Nobel Prize winners profit by hedging their bets

The Nobel Prize in Economics was awarded yesterday to two American academics who can claim to have fostered the explosive growth in financial derivatives. As Diane Coyle, Economics Editor, reports, they put their own ideas into practice as partners in a highly profitable investment fund.

The 30th Nobel Prize in Economics has gone to Robert Merton of Harvard University and Myron Scholes of Stanford University. They, along with Fischer Black, who died in 1995, "made a pioneering contribution to economic sciences by developing a new method of determining the value of derivatives", according to the citation from the Royal Swedish Academy of Sciences.

This year's Nobel award has bucked the trend for the winners to specialise in highly abstract research. Avinash Dixit, a Professor of Economics at Princeton University, said yesterday: "If you ask what idea from the last 50 or 60 years coming from economic research has had the biggest impact on the world, this is it."

Professors Merton and Scholes are partners in a hedge fund, Long-Term Capital Management, which puts their theories into practice. The former Salomons executive, John Merriweather, is also involved.

According to one economist: "They have answered the question `If you're so smart why aren't you rich?' by laughing all the way to the bank." Even Professor Merton's students at Harvard's business school are famed for landing high-paying jobs on Wall Street.

Although their work has ranged over the entire field of financial economics, this year's winners are best known for the Black-Scholes formula. This formula tells traders in derivatives, the financial instruments based on other assets such as shares and bonds, how to price options - that is, it puts a value on the right to buy a stock or other asset on a particular date in the future at a pre-specified price.

The formula looks complicated. But it says that the value of the option depends on an intuitively sensible list of variables: the current price of the underlying asset, the interest rate on a risk-free alternative investment, the time to expiry of the option, the strike price at which the option can be exercised, and the likely volatility of the underlying asset between now and its expiry date.

The idea is that options are a form of insurance or hedging against risk. They should be priced so that they allow a share portfolio to mimic a risk-free alternative such as holding Treasury bills.

Although derivatives have a reputation for being risky, they generally allow investors to reduce their exposure to risk. The Black-Scholes formula has been as important as computer technology in allowing the use of derivatives based on underlying financial assets to grow to an estimated $55 trillion market.

Elisabetta Bertero, a lecturer in finance at the London School of Economics, said of the formula: "It has become a self-fulfilling phenomenon. Because everybody uses it, it is the best way of pricing options." It was published in 1973 and in use in Chicago's trading pits by 1975.

Professor Merton said he was "speechless" on hearing the news that he had jointly won the prize of nearly $1m.