Preparing for the Worst: Incorporating Downside Risk in Stock Market Investments

321 Pages·2004·3.015 MB·English

by  Hrishikesh (Rick) D. Vinod, Derrick Reagle

Preparing for the Worst
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Preparing for the Worst
Incorporating Downside Risk in
Stock Market Investments
HRISHIKESH D.VINOD
Fordham University
Department of Economics
Bronx,NY
DERRICK P.REAGLE
Fordham University
Department of Economics
Bronx,NY
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Library of Congress Cataloging-in-Publication Data:
Vinod,Hrishikesh D.,1939–
Preparing for the worst:incorporating downside risk in stock market investments /
Hrishikesh D.Vinod,Derrick P.Reagle.
p. cm.
“Wiley-Interscience,a John Wiley & Sons Inc.publication.”
Includes bibliographical references.
ISBN 0-471-23442-7 (cloth:alk.paper)
1. Stocks. 2. Investments. 3. Risk management. I. Reagle,Derrick P.(Derrick Peter),
1972– II. Title.
HG4661.V56 2004
332.63¢22—dc22
2004047418
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1
To
ARUNDHATI AND RITA VINOD
ELIZABETH REAGLE

Contents
List of Figures xiii
List of Tables xvii
Preface xix
1. Quantitative Measures of the Stock Market 1
1.1. Pricing Future Cash Flows, 1
1.2. The Expected Return, 6
1.3. Volatility, 9
1.4. Modeling of Stock Price Diffusion, 14
1.4.1. Continuous Time, 16
1.4.2. Jump Diffusion, 17
1.4.3. Mean Reversion in the Diffusion Context, 18
1.4.4. Higher Order Lag Correlations, 19
1.4.5. Time-Varying Variance, 20
1.5. Efficient Market Hypothesis, 22
1.5.1. Weak Form Efficiency, 23
1.5.2. Semi-strong Form Efficiency, 24
1.5.3. Strong Form Efficiency, 25
Appendix:Simple Regression Analysis, 26
2. A Short Review of the Theory of Risk Measurement 29
2.1. Quantiles and Value at Risk, 29
2.1.1. Pearson Family as a Generalization of the Normal
Distribution, 32
2.1.2. Pearson Type IV Distribution for Our Mutual Fund
Data, 36
vii
viii contents
2.1.3. Nonparametric Value at Risk (VaR) Calculation from
Low Percentiles, 37
2.1.4. Value at Risk for Portfolios with Several Assets, 37
2.2. CAPM Beta,Sharpe,and Treynor Performance Measures, 39
2.2.1. Using CAPM for Pricing of Securities, 43
2.2.2. Using CAPM for Capital Investment Decisions, 43
2.2.3. Assumptions of CAPM, 44
2.3. When You Assume..., 44
2.3.1. CAPM Testing Issues, 44
2.4. Extensions of the CAPM, 46
2.4.1. Observable Factors Model, 47
2.4.2. Arbitrage Pricing Theory (APT) and Construction of
Factors, 48
2.4.3. Jensen,Sharpe,and Treynor Performance Measures, 50
Appendix:Estimating the Distribution from the Pearson Family of
Distributions, 52
3. Hedging to Avoid Market Risk 55
3.1. Derivative Securities:Futures,Options, 55
3.1.1. A Market for Trading in Futures, 57
3.1.2. How Smart Money Can Lose Big, 60
3.1.3. Options Contracts, 61
3.2. Valuing Derivative Securities, 63
3.2.1. Binomial Option Pricing Model, 65
3.2.2. Option Pricing from Diffusion Equations, 66
3.3. Option Pricing Under Jump Diffusion, 68
3.4. Implied Volatility and the Greeks, 70
3.4.1. The Role of Dof an Option for Downside Risk, 71
3.4.2. The Gamma (G) of an Option, 71
3.4.3. The Omega,Theta,Vega,and Rho of an Option, 71
Appendix:Drift and Diffusion, 73
4. Monkey Wrench in the Works:When the Theory Fails 75
4.1. Bubbles,Reversion,and Patterns, 75
4.1.1. Calendar Effects, 76
4.1.2. Mean Reversion, 77
4.1.3. Bubbles, 79
4.2. Modeling Volatility or Variance Explicitly, 80