Volume 1, No. 2, Second Quarter 2003

Phase Shifts

by: Mark Rubinstein

The physical world is composed of phase shifts, and we generally accept and understand the implications. The failure to recognize a phase shift that has taken place is exemplified by the perception of investment people about where they stand in the world … even what they stand for. I was part of the first AIMR group to embrace performance standards that implies phase shifts do not take place.

We complain about fair disclosure thinking it might inhibit access, but access comes at the price of acquiescence, a coin of our clients that we have been willing to pay for them. We should be willing to adopt high standards of personal behavior, such as classifying ourselves as insiders with respect to our personal investment accounts.

Great Moments in Financial Economics: II. Modigliani-Miller Theorem

by: Mark Rubinstein

Franco Modigliani and Merton Miller are almost universally credited with the theorem that bears their name. In fact, the theorem was stated and proven 20 years earlier by John Burr Williams, to which he gave the name: "the Law of the Conservation of Investment Value." However, Modigliani-Miller deserve credit for clearly laying out a formal arbitrage proof and popularizing the subsequent use of arbitrage arguments in financial economics. Even after their work (1958) and subsequent simplified proof (1969), there were still issues that needed to be clarified which lead finally to more modern proof of the theorem based on state-prices.

A Practical Framework for Portfolio Choice

by: Ricahrd O. Michaud

Traditional portfolio optimality criteria often have serious theoretical or practical limitations. A financial planning portfolio choice framework consisting of a resampled efficient portfolio set and geometric mean analysis is a practical alternative for many situations of investment interest. While Monte Carlo financial planning is a more flexible framework, geometric mean analysis may be less error prone, theoretically justifiable and convenient. Controversies that have limited applications of geometric mean analysis are resolvable by improved understanding of distributional properties and rational decision-making issues. The geometric mean is also useful in rationalizing a number of investment paradoxes.

Short Volatility Strategies: Identification, Measurement, and Risk Management

by: Mark Anson and Ho Ho

Many investors demand position transparency from hedge fund managers in the belief that more information is better than less. However, certain hedge fund strategies create synthetic investment positions that resemble a short put option, and these positions are not revealed by position transparency. Specifically, event-driven hedge funds and merger arbitrage hedge funds have significant exposure to volatility events. We identify and measure this short volatility exposure, providing the transparency that is lacking from position disclosure. In addition we examine ways to manage this short volatility risk.

Fiscal Policy and Inflation: Pondering the Imponderables

by: Eric M. Leeper

An asset-pricing perspective on inflation reveals that it depends on current and expected monetary and fiscal policies. There are three ways to carry $1 today into the future: money, bonds, and real assets. That dollar's purchasing power varies inversely with the price level. Expected money growth, tax rates, and government spending directly impinge on these expected rates of return of these assets, and determine the price level and the inflation rate. The paper considers a tax reduction that is financed by new government debt. It examines how alternative responses of current and future policies to the tax cut can imply very different outcomes for inflation.

The Treynor Capital Asset Pricing Model

by: Craig W. French

We explore unpublished early work of Jack Treynor, who deserves credit for the original Capital Asset Pricing Model because of his revolutionary manuscripts, "Market Value, Time, and Risk" and "Toward a Theory of Market Value of Risky Assets", which were circulated during the 1960s but have never been published in a journal. Mr. Treynor's early work appears to have predated and anticipated Sharpe (1964), Lintner (1965a,b) and Mossin (1966). However, the Treynor CAPM has not enjoyed a broad public reach. This, apparently, is the reason Mr. Treynor is not consistently recognized as one of the primary architects of the CAPM.

“Hedge” Funds

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.

Iceberg Risk: An Adventure in Portfolio Theory

by: Kent Osband • reviewed by: Craig W. French

Practical Speculation

by: Victor Niederhoffer and Laurel Kenner • 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.

Practitioner’s Digest • Vol. 1, No. 2

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.

The Gauntlet

by: Jack L. Treynor

“Case Studies” presents a case pertinent to contemporary issues and events in investment management. Insightful and provocative questions are posed at the end of each case to challenge the reader. Each case is an invitation to the critical thinking and pragmatic problem solving that are so fundamental to the practice of investment management.