Volume 1, No. 1, First Quarter 2003

Don’t Count On It! The Perils of Numeracy

by: John C. Bogle

Author John C. Bogle argues that the Information Age has given birth to a worship of hard numbers, and, in turn, the attitude that “If you cannot measure it, it doesn’t matter.” Mr. Bogle disagrees with this syllogism, and offers four “Perils of Numeracy,” detailing the threats that each pose not only to Corporate America, and to investors, but to our society at large.

Estimating Default Probabilities Implicit in Equity Prices

by: Tibor Janosi, Robert Jarrow, and Yildiray Yildirim

This paper uses a reduced form credit risk model to estimate default probabilities implicit in equity prices. For a cross-section of firms, a time-series regression of monthly equity returns is estimated. We show that it is feasible to infer the firm's probability of default implicit in equity returns. However, the existence of price bubbles and the difficulty in modeling equity price risk premium confound the estimation of these default probabilities, generating potentially biased estimates with large standard errors. Comparing these default intensities with those obtained from historical data or implicitly from debt prices confirms this result.

A Theory of Inflation

by: Jack L. Treynor

Inflation entails a loop running from prices to wages and back again from wages to prices. Change in inflation rates result from two types of intervention in that otherwise closed loop. Inflation surprise intervenes when the labor productivity of the marginal plant, hence the real wage, turns out different from what negotiators expected when they fixed the money wage. The second kind of intervention is quite predictable. Although changes in tradables prices affect money wages, changes in money wages don't affect tradables prices. The practical result is that the tradables inflation rate affects the home goods inflation rate, but not vice versa. In small, open economies, the predictable tradables effect is more important. In large, closed economies, the effect of real wage surprise on home goods price, is more important. In the many countries somewhere between the extremes, both inflation mechanisms are too important to ignore.

Great Moments in Financial Economics: I. Present Value

by: Mark Rubinstein

This is the first in a series of articles to appear in this Journal on the history of significant ideas in financial economics. Perhaps the most basic of these is the idea of present value. Early contributors include Johan de Witt (1671), the famous mathematician Abraham de Moivre (1725), and the famous scientist Edmund Halley (1761). But it was Irving Fisher who in 1930 laid the theoretical foundations behind the concept as a byproduct of the standard inter-temporal model of rational consumption choice. In 1938 John Burr Williams applied the model to the discounting of dividends and derived what later became known as the Gordon growth formula.

It’s 11PM – Do You Know Where Your Liquidity Is? The Mean-Variance Liquidity Frontier

by: Andrew W. Lo, Constantin Petrov, and Martin Wierzbicki

We introduce liquidity into a mean-variance portfolio optimization framework by defining several measures of liquidity and then constructing three-dimensional mean-variance-liquidity frontiers in three ways - liquidity filtering, liquidity constraints, and a mean-variance-liquidity objective function. We show that portfolios close to each other on the traditional mean-variance efficient frontier can differ substantially in their liquidity characteristics. In a simple empirical example, the liquidity exposure of mean-variance efficient portfolios change dramatically from month to month, and even simple forms of liquidity optimization can yield significant benefits in reducing a portfolio's liquidity-risk exposure without sacrificing a great deal of expected return per unit risk.

Understanding Mutual Funds and Hedge Funds Styles Using Return-Based Style Analysis

by: Arik Ben Dor, Ravi Jagannathan, and Iwan Meier

We illustrate the use of return-based style analysis in practice using several examples. We demonstrate the importance of selecting the right style benchmarks and how the use of inappropriate style benchmarks may lead to wrong conclusions. We show how asset turnover and style graphs over time can be used to ensure right inference about the effective style of a fund, and how to extend return-based style analysis to analyze hedge fund styles. In the examples we consider, return-based style analysis provides insights not available through commonly used peer evaluation alone.

Segmentation, Illiquidity, and Returns

by: Renato Staub and Jeffrey Diermeier

When investing in alternative assets, such as private equity or natural resources - which may be "locked-up" for prolonged periods of time - the question of compensation for illiquidity becomes important. No rational investor will choose the illiquid over the liquid asset unless he gets compensated for his loss of flexibility. We derive two approaches to model illiquidity compensation. In contrast to the ones most commonly seen in the literature, our methods do not analyze trading-based gains, which cannot be realized as a result of illiquidity. Rather, we investigate the implications of illiquidity for a long-term investor.

Private Equity Returns: An Empirical Examination Of The Exit of Venture-Backed Companies

by: Sanjiv R. Das, Murali Jagannathan, and Atulya Sarin

In this paper we examine 52,322 financing rounds in 23,208 unique firms, over the period 1980 through 2000 by venture and buyouts funds and estimate the probability of exit, time to exit, exit multiples and the expected gains from private equity investments. The expected multiple (after accounting for dilution and the probability of exit) ranges from a low of 1.12 for late-stage firms to a high of 5.12 for firms financed in their early stages. We find that the gains from venture-backed investments depend upon the industry, the stage of the firm being financed, the valuation at the time of financing, and the prevailing market sentiment. Our study is a first step in understanding the risk premium required for the valuation of private equity investments.

Working Paper: The Internet and Investors

by: Sanjiv R. Das

“Surveys& Crossovers” This section provides surveys of the literature in investment management or short papers exemplifying advances in finance that arise from the confluence with other fields. This section acknowledges current trends in technology, and the cross-disciplinary nature of the investment management business, while directing the reader to interesting and important recent work.

All About Hedge Funds

by: Robert A. Jaeger • reviewed by: Mark Kritzman

Trading and Exchanges

by: Larry Harris • reviewed by: Mark Kritzman

“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.

Corporate Earnings and Credit Debacles

by: Tony Kao

“Surveys& Crossovers” This section provides surveys of the literature in investment management or short papers exemplifying advances in finance that arise from the confluence with other fields. This section acknowledges current trends in technology, and the cross-disciplinary nature of the investment management business, while directing the reader to interesting and important recent work.

Practitioner’s Digest • Vol. 1, No. 1

The “Practitioners Digest” emphasizes the practical significance of manuscripts featured in the “Insights” and “Articles” sections of the journal. Readers who are interested in extracting the practical value of an article, or who are simply looking for a summary, may look to this section.