Pages 204-207

Fischer Black used the Irving Fisher’s 1930 book in order to develop his theory of business cycles. As Fischer Black, Irving Fisher came to economics from mathematics and physics. This was one of the main reasons for which Fischer exploited his work.

According to Fisher, the actual value of the factory derived from the value of the goods it would produce in the future, linked to the rate of interest. Thus, the quintessential form of capital was the factory, in opposition to Fischer Black’s idea that it was the human being.

Consequently, according to Fischer, “an increase in wealth meant an increase in welfare”, which suggests that we should adopt economic policies that increase wealth. Later, in his wheat theory, Fischer stated that the rate of interest (or the realized return on the stock of capital) and the price of risk, both summarized production opportunities and investors’ preferences throughout the entire economy. However, this theory does not explain anything about unemployment, which is actually the main reason of business cycles in most people’s perceptions.

Pages 200-204

After 25 years of strong economic growth, 1973 ended up with prosperity and set the beginning of the stagflation era in US, with inflation starting to creep up since 1960. In consequence, the S&P 500 index fell of 42 percents and stocks returns were about only 1,3 percent from 1965 to 1974.

Summarizing his view of the future, Fischer stated that "investors may decide to keep in stock the money they currently have in stocks".His rational was the efficient markets idea that return are independent random variables from one year to the next and the absence of explanation for a sure cause of the stagflation. Thus, for him, a past event would not be a good reason to believe it would occur again in the future

At that time, both Keynesians and monetarists visualized business cycles as short run deviations from long-run equilibrium. But Fischer came with the suggestion that economy could be understood as being in full general equilibrium all the time, with uncertainty (and not disequilibrium) causing business fluctuation. This concept in some extent was an extension of Irving Fisher's model of general equilibrium, with now the necessary analytical tools (CAPM) to treat uncertainty. For Fischer, the basic cause of business fluctuation was a mismatch between the pattern of production and the pattern of demand that could arise in equilibrium because of the very limited knowledge one shares about future events. Although, this way of thinking caused a lot of controversy ( theoreticians, MIT colleagues), Fischer was determined to develop his point further.

Pg 195-200

While teaching at MIT, Fischer noticed he did not really fit in with the other professors. It was customary for instruction to be focused on the explanation of already proven practices and industry accepted ideas. Fischer Black was more focused on what has not yet been fully explained or embraced.

Most instructors explained economics and finance with mathematics. Fischer, on the other hand, believed in solving problems first with words. This allowed the problem to be approached from various angles instead of tying it to one mathematical explanation. He argued that finance was more like a language that could be used to arrive at a solution to a given problem.

Pgs 191-195

The Sloan School at MIT offered Black a position after hearing of his family situation and Black quickly took the opportunity to be with his family again. Fischer soon found large contrasts in his views on the market as compared to his new colleagues views. MIT's economic views centered around a neo-Keynesian mindset, led by Paul Samuelson, Robert Solow, and Franco Modigliani. Another sharp contrast between Black's experience at Chicago was that MIT viewed economics as the tool for developing the correct science behind governmental policy. This was quite different from the anti-government regulation theories Black was accustomed to at Chicago. Paul Samuelson at MIT began developing mathematical methods for understanding and making economic observations. His theory behind this approach was that most complex problems can be better understood by more complete and accurate understanding of similar, less complex problems. Therefore, he set about developing his methods in this manner. One example of Samuelson's methods is the theory of economic growth formulated by colleague Robert Solow around a basic aggregate production function.

Pgs 186-189

Fischer began to completely engulf himself in his academic work at the University of Chicago. He loved Chicago because it allowed him to be the free-thinking intellectual he saw himself as. Although initially he struggled with the monotony of teaching classes and lecturing he soon found a teaching method that suited him perfectly. He turned his classes into question and answer sessions in which the questions stayed the same but the answers were always changing. This allowed his students and himself to engage intellectually and he found that his students loved it as much as he did. However, as he began loving his life in Chicago more and more, his wife Mimi hated it more and more. She was unhappy with their life in Chicago and the direction of his career. Fischer even attempted setting up their relationship as a business partnership, which did not work. Mimi eventually took the kids and moved back to Boston to be with her family.

Pages 182-186

After 20 years of hard work, the theory of universal hedging, final piece in Fischer’s monetary theory fell into place. According to the CAPM, you will always earn the same return when holding the world market portfolio, regardless of your location and currency. However, the problem is that the world is not in equilibrium and the currencies fluctuate over time. Thus, investors want to hedge their foreign currency exposure in order to avoid big losses due to exchange rates. During his years at Goldman Sachs, Fischer found a formula to hedge the currency exposure, that he named the “Universal Hedging Formula”.

The key of this result is that, according to their specific country, people measure their wealth with different price indexes. Consequently, “real” returns differ based on the currency used. Nevertheless, if the same mix of goods and services are consumed by everybody in the world, at the same price everywhere, it will be useless to use hedging.

Many practitioners and academics argued that Fischer’s result was based on too many unrealistic assumptions about the world (i.e. the world is always in full international CAPM equilibrium). But even if the world may not literally be in equilibrium, the search for profit is always pushing in that direction.

Pages 178-182

Donald McCloskey and J. Richard Zecher wrote an article about the gold standard that fascinated Black, and in his opinion, helped him finish his theory of money. The important findings in this article were that, for the time period studied, "world commodity and capital markets (those studied were the United States, and Britain) were unified." Black used this to help confirm his "law of one equilibrium" which is that the relative prices of goods are determined by market forces without monetary factors. Black argued that governments should adopt a gold standard without actual gold coins, or an inventory system run by the government. Black wanted a "fiat gold standard."
A fiat gold standard would create a system that was pegged to gold and then change the peg as the domestic price level changes. What would happen is that as price levels rise, the price of gold drops and vice versa, avoiding the importing of inflation or deflation from different countries. As of 1981 Black felt that his theory of money was complete.

Pages 175- 178

Fischer's 1920 proposal for stabilizing the Dollar and Modigliani's plan for international monetary reform were quite similar in the extent that both attempted to build an international system allowing the US to use monetary policy for domestic stabilization. However, while Fischer wanted to link the dollar price to a domestic price index, Modigliani's preference was on an international one. To this regard, commenting on Modigliani's plan, Fischer said that barriers (to trade , to international movement of capital goods, to foreign ownership of a country's assets) were all deficiencies of an international economic system,". In Fischer best international monetary system, although there would be a multiplicity of nation units, we would face a true equilibrium. Indeed, it would exist only one world market for risk-free borrowing and lending (at a single risk free rate of interest), as well as a single world capital market, a single world market portfolio and a single world price of risk. Thus, for Fischer it is clear that both fixed and flexible exchange rates might be compatible with the idea of equilibrium.

On the other hand, moving from his vision of international capital market equilibrium, Fischer started to deal with the monetary approach to the balance of payments. For him the idea of monetarism at the world level, was not relevant, because no flows of international reserves should be necessary to equate supply and demand, and the money supply should remain endogenous. But soon this theory of passive money created controversy because of the absence of any explanation for prices, inflation and exchange rates.

Pages 171-175

This section discusses Robert Mundell's monetary approach to the balance of payments. The monetary approach tries to understand the imbalance between supply and demand for money in the international markets. Mundell, who was trained as a Keynesian at MIT, believed that fiscal policy should focus on domestic income stabilization and that monetary policy should focus on the balance of payments.
In order to better understand and defend the Bretton Woods system Mundell developed his monetary approach. His hope was that the monetary approach would explain the constraints that were placed on the domestic economic policy which needed to be understood so the Bretton Woods system could function.
There was a argument though between what Mundell and the followers of the Bretton Woods system believed, and what Milton Friedman believed. Friedman saw the fixed exchange rates supported by Mundell and Bretton Woods, as price fixing, and that the fixed rates would require assistance to remain fixed. Friedman said that having fixed rates and the intervention that would go along with it is the real threat to world trade.
The problem with fluctuating exchange rates was that investors would have to develop some way to hedge their investment to protect against the flexible rates.

pg 167-171

Futures contracts on currency were once restricted to large firms looking to hedge their risk as they did business overseas. Individual speculators had a hard time getting anyone to satisfy their contracts. The International Monetary Market (IMM) opened to satisfy this untapped market segment. Part of this exclusive thinking came from the sorted history of previous futures exchanges. The biggest problem IMM faced was the fact the government was still using a fixed trading system with many of our European allies. When the government finally gave up regulating exchange rates the flood gate opened wide, attracting business to invest in futures currency. Most of Fischer Blacks involvement in this process involved writing papers and developing models to price the rapidly growing number of securities. These models kind of jump started the industry, as they helped guide investors in the new market to set efficient prices.

Pages 161-165

With all of the criticsm that followed Fischer's model there were some who supported his ideas. Practical bankers welcomed his ideas, although it was mostly because Fischer's ideas were in support of deregulation in the banking industry.
Fischer argued that regulation distorts banking practices and makes them inefficient, which provides opportunities for profit.

Pages 157-161

On August 6, 1971 Milton Friedman responded to a letter that Fischer Black wrote to him. Friedman told Fischer that his model was irrational. It is interesting that such a well known and intelligent man disregarded Fischer's model and despite being told that he was irrational Fischer still continued to study and develop his model. It shows that Fischer was not easily swayed in what he felt was a correct principle even when it was given by someone who is well known. Infact it actually made him work harder to develop a more sound model.
At Friedman's workshop Fischer had to present his paper on the model that he developed and basically defend it against many intillegent individuals. In the end Fischer came out on top despite all of the criticism.

Pages 154-157

Merton Miller believed in markets; markets that can close down due to government regulations. Student in economy at Harvard, Miller was never influenced by the Keynesianism. Indeed, during his studies at the University of Chicago, he was more interested in Fritz Machlup’s theory, a great Austrian economist. The virtues of the free market and the dangers of state control were the main subjects of his lectures.

Miller became famous in 1958 thanks to his collaboration with Modigliani in the Modigliani-Miller paper.

Unlike Miller, Fischer believed in equilibrium. Thus, he brought a new approach to the theory of money, when he arrived at Chicago, stating that income was a prime determinant of money. Moreover, it should be pointed out that the battle between the two theories is not truly relevant as the central bank is mainly irrelevant.

PG 150-154

Milton Friedman became part of Chicago's economics department in 1946. At the time Chicago economics was viewed as pro-market, anti-regulation, and focused heavily on supply and demand in free markets. Friedman's main goal was to counter the extremists of the Keynesian method and keep interest rates permanently low. He also proposed a fixed money growth rule to place a limit on the government's use of money issue and to also act as a stabilizer during economic imbalances.

Modigliani and Friedman agreed on the quantity theory of money as it relates to employment. However, they disagreed if monetary authorities would improve if a money growth rule was implemented.

Merton Miller was looking for something beyond the Efficient Markets Theory and the CAPM; he teamed up with Charles Upton and created a landmark textbook in macroeconomics. Fischer thought highly of Merton Miller and viewed him as one of the best scholars in finance.

Pages 148-150

The main inference of Fischer’s first article was that monetary policy had virtually no effect on the level of economic activity or the price level. He based his research on how money and bonds would work in the world of true equilibrium, emphasizing the idea that “money does not exist”. Thus, the Fed cannot be supposed to control it and the market cannot be supposed to be affected by it.

These conclusions Fischer made about his simpler world would also be true in the real complex one.

While Modigliani believes that the Federal Reserve controls total banks reserves, Fischer argues that the Fed operates a “passive monetary policy”, in his mature theory. Indeed, it only provides to the banks all the reserves they want.

In conclusion, according to Fischer, economic activity and inflation are not affected by monetary policies and if banking were deregulated, it would be easier for commercial banks to do more business.

PG 143-148

Fischer’s knowledge of macroeconomics was obtained mostly from John Lintner and Franco Modigliani. Lintner supported the Keynesian view of the economy, explaining a complex econometrics model that can simulate economic response to various economic conditions and variables. Modigliani focused more on the Irving Fisher approach, showing that the economy is a result of various demand and supply functions. Modigliani’s methods exceeded Fisher’s by providing an explicit amount of the demand for money balances and an explicit account of the money supply. Modigliani’s solution was for the Central Bank to establish a target for money supply, and penalize any wavering from that target.

Fischer Black would have heard all of this from listening to Modigliani at MIT. However, Fischer had questions and criticisms on important concepts Modigliani ignores and overlooks. In 1968 Fischer begins constructing his own views.

Appendix 4.A

There isn't a huge amount of content here - it's just a list of these "financial notes" that Black kept producing.

The importance of this is that an academic would have written these, and then tried to publish them. After publishing them, they'd be kept track of on a CV, and would be accessible through libraries.

In Black's case, he was doing pathbreaking scholarly work in a non-academic setting. So there are amazing nuggets in these notes that never saw the light of day, or didn't until much later. At that time, they may have even been published by others since they hadn't been "claimed" by Black.

Pages 141-143

Fischer moved to Chicago after closing his office in Belmont, selling by the way his house in Arlington. In his first year, he had no teaching responsibilities continuing his consulting projects for Wells Fargo.

He would spend the rest of the time on intellectual projects that interested him: he would soon become a regular presence at the weekly workshop stimulating intellectual life at Chicago.

He was committed through making casual comments and remarks on other people works. One day, he presented his criticism on econometric practices, provoking the audience in order to learn more from them.

Pg. 123 - 135

Scholes and Robert C. Merton had known each other for a few months before they both realized that they were working in the same research area. Merton presented his own paper about options pricing the same day as Black and Scholes. Merton's paper started from very different assumptions, and also lacked the correct options formula. Scholes explained it to him, but he was not persuaded by their formula. Because Merton had some doubts about CAPM, he was skeptical of anything derived from it.

After those conversations between Scholes and Merton, Black and Scholes began working on their formula to make it stronger. A kind of race began between Merton and both black and Scholes. After a few weeks Merton found that his assumptions eventually lead to the Black and Scholes model. He called Scholes and told him that they were right. Merton then waited to publish his derivation until after Black and Scholes.

All three men started buying warrants based on their models and promptly lost money. Black says that he lost less money than the other two though. According to Black, sometimes the market knows more than the formula.

Pg 135-138

Black was having a hard time in the late 60’s getting the world of finance to recognize his somewhat economic approach to valuing warrants. The University of Chicago, at the time, was quite interested in Black’s new ideas. The University of Chicago wanted an options exchange at the Chicago Board of Trade and Fischer Black might just be the guy to help them get there! The university offered Black a visiting professor position to teach finance in 1971.

The SEC approved of the option market idea, developed by James Lorie and Merton Miller, on October 14, 1971. With the Chicago Board Options Exchange quickly emerging, Black was in the perfect position to put his ideas to the test and publish the Black-Scholes formula.

Pg. 129-132

In the fall of 1969 Fischer and Myron Scholes started working on their model for option pricing. It started in a meeting that they were in together and developed in less than a year of them working together on it. This is not to imply that it only took a year to find this model. Both Black and Scholes had been thinking about this for a long time. One of the interesting methods that they used to develop this was to find out what needed to not be in the formula. From there they could get closer to what actually needed to be in the model.

After they had finished it they addressed the issue of why someone should care about what they developed. Black and Scholes wanted this to be useful for more people than just speculators. They concentrated on the fact that their model could actually be used to value the stock of a firm. Allowing people to eventually find the measure of discount due to the chance of default, among other things. I also like that they did give credit to Robert Merton in their first paper about this.

124-129

The prevailing logic of Black's day (and ours too) is that investors should be more risky when they are younger, and less risky when they are older and have a greater dependence on their investment income.
However, Black suggested that risk should be spread out over an investor's lifetime, rather than being reserved only for youth.
He suggested that the dollar amount spent on risky investments should be a function of a leverage parameter, which remains constant over a person's lifetime, b, and the amount of investment in a safe asset w. Multiplying b and w gives you the amount a person should invest in riskier assets over their lifetime.
His assumptions on lifetime risk tolerance lead to the formation of Wells Fargo's Stagecoach Fund, a constantly leveraged fund.

Black claims to have found the solution to option pricing in June 1969. Despite his brilliance however, Black did not yet recognize what he found when he figured it out.
Departing from conventional logic, Black began by assuming that an option's price was only a function of the underlying stock's price x, and time, t. Using CAPM, and adding variables to account for systematic and unsystematic risk, Black came to the following equation:

w₂=rw-rxw₁-½v²x²w₁₁

This equation, though Black did not realize it at the time, was the secret to option pricing.

Pages 121-124

In the summer of 1968, the MIT professor Paul Samuelson proposed to one of his students, Robert C Melton a partnership in order to write a thesis on how to price warrants. Samuelson already published a first attempt elaborating a formula to estimate the value of warrant at a point in time but the weakness was that the assumed expected returns are unknown and unlikely to be constant over time.

After writing the paper together, the new idea was to propose an equilibrium model in which both alpha and beta quantities are determined period by period, by supply and demand, given the risk preferences of investors.

Later, for his PhD work, Melton pioneered writing on the problem of continuous-time stochastic processes. According to his analytical framework, at every immeasurably small instant in time the die that determines the return on an asset is rolled again implying that the return over any limited interval of time is the sum of many rolls.

Pages 116-118

According to Fischer, when there is a lack of correspondence between the data and the theory, it is safer to assume that the theory is correct implying that Wells Fargo was right to prefer the market index fund suggested by the CAPM rather than the low-beta fund implied by the data.

Besides, Fischer had the will to improve his theory using recalcitrant experience referring to stimulating theoretical work with empirical anomalies. He criticized econometrics models because of the exclusive focus on data combined with less theoretical considerations. He said: “A crooked yield curve or unexplained stock price is suggestive, but I generally want to know why these patterns exist before I trade”.

Pages 109-111

Wells Fargo did not change its practices in order to adapt to Black and Scholes orientations; CAPM was still only an academic theory.

Several months later, the new trend was to offer to clients a market index fund (S&P 500) aiming only to match the market no to beat it. Thus, the main issue was to reduce costs of trading. Fischer had the idea to consider that the index fund manager as a liquidity trader who does not care about which particular stock he buys or sells. That flexibility could be exploited by advertising a list of stocks and prices at which one was prepared to trade, so that he would not lose to other markets.

For a leveraged fund, Fischer thought that borrowing at a rate that would change daily could solve the equation. Besides, the banks would prefer such an arrangement that guarantees a profitable loan even if interest rates rise.

Pages 105-109

CAPM states that expected return on a specified stock can be divided into two components, the risk-free rate of interest and a term multiplying the price of risk times the quantity of risk in the stock. The consequence is that low-beta stocks have higher returns and high-beta ones have lower returns than the theory predicts. Besides, CAPM suggests that the best passive portfolio strategy is to hold a value weighted market portfolio.

During the 70s, everyone was looking for inefficiencies to beat the market. For Black and Scholes, there is evidence on mispricing stocks suggesting the existence of a factor called the alpha effect. Indeed, low-betas stocks were underpriced and high-beta ones overpriced.

In order to exploit the anomaly, Black and Scholes proposed three strategies more efficient than the high-beta strategy:

The first is a market portfolio levered to have the same risk as the high-beta portfolio.

The second is a portfolio of low-beta stocks levered to have the same risk as the high-beta one.

The third is a mixture of long positions in low-beta stocks and short positions in high-beta stocks.

PG 102-105

Wells Fargo Bank was established during the gold rush because gold miners needed a way to convert their gold into cash. The bank also operated an express service to ship goods and mail. McQuown wanted to change investment management strategies from the unsophisticated ways of “water walkers” (having a magic touch to pick stocks) to a more quantitative and scientific method. McQuown heard about Fischer-Lorie results on common stock returns. A meeting with Lorie was arranged, and his popularity began to increase. As he was giving a talk in 1963 to IBM, the CEO from Wells Fargo was in the audience. McQuown was hired by Wells Fargo to further develop a quantitative technology for money management.

McQuown was suspicious that stock prices could not be easily exploited for profit, and hired Wagner and Cuneo, who were non-finance minds so he could teach them whatever he wanted. Scholes disapproved of their research, and they turned their focus to efficient market portfolio strategies. The strategy was to gather many great minds together in conferences and focus on helping Wells Fargo; in return wells Fargo financed all the research. The first conference was held in 1969 and focused turned to the CAPM.