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 Brief
Contents

Preface xxi
1 Introduction to Derivatives 1

PART ONE
Insurance, Hedging, and Simple Strategies 23
2 An Introduction to Forwards and Options 25
3 Insurance, Collars, and Other Strategies 61
4 Introduction to Risk Management 89

PART TWO
Forwards, Futures, and Swaps 123
5 Financial Forwards and Futures 125
6 Commodity Forwards and Futures 163
7 Interest Rate Forwards and Futures 195
8 Swaps 233

PART THREE
Options 263
9 Parity and Other Option Relationships 265
10 Binomial Option Pricing: Basic Concepts 293
11 Binomial Option Pricing: Selected Topics 323
12 The Black-Scholes Formula 349
13 Market-Making and Delta-Hedging 381
14 Exotic Options: I 409

vii
viii Brief Contents

PART FOUR
Financial Engineering and Applications 435
15 Financial Engineering and Security Design 437
16 Corporate Applications 469
17 Real Options 509

PART FIVE
Advanced Pricing Theory and Applications 543
18 The Lognormal Distribution 545
19 Monte Carlo Valuation 573
20 Brownian Motion and Itô’s Lemma 603
21 The Black-Scholes-Merton Equation 627
22 Risk-Neutral and Martingale Pricing 649
23 Exotic Options: II 683
24 Volatility 717
25 Interest Rate and Bond Derivatives 751
26 Value at Risk 789
27 Credit Risk 815
Appendix A The Greek Alphabet 851
Appendix B Continuous Compounding 853
Appendix C Jensen’s Inequality 859
Appendix D An Introduction to Visual Basic for Applications 863
Glossary 883
References 897
Index 915
Contents

Preface xxi PART ONE

Insurance, Hedging, and Simple
Chapter 1
Strategies 23
Introduction to Derivatives 1
1.1 What Is a Derivative? 2 Chapter 2
1.2 An Overview of Financial Markets 2 An Introduction to Forwards and
Trading of Financial Assets 2 Options 25
Measures of Market Size and Activity 4 2.1 Forward Contracts 25
Stock and Bond Markets 5 The Payoff on a Forward Contract 29
Derivatives Markets 6 Graphing the Payoff on a Forward
1.3 The Role of Financial Markets 9 Contract 30
Financial Markets and the Averages 9 Comparing a Forward and Outright
Risk-Sharing 10 Purchase 30
1.4 The Uses of Derivatives 11 Zero-Coupon Bonds in Payoff and Profit
Uses of Derivatives 11 Diagrams 33
Perspectives on Derivatives 13 Cash Settlement Versus Delivery 34
Financial Engineering and Security Credit Risk 34
Design 14 2.2 Call Options 35
1.5 Buying and Short-Selling Financial Option Terminology 35
Assets 14 Payoff and Profit for a Purchased Call
Transaction Costs and the Bid-Ask Option 36
Spread 14 Payoff and Profit for a Written Call
Ways to Buy or Sell 15 Option 38
Short-Selling 16 2.3 Put Options 41
The Lease Rate of an Asset 18 Payoff and Profit for a Purchased Put
Risk and Scarcity in Short-Selling 18 Option 41
Chapter Summary 20 Payoff and Profit for a Written Put
Further Reading 20 Option 42
Problems 20 The “Moneyness” of an Option 44

ix
x Contents

2.4 Summary of Forward and Option Chapter 4

Positions 45 Introduction to Risk Management 89
Positions Long with Respect to the 4.1 Basic Risk Management: The Producer’s
Index 45 Perspective 89
Positions Short with Respect to the
Hedging with a Forward Contract 90
Index 46
Insurance: Guaranteeing a Minimum Price
2.5 Options Are Insurance 47 with a Put Option 91
Homeowner’s Insurance Is a Put Insuring by Selling a Call 93
Option 48 Adjusting the Amount of Insurance 95
But I Thought Insurance Is Prudent and 4.2 Basic Risk Management: The Buyer’s
Put Options Are Risky . . . 48 Perspective 96
Call Options Are Also Insurance 49
Hedging with a Forward Contract 97
2.6 Example: Equity-Linked CDs 50 Insurance: Guaranteeing a Maximum Price
Graphing the Payoff on the CD 50 with a Call Option 97
Economics of the CD 52 4.3 Why Do Firms Manage Risk? 99
Why Equity-Linked CDs? 52
An Example Where Hedging Adds
Chapter Summary 53 Value 100
Further Reading 54 Reasons to Hedge 102
Problems 55 Reasons Not to Hedge 104
2.A More on Buying a Stock Option 57 Empirical Evidence on Hedging 104
Dividends 57 4.4 Golddiggers Revisited 107
Exercise 57 Selling the Gain: Collars 107
Margins for Written Options 58 Other Collar Strategies 111
Taxes 58 Paylater Strategies 111
4.5 Selecting the Hedge Ratio 112
Chapter 3 Cross-Hedging 112
Insurance, Collars, and Other Quantity Uncertainty 114
Strategies 61 Chapter Summary 117
3.1 Basic Insurance Strategies 61 Further Reading 118
Insuring a Long Position: Floors 61 Problems 118
Insuring a Short Position: Caps 64
Selling Insurance 66
3.2 Put-Call Parity 68
Synthetic Forwards 68 PART TWO
The Put-Call Parity Equation 70
3.3 Spreads and Collars 71 Forwards, Futures, and
Bull and Bear Spreads 71 Swaps 123
Box Spreads 73
Ratio Spreads 74
Collars 74 Chapter 5
3.4 Speculating on Volatility 79 Financial Forwards and Futures 125
Straddles 79 5.1 Alternative Ways to Buy a Stock 125
Butterfly Spreads 80 5.2 Prepaid Forward Contracts on Stock 126
Asymmetric Butterfly Spreads 82 Pricing the Prepaid Forward by
Chapter Summary 84 Analogy 127
Further Reading 86 Pricing the Prepaid Forward by Discounted
Problems 86 Present Value 127
 Contents xi

Pricing the Prepaid Forward by Differences Between Commodities and

Arbitrage 127 Financial Assets 166
Pricing Prepaid Forwards with Commodity Terminology 166
Dividends 129 6.2 Equilibrium Pricing of Commodity
5.3 Forward Contracts on Stock 131 Forwards 167
Does the Forward Price Predict the Future 6.3 Pricing Commodity Forwards by
Spot Price? 132 Arbitrage 168
Creating a Synthetic Forward An Apparent Arbitrage 168
Contract 133 Short-selling and the Lease Rate 170
Synthetic Forwards in Market-Making and No-Arbitrage Pricing Incorporating
Arbitrage 135 Storage Costs 172
No-Arbitrage Bounds with Transaction Convenience Yields 174
Costs 136 Summary 175
Quasi-Arbitrage 137 6.4 Gold 175
An Interpretation of the Forward Pricing Gold Leasing 176
Formula 138 Evaluation of Gold Production 177
5.4 Futures Contracts 138 6.5 Corn 178
The S&P 500 Futures Contract 139 6.6 Energy Markets 179
Margins and Marking to Market 140 Electricity 180
Comparing Futures and Forward Natural Gas 180
Prices 143 Oil 182
Arbitrage in Practice: S&P 500 Index Oil Distillate Spreads 184
Arbitrage 143
6.7 Hedging Strategies 185
Quanto Index Contracts 145
Basis Risk 186
5.5 Uses of Index Futures 146
Hedging Jet Fuel with Crude Oil 187
Asset Allocation 146 Weather Derivatives 188
Cross-hedging with Index Futures 147
6.8 Synthetic Commodities 189
5.6 Currency Contracts 150
Chapter Summary 191
Currency Prepaid Forward 150
Further Reading 192
Currency Forward 152
Problems 192
Covered Interest Arbitrage 152
5.7 Eurodollar Futures 153
Chapter Summary 157
Further Reading 158
Chapter 7
Problems 158 Interest Rate Forwards and
5.A Taxes and the Forward Rate 161 Futures 195
5.B Equating Forwards and Futures 162 7.1 Bond Basics 195
5.C Forward and Futures Prices 162 Zero-Coupon Bonds 196
Implied Forward Rates 197
Coupon Bonds 199
Chapter 6 Zeros from Coupons 200
Interpreting the Coupon Rate 201
Commodity Forwards and Continuously Compounded Yields 202
Futures 163 7.2 Forward Rate Agreements, Eurodollar
6.1 Introduction to Commodity Futures, and Hedging 202
Forwards 164 Forward Rate Agreements 203
Examples of Commodity Futures Synthetic FRAs 204
Prices 164 Eurodollar Futures 206
xii Contents

7.3 Duration and Convexity 211 PART THREE

Price Value of a Basis Point and DV01 211
Duration 213 Options 263
Duration Matching 214
Convexity 215
7.4 Treasury-Bond and Treasury-Note Chapter 9
Futures 217 Parity and Other Option
7.5 Repurchase Agreements 220 Relationships 265
Chapter Summary 222 9.1 Put-Call Parity 265
Further Reading 224 Options on Stocks 266
Problems 225 Options on Currencies 269
7.A Interest Rate and Bond Price Options on Bonds 269
Conventions 228 Dividend Forward Contracts 269
Bonds 228 9.2 Generalized Parity and Exchange
Bills 230 Options 270
Options to Exchange Stock 272
What Are Calls and Puts? 272
Chapter 8 Currency Options 273
Swaps 233 9.3 Comparing Options with Respect to Style,
8.1 An Example of a Commodity Swap 233 Maturity, and Strike 275
Physical Versus Financial Settlement 234 European Versus American Options 276
Why Is the Swap Price Not $110.50? 236 Maximum and Minimum Option
The Swap Counterparty 237 Prices 276
The Market Value of a Swap 238 Early Exercise for American Options 277
8.2 Computing the Swap Rate in General 240 Time to Expiration 280
Fixed Quantity Swaps 240 Different Strike Prices 281
Swaps with Variable Quantity and Exercise and Moneyness 286
Price 241 Chapter Summary 286
8.3 Interest Rate Swaps 243 Further Reading 287
A Simple Interest Rate Swap 243 Problems 288
Pricing and the Swap Counterparty 244 9.A Parity Bounds for American Options 291
Swap Rate and Bond Calculations 246 9.B Algebraic Proofs of Strike-Price
The Swap Curve 247 Relations 292
The Swap’s Implicit Loan Balance 248
Deferred Swaps 249
Related Swaps 250 Chapter 10
Why Swap Interest Rates? 251 Binomial Option Pricing: Basic
Amortizing and Accreting Swaps 252 Concepts 293
8.4 Currency Swaps 252 10.1 A One-Period Binomial Tree 293
Currency Swap Formulas 255 Computing the Option Price 294
Other Currency Swaps 256 The Binomial Solution 295
8.5 Swaptions 256 Arbitraging a Mispriced Option 297
8.6 Total Return Swaps 257 A Graphical Interpretation of the Binomial
Chapter Summary 259 Formula 298
Further Reading 260 Risk-Neutral Pricing 299
Problems 261 10.2 Constructing a Binomial Tree 300

Continuously Compounded Returns 301
Volatility 302
Constructing u and d 303
Estimating Historical Volatility 303
One-Period Example with a Forward
Tree 305
10.3 Two or More Binomial Periods 306
A Two-Period European Call 306
Many Binomial Periods 308
10.4 Put Options 309
10.5 American Options 310
10.6 Options on Other Assets 312
Option on a Stock Index 312
Options on Currencies 312
Options on Futures Contracts 314
Options on Commodities 315
Options on Bonds 316
Summary 317
Chapter Summary 318
Further Reading 319
Problems 319
10.A Taxes and Option Prices 322
Chapter 11
Binomial Option Pricing: Selected
Topics 323
11.1 Understanding Early Exercise 323
11.2 Understanding Risk-Neutral Pricing 326
The Risk-Neutral Probability 326
Pricing an Option Using Real
Probabilities 327
11.3 The Binomial Tree and Lognormality 330
The Random Walk Model 330
Modeling Stock Prices as a Random
Walk 331
The Binomial Model 332
Lognormality and the Binomial Model 333
Alternative Binomial Trees 335
Is the Binomial Model Realistic? 336
11.4 Stocks Paying Discrete Dividends 336
Modeling Discrete Dividends 337
Problems with the Discrete Dividend
Tree 337
A Binomial Tree Using the Prepaid
Forward 339
Contents xiii
Chapter Summary 340
Further Reading 341
Problems 341
11.A Pricing Options with True
Probabilities 343
11.B Why Does Risk-Neutral Pricing
Work? 344
Utility-Based Valuation 344
Standard Discounted Cash Flow 345
Risk-Neutral Pricing 345
Physical vs. Risk-Neutral Probabilities 346
Example 347
Chapter 12
The Black-Scholes Formula 349
12.1 Introduction to the Black-Scholes
Formula 349
Call Options 349
Put Options 352
When Is the Black-Scholes Formula
Valid? 352
12.2 Applying the Formula to Other
Assets 353
Options on Stocks with Discrete
Dividends 354
Options on Currencies 354
Options on Futures 355
12.3 Option Greeks 356
Definition of the Greeks 356
Greek Measures for Portfolios 361
Option Elasticity 362
12.4 Profit Diagrams Before Maturity 366
Purchased Call Option 366
Calendar Spreads 367
12.5 Implied Volatility 369
Computing Implied Volatility 369
Using Implied Volatility 370
12.6 Perpetual American Options 372
Valuing Perpetual Options 373
Barrier Present Values 374
Chapter Summary 374
Further Reading 375
Problems 375
12.A The Standard Normal Distribution 378
xiv Contents
12.B Formulas for Option Greeks 379
Delta () 379
Gamma () 379
Theta (θ) 379
Vega 380
Rho (ρ) 380
Psi (ψ) 380
Chapter 13
Market-Making and Delta-
Hedging 381
13.1 What Do Market-Makers Do? 381
13.2 Market-Maker Risk 382
Option Risk in the Absence of
Hedging 382
Delta and Gamma as Measures of
Exposure 383
13.3 Delta-Hedging 384
An Example of Delta-Hedging for 2
Days 385
Interpreting the Profit Calculation 385
Delta-Hedging for Several Days 387
A Self-Financing Portfolio: The Stock
Moves One σ 389
13.4 The Mathematics of Delta-Hedging 389
Using Gamma to Better Approximate the
Change in the Option Price 390
Delta-Gamma Approximations 391
Theta: Accounting for Time 392
Understanding the Market-Maker’s
Profit 394
13.5 The Black-Scholes Analysis 395
The Black-Scholes Argument 396
Delta-Hedging of American Options 396
What Is the Advantage to Frequent
Re-Hedging? 397
Delta-Hedging in Practice 398
Gamma-Neutrality 399
13.6 Market-Making as Insurance 402
Insurance 402
Market-Makers 403
Chapter Summary 403
Further Reading 404
Problems 404
13.A Taylor Series Approximations 406
13.B Greeks in the Binomial Model 407
Chapter 14
Exotic Options: I 409
14.1 Introduction 409
14.2 Asian Options 410
XYZ’s Hedging Problem 411
Options on the Average 411
Comparing Asian Options 412
An Asian Solution for XYZ 413
14.3 Barrier Options 414
Types of Barrier Options 415
Currency Hedging 416
14.4 Compound Options 418
Compound Option Parity 419
Options on Dividend-Paying Stocks 419
Currency Hedging with Compound
Options 421
14.5 Gap Options 421
14.6 Exchange Options 424
European Exchange Options 424
Chapter Summary 425
Further Reading 426
Problems 426
14.A Pricing Formulas for Exotic Options 430
Asian Options Based on the Geometric
Average 430
Compound Options 431
Infinitely Lived Exchange Option 432
PART FOUR
Financial Engineering and
Applications 435
Chapter 15
Financial Engineering and Security
Design 437
15.1 The Modigliani-Miller Theorem 437
15.2 Structured Notes without Options 438
Single Payment Bonds 438
Multiple Payment Bonds 441
15.3 Structured Notes with Options 445
Convertible Bonds 446
Reverse Convertible Bonds 449
Tranched Payoffs 451
 Contents xv

Variable Prepaid Forwards 452 The Correct Use of NPV 511

15.4 Strategies Motivated by Tax and The Project as an Option 511
Regulatory Considerations 453 17.2 Investment under Uncertainty 513
Capital Gains Deferral 454 A Simple DCF Problem 513
Marshall & Ilsley SPACES 458 Valuing Derivatives on the Cash Flow 514
15.5 Engineered Solutions for Evaluating a Project with a 2-Year
Golddiggers 460 Investment Horizon 515
Gold-Linked Notes 460 Evaluating the Project with an Infinite
Notes with Embedded Options 462 Investment Horizon 519
Chapter Summary 463 17.3 Real Options in Practice 519
Further Reading 464 Peak-Load Electricity Generation 519
Problems 464 Research and Development 523
17.4 Commodity Extraction as an Option 525
Chapter 16 Single-Barrel Extraction under
Certainty 525
Corporate Applications 469 Single-Barrel Extraction under
16.1 Equity, Debt, and Warrants 469 Uncertainty 528
Debt and Equity as Options 469 Valuing an Infinite Oil Reserve 530
Leverage and the Expected Return on Debt 17.5 Commodity Extraction with Shutdown
and Equity 472 and Restart Options 531
Multiple Debt Issues 477 Permanent Shutting Down 533
Warrants 478 Investing When Shutdown Is Possible 535
Convertible Bonds 479 Restarting Production 536
Callable Bonds 482 Additional Options 537
Bond Valuation Based on the Stock Chapter Summary 538
Price 485 Further Reading 538
Other Bond Features 485
Problems 538
Put Warrants 486
17.A Calculation of Optimal Time to Drill an
16.2 Compensation Options 487
Oil Well 541
The Use of Compensation Options 487
17.B The Solution with Shutting Down and
Valuation of Compensation Options 489
Restarting 541
Repricing of Compensation Options 492
Reload Options 493
Level 3 Communications 495
16.3 The Use of Collars in Acquisitions 499
PART FIVE
The Northrop Grumman—TRW
merger 499
Advanced Pricing Theory and
Chapter Summary 502 Applications 543
Further Reading 503
Problems 503 Chapter 18
16.A An Alternative Approach to Expensing The Lognormal Distribution 545
Option Grants 507
18.1 The Normal Distribution 545
Converting a Normal Random Variable to
Chapter 17 Standard Normal 548
Real Options 509 Sums of Normal Random Variables 549
17.1 Investment and the NPV Rule 509 18.2 The Lognormal Distribution 550
Static NPV 510 18.3 A Lognormal Model of Stock Prices 552
xvi Contents
18.4 Lognormal Probability Calculations 556
Probabilities 556
Lognormal Prediction Intervals 557
The Conditional Expected Price 559
The Black-Scholes Formula 561
18.5 Estimating the Parameters of a Lognormal
Distribution 562
18.6 How Are Asset Prices Distributed? 564
Histograms 564
Normal Probability Plots 566
Chapter Summary 569
Further Reading 569
Problems 570
18.A The Expectation of a Lognormal
Variable 571
18.B Constructing a Normal Probability
Plot 572
Chapter 19
Monte Carlo Valuation 573
19.1 Computing the Option Price as a
Discounted Expected Value 573
Valuation with Risk-Neutral
Probabilities 574
Valuation with True Probabilities 575
19.2 Computing Random Numbers 577
19.3 Simulating Lognormal Stock Prices 578
Simulating a Sequence of Stock Prices 578
19.4 Monte Carlo Valuation 580
Monte Carlo Valuation of a European
Call 580
Accuracy of Monte Carlo 581
Arithmetic Asian Option 582
19.5 Efficient Monte Carlo Valuation 584
Control Variate Method 584
Other Monte Carlo Methods 587
19.6 Valuation of American Options 588
19.7 The Poisson Distribution 591
19.8 Simulating Jumps with the Poisson
Distribution 593
Simulating the Stock Price with
Jumps 593
Multiple Jumps 596
19.9 Simulating Correlated Stock Prices 597
Generating n Correlated Lognormal
Random Variables 597
Chapter Summary 599
Further Reading 599
Problems 599
19.A Formulas for Geometric Average
Options 602
Chapter 20
Brownian Motion and Itô’s
Lemma 603
20.1 The Black-Scholes Assumption about
Stock Prices 603
20.2 Brownian Motion 604
Definition of Brownian Motion 604
Properties of Brownian Motion 606
Arithmetic Brownian Motion 607
The Ornstein-Uhlenbeck Process 608
20.3 Geometric Brownian Motion 609
Lognormality 609
Relative Importance of the Drift and Noise
Terms 610
Multiplication Rules 610
Modeling Correlated Asset Prices 612
20.4 Itô’s Lemma 613
Functions of an Itô Process 614
Multivariate Itô’s Lemma 616
20.5 The Sharpe Ratio 617
20.6 Risk-Neutral Valuation 618
A Claim That Pays S(T )a 619
Specific Examples 620
Valuing a Claim on S a Qb 621
20.7 Jumps in the Stock Price 623
Chapter Summary 624
Further Reading 624
Problems 624
20.A Valuation Using Discounted Cash
Flow 626
Chapter 21
The Black-Scholes-Merton
Equation 627
21.1 Differential Equations and Valuation
under Certainty 627
The Valuation Equation 628
Bonds 628
Dividend-Paying Stocks 629

The General Structure 629
21.2 The Black-Scholes Equation 629
Verifying the Formula for a Derivative 631
The Black-Scholes Equation and
Equilibrium Returns 634
What If the Underlying Asset Is Not an
Investment Asset? 635
21.3 Risk-Neutral Pricing 637
Interpreting the Black-Scholes
Equation 637
The Backward Equation 637
Derivative Prices as Discounted Expected
Cash Flows 638
21.4 Changing the Numeraire 639
21.5 Option Pricing When the Stock Price Can
Jump 642
Merton’s Solution for Diversifiable
Jumps 643
Chapter Summary 644
Further Reading 644
Problems 645
21.A Multivariate Black-Scholes Analysis 646
21.B Proof of Proposition 21.1 646
21.C Solutions for Prices and Probabilities 647
Chapter 22
Risk-Neutral and Martingale
Pricing 649
22.1 Risk Aversion and Marginal Utility 650
22.2 The First-Order Condition for Portfolio
Selection 652
22.3 Change of Measure and Change of
Numeraire 654
Change of Measure 655
The Martingale Property 655
Girsanov’s Theorem 657
22.4 Examples of Numeraire and Measure
Change 658
The Money-Market Account as Numeraire
(Risk-Neutral Measure) 659
Risky Asset as Numeraire 662
Zero Coupon Bond as Numeraire (Forward
Measure) 662
22.5 Examples of Martingale Pricing 663
Cash-or-Nothing Call 663
Contents xvii
Asset-or-Nothing Call 665
The Black-Scholes Formula 666
European Outperformance Option 667
Option on a Zero-Coupon Bond 667
22.6 Example: Long-Maturity Put Options 667
The Black-Scholes Put Price
Calculation 668
Is the Put Price Reasonable? 669
Discussion 671
Chapter Summary 671
Further Reading 673
Problems 673
22.A The Portfolio Selection Problem 676
The One-Period Portfolio Selection
Problem 676
The Risk Premium of an Asset 678
Multiple Consumption and Investment
Periods 679
22.B Girsanov’s Theorem 679
The Theorem 679
Constructing Multi-Asset Processes from
Independent Brownian Motions 680
22.C Risk-Neutral Pricing and Marginal Utility
in the Binomial Model 681
Chapter 23
Exotic Options: II 683
23.1 All-or-Nothing Options 683
Terminology 683
Cash-or-Nothing Options 684
Asset-or-Nothing Options 685
Ordinary Options and Gap Options 686
Delta-Hedging All-or-Nothing
Options 687
23.2 All-or-Nothing Barrier Options 688
Cash-or-Nothing Barrier Options 690
Asset-or-Nothing Barrier Options 694
Rebate Options 694
Perpetual American Options 695
23.3 Barrier Options 696
23.4 Quantos 697
The Yen Perspective 698
The Dollar Perspective 699
A Binomial Model for the Dollar-
Denominated Investor 701
xviii Contents
23.5 Currency-Linked Options 704
Foreign Equity Call Struck in Foreign
Currency 705
Foreign Equity Call Struck in Domestic
Currency 706
Fixed Exchange Rate Foreign Equity
Call 707
Equity-Linked Foreign Exchange Call 707
23.6 Other Multivariate Options 708
Options on the Best of Two Assets 709
Basket Options 710
Chapter Summary 711
Further Reading 711
Problems 712
23.A The Reflection Principle 715
Chapter 24
Volatility 717
24.1 Implied Volatility 718
24.2 Measurement and Behavior of
Volatility 720
Historical Volatility 720
Exponentially Weighted Moving
Average 721
Time-Varying Volatility: ARCH 723
The GARCH Model 727
Realized Quadratic Variation 729
24.3 Hedging and Pricing Volatility 731
Variance and Volatility Swaps 731
Pricing Volatility 733
24.4 Extending the Black-Scholes Model 736
Jump Risk and Implied Volatility 737
Constant Elasticity of Variance 737
The Heston Model 740
Evidence 742
Chapter Summary 745
Further Reading 745
Problems 746
Chapter 25
Interest Rate and Bond
Derivatives 751
25.1 An Introduction to Interest Rate
Derivatives 752
Bond and Interest Rate Forwards 752
Options on Bonds and Rates 753
Equivalence of a Bond Put and an Interest
Rate Call 754
Taxonomy of Interest Rate Models 754
25.2 Interest Rate Derivatives and the
Black-Scholes-Merton Approach 756
An Equilibrium Equation for Bonds 757
25.3 Continuous-Time Short-Rate Models 760
The Rendelman-Bartter Model 760
The Vasicek Model 761
The Cox-Ingersoll-Ross Model 762
Comparing Vasicek and CIR 763
Duration and Convexity Revisited 764
25.4 Short-Rate Models and Interest Rate
Trees 765
An Illustrative Tree 765
The Black-Derman-Toy Model 769
Hull-White Model 773
25.5 Market Models 780
The Black Model 780
LIBOR Market Model 781
Chapter Summary 783
Further Reading 784
Problems 784
25.A Constructing the BDT Tree 787
Chapter 26
Value at Risk 789
26.1 Value at Risk 789
Value at Risk for One Stock 793
VaR for Two or More Stocks 795
VaR for Nonlinear Portfolios 796
VaR for Bonds 801
Estimating Volatility 805
Bootstrapping Return Distributions 806
26.2 Issues with VaR 807
Alternative Risk Measures 807
VaR and the Risk-Neutral Distribution 810
Subadditive Risk Measures 811
Chapter Summary 812
Further Reading 813
Problems 813
Chapter 27
Credit Risk 815
27.1 Default Concepts and Terminology 815
 Contents xix

27.2 The Merton Default Model 817 D.2 How to Learn VBA 864
Default at Maturity 817 D.3 Calculations with VBA 864
Related Models 819 Creating a Simple Function 864
27.3 Bond Ratings and Default A Simple Example of a Subroutine 865
Experience 821 Creating a Button to Invoke a
Rating Transitions 822 Subroutine 866
Recovery Rates 824 Functions Can Call Functions 867
Reduced Form Bankruptcy Models 824 Illegal Function Names 867
27.4 Credit Default Swaps 826 Differences between Functions and
Single-Name Credit Default Swaps 826 Subroutines 867
Pricing a Default Swap 828 D.4 Storing and Retrieving Variables in a
CDS Indices 832 Worksheet 868
Other Credit-Linked Structures 834 Using a Named Range to Read and Write
27.5 Tranched Structures 834 Numbers from the Spreadsheet 868
Collateralized Debt Obligations 836 Reading and Writing to Cells That Are Not
CDO-Squareds 840 Named 869
Nth to default baskets 842 Using the Cells Function to Read and
Chapter Summary 844 Write to Cells 870
Reading from within a Function 870
Further Reading 846
D.5 Using Excel Functions from within
Problems 846
VBA 871
Using VBA to Compute the Black-Scholes
Appendix A Formula 871
The Greek Alphabet 851 The Object Browser 872
D.6 Checking for Conditions 873
Appendix B D.7 Arrays 874
Continuous Compounding 853 Defining Arrays 874
D.8 Iteration 875
B.1 The Language of Interest Rates 853
A Simple for Loop 876
B.2 The Logarithmic and Exponential
Creating a Binomial Tree 876
Functions 854
Other Kinds of Loops 877
Changing Interest Rates 855
D.9 Reading and Writing Arrays 878
Symmetry for Increases and Decreases 855
Arrays as Output 878
Problems 856
Arrays as Inputs 879
D.10 Miscellany 880
Appendix C Getting Excel to Generate Macros for
Jensen’s Inequality 859 You 880
C.1 Example: The Exponential Function 859 Using Multiple Modules 881
C.2 Example: The Price of a Call 860 Recalculation Speed 881
Debugging 882
C.3 Proof of Jensen’s Inequality 861
Creating an Add-In 882
Problems 862
Glossary 883
Appendix D References 897
An Introduction to Visual Basic for Index 915
Applications 863
D.1 Calculations without VBA 863
Preface

Y ou cannot understand modern finance and financial markets without understanding deriva-
tives. This book will help you to understand the derivative instruments that exist, how they
are used, how they are priced, and how the tools and concepts underlying derivatives are
useful more broadly in finance.
Derivatives are necessarily an analytical subject, but I have tried throughout to empha-
size intuition and to provide a common sense way to think about the formulas. I do assume
that a reader of this book already understands basic financial concepts such as present value,
and elementary statistical concepts such as mean and standard deviation. In order to make
the book accessible to readers with widely varying backgrounds and experiences, I use a
“tiered” approach to the mathematics. Chapters 1–9 emphasize present value calculations,
and there is almost no calculus until Chapter 18.
The last part of the book develops the Black-Scholes-Merton approach to pricing
derivatives and presents some of the standard mathematical tools used in option pricing,
such as Itô’s Lemma. There are also chapters dealing with applications to corporate finance,
financial engineering, and real options.
Most of the calculations in this book can be replicated using Excel spreadsheets on
the CD-ROM that comes with the book.1 These allow you to experiment with the pricing
models and build your own spreadsheets. The spreadsheets on the CD-ROM contain option
pricing functions written in Visual Basic for Applications, the macro language in Excel.
You can incorporate these functions into your own spreadsheets. You can also examine and
modify the Visual Basic code for the functions. Appendix D explains how to write such
functions in Excel, and documentation on the CD-ROM lists the option pricing functions
that come with the book. Relevant Excel functions are also mentioned throughout the book.

WHAT IS NEW IN THE THIRD EDITION

The reader familiar with the previous editions will find the same overall plan, but will
discover many changes. Some are small, some are major. In general:

1. Some of the advanced calculations are not easy in Excel, for example the Heston option pricing
calculation. As an alternative to Excel I used R (http://r-project.org) to prepare many of the new graphs
and calculations. In the near future I hope to provide an R tutorial for the interested reader.

xxi
xxii Preface

. Many examples have been updated.

. There are numerous changes to streamline and clarify exposition.
. There are connections throughout to events during the financial crisis and to the Dodd-
Frank financial reform act.
. New boxes cover Bernie Madoff, Mexico’s oil hedge, oil arbitrage, LIBOR during
the financial crisis, Islamic finance, Bank capital, Google and compensation options,
Abacus and Magnetar, and other topics.
Several chapters have also been extensively revised:
. Chapter 1 has a new discussion of clearing and the organization and measurement of
markets.
. The chapter on commodities, Chapter 6, has been reorganized. There is a new intro-
ductory discussion and overview of differences between commodities and financial
assets, a discussion of commodity arbitrage using copper, a discussion of commodity
indices, and boxes on tanker-based oil-market arbitrage and illegal futures contracts.
. Chapter 15 has a revamped discussion of structures, a new discussion of reverse
convertibles, and a new discussion of tranching.
. Chapter 25 has been heavily revised. There is a discussion of the taxonomy of fixed
income models, distinguishing short-rate models and market models. New sections
on the Hull-White and LIBOR market models have been added.
. Chapter 27 also has been heavily revised. One of the most important structuring
issues highlighted by the financial crisis is the behavior of tranched claims that are
themselves based on tranched claims. Many collateralized debt obligations satisfy
this description, as do so-called CDO-squared contracts. There is a section on CDO-
squareds and a box on Goldman Sach’s Abacus transaction and the hedge fund
Magnetar. The 2009 standardization of CDS contracts is discussed.
Finally, Chapter 22 is new in this edition, focusing on the martingale approach
to pricing derivatives. The chapter explains the important connection between investor
portfolio decisions and derivatives pricing models. In this context, it provides the rationale
for risk-neutral pricing and for different classes of fixed income pricing models. The chapter
discusses Warren Buffett’s critique of the Black-Scholes put pricing formula. You can skip
this chapter and still understand the rest of the book, but the material in even the first few
sections will deepen your understanding of the economic underpinnings of the models.

PLAN OF THE BOOK

This book grew from my teaching notes for two MBA derivatives courses at Northwestern
University’s Kellogg School of Management. The two courses roughly correspond to the
first two-thirds and last third of the book. The first course is a general introduction to deriva-
tive products (principally futures, options, swaps, and structured products), the markets in
which they trade, and applications. The second course is for those wanting a deeper under-
standing of the pricing models and the ability to perform their own analysis. The advanced
course assumes that students know basic statistics and have seen calculus, and from that
point develops the Black-Scholes option-pricing framework. A 10-week MBA-level course
 Preface xxiii

will not produce rocket scientists, but mathematics is the language of derivatives and it
would be cheating students to pretend otherwise.
I wrote chapters to allow flexible use of the material, with suggested possible paths
through the material below. In many cases it is possible to cover chapters out of order. For
example, I wrote the book anticipating that the chapters on lognormality and Monte Carlo
simulation might be used in a first derivatives course.
The book has five parts plus appendixes. Part 1 introduces the basic building blocks of
derivatives: forward contracts and call and put options. Chapters 2 and 3 examine these basic
instruments and some common hedging and investment strategies. Chapter 4 illustrates the
use of derivatives as risk management tools and discusses why firms might care about risk
management. These chapters focus on understanding the contracts and strategies, but not
on pricing.
Part 2 considers the pricing of forward, futures, and swaps contracts. In these con-
tracts, you are obligated to buy an asset at a pre-specified price, at a future date. What is the
pre-specified price, and how is it determined? Chapter 5 examines forwards and futures on
financial assets, Chapter 6 discusses commodities, and Chapter 7 looks at bond and inter-
est rate forward contracts. Chapter 8 shows how swap prices can be deduced from forward
prices.
Part 3 studies option pricing. Chapter 9 develops intuition about options prior to
delving into the mechanics of option pricing. Chapters 10 and 11 cover binomial option
pricing and Chapter 12, the Black-Scholes formula and option Greeks. Chapter 13 explains
delta-hedging, which is the technique used by market-makers when managing the risk of
an option position, and how hedging relates to pricing. Chapter 14 looks at a few important
exotic options, including Asian options, barrier options, compound options, and exchange
options.
The techniques and formulas in earlier chapters are applied in Part 4. Chapter 15
covers financial engineering, which is the creation of new financial products from the
derivatives building blocks in earlier chapters. Debt and equity pricing, compensation
options, and mergers are covered in Chapter 16. Chapter 17 studies real options—the
application of derivatives models to the valuation and management of physical investments.
Finally, Part 5 explores pricing and hedging in depth. The material in this part explains
in more detail the structure and assumptions underlying the standard derivatives models.
Chapter 18 covers the lognormal model and shows how the Black-Scholes formula is a
discounted expected value. Chapter 19 discusses Monte Carlo valuation, a powerful and
commonly used pricing technique. Chapter 20 explains what it means to say that stock
prices follow a diffusion process, and also covers Itô’s Lemma, which is a key result in
the study of derivatives. (At this point you will discover that Itô’s Lemma has already been
developed intuitively in Chapter 13, using a simple numerical example.)
Chapter 21 derives the Black-Scholes-Merton partial differential equation (PDE).
Although the Black-Scholes formula is famous, the Black-Scholes-Merton equation, dis-
cussed in this chapter, is the more profound result. The martingale approach to pricing is
covered in Chapter 22. We obtain the same pricing formulas as with the PDE, of course, but
the perspective is different and helps to lay groundwork for later fixed income discussions.
Chapter 23 covers exotic options in more detail than Chapter 14, including digital barrier op-
tions and quantos. Chapter 24 discusses volatility estimation and stochastic volatility pricing
models. Chapter 25 shows how the Black-Scholes and binomial analysis apply to bonds and
interest rate derivatives. Chapter 26 covers value-at-risk, and Chapter 27 discusses credit
products.
xxiv Preface

NAVIGATING THE MATERIAL

The material is generally presented in order of increasing mathematical and conceptual
difficulty, which means that related material is sometimes split across distant chapters. For
example, fixed income is covered in Chapters 7 and 25, and exotic options in Chapters 14
and 23. As an illustration of one way to use the book, here is a rough outline of material
I cover in the courses I teach (within the chapters, I skip specific topics due to time
constraints):
. Introductory course: 1–6, 7.1, 8–10, 12, 13.1–13.3, 14, 16, 17.1, 17.3.
. Advanced course: 13, 18–22, 7, 8, 15, 23–27.
Table P.1 outlines some possible sets of chapters to use in courses that have different
emphases. There are a few sections of the book that provide background on topics every
reader should understand. These include short-sales (Section 1.4), continuous compounding
(Appendix B), prepaid forward contracts (Sections 5.1 and 5.2), and zero-coupon bonds and
implied forward rates (Section 7.1).

A NOTE ON EXAMPLES
Many of the numerical examples in this book display intermediate steps to assist you in
following the logic and steps of a calculation. Numbers displayed in the text necessarily
are rounded to three or four decimal points, while spreadsheet calculations have many
more significant digits. This creates a dilemma: Should results in the book match those you
would obtain using a spreadsheet, or those you would obtain by computing the displayed
equations?
As a general rule, the numerical examples in the book will provide the results you
would obtain by entering the equations directly in a spreadsheet. Due to rounding, the
displayed equations will not necessarily produce the correct result.

SUPPLEMENTS
A robust package of ancillary materials for both instructors and students accompanies the
text.

Instructor’s Resources
For instructors, an extensive set of online tools is available for download from the catalog
page for Derivatives Markets at www.pearsonhighered.com/mcdonald.
An online Instructor’s Solutions Manual by Rüdiger Fahlenbrach, École Polytech-
nique Fédérale de Lausanne, contains complete solutions to all end-of-chapter problems in
the text and spreadsheet solutions to selected problems.
The online Test Bank by Matthew W. Will, University of Indianapolis, features
approximately ten to fifteen multiple-choice questions, five short-answer questions, and
one longer essay question for each chapter of the book.
The Test Bank is available in several electronic formats, including Windows and
Macintosh TestGen files and Microsoft Word files. The TestGen and Test Bank are available
online at www.pearsonhighered.com/irc.
Another random document with
no related content on Scribd:
 RIP VAN WINKLE
A POSTHUMOUS WRITING OF DIEDRICH
KNICKERBOCKER

[From the “Sketch Book,” 1819–1820]

By Woden, God of Saxons,

From whence comes Wensday, that is Wodensday,
Truth is a thing that ever I will keep
Unto thylke day in which I creep into
My sepulchre——
Cartwright.

WHOEVER has made a voyage up the Hudson, must remember the

Kaatskill mountains. They are a dismembered branch of the great
Appalachian family, and are seen away to the west of the river,
swelling up to a noble height, and lording it over the surrounding
country. Every change of season, every change of weather, indeed,
every hour of the day, produces some change in the magical hues
and shapes of these mountains, and they are regarded by all the
good wives, far and near, as perfect barometers. When the weather
is fair and settled, they are clothed in blue and purple, and print their
bold outlines on the clear evening sky; but sometimes, when the rest
of the landscape is cloudless, they will gather a hood of gray vapours
about their summits, which, in the last rays of the setting sun, will
glow and light up like a crown of glory.
At the foot of these fairy mountains, the voyager may have
descried the light smoke curling up from a village, whose shingle
roofs gleam among the trees, just where the blue tints of the upland
melt away into the fresh green of the nearer landscape. It is a little
village of great antiquity, having been founded by some of the Dutch
colonists, in the early times of the province, just about the beginning
of the government of the good Peter Stuyvesant (may he rest in
peace!), and there were some of the houses of the original settlers
standing within a few years with lattice windows, gable fronts
surmounted with weathercocks, and built of small yellow bricks
brought from Holland.
In that same village, and in one of these very houses, (which, to
tell the precise truth, was sadly timeworn and weather-beaten,) there
lived many years since, while the country was yet a province of
Great Britain, a simple goodnatured fellow, of the name of Rip Van
Winkle. He was a descendant of the Van Winkles who figured so
gallantly in the chivalrous days of Peter Stuyvesant, and
accompanied him to the siege of Fort Christina. He inherited,
however, but little of the martial character of his ancestors. I have
observed that he was a simple good-natured man; he was moreover
a kind neighbour, and an obedient, henpecked husband. Indeed, to
the latter circumstance might be owing that meekness of spirit which
gained him such universal popularity; for those men are most apt to
be obsequious and conciliating abroad, who are under the discipline
of shrews at home. Their tempers, doubtless, are rendered pliant
and malleable in the fiery furnace of domestic tribulation, and a
curtain lecture is worth all the sermons in the world for teaching the
virtues of patience and long suffering. A termagant wife may,
therefore, in some respects, be considered a tolerable blessing; and
if so, Rip Van Winkle was thrice blessed.
Certain it is, that he was a great favourite among all the good
wives of the village, who, as usual with the amiable sex, took his part
in all family squabbles, and never failed, whenever they talked those
matters over in their evening gossippings, to lay all the blame on
Dame Van Winkle. The children of the village, too, would shout with
joy whenever he approached. He assisted at their sports, made their
playthings, taught them to fly kites and shoot marbles, and told them
long stories of ghosts, witches, and Indians. Whenever he went
dodging about the village, he was surrounded by a troop of them,
hanging on his skirts, clambering on his back, and playing a
thousand tricks on him with impunity; and not a dog would bark at
him throughout the neighbourhood.
The great error in Rip’s composition was an insuperable aversion
to all kinds of profitable labour. It could not be from the want of
assiduity or perseverance; for he would sit on a wet rock, with a rod
as long and heavy as a Tartar’s lance, and fish all day without a
murmur, even though he should not be encouraged by a single
nibble. He would carry a fowling-piece on his shoulder, for hours
together, trudging through woods and swamps, and up hill and down
dale, to shoot a few squirrels or wild pigeons. He would never even
refuse to assist a neighbour in the roughest toil, and was a foremost
man at all country frolicks for husking Indian corn, or building stone
fences. The women of the village, too, used to employ him to run
their errands, and to do such little odd jobs as their less obliging
husbands would not do for them;—in a word, Rip was ready to
attend to anybody’s business but his own; but as to doing family
duty, and keeping his farm in order, it was impossible.
In fact, he declared it was of no use to work on his farm; it was
the most pestilent little piece of ground in the whole country;
everything about it went wrong, and would go wrong, in spite of him.
His fences were continually falling to pieces; his cow would either go
astray, or get among the cabbages; weeds were sure to grow
quicker in his fields than anywhere else; the rain always made a
point of setting in just as he had some out-door work to do; so that
though his patrimonial estate had dwindled away under his
management, acre by acre, until there was little more left than a
mere patch of Indian corn and potatoes, yet it was the worst
conditioned farm in the neighbourhood.
His children, too, were as ragged and wild as if they belonged to
nobody. His son Rip, an urchin begotten in his own likeness,
promised to inherit the habits, with the old clothes of his father. He
was generally seen trooping like a colt at his mother’s heels,
equipped in a pair of his father’s cast-off galligaskins, which he had
much ado to hold up with one hand, as a fine lady does her train in
bad weather.
 Rip Van Winkle, however, was one of those happy mortals, of
foolish, well-oiled dispositions, who take the world easy, eat white
bread or brown, whichever can be got with least thought or trouble,
and would rather starve on a penny than work for a pound. If left to
himself, he would have whistled life away, in perfect contentment;
but his wife kept continually dinning in his ears about his idleness,
his carelessness, and the ruin he was bringing on his family.
Morning, noon, and night, her tongue was incessantly going, and
everything he said or did was sure to produce a torrent of household
eloquence. Rip had but one way of replying to all lectures of the kind,
and that, by frequent use, had grown into a habit. He shrugged his
shoulders, shook his head, cast up his eyes, but said nothing. This,
however, always provoked a fresh volley from his wife, so that he
was fain to draw off his forces, and take to the outside of the house
—the only side which, in truth, belongs to a henpecked husband.
Rip’s sole domestic adherent was his dog Wolf, who was as
much henpecked as his master; for Dame Van Winkle regarded
them as companions in idleness, and even looked upon Wolf with an
evil eye, as the cause of his master’s so often going astray. True it is,
in all points of spirit befitting an honourable dog, he was as
courageous an animal as ever scoured the woods—but what
courage can withstand the ever-during and all-besetting terrors of a
woman’s tongue? The moment Wolf entered the house, his crest fell,
his tail drooped to the ground, or curled between his legs, he
sneaked about with a gallows air, casting many a sidelong glance at
Dame Van Winkle, and at the least flourish of a broomstick or ladle,
would fly to the door with yelping precipitation.
Times grew worse and worse with Rip Van Winkle as years of
matrimony rolled on; a tart temper never mellows with age, and a
sharp tongue is the only edged tool that grows keener by constant
use. For a long while he used to console himself, when driven from
home, by frequenting a kind of perpetual club of the sages,
philosophers, and other idle personages of the village, which held its
sessions on a bench before a small inn, designated by a rubicund
portrait of his majesty George the Third. Here they used to sit in the
shade, of a long lazy summer’s day, talking listlessly over village
gossip, or telling endless sleepy stories about nothing. But it would
have been worth any statesman’s money to have heard the profound
discussions which sometimes took place, when by chance an old
newspaper fell into their hands, from some passing traveller. How
solemnly they would listen to the contents, as drawled out by Derrick
Van Bummel, the schoolmaster, a dapper learned little man, who
was not to be daunted by the most gigantic word in the dictionary;
and how sagely they would deliberate upon public events some
months after they had taken place.
The opinions of this junto were completely controlled by Nicholas
Vedder, a patriarch of the village, and landlord of the inn, at the door
of which he took his seat from morning till night, just moving
sufficiently to avoid the sun, and keep in the shade of a large tree; so
that the neighbours could tell the hour by his movements as
accurately as by a sun dial. It is true, he was rarely heard to speak,
but smoked his pipe incessantly. His adherents, however, (for every
great man has his adherents,) perfectly understood him, and knew
how to gather his opinions. When anything that was read or related
displeased him, he was observed to smoke his pipe vehemently, and
send forth short, frequent, and angry puffs; but when pleased, he
would inhale the smoke slowly and tranquilly, and emit it in light and
placid clouds, and sometimes taking the pipe from his mouth, and
letting the fragrant vapour curl about his nose, would gravely nod his
head in token of perfect approbation.
From even this stronghold the unlucky Rip was at length routed
by his termagant wife, who would suddenly break in upon the
tranquillity of the assemblage, and call the members all to nought;
nor was that august personage, Nicholas Vedder himself, sacred
from the daring tongue of this terrible virago, who charged him
outright with encouraging her husband in habits of idleness.
Poor Rip was at last reduced almost to despair; and his only
alternative to escape from the labour of the farm and clamour of his
wife, was to take gun in hand, and stroll away into the woods. Here
he would sometimes seat himself at the foot of a tree, and share the
contents of his wallet with Wolf, with whom he sympathized as a
fellow sufferer in persecution. “Poor Wolf,” he would say, “thy
mistress leads thee a dog’s life of it; but never mind, my lad, while I
live thou shalt never want a friend to stand by thee!” Wolf would wag
his tail, look wistfully in his master’s face, and if dogs can feel pity, I
verily believe he reciprocated the sentiment with all his heart.
In a long ramble of the kind on a fine autumnal day, Rip had
unconsciously scrambled to one of the highest parts of the Kaatskill
mountains. He was after his favourite sport of squirrel shooting, and
the still solitudes had echoed and re-echoed with the reports of his
gun. Panting and fatigued, he threw himself, late in the afternoon, on
a green knoll, covered with mountain herbage, that crowned the
brow of a precipice. From an opening between the trees, he could
overlook all the lower country for many a mile of rich woodland. He
saw at a distance the lordly Hudson, far, far below him, moving on its
silent but majestic course, the reflection of a purple cloud, or the sail
of a lagging bark, here and there sleeping on its glassy bosom, and
at last losing itself in the blue highlands.
On the other side he looked down into a deep mountain glen,
wild, lonely, and shagged, the bottom filled with fragments from the
impending cliffs, and scarcely lighted by the reflected rays of the
setting sun. For some time Rip lay musing on this scene; evening
was gradually advancing, the mountains began to throw their long,
blue shadows over the valleys, he saw that it would be dark long
before he could reach the village, and he heaved a heavy sigh when
he thought of encountering the terrors of Dame Van Winkle.
As he was about to descend, he heard a voice from a distance,
hallooing, “Rip Van Winkle! Rip Van Winkle!” He looked around, but
could see nothing but a crow winging its solitary flight across the
mountain. He thought his fancy must have deceived him, and turned
again to descend, when he heard the same cry ring through the still
evening air; “Rip Van Winkle! Rip Van Winkle!”—at the same time
Wolf bristled up his back, and giving a low growl, skulked to his
master’s side, looking fearfully down into the glen. Rip now felt a
vague apprehension stealing over him; he looked anxiously in the
same direction, and perceived a strange figure slowly toiling up the
rocks, and bending under the weight of something he carried on his
back. He was surprised to see any human being in this lonely and
unfrequented place, but supposing it to be some one of the
neighbourhood in need of his assistance, he hastened down to yield
it.
On nearer approach, he was still more surprised at the
singularity of the stranger’s appearance. He was a short square built
old fellow, with thick bushy hair, and a grizzled beard. His dress was
of the antique Dutch fashion—a cloth jerkin strapped round the waist
—several pair of breeches, the outer one of ample volume,
decorated with rows of buttons down the sides, and bunches at the
knees. He bore on his shoulders a stout keg, that seemed full of
liquor, and made signs for Rip to approach and assist him with the
load. Though rather shy and distrustful of this new acquaintance, Rip
complied with his usual alacrity, and mutually relieving one another,
they clambered up a narrow gully, apparently the dry bed of a
mountain torrent. As they ascended, Rip every now and then heard
long rolling peals, like distant thunder, that seemed to issue out of a
deep ravine, or rather cleft between lofty rocks, toward which their
rugged path conducted. He paused for an instant, but supposing it to
be the muttering of one of those transient thunder showers which
often take place in mountain heights, he proceeded. Passing through
the ravine, they came to a hollow, like a small amphitheatre,
surrounded by perpendicular precipices, over the brinks of which
impending trees shot their branches, so that you only caught
glimpses of the azure sky, and the bright evening cloud. During the
whole time, Rip and his companion had laboured on in silence; for
though the former marvelled greatly what could be the object of
carrying a keg of liquor up this wild mountain, yet there was
something strange and incomprehensible about the unknown, that
inspired awe, and checked familiarity.
On entering the amphitheatre, new objects of wonder presented
themselves. On a level spot in the centre was a company of odd-
looking personages playing at nine-pins. They were dressed in a
quaint, outlandish fashion: some wore short doublets, others jerkins,
with long knives in their belts, and most had enormous breeches, of
similar style with that of the guide’s. Their visages, too, were
peculiar: one had a large head, broad face, and small piggish eyes;
the face of another seemed to consist entirely of nose, and was
surmounted by a white sugar-loaf hat, set off with a little red cock’s
tail. They all had beards, of various shapes and colours. There was
one who seemed to be the commander. He was a stout old
gentleman, with a weather-beaten countenance; he wore a laced
doublet, broad belt and hanger, high crowned hat and feather, red
stockings, and high heeled shoes, with roses in them. The whole
group reminded Rip of the figures in an old Flemish painting, in the
parlour of Dominie Van Schaick, the village parson, and which had
been brought over from Holland at the time of the settlement.
What seemed particularly odd to Rip, was that though these
folks were evidently amusing themselves, yet they maintained the
gravest faces, the most mysterious silence, and were, withal, the
most melancholy party of pleasure he had ever witnessed. Nothing
interrupted the stillness of the scene, but the noise of the balls,
which, whenever they were rolled, echoed along the mountains like
rumbling peals of thunder.
As Rip and his companion approached them, they suddenly
desisted from their play, and stared at him with such fixed statue-like
gaze, and such strange, uncouth, lacklustre countenances, that his
heart turned within him, and his knees smote together. His
companion now emptied the contents of the keg into large flagons,
and made signs to him to wait upon the company. He obeyed with
fear and trembling; they quaffed the liquor in profound silence, and
then returned to their game.
By degrees, Rip’s awe and apprehension subsided. He even
ventured, when no eye was fixed upon him, to taste the beverage,
which he found had much of the flavour of excellent Hollands. He
was naturally a thirsty soul, and was soon tempted to repeat the
draught. One taste provoked another, and he reiterated his visits to
the flagon so often, that at length his senses were overpowered, his
eyes swam in his head, his head gradually declined, and he fell into
a deep sleep.
On awaking, he found himself on the green knoll from whence
he had first seen the old man of the glen. He rubbed his eyes—it
was a bright sunny morning. The birds were hopping and twittering
among the bushes, and the eagle was wheeling aloft, and breasting
the pure mountain breeze. “Surely,” thought Rip, “I have not slept
here all night.” He recalled the occurrences before he fell asleep.
The strange man with a keg of liquor—the mountain ravine—the wild
retreat among the rocks—the woe-begone party at nine-pins—the
flagon—“Oh! that flagon! that wicked flagon!” thought Rip—“what
excuse shall I make to Dame Van Winkle?”
He looked round for his gun, but in place of the clean well-oiled
fowling-piece, he found an old firelock lying by him, the barrel
encrusted with rust, the lock falling off, and the stock worm-eaten.
He now suspected that the grave roysters of the mountain had put a
trick upon him, and having dosed him with liquor, had robbed him of
his gun. Wolf, too, had disappeared, but he might have strayed away
after a squirrel or partridge. He whistled after him, shouted his name,
but all in vain; the echoes repeated his whistle and shout, but no dog
was to be seen.
He determined to revisit the scene of the last evening’s gambol,
and if he met with any of the party, to demand his dog and gun. As
he rose to walk, he found himself stiff in the joints, and wanting in his
usual activity. “These mountain beds do not agree with me,” thought
Rip, “and if this frolic should lay me up with a fit of the rheumatism, I
shall have a blessed time with Dame Van Winkle.” With some
difficulty he got down into the glen; he found the gully up which he
and his companion had ascended the preceding evening; but to his
astonishment a mountain stream was now foaming down it, leaping
from rock to rock, and filling the glen with babbling murmurs. He,
however, made shift to scramble up its sides, working his toilsome
way through thickets of birch, sassafras, and witch hazle, and
sometimes tripped up or entangled by the wild grape vines that
twisted their coils and tendrils from tree to tree, and spread a kind of
network in his path.
At length he reached to where the ravine had opened through
the cliffs, to the amphitheatre; but no traces of such opening
remained. The rocks presented a high impenetrable wall, over which
the torrent came tumbling in a sheet of feathery foam, and fell into a
broad deep basin, black from the shadows of the surrounding forest.
Here, then, poor Rip was brought to a stand. He again called and
whistled after his dog; he was only answered by the cawing of a flock
of idle crows, sporting high in air about a dry tree that overhung a
sunny precipice; and who, secure in their elevation, seemed to look
down and scoff at the poor man’s perplexities. What was to be
done? the morning was passing away, and Rip felt famished for want
of his breakfast. He grieved to give up his dog and gun; he dreaded
to meet his wife; but it would not do to starve among the mountains.
He shook his head, shouldered the rusty firelock, and, with a heart
full of trouble and anxiety, turned his steps homeward.
As he approached the village, he met a number of people, but
none whom he knew, which somewhat surprised him, for he had
thought himself acquainted with every one in the country round.
Their dress, too, was of a different fashion from that to which he was
accustomed. They all stared at him with equal marks of surprise, and
whenever they cast their eyes upon him, invariably stroked their
chins. The constant recurrence of this gesture induced Rip,
involuntarily, to do the same, when, to his astonishment, he found his
beard had grown a foot long!
He had now entered the skirts of the village. A troop of strange
children ran at his heels, hooting after him, and pointing at his gray
beard. The dogs, too, none of which he recognized for his old
acquaintances, barked at him as he passed. The very village was
altered: it was larger and more populous. There were rows of houses
which he had never seen before, and those which had been his
familiar haunts had disappeared. Strange names were over the
doors—strange faces at the windows—everything was strange. His
mind now began to misgive him; he doubted whether both he and
the world around him were not bewitched. Surely this was his native
village, which he had left but the day before. There stood the
Kaatskill mountains—there ran the silver Hudson at a distance—
there was every hill and dale precisely as it had always been—Rip
was sorely perplexed—“That flagon last night,” thought he, “has
addled my poor head sadly!”
 It was with some difficulty he found the way to his own house,
which he approached with silent awe, expecting every moment to
hear the shrill voice of Dame Van Winkle. He found the house gone
to decay—the roof fallen in, the windows shattered, and the doors off
the hinges. A half-starved dog, that looked like Wolf, was skulking
about it. Rip called him by name, but the cur snarled, showed his
teeth, and passed on. This was an unkind cut indeed—“My very
dog,” sighed poor Rip, “has forgotten me!”
He entered the house, which, to tell the truth, Dame Van Winkle
had always kept in neat order. It was empty, forlorn, and apparently
abandoned. This desolateness overcame all his connubial fears—he
called loudly for his wife and children—the lonely chambers rung for
a moment with his voice, and then all again was silence.
He now hurried forth, and hastened to his old resort, the little
village inn—but it too was gone. A large ricketty wooden building
stood in its place, with great gaping windows, some of them broken,
and mended with old hats and petticoats, and over the door was
painted, “The Union Hotel, by Jonathan Doolittle.” Instead of the
great tree which used to shelter the quiet little Dutch inn of yore,
there now was reared a tall naked pole, with something on the top
that looked like a red nightcap, and from it was fluttering a flag, on
which was a singular assemblage of stars and stripes—all this was
strange and incomprehensible. He recognised on the sign, however,
the ruby face of King George, under which he had smoked so many
a peaceful pipe, but even this was singularly metamorphosed. The
red coat was changed for one of blue and buff, a sword was stuck in
the hand instead of a sceptre, the head was decorated with a cocked
hat, and underneath was painted in large characters, General
Washington.
There was, as usual, a crowd of folk about the door, but none
whom Rip recollected. The very character of the people seemed
changed. There was a busy, bustling, disputatious tone about it,
instead of the accustomed phlegm and drowsy tranquillity. He looked
in vain for the sage Nicholas Vedder, with his broad face, double
chin, and fair long pipe, uttering clouds of tobacco smoke instead of
idle speeches; or Van Bummel, the schoolmaster, doling forth the
contents of an ancient newspaper. In place of these, a lean bilious
looking fellow, with his pockets full of hand-bills, was haranguing
vehemently about rights of citizens—election—members of
Congress—liberty—Bunker’s Hill—heroes of ’76—and other words,
that were a perfect Babylonish jargon to the bewildered Van Winkle.
The appearance of Rip, with his long grizzled beard, his rusty
fowling piece, his uncouth dress, and the army of women and
children that had gathered at his heels, soon attracted the attention
of the tavern politicians. They crowded around him, eying him from
head to foot, with great curiosity. The orator bustled up to him, and
drawing him partly aside, inquired “on which side he voted?” Rip
stared in vacant stupidity. Another short but busy little fellow pulled
him by the arm, and raising on tiptoe, inquired in his ear, “whether he
was Federal or Democrat.” Rip was equally at a loss to comprehend
the question; when a knowing, self-important old gentleman, in a
sharp cocked hat, made his way through the crowd, putting them to
the right and left with his elbows as he passed, and planting himself
before Van Winkle, with one arm akimbo, the other resting on his
cane, his keen eyes and sharp hat penetrating, as it were, into his
very soul, demanded, in an austere tone, “what brought him to the
election with a gun on his shoulder, and a mob at his heels, and
whether he meant to breed a riot in the village?” “Alas! gentlemen,”
cried Rip, somewhat dismayed, “I am a poor quiet man, a native of
the place, and a loyal subject of the King, God bless him!”
Here a general shout burst from the bystanders—“A tory! a tory!
a spy! a refugee! hustle him! away with him!” It was with great
difficulty that the self-important man in the cocked hat restored order;
and having assumed a tenfold austerity of brow, demanded again of
the unknown culprit, what he came there for, and whom he was
seeking. The poor man humbly assured him that he meant no harm;
but merely came there in search of some of his neighbours, who
used to keep about the tavern.
“Well—who are they?—name them.”
Rip bethought himself a moment, and inquired, “where’s
Nicholas Vedder?”
 There was a silence for a little while, when an old man replied, in
a thin piping voice, “Nicholas Vedder? why he is dead and gone
these eighteen years! There was a wooden tombstone in the
churchyard that used to tell all about him, but that’s rotted and gone
too.”
“Where’s Brom Dutcher?”
“Oh, he went off to the army in the beginning of the war; some
say he was killed at the battle of Stoney Point—others say he was
drowned in a squall, at the foot of Antony’s Nose. I don’t know—he
never came back again.”
“Where’s Van Bummel, the schoolmaster?”
“He went off to the wars too, was a great militia general, and is
now in Congress.”
Rip’s heart died away, at hearing of these sad changes in his
home and friends, and finding himself thus alone in the world. Every
answer puzzled him, too, by treating of such enormous lapses of
time, and of matters which he could not understand: war—Congress
—Stoney Point!—he had no courage to ask after any more friends,
but cried out in despair, “Does nobody here know Rip Van Winkle?”
“Oh, Rip Van Winkle!” exclaimed two or three, “Oh, to be sure!
that’s Rip Van Winkle yonder, leaning against the tree.”
Rip looked, and beheld a precise counterpart of himself, as he
went up the mountain: apparently as lazy, and certainly as ragged.
The poor fellow was now completely confounded. He doubted his
own identity, and whether he was himself or another man. In the
midst of his bewilderment, the man in the cocked hat demanded who
he was, and what was his name?
“God knows,” exclaimed he, at his wit’s end; “I’m not myself—I’m
somebody else—that’s me yonder—no—that’s somebody else, got
into my shoes—I was myself last night, but I fell asleep on the
mountain, and they’ve changed my gun, and everything’s changed,
and I’m changed, and I can’t tell what’s my name, or who I am!”
 The bystanders began now to look at each other, nod, wink
significantly, and tap their fingers against their foreheads. There was
a whisper, also, about securing the gun, and keeping the old fellow
from doing mischief; at the very suggestion of which, the self-
important man in the cocked hat retired with some precipitation. At
this critical moment a fresh likely woman pressed through the throng
to get a peep at the graybearded man. She had a chubby child in her
arms, which, frightened at his looks, began to cry. “Hush, Rip,” cried
she, “hush, you little fool, the old man won’t hurt you.” The name of
the child, the air of the mother, the tone of her voice, all awakened a
train of recollections in his mind. “What is your name, my good
woman?” asked he.
“Judith Gardenier.”
“And your father’s name?”
“Ah, poor man, his name was Rip Van Winkle; it’s twenty years
since he went away from home with his gun, and never has been
heard of since—his dog came home without him; but whether he
shot himself, or was carried away by the Indians, nobody can tell. I
was then but a little girl.”
Rip had but one question more to ask; but he put it with a
faltering voice:
“Where’s your mother?”
“Oh, she too had died but a short time since; she broke a blood
vessel in a fit of passion at a New-England peddler.”
There was a drop of comfort, at least, in this intelligence. The
honest man could contain himself no longer.—He caught his
daughter and her child in his arms.—“I am your father!” cried he
—“Young Rip Van Winkle once—old Rip Van Winkle now!—Does
nobody know poor Rip Van Winkle!”
All stood amazed, until an old woman, tottering out from among
the crowd, put her hand to her brow, and peering under it in his face
for a moment, exclaimed, “Sure enough! it is Rip Van Winkle—it is
himself. Welcome home again, old neighbour.—Why, where have
you been these twenty long years?”
 Rip’s story was soon told, for the whole twenty years had been to
him but as one night. The neighbours stared when they heard it;
some were seen to wink at each other, and put their tongues in their
cheeks; and the self-important man in the cocked hat, who, when the
alarm was over, had returned to the field, screwed down the corners
of his mouth, and shook his head—upon which there was a general
shaking of the head throughout the assemblage.
It was determined, however, to take the opinion of old Peter
Vanderdonk, who was seen slowly advancing up the road. He was a
descendant of the historian of that name, who wrote one of the
earliest accounts of the province. Peter was the most ancient
inhabitant of the village, and well versed in all the wonderful events
and traditions of the neighbourhood. He recollected Rip at once, and
corroborated his story in the most satisfactory manner. He assured
the company that it was a fact, handed down from his ancestor the
historian, that the Kaatskill mountains had always been haunted by
strange beings. That it was affirmed that the great Hendrick Hudson,
the first discoverer of the river and country, kept a kind of vigil there
every twenty years, with his crew of the Half-moon, being permitted
in this way to revisit the scenes of his enterprize, and keep a
guardian eye upon the river, and the great city called by his name.
That his father had once seen them in their old Dutch dresses
playing at nine-pins in a hollow of the mountain; and that he himself
had heard, one summer afternoon, the sound of their balls, like long
peals of thunder.
To make a long story short, the company broke up, and returned
to the more important concerns of the election. Rip’s daughter took
him home to live with her; she had a snug, well-furnished house, and
a stout cheery farmer for a husband, whom Rip recollected for one of
the urchins that used to climb upon his back. As to Rip’s son and
heir, who was the ditto of himself, seen leaning against the tree, he
was employed to work on the farm; but evinced an hereditary
disposition to attend to anything else but his business.
Rip now resumed his old walks and habits; he soon found many
of his former cronies, though all rather the worse for the wear and
tear of time; and preferred making friends among the rising
generation, with whom he soon grew into great favour.
Having nothing to do at home, and being arrived at that happy
age when a man can do nothing with impunity, he took his place
once more on the bench, at the inn door, and was reverenced as one
of the patriarchs of the village, and a chronicle of the old times
“before the war.” It was some time before he could get into the
regular track of gossip, or could be made to comprehend the strange
events that had taken place during his torpor. How that there had
been a revolutionary war—that the country had thrown off the yoke
of old England—and that, instead of being a subject of his Majesty,
George III., he was now a free citizen of the United States. Rip, in
fact, was no politician; the changes of states and empires made but
little impression on him; but there was one species of despotism
under which he had long groaned, and that was—petticoat
government; happily, that was at an end; he had got his neck out of
the yoke of matrimony, and could go in and out whenever he
pleased, without dreading the tyranny of Dame Van Winkle.
Whenever her name was mentioned, however, he shook his head,
shrugged his shoulders, and cast up his eyes; which might pass
either for an expression of resignation to his fate, or joy at his
deliverance.
He used to tell his story to every stranger that arrived at Mr.
Doolittle’s hotel. He was observed, at first, to vary on some points
every time he told it, which was, doubtless, owing to his having so
recently awaked. It at last settled down precisely to the tale I have
related, and not a man, woman, or child in the neighbourhood but
knew it by heart. Some always pretended to doubt the reality of it,
and insisted that Rip had been out of his head, and that this was one
point on which he always remained flighty. The old Dutch
inhabitants, however, almost universally gave it full credit. Even to
this day they never hear a thunder storm of a summer afternoon,
about the Kaatskill, but they say Hendrick Hudson and his crew are
at their game of nine-pins; and it is a common wish of all henpecked
husbands in the neighbourhood, when life hangs heavy on their
hands, that they might have a quieting draught out of Rip Van
Winkle’s flagon.
NOTE
The foregoing tale, one would suspect, had been suggested to Mr. Knickerbocker
by a little German superstition about the Emperor Frederick and the Kypphauser
mountain; the subjoined note, however, which he had appended to the tale, shows
that it is an absolute fact, narrated with his usual fidelity.
“The story of Rip Van Winkle may seem incredible to many, but nevertheless I
give it my full belief, for I know the vicinity of our old Dutch settlements to have
been very subject to marvellous events and appearances. Indeed, I have heard
many stranger stories than this, in the villages along the Hudson; all of which were
too well authenticated to admit of a doubt. I have even talked with Rip Van Winkle
myself, who, when last I saw him, was a very venerable old man, and so perfectly
rational and consistent on every other point, that I think no conscientious person
could refuse to take this into the bargain; nay, I have seen a certificate on the
subject taken before a country justice and signed with a cross, in the justice’s own
handwriting. The story, therefore, is beyond the possibility of a doubt.
“D. K.”
37
POSTSCRIPT
The following are travelling notes from a memorandum book of Mr. Knickerbocker:
The Kaatsberg, or Catskill Mountains, have always been a region full of fable.
The Indians considered them the abode of spirits, who influenced the weather,
spreading sunshine or clouds over the landscape, and sending good or bad
hunting seasons. They were ruled by an old squaw spirit, said to be their mother.
She dwelt on the highest peak of the Catskills, and had charge of the doors of day
and night to open and shut them at the proper hour. She hung up the new moon in
the skies, and cut up the old ones into stars. In times of drought, if properly
propitiated, she would spin light summer clouds out of cobwebs and morning dew,
and send them off from the crest of the mountain, flake after flake, like flakes of
carded cotton, to float in the air; until, dissolved by the heat of the sun, they would
fall in gentle showers, causing the grass to spring, the fruits to ripen, and the corn
to grow an inch an hour. If displeased, however, she would brew up clouds black
as ink, sitting in the midst of them like a bottle-bellied spider in the midst of its web;
and when these clouds broke, woe betide the valleys!
In old times, say the Indian traditions, there was a kind of Manitou or Spirit,
who kept about the wildest recesses of the Catskill Mountains, and took a
mischievous pleasure in wreaking all kinds of evils and vexations upon the red
men. Sometimes he would assume the form of a bear, a panther, or a deer, lead
the bewildered hunter a weary chase through tangled forests and among ragged
rocks; and then spring off with a loud ho! ho! leaving him aghast on the brink of a
beetling precipice or raging torrent.
The favorite abode of this Manitou is still shown. It is a great rock or cliff on the
loneliest part of the mountains, and, from the flowering vines which clamber about
it, and the wild flowers which abound in its neighborhood, is known by the name of
the Garden Rock. Near the foot of it is a small lake, the haunt of the solitary bittern,
with water-snakes basking in the sun on the leaves of the pond-lilies which lie on
the surface. This place was held in great awe by the Indians, insomuch that the
boldest hunter would not pursue his game within its precincts. Once upon a time,
however, a hunter who had lost his way, penetrated to the Garden Rock, where he
beheld a number of gourds placed in the crotches of trees. One of these he seized
and made off with it, but in the hurry of his retreat he let it fall among the rocks,
when a great stream gushed forth, which washed him away and swept him down
precipices, where he was dashed to pieces, and the stream made its way to the
Hudson, and continues to flow to the present day; being the identical stream
known by the name of the Kaaterskill.
 WILLIAM AUSTIN
1778–1841

William Austin was a Boston lawyer of literary tastes. He saw something of the
world in his cruises (1799–1800) on the “Constitution” as chaplain, and of society
during his eighteen months at Lincoln’s Inn. An account of his life and works is
prefixed to the collective edition, now out of print, edited by his son, John Walker
Austin (The Literary Papers of William Austin, Boston, 1890). This also reprints a
large part of Col. T. W. Higginson’s “A Precursor of Hawthorne” (Independent, 29th
March, 1888. A reference will also be found at pages 64 and 68 of Col.
Higginson’s Longfellow). Of his few tales only Peter Rugg has had any currency.
Indeed, the significance of Austin’s narrative art is mainly negative. Even Peter
Rugg shows wherein what might have been a short story failed of its form. For all
its undoubted quality, it is a short story manqué; and in this it is quite typical of its
time. If artistic sense is apparent in the cumulation of foreshadowings, crudity of
mechanism is equally apparent in the management of each through a different
interlocutor. It is artistically right that Rugg should at last be brought home; it is
artistically wrong that the conclusion should be so like a moralising summary. A
conception much like Hawthorne’s is developed as it were by mere accumulation
instead of being focused in a unified progression. (See also pages 10 and 12 of
the Introduction.)
 PETER RUGG, THE MISSING MAN
[First part printed in Buckingham’s “New England Galaxy,”
10th September, 1824; several times reprinted entire, e. g., in
the “Boston Book” for 1841; reprinted here from the standard
collection noted above]

From Jonathan Dunwell of New York to Mr. Herman Krauff

SIR,—Agreeably to my promise, I now relate to you all the
particulars of the lost man and child which I have been able to
collect. It is entirely owing to the humane interest you seemed to
take in the report, that I have pursued the inquiry to the following
result.
You may remember that business called me to Boston in the
summer of 1820. I sailed in the packet to Providence, and when I
arrived there I learned that every seat in the stage was engaged. I
was thus obliged either to wait a few hours or accept a seat with the
driver, who civilly offered me that accommodation. Accordingly, I took
my seat by his side, and soon found him intelligent and
communicative. When we had travelled about ten miles, the horses
suddenly threw their ears on their necks, as flat as a hare’s. Said the
driver, “Have you a surtout with you?”
“No,” said I; “why do you ask?”
“You will want one soon,” said he. “Do you observe the ears of all
the horses?”
“Yes; and was just about to ask the reason.”
“They see the storm-breeder, and we shall see him soon.”
At this moment there was not a cloud visible in the firmament.
Soon after, a small speck appeared in the road.