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.
A for Braley.
ReplyDeleteScholes' idea of constructing a hedging portfolio underlies the Black-Scholes formula, but it's also a major step in Cox, Ingersoll and Ross' later model of binomial pricing (which we covered in class before break, and will continue with after break).
Mehrling notes that Scholes was surprised that the return on the stock did not enter into the formula for the price of the option: you can see this when you examine the formula, which contains the price but not the return on the stock. This is a bit strange, but it's because the asset projects of the firm are generating returns that influence both the price and the value of the call, and thus cancel out.
Mehrling also forshadows a point I made the week before the mid-term: the Modigliani-Miller theorem tells you that the form of finance can't influence the value of the firm, but without option pricing it can't tell you how the form of finance affects the value of the firm's debt and equity.