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Pioneers of Financial Economics
• Geoffrey Poitras, Simon Fraser University• Franck Jovanovic, Université du Québec Montreal
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Finance in Antiquity
• Financial Transactions – involving the future payment for loans of real goods – likely predate the use of common language
• Earliest examples of written language – the Sumerian cuneiform tablets -- deal with financial transactions
• Code of Hammurabi (circa 1750 BC/BCE) had explicit and harsh penalties for loan defaults
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Finance in Medieval Times
• Religious restrictions on financial activities– especially payment of interest on money loans and compensation for risk bearing
• Education of merchants in finance took place largely outside the Church dominated universities in ‘reckoning schools’ -- the Treviso Arithmetic (1478) was a text for such schools.
• Compound interest calculations were used, if not admitted to, and double entry book keeping was popularized by Fra Luca Pacioli (1445-1514?)
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Fra Luca Pacioli
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Finance in Art
• Aristotelian teachings which dominated scholastic humanism of the Church viewed business activities as banal – reflected in lack of attention to business themes in Art from the Reformation to the Enlightenment
• 15th and 16th C. woodcuts of financial activities from Swetz (1987) pale in comparison to Durer’s Four Horsemen … (1498)
• Until the 18th C., European artists were concerned with religious themes – e.g., Rembrandt (1633) to Pannini (1750) with ‘Jesus Throwing out the Money Lenders’
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Finance in Literature
• Shakespeare’s Merchant of Venice (1600) – immortalized Shylock
• Joseph de la Vega Confusion de Confusiones (1688) – written in Spanish by a Portuguese Jewish émigré living in Amsterdam.
• Jonathan Swift, Gulliver’s Travels (1726) and The Bubble (1721), the first two lines:
“Ye wise Philosophers explain, What Magick makes our Money Rise?”
To Swift, Isaac Newton was a Philosopher
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The Early History of Financial Economics
• Where to start the history? What is financial economics?
• Sophisticated pricing formulae for financial securities developed before Adam Smith (1723-1790) was born
• Building on work of Christian Huygens (1620-1699), Jan de Witt (1625-1672) solved the price for a life annuity
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Das Neu Adam Smith Problem?
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Pricing of Life Annuities• The total number of annuities sold on a life starting at year x is x
– x equals the sum of dx + dx+1 +...... + dw-1 where di is the number of annuities which terminate in period i due to the death of annuitant nominees in that half year
– di = 0 for x w. – Taking x+t to be the number of nominees, starting in year x surviving in
period x + t, it follows that: dx+t = x+t - x+t+1 and that the probability of death in any given half year j is (dx+j / x).
An nt 1
1
(1 r)t 1r
1
r(1 r)n
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From E. Halley to A. de Moivre• Halley (1693) is a founding work of actuarial science, demography
and financial economics. His tabular solution to the life annuity value was “the short Result of a not ordinary number of Arithmetical Operations”
• Abraham de Moivre (1667-1754), a giant in mathematical statistics, refined and substantively extended the solution to the life annuity valuation problem.
Assuming arithmetically declining survival probabilities, de Moivre showed that the value of a life annuity (E[An]) can be closely approximated by the formula:
E[An] [An 1 rn
dAnd(1 r)
]
1r
1 rn
[1r
{1r
1
r(1 r)n}] 1
r{1 1 r
nAn}
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The Growth of Stock Trading
• Initial trading in (joint) stock usually traced back to 1602 with the VOC (Dutch East India Company) in Amsterdam recounted in de la Vega (1688) limited number of securities traded
• Dramatic emergence of stock trading in England starting in 1690’s South Sea Bubble and Mississippi Scheme (1719-1721) founding of London Stock Exchange building in 1773
• Emergence of ‘old Finance’ with Thomas Mortimer Everyman his Own Broker (1761)
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The Reverend Richard Price (1723-91)
• A ‘dissenting’ (non-Anglican) English minister
• Intellectual giant of the 18th C. – Observations on Reversionary Payments (1776) the founding work of modern insurance mathematics – took mathematical contributions of de Moivre and applied to problems of insurance and social security design – ‘father of modern public pension plans’ – the first actuary (at the Equitable)
• Essential contributions to political science (‘Give me liberty or give me death’), mathematical statistics (responsible for post-humus publication of Bayes Theorem), philosophy (moral pragmatism) and religious studies (use of Bayes theorem against David Hume’s argument against miracles).
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Philosophy of Financial Economics
Jules Regnault (1834-1894) and the ‘social physics’ project from Adolph Quetelet (1796-1874)
Henri Lefèvre (1827-1885)
and the ‘unity of science’ project from Auguste Comte (1798-1857)
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Henri Lefèvre’s analogies between financial markets and human body
Stock markets(heart)
Government(brain)
Speculation(nervous system)
Options(cardiovascular valve)
Goods and services(blood)
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Efficiency from the division of labor
Producers
Wholesalers
Brokers
Retailers
consumers
spot markets
Futures + options
Futures + spot markets
Futures + spot markets
spot markets
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A graphic method to led financial market more efficient
Call option with a 25c premium Combination of two options (call and put)
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Example of complex strategy
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Jules Regnault and Adolph Quetelet’s ‘social physics’ project
• Jules Regnault (1834-1894): French broker
• “unity of science” and the university of the normal law (also called the law of errors)
• First author to create the random walk model
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Adolphe Quételet and the social physics
the universality of the law of errors:physical phenomena and moral phenomena
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Example of the use of the “unity of science”
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Foundations of mathematical finance
• Louis Bachelier (1870-1946)