Thursday, July 5, 2012

The Guy Who Discovered Black-Scholes Before Mssrs. Black and Scholes

Okay, not all of B-S but enough that if anyone had been paying attention they could have made money off the young man's work.

I was going to do a post on the King of 19th century put and call brokers but you may find this more interesting.
From Bloomberg:
Wall Street Quants Owe a Debt to Obscure French Student
The 21st century began with a major correction on Wall Street and a long period of volatility in global financial markets. The VIX, sometimes called the fear index, soared, and congressional hearings explored why major investment banks couldn’t better hedge market risk. Traders sought reprieve, and risk management became elevated from prudent practice to a tool for financial survival.

Risk is most efficiently managed through the purchase of options and other derivatives. Many investors know that the economists Fischer Black and Myron Scholes are considered the pioneers of derivatives pricing through their options-pricing theory. Their Black-Scholes formula and its variations remain the primary tools in the optimal pricing and determination of derivatives hedges.

Most don’t know that options-pricing theory actually began at the very start the 20th century, in Paris. The innovation, by an obscure graduate student named Louis Bachelier, introduced sophisticated mathematics to finance theory and eventually gave rise to quantitative analysis. It took us almost 70 years to appreciate Bachelier’s contribution -- but he should go down as the father of modern finance.

In his early 20s, following a stint in the French army, Bachelier found himself working at the Paris Stock Exchange. There he tried to understand how options on French government perpetual bonds, or rentes, could be priced.

Brilliant Idea
He enrolled at the Sorbonne to study mathematical physics under one of France’s top mathematicians, Henri Poincare. His supervisor was a bit perplexed when Bachelier chose to study French bond options for his doctoral thesis, but soon agreed that his idea was brilliant.

In just a few pages, Bachelier demonstrated that the volatility of the price of an underlying security affects both the put and call price of its option. He began by postulating that the price of perpetual bonds followed what we now call a “random walk.” He then showed that the range of plausible prices of such an option diffuses, or spreads out, as the time to settlement increases, just as smoke might disperse from a chimney in a manner proportional to distance. By then, the mathematics of such “diffusion processes” were well understood, but they were about to be applied in most novel ways.

Bachelier had hit upon two of the most important concepts of modern finance -- the random walk of securities prices and the pricing of market volatility over time. Five years later in 1905, Albert Einstein used the same diffusion equation to show that the random walk of small particles colliding with even smaller particles helps explain the atomic structure. Einstein was almost universally credited with a mathematical methodology that Bachelier had developed in his thesis and applied to derivatives markets....MORE
Heckuva job, Brownian.

See also:
"Über die von der molekularkinetischen Theorie der Wärme geforderte Bewegung von in ruhenden Flüssigkeiten suspendierten Teilchen"
at Austria's Zentralbibliothek für Physik

Marian Smoluchowski 
(missed it by that much)