity arbitrage using copper, a discussion of commodity
indices, and boxes on tanker-based oil-market arbitrage and illegal futures contracts.
. Chapter 15 has a revamped discussion of structures, a new discussion of reverse
convertibles, and a new discussion of tranching.
. Chapter 25 has been heavily revised. There is a discussion of the taxonomy of fixed
income models, distinguishing short-rate models and market models. New sections
on the Hull-White and LIBOR market models have been added.
. Chapter 27 also has been heavily revised. One of the most important structuring
issues highlighted by the financial crisis is the behavior of tranched claims that are
themselves based on tranched claims. Many collateralized debt obligations satisfy
this description, as do so-called CDO-squared contracts. There is a section on CDOsquareds
and a box on Goldman Sach’s Abacus transaction and the hedge fund
Magnetar. The 2009 standardization of CDS contracts is discussed.
Finally, Chapter 22 is new in this edition, focusing on the martingale approach
to pricing derivatives. The chapter explains the important connection between investor
portfolio decisions and derivatives pricing models. In this context, it provides the rationale
for risk-neutral pricing and for different classes of fixed income pricing models. The chapter
discussesWarren Buffett’s critique of the Black-Scholes put pricing formula. You can skip
this chapter and still understand the rest of the book, but the material in even the first few
sections will deepen your understanding of the economic underpinnings of the models.
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