Investment Science

Author: Robert C. Merton
Publisher:
Publish Date: 2005-03-01
Features: Whether for researchers or practitioners, the field of finance is a worthwhile adventure. The Nobel Prize in Economics has continuously favored the outstanding figures in this field; governments, businesses, and households have come to recognize that the financial system constitutes the heart of the entire economic system. Citizens of poor countries are gradually accepting investment knowledge beyond traditional savings thinking, and stocks and bonds are no longer the exclusive domain of developed capitalist countries. Following the pace of economic globalization, residents of underdeveloped countries have begun to choose financial products from star companies alongside residents of developed countries and have become owners of these companies. However, the complexity of financial products and the inherent speculative nature of financial markets do not just bring excitement. When one's wealth evaporates like steam in a short period of time, finance seems to be closely intertwined with the devil. Even today, people are still discussing events such as the Mississippi Bubble, the Tulip Bubble, and the South China Sea Bubble, while the Great Crisis of the 1930s remains a lingering shadow in the minds of many.
If in such a world, the returns of various financial products could be estimated through probability, and by collecting and processing historical data, one could infer the return variance and standard deviation of a financial product, then investors could use precise mathematical tools to calculate an investment portfolio that meets their requirements, achieving maximum returns under the same level of risk or minimum risk under the same level of returns. If this were true, investors could make decisions in an uncertain world similar to those in a certain condition, thereby avoiding bubbles in financial markets and crises in the financial system. In the 1950s, some representative scholars paid attention to the importance of rational decision-making by investors both theoretically and empirically. First, Arrow, through his research on insurance and risk, particularly through the study of contingent securities in the general equilibrium framework, found that as long as corresponding clauses are designed for every potential future possibility, an "Arrow Security" can be constructed to ensure the general equilibrium of the economy. However, Arrow also noted that rational decision-making by investors depends on certain information conditions, and if these conditions are not met, the contract arrangements for financial products may be incomplete, leading to "moral hazard" issues in the insurance industry. These views had a significant impact on the development of later financial theory.
Second, Harry Markowitz, in the 1950s, developed the mean-variance model using statistical techniques, which was widely used in practical asset portfolio decisions. Markowitz's approach can be traced back to figures such as Bernoulli (1738) and Fisher (1930), the former of whom examined probability and gambling problems, i.e., decision-making under uncertainty, while the latter studied interest theory. These early theories laid a solid foundation for later financial product valuation techniques and the development of financial engineering disciplines. However, it was Markowitz who systematically described the possible behavior of investors in financial markets using the language of mathematical statistics. Although his research did not become the foundation of financial economics at the time, it became widely popular on Wall Street and served as a technical basis for investment decisions by many investors.
Later, Modigliani and Miller also began to focus on the supply of securities in financial markets in the 1950s. They adopted the standard microeconomic equilibrium analysis method, attempting to derive the supply curve of securities based on the financing cost-benefit decisions of companies under the assumption of perfect competition in financial markets. However, this purpose is rarely concerned with now, mainly because their conclusions are famous for the "MM Theorem," and the underlying supply curve of securities has been overlooked. The MM Theorem states that under certain assumptions, the capital structure choice of a company cannot create value for the company. This conclusion laid the framework for modern corporate finance theory, as it provided a basic structure for analyzing complex corporate financial activities, similar to the role of a perfectly competitive market in economics.
Building on the achievements of the aforementioned scholars, Sharpe, Lintner, and others developed the Capital Asset Pricing Model (CAPM) in the 1960s based on Markowitz's work. Ross and others further developed the Arbitrage Pricing Theory (APT), establishing the theoretical framework for studying the prices of capital markets. Fama and others proposed the Efficient Market Hypothesis (EMH) in the 1970s and provided an empirical research approach for the movement patterns of financial market prices. Black, Scholes, and Merton, among others, developed pricing models for financial products in the 1970s based on the MM Theorem and the CAPM, which were widely used in practice, leading to the innovation of a large number of financial products.
On the other hand, Arrow's early research was. In the 1970s and 1980s, a large number of game theory and information economics models were used to analyze financial markets, such as Ross, Grossman, Prescott, Stiglitz, Leland, Brennan, Jensen, Hart, Harrison, Kreps, Bhattacherya, and others. These scholars viewed financial products as contracts, and if the information of the parties was asymmetric, it could lead to incomplete contracts, resulting in adverse selection and moral hazard problems, which in turn led to inefficient allocation of resources in financial markets. To improve resource allocation efficiency, effective governance mechanisms, appropriate securities design, and full information disclosure must be adopted, and these have become increasingly important institutional structures in the financial system.
After nearly 40 years of development, modern financial theory has finally taken shape. It has not only formed a financial economics based on contracts but also developed specialized theories in various aspects, such as the financial activities of companies and financial intermediaries, the price movements of financial markets, market microstructure, the evolution of financial systems, and financial regulation, thereby forming a more complete theoretical system and research methodology.
However, with the diversification of financial products and the increasing complexity of financial systems, scholars have gradually found that financial theories before the 1980s only considered pricing, arbitrage, equilibrium, and contracts, which is insufficient. For example, the core of the Efficient Market Hypothesis is perfect arbitrage, but in the real world, arbitrage is not perfect, which suggests that the assumption of a perfect capital market lacks theoretical foresight. Models such as the Capital Asset Pricing Model and agency theory models, although sophisticated, lack sufficient data support. Security valuation models based on present value lack theoretical significance, and their extension to uncertain conditions and multiple periods is also the case. The assumptions about the risk preferences of parties are unrealistic, and an increasing number of experimental economics results have proven this point. Puzzles such as the equity premium puzzle, market efficiency anomalies, and others cannot be explained rationally, nor can theories related to term structure and volatility. The institutional foundations of financial markets have not been fully addressed, and it is unclear how institutions affect prices, and so on.
Due to the many limitations of past theories, financial scholars have conducted extensive new explorations since the 1980s. This exploration has unfolded along two lines: On one hand, institutional factors such as contracts, the nature and boundaries of financial contracts, the selection and design of financial contracts, the governance of financial contracts and the evolution of financial systems, as well as the impact of legal and customary institutional factors on financial activities, have been emphasized. On the other hand, some financial scholars, based on the nonlinear utility theory developed by Kahneman and others, have introduced psychological perspectives on human behavior to explain abnormal phenomena in financial product transactions, such as limited arbitrage, noise trading, herd behavior, and bubbles. These theories have formed the behavioral school in modern financial theory, also known as "behavioral finance."
From the current perspective of theoretical development, the two lines are competing and promoting each other, leading to common progress. Models based on incomplete and asymmetric information and general equilibrium theory have significant shortcomings in explaining anomalies in financial markets. However, behavioral finance has not yet been effectively applied to the pricing of financial products, and existing theoretical models themselves lack broader empirical evidence support. Both sides are currently in a state of debate, forming the main theme of the development of modern financial theory.
It is clear that modern financial theory has gradually moved away from the purely theoretical state since the 1950s, establishing the central position of asset pricing in finance, similar to the role of general equilibrium theory in economics. It is like a crown, attracting countless pursuers. What is called modern financial theory is essentially the product of precisely characterizing financial activities using the principles and methods of standard mainstream economics. And after the 1980s, through the unremitting efforts of economists, the complexity of financial products and financial systems has been increasingly recognized, and financial theory has begun to move beyond the narrow scope of asset pricing techniques. More and more people are starting to explain the complex phenomena of finance from the behavior of participants themselves. The diversification of behavior leads to the diversification of financial products and financial systems, and also leads to the diversification of financial theory. The core of modern financial theory has shifted from asset pricing to the behavior of participants, which can be seen as a return to the original face of economics.
As modern financial theory continues to evolve rapidly, domestic financial research is still in its infancy. Several obvious characteristics support this judgment: First, from the perspective of teaching, Monetary Banking remains the core course for finance majors, and it is also a foundational course for economics majors. If one understands the logic of the curriculum system, it is somewhat upside down and out of place. From an international perspective, financial engineering has begun to be piloted, but many people merely understand it as a purely technical science, ignoring the underlying economic theory behind it. This view of finance as equivalent to mathematics is actually a one-sided understanding of the new developments in modern financial theory. Second, from the perspective of research level, there is a tendency to imitate foreign research results, with more descriptive discussions of existing problems rather than a lack of understanding of the underlying logic of the phenomena. In fact, financial problems, like any economic problem, have their social institutional background. If this background knowledge is ignored and blindly aligned with international standards, it can only give the feeling of scratching an itch through the wrong spot.
Finally, from the perspective of publications, the publication of financial literature may be one of the most prosperous areas among economic literature publications, but most of these financial publications are descriptive analyses of financial phenomena, lacking strong theoretical logic and scientific research methods. The current state of domestic publications is related to the backwardness of introducing foreign translated works. So far, many publishers have successively launched various translated series of financial classics, but the selected classics mostly represent theoretical achievements before the 1980s, and these works are mostly textbooks for undergraduates, with little introduction to the latest theoretical classics and exploratory works. Financial activities have no borders, but the understanding of financial activities must have cultural and institutional connotations. For the prosperity of China's financial market, it is meaningless to rely on some policy debates lacking theoretical and empirical evidence, and it may even mislead decision-makers and ordinary investors. To form correct financial activity decisions, it is necessary to master scientific research methods, which requires Chinese scholars to have a more comprehensive grasp of foreign research results rather than cherry-picking and being blinded by a single leaf. Only by fully understanding the latest developments in the forefront of modern financial theory can scholars truly fulfill their role in teaching, nurturing talent, and disseminating knowledge. It is precisely the concern about the current state of financial research in China that has led us to the decision to introduce some of the latest research findings from abroad. On one hand, this can enable domestic researchers, especially young researchers, to have a more comprehensive understanding of the progress of modern finance; on the other hand, it also provides an opportunity to exchange insights with many colleagues and improve the level of financial research in China. Based on these ideas, the Western Economics Teaching and Research Office of the School of Economics at Renmin University of China, the Beijing Aldo Investment Research Center, and Renmin University of China Press have jointly organized the translation of this series, "Frontiers of Finance." This series not only includes purely technical works such as "Investment Under Uncertainty" and "Asset Pricing" but also the application of comparative institutional analysis in the field of finance, such as "Comparative Financial Systems." It also includes the latest behavioral finance works, "Not Efficient Markets—An Introduction to Behavioral Finance." At the same time, we have also paid attention to the traditional topic of money in finance, but new research places greater emphasis on the impact of politics on monetary policy and economic cycles, so we have selected "Theories of Monetary Systems" for translation. In these translated works, some may not be classic works, but they can at least broaden our perspective in terms of research level, such as the book "Financial Innovation," which systematically studies financial innovation activities using Schumpeter's theory, providing one of the best theoretical explanations for financial innovation activities to date. Of course, we will continue to select unique works from existing research in foreign countries to present to readers, and we also hope to receive more criticism and corrections from colleagues.
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