Saturday, July 11, 2015

Review of Fischer Black and the Revolutionary Idea of Finance by Perry Mehrling

Remember quant Emanuel Derman who worked for Fischer Black? This is Fischer Black's story, who is best known for being a coauthor of the Black-Scholes model for pricing options.

This is an interesting example of simultaneous invention because his coauthor Myron Scholes presumably might have come up with the model on his own, eventually. Even if he hadn't, Robert Merton also discovered the model, and in fact the two teams split the 1997 Nobel economics prize. Ed Thorp claims that he discovered it too but kept quiet about it and used it to make money trading options.

The story of increased efficiency in options pricing is another example of how profitable trading opportunities go through a lifecycle where the innovation diffuses and they become commodities. No evergreen investment strategies!

Simultaneous invention makes biographies of inventors philosophically uninteresting. Who cares about the idiosyncrasies of somebody who discovered something at the same time as two other people?

Note that the oldest of the three official Black-Scholes discoverers was Fischer who was born in 1938 and the youngest was Robert Merton who was born in 1944. Right place, right time; like Aubrey McClendon and Tom Ward who were born three days apart in Oklahoma. Similarly, J.S. Bach and G.F. Handel were both born in 1685.

Fischer Black was part of the move to get endowments invested in equities. See this paper from 1952 [pdf] when, within recent memory, there were only certain securities that were legal for fiduciaries to purchase. One of causes of the great 20th bull market - which cannot be repeated - was loosening these standards and creating more valuation-insensitive purchasers of stocks.

Similarly, the baby boomers' 401(k) accounts were valuation-insensitive purchasers, and they have absorbed a (false) lesson that one owns securities to make money through rising valuations and capital gains. A stock index with a high enough dividend yield to justify owning absent price momentum is a foreign concept to baby boomers.

Tyler Cowen quotes Fischer Black: "The easiest theory to falsify is a theory which is false."

Black had a pretty good theory of the business cycle. A boom is a period when the pattern of production is a good match for the pattern of demand. A bust is a period when the match is bad. It means that people are working in the wrong sectors, producing the wrong mix of goods and services. Fortunately, price signals will encourage a shift to the right pattern of production (at least if the economy is left alone.)

This fits well with Falky's Batesian mimicry theory: the mimicry of successful entrepreneurs by copycats is what causes the glut and bust.


1 comment:

James said...

John Bender had an interesting strategy for trading options post-B/S, but it's one that can't be reduced to a formula: