July 12, 2006
Ute S. Frey
UC Berkeley Haas School of Business
UC Berkeley Haas School of Business
UC Berkeley Haas School of Business Professor Mark Rubinstein challenges the origins of several financial theories, including the controversial Black-Scholes model, in his groundbreaking new book, “A History of the Theory of Investments: My Annotated Bibliography.”
Rubinstein’s book is a unique chronology of investment theory that draws on his more than 30 years as an award-winning finance professor. Rubinstein is renowned for his work on the binomial options pricing model (also known as the Cox-Ross-Rubinstein model) and his early work on asset pricing in the 1970s.
Dismayed by how little care many scholars take to attribute ideas to their original sources, Rubinstein, in his book, cites 19 well-known examples in financial theory that trace their history many years – even centuries – earlier than commonly thought.
“One of the things I’m trying to do is set the record straight,” says Rubinstein, the Paul Stephens Professor of Applied Investment Analysis. “A scholar needs to show respect to his field and the people who worked in it by properly citing where ideas come from.”
In just one example, Rubinstein points out that the seminal Black-Scholes option pricing model from 1973 shares its foundations with research published decades earlier by Nobel Prize-winning economic theorist Kenneth Arrow. And some concepts behind Arrow’s research can be traced back three centuries to correspondence between Blaise Pascal and Pierre de Fermat on probability theory in 1654, according to Rubinstein.
“The contributions of Black and Scholes were significant and worthy of a Nobel Prize, but there is more of a history behind their work in earlier literature than most academics realize,” Rubinstein says.
Another controversial example highlighted by Rubinstein in his book is the Modigliani-Miller theorem, which showed that a firm’s value is independent of its capital structure. Rubinstein traces the inception of the theorem to a single paragraph in a rarely referenced book written by John Burr Williams (better known for popularizing the theory of discounted cash-flow) in 1938, 20 years before the idea was popularized by Franco Modigliani and Merton Howard Miller.
“Had Williams initial insight been well known and carefully considered, we might have been spared decades of confusion,” Rubinstein writes. He argues that the theory should not be named after Modigliani and Miller, who won Nobel Prizes for their work, but instead should be called the Law of Conservation, the name devised by Williams.
Rubinstein’s book, written for sophisticated business practitioners and finance professors and Ph.D. students, begins in 1202 with the introduction of positional numerical notation in Europe and ends in 2005 with an article on how people let preferences influence probabilities. Rubinstein references 500 books and articles while also tapping his own expertise and knowledge, sometimes using his own derivations and mathematical proofs.
“For me, knowing the history of a subject is really helpful to understanding it,” Rubinstein says. “It’s also more fun to learn that way.”
He makes the book even easier to use as a reference by including an “Index of Ideas” in addition to an “Index of Sources.” To help paint an all-inclusive, engaging picture of the evolution of investment theory, Rubinstein divides the history of financial economics into three periods: the Ancient Period before 1950, the Classical Period from 1950 to 1980, and the Modern Period post-1980.
Rubinstein initially intended to update the book with more entries in the Modern Period. But he has decided instead to focus on an even more ambitious project – writing a 10-volume collection on Western intellectual history. He also continues to teach two courses – Derivates and Fundamentals of Financial Economics – in the Master’s of Financial Engineering Program at Haas.