AUTHOR: Don M.

Chance TITLE: Research Trends in Derivatives and Risk Management Since Black-Scholes SOURCE: Journal of Portfolio Management special issue 35-46 My '99 (C) Institutional Investor, Inc. (1999); Tel: +44-171-779-8999; www.euromoneyplc.com; a) users of this Licensed Information are prohibited from redistributing this information by posting it on a company intranet or other local area network or other electronic means; (b) Licensed Information shall be used for customer's internal business use only; (c) a maximum of ten (10) hard copy print-outs may be made of the Licensed Information; and (d) any further copying or transmission of the Licensed Information without the express permission of the Licensor.

Some day someone will write a lengthy history of twentieth-century finance. Significant dates will be noted and great achievements cited. In these waning months until the millennium, it is not difficult to step back and think about the events that would receive the most attention, events that have had the greatest influence on the practice of finance. Among these events is surely the development and publication of the Black-Scholes model in 1973.(FN1) Although financial archeologists have traced the origins of this model to the seminal work of Bachelier [1900] and the extensions of Sprenkle [1962], Boness [1964], and Samuelson [1967], it is clearly the insights provided by Black and Scholes as well as Merton [1973] that furnished the breakthrough that would create and revolutionize an industry. The key ingredient is well known to be the notion that an option can be perfectly hedged with a unit of the underlying asset. In so doing, one forms a risk-free position with a return over an instantaneous time interval equal to the risk-free rate. This must be so, for if it were not, investors could buy and hedge underpriced options or sell and hedge overpriced options, thereby eliminating market risk and earning a riskless profit in excess of the riskfree rate. Such transactions are appropriately known as arbitrage. This collective buying and selling leads to the condition that if we know all necessary parameter values, we can solve for the option price. In the base case of a Black-Scholes option, the formula is quite simple. Moreover, the model is broadly applicable, lending its analytic beauty and profound insights to a wide range of financial relationships. The publication of the original Black-Scholes article coincided with the opening of the Chicago Board Options Exchange (CBOE), the first retail-oriented market for the trading of standardized options. An outgrowth of Chicago's commodity futures markets, the CBOE was instrumental in generating the public acceptance that brought options trading into its own as a legitimate investment device. Stimulated by the model and aided by the efforts of the options and futures exchanges, academics began teaching and researching options and derivatives. For approximately the next fifteen to twenty years, universities began generating theoretical and empirical studies on options and derivatives. Wall Street began paying attention like it never had before. Professors began leaving academia and working for Wall Street firms, and soon serious intellectual research began to flow even out of Wall Street. Scholarly research in finance had produced modern portfolio theory, which had been embraced by Wall Street. Nonetheless, the reception of academics and the practical value

of what in academia was considered theory gave derivatives research a place in financial history never before seen. Soon Wall Street institutions began hiring not only finance and economics academics but also mathematicians, physicists, and computer scientists to help them develop and market new products. Their findings and the continuing research output from Wall Street firms and academics form a rapidly expanding body of knowledge in derivatives and risk management. The research described here is referred to by many academics as "theory." To practitioners in derivatives and risk management, "theory" is the body of knowledge that they apply to solve real-world problems. Academics often distinguish theoretical research from empirical research, with the latter often thought of as the more applied subject. Yet nowhere in the world of finance are theory and practice more inextricably entwined. Moreover, empirical research, while helpful in testing such tools as option pricing models, is restricted to exchange-listed derivatives, which are almost exclusively the source of derivatives price data.(FN2) In the first fifteen years following the Black-Scholes model, it is probably safe to say that theoretical and empirical research was evenly distributed.(FN3) In the last ten years, however, theoretical research outnumbers empirical research probably by a factor of twenty to one. That practitioners have so widely embraced this body of theoretical research attests to the extraordinary insights and practical implications of it. This article provides a brief overview of research trends in derivatives and risk management in the period following Black-Scholes. It is not a survey of the literature, although many articles are cited. I do refer to classic papers, papers that survey the literature, and papers that are particularly appealing to practitioners. In most cases, there are many papers on a subject, and my preference is to cite one of the more recent works, a particularly classic paper, or one that does a good job in surveying alternative works. I no doubt overlook many outstanding references, and my apologies go to those authors.(FN4) For reasons of space, the coverage of each topic is brief and does not provide full definitions and examples. Although derivatives material is notoriously variable in the requisite level of mathematical skills, this article uses no mathematics. It is aimed at the typical JPM reader, a portfolio manager with a solid understanding of equity and fixedincome markets, but with no special expertise in derivatives. Its objective is to provide a general overview of the research and to point the reader in appropriate directions for learning more about a topic.

THE BINOMIAL MODEL It is not possible to talk about the Black-Scholes model without considering the parallel development of its sister, the binomial model. Although the binomial model's origins are not as well known, it is often traced to a textbook by later-to-be Nobel Laureate William Sharpe in 1978. The binomial model nicely illustrates, using an asset with only two possible future prices, how an option is combined with the asset to form a risk-free hedge, leading to a procedure for obtaining the option price. It is considered a discrete-time model, allowing trading only at finite time intervals. The model is more fully developed by Cox, Ross, and Rubinstein [1979] and Rendleman and Bartter [1979]. Both these articles show that as the life of an option is split into an increasing number of smaller and smaller time intervals, the option price obtained from the binomial procedure converges to the Black-Scholes price. Indeed the Black-Scholes and

the binomial models are not merely sisters; they are twin sisters, simply wearing different clothes.

ARBITRAGE, RISK NEUTRALITY, AND MARTINGALES One of the insights obtained from the binomial and Black-Scholes models is that derivatives can be priced using a risk-neutral approach. Risk neutrality, anathema to modern portfolio theory, is the notion that investors do not care about risk and are content to price a risky asset as the expected payoff of the asset discounted at the risk-free rate. Unfortunately, much of the research on derivatives has left the impression that the use of risk neutrality is equivalent to the assumption of risk neutrality. Derivatives researchers, however, do not assume risk neutrality. They accept that 1) the prices of underlying assets are determined in a fair market and are observable, along with other necessary parameters such as volatility or interest rates, and 2) arbitrage opportunities do not exist. The pioneering work of Harrison and Kreps [1979] and Harrison and Pliska [1981], though replete with complex mathematical results, builds on those assumptions and formally demonstrates that the prices of all assets, suitably discounted at the risk-free interest rate, follow a martingale, which is a random variable whose value is not expected to change. Harrison-Kreps and Harrison-Pliska show that the conditions of no-arbitrage and a martingale process are one and the same.(FN5) To take expectations, however, one is required to assign probabilities to future events. Obtaining the actual probabilities of future asset prices is difficult, but fortunately the procedure does not require actual probabilities. It requires only the probabilities that would exist if the expected return on the asset is the riskfree rate. This is because the asset price discounted at the risk-free rate is the martingale. This is essentially the same as saying that the current asset price is consistent with a world in which artificial probabilities have been chosen so that the expected future price, discounted at the risk-free rate, is the current asset price. Thus, without knowing the actual probabilities or expected returns, one can treat all assets or derivatives as though the expected return is the risk-free rate. That this process appears the same as assuming that investors are risk-neutral has led to it being referred to as risk-neutral pricing. No more appropriate but somewhat less misleading terminology is to call it martingale pricing. There is a body of mathematical literature that identifies the conditions under which the substitution of a new set of probabilities is appropriate. Many specialists in this area of mathematics have made the transition into finance.

VARIATIONS, EXTENSIONS, AND GENERALIZATIONS OF BLACK-SCHOLES The Black-Scholes model in its basic form applies to European options on non-dividendpaying stock. In most actual options, those restrictions are not upheld. Black himself [1975] shows that European options on dividend-paying stocks can be easily priced if it can be assumed that the dividends over the life of the option are known. One then simply subtracts the present value of the dividends over the option's life from the stock price and inserts this adjusted option price into the Black-Scholes formula. Merton [1973] shows that if dividends can be expressed as a continuously compounded yield, one can first discount the stock price at the yield rate, and then insert the discounted stock price into the Black-Scholes formula.

The Merton continuous-yield case provides a framework within which one can price options on foreign currency. The continuous yield can be replaced with the foreign interest rate; the underlying asset price is the exchange rate; and the volatility represents the volatility of the exchange rate. The ensuing formula correctly prices a European option on a foreign currency. This version of the Black-Scholes model that applies to foreign currency options is commonly referred to as the Garman-Kohlhagen [1983] model. In the first decade following publication of the Black-Scholes model, there were several key extensions and generalizations. William Margrabe [1978] developed a model for pricing the right to exchange one asset for another. This instrument, called an exchange option, did not actually exist in options markets, but is easily seen to be a more general version of the Black-Scholes model, which is just an option to exchange one asset, cash, for another asset, the underlying asset. Robert Geske [1979b] developed a model for pricing options on options. In other words, not only is the derivative itself an option, but the underlying asset also is not a traditional asset at all, but rather an option. This instrument, which Geske dubs a compound option, did not yet exist in options markets, at least not in the form described by Geske. Yet as Black and Scholes had argued in their original paper, common stock itself is an option on the assets of the firm written by its creditors. Thus, an option on the stock of a levered firm is a compound option. More important, however, the compound option formula paved the way for pricing other kinds of options. For example, one particularly difficult problem is the pricing of an American option. For American calls on dividend-paying stocks, it is well known that early exercise can occur shortly before the stock goes ex-dividend. Roll [1977], using the Geske model, shows that a closed-form solution for an American call can be obtained. Subsequent refinements by Geske [1979a] and Whaley [1981] have led to reference to that formula as the Roll-GeskeWhaley model. Because an American put can rationally be exercised at any time, a closed-form solution for this type of option proved more elusive. Numerical techniques, which we cover later, can price almost any type of American option, but are traditionally slow. Geske and Johnson [1984] found the closed-form solution as a series of compound options, complicated somewhat by the fact that it contains an infinite number of terms. For more recent developments in pricing American options using numerical methods, see AitSahlia and Carr [1997]. Another major development came with the publication of stulz's [1982] paper on pricing options on the maximum or minimum of two risky assets. The payoff of this type of option is determined by which of two assets has the greater or lesser value at the option's expiration. When that asset is identified at expiration, the option then pays off like an ordinary call or put on that asset. Options of this sort did not exist at that time, but certain other instruments were similar to this type of option. Less than ten years later, however, options of this type did begin to be traded. Some investment managers, for example, are more attracted to the possibility of buying a call option on the better-performing of two market indexes than buying options on the two indexes or investing directly in both markets. Two other discoveries in the early years following Black-Scholes are of note. One is the jump process model of Merton [1976]. Previous work had built on the notion that the underlying stock follows a smooth process, but it is well known that stock prices are subject to abrupt jumps. The risk associated with such jumps is difficult, if not impossible to hedge,

but Merton provides the insight that jump risk can possibly be viewed as diversifiable risk. One can thereby essentially ignore its risk premium, leading to a tractable model for pricing options with jump risk. In unpublished lecture notes, John Cox [1975] shows how to price options on stocks in which the volatility increases as the stock price decreases. This model, called the constant elasticity of variance model, is not used much today, but its significance lies in the fact that it represents the first attempt to incorporate changing volatility into option pricing models. Although buyers of exchange-listed options are protected against default by the exchange, buyers of customized options in the over-the-counter market do have to worry about writers defaulting. Johnson and Stulz [1987] provide formulas for pricing options when the writer could default at expiration. Rich [1996] shows how the Black-Scholes model could be modified to allow for the possibility that the writer could default on other debts and declare bankruptcy prior to expiration.

FORWARD AND FUTURES PRICING Research on forwards and futures markets had existed for many years prior to BlackScholes. Economists had developed models for determining forward foreign exchange rates, and agricultural economists had models for pricing futures contracts. For foreign exchange forwards, the model is known by the name interest rate parity, and trading based on it is called covered interest arbitrage. It is difficult, if not impossible, to attribute this model to any one person. In futures markets, much of the early research on pricing is credited to Holbrook Working [1949, 1958], whose brilliant insights into the economics of those markets remain as influential in that area as do Black and Scholes's in the pricing of options. The Working model shows that the price of a futures contract can essentially be expressed as the price of the underlying asset, grossed up by the cost of storing the asset plus the opportunity cost of funds tied up, minus any yield on the asset. This is commonly referred to as the cost of carry model. Although requiring weaker assumptions than the Black-Scholes model, the cost of carry model is obtained if the Black-Scholes assumptions are made and one forms a risk-free hedge, solving for the implied futures price. So we see three distinct lines of research, all somewhat related but operating independently of each other. There were financial economists working on options, traditional economists working on foreign exchange forward contracts, and agricultural economists working on futures. In the early 1970s, when the era of fixed foreign exchange rates ended, the Chicago Mercantile Exchange created foreign exchange futures. This brought two of the three lines of research together. Given the similarity of forward and futures contracts and their joint similarity to options, financial economists began working on forward and futures problems. Two significant findings came from that line of research. One is the result that futures contracts and defaultfree forward contracts are distinctive instruments owing to their different cash flow patterns resulting from the daily settlement practice in futures markets (Jarrow and Oldfield [1981] and Cox-Ingersoll-Ross [1981]).

Another key finding is Black's [1976] commodity option pricing model. This formula gives the price of an option whose underlying instrument is a forward contract or, under certain assumptions, a futures contract. Black's model is easily seen as just a variation of the Black-Scholes model where the underlying is not an asset but rather a forward or futures contract on the asset.

APPROXIMATE AND NUMERICAL OPTION PRICING Many types of derivative instruments do not lend themselves to closed-form solutions.(FN6) When that occurs, an alternative is usually sought. The problem of pricing an American put is a good example. Before development of the Geske-Johnson model, there were known to be several ways to estimate the price of an American put. One method is to use the binomial model, an accurate albeit somewhat slow approach. Schwartz [1977] shows that the finite difference methodology, used in mathematics to solve differential equations, could be applied to obtain option prices. While binomial methods allow the underlying stock to move to one of two possible future values and spread out in a multiperiod framework in the form of a sequence of steps that looks like a tree, finite difference methods form a rectangular grid and are essentially equivalent to a trinomial, or three-outcome, model. Particularly noteworthy papers on the finite difference approach are Brennan and Schwartz [1978] and Geske and Shastri [1985]. It is accepted in mathematics that any well-behaved function can be approximated with a polynomial equation.(FN7) An approximation formula was developed for American puts (Johnson [1983]), but it proved to be somewhat inaccurate for certain ranges of input values. One of the more promising approximations was developed by Macmillan [1986] and advanced by Barone-Adesi and Whaley [1987]. This formula is based on the notion of approximating the differential equation and obtaining a solution for the approximation. Although it has its limitations for certain ranges of input values, the model has been widely used, especially with options on futures. In the Geske-Johnson [1984] closed-form solution for the American put price, the formula has an infinite number of terms. Using a mathematical technique called Richardson extrapolation, Geske and Johnson obtained an approximation for this formula. This approach proved quite promising since, as they argue, an approximation to an exact solution is better than an exact solution of an approximation. In recent years, however, approximation methods have been less favored, primarily due to increased computing power, which tends to make numerical methods more attractive. Boyle [1977] introduced Monte Carlo simulation into the world of options. Monte Carlo simulation has been known for many years and is widely used in business and military decision-making. In pricing options, one creates thousands of random outcomes representing possible prices of the underlying asset with the same relative frequency as in reality; determines the value of the option at expiration for each of the simulated outcomes; and discounts the average payoff to the present using the risk-free rate. Monte Carlo techniques draw considerable attention today because they can be used to accurately price many complex instruments. Researchers are now focusing on perfecting Monte Carlo techniques. See, e.g., Newton [1997], Lehoczky [1997], and Paskov [1997]. Recent advances in other numerical methods have also attracted much attention. See Broadie and Detemple [1997].

EXOTIC OPTIONS The need for better computational techniques was at least partially stimulated by the demand for it. Wall Street firms turned on the creativity of their high-powered researchers and began to develop a new family of highly complex instruments that required sophisticated mathematical formulas and computations. This group of options has been casually referred to as exotic options.(FN8) One family of exotics, called barrier options, is designed so that if the underlying or any specified asset hits a certain level, called the barrier, the option either terminates or activates, whichever is specified in the contract. In the former case, the option is referred to as an out-option. In the latter case, the option is an inoption, in which case the barrier must be hit in order for the option to start. If the barrier is not hit before expiration, the option expires with no value. In some cases, a cash rebate is paid if an out-option terminates early or an in-option fails to activate. Barrier options have been analyzed in Rich [1994], and good survey articles are Berger [1996] and Heynen and Kat [1997a]. Another group of exotic options is called Asian options. They provide a payoff based not on the underlying asset price at expiration, but on the average price of the underlying over a specified period of time. This effectively reduces the tendency of unusual volatility at expiration to distort the option payoff. Unfortunately, the mathematics of Asian option pricing are quite difficult, rendering it impossible to obtain a closed-form pricing formula, and challenging even numerical methods with obtaining a price within reasonable time constraints. Good reviews of Asian option research are found in Vorst [1996] and Levy [1997]. Look-back options are in some sense the money manager's ideal device. They permit the holder to buy the underlying at the lowest price or sell at the highest price (or both) during the option's life, thereby guaranteeing optimal market timing. Formulas for look-backs have been developed, and good references are Heynen and Kat [1997b]. Many look-back (and also barrier) options, however, are based only on monitoring the daily closing price for purposes of determining the high, the low, or whether the underlying has hit the barrier. This causes problems with standard formulas and necessitates the use of efficient numerical methods. There are many other exotic options. Two excellent sources of information on exotic options are Clewlow and Strickland [1997] and Nelken [1996].

VOLATILITY In nearly all option pricing models, the most critical variable is the volatility of the underlying. Most options are highly sensitive to the volatility, which is an unobservable variable. To obtain an option price, one must estimate the volatility, typically starting with an estimate over a recent historical time period. If the estimate is a good one, it would serve well as a forecast of future volatility. Sophisticated estimation techniques have been used, highlighted in particular by autoregressive models and the family of models called ARCH (autoregressive conditional heteroscedasticity) and GARCH (generalized ARCH) that has gained increasing use in a variety of financial and economic applications. See Duan [1995] for an example of a GARCH-based option pricing model.

One of the more important concepts in option pricing is that of implied volatility, which is the volatility that when inserted into an option pricing model produces a price equal to the current market price. Two critical issues are associated with implied volatility. One is its estimation, and the other is its predictive ability. A good reference on implied volatility is Mayhew [1995]. Tests of the predictive ability of implied volatility are found in Beckers [1981] and Canina and Figlewski [1993]. The results are mixed. It is not really clear whether implied volatility does a good job of predicting actual volatility. Most option pricing models are based on the assumption that volatility does not change, although we know that it does. Indeed, volatility is a random variable itself and is often referred to as stochastic volatility. If volatility itself is risky, then incorporating it into an option pricing model requires that one be able to hedge the volatility risk. Technically it is not possible to hedge volatility risk, although derivative contracts where the underlying is volatility have been designed for this purpose. (See Whaley [1993].) Some recent research on stochastic volatility is found in Ball and Roma [1994]. One of the more perplexing phenomena in option markets is the behavior of volatility across time and across exercise prices for options on a given underlying. The difference in volatility by expirations is referred to as the term structure of volatility. The difference in volatilities for options on the same underlying with the same expiration and different exercise prices is referred to as the volatility smile, which describes the u-shaped plot of implied volatility versus exercise price, with high volatilities associated with high and low exercise prices and low volatilities associated with exercise prices near the current market price. The smile is a well-documented empirical phenomenon, but leads to the inconsistent conclusion that the underlying asset has more than one volatility! Much research has focused on improving option pricing models to allow an accounting for unusual volatility patterns, although one must admit that the models cannot truly be correct if there is more than one volatility. The more notable research in this area is Rubinstein [1994], Dupire [1994], and Derman and Kani [1994].

TRADING AND HEDGING ISSUES A significant body of research, usually conducted by microeconomists, has developed models that explain how and why firms hedge. Such models incorporate hedging as an active decision variable in an environment in which firms acquire resources, enter into production processes, and generate output, all under conditions of uncertainty. Some classic papers focusing on the use of futures are Johnson [1960], Stein [1961], Feder, Just, and Schmitz [1980], and Marcus and Modest [1984]. Detemple and Adler [1988] add options as a hedging tool. These papers generally find that utility-maximizing firms make production decisions first and then decide what to hedge. The hedging decision reflects a part speculation, part risk reduction, motive. More recently, Brown and Toft [1998] investigate the benefits of certain types of derivatives in optimal hedging strategies. A more fundamental question, though, is whether firms should hedge or practice risk management in general. This has led to a series of papers showing that there are transaction cost, tax, agency cost, strategic, and marketing reasons to hedge. See Froot, Scharfstein, and Stein [1993] for an example of this literature. The theory of option pricing assumes that trading can occur continuously, which requires the condition of no transaction costs. Obviously such an assumption is violated in practice. With any transaction costs, trading continuously leads to infinite costs. With discrete-time

trading, the effects of transaction costs will show up in option pricing formulas and in designing optimal trading rules. In recent years, a distinct line of research has emerged that focuses on these problems. The classic paper that stimulated this line of work is Leland [1985], but research in this area is proceeding at a rapid pace. In a similar vein, a body of research has examined the effects on derivatives pricing and trading of other market imperfections, such as short sales restrictions and different borrowing and lending rates. This work is nicely summarized in Chapter 4 of Musiela and Rutkowski [1997]. All the research covered in this section represents a significant move toward bringing the real world of discrete trading, transaction costs, and market imperfections a step closer to the theoretical models. It further underscores the practical relevance of much of the research in this area.

TERM STRUCTURE MODELING AND BOND AND INTEREST RATE DERIVATIVES The enormous market for derivatives based on interest rates has led to a tremendous body of research on modeling the term structure and pricing derivatives on bonds and interest rates.(FN9) Many of the major advances in option pricing theory and estimation in general have come from this arena. There are two primary families of models of the term structure. One is the family of general equilibrium models, headed by the Cox-Ingersoll-Ross [1985] model and including the Vasicek [1977] model. Focusing on the CIR model, we observe that the model produces the term structure as an output to a process in which consumers optimize their utility, leading to equilibrium in the economy: hence the name, general equilibrium. Both CIR and Vasicek, thus, tell us what the term structure should be. All instruments are correctly priced with respect to each other, and no arbitrage profits can be earned by trading one instrument against another. General equilibrium models are internally arbitrage-free and provide formulas for all instruments. General equilibrium models, however, have a major limitation: They are not guaranteed to match the actual current term structure. Thus, their prices and rates do not correspond to those actually prevailing in the market. Consequently, it is possible that users of general equilibrium models could suffer arbitrage losses to parties whose models do fit the current term structure. Thus, general equilibrium models are not externally arbitrage-free. Another class of models, called arbitrage-free models, are both internally and externally arbitrage-free. Their model prices match market prices and permit no theoretical or actual arbitrage opportunities. While general equilibrium models make more assumptions about the factors that determine prices and rates in the economy, and provide more information about the processes that determine interest rates and the term structure, arbitrage-free models provide little if any of these insights. They simply take the current term structure and the volatility of interest rates and assume that this is all the information we need to know. That is indeed true if the objective is to price and trade bonds and interest rate derivatives according to the current term structure. Spot rate models are based on the notion that the term structure is driven by a short-term interest rate, called the spot rate. Interestingly, the Cox-Ingersoll-Ross and Vasicek models also belong in this class. It is possible to alter these models so that they do fit the current term structure. This is the primary contribution of the work of Hull and White [1990], who

show how to fit such models to the term structure and how to price a variety of interest rate derivatives, primarily obtaining their calculated values using a trinomial tree. Two other notable and widely used spot rate models are Black, Derman, and Toy [1990] and Black and Karasinski [1991], which are based on the evolution of the logarithm of the spot rate. Modeling the logarithm removes a common problem in the Vasicek model, which is that the interest rate can become negative. Probably the most significant development in term structure modeling and interest rate derivative pricing was the publication in 1986 of the Ho-Lee model. Ho and Lee's approach starts with the current term structure and allows it to shift to one of two possible new states, making it a binomial tree. They then force the model to be internally arbitrage-free and model the evolution of the term structure. The Ho-Lee model is the first binomial model of the term structure and the first model to allow the entire term structure to evolve. It suffers, however, from the fact that it can permit negative interest rates, implicitly assumes a constant volatility of forward interest rates, and permits the entire term structure to be driven by only one source of uncertainty. This last point causes the model to be referred to as a one-factor model. Heath, Jarrow, and Morton [1990a, 1990b, 1992] generalize the Ho-Lee model to allow for multiple factors and a more complex and flexible structure of the volatilities of forward rates. The Heath-Jarrow-Morton (HJM) model is also the first model to describe the evolution of the term structure entirely in terms of forward, rather than spot, rates. They argue that modeling forward rates is preferable, because the structure of forward rate volatility can be more consistent and easier to estimate, while spot rate volatilities must capture the complex behavior of bond prices as maturity approaches. Modeling forward rates automatically avoids this problem. Unfortunately, the HJM model does not avoid the negative interest rate problem, although there are some methods to minimize its consequences. The multifactor version of the HJM model can be quite difficult to implement, and generally requires a tree with at least three outcomes. An excellent and highly readable reference on the HJM framework is Jarrow [1996]. Many of these models must be computed using numerical methods, specifically, binomial and trinomial trees. This has led to a great deal of research on the use of such methods to solve these types of problems. See, e.g., Hull and White [1994a, 1994b, 1996]. The developers of these and other interest rate models have not only published their work widely throughout the literature, but have also written software and sold their models to Wall Street firms. Surprisingly, however, many firms use a very basic version of the Black-Scholes model to price many interest rate derivatives, having determined that although such a model does not fit the current term structure, it does provide prices that are close to the prices of more complex models and does so with fewer requirements and constraints. An excellent reference on models of the term structure and interest rate derivatives is Ho [1995].

APPLICATIONS OF DERIVATIVES TO VALUE OTHER FINANCIAL INSTRUMENTS AND CONTRACTS

Option pricing theory has provided a rich framework for valuing many types of financial instruments and contracts. Equity itself can be valued as an option on the assets of a firm granted by the creditors. Options can also be used to understand the valuation effects of mergers, the cost of deposit insurance, the value of loan guarantees and revolving credit, and the pricing of instruments like dual-purpose bonds, mortgage-backed securities, and delivery options associated with futures contracts.(FN10) One particularly fruitful area of research is in the valuation of real options. A real option is an implied option imbedded in an investment decision. For example, when a company develops a project, the project often incorporates options to continue, abandon, expand, or contract. These options are highly valuable, as they permit the flexibility necessary to adapt to changing circumstances. The application of modern option pricing theory to such problems has gained increasing attention in recent years. See, for example, the work of Kemna [1993] and Trigeorgis [1993].

CURRENT TRENDS AND DIRECTIONS While research on the creation, pricing, and hedging of new derivative instruments continues to occupy the attention of many researchers, new topics with important contemporary implications have emerged. There is a great deal of emphasis on capital regulation of banks. The growth of emerging markets and instruments creates new and interesting problems in that their markets are often fairly illiquid and particularly unstable. With many derivative instruments based on more than one underlying asset, the effect of uncertainty in the correlation between asset returns poses challenging problems for pricing and trading such derivatives. Probably no topic has drawn more attention than value at risk (VaR). VaR is the minimum loss that one expects to incur a certain percentage of the time. For example, a VaR of $1 million over one day at 5% means that the firm expects to lose a minimum of $1 million on 5% of the days. VaR is consequently just a reading from the tail of the probability distribution of returns on a portfolio. Its estimation and use thus takes advantage of a large body of finance literature on portfolio theory and management. The limitations of VaR are receiving as much attention as its strengths, and spirited debates frequently appear. A good summary of the research on VaR is Dowd [1998]. Another trend in contemporary research on derivatives is the focus on credit analysis, pricing, and the development of credit derivatives. Until the widespread use of derivatives, credit analysis was largely a subjective process, which simply involved the checking of standard financial ratios and in some cases using credit scoring models. In recent years, however, the derivatives industry has begun to be concerned about the credit risk associated with derivatives transactions, and has turned its attention to the development of more rigorous scientific methods of credit analysis. One extremely fruitful product of this research has been the development of credit derivative contracts, which are options, forwards, and swaps that pay off depending on whether a credit event, such as a ratings downgrade or bankruptcy, has occurred. As credit models become more sophisticated and firms place further emphasis on centralized firmwide risk management, loan pricing and management will benefit from the progress of derivatives researchers. Finally, a recent line of research has begun working on operational risk management. By this we mean the management of the risks associated with losses that occur when systems

break down, policies are inadequate, or technology or personnel fail. These problems are particularly challenging because they, fortunately, occur so rarely that their probability distributions are difficult to construct. When or if such events occur, though, the losses can be quite large. Researchers are devoting a great deal of time and effort to better understand the statistical properties of these rare events.

CONCLUSIONS The research in derivatives and risk management since the publication of the original Black-Scholes article has produced enormous advances in a comparatively short period of time. The Nobel committee recognized this in awarding the 1997 price in economics to Robert Merton and Myron Scholes with posthumous recognition to Fischer Black. But just as significant is the fact that much of the cutting edge research is coming from Wall Street firms, which have invested heavily in hardware, software, and personnel. Moreover, there are practical implications in almost every piece of research on derivatives and risk management, regardless of where it was produced. Thus it has been a blissful marriage of the more abstract academic theoretical research and the applied focus of practitioners, quite unlike anything ever witnessed in finance or economics. And this marriage gets stronger every day. ADDED MATERIAL DON M. CHANCE is First Union professor of financial risk management at the Pamplin College of Business at Virginia Tech in Blacksburg (VA 24061-0221).

FOOTNOTES 1 The original article presenting the model, Black and Scholes [1973], was published after the article in which they provided empirical tests of the model (Black and Scholes [1972]). The reason for this and the story behind it are nicely told by Black himself [1989]. 2 Because of the private and unreported nature of the transactions, customized, i.e., OTC derivatives do not usually generate the data necessary to undertake empirical research. 3 For a review of the empirical research until 1983, which covers most of the works testing the Black-Scholes option pricing models, see Galai [1983]. See also Phillips and Smith [1980] for a discussion of the effect of transaction costs on the testing of option pricing models and market efficiency. 4 Two excellent surveys of this literature that have been superseded by subsequent work are Smith [1976] and Cox and Rubinstein [1983]. An excellent and unusually comprehensive, albeit mathematically complex, book is Musiela and Rutkowski [1997]. See also Chriss [1997] for an unusually exhaustive treatment of the Black-Scholes model. An excellent pair of articles that organize option pricing models into a family tree are Smithson [1995a, 1995b].

5 A martingale is a term used to describe the evolution of a random variable through time with the property that the expected change in the random variable is zero. In other words, the value of the variable is not expected to change. 6 A closed-form solution is a formula in which the value one is interested in obtaining is isolated on one side of an equation or can be otherwise easily obtained. Technically, closed-form solutions can be given in very complex forms so that computing the value requires sophisticated and sometimes approximation methods. In the option pricing literature, the term "closed-form solution" usually excludes formulas that are difficult to compute. 7 By "well-behaved," we mean that the function is continuous, and first and second derivatives exist at least over the relevant range of values. 8 There are also exotic swaps and forward contracts. 9 Henceforth, we refer to derivatives on bonds and interest rates as interest rate derivatives. 10 See the excellent set of references in Cox and Rubinstein [1985, pp. 490-491].

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