16 October 1990

THIS YEAR'S LAUREATES ARE PIONEERS IN THE
THEORY OF FINANCIAL ECONOMICS AND CORPORATE FINANCE

The Royal Swedish Academy of Sciences has
decided to award the 1990 Alfred Nobel Memorial Prize in Economic
Sciences with one third each, to

Professor **Harry Markowitz**, City University of New York, USA,

Professor **Merton Miller**, University of
Chicago, USA,

Professor **William Sharpe**, Stanford
University, USA,

**for their pioneering work in the theory of financial
economics.**

**Harry Markowitz** is awarded the Prize for having developed
the theory of portfolio choice;

**William Sharpe**, for his contributions to the theory of
price formation for financial assets, the so-called, *Capital
Asset Pricing Model* (CAPM); and

**Merton Miller**, for his fundamental contributions to the
theory of corporate finance.

**Summary**

Financial markets serve a key purpose in a modern market economy
by allocating productive resources among various areas of
production. It is to a large extent through financial markets
that saving in different sectors of the economy is transferred to
firms for investments in buildings and machines. Financial
markets also reflect firms' expected prospects and risks, which
implies that risks can be spread and that savers and investors
can acquire valuable information for their investment
decisions.

The first pioneering contribution in the field of financial
economics was made in the 1950s by Harry Markowitz who developed
a theory for households' and firms' allocation of financial
assets under uncertainty, the so-called theory of portfolio
choice. This theory analyzes how wealth can be optimally invested
in assets which differ in regard to their expected return and
risk, and thereby also how risks can be reduced.

A second significant contribution to the theory of financial
economics occurred during the 1960s when a number of researchers,
among whom William Sharpe was the leading figure, used
Markowitz's portfolio theory as a basis for developing a theory
of price formation for financial assets, the so-called Capital
Asset Pricing Model, or CAPM.

A third pioneering contribution to financial economics concerns
the theory of corporate finance and the evaluation of firms on
markets. The most important achievements in this field were made
by Merton Miller, initially in collaboration with Franco Modigliani (who received the
Alfred Nobel Memorial Prize in Economic Sciences in 1985 mainly
for other contributions). This theory explains the relation (or
lack of one) between firms' capital asset structure and dividend
policy on one hand and their market value on the other.

**Harrv M. Markowitz**

The contribution for which Harry Markowitz now receives his award
was first published in an essay entitled "Portfolio Selection"
(1952), and later, more extensively, in his book, *Portfolio
Selection: Efficient Diversification* (1959). The so-called
theory of portfolio selection that was developed in this early
work was originally a normative theory for investment managers,
*i.e.*, a theory for optimal investment of wealth in assets
which differ in regard to their expected return and risk. On a
general level, of course, investment managers and academic
economists have long been aware of the necessity of taking
returns as well as risk into account: "all the eggs should not be
placed in the same basket". Markowitz's primary contribution
consisted of developing a rigorously formulated, operational
theory for portfolio selection under uncertainty - a theory which
evolved into a foundation for further research in financial
economics.

Markowitz showed that under certain given conditions, an
investor's portfolio choice can be reduced to balancing two
dimensions, *i.e.*, the expected return on the portfolio and
its variance. Due to the possibility of reducing risk through
diversification, the risk of the portfolio, measured as its
variance, will depend not only on the individual variances of the
return on different assets, but also on the pairwise covariances
of all assets.

Hence, the essential aspect pertaining to the risk of an asset is
not the risk of each asset in isolation, but the contribution of
each asset to the risk of the aggregate portfolio. However, the
"law of large numbers" is not wholly applicable to the
diversification of risks in portfolio choice because the returns
on different assets are correlated in practice. Thus, in general,
risk cannot be totally eliminated, regardless of how many types
of securities are represented in a portfolio.

In this way, the complicated and multidimensional problem of
portfolio choice with respect to a large number of different
assets, each with varying properties, is reduced to a
conceptually simple two-dimensional problem - known as
mean-variance analysis. In an essay in 1956, Markowitz also
showed how the problem of actually calculating the optimal
portfolio could be solved. (In technical terms, this means that
the analysis is formulated as a quadratic programming problem;
the building blocks are a quadratic utility function, expected
returns on the different assets, the variance and covariance of
the assets and the investor's budget restrictions.) The model has
won wide acclaim due to its algebraic simplicity and suitability
for empirical applications.

Generally speaking, Markowitz's work on portfolio theory may be
regarded as having established financial micro analysis as a
respectable research area in economic analysis.

William F. Sharpe

With the formulation of the so-called Capital Asset Pricing
Model, or CAPM, which used Markowitz's model as a "positive"
(explanatory) theory, the step was taken from micro analysis to
market analysis of price formation for financial assets. In the
mid-1960s, several researchers - independently of one another -
contributed to this development. William Sharpe's pioneering
achievement in this field was contained in his essay entitled,
*Capital Asset Prices: A Theory of Market Equilibrium under
Conditions of Risk* (1964).

The basis of the CAPM is that an individual investor can choose
exposure to risk through a combination of lending-borrowing and a
suitably composed (optimal) portfolio of risky securities.
According to the CAPM, the composition of this optimal risk
portfolio depends on the investor's assessment of the future
prospects of different securities, and not on the investors' own
attitudes towards risk. The latter is reflected solely in the
choice of a combination of a risk portfolio and risk-free
investment (for instance treasury bills) or borrowing. In the
case of an investor who does not have any special information,
*i.e.*, better information than other investors, there is no
reason to hold a different portfolio of shares than other
investors, *i.e.*, a so-called market portfolio of
shares.

What is known as the "beta value" of a specific share indicates
its marginal contribution to the risk of the entire market
portfolio of risky securities. Shares with a beta coefficient
greater than 1 have an above-average effect on the risk of the
aggregate portfolio, whereas shares with a beta coefficient of
less than 1 have a lower than average effect on the risk of the
aggregate portfolio. According to the CAPM, in an efficient
capital market, the risk premium and thus also the expected
return on an asset, will vary in direct proportion to the beta
value. These relations are generated by equilibrium price
formation on efficient capital markets.

An important result is that the expected return on an asset is
determined by the beta coefficient on the asset, which also
measures the covariance between the return on the asset and the
return on the market portfolio. The CAPM shows that risks can be
shifted to the capital market, where risks can be bought, sold
and evaluated. In this way, the prices of risky assets are
adjusted so that portfolio decisions become consistent.

The CAPM is considered the backbone of modern price theory for
financial markets. It is also widely used in empirical analysis,
so that the abundance of financial statistical data can be
utilized systematically and efficiently. Moreover, the model is
applied extensively in practical research and has thus become an
important basis for decision-making in different areas. This is
related to the fact that such studies require information about
firms' costs of capital, where the risk premium is an essential
component. Risk premiums which are specific to an industry can
thus be determined using information on the beta value of the
industry in question.

Important examples of areas where the CAPM and its beta
coefficients are used routinely, include calculations of costs of
capital associated with investment and takeover decisions (in
order to arrive at a discount factor); estimates of costs of
capital as a basis for pricing in regulated public utilities; and
judicial inquiries related to court decisions regarding
compensation to expropriated firms whose shares are not listed on
the stock market. The CAPM is also applied in comparative
analyses of the success of different investors.

Along with Markowitz' portfolio model, the CAPM has also become
the framework in textbooks on financial economics throughout the
world.

**Merton Miller**

While the model of portfolio choice and the CAPM focus on
financial investors, Merton Miller - initially in collaboration
with Franco Modigliani - established a theory for the relation,
via the capital market, between the capital asset structure and
dividend policy of production firms on one hand and firms' market
value and costs of capital on the other.

The theory is based on the assumption that stockholders
themselves have access to the same capital market as firms. This
implies that within the limits of their asset portfolios,
investors themselves can find their own balance between returns
and risk. As a result, firms do not have to adjust their
decisions to different stockholders' risk preferences. Corporate
managers can best safeguard the interests of stockholders simply
by maximizing the firm's net wealth. In other words, it is not in
the investors' interest that firms reduce risks through
diversification, as the stockholders can accomplish this
themselves through their own portfolio choice.

The basic model was formulated in Miller's and Modigliani's essay
entitled "The Cost of Capital, Corporation Finance and the Theory
of Investment" (1958); it was followed by two other important
essays in 1963 and 1966. Using this basic model, Miller and
Modigliani derived two so-called invariance theorems, now known
as the MM theorems.

The first invariance theorem states that (i) the choice between
equity financing and borrowing does not affect a firm's market
value and average costs of capital, and (ii) the expected return
on a firm's shares (and hence the cost of equity capital)
increases linearly with the ratio between the firm's liabilities
and equity, *i.e.*, the well-known leverage effect. The
second invariance theorem states that under the same assumptions,
a firm's dividend policy does not affect its market value.

In retrospect, the intuition underlying the MM theorems appears
simple. The effects of every change in a firm's financial asset
structure on the stockholders' portfolios can be "counteracted"
by changes in the stockholders' own portfolios. Investors are
quite simply not prepared to "pay extra" for an "indirect" loan
from a firm which increases its borrowing when the investor
himself can borrow on equal terms on the market.

The intuition behind MM's second invariance theorem, i.e., that
dividend policy does not affect the market value of the firm in
equilibrium, is also apparent in retrospect. An additional dollar
in dividends lowers the net wealth of the firm by one dollar
which, in efficient stock markets, implies that the stockholders'
units are worth one dollar less. This relation is not quite as
simple as it seems. As in the case of the first invariance
theorem, the mechanism which generates this conclusion is that
investors in the capital market can "counteract" changes in
firms' financial structure.

Both of the invariance theorems were originally derived under
highly simplified assumptions. Therefore, subsequent research has
to a large extent dealt with the consequences of various
deviations from the conditions on which the MM theorems were
based. This research has been in progress since the mid-1960s,
with Merton Miller as its leading figure.

Miller thus showed how the design of different tax structures
affects the relation between firms' capital asset structure and
market value, after taking into account the indirect market
effects of taxes through equilibrium price formation on financial
markets. Similarly, Miller analyzed the importance of bankruptcy
costs for the relation between a firm's financial asset structure
and dividend policy on one hand and its stock-market value on the
other.

The main message of the MM theorems may be
expressed as follows: if there is an optimal capital asset
structure and dividend policy for firms, *i.e.*, if the
asset structure and dividend policy affect a firm's market value,
then this reflects the consequences of taxes or other explicitly
identified market imperfections. The MM theorems have therefore
become the natural basis, or norm of comparison for theoretical
and empirical analysis in corporate finance. Merton Miller is the
researcher who has dominated this analysis during the last two
decades. He has thus made a unique contribution to modern theory
of corporate finance.

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