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Finance, Economics, and Mathematics by Robert C. Merton, Oldrich A. Vasicek

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Chapter 1Introduction to Part I

Risk, 72-73, December 2002

The past fifty years or so have been a time of great bloom in the field of finance. This period has seen the birth of concepts such as variance as a quantitative definition of risk, portfolio diversification as a means of controlling risk, portfolio optimization in the mean/variance framework, expected utility maximization as an investment and consumption decision making criterion. These notions were applied in the development of Capital Asset Pricing Model to describe the market equilibrium, to the concepts of systematic and specific risks and the introduction of asset beta. We have witnessed the revolution brought by the theory of options pricing. We have seen the appearance of the general principle of asset pricing as the present value of the cash flows expected under the risk-neutral probability measure. We have seen the development of the theory of the term structure of interest rates and the pricing of interest rate derivatives.

These theoretical developments have been accompanied by equally exciting changes in investment practices and indeed in the nature of capital markets. Few of us can still envision investment decision making without quantitative risk measurement, without hedging techniques, without deep and efficient markets for futures and options, without swaps and interest rate derivatives, and without computer models to price such instruments. And yet, these are all very recent developments. It has not ...

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