MORGAN STANLEY–AMERICAN FINANCE ASSOCIATION AWARD FOR EXCELLENCE IN FINANCE 2014
Stephen A. Ross
First published: 8 May 2014 journal of finance
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Stephen A. Ross, the Franco Modigliani Professor of Financial Economics at the MIT Sloan School of Management, is the 2014 recipient of the Morgan Stanley-American Finance Association Award for Excellence in Finance.
Ross is the author of more than 100 articles in economics and finance and is the coauthor of an introductory textbook in finance. He is probably best known for having developed the Arbitrage Pricing Theory and the Theory of Agency, and as the co-discoverer of risk neutral pricing and of the binomial model for pricing derivatives. Models developed by Ross and his colleagues, are now standards in major securities firms and in the capital markets. He is an extraordinary scholar who has made foundational contributions across our discipline.
Ross’ work has emphasized the power of basic principles and the development of simple frameworks to tackle sophisticated issues. Consistent themes are the absence of arbitrage, the importance of equilibrium considerations, the implications of dynamic optimization, optionality, rational expectations and the importance of incentives and the structure of information. Over the last several decades many of his modeling frameworks have become workhorse paradigms in modern financial economics and they have been fundamental to the discipline's development.
Using the principles of no arbitrage and the diversification of idiosyncratic risk, Ross (1973a, 1976a) developed the Arbitrage Pricing Theory (APT) which serves as a foundation for the factor-based frameworks that emerged subsequently in empirical asset pricing. Ross (1973a) also provided the first statement and proof of the no arbitrage theorem that the absence of arbitrage is equivalent to the existence of positive Arrow-Debreu prices. On a related theme, in Options and Efficiency (1976b), Ross showed that options were isomorphic to Arrow-Debreu securities and could be used to span markets in the same way.
Cox and Ross (1976a and 1976b) developed the concept of risk-neutral (also known as martingale) pricing that lies at the heart of modern option pricing theory and practice. This work showed that if a derivative security such as an option can be priced by the absence of arbitrage (with spanning) then its price must be the discounted expected value of its payoff in a risk-neutral market. This allows mathematically complex security pricing problems to be simplified, gives a neat economic interpretation for solutions such as that for the Black-Scholes model, and opens up a host of analyses in the equivalent risk-neutral economy with and without spanning. More generally, the linkage between risk neutral valuation, the existence of a linear pricing operator and the absence of arbitrage is a central perspective in our discipline.
Ross (1978) extended the work on no arbitrage in the original APT to a dynamic setting. Dybvig and Ross (1987)) collected and extended the various no arbitrage results in the Fundamental Theorem of Asset Pricing and the Representation Theorem which displays the equivalence among the no arbitrage valuation methods, i.e., a positive linear pricing operator, risk-neutral pricing, the existence of positive Arrow-Debreu prices, and the existence of a positive state price density or pricing kernel. These results are fundamental to modern financial theory.
Cox and Ross provides the foundation for the analysis of the binomial option pricing model of Cox, Ross and Rubinstein (1979) and the development of valuation models based upon discrete-time dynamic techniques. The binomial valuation model can be solved by risk-neutral valuation and, equivalently, by exploiting dynamic replication, i.e., spanning, by a portfolio of the underlying stock and a bond with the same payoff. Under appropriate limiting assumptions, the binomial model converges to the Black-Scholes model and it has proven to be a practical and parsimonious alternative to pricing options by the use of the log-diffusion assumption.
Building on Merton's work on the ICAPM and on the earlier papers of Cox and Ross, a series of papers with John Cox and Jon Ingersoll (CIR) from 1977 through 1985 developed the first major equilibrium model of the term structure of interest rates and resolved a variety of issues in this area [for examples, see CIR (1981, 1985a, 1985b)]. These papers offer a range of important characterizations of the dynamics of interest rates, the properties of the term structure and equilibrium bond and fixed income derivatives valuations. A subsequent paper, Dybvg, Ingersoll and Ross (1996), proved the surprising result that no arbitrage and the weakest form of rational expectations implied that long interest rates could never fall.
Nor has Ross's seminal work been confined to asset pricing. His single-authored papers were the earliest modern treatment of agency theory and highlighted the importance of the alignment of incentives (Ross (1973b, 1974)). In the basic agency problem, there is a trade-off between incentives and risk-sharing and in this setting Ross further explores the nature of delegated decision-making, and the role of Pareto efficiency, similarity of preferences and linearity of the fee schedule. Ross's (1977) treatment of dividend signaling is the earliest model of signaling in capital structure choice.
Ross's current research is focused on the Recovery Theorem (Ross (2014)), a result that allows us to extract or ‘recover’ both the pricing kernel and the distribution of future returns from current spot option prices without making parametric assumptions on preferences. By contrast, theories of the term structure of interest rates provide a point forecast of future risk adjusted spot rates, while recovery allows one to determine the entire subjective probability distribution of returns.
Ross's impact has been extraordinary on another level; he has produced an exceptionally distinguished set of scholars among his students. In return, the students share an extraordinarily degree of affection and gratitude for Ross for his influence on their intellectual development. At a 2007 event in his honor, they announced the creation the Foundation for the Advancement of Research in Financial Economics (FARFE) and a prize in his name, and they collected a selection of some of their most famous papers together with individual comments reflecting on his impact on their lives in a book in his honor called Mentor.
Ross has been the recipient of numerous prizes and awards, including the Graham and Dodd Award for financial writing, the Pomerance Prize for excellence in the area of options research, the University of Chicago's Leo Melamed Prize for the best research by a business school professor, and the 1996 IAFE Financial Engineer of the Year Award. In 2006, he was the first recipient of the CME-MSRI Prize in Innovative Quantitative Application, in 2007 he won the Jean-Jacques Laffont Prize given by the Toulouse School of Economics, and in 2012 he won the Onassis Prize in Finance. A Fellow of the Econometric Society and a member of the American Academy of Arts and Sciences, he currently serves as an associate editor of several economics and finance journals and in 1988 was president of the American Finance Association.
Ross holds a BS in physics from Caltech and a PhD in economics from Harvard University.
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