Against the Gods: The Remarkable Story of Risk (61 page)

Options bear a strong family resemblance to insurance policies and
are often bought and sold for the same reasons. Indeed, if insurance
policies were converted into marketable securities, they would be
priced in the marketplace exactly as options are priced. During the
time period covered by the premium payment, the buyer of an insurance policy has the right to put something to the insurance company at
a prearranged price-his burned-down house, destroyed car, medical
bills, even his dead body-in return for which the insurance company
is obliged to pay over to him the agreed-upon value of the loss he has
sustained. If the house does not burn down, if the car never has an accident, if the policyholder enjoys perfect health, and if he lives beyond
his life expectancy, he will be out the premiums he has paid and collects
nothing. The premium itself will depend on the degree of uncertainty
surrounding each outcome-the structure of the house, the age of the
car (and its drivers), the policyholder's medical history, and whether the
man is a coal miner or a computer operator. The derivatives we call
options, by expanding the variety of risks that can be insured, help to
create Kenneth Arrow's ideal world where all risks are insurable.

Derivatives are not transactions in shares of stock or interest rates,
in human lives, in houses vulnerable to fire, or in home mortgages. The
product in derivative transactions is uncertainty itself. That is why options on
Microsoft cost more than options on AT&T, why earthquake insurance
is more expensive in California than in Maine, why the lenders to the
Confederate States were able to extract such onerous terms, and why
bankers worry about a decline in mortgage rates.

Black and Scholes set down their ideas about option valuation in an
article that they mailed in October 1970 to The Journal of Political
Economy, a prestigious journal published by Chicago University. The editors promptly rejected the paper, claiming that Black and Scholes had put too much finance into it and too little economics.*
Harvard's Review of Economics and Statistics was equally prompt in returning the paper. Neither publication even bothered to have a referee review it. The paper finally saw the light of day in the May/June 1973 issue of The Journal of Political Economy, but only after two influential members of the Chicago faculty had interceded. The article turned out to be one of the most influential pieces of research ever published in the field of economics or finance.

In one of those strange coincidences in which events seem to happen in bunches, the Chicago Board Options Exchange opened for business in April 1973, just one month before the Black-Scholes paper appeared in print. That exchange, more familiarly known as the CBOE, began its operations in the smoking lounge of the Chicago Board of Trade, the established center for trading in commodities. The CBOE, for the first time, provided traders in stock options with standardized contracts and with market-makers who gave the options liquidity by standing ready to buy or sell them on demand. The CBOE also promised strict regulation of trading practices as well as prompt, public reporting of all transactions.

On the first day of trading, 911 options changed hands on 16 individual stock issues. By 1978, daily volume had climbed to an average of 100,000 contracts. By mid-1995, a million stock options were changing hands daily. Another 300,000 options were trading on four other exchanges around the country. With each option representing a hundred shares of stock, activity in the option markets is significant relative to the volume on the stock exchanges themselves.

The CBOE now boasts one of the most technologically sophisticated trading centers in the world. It consists of a spacious trading floor, a basement with an acre and a half of computers, enough wiring to reach twice around the Equator, and a telephone system that could service a city of 50,000.

There was a second coincidence. At the very time the BlackScholes article appeared in The Journal of Political Economy and the
CBOE started trading, the hand-held electronic calculator appeared on
the scene. Within six months of the publication of the Black-Scholes
model, Texas Instruments placed a half-page ad in The Wall Street
Journal that proclaimed, "Now you can find the Black-Scholes value
using our ... calculator." Before long, options traders were using technical expressions right out of the Black-Scholes article, such as hedge
ratios, deltas, and stochastic differential equations. The world of risk
management had vaulted into a new era.

In September 1976, Hayne Leland, a 35-year-old finance professor
at Berkeley, had a sleepless night worrying about his family's finances.
As Leland tells the story, "Lifestyles were in danger, and it was time for
invention."'

Necessity is the mother of invention: Leland had a brainstorm. He
would singlehandedly overcome the intense risk aversion that dominated
the capital markets in the wake of the debacle of simultaneous crashes in
both the bond market and the stock market in 1973-1974. He set about
developing a system that would insure investment portfolios against loss in
the same way that an insurance company protects a policyholder from loss
when an accident occurs. Insured investors could then take on the risk
of carrying a large proportion-perhaps even all-of their wealth in
stocks. Like any option holder, they would have unlimited upside and
a downside limited to nothing more than an insurance premium.
Sugarplums began to dance in Leland's head.

By dawn, he was convinced that he had the whole thing figured
out. "Eureka!" he shouted. "Now I know how to do it." But after he
got up and faced the day, he was beset by a host of theoretical and
mechanical difficulties. He went immediately to the office of his friend
Mark Rubinstein, a Berkeley colleague who Leland knew could be
trusted with his secret. Rubinstein was not only a keen theoretician and
a serious scholar; he had had experience trading options on the floor of
the Pacific Stock Exchange.

Groggy but manic, Leland laid out his scheme. Rubinstein's first
reaction was, "I'm surprised I never thought of that myself." He be came an eager collaborator, to the point where the two men, at this
very first meeting, agreed to form a company to market their product,
which would be called, naturally, portfolio insurance.

As Leland described it, portfolio insurance would mimic the performance of a portfolio that owns a put option-the right to sell an
asset to someone else at a stated price over a specific period of time.
Suppose an investor buys 100 shares of AT&T at 50 and simultaneously
buys a put on AT&T with an exercise price of 45. No matter how low
AT&T may fall, this investor cannot lose more than five points. If
AT&T drops to 42 before the option expires, the investor could put the
stock to the seller of the option, receive $4500, and go into the market
and buy back the stock at a cost of only $4,200. The put under these
circumstances would have a value of $300. Net, the investor could lose
no more than $500.

Leland's notion was to replicate the performance of a put option by
what he called a dynamically programmed system that would instruct a
client to sell stocks and increase the cash position as stock prices fell. By
the time the stocks hit the floor that the client has designated-45 in
the AT&T example-the portfolio would be 100% cash and could suffer no further loss. If the stocks went back up, the portfolio would reinvest the cash on a similar schedule. If stocks never declined at all below
the starting price, the portfolio would enjoy all the appreciation. Just as
with a plain-vanilla put option, details of the dynamic program would
depend on the distance from the starting point to the floor, the time
period involved, and the expected volatility of the portfolio.

The distance between the starting point and the floor was comparable to the deductible on an insurance policy: this much loss the policyholder would have to cover. The cost of the policy would be in its
step-by-step character. As the market began to fall, the portfolio would
gradually liquidate but would still hold some stock. As the market
began to rise, the portfolio would start buying but would still be carrying some cash. The result would be a portfolio that underperformed
slightly in both directions; that underperformance constituted the premium. The more volatile the market, the greater the underperformance
premium, just as the premiums on conventional insurance policies
depend on the uncertainty of what is insured.

Two years later after that fateful meeting, Leland and Rubinstein
were ready to go, convinced that they had cleared away all the snags. They had had many adventures along the way, including a catastrophic
error in computer programming that had led them to believe for a time
that the whole idea was impossible. Rubinstein started playing the system with his own money and was so successful at it that he was written up in Fortune magazine. Marketing began in earnest in 1979, but the
concept turned out to be hard for two academics to sell. They brought
on John O'Brien, a professional marketer and an expert in portfolio
theory; O'Brien landed their first client in the fall of 1980. Before long,
the demand for portfolio insurance was so intense that major competitors entered the field, notably the leading portfolio-management group
at Wells Fargo Bank in San Francisco. By 1987, some $60 billion dollars in equity assets were covered by portfolio insurance, most of it on
behalf of large pension funds.

Implementation was difficult at first, because handling simultaneous
orders to buy or sell several hundred stocks was complicated and costly.
In addition, active portfolio managers of pension funds resented having
some outsider give them orders, with little or no warning, to add to or
sell off parts of their portfolios.

These problems were resolved when the market for futures contracts on the S&P 500 opened up in 1983. These contracts are much
like the farmer's contract described earlier, in that they promise delivery at a specified date and at a prearranged price. But there are two
important differences. The other side of the S&P 500 futures contract
is an organized, regulated exchange, not an individual or a business
firm; this has long been the case with futures contracts on commodities
as well. But unlike tangible commodities, the 500 stocks in the S&P
index are not literally deliverable when the contract matures. Instead,
the owner of the contract makes a cash settlement based on the variation in the index between the signing of the contract and its maturity.
Investors must put up cash with the exchange each day to cover these
variations, so that all contracts are fully collateralized at all times; that is
how the exchange is in the position to take the other side when an
investor wants to buy or sell a futures contract on the index.

The S&P futures have another attraction. They give an investor an
effective and inexpensive method of buying or selling a proxy for the
market as a whole, in preference to trying to unload or load up on a
large number of securities in a limited period of time. The investor's
underlying portfolio, and any managers of that portfolio, remain un disturbed. The index futures greatly simplified the mechanics of carrying out portfolio insurance programs.

To the clients who signed up, portfolio insurance appeared to be
the ideal form of risk management that all investors dream about-a
chance to get rich without any risk of loss. Its operation differed in only
one way from an actual put option and in only one way from a true
insurance policy.

But those differences were enormous and ultimately turned out to
be critical. A put option is a contract: the seller of the AT&T put
option is legally bound to buy if the owner of the option puts the
stock. Put options on the CBOE require the seller to post cash collateral to be certain that the potential buyer is protected. Insurance companies also sign contracts obliging them to make good in the event of
a claim of loss, and they set aside reserves to cover this eventuality.