Valuation for Financial Engineers

Feb 9 | 5 pm | Babbio Center 219

We begin with an elegant derivation of a simple formula that values many risk-free cash flow patterns, which we humbly call "The Most Beautiful Equation in Finance" (MBEF).

William Sharpe's version of the CAPM (the one taught to MBA students) values risky cash flows by assuming the Markowitz (MPT) expected return and covariance parameters are known and in equilibrium.  We re-derive the CAPM using the MBEF, leveraging a formulation first put forth by John Lintner, and show that Sharpe's model is only a special case of a more general CAPM.  Sharpe's conclusions depend critically on the assumptions that the market is already in equilibrium, and the parameters are known constants.  Using Lintner's model, we show (i) idiosyncratic risk is priced, (ii) negative asset valuations are possible, and (iii) applying the single-period model blindly to multiple periods may lead to large valuation errors.  The recommended alternative multiperiod models can be used in settings where cash flows are jointly normal and priced risk resolves over time.  Finally, we show that the MBEF together with the CAPM (an equilibrium model) can be used to value European options when there is a no-arbitrage constraint.

Bio:
David Shimko - NYU Tandon

Professor David Shimko began his professional academic career at the University of Southern California and later the Harvard Business School.  One of his PhD students recommended him to JPMorgan as Head of Commodity Derivatives Research, where he advised corporate clients on financial risk management policy.  At Bankers Trust and later in private practice, he pivoted to consult the banks' clients directly, starting Risk Capital, a boutique risk management consulting firm.  Recently, he returned to NYU Tandon to develop and teach the course, "Valuation for Financial Engineers."