Black-Scholes is Dead

Black-Scholes is dead and the libertarians at Google killed it with a new type of stock option. Black-Scholes, you may remember, is the formula derived by Fischer Black and Myron Scholes and published in 1973 based on research done by Edward Thorp, Paul Samuelson and Robert Merton. Merton and Scholes won the Nobel Prize for Economics in 1997 for the work, which estimates the worth of a stock option to its holder.

It’s a complicated piece of mathematics. You need to use partial differential equations to derive the formula yourself or you can use an online calculator to solve the equation to value your options. But even with the help of an online calculator it can be tough going for the financially disinclined.

And it’s not perfect. It’s an estimate that can be artificial and is based on only a limited set of historical data.

That can leave options holders scratching their heads as to the true value of their compensation package.

It’s also difficult for CFOs, who now have to record options as an expense. There’s wiggle-room in the formula to set the cost of options at different levels based on what assumptions are made. Because the options expense basically comes down to expectations of the stock’s future value, CFOs are left on the horns of a dilemma. They can either: (A) Set the expense of options low by estimating a low future value of its shares, thereby signaling to the market they have low expectations for the company’s performance or (B) Estimate a high future value of the company’s shares and get stuck with a big options expense.

Valuing stock options is not a fun place for CFOs to be. And because there are subjective assumptions that go into the math for it, there’s a fair chance we’ll see a shareholder suit at some point contenting they were mislead by inaccurate accounting of options.

Google has solved many of these problems by taking the Nobel-prize-winning mathematics out of the equation. The company established a secondary market for its stock options that will allow employees to auction their options to financial institutions.

The market will set the price of the stock options. When financial institutions bid on the options, they will bake all of their knowledge, assumptions and predictions of the future into the price they’re willing to bid. Black-Scholes becomes a starting point for valuing the options, not the final arbiter.

This will allow Google employees to find out what their options are worth without having to resort to complicated mathematics. CFO George Reyes is going to sleep better at night knowing he can always resort to the market to give him the options value rather than having to choose between low-balling the future worth of the company and getting hit with a big options expense. And financial institutions will love having a new tool to help them hedge or leverage their bets on Google.

Creating a market for stock options makes everyone better off.

Even academics are going to be happy with Google’s plan. No doubt some enterprising doctoral student is already gearing up to compare the auction clearing price an option commands with its value as predicted by Black-Scholes. Who wouldn’t want to tweak a formula that won its inventor the Nobel Prize?