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Financial Economics Seminar Staple Inn Hall, 16th Sept. Shane Whelan 102 Years of Financial Economics

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 Presentation

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Financial Economics SeminarStaple Inn Hall, 16th Sept.

Shane Whelan

102 Years of Financial Economics

Financial Economics SeminarStaple Inn Hall, 16th Sept.

2002

1900

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.