How the Father of Arbitrage Pricing Theory Influenced Wall Street" plus a Special Bonus: "how a situation with risk-less arbitrage profits can persist over a prolonged period of time"

First up, Knowledge@Wharton, Aug. 29:

Wharton's David Musto on the late Stephen A. Ross, this year's winner of the Wharton-Jacobs Levy Prize for Quantitative Financial Innovation.

This year’s winner of the Wharton-Jacobs Levy Prize for Quantitative Financial Innovation, an award given to leading lights in the world of finance, is former Wharton professor Stephen Alan Ross. Many in the field consider him to be one of the most important thinkers in modern finance. One of his best-known ideas, for which he is receiving this award, is arbitrage pricing theory, or APT. It has been a staple of finance since he developed it in 1976 while at Wharton. 

In March, Ross died at 73, shortly after he was announced as the winner of the prize. The award will be given posthumously on September 15 at the Jacobs Levy Center’s annual conference, to be held in New York. More recently, he had been a professor at the MIT Sloan School of Management. Ross’s work covered many fields, from asset pricing to management and corporate finance. 

Wharton finance professor David Musto, who will be speaking about Ross at the conference, joined Knowledge@Wharton to talk about the late professor’s research and contributions to the field. 

An edited transcript of the conversation follows.

Knowledge@Wharton: Let’s start by talking about Ross’s most famous theory, APT. It was truly groundbreaking as a way to analyze risk and returns in financial markets. It looked at how to identify assets that were trading too low or too high, because of market mispricing. Can you explain how important that theory is, and the basics of how it works?

David Musto: I’d be happy to. And to understand the importance of this theory, it is also worth thinking about the contributions of the two previous winners of the Jacobs Levy Prize. And that would be (Nobel laureates) Harry Markowitz and Bill Sharpe. So, let’s rewind all the way back to the 1950s, when Harry Markowitz was finishing his PhD. His graduate work was about the risk of stocks. And in particular, the risk that an investor should care about. His point was that sure, stocks are risky. Investors are averse to risk, and so therefore they should care about the risk of stocks, and maybe discount for it when they buy.

But his additional point was that if you think about the risk that faces an investor, it’s not the risk of individual stocks. An intelligent investor is going to diversify across many stocks. And the risk that faces the investor, the risk that ultimately is going to deliver the payoff to his bank account, is going to be the risk of this portfolio. And once you think of it that way, you realize that the correct measure of risk is not a stock’s risk by itself, but instead, the risk that it’s going to add to a diversified portfolio. So, that was his point. That was a pathbreaking point, and the contribution that won him the Jacobs Levy Prize.

Now go forward from the 1950s to the 1960s. Bill Sharpe is a graduate student. And then his most famous paper, and the one that he won the Jacobs Levy prize for, is one that shows that if, in a world where investors are trying to maximize their expected return for a given unit of volatility, you can reach the conclusion that the risk that really matters about a stock is what you’d call its beta (a stock’s volatility in relation to the market). Essentially, in technical terms, it is the result you would get if you did a regression of the stock’s return on the market portfolio. You get a number, which on average is going to be one, but it can be higher or lower. That [beta] tells you the risk that the stock adds to the market portfolio.

“The correct measure of risk is not a stock’s risk by itself, but instead, the risk that it’s going to add to a diversified portfolio.”

Knowledge@Wharton: Is that a volatility measure, in a way?...

...MUCH MORE, including podcast.

And from Izabella Kaminska, July 18, a BIS paper:

Wither the law of one price?

...This raises the fundamental question of how a situation with risk-less arbitrage profits can persist over a prolonged period of time. We show that such a situation can indeed be part of an equilibrium outcome in a world of segmented money markets and excess liquidity.....MORE

Her emphasis.

As a bonus bonus, back in April's "Keynes’s Art Collection Shows Why Art Investing Is Like the Lottery" we linked to her improvising variations on:

"the intangibles that go into valuation with a look at contango in the market for water from the Grotto of Massabielle in the Sanctuary of Our Lady of Lourdes, France"

First noted in 2013's Are collectibles good long-term investments? "The Investment Performance of Emotional Assets"

September 11, 2013
On Monday we posted a short bit on collectibles, riffing off a Quartz piece:
Cars, coins and stamps are now more profitable luxuries than art, wine and jewelry (there's an ETF for that)

Which we got timestamped just before Izabella Kaminska had three FT Alphaville posts:

A classic car bubble?
The art of myth-making
The growing scarcity of scarce markets

Addressing respectively 1) the Knight Frank luxury investment index; 2) the intangibles that go into valuation with a look at contango in the market for water from the Grotto of Massabielle in the Sanctuary of Our Lady of Lourdes, France and 3) a meta-analysis of the attributes of markets in non-standardized goods.

She is such a show off....