Book Description

The current market theories of Modern Portfolio Theory (MPT), Capital Asset Pricing Model (CAPM) and Black- Scholes Option Pricing Model are all based on th e Efficient Market Hypothesis (EMH). The EMH in turn was formulated based on the assumptions of the normal distribution of returns and rational investor theorem. Both of which have limited empirical validity. In contrast, Hurst (1951) analysis introduced a new insight into distinguishing random from nonrandom series, where market returns were found to be persistent t ime series with an underlying fractal probability distribution, characterized as lon g memory processes. They possess cycles and trends, and are the result of a nonlinear dyn amic system, or deterministic chaos, where information is not immediately reflected i n prices, as the EMH states, but is instead manifest as a bias in returns. This bias goes forward indefinitely, although the system can lose memory of initial conditions. Each in crement of time is correlated with all increments that follow. Information biases the sy stem, until an economic event arrives to change the bias. Empirical evidence will be shown to affirm the aforementioned. Chaos theory, as opposed to standard econometrics, states that systems are generally interdepe ndent; the relationship between the values can have exponents different from 1, the ret urns are not necessarily normally distributed, and it allows for "irrational" investors. The econometric case is a restrictive form of the more general nonlinear case. The i ncrease in complexity, in the chaos case, carries with it a loss of certainty in evaluat ing the problem. We can no longer solve for optimal solution, but must instead be conten t to examine probabilities in a world that can abruptly change when certain critical levels are passed. Nevertheless, it gives a more realistic picture of the financial mar kets; and more importantly of their investors.