Review of Key Risk and Uncertainty Theories Influencing Contemporary Financial Economics

Review of Key Risk and Uncertainty Theories Influencing Contemporary Financial Economics

Colin Read (Department of Economics and Finance, State University of New York, Plattsburgh, NY, USA)
Copyright: © 2012 |Pages: 10
DOI: 10.4018/ijrcm.2012100102
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Abstract

Ironically, the 2008 credit crisis and the subsequent global financial meltdown were brought about by efforts of those whose stated purpose was to manage risk. Somehow, the efforts of financial regulators to manage and contain uncertainty created the greatest downside risk experienced since the Great Depression. At this juncture in financial history, it is purposeful to examine the meaning of risk and uncertainty, how it is priced, the assumptions one makes when one uses market-priced risk hedges, and the degree to which the modern science of financial risk management informs or obfuscates the very nature of risk. This paper performs such a retrospective analysis of key risk theories and how they impact financial markets, through the developments of innovators: Daniel Bernoulli, Carl Friedrich Gauss, Louis Bachelier, Jacob Marschak, Harry Markowitz, William Sharpe, Paul Samuelson, Fischer Black, and Myron Scholes. This paper makes an additional contribution to the literature by identifying unresolved issues that require additional research to improve risk management in financial markets. In particular, this paper concludes that while the author have numerous tools to manage risk, they have few tools to manage uncertainty, the latter of which is where future research should be undertaken.
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Literature Review

I begin by describing the first analytic model of risk, from the work of two Bernoulli cousins and their attempts to understand games of chance. First, I describe how the applied mathematicians of the nineteenth century began to measure and incorporate uncertainty into mathematics, and how a mathematician named Louis Bachelier used these measures to price risk. I then turn to the originator of the modern definition of risk, and father of the Chicago School, Frank Hyneman Knight. Afterwards, I treat the economics pioneer Jacob Marschak. Followed by a description of how his description of the risk-return tradeoff inspired his graduate student, Harry Markowitz, to expand Marschak’s definition of the risk-return tradeoff into Modern Portfolio Theory. Next, I show how William Sharpe and his contemporaries evolved Markowitz’ Modern Portfolio Theory into a technique to 'price' individual securities of uncertain returns.

I then demonstrate how Fischer Black and Myron Scholes reinvented Bachelier’s work in the development of the most common method to price risk and volatility in derivatives markets, through the Black-Scholes options pricing model. I conclude by assessing the current state of our understanding in financial risk management.

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