Volume 22, No. 4, Fourth Quarter 2024
The Future of Derivatives Research: Modeling Risk and Return Dynamics II
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Special
Introduction
We are delighted to present the second special issue of the Journal of Investment Management, commemorating the 50th anniversary of the revolutionary Black-Merton-Scholes (BMS) option pricing model. This edition builds upon the themes of our first special issue, which featured Robert Merton’s keynote address and pivotal contributions from various scholars. In this issue, we have the privilege of highlighting the keynote delivered by Nobel Laureate Myron Scholes, whose insights continue to shape financial theory and practice.
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Special
Keynote Address by Nobel Laureate Myron S. Scholes Fall 2023 UMass Amherst CISDM Conference on: Black–Merton–Scholes Option Pricing: A 50-year Celebration and Looking Ahead
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Special
Black–Merton–Scholes Option Pricing: A 50-Year Celebration—Looking Ahead
It is a great honor to be invited to participate and contribute to the 50-year celebration of the path breaking option pricing theory of Fischer Black, Robert Merton, and Myron Scholes (Black and Scholes (1973) and Merton (1973)). My focus is on financial intermediation and looking ahead on future challenges.
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Article
Hedging Barrier Options Using Reinforcement Learning
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 hedging approaches. RL requires an assumption about the stochastic process followed by the underlying asset during the life of the exotic option, but our tests show that the results from using RL are fairly robust to this assumption. We do not consider transaction costs in this research. However, we show that RL involves less trading than traditional hedging approaches. As a result, the existence of transaction costs can be expected to increase the attractiveness of RL.
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Article
Training Machines to Trade Stocks
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 sum of future rewards using the methods of Now Decision Theory. The nonlinear expectations, unlike expectations, are rendered risk sensitive using a distortion of probabilities. The distortions employed need not be concave and display regions of convexity making them volatility desiring at low volatility levels. The technology is illustrated by trading 589 stocks over 15 years using the policy function.
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Article
Fooled by the Black Swan
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 term. Conversely, underinvestment in the corporate bond and stock markets due to extreme aversion to negative black swans, can result in significant shortfalls in wealth creation for individuals and value destruction for corporations. In defense of the Nobel prize-winning works of Black and Scholes and Merton, I contend that the issue lies not in the scandal of prediction, but in the crafty manipulation of information, which has contributed to Finance becoming a more pseudo-discipline.
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Article
Arbitrage Pricing Theory 50 Years After Black Merton Scholes
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 insight of this review is that the BMS methodology is very robust to modifying all of its assumptions, except for a relaxation of competitive markets.
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Book Review
Mutual Fund Selection: From Theory to 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.