Any financial historian attempting to document the origins of every significant theory used by market practitioners today will have a challenging task ahead. My contribution here is to give a sampling of the impact each discipline has had on the study of financial markets. It is important to remember that while many of these disciplines overlap, I will only emphasize on significant advances that originate squarely from other disciplines.

Economics

Economists were the early settlers. They brought to the study of finance, much of what is known today as standard microeconomic theory. Examples of this include utility theory (Bernoulli), no-arbitrage arguments (Modigliani & Miller) and information asymmetry (Akerloff). Remember, these theorists may be mathematicians in their own right, but the ideas clearly belong to the field of economics.

Mathematics

It is generally hard to de-couple mathematics from many other disciplines since mathematics is often used to demonstrate the properties of a theory. However, the application of optimization theory used by Markowitz (1952) in portfolio theory is a clear and powerful example of the influence of mathematics. Today, advanced optimization methods such as neural networks and genetic algorithm are commonplace. Also in the sub-field of statistics, areas such as stochastic processes, martingales and markov chains have now become an integral toolkit for derivative players. Interestingly, even fractal geometry developed by Mandelbrot, has found its place in financial markets.

Psychology

Kahneman & Tversky pioneered the application of psychology in financial markets in 1979. They developed prospect theory as a descriptive theory of choice under uncertainty. The theory suggests the hypothesis that investors display a disposition to sell winners and ride losers when standard theory suggests otherwise. Following their seminal work, academics spent a good part of the 1980s studying human behavior and its interaction to financial markets.

Physics

Professionals trained in theoretical physics have been involved in the study of finance for three decades. Fisher Black’s use of the heat equation to price options is undeniably the oldest and most famous success story. But that was all that physics had to offer, at least up till now.

In recent years, a growing number of physicists have become interested in financial markets. They even coined the term “Econophysics” to describe this movement. As an example, Ghashghaie et al (1996) proposed a formal analogy between the velocity of a turbulent fluid and the currency exchange rate in the foreign exchange market. Other areas in physics such as phase transitions or even highly excited nuclei have been applied to financial markets.

Conclusion

Undoubtedly each of the disciplines reviewed above has helped enrich our understanding of financial markets. But it’s worth noting that these disciplines have not provided us the financial market’s equivalent of the “Theory of Everything”. In fact, the cynical observer would blame the occurrence of market crashes to the simple fact that market players often unrealistically stretch novel theories into untenable trading strategies.

As we continue our search for the financial-market grail, we can only expect more contributions from disciplines far and wide. So the next time your dentist tells you which stocks to buy and why (as he merrily works on your mouth), pay attention – there might just be a link between dentistry and financial markets.

Any opinions or comments ?