A Primer in Financial Economics

Abstract

This paper is divided into three parts. Taken together, the three parts intend to provide the reader with an overview of the first 101 years of financial economics, with particular attention on those developments that are of special interest to actuaries. In Section 1, S.F. Whelan attempts to capture the flavour of the subject and, in particular, to give an overview or road map of this discipline, highlighting actuarial input. In Section 2, D.C. Bowie gives a concise and self-contained overview of the Modigliani and Miller insights (or MM Theorems, as they are often known). In Section 3, A.J. Hibbert considers the novel option pricing method proposed by Black, Merton, and Scholes. These two insights are highlights of this newscience, and, in both cases, contradict our intuition.T.S. Elliot, the mathematically trained poet, described the darkness that intercedes between the idea and the action as the ‘shadow’. There is a shadow to be considered between these insights and their application. The demonstration of the results requires, of course, some idealised circumstances, and therefore the extent and degree of their applicability to the non- idealised problems encountered by actuaries requires some delicate considerations. An attempt is made to outline these further considerations.

The Construction of the Canonical History of Financial Economics

“…However, with the triumph of the efficient market theory, the canonical history of the University of Chicago Graduate School of Business has been widely spread in scientific journals and in textbooks. It has been pre sented or extended by Bernstein (1992), Walter (1996Walter ( , 2002, Mer ton (1998), Scholes (1998), Dimson andMussavian (1999, 2000), and Whelan, Bowie, and Hibbert (2002), among others. It is, however, important to recall two points.…”

Financial Economics and Actuarial Practice

“…Typical stakeholder categories include shareholders, management, employees, consultants, and the government. Whelan, Bowie, and Hibbert (2002) provide the following examples: "The people making the decisions about capital structure are not always the people who own the company. The company management's interests are not perfectly aligned with those of the shareholders.…”

“…This paper concentrates on the Modigliani-Miller stream of financial economics and does not canvass the classical theories or the option pricing theories of Black-Merton-Scholes, except where they relate to the core themes of the paper. For an excellent survey on the span of financial economics see Whelan, Bowie, and Hibbert (2002).…”

“…They go on to note that "such a test is entirely independent of the tastes of the current owners, since market prices will reflect not only their preferences but those of all potential owners as well" (p. 264). Whelan, Bowie, and Hibbert (2002) correctly state that the Modigliani-Miller propositions were groundbreaking in part because they demonstrated that "focusing too narrowly on any one corporate financial feature could result in unintentional destruction of value" (p. 39). This statement could well be applied also to the narrow focus on current price.…”

Pensions and Capital Structure

“…So as a company issues more debt the expected return to shareholders increases, but this is just fair compensation for the risk. Following the approach used in Whelan, Bowie, and Hibbert (2002), we consider two companies "NoDebtCo" which is totally financed by equity and "HalfDebtCo" which is 50% financed by debt and 50% financed by equity. These companies are identical apart from their financing.…”