Last week, I attended the Conference on Financial Innovation at Vanderbilt University. The purpose of this meeting was to commemorate the 35th anniversary of the publication of two of the most important and influential articles in finance: one by Fischer Black and Myron Scholes, and the other by Robert Merton, both on the theory of option pricing. Scholes and Merton were awarded the Nobel Prize in Economics in 1997 for these and other related research contributions (Fischer Black probably would have been so named had he been alive in 1997 but he passed away in 1995 and the Nobel is not posthumously awarded). Since the conference was given in the honor of Scholes and Merton, quite appropriately both men were present at this meeting.

Options are commonly referred to as “derivative” securities because their values derive from the values of other assets. For example, the Chicago Board Options Exchange (CBOE; coincidentally founded in the same year as these papers were published) makes a market in exchange-traded call and put options on individual stocks as well as on various equity market indices; e.g., S&P 500, DJIA, NASDAQ, etc. Before Black-Scholes and Merton, an important unresolved question in finance concerned how to price and manage risk, and Black-Scholes-Merton provides a remarkably robust framework within which to do just that.

Besides spawning substantial literatures concerning options theory and applications, these papers were also seminal in the sense that they also helped spawn a number of important financial market innovations. The conference sessions featured papers that either build upon or apply the Black-Scholes-Merton framework to the following set of “real world” topics: volatility markets (e.g., VIX), real estate markets, credit markets, index option markets, real options (which involves the application of options theory to corporate decision-making (e.g., the “optionality” of investing or divesting in a capital asset), and valuing managerial compensation contracts.

There was also a panel discussion that featured Merton, Scholes, and Leo Melamed. Not surprisingly, the panel discussion addressed the financial crisis in some depth. Merton picked up on the idea (originally floated by MIT’s Andrew Lo) of creating a “financial NTSB” for the purpose of having experts do some serious analysis of the financial crisis. The problem with political exercises such as the ones that are slated for this coming week is that Congressional hearings held on the eve of a general election are not likely to provide appropriate forums for serious analysis; rather, they are designed primarily to fulfill various political objectives. There is an historical precedent for a financial NTSB; in the aftermath of the 1987 crash, a presidential commission called the Brady Commission (named after Treasury Secretary Nicholas Brady) was formed for the purpose of studying the causes of the 1987 crash and recommending various market reforms which were designed to help restore investor confidence (although in retrospect, a strong subsequent performance by the economy may have been more important than the Brady commission reforms in terms of accomplishing this objective). All three panel members expressed concern about the risk of unintended consequences which may stem from a failure to fully grasp the nature and scope of the crisis. Merton commented that now more than ever, we need more innovation, not less. However, in the rush to “do something” about the problem, a substantial re-regulation of the financial sector could very well undermine incentives for innovation, which in turn could have the unintended consequence of impeding the resiliency and vitality of the financial sector going forward (thereby rendering it all the more vulnerable to future crises).