Jon Hartley interviews Myron Scholes (Nobel ’97) on “Academic Finance, Black-Scholes Options Pricing, and Regulation“(“Capitalism and Freedom in the 21st Century” podcast, January 5, 2025). The interview includes insights about what was happening in economic finance in the 1960s and 1970s after the “big bang” represented by the work of Harry Markowitz. Here are a few points that caught my eye:
The interview has considerable detail on the development of Scholes’s work with Fisher Black in creating the Black-Scholes option pricing formula. Here’s a taste:
And so Fisher and I started talking about options … And we started working together, and we very quickly came to a theory of how to solve the option by setting up the replicating portfolio. But we tried to think about how to do it for myriad state variables. And even though the theory was correct and could be done, it was basically the state variables would be multiple, and then figure out how to integrate. Once you had a differential equations with all these state variables made it impossible to come to a conclusion or solution quickly.
So then Fisher and I said, well, let’s make an assumption, which is false, that the interest rate is constant, and that the volatility is constant. And we got and the option was European, and therefore, we can get a closed form solution. So that we got a closed form solution and that became known as the Black Scholes option pricing model.
The underlying theory was published in the Journal of Political Economy with the model or given its assumptions. Now we know that every model has an assumption, every model has an error, every model is an incomplete description of reality. How well does the model do in making predictions? And that’s the key. Basically the model has done very well over time. There’s a lot of people who say the model doesn’t do this, the model doesn’t do that, but it does pretty darn great. …
At the time the Black-Scholes model was published was coincident with the birth of the first listed options trading in the Chicago Board Options Exchange in Chicago. So there was 16 options were traded on calls, call options at that time on 16 securities.
That was in 1973. Then it was the case that there was the old grizzly traders who thought they had the experience from the over the counter market and the new young turks who were going to be market makers and trade on the floor of the Chicago Board Options Exchange. So here’s an idea with experience only and intuition versus a model. And the young guys had the model … Fisher Black made sheets of paper which talked about the Delta and the pricing at different levels of the stock price relative to the exercise price. And they could look at the sheets. And there was a war between the grizzly intuition people and the model people, the young turks who had no intuition, but they had the model. And in a matter of about six months or so, the young turks had wiped out the grizzlies, okay, the intuition people.
Merton Miller apparently used to refer to criticisms of the the Modigliani-Miller theorem (that the value of a company is based on future profits, not capital structure) with an analogy I had not heard before, about horse and rabbit stew Scholes tells it this way:
When I got to Chicago at the time Merton Miller had come to Chicago in 1960, I came there first as a student in ’62. And Merton came from Carnegie Mellon, having worked with Franco Modigliani to develop the idea of capital structure equilibrium. Because it was felt, prior to Merton and Franco Modigliani’s work, that how you finance your activity was determinant what the cost of capital was on investment. So if you use more debt, it was cheaper than equity, and therefore there would be a level of debt you would use that would reduce your overall cost of capital.
Merton Miller and Franco Modigliani said, no, that’s ridiculous because economically, if you think about the pie, it’s how you’re dividing up the pie is not necessarily what you wanna think about it. What the pie is itself, how the pie is going to grow, and that means that the risk of the underlying investments of the firm are the risk of the assets, and not how they’re financed. And they prove that rigorously by arbitrage models and the like, and showed that basically that was true, which was a great innovation.
Obviously, over time, Merton’s work and Franco’s work was criticized simply because people thought about bankruptcy costs and other things that would interfere. And Merton’s summary was very good, he said, my theory is a little bit like horse and rabbit stew. There’s one horse and one rabbit in the stew, and what my ideas are, obviously the horse and all these conundrums and critic of the horse as the stew is the rabbit.
