(sorry for the formatting...http://www.n-jcenter.com/97/oct/15/nobel.htm Oct. 15, 1997 Two Americans share Nobel economics prize N-J wire services NEW YORK Two Americans won the Nobel Prize in economics Tuesday for their work on derivatives, the risky investments that have brought riches to some but ruin to Britain's oldest bank and California's Orange County. Professors Robert C. Merton of Harvard University and Myron S. Scholes of Stanford University were honored by the Royal Swedish Academy of Sciences for devising a formula for pricing derivatives, such as stock options. The work helped build what now is a $70 trillion global market. "People don't recognize it, but their contributions helped make everybody's life a lot better," said Robert Brusca, chief economist at Nikko Securities International in New York. Derivatives are securities linked to, or derived from, an underlying asset, such as stocks, interest rates or a currency. One common form of derivative is a stock option, which gives the holder the right, but not the obligation, to buy or sell a stock at a specific price within a specific period. Companies routinely use derivatives as a hedge against unforeseen losses due to currency and interest-rate volatility. Derivatives make it possible, for example, to refinance home mortgages when interest rates are falling. But because buyers of derivatives are not directly buying shares in a company or another asset, determining their worth had seemed more like gambling than investing. Merton and Scholes' formula for valuing the investments helped create a widely used standard and allowed for a worldwide trade in derivatives. The market for derivatives is now nearly 10 times the U.S. gross domestic product. "If you ask what idea in the last 50 or 60 years coming from economic research has had the biggest impact on the world, this is it," said Avainash Dixit, an economics professor at Princeton University. In addition to using options and other derivatives to reduce risk, speculators also trade them. Because they are cheaper to buy than the underlying shares, there is a potential to leverage a relatively small amount of cash into a big gain. But the risk of big losses also rises if the bet is wrong. The most notorious loss on the derivatives market was the $1.38 billion that rogue trader Nick Leeson racked up on the Tokyo stock market in 1995. The losses brought down Barings, Britain's oldest bank. In 1994, Orange County lost $1.64 billion in part from derivatives investments that guessed wrong on the direction of interest rates, leading to the biggest municipal bankruptcy in U.S. history. Procter & Gamble, one of America's blue-chip companies, lost more than $100 million on soured derivative investments that same year. Scholes originally developed the theory on how to value derivatives while working with Fischer Black, who died in 1995. After the Black-Scholes formula on valuing stock options was published in 1973, Merton helped apply the work to additional markets. Scholes said he was ecstatic and surprised to share the $1 million prize with Merton. Both men are also partners in Long-Term Capital Management, an investment firm in Greenwich, Conn. Scholes, 56, is a professor emeritus at Stanford. He is the third Stanford professor to win the economics prize and the university's 16th Nobel laureate overall. Merton, a 53-year-old professor of business administration at Harvard, said the news put him "in a state of shock." Both men said they wished Black was alive to share the prize with them; Nobel Prizes are not given posthumously. Merton, the fourth Harvard winner of the economics prize and the school's 35th Nobel laureate overall, earned his Ph.D. in economics in 1970 at the Massachusetts Institute of Technology. Scholes earned his at the University of Chicago in 1969. The economics prize is the newest of the Nobels. It is not one of the original five created by Alfred Nobel, the inventor of dynamite who endowed the prizes in his will in 1896. The Swedish Central Bank persuaded the Nobel Foundation in 1968 to let it endow the award. A look at derivatives Derivatives, a key and often controversial element in today's financial markets, are securities linked to, or derived from, an underlying asset, such as stocks, interest rates, or a currency. One common form of derivative is a stock option, which gives the holder the right, but not the obligation, to buy or sell a stock at a specific price within a specific period. An investor who purchases an option to buy known as a "call option" bets that before the time the option expires, the stock will be selling for more than the price at which he has the option to buy it. One type of derivative that affects personal finances is a mortgage-backed security, which is the backbone for making more favorable interest rates available for obtaining or refinancing mortgages. Homeowners or buyers can lock in rates, which lenders are willing to oblige because they limit their own risk by trading securities backed by mortgages. Investors gain a variety of trading options from those securities, which helps money flow back into the mortgage market to create more loans. There is an international market in options and other derivatives. Companies with global operations routinely use the financial contracts to hedge against unforeseen losses due to currency and interest-rate volatility. Because a person who buys a derivative is not directly buying shares in a company or another asset, determining a derivative's worth seems to many to be more like gambling than investing. Economists Robert C. Merton of Harvard University and Myron S. Scholes of Stanford University were honored today with the Nobel prize for developing a formula for valuing stock options that now is widely used by traders and investors. In addition to their use in reducing investment risk, speculators also trade in options. Because they are cheaper to buy than the underlying shares, there is a potential to leverage a relatively small amount of cash into a big gain. The risk of big losses also rise if the bet is wrong. Perhaps the most notorious loss on the derivatives market was the $1.38 billion that rogue trader Nick Leeson racked up in bad bets on the Tokyo stock market in 1995. The losses brought down Barings, Britain's oldest bank. Orange County in California lost $1.64 billion in 1994 when it incorrectly bet interest rates would hold steady or fall, resulting in the biggest municipal bankruptcy in U.S. history. Despite the widely publicized losses by speculators, regulators have said derivatives generally work well in reducing risk. Excerpts from Nobel Economics Prize citation STOCKHOLM, Sweden Excerpts from the Royal Swedish Academy of Sciences' citation awarding the 1997 Nobel ecooooooooonomics prize to Robert C. Merton of Harvard University and Myron S. Scholes of Stanford University. Merton and Scholes "developed a pioneering formula for the valuation of stock options. Their methodology has paved the way for economic valuations in many areas. It has also generated new types of financial instruments and facilitated more efficient risk management in society." "Thousands of traders and investors now use this formula every day to value stock options in markets throughout the world. Merton devised another method to derive the formula that turned out to have very wide applicability; he also generalized the formula in many directions." Their method "to determine the value of derivatives stands out among the foremost contributions to economic sciences over the last 25 years. (It) laid the foundation for the rapid growth of markets for derivatives in the last 10 years. Their method has more general applicability, however, and has created new areas of research inside as well as outside of financial economics. A similar method may be used to value insurance contracts and guarantees, or the flexibility of physical investment projects." Their work "has become indispensable in the analysis of many economic problems. Banks and investment banks regularly use the laureates' methodology to value new financial instruments and to offer instruments tailored to their customers' specific risks. At the same time institutions can reduce their own risk exposure in financial markets." Thumbnail sketches of the winners of the Nobel prize for economics The Americans who won the Nobel Prize in economics Tuesday: ROBERT C. MERTON: 53, a native of New York. Received bachelor's degree in engineering mathematics in 1966 from Columbia University, where his father was professor. Earned master's in applied mathematics from California Institute of Technology a year later, followed by doctorate in economics from Massachusetts Institute of Technology. Taught at MIT's Sloan School of Management from 1970 to 1988 before moving to Harvard Business School. His reaction to winning: "I'm in a state of shock." MYRON S. SCHOLES: 56, a native of Timmins, Ontario, now an American citizen. Received bachelor's degree from McMaster University in Canada in 1961. Earned master's in business administration in 1964 from University of Chicago. Got his doctorate there in 1969 in finance. Taught at MIT and University of Chicago before joining Stanford University faculty in 1981. Professor emeritus at Stanford. His reaction to winning: "I was ecstatic and really surprised and pleased and all the other words one can say." Scholes and Merton are partners in Long-Term Capital Management in Greenwich, Conn., where Scholes lives. In the 1960s, Merton, Scholes and Fischer Black collaborated on a formula for valuing options and other derivatives in financial markets. Return to the News-Journal Web Edition 1997 News-Journal Corp. Send questions, comments or Feedback to News-Journal Center
