The art and science of mispricing

In his 2004 preface to the 1972 classicMartin Leibowitz recounts how Inside the yield book grew out of a series of “Memoranda to Portfolio Managers” Sidney Homer and Leibowitz prepared for the bond traders at Salomon Brothers & Hutzler. The memoranda shocked the veteran bond traders by deconstructing — well, demolishing — the latters’ “rock-certain” principles that had governed the fixed income universe for decades.

The first memorandum “Interest on interest” came out on October 5, 1970 and attacked the — even today still ingrained — “widespread belief that a bond’s yield described the accumulation of wealth that would be generated over its life.” Yield to maturity is a present-value type of concept; no assumption with respect to reinvestment enters into its calculation or interpretation. But how you reinvest coupon payments is crucial to your future wealth.

A number of paths converged when I realized that (1) the reinvestment effect was theoretically important, (2) this effect was also practically important (i.e., it could affect investment decisions), (3) virtually every bond trader, salesperson, and portfolio manager was woefully unaware of this fact, and (4) perhaps most important, my computer could provide a compelling demonstration of this result. This realization signaled opportunity, and I went to visit Sidney in his off-the-floor office (oak-paneled, naturally).

Sidney was very interested. When I expressed my surprise at how little known this reinvestment effect seemed to be within the bond market (after all, this was not “rocket science”), Sidney observed that there are many myths and half-truths (some of them useful) embedded in daily practice. Sidney’s vast experience gave him a unique vantage point: He knew what was “known” and what was “not known.”

Similar stories can be told in options pricing, where put-call-parity — and the deviations thereof — ruled the practice of trading long before Black, Scholes or Merton appeared on the scene. Then there is the well-known tale of how as a teenager Kenneth Griffin, now master of the Citadel Investment Group stronghold, gave the convertible bond traders a run for their money.

Investment management is not about fair pricing in se. It is about the knowns and the unknowns of present and future value — the known unknowns and the unknown unknowns.

 

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