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04/25/05
Dr. Alex Castaldo Reviews Book on Fischer Black

Fischer Black and the Revolutionary Idea of Finance by Perry Mehrling, to be published by Wiley in May 2005

This book is a biography of Fischer Black (1938-1995), probably best known for the Black-Scholes theory of options, the Black-Derman-Toy model of interest rates, as well as the Treynor-Black and Black-Litterman approaches to portfolio selection. He also attempted to revolutionize macro-economics, but his ideas in this area did not gain any traction in academia, causing him to quit his position as a tenured professor in 1985 to join Goldman Sachs.

My personal knowledge of Fischer Black is very limited. He was of course one of the most respected professors at MIT, though my fellow students were not overawed by him and gave him the nickname "fisch". This book also adopts an informal tone, referring to him throughout by his first name. It isn't a lack of respect, but the recognition that he was a one of a kind, an odd duck to whom normal conventions did not apply. When most professors dressed informally, "fisch" was always dressed in a three piece suit and a tie. I remember him as very tall, with a big forehead, and a friendly but unemotional facial expression that reminded me of "Dr. Spock" from Star Trek. He spent most of his time locked in his office, communicating with his secretary just outside via an intercom. The book pretty much confirms and extends this impression I had of him.

This book overlaps somewhat with Capital Ideas by Bernstein. Some of the same characters appear, such as Jack Treynor, William Sharpe, Myron Scholes, James Lorie and many others who played a role in developing modern finance. But of course this book focuses much more on Black. The "revolutionary idea" mentioned in the title is of course the CAPM.

Black's PhD was in Applied Math, not Economics or Finance. Having a different educational background seems to have helped his originality and creativity, but it was also a barrier to having some of his ideas accepted by the economics profession. He developed most of his ideas by himself, writing a series of numbered memos to himself between 1967 and 1976 entitled Financial Notes. At least the beginning of all his later published work is contained in these notes. In particular he had derived the Black-Scholes partial differential equation by June of 1969, although he didn't at that time know how to solve it. But to him a more important idea was that all of economics should be rebuilt from the ground up based on equilibrium theory and the CAPM. He set out to do this for Monetary Theory and concluded "monetary policy has virtually no effect, either in the long run or in the short run, on the the level of economic activity or the price level". He sent his paper to Milton Friedman for comment and received this friendly reply: "I enjoyed reading it and am glad to report that in my opinion its conclusions are utterly fallacious. [...] Let me urge you to reconsider your analysis and not let yourself get misled by a slick argument, even if it is your own". Fischer Black was not discouraged by this and many other rejections and he continued to develop his unorthodox macroeconomic theories until his death. The book does a good job of trying to explain his reasoning and popularize his views. Time will tell how they will fare, but it seems to me that they will remain outside of the mainstream. They do have some similarity with the rational expectation theory of Lucas and the Real Business Cycle ideas of Prescott and Kydland, but even those authors disagreed with Black's theories.

When Black joined Goldman Sachs as VP of Trading and Arbitrage, one of his first actions was to tour the trading room and confiscate all technical analysis books that he could find. How big was his contribution at Goldman? The author is ambivalent: on the one hand "he often seemed unable to connect with the concerns of the typical client", and "most [people at Goldman] couldn't see that he added much value", on the other hand he was responsible for hiring a number of other quants who made contributions and he had the confidence of the top people at the firm (Rubin, etc.) who found his inputs helpful.

Never very good at managing people, Black gave one newly hired employee a copy of Cox and Rubinstein's option book saying "read this and ask me any questions. If you thoroughly understand this book you'll know more about options than I do". He then retreated to his office and did not have any dealings or provide any guidance to this employee for several months. Anecdotes like this make this book fun to read, though I doubt that it will be a best seller. I certainly enjoyed it.