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Stanford's Scholes wins Nobel for economics

Myron Scholes, the Frank E. Buck Professor of Finance, Emeritus, at the Stanford Graduate School of Business, was awarded the Nobel Memorial Prize in Economic Sciences Tuesday, Oct. 14, along 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.

Scholes, 56, was in Pebble Beach to play golf and give a speech when he first heard he had won the prize in an early morning phone call 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 residents of Menlo Park, several dozen reporters and photographers, and Stanford associates who toasted him with champagne.

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.


By Kathleen O'Toole

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