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Fischer Black and the Revolutionary Idea of

Fischer Black and the Revolutionary Idea of Finance

Perry Mehrling
2005
T2 374 pages · about 6h 14m to read OL13730653Wgoodreads

The option-pricing theory the fund's Nobel laureates were trading on.

Summary

Mehrling, a monetary economist, wrote an intellectual biography of Fischer Black that is as much a history of modern finance as a life. Black co-authored the option pricing formula, worked at Arthur D. Little, taught at Chicago and MIT, and spent his last years at Goldman Sachs.

Mehrling's argument is that Black is misunderstood as a mathematician who produced a formula. Black's actual position was more radical: he took the capital asset pricing model as literally true and applied it to everything, including monetary policy, business cycles and international finance, which produced conclusions that neither Keynesians nor monetarists could accept. His monetary work argued that money is passive, that the quantity of money is determined by demand rather than by the central bank, and that a modern financial system with unrestricted banking would produce a price level indeterminate by any monetary aggregate. Almost nobody agreed and most of it was never published in mainstream journals.

The book also covers Black's paper on noise, which argued that markets need traders acting on noise for liquidity to exist, that prices are efficient only within a factor of two, and that most of what looks like information trading is not.

Mehrling is careful about the finance and about Black's disagreements with Fama, Merton and Samuelson. The book requires some familiarity with financial theory. Its value for investors is the account of what the capital asset pricing model implies if taken seriously, and Black's noise argument, which remains the most useful short statement of how efficiency and inefficiency coexist.

Key takeaways 7

  1. Black took the capital asset pricing model as literally true and applied it beyond securities to money, business cycles and international finance, which is why his monetary work was rejected.
  2. Markets require traders acting on noise rather than information, because without them there would be no liquidity and no trading at all.
  3. Prices are efficient only within a wide band, which Black estimated as a factor of two, and precision beyond that is not available.
  4. The quantity of money in a developed financial system is determined by demand rather than by the central bank, which makes monetary aggregates uninformative.
  5. Business cycles reflect mismatches between the capital stock and what consumers want, not monetary shocks or demand failures.
  6. The option pricing formula was a byproduct of applying equilibrium reasoning to a warrant, not a mathematical exercise in its own right.
  7. Working at an investment bank gave Black access to the practical questions that academic finance had stopped asking.

Who should read it

Investors with a theoretical bent who want the intellectual history of modern finance through its most independent thinker, particularly on noise and market efficiency.

Where it sits in the reference 3

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Who recommended it 1 · 1 direct

Chai with Pabrai bookshelf — Investing and Capital Allocation

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