ANZ Finance blog | The French Connection in Finance Theory

The French Connection in Finance Theory

Published 16 April 2021

By Dr Peter J Phillips, Associate Professor (Finance & Banking) University of Southern Queensland

The French Connection in Finance Theory -- McGraw Hill ANZ Finance Blog

Imagine strolling across an American university campus in 1961. Perhaps MIT, nestled against the Charles River in the Massachusetts city of Cambridge, with its neat array of sandstone-coloured buildings. Postcard perfect in a quintessentially American way. We might stumble across one of the professors then hard at work building modern finance theory. His fingers might be dusty with chalk and his brow might be lightly perspiring in the close heat of a summer’s day. Or perhaps it is January and he is rubbing his hands together to keep warm as he shuffles across campus in his winter coat.

"…if we cast our minds across the Atlantic… until we reach a little French city called Le Havre on an estuary of the Seine, we will have found the birthplace of a man whose contributions to modern finance are every bit as important…”

Yes, for the most part, modern finance theory was created in places like this. But if we cast our minds across the Atlantic, sweeping across England and France until we reach a little French city called Le Havre on an estuary of the Seine, we will have found the birthplace of a man whose contributions to modern finance are every bit as important, though they lay more or less undiscovered for half a century.

Louis Bachelier was born in Le Havre on March 11, 1870. In 1900, he successfully completed his PhD at the University of Paris. It was entitled Théorie de La Speculation. In it, Bachelier accomplished some amazing things. First, he developed a theory of options pricing. Second, he developed the idea of an option payoff diagram. Third, and most importantly, he developed a random walk (Brownian motion) model of stock price movements. And fourth, he anticipated later work in physics, especially Einstein’s model of Brownian motion, which Einstein did not complete until 1905.

"Bachelier’s work was finally recognised during the 1950s and by 1964 an English translation was included in Cootner’s important book, taking Bachelier’s work to a broad aud.ience for the first time."

Bachelier’s work was not recognised by economists until much later. One of the first books I read when I began researching financial markets in the late 1990s was Paul H. Cootner’s collection of papers, published in 1964 as “The Random Character of Stock Market Prices” (MIT Press). Here, Cootner collects research that had appeared in various journals going back to the early 1900s. The collection contains an English translation of Bachelier’s thesis. Bachelier’s work was finally recognised during the 1950s and by 1964 an English translation was included in Cootner’s important book, taking Bachelier’s work to a broad audience for the first time.

Bachelier’s model of stock price movements forms a fundamental part of the efficient market hypothesis developed by Eugene Fama and provides a cornerstone for the Black-Scholes option pricing model. Bachelier’s general idea is that the next movement of the stock price has no connection to the history of price movements. You cannot study the history of prices and use that information to predict the future. We think of stock prices moving because there is some news that is relevant to those prices. But tomorrow’s news is unpredictable. Hence, a model like Brownian motion embeds this logic of unpredictability.

"...a pioneer who never strolled the grassy quads of American university campuses but who holds a place of prominence in the business libraries and finance courses that are taught all over North America."

Bachelier can be thought of as a founding father of quantitative finance. His work was the beginning of the application of mathematical methods to the analysis of financial markets and sits alongside contributions by Markowitz, Black, Scholes and Merton among others as having pointed the way towards the structure and logic that underlies the apparently chaotic oscillations in asset prices. Bachelier died in 1946, before finance theory began to be developed and before his ideas were fully appreciated. We feel bad when someone does not get to see the full influence of their work, but we can recognise the French connection that lies at the heart of modern finance and remember a pioneer who never strolled the grassy quads of American university campuses but who holds a place of prominence in the business libraries and finance courses that are taught all over North America.

Discussion Question

What is Brownian motion and what is its connection with the random walk model of stock market prices?

Further Reading

Some of these themes are touched on in our chapter of the textbook on stock market prices (chapter 7) and options pricing (chapter 20). of the