The role of theory in finance research

Abstract

Over the years, a big part of research in finance has been directed toward the development of new theories based on mathematical formalism. I review classic examples demonstrating the success of this approach, how it enabled transformation in analysis, and had spillovers to measurement, policy, and practice. I discuss the limitations of mathematical models and how these models should be evaluated. Finally, I argue that, despite the greater prevalence of data and empirical methods these days, there are still many opportunities for theory research. I provide some examples. Enabling these opportunities is critical for the continued progress of the field.