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Pioneers of Financial Economics
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  1. Pioneers of Financial Economics • Geoffrey Poitras, Simon Fraser University • Franck Jovanovic, Université du Québec  Montreal HES/AFA New Orleans, Jan. 4, 2008

  2. 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 HES/AFA New Orleans, Jan. 4, 2008

  3. 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?) Finance in Medieval Times HES/AFA New Orleans, Jan. 4, 2008

  4. Fra Luca Pacioli HES/AFA New Orleans, Jan. 4, 2008

  5. 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’ HES/AFA New Orleans, Jan. 4, 2008

  6. 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 HES/AFA New Orleans, Jan. 4, 2008

  7. 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 HES/AFA New Orleans, Jan. 4, 2008

  8. Das Neu Adam Smith Problem? HES/AFA New Orleans, Jan. 4, 2008

  9. 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). HES/AFA New Orleans, Jan. 4, 2008

  10. 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: HES/AFA New Orleans, Jan. 4, 2008

  11. 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) HES/AFA New Orleans, Jan. 4, 2008

  12. 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). HES/AFA New Orleans, Jan. 4, 2008

  13. Philosophy of Financial Economics Henri Lefèvre (1827-1885) and the ‘unity of science’ project from Auguste Comte (1798-1857) Jules Regnault (1834-1894) and the ‘social physics’ project from Adolph Quetelet (1796-1874) HES/AFA New Orleans, Jan. 4, 2008

  14. Henri Lefèvre’s analogies between financial markets and human body Government (brain) Goods and services (blood) Speculation (nervous system) Options (cardiovascular valve) Stock markets (heart) HES/AFA New Orleans, Jan. 4, 2008

  15. spot markets Wholesalers Futures + spot markets Brokers Futures + options Retailers Futures + spot markets consumers spot markets Efficiency from the division of labor Producers HES/AFA New Orleans, Jan. 4, 2008

  16. A graphic method to led financial market more efficient Call option with a 25c premium Combination of two options (call and put) HES/AFA New Orleans, Jan. 4, 2008

  17. Example of complex strategy HES/AFA New Orleans, Jan. 4, 2008

  18. 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 HES/AFA New Orleans, Jan. 4, 2008

  19. Adolphe Quételet and the social physics the universality of the law of errors: physical phenomena and moral phenomena HES/AFA New Orleans, Jan. 4, 2008

  20. Example of the use of the “unity of science” HES/AFA New Orleans, Jan. 4, 2008

  21. Foundations of mathematical finance • Louis Bachelier (1870-1946) HES/AFA New Orleans, Jan. 4, 2008