This paper focuses on the views of Professor Miller as to the highlights of the forty-plus year life of finance in its modern form. He has characterized this as an interaction between the business school (micro normative) stream and the economics department (macro normative) stream. His history extends from finance's "big bang" (Markowitz's "Portfolio Selection" in 1952) through the Sharpe-Litner-Mossin CAPM, the efficient markets hypothesis, and the Modigliani-Miller capital structure propositions to that options research of Black, Scholes, and Merton. The options revolution means that for the first time the field of finance can be rebuilt, according to Miller, on the basis of "observable" magnitudes. Options research the new center of gravity for finance offers much to both the management science/business school wing and the economics wing of the profession.
About the author
Professor Miller was born in Boston, Massachusetts where his father worked as an attorney and his mother was a housewife. During World War II, Miller worked as an economist and later in 1952 received his Ph.D. in economics from Johns Hopkins University.
He wrote a paper on "The Cost of Capital, Corporate Finance and the Theory of Investment" In 1958. His paper proposed a fundamental objection to the traditional view of corporate finance. The approach he took in his conclusion was in the use of "no arbitrage" argument. Miller wrote or co-authored eight books. In 1975, he became a fellow of the Econometric Society and in 1976 he became the president of the American Finance Association. He was on the faculty of the University of Chicago School of business from 1961 until his retirement in 1993 he did continue teaching at the school for several more years following his retirement. In 1990, Miller along with Harry Markowitz and William F. Sharpe shared the Nobel Prize "for their pioneering work in the theory of financial economics." Miller's contribution to the prize was the Modigliani-Miller theory.
Author's rationale for writing the article
This article provides the author's selected views of finance, emphasizing on the tensions between the business school stream and the economics department stream. According to Miller, based on recent developments in finance, also recognized by the Nobel Committee, it would appear that the conflict between the two traditions in finance, the business school stream and the economics department stream, may be on the way to reconciliation.
The literature/concepts section
Harry Markowitz, "Portfolio Selection", the Journal of Finance, Vol. 7, No. 1. (Mar., 1952), pp. 77-91.
In 1952, Harry Markowitz published an article entitled "Portfolio Selection," explaining his theory where he provides a definition of risk and return. Markowitz utilized mathematics and computer methods applied to realistic problems, such as uncertainty in business decisions. A Markowitz Efficient Portfolio is one where no added diversification can lower the portfolio's risk for a given return expectation yet no additional expected return can be gained without increasing the risk of the portfolio. The Markowitz Efficient Frontier is the set of all portfolios that will give us the highest expected return for each given level of risk. The Markowitz model falls within the business school stream of finance. His concepts of efficiency were essential to the development of the Capital Asset Pricing Model. Markowitz was hardly the first to consider the desirability of diversification.
Sharpe, William F. 1964. "Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk." Journal of Finance. 19:3, pp. 425-42.
In 1964, William Sharpe published his article "The Capital Asset Pricing Model (CAPM)". The CAPM extended on Harry Markowitz's portfolio theory by introducing the notions of systematic and specific risk. CAPM considers a simplified world where, there are no taxes or transaction costs, all investors have identical investment horizons, and all investors have identical opinions about expected returns, volatilities and correlations of available investments. William Sharpe was key in transforming the Markowitz Portfolio Selection model from a business school stream to a more economic department stream.
Fama, Eugene (1970), "Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance, 25, 383-417.
The first time the term "efficient market" was used in a 1965 paper by E.F. Fama who said that "in an efficient market on the average, competition will cause the full effects of new Information on intrinsic values to be reflected "instantaneously" in actual prices".
The efficient markets theory (EMT) of financial economics states that asset pricing of an asset reflects all relevant information that is available about the intrinsic value of the asset.
Theoretically, the profit opportunities represented by the existence of "undervalued" and "overvalued" stocks motivate investors to trade, and their trading moves the prices of stocks toward the present value of future cash flows. Thus, investment analysts' search for mispriced stocks and their subsequent trading make the market efficient and cause prices to reflect intrinsic values. Because new information is randomly favorable or unfavorable relative to expectations, changes in stock prices in an efficient market should be random, resulting in the well-known "random walk" in stock prices. Thus, investors cannot earn abnormally high risk-adjusted returns in an efficient market where prices reflect intrinsic value.
As Eugene Fama notes, market efficiency is a continuum. The lower the transaction costs in a market, including the costs of obtaining information and trading, the more efficient the market.
Modigliani, F. and Miller, M. H. (1958). The Cost of Capital, Corporate Finance and the Theory of Investment. American Economic Review, 48, 261-97.
In 1958, Franco Modigliani and Merton Howard Miller, in "The Cost of Capital, Corporation Finance and the Theory of Investment," attempted to extend on the idea of financing and production decisions of a firm.
The theorem of Modigliani-Miller forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. The Modigliani-Miller theorem is often called the capital structure irrelevance principle.
A summary of how the author develops his own conceptual material
In this paper the "father of modern finance" uses the series of Nobel Prizes awarded finance theories in the 1990s as an organizing principle for a discussion of the major developments in finance over the past 50 years.
Professor Miller begins with Harry Markowitz's 1952 paper on "Portfolio Selection," which provided the mean-variance framework that underlies modern portfolio theory and for which Markowitz received the Nobel Prize in 1990. Millerthen continues the paper by considering the Capital Asset Pricing Model, followed by the efficient market theory, and the M & M irrelevance propositions.
In describing these advances, Miller's places great emphasis on the differences between the two main branches in modern finance: 1) the Business School or "micro normative" approach, which focuses on investors 'attempts to maximize returns and corporate managers' efforts to maximize shareholder value, while taking the prices of securities in the market as given; and 2) the Economics Department or "macro normative" approach, which assumes a "world of micro optimizers" and try to see how the market prices actually evolve.
In the early 1970's, the option pricing model is accomplished by Fischer Black, Myron Scholes, and Robert Merton (Merton and Scholes were awarded the Nobel Prize in 1998 for this) that resolved the tensions and converged the two approaches. As Miller says, the Black-Scholes option pricing model and its many successors "mean that, for the first time in it's close to 50-year history, the field of finance can be built, or rebuilt, on the basis of 'observable' magnitudes." Those options values which can be calculated (almost entirely) with observable variables have made possible the impressive growth in financial engineering, a highly lucrative activity where the practice of finance has come closest to attaining the precision of a hard science. Option pricing has also helped give rise to a relatively new field called "real options" that promises to revolutionize corporate strategy and capital budgeting.
Miller and Franco Modigliani also looked at the effect of leverage on a company, and showed that the greater the debt, the greater the return demanded by shareholders, because investors must be compensated for the additional risk. They also showed that dividend policies are irrelevant to the value of a company.
A critical evaluation of what the author has accomplished
In his keynote address to the 2000 Financial Management Association International Annual Meeting, Merton Miller had great contributions to the field of finance. I argue that his most important contribution is to have made arbitrage arguments the cornerstone of modern finance. The arbitrage theory introduced a new standard in finance.
Modigliani and Miller assume that financial markets are perfect, so that there are no frictions whatsoever, and that the firm's cash flow is independent of its capital structure. They then show that if proposition I did not hold, an investor could buy and sell stocks and bonds in such a way as to exchange one income stream for another stream, identical in all relevant respects but selling at a lower price. The exchange would therefore be advantageous to the investor quite independently of his attitudes toward risk. As investors exploit these opportunities, the value of the overpriced shares will fall and that of the underpriced shares will rise, thereby tending to eliminate the discrepancy between the market values of the firms.
The Modigliani-Miller paper did not spend time telling us why it would be reasonable to assume that there would always be firms in a given risk class that would enable investors to arbitrage away differences in valuations between levered and unlevered firms. Instead, the paper went straight to provide empirical evidence supporting the leverage irrelevance proposition.
I believe that Modigliani-Miller propositions were right, but in their own properly limited theoretical context. I argue that these results were not relevant because they were built on assumptions that were too far removed from the real world but the key assumptions of Modigliani and Miller have been used over and over in the field of finance.
Final Note:
Merton Miller was always ahead of the crowd in identifying issues and in thinking about them. Nobody was better than he was in presenting ideas in such a way that they would be understood and would affect the thinking of his readers and listeners. Academic papers matter only in·so·far
adv.
To such an extent.
Adv. 1. insofar - to the degree or extent that; "insofar as it can be ascertained, the horse lung is comparable to that of man"; "so far as it is reasonably practical he should practice
..... Click the link for more information. as they impact the thinking of us. In the case of Merton Miller's, it is safe to say that his impact on the field of finance and on the thinking of financial economists will not be matched.
