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Transit Oriented Development Carey Curtis

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FINANCIAL ENGINEERING AND COMPUTATION

During the past decade many sophisticated mathematical and

computational techniques have been developed for analyzing
financial markets. Students and professionals intending to work in
any area of finance must not only master advanced concepts and
mathematical models but must also learn how to implement these
models computationally. This comprehensive text combines a
thorough treatment of the theory and mathematics behind
financial engineering with an emphasis on computation, in
keeping with the way financial engineering is practiced in today’s
capital markets.
Unlike most books on investments, financial engineering, or
derivative securities, the book starts from basic ideas in finance
and gradually builds up the theory. The advanced mathematical
concepts needed in modern finance are explained at accessible
levels. Thus it offers a thorough grounding in the subject for
MBAs in finance, students of engineering and sciences who are
pursuing a career in finance, researchers in computational finance,
system analysts, and financial engineers.
Building on the theory, the author presents algorithms for
computational techniques in pricing, risk management, and
portfolio management, together with analyses of their efficiency.
Pricing financial and derivative securities is a central theme of the
book. A broad range of instruments is treated: bonds, options,
futures, forwards, interest rate derivatives, mortgage-backed
securities, bonds with embedded options, and more. Each
instrument is treated in a short, self-contained chapter for ready
reference use.
Many of these algorithms are coded in Java as programs for
the Web, available from the book’s home page:
www.csie.ntu.edu.tw/∼lyuu/Capitals/capitals.htm. These
programs can be executed on Windows, MacOS, or Unix
platforms.

Yuh-Dauh Lyuu received his Ph.D. in computer science from

Harvard University. His past positions include Member of
Technical Staff at Bell Labs, Research Scientist at NEC Research
Institute (Princeton), and Assistant Vice President at Citicorp
Securities (New York). He is currently Professor of Computer
Science and Information Engineering and Professor of Finance,
National Taiwan University. His previous book is Information
Dispersal and Parallel Computation.
Professor Lyuu has published works in both computer
science and finance. He also holds a U.S. patent. Professor Lyuu
received several awards for supervising outstanding graduate
students’ theses.

i
FINANCIAL ENGINEERING
AND COMPUTATION
Principles, Mathematics, Algorithms

YUH-DAUH LYUU
National Taiwan University

iii
         
The Pitt Building, Trumpington Street, Cambridge, United Kingdom

  

The Edinburgh Building, Cambridge CB2 2RU, UK
40 West 20th Street, New York, NY 10011-4211, USA
477 Williamstown Road, Port Melbourne, VIC 3207, Australia
Ruiz de Alarcón 13, 28014 Madrid, Spain
Dock House, The Waterfront, Cape Town 8001, South Africa

http://www.cambridge.org

© Yuh-Dauh Lyuu 2004

First published in printed format 2002

ISBN 0-511-04094-6 eBook (netLibrary)

ISBN 0-521-78171-X hardback
In Loving Memory of RACHEL and JOSHUA

v
 Contents

Preface page xiii

Useful Abbreviations xvii

1 Introduction 1
1.1 Modern Finance: A Brief History 1
1.2 Financial Engineering and Computation 1
1.3 Financial Markets 2
1.4 Computer Technology 4

2 Analysis of Algorithms 7
2.1 Complexity 7
2.2 Analysis of Algorithms 8
2.3 Description of Algorithms 9
2.4 Software Implementation 10

3 Basic Financial Mathematics 11

3.1 Time Value of Money 11
3.2 Annuities 14
3.3 Amortization 15
3.4 Yields 17
3.5 Bonds 24

4 Bond Price Volatility 32

4.1 Price Volatility 32
4.2 Duration 34
4.3 Convexity 41

5 Term Structure of Interest Rates 45

5.1 Introduction 45
5.2 Spot Rates 46
5.3 Extracting Spot Rates from Yield Curves 47
5.4 Static Spread 49
5.5 Spot Rate Curve and Yield Curve 50
5.6 Forward Rates 50
5.7 Term Structure Theories 56
5.8 Duration and Immunization Revisited 60

vii
viii Contents

6 Fundamental Statistical Concepts 64

6.1 Basics 64
6.2 Regression 69
6.3 Correlation 71
6.4 Parameter Estimation 72

7 Option Basics 75
7.1 Introduction 75
7.2 Basics 76
7.3 Exchange-Traded Options 77
7.4 Basic Option Strategies 78

8 Arbitrage in Option Pricing 84

8.1 The Arbitrage Argument 84
8.2 Relative Option Prices 85
8.3 Put–Call Parity and Its Consequences 86
8.4 Early Exercise of American Options 88
8.5 Convexity of Option Prices 89
8.6 The Option Portfolio Property 90

9 Option Pricing Models 92

9.1 Introduction 92
9.2 The Binomial Option Pricing Model 93
9.3 The Black–Scholes Formula 104
9.4 Using the Black–Scholes Formula 111
9.5 American Puts on a Non-Dividend-Paying
Stock 113
9.6 Options on a Stock that Pays Dividends 114
9.7 Traversing the Tree Diagonally 118

10 Sensitivity Analysis of Options 123

10.1 Sensitivity Measures (“The Greeks”) 123
10.2 Numerical Techniques 127

11 Extensions of Options Theory 131

11.1 Corporate Securities 131
11.2 Barrier Options 137
11.3 Interest Rate Caps and Floors 140
11.4 Stock Index Options 141
11.5 Foreign Exchange Options 143
11.6 Compound Options 147
11.7 Path-Dependent Derivatives 148

12 Forwards, Futures, Futures Options, Swaps 155

12.1 Introduction 155
12.2 Forward Contracts 156
12.3 Futures Contracts 161
12.4 Futures Options and Forward Options 168
12.5 Swaps 173
 Contents ix

13 Stochastic Processes and Brownian Motion 177

13.1 Stochastic Processes 177
13.2 Martingales (“Fair Games”) 179
13.3 Brownian Motion 183
13.4 Brownian Bridge 188

14 Continuous-Time Financial Mathematics 190

14.1 Stochastic Integrals 190
14.2 Ito Processes 193
14.3 Applications 197
14.4 Financial Applications 201

15 Continuous-Time Derivatives Pricing 206

15.1 Partial Differential Equations 206
15.2 The Black–Scholes Differential Equation 207
15.3 Applications 211
15.4 General Derivatives Pricing 220
15.5 Stochastic Volatility 221

16 Hedging 224
16.1 Introduction 224
16.2 Hedging and Futures 224
16.3 Hedging and Options 228

17 Trees 234
17.1 Pricing Barrier Options with
Combinatorial Methods 234
17.2 Trinomial Tree Algorithms 242
17.3 Pricing Multivariate Contingent Claims 245

18 Numerical Methods 249

18.1 Finite-Difference Methods 249
18.2 Monte Carlo Simulation 255
18.3 Quasi–Monte Carlo Methods 262

19 Matrix Computation 268

19.1 Fundamental Definitions and Results 268
19.2 Least-Squares Problems 273
19.3 Curve Fitting with Splines 278

20 Time Series Analysis 284

20.1 Introduction 284
20.2 Conditional Variance Models for Price Volatility 291

21 Interest Rate Derivative Securities 295

21.1 Interest Rate Futures and Forwards 295
21.2 Fixed-Income Options and Interest Rate Options 306
21.3 Options on Interest Rate Futures 310
21.4 Interest Rate Swaps 312
x Contents

22 Term Structure Fitting 321

22.1 Introduction 321
22.2 Linear Interpolation 322
22.3 Ordinary Least Squares 323
22.4 Splines 325
22.5 The Nelson–Siegel Scheme 326

23 Introduction to Term Structure Modeling 328

23.1 Introduction 328
23.2 The Binomial Interest Rate Tree 329
23.3 Applications in Pricing and Hedging 337
23.4 Volatility Term Structures 343

24 Foundations of Term Structure Modeling 345

24.1 Terminology 345
24.2 Basic Relations 346
24.3 Risk-Neutral Pricing 348
24.4 The Term Structure Equation 350
24.5 Forward-Rate Process 353
24.6 The Binomial Model with Applications 353
24.7 Black–Scholes Models 359

25 Equilibrium Term Structure Models 361

25.1 The Vasicek Model 361
25.2 The Cox-Ingersoll-Ross Model 364
25.3 Miscellaneous Models 370
25.4 Model Calibration 371
25.5 One-Factor Short Rate Models 372

26 No-Arbitrage Term Structure Models 375

26.1 Introduction 375
26.2 The Ho–Lee Model 375
26.3 The Black–Derman–Toy Model 380
26.4 The Models According to Hull and White 384
26.5 The Heath–Jarrow–Morton Model 388
26.6 The Ritchken–Sankarasubramanian Model 395

27 Fixed-Income Securities 399

27.1 Introduction 399
27.2 Treasury, Agency, and Municipal Bonds 399
27.3 Corporate Bonds 401
27.4 Valuation Methodologies 406
27.5 Key Rate Durations 412

28 Introduction to Mortgage-Backed Securities 415

28.1 Introduction 415
28.2 Mortgage Banking 416
28.3 Agencies and Securitization 417
28.4 Mortgage-Backed Securities 419
 Contents xi

28.5 Federal Agency Mortgage-Backed

Securities Programs 422
28.6 Prepayments 423

29 Analysis of Mortgage-Backed Securities 427

29.1 Cash Flow Analysis 427
29.2 Collateral Prepayment Modeling 440
29.3 Duration and Convexity 444
29.4 Valuation Methodologies 446

30 Collateralized Mortgage Obligations 451

30.1 Introduction 451
30.2 Floating-Rate Tranches 452
30.3 PAC Bonds 453
30.4 TAC Bonds 457
30.5 CMO Strips 457
30.6 Residuals 457

31 Modern Portfolio Theory 458

31.1 Mean–Variance Analysis of Risk and Return 458
31.2 The Capital Asset Pricing Model 464
31.3 Factor Models 470
31.4 Value at Risk 474

32 Software 480
32.1 Web Programming 480
32.2 Use of The Capitals Software 480
32.3 Further Topics 482

33 Answers to Selected Exercises 484

Bibliography 553
Glossary of Useful Notations 585
Index 587
 Preface

[A book] is a node within a network.

Michel Foucault (1926–1984), The Archaeology of Knowledge

Intended Audience
As the title of this book suggests, a modern book on financial engineering has to
cover investment theory, financial mathematics, and computer science evenly. This
interdisciplinary emphasis is tuned more to the capital markets wherever quantita-
tive analysis is being practiced. After all, even economics has moved away from a
time when “the bulk of [Alfred Marshall’s] potential readers were both unable and
unwilling to read economics in mathematical form” according to Viner (1892–1970)
[860] toward the new standard of which Markowitz wrote in 1987, “more than half
my students cannot write down the formal definition of [the limit of a sequence]”
[642].
This text is written mainly for students of engineering and the natural sciences
who want to study quantitative finance for academic or professional reasons. No
background in finance is assumed. Years of teaching students of business adminis-
tration convince me that technically oriented MBA students will benefit from the
book’s emphasis on computation. With a sizable bibliography, the book can serve as
a reference for researchers.
This text is also written for practitioners. System analysts will find many compact
and useful algorithms. Portfolio managers and traders can obtain the quantitative
underpinnings for their daily activities. This work also serves financial engineers in
their design of financial instruments by expounding the underlying principles and
the computational means to pricing them.
The marketplace has already offered several excellent books on derivatives (e.g.,
[236, 470, 514, 746, 878]), financial engineering (e.g., [369, 646, 647]), financial theory
(e.g., [290, 492]), econometrics (e.g., [147]), numerical techniques (e.g., [62, 215]),
and financial mathematics (e.g., [59, 575, 692, 725]). There are, however, few books
that come near to integrating the wide-ranging disciplines. I hope this text succeeds
at least partially in that direction and, as a result, one no longer has to buy four or
five books to get good coverage of the topics.

xiii
xiv Preface

Presentation
This book is self-contained. Technically sophisticated undergraduates and graduates
should be able to read it on their own. Mathematical materials are added where they
are needed. In many instances, they provide the coupling between earlier chapters
and upcoming themes. Applications to finance are generally added to set the stage.
Numerical techniques are presented algorithmically and clearly; programming them
should therefore be straightforward. The underlying financial theory is adequately
covered, as understanding the theory underlying the calculations is critical to financial
innovations.
The large number of exercises is an integral part of the text. Exercises are placed
right after the relevant materials. Hints are provided for the more challenging ones.
There are also numerous programming assignments. Those readers who aspire to be-
come software developers can learn a lot by implementing the programming assign-
ments. Thoroughly test your programs. The famous adage of Hamming (1916–1998),
“The purpose of computing is insight, not numbers,” does not apply to erroneous
codes. Answers to all nontrivial exercises and some programming assignments can
be found near the end of the book.
Most of the graphics were produced with Mathematica [882]. The programs that
generate the data for the plots have been written in various languages, including C,
C++, Java, JavaScript, Basic, and Visual Basic. It is a remarkable fact that most – if
not all – of the programming works could have been done with spreadsheet software
[221, 708]. Some computing platforms admit the integration of the spreadsheet’s
familiar graphical user interface and programs written in more efficient high-level
programming languages [265]. Although such a level of integration requires certain
sophistication, it is a common industry practice. Freehand graphics were created with
Canvas and Visio.
The manuscript was typeset in LATEX [580], which is ideal for a work of this size
and complexity. I thank Knuth and Lamport for their gifts to technical writers.

Software
Many algorithms in the book have been programmed. However, instead of being
bundled with the book in disk, my software is Web-centric and platform-independent
[412]. Any machine running a World Wide Web browser can serve as a host for those
programs on The Capitals page at
www.csie.ntu.edu.tw/∼lyuu/capitals.html
There is no more need for the (rare) author to mail the upgraded software to the
reader because the one on the Web page is always up to date. This new way of software
development and distribution, made possible by the Web, has turned software into
an Internet service.

Organization
Here is a grand tour of the book:
Chapter 1 sets the stage and surveys the evolution of computer technology.
 Preface xv

Chapter 2 introduces algorithm analysis and measures of complexity. My con-

vention for expressing algorithms is outlined here.
Chapter 3 contains a relatively complete treatment of standard financial mathe-
matics, starting from the time value of money.
Chapter 4 covers the important concepts of duration and convexity.
Chapter 5 goes over the static term structure of interest rates. The coverage of
classic, static finance theory ends here.
Chapter 6 marks the transition to stochastic models with coverage of statistical
inference.
Chapters 7--12 are about options and derivatives. Chapter 7 presents options and
basic strategies with options. Chapter 8 introduces the arbitrage argument and derives
general pricing relations. Chapter 9 is a key chapter. It covers option pricing under the
discrete-time binomial option pricing model. The celebrated Black–Scholes formulas
are derived here, and algorithms for pricing basic options are presented. Chapter 10
presents sensitivity measures for options. Chapter 11 covers the diverse applications
and kinds of options. Additional derivative securities such as forwards and futures
are treated in Chap. 12.
Chapters 13--15 introduce the essential ideas in continuous-time financial math-
ematics. Chapter 13 covers martingale pricing and Brownian motion, and Chap. 14
moves on to stochastic integration and the Ito process. Together they give a fairly
complete treatment of the subjects at an accessible level. From time to time, we go
back to discrete-time models and establish the linkage. Chapter 15 focuses on the
partial differential equations that derivative securities obey.
Chapter 16 covers hedging by use of derivatives.
Chapters 17--20 probe deeper into various technical issues. Chapter 17 investi-
gates binomial and trinomial trees. One of the motives here is to demonstrate the use
of combinatorics in designing highly efficient algorithms. Chapter 18 covers numer-
ical methods for partial differential equations, Monte Carlo simulation, and quasi–
Monte Carlo methods. Chapter 19 treats computational linear algebra, least-squares
problems, and splines. Factor models are presented as an application. Chapter 20
introduces financial time series analysis as well as popular time-series models.
Chapters 21--27 are related to interest-rate-sensitive securities. Chapter 21 sur-
veys the wide varieties of interest rate derivatives. Chapter 22 discusses yield curve
fitting. Chapter 23 introduces interest rate modeling and derivative pricing with the
elementary, yet important, binomial interest rate tree. Chapter 24 lays the mathemat-
ical foundations for interest rate models, and Chaps. 25 and 26 sample models from
the literature. Finally, Chap. 27 covers fixed-income securities, particularly those with
embedded options.
Chapters 28--30 are concerned with mortgage-backed securities. Chapter 28 in-
troduces the basic ideas, institutions, and challenging issues. Chapter 29 investigates
the difficult problem of prepayment and pricing. Chapter 30 surveys collateralized
mortgage obligations.
xvi Preface

Chapter 31 discusses the theory and practice of portfolio management. In partic-

ular, it presents modern portfolio theory, the Capital Asset Pricing Model, the Arbi-
trage Pricing Theory, and value at risk.
Chapter 32 documents the Web software developed for this book.
Chapter 33 contains answers or pointers to all nontrivial exercises.
This book ends with an extensive index. There are two guiding principles behind
its structure. First, related concepts should be grouped together. Second, the index
should facilitate search. An entry containing parentheses indicates that the term
within should be consulted instead, first at the current level and, if not found, at the
outermost level.

Acknowledgments
Many people contributed to the writing of the book: George Andrews, Nelson
Beebe, Edward Bender, Alesandro Bianchi, Tomas Björk, Peter Carr, Ren-Raw
Chen, Shu-Heng Chen, Oren Cheyette, Jen-Diann Chiou, Mark Fisher, Ira Gessel,
Mau-Wei Hung, Somesh Jha, Ming-Yang Kao, Gow-Hsing King, Timothy Klassen,
Philip Liang, Steven Lin, Mu-Shieung Liu, Andrew Lo, Robert Lum, Chris McLean,
Michael Rabin, Douglas Rogers, Masako Sato, Erik Schlögl, James Tilley, and Keith
Weintraub.
Ex-colleagues at Citicorp Securities, New York, deserve my deep thanks for the
intellectual stimuli: Mark Bourzutschky, Michael Chu, Burlie Jeng, Ben Lis, James
Liu, and Frank Feikeh Sung. In particular, Andy Liao and Andy Sparks taught me a
lot about the markets and quantitative skills.
Students at National Taiwan University, through research or course work, helped
improve the quality of the book: Chih-Chung Chang, Ronald Yan-Cheng Chang,
Kun-Yuan Chao [179], Wei-Jui Chen [189], Yuan-Wang Chen [191], Jing-Hong Chou,
Tian-Shyr Dai, [257, 258, 259] Chi-Shang Draw, Hau-Ren Fang, Yuh-Yuan Fang,
Jia-Hau Guo [405], Yon-Yi Hsiao, Guan-Shieng Huang [250], How-Ming Hwang,
Heng-Yi Liu, Yu-Hong Liu [610], Min-Cheng Sun, Ruo-Ming Sung, Chen-Leh Wang
[867], Huang-Wen Wang [868], Hsing-Kuo Wong [181], and Chao-Sheng Wu [885].
This book benefited greatly from the comments of several anonymous reviewers.
As the first readers of the book, their critical eyes made a lasting impact on its
evolution. As with my first book with Cambridge University Press, the editors at the
Press were invaluable. In particular, I would like to thank Lauren Cowles, Joäo da
Costa, Caitlin Doggart, Scott Parris, Eleanor Umali, and the anonymous copy editor.
I want to thank my wife Chih-Lan and my son Raymond for their support during
the project, which started in January 1995. This book, I hope, finally puts to rest their
dreadful question, “When are you going to finish it?”
 Useful Abbreviations

Acronyms
APT Arbitrage Pricing Theory
AR autoregressive (process)
ARCH autoregressive conditional heteroskedastic
(process)
ARM adjustable-rate mortgage
ARMA autoregressive moving average (process)

BDT Black–Derman–Toy (model)

BEY bond-equivalent yield
BOPM binomial option pricing model
BPV basis-point value

CAPM Capital Asset Pricing Model

CB convertible bond
CBOE Chicago Board of Exchange
CBT Chicago Board of Trade
CD certificate of deposit
CIR Cox–Ingersoll–Ross
CME Chicago Mercantile Exchange
CMO collateralized mortgage obligation
CMT constant-maturity Treasury (rate)
COFI Cost of Funds Index
CPR conditional prepayment rate

DEM German mark

DJIA Dow Jones Industrial Average

FHA Federal Housing Administration

FHLMC Federal Home Loan Mortgage Corporation
(“Freddie Mac”)
FNMA Federal National Mortgage Association
(“Fannie Mae”)
forex foreign exchange
FRA forward rate agreement
FV future value

xvii
xviii Useful Abbreviations

GARCH generalized autoregressive conditional

heteroskedastic
GLS generalized least-squares
GMM generalized method of moments
GNMA Government National Mortgage Association
(“Ginnie Mae”)

HJM Heath–Jarrow–Morton
HPR holding period return

IAS index-amortizing swap

IMM International Monetary Market
IO interest-only
IRR internal rate of return

JPY Japanese yen

LIBOR London Interbank Offered Rate

LTCM Long-Term Capital Management

MA moving average
MBS mortgage-backed security
MD Macauley duration
ML maximum likelihood
MPTS mortgage pass-through security
MVP minimum-variance point

NPV net present value

NYSE New York Stock Exchange

OAC option-adjusted convexity

OAD option-adjusted duration
OAS option-adjusted spread
OLS ordinary least-squares

PAC Planned Amortization Class (bond)

P&I principal and interest
PC participation certificate
PO principal-only
PSA Public Securities Association
PV present value

REMIC Real Estate Mortgage Investment Conduit

RHS Rural Housing Service
RS Ritchken–Sankarasubramanian

S&P 500 Standard and Poor’s 500 Index

SMBS stripped mortgage-backed security
SMM single monthly mortality
SSE error sum of squares
 Useful Abbreviations xix

SSR regression sum of squares

SST total sum of squares
SVD singular value decomposition

TAC Target Amortization Class (bond)

VA Department of Veterans Affairs

VaR value at risk

WAC weighted average coupon

WAL weighted average life
WAM weighted average maturity
WWW World Wide Web

Ticker Symbols
DJ Dow Jones Industrial Average
IRX thirteen-week T-bill
NDX Nasdaq 100
NYA New York Stock Exchange Composite Index
OEX S&P 100
RUT Russell 200
SPX S&P 500
TYX thirty-year T-bond
VLE Value Line Index
WSX Wilshire S-C
XMI Major Market Index
 CHAPTER
ONE
Introduction

But the age of chivalry is gone. That of sophisters, oeconomists, and

calculators, has succeeded; and the glory of Europe is extinguished
for ever.
Edmund Burke (1729–1797), Reflections on the Revolution
in France

1.1 Modern Finance: A Brief History

Modern finance began in the 1950s [659, 666]. The breakthroughs of Markowitz,
Treynor, Sharpe, Lintner (1916–1984), and Mossin led to the Capital Asset Pric-
ing Model in the 1960s, which became the quantitative model for measuring risk.
Another important influence of research on investment practice in the 1960s was
the Samuelson–Fama efficient markets hypothesis, which roughly says that security
prices reflect information fully and immediately. The most important development in
terms of practical impact, however, was the Black–Scholes model for option pricing
in the 1970s. This theoretical framework was instantly adopted by practitioners. Op-
tion pricing theory is one of the pillars of finance and has wide-ranging applications
[622, 658]. The theory of option pricing can be traced to Louis Bachelier’s Ph.D. thesis
in 1900, “Mathematical Theory of Speculation.” Bachelier (1870–1946) developed
much of the mathematics underlying modern economic theories on efficient markets,
random-walk models, Brownian motion [ahead of Einstein (1879–1955) by 5 years],
and martingales [277, 342, 658, 776].1

1.2 Financial Engineering and Computation

Today, the wide varieties of financial instruments dazzle even the knowledgeable.
Individuals and corporations can trade, in addition to stocks and bonds, options,
futures, stock index options, and countless others. When it comes to diversifica-
tion, one has thousands of mutual funds and exchange-traded funds to choose from.
Corporations and local governments increasingly use complex derivative securities
to manage their financial risks or even to speculate. Derivative securities are finan-
cial instruments whose values depend on those of other assets. All are the fruits of
financial engineering, which means structuring financial instruments to target in-
vestor preferences or to take advantage of arbitrage opportunities [646].

1
2 Introduction

The innovations in the financial markets are paralleled by equally explosive

progress in computer technology. In fact, one cannot think of modern financial
systems without computers: automated trading, efficient bookkeeping, timely clear-
ing and settlements, real-time data feed, online trading, day trading, large-scale
databases, and tracking and monitoring of market conditions [647, 866]. These
applications deal with information. Structural changes and increasing volatility in
financial markets since the 1970s as well as the trend toward greater complexity
in financial product design call for quantitative techniques. Today, most investment
houses use sophisticated models and software on which their traders depend. Here,
computers are used to model the behavior of financial securities and key indicators,
price financial instruments, and find combinations of financial assets to achieve
results consistent with risk exposures. The confidence in such models in turn leads
to more financial innovations and deeper markets [659, 661]. These topics are the
focus of financial computation.
One must keep in mind that every computation is based on input and assumptions
made by the model. However, input might not be accurate enough or complete,
and the assumptions are, at best, approximations.2 Computer programs are also
subject to errors (“bugs”). These factors easily defeat any computation. Despite
these difficulties, the computer’s capability of calculating with fine details and trying
out vast numbers of scenarios is a tremendous advantage. Harnessing this power and
a good understanding of the model’s limitations should steer us clear of blind trust
in numbers.

1.3 Financial Markets

A society improves its welfare through investments. Business owners need out-
side capital for investments because even projects of moderate sizes are beyond
the reach of most wealthy individuals. Governments also need funds for public in-
vestments. Much of that money is channeled through the financial markets from
savers to borrowers. In so doing, the financial markets provide a link between sav-
ing and investment,3 and between the present and the future. As a consequence,
savers can earn higher returns from their savings instead of hoarding them, borrow-
ers can execute their investment plans to earn future profits, and both are better off.
The economy also benefits by acquiring better productive capabilities as a result.
Financial markets therefore facilitate real investments by acting as the sources of
information.
A financial market typically takes its name from the borrower’s side of the market:
the government bond market, the municipal bond market, the mortgage market,
the corporate bond market, the stock market, the commodity market, the foreign
exchange (forex) market,4 the futures market, and so on [95, 750]. Within financial
markets, there are two basic types of financial instruments: debt and equity. Debt
instruments are loans with a promise to repay the funds with interest, whereas equity
securities are shares of stock in a company. As an example, Fig. 1.1 traces the U.S.
markets of debt securities between 1985 and 1999. Financial markets are often divided
into money markets, which concentrate on short-term debt instruments, and capital
markets, which trade in long-term debt (bonds) and equity instruments (stocks)
[767, 799, 828].
 1.3 Financial Markets 3

Outstanding U.S. Debt Market Securities (U.S. $ billions)

Agency U.S. Fed Money Asset-
Year Municipal Treasury MBSs corporate agencies market backed Total
1985 859.5 1,360.2 372.1 719.8 293.9 847.0 2.4 4,454.9
1986 920.4 1,564.3 534.4 952.6 307.4 877.0 3.3 5,159.4
1987 1,010.4 1,724.7 672.1 1,061.9 341.4 979.8 5.1 5,795.4
1988 1,082.3 1,821.3 749.9 1,181.2 381.5 1,108.5 6.8 6,331.5
1989 1,135.2 1,945.4 876.3 1,277.1 411.8 1,192.3 59.5 6,897.6
1990 1,184.4 2,195.8 1,024.4 1,333.7 434.7 1,156.8 102.2 7,432.0
1991 1,272.2 2,471.6 1,160.5 1,440.0 442.8 1,054.3 133.6 7,975.0
1992 1,302.8 2,754.1 1,273.5 1,542.7 484.0 994.2 156.9 8,508.2
1993 1,377.5 2,989.5 1,349.6 1,662.1 570.7 971.8 179.0 9,100.2
1994 1,341.7 3,126.0 1,441.9 1,746.6 738.9 1,034.7 205.0 9,634.8
1995 1,293.5 3,307.2 1,570.4 1,912.6 844.6 1,177.2 297.9 10,403.5
1996 1,296.0 3,459.0 1,715.0 2,055.9 925.8 1,393.8 390.5 11,235.0
1997 1,367.5 3,456.8 1,825.8 2,213.6 1,022.6 1,692.8 518.1 12,097.2
1998 1,464.3 3,355.5 2,018.4 2,462.0 1,296.5 1,978.0 632.7 13,207.4
1999 1,532.5 3,281.0 2,292.0 3,022.9 1,616.5 2,338.2 746.3 14,829.4

Figure 1.1: U.S. debt markets 1985–1999. The Bond Market Association estimates. Sources: Federal Home Loan
Mortgage Corporation, Federal National Mortgage Association, Federal Reserve System, Government National
Mortgage Association, Securities Data Company, and U.S. Treasury. MBS, mortgage-backed security.

Borrowers and savers can trade directly with each other through the financial
markets or direct loans. However, minimum-size requirements, transactions costs,
and costly evaluation of the assets in question often prohibit direct trades. Such
impediments are remedied by financial intermediaries. These are financial institu-
tions that act as middlemen to transfer funds from lenders to borrowers; unlike most
firms, they hold only financial assets [660]. Banks, savings banks, savings and loan
associations, credit unions, pension funds, insurance companies, mutual funds, and
money market funds are prominent examples. Financial intermediaries can lower
the minimum investment as well as other costs for savers.
Financial markets can be divided further into primary markets and secondary
markets. The primary market is often merely a fictional, not a physical, location.
Governments and corporations initially sell securities – debt or equity – in the primary
market. Such sales can be done by means of public offerings or private placements.
A syndicate of investment banks underwrites the debt and the equity by buying
them from the issuing entities and then reselling them to the public. Sometimes the
investment bankers work on a best-effort basis to avoid the risk of not being able to
sell all the securities. Subsequently people trade those instruments in the secondary
markets, such as the New York Stock Exchange. Existing securities are exchanged
in the secondary market.
The existence of the secondary market makes securities more attractive to in-
vestors by making them tradable after their purchases. It is the very idea that created
the secondary market in mortgages in 1970 by asset securitization [54]. Securitiza-
tion converts assets into traded securities with the assets pledged as collaterals, and
these assets can often be removed from the balance sheet of the bank. In so doing,
4 Introduction

financial intermediaries transform illiquid assets into liquid liabilities [843]. By mak-
ing mortgages more attractive to investors, the secondary market also makes them
more affordable to home buyers. In addition to mortgages, auto loans, credit card
receivables, senior bank loans, and leases have all been securitized [330]. Securitiza-
tion has fundamentally changed the credit market by making the capital market a
major supplier of credit, a role traditionally held exclusively by the banking system.

1.4 Computer Technology

Computer hardware has been progressing at an exponential rate. Measured by the
widely accepted integer Standard Performance Evaluation Corporation (SPEC)
benchmarks, the workstations improved their performance by 49% per year be-
tween 1987 and 1997. The memory technology is equally impressive. The dynamic
random-access memory (DRAM) has quadrupled its capacity every 3 years since
1977. Relative performance per unit cost of technologies from vacuum tube to tran-
sistor to integrated circuit to very-large-scale-integrated (VLSI) circuit is a factor of
2,400,000 between 1951 and 1995 [717].
Some milestones in the industry include the IBM/360 mainframe, followed by
Digital’s minicomputers. (Digital was acquired by Compaq in 1998.) The year 1963
saw the first supercomputer, built by Cray (1926–1996) at the Control Data Corpo-
ration. Apple II of 1977 is generally considered to be the first personal computer.
It was overtaken by the IBM Personal Computer in 1981, powered by Intel mi-
croprocessors and Microsoft’s disk operating system (DOS) [638, 717]. The 1980s
also witnessed the emergence of the so-called massively parallel computers, some of
which had more than 65,000 processors [487]. Parallel computers have also been ap-
plied to database applications [247, 263] and pricing complex financial instruments
[528, 794, 891]. Because commodity components offer the best performance/cost
ratio, personal computers connected by fast networks have been uprooting niche
parallel machines from most of their traditional markets [24, 200].
On the software side, high-level programming languages dominate [726]. Al-
though they are easier to program with than low-level languages, it remains difficult
to design and maintain complex software systems. In fact, in the 1960s, the software
cost of the IBM/360 system already dominated its hardware cost [872]. The current
trend has been to use the object-oriented principles to encapsulate as much infor-
mation as possible into the so-called objects [101, 466]. This makes software easier
to maintain and develop. Object-oriented software development systems are widely
available [178].
The revolution fostered by the graphical user interface (GUI) brought comput-
ers to the masses. The omnipotence of personal computers armed with easy-to-use
interfaces enabled employees to have access to information and to bypass several
layers of management [140]. It also paved the way for the client/server concept [736].
Client/server systems consist of components that are logically distributed rather
than centralized (see Fig. 1.2). Separate components therefore can be optimized
based on their functions, boosting the overall performance/cost ratio. For instance,
the three-tier client/server architecture contains three parts: user interface, com-
puting (application) server, and data server [310]. Because the user interface de-
mands fewer resources, it can run on lightly configured computers. Best of all, it can
potentially be made platform independent, thus offering maximum availability of the
 1.4 Computer Technology 5

Figure 1.2: Client/server architecture. In a typical three-tier

client/server architecture, client machines are connected to
the computing server, which in turn is connected to the data
server. As the bulk of the computation is with the computing
server and the bulk of the data access is with the data server,
the client computer can be lightly equipped.

server applications, thanks to Internet-induced developments in the mid-1990s. The

server machines, on the other hand, can be powerful multiprocessors for the comput-
ing servers and machines with high disk throughputs for the data servers. The typical
World Wide Web (WWW) architecture, for instance, is a three-tier client/server sys-
tem consisting of the browser, Web server, and database server. The object-oriented
methodology and client/server architecture can be profitably combined for financial
computation [626, 867].
Database management systems are the backbone of information systems
[497, 871]. With products from Computer Associates, IBM, Informix, Microsoft,
Oracle, and Sybase, the database scenery is dominated by the relational database
model invented by Codd at IBM in 1970 [216]. In a relational database, data are
organized as two-dimensional tables. Consider the following table for storing daily
interest rate data.

Attribute Null? Type

maturity NOT NULL CHAR(10)
ratedate NOT NULL DATE
rate — DECIMAL(15,8)

Name the table yieldcurve. The structured query language (SQL)5 statement below
can be used to retrieve the two-year U.S. Treasury yield as of December 1, 1994,

SELECT rate FROM yieldcurve

WHERE maturity = ’2YR’ AND ratedate = ’1994-12-01’

SQL can also be embedded into general-purpose programming languages. The ad-
vancement in the capability of low-cost personal computers and the release of truly
multitasking operating systems for them (IBM’s OS/2, Microsoft’s Windows NT, and
Linux) brought client/server database systems to the masses [1, 182, 688, 888]. How-
ever, by 1996, the relational database market started to be affected by the Internet
momentum [311].
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dragoon regiment, and the sergeant proceeded to take them out of
Toni.
“Look here, my man,” he said, “you have got to learn to do that
trick now and here—do you understand?”
“But, Sergeant,” moaned Toni, “I am afraid of the horse, I swear
I am—”
The sergeant’s reply to this was to run toward Toni with uplifted
whip. Old Caporal, supposing the whip was meant for him, suddenly
broke into a furious gallop. Toni darted toward him, lighted like a
bird with both feet on the horse’s back, folded his arms, stuck his
right leg out as Caporal sped around the circle, changed to his left,
turned a somersault, stood on his head on the horse’s back for a
whole minute, and then with a “Houp-la!” flung himself backward to
the ground, and, approaching the sergeant, stood calmly at
attention. The roof of the riding-hall echoed with thunders of
laughter and applause, Sublieutenant Verney leading off, capering in
his delight, and pinching Powder to make him join his yelping to the
uproar. The sergeant stood grinning with satisfaction. He was one of
the few sergeants who wanted a man to ride well and cared very
little what share of praise or blame accrued to himself in the doing of
it.
“So you were in the circus?” he asked.
“Yes, Sergeant—ever since I was thirteen,” answered Toni, who
had thrown off his stupid expression like a mask and stood up alert,
cool, with a glint of a smile in his eye. Then he stopped. He had not
forgotten those magnanimous offers made by the sergeant to his
mother to marry her for the purpose of thrashing him. His old
cowardice returned to him and he trembled at the idea of the
coming recognition by the sergeant. He certainly would not consider
a circus rider a match for Denise, who, by this time, must be a
young lady.
The seven years which had changed Toni and Paul from boys into
men, had apparently passed over the sergeant without leaving the
smallest sign on him, but they had marked Toni so that Sergeant
Duval so far had no idea that he was the Toni whom he had yearned
to thrash.
A light had been breaking upon Paul Verney’s mind. There had
been something strangely familiar in the awkward recruit. A thrill of
remembrance swept over Paul Verney, but Bienville and Toni were
far from his mind then, and besides, Toni, as a dirty, shock-headed
boy, had been the personification of boyish grace, while this fellow
had been the embodiment of awkwardness in walking as well as
riding. But now things began to grow clearer. As for Toni, the old joy
and love of Paul came over him with a rush. He straightened himself
up, stood at attention, and turned his gaze full on the young
lieutenant.
Paul came up close to him.
“Isn’t this—isn’t this Toni?” he asked.
For answer, Toni saluted and said, “Yes, sir.” He had learned
enough, during his short enlistment, to say that. And then,
surreptitiously opening his hand, Paul caught a glimpse of the old
battered Jacques in Toni’s palm. He covered it up quickly again. Paul
Verney could not trust himself with all the recruits standing by, and
the riding lesson in progress, to say more than:
“Come to my quarters at twelve o’clock,”—and turned away.
Sergeant Duval then recognized Toni, and with severe
disapproval.
“So you have turned up at last!” he said sternly, “while your poor
mother has been breaking her heart in Bienville these seven years
about you. Well, I will talk with you later. I don’t suppose you
learned any good in the circus except how to ride.”
But this could not crush Toni. He had felt all his perplexities and
miseries dwindle since he had spoken to Paul Verney. Paul always
had such a sensible, level head, and knew well that plain, straight
path out of difficulties—telling the truth and standing by the
consequences.
 CHAPTER XII
At Paul Verney’s quarters, therefore, on the stroke of twelve, Toni
presented himself. He had laid aside his pretended awkwardness and
when he stood, erect and at attention, in his dragoon uniform, he
was a model of lithe and manly grace. His circus training had
developed his naturally good figure, and he was as well built a
young fellow as one would wish to see. He was handsome, too, in
his own odd, picturesque way. His teeth were as white as ever and
shone now in a happy grin, while his black eyes were full of the
mingled archness and softness that had distinguished the dirty little
Toni of ten years before.
Paul was as happy as Toni, and the two eyed each other with
delight when they were alone. Paul stepped softly to the door and,
locking it, held out his arms to Toni, and the two hugged each other
as if they were ten years old, instead of being twenty and twenty-
two.
“And now, Toni,” said Paul, “tell me all that you have been doing.
I don’t suppose you learned anything good in the circus except
riding.”
“That’s just what Sergeant Duval said to me,” replied Toni, and
then the memory of all he had suffered since his association with
Pierre and Nicolas came to his mind and his expressive eyes glowed.
“It is true, Pa—I mean, Lieutenant, that I got into bad company
when I was in the circus, and I want to tell you all about it. But first
tell me something about Bienville. I have written regularly to my
mother, but I was afraid to give her my address.”
“Afraid of what?” asked Paul.
Toni’s eyes wandered around the room aimlessly, and came back
to Paul’s.
 “I always was afraid,” he said.
“Your mother is alive and well,” said Paul, “but heart-broken
about you. What induced you, Toni, to run away as you did?”
“Because—because—” That one franc still loomed large in Toni’s
mind. “I took a franc from my mother—only a single franc, to go to
the circus, and Clery, the tailor, caught me and accused me of taking
the money and whipped me and said he would have me arrested
and then—oh, I was so frightened! I have been frightened every
time I thought of that franc in these more than seven years.”
“Some story of the sort got out,” answered Paul, “but your
mother always denied it. I don’t really think she missed the franc
that you took out of the box. But Toni, what a fool you were—what a
monumental fool you were.”
Toni shook his head. “And a coward, too, sir,” he said. It was very
difficult to add that “sir” when he spoke to Paul, and equally strange
for Paul to hear.
“Look here, Toni, don’t call me ‘sir’ when we are alone—I can’t
stand it. As soon as we step outside in the corridor it shall be ‘my
man’ and ‘sir,’ but when the door is locked we are Paul and Toni.”
Toni nodded delightedly. “It never would have worked,” he said,
“when the door is locked on us.”
“I never could understand that cowardice in you,” said Paul. “You
were the most timid boy I ever saw in my life about some things,
and the most insensible to fear about others.”
“I know it, but the reason why you can’t understand it is because
you are not afraid of anything. I am not afraid of horses, nor of
railroad wrecks—I have been in one or two and was not frightened—
nor fires, nor—nor any of those things which come on a man
unawares and where he has just to stand still, keep cool and do
what he is told to do. But when it comes to other things, like going
against another man’s will—oh, Paul—I am the biggest coward alive
and I know it. I would never volunteer for the forlorn hope, but if
there was an officer by the side of me with a pistol I’d march to the
mouth of hell, because I would be more afraid of the officer than I
would be of hell. That’s the sort of courage I have,” and Toni grinned
shamelessly. “But before I tell you all of the evil things that have
befallen me, tell me some more about Bienville. How does my
mother look?”
“About twenty-five years older since you left. And Toni, you must
write to her this very day—do you understand me?—to-day, and I
shall write to her that she may get our letters together.”
“I will,” answered Toni. “And how about little Denise?”
As Toni said this, he blushed under his sunburned skin, and Paul
laughed. They were both very young men and their thoughts
naturally turned in the same direction.
“Denise is here with her father. Mademoiselle Duval has sold out
the bakery shop, so I suppose you will no longer be in love with
Denise.”
Toni giggled like a school-girl.
“To tell you the truth,” he said, “I never have thought about any
girl except Denise, but I can only think of her now as a little creature
in a checked apron with her flaxen plait hanging down her back.”
“She is an extremely pretty young lady, and a great belle with the
young corporals. Mademoiselle Duval has given her a nice little dot
of ten thousand francs to her fortune. But, for that reason, the
sergeant, who is a level-headed old fellow, is looking around very
carefully before he disposes of Denise’s hand.”
Toni struck his forehead with his open palm.
“Oh!” he cried, “Denise is not for me. I am only a private soldier
—I never will be anything else.”
“You can be something else if you choose,” said Paul Verney.
“And I have been in the circus. The sergeant will never forgive
me that.”
 Paul shook his head dolefully. It was pretty bad, and the sergeant
was a great stickler for correctness of behavior. But Paul, being a
lover himself, and a poor man, who sincerely loved a rich girl,
sympathized with Toni.
“Oh, well,” he said, “we must wait and see. One thing is certain—
if Mademoiselle Denise takes a notion into her head to like you the
sergeant will give in, for he is a very doting father. But, Toni, you
must behave yourself after this.”
“Indeed I will,” replied Toni. “When I tell you what I have got by
bad association, you will understand that I mean what I say.”
And then Toni, seating himself at Paul’s command, poured out
the story of all that he had suffered at the hands of Nicolas and
Pierre, ending up with that last dreadful account of the murder of
Delorme.
“And that secret, Paul, I am carrying,” cried poor Toni, putting his
fists to his eyes, into which the tears started, “and sometimes it’s
near to killing me.”
Paul listened closely. He realized, quite as fully as Toni did, the
position in which Toni had got himself, and did not make light of it.
“At all events,” he said, “I don’t think any one regretted
Delorme’s death. He was the worst sort of a rascal—a gentleman
rascal. You know he was the first husband of Madame Ravenel at
Bienville.”
Toni nodded.
“I have seen many women in the seven years that I have been
traveling about the world,” said Toni, “but I never saw one who
seemed to radiate modesty and goodness as Madame Ravenel. Do
the Ravenels still live at Bienville?”
“Yes.” The color came into Paul’s face, which was pink already.
“They live there as quietly as ever, but much respected. They are no
longer avoided, but still live very quietly.”
 Toni, looking into Paul’s eyes, saw his face grow redder and
redder, and his mouth come wide open, as Toni said, with a sidelong
glance and his old-time grin:
“And Mademoiselle Lucie?”
“Beautiful as a dream,” replied Paul, with a lover’s fondness for
superlatives, “and charming beyond words. Only,” here his
countenance fell, “she has a great fortune from America, and why
should she look at a sublieutenant in a dragoon regiment with two
thousand francs a year and his pay?”
“If I recollect Mademoiselle Lucie aright,” answered Toni, “and
she takes a notion into her head to like you, her grandmother will
give in, because you used to tell me, in the old days when we sat in
the little cranny on the bridge, that Mademoiselle Lucie said her
grandmother allowed her to do exactly as she pleased.”
Paul laughed at having his own words turned against him.
“Oh, Toni!” he cried, “we are a couple of poor devils who love
above our stations, both of us.”
“Not you,” replied Toni with perfect sincerity. “The greatest lady
that ever lived might be proud and glad to marry you.” And as this
was said by a person who had known Paul ever since he could walk,
in an intimacy closer than that of a brother, it meant something. “I
have seen Mademoiselle Lucie,” continued Toni. “I saw her one
morning about two months ago, when you and she were riding
together. She rides beautifully—I could not teach her anything in
that line.”
“She does a great many things beautifully, and she is the most
generous, warm-hearted creature in the world.”
“And just the sort of a young lady to fall in love with a poor
sublieutenant and throw herself and her money into his arms.”
“But if the poor lieutenant had the feelings of a gentleman he
could not accept such a sacrifice. He would run away to escape it.”
Paul grew quite gloomy as he said this, and stroked his blond
mustache thoughtfully. But it is not natural at twenty-two, with youth
and health and a good conscience and abounding spirits, to despair.
It was all very difficult, but Paul did not, on that account, cease
loving Lucie.
“And does she still go to Bienville every year to visit Madame
Ravenel?” asked Toni.
“Yes, every year, except two years that she spent in America. She
is just home now, and very—very—American.”
Paul shook his head mournfully as he said this. He had all the
prim French ideas, and the dash of American in Lucie frightened
him, brave as he was.

Lucie.
 “But, on her last visit to Bienville, before she went to America,
her grandmother sent with her a carriage and a retinue of horses
and servants, which quite dazzled Bienville. I think Mademoiselle
Lucie bullies her grandmother shamefully. And whom do you think
she pays most attention to of all the people in Bienville?”
Toni reflected a moment. “Monsieur and Madame Verney?”
Paul’s light blue eyes sparkled. “That’s just it. She has my mother
with her all the time, and as for my father, he adores her, and Lucie
actually pinches his arms and pulls his whiskers when she wants to
be impertinent to him. You know she takes advantage of being half
American to do the most unconventional things, and my father quite
adores her—almost as much so as his son.”
“It looks to me,” remarked Toni, “as if Mademoiselle Lucie were
taking things in her own hands, and meant to marry you whether
you will or not. I have often heard that heiresses run great risks of
being married for their money and then finding their husbands very
unkind. Perhaps Mademoiselle Lucie knows this and wants to marry
a man like yourself, who loves her for herself.”
“I think Mademoiselle Lucie has too much sense to marry me,”
answered poor Paul quite honestly. “I think it is simply her kindness
and generosity that make her kind to me and affectionate to my
father and mother. She will marry some great man—a count or a
duke perhaps—there are still a few left in France—and not throw
herself away on a sublieutenant of dragoons,” and Paul sighed
deeply.
The pair spent nearly two hours together. It seemed to Toni as if
he could never be satiated with looking at his old friend, as pink and
white and blond as ever. Paul felt the same toward Toni, and when,
in the old way, Toni took Jacques out of his pocket and showed him,
it was as if seven years passed away into mist and they were boys
together. But at last Paul was obliged to dismiss Toni, who went back
to his quarters with a heart lighter than it had been for seven years.
 And he was to see more of Paul than he had dared to hope, for
Paul had promised to arrange that Toni should be his soldier servant.
The present incumbent was not exactly to Paul’s liking and he was
only too glad to replace him with Toni.
There was work waiting for him, and that, too, under Sergeant
Duval’s eye, and Toni did it with the energy of a man who is
determined on pleasing the father of his beloved. No one would
have recognized, in this smart, active, natty trooper, the dirty idle
Toni of his boyhood. Sergeant Duval, however, was a skeptic by
nature, and he waited to see more of Toni before reversing the
notion he had formed of that young man. He had heard something,
on his annual visits to Bienville, of Toni’s fondness for Denise, and,
when she was in short frocks and pinafores, had sometimes joked
her about it, but Denise, who blushed at the least little thing, would
hide her head on her father’s shoulder and almost weep at the idea
that she had even glanced at a boy.
Toni was longing to ask after Denise, but he dared not. As soon
as he had a moment’s time to himself—and a recruit lately joined
has not much leisure—he wrote a long letter to his mother. He did
not write very well, and was a reckless speller, but that letter carried
untold happiness and relief with it to the Widow Marcel at Bienville.
His duties as Paul’s servant began at once. Toni was not
overindustrious, but if he had to work for any one he would wish to
work for Paul.
And then came a radiant time with Toni—a time when life
seemed to him all fair. He managed to put that secret horror of
Nicolas and Pierre out of his mind as they were out of his sight. He
got his mother’s forgiveness by return of post, and he laid aside all
the fear he had had of Nicolas and Pierre, and enjoyed the sight and
the occasional society of the two beings who, with his mother, were
nearest to him of the world—Paul Verney and Denise. He dared not
mention Denise’s name to Sergeant Duval, who preserved the most
unfeeling reticence about her toward Toni. The sergeant had no
mind to encourage the attentions of young recruits, just out of the
circus, to his pretty daughter with her splendid dot of ten thousand
francs.
Toni, however, knew that the time of his service would come to
an end in a year, and then he would be able to carry out that
beautiful scheme that had haunted him during his circus life. He
would become an instructor in a riding-school and earn big wages,
as much as two hundred and fifty francs the month, and meanwhile
he would lead so correct a life that even Sergeant Duval would be
forced to approve of him. All these resolutions were very much
increased by the first sight he caught of Denise. It was about a
fortnight after he joined, and during that time he had kept his eyes
open for the lady of his love. Although Sergeant Duval had quarters
at the barracks, Denise and Mademoiselle Duval lived in lodgings in
the town, and Toni did not have many opportunities of going into the
town. One Sunday evening, however, a beautiful August Sunday,
Toni found himself standing in the public square where the band
played merrily and one of those open air balls, which are so French
and so charming, was going on. Ranged on benches around were
the older women, and among them Toni at once recognized the tall,
angular, black figure of Mademoiselle Duval; and whirling around in
the arms of a handsome dragoon with a beautiful pair of black
mustaches, much finer than Toni’s, was Denise. Toni’s heart jumped
into his mouth, his soul leaped into his eyes. It was Denise, of the
acacia tree, and the buns, of long ago.
She was as blond, as modest, as neat as ever, but far prettier.
Her fair hair was twisted up on her shapely head, on which sat a
coquettish white hat. She wore a white muslin gown, with the short,
full skirt much beruffled. Denise would have liked a train, but
Mademoiselle Duval frowned sternly on such unbecoming frivolities
as trained gowns for a sergeant’s daughter.
Denise had developed into as much of a coquette as Lucie
Bernard had been, only in a different direction. Lucie achieved her
conquests by a charming boldness, a bewitching unconventionality.
Denise Duval succeeded in attracting the attention of the other sex
by a demureness and quaint propriety which were immensely
effective in their way.
Toni, having some instinctive knowledge of this, determined to
proceed with great caution and military prudence. He would strive to
carry the fortress of Denise’s affections by gradual approaches and
not by assault. So, in pursuance of this plan, he walked up to
Mademoiselle Duval and making a low bow said:
“Mademoiselle Duval, may I recall myself to your memory? I am
Toni Marcel, the son of Madame Marcel, of Bienville, and had the
honor of knowing you when I was a boy.”
Mademoiselle Duval gave him one grim look, and then cried out:
“Oh, I know you very well, Toni. You were the worst boy in
Bienville, and as dirty as you were bad. Oh, how much trouble did
you give your mother!”
This was not a very auspicious beginning for a young man who
wished to become the nephew-in-law of the lady he addressed, but
Toni was not deficient in the sort of courage which could take him
through an emergency like that. He only said hypocritically, and with
another bow and a sigh of penitence:
“Ah, Mademoiselle, every word that you say is true. I know I was
very naughty and very idle, and my mother was far too patient with
me. I gave her a great deal of trouble, but I hope to be a comfort to
her in the future. I had a letter from her only yesterday in which, like
the rest of your sex, Mademoiselle, she showed a beautiful spirit of
forgiveness. I hope that she will come to visit me for a few days
before long.”
Mademoiselle Duval was not greatly softened by this speech, but
seeing Toni disposed to take a scolding meekly, she invited him to sit
down by her side, when she harangued him on all his iniquities for
the last seven years. The sergeant had told her that Toni had been
in the circus and that was enough. Mademoiselle Duval warned Toni
that all circus people were foredoomed to hell-fire, and that he
would probably lead the procession. Toni took the attack on himself
very meekly, but said:
“I assure you Mademoiselle, there were some good people in the
circus—some good women, even.”
“Good women, did you say?” screamed Mademoiselle Duval,
“wearing tights and spangles, and turning somersaults!”
Toni bethought him of the time when there was an outbreak of
scarlet fever in the circus company and how these same painted
ladies in tights and spangles stood by one another and nursed each
other and each other’s children day and night, and uttered no word
of complaint or reproach. He knew more than Mademoiselle Duval
on the subject of the goodness and the wickedness which dwell in
the hearts of men. He told Mademoiselle Duval, however, the story
of the outbreak of scarlet fever. He had a natural eloquence which
stood him in good stead, and Mademoiselle Duval, who was one of
the best women in the world and had a soft heart, although a sharp
tongue, was almost brought to tears by Toni’s story.

“There was a softness, almost a tenderness, in her look.”

 Just then Denise’s cavalier brought her back to her aunt, and
Toni, jumping up, profoundly saluted Denise. His soul rushed into his
eyes, those handsome, daredevil black eyes which the prim and
proper Denise had secretly admired from her babyhood. She glanced
back at him as she courtesied to him with great propriety, and
something in her face made Toni’s pulses bound with joy. There was
a softness, almost a tenderness, in her look which Toni, having some
knowledge of the world, interpreted to his own advantage. Denise’s
own heart was palpitating, not tumultuously like Toni’s, but with a
gentle quickness which was new to her.
“Ah, Mademoiselle,” said Toni, calling Denise Mademoiselle for
the first time, “how well I remember you in my happy days at
Bienville, when you used to give me buns under the acacia tree.”
He stopped. A soft blush came into Denise’s fair cheeks. She
smiled and looked at him and then away from him. Denise
remembered the bench under the acacia tree and all that had
happened there well enough. Denise knew then, and knew now, that
when the Toni of those days gave up something to eat to a small
girl, his feelings were very deeply engaged to her. She recollected in
particular the first afternoon the Ravenels took tea with the Verneys
that Toni had selected one beautiful, ripe plum, and after eying it
longingly, had put his arm around her neck and put the plum in her
mouth, and what he had said then. Her blushing now revealed it all
to Toni.
Suddenly the band struck up a waltz, Toni politely asked Denise
to favor him with her hand for the dance, and they went off
together. The moon smiled softly at them, and even the electric
lights had a kind of tenderness in their glare, when Toni, clasping
Denise in his arms for the first time, began to whirl around with her
to the rhythm of the music. He felt himself raised above the earth—
all his fears, all his evil-doing had departed from him—he felt, poor
Toni, as if he would never be afraid of Nicolas and Pierre again, and
as if that waltz was a foretaste of Heaven for him.
 And Denise, too, was happy. He saw it in her shy eyes, in the
softness of her smile, and presently Toni drew her closer to him and
whispered:
“Denise, Denise, do you remember?” and Denise whispered back,
“Yes, Toni, I remember all.”
And so as it was with Paul Verney and Lucie Bernard, they called
each other by their first names when they were alone.
Presently in the mazes of the dance Toni looked up and there
was Paul Verney passing through the square. He caught Toni’s eye
and Toni grinned back at him rapturously. When the music stopped,
Toni, putting Denise’s hand within his arm, escorted her back to the
bench where Mademoiselle Duval sat knitting in the electric light. He
contrived to pass directly in front of Paul Verney, whom he saluted
respectfully, and Paul bowed low to Denise and said to her:
“Mademoiselle, we are both natives of Bienville, and I am most
happy to see you here with your worthy aunt and your respected
father,” and then Paul, with an eye single to Toni’s interests, walked
on the other side of Denise up to where Mademoiselle Duval sat and
promptly claimed acquaintance with her. In the old days at Bienville
there had not been such a tremendous difference between Paul
Verney, the poor advocate’s son, and the children of the pastry shop
and the confectioner. Now Paul was an officer, but he was very
pleasant and gentlemanlike, however, though quite dignified, and
gave himself no haughty airs. He inquired with the deepest solicitude
after Mademoiselle Duval’s health, remembered gratefully sundry
tarts and cakes she had given him in the old days, and then said to
her, in the most unblushing manner:
“And, Mademoiselle, we have here another citizen of Bienville,
Marcel”—it was the first time that Paul had ever called Toni, Marcel,
in his life—“who, I assure you, is worthy of our old town. He is
strictly attentive to his duties, and the best rider in my troop. I
predict that he will be a corporal before his enlistment is out.”
 And thus having advanced Toni’s cause with his prospective aunt-
in-law, Paul Verney withdrew, winking surreptitiously at Toni as he
went off. It was impossible that Mademoiselle Duval should not
revise her opinion of Toni after this testimony from his officer, so
Toni at once found himself in a most acceptable position with
Mademoiselle Duval. He danced twice more with Denise, carrying
her off in the face of a couple of corporals, and, by his devoted
attentions and insidious flattery of Mademoiselle Duval, gained that
lady’s good-will. He would have liked to escort his old friends back to
their lodging, but, as he explained, he barely had time to reach the
barracks before the tap of the drum, and he scurried off, the
happiest trooper in Beaupré that night.
When he neared the quadrangle on which the barracks faced, he
overtook Paul Verney, and as he rushed past he whispered in his
ear:
“Thank you, thank you, dear Paul.”
In that moment he could have not refrained, to save his life, from
calling his lieutenant Paul.
 CHAPTER XIII
It was a bond of sympathy between Paul and Toni that each
should, as it were, love above his station. Paul was a frequent visitor
at the Château Bernard, and was regarded by the stately and
imposing Madame Bernard with very mixed feelings. The old lady
looked on Lucie very much as a hen does which has hatched out a
duckling among her brood. Madame Bernard was a representative of
the strictness of manners, such as had prevailed in France fifty years
before.
Although dragon-like in her manner, Madame Bernard was at
heart a grandmother, and that tells the tale. Lucie was her idol, and
the two years the young girl had spent with her mother’s family in
America had been one long nightmare to Madame Bernard. When
she returned she was the same Lucie, with an added dash of
Americanism which frightened Madame Bernard almost out of her
wits. Nevertheless there was something about this wild young
creature, this half American, something which gave Madame Bernard
instinctive confidence that she could never commit the fearful error
of Sophie Ravenel.
Madame Bernard was now more than seventy years of age, and
quite unequal to opposing Lucie’s will, and Lucie, at twenty years of
age, reigned over the Château Bernard in a manner that terrified
and enchanted all under her sway. She had, somewhere in her
beautiful head, a nugget of American common sense—a thing which
none of those around her quite understood, only they saw that
Mademoiselle Lucie never came to grief in any of her pranks and
schemes. She was, of course, surrounded by admirers. Madame
Bernard had been considering offers of marriage for her ever since
her eighteenth year, and had nearly arranged one or two for her of
the most advantageous description, but what should this madcap
Lucie do but laugh at every one of these desirable lovers, declaring
that she did not mean to marry until she was quite ready, and might
not marry at all. This latter grotesque idea mortified Madame
Bernard, who had already promised no less than six ambitious
mamas that in a year or two she was sure that Lucie would come to
her senses. Then Lucie was given to joking, a practice which
Madame Bernard had never heard of any girl indulging, and actually
made fun of the excellent partis which Madame Bernard offered for
her consideration, drew caricatures of them, wrote nonsense verses
about them, and otherwise amused herself at their expense.
Madame Bernard observed that the sandy-haired young
sublieutenant, Paul Verney, cool, calm, and matter-of-fact, seemed
to have a singular influence, and that for good, over Lucie.
Their meeting had come about in the most natural way possible.
On Lucie’s return from America she had gone to Bienville to pay
Madame Ravenel that longed for visit. Her coming upset the whole
town, and was of itself a cyclone. With the rash generosity of youth
Lucie, who now understood Sophie’s sad history, took on herself the
task of placing the Ravenels upon the footing which she thought
they deserved. This meant bringing, as she had promised to do in
her childish days long ago, a retinue of horses and carriages and
servants with her, likewise of dazzling gowns and ravishing hats, and
making her visit one long fête. The Ravenels, wiser than little Lucie,
tried to curb her, but as well try to curb a wandering zephyr as Lucie
Bernard, with a noble and generous impulse in her heart. The people
of Bienville were a kindly set on whom the self-respecting seclusion
of the Ravenels had not been without its impress. When ambitious
mamas and impressionable young officers found that the only way to
make any terms with this child of brilliant destiny was to accept
those she loved at the value she placed on them, it was not so
difficult to accomplish. The Ravenels, in that fortnight of Lucie’s visit,
got more invitations than they had received in all the years they had
lived in Bienville.
Among the first was to drink tea in the Verneys’ garden—a
modest form of entertainment suited to the advocate’s means. It
happened to be Madame Verney’s fête-day, a day which Paul always
spent with his mother, if possible. Madame Verney had not only
written, but telegraphed, for Paul to get leave if he possibly could. It
was a long distance to travel to spend twenty-four hours with his
mother, and Paul’s two thousand francs’ allowance, besides his pay,
had a habit of walking off mysteriously, just like the allowances of
other young officers, but one line at the end of Madame Verney’s
letter settled the matter for Sublieutenant Paul Verney. The line ran
thus—“Mademoiselle Lucie Bernard will be staying with the Ravenels
—her first visit since her return from America—and the Ravenels are
coming to tea with us on my fête-day.” Paul went that moment and
asked boldly for a week’s leave.
He got to Bienville at noon on the great day, and at five o’clock,
when the little festivity was inaugurated in the garden and the
Ravenels entered, there was Paul, still pink and white and sandy-
haired, not spoiled with beauty, but adorned with manliness. With
the new affectation of the young French officers he adopted the
modern fashion of discarding his uniform on every possible occasion
and wearing citizens’ clothes whenever he could, but on this day he
could not but remember what Lucie had said, a long time ago, about
his wearing a uniform next time they should meet. So he put on his
handsome new undress uniform and looked a soldier. His mother
admired him immensely, so did his father, and so, in fact, did Lucie,
when that young lady, in a dazzling white costume and charming
white hat and white shoes, came tripping along the garden path.
Paul blushed from his head to his heels as he made her a beautiful
bow, but Lucie, who had acquired the startling American fashion of
shaking hands with any and everybody, deliberately slipped her little
hand in his and gave him a look from under her long eyelashes
which said as plainly as words—“Welcome, Paul.” And by Madame
Verney’s tea-table in the little garden their hearts were cemented
without one word being spoken between them.
After that Paul was with Lucie every moment he could contrive
while he was in Bienville, cursing himself meanwhile for being a
villain in forcing his company on that radiant creature with her
millions of francs. He had, however, the best excuse in the world—he
could not help it. And when he found that he would shortly be sent
to Beaupré, in the immediate neighborhood of the Château Bernard,
he was the happiest and likewise the most miserable creature alive.
Lucie was unblushingly happy and demanded that as soon as he
arrived at Beaupré he should present himself at the château and pay
his respects to Madame Bernard. Of course, he did it, wicked as he
knew it to be, with the result that he was the only man whom Lucie
really encouraged. And in a little while, as natures quickly adjust
themselves to each other, Paul acquired a species of control over
Lucie, a thing which no one but Sophie Ravenel had ever done
before.
She generally wished to do what was right, but on the occasions
when she wished to do what was wrong, Madame Bernard saw that
the sandy-haired young sublieutenant could turn Lucie from her way.
In particular, he could dissuade her from doing many rash things,
sometimes innocent, sometimes dangerous. She was an
accomplished, though reckless rider and when she would have
ridden a horse which, rightly named Comet, had run away once, and
might be depended on to do so again, Paul Verney had managed to
do more with her by a few words than all of Madame Bernard’s
prayers and the exhortations of the head groom.
Paul often came over to the Château Bernard and, on one special
afternoon he found Comet saddled and waiting, and when he went
into the drawing-room, Madame Bernard implored him to try to
persuade Lucie not to ride Comet. Presently Lucie tripped in, looking
charming in her riding-habit, and with the light of contradiction in
her eyes. Paul, she knew, objected to her riding the horse, and she
was prepared to defy him.
“I think, Mademoiselle,” said Paul quietly, “it would scarcely be
judicious for you to ride Comet.”
Lucie, who was proud of her horsemanship, resented this
promptly, and replied:
 “But I wish to ride Comet. I am perfectly capable of managing
him, and besides, he is not really vicious.”
“The last may be true, Mademoiselle, but I think you are
mistaken in the former. You have no more real control over Comet
than a butterfly has.”
For answer, Lucie tapped her whip smartly on the mantelpiece,
and said:
“Thank you very much, Monsieur Verney—I must beg you to
excuse me—good afternoon,” and was going out of the room when
Paul, who had walked over from his quarters, asked of Madame
Bernard:
“Madame, may I have one of your horses saddled, and follow
Mademoiselle Lucie on her dangerous ride?”
“Indeed, you may,” replied poor Madame Bernard, wringing her
hands, “take anything you may find in the stables.”
Lucie burst out laughing. “And do you mean to ride in that
dress?” she asked of Paul, who had on a frock coat and held a silk
hat in his hand.
“It isn’t the dress that I would choose to ride in, Mademoiselle,”
answered Paul, laughing. “I dare say I shall look quite ridiculous in
this costume scampering after you—everybody we meet will surmise
the reason—nevertheless, I shall go.”
“But you will not,” cried Lucie, running out of doors to where the
horses were standing. She was not equal to the impertinence of
having her groom assist her on horseback with an officer and a
gentleman standing by, and, furthermore, the groom understood the
situation and kept discreetly in the background. Paul further
astounded her by directing the groom to ride to the stables and have
a horse saddled for him and brought at once. Lucie was so angry
that she had to wink her dark, bright eyes to keep the tears from
coming, but Paul was as cool and as calm as possible.
 “Never mind, Monsieur,” said Lucie, in a trembling voice, “I shall
ride Comet—of that you may be sure. You may force yourself on me
to-day, but you can not do it every day, and I shall ride what horse I
please.”
Paul, urged by his love and tenderness for her, said words for
which he thought he would have died rather than have spoken:
“Dear Lucie, if you are as reckless as that you will break my
heart. Forgive me for calling you by your name, but don’t you
remember, seven years ago, in the park at Bienville, you told me that
when we were grown up we should call each other Paul and Lucie in
private?”
Paul stopped. He felt as if he were guilty of a crime in saying
these words to that enchanting creature, who would marry so far
above him in every way. All at once he saw a vision of his father’s
modest house at Bienville, and thought of his own small allowance
and slender pay, and reckoned himself the greatest fool in existence.
But Lucie’s reply to this was to look at him with a mysterious smile
on her expressive face, and to say softly:
“This is the first time that you have ever called me by name, Paul
—”
They were standing on the lawn, in full view of dozens of eyes,
while this was passing. Paul looked at her in dumb admiration and
despair, but there was nothing in the least despairing in the smile
which presently rippled over Lucie’s face, with her eyes all fire and
dew. The fact is that Mademoiselle Lucie had been very much in love
with Sublieutenant Paul Verney, ever since they had been children
together in the park at Bienville, and wished him to know it, and she
was in love with the best part of him—his courage, his modesty, his
good sense, his clean and upright life, and having the American
archness in her nature, she saw the humorous side of it and could
not forbear laughing at poor Paul.
“But I think,” she said, “a gentleman should keep his word. You
promised me that you would call me by my first name in private, and
you have only done it once, and now you speak as if you would
never do it again.”
Paul secretly thought Lucie, just as he had always done, a very
improper little person, but quite irresistible.
“At all events,” said Lucie airily, flicking the blossoms of a tall,
blue hydrangea nodding gravely in the sun, “I intend to call you
Paul, in private that is—and I don’t think I shall go to ride this
afternoon.”
“And promise me,” said Paul, coming a little closer and looking at
her earnestly, “that you won’t ride Comet any more—Lucie.”
“I promise then, Paul,” replied Lucie, with an affectation of a
meekness which was far removed from her, and which she only used
for purposes of her own. Then the horses were sent away, and the
two walked together across the lawn and into the drawing-room
where Madame Bernard sat in an agony.
“I shall not ride this afternoon, Grandmama,” said Lucie.
“Monsieur Paul would insist on going with me, and he would look so
utterly ridiculous on horseback dressed as he is that I was ashamed
to be seen with him; so, instead, he will stay and have tea with us,
and meanwhile we shall go and play billiards.”
This charmed Madame Bernard, who concluded that the next
time Lucie was refractory she would send post-haste for
Sublieutenant Verney to manage her. It is not to be supposed that
Madame Bernard did not see the possibilities of the future as well as
Madame Verney had done long years before, when Paul and Lucie
had played together as children. But Madame Bernard, like many
other women who know much of the world, was beginning dimly to
reach a just estimate of things. After having seen many marriages
and a considerable number of divorces she had realized that it was
the man, and not the title or the estate, with which a woman must
reckon. And Paul was so very attentive to Madame Bernard, picking
up her ball of worsted when she was knitting, and giving her his
advice, when asked, regarding the colors of her embroidery, that she
had begun to wish Paul Verney had at least a family tree if not a
title. Money she was not so particular about, as Lucie had plenty of
that. But he was only a sublieutenant and his father was an
advocate in a small way in a provincial town. Madame Bernard
groaned when she thought of these last things.
When billiards was proposed, the old lady made no objection
whatever, but followed the two young people into the large, cool
billiard room with its parquet floor and ground glass ceiling, and
embroidered industriously while the two played a merry game and
Lucie beat Paul two points to one. She could beat him at billiards, at
tennis, and at cards; she sang and played much better than he, and
rode quite as well; and she delighted in showing her skill over him;
but, having a great deal of sense in her pretty head, she realized
that in all considerable things Paul stood near the top. He took his
defeats so pleasantly, for he was the most modest fellow alive, that
Lucie often declared there was no pleasure in beating him.
This particular afternoon Lucie beat him most shamefully, but
Paul had his reward in the enjoyment of her exquisite grace in
playing the most graceful game in the world. Madame Bernard,
apparently absorbed in her embroidery, was watching every tone
and motion and saw that they were playing another game far more
interesting and with much greater stakes than any game of billiards.
And, as she had a presentiment that Lucie would have her own way
in the matter of a husband, Madame Bernard, with calm resignation,
was quite reconciled to Paul, and was glad in the present instance it
was no worse. They played through the whole afternoon, and
Madame Bernard asked Paul to stay to dinner, but this he was
obliged to decline, much to his vexation. A sublieutenant of
dragoons is not master of his own time, so Paul went away
reluctantly, and was followed by the vision of a charming figure,
showing the most beautiful hand and arm in the world, and dealing
the most deadly shots to her antagonist.
 “Saw that they were playing another game far more
interesting.”

When dinner was over, Lucie came and sat by Madame Bernard
in her own small drawing-room as the old lady stitched at her
embroidery under the evening lamp.
“Grandmama,” she said quietly, after a long pause, “what do you
think of Paul Verney?”
“A most estimable young man,” replied Madame Bernard.
“His family are not at all rich or distinguished,” said Lucie, “but
they are very dear. I wish you could see his father, so kind, so
pleasant, so gallant toward Madame Verney, and like an older
brother to Paul. And Madame Verney is sweet—I love to see them
together, Paul and his father and mother. And then they are so kind
to poor Sophie and Captain Ravenel.”
Whenever Sophie Ravenel’s name was mentioned, it was like a
knife to Madame Bernard’s proud, weak, sensitive heart. It was not
only that Sophie’s conduct had been sinful, but, what was worse, it
was such bad form. Lucie meditated a while, and then added:
 “And Paul is a poor man even for a sublieutenant, and he will not
have an easy time of it. He has no family influence or powerful
friends to push him forward, and he will only get on by his own
merits. But that always tells in the long run. When Paul is forty, all
his superiors will know what a fine man and what a fine officer he is.
He will be given things for the asking, that other men strive and
struggle for. And he is not at all handsome, though he looks well in
uniform, and on horseback.”
Then a silence fell in the drawing-room. There was not a sound,
except the ticking of the gilt clock. Lucie was sitting by the table, her
elbows upon it, her rounded chin in her hands.
“My dear,” said Madame Bernard, “why do you call Monsieur
Verney by his first name?”
“Because,” said Lucie, quite calmly, taking Madame Bernard’s
embroidery out of her hands, and looking her full in the face,
“because I love him.”