American Finance Association

Review
Author(s): Bernell K. Stone
Review by: Bernell K. Stone
Source: The Journal of Finance, Vol. 30, No. 3 (Jun., 1975), pp. 938-947
Published by: Wiley for the American Finance Association
Stable URL: http://www.jstor.org/stable/2326892
Accessed: 10-07-2015 08:53 UTC

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at http://www.jstor.org/page/
info/about/policies/terms.jsp

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content
in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship.
For more information about JSTOR, please contact support@jstor.org.

Wiley and American Finance Association are collaborating with JSTOR to digitize, preserve and extend access to The Journal
of Finance.

http://www.jstor.org

This content downloaded from 119.15.93.148 on Fri, 10 Jul 2015 08:53:03 UTC
All use subject to JSTOR Terms and Conditions
938 The Journal of Finance
Ritter argues the case for job quotas and Silber argues against them. What other
text in money and banking would include a chapter on job quotas?
Internationalfinance is covered in Part Eight. The authors present arguments
in favor of floating exchange rates. They also discuss the various balance of
payments measures and recent internationalfinancialcrises. Finally, there is an
interesting chapter describing the domestic and internationalaspects of gold.
Part Nine contains the only chapter specifically devoted to history; it covers
Federal Reserve history in the post-WorldWarII period. The last chapterof the
text is a stimulatingdiscussion of the financial system of the future.
The text is not an entirely new one. Although no mention is made of the
authors' popular book, Money (first edition, 1970; second edition, 1973), two-
fifths of Principles of Money, Banking, and Financial Markets is taken from the
formerbook. Anotheromission is any mentionof Ritteror of Silber in the Index.
References to all other names cited in the text are included in the Index, but
there is no reference in the Index to the publicationsby the authors of the text.
This reviewer found the book to be disappointingfor a reason which is not
really the authors'fault. The materialis covered at a more elementarylevel than
I expected it to be. Only the footnotes and the suggestions for furtherreadingat
the end of the chapters refer to less elementaryanalysis. For example, there is
little formal analysis in the text of the refinementsin the theory of the demand
for money by WilliamBaumol, James Tobin, or Milton Friedman.But the text is
presumablywritten for students who have previously taken only the introduc-
tory economics course. Also, the text presumes little trainingin mathematicsor
statistics. There remains a need for a well written textbook designed for an
undergraduatecourse in monetaryeconomics for students who have completed
courses in intermediate macroeconomics and microeconomics and who have
some knowledge of statistics.
In summary,this textbook by Ritter and Silber is highly recommendedfor an
introductorycourse in money and banking.It consists of an appropriateblend of
theory, institutionsand policy. The advantageof this book over competingtexts
is that it is written in a style that makes it enjoyable to read.
DAVID H. VROOMAN
St. Lawrence University

The Collected Scientific Papers of Paul A. Samuelson, Vol. III. Edited by

ROBERTC. MERTON.Cambridge, Mass.: The M.I.T. Press, 1972. Pp. xii +
930. $15.00..
Volume III contains 207 articles and notes, most of them being theoreticaland
scientific in nature. As in Volumes I and II, the articles are first grouped and
then subgroupedinto five books and then a numberof parts. The subject areas
correspond to those in Volumes I and II except that: 1) Part XIX, "Portfolio
Selection, WarrantPricing, and the Theory of Speculative Markets" is a new
part that was not present in the earlier volumes; 2) five parts in the previous
volumes are not in this one, namely II (Stochastic'Models of Consumer Be-
havior), V (Essays on Linear Programmingand Economic Analysis), VI (Non-
substitution Theorems), VII (Some Metaeconomic Propositions: Comparative
Statics, Dynamics, and the Structure of Minimum EquilibriumSystems), and
XV (Comments on Economic Programs).
The articles in Part XIX treat issues particularlypertinent to the foundations

This content downloaded from 119.15.93.148 on Fri, 10 Jul 2015 08:53:03 UTC
All use subject to JSTOR Terms and Conditions
 Book Reviews 939
of modern finance-contemporary risk and valuation theory. Of the articles in
Volume III, these are the ones that are of particularrelevance to the field of
finance. Part XIX is the focus of this review.
The number of articles in Volume III alone is testimony to Samuelson's
fantastic productivity.I can say little about their overall qualitythat is not better
said by a Nobel prize. Thus, I shall proceed forthwithto consider the ten articles
in Part XIX. Nine of these are technical articles that provide advanced
mathematicalanalysis of topics on asset pricingand/orasset selection. Two deal
with commodity futures prices. Two treat warrant valuation. Five concern
aspects of asset selection beyond the usual mean-varianceframework. The five
asset selection papers concern: 1) sufficient conditions for diversifying among
assets with a common expected value; 2) mean-dispersionportfolio selection
when assets are distributed according to a non-normal stable distribution; 3)
sufficientconditions for the validity of mean-variancerules as an approximation
to utility maximization;4) the time-pathof wealth allocationto risk-assets over a
lifetime; 5) the validity for sequentialdecisions of a particularportfolio decision
rule, maximizingthe geometric mean return. The non-technicalpaper is a fore-
ward to Richard Roll's The Behavior of Interest Rates, which I shall not treat
further in this review.
In "Proof that Properly AnticipatedPrices Fluctuate Randomly," Samuelson
investigates the incorporationof probabilisticinformationin futures prices under
the assumption of a stationary probability structure, i.e., under the assumptions
that: 1) a spot price T periods away has a distributionthat depends only on the
length of the time interval T and the past sequence of prices, and 2) that this
distributionhas the same functional dependence across time. Allowing the dis-
tributionto depend on past prices involves a more general concept of stationar-
ity than the usual strict stationarity in which the distributionis the same at all
points in time. It means that new information can change the form of the
unconditionaldistribution.By allowing the currentdistributionto depend on the
entire past sequence of spot prices and not just the current price, Samuelson
explicitly avoids the restriction of a Markovianprocess.
The two theorems proved are:1
TheoremI (Theorem of Fair-GameFutures Pricing). If spot prices are sub-
ject to a stationaryprobabilitydistributionand if the currentfutures price repre-
sents the expected future spot price on the expiration date of the futures
contract, then the sequence of futures prices must represent a fair game in the
sense of having unbiased price changes, i.e., the expected futures price change
between two points in time must be zero.
Theorem II (Theorem of Fair-ReturnFutures Pricing). If spot prices are
subject to a stationary probability distribution and if the futures price at any
point in time is the present value discounted at a rate appropriatefor time and
risk,2 then the sequence of futures prices represents a fair-returnsubmartingale,
1. Throughoutthis review, the statement of theorems are my own verbal restatementof what
Samuelson generally stated as mathematicalpropositions.
2. Samuelson calls this assumption the "Axiom of Present-Discounted Expected Value."
Mathematically,it can be stated as
T

Y(T, t) = Xi-I E[Xt+TlXt,Xt1, Xt-2,

where Xt is the spot price at time t, Y(T, t) is the futuresprice quotedat time t for deliveryT.periods
away, and Xi-' is the discountfactor for the time intervali periodsaway (whichis assumedto be an
exogenously given constant).

This content downloaded from 119.15.93.148 on Fri, 10 Jul 2015 08:53:03 UTC
All use subject to JSTOR Terms and Conditions
940 The Journal of Finance
i.e., the expected futures price change between two points in time is that which
provides the required fair return for time and risk.
Theorem I is clearly a special case of Theorem II in which the requiredfair
return is zero in every time period. While Theorem II does allow for different
discount rates in different periods, Samuelson does assume that the rate for a
given time interval is fixed and not subject to change.3 Time dependence in the
pattern of returns allows for the widely held view that the risk of a futures
contract varies with time to maturity and is consistent with the Keynes-
Hauthakker-Cootnerconcept of normal backwardation.
Samuelsoncomments [p. 786]: "The theorem is so general that I must confess
to having oscillated over the years in my own mind between regardingit as
trivially obvious (and almost trivially vacuous) and regardingit as remarkably
sweeping." I must rate it as both sweeping and important.The nature of theory
is to spell out precisely how certain assumptionsimply certain results and what
assumptions are necessary and/or sufficient for certain results. These theorems
formalize the intuitively appealing idea that all informationin past spot prices
must be reflected in current futures prices. The generality of the result arises
from placingno restrictionon the probabilitydistributionother than the assump-
tion of a stationaryprocess. In [11], Samuelson generalizes these theorems by
expandingthe informationthat influences the probabilitydistributionfrom past
prices alone to a general vector of all relevant past information.The expanded
information set constitutes a much more general fair-returnprocess than one
restricted to price information alone. In [11], Samuelson also expands the
theorem to cover stock prices formed on the basis of the present discounted
value of expected future dividends. Since a warrantcan be viewed as a futures
contract for common stock, a fair-returntheorem can also be developed for
warrants. A "European option" (i.e., one exercisable only at expiration) is a
straight-forwardextension of Samuelson's analysis. The American-typeoption,
which can be exercised at any time prior to expiration, is more complex and
requires generalizingthe analysis to the case of multivariatedistributions.4
The fair-returntheorems have importantimplicationsfor testing for departures
from fair-returnprocesses. Within the conceptual framework of the theorems,
departuresfrom a fair-returnrequirenonstationarity.Hence successful empirical
refutation (if there is to be any) must look for nonstationarity. Since many
empirical tests implicitly assume that the process generating observations is
stationary, empiricaldetection imposes the following dilemma:if the process is
stationary (and the other theorem assumptions are accepted), then it must
conform to a fair-returnmodel; if the process does not conform to a fair-retur
model, then its statistical detection cannot rely on statistical methods that
assume stationarity.
Another importantimplication is the role of the informationset assumed to
influence the distributionand used in the construction of tests. What may be a
nonstationaryprocess with a restricted information set (e.g., only past price
data) may be stationary with an expanded informationset (e.g., past price and
volume data on all publicly available information).Just as economic statements
of market efficiency have distinguished different information sets (e.g., weak,
semi-strong, and strong), analogous distinctions can be made for statistical
3. In [14], I generalizethis to allow the futurediscount rates to be randomvariablesand I specify
restrictionsbetween currentand expected futurediscountrates that are both necessary and sufficient
for conformityto a fair-returnprocess. Of course, the special case of fixed rates is a valid sufficient,
but not necessary, condition for conformityto a fair-returnprocess.
4. See [15] for statements and proofs of the fair-returntheorem for options.

This content downloaded from 119.15.93.148 on Fri, 10 Jul 2015 08:53:03 UTC
All use subject to JSTOR Terms and Conditions
 Book Reviews 941
concepts of market efficiency in the context of a fair-returnprocess.5 Samuel
son's theorems, especially with the expanded information structure of [11],
provide for a fair-returnprocess the conceptual framework required to give
precise meaningto a given informationset, namely as parametersof a probabil-
ity distribution.
In the second paper on commodity markets, "Stochastic Speculative Price,"
Samuelson formulates the coupled dynamic second-order difference equations
relatingprices of a commodity at two adjacent years in the presence of storage
(interest)costs and spoilage losses underthe strong assumptionthat: 1) expected
futureprices play the role in a stochastic world that known futures prices play in
a deterministicworld; 2) harvests are describable by a known, stationary (time
independent)distribution.The problemis then analyzed as a stochastic dynamic
program.It is argued that this simple model captures properties of actual com-
modity price behavior, but not normal backwardation or negative carrying
prices. The exposition is very pithy. This two-and-one-fourthpage paper is more
an outline of solution approaches and properties than it is an exposition of the
problem.
The central problem of warrantvaluation is to relate warrantprice to stock
price and remaininglife given the exercise price, given stock attributessuch as
dividendpolicy, and given the stock price distribution.The "RationalTheory of
WarrantPricing" is the importantearly work on warrants that structures and
investigates this problem. Samuelson discusses features of a warrant that
influencesits value to investors and shows that the warrantvalue per share must
be bounded above by the stock price and below by its immediate conversion
value, i.e., that at all times t
Xt - Vt - max{Xt - Xe, 0}
where Xe is the exercise price, Xt is the stock price, and Vt is the price of a
warrantconvertible into one stock share.
The valuation models developed by Samuelson are based on two strong
assumptions: 1) that future stock prices conform to a stationary Markovian
probabilitydistributionthat depends only on the currentstock price and elapsed
time so that the expected future stock price has a constant continuously com-
pounded growth rate a - 0 such that
E[Xt+TlXt] = eaTXt;

2) the dependency of the warrantvalue upon the stock value must be such that
expected future warrant prices imply a constant continuously compounded
growth rate ,(3 a, i.e.,
E[Vt+T|Vt] = eTVt.
Once these assumptions are made, solving the warrant valuation problem be-
comes a determinateproblem of mathematicalanalysis. For special cases such
as a perpetual warrant with a log-normal stock price distribution, Samuelson
obtains a closed-form warrant value equation. As shown in the appendix by
McKean, "A Free Boundary Problem for the Heat Equation Arising From a
Problem of Mathematical Economics," the problem is not generally amenable to

5. By economic statementsof marketefficiency, I refer to propositionsabout the ability to make

money, generally on an after-transaction-costsbasis. In contrast, statistical statements involve
propositionsaboutthe statisticalpropertiesof price or returnseries, e.g., thatit is a randomwalk, an
independentincrementprocess, or a fair-returnsubmartingale.

This content downloaded from 119.15.93.148 on Fri, 10 Jul 2015 08:53:03 UTC
All use subject to JSTOR Terms and Conditions
942 The Journal of Finance
closed-form solution, even when stock price distribution is restricted to the
general class of multiplicativeprocesses.
The structuringof the problemis clearly importantand provides a foundation
for future work. However, while the Samuelson-McKeanresults follow logically
from the assumptions, the basic assumptions themselves are questionable.6In
particular,I question the postulate that a and f3 are constants characteristicof a
stock and its warrantand independentof X/X, and time to expiration. My basis
for questioningthe constancy of a and ,Bis market efficiency and the need for
stock and warrantprices to reflect continuously the probabilitythat the warrant
will be exercised. As stock price increases, it is more and more likely that the
warrant will be exercised. The warrant should behave more like the stock.
Unless the warrant initially had the same risk as the stock, its risk should
decline. Thus, expected warrant return should decline continuously as stock
price increases for X > Xe.7 In general, the parameter,3 should be a continuous
function of both X/X, and time to expiration. Constant / is a possible but very
restrictive case.Y9
Some more recent valuation models allow for continuous variationin required
return and risk. For instance, the basis of [2] is the impossibility of riskless
profitablearbitrage.The basis of [13] is the impossibility of earning an excess
return (after adjustmentfor time and systematic risk). Samuelson (in private
conversation)has indicated to me that he regardsthe Black-Scholes analysis of
[2] as superceding his own. However, despite the restrictive assumptions and
current existence of possibly more complete models, "The Rational Theory of
WarrantPricing" should be the startingpoint for any serious student of warrant
valuationif he has the requiredmathematicalbackground.In additionto the fact
that most of the subsequent literature has built on Samuelson's model, the
problem structuringand presentation of special cases are outstanding.
6. 1 emphasize that I have said questionable and not incorrect.
7. Samuelson (p. 800) recognizes the possibility of this behavior but uses the fact that /3 > a
cannot persist as a criterion for conversion.
8. The reader is warned to be careful of the fact that there are several concepts of return pertinent
to warrants. The instantaneous return /3I is

_1 dV I aV dX IaV X V a 1 av
/' V dt x dt
aX v at (V )ai v at
where a, is the instantaneous stock growth (dX/dt)/X. The first term on the right-hand-side is the
component of instantaneous return due to movement along a valuation curve and the second term is
from changes in time to expiration. The actual continuously compounded return is the time average
of these instantaneous returns. The measure of warrant return postulated to be constant by Samuel-
son is the continuously compounded return imputed from expected future warrant price, i.e.,
,P = log (E[Xt+TIXt]/Xt).
This is not the expected continuously compounded return, conditional on Xt, which is
E[,B] = E[log(Xt+T/Xt)|Xt].
Finally, for a stock paying dividends, appreciation is only part of the total stock return so that ,3 > a
is not the same as warrant return being greater than stock return.
9. The assumption of constant beta is by no means unique to Samuelson. Most warrant valuation
models involve this assumption, often implicitly. For instance, the most common basis for warrant
valuation is the discounted expected value at expiration, i.e.,
V = e ALE[max{Xt+L
- Xe, O}IXt]

where L is remaining life and X is the appropriate (and presumably constant) continuously com-
pounded return.

This content downloaded from 119.15.93.148 on Fri, 10 Jul 2015 08:53:03 UTC
All use subject to JSTOR Terms and Conditions
 Book Reviews 943
"A Complete Model of WarrantPricing" (written with Robert C. Merton)
extends the "RationalTheory of WarrantPricing." However, like the preceding
paper, the assumed probabilisticprocess is chosen to ensure that the expected
rate of return on the stock is constant. Hence, both return and risk being
dependenton X/X, are precluded. Thus, as in the case of the 1965paper, I must
question the appropriatenessof the assumptions upon which the analysis is
based.
What does seem importantin "A Complete Model of WarrantPricing" is the
general approach to valuation theory based on utility maximization in an
n-period world rather than the more common mean-varianceanalysis. The de-
velopment of the "fundamentalequation" (given by (5b), p. 820), the "digres-
sion" on general equilibrium pricing (p. 826-27), and the illustration of the
quadraturesolutions are, in my opinion, of far greater theoretical significance
than the warrant pricing results themselves. The importance of this material
seems to have been obscured by being buried within a work on warrantpricing.
It clearly merits further attention and development.
"General Proof that Diversification Pays" is a misleading title. The article
does not prove that a "risk-averse" investor (i.e., an investor with a strictly
concave, smooth, one-periodutility of wealth function) is always better off if he
diversifies. In fact, Samuelson (p. 853-54) explicitly notes that diversification
does not always pay.
The analysis in this paper is restricted primarilyto assets with a common
mean. Samuelson shows:
TheoremI. If utility of wealth is a strictly concave smooth function, then,
given n assets with independent identical distributions, expected utility is
maximized for equal holdings of the n assets.
TheoremIl. Given n assets with a symmetricjoint distributionwith common
finite mean ,u and finite covariances that are elements of a positive definite
covariance matrix,expected utility is maximizedby equal holdings of each asset.
TheoremIII. Given n assets with a common mean, an asset that is indepen-
dent of the remainingn - 1 assets will be held at a positive level when a strictly
concave smooth utility of wealth function is maximized.
Finally, Samuelson generalizes the usual measures of linear correlation. If
P(XilXi)is the cumulative probabilitydistributionof Xi conditional on values of
all other variates, then the distributionis said to exhibit negative interdepen-
dence if aP(XilXi)/aXj< 0 for i Zj. Samuelson then states but does not prove:
TheoremIV. Given n assets with a common mean and a joint probability
distributionhaving negative interdependence, each asset must have a positive
weight in the optimal portfolio of an investor with a strictly concave utility
function.
The term "General" in the title refers to the fact that the analysis of diver-
sificationgoes beyond the usual mean-varianceframework.Samuelson states [p.
859] that "my demonstrationsin this paper have shown that even a purist can
develop diversificationtheorems of great generality." However, one can ques-
tion the generalityof these theorems. The usual Markowitziananalysis involves
risk-returntrade-offs. These theorems all involve assets with identical means.10
No variationin relative holdings can change expected return.Thus, there can be
no issue of risk versus return;The only issue is minimizingrisk, which takes the
form of maximizingexpected utility. Moreover, the distributionalassumptionsof
independence or joint symmetry are extremely restrictive.
10. In mean-varianceterms, this correspondsto assets with means at the same expected return
with possibly differingvariances and possibly non-zero covariances.

This content downloaded from 119.15.93.148 on Fri, 10 Jul 2015 08:53:03 UTC
All use subject to JSTOR Terms and Conditions
944 The Journal of Finance
"Efficient Portfolio Selection for Pareto-Levy Investments" first reviews
properties of stable distributions,formulates a mean-dispersioncriterion as the
analogue to the usual mean-variance criterion, states the Kuhn-Tucker in-
equalities associated with the convex programmingproblem implied by the
mean-dispersioncriterion, and then considers various propertiesof the solution.
The section entitled "GraphicalResults" (pp. 868-73)considers the two-security
efficient frontiers for a variety of special cases. This section is outstandingfor
developing an intuitive feel for risk-returnpossibilities associated with portfolio
formation.It is in fact insightfulto repeat the analysis for the usual special case.
of mean-standarddeviation frontiers. This article is an excellent complementto
that by Fama [17]. Since recent empirical work [see e.g., 1, 3, 9, 16] indicates
that stocks are apparentlynot distributedaccordingto a stable distribution,this
paper should be read to develop insights to risk-returntrade-offs in a two-
parameterconceptualframeworkother than mean-varianceratherthan to obtain
methods for the selection of actual portfolios.
Conditionsfor justifying the mean-varianceapproachto risky decisions, espe-
cially for portfolio decisions, have been a subject of considerable research and
controversy. An alternativeto rigorousjustificationfirst advanced by Markowitz
[10] and developed further by Farrar [8] is to argue that mean-varianceis a
reasonable approximationto expected utility maximizationwhen the net effect
of higher moments is negligible."
In "The FundamentalApproximationTheorem of Portfolio Analysis in Terms
of Means, Variances, and Higher Moments", Samuelson employs the now
widely used device of a Taylor's series expansion of the utility function to study
the effect of various moments of the probabilitydistributionon expected utility.
Samuelsoninvestigates the validity of variance as a risk summaryfor the special
situation that Samuelson calls compact probability. A set of random variables
{X1, .. ., Xn} has a compactjoint distributionwhenever all variates converge to
a sure outcome as some specified parametergoes to zero. While this reviewer
would appreciate more precision and rigor in defining compactness than the
illustrationsand restrictionsstated on pp. 878-79, the essential idea seems to be
that the distribution for {XI, . . . , Xn} becomes more concentrated in a smooth
fashion at the unique limit points {XIO, . . . , Xno} as some scale parameter s
approaches zero so that compact distributionscan be thought of as smoothly
becoming "small-risk" distributionsthat approach certainty.
Samuelson shows that when the scale parametertends to zero, the solution to
the general utility maximizationproblem approachesthe solution to the quadra-
tic problem correspondingto truncationof the Taylor's series after the second
moment. Similarly, the general solution approaches the r-momentsolution cor-
responding to truncationof the Taylor's series after the r-th moment.
The essence of the question posed is: when is a quadratic approximation
asymptotically valid for representing expected utility? The answer is:
whenever-highermomeantsbecome negligible. From the viewpoint of portfolio
theory, compact probabilitiesmay be an overly stringentsufficient conditionfor
a mean-variance approximation. In the framework of modern asset pricing
theory, well-diversifiedportfolios have distributionsthat are some scale-factor
times the distributionof the market portfolio. Hence, except for the trivially
unimportantcase of all holdings being concentrated in the riskless asset, the
distributionof well-diversifiedportfolios can be compact only if the distribution
11. The argumentof negligiblehighermomentsis distinctfrom the other widely-usedjustification,
namely that variance also adequatelysummarizeshigher moment effects, e.g., the two-parameter
distributionargumentof Tobin [17], of which multi-variatenormalityis a special case.

This content downloaded from 119.15.93.148 on Fri, 10 Jul 2015 08:53:03 UTC
All use subject to JSTOR Terms and Conditions
 Book Reviews 945
of the marketportfolio is itself compact, a clear contradictionto known proper-
ties of the distributionof the market portfolio.
It is importantto distinguishbetween sufficient and necessary conditions for
justifying the mean-variancecriterion as an approximationin evaluating Sam-
uelson's analysis. He presents a particularsufficient condition. To illustrate its
limitations, assume security returns are jointly distributed in accord with a
multi-variatenormaldistribution.It is well known that multi-variatenormalityis
sufficient for exact justification of the mean-variancecriterion. However, for
most utility functions (e.g., the logarithmicor exponential), the exact solution to
the expected utility maximizationproblemunder a multi-variatenormaldistribu-
tion is differentfrom that for the quadraticapproximation.The difference is due
to the fact that higher moments are present as functions of variance in the
multi-variatenormal case but not in the quadraticapproximation.Unless higher
momets are negligible under a multi-variatenormal distribution, the quadratic
approximationdoes not provide (or even necessarily approximate)the correct
solution to the utility maximizationproblem.
Within the framework of a Taylor's series expansion, any of the following
conditions are sufficient for the mean-variance criterion to be a reasonable
approximationto utility maximization:1) The coefficients of higher moments are
negligibly small or vanish;12 2) Higher moments become negligibly small, a
special case of which is an approachto zero; 3) Higher moments approachsome
function of variance. A particularexample of Point 3 would be to have higher
moments take the form
Mn = Cne + "other terms"
where cris standarddeviation and Cnis a constant. For multi-variatenormality,
"other terms" are identicallyzero and Cnequals zero for odd moments and (n -
1)(n - 3) . . 3 1 for even moments. For approximate normality of the
portfolio distribution, "other terms" must be negligibly small.
Compact probabilityis a special case of approximationCondition 2 above.
While possibly of theoretical interest, its questionable applicability to well-
diversifiedcommon stock portfolios suggests that it is not a particularlyimpor-
tant basis for justifying mean-variance analysis as a good approximation to
expected utility maximization.There is clearly a need for strongerstatements of
approximation conditions, especially for statements that jointly encompass
properties of both the utility function and the distribution.
"Lifetime Portfolio Selection By Dynamic Stochastic Programming"-struc-
tures the usual Ramsey problem as a discrete time dynamic program, briefly
states recursion equations that produce an optimal lifetime consumption-
investment program (when there is a regular interior maximum). Then the
uncertaintycase is introducedby admittingthe existence of a risk asset subject
to the assumption that yields at different points in time are independently and
identically distributed.The paper focuses on the intertemporalattributesof risk
bearing. Within the frameworkof the model, Samuelson shows (for isoelastic
marginalutilities) that risk tolerance is the same at the start and end of a life. He
thus disputes the usual idea of "businessman's risk" and the popular idea that
the chance to recoup losses and the operationof the law of large numberslead to
greaterrisk tolerance in early stages of life. Samuelsonfurthercomments on the
fallacy of maximizing the geometric mean return as a decision rule, a point
12. If U(W) is utility of wealth, then (anU/hWn)/n!
evaluatedat E[W] is the coefficientof the nt
centralmoment.For the popularutilityfunctions, this termdoes decline as shown in the expansions
presented in Table 3.1 of [12].

This content downloaded from 119.15.93.148 on Fri, 10 Jul 2015 08:53:03 UTC
All use subject to JSTOR Terms and Conditions
946 The Journal of Finance
expanded upon in the final paper of this section, "The 'Fallacy' of Maximizing
the Geometric Mean in Long Sequences of Investing or Gambling."
Compared to the average finance article, all of these papers are highly
mathematical.Most of them are also sufficiently succinct that all but the most
mathematicallysophisticatedof readersmust expend considerableeffort to fill-in
the details requiredto follow the analysis. In this respect, these articles contrast
markedly with most others in Volume III where Samuelson is usually less
mathematicaland almost always more readablein the sense of effort requiredby
the reader to seriously follow the paper. While these papers are widely read and
cited, the combinationof sophisticatedmathematicalexposition and terseness of
presentationclearly limit the readershipand make at least some of these works
less quoted and less understood then they deserve to be.
Most of these papers are characterized by the structuringof an important
problem. Then simplifyingassumptionsare made to performmeaningfulanalysis
and obtain conclusions about the problem. Samuelson is extremely good at
perceiving the key assumptions necessary to obtain results at an unusually high
level of generality. As some of my comments in this review suggest, Samuelson
is not always as good at emphasizingthe limitationsof the analysis. Samuelson's
often employed tactic of first developingresults for very simple assumptionsand
then generalizingis excellent pedagogy that greatly facilitates understandingthe
role of assumptions. The formal statementof importantpropositionsas theorems
clearly and succinctly isolates and summarizes the key ideas. This reviewer
would, however, appreciate more detail and structure in their proof.
While almost always very brief, Samuelson often spices his articles with
clever examples, special cases, and counter-examplesto possible propositions.
The illustrationsin "The Theory of WarrantPricing"are, for instance, outstand-
ing. It is unusual in finance articles that general results are illustrated for
particularprobability distributions. In this area, several of these articles are
excellent exercises for the reader willing to fill in details with pen and paper in
hand.
The editorial task in preparingthis third volume consisted primarilyof group-
ing articles by topic and apparently making selection decisions about some
"popular articles" such as those from Newsweek. Editorial commentary along
the lines provided by Cohen and Hammer [5] or Cootner [6] would greatly
enhance Part XIX.
I shall conclude on a personal note. As a graduate student at M.I.T. in
1966-68, I was, to my great disappointment,unable to schedule Samuelson's
classes because of conflicts with so-called "required" courses. Nevertheless,
despite the time and effort required, I studied most of the finance-oriented
papers that Samuelson wrote at this time. With varying degrees of diligence, I
have continued this practice since graduation.My investment of time has been a
sound one that has paid good intellectual dividends. Samuelson's ideas and
methods have stronglyinfluencedmy own thinkingabout these problems. I now
recommend these papers to my graduate students, especially "Proof that Prop-
erly Anticipated Prices Fluctuate Randomly," the two warrantpricing papers,
"General Proof That Diversification Pays," and "Efficient Portfolio Selection
for Pareto-Levy Investments." I also suggest "The FundamentalApproximation
Theorem" but caution students to look for and understandits limitations. While
these are the papers I personally regardas most outstanding,I commend all of
Part XIX to serious students of mathematicalfinance.
BERNELL K. STONE
Cornell University

This content downloaded from 119.15.93.148 on Fri, 10 Jul 2015 08:53:03 UTC
All use subject to JSTOR Terms and Conditions
 Book Reviews 947
REFERENCES
1. Amir Barneaand David H. Downes. "A Re-examinationof the EmpiricalDistributionof Stock
Price Changes," Journal of the American Statistical Association, 68 (June 1973) 348-50.
2. Fischer Black and Myron Scholes. "The Pricing of Options and CorporateLiabilities," The
Journal of Political Economy, 81 (May-June 1973), 637-54.
3. MenachemBrenner. "On the Stabilityof the Distributionof the MarketComponentin Stock
Price Changes," Journal of Finance and Quantitative Analysis (forthcoming).
4. David Cass and Joseph E. Stiglitz. "The Structureof Investor Preferencesand Asset Returns
and Separabilityin PortfolioAllocation,"Journalof Economic Theory,2 (June 1970), 122-60.
5. KalmanJ. Cohen and FrederickS. Hammer,eds. AnalyticalMethodsin Banking, Homewood,
Ill.: RichardD. Irwin, Inc., 1966.
6. Paul H. Cootner, ed. The Random Character of Stock Market Prices, Cambridge, Mass.: The
M.I.T. Press, 1964.
7. Eugene F. Fama. "PortfolioAnalysis in a Stable ParetianMarket,"ManagementScience, 11
(January1965), 404-19.
8. Donald E. Farrar. The Investment Decision Under Uncertainty, Englewood Cliffs, N.J.:
Prentice-Hall,Inc., 1962.
9. Bruce D. Frielitzand E. W. Smith. "AsynnetricStable Distributionsof Stock Prices," Journal
of the American Statistical Association, 67 (December 1972) 813-14.
10. Harry Markowitz.Portfolio Selection, New York: John Wiley & Sons, Inc., 1959 (Reprinted,
New Haven: Yale University Press, 1970).
11. Paul F. Samuelson. "Proof that Properly Discounted Present Values of Assets VibrateRan-
domly," The Bell Journal of Economics and Management Science, 4 (Auburn 1973), 369-74.
12. Bernell K. Stone. Risk, Return, and Equilibrium,Cambridge,Mass.: The M.I.T. Press, 1970.
13. . "WarrantBetas and the Effect of WarrantFinancing on Systematic Risk,"
Journal of Finance (forthcoming).
14. . "The Conformityof Stock Values Based on Discounted Dividends to a Fair-
Return Process," WorkingPaper (November 1974).
15. . "The Conformityof Warrantsto a Fair-ReturnProcess," WorkingPaper (De-
cember 1974).
16. John Tiechmoller. "A Note on the Distributionof Stock Price Changes," Journal of the
American Statistical Association, 66 (June 1971), 282-84.
17. James Tobin. "LiquidityPreferenceas BehaviorTowardsRisk," Review of Economic Studies,
25 (February, 1958), 102-10.

Replacement Cost Accounting. By LAWRENCEREVSINE. Englewood Cliffs:

Prentice-Hall, Inc., 1973. Pp. xiv + 194. $7.95.
Professor Revsine has written a book in the spirit of Edwardsand Bell's, The
Theory and Measurement of Business Income. If you are sympathetic to the
reportingof holding gains and losses as well as operatingincome then you will
appreciate this book.
However, Revsine hedges his bets. He states in his preface (p. xi): "This
study is not designed to advocate either corporate reporting of market value
measures in general, or replacementcosts in particular."Since this reviewer has
a bias for reportingat least some informationon a replacementcost basis (e.g.,
securities and inventories) the failure of the author to take a firmerstand is a bit
of a disappointment.On the other hand, he is to be praised for being academi-
cally (in the best sense) objective in his analysis of the merits of replacement
cost accounting.
I would have preferred a slightly different order of chapters. The nature of
replacement cost information is explained in Chapter 3. Since there are many
different possible definitions of replacement cost accounting I would have liked
an earlier explanation. I recommend the reader start with Chapter 3. Happily, I
assumed the author would use the "best" definition of replacement cost ac-
counting, and the author came through and used the procedure I liked (for
example, the moment of sale replacement values are used).

This content downloaded from 119.15.93.148 on Fri, 10 Jul 2015 08:53:03 UTC
All use subject to JSTOR Terms and Conditions