The Royal Swedish Academy of Sciences has decided to award the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 1997, to Professor Robert C. Merton, Harvard University, and to Professor Myron S. Scholes, Stanford University, jointly. The prize was awarded for a new method to determine the value of derivatives.
This sounds like a trifle achievement – but it is not. It touches upon the very heart of the science of Economics: the concept of Risk. Risk reflects the effect on the value of an asset where there is an option to change it (the value) in the future.
We could be talking about a physical assets or a non-tangible asset, such as a contract between two parties. An asset is also an investment, an insurance policy, a bank guarantee and any other form of contingent liability, corporate or not.
Scholes himself said that his formula is good for any situation involving a contract whose value depends on the (uncertain) future value of an asset.
The discipline of risk management is relatively old. As early as 200 years ago households and firms were able to defray their risk and to maintain a level of risk acceptable to them by...