PROFILES OF WORLD ECONOMISTS WILLIAM F. SHARPE doc. Ing. Veronika Piovarčiová, CSc. Faculty of National Economy, University of Economics in Bratislava Financial markets form an indispensable portant indicator and accelerator of econo- part of well-functioning modern market eco- mic development. nomies. Their impact upon the development The theory of financial markets is relative- of the main macro-economic parameters ly new. In commemoration of Alfred Nobel, such as economic growth, employment and the Swedish Royal Academy of Sciences ga- balance of payments has been growing in ve the prize for economics for the year 1990 importance. These markets are a vehicle for to the pioneers in this area, Harry M. Mar- transferring savings from different sectors of kowitz, William F. Sharpe and Merton Mil- the economy to firms, which in turn transform them in ler, whose research laid the foundations of the econo- investments into buildings, equipment, and modern mic theory of finance. technologies. Financial markets are therefore an im- William F. Sharpe was born in Boston, Massachussets on Ju- sertation. In terms of its title as well as contents, this paper con- ne 16, 1934. He received his secondary-level schooling from stituted a basis for what was later termed the Capital Asset Pri- eminent public schools in Riverside, California. In 1951 he en- cing Model (CAPM). rolled for the study of medicine and natural sciences at the Uni- In 1968 W. Sharpe moved to the University of California at Ir- versity of California at Berkeley. After one year, however, he vin, where he was supposed to take part in an attempt to create found that his interests lay somewhere else, and so he went to a school of social sciences with quantitative and interdisciplina- the University of California at Los Angeles, where he chose as ry orientation, which was not particularly successful. That is his major subjects corporate management, accounting and eco- why he left for the Stanford University Graduate School of Bu- nomics. In 1955 he received the degree of Bachelor of Econo- siness in 1970. At that time he finished the book called Portfolio mics and in 1956 he obtained the academic masters degree. Theory and Capital Markets, which summarized his research up Sharpe’s future career was notably influenced by two UCLA to that date, with a focus on the issues associated with the equi- professors. First and foremost it was Professor of Economics librium of capital markets and impacts on investors’ portfolio Armen Alchian, under whose influence he came to be enchanted choice. by the theory of microeconomics. He taught his students to chal- In 1973, W. F. Sharpe was appointed the Professor of Finan- lenge everything, to concentrate on the main issues and disre- ce at Stanford University. He extended his research into the ro- gard inessential ones, but most importantly, he was able to per- le of the investment policy of funds, focusing on the discharge of fectly defend his own thoughts. obligations with regard to the payment of pension benefits. At Fred Weston, Professor of Finance, under whose leadership that time he wrote his first textbook, Investments, which was Sharpe worked as a research assistant, not only introduced him published in 1978. It provided a summary of institutional, theo- to the work of Harry Markowitz, which at that time initiated the retical and empirical issues in the area of financial market in- revolution in the field of finance, but also recommended him to vestments and its publication met with great success. Its fourth consult with Markowitz on the topic of his dissertation entitled edition, co-authored by Gordon Alexander, has already been “Analysis of Portfolio Based on Simplified Model of Relations- published. The work on this textbook led Sharpe to extend his hips Between Securities”. Sharpe defended this dissertation in original theories and conduct new empirical analysis. This re- 1961, winning the PhD. degree. At the same time, he moved to sulted in the formation of a binomal process of option pricing, Seattle and started to teach finance, microeconomics, statistics, which provides a practical method for valuing instruments in- operational research and computer science at the Business volving multiple put options and is widely used today. He also School at the University of Washington, where he stayed until developed a simple, but efficient method – namely a portfolio 1968. analysis algorithm. In his dissertation work, Sharpe dealt in particular with the Apart from theoretical research, W. F. Sharpe also pursued positive theory of securities market behavior. The closing cha- the issue of practical utilization of findings made as part of the pter of this paper contained results similar to those nowadays economic theory of finance. During the course of his entire re- referred to as the securities market line relationship, but under search, he cooperated with a number of organizations in the the restricted conditions of a one-factor model. area of investment. He sat on the Board of Directors of nume- In 1963, he published a paper summarizing the normative rous investment firms and trusts. He worked as a consultant for conclusions from his dissertation work in Management Science, Merril Lynch, Pierce, Fenner and Smith and Wells Fargo In- and later on he expanded it for the generalization of the theory vestment Advisors. In 1980 he was elected the President of an of equilibrium contained in the concluding chapter of his dis- American financial corporation. His main focus was on decent- BIATEC, Volume X, 9/2002 21 PROFILES OF WORLD ECONOMISTS ralized investment management, but he also continued his work help pension funds and foundations in making decisions about on issues relating to the investment policy of pension funds, stu- the allocation of assets, as well as the provision of consulting died the process of generation of earnings in the American mar- services. ket for shares, as well as the allocation of investors’ funds to the In 1989 he became Emeritus Professor of Finance at Stanford main classes of assets. In order to make his findings available to University, and mainly focused on research and consulting for the public at large, he developed a program to optimize softwa- his company William F. Sharpe Associates. re and databases under the title of Asset Allocation Tools. W. F. Sharpe holds a number of acknowledgments for out- In 1983 W. Sharpe was involved in the international invest- standing contributions he made while lecturing on and resear- ment management program offered by the Geneva International ching into the science of finance. In 1990 he was awarded The Management Institute, and later by the London Graduate Scho- Nobel Prize for Economics for the formation of the Capital As- ol of Business as well as the Nomura School of Advanced Ma- set Pricing Model. nagement. He aimed to acquaint domestic and foreign invest- In 1986 he got married. His wife, Kathryn, is a painter and ment specialists practicing in the field of investment with the trustee of William F. Sharpe Associates. Sharpe has two child- latest findings of the economic theory of finance. ren – daughter Deborah and son Jonathan. His hobbies include In 1986 he founded the Sharpe-Russel Research, a firm targe- yachting, opera, as well as American football and basketball ted at the research and development of procedures intended to matches. The Contribution of W. Sharpe to the Science • taxes and transaction costs are negligible; of Economics • information is freely and immediately available to all inves- tors; The contribution W. Sharpe made towards the economic • investors have homogenous expectations, which means, science is very weighty and can be classified as falling under they have the same attitudes with respect to the expected re- the micro-economic theory of the capital market. According turns, standard deviation and covariance of securities. to his own words, he has always stayed within the confines of It is evident from the said assumptions that securities are as- positive economics, which enabled him to develop a descrip- sumed to be perfectly competitive under this model. These as- tive model of capital asset pricing. sumptions made it possible for Sharpe to examine what hap- Markowitz’s theory of portfolio choice presupposes that the pens to the prices of securities if everybody invests in a similar prices of securities are given and, assuming this, it defines manner, and thus to derive the essence of the resulting equilib- a procedure followed by a optimizing investor in his behavior. rium relationship between the risk and return of any security. Therefore the next necessary analytical step was to explain A very important feature of the CAPM is the so-called se- how prices of various assets are determined. The answer – alt- paration theorem, which reads as follows: an optimum com- hough very simple at first glance, that is by means of demand bination of risky securities can be determined without any for and supply of securities – however requires the definition knowledge about the investor’s attitude towards risk and re- of factors determining this demand and supply. That is why turn. The separation theorem relies on the attribute of a line- Sharpe concentrated on the determination of economic equi- ar efficient set, due to which all the portfolios located within librium through the price mechanism operating in the capital the linear effective set consist of a combination of one port- market. Drawing upon elementary microeconomic theory it folio solely formed of risky assets, involving either a risk-free holds true that current market prices for any security must al- investment or risk-free lending. From this it follows that the ways stand at such a level, where the number of each particu- risky portion of any investor’s portfolio is independent of the lar security demanded equals the number of this security offe- investor’s attitude towards return and risk.