Winners of the 1997 Nobel Prizes in Economy
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Winners of the 1997 Nobel Prizes in Economics
Summary
The Royal Swedish Academy of Sciences awarded the 1997 Nobel Prize in Economic Sciences to Professor Robert C. Merton from Harvard University and Professor Myron S. Scholes from Stanford University. Their joint recognition was for developing a groundbreaking method to determine the value of derivatives.
Article
In 1997, the Royal Swedish Academy of Sciences honored Professors Robert C. Merton and Myron S. Scholes with the Nobel Prize in Economic Sciences. Their pioneering work introduced a novel approach to valuing derivatives, a key concept in understanding risk in economics.
Understanding Risk in Economics
Risk in economics is crucial as it impacts the value of assets, whether tangible or intangible, like contracts or investments. Scholes highlighted that their formula applies to any scenario involving contracts dependent on an asset's future value.
The Evolution of Risk Management
Risk management is an age-old practice, dating back 200 years when households and firms managed their risks by transferring them to others willing to bear them. In the financial markets, this risk reallocation is achieved using derivative securities such as options and futures. These tools hedge against potential future risks, allowing firms to stabilize expectations by transferring risks to buyers of these contracts.
The Black-Scholes Formula
The Black-Scholes formula was a revolutionary leap in pricing derivatives. Developed in the early 1970s by Fischer Black, Robert Merton, and Myron Scholes, it solved a fundamental problem in financial theory: how to accurately value financial risk. Sadly, Fischer Black passed away in 1995 and was unable to share in the Nobel Prize.
Foundations of Option Valuation
Early efforts to value stock options began with Louis Bachelier in 1900, though his assumptions were impractical. Scholars like Case Sprenkle and Paul Samuelson refined these notions, integrating realistic factors like investor risk aversion and non-zero interest rates.
Before 1973, stock options were valued based on expected future stock prices, with arbitrary risk premiums accounting for volatility. The Black-Scholes model eliminated the need for these risk premiums by incorporating all necessary data into a singular formula.
The Impact of Merton and Scholes
The Black-Scholes formula calculates option value by considering factors such as current share price, volatility, interest rates, and time to maturity, among others. Merton further enhanced the formula by allowing for a fluctuating interest rate, applying it to complex options, and emphasizing the absence of arbitrage in market equilibrium.
Practical Applications
Merton and Scholes' work had profound implications, extending beyond derivatives to valuating currency options, interest rate options, and more. Though the original formula has evolved, its core principles remain vital.
For instance, in financial contracts, the formula helps design optimal agreements considering bankruptcy laws. Investment evaluations can use the model to discern flexibility in decisions regarding equipment usage or energy sources. Additionally, it applies to insurance and guarantees, treating them as analogous to put options.
Modern Financial Markets
The legacy of Merton and Scholes transformed financial markets, where their formula is now integral. Option contracts first traded on the Chicago Board Options Exchange in 1973, shortly before the formula was published. By 1975, it became a staple tool for traders, legally mandated in several countries for pricing stock warrants and options.
Continuing Influence
Today, the Black-Scholes model is indispensable in financial markets. Investment managers use it to hedge against share price declines, while firms leverage derivatives to manage financial risks. Banks employ the formula to innovate new products and reduce their own exposure.
Further Contributions
Both Merton and Scholes made significant academic contributions beyond their famous formula. Merton explored individual consumption and investment behavior, adding dynamism to the CAPM model. He developed a formula for discontinuous stock price movements. Scholes, a proponent of market efficiency, analyzed the impact of dividends on share prices and unraveled non-specific risks.
In conclusion, the work of Merton and Scholes laid the foundation for modern financial risk management, continuing to impact economic theories and practices worldwide.
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