GSB's Scholes wins
Nobel for economics
BY JANET ZICH AND KATHLEEN
O'TOOLE
Myron Scholes was in
Pebble Beach to play golf and give a speech when he heard
he had won the Nobel Memorial Prize in Economic Sciences.
The unexpected news came in an early morning phone call
on Oct. 14 from his brother David in New York, who heard
it on his car radio on his way to work.
After delivering the
speech, the new Nobelist drove to Stanford, where he met
with his daughters Sara and Anne, both of whom live in
Menlo Park, several dozen reporters and photographers,
and Stanford associates who toasted him with champagne.
Related
Information:
Scholes is the Frank E.
Buck Professor of Finance, Emeritus, at the Stanford
Graduate School of Business. He will share the Nobel with
Robert C. Merton of Harvard Business School.
The prize was given by the
Royal Swedish Academy of Sciences for "a new method
to determine the value of derivatives" developed by
Scholes and Merton, along with the late Fischer Black,
and published in the Journal of Political Economy
in 1973, shortly after the first options exchange opened
in Chicago.
What has become known as
the Black-Scholes options pricing model, a benchmark
formula for the valuation of stock options, put a
fledgling market on its feet. The formula was further
developed by Merton, a friend of Scholes for 30 years,
who in different published papers showed its broad
applicability.
Explaining the value of
the formula to its readers in a 1991 series of articles
on "modern classics" of economics, The
Economist wrote: "Corporate strategists use the
theory to evaluate business decisions; bond analysts use
it to value risky debt; regulators use it to value
deposit insurance; wildcatters use it to value
exploration leases." In fact, said the magazine,
"the model can be used to examine any 'contract'
whose worth depends on the uncertain future value of an
'asset.' "
At the time he and Black
first published the work, Scholes said at a press
conference at Stanford Tuesday, neither anticipated its
broad usage. "If I had, I would be a genius,"
he joked. Now, however, he said he can predict it will be
used more and more by individual investors as banks and
other intermediaries develop more investment products
with different payoff patterns, to maximize returns and
hedge risk.
Friends and colleagues had
been predicting for some time that he would win the
prize, Scholes told reporters, but the announcement was
"still a tremendous shock." Asked what he would
do next, he said he needed some time to think about
whether he would go back to academic life or stay at his
current investment firm in Connecticut, where he is one
of 15 partners. Asked how he would spend his half of the
$1 million prize, Scholes, who is also an expert on
taxation, noted that he had a "third partner the
U.S. government," and that "Stockholm is a very
expensive city" to take his family for the December
presentation of the prize.
Scholes was on the faculty
of the Stanford Graduate School of Business from 1983 to
1996 and was also a professor of law at the Law School
and a senior research fellow at the Hoover Institution.
He retired from the school last year after cofounding in
1994 Long-Term Capital Management, L.P., a Greenwich,
Conn., investment management firm that specializes in the
development and application of sophisticated financial
technology to investment management. He continues to
serve the firm as a principal and a limited partner. He
also worked at Salomon Brothers in 1992 and 1993 as
managing director and co-head of its fixed-income
derivative sales and trading department.
At the press conference,
Scholes said that he loved academic work but was partly
persuaded by students that he should try applying his
knowledge in the investment world. "Students say,
'You don't do, you just teach,' " he said.
After earning a doctorate
at the University of Chicago, Scholes said, he was a
young assistant professor at MIT's Sloan School of
Management in 1968 when he and Black, who died in 1995,
developed their formula. They were consulting for Wells
Fargo Bank, trying to better understand the relationship
between investment risk and return as part of their
research for a new investment product.
Within two months, he
said, they were able to come up with a method for pricing
all contingency contracts, but it took them a year and a
half to solve how to apply it to put-call options. Their
article was initially rejected for publication, he said,
partly because the young assistant professors tried to
save some of their work for another paper. "Even
though quality is important, quantity is also," he
said, prompting broad laughter from the audience of
reporters and colleagues. The paper was published after
several scholars lobbied the editors and Scholes and
Black added a section explaining how their work applied
to determining the value of corporate stock and debt.
Scholes was surprised, he said, to see how quickly
traders on the Chicago options market applied the model
and Texas Instruments incorporated it into one of its
calculators.
He described his paper
with Black as a "prototype" and said Merton
"pulled in the heavy apparatus and really made the
thing fly."
Several reporters wanted
to know if Scholes thought his model was responsible for
the 1987 stock market crash. At the time, he said, a Forbes
headline blamed the model and "it was kind of
tough to go home to your kids and say you just caused the
crash." Seriously, he said, it was still difficult
to know what role the model played because so many
factors were involved. " People felt the market was
much more liquid than it actually turned out to be, which
was a shock." Today the market is much more liquid
than in '87, he said.
In general, he said, new
technologies are "often adopted before all the
infrastructure" necessary for them to work at their
best is ready. "If there is a value to a new
technology it will survive." As an analogy, he told
of his recent trip to China's Yangtze River region where
people in relatively large numbers have just learned to
drive automobiles. "They drive everywhere and stop
in the middle of the fast lane if the rice falls
off," he said. That accounts for many more accidents
than in Beijing, where people have learned to drive cars
on crowded streets.
Aside from his seminal
work in options pricing and the pricing of corporate
liabilities, Scholes is also known for his work on the
effects of global tax policies on decision making. In
1992 he co-authored the book Taxes and Business
Strategy with Mark Wolfson, the Dean Witter Professor
of Accounting and Finance at the Business School.
On learning of Scholes'
award, Wolfson said: "The pioneering efforts of
Black, Merton and Scholes in the field of option pricing
have had an explosive impact on both the theory and
practice of financial markets. The work, and its
relevance to both academic research and the daily
activities of financial market professionals, rivals in
significance all preceding contributions to financial
theory."
He added that all three
had also produced "brilliant work" beyond
option pricing. "A consistent feature of all their
work, whether in asset pricing, financial policy or
taxation, is depth of insight with the objective of
creating order out of the apparent chaos of capital
market behavior. I am thrilled for each of them."
Nobel laureate William F.
Sharpe, who shared the 1990 Nobel Memorial Prize in
economics for work on another model to aid investment
decisions, the "capital asset pricing model,"
was also on hand to congratulate his colleague. The
Stanco 25 Professor of Finance at the Graduate School of
Business, Sharpe said the Black-Scholes model did not
create the options industry but is responsible for its
rapid development. It was the first to specify a way to
place a value on any asset where there was an option to
do something that might change the value in the future.
Asked how Scholes might
expect his life to change now that he has received a
Nobel, Sharpe ticked off a long list of changes in his
life. He gets several requests for autographs weekly, the
majority from Germany, he said, plus numerous invitations
to speak, a number of "crank" letters and
people asking him for his expertise on topics he knows
nothing about. Sharpe said he had to learn quickly to
tell people his expertise wasn't as broad as they
thought.
If Scholes needs advice,
he can turn to 12 living Nobel laureates on the Stanford
campus 10 on the faculty and two who are scholars at
the Hoover Institution. SR
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