Contents
List of contributors ix
Introduction xi
1 Market efficiency and forecasting 1
Wayne Ferson
1.1 Introduction 1
1.2 A modern view of market efficiency and predictability 2
1.3 Weak-form predictability 3
1.4 Semi-strong form predictability 5
1.5 Methodological issues 8
1.6 Perspective 10
1.7 Conclusion 12
References 12
2 A step-by-step guide to the Black–Litterman model 17
Thomas Idzorek
2.1 Introduction 17
2.2 Expected returns 18
2.3 The Black–Litterman model 21
2.4 A new method for incorporating user-specified confidence levels 32
2.5 Conclusion 36
References 37
3 A demystification of the Black–Litterman model: managing quantitative
and traditional portfolio construction 39
Stephen Satchell and Alan Scowcroft
3.1 Introduction 39
3.2 Workings of the model 40
3.3 Examples 42
3.4 Alternative formulations 46
3.5 Conclusion 50
Appendix 50
References 53
4 Optimal portfolios from ordering information 55
Robert Almgren and Neil Chriss
4.1 Introduction 55
4.2 Efficient portfolios 58
4.3 Optimal portfolios 70
vi Contents
4.4 A variety of sorts 77
4.5 Empirical tests 82
4.6 Conclusion 95
Appendix A 96
Appendix B 97
References 99
5 Some choices in forecast construction 101
Stephen Wright and Stephen Satchell
5.1 Introduction 101
5.2 Linear factor models 104
5.3 Approximating risk with a mixture of normals 106
5.4 Practical problems in the model-building process 108
5.5 Optimization with non-normal return expectations 112
5.6 Conclusion 115
References 115
6 Bayesian analysis of the Black–Scholes option price 117
Theo Darsinos and Stephen Satchell
6.1 Introduction 117
6.2 Derivation of the prior and posterior densities 119
6.3 Numerical evaluation 131
6.4 Results 134
6.5 Concluding remarks and issues for further research 140
Appendix 142
References 148
7 Bayesian forecasting of options prices: a natural framework for
pooling historical and implied volatility information 151
Theo Darsinos and Stephen Satchell
7.1 Introduction 151
7.2 A classical framework for option pricing 155
7.3 A Bayesian framework for option pricing 156
7.4 Empirical implementation 163
7.5 Conclusion 172
Appendix 173
References 174
8 Robust optimization for utilizing forecasted returns
in institutional investment 177
Christos Koutsoyannis and Stephen Satchell
8.1 Introduction 177
8.2 Notions of robustness 178
8.3 Case study: an implementation of robustness via forecast
errors and quadratic constraints 182
8.4 Extensions to the theory 184
8.5 Conclusion 187
References 188
Contents vii
9 Cross-sectional stock returns in the UK market: the role of liquidity risk 191
Soosung Hwang and Chensheng Lu
9.1 Introduction 191
9.2 Hypotheses and calculating factors 193
9.3 Empirical results 196
9.4 Conclusions 211
References 212
10 The information horizon – optimal holding period, strategy aggression
and model combination in a multi-horizon framework 215
Edward Fishwick
10.1 The information coefficient and information decay 215
10.2 Returns and information decay in the single model case 217
10.3 Model combination 221
10.4 Information decay in models 222
10.5 Models – optimal horizon, aggression and model combination 224
Reference 226
11 Optimal forecasting horizon for skilled investors 227
Stephen Satchell and Oliver Williams
11.1 Introduction 227
11.2 Analysis of the single model problem 228
11.3 Closed-form solutions 232
11.4 Multi-model horizon framework 236
11.5 An alternative formulation of the multi-model problem 241
11.6 Conclusions 243
Appendix A 244
Appendix B 246
References 250
12 Investments as bets in the binomial asset pricing model 251
David Johnstone
12.1 Introduction 251
12.2 Actual versus risk-neutral probabilities 252
12.3 Replicating investments with bets 255
12.4 Log optimal (Kelly) betting 256
12.5 Replicating Kelly bets with puts and calls 258
12.6 Options on Kelly bets 259
12.7 Conclusion 260
References 261
13 The hidden binomial economy and the role of forecasts
in determining prices 265
Stephen Satchell and Oliver Williams
13.1 Introduction 265
13.2 General set-up 266
13.3 Power utility 271
viii Contents
13.4 Exponential utility, loss aversion and mixed equilibria 276
13.5 Conclusions 277
Appendix 278
References 278
Index 281