(continued from front flap) praise for tapiero risk ... · charles s. tapiero is the topefr...

$95.00 USA/$114.00 CAN

Over the past two decades, fi nancial fi rms, companies, and governments have shifted greater attention to financial

manipulations in which they capitalized on leverage and short-term returns. These actually resulted in an explosive and global growth in fi nancial activity. A fi nancial Pandora’s box had been opened, and countries and blue chip corporations believing in perpetual growth and once thought too big to fail, found themselves strangled with a debt they were not able to bear.

The recent market melt-down and credit liquidity crisis created full realization that complex fi nancial products—when misun-derstood and misused—can have devastating effects. Risk Finance and Asset Pricing: Value, Measurements, and Markets is a comprehen-sive introduction to fi nancial engineering that presents the foundations of asset pricing and risk management, while stressing real-world applications.

Written for both beginning and practicing fi nancial engineers, author Charles Tapiero—the Topfer Distinguished Professor of Financial Engineering and Technology Management at the NYU Polytechnic Institute—provides:

• A non-quantitative introduction to the business of fi nance, risk, and their many applications

• An overview of the statistical approaches for measuring risk

• An introduction to the concept of utility and fi nancial risk management

• An outline of the Arrow-Debreu frame-work in discrete states and time for assets and derivatives (options) pricing

• An outline of credit risk, scoring, and complex structured fi nancial products

such as credit derivatives, their models, their demystifi cation, pricing, and fi nally, a cursory view of technical approaches to implied pricing

Each chapter includes a summary of the techniques described, and concludes with a series of problems so readers can test what they’ve learned.

Financial engineering, despite its challenges and opportunities, when misunderstood, has the potential to wreak havoc on world economies and individual portfolios. Risk Finance and Asset Pricing presents a new direction in fi nancial engineering education that combines reality and theory so that risk fi nance might again work as intended.

CHARLES S. TAPIERO is the Topfer Distinguished Professor of Financial Engi-neering and Technology Management at the New York University Polytechnic Institute. He is also Chair and founder of the Depart-

ment of Finance and Risk Engineering, as well as cofounder and co–Editor in Chief of Risk and Decision Analysis. An active researcher and consultant, Professor Tapiero has pub-lished over 350 papers and thirteen books on a broad range of issues spanning risk analysis, actuarial and fi nancial risk engineering, and management, including Risk and Financial Management: Mathematical and Computational Methods, also by Wiley.

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( c o n t i n u e d f r o m f r o n t f l a p )

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Risk Finance AND Asset PricingVALUE, MEASUREMENTS, AND MARKETS

Risk Finance ANDAssetPricing

VALUE,MEASUREMENTS,AND MARKETS

Charles S. Tapiero

Risk Finance ANDAsset Pricing

Tapiero

“An impressive text on fi nancial engineering that stands out as a logical and well-written description of many of the important models in quantitative fi nance, providing numerous relevant examples and instructive problems that help to drill home these conceptual underpinnings. The combination is especially useful for the pedagogic delivery of materials in fi nancial engineering courses andpractitioner applications of real-world issues. I highly recommend it to enhance student andpractitioner understanding of fi nancial markets.”

—EDWARD I. ALTMAN, Max L. Heine Professor of Finance and Director of Credit and Debt Markets Research Program at the NYU Salomon Center, Stern School of Business

“Recession frequently leads both students and the general public to realize that they have given far from suffi cient attention to the role and nature of risk in the arena of investment. All too often, they have been lured to their fi nancial destruction by mysterious types of assets whose nature they did not understand. Students in the fi elds of fi nance and investment, in particular, are surely ready for guid-ance in the fi eld. Here is a book that provides it very effectively. Comprehensive, rigorous, and clearly written, it will be considered indispensable by instructors, students, and thoughtful investors.”

—WILLIAM BAUMOL, Professor of Economics and Director, C.V. Starr Center for Applied Economics, NYU

“Charles Tapiero has raised masterfully both the essential problems and questions that we are confronting in a post fi nancial crisis world and reveals the many approaches and techniques that can be used to provide answers for better fi nancial risk management.”

—PROFESSOR ALAIN BENSOUSSAN, Distinguished Research Professor of Operations Management, Director of the International Center for Decision and Risk Analysis, University of Texas

“Charles Tapiero is a world-renowned scholar who has made numerous contributions in the fi eld of risk management. His book is a timely and much needed integration of the latest developments in theory and practice. Replete with real-world examples, it is a must-read for practitioners, researchers, and students interested in the fi eld of fi nancial engineering and risk management.”

—LORNE N. SWITZER, Professor of Finance and Associate Director, Institute for Governance in Private and Public Organizations,

John Molson School of Business, Concordia University

“Charles Tapiero is one of the best collaborators I ever had. He ferrets out hidden risks and reduces complexity to being tractable. He writes in a clear style without taxing the reader.”

—NASSIM NICHOLAS TALEB, Author of The Black Swan, Distinguished Professor of Risk Engineering, NYU-Polytechnic Institute

Praise for

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fm JWBT333-Tapiero August 12, 2010 10:0 Printer: Hamilton

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Risk Finance andAsset Pricing

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Founded in 1807, John Wiley & Sons is the oldest independent publishing com-pany in the United States. With offices in North America, Europe, Australia andAsia, Wiley is globally committed to developing and marketing print and electronicproducts and services for our customers’ professional and personal knowledge andunderstanding.

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For a list of available titles, please visit our Web site at www.WileyFinance.com.

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Risk Finance andAsset Pricing

Value, Measurements, and Markets

CHARLES S. TAPIERO

John Wiley & Sons, Inc.

iii



Copyright c© 2010 by Charles S. Tapiero. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted inany form or by any means, electronic, mechanical, photocopying, recording, scanning, orotherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization throughpayment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Webat www.copyright.com. Requests to the Publisher for permission should be addressed to thePermissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030,(201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

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Library of Congress Cataloging-in-Publication Data:

Tapiero, Charles S.Risk finance and asset pricing : value, measurements, and markets / Charles S. Tapiero.

p. cm. — (Wiley finance ; 563)Includes index.ISBN 978-0-470-54946-9 (cloth); 978-0-470-89237-4 (ebk); 978-0-470-89238-1 (ebk)1. Financial engineering. 2. Financial risk management. 3. Finance—Mathematical

models. 4. Investments—Mathematical models. I. Title.HG176.7.T37 2010658.15′5—dc22

2010015106

Printed in the United States of America

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To Carole, Oscar, Bettina, Scarlett, Laura-Julia,Talya, and not least, Arielle



i



Contents

Introduction xvWho This Book Is For xviHow This Book Is Structured xviiWhat’s on the Companion Web Site xix

CHAPTER 1Risk, Finance, Corporate Management, and Society 1Overview 1

Risks Everywhere—A Consequence of Uncertainty 1Risk and Finance: Basic Concepts 4

Finance and Risks 6Financial Instruments 7

Securities or Stocks 7Example: An IBM Day-Trades Record 7

Bonds 9Portfolios 10

Example: Constructing a Portfolio 11Derivatives and Options 12Real and Financial Assets 15Financial Markets 16

Option Contracts 16Problem 1.1: Options and Their Prices 17

Options and Specific Needs 18Example: Options and The Price of Equity 19Example: Management Stock Options 19

Options and Trading in Specialized Markets 20Trading the CO2 Index 20Trading on Commodities (Metal, Gold, Silver, Corn, Oil) 20Trading the Weather and Insurance 21Securitization, Mortgage-Backed Securities, and Credit Derivatives 21

Real-Life Crises and Finance 22The ARS Crisis 22The Banking–Money System Crisis 23

The 2008 Meltdown and Financial Theory 24Finance and Ethics 27

Crime and Punishment 29Summary 30

vii



viii CONTENTS

CHAPTER 2Applied Finance 35Overview 35

Finance and Practice 35Risk Finance and Insurance 35Infrastructure Finance 36Finance, the Environment, and Exchange-Traded Funds Indexes 37Finance and Your Pension 38Contract Pricing and Franchises 39Catastrophic Risks, Insurance and Finance 40The Price of Safety 41The Price of Inventories 42Pricing Reliability and Warranties 42The Price of Quality Claims 43

Financial Risk Pricing: A Historical Perspective 44Essentials of Financial Risk Management 47

Comprehensive Financial Risk Management 49Technology and Complexity 49

Retailing and Finance 51Finance, Cyber Risks, and Terrorism 52IT and Madoff 52Virtual Markets 52Virtual Products 52Virtual Markets Participants 53Virtual Economic Universes 53

Market Making and Pricing Practice 53Market Makers, Market Liquidity, and Bid-Ask Spreads 55Alternative Market Structures 56

Summary 57

CHAPTER 3Risk Measurement and Volatility 63Overview 63

Risk, Volatility, and Measurement 63Moments and Measures of Volatility 66

Expectations, Volatility, Skewness, Kurtosis, and the Range 67Example: IBM Returns Statistics 69Example: Moments and the CAPM 70Problem 3.1: Calculating the Beta of a Security 72

Modeling Rates of Return 72Models of Rate of Returns 73

Statistical Estimations 77Least Squares Estimation 77Maximum Likelihood 79ARCH and GARCH Estimators 80

Example: The AR(1)-ARCH(1) Model 81



Contents ix

Example: A GARCH (1,1) Model 83High-Low Estimators of Volatility 83Extreme Measures, Volume, and Intraday Prices 84

Statistical Orders, Volume, and Prices 85Problem 3.2: The Probability of the Range 87

Intraday Prices and Extreme Distributions 87Data Transformation 88

Example: Taylor Series 89Value at Risk and Risk Exposure 90

VaR and Its Application 92Example: VaR and Shortfall 94Example: VaR, Normal ROR, and Portfolio Design 95

The Estimation of Gains and Losses 97Summary 99

CHAPTER 4Risk Finance Modeling and Dependence 109Overview 109

Introduction 109Dependence and Probability Models 111

Statistical Dependence 111Dependence and Quantitative Statistical Probability Models 113Many Sources of Normal Risk: Aggregation and Risk FactorsReduction 114

Example: Risk Factors Aggregation 115Example: Principal Component Analysis (PCA) 116Example: A Bivariate Data Matrix and PCA 117Example: A Market Index and PCA 119

Dependence and Copulas 120Example: The Gumbel Copula, the Highs and the Lows 123Example: Copulas and Conditional Dependence 124Example: Copulas and the Conditional Distribution 125

Financial Modeling and Intertemporal Models 126Time, Memory, and Causal Dependence 127Quantitative Time and Change 129Persistence and Short-term Memory 130

The R/S Index 133Summary 135

CHAPTER 5Risk, Value, and Financial Prices 141Overview 141

Value and Price 141Utility, Risk, and Money 143

Utility’s Normative Principles: A Historical Perspective 144Prelude to Utility and Expected Utility 145

Lotteries and Utility Functions 147



x CONTENTS

Example: The Utility of a Lottery 148Quadratic Utility and Portfolio Pricing 149Utility and an Insurance Exchange 150

Example: The Power Utility Function 151Example: Valuation and the Pricing of Cash Flows 152Example: Risk and the Financial Meltdown 153Utility Rational Foundations 155

The Risk Premium 155Utility and Its Behavioral Derivatives 156

Examples: Specific Utility Functions 159The Price and the Utility of Consumption 161

Example: Kernel Pricing and the Exponential Utility Function 164Example: The Pricing Kernel and the CAPM 165Example: Kernel Pricing and the HARA Utility Function 166

The Price and Demand for Insurance 167Summary 170

CHAPTER 6Applied Utility Finance 177Overview 177

Risk and the Utility of Time 177Expected Utility and the Time Utility Price of Money 177Risk, Safety, and Reliability 178

Asset Allocation and Investments 180Example: A Two-Securities Problem 182Example: A Two-Stocks Portfolio 184Problem 6.1: The Efficiency Frontier 185Problem 6.2: A Two-Securities Portfolio 187

Conditional Kernel Pricing and the Price of Infrastructure Investments 188Conditional Kernel Pricing and the Pricing of Inventories 191Agency and Utility 193

Example: A Linear Risk-Sharing Rule 194Information Asymmetry: Moral Hazard and Adverse Selection 195Adverse Selection 196The Moral Hazard Problem 197Signaling and Screening 199Summary 200

CHAPTER 7Derivative Finance and Complete Markets 205Overview 205

The Arrow-Debreu Fundamental Approach to Asset Pricing 206Example: Generalization to n States 210Example: Binomial Option Pricing 212Problem 7.1: The Implied Risk-Neutral Probability 213Example: The Price of a Call Option 213



Contents xi

Example: A Generalization to Multiple Periods 215Problem 7.2: Options and Their Prices 218

Put-Call Parity 218Problem 7.3: Proving the Put-Call Parity 219Example: Put-Call Parity and Dividend Payments 219Problem 7.4: Options Put-Call Parity 220

The Price Deflator and the Pricing Martingale 220Pricing and Complete Markets 222

Risk-Neutral Pricing and Market Completeness 224Options Galore 226

Packaged and Binary Options 227Example: Look-Back Options 227Example: Asian Options 227Example: Exchange Options 228Example: Chooser Options 228Example: Barrier and Other Options 228Example: Passport Options 229

Options and Their Real Uses 229Fixed-Income Problems 231

Example: Pricing a Forward 231Example: Pricing a Fixed-Rate Bond 232

Pricing a Term Structure of Interest Rates 232Example: The Term Structure of Interest Rates 234Problem 7.5: Annuities and Obligations 235

Options Trading, Speculation, and Risk Management 235Option Trading Strategies 237

Problem 7.6: Portfolio Strategies 240Summary 245Appendix A: Martingales 246

Essentials of Martingales 246The Change of Measures and Martingales 248

Example: Change of Measure in a Binomial Model 249Example: A Two-Stage Random Walk and the Radon Nikodym

Derivative 251Appendix B: Formal Notations, Key Terms,

and Definitions 253

CHAPTER 8Options Applied 259Overview 259

Option Applications 259Risk-Free Portfolios and Immunization 260Selling Short 261Future Prices 262

Problem 8.1: Pricing a Multiperiod Forward 264Pricing and New Insurance Business 264



xii CONTENTS

Example: Options Implied Insurance Pricing 266Option Pricing in a Trinomial Random Walk 267Pricing and Spread Options 269Self-Financing Strategy 270

Random Volatility and Options Pricing 271Real Assets and Real Options 273

The Option to Acquire the License for a New Technology 275The Black-Scholes Vanilla Option 276

The Binomial Process as a Discrete Time Approximation 277The Black-Scholes Model Option Price and Portfolio Replication 278Risk-Neutral Pricing and the Pricing Martingale 281

The Greeks and Their Applications 284Summary 287

CHAPTER 9Credit Scoring and the Price of Credit Risk 291Overview 291

Credit and Money 291Credit and Credit Risk 294

Pricing Credit Risk: Principles 296Credit Scoring and Granting 299

What Is an Individual Credit Score? 299Bonds Rating or Scoring Business Enterprises 300Scoring/Rating Financial Enterprises and Financial Products 301

Credit Scoring: Real Approaches 304The Statistical Estimation of Default 305

Example: A Separatrix 310Example: The Separatrix and Bayesian Probabilities 311

Probability Default Models 312Example: A Bivariate Dependent Default Distribution 314Example: A Portfolio of Default Loans 315Example: A Portfolio of Dependent Default Loans 316Problem 9.1: The Joint Bernoulli Default Distribution 317

Credit Granting 317Example: Credit Granting and Creditor’s Risks 319Example: A Bayesian Default Model 322Example: A Financial Approach 323Example: An Approximate Solution 326Problem 9.2: The Rate of Return of Loans 327

The Reduced Form (Financial) Model 327Example: Calculating the Spread of a Default Bond 328Example: The Loan Model Again 329Example: Pricing Default Bonds 330Example: Pricing Default Bonds and the Hazard Rate 331

Examples 332Example: The Bank Interest Rate on a House Loan 333



Contents xiii

Example: Buy Insurance to Protect the Portfolio from LoanDefaults 333

Problem 9.3: Use the Portfolio as an Underlying and Buy or SellDerivatives on This Underlying 334

Problem 9.4: Lending Rates of Return 334Credit Risk and Collateral Pricing 334

Example: Hedge Funds Rates of Return 337Example: Equity-Linked Life Insurance 338Example: Default and the Price of Homes 339Example: A Bank’s Profit from a Loan 341

Risk Management and Leverage 342Summary 344

CHAPTER 10Multi-Name and Structured Credit Risk Portfolios 353Overview 353

Introduction 353Credit Default Swaps 357

Example: Total Return Swaps 359Pricing Credit Default Swaps—The Implied Market Approach 359

Example: The CDS Price Spread 360Example: An OTC (Swap) Contract under Risk-NeutralPricing and Collateral Prices 362

Example: Pricing a Project Launch 364Credit Derivatives: A Historical Perspective 368

Credit Derivatives: Historical Modeling 369Credit Derivatives and Product Innovation 372

CDO Example: Collateralized Mortgage Obligations (CMOs) 376Example: The CDO and SPV 377

Modeling Credit Derivatives 379CDO: Quantitative Models 380

Example: A CDO with Numbers 380Example: A CDO of Zero Coupon Bonds 382Example: A CDO of Default Coupon-Paying bonds 385Example: A CDO of Rated Bonds 387Examples: Default Models for Bonds 391

CDO Models and Price Applications 395Example: The KMV Loss Model 396

CDOs of Baskets of Various Assets 397Credit Risk versus Insurance 398Summary 399

CHAPTER 11Engineered Implied Volatility and Implied Risk-Neutral Distributions 407Overview 407

Introduction 407The Implied Volatility 409



xiv CONTENTS

Example: The Implied Volatility in a Lognormal Process 410The Dupire Model 411

The Implied Risk-Neutral Distribution 412Example: An Implied Binomial Distribution 413Example: Calculating the Implied Risk-Neutral Probability 414

Implied Distributions: Parametric Models 417Example: The Generalized Beta of the Second Kind 418

The A-parametric Approach and the Black-Scholes Model 420Example: The Shimko Technique 421

The Implied Risk Neutral Distribution and Entropy 423Examples and Applications 426

Risk Attitude, Implied Risk-Neutral Distribution and Entropy 431Summary 432Appendix: The Implied Volatility—The Dupire Model 433

Acknowledgments 439

About the Author 441

Index 443



Introduction

A t both theoretical and practical levels, finance theory has made extraordinaryintellectual strides while contributing immensely to economic development. At

the same time it has enriched the many financial engineers able to innovate and tradein financial products that create greater liquidity, predict and price assets, managefinancial risks, and contribute to the growth of financial markets.

Today, risk finance and engineering is confronted with immense challenges andopportunities. They include:

� Bridging theory and practice following the important contributions made thesepast decades by Kenneth Arrow and Gerard Debreu’s fundamental theory ofasset pricing and its many uses to better comprehend the working of financialmarkets and price assets and their derivatives.

� Reconciling the doubts raised by assumptions of fundamental finance and op-portunities to profit by the initiated who can appreciate the pro and cons ofthese theories.

The motivation for this book arose in the course of my lectures in the Departmentof Finance and Risk Engineering at the New York University (NYU) PolytechnicInstitute following the financial meltdown of 2008–2009. This was a year whenrisks and all their financial manifestations struck at the heart of financial citadelsand world economies. No firm was too big to fail, and risks hitherto conceived oftheoretically, ignored, or only dreamed of have revealed their potency. This wasalso a year when extreme events have come into their own: ex ante ignored, butfactual and painful ex post for all those who ignored the unlikely. The whole worldwas hurting: Unemployment, deflation of assets, and times of reckoning with greed,regulation, constraints, and finiteness of resources have become the underlying tuneof financial discourse. Both persons and institutions have questioned the validity offinancial models and their practical implications. On the academic front, challengingquestions have been raised against the fundamental and complete markets dogma offinance, claiming that models can default and that incomplete markets are far moreprevalent than theoretical finance would have us believe.

The financial meltdown of 2008–2009 has also ignited a far greater concernfor the underlying purposes of finance, not only as a means to get rich but to con-front the risks that beset us—whether predictable or not. These include populationgrowth, environmental challenges, globalization of finance, infrastructure, wellness,and so on. These are real problems of common and personal importance. Financialtransparency is called for to be part of the answer. The intent of this book is toprovide an accessible formulation of theoretical financial constructs embedded in abroad variety of real and useful problems.

xv



xvi INTRODUCTION

The crisis of 2008–2009 has revealed that risks borne by those uninitiated in thecomplexity of financial products and markets can be very costly. It has also becomeapparent that corporations and financial firms, traditionally managing real resources,have gradually shifted their economic activity by turning to financial manipulations,acting as intermediaries, with losses assumed by uninformed investors. These firmshave capitalized on leverage and short-term returns while strapping healthy corpo-rations with a debt they may not be able to bear. Governmental institutions havenot been spared either. They, too, have turned to financial markets to seek the fundsneeded for investments in infrastructure or to meet their financing needs. Pandora’sfinancial box has been opened, and finance—for all the good and the risks it dealswith and manages—has at the same time the potential to cause great damage if notunderstood.

Further, there is an increased awareness that financial systems are changing. Forexample, the traditional role of banks to provide liquidity to borrowers and businessfirms may have been jeopardized in their pursuit of (short-term) profits. These finan-cial institutions have become marketers of financial products and intermediaries toever-growing financial markets, rather than filling the role of providers of liquiditywhich underlies their charter granted by society and its governments. In the pursuitof profits, new financial institutions and previously nonfinancial firms have emergedand converged in new enterprises that both offer financial services and manage theirown economic interests. These firms, such as insurance companies, provide liquid-ity and are transforming the financial system. In these processes, financial engineersremain the means to provide financial products and help decide how and where toinvest and how to manage risks. The insurance-finance convergence has also affordeda means to assure buyers and sellers and thus contribute to the liquidity needed. Thecreation of a global insurance exchange in New York to cover complex risks, mod-eled after Lloyd’s of London, is just such an example. Finally, the recent financialcrisis has revealed that liquidity matters very much and the future may be unpre-dictable. Non-transparency, complexity and ambiguity have combined with greedto induce “Management’s Risks” as being able to derail financial sustainability andproduce financial models that are not efficient. These revelations have increased ourawareness that financial expectations can and do falter. This renewed awareness mayalter the financial regulatory environment, financial markets, financial attitudes andby extension the future challenges of financial risk engineering. In such an environ-ment, we may be confronted with new problems and new opportunities to providethe solutions needed by financial, corporate firms and individuals.

WHO THIS BOOK IS FOR

This book is intended for both beginning and practicing financial engineers and seeksto engender an appreciation for and understanding of pricing of real financial prob-lems. Throughout my classes I have become aware that many concepts transparentto mathematically savvy students are not understood by others. Inversely, manystudents with an extensive mathematics background fail to understand that finan-cial engineering is not about mathematics but about complex relationships betweenbuyers and sellers acting in financial markets, imputing values and prices to justabout everything that can be traded. To better appreciate what financial engineering



Introduction xvii

is, can do, and its limitations, it is necessary to have a strong footing in principlesof economics and finance, data and statistical analysis, personal utility, and theirbehavioral manifestations in financial markets and financial modeling. In particular,financial modeling provides a means to interpret implied values and prices such asoptions, credit derivatives, and so on.

In this sense, financial engineering is both real and virtual. Its usefulness is fu-eled by the needs of financial parties and by its potential contributions to investors,speculators, and society at large. The perspectives of this book, unlike many im-portant books in financial engineering and mathematics, are thus: to bridge theoryand practice; to study financial engineering as a means and not only as an end tomake money; and to emphasize a real finance that can provide the support neededto meet both individual and collective needs. At the same time, the book emphasizesan intuitive and comprehensive approach to the foundations of risk finance and itsmany applications to asset pricing, real financial problems, and financial risk man-agement. In such a frame of mind, the book’s theoretical frameworks for expectedutility, the Arrow-Debreu foundations of fundamental finance, and basic statisticalmanipulations of data and financial modeling, are shown to be useful, relevant, andcomplementary.

HOW THIS BOOK IS STRUCTURED

Theoretical concepts and theories applied mindlessly can have dire consequences.Thus, understanding the underlying rationales that financial engineers use in finan-cial modeling, optimization, and decision making is important. By the same token,financial engineers cannot be the canary in the coal mine and ought to recognizethat there is an inherent social and ethical responsibility that need not contradict thepursuit of wealth and money. There are as many opportunities to profit by contribut-ing to economic sustainability—via investment in needed infrastructures, preventingbooms and busts, reducing social inequities, pointing to market potential defaultsand failures, and so on—as there are opportunities to profit from the design of com-plex and marketable financial products that provide greater and needed financialliquidity, and from seeking arbitrage opportunities and better forecasting financialmarket prices.

The many applications treated in this book, drawn from a variety of financial,engineering, and business professions, include insurance, pricing corporate loansand managing their risks, pricing safety and reliability, pricing franchises, oper-ations risks, environmental quality and its control, infrastructure pricing, pricingwater, pricing the insurance of rare events and uncommon risks, and more. Theseapplications are used to establish a motivation and a background for a greater ap-preciation of finance and its risk engineering. Throughout the book, simplificationsare made to focus greater attention on the problem-solving rationality financial engi-neers use. The required quantitative level needed for the book is kept at a consistentand introductory level. Some sections, however, require a slightly more advancedmathematical background; these are marked with an asterisk (∗) in the table of con-tents and offer an added motivation to ambitious students. Additional extensions toeach of the book chapters and problems solved are relegated to a web site compan-ion, www.charlestapiero.com. This web site introduces as well in far greater detail



xviii INTRODUCTION

facets of continuous-time finance that this book has sought to avoid as a price forsimplicity.

The book is structured as follows. Chapters 1 and 2 provide an introduction tothe business of finance, risk, and their many applications. Issues such as ethics andfinance are discussed.

Chapters 3 and 4 are an introduction to risk measurement and to various statis-tical approaches to doing it. These chapters use data to measure risk and to estimatefinancial trends, financial volatility, and the many terms that make up the essentialcontent of basic financial applications. These two chapters introduce the student tothe need to confront the measurement, the quantification of finance, and to performbasic analyses using financial data. Chapter 4 is of a more advanced nature, how-ever, and emphasizes the problems of dependence including statistical dependence,complexity, contagious risks, latent risks, and black swan risks. The rationale forintroducing these complex issues prior to a thorough study of financial and economicconstructs used by financial engineers is to point out the true complexity of quantfinance, which cannot always be explained by available theories. Allowing studentsto grapple with complicated issues sooner rather than later offers a challenge thatis similar to the concerns and the manner in which we proceed to financial riskmanagement.

Chapters 5 and 6 introduce the concept of utility and financial risk management.Many theories applied in financial economics are applications of or interpreted interms of utility concepts. These include risk aversion, portfolio selection, certainequivalents in financial valuation, the capital asset pricing model (CAPM), kernelpricing, insurance, and utility-based risk management. These applications are stillprofusely used (explicitly or implicitly) in many practical problems. The presumptionthat financial engineering is essentially concerned with options pricing is, I believe,misguided. These chapters will show through applications that underlying financialtheory there are almost always three issues to reckon with: the rationality of theparties to a financial transaction, their private and common information, and themarket price. In many cases, any two would imply the other. In other words, anymodel in fundamental finance implies in fact an underlying rationality—which whenviolated leads to model defaults.

Chapter 7 outlines the Arrow-Debreu framework in discrete states and time forassets and derivatives (options) pricing. An intuitive introduction to martingales andtheir importance for asset pricing is included in the appendix to Chapter 7. Chapter8 provides a review of financial markets and optional portfolios used to manage andtrade risks. These two chapters present the basic concept of fundamental finance.The theory is discussed, criticized, and applied to many examples. To keep thisintroduction tractable (without losing its essential implications and applications)simple binomial, multinomial, and discrete state models are used. Extensions tocontinuous-time finance are considered briefly, and specific problems are posted onthe book web site, www.charlestapiero.com. Applications to a variety of problemsincluding derivatives pricing, default bonds, pricing insurance contracts, stochasticvolatility models, multiple sources of risks models, and a plethora of problems com-monly treated in practice and in advanced texts are also presented simply to explainthe rationale that the Arrow-Debreu financial framework uses to solve such prob-lems. Throughout these chapters, issues and instruments of current interest, such asthe financial meltdown of 2008, volatility and chaos, globalization, outsourcing, and



Introduction xix

so on, are used to explain these important facets of financial practice and the limitsof the current theoretical models of finance.

Chapters 9, 10, and 11 can be seen as a whole that can be delivered as one courseon credit risk. Chapters 9 and 10 deal with credit risk and scoring, multi-name creditrisk, and credit derivatives. Several approaches to pricing credit risk are outlined.Following the credit crisis, a greater awareness has developed that these risks oughtto be better regulated. Chapter 10 focuses on multi-name credit risk portfolios andstructured financial products such as collateralized debt obligation (CDO), collateral-ized mortgage obligation (CMO), and collateralized loan obligation (CLO). Finally,Chapter 11 addresses the important and practical problems in calculating an impliedvolatility and an implied risk-neutral distribution. Three approaches are emphasized:parametric, a-parametric, and a utility-rationality–based approach.

Chapters also include:

� Examples and problems. These highlight both some of the techniques used inasset pricing and their very broad applications.

� “Test Yourself.” Most chapters end with a series of questions to test yournewfound knowledge.

WHAT’S ON THE COMPANION WEB SITE

At www.wiley.com/go/tapiero (password: risk) you will find a number of additionalresources for this book, including:

� Additional examples, errata, and updates to the book.� Links to the author’s other publications.� Recommended reading.� Information about the author’s classes at the New York University Polytechnic

Institute.

The Instructor’s site includes answers to the problems and “Test Yourself” materialfound in the book, as well as PowerPoint slides and other materials for classroom use.

http://www.wiley.com/go/tapiero


c01 JWBT333-Tapiero August 6, 2010 11:22 Printer: Hamilton

CHAPTER 1Risk, Finance, Corporate

Management, and Society

OVERVIEWFinancial engineering is a profession that bridges theoretical finance and finan-cial practice. It spans the many occupations prevalent in financial services. Thischapter provides a nonquantitative introduction to financial management andrisk engineering. Terms such as risk, uncertainty, securities, bonds, derivatives,options, and the like are defined and their applications to a broad numberof financial concerns outlined. Terms such as trading, investing, speculating,credit, leverage, environmental finance, securitization, and others are definedand applications considered. Real-life financial problems, including safety,reliability, claims, insurance, your pension, and so forth, are highlighted toemphasize the relevance of financial analysis and management to everyday life.Finally, outstanding financial issues, a growing concern for financial ethics,and regulation are also discussed. This chapter may be covered singly or to-gether with the next chapter in one or two lectures with students reading andcommenting on the issues the chapter raises.

RISKS EVERYWHERE—A CONSEQUENCE OF UNCERTAINTY

Uncertainty is part of our lives. Its presence underlies our attitudes, our search forinformation, and the efforts we expend to mitigate and manage its positive andadverse consequences. To do so, we seek definitions, measurements, and the quan-tification of uncertainty in order to analyze the risks, protect ourselves from thelosses uncertainty may lead to, and profit from the opportunities it can provide. Intheory and in practice, uncertainty is latent in everything we do. It remains a shadowthat never departs, always challenging, for better or for worse.

Risk may be specific or have broad connotations to various persons or groups.For some, it is a threat; for others it is an opportunity to be sought and to revelin. In all cases, risk results from uncertain events and their consequences: whetherpositive or negative; whether direct or indirect; whether they are accounted for ornot; whether of external origin or internally induced; whether predictable or not;and whether of concern to individuals, firms, or the society at large. Uncertain

1



2 RISK FINANCE AND ASSET PRICING

events may be due to failures of persons or machines, a misjudgment by investorsor speculators, accidental hazards, or macroeconomic and environmental factorsover which we have partial or no control. To mitigate or profit from risk (alsoknown as risk management), preventive means, controls, insurance, hedging, tradesin optional markets, and other actions are taken ex ante (before the fact) and expost (after the fact, seeking to recover from adverse consequences). These activitiesbroadly summarize the function of financial and risk management.

Risk mitigation is common to many professions, each of which has an approachand uses techniques based on the needs and the accrued experience specific to thatprofession and acquired over long periods of time. For example, a machine operatormaintains a machine to prevent failure or nonconforming operations. Careful dietand exercise, medicines, and planned visits to a doctor for a checkup are usedpreventively to maintain one’s health and avoid disease. By the same token, anairplane has numerous built-in fail-safe mechanisms to counter predictable (albeitextremely rare) potential components or system failures.

Risk finance is focused in particular on money: how to invest it and manage it;how to price assets, contracts, options, and so on; and how to use it for the manyreal ends for which individuals and corporate, social, or other entities may needit. Pricing assets and the risks of mispricing are particularly important. When anasset is priced properly it allows an efficient exchange between the many parties thatconsume and supply such an asset. When it is mispriced, exchanges may be severelycurtailed, contributing to a lack of liquidity. Financial pricing of an asset allows oneto unlock the values embedded in the asset, whether real or virtual values, and rendersuch an asset tradable.

For example, to price a corporate firm engaged in a real economic activity(such as producing cars, making movies, selling a service, performing high-tech ormedical research and development, etc.), its value is unlocked by trading current andfuture returns and risks in units called securities or shares of stock. A security thentranslates the firm value into money by letting a buyer and a seller exchange moneyin a financial market for the right to own part of the firm’s future monetary potential.Such an exchange defines, then, both the price of the security and the monetary valuethat buyers and sellers of the security ascribe to the firm being traded. Real firmsand assets and their prospects are thus securitized and exchanged in denominatedprice contracts (in this case, a unit of stock ascribing to its owner some rights overthe firm). Predicting the price of a security can be quite complex, however, basedon all available real and financial data, future predictions regarding the economicenvironment, competitive forces, technology, management, and other factors thatcontribute to enhancing or decreasing the value of firms and their price. A commonbelief is that such prices cannot be predicted with absolute certainty but may beguessed at best by using the information we can assemble, interpret, and understand,based on insights and an understanding of the market mechanism.

To meet the many challenges of finance and its application in real life, financialinstitutions and financial markets have defined and commercialized standard finan-cial instruments that are traded, including, among many others, securities, insurancecontracts, bonds, options, credit contracts, and the like. In addition, a plethoraof financial institutions—banks, insurance firms, brokers, credit providers, and soforth—have conspired to provide the means for investors, speculators, firms, andpersons to improve their financial well-being while managing the risks of financial



Risk, Finance, Corporate Management, and Society 3

transactions. In other words, investors willing to assume more risks will do so, andthose who seek to assume less risk will do so as well.

This is possible, of course, if markets are liquid. In some cases, a price resultsfrom contractual negotiations between specific parties. These contracts assume manyforms, such as insurance contracts, over-the-counter (OTC) trades, and so on. Inother cases, prices are set arbitrarily to a price level or allowed to fluctuate betweentwo specific levels (for example, in some countries the prices of certain commoditiesare set by political decisions while in others they are set by exchanges and allowedto fluctuate between upper and lower limits). When markets are not liquid, we canexpect firms and persons to cling to their money, each uncertain of the market price.In these conditions, a lack of business and a lack of needed funds to function maycause firms to falter. For this reason, financial institutions seek to provide liquidityfor businesses to remain active, both for their own good and for the public good. Thepotential for financial institutions to make money in such processes is both immenseand varied.

For example, insurance firms set a price that insured parties pay, while at thesame time seeking a market price for the risks they aggregate in portfolios. Theydo so both to profit from a spread between insurance cost and the portfolio priceand to maintain the capacity to meet claims when they occur. To mitigate insurancerisks, insurers can also buy and sell these risks to other parties (to reinsurers whoshare payments if claims are made, in return for a portion of the premium paidby the insured) or use securitization—that is, selling standardized revenues andtheir associated claims in an insurance portfolio to financial markets. The sameapproach is used by mortgage lenders that aggregate mortgage contracts into aportfolio, which is sold through intermediaries to financial markets (as is discussedin Chapters 9 and 10). By the same token, a municipality seeking to build a subwayby issuing a debt obligation will float a proposal to be priced by buyers (the banks)or financial intermediaries seeking to finance such a transaction through financialmarkets. Throughout, financial engineering contributes by financial innovations thatunlock value that can be traded and priced viably and sustainably by an exchangeof buyers and sellers.

On the environmental front, financial markets are assuming a growing respon-sibility to price and allocate, economically and efficiently, environmental risks. Inparticular, in the matter of global warming, standardized units of carbon dioxideemission rights are traded. Current beliefs are that carbon emissions would be bettercontrolled by money equivalents and thus would contribute to global and sustain-able emission levels (at the same time, carbon taxes may be used to raise additionaltaxes for needed government revenues). Discussions at the World Economic Forumin Davos, Switzerland, and the U.S. policy of 2009 have emphasized the need touse financial markets for greater environmental and social (economic) efficiency. Forsome, the concern about global warming has become an opportunity to profit. For ex-ample, for countries or firms owning rights that they do not use, it becomes a bountythey never had (which of course leads detractors of such a scheme to assert thatcarbon trades contribute only to an important transfer of financial resources fromdeveloped to undeveloped countries). Nonetheless, there are a growing number offinancial markets specializing in such trades, such as the Chicago Climate Exchangeand Amsterdam markets. Research and applications are needed, however, to developthis potential further and to understand the mechanism for the market making of




environmentally friendly products, priced sustainably. Our concern is to define theseproblems and use finance to manage the risks and the opportunities they imply.

Globalization and financial technology have also provided an extraordinaryboost to global finance and financial markets and at the same time have contributedto appreciable investment opportunities and risks. However, whether globalizationcontributes to an increase in risk dependence and risk contagion (see Chapters 4 and10) across financial markets remains an issue that has no simple or clear-cut answer.Networking, the density of human settlements and their consequences (both goodand bad), and other factors have contributed to a far greater awareness that risksare dependent and have many sources. Further, identity thefts, cyber-crimes, virtualenterprises that operate globally, and the breakdown of traditionally secured pensionfunds and the like are colluding to highlight that risk is no longer an abstract financialissue but a real one—felt by each one of us, wherever we may be. In a global world,risks are global, and risks are thus assumed, exchanged, shared, traded, valued, andpriced globally. They are also implied in corporate strategies, whether financial ornot. In such an environment, finance and the risk business are necessarily far greaterthan ever before.

There are many risks that are not easily defined in monetary terms, however, andcannot be exchanged to produce an agreed-on price. For example, rare events (withan extremely small probability of occurring) and catastrophic risks are notoriouslydifficult to price as only very few financial parties may have the capacity to bearthe implied risks. Such risks are a financial engineering challenge—to better manage,define, value, and price these risks, either uniquely or approximately, and unlock thevalue or financial consequences embedded in them.

RISK AND FINANCE: BASIC CONCEPTS

Risk and finance are defined by a complex set of factors, each determining the others.It has been claimed that a risk with no financial consequence is not a risk. Thisstatement, of course, cannot be true since one’s accidental death might not have anyfinancial consequence. For our purposes here, risk and finance are defined implicitlyand explicitly by factors that have an underlying financial value. Monetizing thisvalue is a financial engineering challenge. Seven essential factors are used to definethe value and price of risk:

1. Events and their probabilities (whether common or rare).2. Predictability and timing of these events and their recurrence.3. Uncertain financial consequences (whether adverse or beneficial).4. Individuals’ tolerance for risk bearing, implied in their preferences.5. Individuals’ information and ability to measure and to assess risks.6. Risk sharing and exchange (contractual or not).7. Market pricing, arising from the interaction of many buyers and sellers in a fair

and efficient manner with common and shared information.

The first two factors, events and their probabilities and their predictability andtiming, need not have financial relevance if they have no financial consequence.An individual’s rationality and personal information expressing a latent preference




for uncertain outcomes (see Chapters 5 and 6) are relevant to personal finance butmight or might not be relevant to financial markets pricing. Finally, risk sharing andexchange as well as financial markets pricing imply the value of a trade, product, orrights conferred by an exchange, reached at an agreed-on price. Each of these factorsunderlies the concerns of investors, traders, speculators, and financial engineers. Forexample, the value of an asset or returns derived from an asset held by an investorwill depend on the returns or the obligations of the asset and the timing of thosereturns—whether uncertain or not. The market price of an asset, however, is definedby the buyers and the sellers trading in this asset. When a price is not set by amarket, it may be defined by a contractual agreement between a buyer and a seller orby a collective entity (such as by a government that regulates prices, or by a privateagreement between an insured and an insurer).

An individual’s rationality (or that of a corporate entity) expresses the subjectivepredisposition of an investor to bear risks and to choose and pay for an investmentas a function of its risk/reward characteristics. These factors, combined with macroe-conomic effects (such as interest rates, employment statistics, etc.) contribute to apricing of all valuable assets, with prices based on the attitudes of all parties to a trade.

Risk may be more or less accepted or abhorred by individuals and firms. Historyoffers examples where risk is accepted and even sought out: Egyptians knew of thefloods of the river Nile, but knew also that floods would irrigate their agriculturalfields near the banks of the river. Thus, Egyptian farmers intentionally settled next tothe river with the prospect of growing abundant crops. It was impossible to predictthe amount of the flooding from year to year, but over many centuries the ancientEgyptians were able to anticipate when the flooding would occur (it occurs at aboutthe same time every year). By the same token, many hedge funds nurture theirfunds with risky bets in expectation of extremely large returns. Individual investors,corporations, and societies relate differently to the risks they assess, assume, orare willing to bear. Risk behavior, as well as the attitudes it implies, is therefore afundamental concept (expanded on further in Chapters 5 and 6). It characterizes thedegree to which an investor accepts probabilities of adverse consequences. Similarly,it underlies the investor’s need to hedge and tailor the risks assumed to a tolerablelevel, where the risk and its rewards are balanced (in the investor’s view and interest,of course).

Risk events, their timing, and their consequences have both direct and indirecteffects. The former are usually well defined and accounted for, while the latter areharder to assess and might be neglected. It is therefore useful to categorize risks tobetter appreciate their origins and their consequences. For brevity, we can summarizethe categories of risk as follows:

� External-hazard risks (such as weather risks, macroeconomic risks to a firm, orrisks over which we have little or no control).

� Endogenous risks (such as some operational risks arising from human, organi-zational, mechanical, or process dysfunctions; endogenous indicates that theserisks are inherent to the process in place).

� Strategic or counterparty risks (originating in exchanges between multiple par-ties, each with different agendas and risk attitudes; for example, counterpartyand contractual risks, information and power asymmetries are such risks andare considered in Chapters 9 and 10).




� Risk externalities or risks with consequences and origins that are disparate (e.g.,when risk consequences are not assumed by the perpetrator—as is sometimesthe case in environmental pollution). These risks can have both an adverse anda positive consequence.

Examples of strategic and risk externalities abound. The pollution perpetrated bya chemical firm spilling its wastes in nature is a risk externality. By the same token, alarge bank that assumes exuberant risks in the pursuit of short-term profits and hugebonuses because it believes that it is too big to fail is another form of a polluter thatputs at risk the financial system. When the parties to business or financial transactionshave different objectives, whether these are conflicting or not, a counterparty orstrategic risk arises. Similar risks recur in contractual risk exchanges or risk sharingbetween parties that have different objectives and use their information to takeadvantage of contract clauses. In this vein, OTC contracts as well as insurancecontracts may have a strategic risk (more on this in Chapters 9 and 10).

The definition and measurement of these risks is difficult, however, compoundedby the use of risk as a panacea for the many ills, real, potential, or imaginary, thatindividuals and corporate firms face (either internally or externally). In an era of glob-alization, some of these risks may become intractable and therefore nontransparent.For example, securitization (the process by which many risks are compounded, con-founded, marketed, and traded as a package—in whole or in parts) in global financialmarkets and transferring risk from one entity to another (from investors, debtors,etc.) through multiple intermediaries have contributed to increased disparities be-tween real and perceived risks. Risks have thus become less transparent, less specific,and more complex. As a result, many financial risks are ill understood, poorly mea-sured, and may potentially contribute to an incentive to assume ever-greater risks(referred to by Robert Shiller as irrational exuberance). The measurement of riskis therefore both important and challenging and is addressed in greater detail inChapters 3 and 4.

F inance and Risks

Financial institutions are motivated by five essential purposes:

1. Provide liquidity (the intent of bank charters and therefore their legalresponsibility).

2. Price and manage financial risks—whether these risks are or are not predictable.3. Allocate wealth to financial and other assets to meet investors’ objectives. To

do so, finance seeks to define and explain investors’ risk attitudes, meet theirrisk/reward expectations, and prevent or counteract the effects of risk, regula-tion, and taxes.

4. Provide a decision framework to guide and justify individuals’ and firms’ finan-cial decisions.

5. Innovate and design financial instruments that meet the needs of investors, indi-viduals, firms, and society for profit, risk bearing, and liquidity.

Financial economic theory, based on specific assumptions of rational behavior,has provided a strong anchor to financial modeling and decision making to support




these needs. The efficient market hypothesis (EMH), which claims that underspecific assumptions financial markets are rational, is such an example. While theEMH is a powerful and useful theoretical framework, it is also violated in practice,leading to some competing theories—albeit none as general as the EMH. Behavioralfinance (BH) in particular seeks to integrate human and behavioral processes intofinancial decision-making processes. Financial practice, in contrast, seeks the bestit can do for financial principals, intermediaries, or agents in a given situation. It isnot constrained by theory but by its financial performance, with the stance that itsproof is in its results.

F INANCIAL INSTRUMENTS

Financial instruments are varied, including essentially securities, bonds, options, andportfolios on these assets, as well as a large variety of agreements for credit risk andcredit derivatives. These instruments and their variants are used for specific financialpurposes.

Securit ies or Stocks

Factories, retail firms, banks, film companies, soft-drink bottlers, utilities, and soon are economic entities transforming assets, production, and services into returns.Stocks are obligations to share in the equity of a firm, and they give the owner ofthe equity the right to vote for governing board members and to share in the firm’sresidual profits. These rights confer a value, priced by the security market price.Financial markets have, then, an important role in liquefying (or securitizing) thefirm’s real functions into a financial product that is bought and sold and shared withinvestors. The ownership of securities publicly traded is thus a common ownershipof obligations and returns derived from these stocks.

In 1938, John Burr Williams postulated that the value of any financial asset (astock) equals the present value of all of its future cash flows. For example, if a firmprovides its shareholders a periodic cash distribution—the stock dividend—then thestock price equals the present value of these planned disbursements by the firm. Theprice of a stock and its prediction includes many more considerations, however, ex-pressing the firm’s current and future macroeconomic environment, its management,the firm’s returns and growth, investors’ motives summarized by their risk attitudesand the information they possess, and so forth. In this sense, a stock price expressesmore than just current and expected cash flows. The manner in which we calculatethe price of securities is critically important, complex, and useful, and is the topicof several chapters where different approaches are used—both subjective estimationusing utility-based approaches and by financial market EMH-based theories.

EXAMPLE: AN IBM DAY-TRADES RECORD

Consider the IBM security price recorded daily as shown in Table 1.1. Such informa-tion is available daily in the great majority of financial markets and for all productstraded. Open defines the day’s opening price; high, low, and close prices define the




TABLE 1.1 IBM Stock Price over Five Years

Date Open High Low Close Volume Adj Close

01/02/2003 78.8 80.57 78.19 80.57 7,864,500 74.3801/03/2003 80.7 81.65 80.21 81.65 5,962,300 75.3801/06/2003 81.9 84.8 81.81 83.59 7,921,300 77.1701/07/2003 83.95 86.18 83.75 86 11,906,900 79.3901/08/2003 85.55 85.69 84.07 84.19 9,508,800 77.7201/09/2003 84.75 87.02 84.75 87 10,711,600 80.3201/10/2003 85.85 88.04 85.7 87.68 9,955,400 80.9401/13/2003 88.31 88.95 87.35 87.51 10,499,000 80.7901/14/2003 87.23 88.59 87.22 88.58 7,569,100 81.78. . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . .

12/18/2008 85.77 86.64 82.96 84 8,029,500 83.1112/19/2008 85.22 85.22 82.97 83.52 13,098,600 82.6412/22/2008 83.27 83.45 80.32 81.99 7,083,300 81.1212/23/2008 82.35 82.81 80.13 80.6 6,374,400 79.7512/24/2008 80.55 81.22 79.92 80.52 2,415,200 79.6712/26/2008 80.93 81.8 80.55 81.33 3,101,300 80.4712/29/2008 81.72 81.72 79.68 81.25 6,062,600 80.3912/30/2008 81.83 83.64 81.52 83.55 5,774,400 82.6712/31/2008 83.5 85 83.5 84.16 6,667,700 83.27

prices statistics for that day; volume denotes the number of trades effected duringthat day. Such data may be used to predict trends in IBM’s stock price, although pre-dicting IBM’s price from one day to the next may be tricky. The study of a historicalstock price can provide ex post a technically acceptable explanation of price move-ments. An ex ante prediction of prices is much more difficult. However, Chapter 3provides a number of statistical approaches to characterize security price processes,asking questions such as whether a security price change is due to macroeconomicfactors, statements by corporate leaders or leading analysts, a perceived future profitpotential for the security, or other factors. These questions are, of course, difficultto analyze quantitatively, but numerous attempts to do so are made nonetheless.

Pricing a firm’s security based only on its daily price record might not reflect thetrue value of the firm. Macroeconomic factors (such as the gross national product,interest rates, exchanges rates, etc.) as well as industry- and firm-specific factors (suchas the industry market structure, technology, management, regulation, governmentsupport, etc.) are also important. Some firms are cost-driven, augmenting their profitsby increasing their costs (for example, public transportation, health care, etc.), whileothers are value-driven, based on consumers’ ability to pay the value they extract bybuying a product or service (in particular, luxury and consumer-branded goods). Ingeneral, both costs and values interact in a push-pull process that causes certain firmsto have prospective profits or losses (and thereby to have a greater or a lesser value).Prices set in financial markets are then derived from firms’ cost and value push-pullprocesses with a large number of financial parties (including investors, speculators,pension funds, insurance firms, etc.) expressing their needs and choices by buying

(continued from front flap) praise for tapiero risk ... · charles s. tapiero is the topefr...

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