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in an unpublished early draft of their famous article) is that when you have a messy option it usually pays to visit CRW to find its value. It is not an exaggeration to attribute much of In a risk-neutral world, yield spreads are just wide enough to cover the the revolution in derivatives and financial engineering to the widespread adoption of capital losses from adverse credit Cox and Rosss clever trick. An unintended events side effect, however, is that in the nearly thirty years since CRW was discovered it has become greatly overpopulated with models lacking proper papers. Two classes of undocumented models now call CRW their home. The first are models that did not meet the requirements to enter BSW and snuck into CRW instead. Most of them are now upstanding members of the community and everyone (save the pickiest economists) is willing to let their illegitimacy slide. The second class of models is more troubling. These models, rightly or wrongly, got into CRW and never left. You see, the standard visa for getting into CRW does not last long; in fact, it expires the moment that it is granted. The risk-neutral paradise that CRW provides is only valid for a single point in time. As soon as the second hand on the clock moves, all bets are off and the model should be whisked back to a world where people need to be compensated for at least some flavors of risk. Those who instinctively believe that all option investments, including the at-the-money call in my thought experiment, should earn the risk-free rate of return are trapped in the twilight zone of CRW. In contrast, a well-indoctrinated inhabitant of CAPM World should believe that the expected return on the option will reflect the beta that it inherits from its underlying security, creating a positive risk premium for calls and a negative risk premium for puts. Unlike the beta on the underlying, which is assumed to remain constant, this implied beta will vary over time, so calculating the options expected return over any noninfinitesimal amount of time is a daunting proposition. The living is much easier in CRW than in the real world. And this is where the plot twist comes in. What happens to the financial world if enough people (and, more importantly, their models) begin to believe that they reside in CRW? As Madge the Palmolive lady used to say, Youre soaking in it. And for quite a while, I might add. Take the collapse in spreads on risky debt. In a risk-neutral world, yield spreads are just wide enough to cover the expected capital losses from adverse credit events. While unquestionably much of the tightening over the past few years has come from good news on the credit front, there appears to be more going on vanishing risk premia. And then there is the hunt for that elusive alpha that has launched a thousand hedge funds. Because alpha is notoriously difficult to pin down (much less capture) in CAPM World and its environs, much of that hunt has moved to CRW. (You wont find alpha there either, but dont tell anyone.) It is natural to wonder whether all of this is just another recipe for disaster whipped up in the financial engineers kitchens. Unfounded assumptions of option replicability (portfolio insurance in 1987) and market liquidity (LTCM in 1998) turned out to have a destabilizing effect on financial markets.
Maybe it will be different this time around. After all, there is nothing inherently unstable about a risk-neutral world, real or imagined. Where the potential instability arises is when everyone wakes up to the fantasy simultaneously. Such a sudden arousal could be triggered by GM, Fannie Mae or any number of crises that lurk over the horizon. It all boils down to this: Be careful what you model, you may end up living there. Whats more, you never know when the series might be cancelled Dr. Ross M. Miller is a professor of finance at the State University of New York at Albany and president of Miller Risk Advisors. He can be contacted at rmiller@fenews.com.