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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

the bank for central banks. Financial engineering


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

out to be a monster.” drunken sailor is equally likely to wander left or


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

Samuelson began his


research into derivatives
in the 1940s.

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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
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��
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?” ≤

Peter Carr heads Bloomberg’s Quantitative Financial


Research Group in New York. pcarr4@bloomberg.net

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Bloomberg Markets April 2008

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