shane whelan
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102 Years of Financial Economics. Shane Whelan. 2002. 1900. 2002. Louis Bachelier: Theory of Speculation. 1900. 2002. Fischer Black & Myron Scholes: The Pricing of Option Contracts and Corporate Liabilities. Robert Merton: Theory of Rational Option Pricing. 1973. - PowerPoint PPT PresentationTRANSCRIPT
Financial Economics SeminarStaple Inn Hall, 16th Sept.
Shane Whelan
102 Years of Financial Economics
Financial Economics SeminarStaple Inn Hall, 16th Sept.
2002
1900 Louis Bachelier: Theory of Speculation.
Financial Economics SeminarStaple Inn Hall, 16th Sept.
2002
1973
1900
Fischer Black & Myron Scholes: The Pricing of Option Contracts and Corporate Liabilities.Robert Merton: Theory of Rational Option Pricing.
Louis Bachelier: Theory of Speculation.
Financial Economics SeminarStaple Inn Hall, 16th Sept.
2002
1973
1900
Fischer Black & Myron Scholes: The Pricing of Option Contracts and Corporate Liabilities.Robert Merton: Theory of Rational Option Pricing.
Louis Bachelier: Theory of Speculation.
1944 John von Neumann & Oskar Morgenstern: Theory of Games and Economic Behaviour.
Financial Economics SeminarStaple Inn Hall, 16th Sept.
2002
1973
1900
Fischer Black & Myron Scholes: The Pricing of Option Contracts and Corporate Liabilities.Robert Merton: Theory of Rational Option Pricing.
Louis Bachelier: Theory of Speculation.
1944 John von Neumann & Oskar Morgenstern: Theory of Games and Economic Behaviour.
Bulletin of A.M.S.: Posterity may regard this book as one of the major scientific achievements of the first half of the twentieth century.
Financial Economics SeminarStaple Inn Hall, 16th Sept.
2002
1973
1900
Fischer Black & Myron Scholes: The Pricing of Option Contracts and Corporate Liabilities.Robert Merton: Theory of Rational Option Pricing.
Louis Bachelier: Theory of Speculation.
1944 John von Neumann & Oskar Morgenstern: Theory of Games and Economic Behaviour.
Financial Economics SeminarStaple Inn Hall, 16th Sept.
2002
1973
1900
Fischer Black & Myron Scholes: The Pricing of Option Contracts and Corporate Liabilities.Robert Merton: Theory of Rational Option Pricing.
Louis Bachelier: Theory of Speculation.
1944John von Neumann & Oskar Morgenstern: Theory of Games and Economic Behaviour.
Work of Probabilists:Levy,Cramér,Wiener,Kolmogorov,Doblin,Khinchine,Feller,Itô.
Financial Economics SeminarStaple Inn Hall, 16th Sept.
2002
1973
1900
Fischer Black & Myron Scholes: The Pricing of Option Contracts and Corporate Liabilities.Robert Merton: Theory of Rational Option Pricing.
Louis Bachelier: Theory of Speculation.
Work of Probabilists:Levy,Cramér,Wiener,Kolmogorov,Doblin,Khinchine,Feller,Itô.
“Looking back it is difficult to understand why the approaches and solutions developed for today’s financial sector, which are clearly oriented towards mathematics, or to be more precise towards probability theory, did not originate from the breeding-ground of actuarial thinking.” Bühlmann, H., The Actuary: the Role and Limitations of the Profession since the Mid-19th Century. ASTIN, 27, 2, 165-171
Financial Economics SeminarStaple Inn Hall, 16th Sept.
Financial Economics: Three Prongs
Market Efficiency modelling how prices evolve in (near) efficient markets e.g., quantifying mismatch risk; probability of market
crashes
Asset Pricing factors that drive individual security prices e.g., comparative assessment of growth versus value
indicators; pricing anomalies
Corporate Finance optimum financial management of companies e.g., capital structure; dividend policy; pension fund
investment
Financial Economics SeminarStaple Inn Hall, 16th Sept.
2002
1973
1900
Fischer Black & Myron Scholes: The Pricing of Option Contracts and Corporate Liabilities.Robert Merton: Theory of Rational Option Pricing.
Louis Bachelier: Theory of Speculation.
Orthodox History
Financial Economics SeminarStaple Inn Hall, 16th Sept.
2002
1973
1900
Fischer Black & Myron Scholes: The Pricing of Option Contracts and Corporate Liabilities.Robert Merton: Theory of Rational Option Pricing.
Louis Bachelier: Theory of Speculation.
1958 Franco Modigliani & Merton Miller: The Cost of Capital, Corporation Finance and the Theory of Investments
Orthodox History
Financial Economics SeminarStaple Inn Hall, 16th Sept.
1900: Bachelier’s Theory of Speculation
‘It seems that the market, the aggregate of
speculators, at a given instant, can believe in
neither a market rise nor a market fall…’; ‘…the
mathematical expectations of the buyer and the
seller are zero’.
His research leads to a formula ‘which expresses
the likelihood of a market fluctuation’.
Brownian Motion, Wiener Process; Random Walk.
Financial Economics SeminarStaple Inn Hall, 16th Sept.
1900: Bachelier’s Theory of Speculation
Future Period
Price
Financial Economics SeminarStaple Inn Hall, 16th Sept.
Actuaries’ Role Main practical import of Bachelier’s model
– s.d. of return distribution is directly proportional to elapsed time
– “In order to get an idea of the real premium on each transaction, one must estimate the mean deviation of prices in a given time interval...the mean deviation of prices is proportional to the square root of the number of days” .
– Émile Dormoy, Journal des Actuaries Français, (1873) 2, p. 53.
Was Bachelier original ideas influenced by actuaries?– Henri Lefèvre and his diagrams?
Financial Economics SeminarStaple Inn Hall, 16th Sept.
Actuaries’ Role Text-book for French actuaries in 1908
disseminated the Bachelier model.– Alfred Barriol, Théorie et pratique des
opérations financières. Paris 1908.
Financial Economics SeminarStaple Inn Hall, 16th Sept.
Wilderness Years to 1950s Data Collection
1932 Cowles Commission for Research in Economics (Econometrica, S&P 500)
Actuaries Investment Index (Douglas, TFA XII; Murray, TFA XIII)
Little Processing/inference capability no computer; statistical testing primative, prices have
nasty statistical properties (Working (1934)). Markets seen as a ‘compleat System of Knavery’
1929 Crash Richard Whitney, President of NYSE, jailed.
Financial Economics SeminarStaple Inn Hall, 16th Sept.
Wilderness Years to 1950s
The Dividend Discount Model – V=D/(i-g)
Generally attributed to Williams (1938) but... Standard formula for actuaries
– Todhunter, The Institute of Actuaries’ Textbook on Compound Interest and Annuities Certain. 1901.
– Makeham, On the Theory of Actuaries Certain, JIA Vol. XIV 1869.
Financial Economics SeminarStaple Inn Hall, 16th Sept.
1973
1950
1952 Harry Markowitz: Portfolio Selection.
Portfolio Selection, CAPM, & Equilibrium Models
Financial Economics SeminarStaple Inn Hall, 16th Sept.
Portfolio Selection (MPT or Mean-Variance Analysis)
Define risk as standard deviation (s.d.) If, for each security, we can estimate its
expected return, its s.d., and its correlation with every other security, then we can solve for the efficient frontier.
Expected Return
Risk (s.d.)
Efficient Frontier
All Possible Portfolios
Financial Economics SeminarStaple Inn Hall, 16th Sept.
1973
1950
19521953
Harry Markowitz: Portfolio Selection.
Maurice Kendall: The Analysis of Time Series, Part I: Prices.
Portfolio Selection, CAPM, & Equilibrium Models
Financial Economics SeminarStaple Inn Hall, 16th Sept.
1973
1950
19521953
Harry Markowitz: Portfolio Selection.
Maurice Kendall: The Analysis of Time Series, Part I: Prices.
Portfolio Selection, CAPM, & Equilibrium Models
“Investors can, perhaps, make money on the Stock Exchange, but not, apparently by watching price-movements and coming in on what looks like a good thing.”
Financial Economics SeminarStaple Inn Hall, 16th Sept.
1973
1950
19521953
Harry Markowitz: Portfolio Selection.
Maurice Kendall: The Analysis of Time Series, Part I: Prices.
Portfolio Selection, CAPM, & Equilibrium Models
Financial Economics SeminarStaple Inn Hall, 16th Sept.
1973
1950
1952
1958
1953Harry Markowitz: Portfolio Selection.
Maurice Kendall: The Analysis of Time Series, Part I: Prices.
Portfolio Selection, CAPM, & Equilibrium Models
Franco Modigliani & Merton Miller: The Cost of Capital, Corporation Finance and the Theory of Investments
Financial Economics SeminarStaple Inn Hall, 16th Sept.
1973
1950
1952
1958
1953Harry Markowitz: Portfolio Selection.
Maurice Kendall: The Analysis of Time Series, Part I: Prices.
Portfolio Selection, CAPM, & Equilibrium Models
Franco Modigliani & Merton Miller: The Cost of Capital, Corporation Finance and the Theory of Investments
Financial Economics SeminarStaple Inn Hall, 16th Sept.
1973
1950
1952
1958
1953Harry Markowitz: Portfolio Selection.
Maurice Kendall: The Analysis of Time Series, Part I: Prices.
Portfolio Selection, CAPM, & Equilibrium Models
Franco Modigliani & Merton Miller: The Cost of Capital, Corporation Finance and the Theory of Investments
James Tobin: Liquidity Preference as Behavior Toward Risk.
Financial Economics SeminarStaple Inn Hall, 16th Sept.
Tobin: Unique Role of Risk-Free Asset
Separation Theorem: The proportion of a portfolio held in the risk-free asset depends on risk aversion. The composition of the risky part of the portfolio is independent of the attitude to risk.
Expected Return
Risk (s.d.)
All Possible Portfolios
Efficient Frontier
Financial Economics SeminarStaple Inn Hall, 16th Sept.
1973
1950
1952
1958
1953Harry Markowitz: Portfolio Selection.
Maurice Kendall: The Analysis of Time Series, Part I: Prices.
Portfolio Selection, CAPM, & Equilibrium Models
Franco Modigliani & Merton Miller: The Cost of Capital, Corporation Finance and the Theory of Investments
1961 Franco Modigliani & Merton Miller: Dividend Policy, Growth, and the Valuation of Shares.
Financial Economics SeminarStaple Inn Hall, 16th Sept.
1973
1950
1952
1964
1958
William Sharpe: Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.
1953Harry Markowitz: Portfolio Selection.
Maurice Kendall: The Analysis of Time Series, Part I: Prices.
Portfolio Selection, CAPM, & Equilibrium Models
Franco Modigliani & Merton Miller: The Cost of Capital, Corporation Finance and the Theory of Investments
1961 Franco Modigliani & Merton Miller: Dividend Policy, Growth, and the Valuation of Shares.
Financial Economics SeminarStaple Inn Hall, 16th Sept.
Sharpe: Equilibrium Model
Everyone has the same optimum portfolio: it is the market portfolio.
Expected Return
Risk (s.d.)
All Possible Portfolios
Efficient Frontier
Market Portfolio
Financial Economics SeminarStaple Inn Hall, 16th Sept.
Treynor-Sharpe-Lintner-Mossin CAPM
CAPM in form presented in modern textbooksE[Ri]-r = i(E[Rm]-r)where,i = Cov(Ri, Rm)/Var(Rm)
Predictions empirically testable. Does not stand up to testing –
is have less explanatory power in counting for excess returns than relative market capitalisation or price-to-book ratios. [See Hawawini & Keim (2000) for a recent review of finding.]
Financial Economics SeminarStaple Inn Hall, 16th Sept.
1973
1950
1952
1964
1958
1965
Paul Samuelson: Proof that Properly Anticipated Prices Fluctuate Randomly.
William Sharpe: Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.
1953Harry Markowitz: Portfolio Selection.
Maurice Kendall: The Analysis of Time Series, Part I: Prices.
Portfolio Selection, CAPM, & Equilibrium Models
Franco Modigliani & Merton Miller: The Cost of Capital, Corporation Finance and the Theory of Investments
1961 Franco Modigliani & Merton Miller: Dividend Policy, Growth, and the Valuation of Shares.
Financial Economics SeminarStaple Inn Hall, 16th Sept.
1973
1950
1952
1964
1958
1965
Paul Samuelson: Proof that Properly Anticipated Prices Fluctuate Randomly.
William Sharpe: Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.
1953Harry Markowitz: Portfolio Selection.
Maurice Kendall: The Analysis of Time Series, Part I: Prices.
Portfolio Selection, CAPM, & Equilibrium Models
Franco Modigliani & Merton Miller: The Cost of Capital, Corporation Finance and the Theory of Investments
Fischer Black & Myron Scholes: The Pricing of Option Contracts and Corporate Liabilities.Robert Merton: Theory of Rational Option Pricing.
1961 Franco Modigliani & Merton Miller: Dividend Policy, Growth, and the Valuation of Shares.
Financial Economics SeminarStaple Inn Hall, 16th Sept.
Option Pricing - Actuaries’ Role
Colm Fagan (1977), Maturity Guarantees under Unit-Linked Contracts.– Independently arrives at the Black-Merton-Scholes breakthrough.
Tom Collins (BAJ, Vol. 109, 1982)– The replicating strategy
“…compares unfavourably with the conventional strategy”
and that a “…disturbing reason for the poor performance of the immunization strategy was that from time to time (e.g. early in 1975) the unit price was subject to sudden large fluctuations which were inconsistent with the continuous model assumed in deriving it.”
Financial Economics SeminarStaple Inn Hall, 16th Sept.
1973: Only a beginning Option pricing
interest rate, e.g., Ho & Lee modelcapital project appraisals, e.g.,
Brennan & Schartz Empirical studies
Empirical models of asset pricingStatistical regularities in asset returnsForm of unconditional distribution
known
Financial Economics SeminarStaple Inn Hall, 16th Sept.
Can this 102 Year Old Science
Still Surprise?
Financial Economics SeminarStaple Inn Hall, 16th Sept.
102nd Year Bouman & Jacobsen (2002) investigate
“Sell in May and go away but buy back by St. Leger Day”
It works – halves the risk of equity markets but leaving return
largely unchanged In 36 out of 37 markets investigated over last decade
and three decades
Financial Economics SeminarStaple Inn Hall, 16th Sept.
Returns on 19 Major Stock Markets, 1970-1998
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
14%
16%
Austra
lia
Austri
a
Belgiu
m
Canad
a
Denm
ark
Franc
e
Germ
any
Hong K
ong
Italy
Japa
n
Nether
lands
Norway
Singa
pore
South
Afri
ca*
Spain
Sweden
Switzer
land
UK US
Average November-April Average May-October
Source: MSCI Total Return Indices, data kindly supplied by Bouman & Jacobsen
Financial Economics SeminarStaple Inn Hall, 16th Sept.
102nd Year Bouman & Jacobsen (2002) investigate
“Sell in May and go away but buy back by St. Leger Day” It works –
halves the risk of equity markets but leaving return largely unchanged
In 36 out of 37 markets investigated over last decade and three decades
It works almost everytime In small markets and large markets. In 10 out of 11 markets as far back as records allow In particular, UK market as far back as 1694 Results statistically significant
Not a result of data mining – it holds when further tested on an independent and near virgin
data set (Lucey & Whelan).
Financial Economics SeminarStaple Inn Hall, 16th Sept.
The Contribution of Actuaries
Superficially, Bühlmann not altogether correct.
Bühlmann right in a deeper more disturbing way– Did not build on knowledge or disseminate it
Are we a learning profession?– Will we recognise and seize on the next
major development in our underlying science to further our profession?
Financial Economics SeminarStaple Inn Hall, 16th Sept.
Concluding Words by Merton
“Any virtue can become a vice if taken to an extreme, and just so with the application of mathematical models in finance practice. I therefore close with an added word of caution about their use…The practitoner should therefore apply the models only tentatively, assessing their limitations carefully in each application.”
R.C. Merton, Influence of mathematical models in finance on practice: past, present and future in Mathematical Models in Finance, Chapman & Hall for The Royal Society (London), 1995.
Financial Economics SeminarStaple Inn Hall, 16th Sept.
Shane Whelan
102 Years of Financial Economics
Financial Economics SeminarStaple Inn Hall, 16th Sept.
Key References Whelan, Bowie, & Hibbert (2002)
A Primer in Financial Economics. British Actuarial Journal, Vol. 8, I.
Bernstein, P.L. (1992) Capital Ideas: The Improbable Origins of Modern Wall Street. The Free Press, New York, 340 pp.
Dimson, E. & Mussavian, M. (1998)A brief history of market efficiency. European Financial Management, Vol. 4, No. 1, 91-103.
Nobel Prize Website: www.nobel.se/
Cootner, P. (Ed) (1964) The Random Character of Stock Market Prices. MIT Press.Journal of Banking & Finance, Vol. 23.
Financial Economics SeminarStaple Inn Hall, 16th Sept.
Selected Other References Dimson, E. & Mussavian, M. (1999)
Three centuries of asset pricing. Journal of Banking & Finance, Vol. 23.
Hawawini, G. & Keim, D.B (2000)The cross section of common stock returns: a review of the evidence and some new findings. In Security Market Imperfections in World Equity Markets, Keim & Ziemba (Ed.), CUP.
Bouman, S. & Jacobsen, B. (2002)The Halloween indicator, ‘sell in May and go away’: another puzzle. Forthcoming in American Economic Review.
Lucey, B. & Whelan, S. (2001)A promising timing strategy in equity markets.Forthcoming in Journal of the Statistical & Social Inquiry Society of Ireland.