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.
I think you mean pp. 132-135 not 123-135.
ReplyDeleteB for Braley for poor capitalization and editing.
ReplyDeleteMerton's idea — that you can price any asset if you can find a combination of other assets that match its pattern of returns — is now standard practice for pricing derivatives. The beginnings of this are the put-call parity formula from Chapter 8 of the Brigham and Ehrhardt text.
The fact that the formula didn't allow them to make money is no different than the fact that a knowledge of basketball statistics doesn't make someone like Dave Berri a good basketball coach. It isn't that the formulas are wrong, but rather that they miss many nuances.