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

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  • Edition: 1st
  • Format: Hardcover
  • Copyright: 2009-06-29
  • Publisher: Wiley
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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 Returnsp. 1
The Response: Return (Risk (Return))p. 4
Failed Paradigmsp. 6
You Minimize Some Risks, Pay to Take Othersp. 9
The Creation of the Standard Risk-Return Modelp. 15
The CAPMp. 17
Pillar 1: Decreasing Marginal Utility Means Risk Aversionp. 18
Pillar 2: Diversification Means Not All Risk Is the Samep. 21
The Arbitrage Pricing Theory (APT)p. 25
The Stochastic Discount Factor (SDF)p. 27
Adding Non-Normalityp. 32
The Uncertainty Revivalp. 34
CAPM: A Special Case of the Stochastic Discount Factor Modelp. 36
An Empirical Arcp. 39
The Beginning of the End of CAPMp. 44
APT Testsp. 50
Fama and French Put a Fork in the CAPMp. 52
Saving the Standard Modelp. 55
Serial Changes to APTp. 58
Skewnessp. 61
Analogy to Business Cycle Forecastingp. 63
Summaryp. 68
Volatility, Risk, and Returnsp. 69
Total Volatility and Cross-Sectional Returnsp. 70
Beta-Sorted Portfoliosp. 72
Call Optionsp. 75
Small Businessp. 76
Leveragep. 77
Mutual Fundsp. 79
Futuresp. 79
Currenciesp. 82
Lotteriesp. 84
Moviesp. 84
World Country Returnsp. 84
Corporate Bondsp. 85
The Long End of the Yield Curvep. 88
Distress Riskp. 91
Sports Booksp. 92
Total Volatility and Expected Equity Index Returnsp. 93
Uncertainty and Returnsp. 95
IPOsp. 96
Trading Volumep. 96
Volatility as Shorthand for Riskp. 97
Investors Do Not Mind Their Utility Functionsp. 99
Behavioral Violation 1: Investors Trade Too Muchp. 101
Behavioral Violation 2: Too Many Fundsp. 102
Behavioral Violation 3: Underdiversificationp. 102
Behavioral Violation 4: No Fundamental Analysisp. 103
Behavioral Violation 5: Buy Recommendations Exclude Firms with Merely Low Riskp. 104
Behavioral Violation 6: Agents Do Not Agreep. 104
Behavioral Violation 7: The Home Biasp. 105
The Rotten Core: The Utility Functionp. 106
Absurd Extrapolationsp. 106
Easterlin's Paradoxp. 108
Summaryp. 112
Is the Equity Risk Premium Zero?p. 113
Geometric versus Arithmetic Averagingp. 115
Surviorship Biasp. 116
Peso Problemsp. 117
One-time Effect of an Anomalous Post-Depression Periodp. 118
Asymmetric Tax Effectsp. 118
Market Timingp. 119
Transaction Costsp. 121
Summaryp. 124
Undiminished Praise of a Vacuous Theoryp. 127
Why Relative Utility Generates Zero-Risk Premiumsp. 135
Benchmark Riskp. 136
Why Relative Risk Leads to No Risk Premiump. 137
Why We Are Inveterate Benchmarkersp. 143
Typical Economic Assumptionsp. 146
Virtue of Selfishnessp. 147
Why Envy Is Virtuousp. 149
Why Economists Dislike Envy in Generalp. 150
Alpha, Risk, and Hopep. 153
The Search for Safetyp. 154
Most Financial Risk Takers Are Foolishp. 156
Two Types of Priced Riskp. 156
Uncertainty in Innovationp. 157
Why Risk Taking Hurtsp. 158
Confusion of Risk and Gamblingp. 160
Standard Alpha Contradictionp. 163
Why We Take Risk Anywayp. 165
Experiments, Risk, and Alphap. 168
Examples of Alphap. 173
Finding the Right Alphap. 175
Arbitraging Put-Call Parityp. 179
Convexity Trade in Futures and Swapsp. 179
Pairs and Mean Reversionp. 183
Fund Innovationsp. 186
Convertible Bondsp. 190
Long and Short Equity Hedge Fundsp. 194
Automating Activitiesp. 196
Conclusionp. 202
Alpha Gamesp. 205
Benign Deceptionp. 210
The Favor Bankp. 214
Managerial Alphap. 218
The Alpha in Risk Managementp. 222
A Singular Risk Management Decisionp. 226
Risk Management Like Auditp. 229
Overpaid Alpha Deceptorsp. 231
Investor Meets Alphap. 233
Alpha Seeking Applicationsp. 237
Minimum Volatility Portfoliop. 238
Beta Arbitragep. 244
Investing in Anomaliesp. 248
Safety Investingp. 250
Hope Investingp. 252
Relative Risk and Bubblesp. 253
Capital Finding Alpha Strategiesp. 254
Search for Alphap. 262
Conclusionp. 265
Notesp. 271
Indexp. 293
Table of Contents provided by Ingram. All Rights Reserved.

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