Wednesday, 25 February 2009

A Brief History of Financial Engineering

c 550 BCE Thales, the father of western science makes money by using his scientific knowledge to become rich through olive speculation (Aristotle, Politics Book 1 part 11).

1202 Leonardo the Pisan (Fibonacci) introduces Hindu-Arabic numbers to Europe to aid in commercial calculations.

c 1250 Pope Innocent IV, in a commentary on cannon law, justifies the charging of risk premium for assets (Murray Rothbard, Economic Thought Before Adam Smith , Edward Elgar,1996)

c 1260 St Thomas Aquinas endorses insider trading (making profits based on information not know to the buyer) (Summa Theologica, Second part of the second part, 77, 3)

c 1564 Girolamo Cardano identifies the concept of mathematical probability.

1610 Galileo becomes the first “quant”. Having used a telescope to observe Jupiter, Galileo publishes his results, leaves Padua, and becomes “First and Extraordinary Mathematician of the University of Pisa and Mathematician to his Serenest Highness Cosimo II de Medici”. At Cosimo’s request, he investigates a gambling problem and publishes Sopra le Scoperte dei Dadi (Upon the Discoveries of Dice).

1654 The first derivative pricing formula is developed by Pascal and Fermat in answering the Problem of Points. The solution to the problem of points is essentially the same as the Cox-Ross-Rubenstein model. A special case of the discrete time CRR model converges to the continuous time Black-Scholes option pricing model.

1696 Newton becomes a quant, moving from Cambridge to the Royal Mint. In 1717 Newton moves England from the silver standard to the gold standard, fixing the price of silver to gold.

1738 Daniel Bernoulli publishes “An Exposition on a New Theory of the Measurement of Risk” in Russia. The manuscript appears to have been lost, reprinted in Germany in the late 19th century and then in English in 1954, 10 years after von Neuman and Morgenstern had introduced Expected Utility in the Theory of Games and Economic Behavour.

1860-1926 Maxwell develops the kinetic theory of gases, investigated by Einstein who discusses Brownian motion, which is defined mathematically by Weiner in 1926. In the late 1960s Robert Merton develops the theory of continuous time finance based on the Weiner process.

1933 Kolmogorov identifies probability with measure, enabling financial mathematicians to use the ideas of conditional probability and equivalent measures, which are the fundamental tools of derivative pricing.

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