Finding Alpha : The Search for Alpha When Risk and Return Break Down

by Falkenstein, Eric

• ISBN13: 9780470445907
• ISBN10: 0470445904
• Edition: 1st
• Format: Hardcover
• Copyright: 2009-06-29
• Publisher: Wiley

Summary

Praise for Finding Alpha"Eric Falkenstein is more than one of the smartest and funniest people in finance. He's been a banker, a key model builder at a major rating agency, and a hedge fund trader. In this tour de force, he outlines the successes and failures of financial theory applications in the real world from the perspective of an aggressive early adopter of the best ideas in finance. To this day, I think Eric's private firm default model is one of the best papers ever published in applied finance, and this wonderful book falls into the same category." -Donald R. van Deventer, PhD, founder and Chief Executive Officer, Kamakura Corporation"People dismissed Columbus when he said the world was round. Thank goodness he persisted. Like Columbus, Falkenstein challenges standard thinking, only this time about risk and reward. As the meltdown of the capital markets has shown, the financial industry clearly missed something with regard to risk management. As an industry, we need to consider alternative theories on risk, and clearly Falkenstein is on to something here. Agree with him or not, Finding Alpha is worth a read." -Kevin M. Blakely, President and CEO,The Risk Management Association"Writing through the lens of an experienced practitioner, Falkenstein digests decades of research in capital markets, financial economics, and investment psychology that have shaped modern investment theory. This text is an excellent companion for portfolio managers, investment students, or anyone seeking to better understand the relationship between risk, returns, and financial reward." -Todd Houge, PhD, CFA, The University of IowaHow do we find alpha whenrisk does not correlate with return?Finding Alpha is a practical guide to achieving alpha when conventional measures of risk rarely correlate with higher returns. Author Eric Falkenstein-a PhD who has also been a risk manager and portfolio manager-tells the story of alpha from its beginnings to its current reversal, where risk is now evidenced by return as opposed to vice versa.Falkenstein begins by walking readers through the Capital Asset Pricing Model (CAPM), as well as other well-documented theories about risk and return, and explores how these theories measure up to current empirical evidence being documented by researchers and academics. He also outlines a novel approach to the issues of how benchmark risk and investor overconfidence affects expected asset returns, how to understand the nature of alpha and risk, and how to use practical applications of alpha-seeking strategies that he developed as a successful hedge fund manager.Finding Alpha concludes by outlining some real-life applications of alpha in finance and explains how the search for alpha affects the day-to-day life of all financial professionals.

Author Biography

Eric Falkenstein, PhD, developed the RiskCalcTM, the world's leading scoring tool for evaluating private firm default risk, while at Moody's Risk Management Services. The celebrated tool is used by banks worldwide, as well as by regulators and Moody's own CDO group. He was head of capital allocations and quantitative modeling at KeyCorp prior to joining Moody's and later was with Deephaven Capital Management where he developed and managed a long/short equity strategy. Between 1996 and 2002, Falkenstein formed his own investment company, the Falken Fund, which had returns of 16.0% versus 3.8% for the S&P500. His hedge fund activities are ongoing and, by law, proprietary. He is a consultant and a member of CapRock Advisors LLC, a hedge fund advisor.

Table of Contents

Risk Uncorrelated with Returns	p. 1
The Response: Return (Risk (Return))	p. 4
Failed Paradigms	p. 6
You Minimize Some Risks, Pay to Take Others	p. 9
The Creation of the Standard Risk-Return Model	p. 15
The CAPM	p. 17
Pillar 1: Decreasing Marginal Utility Means Risk Aversion	p. 18
Pillar 2: Diversification Means Not All Risk Is the Same	p. 21
The Arbitrage Pricing Theory (APT)	p. 25
The Stochastic Discount Factor (SDF)	p. 27
Adding Non-Normality	p. 32
The Uncertainty Revival	p. 34
CAPM: A Special Case of the Stochastic Discount Factor Model	p. 36
An Empirical Arc	p. 39
The Beginning of the End of CAPM	p. 44
APT Tests	p. 50
Fama and French Put a Fork in the CAPM	p. 52
Saving the Standard Model	p. 55
Serial Changes to APT	p. 58
Skewness	p. 61
Analogy to Business Cycle Forecasting	p. 63
Summary	p. 68
Volatility, Risk, and Returns	p. 69
Total Volatility and Cross-Sectional Returns	p. 70
Beta-Sorted Portfolios	p. 72
Call Options	p. 75
Small Business	p. 76
Leverage	p. 77
Mutual Funds	p. 79
Futures	p. 79
Currencies	p. 82
Lotteries	p. 84
Movies	p. 84
World Country Returns	p. 84
Corporate Bonds	p. 85
The Long End of the Yield Curve	p. 88
Distress Risk	p. 91
Sports Books	p. 92
Total Volatility and Expected Equity Index Returns	p. 93
Uncertainty and Returns	p. 95
IPOs	p. 96
Trading Volume	p. 96
Volatility as Shorthand for Risk	p. 97
Investors Do Not Mind Their Utility Functions	p. 99
Behavioral Violation 1: Investors Trade Too Much	p. 101
Behavioral Violation 2: Too Many Funds	p. 102
Behavioral Violation 3: Underdiversification	p. 102
Behavioral Violation 4: No Fundamental Analysis	p. 103
Behavioral Violation 5: Buy Recommendations Exclude Firms with Merely Low Risk	p. 104
Behavioral Violation 6: Agents Do Not Agree	p. 104
Behavioral Violation 7: The Home Bias	p. 105
The Rotten Core: The Utility Function	p. 106
Absurd Extrapolations	p. 106
Easterlin's Paradox	p. 108
Summary	p. 112
Is the Equity Risk Premium Zero?	p. 113
Geometric versus Arithmetic Averaging	p. 115
Surviorship Bias	p. 116
Peso Problems	p. 117
One-time Effect of an Anomalous Post-Depression Period	p. 118
Asymmetric Tax Effects	p. 118
Market Timing	p. 119
Transaction Costs	p. 121
Summary	p. 124
Undiminished Praise of a Vacuous Theory	p. 127
Why Relative Utility Generates Zero-Risk Premiums	p. 135
Benchmark Risk	p. 136
Why Relative Risk Leads to No Risk Premium	p. 137
Why We Are Inveterate Benchmarkers	p. 143
Typical Economic Assumptions	p. 146
Virtue of Selfishness	p. 147
Why Envy Is Virtuous	p. 149
Why Economists Dislike Envy in General	p. 150
Alpha, Risk, and Hope	p. 153
The Search for Safety	p. 154
Most Financial Risk Takers Are Foolish	p. 156
Two Types of Priced Risk	p. 156
Uncertainty in Innovation	p. 157
Why Risk Taking Hurts	p. 158
Confusion of Risk and Gambling	p. 160
Standard Alpha Contradiction	p. 163
Why We Take Risk Anyway	p. 165
Experiments, Risk, and Alpha	p. 168
Examples of Alpha	p. 173
Finding the Right Alpha	p. 175
Arbitraging Put-Call Parity	p. 179
Convexity Trade in Futures and Swaps	p. 179
Pairs and Mean Reversion	p. 183
Fund Innovations	p. 186
Convertible Bonds	p. 190
Long and Short Equity Hedge Funds	p. 194
Automating Activities	p. 196
Conclusion	p. 202
Alpha Games	p. 205
Benign Deception	p. 210
The Favor Bank	p. 214
Managerial Alpha	p. 218
The Alpha in Risk Management	p. 222
A Singular Risk Management Decision	p. 226
Risk Management Like Audit	p. 229
Overpaid Alpha Deceptors	p. 231
Investor Meets Alpha	p. 233
Alpha Seeking Applications	p. 237
Minimum Volatility Portfolio	p. 238
Beta Arbitrage	p. 244
Investing in Anomalies	p. 248
Safety Investing	p. 250
Hope Investing	p. 252
Relative Risk and Bubbles	p. 253
Capital Finding Alpha Strategies	p. 254
Search for Alpha	p. 262
Conclusion	p. 265
Notes	p. 271
Index	p. 293
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