What is Black-Scholes? Investing Explained

In this series, we break down the jargon and explain a popular investment term or theme. Here it is Black-Scholes.

What is this?

The Black-Scholes model – its full name is the Black-Scholes-Merton model – is an equation widely used by hedge funds and others to estimate the value of a derivative – a security that derives its value from an underlying entity , like part. Options are the best-known derivative. A call option gives the holder the right to buy a stock by a certain date at a certain ‘strike price’; a put option gives the right to sell.

Despite the enormous risk involved, options trading can outpace stock trading on some days in the US, and Black-Scholes helped start this revolution.

Why are we reading about it now?

This month marks 50 years since the controversial equation first appeared.

It was outlined in an article published around the time of the opening of the Chicago Board Options Exchange in 1973.

The authors were American economists: Fischer Black, Myron Scholes and Robert C Merton, son of sociologist Robert K Merton, the academic who coined the term ‘self-fulfilling prophecy’. Traders on the exchange soon began using the equation.

The rate of adoption was so great that the perception of options, previously considered the worst form of gambling, changed.

Investors forgot about the risks, which sowed the seeds of subsequent crises that threatened the global financial system. Merton and Scholes won the Nobel Prize in economics in 1997 (Black died in 1995).

How does it work?

The equation is complex, with several factors taken into account when valuing an option contract: the current price of the stock, the dividends that will be paid, the strike price of the option, the time to expiration of the contract, interest rates and expected volatility.

Traders use online calculators instead of doing the math.

Did Merton and Scholes make any money off this?

They joined the Connecticut hedge fund Long-Term Capital Management (LTCM). The rise and catastrophic fall of the fund—at its peak, it had $100 billion in investor money—is chronicled in Roger Lowenstein’s book When Genius Failed.

For a period, LTCM delivered returns of more than 40 percent per annum. But losses mounted in 1998 due to exposure to the Russian debt crisis and the fund’s absurdly high levels of borrowing. Concerns about banks’ exposure to LTCM’s options contracts were so great that the New York Federal Reserve organized a bailout by creditor banks.

Merton and Scholes were not traders, but they were considered the philosophical fathers of the fund.

Has this discredited the model?

Investors wanted to believe that a surefire way to make money had been invented.

As one bank put it, LTCM’s lenders were “mesmerized by the supermen” behind the fund. It is a cautionary tale, but later crises show that lessons have been learned.

The Black-Scholes model has its shortcomings, but it remains popular because it is considered an effective means of calculating value. Since some of the funds you have your savings in will likely invest in options to optimize returns, you should hope that the managers take steps to reduce risk.