Louis Bachelier’s “Theory of Speculation” & The Origins Of Modern Finance
Bachelier’s use of brownian motion to evaluate stock options has provided the foundation for much of modern finance. Ironically, Mandelbrot disagrees with Bachelier’s notion that stocks options are “elementary particles” conforming to the rules of physics. I hope you enjoy this paper – regardless of external validity Bachelier’s work is a must read for students of financial history.
Background (Via Wikipedia)
Louis Jean-Baptiste Alphonse Bachelier (March 11, 1870 – April 28, 1946) was a French mathematician at the turn of the 20th century. He is credited with being the first person to model the stochastic process now called Brownian motion, which was part of his PhD thesis The Theory of Speculation, (published 1900).
His thesis, which discussed the use of Brownian motion to evaluate stock options, is historically the first paper to use advanced mathematics in the study of finance. Thus, Bachelier is considered a pioneer in the study of financial mathematics and stochastic processes.
Louis Bachelier’s 1900 PhD thesis Th´eorie de la Sp´eculation introduced mathematical finance to the world and also provided a kind of agenda for probability theory and stochastic analysis for the next 65 years or so. The agenda was carried out by succession of the 20th century’s best mathematician and physicists, but the economic side of Bachelier’s work was completely ignored until it was taken up by Paul Samuelson in the 1960s. By that time the mathematics— which certainly was not developed with any view towards applications in economics—was in perfect shape to solve Samuelson’s problems, and quickly led to the Black-Scholes formula, the watershed event in financial economics. The aim of this talk is to give some account of this twin-track development, based on the discussion in the recent book Davis and Etheridge (2006). The text below consists of some abridged extracts from the book.