markowitz, miller, and sharpe: the first nobel laureates

Review of Quantitative Finance and Accounting, 1 (1991): 209-228 �9 1991 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.

Markowitz, Miller, and Sharpe: The First Nobel Laureates in Finance

CHENG-FEW LEE* Rutgers University, School of Business, New Brunswick, NJ 08903

1. Introduction

Three days before the Conference on Financial Economics and Accounting, held on October 19 and 20, 1990 at the School of Business, Rutgers University, New Brunswick, Three finance professors, Harry Markowitz, Merton Miller, and Wil l iam Sharpe, were awarded the Nobel Prize in Economics. This was the first time that that prestigious award was given to members of the finance community.

Because of this, as organizer of the Conference on F inanc ia l Economics a n d Account- ing, I added a special session to discuss the event. At the session, I distributed copies of the winners ' resumes to the approximately 100 well-known finance professors and professionals in attendance. Quite a few people-- including Steve Ross, Larry Fisher, Frank C. Jen, and Jack C. Francis--expressed their opinions about the contribution of these scholars. During the discussion, I invited the attendees to write something about the Nobel laureates. ~ The following is a compilation of essays submitted; they are ordered alphabetically by author's last name.

Finally, based upon the resumes of these three scholars, I have summarized and analyzed their work, the subject areas they have researched, and the journals in which their work

has been published. In closing, a brief overall summary of the views expressed is presented.

*Due to space constraints, I have only requested Professor Lawrence Fisher's comments on all three winners. In addition, I have requested Professors Frank C. Jen and Jack C. Francis to comment only on Professor Markowitz and Professor Miller, respectively.

I would like to dedicate this article to my personal and professional friends Professors Harry Markowitz, Merton Miller, and Bill Sharpe, in honor of them becoming the first Nobel Laureates in Finance on October 16, 1990. ~See appendix A for the names of the attendees and program of the conference.

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2. Remarks from finance professors and professionals

2.1. SOME REFLECTIONS ON THE CONTEXT OF THE DISCOVERIES OF MARKOWITZ, MILLER, AND SHARPE AND THEIR SIGNIFICANCE IMMEDIATELY AFTER THEY WERE MADE

LAWRENCE FISHER Graduate School of Management, Rutgers University

Introduction

Harry M. Markowitz, Merton H. Miller, and William E Sharpe have been colleagues of mine at various times during the past 35 years. Moreover, my own research was affected by Miller's and Sharpe's discoveries as soon as they became known. Hence, the occasion of the award of the Nobel Memorial Prize in Economics to them is an opportunity for renewed consideration and realization of the overwhelming significance of their work, especially in view of the state of the theory of finance at the time they made their early discoveries.

At the present time, Markowitz's, Miller's and Sharpe's discoveries are the very basis for most of our thinking about financial economics. Hence, they may now seem to be per- fectly obvious to anyone who gives the subject serious thought. However, these discoveries were made in a context in which they were not obvious at all. For their work, Markowitz and Miller had to look at the problems at hand in ways that violated the established paradigms for the consideration of risk, uncertainty, and portfolio selection. In discovering the Capital Asset Pricing Model (CAPM), Sharpe solved a series of problems that could hardly be examined fruitfully without Markowitz's and Sharpe's own earlier work.

Markowitz

The important paradigm of the 1930s and 1940s for examining the role of risk in economics was developed by Frank H. Knight (1921). It might be summarized as follows:

For centuries, the operations of insurance companies have allowed risk to be diversified away. However, returns to business ventures are uncertain. Events that are determined at least in part by chance will be called "risks" if they are subject to an objective probability distribution and "uncertainties" if the probability distribution cannot be quantified or is subjective. "Risks" [Knight believed] can, in principal, be totally diversified away; however, since their probability distributions are unknowable, "uncertainties" can only partially be diversified away. Therefore, only "uncertainties" give rise to "profits" which are windfall gains and losses. 1

Knight was a very smart man, but in his seminal work the idea of covariance is simply missing.

One finds similar ideas in the elementary discussion of insurance-company operations. Quantifiable risks could be accepted because they could be diversified away, but large general catastrophes (whether subject to known probability distribution or not) should not be insured

MARKOWITZ, MILLER, AND SHARPE 211

against because a single event could have a large adverse effect on the insurer (Hedges, 1957). Similarly, investors were often urged to diversify in every possible way.

Markowitz (1952) suggested summarizing the entire process of protfolio selection as an allocation of resources among "expected return" which is a good thing, and risk as measured by variance of return, which is a bad thing, i.e., a negative good. He showed that expected return was a straightforward average of the expected returns of the securities involved but, perhaps for the first time, pointed out that portfolio variance depended on both the variances and the covariances of the returns of the securities that were in the portfolio. In that article, Markowitz also showed explicitly how to find efficient portfolios when the choice involved three or four securities.

Markowitz's 1952 article had no immediate impact on finance. 2 Marshall D. Ketchum, the editor who chose to publish it, recalled that no one could understand it (Ketchum, c. 1985). Moreover, the computers and computer programming methods for solving practical portfolio selection problems had yet to be developed.

Finding efficient portfolios of many securities when short sales are not permitted is a quadratic programming problem, so Markowitz (1956) helped invent quadratic programming. Finding the entire set of mean-variance efficient portfolios requires solving a series of linear programming problems. Markowitz (1957) pointed out how to greatly speed up the process of solving such problems when the relevant matrix of coefficients contains only a small fraction of nonzero elements. Markowitz summarized his work to that time in his Cowles Foundation Monograph (1959). Among other things, he suggested that covariances might be estimated through taking the product of each pair of securities' regression coefficients with respect to some index (Markowitz, 1959, pp. 96-101). This monograph forms the basis for almost all current thinking about investment and portfolio management.

Miller

The paradigm about the appropriate capital structure for a corporation was apparently based on acceptance of established financial practices without seeing whether the ad hoc models that were in use were consistent with either full or partial equilibrium. To the best of my recollection, the paradigm was supported by an argument along the following lines:

Many large companies issue bonds. "Therefore," it must pay to do so. However, companies that issue too many bonds get into trouble. "Therefore," one must be careful not to issue too many bonds. Hence, the cost-of-capital function must be U-shaped, declin- ing as bonds are added to an all-equity positon but rising again after some point.

Modigliani and Miller showed that, if the relative prices of the securities issued by a firm were in equilibrium (and taxes and transaction costs were negelcted), the total market value of the firm's securities must be independent of the capital structure. Even if there were a difference, security holders could do their own lending or borrowing and offset any errors made by the management of the firm. In any case, tax deductibility of interest should make only a small difference. Miller and Modigliani (1961) showed that, under similar assumptions, dividend policy did not matter either. Modigliani and Miller (1963) agreed that the deductibility of interest paid by the firm would tend to encourage issuance of bonds;

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but Miller (1977) showed that, under full equilibrium, while there might be an optimal (i.e., tax-minimizing) capital structure for the economy as a whole, the cost of capital of any particular firm would nevertheless be independent of its capital structure.

Modigliani and Miller's (1958) article was immediately recognized as important and con- troversial? Their work, especially their first article, caused research in corporate finance to stop in its tracks. Within a few years it was clear that Modigliani and Miller (1958) had destroyed the old paradigm; research thereafter had to seek new directions. As before, there are many who are trying to understand the determinants of capital structure; however, serious researchers must build models that are in fact consistent with equilibrium conditions.

Sharpe

Sharpe made two vital contributions within a very short period. The first was his 1963 article on the single-index model, for which the research was done during the 1960-1961 academic year. Sharpe noticed that, if he applied the instrumental-variable method of estimating covariance by finding the beta of each security (Markowitz, 1959, pp. 96-101), he could transform the variance-covariance matrix to one that was sparse by adding a single row and column to it. With a matrix that contained zeros except for one row, one column, and one diagonal, Sharpe could write a new quadratic programming code that was about 100 times as fast as the code that had to be used when the matrix was not sparse.

Given the cost of computer time in the early 1960s, it then became feasible to examine the entire efficient frontier under a variety of conditions. By September 1961, Sharpe had noted that, if cash were added to the list of assets that could be included in the portfolio (see Tobin, 1958), the otherwise efficient portfolios of risky assets with expected returns that were less than that of the corner portfolio with an infinitesimal amount of cash were no longer efficient. By January 1962. Sharpe had the CAPM, which was published in 1964. 4

Through his work in operations research and computers, Sharpe made it feasible to examine the implications of many theories. The influence of the CAPM is pervasive in almost all areas of financial economics, with the possible exception of option theory. 5

Conclusion

By the early 1960s, the ideas of Markowitz, Miller, and Sharpe were affecting the MBA and doctoral curricula in finance; and by the late 1960s, their discoveries were actually receiving practical application. Now, of course, their influence is ubiquitous.

No~s

1. Knight's "profits" are economic profits, i.e., amounts above or below the expected net income of the enter- prise. In the late 1940s, accountants renamed the "Profit and Loss Statement" the "Income Statement" or "Statement of Earnings?'

2. However, by 1956 Knight's view bad come close to Markowitz's. Now, "uncertainty" was meant to distinguish "the defects of managerial knowledge from the ordinary 'risks' of business activity, which can feasibly be reduced if not eliminated by applying the insurance principal... "' (1964, p. lix, my italics).

MARKOWlTZ, MILLER, AND SHARPE 213

3. At least some were uneasy about the U-shaped curve that was put to rest by Modigliani and Miller. I taught my first corporate finance course just before their 1958 article appeared. I presented the U-shaped curve. However, when a student asked why it was U-shaped, I could not give a satisfactory answer. Hence, for me, Modigliani and Miller's (1963) rigorous analysis was welcome.

4. Lintner, Mossin, and Treynor are also given credit for independent discovery of the CAPM. Treynor wrote an unpublished paper in 1961 and therefore may have been first discoverer. Some implications of the CAPM are the basis for his method of measuring the effectiveness of portfolio managers (Treynor, 1965). In developing their versions of the CAPM, Lintner (1965) and Mossin (1966) made an extra assumption by permitting the risky assets to be sold short and the income from the cash proceeds of the short sale to rebound to the benefit of the portfolio. Hence, their models (which were influential) were overdetermined.

5. It is also interesting to note that there were others who came close to finding some of the same theories. For example, Roy (1952) suggested holding mean-variance efficient portfolios. However, his principle for selecting among the efficient portfolios (safety first) is not directly compatible with utility maximization.

References

Hedges, J. Edward, "Insurance: General Considerations," in Encyclopedia Britannica, 1957 edition, vol. 12, pp. 454-456 (1957).

Ketchum, Marshall D., personal communication (c. 1985). Knight, Frank H., Risk, Uncertainty, andProfit. Boston and New York: Houghton and Mifflin (1921). Reprinted

with Prefaces to the 1933 re-isue and the 1948 and 1957 reprints, Reprints of Economic Classics, New York: Augustus M. Kelley (1964).

Limner, John E , "The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets." Review of Economics and Statistics 47, pp. 13-37 (February 1965).

Markowitz, Harry M., "Portfolio Selection." Journal of Finance 7(1), 77-91 (March 1952). Markowitz, Harry M., "The Optimization of a Quadratic Function Subject to Linear Constraints." Naval Research

Logistics Quarterly 3, 111-133 (March/June 1956). Markowitz, Harry M., "The Elimination Form of the Inverse and Its Application to Linear Programming" Manage-

ment Science 3, 255-269 (1957). Markowitz, Harry M., Portfolio Selection: Efficient Diversification oflnvestments. New York: John Wiley &

Sons (1959) and New Haven: Yale University Press (1970). Miller, Merton H., "Debt and Taxes." Journal of Finance 32(2), 261-275 (May 1977). Miller, Merton H. and Franco Modigliani, "Dividend Policy, Growth and the Valuation of Shares." Journal of

Business 34(4), 333-364 (October 1961). Modigliani, Franco and Merton H. Miller, "The Cost of Capital, Corporation Finance, and the Theory of Invest-

ment." American Economic Review 48(3), 261-297 (June 1958). Modigliani, Franco and Merton H. Miller, "Taxes and the Cost of Capital: A Correction," American Economic

Review 53(3), 433--443 (June 1963). Mossin, Jan, "Equilibrium in a Capital Asset Market." Econometrica 34, 768-783 (October 1966). Roy, A.D., "'Safety First and the Holding of Assets." Econometrica 20, 431-449 (1952). Sharpe, Wtlliana E, "A Simplified Model for Portfolio Analysis?' Management Science 9(2), 277-293 (January 1963). Sharpe, William E, "Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk." Journal

of Finance 19(3), 425-442 (September 1964). Tobin, John, "Liquidity Preference as Behavior Towards Risk?' Review of Economic Studies 25(67), 65-86 (February

1958). Treynor, Jack L., "Toward a Theory of the Market Value of Risky Assets." Unpublished paper, Arthur D. Little

Co., Boston, MA (1961). Treynor, Jack L., "How to Rate Mutual Fund Performance?' Harvard Business Re~'ew 43, 63-75 (january/February

1965).

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2.2. SOME THOUGHTS ABOUT HARRY M. MARKOWITZ

JACK CLARK FRANCIS Baruch College

Harry Markowitz was born and grew to adulthood in Chicago, Illinois. His father owned a small retail food business on the south side of Chicago where Harry sometimes worked when he was a boy. Harry received his Bachelors degree in liberal arts in 1947, his Masters degree in Economics 1950, and his Ph.D. in Economics in 1954. All three degrees were from the University of Chicago. Milton Friedman, who won a Nobel Prize for his theory of monetary economics, was one of Harry's mentors at the University of Chicago.

In 1989 Professor Jack Clark Francis wrote, with the editorial aid of Harry Markowitz, the following Dedication to an inverstments textbook. 1

To Harry M. Markowitz-- He received his Ph.D. from the University of Chicago in 1952 and, early in his career, he laid the foundation for modem financial theory when he published "Portfolio Selection,'

During the 1950s and 1960s he did research for the Rand Corporation and the General Electric Corporation.

In the early 1960s he designed and helped develop the computer simulation language SIMSCRIPT.

He was President of the Arbitrage Management Company from 1969-1972. During the 1970s and 1980s he worked at the IBM Corporation's T.J. Watson Research

Center. He was the recipient of the 1989 John von Neumann Theory Prize awarded by

ORSA/TIMS. I first became acquainted with Harry Markowitz as a graduate student during the late

1960s when I studied portfolio theory and SIMSCRIPT. In the early 1970s I had the privilege of becoming his faculty colleague at the Wharton

School. During the 1980s I had the privilege of becoming a faculty colleague of his again--at

Baruch College. In 19891 was a Student in his Measure Theory seminar for doctoral students at Baruch

College. I was again his Student in a Stochastic Calculus seminar for doctoral students at Baruch

College in 1990. Over the years I have known him, he has been an outstanding scholar, a fine teacher,

and a channing person.

The Dedication above provides a synopsis of Harry Markowtiz's professional career. How- ever, Jack Francis can supply some additional insights because he is a long-time student and friend of Harry Markowitz.

Mathematician is a word that would characterize Harry Markowitz more accurately than the phrase financial economist. Furthermore, Harry is a top-flight computer scientist. These observations are not meant to deny the fact that Harry is an outstanding financial economist.


Rather, they are reflective of what Jack Francis believes to be Harry Markowitz's self-image and personal priorities.

Harry Markowitz is very proud, for example, of the John von Neumann Theory Prize he was awarded in May of 1989 by the Operations Research Society of America and The Institute of Management Science (ORSA/TIMS). That award was for Harry's ground break- ing in three areas: portfolio selection, mathematical progranlming, and computer simulation.

Also of interest is the fact that Harry was the President of the Arbitrage Management Company from 1969-1972. Harry Markowitz was using arbitrage to trade the securities markets before the name Steve Ross or the phrase Arbitrage Pricing Theory was known.

Finally, it should be noted that Nobel laureate William Sharpe was Harry Markowitz's Ph.D. student. While working at the Rand Corporation, Harry Markowitz was on William Sharpe's Ph.D. dissertation committee at UCLA. Sharpe's dissertation provided some initial development of the beta coefficient and explicated the Single-Index model. 2 The earliest reference to these concepts can be found at footnote 1 on page 100 of Markowitz's 1959 book entitled Portfolio Selection?

In summary, Harry Markowitz is the father of modern portfolio theory and one of the great leaders of our time.

No~s

1. Francis, Jack C., Investments: Analysis and Mangement. New York: McGraw-Hill, Inc., 1991. 2. The essence of Sharpe's dissertation was published. See Sharpe, W.E, "A Simplified Model For Portfolio

Analysis" Management Science (January 1963). 3. Markowitz, Harry M., Portfolio Selection. Cowles Foundation Monograph 16. New York: John Wiley & Sons,

Inc., 1959.

2.3. FROM INTELLECTUAL WAVE TO NOBEL LAUREATE

JEAN L. HECK Villanova University

PHILIP L. COOLEY Trinity University

The awarding of the 1990 Nobel Prize in Economics to Harry Markowitz, Merton Miller, and William Sharpe truly represents the high-water mark in the stream of contributions from financial economics. The prize is the consummate achievement in the field and recog- nizes what all financial economists have long known, namely, that the recipients' contributions shaped the direction and scope of the field.

To best appreciate the impact these honorees have had on finance consider the words of Gordon Donaldson in his 1977 FMA presidential address: 1

Each decade, if we are lucky, there are one or two major innovations in the development of thought followed by a prodigious amount of secondary and tertiary effort to test and consolidate the implications of these ideas. Most academicians are like surfers who, with their shiny new doctoral surfboards tucked under them, paddle out in search of

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an intellectual wave created by a force outside themselves and who, with a host of others, will proceed to mount and ride the crest until the wave loses its energy and breaks as a gentle ripple on the shore of established thought.

The contributions of Professors Markowitz, Miller, and Sharpe represent intellectual waves of tidal proportions that have shaped the direction of finance and supported thousands of academic surfers on waves that have still not come ashore after more than a quarter century.

In our study published in Financial Management in 1981, academicians from across the country were asked to select the articles that they believed represented the most significant contributions ever made to the finance literature. 2 Not surprisingly, the celebrated works of the three Nobel laureates were ranked as the number one, two, and three most significant articles ever to appear in the literature. Among the criteria given by the respondents in that study for determining the most significant articles, the majority considered "changed direction of the finance field" and "theoretical or empirical breakthrough" the most important determinants. Clearly the contributions of the newest Nobel laureates epitomize these criteria. Much to the pleasure of finance academicians worldwide, the Nobel Committee has recognized what the "efficient market" in finance literature recognized decades ago.

NoWs

1. See Donaldson, Gordon, "Making Intellectual Waves" Financial Management 6(4), 7-10 (1977). 2. See Cooley, Philip and J. Louis Heck, "Significant Contributions to Finance Literature." Financial Mangement

10(2), 23-33 (1981).

2.4. MERTON H. MILLER, CO-WINNER, 1990 NOBEL LAUREATES IN ECONOMICS

FRANK JEN SUNY at Buffalo

I am very pleased to have the opportunity to write a note for The Review celebrating the winning of the 1990 Nobel Prize for Merton H. Miller.

Miller's scholarly achievement is well known. His well-known leverage and dividend irrelevance theorems presented in the articles cited by the Nobel Prize Selection Committee forced the profession to identify the source of market imperfections to justify the way the decision makers appeared to behave in both debt and dividend policies. This has led to the identification of such important factors as direct and indirect bankruptcy cost, asymmetric information, managerial agency cost, stockholder-debtholder conflicts, etc. as factors affecting both debt and dividend policies. Indeed, because of Miller's original propositions, the profession became more articulate and precise in both theoretical and empirical work in the area. Further, Miller himself participated in the development of such literature. ~

In addition to Miller's contribution in debt and dividend policies, his article with Daniel Orr on cash management is also well known. 2 Recently he shifted his attention to study how such activities as margin regulation liquidity and index arbitrage affect characteristics of returns of stocks, futures, and options? In addition, he is helping various countries to analyze how their capital markets should be regulated. I believe, therefore, that the finance profession is indeed fortunate to claim Miller as a member. Further, I believe all of us


in the profession are looking forward to his continuing contributions to the profession and to the area of finance.

Finally, Mil ler is known to be generous with his time and ideas to his colleagues and

students at the University of Chicago. In addition, he is also known to be generous to the junior faculty and Ph.D. students in other universities. In this connection, I would like to acknowledge that past Ph.D. graduates from the State University of New York at Buffalo have benefited significantly from their associations with Miller. Example of these students include E. Han Kim, Stanley Kon, and Cheng F. Lee. Indeed, Miller 's scholarly achieve-

ment and his generous attitude toward other members in the profession lead me to believe that he should be called a "professor 's professor."

N o ~ s

1. Additional selected important articles by Miller about capital structure and dividends include "Some Estimates of the Cost of Capital in the Electric Utility Industry" (with E Modigliani). American Economic Review 56, 333-391 (June 1966); "Debt and Taxes?' 1976 Presidential Address of the American Finance Association, Journal of Finance 32(2), 261-275 (May 1977); "Dividend and Taxes" (with Myron Scholes). Journal of Financial Economics 6(4), 333-364 (December 1978); and "Dividend Policy Under Asymmetric Information" (with Kevin Rock). Journal of Finance 40(4), 1031-1051 (September 1985).

2. Merton Miller and Daniel Orr, "The Demand of Money by Firms: Extensions of Analytical Results." Journal of Finance 23(5), 735-759 (December 1968).

3. See for example, "Margin Regulation and Stock Market Volatility?' Journal of Finance 45(1), 3-29 (March 1990); "Liquidity and Market Structure." Journal of Finance, (July 1988); "Index, Arbitrage and Volatility." Financial Analyst Journal 43(3), 617-633 (1990).

2.5. M Y EXPERIENCE WITH THE PRESS THE DAY THAT THE NOBEL PRIZES FOR

HARRY M. MARKOWITZ, MERTON H. MILLER, AND WILLIAM E SHARPE

BRUCE N. L E H M A N N Graduate School o f Business, Columbia University

I do not have a really good story illustrating the intellectual generosity of the three Nobel laureates in finance, nor am I old enough to describe first-hand their extraordinary intellectual impact. However, my experience with the press on Tuesday, October 16 illustrates the bril- liance and simplicity of their intellectual insights.

I received roughly half a dozen calls from reporters on October 16. The last four all

asked me the same question: "How come they gave Nobel Prizes to guys who simply said "Don' t put all your eggs in one basket?" I thought about this a little bit and gave a simple answer. "Everybody knows that you shouldn't put all your eggs in one basket, but how many eggs should you put in each basket? Bill SHarpe described what happens to egg- basket prices when investors do their best at egg placement. Merton Mil ler explained that the value of all the baskets taken together is not affected by how many baskets are created by business firms." I then went on to describe the relations between eggs, baskets, and security markets.

Simplicity is the hallmark of great science. It seems to me that this story illustrates the great simplicity of the intellectual insights of Harry Markowitz, Merton Miller, and William Sharpe. These insights placed the analysis of capital markets and corporate finance on a

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scientific footing, and the much deserved receipt of the Nobel Award in Economics by Professors Markowitz, Miller, and Sharpe enhances the intellectual respectability of the field of finance.

2.6 ON FATHER'S DAY IN FINANCE

RONALD L. MOY St. John's University

October 16, 1990 will be remembered by the finance community as Father's Day in Finance. On that day, the Nobel Prize Committee decided to honor three of the founding fathers in finance, Harry Markowitz, William E Sharpe, and Merton Miller.

Perhaps the most important test of a father's greatness is how and where he leads the next generation. If this is true, then these three scholars certainly deserve to be called the fathers of finance. The lessons they taught have and will continue to lead generations of academics and practitioners in the field of finance.

Harry Markowitz, the father of modern portfolio theory, created a generation of security analysts devoted to systematically analyzing the benefits of diversification through the use of mean-variance analysis. The wisdom provided by Markowitz not only leads those generation that have chosen to follow in his footsteps in academic research but also business school students everywhere. Undergraduate students of business have Harry Markowitz to thank (or blame) for the statistical analyses that so encompass the study of finance.

William F. Sharpe, the father of the single index model and father of the capital asset pricing model, like a son following in his father's footsteps, took Markowitz's work to new heights. By introducing the single-index model and the captial asset pricing model, Sharpe operationalized portfolio theory and fathered a new generation of analysts devoted to using the beta or systematic risk of the firm in security analysis. This generation carried these lessons from the academic world into the real world of securities analysis.

Merton Miller, along with 1985 Nobel Prize Winner Franco Modigliani, the father of modern finance theory, is perhaps the most prolific of these founding fathers. Although the well-known Modigliani-Miller Theorem dealt with the capital structure of the firm and later with dividend policy, its use of the principle of arbitrage has produced more offspring than any other principle in finance. Among its distinguished offspring are perhaps the future Nobel-Prize-winning option pricing model of Black and Scholes and the arbitrage pricing theory of Ross.

On this historic day in finance, we the next generation would like to wish these distinguished gentlemen and scholars a happy father's day.

2.7. COMMENTS ON MERTON MILLER

TODD E. PETZEL Chicago Mercantile Exchange

You may have noted that a pool of economists prior to the award had Gary Becker a 4-1 favorite. Merton was ranked, but in horse-racing jargon you would have said he was with the field, not one of the favorites.


Personally, I was in a win/win situation. As someone who went through the Labor/Human Capital field at Chicago with Ted Shultz and Gary Becker, having the favorite win would have fulfilled a longstanding personal wish. But I also have had the distinct honor and pleasure of working with Merton Miller and learning what a wonderful scholar and gentle- man he is. As a public governor of the Chicago Mercantile Exchange, Merton is one of my bosses, and since I 've become a part-time instructor of Finance at the University of Chicago, he is also a colleague. In both roles he is generous, thoughtful, and dedicated to quality.

There is no need to recite his extensive list of finance contributions. The Nobel Prize Committee has chosen these men whose works form the core of modern finance theory. There isn't a person in this room whose professional development hasn't been shaped pro- foundly by Miller's contributions.

What may be more instructive in a set of brief comments are some thoughts about the man himself. When he spoke of the award on Tuesday, he said that "this is an honor to business schools and finance. It shows we're finally accepted in the mother church of economics." This certainly reflects his genuine feelings because he takes great pride in the contributions made by finance practitioners.

He has a fundamental trust in markets and is suspicious of those who would put barriers up to restrict them, but he is always open to the views of practitioners. This is most clearly seen in his treatment of "coordinated circuit breakers" that put price limits or trading halts on stocks, stock options, and futures. I think it would be fair to say that prior to their crea- tion he was strongly opposed to them. Like most academics who believe in markets, he views trading halts or market closes as an admission of defeat, that the mechanism has somehow failed. But Merton has not closed his mind on the subject, unlike some economists who know what's right and don't wish to be confused by the facts.

Merton looks at circuit breakers as another research opportunity. He anxiously seeks out the behavior that is produced in such a world, and then tries to explain what features of the program produce that behavior. At this point it is clear that closing the Hong Kong market for a week is not an effective circuit breaker, while a half-hour price limit on the S&P 500 doesn't seem too bad. But there is much in between we don't know, and Merton Miller views this as just another academic challenge.

2.8. ON MILLER'S CONTRIBUTIONS

GILI YEN National Central University, Taiwan

At the panel discussion at the Conference on Financial Economics and Accounting on October 19, 1990 (see appendix A), Stephen Ross made a comparison between Miller's and Arrow's contributions. He said that similar to Kenneth Arrow's impossibility theorem, Modigliani and Miller (1958) show that under a set of restrictive assumptions an optimal capital structure does not exist. This is a very illuminating analogy. Nonetheless, I think differences as well as similarities should be recognized. By relaxing assumption(s) as envi- sioned originally by Modigliani and Miller, scholars in the follow-up studies are able to identify determinants of the optimal capital structure. In contrast, we won't be able to do

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something like that in the case of Arrow's Impossibility Theorem. Simply put, Arrow's theorem illustrates that, unless members of a society are willing to accept a benevolent dictator, no social concensus can be reached.

At this juncture, I would also like to take issue with Holstrom and Tirole's evaluation on Modigliani and Miller's works. In their joint article entitled "The Theory of the Firm," Holmstrom and Tirole (1989) have written: "Work on the capital structure of the firm was paralyzed for two decades upon discovery of Modigliani and Miller's (1958, 1963) famous irrelevance propositions." (See R. Schmalensee and R.D. Willing (1989), eds., Handbook of Industrial Organization, Vol. 1, p. 78). In my opinion, Modigliani and Miller's seminal analytic article should be viewed as a point of departure as to why an optimal capital structure exists. Viewed from such a perspective, their powerful insights stimulate rather than hamper scholarly endeavor in investigating capital-structure related issues.

3. Summary

The opinions expressed here and at the Conference on Financial Economics and Account- ing (see appendix A) provide evidence of the broad and far-reaching impact that the works of Markowitz, Miller, and Sharpe have had in financial economics.

Scholars in the field of corporate finance know well the importance of Merton Miller's work with Franco Modigliani to research in the area of corporate finance. As Frank Jen noted above, the importance of the Modigliani-Miller theorems stimulated research not only in the areas of optimal capital structure but also in the study of bankruptcy costs, asymmetric information, and agency costs. Others, both here and elsewhere, have noted the impact of the Markowitz-Miller approach in areas outside of corporate finance, such as the valuation of options and futures and in the derivation of the arbitrage pricing model.

The works of Markowitz and Sharpe have also had an important impact in areas outside of investments and portfolio analysis. For instance, cost-of-capital estimates still incorporate the concept of systematic risk that so encompasses the works of Markowitz and Sharpe. In addition, the portfolio-selection model of Markowitz can be used to understand how corporations can reduce business risk by diversifying into other lines of business. Finally, Markowitz and Sharpe have made important contributions in the areas of computer programming and quadratic programming.

The opinions expressed here and elsewhere show the diverse impact that the works of these scholars have had in all areas of finance. While researchers working in the area of corporate finance are well aware of the contributions that Miller has had in their research, those working in options, futures, and asset pricing also owe a great debt to the works of Miller. In the areas of investment and portfolio analysis, the contributions of Markowitz and Sharpe are well recognized. However, scholars and practioners in corporate finance also owe a debt to Markowitz and Sharpe. In order to provide some indication as to the diversity of works of Markowitz, Miller, and Sharpe, a list of the journals where they have published (based on their resumes as of October 1990) is given in appendix B.

From this appendix, we can see that the works of these scholars have reached a broad and truely diverse audience. If the true test of a scholar's greatness is how long his work endures and how much discussion his work stimulates, then Harry Markowitz, Merton Miller, and Bill Sharpe serve as fitting choices for the first Nobel Prizes awarded to researchers in finance.


Appendix A. Program of Conference on Financial Economics and Accounting, October 19 and 20, 1990, School of Business, Janice H. Levin Building, Rutgers University, New Brunswick

OBJECTIVES

This conference will discuss different aspects of financial, economic and accounting theories and their practical applications. The conference will explore the use of different quantitative techniques in solving real world financial problems for academicians, financial analysists and accountants. Finally, this conference will also provide a forum for scholars in different fields to discuss the interaction of financial, economic and accounting theories.

This is the first time in North America that well-known scholars and corporate executives in finance, accounting and economics will join together to discuss the interdisciplinary issues related to finance, accounting, and economics.

PROGRAM COMMITTEE

Program Director: Cheng-few Lee, School of Business, Rutgers University Associate Director: Bikki Jaggi, School of Business, Rutgers University

Committee Members: Victor Bernard, Univeristy of Michigan Edwin Burmeister, University of Virginia Vihang Errunza, McGill University Jack Clark Francis, Baruch College Frank C. Jen, SUNY at Buffalo Kose John, New York University Richard Kihlstrom, University of Pennsylvania E. Han Kim, University of Michigan Kenneth Lawrence, Rutgers University James C. McKeown, Pennsylvania State University Todd Petzel. Chicago Mercantile Exchange Robert E. Verrecchia, University of Pennsylvania

SPONSORS

Center for Management Development, Rutgers University Chicago Mercantile Exchange Dun & Bradstreet Treasury Management Association of New Jersey New Jersey Center for Research in Financial Services, Graduate School Management,

Rutgers University School of Business--New Brunswick, Rutgers University

PROGRAM

October 19, 1990

8:00- 8:45 Registration

222 CHENG-FEW LEE

8:45- 9:20

9:20-11:40

Opening Remarks: T. Alexander Pond Executive Vice President, Rutgers University

Paul L. Leath Provost, Rutgers University

Professor Cheng-few Lee, Rutgers University Program Director

1) APT and Asset Pricing: Theory and Application Session Chair: Edwin Burmeister, Duke University and the University

of Virginia

Fundamentals and Stock Prices in Japan, Yasushi Hamao, UC at San Diego

Global Asset Pricing, Stephen J. Brown, New York University, and Toshiyuki Otsuki, International University, Japan

On the Estimation of Beta-Pricing Models, Jay Shanken, University of Rochester

Pricing Implications of an Unconditional Factor Structure in Security Returns, Bruce N. Lehmann, Columbia University

Discussants: Edwin Burmeister, University of Virginia Yasushi Hamao, UC at San Diego Bruce N. Lehmann, Columbia University Stephen J. Brown, New York University

2) Capital Budgeting and Investment Decision Session Chair: Ken Lawrence, Rutgers University

Optimality of "Cut Across The Board" Rule for Constrained Optimiza- tion Problems With An Application To An Inventory Model, Meir J. Rosenblatt, Technion-Israel Institute of Technology and Washington University, and Uriel G. Rothblum, Technion-Israel Institute of Tech- nology and Rutgers University

Estimating Divisional Cost of Capital With Diversified Firm Data, Robert A. Wood and Thomas H. Mclnish, Memphis State University, and Kenneth D. Lawrence, Rutgers University

Portfolio Selection With Skewness: A Multiple Objective Approach, Tsong-Yue Lai, Kansas State University

Capital Budgeting and Investment Decision: A Look at Implications in an Efficient Market, John Guerard, Daiwa Securities Trust Com- pany, and Kenneth D. Lawrence, Rutgers University


11:40- 1:00

1:00- 3:20

Discussants: Ronald Armstrong, Rutgers University Ronald Moy, St. John's University Russell P. Boisjoly, Fairfield University Ivan Brick, Rutgers University

Lunch/Informal Session Markowitz, Miller and Sharpe: The First Nobel Laureates in Finance, Jack C. Francis, CUNY-Baruch College, Frank C. Jen, SUNY at Buffalo, and Cheng E Lee, Rutgers University

3) Options and Futures: Theory and Application Session Chair: Todd Petzel, Chicago Mercantile Exchange

Evaluating the Performance of the Protective Put Strategy, Stephen Figlewski and Nemmara Chidambaran, New York University, and Scott Kaplan, Citibank

The Poisson Jump-Diffusion Model for Options of Stocks: Small Sam- ple Properties of Maximum Likelihood and Characteristic Function Estimators, Mitchell B. Stern, University of Virginia

Futures, Forwards, Options and the Equivalent Martingale Measure, Stephen E. Satchell, Trinity College, Richard C. Stapleton, University of Lancaster, and Marti G. Subrahmanyam, New York University

Closed Form Solutions for Bond Futures and Options on Bond Futures, Ren-Raw Chen, Rutgers University

Discussants: Todd Petzel, Chicago Mercantile Exchange Stanley Kon, University of Michigan Susan T. Cheng, Columbia University P.V. Viswanath, Rutgers University

4) Financial Analysis and Analytical Finance Session Chair: Jack Clark Francis, Baruch College

The Effect of Information Releases on the Pricing and Timing of Equity Issues: Theory and Evidence, Robert Korajczyk, Deborah J. Lucas and Robert L. McDonald, Northwestern University

Arbitrage-Free Evaluation of the Quality Option in Treasury Bond Futures, Gregory Habeeb and Joanne M. Hill, Paine Webber

Treasury Interface with Accounting Information, Basil P. Mavrovitis, Treasury Mangement Association of New Jersey

The Performance of Mutual Fund Investment Advisors, Ravi Shukla, SUNY at Brock Port, and Charles Trzcinka, SUNY at Buffalo

224 CHENG-FEW LEE

3:20- 3:35

3:35- 5:50

6:00- 7:00

7:00- 8:30

Discussants: Jack Clark Francis, Baruch College Anthony Tessitore, Rutgers University Paul Zarowin, New York University John Guerard, Daiwa Securities Trust Co.

Break

5) Financial Contracting and Agency Cost Session Chair: Elazar Berkovitch, University of Michigan

Market Timing and Financing Decision, Elazar Berkovitch and M.T. Narayanan, University of Michigan

Financial Contracting: An Analysis of Reset Notes and Rating Sensi- tive Notes, Joseph P. Ogden and Taegoo Moon, SUNY at Buffalo

Multiperiod Environments and the Strategic Use of Financial and Con- tractual Commitments, S. Avri Ravid, Rutgers University, and Matthew Spiegel, Columbia University

Discussants: Matthew Spiegel, Columbia University Nusret Cakici, Rutgers University John L. Teall, Fordham University

6) Research Methods in Accounting and Finance Session Chair: Victor Bernard, University of Michigan

Finite Sample Properties of Methods of Moments in Latent Variable Tests of Asset Pricing Models, Wayne E. Ferson, University of Chicago, and Stephen R. Foerster, University of Western Ontario

Structural Decomposition of Time Series with Applications in Eco- nomics, Finance and Accounting, Paul Newbold, University of Illinois

A Jump-Diffusion Model for Event Tests, Mahendrarajah Nimalendran, University of Michigan

On Unit Root Tests of Empirical Models for Accounting and Finance Research, Chihwa Kao and Chunchi Wu, Syracuse University, and Cheng E Lee, Rutgers University

Discussants: Choon-Geol Moon, Rutgers University Jack, C. Lee, Bell Communications Research Wayne Ferson, University of Chicago James McKeown, Pennsylvania State University

Cocktail Hour

Dinner

Introduction of Keynote Speaker by Arthur Kraft, Dean, School of Business, Rutgers University


October 20, 1990

8:00- 8:30

8:30-10:30

10:30-10:45

10:45-12:45

Keynote Speaker: Stephen Ross, Yale University Topic: Financial Innovation and Financial Regulation

Registration

7) Financial Accounting Session Chair: James McKeown, Pennsylvania State University

Evidence That Stock Prices do not Fully Reflect the Implications of Current Earnings for Future Earnings, Victor Bernard, University of Michigan, and Jacob K. Thomas, Columbia University

The Long-Horizon Properties of Annual Earnings: An Analysis of Per- sistence and Valuation, Robert Lipe and Roger Kormendi, University of Michigan

Price-Earnings and Price-to-Book Anomalies: Tests of an Intrinsic Value Explanation, Patricia M. Fairfield, Georgetown University, and Trevor S. Harris, Columbia University

Discussants: Mark Grinblatt, UCLA Mike Stein, Rutgers University Kevin Chen, Rutgers University

8) Information and Market Structure Session Chair: Richard Kihlstrom, University of Pennsylvania

Financing Losers in Competitive Markets, Andrew Abel and George Mailath, University of Pennsylvania

Exchange and Production Efficiency in an Economy with Collective and Individual Risks, Arthur E Moreau and C.W. Sealey, McGill University

Managerial Incentive and Diversification, Richard Kihlstrom, Univer- sity of Pennsylvania, and Steven A. Matthews, Northwestern University

Market Making Systems, Asymmetric Information and Welfare, Larry Glosten, Columbia University

Discussants: Gikas Hardouvelis, Rutgers University Kose John, New York University B. Douglas Bernheim, Princeton University S. Nagarajan, New York University

Break

9) Signaling Theory: Theory and Application Session Chair: Kose John, New York University

226 CHENG-FEW LEE

12:45- 2:45

2:45- 4:45

Tax Policy and the Dividend Puzzle, B. Douglas Bernheim, Princeton University

Convertible Calls and Corporate Taxes under Asymmetric Informa- tion, Yong O. Kim, Rutgers University and Jarl Kallberg, New York University

Loan Commitments, Investment Decisions and the Signaling Equilib- rium, Jin-Chuan Duan and Suk Heun Yoon, McGill University

Discussants: Gur Huberman, Columbia University Masako Darrough, Columbia University Gregory E Udell, New York University

10) International Finance Session Chair: Vihang Errunza, McGill University

Mean Reversion in the Real Exchange Rate: Evidence from Equities Prices, Richard Sweeney, Georgetown University

International Asset Pricing and Barriers to Investment Flows: A Generalized Framework, Prasad Padmanabhan, Pennsylvania State University

International Market Segmentation and the Corporate Borrowing Deci- sion, Stavros Thomadakis, Baruch College, and Nilufer Usmen, Rutgers University

Stein & CAPM Estimators of the Means in Portfolio Choice: A Case of Unsuccess, Robert Grauer, Simon Fraser University, and Nils H. Hakansson, UC at Berkeley

Discussants: Philippe Jorion, Columbia University James Bicksler, Rutgers University S. Nagarajan, McGill University Dennis Logue, Dartmouth College

Lunch

Introduction of Keynote Speaker by Professor Bikki Jaggi, Associate Program Director

Keynote Speaker: John Y. Campbell, Princeton University Topic: A Variance Decomposition for Stock Returns

11) The Role of Information in Accounting Theory Session Chair: Robert E. Verrecchia, University of Pennsylvania

The Impact of Disclosure on the Incentive Properties of Share Prices, Robert Bushman and Raffi Indjejikian, University of Chicago


4:45- 5:15

Private Acquisition of Information and Firms' Disclosure Policies, Oliver Kim, UCLA

Bond Ratings, Bond Yields and Financial Information, David A. Ziebart, University of Illinois at Urbana-Champaign, and Sara A. Reiter, SUNY at Binghamton

Discussants: Robert E. Verrecchia, University of Pennsylvania Joshua Ronen, New York University Yaw Mensa, Rutgers University

12) Capital Structure: Theory and Evidence Session Chair: Frank C. Jen, SUNY at Buffalo

Capital Structure and Compensation: Theory and Evidence, Sreenivas Kamma, Indiana Univeristy, and Frank C. Jen, SUNY at Buffalo

Asymmetric Information and Capital Strucutre, Gili Yen and Eva C. Yen, National Central University, Taiwan, and Cheng E Lee, Rutgers University

Limited Liability, Tax Deductibility of Corporate Debt and Public Policy, Kose John, New York University, and Lemma W. Senbet, Uni- versity of Maryland

Discussants: Charles Jacklin, Stanford University Dilip Ghosh, Rider College Oded Palmon, Rutgers University

Meeting of Program Committee Members

Appendix B. Publication journals of Markowitz, Miller, and Sharpe (as of October 1990)

Harry Markowitz

Journal of Finance 5 Journal of Political Economy 1 National Bureau of Standards 1 Naval Research Logistics 1 Econometrica 1 Management Science 2 IBM Systems Journal 2

Financial Analysts Journal 1 American Economic Review 1 ACM Transactions on Database

Systems 1 Journal of Portfolio Management 1 IEEE Transactions on Software

Engineering 1

Merton Miller

American Economic Review Public Finance Southern Economics Journal

National Tax Journal 1 Management Science 1 Naval Research Logistics Quarterly 1

228 CHENG-FEW LEE

Journal of Business 7 Quarterly Journal of Economics 2 Studii Economici 1 Journal of Finance 8 Econometrica 1 Law and Contemporary Policy 1

William E Sharpe

Naval Research Logistics Quarterly 1 University of Washington Business

Review 2 Quarterly Review of Economics and

Business 1 Journal of Finance 11 Datamation 1 Journal of Business 2 Management Science 3 Journal of Financial and Quantitative

Analysis 4 American Economic Review 1 Financial Analysts Journal 11 Journal of the Midwest Finance

Association 1

Journal of Monetary Economics 1 Journal of Financial Economics 1 Journal of PorOColio Management 2 Journal of Futures Markets 1 Journal of Financial and Quantitative

Analysis 1

Journal of Portfolio Management 4 Revista Brasileirade Mercado de

Capitais 1 Bedriffskude Tydschriff voor Modern

Management 1 Journal of Financial Economics 1 Financial Management 1 Japanese Security Analysts Journal 2 0 Merdado de Capitais e a Estrura

Empresarial Brasiliera 1 PC Magazine 1 PC Tech Journal 1 Investment Management Review 1 Behavioral Science 1

markowitz, miller, and sharpe: the first nobel laureates

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