JOIM: 2024
Volume 22, No. 1, First Quarter 2024
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Practitioner's Digest
Practitioner’s Digest • Vol. 22, 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.
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Article
Limiting Investment Opportunity Sets, Asset Pricing, and the Roll Critique
We consider the impact of low volatility assets on the investment opportunity set (IOS) and resultant asset pricing. The limiting IOS and its finite investable proxy imply an asset pricing model that differs from standard asset pricing models. The Sharpe (1964)–Lintner (1965) CAPM with a unique market portfolio is not descriptive of asset pricing and the zero-beta rate of the Black model, converges to the exogenous riskless rate. Spanning tests show that the limiting IOS, with estimated slope and upper bound Sharpe ratio of 0.18, is given by the linear limiting IOS asymptotes, implying multiple efficient portfolios of risky assets. We find no evidence of any efficient portfolio with only positive weights, implying that the market portfolio is not mean–variance efficient.
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Article
Accelerating the Capital Solution to Climate Change
The missing “I’s” of information and incentives have restrained the potential of the capital markets in previous decades to respond to the growing demand for climate solutions. Progress on both fronts in recent years, however, is moving us rapidly beyond an inflection point in climate investing to its turning point. In this article, the authors build upon previous work to examine this progress as well as analyse the potential for an enhanced return—a “greenium”—from investments in the transition to a low-carbon economy.
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Article
Biotech Asset Valuation Methods: A Practitioner’s Guide
Biotech innovations lead to the development of life-saving drugs and vaccines. However, bringing a new drug to market is an expensive,risky, and time-consuming process. According to one survey, the probability that a drug that has completed pre-clinical trials, would successfully pass all three stages of clinical trials (the primary source of regulatory risk) and receive the FDA’s approval to be commercialized was less than 12%, is expected to take nearly 10 years on average, and costs $1.4 billion (in 2013 dollars, including the cost of compounds abandoned during testing). Biotech startups, which undertake such drug development efforts, typically have no existing revenue streams, and rely heavily on venture capitalists (VCs) for funding. This requires the VC and the startup’s founders to agree on the value of the drug in development (or equivalently, the startup’s value as the drug in development may be the startup’s only asset).
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Survey & Crossover
Unrealistic Expectations: The Futility of Precisely Estimating a Stock’s Expected Return
...dedicated to the memory of Mark S. Joshi, who worked to make results like these better known
We reprise the result that even underthe best circumstances, it is impossible to use observed return data for a stock to determine its expected return with any useful precision in a reasonable time frame. This is because the sample mean of returns, which is the best estimator for the expected return, has a large standard error. More specifically, the formula for this standard error is σ/√T, where σ is the stock’s annual volatility and T is the number of years over which the returns are sampled. We note in particular that this standard error formula is not reduced by increasing the frequency of sampling the returns within the given time frame T. -
Book Review
Scary Smart: The Future of Artificial Intelligence and How You Can Save Our World
“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.
Volume 22, No. 2, Second Quarter 2024
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Practitioner's Digest
Practitioner’s Digest • Vol. 22, 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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Book Review
The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival
“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.
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Case Study
AI Applications in Mass Customization: From Predictive Analytics to Generative AI.
“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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Article
Full-Scale Currency Hedging
After years of spirited debate, most investors agree that to minimize the risk currencies add to a portfolio they should hedge its currency exposures based on its betas relative to the currencies to which it is exposed. However, this notion of hedging makes sense only if the betas reliably reflect the co-occurrences of the cumulative returns of the portfolio and currencies over the investor’s horizon. And this will be true only if the correlations of currencies with the portfolio and with each other are constant across the return intervals used to estimate them and stationary through time. Neither of these conditions holds empirically. The authors propose a new currency hedging technique called full-scale hedging, which explicitly considers the full distribution of horizon co-occurrences.
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Article
Night Moves: Is the Overnight Drift the Grandmother of all Market Anomalies?
Our research in single name stocks suggests that retail trading likely explains the phenomenon of outsized overnight returns at both the level of the overall stock market, and that of individual stocks. We find that the effect exists at the index level as previously reported, but more strikingly in a suggestively clustered pattern of individual stocks returns, particularly those known as “Meme” stocks. The effect is also prominent in other investments such as Bitcoin that appeal to retail investors. This research is important for three reasons. First, Retail traders are potentially missing out on billions of dollars of returns due to mistimed trades. Second, there is speculation that the overnight effect might have implications for the long-term valuation of the entire equity market. And finally, assuming our findings are correct, this is one of the most consistent, significant and overlooked anomalies in finance.
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Article
Extreme Weather and Retirement Savings
In this paper, we discuss the impact of extreme weather on US families with a specific focus on household finances. We first derive a life-cycle model of consumption, then introduce climate change-oriented consumption shocks as an additional expense which is proportional to labor income. Our key finding is that exposure to shocks associated with natural disasters may lower lifetime wealth by interrupting savings contributions. We test this model by demonstrating that households living in counties which experience a high amount of natural disasters suffer lower contributions to long-term savings between 1970 and 2020. We suggest this is driven in part by temporarily lowered income and increased labor market turnover. We conclude with a discussion on how climate change may accelerate a retirement crisis and recommend suggestions for how the financial industry can help households address this challenge.
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Article
Optimal Portfolio Choice with Absorbing Markov Chains: Application to Markets that May Potentially Decouple
We develop a model of optimal asset allocation with a market that has the potential to decouple. There are three Markov regimes: a regime where the market remains fully investable, a second regime where the market may become potentially decouple, and a third regime where the market becomes decoupled and investors lose all capital. The investor wishes to hold the potentially decoupled market as it can provide a source of returns that can be partially liquidated to provide intermediate consumption. With the framework, we compute certainty equivalents of foregoing investment in the potentially decoupling market and investigate a range of comparative statics including varying the probability of decoupling
Volume 22, No. 3, Third Quarter 2024
The Future of Derivatives Research: Modeling Risk and Return Dynamics
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Special
Letter from the Editor
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Special
Introduction
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Special
Retirement Security Bonds
50th Anniversary Speech by Nobel Laureate Robert C. Merton December 1, 2023 CISDM, UMass Amherst
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Special
About Fischer Black
This speech is based on the chapter about Fischer Black in my 2004 book My Life as a Quant.
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Article
Equivalent Expectation Measures for Risk and Return Analysis of Contingent Claims
Nearly half-a-century after the advent of equivalent martingale measures (EMMs), Nawalkha and Zhuo (2022, 2023) generalize these measures to obtain equivalent expectation measures (EEMs) for analyzing risk and return of portfolios of contingent claims over a finite horizon date. The new measures allow the derivation of analytical solutions of the physical moments and co-moments of contingent claim returns until before the horizon date, and serve as pricing measures on or after that date. This novel approach allows Markowitz’s (1952) mean–variance optimization to be applied to equity portfolios embedded with options as well as fixed-income portfolios with or without options. This is useful in the investment management of equity funds, bond funds, and hedge funds, for managing risk–return trade-offs more effectively over finite planning horizons.
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Article
Forecasting the Distribution of Option Returns
We propose a method for constructing conditional option return distributions. In our model, uncertainty about the future option return has two sources: Changes in the position and shape of the implied volatility surface that shift option values (holding moneyness and maturity fixed), and changes in the underlying price which alter an option’s location on the surface and thus its value (holding the surface fixed). We estimate a joint time series model of the spot price and volatility surface and use this to construct an ex ante characterization of the option return distribution via bootstrap. Our “ORB” (option return bootstrap) model accurately forecasts means, variances, and extreme quantiles of S&P 500 index conditional option return distributions across a wide range of strikes and maturities. We illustrate the value of our approach for practical economic problems such as risk management and portfolio choice. We also use the model to illustrate the risk and return tradeoff throughout the options surface conditional on being in a high-or low-risk state of the world. Comparing against our less structured but more accurate model predictions helps identify misspecification of risks and risk pricing in traditional no-arbitrage option models with stochastic volatility and jumps.
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Book Review
The Puzzle of Sustainable Investment: What Smart Investors Should Know
“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.
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.