Tuesday, September 5, 2023

"Myron Scholes on Black–Scholes, Decarbonization, AI, and Parenting"

There's a headline I did not have on my 2023 Bingo card.

From the CFA Institute's Enterprising Investor blog, August 28:

Through his examinations of how uncertainty influences asset prices, Nobel laureate Myron Scholes has helped revolutionize our understanding of the financial markets. His development of the BlackScholes options pricing model with Fischer Black more than half a century ago redefined how investment professionals do their jobs and opened up a new era in the world of finance.

Even though he is one of the most influential living economists, Scholes is not resting on his laurels. His explorations of the inner workings of the financial markets continue, with a particular focus on both artificial intelligence (AI) and carbon credits and how they compare with options, among other phenomena.

He recently participated in a wide-ranging fireside chat arranged by Janus Henderson,hosted by CFA Society Hong Kong, and moderated by Alvin Ho, PhD, CFA. The conversation, which took place on 3 July 2023 in Hong Kong, covered both the continued relevance of the BlackScholes model 50 years after its unveiling as well as Scholes’s current research interests. Below is a lightly edited transcript of the discussion.

The Black–Scholes Revolution

CFA Society Hong Kong: It has been 50 years since you published the famous BlackScholes model, and it remains one of the most popular readings among financial professionals. How did that happen?

Myron Scholes: The model was really about explaining how to price options, but I’m happy that it has changed the banking landscape from an agency-only to a principal business.

Now, if you think about it, uncertainty is the most important thing in your life. The mean is nothing! Having options to deal with uncertainties and risks is so important. If life were unchanging, then options would not be as valuable, but life is always changing, which makes options and the ability to deal with uncertainties very precious.

With the BlackScholes technology, we can help clients figure out what exactly they want and how to offset the delta and risks associated with it. Essentially, I see the options market as a crowd-sourcing place to determine what level of risk the market is signaling and subsequently help business owners to make decisions.

Decarbonization and Portfolio Construction

Going into your decarbonization and portfolio theory, how does the work that you have done in the options space help here?

I have done a lot of riskreturn portfolio theory. To me, understanding constraints is of the utmost importance. You do not need to be a better forecaster than everyone else, but you do need to understand the constraints of others. For example, if people are constrained, if they trust you, they would be willing to pay you to take their constraints off. That’s when your options are valuable. This ability to unconstrain the constrained also happens in parenting and M&A.

If you want to make money in your life, being “boring” is important. You wouldn’t want the choppiness of your life affecting your returns, but you would want to smooth the volatility of returns and cut the tails. If you managed to do that, your compounded return would be so much better. My options theory is really meant to help understand the tail. If you think about decarbonization, we also want to smooth the path to decarbonization, and one way to do that is to create more paths to achieve it, and to some extent, it’s quite like a put option.

Myron, to dive deeper into the same topic, I want to ask a three-part question. First, how should investors determine the fair value of carbon credits?....