Finance Papers

In 1979, Daniel Kahneman and Amos Tversky published a 29-page paper in Econometrica that took the standard model of rational choice apart using nothing but a questionnaire: "Prospect Theory: An Analysis of Decision under Risk."

Six episodes on how markets price risk, all of them resting on one assumption nobody had tested: that people evaluate their final wealth. Episode 7 is the paper that tested it and found it false. Fourteen pairs of choices, put to students and faculty, and the same person contradicts himself minutes apart. Join Finance Papers for a section-by-section breakdown of Kahneman and Tversky's original text, stripped of textbook shortcuts and industry buzzwords.

Key Topics Covered in This Deep Dive:

- The Assumption Nobody Questioned: the three tenets of expected utility theory, and why the second one — asset integration, which says the thing being valued is your total wealth — is the load-bearing wall this paper knocks out.

- Play Along and Catch Yourself: two problems, four seconds apart, where 82% pick one way and 83% pick the other — and 61% of respondents made both of those choices. Not two groups disagreeing. One person, twice.

- The Reflection Effect: flip every sign from gains to losses and the preferences flip with them. Risk averse when you are ahead, risk seeking when you are behind — which is why people gamble to avoid a sure loss.

- The Isolation Effect: people throw away whatever two options have in common, so the same final position, described two ways, gets two different answers. The floor under "rational choice" moves here.

- The Editing Phase, the Underrated Half: before anyone evaluates anything, they recode the problem — outcomes become gains and losses against a reference point, and shared components get cancelled. Most retellings skip this and go straight to the curve.

- Value and Weight, Neither of Them What You Think: a value function defined on changes rather than states, steeper going down than up — "losses loom larger than gains" is the paper's own sentence — and decision weights that overweight small probabilities and do not sum to one.

- The Free Parameter: the reference point is a choice, not a fact. It moves with how the offer is worded. That is simultaneously the theory's power and its soft spot, and the paper says so.

Paper Explored: Kahneman, D., & Tversky, A. (1979), PROSPECT THEORY: AN ANALYSIS OF DECISION UNDER RISK. Econometrica, 47(2): 263–291.

🔗 Read the full paper here: https://doi.org/10.2307/1914185

Finance Papers is conceptualized and curated by Luiz Gidrão, CFA, CAIA (founder of stock.cash). Hit play, open the paper PDF, and learn with us.

In 1976, Michael Jensen and William Meckling published a 56-page paper that gave corporate governance both its foundation and its vocabulary: "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure."

After five episodes on how markets price assets from the outside, Episode 6 turns inward: not what the firm is worth, but what happens inside it when the person running the company is not the person who owns it.

Adam Smith flagged the problem in 1776. Two hundred years later, this paper names the cost, proves who actually pays it, and rebuilds capital structure theory on top of the answer. Join Finance Papers for a section-by-section breakdown of Jensen and Meckling's original text, stripped of textbook shortcuts and industry buzzwords.

Key Topics Covered in This Deep Dive:

- The Definition That Started a Field: agency costs as the sum of exactly three things — the monitoring expenditures by the principal, the bonding expenditures by the agent, and the residual loss — and why that third term never reaches zero.

- The 95-Cent Problem: why an owner-manager who sells part of his equity starts consuming more perquisites, and the Theorem that settles who pays for it — rational buyers price the behavior in, so the founder bears the entire decline in value, not the minority investor.

- Why Firms Pay for Their Own Audits: monitoring versus bonding, and the counterintuitive result that the manager voluntarily writes the contract that constrains him, because the wealth it protects is his.

- The Nirvana Fallacy: why positive agency costs are not evidence of inefficiency, and why judging the corporation against a world of costless monitoring is like calling our world non-optimal because iron ore is not free.

- Equity as a Call Option on the Firm: how Black-Scholes (Episode 4) explains why a levered owner wants variance, why bondholders write covenants, and precisely what Modigliani-Miller (Episode 3) had assumed away.

- The Trade-Off That Sets Ownership Structure: the agency cost of outside equity rises as the agency cost of debt falls, so the minimum sits at a mixture of both — and why the authors reject the term "capital structure" in favor of "ownership structure."

- The Answer to Episode 5: Fama ended on a question — if prices already reflect everything, what is a stock analyst being paid to do? Jensen and Meckling answer it directly: the analyst is monitoring managers, and that is socially productive even when it earns his clients nothing.

Paper Explored: Jensen, M. C., & Meckling, W. H. (1976), THEORY OF THE FIRM: MANAGERIAL BEHAVIOR, AGENCY COSTS AND OWNERSHIP STRUCTURE. Journal of Financial Economics, 3(4): 305–360.

🔗 Read the full paper here: https://doi.org/10.1016/0304-405X(76)90026-X

Finance Papers is conceptualized and curated by Luiz Gidrão, CFA, CAIA (founder of stock.cash). Hit play, open the paper PDF, and learn with us.

In 1970, Eugene Fama published a 35-page paper that transformed modern finance from a collection of elegant theoretical models into a rigorous empirical science: "Efficient Capital Markets: A Review of Theory and Empirical Work."

After four episodes building the foundational edifice of modern finance—Markowitz's portfolio selection, Sharpe's CAPM, Modigliani-Miller's capital structure, and Black-Scholes' option pricing—Episode 5 opens a brand-new act: testing whether real-world markets actually behave the way that theory assumes. Join Finance Papers for a section-by-section breakdown of Fama’s classic text, stripped of textbook shortcuts and industry buzzwords.

Key Topics Covered in This Deep Dive:

- The Untestable Claim: Why the statement "prices fully reflect available information" has zero empirical meaning on its own—and why every test of market efficiency is inextricably a joint test of efficiency and an assumed model of expected returns.

- The Three-Form Taxonomy: The definitive breakdown of Weak, Semi-Strong, and Strong form efficiency—crediting Harry Roberts’ original insight and Fama’s completion of the framework.

- From Bachelier to Alexander's Filter Rules: Louis Bachelier's forgotten 1900 doctoral thesis, Mandelbrot’s fat tails, and why technical trading rules lose all statistical edge once real-world transaction costs are deducted.

- The Birth of the Event Study (FFJR 1969): How Fama, Fisher, Jensen, and Roll revolutionized empirical finance by measuring price adjustments before and after stock splits.

- The Intellectual Origin of Index Investing: Michael Jensen’s landmark study of 115 mutual funds, proving that active managers failed to outperform a risk-adjusted benchmark—four years before the first retail index fund existed.

- The Exceptions and the Frontier: Documented violations by NYSE specialists and corporate insiders, ending on Fama's ultimate question: if prices already reflect everything, what is a stock analyst being paid to do?

Paper Explored: Fama, E. F. (1970), EFFICIENT CAPITAL MARKETS: A REVIEW OF THEORY AND EMPIRICAL WORK. The Journal of Finance, 25(2): 383–417.

🔗 Read the full paper here: https://doi.org/10.1111/j.1540-6261.1970.tb00518.x

Finance Papers is conceptualized and curated by Luiz Gidrão, CFA, CAIA (founder of stock.cash and goa.capital). Hit play, open the paper PDF, and learn with us.

In 1973, Fischer Black and Myron Scholes solved a problem that had defeated finance for seventy years: how to price an option without knowing where the stock is headed. Their formula didn't just settle an academic debate — it launched a derivatives market now worth trillions and quietly redefined what a share of stock actually is.

This is the finale of a four-episode arc. After Markowitz, Sharpe, and Modigliani-Miller, Black and Scholes bring together everything we've covered — hedging, CAPM, and capital structure — into a single closed-form result. Join Finance Papers for a section-by-section breakdown of the original text, stripped of textbook shortcuts.

Key Topics Covered in This Deep Dive:

The Seven Ideal Conditions: The frictionless, cost-free market the authors had to construct before the math could work — and why every subsequent advance in derivatives theory maps where one of these seven assumptions breaks.

The Hedge That Cancels Out: How a continuously adjusted long-stock, short-option position eliminates risk entirely, and why a riskless position must earn exactly the risk-free rate.

The Disappearing Expected Return: The most counterintuitive result in the paper — the stock's expected return drops out of the formula, meaning a bull and a bear must agree on the option's price.

Implied Volatility, Invented on the Spot: Why variance is the only unobservable input in the formula, and how the market built an entire concept — and later the VIX — just to estimate it.

Equity as an Option: The paper's most underread section. Why common stock in a leveraged firm is mathematically a call option on the firm's assets, and what that reveals about leverage, covenants, and default risk.

Paper Explored: Black, F., & Scholes, M. (1973), THE PRICING OF OPTIONS AND CORPORATE LIABILITIES. Journal of Political Economy, 81(3): 637–654.

🔗 Read the full paper here: https://doi.org/10.1086/260062

Finance Papers is conceptualized and curated by Luiz Gidrão, CFA, CAIA (founder of stock.cash and goa.capital). Hit play, open the paper PDF, and learn with us.

In 1958, two young economists published a paper that enraged corporate finance professors and quietly rewired the foundations of the field. Franco Modigliani and Merton Miller’s “The Cost of Capital, Corporation Finance and the Theory of Investment” claimed that, in a perfect market, a firm’s value is completely independent of how it mixes debt and equity—an idea so radical that many dismissed it as academic trickery.

In this third episode of Finance Papers, we strip away the folklore and walk through Modigliani & Miller’s original text section‑by‑section. Instead of treating “capital structure irrelevance” as a slogan, we focus on the arbitrage proof itself: the intellectual “magic trick” where investors reshuffle equity and debt between identical firms to expose any supposed free lunch.

Key Topics Covered in This Deep Dive:

• The Irrelevance Benchmark: Why, under no taxes, no distress costs, no agency problems and symmetric information, leverage alone cannot change firm value—only redistribute risk and cash flows across claimholders.

• Homemade Leverage: How investors can lever or de‑lever their own portfolios using borrowing and risk‑free assets, and why this undermines the idea that managers can create value purely by changing the debt‑equity mix.

• The Arbitrage Argument: Step‑by‑step through MM’s invariance proof, showing how any mispricing between levered and unlevered firms translates into a true free lunch until prices converge.

• From Irrelevance to Frictions: How the theorem doesn’t say “capital structure never matters”, but instead tells you exactly where to look when it does—tax shields, bankruptcy and distress costs, agency conflicts, and information asymmetry.

• Closing the Foundations: How Modigliani & Miller complete the structural base laid by Markowitz (portfolios) and Sharpe (CAPM), and set the stage for Fama’s formalization of “perfect markets” and the Efficient Market Hypothesis.

  
  

Paper Explored: Modigliani, F. & Miller, M. H. (1958), “The Cost of Capital, Corporation Finance and the Theory of Investment”, The American Economic Review, 48(3): 261–297.

🔗 Read the full paper: https://www.jstor.org/stable/1809766

Finance Papers is conceptualized and curated by Luiz Gidrão, CFA, CAIA (founder of ⁠stock.cash⁠ and ⁠goa.capital⁠). Hit play, open the PDF, and learn with us.

In 1952, a 25-year-old graduate student published a 14-page paper that changed Wall Street forever. Harry Markowitz’s "Portfolio Selection" laid the mathematical foundation for modern quantitative finance and earned him a Nobel Prize.

In this inaugural episode of Finance Papers, we strip away the fluff and do a section-by-section deep dive into the actual math and mechanics of Markowitz's original text.

Key Topics Covered:

• ​The Concentration Trap: Why trying to purely maximize returns mathematically forces you to put 100% of your money into a single stock.
• ​The Myth of Large Numbers: Why holding 60 railway stocks isn't true diversification when a systemic market crash hits.
• ​The Magic of Covariance: How the interaction between assets—not their individual volatility—defines true portfolio risk.
• ​The Computing Bottleneck: How the sheer impossibility of calculating 125,000 covariance pairs by hand in 1952 eventually led to the creation of Beta and CAPM.
• ​The Math of Gambling: Why rational humans willingly buy lottery tickets (the statistical concept of Skewness).

Paper Explored: Markowitz, H. (1952), PORTFOLIO SELECTION*. The Journal of Finance, 7: 77-91.

🔗 Read the full paper here: https://doi.org/10.1111/j.1540-6261.1952.tb01525.x

Finance Papers is conceptualized and curated by Luiz Gidrão, CFA, CAIA (founder of stock.cash and goa.capital). Hit play, open the paper PDF, and learn with us.

Following up on Harry Markowitz’s foundational concept of diversification, William Sharpe’s 1964 paper took Modern Portfolio Theory to the next level.

This seminal work is the practical key that unlocked MPT for the investing world, introducing the Capital Asset Pricing Model (CAPM) and fundamentally changing how we evaluate investment returns in relation to risk. Like Markowitz, Sharpe also received a Nobel Prize for this foundational contribution to finance.

Join Finance Papers for a focused breakdown of Sharpe's masterwork. We strip away the textbook simplifications to analyze how the model truly works from its original source text, section-by-section.

Key Topics Covered in This Deep Dive:

• The Risk-Free Addition: How introducing a risk-free borrowing and lending asset collapses the complex Efficient Frontier into a single, elegant visual: The Capital Market Line (CML).

• The Separation Theorem: Understanding why the "efficient" portfolio is identical for every investor, regardless of their personal risk tolerance.

• Defining Beta (β): The exact mathematical meaning of Sharpe’s original metric for systematic risk and its relationship to the total market portfolio.

• The Undiversifiable Problem: Why diversification (as taught by Markowitz) cannot eliminate market risk—only firm-specific risk.

• Market Equilibrium: How collective investor behavior forces asset prices to adjust to a state of balance based on risk premiums.

Paper Explored: Sharpe, W.F. (1964), CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK*. The Journal of Finance, 19: 425-442.

🔗 Read the full paper: https://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1964.tb02865.x

Finance Papers is conceptualized and curated by Luiz Gidrão, CFA, CAIA (founder of stock.cash and goa.capital). Hit play, open the PDF, and learn with us.