History of Option Pricing
By Arnold Kling
The development of the Black-Scholes option pricing formula is a fascinating story. It is well told in this article by sociologist Donald MacKenzie.
The Black-Scholes-Merton analysis provided a range of intellectual resources for those tackling problems of pricing derivatives of all kinds. Amongst those resources were the idea of perfect hedging (or of a ‘replicating portfolio’, a portfolio whose returns would exactly match those of the derivative in all states of the world); no-arbitrage pricing (deriving prices from the argument that the only patterns of pricing that can be stable are those that give rise to no arbitrage opportunities); and a striking example of the use in economics of Itô’s stochastic calculus
MacKenzie also points out how important the “replicating portfolio” approach to option pricing was in changing the perception of options. Rather than being viewed as unnatural gambles, they were shown to be equivalent to established securities. (Thanks to Daniel Davies for linking to the article.)
There are still people who view financial derivatives as dangerous. Notably Warren Buffett, who wrote that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
For Discussion. The Black-Scholes formula seems to provide us with a tool to deal with risk. Is this command over risk real, or an illusion?