to make are only made possible by our ability to manage risks—the risk of
house fire; the risk of losing a job; the risk to the entrepreneur who invests in a
business; the risk to the farmer who plants a crop that will have an uncertain
yield and be sold at an uncertain price in several months’ time; the risk to the investor
in the stock market; and so on.
For each of these problems, society has found solutions. For example, most
people agree that house insurance and unemployment insurance increase social
well-being. The role of futures markets in insuring farmers against commodity
price uncertainty is also understood to increase welfare. Equally, the role of the
stock market in enabling the risks of businesses to be shared is now well understood—
as indeed is the role of diversification in enabling investors to achieve the
minimum risk for the returns generated on their portfolios.
But such widespread public acceptance is almost certainly not true of derivatives,
and their role as a means for managing risk through the financial markets
is frequently misunderstood. This may, in part, be due to the idiosyncratic
nature of the instruments themselves, as illustrated by a number of controversial
episodes: the failure of portfolio insurance in the 1987 stock market crash; their
misuse in the cases of Barings, Gibson Greetings Cards, Metallgesellschaft, Orange
County, California, and Procter and Gamble; and the near failure of Long
Term Capital Management (LTCM) whose board included the pioneers of op-
tion pricing, 1997 Nobel Laureates for Economics, Robert Merton and Myron
Scholes.
Yet these instruments futures, options, and a multitude of variations on
these themes—are packages of the basic components of risk: they more than anything
else traded come close to the theoretically ideal instruments for the trading
of risk. On the one hand, insurance can be a cost borne to eliminate a
negative occurrence, accidental or structural, an outcome you cannot tolerate.
On the other hand, it becomes a tool to shape a risk–return relationship, unique
to each investor, from quite common investment alternatives. Derivatives can
turn stocks into bonds and vice versa. And derivatives can pinpoint very precisely
specific risks and returns that are packaged within a complex structure.
Risk Management Gurus: Fischer Black, Robert Merton, and Myron Scholes
Since the mid-1970s, financial futures and options have established themselves as
an integral part of the international capital markets. While futures and options
originated in the commodities business, the concept was applied to financial securities
in the United States in the early 1970s. Currency futures grew out of the
collapse of the Bretton Woods fixed exchange rate system, and heralded the
growth of a wide variety of financial instruments designed to capture the advantages
or minimize the risks of an increasingly volatile financial environment. Now
these products are traded around the world by a wide variety of institutions.
The quantitative tools that brought derivatives into common use were the
invention of the late Fischer Black and Myron Scholes in what is called the
Black–Scholes option pricing model. Their sometime collaborator Robert Merton
took the work further into a form for everyday application by applying his
notions of continuous time relationships in security pricing. Merton’s modifications
made the leap from the theory to a practical tool.
As Peter Bernstein’s excellent books on risk and capital ideas recount, having
been rejected by two academic journals, the original Black–Scholes paper was
eventually published in the University of Chicago’s Journal of Political Economy.
It is said that the option formula can be derived from the heat transform formula;
while wrestling with the problem, Black was inspired by a conversation after a
game of tennis. Apparently, his playing partner, an engineer, saw the analogy
with his own field.
Of the three developers of options theory (its earlier roots date back to
work done in 1900 by Louis Bachelier in Paris), two—Black and Scholes—
moved full-time into investment practice. Merton moved from MIT to Harvard,
a short distance upriver, though he too was involved with LTCM. Thus, the
widespread application of academic theory from the early 1970s influenced investments
but also the course of the lives of the developers.
The partnership of academia and investments is emphatically illustrated by
the integration of derivatives into the everyday work of investment people. Some
extracts from the Nobel citation for Merton and Scholes from the Royal Swedish
Academy of Sciences provide a useful overview of their work and its many practical
applications:
Risk management is essential in a modern market economy. Financial markets
enable firms and households to select an appropriate level of risk in
their transactions, by redistributing risks toward other agents who are willing
and able to assume them. Markets for options, futures, and other socalled
derivative securities have a particular status. Futures allow agents to
hedge against upcoming risks; such contracts promise future delivery of a
certain item at a certain price. As an example, a firm might decide to engage
in copper mining after determining that the metal to be extracted can be
sold in advance at the futures market for copper. The risk of future movements
in the copper price is thereby transferred from the owner of the mine
to the buyer of the contract.
Due to their design, options allow agents to hedge against one-sided
risks; options give the right, but not the obligation, to buy or sell something
at a prespecified price in the future. An importing British firm that anticipates
making a large payment in U.S. dollars can hedge against the onesided
risk of large losses due to a future depreciation of sterling by buying
call options for dollars on the market for foreign currency options.
Effective risk management requires that such instruments be correctly
priced. Black, Merton, and Scholes made a pioneering contribution to economic
sciences by developing a new method of determining the value of derivatives.
Their innovative work in the early 1970s, which solved a
long-standing problem in financial economics, has provided us with completely
new ways of dealing with financial risk, both in theory and in practice.
Their method has contributed substantially to the rapid growth of
markets for derivatives in the last two decades. Fischer Black died in his early
fifties in August 1995.
The Chicago Board Options Exchange introduced trade in options in
April 1973, one month before publication of the option pricing formula. By
1975, traders on the options exchange had begun to apply the formula—
using especially programmed calculators—to price and protect their option
positions. Nowadays, thousands of traders and investors use the formula
every day to value stock options in markets throughout the world.
Such rapid and widespread application of a theoretical result was new
to economics. It was particularly remarkable since the mathematics used to
derive the formula were not part of the standard training of practitioners or
academic economists at that time.
The ability to use options and other derivatives to manage risks is quite
valuable. For instance, portfolio managers use put options to reduce the risk
of large declines in share prices. Companies use options and other derivative
instruments to reduce risk. Banks and other financial institutions use the
method developed by Black, Merton, and Scholes to develop and determine
the value of new products, sell tailor-made financial solutions to their customers,
as well as to reduce their own risks by trading in financial markets.
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