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2013 | Buch

The Efficient Market Hypothesists

Bachelier, Samuelson, Fama, Ross, Tobin and Shiller

verfasst von: Colin Read

Verlag: Palgrave Macmillan UK

Buchreihe : Great Minds in Finance

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Describes the lives, theories, and legacies of six great minds in finance who changed the way we look at financial markets and equilibrium. Bachelier, Samuelson, Fama, Ross, Tobin, and Shiller; proponents and critics of the market efficiency theories who redefined modern finance, creating the foundation on which all financial analysis rests.

Inhaltsverzeichnis

Frontmatter

Introduction

1. Introduction

This book is the fourth in a series of discussions about the great minds in the history and theory of finance. While the series addresses the contributions of significant individuals to our understanding of financial decisions and markets, this entry in the series describes a paradigm that was almost universally accepted by finance scholars upon its inception in the mid-1960s and questioned by financial practitioners ever since. We will describe the controversial efficient market paradigm and attempts by the finance discipline to make our financial models more realistic.

Colin Read

Louis Bachelier: The First Physicist Financial Theorist

Frontmatter
2. The Early Years

There is some mystery surrounding the early life of Louis Jean-Baptiste Alphonse Bachelier. Our culture documents in great detail the lives of the famous, influential, and powerful. Less is known about scholars whose contributions are not recognized until long after they have passed. Bachelier’s story was further obscured because a fire destroyed some archives, because he departed early from the traditional upbringing of scholar prodigies when he was thrust into independent adulthood at too young an age, and because his life was punctuated by the chaos of two wars.

Colin Read
3. The Times

The mystery of Louis Bachelier is why he has remained relatively obscure within the finance literature until his “discovery” by Paul Samuelson in 1964. To better understand why results so fundamental today remained almost unknown for three generations, we must peer into the nature of scientific research before the emergence of English as the de facto international language of academia.

Colin Read
4. The Theory

Louis Bachelier had an interest in the theories of games of chance that had intrigued French scholars before him and, most significantly, following him for a long time. Bachelier’s formal training in mathematical physics at the Sorbonne University under Jules Henri Poincaré also exposed him to the diffusion theory of heat and gases. However, before Bachelier, no scholar had made the profound connection between mathematical physics and the decision-making sciences, even if many have done so since.

Colin Read
5. Discussion and Applications: Einstein and Bachelier

Louis Bachelier’s narrow application of a powerful mathematical insight to the then-obscure financial markets explained his inability to gain recognition within the mathematical physics community. Not all contemporaries faced this same limitation, though.

Colin Read
6. Life and Legacy

There are only a handful of scholars in any discipline that spark a movement. In this instance, Louis Bachelier never fully comprehended the role his thesis would play and, for that matter, nor did the discipline. However, Bachelier’s life after his thesis remained surprisingly controversial.

Colin Read

Paul Samuelson’s Random Walk

Frontmatter
7. The Early Years

The subtext of Bachelier’s career-long plight and lifelong pursuit for academic recognition was the French penchant at the time of intellectual style over substance. An elitist academic climate meant that scholarship of value could only come from elite scholars and that one need not read works in other languages, especially when so much good work was presumed to be done by French scholars. Such academic provincialism ultimately serves no greater purpose. Yet, it preserved the status quo and the vaunted position of those admitted to the club of the scholarly elite.

Colin Read
8. The Times

Paul Samuelson arrived not only to MIT but also to a profession that was undergoing a metamorphosis. In the early 1930s, the American economist Irving Fisher had extended his earlier work on the role of the interest rate in intertemporal decision-making. He was considered by many to be the best and most sophisticated economist of his day, and was regarded as the first popularly known financial theorist. However, his discipline was economics and finance based primarily on rhetoric rather than on the compact language of mathematics almost universally employed in the hard sciences.

Colin Read
9. The Theory

Paul Samuelson, in a foreword to the full translation of Louis Bachelier’s

Theory of Speculation: The Origins of Modern Finance

, stated:

[The] discovery or rediscovery of Louis Bachelier’s 1900 Sorbonne thesis, “Théorie de la spéculation,” began only in the middle of the twentieth century, and initially involved a dozen or so postcards sent out from Yale by the late Jimmie Savage … in paraphrase, the postcard’s message said, approximately, “Do any of you economist guys know about a 1914 French book on the theory of speculation by some French professor named Bachelier?” …

[O]pportunistically, I suggested replacing Bachelier’s absolute Gaussian distribution by “geometric” Brownian motion based on log-Gaussian distributions. Independently, the astronomer M.F.M. Osborne made the same suggestion.

34

In an interview with Samuelson and his former prodigy, Robert Merton, Samuelson told the story of how he discovered the work of Louis Bachelier. Even before he received that fateful postcard from Leonard Jimmie Savage that elevated the discipline’s awareness of Bachelier, Samuelson was aware of Bachelier’s work. He also had an almost lifelong interest in price dynamics and was familiar with the analyses of commodity futures prices by Holbrook Working and Maurice Kendall who concluded that such a time-series plot appeared much like a random walk.

Colin Read
10. Discussion and Applications

Paul Samuelson’s result that prices follow a random walk buffeted only by random and unknowable forces once arbitrage has extracted value from every last bit of price disparity clearly created a school of its own, and perhaps even a faith, among financial theorists. Believers have constructed myriad reasons why it must be true as a matter of faith. Still others believe that markets are not as perfect as the arbitrage proponents insist. Both can cite many examples and scenarios to “prove” their case. However, their protestations seem to do little but preach to the converted and seem to have little effect on changing the minds of the skeptics.

Colin Read
11. The Nobel Prize, Life, and Legacy

Paul Samuelson is not the definitive economist known most broadly among laypeople. In the latter half of the twentieth century, the names of John Maynard Keynes or Milton Friedman were more familiar. At the start of the new millennium, we have perhaps heard of Ben Bernanke and Paul Krugman. In the first half of the twentieth century, Professor Irving Fisher was well known. Among finance theorists, William Sharpe, Fischer Black, Myron Scholes, Michael Jensen, and Eugene Fama might be more familiar, perhaps because each, except Fama, had their name immortalized in the names of famous equations or coefficients. However, among financial and economic scholars, Samuelson stands alone, much like Albert Einstein might among physicists, or Robert Goddard and Werner von Braun among rocketeers.

Colin Read

Eugene Fama’s Efficient Market Hypothesis

Frontmatter
12. The Early Years

Malden, Massachusetts and nearby Melrose, Stoneham, and Medford are working-class towns north of Boston known early in the twentieth century for their population of immigrants to America and for the sports legends produced by neighborhood heroes. The streets and sand lots were where local boys played baseball, basketball, and street hockey. These towns had a tradition of hard work, of pride in their local boys and girls, and of healthy sporting competition between the high schools in the area.

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13. The Times

As Eugene Fama researched and prepared his PhD thesis at the University of Chicago under the supervision of Merton Miller, he sought to resolve an increasingly problematic empirical observation at odds with emerging theory. By the early 1960s, especially after the analysis by Matthew Fontaine Maury Osborne in 1959, it had become accepted that the logarithm of securities prices was the appropriate measure of analysis. However, the resulting distribution of unexplained price variations under this transformation remained a subject of debate, and the serial correlation of observations that follow this distribution was a topic of growing interest.

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14. The Theory

In 1889, George Gibson wrote in The Stock Exchanges of London, Paris and New York that when “shares become publicly known in an open market, the value which they acquire may be regarded as the judgment of the best intelligence concerning them.” More than a century later, the finance literature still grapples with the significance of that simple statement.

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15. Discussion and Applications

By the late 1960s, a number of scholars began to research the new tools of the CRSP and Compustat tapes and the event study methodology, and implicitly began to explore the implications of the efficient market hypothesis. The resulting sequence of studies seemed to support the semi-strong version of market efficiency in which a security price incorporated all available public information.

Colin Read
16. Life and Legacy

Eugene Fama formulated the most compact and profound statement in modern finance. Many academics have adopted his notion of the efficient market as an act of faith that has defined entire scholarly careers. Still others created careers around its refutation. Regardless of this controversy, Fama is considered an elder statesman of modern finance and is the name most strongly associated with finance’s most powerful and controversial paradigm.

Colin Read

Stephen Ross and Arbitrage Pricing Theory

Frontmatter
17. The Early Years

Like so many of the great minds in finance before him, Stephen Alan Ross’ ancestors were from Eastern Europe. His grandfather, Benjamin Ross, was born in Courland, Russia in March 1880 and made his way to the USA as a very young man of 17 in 1897. Soon after he arrived, he met his future bride, Katherine Cohen, who, while also born in Russia, had come over with her parents and older sister Elizabeth in 1885 when she was only two years old.

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18. The Times

The two-decade period from 1952 to 1972 created a revolution in finance theory. However, the modern era in finance started slowly. Harry Markowitz had developed the Modern Portfolio Theory, which, while intuitively appealing, was nearly impossible to apply because of limitations in computing power. Indeed, Modern Portfolio Theory was not even taught at the business school of its creation until the great mind Eugene Fama began teaching there. Nor was its intuition immediately obvious until James Tobin, the great mind described in the next part of this book, created a new interpretation based on a risk-free asset.

Colin Read
19. The Theory

The primary goal of Stephen Ross’ APT was to relax the implication that every investor chooses the same portfolio. Instead, Ross sought to show that different investors balance a spectrum of possible risks. This relaxation allowed an investor to ameliorate those risks based on his or her individual risk preferences.

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20. Discussion and Applications

Finance is an analytically challenging discipline. Often, simplifying assumptions or conditions, such as risk neutrality, a representative investor, arbitrage, or market efficiency, are imposed to allow formal models to be tractable. However, the overly simplifying assumptions run the risk of creating theories that create an analytic power that is out of proportion with the various assumptions, such as the premise of the efficient market hypothesis. Other models adopt assumptions of such strong generality that it becomes difficult to draw strong conclusions from them. This is the criticism that at times has been leveled against the APT.

Colin Read
21. Life and Legacy

Stephen Ross provided to the finance discipline the APT that was intuitively appealing, consistent with well-understood methodologies, that invoked the equilibrium concept of arbitrage and the efficient market hypothesis, and was rooted in the sound theory of the Arrow-Debreu competitive equilibrium. He was able to do so because he brought to the theoretical problem an excellent foundation in mathematics, from his attendance at Caltech, a firm foundation in economics from his PhD, and his experience from an immersion in leading-edge finance at the finance workshops upon his initial appointment at Wharton.

Colin Read

James Tobin and a New Policy

Frontmatter
22. The Early Years

At one time, economics and finance did not include the many specialties they embrace today. Some of the giants of finance laid the foundations we all know nowadays, even if few current scholars have actually read their original expositions. Rather, their works have been incorporated into our standard theories, while we vaguely recall from whom the original ideas flowed.

Colin Read
23. The Times

By the 1970s, the efficient market hypothesis was beginning to divide the field of finance into camps of supporters and detractors. Supporters subscribed to the Chicago School, which is premised on their faith in the ability of the free market to process and price information and maintain efficiency and competitiveness. This support was primarily from the academic side, even though there were some in the finance academy who were suspicious of its far-reaching implications.

Colin Read
24. Tobin’s Efficient Market Paradigm

An ancient proverb attributed to an anonymous Arabic poet says:

He who knows not and knows not he knows not: he is a fool — shun him.

He who knows not and knows he knows not: he is simple — teach him.

He who knows and knows not he knows: he is asleep — wake him.

He who knows and knows he knows: he is wise — follow him.

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25. Discussion and Applications

James Tobin offered the finance literature a paradigm, a measurement tool, and a solution. He expanded Eugene Fama’s efficient market hypothesis to explore further not only the arbitrage process arising out of information, but also the very definition of fundamentals pricing. He then offered one measure, Tobin’s q, to benchmark a financial market’s capitalization of a corporate security relative to the value of its underlying physical assets that create the means to produce and generate profits. He observed that the volatility of measures of Tobin’s q or of market prices for securities seems to defy the current state of theoretical understanding of securities pricing. From this conclusion, his idea of a Tobin tax to stem excessive market volatility has been discussed extensively.

Colin Read
26. The Nobel Prize, Life, and Legacy

James Tobin was the last of the pioneering breed who provided the foundations of modern financial theory. He specialized in the microeconomic foundations of macroeconomics, but he found himself inevitably exploring the important role of finance markets. He provided the first significant insight to Modern Portfolio Theory just as finance began to emerge as a distinct field in the study of decision-making. In developing his separation theorem that generalized Markowitz’s theory, he brought Modern Portfolio Theory into the economic mainstream and initiated a wave of innovation in financial theory beginning with the CAPM model of the early 1960s.

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Robert Shiller and Irrational Exuberance

Frontmatter
27. The Early Years

In the last decade of the nineteenth century and the first decade of the twentieth century, there was an exodus of immigrants from Eastern Europe and Russia who sought refuge in the USA from the increasingly volatile politics of their homeland.

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28. The Times

There is an almost irreverent and compelling regard for the power of nature that can likewise be applied to human-made creations. We use analogies such as a perfect storm and natural chaos theory to describe financial chaos, and John Maynard Keynes used the concept of animal spirits to describe investing behavior. The random walk was most helpful in explaining Brownian motion and the movement of molecules, and was successfully applied to the movement of securities prices as early as 1900 by Louis Bachelier.

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29. The Theory

We spoke earlier about the contribution of the novel 1969 event study of Eugene Fama, Michael Jensen, and Richard Roll, and the earlier pioneering event studies by Ray Ball and Phillip Brown and by Jensen in the previous year. These were the first scholars to explore and affirm the efficient market hypothesis. Each of these event studies seemed to support the semi-strong version of market efficiency in which, upon the release of new public information, a security price is revised accordingly. Two decades later, Robert Shiller used an almost identical methodology to refute the efficient market hypothesis.

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30. Discussion and Applications

Robert Shiller is, admittedly, an empiricist, a prognosticator, and an advocate. His advocacy is in the rejection of the efficient market hypothesis, even if he does not necessarily assert a better paradigm. While his approach has not been without controversy, few can deny that he has become one of the most influential economists of his generation.

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31. Life and Legacy

Following his MIT PhD in 1972 and his residencies at the University of Minnesota and the Wharton Business School over the next decade, Robert Shiller has remained at Yale University since 1982 as its Arthur Okun Professor of Economics.

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What We Have Learned

Frontmatter
32. Combined Contributions

Modern finance today very much reflects how it began. Now, rocket scientists and advanced mathematicians, trained in our schools of science and finance, develop sophisticated models to price risk and returns. More than a century ago, in 1900, Louis Bachelier, a mathematical physicist who had earned an income to put himself through school at the Sorbonne in Paris by working at the Paris Stock Exchange, brought his mathematical prowess to an at that time obscure problem in finance. While his mentor, Jules Henri Poincaré, may have been chagrined by his academic blasphemy at that time, Poincaré saw flashes of brilliance in his idea.

Colin Read
33. Conclusions

The efficient market hypothesis has provoked more debate than any concept in the history of finance theory and practice. The previous three volumes of this series, on the life cyclists, the portfolio theorists, and the rise of the quants, uncovered no fundamental disagreements among scholars or practitioners, and described no dividing lines among financial theories. Each great mind built upon the foundations of his predecessors and each evolution added broadly accepted intuition into the discussion. However, the efficient market hypothesis is profound and intuitive to many, and dubious and distracting to others.

Colin Read
Backmatter
Metadaten
Titel
The Efficient Market Hypothesists
verfasst von
Colin Read
Copyright-Jahr
2013
Verlag
Palgrave Macmillan UK
Electronic ISBN
978-1-137-29221-6
Print ISBN
978-1-349-32435-4
DOI
https://doi.org/10.1057/9781137292216