Working Paper, University of Utah, Department of Economics 2010-04
Modern finance has a conceptually unified theoretical core that includes the efficient market hypothesis (EMH), the relationship between risk and return based on the Capital Asset Pricing Model (CAPM), the Modigliani-Miller theorems (M&M) and the Black-Scholes-Merton approach to option pricing. The core has been instrumental to the growth of the financial services industry, financial innovation, globalization, and deregulation. The significant impact of the core is explained by their success in elevating finance to the category of a science by extracting the acquisitiveness associated with economic freedom from the workings of a free market society. This success was somewhat of a paradox. The core theories/theorems were based on wildly unrealistic assumptions and did not stand out for their empirical strength. Overcoming this paradox required a methodological twist whereby theories were devised to create rather than to interpret or predict reality. This view led to a series of financial practices that increased the fragility and vulnerability of financial institutions setting the context for the occurrence of financial crises including the current one.