Fifty years ago, a brilliant young Stanford University assistant professor named Kenneth J. Arrow published a five-and-one-third-page paper that laid the theoretical basis for pricing assets and options. The problem is, few outside academia are aware of the paper's significance.
"This may be the most important paper ever written for financial economics," writes Mark Rubinstein, a finance professor at the University of California at Berkeley's Haas School of Business, in a history he is writing of the financial world.
Mr. Arrow's paper, "The Role of Securities in the Optimal Allocation of Risk-bearing," originally was translated into French for a 1952 conference held in Paris. The translated version was published in the conference's proceedings, but the English version wasn't published until 1964.
The conference dealt with one of the raging topics of the day, the theory of uncertainty — that is, how the world deals with risk. Mr. Arrow, as well as fellow academic Gerard Debreu, later became famous for explaining how uncertainty affects general equilibrium theory. In fact, Mr. Arrow (along with John R. Hicks, an Oxford University economist) won the 1972 Nobel Memorial Prize for Economic Sciences for his work in this area.
What Mr. Arrow did in his 1952 paper was link the notion of uncertainty with the idea of states of the world, a concept borrowed from probability theory. "There's a state of the world that describes every aspect that's right, and I'm only interested in certain aspects of it," he explained in an interview. Uncertainty is not knowing which state of the world will prevail.
In a complete market, Mr. Arrow postulated, there is a state security to represent every possible outcome, or state of the world. So, if a certain outcome occurred, the investor would get paid $1 for holding the security related to that outcome. If a different outcome occurred, that security would be worthless.
Of course, complete markets exist only in theory, Mr. Arrow acknowledged. In reality, investors purchase contingent securities, such as options, and calculate what the fair value of the option would be.
Introducing the concept of a contingent contract into equilibrium theory was a huge leap forward, said William F. Sharpe, who won his own Nobel Prize in 1990 for developing the capital asset pricing model, which provides the current basis for portfolio construction.
In a 1993 paper, Mr. Sharpe argued the work of Messrs. Arrow and Debreu laid the theoretical basis for modern financial engineering as well as corporate finance and investment analysis. "Curiously, however, many practitioners of financial engineering are unaware of the intellectual underpinnings of the methods that they employ," he wrote in his paper, "Nuclear Financial Economics."
Mr. Arrow's work is usually ignored in MBA programs, which instead favor Nobel Laureate Harry Markowitz's mean-variance approach, Mr. Sharpe wrote. In an interview, Mr. Sharpe explained that the Arrow-Debreu state of the world approach provides "a lot more flexibility," avoiding the constraints of the normal distribution found in typical portfolio analysis. The downside, he added, is that Arrow-Debreu requires a huge number of scenarios.
Some scholars now believe that Mr. Arrow's pioneering work laid the theoretical basis for the options-pricing work developed 20 years later by Fischer Black, Myron Scholes and Robert Merton. Mr. Arrow's notion that "frequent trading in a few securities could be just as good as having many securities … is the basis of the Black-Scholes-Merton arbitrage approach to valuing options," explained John Campbell, a Harvard University economics professor, in an e-mail to this newspaper.
No one is claiming the ground-breaking Black-Scholes model was derived from Mr. Arrow's work, least of all Mr. Arrow, who praises Messrs. Black and Scholes for the complex mathematical work they did in modeling options-pricing. And in an e-mail, Mr. Scholes said their model stemmed from CAPM.
However, few outside academia recognize Mr. Arrow's pioneering paper, written hastily for a Paris conference, that Mr. Sharpe said should put Mr. Arrow in the "pantheon" of investment management greats.