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The Father of

Financial Engineering

Paul Samuelson’s research on pricing warrants helped lay the groundwork for derivatives to grow

into a trillion-dollar industry. By PETER CARR

was supposed to reduce risk. Samuelson says his cre-

ation’s dark side comes because derivatives lend

themselves to “nontransparency and tremendous

P

overleveraging.”

aul a. samuelson helped chart the Samuelson’s ideas about financial engineering

course of 20th-century economics. He date to the 1940s. “I became interested in deriva-

has published more than 550 scientific tives, in puts and calls, immediately after World

papers. His 1948 textbook, Economics, War II,” he says. Puts and calls were then sold by

now in its 18th edition, introduced generations of dealers based in small offices off Wall Street in New

college students to economics. And he has won York. “I assure you this was not the high-rent dis-

prizes ranging from the 1947 John Bates Clark trict,” Samuelson says. Put options grant the right

Medal for the most significant contribution to eco- but not the obligation to sell the underlying secu

nomics by an American under 40 to the 1970 Nobel rity at a set price on or before a fixed date. Call

Memorial Prize in Economic Sciences. “He has in options similarly grant the right to buy.

fact simply rewritten considerable parts of eco- To do his research, Samuelson would go to New

nomic theory,” the Royal Swedish Academy of Sci- York and talk to the dealers. Once, the late Herbert

ences said in presenting the prize. Filer, head of the Puts and Calls Brokers and Deal-

Today, at 92, Samuelson continues to ers Association, a trade group, asked Samuelson

‘I’m never sure of the write for a wide audience as well as for what he was doing. “I’m trying to advance the sci-

academics. His output includes a ence of modern finance in understanding options,

more than 10 million monthly column that’s syndicated to derivatives,” Samuelson says he told Filer.

people who are exposed newspapers, including one in Japan “It’s hopeless!” Filer said. “You have to have

to that, whether there with 10 million readers. “I’m never sure a European kind of mind to understand it.”

of the more than 10 million people who Samuelson took his revenge when he published

are more than 10 of are exposed to that, whether there are his results in the 1960s. He gave the name European

them who understand more than 10 of them who understand options to the simplest kind: options that can be ex-

my nuances,’ my nuances,” he says in a December ercised only at maturity. For the more-complicated

interview at his office at Massachusetts case of options that can be exercised at any time

Samuelson says. Institute of Technology in Cambridge. before maturity, he used the term American options.

Samuelson’s December column is In the 1950s, Samuelson became the first econo-

about financial engineering, a field that the MIT mist to recognize the importance of a dissertation

Institute Professor Emeritus is often credited with written by mathematician Louis Bachelier in 1900

creating. “I helped train at MIT a generation of at the Sorbonne. The thesis, “Théorie de la spécula-

financial engineers,” he writes. “Maybe I should tion,” said that the price of an asset underlying an

feel like Dr. Frankenstein, who created a poten option could be modeled as a Brownian motion, also

tially fabulous robot but, alas, one that turned known as a continuous random walk. Just as a

jason grow

The derivatives market today is huge. At the end of right, Bachelier assumed that financial assets are

June, the notional value of over-the-counter deriva-

tives was $516 trillion, according to the Basel, Swit-

zerland–based Bank for International Settlements,

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Bloomberg Markets April 2008

photo/illo credit here

research into derivatives

in the 1940s.

173

month 2008 Bloomberg Markets

quant corner

priced so that they’re equally likely to rise or fall by others is unorthodox, and the paper stands as a tes-

the same amount. Samuelson also spotted the flaw tament to how mathematically rigorous economics

in Bachelier’s main assumption. Since Bachelier pre- had become under Samuelson’s influence. Robert

sumed that the size of each price change is indepen- Merton, a Nobel Prize–winning student of Samuel-

dent of the price level, a run of bad luck could lead to son’s, refers to McKean’s appendix in the 1965 paper

negative prices—an impossibility for stocks. as “formidable.”

Samuelson proposed that price “Rational Theory of Warrant Pricing” contains

changes should instead be proportion- most of the elements of the standard theory of

Paul Samuelson al to the level of the asset price. Under option pricing as used today. As Merton points out,

Rational Theory of Warrant Pricing Samuelson’s geometric Brownian the importance of Samuelson’s paper became appar-

motion, even an infinite stream of bad ent only after subsequent publications in 1973 by

Education luck would leave the price positive. Fischer Black, Myron Scholes and Merton himself.

Attended the University of Chicago.

“On Jan. 2, 1932, I guess the Although an astronomer named Samuelson set out to derive the relationship that

mathematical bottom of the Great M.F.M. Osborne at the U.S. Naval would pertain in economic equilibrium between

Depression, I walked into the Research Laboratory in Washington in the value of a warrant and the price of its underlying

economics classroom, and I was born,”

Samuelson says. Earned a bachelor’s 1959 published this idea before Samu- stock. A warrant differs from a call option mainly in

degree from Chicago in 1935. Was a elson, both authors are generally given that it’s written by the issuer of the stock. Samuel-

member of the Society of Fellows at credit for proposing this stochastic son’s interest in warrants over options came from

Harvard University, where he earned

a master’s in 1936 and a Ph.D. in 1941. process, which is the benchmark the fact that in 1965, warrant prices were listed

against which all subsequent pro while puts and calls traded only over the counter. In

Career posals have been evaluated. his paper, Samuelson considered two types of war-

Began teaching in 1940 at

Massachusetts Institute of Technology, In 1965, Samuelson published rants: those that can be exercised only at their expi-

where he is Institute Professor two papers in the same issue of an ry, European; and those that can be exercised at any

Emeritus in economics. Received the MIT journal called Industrial Man- time up to their expiry, American.

Nobel Memorial Prize in Economic

Sciences in 1970. The first five volumes agement Review. The first one, “Proof

of The Collected Scientific Papers of That Properly Anticipated Prices since the price of the stock underlying a war-

Paul Samuelson (MIT Press) run to Fluctuate Randomly,” proved that in rant trades in a spot market, Samuelson under-

4,834 pages and cover his work

through 1986. an informationally efficient and fric- stood that this price would not be a martingale for

tionless market, futures prices would two reasons. First, unlike futures, the stock has a

personal follow a martingale, once the effects carrying cost given by the difference between the

Age 92. Born in Gary, Indiana.

Married, with six children and of the market’s aversion to risk have interest rate and the dividend yield. While Samuel-

15 grandchildren. been accounted for. The defining son’s paper never explicitly makes assumptions on

property of a martingale is that the interest rates, he does make clear that he’s allowing

conditional expectation of the next value, given the for the possibility of dividends’ being paid continu-

current and preceding values, is the current value. ously such that the dividend yield is constant. The

A martingale is a weaker concept than a random second reason that a spot price wouldn’t evolve as

walk, as it implies zero correlation between incre- a martingale is that the spot price is risky and, as

ments rather than independence. For a martingale, such, the expected growth rate of the stock reflects

squared price changes or returns can be serially cor- a risk premium. While not modeling this risk pre-

related. In contrast, applying any function to the mium directly, Samuelson places a strong con-

increments of a random walk results in random vari- straint on the sum of the stock’s carrying cost and

ables that remain independent. Samuelson’s 1965 the stock’s risk premium by requiring that the

paper appears to be the first application of the prob- expected growth rate in the underlying stock price

abilistic concept of a martingale in finance. is a nonnegative constant he calls α. He similarly

The other paper by Samuelson in the spring 1965 assumes that the expected growth rate of the over-

issue of the journal is called “Rational Theory of lying warrant price is a second constant he calls β.

Warrant Pricing.” The paper includes an appendix Since models are by definition an abstraction

written by Henry McKean, now of New York Univer- of reality, modelers always make assumptions,

sity, whom Samuelson refers to in the December

interview as a “hotshot mathematical probabilist.”

The practice of including appendices written by

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Bloomberg Markets April 2008

explicitly or implicitly, that specify these abstrac- a mathematical expression that depends only on

tions. Good modelers state all of their assumptions the inputs to the problem. As a result, Samuelson

and ensure that these assumptions don’t contra- outlines a numerical method by which finite-lived

dict one another. American warrant prices and this boundary can be

As a modeler without peer, Samuelson explicitly approximated. In contrast to the case of finite-lived

states that his two assumptions are that the stock’s warrants, the critical boundary is independent

mean growth rate is constant at α ≥ 0 and that the of time for a perpetual American war-

warrant’s mean growth rate is constant at β ≥ α. rant. As a result, McKean derives closed- ‘Rational Theory of

From the title of his paper, it’s clear that Samuelson form formulas for both this boundary

is also assuming that investors are rational, and it’s and for the value of a perpetual Ameri- Warrant Pricing’

safe to presume that he’s also assuming that mar- can warrant. contains most of the

kets are in equilibrium. The McKean result is interesting elements of the standard

However, Samuelson doesn’t explicitly assume from a methodological viewpoint

that interest rates are constant or that investors can because it shows just how tantalizingly theory of option pricing

trade continuously as Black, Scholes and Merton close the two authors were in 1965 to as used today.

later assumed. Had he made these assumptions, the stunning result published in 1973

then you could show that his two assumptions con- that when investors can trade continuously, deriva-

tradict each other in general. tive security prices are independent of the expected

For example, if α is constant, then the mean growth rate of the underlying asset—that is, α.

growth rate for a finite-lived warrant can be shown Let’s now review this development using modern

to depend nontrivially on the contemporaneous notation and concepts. Samuelson assumed that

stock price and time. Interestingly, when α is con- under the real-world probability measure, the

stant, then under constant interest rates, continu- stock price S follows geometric Brownian motion:

ous trading opportunities and no arbitrage, the

dSt

mean growth rate of a perpetual warrant can be = αdt + σdBt , t ≥ 0,

St

shown to be constant. Had Samuelson explored the

implications of the ability to trade continuously where σ denotes the stock’s constant volatility and

for perpetual warrants, it seems plausible that he B is a standard Brownian motion. The last term on

would have discovered that the perpetual warrant the right side of the equation is the differential of

value depends on neither α nor β. The proof of this an Itô integral.

result is straightforward, as shown below. Now assume that a risk-free asset exists and that

In his paper, Samuelson assumed that the war- the risk-free rate is constant at r ∈ R+. Consider a

rant price has a mean growth rate at least as large as portfolio of stock and the riskless asset that’s con-

that of the stock—that is, β ≥ α. He considers the tinuously rebalanced so that a constant proportion

two logical subcases β = α and β > α separately. p ∈ R of the wealth is kept in the stock. Assume

He shows that when β = α ≥ 0, American war- that the stock’s dividend yield is constant at q > 0,

rants have the same value as European warrants and assume that dividends are reinvested into the

and hence there’s no early exercise premium. He stock under this fixed-mix trading strategy. It

also shows that as time to maturity becomes infi- would have been well known to portfolio theorists

nite, this common value converges to the underly- in the 1960s that, letting Wt denote the wealth at

ing stock price, regardless of the strike price of the time t of this portfolio, wealth also follows geomet-

warrant. He takes this property as a rejection of the ric Brownian motion under this simple fixed-mix

possibility that β = α and goes on to consider the strategy. In terms of the Itô calculus that was devel-

case where β > α ≥ 0. For this case, he shows that oped by Kyoto University probabilist Kiyoshi Itô

the early exercise premium is positive. and introduced to finance by Merton, the wealth

solves the stochastic differential equation:

samuelson recognizes the existence of a criti-

dWt

cal boundary situated above the strike price of = [r + p(α + q − r)]dt + pσdBt , t ≥ 0.

Wt

the American warrant. For finite-lived warrants,

this boundary depends nontrivially on time and

inhibits the development of a closed-form formula,

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April 2008 Bloomberg Markets

quant corner

��

The unique solution of this stochastic differen- �2

r − q − σ 2 /2 r − q − σ 2 /2 2r

tial equation is: p+ ≡ − + + .

σ2 σ2 σ2

2 2

Wt = W0 e[r+p(α+q−r)−p σ /2]t+pσBt

, t ≥ 0. (1) With this choice of p, (3) simplifies to:

� �p+

Likewise, the solution of the stochastic differen- Wt = W0 SS0t , t ≥ 0.

tial equation describing the stock price process is:

Consider a perpetual warrant with strike K that

2

St = S0 e(α−σ /2)t+σBt

, t ≥ 0. must be exercised when the stock price hits a barrier

b. At�the first

�p+ passage time, the wealth would be

Raising this expression to the power p implies: W0 Sb0 . Replication occurs if we equate this

wealth to the payoff:

2

Stp = S0p ep(α−σ /2)t+pσBt

, t ≥ 0. (2) � �p+

b

W 0 = b − K.

S0

Comparing (1) and (2), we have:

� �p Solving for W0 gives the initial cost of creating this

2

Wt = W0 e[pq+(1−p)(r+pσ /2)]t St

S0 , t ≥ 0. (3) warrant: � �p+

S0

W0 = (b − K) . (4)

b

Thus, when the wealth of a self-financing trading

strategy is expressed relative to the contemporane- Samuelson and McKean point out that optimizing

ous stock price, the mean growth rate of the stock the fixed boundary warrant value over all possible

is irrelevant. This is an extremely important result, boundaries results in the value of an American war-

and it was shown later by Yaacov Bergman at the rant. They also point out that this can be captured

University of California, Berkeley, in a by the high-contact condition equating the slope in

Samuelson and 1981 working paper that the irrele- S to one. Choosing b in this way leads to the opti-

McKean point out vance still holds when the proportion mal boundary:

p+

p depends on the stock price and time.

that optimizing Note that this irrelevance has nothing

b∗ =

p+ − 1

K.

the fixed boundary to do with eliminating variance in a Replacing b in (4) with b∗ leads to the desired

warrant value over all hedge portfolio; the result holds true closed-form solution.

even if derivatives don’t exist. Further- In retrospect, the Samuelson-McKean paper

boundaries results more, the above irrelevance holds was a near miss. To this day, Samuelson is dubious

in the value of an under price jumps and stochastic vola- about the efficacy of the standard model and in par-

American warrant. tility where perfect hedges don’t exist. ticular the assumption that volatility is constant.

Continuing with our fixed-mix The late Black shared this skepticism. By now, most

strategy, suppose we try to have the wealth process practitioners are inured to the constant volatility

be the replication cost of a perpetual warrant. As assumption. The model has stimulated a plethora

Samuelson points out, time t wouldn’t enter the of new products. This brave new world is not with-

cost function, and hence we choose p so that the out its detractors.

coefficient of t in (3) vanishes: In his December column, Samuelson writes that

financial engineering is like the science that can

pq + (1 − p)(r + pσ 2 /2) = 0. help mankind or create atomic bombs. “Under

proper regulation and with optimal transparency,

The quadratic function of p on the left has two it can spread risk efficiently and in that sense

roots, and it’s easily shown that one is negative and reduce intrinsic riskiness,” he writes. “But sans

the other is greater than one. The perpetual war- transparency and lacking understanding of the

rant has zero value at zero stock price, so we can arithmetic of cancerous leveraging, maybe it intro-

discard the negative root. The positive root is: duces into modern finance new fragility?” ≤

Research Group in New York. pcarr4@bloomberg.net

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Bloomberg Markets April 2008