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Über dieses Buch

The third book in the Great Minds in Finance series examines the pricing of securities and the risk/reward trade off through the legends, contribution, and legacies of Jacob Marschak, William Sharpe, Fischer Black and Myron Scholes, and Robert Merton, influencing both theory and practice, answering the question 'how do we measure risk?'

Inhaltsverzeichnis

Frontmatter

Introduction

1. Introduction

Abstract
This book is the third in a series of discussions about the great minds in the history and theory of finance. Each volume addresses the contributions of brilliant individuals to our understanding of financial decisions and markets.
Colin Read

A Roadmap to Resolve the Big Questions

2. A Roadmap to Resolve the Big Questions

Abstract
In the first half of the twentieth century, Irving Fischer described why people save. John Maynard Keynes then showed how individuals adjust their portfolios between cash and less liquid assets, while Franco Modigliani demonstrated how all these personal financial decisions evolve over one’s lifetime. John von Neumann, Leonard Jimmie Savage, and Kenneth Arrow then incorporated uncertainty into the mix, and Harry Markowitz packaged the state of financial science into Modern Portfolio Theory.
Colin Read

Jacob Marschak

Frontmatter

3. The Early Years

Abstract
Jacob Marschak was not at all unusual among the cadre of great minds that formed the discipline of finance in the first half of the twentieth century. Like the families of Milton Friedman, Franco Modigliani, Leonard Jimmie Savage, Kenneth Arrow, John von Neumann, and Harry Markowitz, Marschak’s family tree was originally rooted in the Jewish culture and derived from the intellectually stimulating region of Eastern, Central and Southern Europe at the beginning of the twentieth century. This region, comprising what is now Ukraine, Hungary, Poland, Romania, and parts of Italy, was under the influence of the Austro-Hungarian Empire in the late nineteenth and early twentieth centuries.
Colin Read

4. The Times

Abstract
Jacob Marschak was a profound intellectual catalyst in a number of areas in finance. His insistence in mathematical rigor and an axiomatic approach, his definition of the problem of asset choice and portfolio theory, and his modeling of uncertainty and optimal investment theory were at once original and profound. While others are more typically credited with pioneering work in these areas, the roots of their innovations and, indeed, their early finance education can be traced back to him.
Colin Read

5. The Theory

Abstract
Marschak brought not just a single new idea to a new world — he brought forth a number of new approaches to vexing problems known or not yet understood, and defined a lifelong research agenda for himself that would leave an indelible mark on our understanding of finance. A much more nuanced approach to markets, with explicit recognition of the ways in which one market affects another, became a hallmark of his work. His strong mathematical skills also allowed him to contribute to a movement that began in the late 1920s.
Colin Read

6. Applications

Abstract
Jacob Marschak proposed a simple translation between finance and economics. If financial variables can be described by their mean and variance, then, under certain assumptions, these measures can be directly incorporated into measures of utility and hence act to motivate the financial choices of human decision-makers. Marschak knew that such a simplification would permit a much more tractable approach to the decision sciences, just as the mean and variance approach allowed many physical processes to be described by the laws of thermodynamics. Certainly, higher order terms beyond the first and second moments on both the finance side and the utility side can be important in some circumstances. However, the mean and variance is relevant in all circumstances.
Colin Read

7. Life and Legacy

Abstract
Today there is perhaps no person who was at the epicenter of and more substantially influenced the post-Second World War financial revolution who is less well known than Jacob Marschak. However, the testimonies of great minds in finance, from Milton Friedman to Kenneth Arrow, Leonard Jimmie Savage, and Harry Markowitz, demonstrate his lasting legacy through a combination of his ideas and his generous mentoring of these future Nobel Prize winners. And each has paid tribute to Marschak as a major force in motivating their Nobel Prize-caliber work.
Colin Read

William Forsyth Sharpe, John Lintner, Jan Mossin, and Jack Treynor

Frontmatter

8. The Early Years

Abstract
Jacob Marschak and Sir John Hicks pioneered the concept of a mean-variance approach, also known to mathematicians and physicists as the first and second moment approach, to the risk reward trade-off in the 1930s and 1940s. However, it was not until Harry Markowitz formally incorporated risk and uncertainty into financial decision-making in his description of the mean-variance approach to portfolio design in the 1950s that a more general theory of finance began to foment. Following Markowitz’s Modern Portfolio Theory, the discipline of finance had to ruminate on these ideas for a decade. Suddenly, four researchers independently arrived at the same revolutionary insight at about the same time. If we can design a portfolio based on the mean and variance of securities, perhaps we can also price individual securities based on their historic level of variability.
Colin Read

9. The Times

Abstract
Over a three-decade period from the early 1930s, finance theory had followed an esoteric and elegant path that brought it to the cusp of a flourish of activity in the 1960s. It had advanced only through a series of mathematical innovations, mostly at the hands of scholars associated with the University of Cambridge and Princeton University and the Cowles Commission, first at the University of Chicago and then at Yale.
Colin Read

10. The Theory

Abstract
Before we describe the brilliant insight that provided a tool for securities pricing that was so simple and practical that we still use it today, let us take a moment to review James Tobin’s simplification.
Colin Read

11. Applications

Abstract
Markowitz’s Modern Portfolio Theory spawned contributions from individual securities pricing to project analysis, multi-period portfolio modeling and optimal capital structure for corporations. These various branches all stemmed from the same seed planted by Jacob Marschak and Sir John Hicks — the mean and variance description of returns subject to uncertainty. None of these extensions could have occurred were it not for the microeconomic foundations created by those associated with the Cowles Commission in the 1940s and 1950s. This approach has formed the basis for the pricing of financial securities ever since.
Colin Read

12. Life and Legacy

Abstract
The practicality and intuitive appeal of the CAPM has allowed it to endure. Certainly, no one would deny that past observed measures of risk ought to influence expected returns, even if one can imagine other forces that could impinge as well. Of course, expected returns are not an observable variable. Our regressions are based on realized returns, with all their attendant noise from other unrelated factors.
Colin Read

Fischer Black and Myron Scholes

Frontmatter

13. The Early Years

Abstract
The two names of the original formulators of the Black-Scholes options pricing model will be forever associated with each other. However, had it not been for the theory that linked them for financial eternity, it would be difficult to even imagine them are collaborators. One was a tall all-American boy, with a family tree that dates back to well before the USA was a nation, while the other was the grandson of Russian and Polish immigrants and grew up in the brawling frontier mining towns of Canada. We begin with the second story first.
Colin Read

14. The Times

Abstract
The pricing of the most elementary of securities has been well understood since the nineteenth century. Financial practitioners had used the simple bond pricing formula to determine the price of a bond with a specified coupon payment rate and the redemption (or face) value.
Colin Read

15. The Black-Scholes Options Pricing Theory

Abstract
There has perhaps been no other time in the history of economics and finance when a new financial theory was more timely and influential. Paul Samuelson and others had been working on the options and warrants issue in the 1960s, but the topic seemed to have little pressing need. However, by the end of the 1960s, a shrinking business in futures trading for the CBOT motivated the formation of a new market for options trading as a vehicle for its survival. Yet, only if such options contracts were standardized and if a model could be developed for the pricing of options as there had been a decade earlier for securities could the options market be successful and the derivative become an efficient and effective instrument for hedging risk. The CBOT could take care of the first precedent. The team of Fischer Black and Myron Scholes would take care of the second.
Colin Read

16. Applications

Abstract
There has perhaps been no application in the decision sciences for which there was such a dire need for a theoretical solution to an important practical problem as with the options pricing problem on the cusp of the formation of a new and potentially large and lucrative financial market. Nor has there been an application on which tens of trillions of dollars of activity per year would depend. Almost immediately upon the release of the Black-Scholes equation, its two principal authors were enlisted in an institution of potential size and importance beyond their wildest dreams.
Colin Read

17. The Nobel Prize, Life, and Legacy

Abstract
Each in their own way, Fischer Black and Myron Scholes redefined finance theory and application in a way that is perhaps more substantial than anyone before or since. Many others, such as Irving Fischer and his intertemporal model of consumption and savings, made contributions that informed and defined the literature. Some, like John Maynard Keynes and his concept of liquidity preference, motivated others to further flesh out his idea. Even Franco Modigliani and his Life Cycle Model, and Harry Markowitz with his Modern Portfolio Theory, created new ways to look at old problems that may have been revolutionary but yet were unable to transcend their immediate application.
Colin Read

Robert Merton

Frontmatter

18. The Early Years

Abstract
While the Black-Scholes formula for options pricing remains the contribution most associated with that pair of great minds, the results were motivated behind the scenes by another most intellectually generous collaborator. And while Fischer Black came from a long lineage that dated right back to the first European settlers in the USA, and Myron Scholes was the grandson of an entrepreneurial set of immigrants from Polish Russia, Robert Carhart Merton embodied both such lineages.
Colin Read

19. The Times

Abstract
Most successful scholars are a product of their times. Many academicians struggle over a career to keep up with the academic times. It is the hallmark of great minds that they define the times. In this respect, Robert Merton’s work early in his studies and career was no exception. But if he was a product of his times, it cannot be said that he was necessarily a product both of space and time. He defined a new space of research in finance, one that had more in common with rocket science and mathematics than with financial or economic theory. While he did not develop a new field of mathematics, the mathematics he freshly applied to finance was novel. And it was revolutionary. In collaboration with Fischer Black and Myron Scholes, he firmly placed finance on a rigorous and quantitative foundation. However, the tools he brought over, and the intuition he developed to motivate his best work, initiated a revolution in finance.
Colin Read

20. The Theory

Abstract
Fischer Black derived the differential equation. Myron Scholes provided an interpretation and assisted in its solution. However, it was Robert Merton who sparked the revolution that transformed finance.
Colin Read

21. Applications

Abstract
A tradition had been started by Louis Bachelier in 1900 but had been lost from finance until Robert Merton resurrected it in the early 1970s. Merton recognized the importance of economic analyses over time when uncertainty exists. He also recognized the relevance of the tools of stochastic calculus developed for the space race arising as a result of the Cold War. However, his reintroduction of continuous-time stochastic calculus to finance and economics, after the 70-year period of dormancy, awakened both economics and finance, and has resulted in a productive outpouring of results that have rewritten and generalized much of what we thought we previously understood.
Colin Read

22. The Nobel Prize, Life, and Legacy

Abstract
Robert Merton may best be known as the name that was omitted from the most important namesake equation in finance and economics. Few who know him, including his more famous colleague and collaborator Myron Scholes, underestimate his contribution.
Colin Read

What We Have Learned

Frontmatter

23. Combined Contributions

Abstract
James Tobin’s 1958 refinement of Harry Markowitz’s 1952 paper on Modern Portfolio Theory ushered in an era in which economics and finance diverged. While these scholars inspired the finance revolution of the 1960s, their contributions remained elegant, intuitive, esoteric, but primarily academic. While elegance remained the goal of economists, finance theorists sought pragmatism, and practical conclusions were paramount. Fortunately for the study and practice of finance, others took their inspiration to create a new American school of finance with an eye toward quantifiable methods and application. This new quantitative school of finance has not disappointed.
Colin Read

24. Conclusions

Abstract
The 1960s saw the emergence of finance as a discipline of its own, out of the shadow of economics. It managed this transition by producing models that were both rigorous and practical, and arrived at just the right time to provide the tools for new and burgeoning financial markets. It also heralded in an era of quantifiable methodologies, always with an eye toward practical application. The backrooms of investment banks would soon be staffed not by seasoned cigar-smoking professionals who knew finance as an art form, but rather by young physicists, mathematicians, and prodigies who grasped the significance of complicated differential equations and could translate their cascade of Greek letters into financial profits.
Colin Read

Backmatter

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