The recent financial crisis is often associated with unintended consequences of financial innovation. According to the common narrative, the development of "financial weapons of mass destruction" allowed deteriorations in public and private debt that brought down private households, banks, and even national governments. The present essay aims to make use of the financial crisis as "large scale and unusual event … [that] provides an opportunity to ask basic questions." It will investigate into factors that determine success and failures of financial innovations. Why is it that at certain times, new theories and perceptions of financial markets are convincing to academics and practitioners, while at other times the same instruments and ideas are only met with disapproval in universities, board and trading rooms?
In order to answer this question, this essay focuses on the case of LOUIS BACHELIEr. In 1900, BACHELIER, a young French mathematician and disciple of LOUIS POINCARÉ defended his dissertation for the degree of Doctor of Mathematical Science at the Sorbonne in Paris. The title of the dissertation was "The Theory of Speculation" . In the thesis, BACHELIER proposed a model for calculating option prices based on mathematical predictions concerning the price movement of the underlying asset. His thesis did not contain a single formal error and while BACHELIER referred to equilibrium assumptions where modern option pricing models rely to the no-arbitrage-theorem, his approach follows the same principles as the models brought forward by BLACK-MERTON-SCHOLES (1972) more than 70 years later. Yet, while F. BLACK, R. C. MERTON, AND M. S. SCHOLES' papers revolutionized modern financial theory and industries, BACHELIER'S achievements went by almost unnoticed during his time.
The present paper compares the works of BACHELIER, and BLACK-MERTON-SCHOLES in order to find reasons for their different rates of success. Formal differences between the models of BACHELIEr and BLACK-MERTON-SCHOLES have already been investigated. Building onto these results the paper aims at filling gaps in the existing discourse, and looks at additional factors that may help to explain why models that were very similar in structural terms, caused almost opposite reactions in the financial communities of their respective time. The aforementioned goals imply that the paper will not only focus on theoretical congruencies and differences in the models of BACHELIER and BLACK-MERTON-SCHOLES. Rather, the paper is also looking at differences in the historic contexts in which the models were developed so as to understand variations in the latters' receptions. As the paper is thus providing a multi-layered perspective on crucial points within the evolution of modern financial theory, it provides insight for audiences that look at financial concepts and institutions as products of abstract reasoning, as well as results of specific economic and social contexts.
The paper will proceed as follows: In a first part (II) it will provide a short history of stochastic approaches to asset pricing so as to determine the respective relevance of the approaches of BACHELIER and BLACK-SCHOLES-MERTON due to the role each of the approaches played for the evolution of modern financial theory. In a second part (III), the paper will review the basic mechanics of the BACHELIER model so as to compare them to the theories of BLACK-SCHOLES-MERTON. In a third part (IV), the paper will analyse the reasons that explain the different "rates of success" of the models. The fourth part (V) concludes with a summary of results and their limitations and provides an outlook on further research.
The paper contrasts the models of BACHELIER and BLACK MERTON SCHOLES in terms of formal content, as well as with regard to their respective scientific contexts, and financial environments in 1900 and 1973. As the paper aims at obtaining generalizable information on factors that help explain the successful evolution of financial theorems, concepts, and institutions, biographic aspects such as the personality and individual characters of BACHELIER, BLACK, MERTON, and Scholes will be excluded from its analysis. Econometrically speaking, the paper is regarding these factors as error terms due to their subjective individuality, which - as interesting and relevant as these factors may be - does not allow for structural generalizations. The present paper thus aims at nothing more - but also at nothing less - than offering an explanation which in analogy to the observation of the Italian physicist E. MAJORANA provides insights into "basic laws governing elementary phenomena" while only being able to establish "the probability that a measure performed in a prepared system will give a certain result."
