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The Actuary The magazine of the Institute & Faculty of Actuaries

Derivatives the tools that changed finance

Phelim Boyle has worked in the field of derivatives for some years and has put his name to more than a few papers on the subject. So you might be forgiven for assuming that this book is going to be a technical guide aimed at the specialist or a detailed account of academic developments over the years. It is neither. Far from it, the father-and-son team of Phelim and Feidhlim Boyle have instead set out to bring the world of derivatives to a more general audience. No small task when one considers the ratio of fact to fiction found in typical media coverage of the subject, and the relatively low level of understanding found in the average finance worker. The Boyles should be applauded, first for attempting to demystify and defend derivatives, and second for managing to pull it off.
Minimum tricky mathematics
Throughout the book they are careful to keep formulae and tricky mathematics to an absolute minimum. That’s not to say they are guilty of dumbing down. All the important ideas are covered, but by the use of easy-to-grasp illustrations and real-life examples. The no-arbitrage principle is illustrated with a HingisWilliams tennis match. The merit of forward contracts is shown through real examples from the power generating industry. Microsoft’s management of its overseas businesses forms the basis for a discussion of currency swaps. The list goes on.
All very useful reading for the derivative novice but what’s in this book for the typical actuarial reader who (thinks he) knows the basics? He might be tempted to head straight for the later sections with such enticing titles as ‘Chapter 8: Disasters’. Here we find concise analyses of the usual derivative suspects. Nick Leeson’s sinking of Barings Bank, the rise and plummet of Long-Term Capital Management, and the bankrupting of Orange County in California are all put under the spotlight. Unsurprisingly, the conclusion drawn is that these fiascos were not caused by derivatives per se, rather they were the result of ‘star performers’ being allowed to take on ever more risky positions without proper checks being made.
The quest
Another chapter gives a fine historical account of the quest for the option pricing formula. How many actuaries are aware of the work of Frenchman Louis Bachelier? I know I wasn’t. Yet over 100 years ago he completed a thesis in which he demonstrated a clear understanding of the no-arbitrage principle and had gone some way towards arriving at an option pricing formula, only to have his work sit, untouched, in a Paris library for 50 years.
I found this book well worth a read. It’s unlikely to break new ground for most actuarial readers but then that isn’t what it’s trying to do. What it does attempt, and achieve, is an unintimidating introduction to derivatives explaining their uses, highlighting the risks, and providing plenty of background and context. Next time you hear someone say, ‘I don’t know much about derivatives, but aren’t they really dangerous?’ you could do a lot worse than recommend this book to them.
Derivatives The Tools that Changed Finance, by Dr Phelim P Boyle and Feidhlim Boyle (June 2001) Hardcover, 200pp, £20, Risk Books, ISBN 1 899332 88X
Leon Jones is an actuarial trainee working for Zurich Financial Services