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Deriving
derivatives
Faced
with a lack of appropriate texts, Kellogg Finance Professor
Robert McDonald completes a quest to develop his own
By
Janice Neumann
When Professor
Robert
McDonald was teaching an advanced derivatives class in
1994, he was struck by the paucity of texts on the subject
appropriate for gifted MBA students. Though there were books
about derivatives — the financial contracts whose values
stem from stocks or bonds, commodities or market indexes —
some were too mathematical, and others not analytical enough.
In response, McDonald,
the Erwin P. Nemmers Distinguished Professor of Finance, began
writing the text he was looking for. The resulting work, Derivatives
Markets, published last summer, takes a methodical, sophisticated
approach.
Derivatives are
so critical to finance, McDonald says, it’s difficult
to talk about investment decisions and whether firms should
issue debt or equity without an understanding of them. Derivatives
are even critical to everyday life: “You can’t
even be a homeowner anymore without understanding derivatives,”
he points out.
For example, a
homeowner who needs to heat her house might opt to pay per
unit of gas used, with the price fluctuating, or may choose
to pay a fixed dollar amount each month regardless of the
amount consumed. The plans are simply forward contracts, or
contracts that specify the price and quantity of an asset
to be purchased in the future. “If you don’t understand
derivatives, you can’t really understand where the prices
come from,” McDonald says.
MBA students should
understand the advantages and disadvantages of the types of
derivatives included in the book, he says. Call options, one
of the derivatives discussed, give the holder the right to
purchase a certain number of shares of stock or other assets
at a given price on or before the contract’s expiration
date. Put options provide a security that lets investors sell
a fixed number of shares at a fixed price within a given period.
Forward contracts specify the price and quantity of an asset
to be delivered in the future.
The book also includes
chapters on risk management, commodity forwards and futures
(similar to forwards), exotic options and financial engineering.
Through all the chapters, McDonald infuses the book with an
enthusiasm for the subject, apparent in the energetic clip
of his writing and the real-life examples he employs. When
equations are used, they elucidate material already explained.
The Black-Scholes
Formula also is covered. It’s a model for pricing equity
options that has inputs of the stock price, the exercise price
of the option, the risk-free interest rate that prevails,
the time that the option has to expiration and the expected
volatility of the stock return.
To McDonald, the
model is important because it made Wall Street more scientific.
“What Black and Scholes really did is to provide a coherent,
novel way to think about how to price an option. It revolutionized
finance, there’s no question about it,” he says.
Despite the ease
of reading, the book wasn’t easy to write, McDonald
recalls. Time and effort spent writing meant more juggling
of other priorities, such as his family, research and teaching.
“It’s brutal,” he says emphatically. “You
put a lot of things on hold.”
Still, McDonald
says it was critical for him to write the book, not only because
of the importance of the subject, but because the material
formed such an integral part of his teaching. One of his favorite
things about being a professor, he says, is sharing these
insights and his academic passion with others.
“At some
point you find yourself writing class notes, revising them
and you realize either you’d better stop it or write
a book. Or else eventually you’re just spinning your
wheels.”
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