2 U.S. Scholars Win Nobel for Formula on Stock Options

Two Americans, Myron S. Scholes of Stanford University and Robert C. Merton of Harvard Business School, on Tuesday were awarded the Nobel Memorial Prize in Economics for work that has formed the bedrock of a multitrillion-dollar market in options and other financial derivatives.

That market allows corporations, investors and speculators around the world to hedge risks ranging from changes in the price of oil and other raw materials to the likelihood that lower interest rates will lead homeowners to refinance their mortgages.

An arcane process rarely understood by lay people but essential to the inner workings of the world financial system, the proper hedging of risk tends to make financial markets more stable, many economists say.

In announcing the shared $1-million award to Scholes, 56, and Merton, 53, the Swedish Academy of Sciences said the scholars’ work “stands out among the foremost contributions to economic science over the last 25 years.”

Their achievement, in turn, built on work published by Scholes in partnership with Fischer Black in 1973, when Scholes was teaching at the Massachusetts Institute of Technology and Black was a financial consultant. Black, who died in 1995, is not named in the award because the Nobel prizes are not awarded posthumously.

Black and Scholes developed, for the first time, a formula to establish the price of stock options, which represent the right--but not the obligation--to buy or sell a share of stock.

The so-called Black-Scholes model showed that option prices are dependent on five variables interacting in a complex but verifiable way. Once investors had this useful benchmark, the nation’s options markets mushroomed in size.

The variables are the time left to the option’s expiration; its “strike” price, which is the price at which the option is exercisable; the price of the underlying stock; the prevailing interest rates; and the volatility of the underlying stock, or the rate at which its price fluctuates.

Coming up with a formula that worked “was an amazing feat,” said Merton Miller, a professor of finance emeritus at the University of Chicago and himself a 1990 Nobel Economics laureate.

Miller noted that before Black-Scholes tied the price of options to factors that could be independently measured, option prices were indeterminate and relatively easy to manipulate and the market itself prone to scandal. “The options market was considered sort of raffish,” he said.

Appearing fortuitously just as the Chicago Board Options Exchange opened for business, the Black-Scholes model helped the exchange grow to its current rank today as the world’s largest options marketplace.

“Because people have confidence in the tools,” Scholes said Tuesday in a telephone interview from Monterey, where he had a speaking engagement, “they have become more of a fact of life about how you run an organization.”

Since 1973 the market in derivatives--securities that depend on the price of other assets--has virtually exploded.

The Black-Scholes model has spawned an entire industry of “custom” derivatives--financial transactions aimed at helping investors and traders manage risks. Today about $70 trillion a year in financial risk is traded through such arcane instruments as futures, options and swaps.

Nevertheless, the use of derivatives remains so complicated that inexpert trading, coupled with unexpected turns in underlying markets, have contributed to such spectacular financial disasters as Orange County’s $1.64-billion investment loss and the $1.38-billion options loss that brought down Britain’s oldest bank, Barings, in 1995.

Options pricing is crucial in helping investors determine the appropriate price of such instruments as convertible bonds and mortgage securities, which have option elements embedded in their terms.

As stock options have become a larger component of corporate executive pay, the formula is increasingly used to allow companies to state the cost of those options for their top executives in reports to shareholders.

“Black-Scholes is embedded in the warp and woof of financial reports nowadays,” said Graef Crystal, an expert in executive compensation.

Ironically, the nearly instant success of their formula surprised Scholes and Black at the time.

“We thought it would be an academic curiosity,” Scholes said. In fact, the work was initially rejected by editors at the Chicago-based Journal of Political Economy, who thought it so narrow that it was of no general use to the world of finance.

“They asked us to flesh it out, which we did,” Scholes said, “which turned out to be a good thing.”

Merton, who was a friend and colleague of Scholes and Black and is now a partner with Scholes in a Connecticut money management firm, later contributed more rigorous mathematical research that refined the model and broadened its applications throughout the world of finance.

Options models are also being tested outside the financial markets. Environmentalists are using them to measure the value of natural resources or the costs of losing biodiversity--in other words, allowing researchers to estimate “how much it is worth to invest in [lowering] ozone and carbon emissions today,” in the words of Graciela Chichilnisky, UNESCO professor of mathematics and economics at Columbia University. “The range of applications is enormous.”

Scholes, a professor emeritus of finance at Stanford, and Merton, a professor of business administration at Harvard, both said their receiving the Nobel was something of a bittersweet experience. That’s because of Black’s untimely death at the age of 57.

“The only sad part is that Fischer isn’t here to share it,” Merton said.