CHAPTER 1

Introduction

The past century has seen amazing strides in the area of financial economics. In this span, brief by historical standards, we have seen the development of the idea of equities being valued on the basis of discounted cash flow streams to perpetuity. In short order, there followed measures of bond duration, principles of portfolio diversification, development of risk-based asset pricing models, and theories of capital structure and dividend strategy. In more recent years, we have welcomed the rigorous theory of option and other derivatives pricing and we have, as a profession, grappled with questions of just how efficient financial markets may (or may not) be. Our collective thoughts have also turned to the theoretical questions of how price and volatility series evolve over time. To shed light on these questions, some researchers have focused on econometrics and microeconomic theory, while others have looked to the areas of psychology, behavioral studies, and experimental economics.

The focus of this book is on equity valuation, risk, and investment. The admittedly ambitious goal is to integrate and apply the insights of these theories to the day-to-day decisions that need to be made by portfolio managers, investment strategists, securities analysts, corporate managers, regulators, policy makers, and, ultimately, their investment public constituency.

Right off the bat, however, we face the problem that the body of theory in this area of study is not unified. ...

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