Vol. 23, No. 1, 2025 by Stephen Laipply, Ananth Madhavan, James Mauro and Nogie Udevbulu Assets in fixed income index mutual funds and exchange-traded funds (ETFs) have grown substantially in recent years. This paper examines fixed income index fund portfolio rebalancing efficiency using empirical evidence from four large fixed income index funds. We show how… Read more
Articles
The CAPM, APT, and PAPM
Vol. 23, No. 1, 2025 by Thomas M. Idzorek, Paul D. Kaplan and Roger G. Ibbotson The Popularity Asset Pricing Model (PAPM) generalizes the Capital Asset Pricing Model (CAPM) with popularity as the basis for multiple priced characteristics. The CAPM along with the Arbitrage Pricing Theory (APT) are the dominant textbook asset pricing models. Both… Read more
Can Under-Diversification Explain the Size Effect?
Vol. 23, No. 1, 2025 by Moshe Levy None of the explanations suggested so far for the size anomaly seems to be consistent with the empirical evidence. This paper examines under-diversification as a possible explanation for the size effect. When the portfolio weight of a stock is non-negligible, its variance is priced. As small stocks… Read more
Forecasting and Managing Volatility: An S&P 500 Case Study
Vol. 23, No. 1, 2025 by Wei Dai, Xing Hong, Robert C. Merton and Mathieu Pellerin Using daily and intraday data from 1997 to 2023, we study strategies that stabilize volatility around a target by rebalancing between the S&P 500 and Treasury bills based on a broad set of volatility forecasts. Somewhat counterintuitively, lower forecasting… Read more
Arbitrage Pricing Theory 50 Years After Black Merton Scholes
Vol. 22, No. 4, 2024 Robert A. Jarrow In the past 50 years, the Black Merton Scholes option pricing methodology has advanced in three directions: the mathematical foundations, modifying its assumptions, and applications to new derivatives. This lecture reviews the advances with respect to the mathematical foundations and the modifications of its assumptions. The key… Read more
Fooled by the Black Swan
Vol. 22, No. 4, 2024 Sanjay K. Nawalkha This paper offers a critical analysis of the normative theory of investment decisions as presented in Taleb’s The Black Swan. I find that the relentless pursuit of positive black swans can lead investors to overprice opportunities, potentially triggering financial bubbles and crashes in the medium to long… Read more
Training Machines to Trade Stocks
Vol. 22, No. 4, 2024 Dilip B. Madan and King Wang Machines are trained to trade stocks by developing an investment policy for stock investment in a Markovian context. Importantly, the investment actions impact just the immediate reward and not the state transitions. The policies are designed to maximize a nonlinear expectation of the undiscounted… Read more
Hedging Barrier Options Using Reinforcement Learning
Vol. 22, No. 4, 2024 Jacky Chen, Yu Fu, John Hull, Zissis Poulos, Zeyu Wang and Jun Yuan We examine the use of reinforcement learning (RL) to hedge barrier options. We find that, when the hedger’s objective is to minimize value at risk or conditional value at risk, RL is an attractive alternative to traditional… Read more
Forecasting the Distribution of Option Returns
Vol. 22, No. 3, 2024 Leandro Gomes, Roni Israelov and Bryan Kelly We propose a method for constructing conditional option return distributions. In our model, uncertainty about the future option return has two sources: Changes in the position and shape of the implied volatility surface that shift option values (holding moneyness and maturity fixed), and… Read more
The Options-Inferred Equity Premium and the Slippery Slope of the Negative Correlation Condition
Vol. 22, No. 3, 2024 Gurdip Bakshi, John Crosby, Xiaohui Gao, Jinming Xue and Wei Zhou The negative correlation condition (NCC) of Martin (2017) is that covPt (MT RT,RT )≤ 0 for all MT, where MT is the SDF and RT is the gross market return. He employs this assumption to derive a lower bound… Read more