The formula two journals
had turned down
On 26 April 1973, an options exchange opened in Chicago, in a room the grain market had used as a smoking lounge. A month later came the paper that would teach the world how to price what traded there. Two journals had rejected it, the first without even reading it.
A smoking lounge, a journal and a formula
By 1970 Fischer Black, a physicist turned consultant, and Myron Scholes, a young professor, held what generations of economists had been looking for: a closed-form expression for the value of a call option. The Journal of Political Economy rejected it without sending it out for review. The Review of Economics and Statistics rejected it in turn. It took the intervention of Eugene Fama and Merton Miller for the first journal to reopen the file and publish "The Pricing of Options and Corporate Liabilities" in its May-June 1973 issue.
Meanwhile, on 26 April 1973, the Chicago Board Options Exchange opened its doors in a room the neighbouring grain market had used as a smoking lounge. The first session traded 911 contracts on sixteen stocks, calls only: puts would not be approved for another four years. Theory and its market were thus born a month apart, without having consulted each other.
The formula predicts nothing. It observes that an option can be replicated by a portfolio of stock and borrowing, continuously readjusted, and that its price can therefore only be the cost of that replication. The expected return on the stock drops out. Just one quantity remains that no screen displays: volatility.
When theory builds its own market
Success came first in hardware. Texas Instruments sold a calculator programmed with the formula, and traders were soon walking the Chicago pit with the device in hand. Scholes asked for royalties; the company answered that the formula was in the public domain and suggested he buy one. In 1997 the Nobel prize in economics went to Scholes and Robert Merton: Black had died two years earlier.
The deeper lesson is more unsettling. Since volatility is the only unknown, the market ended up reversing the procedure: instead of computing a price from a volatility, it reads a volatility out of a price. The formula became the language in which options are quoted, which makes it a convention rather than a description. And the year after the Nobel, the LTCM fund, where Scholes and Merton were partners, had to be rescued: continuous replication assumes a market that is always liquid, and that is a hypothesis, not a law.
A formula does not always describe the market it finds. Sometimes it builds the one that follows it.