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    SUMMER 1999 THE JOURNAL OF PORTFOLIO MANAGEMENT95At five years, the German Finance Associationis not very old as professional societies go,but then neither is the field of finance itself.

    Finance in its modern form really dates onlyfrom the 1950s. In the forty years since then, the fieldhas come to surpass many, perhaps even most, of themore traditional fields of economics in terms of thenumbers of students enrolled in finance courses, thenumbers of faculty teaching finance courses, and aboveall in the quantity and quality of their combined schol-arly output.The huge body of scholarly research in financeover the last forty years falls naturally into two mainstreams. And no, I don't mean asset pricing and cor-porate finance, but instead a deeper division that cuts

    across both. The division I have in mind is the morefundamental one between what I will call the businessschool approach to finance and the economics departmentapproach. Let me say immediately, however, that mydistinction is purely notional, not physical a dis-tinction over what the field is really all about, notwhere the offices of the faculty happen to be located.In the United States, the vast majority of aca-demics in finance teach in business schools, not eco-nomics departments, and always have. At the sametime, in the elite schools at least, a substantial fractionof the finance faculties have been trained in that is,have received their Ph.D.s from economics depart-

    ments. Habits of thought acquired in graduate schoolhave a tendency to stay with you.MERTON H. MILLER is RobertR. McCormick distinguished ser-vice professor emeritus at theUniversity of Chicago (IL 60637).The History of FinanceAn eyewitness account.Merton H. MillerCopyright @ Institutional Investor, Inc. All rights reserved.*



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    NYFORMAT***The characteristic business school approachtends to be what we would call in our jargon micronormative. That is, a decision-maker, whether an indi-vidual investor or a corporate manager, is seen as max-imizing some objective function, be it utility, expectedreturn, or shareholder value, taking the prices of secu-rities in the market as given. In a business school, afterall, that's what you're supposed to be doing: teachingyour charges how to make better decisions.To someone trained in the classical traditions of

    economics, however, the dictum of the great AlfredMarshall stands out: It is not the business of theeconomist to tell the brewer how to make beer. The

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    characteristic economics department approach thus isnot micro, but macro normative. The models assume aworld of micro optimizers, and deduce from that howmarket prices, which the micro optimizers take asgiven, actually evolve.Note that I am differentiating the stream ofresearch in finance along macro versus micro lines, and

    not along the more familiar normative versus positiveline. Both streams of research in finance are thorough-ly positivist in outlook in that they try to be, or at leastclaim to be, concerned with testable hypotheses. Thenormal article in finance journals over the last fortyyears has two main sections: the first presenting themodel, and the second an empirical section showingthat real-world data are consistent with the model(which is hardly surprising, because had that not beenso, the author would never have submitted the paper inthe first place, and the editors would never have accept-ed the article for publication).

    The interaction of these two streams, the busi-ness school stream and the economics departmentstream the micro normative and the macro norma-tive has largely governed the history of the field offinance to date. I propose to review some of the high-points of this history, taking full advantage of a handyorganizing principle nature has given us: to wit, theNobel Prizes in Finance.Let me emphasize that I will not be offering acomprehensive survey of the field the record is fartoo extensive for that but rather a selective view ofwhat I see as the highlights, an eyewitness account, as itwere, and always with special emphasis on the tensions

    between the business school and the economics depart-ment streams.After my overview, I offer some very personalviews on where I think the field is heading, or at leastwhere I would be heading were I just entering thefield today.MARKOWITZ AND THETHEORY OF PORTFOLIO SELECTIONThe tension between the micro and macroapproaches was visible from the very beginning ofmodern finance from our big bang, as it were which I think we can all agree today dates to the year1952 with the publication in the Journal of Finance ofHarry Markowitz's article, Portfolio Selection.Markowitz in this remarkable paper gave, for the firsttime, a precise definition of what had hitherto been justvague buzzwords: risk and return.Specifically, Markowitz then identified the yieldor return on an investment with the expected value orprobability-weighted mean value of its possible out-comes; and its risk with the variance or squared devia-tions of those outcomes around the mean. This identi-fication of return and risk with mean and variance, soinstinctive to finance professionals these days, was farfrom obvious then. The common perception of risk

    even today focuses on the likelihood of losses onwhat the public thinks of as the downside risk notjust on the variability of returns.

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    Markowitz's choice of the variance as his mea-sure of risk, counterintuitive as it may have appeared tomany at the time, turns out to have been inspired. Itnot only subsumes the more intuitive view of risk because in the normal or at least the symmetric distri-butions we use in practice the downside risk is essen-tially the mirror image of the upside but it also has

    a property even more important for the development ofthe field. By identifying return and risk with mean andvariance, Markowitz makes the powerful algebra ofmathematical statistics available for the study of portfo-lio selection.The immediate contribution of that algebra isthe famous formula for the variance of a sum of randomvariables; that is, the weighted sum of the variance plustwice the weighted sum of the covariances. We infinance have been living on that formula, literally, formore than forty years now. That formula shows, amongother things, that for the individual investor, the rele-

    vant unit of analysis must always be the whole portfo-lio, not the individual share. The risk of an individualshare cannot be defined apart from its relation to thewhole portfolio and, in particular, its covariances with96THE HISTORY OF FINANCE SUMMER 1999Copyright @ Institutional Investor, Inc. All rights reserved.ItIs



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    permission.the other components. Covariances, and not merenumbers of securities held, govern the risk-reducing

    benefits of diversification.The Markowitz mean-variance model is theperfect example of what I call the business school ormicro normative stream in finance. And this is some-what ironic, in that the Markowitz paper was original-ly a thesis in the University of Chicago's economicsdepartment. Markowitz even notes that MiltonFriedman, in fact, voted against the thesis initially onthe grounds that it wasn't really economics.And indeed, the mean-variance model, as visu-alized by Markowitz, really wasn't economics.Markowitz saw investors as actually applying the modelto pick their portfolios using a combination of past dataand personal judgment to select the needed means,variances, and covariances.For the variances and covariances, at least, pastdata probably could provide at least a reasonable startingpoint. The precision of such estimates can always beenhanced by cutting the time interval into smaller andsmaller intervals. But what of the means? Simply aver-aging the returns of the last few years, along the lines ofthe examples in the Markowitz paper (and later book)won't yield reliable estimates of the return expected inthe future. And running those unreliable estimates ofthe means through the computational algorithm can

    lead to weird, corner portfolios that hardly seem tooffer the presumed benefits of diversification, as anyfinance instructor who has assigned the portfolio selec-

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    tion model as a classroom exercise can testify.If the Markowitz mean-variance algorithm isuseless for selecting optimal portfolios, why do I take itspublication as the starting point of modern finance?Because the essentially business school model ofMarkowitz was transformed by William Sharpe, JohnLintner, and Jan Mossin into an economics department

    model of enormous reach and power.WILLIAM SHARPE AND THECAPITAL ASSET PRICING MODELThat William Sharpe was so instrumental intransforming the Markowitz business school modelinto an economics department model continues theirony. Markowitz, it will be recalled, submitted his the-sis to an economics department, but Sharpe was alwaysa business school faculty member, and much of his ear-lier work had been in the management science/opera-tions research area. Sharpe also maintains an activeconsulting practice advising pension funds on their

    portfolio selection problems. Yet his capital asset pric-ing model is almost as perfect an example as you canfind of an economists' macro normative model of thekind I have described.Sharpe starts by imagining a world in whichevery investor is a Markowitz mean-variance portfolioselector. And he supposes further that these investors allshare the same expectation as to returns, variances, andcovariances. But if the inputs to the portfolio selectionare the same, then every investor will hold exactly thesame portfolio of risky assets. And because all riskyassets must be held by somebody, an immediate impli-cation is that every investor holds the market portfo-

    lio, that is, an aliquot share of every risky security inthe proportions in which they are outstanding.At first sight, of course, the proposition thateveryone holds the same portfolio seems too unrealisticto be worth pursuing. Keep in mind first, however, thatthe proposition applies only to the holdings of riskyassets. It does not assume that every investor has thesame degree of risk aversion. Investors can alwaysreduce the degree of risk they bear by holding risklessbonds along with the risky stocks in the market portfo-lio; and they can increase their risk by holding negativeamounts of the riskless asset; that is, by borrowing andleveraging their holdings of the market portfolio.Second, the idea of investing in the market port-folio is no longer strange. Nature has imitated art, as itwere. Shortly after Sharpe's work appeared, the marketcreated mutual funds that sought to hold all the sharesin the market in their outstanding proportions. Suchindex funds, or passive investment strategies, as theyare often called, are now followed by a large andincreasing number of investors, particularly by U.S.pension funds.The realism or lack of realism of the assumptionsunderlying the Sharpe CAPM has never been a subjectof serious debate within the profession, unlike the case

    of the Modigliani and Miller propositions to be consid-ered later. The profession, from the outset, wholeheart-edly adopted the Friedman positivist view: that what

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    counts is not the literal accuracy of the assumptions, butthe predictions of the model.In the case of Sharpe's model, these predictionsare striking indeed. The CAPM implies that the distri-bution of expected rates of return across all risky assetsis a linear function of a single variable, namely, eachSUMMER 1999 THE JOURNAL OF PORTFOLIO MANAGEMENT

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    ssion.asset's sensitivity to or covariance with the market port-folio, the famous beta, which becomes the natural mea-sure of a security's risk. The aim of science is to explaina lot with a little, and few models in finance or eco-nomics do so more dramatically than the CAPM.The CAPM not only offers new and powerful

    theoretical insights into the nature of risk, but also lendsitself admirably to the kind of in-depth empirical inves-tigation so necessary for the development of a new fieldlike finance. And its benefits have not been confined nar-rowly to the field of finance. The great volume of empir-ical research testing the CAPMhas led to major innova-tions in both theoretical and applied econometrics.Although the single-beta CAPM managed towithstand more than thirty years of intense economet-ric investigation, the current consensus within the pro-fession is that a single risk factor, although it takes us anenormous length of the way, is not quite enough fordescribing the cross-section of expected returns.

    Besides the market factor, two other pervasive risk fac-tors have by now been identified for common stocks.One is a size effect; small firms seem to earnhigher returns than large firms, on average, even aftercontrolling for beta or market sensitivity. The other isa factor, still not fully understood, but that seems rea-sonably well captured by the ratio of a firm's account-ing book value to its market value. Firms with highbook-to-market ratios appear to earn higher returnson average over long horizons than those with lowbook-to-market ratios after controlling for size and forthe market factor.That a three-factor model has now been shownto describe the data somewhat better than the single-factor CAPM should detract in no way, of course, fromappreciation of the enormous influence of the originalCAPM on the theory of asset pricing.THE EFFICIENT MARKETS HYPOTHESISThe mean-variance model of Markowitz andthe CAPM of Sharpe et al. are contributions whosegreat scientific value was recognized by the NobelCommittee in 1990. A third major contribution tofinance was recognized at the same time. But beforedescribing it, let me mention a fourth major contribu-tion that has done much to shape the development of

    the field of finance in the last twenty-five years, but thathas so far not received the attention from the NobelCommittee I believe it deserves.

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    I refer, of course, to the efficient marketshypothesis, which says, in effect, that no simple rulebased on already published and available informationcan generate above-normal rates of return. On thisscore of whether mechanical profit opportunities exist,the conflict between the business school tradition infinance and the economics department tradition has

    been and still remains intense.The hope that studying finance might open theway to successful stock market speculation served tosupport interest in the field even before the modern sci-entific foundations were laid in the 1950s. The first sys-tematic collection of stock market prices, in fact, wascompiled under the auspices of the Alfred CowlesFoundation in the 1930s.Cowles had a lifelong enthusiasm for the stockmarket, dimmed only slightly by the catastrophic crashof 1929. The Cowles Foundation, currently an adjunctof the Yale University economics department, was the

    source of much fundamental research on econometricsin the 1940s and '50s.The Cowles indexes of stock prices have longsince been superseded by much more detailed and com-puterized data bases, such as those of the Center forResearch in Security Prices at the University of Chicago.And to those computer data bases, in turn, goes much ofthe credit for stimulating the empirical research infinance that has given the field its distinctive flavor.Even before these new computerized data basescame into widespread use in the early 1960s, however,the mechanical approach to above-normal investmentreturns was already being seriously challenged. The

    challenge was delivered, curiously enough, not byeconomists, but by statisticians like M.G. Kendall andmy colleague, Harry Roberts who argued that stockprices are essentially random walks. This implies,among other things, that the record of past stock prices,however rich in patterns it might appear, has no pre-dictive power for future stock returns.By the late 1960s, however, the evidence wasaccumulating that stock prices are not random walks bythe strictest definition of that term. Some elements ofpredictability could be detected, particularly in long-runreturns. The issue of whether publicly available informa-tion could be used for successful stock market specula-tion had to be rephrased a task in which my colleague,Eugene Fama, played the leading role as whether theobserved departures from randomness in the time seriesof returns on common stocks represent true profit98THE HISTORY OF FINANCE SUMMER 1999Copyright @ Institutional Investor, Inc. All rights reserved.ItIs


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    reprintsorpermission.opportunities after transaction costs and after appropri-

    ate compensation for changes in risk over time. With thisshift in focus from returns to cost- and risk-adjustedreturns, the efficient markets debate becomes no longer

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    a matter of statistics, but one of economics.This connection with economics helps explainwhy the efficient markets hypothesis of finance remainsas strong as ever, despite the steady drumbeat of empir-ical studies directed against it. If you find somemechanical rule that seems to earn above-normalreturns and with thousands of researchers spinning

    through the mountains of tapes of past data, anomalies,like the currently fashionable momentum effects, arebound to keep turning up then imitators will enterand compete away those above-normal returns exactlyas in any other setting in economics. Above-normalprofits, wherever they are found, inevitably carry withthem the seeds of their own decay.THE MODIGLIANI-MILLER PROPOSITIONSStill other pillars on which the field of financerests are the Modigliani-Miller propositions on capitalstructure. Here, the tensions between the micro nor-mative and the macro normative approaches were evi-

    dent from the outset, as is clear from the very title ofthe first M&M paper, The Cost of Capital,Corporation Finance and the Theory of Investment.The theme of that paper, and indeed of the whole fieldof corporate finance at the time, is capital budgeting.The micro normative wing was concerned withfinding the cost of capital, in the sense of the optimalcutoff rate for investment when the firm can financethe project either with debt or equity or some combi-nation of both. The macro normative or economicswing sought to express the aggregate demand forinvestment by corporations as a function of the cost ofcapital that firms are actually using as their optimal cut-

    offs, rather than just the rate of interest on long-termgovernment bonds.The M&M analysis provided answers, but onesthat left both wings of the profession dissatisfied. At themacro normative level, the M&M measure of the costof capital for aggregate investment functions never real-ly caught on, and, indeed, the very notion of estimat-ing aggregate demand functions for investment has longsince been abandoned by macro economists. At themicro level, the M&M propositions imply that thechoice of financing instrument is irrelevant for theoptimal cutoff. Such a cutoff is seen to depend solelyon the risk (or risk class) of the investment, regard-less of how it is financed, hardly a happy position forprofessors of finance to explain to their students beingtrained, presumably, in the art of selecting optimal cap-ital structures.Faced with the unpleasant action consequencesof the M&M model at the micro level, the tendency ofmany at first was to dismiss the assumptions underlyingM&M's then-novel arbitrage proof as unrealistic. Theassumptions underlying the CAPM, of course, areequally or even more implausible, as noted earlier, butthe profession seemed far more willing to acceptFriedman's the assumptions don't matter position for

    the CAPM than for the M&M propositions.The likely reason is that the second blade of theFriedman positivism slogan what does count is the

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    descriptive power of the model itself was not fol-lowed up. Tests by the hundreds of the CAPM fill theliterature. But direct calibration tests of the M&Mpropositions and their implications do not.One fundamental difficulty of testing the M&Mpropositions shows up in the initial M&M paper itself.The capital structure proposition says that if you could

    find two firms whose underlying earnings are identical,then so would be their market values, regardless of howmuch of the capital structure takes the form of equityas opposed to debt.But how do you find two companies whose earn-ings are identical? M&M tried using industry as a way ofholding earnings constant, but this sort of filter is far toocrude. Attempts to exploit the power of the CAPM fortesting M&M were no more successful. How do youcompute a beta for the underlying real assets?One way to avoid the difficulty of not havingtwo identical firms, of course, is to see what happens

    when the same firm changes its capital structure. If afirm borrows and uses the proceeds to pay its share-holders a huge dividend or to buy back shares, does thevalue of the firm increase? Many studies have suggestedthat it does. But the interpretation of such results facesa hopeless identification problem.The firm, after all, never issues a press release say-ing we are just conducting a purely scientific investiga-tion of the M&M propositions. The market, which isforward-looking, has every reason to believe that thecapital structure decisions are conveying management'sviews about changes in the firm's prospects for the future.These confounding information effects, present in

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    ission.every dividend and capital structure decision, renderindecisive all tests based on specific corporate actions.Nor can we hope to refute the M&M proposi-tions indirectly by calling attention to the multitudeof new securities and of variations on old securitiesthat are introduced year after year. The M&M propo-sitions say only that no gains could be earned fromsuch innovations if the market were in fact com-plete. But the new securities in question may well beserving to complete the market, earning a first-mover's profit to the particular innovation. Onlythose in Wall Street know how hard it is these days tocome by those innovator's profits.If all this seems reminiscent of the efficient mar-kets hypothesis, that is no accident. The M&M propo-sitions are also ways of saying that there is no free lunch.Firms cannot hope to gain by issuing what looks likelow-cost debt rather than high-cost equity. They just

    make the cost of higher-cost equity even higher. And ifany substantial number of firms, at the same time, seekto replace what they think is their high-cost equity

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    with low-cost debt (even tax-advantaged debt), thenthe interest costs of debt will rise, and the requiredyields on equity will fall until the perceived incentivesto change capital structures (or dividend policies forthat matter) are eliminated.The M&M propositions, in short, like the effi-cient markets hypothesis, are about equilibrium in the

    capital markets what equilibrium looks like, andwhat forces are set in motion once it is disturbed. Andthis is why neither the efficient markets hypothesis northe Modigliani-Miller propositions have ever set wellwith those in the profession who see finance as essen-tially a branch of management science.OPTIONSFortunately, however, recent developments infinance, also recognized by the Nobel Committee, sug-gest that the conflict between the two traditions infinance, the business school stream and the economicsdepartment stream, may be on the way to reconciliation.

    This development, of course, is the field ofoptions, whose pioneers, recently honored by theNobel Committee, were Robert Merton and MyronScholes (with the late Fischer Black everywhereacknowledged as the third pivotal figure). Because theintellectual achievement of their work has been com-memorated over and over and rightly so I willnot seek to review it here. Instead, in keeping with mytheme, I want to focus on what options mean for thehistory of finance.Options mean, among other things, that for thefirst time in its close to fifty-year history, the field offinance can be built, or as I will argue be rebuilt, on the

    basis of observable magnitudes. I still remember theteasing we financial economists, Harry Markowitz,William Sharpe, and I, had to put up with from thephysicists and chemists in Stockholm when we conced-ed that the basic unit of our research, the expected rateof return, was not actually observable. I tried to parryby reminding them of their neutrino a particle withno mass whose presence is inferred only as a missingresidual from the interactions of other particles. Butthat was eight years ago. In the meantime, the neutrinohas been detected.To say that option prices are based on observ-ables is not strictly true, of course. The option price inthe Black-Scholes-Merton formula depends on thecurrent market value of the underlying share, the strik-ing price, the time to maturity of the contract, and therisk-free rate of interest, all of which are observableeither exactly or very closely. But the option pricedepends also, and very critically, on the variance of thedistribution of returns on the underlying share, whichis not directly observable; it must be estimated.Still, as Fischer Black always reminded us, esti-mating variances is orders of magnitude easier than esti-mating the means or expected returns that are centralto the models of Markowitz, Sharpe, or Modigliani-

    Miller. The precision of an estimate of the variance canbe improved, as noted earlier, by cutting time intosmaller and smaller units from weeks to days to

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    hours to minutes. For means, however, the precision ofestimate can be enhanced only by lengthening the sam-ple period, giving rise to the well-known dilemma thatby the time a high degree of precision in estimating themean from past data has been achieved, the mean itselfhas almost surely shifted.Having a base in observable quantities or vir-

    tually observable quantities on which to value secu-rities might seem at first sight to have benefited pri-marily the management science stream in finance. Andindeed, recent years have seen the birth of a new andrapidly growing specialty area within the profession,that of financial engineering (and the recent establish-ment of a journal with that name is a clear sign that thefield is here to stay). The financial engineers have100THE HISTORY OF FINANCE SUMMER 1999Copyright @ Institutional Investor, Inc. All rights reserved.I




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    [email protected]


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    on.already reduced the original Black-Scholes-Mertonformula to Model-T status.Nor has the micro normative field of corporatefinance been left out. When it comes to capital bud-geting, long a major focus of corporate finance, thedecision impact of what have come to be called realoptions even simple ones like the right to closedown a mine when the output price falls and reopen itwhen it rises is substantially greater than that of vari-ations in the cost of capital.

    The options revolution, if I may call it that, isalso transforming the macro normative or economicsstream in finance. The hint of things to come in thatregard is prefigured in the title of the original Black-Scholes paper, The Pricing of Options and CorporateLiabilities. The latter phrase was added to the title pre-cisely to convince the editors of the Journal of PoliticalEconomy about as economics a journal as you can get that the original (rejected) version of the paper wasnot just a technical tour de force in mathematical statis-tics, but an advance with wide application for the studyof market prices.And indeed, the Black-Scholes analysis shows,among other things, how options serve to completethe market for securities by eliminating or at least sub-stantially weakening the constraints on high leverageobtainable with ordinary securities. The Black-Scholesdemonstration that the shares in highly leveraged cor-porations are really call options also serves in effect tocomplete the M&M model of the pricing of corporateequities subject to the prior claims of the debtholders.We can go even further: Every security can be thoughtof as a package of component Arrow-Debreu state-price contingent claims (options, for short), just asevery physical object is a package of component atoms

    and molecules.RECONSTRUCTION OF FINANCE?I will speculate no further about these and other

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    exciting prospects for the future. Let me close ratherwith a question: What would I advise a young memberof the German Finance Association to specialize in?What would I specialize in if I were starting over andentering the field today?Well, I certainly wouldn't go into asset pricingor corporate finance. Research in those subfields has

    already reached the phase of rapidly diminishingreturns. Agency theory, I would argue, is best left to thelegal profession, and behavioral finance is best left to thepsychologists. So, at the risk of sounding a bit like thecharacter in the movie The Graduate, I reduce myadvice to a single word: options.When it comes to research potential, optionshave much to offer both the management science/busi-ness school wing within the profession and the eco-nomics wing. In fact, so vast are the research opportu-nities for both wings that the field is surely due for atotal reconstruction as profound as that following the

    original breakthrough by Harry Markowitz in 1952.The shift toward options as the center of gravityof finance that I foresee should be particularly welcomedby the members of the German Finance Association. Ican remember when research in finance in Germanywas just beginning and tended to consist of replicationof American studies using German data. But when itcomes to a relatively new area like options, we all standroughly equal at the starting line. And this is an area inwhich the rigorous and mathematical German academ-ic training may even offer a comparative advantage.It is no accident, I believe, that the DeutscheTermin Borse (or Eurex, as it has now become after

    merging with the Swiss exchange) has taken the high-tech road to a leading position among the world'sfutures exchanges only eight years after a great confer-ence in Frankfurt where Hartmut Schmidt, FischerBlack, and I sought to persuade the German financialestablishment that allowing futures and options tradingwould not threaten the German economy. Hardwareand electronic trading were the key to DTB's success,but I see no reason why the German scholarly commu-nity cannot duplicate that success on the more abstractside of research in finance as well.Whether it can should be clear by the time ofthe twenty-fifth annual meeting. I'm only sorry I won'tbe able to see that happy occasion.ENDNOTEThis is a slightly modified version of an address deliveredat the Fifth Annual Meeting of the German Finance Association inHamburg on September 25, 1998.SUMMER 1999 THE JOURNAL OF PORTFOLIO MANAGEMENT101Copyright @ Institutional Investor, Inc. All rights reserved.ItI


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