“Inherent Risk and Reward: A New Paradigm for Investment Analysis” by Liang Zou
University of Amsterdam
In this paper, we develop a new paradigm for analyzing investment strategies and pricing financial assets. At the bottom of this paradigm is the notion that any investment strategy, broadly defined, has its own "inherent risk" and "inherent reward" — the risk and reward that are independent of any particular investor's preference or behavior. An axiomatic approach leads us to the definition of inherent reward and risk measures, and the notion of "inherent efficiency" of capital market. The inherent reward-to-risk ratio is shown to be capable of ranking all the investment strategies with any return distributions, while respecting the fundamental principles of no-arbitrage and stochastic dominance. Inherent efficiency of capital market directly implies a capital asset pricing formula that enjoys both simplicity and the power to price any sophisticated securities. Thus, provided that the market is inherently efficient, there is a simple formula for us to price derivative securities without having to assume a complete capital market or any particular type of security return distributions (such as binomial or normal). Other issues discussed in the paper include Allais paradox, performance evaluation, time diversification, and empirical testing of the hypothesis of the inherent efficiency of a market.