The Nobel Prize

William F. Sharpe (b. 1934)

William Sharpe was born in Boston, Massachusetts, USA, in 1934. In the 1940s his family moved to California and Sharpe enrolled at the University of California at Berkeley intending to study medicine. However, the preparatory courses were not to his taste and after a year he switched to a business administration degree at the University of California at Los Angeles (UCLA). He graduated from UCLA in 1955 with a BA and was awarded an MA, also by UCLA, in 1956.

After a short period of service in the US Army, Sharpe started work as an economist for the RAND Corporation in 1956. At the same time he registered for a PhD at UCLA. Sharpe’s PhD research benefited from advice given by his fellow Laureate, Harry Markowitz, then also at RAND. After completing his PhD in 1961, Sharpe was appointed assistant professor at the University of Washington in Seattle; he was promoted to associate professor in 1963 and professor in 1967. In 1968, Sharpe took up a professorial post at the University of California at Irvine, attracted by the prospect of interdisciplinary quantitative work in the social sciences (Nobel Foundation, 2004). However, the venture was not a success and in 1970 Sharpe moved as professor to Stanford University, where he stayed for the remainder of his academic career. In 1973 he became the Timken Professor of Finance at Stanford and then, from 1989 to 1992, the Timken Professor Emeritus of Finance, as he simultaneously branched out into private practice. He had also been senior research associate at the National Bureau of Economic Research in 1976–77. From 1992 to 1995, Sharpe was Professor of Finance at Stanford and from 1995 to 1999 STANCO 25 Professor of Finance. Since 1999 he has been STANCO 25 Professor Emeritus of Finance. Sharpe has extensive experience in the corporate sector. He has been consultant to more than 20 firms and has been chairman or president of several others.

Sharpe was director of the American Finance Association in 1977– 78, the association’s vice-president in 1979 and its president in 1980. He was director of the Western Finance Association from 1978 to 1980. He is also a recipient of the UCLA Medal, UCLA’s highest honour. In 1990, Sharpe was awarded the Nobel Memorial Prize in Economics, together with Harry Markowitz and Merton Miller, ‘for their pioneering work in the theory of financial economics’, and more specifically in Sharpe’s case ‘for his contribution to the theory of price formation for financial assets’ (Nobel Foundation, 2004).

Sharpe’s Nobel citation highlights his work on the capital asset pricing model (CAPM), which the Royal Swedish Academy of Sciences (1991, p. 4) calls ‘the backbone of modern price theory for financial markets’. His research interest in financial economics was confirmed by his choice of PhD topic. Under the aforementioned unofficial supervision of his RAND colleague Markowitz, Sharpe tried to produce a model that would simplify Markowitz’s prescription for portfolio choice.7 Sharpe’s PhD was entitled ‘Portfolio Analysis Based on a Simplified Model of the Relationship Among Securities’. His approach involved fastening co-variances between asset returns to the aggregate movement of returns for the market as a whole. Sharpe was adroitly using the observation that assets tend to move together broadly with the market. This allowed him to express asset co-variances with a common feature – the market – instead of pair-wise with each other as Markowitz had done, thus making for a much leaner calculation to arrive at an efficient portfolio. Sharpe (1963) called his finding the ‘single index model’, though it is now more generally known as the ‘market model’ (see Varian, 1993).

7 For which Markowitz himself was awarded the Nobel Prize – see entry for Markowitz in this volume. Although the market model was the first published outcome of Sharpe’s dissertation, its final chapter also contained the seeds of his work on the CAPM (Nobel Foundation, 2004). The paper that proposed the CAPM – ‘Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk’ – was published in the Journal of Finance in 1964.8 At about the same time, the late John Lintner independently derived the CAPM (see Lintner, 1965). The CAPM is a positive or descriptive theory of the relationship between a security’s expected rate of return and its risk. Although Sharpe’s research built primarily on Markowitz’s theory of portfolio choice, Markowitz’s approach had been to consider choice only among the family of risk-bearing assets, such as stocks, and not risk-free assets such as government securities. James Tobin9 extended Markowitz’s analysis by including the risk-free asset in the spectrum of portfolio choice. This produced the important result that the trade-off between risk and return for investors becomes linear. Its implication in the CAPM is that an identical portfolio of risky assets is appropriate for all investors. The only decision individuals have to make is how they should apportion investment between the risk-free asset and the risky asset portfolio. The outcome turns on their risk preferences. Sharpe’s insight was to recognise that the risky portfolio would, in equilibrium, precisely mirror that held by the market as a whole (Varian, 1993). The market portfolio is simply the aggregation of identical portfolios of the individuals who make up the market.

Sharpe employed the ‘beta’ of a risky asset to indicate the contribution of its specific risk to that of the market-wide portfolio of risky assets. The return on an asset with a beta of 1 will tend to move in tandem with the market. However, a risky asset with a beta of more than 1 will tend to be more volatile than the market as a whole with higher expected returns. A beta of less than 1 indicates an asset that carries less risk than the market with a lower expected return.

Adding an asset to a portfolio presents an investor with the opportunity to adopt an aggressive or defensive posture; for example, an asset with a beta greater than 1 is considered an aggressive asset. Note, however, that the CAPM demonstrates that, in all cases, in8 Publication was not a smooth process – Sharpe recollects that the paper was initially greeted by a negative referee’s report (Nobel Foundation, 2004). 9 Tobin was the 1981 Nobel Laureate – see entry in this volume. with the market portfolio and not according to the volatility of the asset itself. This is because any specific risk associated with an asset can be easily eliminated by appropriate diversification. In other words, the CAPM shows that expected returns are related to market risk rather than to total risk. Prior to Sharpe’s contributions it was understood that the risk associated with an asset simply reflected the dispersion of its returns.

In addition to his work on the CAPM and the market model (see also Sharpe, 1991), Sharpe is also known for his contributions to the analysis of mutual fund performance (Sharpe, 1966), the pricing of American options (Sharpe, 1978a), and for his analytical concerns regarding the distortions associated with deposit insurance in the banking sector (Sharpe, 1978b; and see Litzenberger, 1991). Finally, his books on finance include Sharpe (1970; 1985).

Main Published Works
(1963), ‘A Simplified Model for Portfolio Analysis’, Management Science, 9, January, pp. 277–
(1964), ‘Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk’, Journal of Finance, 19, September, pp. 425–42.

(1966), ‘Mutual Fund Performance’, Journal of Business, 39, January, pp. 119–38.

(1970), Portfolio Theory and Capital Markets, New York: McGraw-Hill; 2nd edn 2000.

(1978a), Investments, Englewood Cliffs, NJ: Prentice Hall; 2nd edn 1981; 3rd edn 1985; 4th
edn (with G.J. Alexander), 1990; 5th edn (with G.J. Alexander and J.V. Bailey), 1995; 6th edn (with G.J. Alexander and J.V. Bailey), 1999.

(1978b), ‘Bank Capital Adequacy, Deposit Insurance, and Security Values’, Journal of Finan
cial and Quantitative Analysis, 13, November, pp. 701–18.

(1985), Asset Allocation Tools, The Scientific Press; 2nd edn 1987.

(1991), ‘Capital Asset Prices With and Without Negative Holdings’, Journal of Finance, 46,
June, pp. 489–509.
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