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

part of everyday trading life. even more importantly, Black and Scho-
les pointed a way forward for modeling other derivatives contracts, 
too, which rapidly grew at the IMM as businesses sought new ways of 
protecting themselves against currency risk. Between the IMM and 
the cBoe, Black and Scholes found a world that was perfectly poised 
to take advantage of their new ideas.
the options pricing formula that Black, Scholes, and Merton discov-
ered was equivalent to the method that thorp had worked out in 1965 
for pricing warrants — though thorp used a computer program to 
calculate options prices, rather than derive the explicit equation that 
bears Black’s, Scholes’s, and Merton’s names. But the underlying ar-
guments were different. thorp’s reasoning followed Bachelier’s: he ar-
gued that a fair price for an option should be the price at which the 
option could be interpreted as a fair bet. from here, thorp worked 
out what the price of an option should be, assuming that stock prices 
satisfy the log-normal distribution osborne described. once he had 
a way of calculating the “true” price of an option, thorp went on to 
work out the proportions of stocks and options necessary to execute 
the delta hedging strategy.
Black and Scholes, meanwhile, worked in the opposite direction. 
they started with a hedging strategy, by observing that it should al-
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Physics Hits the Street 
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ways be possible to construct a risk-free portfolio from a combination 
of stocks and options. they then applied cAPM to say what the rate 
of return on this portfolio should be — that is, the risk-free rate — and 
worked backward to figure out how options prices would have to de-
pend on stock prices in order to realize this risk-free return.
the distinction may seem inconsequential — after all, the two argu-
ments are different paths to the same model of options prices. But in 
practice, it was crucial. the reason is that dynamic hedging, the basic 
idea behind the Black-Scholes approach, gave investment banks the 
tool they needed to manufacture options. Suppose you are a bank and 
you would like to start selling options to your clients. this amounts 
to selling your clients the right to buy or sell a given stock at a prede-
termined price. Ideally, you don’t want to make a risky bet yourself —
your profits are going to come from the commissions you will earn on 
the sales, not on the proceeds of speculation. In effect this means that 
when a bank sells an option, it wants to find a way to counterbalance 
the possibility that the underlying stock will become valuable, without 
losing money if the option doesn’t become valuable. Black and Scho-
les’s dynamic hedging strategy gave banks a way to do exactly this: 
using the Black-Scholes approach, banks could sell options and buy 
other assets in such a way that (at least theoretically) they didn’t carry 
any risk. this turned options into a kind of product, something that 
banks could construct and sell.
Black stayed in chicago until 1975, when MIt wooed him back to 
cambridge. for a few years, academia seemed like the perfect fit for 
Black. He could work on whatever he liked, and at least in the early 
heyday of exchange-based options trading, it seemed he could do 
no wrong. He was an academic celebrity of the highest order, which 
brought both respect and freedom. His personal life, however, was a 
growing disaster: his (second) wife, Mimi, hated their chicago life, 
which was an important part of the decision to move back to cam-
bridge, nearer to her family. But the move east didn’t help much. In-
creasingly alienated at home, Black devoted more and more time to his 
work, branching off now in new directions. He began to work on gen-
eralizing cAPM to try to explain cycles in the economy: why, in a ra-

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tional world, would there be periods of growth, followed by periods of 
contraction? this led him to a new theory of macroeconomics, which 
he called “general equilibrium.” He also launched a crusade against the 
accounting industry, which he considered backward and unhelpful to 
investors.
But these other strands of his work were terribly received. It was 
as though Black had used up all his luck and timing with the options 
paper, and the string of other papers on derivatives and financial mar-
kets that followed it. His work on macroeconomics in particular was 
out of step with the times. economists in the 1970s and 1980s were 
deeply engaged in an ongoing debate about economic regulation and 
monetary policy. on one side were the chicagoans; on the other, the 
Keynesians, who favored government intervention throughout the 
economy. General equilibrium was a third way, thrust into a bipolar 
community. Black found himself attacked, and then ignored, by both 
sides. no one would publish his papers. His colleagues began to write 
him off as irrelevant. In less than a decade, he went from outsider to 
idol, and then back to outsider. By the early 1980s, Black was fed up 
with academia. He wanted out.
In december 1983, robert Merton, Black’s old collaborator from 
the Black-Scholes days, was doing consulting work for the investment 
bank Goldman Sachs. Merton was doing at Goldman what Black and 
Scholes had been doing at Wells fargo back in 1970: bringing in the 
new ideas from academia and trying to implement them in a practical 
setting. In this capacity, he argued to robert rubin, then head of the 
equities division, that Goldman Sachs should hire a theorist, an aca-
demic of its own, at a high enough level of the company that the new 
ideas would have a chance to seep through the culture. rubin was con-
vinced, and so Merton went back to MIt, brainstorming who among 
their current crop of graduate students he would recommend for this 
important position. Merton asked Black for his advice and received a 
surprising answer: Black wanted the job himself. three months later, 
Black left academia for a new job at Goldman Sachs, to organize a 
Quantitative Strategies Group in the equities division. thus he be-
came one of the first quants, a new kind of investment bank employee 
with an intensely quantitative and scientific focus, as interested in in-
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