Nov. 1 1997 3:30 AM


The Nobel Prize in economics was recently awarded to Myron Scholes and Robert Merton. Their work has had tremendous practical impact on the world of finance. Yet their own lives call into question a key assumption of economic theory.


The issue is simple. One day in 1970, three hard-working associate professors of finance scribbled down a few equations on a blackboard, and eureka! They had discovered a method for pricing options. (The third man, Fischer Black, died in 1995.) What did they do with this extremely valuable information? They gave it to the rest of us for free. That is the problem.

The assumption that appears to be in jeopardy is profit maximization. In markets, particularly financial markets, when profit opportunities arise, it is assumed that savvy individuals will take advantage of them in order to capture profits. Some economists describe it this way: No one leaves $500 bills lying on the street. Indeed in finance theory--including the Nobel prize winners' own formula--the profit motive is the engine that moves financial markets from one equilibrium to another. (Equilibrium being the place where nothing really happens.)

Modern financial theory is highly dependent on such strange theoretical beings--greedy fortunetellers who can compute the third derivative of their utility function. For example, the creatures assumed in the Capital Asset Pricing Model, the keystone of most academic finance, are assumed to care only about risk and return. The people trapped in the CAPM are assumed to apply the equations provided by Sharpe, Lintner, and Treynor (for which only Sharpe won a Nobel) to pounce on the slightest deviation from equilibrium in order to get more. This greed is their most important trait. If they aren't greedy, the theory falls apart, as would most other economic theories. Professors Merton and Scholes have undoubtedly assumed unbridled greed hundreds of times in classrooms, academic conferences, and cocktail parties. The question at hand is whether our generous academics were greedy enough to be consistent with their own assumptions.

On that day in 1970, they surely knew that they had discovered something of great value. Why didn't they take their solution and their measly academic salaries and start trading options? With the formula programmed into only their calculators, they could have ruled the emerging Chicago Board of Options Exchange, taking the money of the hapless traders who were still pricing based on history, rules of thumb, or their guts (a potentially substantial source of wisdom here in Chicago). There is no way to know how much money they would have made, but it surely would dwarf the million bucks they scored for the Nobel. They had the key equation that now drives hundreds of billions, if not trillions, of dollars of annual trading volume in stock options, futures options, mortgages, over-the-counter currency options, and most of the derivatives industry.


To be sure, these guys have made a lot of money working for Wall Street firms in recent years. They surely have been adequately greedy in the rest of their careers to satisfy their own assumptions. But their youthful charitable lapse must still be explained.

One possible explanation is that if they had kept the formula to themselves, the budding options market would have been stunted. They would have quickly taken all the money from the suckers trading against them, and no one would have been foolish enough to take them on. Perhaps they actually have maximized their income by settling for a tiny piece of the huge pie that their formula created? This explanation ignores the underlying premise of the financial markets: There's a sucker born every minute. The market might not have grown as big if they had hoarded their secret, but they would have been able to dominate it.

Another explanation is that they may have feared some other finance professor would ruin their monopoly. There usually is a pathetic close second for any theoretical breakthrough in academia. That's the nature of the idea market. Someone else eventually would have stumbled onto the same formula. In which case they would have had to cut the spoiler in for half. Or even worse, the spoiler might have given the formula away, leaving our laureates with neither fame nor fortune. Any claims that they actually discovered it first, but kept it to themselves, would have been met with skepticism at the faculty club.


This leads us to a third possibility: They couldn't trust each other. Perhaps The Treasure of the Sierra Madre was showing in Cambridge that weekend and each economist realized that he would always have to worry about the other two guys. As any 10-year-old knows (and game theorists can now elaborately prove), three-person secrets are particularly troublesome in this regard, because nobody can ever pinpoint which of the other two might have cheated. Thus, they may have opted for full, public disclosure because they knew that that was the only way to ensure that they shared equally in the spoils. (In the end, they didn't share equally, though. Scholes got his name on the formula and the Nobel, Black only got his name on the formula, and Merton only got the Nobel.)


Here's a thought: Maybe Black, Scholes, and Merton were interested in serving the public good, and the giveaway was strictly for the betterment of humanity! Before the guffaws start, we should at least consider this alternative. The formula was most directly a gift to the options traders around the world, which is not a group that usually inspires charitable acts. So these three weren't in the same league with Mother Teresa. Scholes and Merton reportedly are applauded when they appear on the floor of the options exchange, which shows that options traders are at least appreciative, if not deserving, of the rare charities that they receive. However, the benefits of this formula do extend beyond the pits. The efficient and accurate pricing of options has helped to make the economy more efficient. So we all have benefited indirectly.

Another alternative is that our heroes were pursuing the noble goal of academics everywhere--tenure. Certainly tenure was in the bag for these fellows after coming up with the formula, though it probably was likely for them anyway. Or, if not tenure, their goal might have been the eternal fame associated with having your name on an important piece of human wisdom. Economists are as guilty of this hubris as are members of any discipline: There's the Fischer Effect, the Sharpe Ratio, the Miller-Modigliani Theorem, Tobin's Q, the Laffer Curve (the only one in which the name helps characterize the discovery), and the greatest of them all, Pareto Optimality. Of these bits of academic immortality, Black-Scholes is probably the most widely used by nonacademics, so they have made a good buy on the formula's fame value.

The first three explanations all rely on various forms of greed or other base human motivations that are close enough to greed to be easily worked into economic theory. The last three motives--public good, tenure, and fame--don't fit as well with the basic assumptions of economics. It is possible to fit them in by the economist's magic trick of defining any behavior as maximizing something called "utility," utility being defined as whatever you choose to maximize. But plain old greed should be adequate to explain nearly everything in finance, because finance is about making money. If the behavior of people who are in the profession of making money isn't well explained by the motivation of making money, then it seems a real stretch to apply it elsewhere--for example, to nurses.

For straight cash greed, our Nobel laureates fall woefully short of their own standard. Someday a Nobel may go to theoreticians in behavioral finance who will be able to build a model that explains their own behavior as well as it does that of others.