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Far from Academic

It was 50 years ago that Franco Modigliani and Merton Miller turned the world of finance upside down. Today, the debate continues over why companies choose the capital structures they do.

Edward Teach, CFO Magazine
July 15, 2008

Financial Economics & Arbitrage

I've just stumbled across a near-tautology that financial economists have somehow overlooked. It's best explained in terms of the Fair Value Hierarchy of FAS 157. Level 1 instruments have an observable market price, while Level 3 instuments lack "observable inputs". An asset or liability is subject to arbitrage if and only if it can be decomposed into level 1 components. In particular, level 3 assets & liabilities are not subject to arbitrage. So, they are not subject to the 'law of one price'. In contrast, financial economists presume that all assets & liabilities are subject to arbitrage. So they are coming to some outrageous conclusions about level 3 assets & liabilities. And the accounting standards boards are buying it.

Posted by Daniel Moore | July 31, 2008 02:14 pm

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