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Fischer Black is best known for the eponymous Black–Scholes option pricing formula that laid the foundations for so much of modern finance (Black and Scholes 1973), a contribution that was recognized posthumously in the citation for the 1997 Nobel Prize in Economics that was awarded to Robert C. Merton and Myron Scholes. Today, the best known derivation of the famous formula follows the no-arbitrage argument laid out in Merton (1973), but Black approached the problem as simply an application of the capital asset pricing model (CAPM) developed by Sharpe (1964), Lintner (1965), and especially Jack Treynor (1962), whose version of CAPM was Black’s first introduction to finance. Indeed, it is no exaggeration to say that not just the options formula but also everything Black ever wrote has its roots in CAPM, which Black always understood quite broadly as a model of general economic equilibrium, not just a model of how to price risky capital assets (Black 1972b).

Born 11 January 1938, Fischer Black grew up in Bronxville, New York, before attending both college and graduate school at Harvard University. After earning his Ph.D. in applied mathematics in 1964 for a thesis in the new area of artificial intelligence, Black took his first job as an analyst in the operations research section of the consulting firm Arthur D. Little, Inc. That’s where he met Treynor and learned CAPM. Although he never took even a single course in either economics or finance, Black subsequently built a career as a financial consultant, a research professor (University of Chicago 1971–5, Massachusetts Institute of Technology 1975–83), and then a partner in the Wall Street investment firm Goldman Sachs (1984–95). He died prematurely on 30 August 1995, shortly after the publication of Exploring General Equilibrium, the book he considered to be his magnum opus.

Straddling the worlds of academia and business, Black developed his ideas by using practical problems in business as the stimulus for his abstract theorizing. The accessible early paper with Treynor, ‘How to use security analysis to improve portfolio selection’ (Treynor and Black 1973) set the agenda that would occupy Black and the generation of financial engineers that grew up after him, namely, to find practical applications of the new academic theories of finance. Just so, Black’s early work with Myron Scholes for the Wells Fargo Bank sought to develop a new ‘passive’ portfolio strategy from the implications of CAPM, a kind of leveraged index fund that anticipated the later development of portfolio insurance (Black and Scholes 1974; Black 1988a; Black and Perold 1992). Similarly, his paper on ‘Bank funds management in an efficient market’ (1975) anticipated the eventual consequences of bank deregulation, and his paper ‘Toward a fully automated stock exchange’ (1971) anticipated the eventual consequences of computerized trading.

All of this was about remaking the world in the image of CAPM, an image that kept expanding in Black’s mind as he worked to extend CAPM to a world without any riskless asset in his famous zero-beta model (1972a), to a world with long-term debt in the famous BDT term structure model (Black et al. 1990; Black 1995b), and to an international environment in his controversial universal hedging model (1974, 1990) that formed the analytical core of the Black–Litterman model of global asset allocation (Black and Litterman 1991, 1992).

The irony is that the world of the original CAPM is a world of debt and equity only, no options at all. That explains why Black was not sure that the opening in April 1973 of the Chicago Board Options Exchange was a good thing, even though it provided an immediate application for the Black–Scholes formula. Similarly, Black’s extension of the options analysis to the problem of pricing commodity futures (1976), although immediately useful in the currency futures markets that sprang up after the collapse of the Bretton Woods fixed exchange rate system, left him unsure whether he was helping to move the world toward CAPM or away from it. From this point of view, his work on pension fund investment policy, the theory of business accounting, and a practical method of capital budgeting more clearly contributed to the creation of a CAPM world (1980b, a, 1993, 1988b).

Only after leaving academia for Goldman Sachs did Black come to fully appreciate the positive contribution of options and other derivatives to the brave new world of finance. The turning point was the theory of noise trading that he revealed for the first time in his presidential address to the American Finance Association (1986). Noise traders are people who trade, knowingly or not, without any information advantage. Earlier in his career, Black had assumed that such traders would eventually be driven out as markets become more and more efficient, but he changed his mind once he realized that ‘Noise trading actually puts noise into prices’. As a consequence, ‘we might define an efficient market as one in which price is within a factor of 2 of value; i.e. the price is more than half of value and less than twice value’ (1986, 532–3). Because of noise trading, psychology matters for asset pricing, and it is in options prices that this effect can most clearly be seen; it shows up in the Black–Scholes formula as volatility.

Black’s intellectual strategy to understand the world through the equilibrium lens of CAPM, as properly extended, was not confined to finance. He also used CAPM to lay the foundations of an alternative equilibrium understanding of macroeconomics, including the theory of money and the theory of business cycles, and he always considered this work at least as important as his work in finance. In this respect, his very first published paper, ‘Banking and interest rates in a world without money: the effects of uncontrolled banking’ (1970), set the agenda that would occupy him for the rest of his life. His two subsequent books Business Cycles and Equilibrium (1987) and Exploring General Equilibrium (1995a) had little impact on economics at the time they were published. In retrospect, however, they can be seen to have anticipated themes that eventually did enter economics, through the new classical revolution of Robert Lucas and his associates and the real business cycle revolution of Edward Prescott and his associates. More than anyone else, Fischer Black demonstrated that we must look to finance to discover the origin of the dramatic changes in macroeconomic thinking in the last quarter of the 20th century (Mehrling 2005).

See Also

Selected Works

  • 1970. Banking and interest rates in a world without money: The effects of uncontrolled banking. Journal of Bank Research 1: 8–20. Reprinted as ch. 1 in Black (1987).

  • 1971. Toward a fully automated stock exchange. Financial Analysts Journal 27, Part I: 28–35, 44; Part II: 24–28, 86–87.

  • 1972a. Capital market equilibrium with restricted borrowing. Journal of Business 45: 444–445.

  • 1972b. Equilibrium in the creation of investment goods under uncertainty. In Studies in the theory of capital markets, ed. M. Jensen. New York: Praeger.

  • 1973 (With M. Scholes). The pricing of options and corporate liabilities. Journal of Political Economy 81: 637–654.

  • 1973 (With J. Treynor). How to use security analysis to improve portfolio selection. Journal of Business 46: 66–86.

  • 1974. International capital market equilibrium with investment barriers. Journal of Financial Economics 1: 337–352.

  • 1974 (With M. Scholes). From theory to a new financial product. Journal of Finance 19: 399–412.

  • 1975. Bank funds management in an efficient market. Journal of Financial Economics 2: 323–339.

  • 1976. The pricing of commodity contracts. Journal of Financial Economics 3: 167–179.

  • 1980a. The magic in earnings: Economic earnings versus accounting earnings. Financial Analysts Journal 36: 19–24.

  • 1980b. The tax consequences of long-run pension policy. Financial Analysts Journal 36: 21–28.

  • 1986. Noise. Journal of Finance 41: 529–543.

  • 1987. Business cycles and equilibrium. Cambridge, MA: Basil Blackwell.

  • 1988a. Individual investment and consumption under uncertainty. In Portfolio insurance: A guide to dynamic hedging, ed. D. Luskin. New York: Wiley.

  • 1988b. A simple discounting rule. Financial Management 17: 7–11.

  • 1990. Equilibrium exchange rate hedging. Journal of Finance 45: 899–907.

  • 1990 (With E. Derman and W. Toy). A one-factor model of interest rates and its application to treasury bond options. Financial Analysts Journal 46: 33–39.

  • 1991 (With R. Litterman). Asset allocation: Combining investor views with market equilibrium. Journal of Fixed Income 1: 7–18.

  • 1992 (With R. Litterman). Global portfolio optimization. Financial Analysts Journal 48: 28–43.

  • 1992 (With A. Perold). Theory of constant proportion portfolio insurance. Journal of Economic Dynamics and Control 16: 403–426.

  • 1993. Choosing accounting rules. Accounting Horizons 7: 1–17.

  • 1995a. Exploring general equilibrium. Cambridge, MA: MIT Press.

  • 1995b. Interest rates as options. Journal of Finance 50: 1371–1376.