Finance theory has a surprisingly short history in economics. Economists havelong been aware of the basic economic function of credit markets but they were not keen onanalyzing it much further than that. As such, early ideas about financial marketswere largely intuitive, mostly formulated by practitioners. Pioneeringtheoretical work on financial markets, notably that of LouisBachelier (1900), tended to be basically ignored bytheoreticians and practitioners alike.
Portfolio Theory
This does not mean that the early economists ignored financial markets. IrvingFisher (1906, 1907, 1930) had already outlined the basicfunctions of credit markets for economic activity, specifically as a way of allocatingresources over time -- and had recognized the importance of risk in the process. Indeveloping their theories of money, John MaynardKeynes(1930, 1936), JohnHicks (1934, 1935, 1939), NicholasKaldor (1939) and JacobMarschak (1938) had already conceived of portfolioselection theory in which uncertainty played an important role.
However, for many economists during this early period, financial markets were stillregarded as mere "casinos" rather than "markets" properlyspeaking. In their view, asset prices were determined largely by expectationsand counter-expectations of capital gains and thus they were "held up by their ownbootstraps" as it were. John MaynardKeynes's"beauty contest" analogy is representative of this attitude.
As such, a good amount of ink was spent on the topic of speculative activity (i.e. thepurchase/temporary sale of goods or assets for later resale). For instance, in theirpioneering work on futures markets, John MaynardKeynes(1923, 1930) and JohnHicks (1939) argued thatthe price of a futures contract for delivery of a commodity will be generally belowthe expected spot price of that commodity (what Keynes called "normalbackwardation"). This, Keynes and Hicks argued, was largely because hedgersshifted their price risk onto speculators in return for a risk premium. NicholasKaldor (1939) went on to analyze the question of whetherspeculation was successful in stabilizing prices and, in so doing, expanded Keynes'stheory of liquidity preference considerably.
(In later years, HolbrookWorking (1953,1962) would dispute this, arguing that there was, in fact, no difference between themotivations of hedgers and speculators. This led to an early empirical race --HendrikHouthakker (1957, 1961, 1968, 1969) findingevidence in favor of normal backwardation and LesterTelser(1958, 1981) finding evidence against it.)
John BurrWilliams (1938) was among the first to challenge the"casino" view economists held of financial markets and questions of assetpricing. He argued that asset prices of financial assets reflected the"intrinsic value" of an asset, which can be measured by the discounted stream offuture expected dividends from the asset. This "fundamentalist"notion fit well with IrvingFisher's (1907, 1930)theory, and the "value-investing" approach of practitioners such as BenjaminGraham.
HarryMarkowitz (1952, 1959) realized that as the"fundamentalist" notion relied on expectations of the future, then the elementof risk must come into play and thus profitable use could be made of the newly developedexpected utility theory of Johnvon Neumann and OskarMorgenstern (1944). Markowitz formulated thetheory of optimal portfolio selection in the context of trade-offs between risk andreturn, focusing on the idea of portfolio diversification as a method of reducing risk --and thus began what has become known as "Modern Portfolio Theory" or simply MPT.
As noted, the idea of an optimal portfolio allocation had already been considered byKeynes,Hicks andKaldor in their theories of money, and thus it wasa logical step for JamesTobin (1958) to add money toMarkowitz's story and thus obtain the famous"two-fund separationtheorem". Effectively, Tobin argued that agents would diversify theirsavings between a risk-free asset (money) and asingle portfolio of risky assets(which would be the same for everyone). Different attitudes towards risk, Tobincontended, would merely result in different combinations of money and that uniqueportfolio of risky assets.
The Markowitz-Tobin theory was not very practical. Specifically, to estimate thebenefits of diversification would require that practitioners calculate the covariance ofreturns between every pair of assets. In their Capital Asset Pricing Model (CAPM),WilliamSharpe (1961, 1964) and JohnLintner (1965) solved this practical difficulty bydemonstrating that one could achieve the same result merely by calculating the covarianceof every asset with respect to a general market index. With the necessarycalculating power reduced to computing these far fewer terms ("betas"), optimalportfolio selection became computationally feasible. It was not long beforepractitioners embraced the CAPM.
The CAPM would be eventually challenged empirically in a series of papers by RichardRoll (1977, 1978). One of the alternatives offered up wasthe "intertemporal CAPM" (ICAPM) of RobertMerton(1973). Merton's approach and the assumption of rational expectations led the way tothe Cox, Ingersoll andRoss (1985) partial differentialequation for asset prices and, perhaps only a step away, Robert E.Lucas's (1978) theory of asset pricing.
A more interesting alternative was the "Arbitrage Pricing Theory" (APT) ofStephen A.Ross (1976). Stephen Ross's APT approach moved away from the risk vs. returnlogic of the CAPM, and exploited the notion of "pricing by arbitrage" to its fullestpossible extent. As Ross himself has noted, arbitrage-theoretic reasoning isnot unique to his particular theory but is in factthe underlying logic andmethodology of virtually all of finance theory. The following famousfinancial theorems illustrate Ross's point.
The famous theory ofoption pricing byFisherBlack and MyronScholes (1973) and RobertMerton (1973) relies heavily on the use of arbitragereasoning. Intuitively, if the returns from an option can be replicated by aportfolio of other assets, then the value of the option must be equal to the value of thatportfolio, or else there will be arbitrage opportunities. Arbitrage logic wasalso used by M. Harrison and David M. Kreps (1979) andDarrell J. Duffie and Chi-Fu Huang (1985) to valuemulti-period (i.e. "long-lived")securities. All this spills over into theNeo-Walrasian theories of general equilibrium with asset markets(complete and incomplete) developed by RoyRadner(1967, 1968, 1972), Oliver D.Hart (1975) and manyothers since.
The famous Modigliani-Miller theorem (or "MM") on the irrelevance ofcorporate financial structure for the value of the firm also employs arbitrage logic. This famous theorem FrancoModigliani andMerton H.Miller (1958, 1963) can actually be thoughtof as an extension of the "SeparationTheorem" originally developed by IrvingFisher(1930). Effectively, Fisher had argued that with full and efficient capital markets,the production decision of an entrepreneur-owned firm ought to be independent of theintertemporal consumption decision of the entrepreneur himself. This translatesitself into saying that the profit-maximizing production plan of the firm willnotbe affected by the borrowing/lending decisions of its owners, i.e. the production plan isindependent of the financing decision.
Modigliani-Miller extended this proposition via arbitrage logic. Viewing firms asassets, if the underlying production plans of differently-financed firms are the same,then the market value of the firms will be the same for, if not, there is an arbitrageopportunity there for the taking. Consequently, arbitrage enforces that the valueof the firms to be identical,whatever the composition of the firm's financialstructure.
Efficient Markets Hypothesis
The second important strand of work on finance was the empirical analysis of assetprices. A particularly disturbing finding was that it seemed that prices tended tofollow arandom walk. More specifically, as documented already byLouisBachelier (1900) (for commodity prices) andlater confirmed in further studies by HolbrookWorking(1934) (for a variety of price series), AlfredCowles (1933, 1937)(for American stock prices) and Maurice G.Kendall (1953) (forBritish stock and commodity prices), it seemed as there wasno correlationbetween successive price changes on asset markets.
The Working-Cowles-Kendall empirical findings were greeted with horror anddisbelief by economists. If prices are determined by the "forces of supply anddemand", then price changes should move in particular direction towards marketclearing and not randomly. Not everyone was displeased with these results,however. Many viewed them as proof that the "fundamentalist" theory wasincorrect, i.e. that financial marketsreally were wild casinos and that financewas thus not a legitimate object of economic concern. Yet others crowed that itproved the failure of traditional "statistical" methods to illuminate muchof anything. High-powered time series methods were used by CliveGranger and OskarMorgenstern(1963) and Eugene F.Fama (1965, 1970), but they cameup with the same randomness result.
The great breakthrough was due to Paul A.Samuelson(1965) and BenoitMandelbrot (1966). Far fromproving that financial markets did not work according to the laws of economics, Samuelsoninterpreted the Working-Cowles-Kendall findings as saying that they worked all toowell! The basic notion was simple: if price changes were not random (and thusforecastable), then any profit-hungry arbitrageur can easily make appropriate purchasesand sales of assets to exploit this. Samuelson and Mandelbrot thus posited thecelebrated "Efficient Market Hypothesis" (EMH): namely, if markets are workingproperly, then all public (and, in some versions, private) information regarding an assetwill be channelled immediately into its price. (note that the term "efficient",as it is used here, merely means that agents are making full use of theinformationavailable to them; it says nothing about other types of "economic efficiency",e.g. efficiency in the allocation of resources in production, etc.). If pricechanges seem random and thus unforecastable it is because investors are doing theirjobs: all arbitrage opportunities havealready been exploited to the extent towhich they can be.
The "Efficient Markets Hypothesis" was made famous by EugeneFama (1970) and later connected to the rationalexpectations hypothesis ofNew Classical macroeconomics. It did not please many practioners. "Technical" traders or"chartists" who believed they could forecast asset prices by examining thepatterns of price movements were confounded: the EMH told them that they could not"beat the market" because any available information would already beincorporated in the price. It also had the potential to annoy some fundamentalistpractioners: the idea of efficient markets rests on "information" and"beliefs", and thus does not, at least in principle, rule out the possibility ofspeculative bubbles based on rumor, wrong information and the "madness ofcrowds".
More disturbingly, the EMH has not pleased economists. EMH is probably one of the moreresiliant empirical propositions around (albeit, see Robert Shiller's (1981) critique),yet it does not seem to have a clearly sound theoretical standing. It all seems tocollapse on one particular objection: namely, that if all information isalreadycontained in prices and investors are fully rational, then not only can one not profitfrom using one's information, indeed, there might not be any trade at all! Thesepeculiar, contradictory implications of rational expectations were demonstrated by SanfordJ.Grossmanand Joseph E.Stiglitz (1980) and PaulMilgrom and NancyStokey(1982). Intuitively, the objection can be put this way (and here we areoversimplifying a bit). The efficient markets hypothesis effectively implies thatthere is "no free lunch", i.e. there are no $100 bills lying on the pavementbecause, if there were, someone would have picked them up already. Consequently,there is no point in looking down at the pavement (especially if there is a cost tolooking down). But if everyone reasons this way, no one looks down at the pavement,then any $100 bills that might be lying there willnot be picked up by anyone. But then thereare $100 bills lying on the pavement and oneshouldlook down. But then if everyone realizesthat, theywill look downand pick up the $100 bills, and thus we return to the first stage and argue that there arenot any $100 bills (and therefore no point in looking down, etc.) This circularityof reasoning is what makes the theoretical foundations of the efficient markets hypothesissomewhat shaky.
Pioneers of Finance Theory
Modern Portfolio Theory (MPT)
Arbitrage and Equilibrium Theory
Finance and the Firm
Empiricists and the Efficient Markets Hypothesis
Resources on Finance Theory
