Fisher black and the revolutionary idea of finance

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Fisher Black and the Revolutionary of
Finance
Books Reading
Title Authors Publisher
Fisher Black and the
revolutionary idea of finance
Mehrling, Perry John Wiley & Sons, 2004
The Corporation : The
Pathological Pursuit of Profit
and Power
Bakan, Joel Free Press, 2005
Rethinking Corporate Crime J. Gobert & M. Punch Butterworths, 2003
Winning in Asia : strategies
for competing in the new
millennium
Williamson, Peter J. Harvard Business School
Press, 2004
Success Built to Last Jerry Porras, Stewart &
Emery & Mark Thompson
Wharton School Publishing,
2006
Background of book critique
We took Fisher Black and the Revolutionary Idea of Finance as the anchor book and link
the CAPM concept to other books.
1. FISHER BLACK AND THE REVOLUTIONARY IDEA OF FINANCE
The author, Perry Mehrling, closes his fascinating book on “Fisher Black and the
revolutionary idea of finance” with the following paragraph:
“Fisher Black was many things. But first and foremost, from beginning to end, through
thick and thin, he was a man of ideas. And the big idea that occupied his mind, first and
Sukarnen
DILARANG MENG-COPY, MENYALIN, ATAU
MENDISTRIBUSIKAN SEBAGIAN ATAU SELURUH
TULISAN INI TANPA PERSETUJUAN TERTULIS
DARI PENULIS
Untuk pertanyaan atau komentar bisa diposting
melalui website www.futurumcorfinan.com

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foremost, from beginning to end, through thick and thin, was CAPM, the revolutionary
idea of finance”
Fisher was an original, but it was Jack Treynor who set his originality on the path of
exploring the revolutionary idea of finance by introducing him to CAPM. Fisher Black
originally started out in science and mathematics and never had a course in economics
or finance. In 1965 while working at Arthur D. Little in Boston, he met Jack Treynor and
was captivated by his theories, one of them is CAPM, the revolutionary idea of finance.
The revolutionary idea of finance is about risk. In all investment decisions, the biggest
source of risk is time. The world around us is always changing, so it is impossible to
know what the future holds. In Fisher’s world, the future is unknown, and it is probably
not even stationary, so knowledge of the past is not much help to us. From a scientific
point of view, formal mathematical theories that rely on assumptions of stationarity in
order to find determinate solutions to the optimizing problems of the firm or the
household assume away the essential core of the problem!!!
Risk and time, Fisher said, are the problems that define the modern field of finance. To
make matters worse, of the two prices that guide individual choices, we actually observe
only the rate of interest, not the price of risk. In Fisher’s world, we can’t observe the price
that links today with tomorrow, so we can’t hope to optimize over time. What we observe
is the market price of current wealth, and all we can choose is how to allocate that
wealth today. Modern finance tells us how to reduce risk by diversifying over time, if only
we know the expected return and so can confine our attention to fluctuations around the
return. In that case we simply adjust our risk exposure so that we hold constant the
fraction of our wealth invested in risky assets. There is unfortunately, no particular
reason that expected return is constant over time, and there is also no particular way to
know how it changes. Fisher kept reminding himself that what matters is not the realized
historical return but the expected future return. He once said, “It’s one thing to have a
clear vision of the investment future; it’s another to be right”.
The CAPM tells how you can improve the expected return on your portfolio of risky
stocks without increasing your exposure to risk, simply by holding a widely diversified
market portfolio and then using leverage, rather than stock selection, to adjust your
overall risk exposure. This works because the risk in the market portfolio comes with a
commensurate expected payoff, whereas the risk in an individual stock may not. The
reason is market equilibrium. In a world where people get to choose whether to take a
risk or play it safe, they will take the risk only if there is a prospect of sufficient expected
return. The return associated with a given risk is the price of that risk, the price that
needs to be paid in order to induce people to take it. It doesn’t make sense to take risks
unless you get paid for doing so. But it also doesn’t make sense to avoid risks that do
pay, since risk is the cost of rewards. So the revolutionary idea of finance is about
when and how to avoid it but also when and how to embrace it.

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Although the CAPM seems to be about stocks and the stock market, its argument,
especially market equilibrium, is more widely applicable, and that wider application is
what caught the imagination of the young Fisher Black.
The extension of the CAPM introduced by Fisher is a world in equilibrium is a world with
no role for monetary policy. Fisher extended CAPM idea of equilibrium in the markets for
risky stocks to include also equilibrium in the market for riskless borrowing and lending.
A world in which the central bank controls the money supply is a world out of equilibrium,
which means there are profit opportunities for the savvy investor to exploit. This is why
when he was in Goldman Sach, Fisher concluded that there were at least two reliable
sources of trading profit that would survive even in full equilibrium. One of them is being
involved in taking advantage of central bank intervention, either in currency markets or in
credit markets.
However, as Fisher learnt from his experience in academia and as being a practitioner,
the real world is not this ideal CAPM world. In time, Fisher would come up with three
good reasons: costly information, costly management and costly selling. The great
contribution of CAPM is that it gives us the knowledge we need to reconstruct the world
on rational grounds, starting with index mutual funds and uncontrolled banking. And it is
worthy noted that CAPM as finance people know, is, and is, a formula, which sometimes
the market knows more than the formula. And the formula had become a source of
noise, as discovered by Fisher at Goldman Sachs, that markets often seemed to follow
Black-Scholes even when there were good reasons not to.
This book is not typical biographies, and devoted relatively little attention to Fisher’s life
beyond his professional activities. Initially, the research for the book project was almost
entirely archival. Since the author expanded to not only straddle the worlds in which
Fisher lived, both academia and practical business, but also the personal life that
supported the intellectual venture of this unusual mind, the author did more than a
hundred people, including Fisher’s family, high school buddies, college, graduate school
roommates, friends and housemates, people he was interacting with at Arthur D. Little
(ADL), Wells Fargo Bank, the University of Chicago, the Massachusetts Institute of
Technology, and Goldman Sachs.
2. The relationship of this book with other views in other books
The idea with the CAPM world is an equilibrium, which means that any deviation from it
must offer an opportunity for profit somewhere. So it is the profit motive that drive the
whole CAPM world. What we call a business cycle, is actually, is the fluctuating return
on capital. The business cycle we get is a business cycle we choose, based on the
community tolerance for risk. If we want an economy that produces a lot of
goods/services, resulting in higher revenue and profit growth, then we simply have to
learn to live with a rather wide range of fluctuation.

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The Anglo-American markets have a philosophy that a firm’s objective should follow the
shareholder wealth maximization model. More specifically, the firm should strive to
maximize the return to shareholders, as measured by the sum of capital gains and
dividends, for a given level of risk. Alternatively, the firm should minimize the risk to
shareholders for a given rate of return. The shareholder wealth maximization model
assumes as a universal truth that the stock market is efficient. And its definition of risk as
a universal truth. Risk is defined as the added risk that the firm’s shares bring to a
diversified portfolio. The total operational risk of the firm can be eliminated through
portfolio diversification by investors. This concept reflects risk that the share price will be
a function of the stock market.
It is where instead of seeking long-term value maximization, the companies sought
short-term value-maximization.
2.a. RETHINKING CORPORATE CRIME
Conventional view attributes corporate offences primarily to a desire to enhance profit.
While it might seem logical that companies in financial difficulties, or which were
performing poorly, would be more inclined to violate the law than financially solvent
organizations, the correlation appears weak (Jamieson: 1994). Many underperforming
companies do not succumb to illegal shortcuts, and perhaps even more significantly,
many companies that are prospering also break the law (Snider: 1993: 75). Single
variable explanations, such as the pursuit of profit, the pressures of competition, market
condition, or greedy manager, fail to explain why some companies are inclined to
criminality while other similarly situated companies are not.
While not proposing to make exhaustive survey of all possible explanation, we believe
that five key variables are worthy of closer examination. First, is a constellation of social,
economic and cultural factors that may contribute to a climate that is tolerant of
corporate law breaking. Second, different organizational structures may have an impact
on whether or not a company engages in rule-bending. Third, it maybe useful to consider
to what extent corporate crimes are the product intentional and rational decision, or
whether they are attributable to incompetence, negligence, recklessness or sheer bad
luck. This variable will take on particular importance in determining legal accountability.
Fourth, what effect does engaging in criminal activity have both on a company and those
who make the decision to turn illegality? Does it affect the latter’s operating style and self
image? And what defense mechanisms and techniques do they, and the company,
employ to dissociate them from criminality? A fifth and final consideration is the nature of
various industries. Most industries offer some opportunity for illegality; some however,
may be more ‘crime—facilitative’ than others, and a few may even be described as
virtually ‘crime coercive’.

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2.b. THE CORPORATION : THE PATHOLOGICAL PURSUIT OF PROFIT AND
POWER
Corporations would like us to believe that they could be trusted to behave in a socially
responsible way and work for the public good: that the tyranny could be benevolent. And
of course, some do, and some work for the public good, sometimes. But, as Bakan
argues, it can be only done in service of the profits and thus cannot be relied upon. It
would be illegal, or even, as Milton Friedman claims, immoral, for corporations to behave
otherwise.
Corporations would also like us to believe that we can rely on self-regulation and market
pressure from consumer and shareholders in order to keep them in check and that the
democratic control and government regulation is unnecessary. That corporations should
be the partners of the government. This notion is so ubiquitous now that it's not often
argued with, but Bakan questions it and a very valid point he makes. The notion of
partnership suggest equal rights: but democratically elected government and
corporations are not equal. The government which, has to be remembered, creates the
corporate entity also controls it and has the power to invoke its charter.
The weakness of the government is illusory: the governments are not weak, they simply
are playing more and more on the corporate side. The power has been redistributed
towards protecting the interests of corporations and not the interest of the public. The
state still regulates the corporations, but more in the corporations' interest. But it doesn't
have to be this way.
2.c. SUCCESS BUILT TO LAST
Although Fisher never took a course in either economics or finance, however, the quest
for new knowledge was the motivation behind almost everything that Fisher ever did.
Fisher got away with his persistent nonconformity mainly because he was so clearly
sincere. He wasn’t chasing status, or money, or personal power, only ideas. Most
important, he simply enjoyed the process of using his mind to solve the problems. In his
view, if a problem does not yield to known methods, that doesn’t mean we need more
sophisticated methods, indeed probably just the opposite. Usually problems are hard not
because our technique is deficient but because our understanding is deficient.
Kemampuan untuk terus berfikir positif dan selalu mencoba untuk mencari solusi dari
suatu masalah adalah ciri orang-orang sukses yang digambarkan dalam hasil penelitian
Porras dkk ini. Dari hasil interview yang didapat bahwa sukses seseorang bukan
bersandar pada persetujuan orang lain untuk mengejar tujuan mereka, orang-orang
sukses mengambil inisiatif meskipun tingginya tekanan sosial yang dihadapi karena
mereka lebih merasa terikat melakukan apa yang mereka cintai dibanding mengikuti
keinginan orang lain. Walaupun sekarang kita hidup di jaman ekonomi gobal, tetapi
bukan uang namun bakat, keahlian, ketahanan yang dinomorsatukan, dapat
berhubungan baik dengan semua orang dan kemauan keras lebih penting.

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Dikaitkan dengan tiga tahapan menuju sukses yang tertuang dalam buku ini, yaitu:
Meaning diartikan sebagai sikap teguh pada keyakinan sendiri, berani membuat
perbedaan. Pelajarannya adalah anda tidak bisa membajak sistem orang lain,
Thought diartikan sebagai pemikiran positif yang dibutuhkan untuk menghadapi masalah
Action sebagai bentuk manifestasi dari meaning dan thoughts. Bagaimana cara
merubah keinginan menjadi tindakan (action). Berdasarkan hasil survey responden lebih
memilih melakukan pekerjaan yang benar-benar mereka suka untuk mendapatkan hasil
yang sempurna.
2.d. WINNING THE ASIA
Started from the efficient markets idea, that returns are, independent random variables
from one year to the next. The fact that returns have been low does not mean they will
continue to be low. Indeed, if anything the recent experience of low returns might lead
one to anticipate higher returns in the future. Why so? Fisher reasoned that since,
empirically, volatility tends to decrease as stock prices rise and since, theoretically,
expected returns should be correlated with volatility, it follows that expected returns
should be high when prices are low and low when prices are high. What causing
volatility? Uncertainty, and not disequilibrium, that was the source. The same
applies to business fluctuation. For Fisher the important thing was not the aggregates
but rather the detailed sectoral pattern of production and demand. It is in this context,
that the strategies for competing in the new millennium of Asia, a world of uncertainty,
that Fisher’s idea becomes relevant.
Strategies for competing in the new millennium, presents one perspective on the Asian
business crisis, and Williamson attempts to paint a picture of Asian businesses in the
future by examining the challenges businesses face, and the new and different
approaches they might take to re-build. He makes a number of predictions about how
Asian businesses will change their approach to regain, build and maintain market
position to make profit and return for the company and shareholder’s wealth. Regarding
with Fisher’s idea, the important thing was not the aggregates but rather the detailed
sectoral pattern of production and demand, so according Williamson in this book the
winning in Asia addresses the sectoral pattern in that region have to:
1. Moving from operational productivity to “total productivity”
2. Building new capabilities for innovation and differentiation
3. Creating powerful new brands that leverage long-standing Asian traditions
4. Coordinating and managing business across geographic borders
5. Using mergers and acquisitions to drive industry consolidation

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However, these changes will take time and will not be easy, and within uncertainty. It’s
mean, in uncertainty equally with variance which Fisher said risk and time are the
problems that define the modern field of finance.
3. PERSONAL’S CRITIQUE
3.a. FISHER BLACK AND THE REVOLUTIONARY IDEA OF FINANCE
Although the book titled “….. and the Revolutionary Idea of Finance”, the readers will
barely find any mention of Markowitz (page 85). Yet it was widely recognized that the
CAPM comes out of two things : Markowitz, who showed how to create an efficient
frontier (provided we feed the expected returns and covariance’s for every asset under
consideration), and James Tobin, who in a 1958 paper said if you hold risky securities
and are able to borrow – buying stocks on margin --- or lend --- buying risk-free assets --
- and you do so at the same rate, then the efficient frontier is a single portfolio of risky
securities plus borrowing and lending, and that dominates any other combination, or
well-known referred to as Tobin’s separation theorem. Both the CAPM and index funds
come from that.
In Chapter 3 “Some Kind of an Education” it was said that “Whereas Sharpe started from
the problem faced by the individual investor, and Lintner started from the problem faced
by the individual firm, Fisher consistently took the perspective of the economy as a
whole. Everyone else used the idea of equilibrium only to help solve the problem. Only
Fisher adopted the idea of equilibrium as the very essence of the problem”. However, it
is not yet clear how Fisher (or Treynor) took the perspective of the economy as a whole
to build its theory on CAPM”. It was Sharpe that has a broader aim of constructing “a
market equilibrium theory of asset prices under conditions of risk”. Portfolio theory
focused on the actions of a single investor with an optimal portfolio. What would happen
to risk and return if everyone followed Markowitz and built efficient portfolios. What if
everyone was optimizing. The process of upward and downward pressure on prices
continues until prices reach an equilibrium and everyone collectively wants to hold
what’s available.
3.b. RETHINKING CORPORATE CRIME
The foundation for analysis rests on writer’s view of the company as an organic entity
that has responsibility as a corporate citizen to obey the law and to promote law-abiding
behavior by its employees and officers, but the analysis primarily within an English law
context.
3.c. THE CORPORATION : THE PATHOLOGICAL PURSUIT OF PROFIT AND
POWER
A bigger problem, at least for a non-American reader is in the fact that Bakan concerns
himself exclusively with the Anglo-American model of corporate business. He doesn't
look to how things can be done - are done - in other countries, especially countries

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where the European social model of capitalism operates, like Sweden and Germany. I
am not entirely sure if I am correct, but I believe that for example Indonesian
corporations have a legal duty to uphold interests of other stakeholders. It would be
interesting, and would probably strengthen the argument if examples of existing
solutions could be explored.
3.d. SUCCESS BUILT TO LAST
Berbagai profil disajikan dalam jelas dalam buku ini termasuk tokoh-tokoh politik
Amerika juga menjadi bagian dalam buku ini dan coba dibandingkan satu dengan yang
lain, sehingga terkesan penulis mencoba mengarahkan pembaca untuk menilai tokoh-
tokoh tadi sesuai dengan pemikiran penulis, hal ini dirasa kurang etis karena identitas
mereka pun tidak disamarkan, akan lebih baik jika penulisan tentang kehidupan masing-
masing mereka lebih imbang mengingat seperti yang dijabarkan dalam buku ini terlalu
membahas satu tokoh dibandingkan tokoh lainnya
3.e. WINNING IN ASIA
Williamson states, 'will require Asian companies to combine their traditional strengths
with the best business practices from around the world to create new and distinctive
Asian multinational companies' (p.1), and 'to develop and implement these kinds of
strategies requires much more than the absorption of new technologies and skills. It
demands fundamental changes in yesterday's mind-sets, organizational structures, and
management processes' (p.3). But in fact in Asia’s region attention must also be given to
the traditional Asian views regarding fear of failure/low risk-taking, family ownership, and
the low levels of regulation and monitoring of business practices. However, they also
caution against the automatic adoption of successful Western turnaround approaches
because these need to be adjusted to take into account the differences in culture,
institutional environment and implementation strategies
4. RECOMMENDATIONS OR COMMENTS FOR FURTHER RESEARCH
One of the distortions in the trading strategies is the tendency of human beings to have
excessive faith in the results of complicated calculations rather than asking whether and
how they make sense. A case in point mentioned on page 248 is about the Black-
Scholes options formula. Markets often seems to follow Black-Scholes even when there
were good reasons not to. The formula had become a source of noise. It is interesting to
become a further research to see how a CAPM-based analysis could be a source of
noise in the trading.
Globalization brings new challenges, new opportunities, but it also raises new
vulnerabilities that need to address. For further research, it is necessary to ensure both

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effective legal controls and enforcement strategies to deal with important issues that
arise in the field of organized crime, to understand the conditions in which they flourish,
and the means by which they can be controlled.
POWER
At a time of unprecedented economic expansion and a booming stock market, it seems
strange to find that business facing a crisis. The changes being forced on business by
major stakeholders who themselves were victimized by shareholder-value-driven
managers, however, have crisis-like implications for the future of business. No less of a
crisis is that managers themselves have mortgaged the future of their corporations in
return for a higher stock price now. Who is to blame for allowing this crisis to develop? In
the Enron case, it were widely recognized that all parties have taken part in getting this
happen, management, shareholders, regulatory bodies, government, investment
bankers, accounting firm, lawyers, etc. This will be a good research to see whether
shareholder value is drawing near to end?
Secara keseluruhan buku ini apik yang membahas tentang cara positif mencintai diri
sendiri dan meraih kesuksesan namun pada studi ini dibatasi untuk responden yang
memiliki kesuksesan minimal 20 tahun, sehingga tidak heran jika usia responden
berkisar 40-95 tahun dengan berbagai kisah dan prinsip hidup mereka hingga mencapai
sukses, padahal banyak pula orang yang bisa meraih sukses diusianya yang masih
muda dan diharapkan ada studi lanjut yang bisa menjabarkan kisah sukses mereka
(kurang dari 40 tahun) sehingga bisa lebih mewakili kaum muda saat ini untuk
menghadapi permasalahan yang dihadapi di masa sekarang yang tentunya berbeda
masa dengan responden yang dipilih dalam buku ini.
In Winning in Asia, Williamson describes what this Asian hybrid will look like and what
local firms must do to build it. Williamson reveals the new business models,
organizational structures, strategic mind-sets, and management processes that will
become the hallmarks of success in the future. For future research, it will be interesting
to describe and explain how relationship between strategic mind sets could create value
of the firm to maximize shareholder’s wealth in uncertainty and unpredictable changes .
4. RELEVANCY
What the most interesting part of the book “Fisher Black and the Revolutionary Idea of
Finance” is not about CAPM as an equilibrium model, yet it was what Fisher Black’s view

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about finance. Fisher originally started out in science and mathematics and never had a
course in economics and finance. However, he saw finance not as merely a collection of
academic papers theorizing what the (financial) markets should be or to explain why the
markets behave in such way. Rather it was more like a language, and learning finance
was essentially about learning to construct grammatical sentences in the language of
finance. That’s why when faced with a new problem, he was not to go the blackboard
and write down a mathematical model, but rather to talk around the problem,
approaching it simultaneously from as many different angles as possible, and almost
entirely with words, not mathematics. It is framework that matters, not formal modeling.
Formal modeling would come later, if and only if, the problem has been essentially
solved. Oftentimes, the breakthrough comes by thinking not about what had to be in the
formula but rather about what had to be absent from it.
Other point that is relevant to finance graduates is what Jack Treynor had in his Editor’s
comment of Financial Analyst Journal March/April 1973, page 6, which he said that “one
of the dangers in our system of formal education, however, is that a student can go all
the way through to an advanced degree in many fields without ever having seen an idea
in the rough. An academic with this kind of background may even have trouble
recognizing a new idea when he has one”. This is a critique towards current traditional
methods which are better at producing academic careers than new knowledge.
The analysis entails looking closely at the organizational and managerial context in
which corporate misconduct takes place that will prove of value to finance graduate.
POWER
This is a point to consider, but what's so bad about corporations? Don't they make
available cheap food, cheap computers, and reasonably-priced cars? Haven't the U.S.
(or multinational) companies made the U.S. the world's most prosperous country, the
envy of most people globally? This may be true, but as with all things, there has been a
cost.
Orang yang membangun kehidupan yang sukses dan penuh arti tidak pernah memasuki
fame, power or fortune (ketenaran, kekuasaan atau kekayaan), banyak diantara mereka
percaya bahwa kesuksesan tidak akan hilang jika semuanya adalah hasil yang telah
kamu coba untuk mencapainya. akhirnya fame, power dan fortune akan mengikutinya.
Pengertian ‘sukses’ menurut buku ini adalah kemampuan untuk membuat perbedaan,
menciptakan dampak yang kekal, dan terlibat dalam suatu relationship. Yang khusus
dari menjadi orang sukses yang abadi adalah bahwa mereka ingin terus lebih,

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dibandingkan saat ini. Pernyataan di atas relevan dengan gambaran tokoh-tokoh
populer yang memiliki kesuksesan yang kekal.
Williamson has provided a comprehensive look at the Asian business approach and
some valuable insights into the potential development focus of Asian businesses. The
many examples from local Asian firms used to illustrate his argument serve to reinforce
his perspective and prognosis for the Asian business scene. Providing unique insights
into how these new Asian rivals will compete, Williamson helps multinationals leverage
their strengths to develop potent counterstrategies. A must-have strategy guide for local
Asian firms and multinational operations alike, this book provides a blueprint for
competing – and winning – on the new Asian playing field. To successfully move Asian
businesses in the direction proposed by Williamson will require a change to the general
strategic mind-set of most CEOs, a re-examination of structural and management
processes, and a willingness to adopt models and practices from outside their comfort
zone .
~~~~~~ ####### ~~~~~~

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Disclaimer
This material was produced by and the opinions expressed are those of FUTURUM as of the date
of writing and are subject to change. The information and analysis contained in this publication
have been compiled or arrived at from sources believed to be reliable but FUTURUM does not
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