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B. Venkatesh

IN 1905, Albert Einstein, one of the greatest physicists ever, published three seminal papers. The first was on special relativity, the second on photoelectric effect and the third on Brownian motion. Through the years, several great scientists have applied these concepts to further scientific development for the benefit of mankind.

Small wonder that 100 years after Einstein's path-breaking research, 2005 will be celebrated as the World Year of Physics. Modern-day financial economics owes a lot to these physicists. How is financial economics related to physics?

Five years before Einstein researched on Brownian motion, a French mathematician called Louis Bachelier submitted his PhD thesis on the movement of stock prices on the Paris stock exchange. He was the first to assume that stock prices follow a random process. He did so by assuming that stock prices move just like the particles in a fluid, which is described by the Brownian motion. Thus was laid the seeds of mathematical finance.

More recently, Professor Stephen Ross, now with MIT, used physics to explain the famous Black and Scholes model. Initially, this option valuation model was based on an esoteric branch of math called Ito's calculus. Such high-level math put the model beyond every-day application. Professor Ross then applied quantum physics to make the valuation model simpler!

And for that, we move to another great physicist, Richard Feynman. As a professor at California Institute of Technology, Feynman had developed a model called the sum-over-paths to study the movement of electromagnetic particles. Professor Ross, along with John Cox, applied the principle behind this model to price call options.

These are two well-known applications of physics in finance. A whole body of knowledge now exists what with a branch called econophysics, dedicated to applying principles of mathematical physics to finance.

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