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Principles of Financial Engineering (2nd Ed) by Salih Neftci

Principles of Financial Engineering (2nd Ed) by Salih Neftci 2016-07-11

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Principles of Financial Engineering by Salih Neftci
This is David's review of the 2nd Edition:
"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."
The virtue of this book is (i) is does not require advanced mathematics in most cases; the math is accessible, which is rare for this topic and (ii) it deconstructs instruments visually into their components. Here is a recent reference in regard to the deconstruction of credit default swaps (CDS), see https://www.bionicturtle.com/forum/threads/hull-23-17-cds-basis.1970/#post-43770
Hi @taunk You already got great replies, but also FYI, I just added Neftci's Financial Engineering (2nd Ed; there is a 3rd on amazon) to Resources at https://www.bionicturtle.com/forum/...ancial-engineering-2nd-ed-by-salih-neftci.18/ This has the most exact decomposition of the CDS that I've read (Chapter 16:CDS Engineering), see diagram below. The whole book is great at visual decomposition of instruments. He shows exactly how to get to:
  • Long risky bond = Short CDS (sell protection) + make default-free LIBOR-based money market deposit + receive-fixed in an interest rate swap, such that:
  • Short CDS = Long a risky bond + borrow at money market rate + pay-fixed in an interest rate swap
The latter is an exact elaboration. In simple terms, we usually say something like: Short CDS (i.e., to sell credit protection) is long the underlying reference but unfunded; aka, synthetically long the underlyling. I hope that is additive!

David Harper CFA FRM
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Has been on my 'buy' list for a long time - thanks a tonne!
Dear David

Thanks for this wonderful book, just the thing I was looking for!
David Harper CFA FRM
David Harper CFA FRM
Sure thing! I added a some additional information above (link to 3rd edition on Amazon and link to the CDS thread referencing the book)