Volume 8, No. 2, Second Quarter 2010
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Practitioner's Digest
Practitioner’s Digest • Vol. 8, 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.
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Insight
The Power to Spend
“Insights” features the thoughts and views of the top authorities from academia and the profession. This section offers unique perspectives from the leading minds in investment management.
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Insight
The Inevitable Baggage We Display
Until the point at which investment models began melting, too many investment practitioners operated within a myopic belief system that failed to contemplate certain fundamentals that are rigorously observed in other scientific disciplines. Flaws crept into our research under various headings of convenient simplification, behavioral finance, and statistical tools. Biases influenced our work leading to conclusions that, in retrospect, should logically have been suspect. We are writing a new chapter of economic history where the future will, quite likely, be unlike anything we can remember from the past. We can no longer assume that the best forecast of the future is the present condition; that autocorrelation is the rule of the day; and that, of course, the future repeats the past. We must recognize our biases and understand their influence on our work.
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Article
The Future of Finance
The future of finance is bright, if for no other reason, because our financial system failed. This failure raises the level of urgency for developing more realistic models, more effective regulation, and more responsible financial institutions, and it permits us to start with a clean slate.
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Article
The Study of Crises
A study of financial crises can improve our understanding of theories, and of the relative strengths and weaknesses of different institutional arrangements. This article discusses four examples. (1) During the crisis, risk converged towards a global risk factor that dominated secondary risk factors. (2) Value is a secondary risk factor because it is closely related to this global factor. (3) Momentum did not behave like a risk factor. (4) The dealer market in subprime debt may have worsened the crisis by failing to provide liquidity or price transparency. As it is currently structured, the market increases systemic risk.
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Article
Warning: Physics Envy May Be Hazardous to Your Wealth!
The quantitative aspirations of economists and financial analysts have for many years been based on the belief that it should be possible to build models of economic systems and financial markets in particular that are as predictive as those in physics. While this perspective has led to a number of important breakthroughs in economics, physics envy has also created a false sense of mathematical precision in some cases. We speculate on the origins of physics envy, and then describe an alternate perspective of economic behavior based on a new taxonomy of uncertainty. We illustrate the relevance of this taxonomy with two concrete examples: the classical harmonic oscillator with some new twists that make physics look more like economics, and a quantitative equity market-neutral strategy. We conclude by offering a new interpretation of tail events, proposing an uncertainty checklist with which our taxonomy can be implemented, and considering the role that quants played in the current financial crisis.
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Article
Quantifying Systemic Risk and Reconceptualizing The Role of Finance for Economic Growth
Contingent claims analysis (CCA) has formed part of the core of modern financial theory since the early 1970s as basis for many credit risk measurement methods. The adaptation of CCA for the measurement and analysis of systemic risk that arises due to the cross-exposures of economic sectors is a new and promising area for applications of finance in the future. Finance tools can be adapted to analyze a wide range of macro issues including sovereign risk, economic output, and economy-wide risk transmission. Modern finance provides a way to unify macroeconomics, risk-adjusted balance sheets, and risk transmission. We demonstrate that the traditional macroeconomic accounts, in particular the flow-of-funds, can be derived as a special case of a risk-adjusted balance sheet of the economic sectors when asset volatility is ignored. We show that the CCA macroeconomic balance sheet can be used to identify the contribution of the financial sector to an important new measure of economic output value, which adjusts the traditional flow-based measures of GDP, and its components, for the level of risk. Systemic risk can be analyzed using a portfolio of implicit put options in the financial sector using a multivariate dependence structure. The systemic risk dynamics are interlinked with the new measures of risk-adjusted economic value via the CCA balance sheets and put-call parity relationships. In this way, the contribution of the financial sector to risk-adjusted economic output can be measured conditional on the public cost of the joint contingent claim of financial sector activity.
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Case Study
Household Risk
“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.
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Book Review
Active Credit Portfolio Management in Practice
“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.