Fischer Black, an American mathematician-turned-businessman, revolutionized Wall Street trading by figuring out an answer to a problem that had vexed traders for generations: how to assess the value of an option.
The Black-Scholes-Merton option pricing model, a complex mathematical formula that Black developed with fellow economists Myron Scholes and Robert Merton, allowed a niche options trading industry to blossom into a behemoth that transformed international capital markets. Black’s work is not without critics, but its tremendous impact on the global economy is unquestioned.
An option is simply a contract that provides somebody the opportunity (but not the obligation) to buy an asset in the future at a fixed price. The concept has existed for millennia, but it became a major investment focus after the Chicago Board Options Exchange, the world’s first options-only exchange, opened in 1973.
Like any other financial instrument, options became a popular form of speculation. Buying and selling options became a way to place big bets on or against a certain company.
For instance, let’s say a company is currently trading at $30 per share but you believe that the price of the stock will double in the next six months to $60. If your prediction comes true, a contract that gives you the right to buy 100 shares at the current price six months from now for $30,000 and then immediately resell them at market value for $60,000. But of course, maybe your prediction will not come true. Maybe the stock will only rise slightly in price. Maybe it will even decline. So what should you be willing to pay for that contract?
This is where Black-Scholes-Merton comes in. A month after the Chicago Exchange opened, the economists published their groundbreaking formula, a partial differential equation that calculates the expected profit a trader will make on an option.
The formula incorporates numerous variables, including:
- The underlying stock’s price
- The stock’s volatility (how much it swings in price)
- The time until the option can be exercised
- The current interest rate on risk-free investments (such as government bonds)
By devising a way to price options, Black offered investors a template for reducing the risk of their portfolios. If they owned a large share of a firm’s stock and were concerned about the prospect of the stock declining in value, they could purchase options to sell the stock at fixed price.
“One of the things I like about doing science, the thing that is the most fun, is coming up with something that seems ridiculous when you first hear it but finally seems obvious when you’re finished.”
Black was part of a larger trend of academics who transitioned from the ivory tower to the trading floor, leveraging their understanding of mathematics to make fortunes in business. Dubbed the “rocket scientists,” these numbers whizzes helped bring high-level math into the mainstream.
Fischer died of throat cancer at age 57 in 1995. Two years after his death, his former colleagues Scholes and Merton were awarded the Nobel Prize in economics for the work they had done with him on options pricing. Noting that “thousands of traders” a day used the formulas devised by the three men, the Nobel committee reasoned that their work had “laid the foundation for the rapid growth of markets for derivatives” and that it had become “indispensable in the analysis of many economic problems.”
The beginning of a passion
As a graduate student in physics at Harvard, Black takes an interest in computers. He writes to his parents: “One of the things I am most interested in is building computers that can think like human beings. I think it will be possible within 20 years.”
Black-Scholes-Merton Model creation
Black, along with Myron Scholes and Robert Merton, develop the Black-Scholes-Merton model for pricing options.
Nobel Prize in Economic Sciences award
Scholes and Merton are awarded the Nobel Prize in Economic Sciences for their work in option-pricing two years after Black died.