The Portable Financial Analyst: What Practitioners Need to Know, 2nd Edition

274 Pages·2003·0.86 MB·English

by  Mark P. Kritzman

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The Portable
Financial Analyst
What Practitioners
Need to Know
Second Edition
MARK P. KRITZMAN
John Wiley & Sons, Inc.
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The Portable
Financial Analyst
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Founded in 1807, John Wiley & Sons is the oldest independent publishing
company in the United States. With offices in North America, Europe,
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and personal knowledge and understanding.
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The Portable
Financial Analyst
What Practitioners
Need to Know
Second Edition
MARK P. KRITZMAN
John Wiley & Sons, Inc.
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Copyright © 2003 by Mark P. Kritzman. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Kritzman, Mark P.
The portable financial analyst: what practitioners need to know / Mark
Kritzman.—2nd ed.
p. cm.—(Wiley finance series)
Includes bibliographical references and index.
ISBN 0-471-26760-0 (cloth)
1. Investment analysis. 2. Portfolio management. 3. Investments.
I. Title. II. Series.
HG4529.K747 2003
332.6—dc21 2003057656
Printed in the United States of America.
10 9 8 7 6 5 4 3 2 1
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Contents
Foreword
Time and Magic: What This Book Is About vii
Preface xi
CHAPTER 1 The Nobel Prize 1
CHAPTER 2 Uncertainty 7
CHAPTER 3 Utility 17
CHAPTER 4 Lognormality 27
CHAPTER 5 Return and Risk 33
CHAPTER 6 Higher Moments 41
CHAPTER 7 Duration and Convexity 49
CHAPTER 8 The Term Structure of Interest Rates 57
CHAPTER 9 Serial Dependence 66
CHAPTER 10 Time Diversification 75
CHAPTER 11 Regressions 85
CHAPTER 12 Factor Methods 94
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vi CONTENTS
CHAPTER 13 Estimating Volatility: Part I 102
CHAPTER 14 Estimating Volatility: Part II 110
CHAPTER 15 Hypothesis Testing 114
CHAPTER 16 Future Value and the Risk of Loss 123
CHAPTER 17 Event Studies 132
CHAPTER 18 Simulation 139
CHAPTER 19 Value at Risk 148
CHAPTER 20 Optimization 158
CHAPTER 21 Risk Budgets 173
CHAPTER 22 Hedging 182
CHAPTER 23 Option Valuation and Replication 192
CHAPTER 24 Commodity Futures Contracts 201
CHAPTER 25 Currencies 210
Glossary 221
Notes 241
Index 253
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Foreword
Time and Magic:
What This Book Is About
I
once referred to financial markets as “dazzling creations.” Mark Kritzman’s
superb essays in this book will show you where the dazzle is. Equally im-
portant, he will show you how to avoid being blinded by razzle-dazzle.
The book begins with a masterful summary of the contributions of the
Nobel Prize winners to the theory of finance and investment. Before the
1950s, there was no theory in finance, just crude rules of thumb encrusted
with fables, myths, and lore. Risk was measured in the gut; there were no
rules for managing risk; expected return was what the latest tout pro-
claimed it to be; and the interactions among bonds, stocks, and other assets
were a matter of little interest because bonds were for buy-and-hold invest-
ing and stocks were for trading; other assets were of no particular interest.
In the course of about 20 years, from the early 1950s to the early 1970s,
powerful advances in financial theory transformed a century or more of
folklore about investing into a systematic structure for managing risk, for
expanding the opportunities for higher rates of return, for calibrating per-
formance, and for decision-making by issuers as well as buyers.
Financial theory as originally set forth by the Nobel laureates has under-
gone many modifications with the passage of time, not only in overcoming
some of the oversimplifications that all theories exhibit, but also in broaden-
ing the applications of these ideas in ways no one ever conceived of in the
early days. The art of investing will never be the same as it was before 1952.
This book demonstrates how investors can put these fundamental prin-
ciples into practice. Nobody has made us so smart we can be certain of get-
ting rich. But investors who heed the lessons here will gain a keen sense of
how markets function; how to understand the essential character of differ-
ent kinds of assets; how to measure, combine, and manage risks in a ratio-
nal manner; and how to deal with the most puzzling and yet most
dominant feature of investing: the passage of time.
Time is at the heart of every transaction in financial markets. Without fi-
nancial markets, all assets would be buy-and-hold investments. Changing
vii
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viii FOREWORD
your mind after you have made an investment, at a moment of your own
choosing, would be extremely costly or even impossible under such condi-
tions. You would hesitate a long time before buying an asset with these con-
straints, and even then you would demand high compensation for taking
the risk that matters could take a turn for the worse without any opportu-
nity for you to get out. Or perhaps more attractive investments might come
along after you have committed your money to this illiquid situation. Let’s
face it: Many individuals in the investment management profession take a
lot longer to reach a decision about which house to buy for their family, and
how much to pay for it, than they spend before committing millions of dol-
lars of client money in stocks like General Electric or Microsoft.
Financial markets are a kind of magic elixir providing you with the op-
portunity to change your mind after you have made a commitment. You
may have to pay a price for that reversibility—a price you will never know
in advance—but the trade-off for that risk is in sustaining your flexibility
instead of locking yourself up in what might be a much greater risk over
the indefinite future. In more technical terms, whatever the present value of
the expected future cash flows from your investment might be, you can re-
alize them in the markets at your discretion without having to wait
through the future to cash out.
That is the picture from the perspective of an investor who wants to
sell an asset, but someone else is always at the other side of every market
transaction. If, as I have just pointed out, sellers are realizing the present
value of future cash flows today, buyers are doing the opposite. They are
using today’s cash—or instant purchasing power—to purchase a stream
of cash flows expected to arrive in the future. In short, financial markets
are a time machine that allows selling investors to compress the future
into the present while allowing buying investors to stretch the present
into the future.
But there are no free lunches and no sure things. Through all of this
wonderful magic lurks uncertainty. We do not know what the future holds,
we never have known, and we never shall know. As Frank Sinatra used to
phrase it, “That’s life!” Everyone reading these words will nod their heads
in agreement. But few people reading these words will behave as though
the future is unknown. Consider what “the future is unknown” really
means: that surprise is endemic, an inescapable feature of daily life. There
would be no such thing as surprise if we knew the future.
Yet humans have never learned how to live with surprise, which is just
another way of saying they persist in believing they know what lies ahead.
The most vivid proof of that assertion is in stock markets, where volatility
seems to be a permanent feature—sometimes more, sometimes less, but al-
ways present. These sharp and often discontinuous price movements in ei-
ther direction are clear evidence that surprise takes us by surprise. If we