interview with myron s. scholes_jaf_2009

8/7/2019 Interview with Myron S. Scholes_JAF_2009

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Pioneers of Finance

Interview w ith Myron S. Scholes : 1997 NobelLaureate in Economic Sciences"For a new m ethod to determine the value of derivatives."^

Interviewed by Charles Smithson and Betty Simkins

On July 9'^ 2009. Charles Smithson and Betty Simkins (co-editors of the Journal of Applied Finance, JAF) interviewedMyron S. Scholes for this issue of JAF. Myron Scholes. in collaboration w ith the late Fischer Black, developed a pioneeringformula for the valuation of stock options. Their methodology, together with the work of Robert C . Merton. has paved theway for economic valuations in many areas. This work has also led to the generation of new types of financial instrumentsan dfacilitated more efficient risk management globally. '

'Professor Scholes is cuetuly the Chaimian of Platinum Grove Asset Management and is also the Frank E. Buck Professor of Finance Emeritus, at theStanford University Graduate School of Business since 1996, In 1997, he was a co-recipient of the Alfred Nobel Memorial Prize in Economic Sciences "fora new tnethod to determine the value of derivatives". He is a Director of the Chicago M ercantile Exchang e, Dimensional Fund investors mutual funds, andAmerican Century (M ountain View) mutua! funds. Professor Schoies is widely known for his seminal work in options pricing, capital markets, tax policiesand the finaneial services industry and he is widely published in academic journa ls.Other past positions he has held (among others) are: Frank E. Buck Professor of Financ e at the Stanford Un iversity Gradu ate School of Busines s from1983 to 1996: Senio r Research Fellow at the Hoover Institution from 1987 to 1996; Principal and Limited Partner at Long-Term Capital M anage men t,L.P., from 1993-19 98; Managing Direc tor at Salomo n Brothers from 1991 to 1993; Edward Eagle Brown Professor of Finance at the University of Chicagofrom 1974 toi 983; and Assistant and Associate Professor of Finance at MIT's Sloan School of Managem ent from 1969 to 1974. He reeeived a PhD in1969 Trom the University of Chicago. He also holds honorary doctorate degrees from th e University of Paris. McMaster University. Louvain University.and Wilfrid Laurier University.


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130JA F Editors: What type of work and research are youcurrently doing?

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Sch oles: Over the last number of years, I have been thinkingabout liquidity and why the price of liquidity changes. Thishas been an impo rtant research topic for me. I have alsobeen thinking about some of the valuation issues such asvaluation models and method ologies as anchors. There arereasons that valuations differ from the standard models thatwe used in the past. I have also written some pap ers, as manyacademics and some practitioners have done, on financialcrises and have been thinking about what we can learn fromthem. I have been thinking about macroeconom ics - why itis successful; why it fails; what it actually tries to achieve.

I have also been thinking about areas in terms of theinvestment m antra ofthe future; what it is for pension funds;what it is for investors generally; and the evolution goingforward.I have been running a hedge fund with others calledPlatinum Grove Asset Management and we have beenoperating the fund since M ay 2000. We concentrate in thefixed income area and for the last number of years I havebeen directing the research projects for our equity strategies.I have been more involved with the quantitative equity sideofthe business - working in conjunction with my team andbuilding a framework; understanding the philosophy of howwe are making money and why people are paying us for our

services.JAF Editors: It certainly has been a fascinating time periodfor you with the fund starting in May 2000.Seh oles: Yes, that was a good time to start the business.Obviously, in 2008 after Lehman collapsed the fixed-ineomemarkets were in turmoil. It has been an experience that all ofus would have preferred not to have gone through.

Risk management systems work and apply but sometimespeople criticize academ ics or criticize the philosophy of riskmanagem ent. Risk management systems tells you how tothink about risk and manage risk. But if you have extremeevents such as those that occurred subsequent from 2007through 2008 (in particular with the collapse ofthe worldfinancial system), it is very hard to build any risk m anagementsystem that would protect any entity against the shocks thatwere experienced at that time, unless your risk managementsystem said you are always 100 percent in cash.JAF Editors: How would you define the economicenvironment in 2008? Is crisis the right word?Scholes: Shocks or crises have occurred m yriad of timesover the last 50 years. This shock is was many times themagnitude of other shocks I have seen in my professional

JOURNAL OF APPLIED FINANCE - ISSUES 1 & 2, 2009career. The consequences of this shock and the advent ofgovernment intervention far exceeded my expectations.This has led to a complete change in the way society thinksabout the economy, financial institutions, and innovations.

This shock was a large one. If you think about the powerlaw of shocks, where you have the logarithm o fthe effect ofthe shock (or magnitude) regressed on the logarithm of thenumber of shoc ks, the coefficient is somewhat con stant. Thismeans that although the number of shocks (earthquakes)that occur are large, they have small magnitude effects.Occasionally, there is an earthquake that occurs that hasa gigantic etect similar to what we have seen in financialmarkets. The magnitude of the 2008 shock was gigantic.We seldom see the collapse ofthe global financial system.It basically means that in finance, there is a shock that is amonster and we just ca n't plan for it.JAF E ditors: If you w ere to identify the one thing - or atmost three things that were most responsible for the crisis,what would they be? What role did regulation play? Did itcause (or accelerate) the crisis or did it cushion the crisis?Sch oles: Well, that's a good question, W e are still in the crisisand not necessarily out of it as of yet. fCnowing exactly thecause of tbe crisis is difficult to pinp oint. We can rush tojudgment but even with airline crashes, we appoint a boardthat examines why an airline crashes or why the space shuttleblows up. Sometimes your initial views of what happenedturns out to be fallacious, The post mortem analysis shouldoccur to determine the cause.

Can we learn from th is? I think when tryin g to learn froma crisis that we have to not mix understanding with eitherretribution or governance. We have witnessed a tremendou samount of anger against Wall Street and the financial world.When you have anger, it can lead to wrong assum ptions andwrong governance solutions. Wrong governance solutionsmight actually be very costly to society.Backing up to your question - First, I think that we haveto answer why the entities decided that risk was tame and

as a consequence of deciding that risk was tame, taking onadditional leverage or taking on riskier projects withouthaving enough optionality or flexibility built into theirprograms. Operating flexibility and financial flexibilitybecame much less. Why was that the case? Becausevolatility was low and deemed to remain low going forward,entities reduced their optionality. With low volatility, thevalue of an option is lower and that mean s that many entitiestook actions and activities that reduced their financingflexibility and operating flexibility.Why is it the case that individuals thought that theycould have more consumer debt, housing debt, or student

debt? Obviously in some cases, they felt that the valueof human capital was secure and that they could then take


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SiMKINS & SutTHS ON - MVRO N S . SCHOLES INTERVIEW

greater consum er loans or student loans. Housing was thesame way. Why was it that private equity firms leveredthemselves to such an extent? Why was it the case thatmany financial entities cut back on financing flexihility andoperating fiexibility?The main question that has to be asked is the volatilityquestion. Why was the world thought to be tamer orcalmer that caused actionsto be taken? Spreadsfrom higher yieldinginstruments compressed to50 basis points. Now afterthe fact., everyone couldsay; 'This was stupid.'or 'Bad models' or 'badinputs to models." A lotof criticism has blamedmodels for not working.Models did work. I thinkwe have to distinguishmodeling from inputsto mod els. It might bethat the inputs to modelsare incorrect such asmisassumptions aboutcorrelations or bad assump tions about volatility. Basically.the inputs used assumed that the world was calmer.

Why was the world thought to be calmer? Tha t's thequestio n. We found out after the fact that the world wasnot as calm as we thought it was. Measured volatility waslower but that does not mean that real volatility was low.To me, this is the one thing to try to understand. Was it thegovernment and regulation and rules that made us believethe world was tame? Was it Mr. Greenspan and otherewho said that derivatives could spread risk around theworld? Was it the idea that through the"great m oderation",macroeconomics understood how to control recessions orbooms to smooth out the economy?Was it that the you nger generation had not experienced bad

times for a long w hile? As a Bayesian, we alter our priorsthrough information and end with a posterior. A posterioris based on observations so we could end up in a view thatthings were now und er control. We had suffered a 1987 stockmarket crash and we got through it. There was the 1990scrash where the emerging market countries defaulted. Therewas a 1994 problem in Mexico and the emerging marketcountries; the 1997 problem in Asian countries; a 1998problem with Russia and Long Term Capital Management;the 2000 dot.com bubble bursting; unfortunately, the 2001attacks on the World Trade Center and the market collapsesafter that; the 2002 corporate scandals; the 2003 creditproblems where General Motors almost defaulted; and thenwe had interest rates that had fallen to one percent. We came

I think when try ing to learn from a crisisthat we have to distinguish retributionor anger from governance. We haveseen demonstrated up to March atremendous amount of anger againstWall Street and the financial world.When you have anger, it can lead to wrongassumptions and wrong governancesolutions. Wrong governance solutionsmight actually be very costly to society.

131out of all of these problems with little effect on the economy.I was reading Mr. Buffett's annual report and two thingshe said are: First, you can't use historical data to predict thefuture; and second, he said in a subsequent paragraph - Wehave come out of all crises in the past.Look at the history of our world, globalization, whatwe have done, and the relative peace we were having.

Political unrest seemsto be more insular. Somaybe it was the casethat we kept gatheringdata and coming to theconclusion that thingswere more sanguine.But they w eren't.Second and ancillaryto this - We did developmany new technologiesand instmments thatallowed us to satisfy thedemands that individualsand corporations hadfor less flexibility. Thedemand was there andwe had the physical

capab ility to create it. Were the derivative structures andthese new instruments/technologies part ofthe problem?Third, with less volatility entities such as the banks triedto keep up with their brethren and increased their risk totarget retum on equity. Basically as they increased risk totarget retum on equity, they increased leverag e. You haveless flexibility; fewer reserves; less agility; more productsthat will have to be held for the longer haul; less reliance onmarkets; less flexibility to adjust your o perating po licies. Sowith lower volatility, do you target retum on equity to get ahigher retum? One way to achieve a higher retum on equityis picking great investment projects and activities. Anotherway is to use leverage. And conditional on things workingou t. leverage is terrific. But unfortunately, if thing s don't

work out, you have to reduce leverage - and it is very costlyto adjust leverage or sell assets. In a crisis, leverage is likea cancer.So yes, the financial markets did innovate and create newways to satisfy dem and. Going back to my original focus,1 think a major reason for the crisis is that volatility wasdeemed to be tamed. This was false. ; ;

JAF Editors: Let's discuss the valuation questions now.It seems to me that valuation is getting trendy. Valuationseems to be in the press a lot lately and in thinking aboutvaluation as a more general thing, I have been going back totextbooks looking to see what students are being taught. Itseems to me there ought to be some kind of key principles


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132that drive valuation. When you think about valuation, whatprinciples would you suggest as the key principles?Sch oies : One aspect is that I have never been satisfiedabout our valuation criteria in the sense that, we know ina certainty world that the casb flows that are certain arediscounted by the bond rate and that gives us a present valu e.But no one has ever proved in academics or practice thatwhen we move from the world of certainty to the world ofuncertainty, that we can just take expected values on the cashflows; then discount the cash flows back to present value byusing a discount rate that includes a risk premium howeverdetermined. One determines a risk premium or uses thecapital asset pricing mode! if you believe in it (which I don'treally believe in), or some sort of beta adjustment or a moread hoc measure such as a three factor model (e.g., Fama-French 3 factor model).

I think the field of valuation, other than relative valuation,is not defined fully. The interesting part about valuation isthat it is an anchor on decision m aking. If we look at cashflows, the interesting issue for me is real options and howthat affects decision making once you gamer information.There are the shocks that occur and the resultant adjustmentcosts that afect your valuatio ns. Most oft he literature onvaluation assumes that we are in a putty world. We make aninvestment today, we build a factory such as General Motorsdoes or hire employees and then if things don't turn out, wecan take these buildings or employees and just compressthem into putty again and start over again at the end of theperiod. As a first approximation, valuation has to assumehow you want to adjust conditional on things happening.The valuation models that I learned and taught were basedon this putty view or the view that the cost of adjustmentwas very low - or that there was no learning after making aninitial investment decision.

My world is optionality, the value of options, and tbecost to adjust. For exam ple, in making a valuation decisionthe values that we see in the market might be aflectedby liquidity. It could be affected by the adjustment costsnecessary under certain states ofth e world. If it were thecase that there were no adjustment costs to change my mind,then I would have a different v aluation. Many of bankingand insurance organizations have gone bankrupt because ofthese adjustment costs. The interesting part is if I can specifythe form of contract that I need to protect myself, then I candefine liquidity cos ts. For examp le, if I own a stock and Ibuy a put option on that common stock, when the stock goesdown, the value of my put increases to offset the losses onmy underlying stock. So I protect myself, it self liquidates.I created a way to go from clay to putty and protect mydow nside. The put option is the value of liquidity because ittells me exactly the cost of getting out of my positions and

JOURNAL OF APPLIED FINANCE - ISSUES 1 & 2, 2009liquefying them. How ever, I was able to specify the form ofmy protection I needed in advance.

If we don't know all the states of nature that could ariseand under what states we will need protection, then it is veryhard to value that liquidity or that flexibility that we need inour investment program. Valuation technology has to at leastattempt to look at the states of nature under which we aregoing to want to change decisions and what the costs will beof making those changes in those states. On ce I define thestates, I can then go forward and price the option that 1 wantto buy and subtract that or think ofth at as part ofthe cost ofmaking my investment.

So the first principle is: What are the cash flows of theassets 1 am investing in? I also think first order is "wha tare the adjustment costs?". Will I want to change my mind?Do I want to add more investment? Do I want to hedgemy risks associated with the tails of my investment? Takethe housing ma rket as an illustration. For those who tooklevered loans and have no income, they have no flexibility.They have to immediately sell their home or default on theirloans. Many other home owners who would like to adjustor change their house size given their circumstances are notdefaulting but are buying an option to provide liquidity andwill actually try to liquidate their hom es later. They ha veflexibility to stay the course . This affects all investmentdecision s. As a result, all valuation is affected by the timesequence or evolution.Another dimension of valuation that has been fascinatingto me has been the trade-off between the costs of hedgingand the cost of equity. We incorrectly assume that equity isnot costly. You can gamer eq uity from others if you needit for the projects that have positive present value. Butthere is a deadw eight cost of equity. Hedging is a costlyalternativ e. If we can hedge our risks in the finn, then weneed less equity. So there is a cost of hedgin g and a cost ofequity. That tradeoff is going to affect valuation. W hat canwe hedge? Hedging system atic risk is much less expensivethan hedging risks that are idiosyncratic. If we can hedgegeneralized risks or transfer generalized risks, we reduce the

amount of equity that we need because equity is a generalpurpose risk cushion. You dip into it when need ed and withhedging, we need less of a cushion.To make money, every business has to concentrate.You can't diversify across everything and make money.The valuation necessitates that the risks taken are moreso than jus t the concentrated risk that you know. It alsoinvolves interest rates, currencies, government activities, ortechnologica l advances in other areas . These are ancillaryrisks. If the entity takes on these ancillary risks, the entityhas to have more equity capital. If the entity can reducethese ancillary risks and concentrate more on the risks that

it knows by hedging these ancillary risks, less capital is


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& SMITHSON - MYR ON S . SCHOLES INTERVIEW 133needed.

It is the same question that I have always had about thefinancia l institutions. Do they make money by carryinginventory or do they make money by tuming over inventory.My belief has always been that they make money by tum ing

fiind that invests in riskier assets, can promise $1 forever? Itis impossible. The probability is that the funds will need tobreak that dollar as we saw happen over the crisis time. Also,the stable value products offered by insurance companies areinvested in equities or high-yielding bonds like CDOs that

promise a higherA lot of criticism has blamed models for notworking. Models did work. I think we have todistinguish modeling from inputs to models. Itmight be that the inputs to models are incorrectsuch as misassumptions about correlations orbad assum ptions about volatility. Basically, theinputs used assumed that the world was calmer.Why was the world though t to be calmer? Th at'sthe question. We found out after the fact tha tthe world was not as calm as we thought it was.Measured volatility was lower but that doesnot mean that real volatility was low. To me,this is the one thing to try to understand . Wasit the government and regulation and rules thatmade us believe the world was tame? Was it Mr.Greenspan and others who said that derivativescould spread risk around the world? Was itthe idea that through the"great moderation",macroeconomics understood how to controlrecessions or booms to smooth out the economy?

stocks as comparedto bonds. With a long horizon stocks are virtually certain tooutperform bonds and you will get high retums. This is theexpected retum and this is higher for any horizon becausethere exists the risk of a shortfall. Suppo se 1 have a 30-year horizon and I ask my fund manager whether to investin stocks or bonds and he advises me to invest in stocks.Following that. I go to an investment bank and tell them thatmy advisor asked me to invest in stocks over bonds becauseit's virtually certain that stocks will outperform bonds overthe 30-year horizon. But, if I would want to guarantee this

over mventory.but manyfinancial entitiesbelieve that youmake money byholding inventoryas well. I thinkthat mistakes aremade in valuationbecause of thebelief that if youhold the inventorythat providesa liquiditypremium becauseit is expensive toliquidate. In theshort-run. onemakes money.Take the financialinstitutions theyare making moneyin many instancesby buyingilliquid assets orholding illiquidinventory and thatilliquid inventoryprovides superiorretums a lot ofthe time. butoccasionally theysufter a big loss asthey have to liquidate. That has to be taken into account inthese valuation m odels. Taking the expectation in valuationmodels doesn't necessarily mean that you have taken intoaccount cost ofthe tails or the risk in the tails.

There are myriad illustrations of this. Let us examinestable value produ cts. Mon ey Market funds are oneexamp le of a stable value produ ct. Anoth er stable valueproduct is annuities at insurance companies. These stablevalue products promise one dollar and the ability to liquidateyour money market fund at any time . Insurance annuitiesguarantee you will always get your money back or you getyour money back plus a guaranteed 3% or 2% interest rate.But the prom ise is much riskier than though t. How can it bethe case in equilibrium, the stable valued dollar m oney market

rate of return thangovemment bonds.This is becausethey don't take intoaccount the factthat they would notbe able to fulfill atcrisis times. So.many insurancecompanies wentbroke or effectivelywent broke becausethey offered theseannuities. Butwe are missing aleaming here. Theidea of promisedretums, promisedyields, promisedways of doingthings is not a surepayment.Take anothersituation of pensionfund investing.They believe thatthey are longhorizon investors.They then considerit better to invest in


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134Ifor sure, I would like to buy a "chooser" option whichwould allow me to choose the maximum of stocks andbonds.^ Since it is virtually certain that stocks are going tooutperform bonds over a 30 year horizon , a chooser option is

not going to cost me very much. But in reality, this is goingto be very expensive. A chooser option could cost 40% ofthe valuation of your investment. What it means is, if youhave a long horizon, the expected returns are higher but thedistribution of payoffs could be very diffused. You mighthave large shortfalls to protect and that is very expen sive.So this virtually certain thing doesn 't m ean very much.In reality, we are not learning credit valuation and we alsosomehow do not teach valuation. We don't take into accountequity adjustment costs, flexibility costs, promises versusrealization, self insurance, etc. Self insurance is not free.To value an investment correctly at least in tbe investment

criteria, if you are self insured you should include the cost ofthe self insurance, the worth of tbe insurance in your deisionmaking.JAF E ditors: When you m entioned liquidity cost, it makesme think about the recent stress test conducted by the Fed onthe 19 large banks. Mr. Bemank e made a point that the valuethey wanted was the hold-to-maturity value rather than thecurrent fair market value. It actually surprises me to thinkthat an asset can have two different values. What is yourtake on this?Scholes: If the government is going to assure that all bankswon't fail, then it wouldn't have to liquidate any of tbe assetsin the interim. That assumption w ould obviously imply adifferent stress test. If T tell my children that 1 am tbere totake care of them, the actions that they take will definitelybe different than the actions they will take when they arefinancially on their own forthe rest of their lives. It certainlyis a different operating decision. So, the hold-to-maturityvalue is to discount cash flows based on tbe ability to hold-to-maturity. It is also based on the assumption that I am ableto do so.

Let us assume that the assumptions are correct and I don 'thave to liquidate. This ignores the fact that banks mighthave to liquidate assets before they mature. Therefore, youwould certainly get a different value than if I am goingto adjust for holding liquid assets. I would have to valueit less considering the state that I would have to liquidatethat investment. But, if I have my father who tells me thatI would never have to liquidate, in that case I would value^Chooser options are exactly what the name suggestions, an option thatis transacted in the present that allows the holder to choose what type ofoption it is al a specified future d ate, Mo.st comm only, it allows the holderto choose wh ether their option is a call or a put. In the context of thisinterview, it means the holder can choose between an investment in eitherstocks or bonds after the fact.

JOURNAL OF APPLIED FINANCE - ISSUES 1 & 2, 2009my assets more highly than in a case where 1 would have toliquidate and potentially incur large costs to do so. If 1 holdilliquid assets, I am likely to make money in the short run,however, it's like insurance without loss reserves. You can'tkeep selling insurance policies thinking that you are m akingmoney without taking account payout possibilities. So,the idea of valuation goes back to the initial questions youasked on the principles. Now, the unintended consequenceis obviously how you control the behavior of your children.If my children were going to think that I would be there tosupport them financially, then they would take more andmore risks. But, if they assume that they would have torely on themselves, they will keep more cash reserves, moreliquid assets, more equity capital etc to support themselves.If conversely they don't have to worry about anything, theydon 't have any reserves at all. They borrow a lot; they takea lot of risks. Is that the transfer function you want? Is thatthe transfer you want from a parent to the child?JAF Editors: You have given our readers a whole lot oftopics for research. We are now at a period in this crisissituation where they are beginning to propose reforms tomaking rules and regulatory rules in general. Recognizingthat we are still in very early parts of this, what is yourfeeling about the direction it is taking?Scho les: One interesting point about finance is tbat we knowinstitutions change a lot. We know the functions of financewill be static: transac tions, making investm ents, saving fortbe future, risk transfer, risk management, price discovery,reducing information costs, and asymmetric information.All these are areas of finance are static whether it's Slovakiaor China. But the institutions change dramatically becausewe try to find lower cost ways to satisfy these functions,perform savings functions, or risk transfer functions, etc. Tbeproblem with regulations is that it is much easier to regulateinstitutions but it is not easy to regulate functions. This isbecause people think in terms of activities while entities thin kin terms of products. You may say that we could regulatethe subprime product, but the individual thinks in terms ofbuying or financing a house. That is an activity but not aproduct whether you buy this mortgage or that mortgage.Regulators tbink in terms of regulating institutions andproducts that they regulate: individuals and finance thinkof activities and functions. The difficulty is therefore theleakage of the system. The more you tend to regulate theinstitution, tbe evolution and cost functions change to suchan extent that basically the institution you are regulating nolonger perform the functions. So, the principles of regulationbave to be based on the rules ofth e game.

I would love to study the fonTi of debt contracts. Is tbedebt contract that we built for the last 200 years the correctcontract? Has that really worked as an institutional form? I


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SrMKiNS & S MI TH S ON - MY R ON S . S C H OL E S IN TE R VI E W

would like to see new debt contracts for banks. Look at thecost reduction for society if banks use debt contracts thatare convertible automatically into equity on the event of asystemic event. Govem ment wo n't have to bailout the banksand debt holders wil! be more cautious as they wouldn't bebailed out. 1 would like finance to understand what newinnovations should occur as a result of this shock. Are therethings we can be smarter about to reduce adjustment coststo shocks? We would alt agree that if there are fi-audulentpractices, we should try to stop them. But don't we have alot of mie s on the books already that actually stop fraudulentpractices? Creating more mies does not necessarily mean

13that they have solved the problem. If people are not educatedthey would always claim that sophisticated products are toosophisticated. It reminds me of throwing out inventions ifyou don't understand things. Rather we should educateourselves to use them. Maybe we have a Porsche; it is verybeautiful and fast. We cannot say that the P orsche should notexist but rather people who plan to drive it should leam to doso . and those who cannot should not drive it.JAF Editors: Thank you very much for your time thismoming.


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interview with myron s. scholes_jaf_2009

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