Monday, August 22, 2011

Risk Premium Worthless, Convoluted

One of the most obvious failings of modern finance is that the risk premium that is so central to its core appears fleetingly and parochially. Much of what distinguishes a PhD in finance or economics from a PhD in physics is that the former know a lot more about utility functions. Yet anyone working in finance sees this is hardly an intellectual asset that makes them more valuable, precisely because any risk premium derived via Stochastic Discount Functions and the like aren't very convincing to someone wanting to invest real money. The failure of this approach is best reflected by the absence of any value to finance/econ-specific quantitative rigor, which is mainly built around utility functions. I know a lot about these, and know they are a waste of time.

Another problem with this line of reasoning is that orthodox economists tend to find risk premiums in the most bizarre cases. Consider this explanation for why highly levered stocks have lower than average equity returns (George and Hwang, 2010):
Costs associated with financial distress are crucial to our explanation for two reasons. First, distress costs depress asset payoffs in low states. Since the occurrence of low states is at least partly systematic, distress costs heighten exposure to systematic risk. Second, firms with high distress costs optimally utilize less leverage than firms with low costs. Since firms with high costs choose low leverage, low leverage firms will have the greatest exposure to systematic risk relating to distress costs. The cross section of expected returns will therefore be negatively related to leverage.

So, as opposed to Miller-Modigliani, which implies that higher leverage is associated with higher risk, higher leverage implies lower risk because such firms are actually less risky, which is why they have higher leverage. Never mind that higher leverage is associated with higher default rates, or that higher leverage is associated with higher volatility. Higher returning assets must be riskier, and so assets that have high volatility, default risk, etc., are just risky in a very subtle way because they must!

One sees what one believes.


human mathematics said...

What you're saying about utility functions is so true! It's really frustrating the seriousness / literalness with which they're read.

Economists have, and have had, a serious problem with probability. It's so tempting to use the exact same machinery on a prob. distribution. But, all the philosophical problems with probabilities of one-off events are inherited, grotesquely, by real-world applications / measurements of probabilities.

Not that I want to throw the baby out with the bathwater -- even if I can't say that I have literally a 1-in-3 chance of getting this job, the way probabilities add (say I apply to seven 1-in-3 jobs) seems reasonable. And likewise with utility: unmeasurability is a problem; yet certain axioms like d/dx>0, d²/dx²<0 and &partial;/&partial;x × &partial;/&partial;y > 0 are in the right spirit.

I don't totally understand G&H's English (I didn't click thru) but it does sound like assuming everything always works out perfectly unless proven otherwise.

human mathematics said...

On the other hand, econo-physicists perpetrate worse intellectual misdemeanors. E.g., percolation modelling; treating price as a primitive rather than the result of an underlying process. (<-- which the "utility" approach gets right)

Anonymous said...

Folks, it is a symptom of our modern economy. Since there is not much real work left to do (and what is left to do is quite unpleasant), people sit around thinking up dumb ideas, shuffling papers around, and basically participating in giant circle-jerk sessions.

Welfare disguised as work = the future for most "workers".