Capital Ideas: The Improbable Origins of Modern Wall Street

In his book, Capital Ideas: The Improbable Origins of Modern Wall Street, Peter L. Bernstein examines the innovative financial work of various academics that helped shape modern Wall Street. Bernstein sets out to show that Wall Street is in fact a fundamental and useful model to follow, rather than something to be feared. He points out that, “By combining the linkage between risk and reward with the combative nature of the free market, these academics brought new insights into what Wall Street is all about and devised new methods for investors to manage their capital.” (2) These impressive scholars have incorporated scientific measurement to the art of finance, forever
In the real world firms with similar earning power and risk have very different capital structures, confirming the findings of Modigliani and Miller. Fischer Black, Myron Scholes, and Robert Merton paved the way for the establishment of financial derivatives in controlling risk. Black recognized that the relationship between gain and pain in the Capital Asset Pricing Model drives the market toward the equilibrium that Modigliani and Miller had described, and set out to apply this model to assets other than stocks. With this model and several assumptions, he derived the differential equation. When Black and Scholes joined forces, they found that neither risk nor return belonged in this new equation because they cancelled each other out. With this new discovery, they concluded that the expected gain on an asset is irrelevant in calculating what the current price of the asset should be. Merton soon joined Black and Scholes in their work, developing the intertemporal capital asset pricing model. This model used continuous time analysis to “transform CAPM into a description of what happens over a sequence of time periods during which conditions are changing rather than standing still.” (215) Black and Scholes were experimenting with combining stocks and options in such a way that the value of the option and the value of the stock would move by exactly the same amount in opposite directions. They found this combination to mimic