The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1990
Harry M. Markowitz, Merton H. Miller, William F. Sharpe
Presentation Speech by Professor Assar
Lindbeck of the Royal Swedish Academy of Sciences, December
Translation of the Swedish text.
Your Majesties, Your Royal Highnesses,
Ladies and Gentlemen,
Financial markets fulfill an important function in modern market economies. It is largely via such markets that savings in various sectors of a national economy are transferred to firms for investment in buildings and machines. Moreover, financial markets reflect the future prospects of firms.
Before the 1950s, there was hardly any theory whatsoever of financial markets. A first pioneering contribution in the field was made by Harry Markowitz, who developed a theory of portfolio decisions of households and firms under conditions of uncertainty. The theory shows how the multidimensional problem of investing under conditions of uncertainty in a large number of assets, each with different characteristics, may be reduced to the issue of a trade-off between only two dimensions, namely the expected return and the variance of the return of the portfolio.
Earlier, writers in this field had argued that an asset which is characterized by relatively large risk, i.e., great variability of the return, necessarily requires a high risk premium. The theory of portfolio choice clarified that the crucial aspect of the risk of an asset is not its risk in isolation, but the contribution of each asset to the risk of an entire portfolio. Markowitz also showed how the problem of actually calculating an optimum portfolio can be solved as a quadric programming problem.
Portfolio theory analyzes the decision-making problems of an individual portfolio manager. For this reason, the market price of various assets is regarded as given. The next step in the analysis is to explain how these asset prices are determined. This was achieved by development of the so-called Capital Asset Pricing Model, or CAPM. It is for this contribution that William Sharpe has been awarded. The CAPM shows that the optimum risk portfolio of a financial investor depends only on the portfolio manager's prediction about the prospects of different assets, not on his own risk preferences. The model also shows how risks can be bought and sold, and hence how risks can be spread via capital markets.
The Capital Asset Pricing Model has become the backbone of modern price theory of financial markets. The model's so-called beta values, which measure the degree of covariation between the return on a specific share and the stock market as a whole, are now a standard tool in the analysis of financial markets and investment decisions.
While the portfolio model and the Capital Asset Pricing Model focus on financial markets, Merton Miller, initially in cooperation with Franco Modigliani, founded the modern theory of corporate finance. This theory can be summarized in two theorems. One deals with the relationship between the capital structure of the firm and its market value. The other clarifies the relationship between the dividend policy of the firm and its market value.
The theorems show that when shareholders themselves can use the capital market to make a trade-off between return and risk, firms do not have to adjust their own decisions to the varying risk evaluations of stockholders. A firm can best safeguard the interests of stockholders by simply striving to maximize its capital value. In other words, it is not in the interest of stockholders that firms diversify away risks, since the shareholders can do so themselves by way of their own portfolio decisions.
The analysis also shows that the choice between equity financing and borrowing in a perfect capital market does not affect the market value and the capital costs of a firm. Under the same conditions, the market value of the firm is also unaffected by its dividend policy. This gives rise to the basic postulate of the theory: if there is an optimum capital structure and dividend policy for firms, i.e., if the capital structure and dividend policy influence the market value of firms, then this reflects deviations from the assumption of perfect capital markets, i.e., the consequences of taxes or other market imperfections.
Professors Markowitz, Miller and
You have by your research established the foundation for the field "Financial Economics and Corporate Finance". The impressive development of this field of research in economics in recent years is largely based on your achievements. It is a pleasure to convey to you the warmest congratulations from the Royal Academy of Sciences and to ask you to receive from the hands of His Majesty the King the 1990 Prize in Economic Sciences in Memory of Alfred Nobel.
From Nobel Lectures, Economics 1981-1990, Editor Karl-Göran Mäler, World Scientific Publishing Co., Singapore, 1992
Copyright © The Nobel Foundation 1990