I'm Paul Kaplan, research director at Morningstar Canada.
Options play an enormous role in our modern financial markets. They are important tools for risk management, portfolio strategies, and sometimes are part of employee compensation. Yet, it wasn’t until the works of Fisher Black, Robert Merton and Myron Scholes were published in 1973, that there were any rigorous analytical tools for pricing options and creating strategies based on them. For these contributions, Robert Merton and Myron Scholes were awarded the 1997 Nobel Prize in Economic Sciences.
Because Fisher Black passed away in 1995 and Nobel prizes are not awarded posthumously, he did not share in the prize. However, the Nobel committee took the extraordinary step of discussing his contributions together with those of Merton and Scholes.
A call option gives its holder the right, but not the obligation, to purchase a security at or by a certain date for a predetermined price, called the strike price. A put option gives the right to sell a security at or by certain date for its strike price. According to the pricing formula developed by Black, Scholes and Merton, the price of an option (call or put) depends on (1) the current price of the underlying security, (2) the strike price, (3) the current rate of interest, (4) the time until the option expires, (5) the volatility of returns on the underlying security, and (6) for dividend paying stocks, the dividend yield.
There are two notable things about the option pricing formula. First, it makes no references to the expected return or beta of the underlying security. Second, it is immensely practical since all but one of the inputs are directly observable, volatility being the only input that needs to be estimated. The practicality of the formula has led to its widespread use.
As important as the option pricing formula is, the significance of the contributions of Black, Scholes and Merton go well beyond pricing stock options. In their 1973 publication, Black and Scholes noted that a stock is essentially an option on the firm as a whole (debt plus equity), with the size of its debt obligations playing the role of the strike price. Hence their formula can be used to value stocks. Also, an insurance contract is essentially an option, so their approach can be used to value insurance contracts. In fact, any contract that contains option features can be valued using the Black-Scholes-Merton formula.
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