hes/afa new orleans, jan. 4, 2008 1 pioneers of financial economics geoffrey poitras, simon fraser...

HES/AFA New Orleans, Jan. 4, 20081

Pioneers of Financial Economics

• Geoffrey Poitras, Simon Fraser University• Franck Jovanovic, Université du Québec Montreal


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


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?)


Fra Luca Pacioli


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’


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


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


Das Neu Adam Smith Problem?


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


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}


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)


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).


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)


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)


Efficiency from the division of labor

Producers

Wholesalers

Brokers

Retailers

consumers

spot markets

Futures + options

Futures + spot markets

Futures + spot markets

spot markets


A graphic method to led financial market more efficient

Call option with a 25c premium Combination of two options (call and put)


Example of complex strategy


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


Adolphe Quételet and the social physics

the universality of the law of errors:physical phenomena and moral phenomena


Example of the use of the “unity of science”


Foundations of mathematical finance

• Louis Bachelier (1870-1946)

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