In the final episode of Season 1, Alex and Tyler explore one of the most consequential quests in the history of economics and finance: the decades-long search for a formula to price options. From Louis Bachelier's groundbreaking work in 1900 to the eventual triumph of Black, Scholes, and Merton in the 1970s, they trace how brilliant minds across mathematics, physics, and economics gradually unlocked the how to properly price financial instruments like calls and puts. Along the way, they examine how this theoretical breakthrough revolutionized modern markets, sparked the creation of the Chicago Board Options Exchange, and transformed our understanding of uncertainty and risk management. The conversation ranges from the hidden histories of early options traders to how options theory now shapes everything from portfolio insurance to oil well investments to mega-sized chip plants. They close by reflecting on how options theory has become fundamental to modern decision-making far beyond trading floors, revolutionizing how we think about and manage uncertainty across the entire economy.

Transcript and links: https://www.mercatus.org/marginal-revolution-podcast/quest-price-options

Stay connected:

• Follow Alex on X: https://x.com/ATabarrok
• Follow Tyler on X: https://x.com/tylercowen

See Alex and Tyler's recent posts on Marginal Revolution: https://marginalrevolution.com/

Chapters

• 00:00 - The puzzle of pricing options
• 03:46 - Louis Bachelier's contribution
• 09:52 - Enter Paul Samuelson
• 15:05 - Black, Scholes, and Merton
• 27:05 - Kassouf, Thorp, and cashing in on options theory
• 32:28 - Other applications of options pricing theory

Recorded 4/12/2024