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Capital Multiplication Partners
 
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kunduanil
Posted: 05 August 2008 12:15 AM   [ Ignore ]  
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Joined  2008-05-09

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.

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David Harper, CFA, FRM, CIPM
Posted: 05 August 2008 10:24 AM   [ Ignore ]   [ # 1 ]  
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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

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‹‹ Implied Volatility vs. Historical Volatility      Jensen’s alpha -- question about a term in the Study Notes ››

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