The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty

CHAPTER 26

When Fischer and Myron Met Bob: Option Theory

It is 1969. Myron Scholes, with a freshly minted PhD in finance from the University of Chicago, joins MIT’s Sloan School as an assistant professor. He meets Fischer Black, a consultant at Arthur D. Little with a Harvard PhD in applied mathematics. They are both up to speed on the Capital Asset Pricing Model of Bill Sharpe and are trying to apply it to options instead of to stocks. Fischer and Myron meet Bob Merton when he arrives at Sloan for a job interview as an assistant professor of finance. Bob lands the job, and it emerges that he too is investigating option valuation. I encourage you to read Peter Bernstein’s Capital Ideas and the Nobel Prize acceptance lectures of Scholes and Merton to see whether you can untangle the intellectual paternity issues involved.¹,² But clearly all three of these pioneers share credit for deriving the theoretical value of options, and Fischer Black would certainly have shared the Nobel Prize with the other two in 1997 had he not sadly passed away in 1995.

Risk-Neutral Pricing

Here is the basic argument by which the team arrived at a theoretical price for options:

1. Recall from the last chapter that options can behave like fire insurance policies on stocks. Therefore it is possible to bundle a combination of stocks and options into a portfolio, which, like a house and its insurance policy, is essentially risk free.

2. According to CAPM, such a bundle would be priced by the market to ...