Volume 9, No. 2, Second Quarter 2011

Practitioner’s Digest • Vol. 9, 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.

Efficient Markets in Crisis

by: Meir Statman

A belief that markets are efficient is blamed for instigating the crisis we are in and lulling us into complacency as the crisis was approaching. But the debate about the role of such belief in the crisis is unfocused for two reasons. First, a lack of a common definition of market efficiency precludes a common language. Second, efficient markets are conflated with free markets.
The ambitious definition of efficient markets is their definition as rational markets, where security prices always equal intrinsic values. The modest definition of efficient markets is their definition as unbeatable markets. Bubbles cannot occur in rational markets but they can occur in unbeatable markets. I argue that a belief in market efficiency cannot bear responsibility for our crisis since most investors do not believe that markets are either rational or unbeatable.

Free markets are markets where government places little or no imprint on the financial behavior of individuals and organizations and on markets through regulations and direct intervention. Many advocates of free markets believe that such markets are also more efficient than markets which are not as free. But free markets are distinct from efficient markets. Highly regulated markets can be no less efficient in the sense of rational markets or unbeatable markets than lightly regulated markets. I argue that a belief that free markets are always superior to regulated markets and lightly regulated markets are always superior to heavily regulated markets does bear some responsibility for our crisis. Regulations that would have limited the types of mortgages offered to homeowners would have helped stem the crisis or mitigate it. So would have limits on the degree of leverage employed by banks and homeowners alike.

Yet not all regulations and government interventions bring unmitigated benefits. We have no precise measures by which we might distinguish real bubbles from illusory ones. Governments which aim to pop real bubbles run the risk of plunging us into recessions by popping illusory ones. The challenge we face is the challenge of seeing an opaque future as clearly as possible, knowing not only that foresight is not as clear as hindsight but also that we would be judged in the future as if it is.

Predicting Financial Distress and the Performance of Distressed Stocks

by: John Y. Campbell, Jens Hilscher and Jan Szilagyi

In this paper, we consider the measurement and pricing of distress risk. We present a model of corporate failure in which accounting and market-based measures forecast the likelihood of future financial distress. Our best model is more accurate than leading alternative measures of corporate failure risk. We use our measure of financial distress to examine the performance of distressed stocks from 1981 to 2008. We find that distressed stocks have high stock return volatility and high market betas and that they tend to underperform safe stocks by more at times of high market volatility and risk aversion. However, investors in distressed stocks have not been rewarded for bearing these risks. Instead, distressed stocks have had very low returns, both relative to the market and after adjusting for their high risk. The underperformance of distressed stocks is present in all size and value quintiles. It is lower for stocks with low analyst coverage and institutional holdings, which suggests that information or arbitrage-related frictions may be partly responsible for the underperformance of distressed stocks.

Multiple Time Scale Attribution for Commodity Trading Advisor (CTA) Funds

by: Brian T. Hayes

Commodity trading advisors (CTAs) make directional investments in liquid futures and forward markets. Since CTAs generally do not engage in security selection or relative value trades, their performance depends to a large extent on funds ability to time market exposures. We analyze CTA return attribution, splitting returns into contributions from asset class (beta) factors and market timing factors. For each asset, we use timing factors at several frequencies. The highest frequency (e.g., daily) timing factors are absolute values of asset returns, while lower frequency (e.g., weekly or monthly) timing factors also use high-frequency returns. Average fund returns net of beta and market timing contributions are called residual alpha. For CTAs, the market timing contribution varies by frequency. By combining timing factors at different frequencies, we estimate aggregate market timing alpha and residual alpha; this latter quantity is around −8% per year for CTA indexes, with transaction costs being a potential contributor.

Robust Portfolio Rebalancing with Transaction Cost Penalty An Empirical Analysis

by: Vitaly Serbin, Milan Borkovec and Michael Chigirinskiy

The goal of this paper is to study and compare two popular techniques used by practitioners to reduce the sensitivity of optimal portfolios to uncertainty in expected return for a typical portfolio optimization problem. Specifically, we investigate whether including transaction costs into the optimization problems objective function addresses the robustness issue. We weight this approach against the robust optimization method described in Goldfarb and Iyengar (2003). The latter directly incorporates the distribution of estimation errors in the optimization problem and determines the optimal portfolio allocation by selecting the least favorable realization of the expected returns in the investors uncertainty region.

Our analysis focuses on the return maximization problem with constraints on total risk or tracking error and a transaction cost penalty in the objective function. We demonstrate that not only are the effects of incorporating a transaction cost penalty into the optimization problem similar to those of modeling uncertainty in expected returns, but that there are also some interesting differences. We offer some insights into the observed interplay between modeling transaction costs and modeling return uncertainty.

A Lively Expectation of Favors Yet to be Received

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.

The Endowment Model Of Investing: Return, Risk and Diversification

by: Martin L. Leibowitz, Anthony Bova, P. Brett Hammond • reviewed by: Bruce Grantier

“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.

Random Lattices for Option Pricing Problems in Finance

by: Sanjiv R. Das

While the use of Monte Carlo methods is well established for pricing derivatives, this paper focuses on a random-lattice approach, also known in the literature as the stochastic-mesh method. The method is reviewed here. We show that the method may be refined with an ad-hoc bias correction, that suitably adjusts these models for accuracy. The paper presents experimental results, related analysis, and a set of applications, demonstrating easy applicability to popular choices for option pricing stochastic processes. The flexibility and ease of implementation of this approach, as seen from the examples, suggests that this approach has wide practical applicability.