Inherent Reward and Risk (Part I): Towards a Universal Paradigm for Investment Analysis

In this paper, a new paradigm is developed for analyzinginvestment strategies and pricing financial assets. This paradigmassumes that any investment strategy has its own “inherent reward”and “inherent risk” that can be judged with common sense. Ijustify axiomatically the existence and uniqueness (ratio scale)of inherent reward (U) and inherent risk (D) that could beregarded as universal measures of reward and risk for any giveninvestment strategy. Incorporating the notion of “inherentefficiency” in a portfolio context, I show that the inherentreward-to-risk ratio (Z=U/D) is capable of ranking all theinvestment strategies with any return distributions, while beingconsistent with the fundamental principles of no-arbitrage andfirst-order stochastic dominance. If there exists an inherentlyefficient benchmark portfolio within any given set of feasiblestrategies, then the risk premium on any of these strategies mustsatisfy a simple relationship with the benchmark risk premium (theInherent CAPM). Sophisticated securities such as options orportfolios with imbedded options can then be priced without havingto assume that the market is complete or that the security pricefollows a specific process. Other issues discussed in the paperinclude prospect theory, the Allais paradox, the computation ofinherent reward and risk, the mean-variance CAPM, and performanceevaluation.