Nobel Prize: Economics
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PAUL SOLMAN: Options. To some they suggest a world of fancy financial finagling, puts, calls, derivatives and the like. But really options are everywhere, and to economists they basically mean something close to what they mean to you and me.
You real estate developers know options. You buy an option on a plot of land for a tiny fraction of its total value. That gives you the right to buy it at a fixed price by a fixed date. If you get the financing, tenants, whatever you need, you can exercise the option and develop the property. Or, if the land goes up in value, you can simply sell the option at a profit to somebody else. Ultimately, if the deal never gets made, the option simply isn’t exercised.
Insurance is also essentially an option of a different sort, an option that provides protection on your house and your car, your life. You pay a modest premium, and if something bad happens, say your house burns down, you get paid a much bigger amount to replace it. In essence then options are ways of coping with uncertainty over time, of transferring risk, of making contracts based on if this happens, if that happens, and so on. No wonder they’re so popular.
But today’s Nobel Prize was given for the use of options in the stock market. So two final examples from Wall Street: First, options can provide insurance on the stock market, just like in real life. Say you’re two years away from retirement, with lots of stock in your pension account. You can’t sell the stock. But you want to protect yourself against the market falling. Well, you can buy an option, cheaply, a so-called “put” option. What you buy is a contract, which is really just an insurance policy against your portfolio plummeting in value. It will pay you handsomely if the market falls within a certain time frame. On the other hand, suppose you’re sure the market is going up in the next two years, but you can’t afford or just don’t want to buy a lot of stock. Instead, for far less money, you can buy an option, in this case a call option, which will pay you if the price rises by a certain date.
PAUL SOLMAN: But options aren’t just for the long-term. They’re now traded minute by minute every day all over the world. And much of the credit for the explosion of options trading is given to the winners of today’s Nobel Prize. They figured out how to price options mathematically. They’ve also exercised the option today of talking with us. Here in Boston Robert Merton of the Harvard Business School, and at Stanford University Myron Scholes. Gentlemen, welcome to you both and congratulations.
Professor Merton, I wanted to ask this question of a Nobel Laureate for years. Did you think about maybe I’m going to win today?
ROBERT MERTON, Nobel Laureate, Economics: Well, of course, I knew that Myron and I were being considered in past years on some sort of a notion of a list, and that was very exciting. But frankly, no, I really didn’t anticipate today’s announcement. It was an enormous surprise to me.
PAUL SOLMAN: A shock? Did your heart start beating when you got the call?
ROBERT MERTON: Well, I got the call. I was–I didn’t know what to think. It was a shock but a wonderful one. It was a real thrill.
PAUL SOLMAN: Professor Scholes, how about you–this time of year do you begin to wonder if there’s going to be a phone call early in the morning? Do you begin to think, hey, it’s 5:30, and nobody’s called yet?
MYRON SCHOLES, Nobel Laureate, Economics: Yes and no. Given the fact that over the last number of years and friends keep saying when are you going to win the Nobel Prize, and as a result of that, you think of it as, well, maybe they know something I don’t know. But there’s a huge difference between anticipating or saying there might be some chance winning it and when you actually do get the call in the morning saying you’ve won it. It seems as though the whole world has changed, and it is, as Bob said, a very exciting experience, and something that I don’t know when I’ll get over it. Right now we’re sort of on cloud nine.
PAUL SOLMAN: Professor Merton, you were a math student. How did you get interested in finance?
ROBERT MERTON: Well, actually, when I was very young, I used to buy stocks, and then–
PAUL SOLMAN: How young?
A Wee Investor
ROBERT MERTON: Well, my first stocks I bought I think when I was ten.
PAUL SOLMAN: You have this famous sociologist father, Robert Merton, and you actually were buying stocks at age ten?
ROBERT MERTON: Well, with his advice and counsel. He’s going to have to hold responsibility for it as well, but then later on, when I was a graduate student at Cal Tech, I used to get up very early in the morning and then the markets opened, which was 6:30 California time, and trade over-the-counter options, and convertibles and so forth, and enjoyed it immensely, and was very interested in it. It never occurred to me, though, that he could make a career of it and certainly do research in that, so then I would come back and do my mathematics the rest of the day.
PAUL SOLMAN: And when did the bridge occur that actually wound up leading to a Nobel Prize?
ROBERT MERTON: Well, the bridge occurred in two steps. The first was I decided that I wanted to go into economics, which I switched to MIT. But I still didn’t think of this as something one could do for real research, and this was kind of a side thing.
PAUL SOLMAN: This meaning the trading and–
ROBERT MERTON: Well, not the trading but the whole idea of finance as an academic experiment, doing research in it, and then when I had the great good fortune to move into Paul Samuelson’s offices–he opened up the world to me–indeed, I could combine both, my interest in the markets and my interest in mathematics, and I could do serious research, and that was a really big kick. And that’s where it all started.
PAUL SOLMAN: Prof. Scholes, does this come as a flash of insight–I mean, the nub of what became your famous mathematical model, or is this something you sort of slog away at year after year until you finally get something?
MYRON SCHOLES: Well, it was sort of a combination of both because, as you know, Fisher Black, late colleague in Boston, MIT area, and I were working on some consulting projects together, and in our spare time we started to work on the pricing of options. And we both worked on it together and found that after a period of time that we’d come up with a result that was to us very interesting, but it took us a long time after that to actually get a solution to what we had found. So it took a long time to get it–took a short time.
PAUL SOLMAN: Do you think about something like a Nobel Prize when you say, gee, we’ve got an idea here that could really–that’s really interesting, or not a Nobel Prize but can–you know, that it would affect the world as, in fact, this mathematical model actually has?
To Provide Understanding
MYRON SCHOLES: Well, it’s very interesting, but at the time we were working on options, they were very arcane. There were very few financial institutions that were using options or thinking about option pricing directly. There were no organized exchanges in options as we now see, so I always thought and Fisher thought as well, and I know Bob thought that what we were doing is providing an understanding for the academic community, and I was very surprised with how quickly it all spread to the world of finance at large.
PAUL SOLMAN: Professor Merton then, picking up on that, how does a mathematical formula actually have an impact on the real world and really, I guess, in this case the world economy?
ROBERT MERTON: Well, I think the first part you mentioned a mathematical formula and the formula, itself, was important, but really it was the concept that began with Myron Fisher and then I did something to add to it, but in any case, it was the concept underlying the development of the formula which was most important.
PAUL SOLMAN: Now, can you actually put that into lay terms so that we can understand what you’re talking about?
ROBERT MERTON: Well, it was the recognition that could undertake dynamic trading in the trading every day or over short periods of time between in this case the stock and bonds in such a way that you could hedge out all the risk of an option.
PAUL SOLMAN: Hedge out meaning–
ROBERT MERTON: Hedge out means to eliminate the risk of that option by offsetting this if you had bought an option, you could trade these things to offset the risks of that option. And it was this insight that led eventually to the understanding of how you could go about doing this with almost any type of contract or contingent claims as they’re called–insurance–all the things that we heard in the opening segment.
PAUL SOLMAN: Professor Scholes, do you have a simple way of putting this after working on it all day here trying to explain it to people in the media who don’t understand some of these things, include myself in it–
MYRON SCHOLES: It was interesting because, as Bob said, we developed a way or a methodology of pricing any option like instrument or security, and then we–that methodology then we applied to a more simple structure, such as at that time a more simple structure such as put options and call options because we could choose the examples we wanted to put forward.
But basically the methodology says, look, you know, if you can find two substitutes for something, a combination of stock and bonds that substitutes each period of time for the underlying option, then once you have two substitutes that are perfect, you can buy one and sell the other, and sort of get rid of the risk of the underlying say in the case of a call option or put option stock. And so what fell out of that was the pricing relationship.
PAUL SOLMAN: I think that’s still awfully tough for most of us to understand. I mean, why does it matter, assuming for a moment that we’re not going to master it in this 10-minute segment, why does it matter that you figured out this way of pricing options?
MYRON SCHOLES: I don’t know. Bob–
PAUL SOLMAN: Yes. I was going to ask Professor Merton.
ROBERT MERTON: Well, Myron and I have been doing these back and forth for so many years that I almost feel even though he’s in California–but I think the importance was that not only could you come up with a price but by doing this type of analysis you were able to break down the risks of the underlying option. And from the point of view of producer of that option, the seller of that option, that allowed you to understand the exposure. So if an institution issued an option–
PAUL SOLMAN: So, in other words, if I buy one–
ROBERT MERTON: Someone has to issue it to you.
PAUL SOLMAN: Somebody has to sell it.
ROBERT MERTON: And so that institution, to be able to manage that risk, this gave them simultaneously a way of not only pricing it but also managing the risks. And it also–this was what made it substantively different from earlier work.
PAUL SOLMAN: And that’s why everybody adopted it, and the market’s–
ROBERT MERTON: Right.
PAUL SOLMAN: –going to explode as a result. Last question, Professor Scholes, options are a form of financial derivative, right, and people keep talking about the worries the derivatives raise. At the end of the day more risk in a system because of your formula and the explosion of this market, or less risk, or is that the wrong question?
MYRON SCHOLES: No, it’s the correct question. I do think it’s a hard question to answer because we don’t know the but for case. You know, if option pricing models hadn’t been developed, what risks we would see today, and my view is because we have more complete markets and we have products now that satisfy investor demands more acutely than the general products we would have without options that I think the risk in a system is probably ameliorated, mitigated to a great degree.
PAUL SOLMAN: And you get one line on that.
ROBERT MERTON: Yes.
PAUL SOLMAN: Just a quickie.
ROBERT MERTON: Yes.
PAUL SOLMAN: Yes.
ROBERT MERTON: I think the risk has been reduced. Certainly the cost of financial service has been reduced by this structure.
PAUL SOLMAN: Okay, gentlemen. Thank you both very much.