I have a new website with my co-author here. Let me know if you see any problems. You are my Quality Control. I want Bob Roddis’ stamp of approval before I tweet it out…
==> This Saturday I’ll be participating in the IBC Workshop in Birmingham, AL.
==> On February 27 I’ll be at the ISFLC conference in DC, talking about Rothbard (for the Mises Institute) and Mises (for the Independent Institute).
==> On May 25 Lew Rockwell, Jeff Deist, Tom Woods, and I will be at the Seattle Mises Circle.
==> In mid-July I’ll be at FreedomFest in Vegas.
==> July 24-30 I’ll be at Mises University in Auburn, AL. (Students, apply for scholarships.)
Now I’m not going to be involved with the following two, but the organizers asked me to mention them:
==> February 19-21 is “Anarchapulco” (guess where?). I hear that Walter Block will be debating Mark Skousen, amongst other festivities.
==> If you’re in Canada, July 20-23 is “Rothbard University” put on by Mises Canada. (Students, apply for scholarships.)
==> This EconTalk with James Heckman is great.
==> John Goodman on Krugman on health care.
==> I realize Bryan is ultimately disagreeing with Jerry Taylor, but I don’t like the way he did it. Look, do markets not work very well when it comes to books? After all, there can only be one true explanation of what caused the Great Depression, and yet Friedman/Schwartz still sell a lot along with Keynes. When you stop and ask yourself, “What does it mean for a market to ‘work’?” then I think the “market in ideas” works pretty awesome. I mean, the 18 people on earth who have my worldview can talk to me quite easily. That wouldn’t be true under other non-market social arrangements throughout history.
==> I have to be VERY careful when commenting on this post, in which Tyler responds to the fact that he lost a bet to Bryan. Let the following remarks suffice:
(a) Tyler is totally right about Krugman.
(b) If you’re going to bet Tyler, you should do it for a lot more than $10.
(In case I have newcomers, let me make sure I point you to this so you’ll understand the delicate situation we’ve got here.)
What better way to get your head right for Yellen’s conference? For real, this song grows on ya.
Here’s the link to the latest episode, where Tom and I kinda sorta agree with Krugman’s reaction to Market Monetarists on the Fed and the Great Recession.
But perhaps more important, you can now reserve your spot on the 2016 Contra Cruise!!
The eclectic von Pepe asked me to dig these up… I haven’t reviewed them, but 2003 Bob knew this stuff better than 2016 Bob so let’s hope he didn’t screw up.
Notes on Black-Scholes
Robert P. Murphy
A friend from the finance world asked me to review the original Black-Scholes paper on option pricing. I realized that my comments on the journal article might be of interest to others, and so I am preparing these notes for public consumption. Let me confess at the outset that I am an expert in neither finance nor statistics. (Please drop me an email if you think there’s an error below.) Nonetheless, I hope to shed at least some light on what Black and Scholes do in this seminal work.
I will go through the paper, “The Pricing of Options and Corporate Liabilities,” published in the Journal of Political Economy. (I don’t have an exact citation handy at the moment.) These notes will make more sense if you have a copy of the paper yourself.
An option is “a security giving the right [but not the obligation] to buy or sell an asset, subject to certain conditions, within a specified period of time” (637). The most straightforward example is a call option, which gives its owner the right (but not the obligation) to buy a share of stock at a certain price (called the “strike price”), in a specified time interval.
The problem is, how much should these options be worth? If a share of IBM stock currently sells for $10, how much should I pay for an option that gives me the right to buy a share of IBM for $15 anytime in the next 12 months? How much should I pay for the option if the strike price is $8?
The Black-Scholes formula gives us a rational procedure for computing the “true value” of options. The problem is not so much in predicting what options will actually sell for on the market; the problem is to define what the “rational” speculator will do on the market. When it comes to regular consumer goods, this problem doesn’t arise: People pay more for steak than hamburger because they enjoy steak more than hamburger. But when it comes to options, it is not clear how much people should value such complicated assets. This is where the Black-Scholes formula comes in.
We can first turn to the article abstract, to see how Black and Scholes themselves viewed their contribution:
If options are correctly priced in the market, it should not be possible to make sure profits by creating portfolios of long and short positions in options and their underlying stocks. Using this principle, a theoretical valuation formula for options is derived.
Here Black-Scholes rely on the no-arbitrage condition, which has proved so useful in formal economics. To give some background: In mathematical economics, an equilibrium set of prices is defined as one in which all market participants, given their endowments of resources and the market prices, formulate plans (of buying and selling decisions) that (a) maximize the utility of each agent and (b) are all compatible with each other. For example, if the equilibrium price of apples is $2/pound, then people must collectively desire to sell X apples at this price, and people must collectively desire to buy X apples at this price.
In this framework, a necessary condition for equilibrium is that the price system contains no arbitrage or pure profit opportunities. If this were not the case, then individual agents would attempt to earn an infinite amount of money by exploiting the price differentials; since this is impossible, the prices would have to quickly adjust to eliminate the arbitraging action. But if the prices must change, that means the original set of prices (which contained the pure profit opportunity) must not have been an equilibrium one.
Returning to Black-Scholes, we see that they are employing this technique to determine how options “should” be priced. Black-Scholes are adopting the rather modest position that a necessary condition of option prices is that they do not allow for arbitrage in the securities market.
Before proceeding, consider an analogy with production. Suppose oranges are selling in Florida at $2 per pound, and that the transportation costs to ship them to New York are ten cents per pound. If oranges sell in New York at more than $2.10 per pound, then a merchant can engage in (almost) riskless arbitrage by buying the oranges in Florida and selling them in New York. From an economic point of view, the Florida-oranges-plus-transportation is “equivalent” to New-York-oranges, and so the market price of both “portfolios” must be the same in equilibrium. When the prices of the two portfolios diverge, we would say that the oranges are incorrectly priced.
With this approach, we can say that an option is “underpriced” if its buyer is assured of pure (riskless) profits, and we can say that an option is “overpriced” if its seller is assured of the same. By the process of elimination, if an option is neither underpriced nor overpriced, we say it is correctly priced.
How can someone make sure profits through securities transactions? Well, notice that certain portfolios are “equivalent” from a financial point of view. For example:
Regardless of the movement in the price of the stock, both portfolios will always give the same payoff at expiration. If the price S remains at $x, then the put and call options are worthless at expiration, and the bond pays (at time of expiration) $x while the stock can be sold for $x. If the price of the stock goes above the strike, then at expiration the call is worth S-x, while the put is worthless. Thus the left-hand portfolio above is worth (S-x)+x, while the right-hand portfolio is worth the share price of the stock, S. Finally, if the price of the stock goes below the strike, then at expiration the call is worthless while the put is worth x-S. Thus the left-hand portfolio is worth x while the right-hand portfolio is worth S+(x-S).
Because these two portfolios have the same payoff (at expiration), regardless of what happens to the price of the underlying stock, no-arbitrage requires that the price (at any time prior to expiration) of both portfolios be the same. If the price of one of the portfolios, say the left-hand one, were lower than the other, then a speculator could earn a “riskless” profit by buying the left-hand portfolio and selling the right-hand one.
For example, suppose that a share of stock XYZ sells for $100, and that calls and puts (with strike price $100) sell for $10 and $5, respectively. That means the right-hand portfolio above costs $105. Now if a risk-free bond paying $100 at the time of expiration currently sells for anything less than $95, a speculator can earn a pure profit by buying the left-hand portfolio and selling the right-hand one. (This will happen—i.e. the risk-free bond with face value of $100 will sell for under $95—whenever the relevant interest rate is higher than roughly 5.3%.)
In the example above, all I’ve done is show that the prices of puts, calls, and stocks must obey a certain relationship, given an interest rate. This alone doesn’t tell us how to actually price an option. (Further restrictions are described at this website.) Nonetheless, my example does illustrate the approach of Black-Scholes. A correctly priced option can withstand any type of portfolio selection, not just the specific two that I described above.
Black-Scholes specifically state their goal later at the end of their Introduction: “[I]n equilibrium, the expected return on such a hedged position must be equal to the return on a riskless asset. What we show below is that this equilibrium condition can be used to derive a theoretical valuation formula.” (p. 640)
By “hedged position” they are referring to a portfolio that gives a guaranteed return, regardless of the movement of the stock price. For example, suppose an investor buys a share of stock XYZ, buys a (European) put, and sells a (European) call, with strike prices of $100 each, which can only be exercised in twelve months’ time. The resulting portfolio is a hedged position, guaranteeing $100 in twelve months. If the price of XYZ turns out to be $100, then the options expire worthless and the investor can sell the stock. If the price is higher than $100, then the put is worthless, but the sold call will be exercised—the investor will have to surrender his share for only $100. Finally, if the price is lower than $100, then the call will not be exercised, and the investor can use his put to sell his share for $100.
Keep in mind, though, that this guaranteed return can only be enjoyed in one year. During that time, whatever funds the investor originally spent on the portfolio will remain tied up (when they could have been earning interest on a risk-free bond). In the example above, suppose the stock initially sells for $90, while the put sells for $10 and the call sells for $5. In that case, the investor would need to invest $95 today in order to receive $100 (guaranteed) in twelve months. This can only be an equilibrium outcome if the rate of return on risk-free bonds for twelve months is also 5.26% (approximately).
The final thing I will do in these notes is elaborate on one of the Black-Scholes assumptions. (The other assumptions are fairly self-explanatory.) This is the second assumption, which states, “b) The stock price follows a random walk in continuous time…”
A random walk model of stock prices means that, at any time t, the expected value of the stock at any time t+∆ is simply its current price. This doesn’t mean that people “expect” that the price of the stock will actually remain constant. Rather, it means that the “best guess” is the current price, because there is just as much chance for the price to go up as for it to go down.
The motivation for this assumption is that markets are assumed to be efficient. Whatever information individual traders possess about the company or the economy in general, is assumed to have already worked its way into all current share prices.
If this is one’s view of the economy, then it would be silly to argue that, “You should buy shares in Oscar Mayer right before the 4th of July, because hot dog sales will go through the roof.” Presumably, enough people already know this fact, and so the price of Oscar Mayer stock will already take this consideration fully into account. Absent any insider information, then, one should expect the price of Oscar Mayer to be just as likely to go down on July 4th as to go up. (Of course, the price of the stock is higher than it would have been had the government previously announced a cancellation of the holiday, but the point is that the price is at its higher level all along; it doesn’t jump up to the high level on the day of the holiday itself.)
When modeling stock prices, then, Black-Scholes assumes that the change in levels has a mathematical expectation of 0, with a certain variance and other properties that allow for tractable analysis.
Especially for those of you who are believers, I strongly encourage you to get into a systematic study of the Bible. This should include not only reading the whole thing cover to cover (you might take more than a year to do it), but also supplementing your personal reading with expert commentary. For example, once you get used to his style, you might really enjoy Vernon McGee. I travel a lot back and forth from Lubbock to Houston, and now the 9 hour trip zips by because I load up my iPod with McGee’s commentary.
To give an example of how much my own understanding of the God of the Bible has changed, let me relate a personal anecdote. Back when I was in grad school, but before I had gone through the experiences that rescued me from atheism, I wrote an article for LewRockwell.com in which I defended the website from someone who had launched a quite patronizing attack.
So the person attacking LRC had written something like, “Those whiny libertarians are banging their high chairs and yelling that they think taxes are TOO HIGH. God bless ’em.” (That’s a paraphrase.)
Now you must understand, I was an angry young man at the time, and this guy’s column really set me off. So in response to his “God bless ’em” line, I wrote something like, “The people at LRC would never ask their God to fight their battles for them.”
What I was trying to do was contrast the serious people who were warning about civil liberties and the warfare state, with the smart aleck Republican thinking we were babies and needed to defer to the adults in the room who knew the real issue was the payroll tax rate.
But now when I think back to that episode, it’s funny to me just how ignorant I was of the Old Testament–even though I had nominally read a lot of it when I was younger. In fact, the children of Israel were SUPPOSED to let their God fight their battles for them. They got into trouble whenever they DIDN’T rely on God, and instead tried to solve their problems through their own strength or alliances with pagan kings.
In conclusion, even if you are a believer and even if you have kinda sorta read the Bible cover to cover once in your life, I strongly encourage you to begin a systematic study with an expert commentator. You will begin to see themes and–if your experience is like mine–you will no longer see such a huge contrast between the super nice guy Jesus and that mean God of the Old Testament. Instead the whole book will become a seamless tale of God’s faithfulness in the face of His fickle children, who must ultimately be saved not because they earned it but because of His unmerited gift. Even the “heroes” of the Old Testament are often scoundrels, and their only admirable trait is that they occasionally have amazing faith that God will achieve mighty things through them.