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'Accounting for Value': Ignore this at your peril, part 4

Financial engineering | 'Accounting for Value': Ignore this at your peril, part 4 Anthony Harrington

In the closing part of the review of Accounting for Value by Stephen Penman, Professor of Accounting at Columbia Business School, I continue with Penman’s elaboration of the contribution modern financial engineering can make to value accounting, and some of his strictures on its limitations for the value investor. For Penman, the founding principle of financial engineering is the concept of “no arbitrage” that we met briefly in part 3.

'No arbitrage'

"The no-arbitrage principle is the cornerstone of modern finance; prices are set in relation to each other such that there is no profit to be gained from selling at one price and buying at another. Prices cannot be arbitraged. Oil should trade in Rotterdam and New York at the same price, adjusted for transport and other transaction costs. Oil futures trade relative to spot prices such that there is no advantage to arbitraging the two. And the price of a call or put option on a stock must bear a no-arbitrage relation to the stock price.”

The beauty of the no-arbitrage principle, Penman notes, is that it enables theorists, particularly mathematical modellers, to move much more cleanly towards their goals, unencumbered by a whole bunch of assumptions about consumer or investor likes and dislikes. Price and risk could be put into direct relation to each other, with additional risk being rewarded by additional price.

However, he points out that fundamental investors pick up the no-arbitrage principle from a different standpoint. For them, it holds good for value, but not for price, and is a function of information. Prices obey the no-arbitrage rule, as far as fundamental investors are concerned, not because of their relationship to other prices, but because of their relationship to information. “Information is the arbitraging mechanism in the market”, he notes. “Prices gravitate to fundamentals as information on which value is based is recognised by the markets.”

The Black-Scholes formula for pricing derivatives, by Black, Scholes and Merton, rests on the no-arbitrage principle and has enabled financial engineers to develop a huge range of hedging instruments which reach through to the underlying prices of whatever is in question, be it share prices, indexes, commodities or mortgages. This has had huge benefits since it has enabled the development of markets in those instruments, enhancing risk sharing in the economy and has greatly improved our understanding of risk.

For the value investor, the positive outcomes of all this are many and various. The investor can now focus on the alpha performance they are after, while specifically identifying and hedging out the risks that they do not want to be exposed to. Of course there is a cost to buying insurance against those other risks, but evaluating this cost against the benefits of the hedge is now part of the investor’s skill set.

New financial instruments

Where it all gets tricky, Penman points out, is that these new financial instruments can be used as speculative tools as well as being pressed into service as hedging tools. The price at which insurance can be bought can become the prime area for speculation. This whisks us straight to the colourful history of Credit Default Swaps (CDSs) and their role in amplifying the crash of 2008. There is a more basic problem for the fundamentalist, however, Penman notes, based on the fundamentalist’s distinction between price and value. The instrument might tell you the price of the underlying share, but it is silent on its value, assuming that the two are identical. From this standpoint, for fundamentalists, the no-arbitrage principle, Penman warns, “is no help at all, indeed, is exactly wrong”!

Penman sums it all up thus:

“How do fundamental investors greet these innovations? Surely they welcome the risk-sharing opportunities that financial engineering products offer, for now (in the language of active investing) investors can be exposed to “alpha” [manager outperformance] while buying insurance against risk factors to which they do not wish to be exposed. But fundamentalists have reservations. They see arbitrage opportunities, so no-arbitrage engineering goes against the grain.”

The “unease” of the fundamental investor is actually rather similar to the unease of a traveller confronted by a fork in the path ahead. Which to take? The left hand path leads to mathematical analysis and quantitative techniques. The right hand path leads to the citadel of fundamental investing. Penman resolutely chooses the right hand path. Readers will have to make up their own minds.

Further reading on accounting and fundamental values:

Tags: Accounting , Black-Scholes , derivatives , fair value , fair-value accounting , financial engineering , Miller and Modigliani , speculation
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