Author Stephen
Ross is perhaps best known for developing the arbitrage pricing theory (APT). He
also co-discovered risk neutral valuation, which makes possible the methodology
of binomial tree pricing.
The first thing
you will notice about this book is how light it is in your hands. At barely 100
pages, it is succinct. The book is based on the Princeton University Lectures in
Finance that professor Ross gave in 2001. Its four chapters read like four
related journal articles. Perhaps the most apt description of the book is the
authors own:
I hope this monograph will be interesting to those who know something about the
subject, and I hope that it can also serve as an entry point to the field for
those with a serious interest in finance and a background in economics. This
monograph will not, however, replace a textbook introduction; it is too
idiosyncratic and personal to serve that purpose. Rather, the intention is that
the reader will come to appreciate both the elegance and the power of
neoclassical financial theory and analysis.
Today, the
challenges of pricing assets in incomplete markets—a need motivated by such
market realities as stochastic volatility and credit derivatives—is
reintroducing concepts such as utility functions and pricing kernels into
financial engineering. For this reason, financial engineering and related
branches of applied finance are somewhat returning to their roots. Because it is
about those roots, this book is highly relevant.
Contents
1. No arbitrage: the fundamental theorem of
finance
2. Bounding the pricing kernel, asset pricing,
and complete markets
3. Efficient markets
4. A neoclassical look at behavioral finance:
the closed-end fund puzzle
The first chapter
discusses the foundations of asset pricing theory: no arbitrage, the fundamental
theorem of asset pricing, representation theory, risk neutral valuation, etc.
The discussion has the brevity and clarity of a well written mathematics paper.
It is not about how to price some exotic derivative with stochastic volatility
models. Rather, it is about theory. If you have been struggling with some of the
more recent books or articles on financial engineering in incomplete markets,
you will really appreciate the explanations of basic concepts this chapter
affords.
The second chapter is the most technical of the
book. It takes a more detailed look at the pricing kernel, using the no
arbitrage argument to derive a bound on its volatility.
What the first two
chapters do more than anything else is clarify what a pricing kernel is and what
its significance is. If you have been struggling with this concept, definitely
grab a copy of this book.
Chapter three
takes a fresh look at market efficiency and makes the important observation that
tests of efficiency are difficult (impossible?) to divorce from the asset
pricing models on which they are based. Ross is hardly going to start promoting
technical analysis, but this chapter will prompt some soul searching.
The last chapter
explores a neoclassical finance explanation for the discounts to net asset value
at which closed-end mutual funds routinely trade. Actually, the chapter is more
than that. The closed-end fund "anomaly" is one of the strongest empirical
arguments in favor of the emerging field of behavioral finance. This chapter is
a general refutation of behavioral finance. It also contains a nice derivation
of the present value of a closed end fund's future management fees. If you would
like to see financial mathematics used for something other than pricing Wall
Street's latest creation, this derivation will tickle your fancy.
Actually, I think
that is why I like this book so much. Sure, it teaches you much important
finance, but the real pleasure is seeing how the mathematics is used. Ross
is a master. His book is a pleasure to read.
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