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 Ko nstantin No vo selo v
Eco no mic Sciences in Memo ry o f Alfred No bel 19 9 7, to
Che m ist ry
Pro fesso r Ro be rt C. Me rt o n, Harvard University, and Richard F. Heck
Pro fesso r Myro n S. Scho le s, Stanfo rd University Ei-ichi Negishi
Akira Suzuki
f or a new method to determine the value of derivatives. Physio lo gy o r Me dicine
Ro bert G. Edwards
Risk management is essential in a mo dern market eco no my. Financial markets enable firms
and ho useho lds to select an appro priate level o f risk in their transactio ns, by redistributing Lit e rat ure
risks to wards o ther agents who are willing and able to assume them. Markets fo r o ptio ns, Mario Vargas Llo sa
futures and o ther so -called derivative securities - derivatives, fo r sho rt - have a particular
status. Futures allo w agents to hedge against upco ming risks; such co ntracts pro mise future Pe ace
Liu Xiao bo
delivery o f a certain item at a certain price. As an example, a firm might decide to engage in
co pper mining after determining that the metal to be extracted can be so ld in advance at the Eco no m ic Scie nce s
futures market fo r co pper. The risk o f future mo vements in the co pper price is thereby Peter A. Diamo nd
transferred fro m the o wner o f the mine to the buyer o f the co ntract. Due to their design, Dale T. Mo rtensen
o ptio ns allo w agents to hedge against o ne-sided risks; o ptio ns give the right, but no t the Christo pher A. Pissarides
o bligatio n, to buy o r sell so mething at a pre-specified price in the future. An impo rting British
firm that anticipates making a large payment in US do llars can hedge against the o ne-sided
risk o f large lo sses due to a future depreciatio n o f sterling by buying call o ptio ns fo r do llars AR T IC LE
o n the market fo r fo reign currency o ptio ns. Effective risk management requires that such
instruments be co rrectly priced. ALFRED NO BEL
Who Was Alf red
Fischer Black, Ro bert Merto n and Myro n Scho les made a pio neering co ntributio n to Nobel?
eco no mic sciences by develo ping a new metho d o f determining the value o f derivatives. Read more about the
Their inno vative wo rk in the early 19 70 s, which so lved a lo ngstanding pro blem in financial founder of the Nobel Priz es.
eco no mics, has pro vided us with co mpletely new ways o f dealing with financial risk, bo th in
theo ry and in practice. Their metho d has co ntributed substantially to the rapid gro wth o f
markets fo r derivatives in the last two decades. Fischer Black died in his early fifties in FO LLO W US
August 19 9 5.

Black, Merto n and Scho les´ co ntributio n extends far beyo nd the pricing o f derivatives, Yo utube
ho wever. Whereas mo st existing o ptio ns are financial, a number o f eco no mic co ntracts and
Facebo o k
decisio ns can also be viewed as o ptio ns: an investment in buildings and machinery may
pro vide o ppo rtunities (o ptio ns) to expand into new markets in the future. Their metho do lo gy Twitter
has pro ven general eno ugh fo r a wide range o f applicatio ns. It can thus be used to value no t
o nly the flexibility o f physical investment pro jects but also insurance co ntracts and Newsletter
guarantees. It has created new areas o f research - inside as well as o utside o f financial
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eco no mics.

The history of option valuation

Attempts to value o ptio ns and o ther derivatives have a lo ng histo ry. One o f the earliest
endeavo rs to determine the value o f sto ck o ptio ns was made by Lo uis Bachelier in his Ph.D.
thesis at the So rbo nne in 19 0 0 . The fo rmula that he derived, ho wever, was based o n
unrealistic assumptio ns, a zero interest rate, and a pro cess that allo wed fo r a negative

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share price.

Case Sprenkle, James Bo ness and Paul Samuelso n impro ved o n Bachelierís fo rmula. They
assumed that sto ck prices are lo g-no rmally distributed (which guarantees that share prices
are po sitive) and allo wed fo r a no n-zero interest rate. They also assumed that investo rs are
risk averse and demand a risk premium in additio n to the risk-free interest rate. In 19 6 4,
Bo ness suggested a fo rmula that came clo se to the Black-Scho les fo rmula, but still relied
o n an unkno wn interest rate, which included co mpensatio n fo r the risk asso ciated with the
sto ck.

The attempts at valuatio n befo re 19 73 basically determined the expected value o f a sto ck
o ptio n at expiratio n and then disco unted its value back to the time o f evaluatio n. Such an
appro ach requires taking a stance o n which risk premium to use in the disco unting. This is
because the value o f an o ptio n depends o n the risky path o f the sto ck price, fro m the
valuatio n date to maturity. But assigning a risk premium is no t straightfo rward. The risk
premium sho uld reflect no t o nly the risk fo r changes in the sto ck price, but also the
investo rsí attitude to wards risk. And while the latter can be strictly defined in theo ry, it is hard
o r impo ssible to o bserve in reality.

The Black-Scholes f ormula

This yearís laureates reso lved these pro blems by reco gnizing that it is no t necessary to use
any risk premium when valuing an o ptio n. This do es no t mean that the risk premium
disappears, but that it is already inco rpo rated in the sto ck price. In 19 73 Fischer Black and
Myro n S. Scho les published the famo us o ptio n pricing fo rmula that no w bears their name
(Black and Scho les (19 73)). They wo rked in clo se co o peratio n with Ro bert C. Merto n, who ,
that same year, published an article which also included the fo rmula and vario us extensio ns
(Merto n (19 73)).

The idea behind the new metho d develo ped by Black, Merto n and Scho les can be explained
in the fo llo wing simplified way. Co nsider a so -called Euro pean call o ptio n that gives the right
to buy a certain share at a strike price o f $10 0 in three mo nths. (A Euro pean o ptio n gives the
right to buy o r sell o nly at a certain date, whereas a so -called American o ptio n gives the
same right at any po int in time up to a certain date.) Clearly, the value o f this call o ptio n
depends o n the current share price; the higher the share price to day the greater the
pro bability that it will exceed $10 0 in three mo nths, in which case it will pay to exercise the
o ptio n. A fo rmula fo r o ptio n valuatio n sho uld thus determine exactly ho w the value o f the
o ptio n depends o n the current share price. Ho w much the value o f the o ptio n is altered by a
change in the current share price is called the "delta" o f the o ptio n.

Assume that the value o f the o ptio n increases by $1 when the current share price go es up $2
and decreases by $1 when the sto ck go es do wn $2 (i.e. delta is equal to o ne half). Assume
also that an investo r ho lds a po rtfo lio o f the underlying sto ck and wants to hedge against
the risk o f changes in the share price. He can then, in fact, co nstruct a risk-free po rtfo lio by
selling (writing) twice as many o ptio ns as the number o f shares he o wns. Fo r reaso nably
small increases in the share price, the pro fit the investo r makes o n the shares will be the

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same as the lo ss he incurs o n the o ptio ns, and vice versa fo r decreases in the share price.
As the po rtfo lio thus co nstructed is risk free, it must yield exactly the same return as a risk-
free three-mo nth treasury bill. If it did no t, arbitrage trading wo uld begin to eliminate the
po ssibility o f making risk-free pro fits.

As the share price is altered o ver time and as the time to maturity draws nearer, the delta o f
the o ptio n changes. In o rder to maintain a risk-free sto ck-o ptio n po rtfo lio , the investo r has to
change its co mpo sitio n. Black, Merto n and Scho les assumed that such trading can take
place co ntinuo usly witho ut any transactio n co sts (transactio n co sts were later intro duced by
o thers). The co nditio n that the return o n a risk-free sto ck-o ptio n po rtfo lio yields the risk-free
rate, at each po int in time, implies a partial differential equatio n, the so lutio n o f which is the
Black-Scho les fo rmula fo r a call o ptio n:

where the variable d is defined by:

Acco rding to this fo rmula, the value o f the call o ptio n C , is given by the difference between
the expected share price - the first term o n the right-hand side - and the expected co st - the
seco nd term - if the o ptio n is exercised. The o ptio n value is higher, the higher the current
share price S, the higher the vo latility o f the share price (as measured by its standard
deviatio n) sigma, the higher the risk-free interest rate r , the lo nger the time to maturity t, the
lo wer the strike price L, and the higher the pro bability that the o ptio n will be exercised (this
pro bability is, under risk neutrality, evaluated by the standardized no rmal distributio n functio n
N ). All the parameters in the equatio n can be o bserved except sigma, which has to be
estimated fro m market data. Alternatively, if the price o f the call o ptio n is kno wn, the fo rmula
can be used to so lve fo r the marketís estimate o f sigma.

The o ptio n pricing fo rmula is named after Black and Scho les because they were the first to
derive it. Black and Scho les o riginally based their result o n the capital asset pricing mo del
(CAPM, fo r which Sharpe was awarded the 19 9 0 Prize). While wo rking o n their 19 73 paper,
they were stro ngly influenced by Merto n. Black describes this in an article (Black (19 8 9 )):

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"As we wo rked o n the paper we had lo ng discussio ns with Ro bert Merto n, who also was
wo rking o n o ptio n valuatio n. Merto n made a number o f suggestio ns that impro ved o ur
paper. In particular, he po inted o ut that if yo u assume co ntinuo us trading in the o ptio n o r the
sto ck, yo u can maintain a relatio n between them that is literally riskless. In the final versio n o f
the paper we derived the fo rmula that way because it seemed to be the mo st general
derivatio n."

It was thus Merto n who devised the impo rtant generalizatio n that market equilibrium is no t
necessary fo r o ptio n valuatio n; it is sufficient that there are no arbitrage o ppo rtunities. The
metho d described in the example abo ve is based precisely o n the absence o f arbitrage (and
o n sto chastic calculus). It generalizes to valuatio n o f o ther types o f derivatives. Merto nís
19 73 article also included the Black-Scho les fo rmula and so me generalizatio ns; fo r
instance, he allo wed the interest rate to be sto chastic. Fo ur years later, he also develo ped
(Merto n (19 77)) a mo re general metho d o f deriving the fo rmula which uses the fact that
o ptio ns can be created synthetically by trading in the underlying share and a risk-free bo nd.

Scientif ic importance
The o ptio n-pricing fo rmula was the so lutio n o f a mo re than seventy-year o ld pro blem. As
such, this is, o f co urse, an impo rtant scientific achievement. The main impo rtance o f Black,
Merto n and Scho les´ co ntributio n, ho wever, refers to the theo retical and practical significance
o f their metho d o f analysis. It has been highly influential in so lving many eco no mic
pro blems. The scientific impo rtance extends to bo th the pricing o f derivative securities and to
valuatio n in o ther areas.

Pricing of derivatives
The metho d described here has been eno rmo usly impo rtant fo r the pricing o f derivative
instruments. The laureates initiated the rapid evo lutio n o f o ptio n pricing that has taken place
during the past two decades. Optio ns o n instruments o ther than shares give rise to o ther
fo rmulas that so metimes have to be so lved numerically. The same metho d has been used
to determine the value o f currency o ptio ns, interest rate o ptio ns, o ptio ns o n futures, and so
o n.

Several o f the o riginal - and so mewhat restrictive - assumptio ns behind the initial derivatio n
o f the Black-Scho les fo rmula have subsequently been relaxed. In mo dern o ptio n pricing the
interest rate can be sto chastic, the vo latility o f the sto ck price can vary sto chastically o ver
time, the price pro cess can include jumps, transactio n co sts can be po sitive, and the price
pro cess can be managed (e.g. as currencies are restricted to mo ve inside bands). These
extensio ns all rely o n the metho d o f analysis that Black, Merto n and Scho les intro duced.

Corporate liabilities
Black, Merto n and Scho les realized already in 19 73 that a share can be interpreted as an
o ptio n o n the who le firm (the title o f their 19 73 article is "The pricing o f o ptio ns and co rpo rate
liabilities"). When lo ans mature and the value o f the firm is lo wer than the no minal value o f

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debt, the shareho lders have the right, but no t the o bligatio n, to repay the lo ans. The metho d
can thus be used fo r determining the value o f shares, which can be impo rtant if the shares
are no t traded. Since o ther co rpo rate liabilities are also derivative instruments (who se value,
to o , depends o n the value o f the firm), they can be valued using the same metho d. Black,
Merto n and Scho les thus laid a satisfacto ry fo undatio n fo r a unified theo ry to price all
co rpo rate liabilities.

Financial co ntract theo ry is undergo ing rapid develo pment. The Black-Merto n-Scho les
metho do lo gy has been impo rtant in recent effo rts to design o ptimal financial co ntracts,
taking into acco unt vario us aspects o f bankruptcy law.

Investment evaluation
In the cho ice between different investment alternatives, flexibility is a key facto r. Machines
may differ in their flexibility regarding the shut-do wn and start-up o f pro ductio n (as the
market price o f the pro duct varies), the use o f different so urces o f energy (as, say, the
relative price between o il and electricity varies), etc. The Black-Merto n-Scho les metho do lo gy
can o ften be used to facilitate mo re info rmed investment decisio ns in such cases.

Guarantees and insurance contracts

Many types o f insurance co ntracts and guarantees can be valued using mo dern o ptio n-
pricing theo ry. Assume that an insurance co mpany wants to determine the value o f an
insurance co ntract that pro tects a bo ndho lder against the risk that the co mpany issuing the
bo nd will go bankrupt. The value o f such an insurance co ntract can be appro ximated by a put
o ptio n o n the bo nd with a strike price equal to the no minal value o f the bo nd. If the value o f
the bo nd declines belo w the strike price, the ho lder has the right to sell the bo nd at that price
- that is, his po ssible lo ss is limited. In practice, therefo re, an insurance co mpany no t o nly
co mpetes with o ther insurance co mpanies, but also with the o ptio n market.

Complete markets
Metho ds develo ped by Merto n (in Merto n (19 77)) have been used to extend the dynamic
theo ry o f financial markets. In the 19 50 s, Kenneth Arro w and Gerard Debreu (bo th previo us
laureates) sho wed ho w individuals o r co mpanies can eliminate their particular risk pro file if
there exist as many independent securities as there are future states o f the wo rld. This might
well require a large number o f securities. These findings have no w been extended to sho w
that a few financial instruments are sufficient to eliminate risk, even when the number o f
future states is very large.

Practical importance
The Chicago Bo ard Optio ns Exchange intro duced trade in o ptio ns in April 19 73, o ne mo nth
befo re publicatio n o f the o ptio n-pricing fo rmula. By 19 75, traders o n the o ptio ns exchange
had begun to apply the fo rmula - using especially pro grammed calculato rs - to price and
pro tect their o ptio n po sitio ns. No wadays, tho usands o f traders and investo rs use the

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fo rmula every day to value sto ck o ptio ns in markets thro ugho ut the wo rld.

Such rapid and widespread applicatio n o f a theo retical result was new to eco no mics. It was
particularly remarkable since the mathematics used to derive the fo rmula were no t part o f the
standard training o f practitio ners o r academic eco no mists at that time.

The ability to use o ptio ns and o ther derivatives to manage risks is quite valuable. Fo r
instance, po rtfo lio managers use put o ptio ns to reduce the risk o f large declines in share
prices. Co mpanies use o ptio ns and o ther derivative instruments to reduce risk. Banks and
o ther financial institutio ns use the metho d develo ped by Black, Merto n and Scho les to
develo p and determine the value o f new pro ducts, sell tailo r-made financial so lutio ns to their
custo mers, as well as to reduce their o wn risks by trading in financial markets.

Financial institutio ns emplo y mathematicians, eco no mists and co mputer experts who have
made impo rtant co ntributio ns to applied research in o ptio n theo ry. They have develo ped
databases, new metho ds o f estimating the parameters needed to value o ptio ns and
numerical metho ds to so lve partial differential equatio ns.

Some other scientif ic contributions

Merto n and Scho les have made impo rtant scientific co ntributio ns in additio n to tho se
described so far.

Merto n has made fundamental co ntributio ns (Merto n (19 6 9 ) and (19 71)) to the analysis o f
individual co nsumptio n and investment decisio ns in co ntinuo us time. He presented (Merto n
(19 73b)) an impo rtant generalizatio n o f CAPM, extending it fro m a static to a dynamic
mo del. He also impro ved and generalized o ptio n pricing fo rmula in different directio ns. In
particular, he derived (Merto n (19 76 )) a fo rmula which allo ws sto ck price mo vements to be
disco ntinuo us.

Scho les has studied the effect o f dividends o n share prices (Black and Scho les (19 74) and
Miller and Scho les (19 78 ) (19 8 2)). He has also made empirical co ntributio ns, e.g. regarding
estimatio n o f b, the parameter that measures the risk o f a share in the CAPM (Scho les and
Williams (19 77)), and market efficiency (Black, Jensen and Scho les (19 72)).

Summary
Ro bert C. Merto n and Myro n S. Scho les have, in co llabo ratio n with the late Fischer Black,
develo ped a pio neering fo rmula fo r the valuatio n o f sto ck o ptio ns. Their metho d has had
pro fo und impo rtance fo r eco no mic valuatio ns in many areas. It has also helped generate
new financial instruments and facilitated mo re efficient management o f risk in so ciety.

Ref erences
Black, F. and Scholes, M., 1972, " The Valuation of Option Contracts and a Test of Market
Efficiency" , Journal of Finance , Vol. 27, pp. 399- 417.

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 Black, F. and Scholes, M., 1973, " The Pricing of Options and Corporate Liabilities" , Journal of
Political Economy , Vol. 81, pp. 637- 654.

Black, F. and Scholes, M., 1974, " The Effects of Dividend Yield and Dividend Policy on Common
Stock Prices and Returns" , Journal of Financial Economics ,Vol.1,pp.1- 22.

Black, F., 1989, " How We Came Up with the Option Formula" , The Journal of Portfolio Management,
Vol. 15, pp. 4- 8.

Black F., Jensen, M.C. and Scholes, M., 1972, " The Capital Asset Pricing Model: Some Empirical
Tests" in Jensen, M.C., ed., Studies in the Theory of Capital Markets , Praeger.

Merton, R.C., 1969, " Lifetime Portfolio Selection under Uncertainty: The Continuous- Time Case" ,
Review of Economics and Statistics, Vol. 51, pp. 247- 257.

Merton, R.C., 1971, " Optimum Consumption and Portfolio Rules in a Continuous Time Model" ,
Journal of Economic Theory , Vol. 3, pp. 373- 413.

Merton, R.C., 1973a, " Theory of Rational Option Pricing" , Bell Journal of Economics and
Management Science, Vol. 4, pp. 637- 654.

Merton, R.C., 1973b, " An Intertemporal Capital Asset Pricing Model" , Econometrica, Vol. 41, pp.
867- 887.

Merton, R.C., 1976, " Option Pricing When Underlying Stock Returns Are Discontinuous" , Journal
of Financial Economics, Vol. 3, pp. 125- 144.

Merton, R.C., 1977, " On the Pricing of Contingent Claims and the Modigliani- Miller Theorem" ,
Journal of Financial Economics, Vol. 5, pp. 141- 183.

Miller, M.H. and Scholes, M., 1978, " Dividends and Taxes" , Journal of Financial Economics , Vol. 6,
pp. 333- 364.

Miller, M.H. and Scholes, M., 1982, " Dividends and Taxes: Some Empirical Evidence" , Journal of
Political Economy , Vol. 90, pp. 1118- 1141.

Scholes, M. and Williams, J., 1977, " Estimating Betas from Nonsynchronous Data" , Journal of
Financial Economics, Vol. 5, pp. 309- 327.

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