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A Rational Approach to Unsystematic Risk: Re-Thinking Modern Finance

A Rational Approach to Unsystematic Risk: Re-Thinking Modern Finance

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The market fall during the week of April 10th to 14th, 2000, is a timely reminder that modern finance is unable to monitor the "health" of a market. "A Rational Approach to Unsystematic Risk, Re-Thinking Modern Finance" enables market managers to determine the health of their markets.

Unsystematic risk is composed of financial, operational, economic and strategic risks. Systematic risk on the other hand, is the day-to-day share price risk exhibited by a market. New financial models, based on heterogeneous investors’ expectations, derived from John Burr Williams's Dividend Discount Model demonstrate that portfolios consist of 80% unsystematic risk and 20% systematic risk. In essence, unsystematic risk is vital to managing markets, portfolios and companies.

A wide range of financial issues from corporate risks, portfolio management, stock exchange management, market players and market manipulation are discussed. These topics inform us on how unsystematic risk can be used to better manage your investment funds and your companies.

For example, in the first half of the 1990s, the New York Stock Exchange exhibited the Weak-Form and Strong-Form of market efficiency, 84% and 81% of the time, respectively. (The Efficient Market Hypothesis is finally quantified in this book.) The best managed, stock exchange during this same period (out of 9 in the US, Europe and Asia) was Hong Kong, exhibiting Weak-Form and Strong-Form of market efficiency, 100% and 91% of the time, respectively.

Unsystematicrisk is used to optimize portfolios to provide better risk-return relationships than the market can provide. Yes, the market can be beaten on a risk-adjusted basis, and markets are only as efficient as the market players and market instruments, i.e. markets are not efficient.

The examples in this book demonstrate how one can build a risk-minimized or a return-maximized portfolio, using dynamic programming techniques.

Both example portfolios provide risk-return ratios of 2.96 (4.86% risk & 1.64% return) and 2.08 (5.23% risk & 2.52% return) respectively. This is much better than the market portfolio of 3.57 (5.79% risk & 1.62% return). If your fund manager does not believe this ask him to read this book.

If you are interested in how cash flow affects your company's share price, this book explains how unsystematic risk is created by cash flow and how you can use this information to manage your business in such a manner as to maximize your share price. The examples, from the Kuala Lumpur Stock Exchange, show that Nestle is better managed than Matsushita but a local company, Genting Bhd., is better managed than either of them. Their average risks are 0.478, 0.933 and 0.170 respectively. The risk-ranking scheme presented in this book recognizes the 'super-blue-chip' category. No company made it to this category, not even the multinationals.

The risk-ranking scheme presented in this book, ranks the total company risk, unlike the ranking schemes used by rating agencies such as Standard & Poors,and Moody, which use credit risk to rank companies.

This book is the first step to improving the U.S. competitive position by altering the commonly held perception and handling of corporate risks. If you acknowledge the significant role of unsystematic risks, the resulting paradigm shifts present a whole world of new perspectives on manag