Presentation Speech by Professor Bertil Näslund of the Royal Swedish Academy of Sciences, December 10, 1997.
Translation of the Swedish text.
Your Majesties, Your Royal Highnesses, Ladies and Gentlemen,
If a Swedish company has to pay 10 million dollars for a machine in six months, it runs the risk that the exchange rate will change. In order to protect itself against a future increase in the value of the dollar, the company can purchase an option with the right, but not the obligation, to buy dollars in six months at a predetermined price.
A financial option contract is an example of a derivative instrument. The price of a derivative depends on an underlying financial instrument. The price of the above-mentioned currency option is determined by the value of the dollar. Derivative instruments serve a highly useful purpose in society by redistributing risks to those who are willing and able to take them.
Options have a long history. As far back as in ancient Greece Aristotle described the use of option-type contracts. We also know that options were actively traded in Amsterdam, the financial center of Europe in the seventeenth century. In spite of its potential importance, option trading remained rather limited. Up until the end of the 1960s, there did not exist a fully acceptable method of evaluating and pricing option contracts.
Three young Ph.D.’s connected with the Massachusetts Institute of Technology – Fischer Black, Robert Merton and Myron Scholes – worked on option valuation around 1970. In 1973, Black and Scholes published the so-called Black-Scholes formula for pricing stock options, which solved the evaluation problem. Merton had a direct influence on the development of the formula and has generalized it in important ways.
Soon afterwards, the formula was applied on the new options exchange in Chicago; it is now used daily by thousands of agents on markets all over the world. More important than the formula itself, however, was the method that this year’s Laureates used to derive it. In one stroke they solved the problem which had been an obstacle in the pricing of all kinds of options, that is: what risk premium should be used in the evaluation.
The answer given by the Prize-Winners was: no risk premium at all! This answer was so unexpected and surprising that they had considerable difficulties in getting their first articles accepted for publication. But this insight proved to be the key to a very general and powerful method for determining the value of all kinds of options and other derivative securities. In combination with advances in information technology, it is this method which has generated the explosive growth of new financial products and markets over the past 10-15 years.
The method developed by Merton and Scholes has also had a great impact in several areas outside of financial markets. In deciding between investment alternatives, it is often important to determine the value of flexibility. One investment alternative may be more flexible than another regarding, for example, the use of different sources of energy. The possibility of switching from one type of energy to another is an option, and the economic value of flexibility can now be determined. The methodology can also be used to determine the value of corporate liabilities and the value of insurance and economic guarantees.
Dear Professor Merton, Dear Professor Scholes,
In collaboration with Fischer Black, who sadly passed away just two years ago, you have developed a new method to determine the value of derivatives. Your methodology has paved the way for economic valuations in many areas. It has also generated new financial instruments and facilitated more effective risk management in society. It is a great honor and a privilege for me to convey to you, on behalf of the Royal Swedish Academy of Sciences, our warmest congratulations.
I now ask you to receive the Prize from his Majesty the King.
Their work and discoveries range from the formation of black holes and genetic scissors to efforts to combat hunger and develop new auction formats.
See them all presented here.