The New York Times - October 15, 1997
2 North Americans Share Nobel Prize in Economics
By PETER PASSELL
Two North American scholars won the Nobel Memorial Prize in Economic Science on Tuesday for work that enables investors to price accurately their bets on the future, a breakthrough that has helped power the explosive growth in financial markets since the 1970s and one that plays a profound role in the economics of everyday life.Robert Merton of the Harvard Business School and Myron Scholes, a Canadian-born professor emeritus at the Stanford Business School, will share the $1 million award for helping devise a mathematical formula that provided the answer to a simple but seemingly insurmountable problem confronting Wall Street: how to measure the worth of an option.
Their solution helped lay the basis for today's vast global options marketplace, where the trading affects everyone with a stake in the financial markets, from employees who receive stock options as part of their pay to mutual fund investors who use options to hedge interest-rate risk.
An option is a type of investment that allows, but does not require, an investor to buy an asset, like stocks or bonds or wheat or pork bellies, at a prearranged price during a preset period of time.
Until 1973, when Merton and Scholes published their analysis, it was extremely difficult to assess all the variables that could affect an option's price. Their work overcame that difficulty, which had limited the growth of options trading.
"Such rapid and widespread application of a theoretical result was new to economics," the prize committee wrote. "Nowadays, thousands of traders and investors use the formula every day"' -- making it easy for businesses and individuals to hedge risks in the incredibly complex world of modern finance.
The choices for the Nobel in economics, awarded annually by the Bank of Sweden since 1969, are typically applauded by fellow academics; but the announcement of the prize usually ignites little genuine enthusiasm on Wall Street. That was not the case this year.
"I'm thrilled," said William Brodsky, chairman of the Chicago Board Options Exchange, which owes a large part of its growth to the Nobel winners. "This Nobel not only recognizes Merton and Scholes' accomplishments, it underscores the importance of options in the world of finance."
The analysis the two worked out has been successfully applied not only to pricing options but also to numerous other "derivative" securities, so named because their value is determined by fluctuations in the value of other assets.
Using derivatives is now a common way to redistribute the risks of doing business. Although in recent years derivatives have been associated with some financial disasters -- they played a role in the bankruptcy of Orange County, Calif., and the demise of Barings, Britain's oldest investment bank -- derivatives are widely regarded as beneficial.
Farmers, for example, use derivatives when they sell crops on the futures markets even before the planting has been finished. By locking in a price, they protect themselves if prices fall, although they alsogive up the chance of a windfall if prices surge.
By the same token, grain dealers, bakeries and other corporate customers often buy grain futures to hedge against the risk of rising crop prices.
But what is the real worth of, say, an option to buy 100 shares of Intel at $105 each before next April or the right to borrow 400 million French francs at 9 percent by next Tuesday? As early as 1900 a French mathematician named Louis Bachelier recognized the practical importance of valuing the risk component of assets. By the early 1960s, there were a handful of economists with both an interest in the puzzle and the advanced mathematical tools needed to solve it.
"We knew the answer was there, and that someone was going to find it," recalled Paul Samuelson, an economist at MIT who later won a Nobel for work in other areas of economics.
The breakthrough came from three researchers, each under the age of 30 -- and one not even an economist. Fischer Black, a mathematician with Arthur D. Little consultants in Boston, discovered that an acquaintance, Scholes, a professor of finance at MIT, was also fascinated by the question of options value. They enlisted the help of an assistant to Samuelson at MIT, Merton, the son of the famous Columbia University sociologist, Robert K. Merton.
Together they devised a mathematical formula, known as the Black-Scholes model, that took into account a variety of variables.
Black and Scholes had considerable difficulty finding a publisher. Their paper languished for three years before the prestigious Journal of Political Economy printed it in 1973. Merton walked an easier path, but only because he was a friend of the editor of the new Bell Journal of Economics. "Finance just wasn't part of the economics mainstream," Merton recalled in an interview on Tuesday.
The Chicago Board Options Exchange, the first devoted to options trading, opened just as the Black-Scholes theory was published. Although complicated, the computation involved could be easily -- and virtually instantly -- done on the pocket calculators that were just becoming popular.
Soon traders were valuing options on the floor of the exchange, punching half a dozen numbers into electronic calculators hard-wired with the formula. This not only meant quicker and more accurate pricing, it increased the volume of options markets and reduced the cost of using options.
Black and Scholes became so highly regarded at the exchange that when they visited, traders would give them a standing ovation.
Thanks to extensions suggested by Merton, uses for the formula have been found in virtually every nook and cranny of finance.
Merton, who earned his Ph.D. from MIT in 1970, taught there until 1988 when he moved to the Harvard Business School. The Nobel caps a long career in helping to transform corporate finance from a backwater to the hot zone of economics. "Bob Merton is the Isaac Newton of his field," Samuelson said.
Scholes went back in 1973 to teach at the University of Chicago Business School, where he had earned his Ph.D. In 1983 he moved on to the Stanford School of Business, where he taught until his retirement in 1996. That was hardly the end of his career, though. Scholes and Merton are principals in Long Term Financial Management, the immensely successful multibillion-dollar private investment fund formed by John Meriwether when he broke with his partners at Salomon Brothers.
Peter Bernstein, a consultant to institutional investors and a historian of the securities industry, said on Tuesday, "All I can say is: What took the Nobel Committee so long?"
Merton has no particular plans for the $500,000 check he will receive at a ceremony on Dec. 10.
"It's all been a blast," he said. "My only regret is that Fischer Black isn't here to share the prize." Black, a partner in Goldman, Sachs and a former president of the American Economic Association, died in 1995 at the age of 57.