The Physics of Wall Street: a brief History of Predicting the Unpredictable

Physics Hits the Street 
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in finance. He had a Phd, but in an unrelated field. none of this mat-
tered. chicago wanted him.
chicago wasn’t working on a hunch that Black’s work would become 
important. the faculty there had some inside information: options 
were about to become a really big deal — and a formula that allowed 
investors to price them would prove essential. two major changes to 
U.S. and international policy were in the works, both centered in chi-
cago, that would soon revolutionize the derivatives industry. Having 
someone like Black on one’s team could only help.
the first major change took place on october 14, 1971, just a few 
weeks after Black arrived in chicago. the Securities and exchange 
commission (Sec) gave the go-ahead to the chicago Board options 
exchange (cBoe), the first open, dedicated options market in United 
States history. options had been around for hundreds of years, and 
they had been traded in the United States, often in the guise of war-
rants, since at least the middle of the nineteenth century. But they had 
never been traded on an open market before. economists in chicago 
had been agitating for the Sec to remove barriers to an open options 
exchange for years, until finally they convinced the chicago Board of 
trade (cBot) to convene a committee to consider the possibility, in 
1969. the head of that committee was James Lorie, a faculty member 
at the University of chicago business school; later, Lorie and Merton 
Miller were essential in writing the report on the public impact of an 
options exchange that would become a major part of the cBot’s pro-
posal to the Sec in March 1971.
the cBoe and the Black-Scholes paper were greenlit within 
months of each other; two years later, the cBoe opened for trading, 
just a month before the Black-Scholes article would appear in print. 
on the first day of trading, nine hundred options were traded on six-
teen underlying stocks. But volume grew at an astonishing rate: well 
over a million options were traded in 1973 alone, and by october 1974, 
the exchange began seeing single days in which as many forty thou-
sand options were traded, with regular volume above thirty thousand. 
Within a decade, this number would reach half a million. And com-
petition from other exchanges popped up quickly: first the American 

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Stock exchange announced it would begin trading options, followed 
quickly by the Philadelphia and Pacific stock exchanges. In January 
1977, the european options exchange was established in Amsterdam, 
modeled on the cBoe. options trading was suddenly a big business, 
and, at least at first, investors were anxious to learn as much as they 
could about the new instruments. Black, Scholes, and Merton quickly 
became household names, at least in finance.
the second fortuitous policy change, as far as Black’s career was 
concerned, occurred almost simultaneously with the creation of the 
cBoe, though its impact on Black was slower. once again, chicago’s 
influential economists, and especially the famous monetarist Milton 
friedman, were behind the initiative. In 1968, when nixon was elected 
president, friedman wrote him a letter urging him to abandon the so-
called Bretton Woods system. Bretton Woods, named for the town in 
new Hampshire where the system was devised in July 1944, was the 
international monetary agreement put in place at the end of World 
War II. the Bretton Woods conference led to the creation of the In-
ternational Monetary fund (IMf) and the International Bank for re-
construction and development (now part of the World Bank). More 
important for our story was the fact that under the Bretton Woods 
system, major world currencies were valued at fixed exchange rates, 
based on the value of the U.S. dollar (and ultimately on gold, because 
the dollar was freely exchangeable for gold, at least for foreign govern-
ments). changes in these exchange rates were infrequent, involving a 
long diplomatic process.
By 1968, however, when friedman wrote to nixon, the Bretton 
Woods system was beginning to show cracks. the main problem was 
that there simply wasn’t enough gold in the world to back the explo-
sion in postwar international trade. While the United States held most 
of the world’s gold supply, gold continued to be traded on the open 
market, where its price could fluctuate. As long as the United States 
and its allies could keep open-market gold prices in line with the Bret-
ton Woods price, there was no problem. But if the price of gold on the 
open market rose too high, as it naturally would with growing demand 
and a limited supply, there would be a risk of a run on the dollar (in 
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t h e p h y s i c s o f wa l l s t r e e t

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Physics Hits the Street 
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the sense of a rush to convert dollars to gold), as foreign governments 
sought to settle their own debts by buying U.S. gold and selling it for 
a profit on the open market — in which case the system would simply 
collapse. Such a rush in fact occurred in late 1967, which was the impe-
tus for friedman to write his letter. But for a thinker like friedman, the 
Bretton Woods system was ill conceived from the start: it was hopeless 
for governments to try to set exchange rates at all. exchange rates, like 
anything else, should be determined freely in an open market.
nixon didn’t listen to friedman at first, but by 1971, with increased 
spending in vietnam accelerating the accumulation of U.S. debt, he 
saw the writing on the wall. first West Germany and Japan pulled 
out of the Bretton Woods agreement and announced their currencies 
would no longer maintain parity with the dollar. then, rather than 
wait for the world economy to collapse, nixon administered the coup 
de grâce to the Bretton Woods system by ending the convertibility of 
U.S. dollars to gold. over the next years, the fixed exchange rates gave 
way to floating rates, creating a system whereby the relative prices of 
currencies were determined on the open market.
Meanwhile in chicago, Leo Melamed, the chairman of the chicago 
Mercantile exchange (cMe), another futures exchange that had spun 
off from the cBot in the early twentieth century, saw that global 
fiscal policy was in flux. following a hint from friedman, Melamed 
launched a new exchange of his own in May 1972, called the Interna-
tional Monetary Market (IMM), for trading futures contracts in for-
eign currency. As long as the Bretton Woods system was in place, trad-
ing currency futures wasn’t very interesting because currency values 
could change only through a laborious and public process. But once 
the exchange rate was allowed to float and be determined by open-
market trading, futures markets became essential. Most important 
was that companies, and especially banks, could use currency futures 
to protect themselves against unexpected changes in currency values. 
Suppose that a company in the United States contracts with a com-
pany in the United Kingdom to send a shipment of cowboy boots in 
exchange for payment in pounds on delivery. the agreement is made 
at a particular time, but the payment won’t come in until the cowboy 

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boots hit Britain. And in the meantime, the pound could change in 
value, so that the U.S. company’s profits (in dollars) would be lower 
than they were when the contract was made. to protect against such 
changes, the U.S. company could sell a futures contract for the amount 
it plans to receive when the shipment arrives, effectively eliminating 
the risk that the currency might change unexpectedly.
What does the IMM have to do with Black and Scholes’s options 
pricing formula? At first glance nothing — but within a few years, fu-
tures trading at the IMM had expanded to include new derivatives 
based on currencies, including options. Because currency risk is an 
important part of any international transaction, currency derivatives 
very rapidly became essential to the international economy. And once 
again, as at the cBoe, the Black-Scholes model became an integral