Dynamic Hedging: Managing Vanilla and Exotic Options by Nassim Taleb

Dynamic Hedging: Managing Vanilla and Exotic Options by Nassim Taleb

I
MARKETS, INSTRUMENTS,
PEOPLE

Chapter 1

Introduction to the Instruments
Understanding a theory means (...) understanding it as an attempt to
solve a certain problem.
Sir Karl Popper
In this chapter, we will rapidly but formally define the instruments and
present their major characteristics. It is recommended that all readers,
even those knowledgeable in this area, study the following definitions,
as they will provide the framework of analysis used in the book.
DERIVATIVES
■ A derivative is a security whose price ultimately depends on that of
another asset (called underlying). There are different categories of
derivatives, ranging from something as simple as a future to
something as complex as an exotic option, with all the shades in
between.
The best way to look at derivatives is to separate them into two broad
categories: linear and nonlinear derivatives. A linear derivative is easy
to hedge and lock in completely, whereas a nonlinear one will present
serious instability and require dynamic hedging.
■ A nonlinear derivative with respect to a parameter is one that
presents a second derivative (or partial derivative with respect to that
parameter) different from 0.
The option wizard presents a graphic linear or nonlinear derivative view
of the concept of nonlinearity.

Dynamic Hedging: Managing Vanilla and Exotic Options by Nassim Taleb