Merton Miller and Modern Finance

Financial Management (Financial Management Association), Winter, 2000 by Rene M. Stulz

So, if the leverage irrelevance proposition is not the most important contribution that we should remember from the paper, what is? What makes Proposition I memorable and changed finance is not the Proposition itself but its proof. The other authors did not have the proof. Remember how the proof works. Modigliani and Miller assume that financial markets are perfect, so that there are no frictions whatsoever, and that the firm's cash flow is independent of its capital structure. They then show that "if Proposition I did not hold, an investor could buy and sell stocks and bonds in such a way as to exchange one income stream for another stream, identical in all relevant respects but selling at a lower price. The exchange would therefore be advantageous to the investor quite independently of his attitudes toward risk. As investors exploit these arbitrage opportunities, the value of the overpriced shares will fall and that of the underpriced shares will rise, thereby tending to eliminate the discrepancy between t he market values of the firms" (Modigliani and Miller (1958), p. 269).

I would like to submit that it is the idea of arbitrage that is at the center of Merton Miller's career and of his contributions to our field. The arbitrage mechanism is how Merton Miller thought about finance phenomena. Results that would lead to arbitrage opportunities could not possibly be important because market forces would step in to make prices right. Fischer Black called Merton Miller a "warrior," [1] and he certainly was, but he was a "warrior" who always fought to make sure that market forces would be allowed to play their role and that we in finance would not be misled by a poor understanding of these forces. In the remainder of this address, I first consider how the idea of arbitrage has affected the development of finance. I then turn to the role of arbitrage as the cornerstone of modern corporate finance. Merton Miller was always passionate in his defense of market efficiency and arbitrage played a key role in his thinking about market efficiency. I therefore consider the relation between mark et efficiency and arbitrage in the third part of my address. I finally turn to how liquidity and regulation affect arbitrage in the last section.

I. Arbitrage in the History of Finance

When Modigliani and Miller wrote their paper, there already was a powerful arbitrage argument in the economics literature. In international finance, academics and practitioners knew how to price forward currency contracts by arbitrage. Modigliani and Miller did not, therefore, invent arbitrage. To prove the interest rate parity theorem, we take a position in a risk-free asset and a forward contract to create a foreign currency synthetic risk-free asset. That synthetic foreign currency risk-free asset must then sell for the same price as the foreign currency risk-free asset. The proof of the irrelevance proposition is on a different intellectual plane from the arbitrage argument used in international finance. With the interest rate parity theorem, one uses securities that exist and are risk-free in their respective numeraires. With the irrelevance proposition, the argument proceeds with the assumption that there are firms in a similar risk class. More precisely, there are firms whose assets have proportional- -perfectly correlated--returns. Hence, one does not start from existing risk-free securities that are easily identifiable in markets, but instead derives a relation between the present values of two hypothetical risky cash flow streams.