By John Thackray

Last August The Wall Street Journal made a unusual foray into the internecine snake pit of derivatives scholarship. A 500-word piece by columnist Roger Lowenstein told the sad and faintly humorous tale of Professor John E. Gilster Jr. of Michigan State University. The gist of the story was that the professor had written a pathbreaking article on options pricing theory that he'd submitted to the prestigious Journal of Finance. "As per usual," writes Lowenstein, "it sends the paper to an expert referee: in this case, to Prof. Gilster. He replies that he has a high opinion of the paper, but points out that he is also the author. Realizing its mistake, the journal sends the paper to another referee who recommends against publishing. Gilster is then rejected by two more journals and scores a perfect three rejections for three; in part, the referees cite the contrary work of previous experts, including Prof. Gilster." This year Gilster tries the Journal of Finance yet again and is shown the door. Lowenstein then quotes three approving Wall Street traders who read an abstract of Gilster's paper on the Financial Economics Network.

I called up Gilster and asked if the Journal's story was true. "Oh yes," he replied, "if anything it is understated. However I've not been suffering the last five years. I've got tenure. The story is as amusing, I suppose, as it is painful. Some people who read the article were enraged that something so obvious was hidden so long."

Sensing some foul conspiracy to squash a challenge to the conventional wisdom I got a copy of "Option Pricing Theory: Is "Risk Free" Hedging Feasible?" and found that it was a broadside against none other than the Black­Scholes model. That model of a risk-free hedge required investors to rebalance their positions as often as transaction costs would allow. Black­Scholes and others, including Gilster in a 1990 paper in the Journal of Finance, "measured the risk of discreetly rebalanced option hedges from a point at which the hedge was perfectly balanced," writes Gilster in the unpublished paper, adding "Unfortunately, the resulting risk measures were of limited practical value because the point of perfect balance is in general the minimum risk point within a discrete rebalancing interval, and it is the only point within the rebalancing interval at which we can be absolutely certain we do not need to rebalance."

Unhedged better?

Throwing down the gauntlet, the bold professor asserts that a long position in a stock which has been "hedged by a short position in options (Black­Scholes hedge ratios) can develop a higher standard deviation of returns and a higher absolute value of systematic risk than the corresponding risks of the unhedged stock position by itself." Gilsters' nonexistent risk-free hedge "calls into question the applicability of the prices, hedge ratios and hedging strategies derived from theories based on such a hedge."

What do other professors think of the idea? "From an academic point of view it is not interesting," says Andrew Kalotay, director of the Center for Finance and Technology at Polytechnic University. "In fact, it is well known that the initial Black­Scholes model assumes there are no transaction costs. But in the real world you can't rebalance continuously so you are going to have to follow a different strategy. From a theoretical point of view this is not a new idea."

Gilster may have made problems for himself by setting his heart on a second appearance in the Journal of Finance. "I'm familiar with his work from the past and what I've seen of it is quite good," says Alan Tucker, editor of the Journal of Financial Engineering. "But you must remember that the acceptance rate of the Journal of Finance is about four percent. This implies that if an academic submits an average paper once a year, which is actually a high rate, he or she would get accepted for publication there once every 20 years. People go through their whole careers without publishing in the Journal of Finance."

"Lots of brilliant articles get rejected," adds Jack Marshall, a professor currently teaching at St. John's University. "Black and Scholes were turned down by every publication for years."

Okay, class, what's historically the best-performing stock group coming out of a recession? Early cyclicals is the correct answer. Late cyclicals do best in recoveries. This wisdom comes to us courtesy of Merrill Lynch's Steve S. Kim, assistant vice president, and Richard Bernstein, director of quantitative & equity derivatives research. This duo have just released The Economic Cycle and Its Implications for Investing, which focuses on stock behavior and economic cycles. Their study emphasizes the reactions, under various conditions, of four different stock types or traded indices: Early Cyclicals, Late Cyclicals, Stable Growth and Interest Rate Sensitivities, respectively ECYC, LCYC, SGRO and ISEN on the Bloomberg ticker.

These researchers calculated average S&P 500 return and volatility for recoveries, expansions and recessions between 1970 and 1996 and found that volatility is lowest during recovery and expansion and highest in a recession. It is also lower during the early part of an expansion compared to the later phase. Overall the cyclicals of both types "exhibited inferior return for risk, which make these stocks less desirable buy/hold candidates," says the report, which stresses, too, that return-for-risk relationships are not constant when it comes to the economic cycle.

What's the point of these indices? They can be "used to observe and assess market conditions and to help in portfolio and derivatives applications." They give important clues to determine how the market is leaning and to assess portfolio risk and portfolio construction. The authors suggest that "investors could use each of the indices to tilt toward early or late cyclical or stable growth categories. The strategy can also be implemented through derivatives such as calls, puts, spreads and relative performance options."

Against the Gods: The Remarkable Story of Risk
by Peter L. Bernstein
Wiley, $27.95

Modern times are distinguished not by scientific invention or the industrial revolution (or any other likely theories) but by the mastery of risk, according to Peter Bernstein, professional money manager, founding editor of the Journal of Portfolio Strategy and a peripatetic figure at finance conferences. Bernstein elaborates on his theme in a well-researched historical picture of the evolution of the ideas behind measured financial risk, from the Greeks and the early Arab mathematicians to the emergence of probability-and all the way to game theory and Fischer Black. He does a fine job of weaving together discreet intellectual discoveries and explaining why advances happened when they did and not before. Along the way one meets scores of interesting and often eccentric figures among Renaissance gamblers, mathematicians like Pascal, Fermat, Bernoulli and Gauss, economists like Keynes, Frank Knight and Oskar Morgenstein, and pioneer quants like Markowitz, Leland and Rubinstein.

Derivatives coverage is limited to one chapter entitled "The Fantastic System of Side Bets." Derivatives, Bernstein emphasizes, "only have value in an environment of volatility-they are symptomatic of the state of the economy and of the financial markets, not the cause of the volatility that is the focus of so much concern." With customary erudition, Bernstein gives a light account of the social utility of hedging, including a discussion of the ingenious risk management contract issued on June 1, 1863 by the Confederate States of America, in the form of a seven percent cotton loan, which "has some unusual provisions that gave it the look of a derivative instrument." Bernstein also offers some well-crafted words to explain to the layman Black­Scholes, the rise and fall of portfolio insurance, and even the debacles at Procter & Gamble and Gibson Greetings.

The Handbook of Derivatives Instruments (Revised)
Edited by Atsuo Konishi and Ravi E. Dattatreya
Irwin, $80.00

The world may be short of love and money, but it is not lacking in derivatives books. And the bigger the better. This comprehensive clutch of essays edited by the chairman and senior vice president of Sumitomo Bank Capital Markets is just under a thousand pages long.

In their introduction, Konishi and Dattatreya sketch some of the dramatic changes that have occurred in the marketplace since their original handbook was published in 1991: the use of derivatives machinery to enhance yields for yield-hungry early-1990s investors. The way technological advances and the increased comfort dealers had in their computer models fueled this development-added, as the authors acidly note, to the "often excessive margins enjoyed by dealers in such transactions." And of course, structured notes and other derivative-embedded investments that did not turn out to be the gravy train that they may at one time have seemed to be. The authors show how the collapse of the European Monetary System (ERM) in September 1992, and, even more significantly, the sudden and dramatic upswing in U.S. rates in 1994, shattered the investment assumptions on which most of these notes were based.

The authors claim that many good things emerged from this meltdown, most importantly an increased awareness of derivatives on the part of management and a recognition of the need to understand them. Disclosure and transparency standards have improved. On a negative note they observe that some corporations simply ripped all derivatives off their books, whether they were genuine hedges or not. The duo bemoan the "stifling legislative and regulatory scrutiny of derivatives" by scrutinizers with little understanding of the importance of the profit motive to innovation.

The handbook goes on to investigate many of the most intriguing areas of the contemporary market, with chapters contributed by some of the foremost thinkers and practitioners, including Myron Scholes, Fischer Black, Satyajit Das, Ira Kawaller, John Hull, Leslie Rahl, Tanya Beder and Richard Sandor. There are over 40 contributions on interest rate, equity and currency derivatives, risk management techniques, and investment and hedging strategies.

Konishi and Dattatreya believe that just as the 1980s were dominated by debt derivatives, so the 1990s will be the decade of equity derivatives. In this process the convertible bond, "the most neglected security in the area of modeling," will gain a new eminence. Thomas Ho provides a guide to pricing these instruments.

Das tackles the thorny question of derivative-embedded securities, and concentrates on the so-called collared FRN market, which the now-defunct Kidder Peabody pioneered in 1992 during a time of very low interest rates and a steep yield curve. These transactions incorporated a minimum and maximum coupon, usually set at 5 percent and 10 percent respectively, and essentially involved the purchase of a floor and the sale of a cap by the investor. The issuer then sold the cap and used the proceeds to lower the cost of funding. The sub-Libor margins were often spectacular; after-swap costs of Libor less 50 basis points were not uncommon. Levels like this had not been seen since the juvenile days of the currency swap market. The juice for these transactions came from the fact that the investors, often money market funds, were more worried about rates slipping than going above the 10 percent caps, so were prepared to sell the cap at prices that did not reflect its true market value. Of course, when rates climbed, the floors expired virtually worthless while the caps became extremely valuable.

Despite the sour taste these investments, and others, left in the mouths of buyers, Das believes that the structured note market has a bright future. One possible growth area is use by corporations with underlying risk positions that mirror the security package, thus obtaining attractive funding and risk management.

This book is admirably free of math overload and the profusion of formulae of the typical derivatives tome. When considering the very vexing debate surrounding the convexity bias in the Eurodollar future market, Galen Burghardt and Bill Hoskins of Dean Witter Reynolds strain to make esoteric concepts accessible. The authors claim that though the market understands the convexity bias better than it did several years ago, it "has not fully absorbed the implications of this pricing problem." Consequently, medium-term swaps are still priced slightly more generously than they should be, and there are still profit-making opportunities for dealers to short the swap and hedge the position with Eurodollar futures. Controversially, the authors also claim that the value of convexity can be calculated accurately by anyone with a spreadsheet program and an understanding of rate volatilities, and without recourse to expensive research facilities.

An Introduction to Option-Adjusted Spread Analysis
By Tom Windas
Bloomberg Professional Library, $40.00

If you were going on a day's hike you could take this slim four-by-eight-inch volume along with you to read at picnic time. And it is easy reading, too: a lucid and well-written stitching together of articles from Bloomberg Magazine, Option-Adjusted Spread Analysis focuses on the evaluation of put, callable and sinking fund bonds. It is critical of the use of classic yield analysis for assessing the incremental return on callables or on worst-case scenarios, and advocates option valuation models to evaluate put, call and sinking fund provisions. OAS uses binomial approaches and implied spot and forward rates to arrive at estimates of a bond's fair value.

This book is the second presented by Bloomberg Professional Library. The first was Swap Literacy by Elizabeth Ungar, published some months ago, also in pocket-size format at the same price and also a top-quality job in terms of printing, paper and graphics. But then that's only right, since word-for-word these are far and away the most expensive packages of derivatives wisdom anywhere. If Irwin's Derivatives Handbook were equivalently priced we reckon it would break all records and cost a staggering $800.00.