by Robert Litan
There is an abundant literature in economics journals on the virtues and drawbacks of speculators, but on the whole, financial economists support the presence of speculators (some call them noise traders as opposed to fundamental traders) for at least two reasons:
Hedgers need someone to take the other sides of their trades, and there may not be equivalent volumes of offsetting hedgers to do this; speculators are essential to fill the gap.
Speculators add volume to the market for any financial instrument, which makes them more liquid—that is, easier to buy or sell without moving the price.
Although options have traded for hundreds of years in other locales, the Chicago Board Options Exchange (CBOE) was the first exchange authorized to trade financial options in the United States, opening for business in April 1973. Not coincidentally, two financial economists, Fischer Black and Myron Scholes, some months before had developed an options pricing formula that traders would be able to use easily to make informed purchase and sale decisions. The Black-Scholes paper was published shortly after the CBOE opened.17 At around the same time, Texas Instruments introduced a pocket calculator that had the Black-Scholes pricing formula embedded in it.18 Later, Robert Merton published a paper generalizing the Black-Scholes result.19
The Black-Scholes-Merton (BSM) options pricing formula has since become one of the most widely used formulas in economics, used by traders at banks, hedge funds, nonbank firms, and other financial institutions around the world. Two of the developers of the formula, Scholes and Merton, received the Nobel Prize in 1997 for their work.
The prize is not without controversy, however, on two counts. One reason is that two hedge fund traders, Ed Thorp and Sheen Kassouf, had earlier developed and used a proprietary formula for pricing warrants, which are options to buy stock that were then (and still are) issued with other securities, such as convertible bonds (bonds that can be converted to stock). The Thorp-Kassouf formula was similar to the one developed by Black and Scholes, but was not made public in the form of an academic journal article (although a trading strategy relating to their formula had been published elsewhere).20
Second—and coincidentally less than a year after Scholes and Merton received their Nobel—Long-Term Capital Management (LTCM), a large hedge fund in which Scholes and Merton had been partners, collapsed and had to be rescued (at the instigation of the Federal Reserve) by its bank creditors.21 The fund collapsed largely because its founders assumed that extremely unlikely events—precipitated by the 1997 financial crisis in Russia—or so-called tail risk could not occur, but in fact did.
Still, neither the prior work by Thorp nor the LTCM debacle can detract from the importance of the BSM breakthrough. It is widely understood that the options market—where today options on a range of financial instruments are traded on multiple platforms around the world—would not have developed as rapidly and deeply as it did had the BSM equation not been invented and widely publicized (and not held closely as the proprietary tool of one hedge fund).
Although the BSM formula itself is complicated (and can be found not only in the original articles but in financial economics textbooks),22 with the advent of pocket calculators and later apps for personal and tablet computers, any trader can easily use it to figure out what price to bid or ask for an option simply by punching in a few key known or easily estimated parameters: the disparity between the current market price of the underlying financial instrument on which the option is written (say, a stock or a stock index) and the strike price; how volatile the stock historically has been; the time left before the option expires (its current maturity); and the interest rate for borrowing funds.
Here’s the intuition behind each of these parameters, each holding the other factors constant. For example, an option is worth more the closer the market price is to the strike price, the more volatile the movements are in the underlying stock price (making it more worthwhile to invest in the option), the more time is left to exercise the option, and the lower the interest rate (which, among other things, measures the money foregone by not investing in an alternative asset).
The original Black-Scholes equation used a number of unrealistic assumptions. Merton later revised the equation and removed some of the assumptions. But the BSM model is still not perfect: Most notably, it underestimates extreme moves in the markets, of the kind that upended LTCM (tail risk, again), and incorrectly assumes that transactions are costless (though the costs have come down hugely since the equation was first published, largely due to the deregulation of brokerage commissions, discussed in Chapter 12). Even with these limitations, traders continue to use it as they widely view the BSM model as a sufficient approximation of the true value of an option.
The easy pricing of options made possible by the BSM model has had major effects, both welcome and unwelcome, on the real economy outside of Wall Street and Chicago where options and their underlying financial instruments are traded.
Let’s take the good part first: the positive impact of stock options on the formation and growth of new companies. All new companies have the common challenge of conserving cash. This is true even for the fortunate few that receive seed financing from one or more angel investors, or even more rarely, from a venture capital firm. Outside financiers want founders to do everything to conserve cash, especially cash they provide in return for shares in the company.
Worried about drawing down their cash reserves, founders of new companies turn to stock options as a way of partially compensating new employees, whom they will need, at some point, to make their companies grow. From the vantage of the founders, options are better than giving stock outright (even if its sale is restricted), since the options will only be exercised if the company does well (depending on the strike price), and meanwhile the founders will not have given up equity ownership slices of their companies (diluting their shares or those of their investors). From the employees’ vantage, the options are like long-shot tickets in horse racing: If they pay off, they can bring riches.
Although publicly held companies have granted their senior executives, and in some cases other employees, stock options for some time, they became a dramatically more important component of compensation after Congress, at the request of the Clinton Administration, denied companies the ability to deduct as expenses for tax purposes executive salaries in excess of $1 million. As often happens with legislation with good intentions—this one aimed at narrowing the widening disparity between compensation paid to top managers and other employees of publicly held companies—this particular proposal had some undesirable unintended consequences, which illustrate the downside of the increased use of options.
In particular, with companies no longer allowed to deduct high salaries as expenses, they were incentivized to accept demands by top executives for stock options in lieu of cash above the $1 million cap. From a tax point of view, this was ideal for the executives, since the tax rate on any capital gains from an increase in their company’s stock price was considerably lower than the highest marginal tax rate on salary income. Even better, the executives didn’t have to pay even the lower capital gains taxes until they exercised their options, which could be years away. Options also benefited the companies issuing them, because, for financial reporting purposes at the time, options were not recognized as an expense until they were exercised.
The problem with large option grants, however, was that they unintentionally gave some unscrupulous executives incentives to have their companies take big risks, or even to engage in accounting tricks, in order to goose the prices of the companies’ stocks so that the executives could cash in their options with big gains. Because the options were just that—a right to buy stock at a potentially discounted price at a later point—they carried very limited downside risk. The worst the executives could suffer if their bets turned sour was to lose the value of the option.
Unfortunately, the potential downside to options was realized in the late 1990s and early 2000s when it was revealed that top
executives of Enron, Worldcom, and Tyco, among other companies, cooked their companies’ books and eventually led them into actual or near bankruptcy. Along the way, the executives cashed in bundles of stock options. While it is impossible to prove cause and effect, it is difficult to escape the conclusion that at least for some executives who may have been predisposed to engaging in or encouraging deceptive accounting, the incentives provided by stock options could have been the decisive factor tipping them to actually do it.23
The corporate accounting misdeeds landed a number of the executives in jail for fraud, while spurring the enactment of sweeping legislation, the Sarbanes–Oxley Act of 2002, that subjected publicly held companies, their executives, directors, and accountants to a new set of corporate governance standards and other requirements that remain controversial to this day. Several years later, after a bruising quasi-political campaign, the official American and international bodies that set accounting standards changed the rules governing the reporting of options and required companies to record the value of options as an expense at the time they are granted, using the best methods available for that purpose. The BSM formula is one such method.
The Bottom Line
The ideas of economists, or a subset of them known as finance specialists, have had a powerful impact on the world of finance, and the firms engaged in the business. The indexed financial products business owes its origins to, or at least was accelerated by, the ideas of financial economists. The efficient markets hypothesis has found practical application in the world of investing, even though many money managers reject it, believing their stock picking can outperform the market. Also, some money managers and hedge funds engage in some form of momentum trading, a fact that behaviorists would cite to support their view of financial markets. It is not clear, however, what specific impacts academic behavioral finance specialists have had on the world of investing.
Finally, financial economists played a huge role in facilitating the rise of options trading and had an important influence on the use of options as employee compensation. This was more clearly a positive development for startups than it has been for established public companies.
Notes
1. Burton G. Malkiel, A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing, 10th ed. (New York: W.W. Norton & Company, 2012).
2. Bogle’s reference to Samuelson in particular can be found in his letter to the editor in the Wall Street Journal, October 19–20, 2013. As for Malkiel’s influence on Bogle, I heard it directly from Bogle in a short speech he gave at a dinner held at Princeton in the early 2000s.
3. John C. Bogle, The Battle for the Soul of Capitalism (New Haven, CT: Yale University Press, 2005).
4. Investment Company Institute, 2013 Investment Company Fact Book, Figure 2.13, available at www.ici.org.
5. Liam Pleven, “Family Wins Out for Bogles,” Wall Street Journal, November 29, 2013.
6. For a guide to ETFs, see Gary L. Gastineaux, The Exchange-Traded Funds Manual (Hoboken, NJ: Wiley Finance, 2010).
7. Investment Company Institute, Fact Book, Figure 3.3.
8. Nathan Silver, The Signal and the Noise: Why So Many Predictions Fail—But Some Don’t (New York: Penguin Press, 2012).
9. Alice Schroeder, The Snowball: Warren Buffett and the Business of Life (New York: Bantam Dell, 2008), 529–530.
10. Ibid.
11. Silver, Signal and the Noise. This profile draws heavily on Eugene F. Fama, “My Life in Finance,” Fama/French Forum, Dimensional, 2013. See http://www.dimensional.com/famafrench/essays/my-life-in-finance.aspx.
12. Dimensional, Dimensional Fund Advisors at Thirty, With Insights from David Booth and Eduardo Repetto (Austin, TX: Dimensional, 2011).
13. Ibid.
14. Profile based on a personal interview with Booth, May 10, 2013; Pauline Skypala, “Still a Firm Believer of Market Efficiency,” Financial Times, November 22, 2010.
15. The article in which this finding was published is one of the most cited articles in the history of the American Economic Review. Robert J. Shiller, “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?” American Economic Review 71, no. 3 (June 1981): 421–436.
16. For a fascinating compilation of a number of these oddities, see Richard Thaler, The Winner’s Curse: Paradoxes and Anomalies of Economic Life, (Princeton, NJ: Princeton University Press, 1994).
17. Fischer Black and Myron Scholes, “The Pricing of Options and Corporate Liabilities,” Journal of Political Economy 81, no. 3 (1973): 637–654.
18. Scott Patterson, The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (New York: Crown Business, 2010), 40.
19. Robert Merton, “Theory of Rational Option Pricing,” Bell Journal of Economics and Management Science 4, no. 1 (1973): 141–183.
20. Patterson, The Quants, 39–40.
21. Fischer Black died in 1995, and thus was ineligible for the 1997 award. He surely would have shared it had he lived.
22. One of the simplest expositions I have found is in Robert W. Ward, Options and Options Trading (New York: McGraw-Hill, 2004).
23. See George Benston, Michael Bromwich, Robert E. Litan, and Alfred Wagenhofer, Following the Money: The Enron Failure and the State of Corporate Disclosures (AEI-Brookings Joint Center on Regulatory Studies, Washington, DC: The Brookings Institution Press, 2003).
PART II
ECONOMIST-INSPIRED POLICY PLATFORMS FOR PRIVATE BUSINESS
All capitalist economies require a certain amount of legal as well as physical infrastructure to operate. Citizens and companies must know that the property they currently own or hope to own in the future is legally and physically secure. Likewise, consumers and businesses must have faith that their agreements will be adhered to by parties on the other side of transactions (counterparties) and, if not, that the agreements will be enforced by a well-functioning judicial system.
There are other aspects of the legal infrastructure that are helpful to business formation and growth. Ideally, licenses and fees to launch a business are kept to a minimum, but those that remain should be obtained as quickly as possible. The World Bank’s Doing Business report annually ranks all countries around the world on the ease of launching a legal business.
Not as well recognized, but also equally important, are bankruptcy laws that enable failing firms to reorganize and not necessarily go completely out of business and strand customers and suppliers. Liability laws that assign responsibility for compensating injured parties to those whose negligence causes harm not only seem just, but also provide incentives to others to be careful. At the same time, corporate laws that limit the liability of shareholders for the losses of companies to the amounts shareholders invest are essential to encourage investment in new and existing enterprises in the first place.
This book assumes that these basic elements of an effective legal infrastructure are in place, although not necessarily in an ideal fashion in every location in the country. Indeed, there has long been and will continue to be tension between those who want more government regulation to protect against harms that business activity may cause and many in the business community who believe that regulatory burdens are already too high and need to be curtailed.
Although I will not attempt to resolve this particular debate, which likely has no end, the chapters in this second part of the book focus on industries where government has eliminated or significantly cut back what economists call economic regulation, which limits the prices of what firms in particular industries may charge and determines which firms may even enter an industry. Economic regulation is to be distinguished from what economists call social regulation, aimed at correcting market failures, such as pollution, or unequal information between buyers and sellers.
Although many businesses have been formed as a direct result of social regulation—think of those who make scrubbers that reduce emissions from electric power plants or airbag manufacturers that e
nable automakers to meet auto safety rules—I focus on economic deregulation and the economic arguments for it for two reasons.
First, as you will learn in the chapters that follow, economists have been arguing for years that the case for economic regulation for most industries has been weak or nonexistent, and thus most of it should be eliminated. This is not the case with social regulation in general, which is widely accepted in principle, but is argued over in its details (specifically whether certain rules have benefits that exceed their costs, and even if they do, whether the rules are the least restrictive alternatives available).
Second, when policy makers finally responded to the economists’ critiques and cut back or eliminated economic deregulation, it opened vast new horizons for many new businesses or business models to launch and flourish. In effect, economic deregulation has become a policy platform on which many new businesses have been formed and innovations developed. In the process, the U.S. economy has been changed forever, for the good, or so I argue.
Much of this change was brought about by the urgings, research, and writing of economists, demonstrating how economists in these instances indirectly contributed to the success of many businesses, an outcome of which the founders, executives, and employees of these firms may only be dimly aware. The stories you will read in this part are important for people in all walks of life to understand and strengthen the central theme of this book: that economists and their ideas are really important, much more so than many people may realize.
The chapters share another common thread: Each deals with an industry that either helps define what it is to be a modern economy, or is an essential part of what makes that economy—the U.S. economy in particular—tick. Thus Chapter 9 deals with mass transportation; Chapter 10 is devoted to energy; Chapter 11 discusses telecommunications; and, finally, Chapter 12 deals with finance. It is difficult to imagine how a modern economy would work without advanced technologies and practices in each of these industries. That they exist now, although imperfect and constantly evolving, is due in significant part to the rules and institutions that govern prices and entry into these industries. Broadly speaking, economists have argued for decades that these industries are fundamentally competitive (if not when economic regulation was adopted then certainly now) and should not be subject to regulatory regimes more suitable for natural monopolies. It has taken policy makers time to catch up and act on this insight, and I believe this would not have happened, or would have occurred much later, had economists not first laid the intellectual groundwork for it all.
