Black-Scholes Valuations

HISTORY OF BLACK-SCHOLES

One of the constants in the field of finance is the quest to reduce risk and uncertainty.

During the 1960s, the use of options and other derivatives became methods for reducing risk. But the problem of placing a value on these financial instruments remained.

A Statistical Model

In the late 1960s, the Finance Department of the Massachusetts Institute of Technology recruited a group of young professors whose approach to finance was based on mathematics and statistics. Among this group were Fisher Black and Myron Scholes.

They began to review and develop models to explain price movements within financial markets. The models at that time were all theoretical in the sense that they contained factors or assumptions that weren’t measurable.

Black and Scholes reduced the variables by removing all those that couldn’t be measured. To help them in devising the formula, Black and Scholes brought in another mathematically trained professor, Robert Merton.

The Journal of Political Economy published the resulting formula in an article titled “The Pricing of Options and Corporate Liabilities” in May 1973. The article itself was turned down three times before it was published. But it became clear that this formula worked and could be used in pricing options.

Impact of the Black-Scholes Formula

The formula had an enormous impact on the world of finance.

The ability to price an option with more assurance than a subjective judgment established a more ordered marketplace. It provided risk-management strategies that would reduce vulnerability inherent in the rapidly changing global economy. This created an entirely new field: financial engineering.

Myron Scholes and Robert Merton received the Nobel Prize for Economics in 1997. (Much of this is recorded in a PBS show on Nova titled “Trillion Dollar Bet.” See www.pbs.org/wgbh/nova/stockmarket.)

Today, most traders will include the Black-Scholes formula in their financial toolbox.