From the February 2014 issue of Futures Magazine • Subscribe!

Futures industry: A story of crisis and opportunity

University of Chicago fed industry growth

One historic example of the University of Chicago’s originality is as follows: “[B]y 1950, [Friedrich] Hayek’s market economics were so completely out of fashion that when he sought a full-time academic job in the United States, …only one university was willing to hire him,” and that was the University of Chicago, according to the PBS documentary, The Commanding Heights. Hayek later became a Nobel Laureate.

Another Nobel Laureate associated with the University of Chicago was Myron Scholes, who earned his doctorate at the university. “Scholes and his co-author, the late Fischer Black, derived the [eponymous option pricing] formula in 1970. They submitted the article to the Journal of Political Economy, and it was rejected without even being reviewed. Merton Miller and Eugene Fama, two financial economists at the University of Chicago persuaded the [journal’s] editors to take another look, and the journal published the article in 1973, recounted an encyclopedia entry on Scholes. Fama joined Scholes this year in receiving a Nobel Prize.

The timing of the journal article on pricing options was fortuitous. The bear market of 1973-1974 was so financially destructive that market participants became open to the idea that perhaps there was a “scientific and rational way to tame the markets, to use the power of mathematics to conquer risk,” explained the BBC documentary, The Midas Formula.

At this time, the University of Chicago already had a tradition of training graduates with the skills that would become useful in the new field of mathematical finance. Many of these graduates would later staff up Chicago’s proprietary trading firms from the 1970s onward and deepen Chicago’s already diverse group of financial risk-takers.

The Chicago Board Options Exchange (CBOE) “opened for business just one month before the Black-Scholes paper appeared in print,” noted Baeckelandt’s CFA presentation. Mathematically trained graduates were able to turn crisis into opportunity. Stan Jonas, a derivatives expert, recounted to The Midas Formula documentarians: “Word of the [Black-Scholes] model began to circulate, particularly amongst people in the University of Chicago and more particularly amongst the option traders, and literally before the official publication of the model, traders had effectively started to program the model and begin to use it to trade [at the CBOE].”  The CBOE thereby became the first options exchange in the world, and the first exchange to establish an industry, noted Baeckelandt’s presentation to the CFA Society of Chicago.

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