Hi David,

I was not able able to grasp anything about Capital Multiplication Partners concept from core readings.Please help me out in figuring out what author is trying to say.

Hi Anil,

The strategy is marketing timing between the S and P 500 and a (T bill): each month to switch into the better asset, as if that can be known somehow ahead of time, for only the short one-month period. To formulate the value of this strategy, they say:

“The source of this strategy’s alpha is clear: Merton (1981) observes that perfect market-timing is equivalent to
a long-only investment in the S&P;500 plus a put option on the S&P;500 with a strike price equal to the T-Bill return. Therefore, the economic value of perfect market-timing is equal to the sum of monthly put-option premia over the life of the strategy.”

So the payoff to a perfectly timing strategy is (let SP = S and P)
SP + MAX(T- SP,0)

recall the payoff of a put is MAX(strike - asset,0)

See how each month, if the SP has a better return, the put option is worthless and the payoff is SP.
But if the T-bill is better, the payoff is SP + (T - SP) = T, and the payoff it T

what would this perfect strategy cost you? the payoff would cost the put option premium.

David