William
Sharpe received the Nobel Prize in Economics for developing the Capital Asset
Pricing Model, which is now widely used by investment firms to predict how a
stock will perform in relation to the overall market. Sharpe’s theory explains how securities prices
are established to reflect risks and potential returns. His concepts influence the investment
decisions of stockbrokers, bankers, mutual fund managers, government agencies
and millions of individuals. Sharpe is
past president of the American Finance Association and serves as a consultant
to many corporations and investment organizations.
The
Nobel Committee recognized Professor Sharpe jointly with Harry M. Markowitz and
Merton H. Miller “for his pioneering work in the theory of financial
economics.”
Quotes from William Sharpe’s February 1992 lecture at
From a more theoretical viewpoint,
one can focus on the nexus between the present
and the future. A financial instrument typically represents a
property right to receive future cash flows.
Such cash flows will, of course, come in the future – hence the economics of time must be
understood. In many cases the flows are
uncertain, hence the need for an approach to the economics of uncertainty.
In addition, cash flows in the far future may depend on actions taken
(or not taken) in the near future. This
gives rise to the need for a theory of the economics of options (broadly construed). Finally, one needs information to estimate
likely future outcomes, hence the requirement for an understanding of the economics of information. I define financial economics so that it
embraces all four of these important, difficult, and fascinating aspects of
economics.
The central question for positive
financial economics is valuation
– what is the value today of a set of future prospective cash flows? The central question for normative financial
economics is the appropriate use
of financial instruments in a world in which values are set wholly or partially
in accord with the principles of positive financial economics.
In the first semester of my
sophomore year I took required courses in accounting and microeconomics. The former was, in reality, bookkeeping – and
mindless bookkeeping at that. I loathed
it. But microeconomics had everything:
rigor, relevance, structure, and logic.
I found its allure irresistible.
The next semester I changed my major to economics and never turned
back. Thus my first
stroke of luck. I sometimes break
out in a cold sweat thinking about what might have
happened had I taken a modern accounting course and an institutional economics
course.
The Rand Corporation of 1956 was a
truly unique organization. Funded almost
entirely by the Air Force, it had contracted simply to do research that it
considered worthwhile for its main client, along with a goodly dose of other
work that would serve the public good.
Employees were free to work any hours they chose, within wide
limits. Office doors were open,
intellectual discussions on the most wide-ranging topics were de rigeur, and everyone was expected
to spend one day per week on research of strictly personal interest. Those were heady days. Some of the key work in systems analysis,
operations research, computer science and applied economics was being done at
I asked the question that
microeconomists are trained to ask. If
everyone were to behave optimally, what prices will securities command once the
capital market has reached equilibrium? The conclusion was both startling and
provocative. Security prices will adjust
until there is a simple linear relationship between expected return and
sensitivity to changes in the factor in question. Following the conventions of regression
analysis, I used the symbol beta
for the latter. Thus the result could be
succinctly stated: securities with higher betas will have higher expected
returns. Only the portion of risk due to
the influence of the common factor will be rewarded in the long run. No compensation is needed nor available for
the remainder (which I termed “nonsystematic risk”), since it can be reduced to
a small amount by sensible diversification.
Thus was the capital asset pricing model born.
Additional
resources on William F. Sharpe are available at the Nobel web
site.