[MUSIC] Good morning, Myron.
>> Morning, Daryl.
>> Let's go right to the heart of the matter. What most people remember about
your Nobel Prize in Economics, is that it led to a precise mathematical
formula for the price have been option, and we'll get into this story
of that in a couple minutes, but for those who've watching that
don't know whole lot about finance. What exactly is an option?
>> [LAUGH] Bad question. Basically, an option is the right but
not the obligation to buy a security at a fixed price over a set period of
time, that's called a call option. And there is also other options, which
give you the right, but not the obligation to do so to establish security at a set
price over a specified time period. So the interesting thing about options
are basically, they are right or ability to do something without
the requirement to do something. So it's that flexibility, or the
optionality that we think about in life. And it similarly applies
to securities as well. >> So it could be equities, could be bonds, could be commodities.
>> Correct, equities, bonds, commodities. Commitments to a lot of different things.
>> Okay, so now let's go way back in time. Think of yourself in the late 1960s, and a lot of things were going on
in finance around that time. Major development emerging
fields of financial economics. A lot of people had worked on how to
price an option, it was a hard problem. And I'm just curious to hear how
you actually got involved in this. I mean, what was it that triggered your
interest in solving this really hard problem?
>> Well, that’s interesting involved question. But, basically when I was at the
University of Chicago, as a PhD student, that was a very, as you’ve mentioned,
a very embryonic time for the development of finance, it was a completely
different way of looking at finance, mostly from an economic perspective as
opposed to a rules-based perspective, and it led to the development of
finance as a part of economics, really. Which was much different from
the finances being an auxiliary sort of rules-based way of thinking about things. At that time, there was a great
understanding of how to manage risk. And the idea of thinking about risk
is the idea of buying risky assets, versus safe assets that was one
dimension of risk management. And the other dimension of risk
management was diversification. How you would diversify risky assets. That led to development of things. Such as Bill Sharps great discoveries and
amplification of Markowitz work and talking about the capital
acid pricing model. That, for us was a great breakthrough,
because there was an equilibrium model of how individual assets should
be priced relative to a benchmark or asset portfolio, and that was one
strand that was very prevalent. So the culmination of risk and how to
think about risk, but no one had really yet, had thought about risk from
the dimension of insurance in our area. A lot of people had talked about insurance
from an actuarial way, actuarial science. They had talked about pricing insurance
from the idea of thinking about it, only in the form of
an option as I describe. Had a value and option. But no one had really thought about it
in terms of an equilibrium context, or thinking about how it fit
in to how assets were held. How they were priced, and the dynamics. And that fascinated me when I, before I went to [COUGH] MIT
as an assistant professor. And when I went to MIT as
an assistant professor, it was mandatory at the time
that Masters students in the Masters program had to write a thesis. And several students came to me and
asked me to be their advisor, and they had option pricing data from
the over the counter market. And using that data,
they wanted to price options. So basically, they wanted to use
the capital asset pricing model which we had discussed in our classes and
apply that to the option. Terminal rapid use discounted
it to present value, and look at the value of the option. When I started reading the thesis and
thinking about it much more deeply, I realized that,
although it might be easy to get the expected terminal [LAUGH] value of the
option, it wasn't possible to think about discounting it back to present value
by using a constant discount rate. Because the risk of the option changed
dramatically as a function of time and as a function, more importantly,
of how the underlying asset price change relative to the strike
price of the option. You have a weight in the money option that
behaved almost like the stock instrument. And basically, as it was out of
the money that moved very little with regard to changes in
the underlying stock or asset price. So, that got me thinking again,
about options. And then, I started reading a lot of
the literature on options that existed. Paul Kudner, who was a faculty
member here at Stanford as well, came under the Bill Sharps auspices. And he had passed away
in the late 70's here. But he had written a book or had a compendium of articles
on option pricing in his book. And I read through all of them,
all the articles plus the literature, and none were very satisfying, because they
didn't have any really equilibrium model, or equilibrium thinking
about option pricing. So that's how I started in to
thinking about options, and then I thought about the idea of saying,
what is, in economics, we think about equilibrium and having to think about
one asset price relative to another and how the dynamics of that asset's
price would evolve over time. And since I was schooled and enamored
with, and in love with the capital asset pricing model, and
what it implied about it's risk, an asset's risk and
how that asset's risk would be priced. It became obvious to me that I should
think in terms of the beta of the assets, so the beta is the idea of how the returns
on a particular asset is related to some market portfolio equilibrium
portfolio, when all assets should be differential expected return,
just based on the proportionality or the beta of that asset regarding its
relation to the market portfolio. At least over a very short period of time. And so thinking in that way, I said, well, let me think if I can think what
that beta of this option is, okay? That would be. And so then, I would know what the
expected return would be on the option for the next period of time, and
how it'd relate then to the market itself. And then I Thought about
this idea of the hedging, or the selling one and buying the other. And that's when I then started
talking with Fischer Black, who I was working with in other projects,
and we then started to. He had been thinking
about options as well and working on options on his own
independently of me, and then we joined forces together at that time.
>> He was visiting MIT at the time? >> No, Fischer Black, actually, I met Fischer Black in
the fall of 1968 when I, I'm dating myself, and
I'm making myself very old, which I am, but [LAUGH].
>> Half century ago. >> I know, were you born yet?
>> High school. >> [LAUGH] High school, okay, but basically, I came to MIT, and Michael
Jensen, who was a colleague of mine, not a colleague of mine, a fellow student
of mine at the University of Chicago, had met Fischer Black because Fischer
Black was working at Arthur D Little, that's a consulting firm, and
then had asked Michael questions about a study that he,
Fischer Black, was working on. And Michael said that I should have
lunch with him, so I phoned him up, and we had lunch together. And in the meantime, I had talked with Wells Fargo Bank in the summer
of 68 before I went to MIT about their management science group and
what they had been doing in terms of using Markowitz technology to
build optimal portfolios. When I wrote my report, they had had
wonderful technology in being able to use covariance matrices and
figure out the efficient portfolio. However, they had no inputs
to put into the model, and they had very few clients that they
could use any of what they had done on. >> This was Harry Markowitz, who also got a Nobel Prize.
>> Yeah, Harry Markowitz also had a Nobel Prize, with Merton Miller and
with Bill Sharpe, in 1990. So I recommended to them that they
think about moving to passive strategies because they had
nothing to lose by doing that. And I just felt that, at that time,
from studies that Mike Jensen had done and others, that just buying a portfolio and
not trying to active management, that portfolio could do approximately
as well as passive portfolios, at least from the data, and
doing it at much less cost. And so that was the end of my project,
and later, in December of that year,
Wells Fargo phoned me up, Mac McQuown, and said, we'd like you to do more studies on
this idea, this passive portfolio idea. And I said, well,
I'm a young assistant professor, I'm stuck here at MIT, I can't travel. But I have this fellow, Fischer Black,
who I had talked with and enjoyed my discussions, and
he wants to set up his own firm, which was called
the Associates in Finance. And he then became, with me,
we go talk with Wells Fargo and developed a lot of empirical tests
to verify that passive investing, you could do approximately as well
as investing with an active manager. And I think that was sort of the genesis
of, for the institutional side, the genesis of the idea
of passive investing, which later been called index investing or
ETF investing. And it was the case that
Vanguard in 74 put out the first individual index fund,
the S&P 500 index fund. But Wells Fargo was really the one
that started off in 68 and later built a huge business. And now Blackrock has the-
>> ETF business.
>> ETF business that all generated from that particular genesis. So Fischer Black and I were doing
a lot of empirical research and trying to show that this had efficacy,
you can do it. And through that we discussed myriad
things, we wrote a lot of papers together. It was kind of great to be doing
research and this getting and publishing things at the same
time as trying to think about building this wing of
investments in finance. And we talked then, I talked to
Fisher a lot about options, and he talked to me about his
views on options, and that's how the partnership was born.
>> He's said to be an interesting person. What was it like on a personal
level to work with Fischer Black? >> Fischer Black evolved over time, and Fischer Black was wonderful to work
with when I was working with him. I always felt that his ideas were,
he was a genius in myriad ways. And he would argue his points, but he was
very, very strong in arguing his points, but he's very malleable once he
agreed with you, he would switch and come to agree with you and then amplify
on what you were saying, so I was more voluble, talking a lot, and he was-
>> That hasn't changed. >> [LAUGH] No, I'm sorry about that, but he was listening, and listening, and
then he would intervene, and I'd say, okay, that's great, and we would move off in that direction.
>> Yeah, I can almost visualize you two guys hammering away at the chalkboard,
working on that formula. I know it's mathematically
a very deep subject, but was there some kind
of lights went on and some kind of breakthrough idea
that you had that allowed you to actually come up with the formula?
>> Well, I think in science, I don't know, maybe from your own experience and your
own research you have a different view, but a lot of people believe in the eureka
moment, all of a sudden the lights go on. But a lot of science and
a lot what we did was connectivity, connecting various pieces together and
thinking about the various pieces, and then that connectivity, because
it's all in your mind, it connects. So maybe there is, quote, a eureka moment, where you see the connectivity, but a lot
of it, as I said in the introduction, came from the view of thinking about what the
beauty of the Capital Asset Pricing Model, what others had done,
like Merton Miller and Franco Modigliani's views on capital structure and
how they thought about arbitrage. That idea in their papers,
they had the idea that debt in a firm, there's a pie concept, you have debt and
equity, and you have the assets. So you can't have the debt be independent
of the assets and the equity, they all have to be tied together. And so all those things were in the mind,
and they were all fresh, and they were alive because that was so
new to everyone at that time. Now, if people are studying it in class,
it's all old, so okay, but at that time it was all, just everything was so exciting.
>> It's exciting for you, but as you said, at the time probably not that
many people understood the significance of what you've discovered and how important
it would eventually become for the practice of finance. I heard, maybe this is just a rumor,
that you actually had difficulty getting that paper published
when you first submitted it, is that true? >> Yes, actually it was, when Fischer and I first submitted our paper,
it was rejected myriad times, okay. It was rejected as being either
too arcane or insignificant. For finance and when it was finally after
the intervention of Merton Miller and Gene Famat tells the Journal
of Political Economy that they should look at the paper
again after having rejected it, they finally came back and
said that they would publish it. And I think,
I'm not sure if this is 100% accurate, but I think it is been the most cited
paper in the history of the journal of economy.
>> It's probably one of the most cited papers in all of economics.
>> Thank you. >> So you discovered the formula, you wrote the paper,
somewhere after you got the formula, Bob Merton comes into the picture. He was interested in the same problem. Tell us the story about your discussions
with Bob, and what he eventually did. because he also got
the Nobel Prize with you. >> Sure, yes, very definitely. In science,
we're a little bit like hunters. So Fisher and I husbanding what we did. We tried to work and get as far as we
could in what we were working on together, without broadcasting it or telling
other people what we were working on. Now Hunter makes sure that he
doesn't have where the fish are. And when Bob Merton who is colleague
of mine at MIT came into my office, and was talking about his continuous time
finance, and the idea of thinking about that the hedging portfolios that he was
working on and developing at that time, which were very important,
I said, great, Bob. Keep working on that, because both Fischer
and I knew that Samuelson alone and then Samuelson and Burton had written papers
on option pricing or warrant pricing. And we knew that there was fundamental
assumptions in their papers that were incorrect because of our discovery. And we wanted to move as
far along as we could. In 1970, Wells Fargo had a conference
that they sponsored at MIT. All us people were brought in
from around the country and the world wasn't at that time
involved in finance as it is today. But at the time, so
we had Bill Sharpe would come in and Michael Jenson and others, for example,
and Merton Miller, and the like. So I was to give the opening paper
of the second day of the conference. And I was going to open
what we had done and discuss what we had done with the group. It was for me and Fisher it was here is a
great group of people to introduce it to. And Bob Merton was supposed to come but
he overslept, so he didn't hear the paper at that time. About a couple of weeks later he
came into my office and he said, I heard you gave this
paper at this conference. You had an exact formula
to price an option. And he said, I think that's impossible. You know what I mean? And it can't be true. So I explained to him,
I put up how hedging worked, and the capital asset pricing model. And I showed the differential
equation to him. And he looked at it said, no no, because
you still have a systematic component that you haven't got rid
of in the form of it. It has to be part of the pricing. So the brilliance of what was discovered
was when you went through this inductive approach to value and option,
as opposed to deductive approach, everyone had taken the deductive approach,
trying to figure out what the terminal value of the option was and
bring it back to present value. What we did is say,
no you don't have to do that, you can do it each period
of time inductive. And then add it up at that time, and
that would give you the valuation. And so he said no, that didn't work,
there's an error in that. And so we argued,
which is great when you have wonderful colleagues you know through
your career as well as mine. Having colleagues around that
you can talk to about things and argue about various things,
really enhances the value for everyone. In talking to him and
going through things I said, look as we use the capital asset
pricing model as a way to do things for the simple reason that we
believe in equilibrium pricing. So, if the capital asset pricing
model applied every instant of time, then you would have an equilibrium
every instant of time. And then you could figure out how every
asset was priced relative to every other asset and that would mean
that you would be able then to have this sequence of correctly
priced assets in the market. And you can hedge them. And figure out from that how
the differential equation came about. So I explained everything to Bob,
and then he argued that that was not true, and
then the argument was what does it mean? Every instant of time or
every short period of time? How close should we get
to the instant of time? And then he's left the office at midweek. Sometimes, these things are so
vivid because you respect someone's brilliance in its ability to
argue with you and talk to you. And then on midweek and then on
Saturday he phoned me at my house and he said that he agreed now
that our was right and he used Calculus and we didn't use stochastic calculus to come to our
>> Almost nobody did at that time. >> No one did at that time, right [LAUGH]. We used stochastic calculus
to achieve an exact result, which he then showed there was actually
the replication if you believed And the generating processes of
processes that he had used that it was exact replicate,
exactly replicated. I think Fisher and
I have argued with Bob over the years that we liked our initial
formulation better than Calculus or the continuous time
framework because of the ability of us to allow for pricing to change
in the economy and that you would then be able to to have every asset
to be priced correctly and held. We didn't have to assume that but
we had to argue that we assume the capital asset pricing model applied in continuous
time or in very short periods of time. So it was his work, and his evolution, and then he formalized any more
components than we had done. Once you show where the gold is
in them hills, it's very hard. Once you have your stake, for others not to continue to stake out
lots of different parts as well and find more gold and there was a lot of
gold that was available at the time with the option pricing technology.
>> Yeah, clearly. I read that he generously
held up the publication of his next paper on option pricing. So that your paper would get
priority because you were first. Is that right?
>> Correct, yeah, he did. I mean, his paper on one, pricing and his extensions and what he'd done
was published in the Bell Journal. And, they're ready to go and then the. Because we kept getting rejected and
asking for revisions, that basically the Journal of Public Economy published
our Paper, in May of 1973, finally. [LAUGH]
>> So changing gears just a bit, as I mentioned earlier, most people who
are not deeply immersed in finance, do know that there's this
famous option pricing formula. But right in the title of your
paper it says that your formula could be applied to price corporate debt.
>> Right. >> And that's now, one of the most important
applications of the formula. Did you notice that at the same time
that you came up with the formula, or before and
you were trying to solve both problems? Or did it occur to you after you priced
options that you could at the same time calculate the market value
of a debt claim on a corporation? >> Wow, once Fisher and I had the option pricing formula,
came up with a pricing formula, then the idea of an option
which is the right to and not the obligation to do something. Then both of us started
talking in every direction about how our lives were,
options were everywhere. And in other words, it's going through the
forest if you start focusing on something. You'll see things, in myriad of
different ways, then if you go somewhere else through the forest and
focus on something completely differently. As a result, I remember our
taking vacations together and walking on the beach and just talking,
talking, talking about how options were. And how we could apply what
we had done to other things, as well and it became obvious
because of Franco Modigliani and Merton Millers work on
the idea of capital structure. But they and their capital
structure work only had it be for riskless debt and not risking debt. And so, we talked about that and
how our work would apply to risking that, as well, and
why debt equity to us became an option. The equity holders had the right
to buy back the firm from the debt holders by paying off on the debt
obligation and no-fault bankruptcy world. If they didn't they just turn
the keys over to the debt holders and they would take over. So basically,
the arguments that Miller and Modigliani held at least a frictionless
world apply in the same thing, if you had risky debt as
you had non risky debt. But the important thing in the debt
contract was that with risky debt, there was a whole number of
incentives that would come into play. And there was a friction
between debt holders, an equity holders because if they
change the risk of their assets, that could affect to that holders
differentially from the equity holders. And basically, if the firm got into
trouble then if they issued equity, that would,
increase the value of the debt, etc. And so, all that was so
exciting to talk about and think about, as you know in your own work,
over time as you formalize those things. So that became a very important part. So we talked a lot about that. And actually, once you had the basic
formula to price an option, then you obviously had the basic formula. The dynamics, the price of debt contract. But unlike the option contract
which can think as isomorphic, meant that you're above it and
you're watching it. When you go to the firm and
thinking about the firm can do, then there was this war between the debt
holders and the equity holders. And they could change the characteristics
of the assets or the evolutionary process of the assets that would affect debt and
equity, they could have a dividend policy. So they can have issuing
more debter\g etc., or buying back equity and
to all the covenants would come in. And so, that was a rich area
that led to many papers and more Merton formalize a lot of that, and
what he had written on in his paper. So we did describe how to price a simple
debt contract as that in an extension, because what we had try to do
was we published initial paper, we just thought about being a piece. We'd have this sequence of
other papers and we have- >> Publish your perish. >> Publish your perish [LAUGH] >> Now my system festers from having a list of favors, so once you have
a train, you want to have published more. But I didn't realize more that, once you expose a whole new area,
people will then give up. I remember giving the paper
here at Stanford University, coming here was a Berkeley,
Stanford joint seminar. So there was 150 people in the audience
listening to the Black Schulz paper. And a lot of people,
obviously, because it was so unusual to think you could value
something in finance, without having to know what the expected return was that
people were shocked in the audience. And so it was,
those answer that was false, but I remember Mark Rubenstein coming up to
me after the seminar, we're sobering. Mark said, this is going to change
the whole nature finance that I didn't. >> He was right. >> He was right, I didn't know that. >> Yeah, it opened up a lot of avenues. So speaking of that, moving ahead
through time like about 25 years later, the phone rang early in the morning.
>> Yeah. >> They were calling from Stockholm, I suppose.
>> Yes. >> Tell us about that phone call. How did you react to that?
>> Well it's actually, I was in Pebble Beach giving a talk or remember and it was, okay. Obviously, everything is
always a shock to you, when you have the phone ringing and people
say, you've been awarded that prize. I had, unfortunately,
Fisher Black had passed away in 1995, two years earlier and I had thought that,
because people said that, your work was possibly
going to be awarded the prize. And it's interesting that even though
the expectation might be high. There's an error to the expectation.
>> Right, and you'll never know in any given year.
>> In any given year and it's likely to go get
the prize at some point. We don't know what year it's going to be.
>> That's correct. >> So it must have been quite a shock. >> It was a shock and also, I had thought that obviously the first
thing that I had thought was that it was great that Bob and
I awarded the Nobel Prize. But then, I bemoan the fact that Fischer,
of course, had passed away and wasn't going to participate as well.
>> And then, you had to go to Stockholm.
>> Correct. >> And there's this big event, the king is there. kind of take us back, paint the picture
owhat this event was like for you and what happened?
>> Right, well, it was new for me, in the sense that I
went to Stockholm and everything is very well prepared. They have a playbook because they had
about a hundred or so years of experience. And so, they know everything in
the order everything's going to happen. I was just this person that's there and
alike. But it's very a great ceremony, because they come by in
a combination of frivolity. In other words,
the students have scheds and preparations. They also have ceremony
in honor of the King and. >> Queen of Sweden award the prize and they have a banquets that follow,
informal banquets, and they also have serious scholarship. You give seminars at various
universities in Sweden. And so the combination of the scholarship, the frivolity and
the ceremony is a pretty rich experience. When I returned home
after the whole affair, they'd given me before a driver and
a cache and you had your own cars and everyone would watch you in Stockholm
as you're going through Stockholm. So it was a very important event for those
people in Stockholm and Sweden, generally. And so I got into the back seat of my car, expecting my car to go to
the supermarket to buy my food. And obviously, it didn't go anywhere so
I had to go in the front. But the fascinating is everyone in the
press always asks you about what are you going to do with the prize money now?
>> [LAUGH] >> At the time, the prize was approximately $1 million and I obviously had to split
it with Robert Merton. So he received 500,000 and
then the United States government, they wanted about 250,000 of my 500,000. But you've been in Stockholm and
it's very expensive. So I had to bring my family and pay for
their air fare, and their dresses, and all the other things they needed to
wear for the ceremonies, and the like. And so I think when I got home,
maybe I had about $32,000 left of the money to either
spend on myself or invest. So one of the Nobel Prize winners,
Phillips, who was awarded the Nobel Prize
with Steven Chu and is the Stanford physics professor was
awarded the prize in the same year. There was three who were awarded the prize
in physics and he bemoaned the fact to me that actually he lost money, because
he has to split the prize in three. The award of the prize
itself is ignoring or forgetting the monetary value is so
huge, because your life changes so dramatically after that.
>> Well, it's certainly. I mean, you didn't need the prize to
validate the impact of your contribution. So speaking of that, another quarter
century has passed almost and the world has been changed a lot by
the work that you did almost 50 years ago. Help us understand that legacy,
what's going on in finance today that had you
not discovered this prize. Pardon me, had you not discovered
this breakthrough formula and this methodology for pricing options, and for pricing corporate that
what would be different today? What's the legacy of what you did?
>> Conditional on others not to speak of it.
>> Well, okay. >> because you always worry about that, that someone. Once you discover something,
you have to publish it. Because others will discover as well, but I think that it's changed the whole nature of finance in applications
of finance to practice. Because when we started
off in the business, then the investment banking world,
for example, or insurance companies or banks are just marrying
together buyers and sellers. They were just sort of agents. And once the technology was developed,
technology was developed, they then moved from the world of
agency to being principal in part and they innovated in so many different
ways to make things faster for clients. When you're just an agent,
you have to find a buyer and a seller.
>> If they could act as a principal in part and hedge their risks and
learn how to use quantitative techniques in what they were doing, then-
>> So let's go through that in a concrete way.
>> Sorry. >> I'm a client of whatever, Goldman Sachs. I call them up and I say, I have this
corporate or personal investment problem. What do I do?
I mean, where does the work that you did come
into the solution for a problem? And give me an example of a problem.
>> All right, an example of that might be that a particular corporation
might want a security that would pay off in different states
under different conditions and that would not be
a standard form contract. They might have oil or they have different things they
would be willing to pay off more on, if oil prices were higher than lower.
>> So that's already not traded on an exchange?
>> No, it's not traded.
>> So Goldman has to kind of manufacture
that contingent claim for you. >> Correct. >> And how does your work help them figure out how to do that? And how much to charge you for that?
>> Right, well, charging part, I don't know.
>> [LAUGH] >> There's obviously that charging part first is what the value increment would
be, that how much I'm willing to pay for the solution that befits
me versus the one. My shoe size versus
having one shoe fit all, that the old way of doing
things was one shoe fit all. You just had a standard contract. And then as you can make things more
individualized, the value to me increases. But then the charge or the pricing
of that depends on competition, and Goldman would be doing it, or JP Morgan
would be doing it, etc., the same way. So as the technologies develop and
people know it, the pricing comes down. Because then everyone can learn and
copy from each other. So we're all better off in our using it, but individualization of is that the manufacturing process
became one of say, okay, we will issue this claim that you have to a client that we have. But that client doesn't
want to buy what you want, but we will give the client what they want and
we will hedge the risks on our own. So Goldman would then
act as an intermediary, they would buy the claim that
the corporation wanted to issue and they would sell another claim to someone
else who wanted to buy something else. And then they'd have to figure out
how to handle the middle part, which is the excess risks or the excess
pieces that weren't matched in the match. And then they would use the derivative
technology to be able to hedge that risk and be able to manufacture by going to
the capital markets, and buying things. You've done obviously a lot
of research on your own, thinking about these
hedging technologies and how they would apply to
the intermediation business. So it changed the nature of
intermediation quite dramatically and that attracted a lot of
quantitative people or quantitative interests in
coming to investment banks, and finance generally.
>> So there seem to be no end of
applications of what you've done. Looking forward, do you foresee
>> Some new kind of technology for finance that either enhances what
you did or takes us in a completely different direction going forward?
>> Well, I don't know if I'd say it's a completely
new direction, but I do think that as being a way to think about
using what we know in a different way. And what I mean by that
is one of the great findings sort of the arrow
brute technology or the state technology,
they built a technology that tried to price
risk in various states. So instead of thinking
about a riskless world, we thought about a risky world where
the prices of assets would change cross sectionally, depending on
the state of nature that arose. Now the interesting thing is that,
that had myriad states and myriad prices and just as we have
thousands of goods around the world today. Well, that technology,
the option pricing technology if you believe there are certain
state variables like growth assets or interest rate assets allows you to
be able to economize on pricing and everything becomes price relative to
the evolution of the state prices. The interesting thing is that we
observe in the option prices or market prices is the prices of insurance. And if you look at the prices of
insurance, they are not constant overtime. They're changing over time. That means that the risk
is changing over time. And if the risk is changing over time,
the distribution of risk is changing over time, then we have to now give up the
one period models that we had been using. Or in a one period model, I mean,
in an evolutionary sense, we just assume that the evolution is
known and the calibration is constant. And then figure out how to use the
information in the market prices to decide on then how to change the way we think
about capital budgeting decisions, the way we think about discounting, the
way we think about portfolio management. So there's tremendous amounts of
dynamics that are left to still work on in that area which I think
using that basic framework and the value of prices that we see
in the market to really enhance our ability to understand those things,
and we know that we can assume that we're drawing from
the same urn each period of time. Yourself have done tremendous amount
of thinking about what happens at times of shock in which, and
how prices change dramatically. And so
we can start incorporating those and more directly in what we're doing,
and I think those are tremendous growth areas had.
>> Speaking of shocks, those finance is often associated
with big shocks to the economy associated with financial crises,
financial instability. But with what you've
described this morning, I hope that those watching will
understand that research discoveries like yours can improve society,
can add a lot of value to the real economy by providing solutions that
weren't otherwise available and I really want to thank you.
>> You're welcome. >> For coming in today and going over. I know it's old history, but
going over how this came about. So thanks again.
>> You're welcome, Derek. Thank you very much.
I really appreciate it. >> Yeah, thank you. [MUSIC]
