Investment Science Published
The text, Investment Science, was published
by Oxford University Press in early June this year. This is good
news to the students who in the past have had to put up with
preliminary versions. The book can be purchased through the web at
Amazon.com or through many bookstores.
Order Investment Science from Amazon.com Here
The course, Investment Science for Industry,
presents the concepts of Investment Science to practioners in
industry and to industry leaders who wish to learn how modern
concepts can b applied to business problems. the course also is an
important window to the business world, bringing us in contact with
those who deal with real problems. The interchange is always very
November and April
Investment Science for Industry will be offered at Stanford
November 13-14, 1997 and April 30-May1, 1998.
Investment Science for Industry will be
taught in Taiwan, hosted by Yuan-Ze University, on September 19-20,
The course was taught last May 15-16 at Stanford. There was a
very good group of people from a wide range of backgrounds and
industries. We learned a great deal from each other and several new
relationships were formed.
Several projects with industry
sponsorship are underway:
ENRON has sponsored general research in the
department, which this year focused on evalution of foreign
investments subject to specific country risk as well as other
technological and market risks. This reearch is being carried out
by Kian Esteghamat.
CHEVRON is sponsoring research on real options
theory which is being carried out by Marius Holtan.
NATIONAL SEMICONDUCTOR sponsored a student project
team (directed by Professor Blake Johnson) on licensing
arrangements. National also held a one-day conference on valuation.
Several people from our departmen were on the program.
HEWLETT-PACKARD has worked with us on an exciting project
that applies the concepts of valuation to commodity contract
Student interest in Investment Science
continues to be very strong, and support from industry as well as
industry interaction is greatly valued.
This June three students in Investment Science
received Ph.D degrees.
Lucie Tepla's dissertation title is
"Constrained Optimal Portfolio Insurance." Her research solves the
problem of determining an optimal portfolio of stocks when the
portfolio is constrained to hold certain assets. This is an
important problem for owners of firms who are restricted from
selling their shares after an IPO, for owners of inherited stock
who for varius reasons cannot sell their stock, and for owners of
Lauren Wang's dissertation title is "The
Valuation of Assets with Non-Traded Risks." Her research develops
an innovative way of determining the value of a future cash flow
associated with a commodity sale or purchase. Her method relates
that cash flow to the operations of companies that deal with that
commodity. The method is based on the assumption that the company
is operated to maximize its long term growth rate. From this
assumption, the implied forward price of the underlying commodity
can be inferred. An example treated in the dissertation is to
determine the foward price (10 years out) of oil.
Marius Holtan's dissertation title is
"Evaluation and Portfolio Optimization in Incomplete Markets."
Marius develops a complete systematic theory of pricing that can be
applied in either continuous or discrete time, which covers
complete, incomplete, or partially complete markets, and which
accounts for investor preferences and asset holding. He also
developed efficient numerical procedures for finding prices and
The fundamental problem of financial valuation
is that of assigning a current value (or price) to a cash flow that
will occur in the future. If this cash flow is deterministic (that
is, known with certainty) then the proper way to assign a current
value is to use its present value. For a cash flow x that occur in
one year, the present value is defined as PV=x/(1+r) where r is the
riskfree rate of interest. Hence, in this simple case, there is a
simple answer to the question of valuation. Typically, however, the
magnitude of the future cash flow is uncertain -- but nevertheless
a current value must be assigned to complete a useful analysis.
There are a number of methods that can be used
to find an appropriate value, depending on the relation of the cash
flow to existing markets. In this article we discuss some of the
simplest methods, which apply when suitable markets are
Consider the cash flow generated by the harvest of 1000
pineapples that will occur in one year. The cash flow is uncertain
because it depends on the price of pineapples one year from now. At
first it may seem difficult to assign an equivalent value to this
cash flow. However, if there is a forward market for pineapples
with a price of, say, F per 1000 pineapples, then the value, today,
of the harvest that will take place in a year is exactly F/(1+r)
where again r is the riskfree rate of interest. The reason, of
course, is that we can duplicate the harvest by currently placing
F/(1+r) in a bank and entering a foward contract to buy 1000
pineapples. In one year our deposit will have grown to F, which we
can use to satisfy our side of the contract, buying the pineapples
at the previously agreed upon price. At that time we will have 1000
pineapples, just like we would if we had harvested them.
In general, if a foward market exists for a
commodity whose price is perfectly tied to the cash flow we wish to
value, we can assign value unambiguously without further analysis
-- the proper value is the foward price discounted to the present.
This is the easy case. The foward market solves our valuation
Now consider a project that will in one year
general a cash flow equal to the value of a share of IBM stock at
that time. The magnitude of this cash flow is uncertain, and there
is no forward market for shares of IBM stock. How can we assign
value in this case? Must we attempt to predict the value of IBM?
Must we search for a suitable discount rate? The answer is again
simple. The value of the project cash flow is exactly equal to the
current value of a share of IBM stock (we are assumming for
simplicity that no dividends are to be paid during the year). The
reason that this is the value is, again, that we can duplicate the
project cash flow with a marketed asset. In this case th cash flow
can be duplicated by buying a share of IBM; it will have the same
value as the project in one year. Hence, the market for current IBM
stock acts almost like the forward market for pineapples in the
previous example. However, in the case of IBM stock it is not
necessary to apply a discount factor because the price is already
in current terms. This example works because there is no cost for
sotring IBM stock and it can be sold short. Hence, purchase (or
short sale) of the stock now gives exactly the same effect as
initiating (or selling short) the project cash flow now. the
general principle is that if we can find an asset, such as a
commodity or security, that duplicates the cash flow, the value of
this asset provides the proper value of the cash flow.
There are sometimes complications. If the
duplicating asset has associated storage costs, the relationship
must be slightly modified. If the duplicating asset cannot b sold
short (at the negative of the purchasing price), the simple
relationship may destroyed.
As a general rule, if the duplicating asset is
widely held by investors (such as is the case for stock, gold,
silver, and some collectibles) a simple relation of the type abov
can be used. If, on the other hand, people do not hold the
commodity for investment purposes (such as is the case for soy
beans, crude oil, DRAM, and electricity) the simple relation breaks
down. Other methods must be used.
In most situations future cash flows are not as
closely related to marketed assets as in the above examples.
However, the basic methods discussed here often form the starting
point for better approaches. Many of the research topics carried
out in the Investment Science program are directed at finding
suitable methods of valuation in complex situations.