The Paradox Of Asset Pricing

0 v " It is a very beautiful line of reasoning. The only problem is that perhaps it is not true. (After all, nature does not have to go along with our reasoning.) " Richard P. Feynman, in Lectures on Physics. Preface The purpose of this book is to explore the scientific achievements of finance over the last forty years. That is, we will investigate whether finance has improved our understanding of financial markets. The book is based on a series of lectures, first given in Oslo, Norway, in June of 1999. It seems that modern finance is most successful when it is asked to create tools to improve financial decision making in an inherently uncertain world. The term financial engineering is appropriate here. Dynamic hedging (and its pricing counterpart, options or fixed-income pricing) is a prime example. Its successes derive of course from the adequateness of the underlying econometric modeling of the regularities in price behavior (e.g., stochastic volatility). But the real meaning or even the economic sense of the econometric descriptions have not yet been explained. The statistical approach reflects an agnostic attitude similar to the one often encountered in the medical sciences, and driven by, perhaps, the urgency of the situation (an investment decision has to be made now). In this book, we will rather be interested in: why? The goal is a deeper understanding of the workings of financial markets, not just a statistical description of their history. Modern finance has generated a set of formal models of the workings of financial markets that certainly excel in terms of mathematical elegance. But abstract beauty and logical appeal do not guarantee scientific validity. The illustrious late Richard Feynman, professor of physics at Caltech, made the same observation when he discussed the derivation of the law of gravitational potential energy from the " axiom " of conservation of energy. (See the above quote.) Fortunately for physicists, there is ample evidence that the law of gravitational potential energy is correct (to a certain degree). In contrast, there appears to be surprisingly little scientific support for even the most widely used financial model, namely, the CAPM. One can sympathize with E. Fama and K. French when they have recently begun to promote a pricing model that is based entirely on statistical regularities, even if it begs the question why it is more successful. To put this differently, asset pricing is …