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“We need to think about creating a new, more dynamic accounting system … and new risk management systems to handle [market] shocks,” Nobel Laureate Myron Scholes told Kellogg students Oct. 26.

Myron Scholes

Flexibility: The key to a better financial system

Nobel Prize-winning economist Myron Scholes shares his views on the systemic factors that contributed to the financial meltdown

By Matt Golosinski

10/29/2009 - “Debt is like a cancer,” Nobel Laureate Myron Scholes says. “You have to proactively do something to reduce it.”

But what?

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That was the chief question raised by Scholes, co-author of the seminal Black-Scholes option pricing model, during an Oct. 26 lecture at the Kellogg School. The 1997 Nobel Memorial Prize winner in economic sciences assessed debt’s precipitating effect on the global liquidity crisis. 

Several hundred Kellogg students and faculty members listened as Scholes offered his views on systemic factors — including the heavy leveraging of debt financing and what he called serious errors by ratings agencies — that contributed to the financial meltdown.

“We need to think about creating a new, more dynamic accounting system … and new risk management systems to handle [market] shocks,” said Scholes, who argued that more economic flexibility would help reduce — though not eliminate — such destabilizing events.

One simple form of flexibility, Scholes offered, is a “put” option on an asset. This type of financial contract provides liquidity when it is needed most and defines that liquidity for a specific payoff, he explained.

In response to some claims that derivatives eliminate risk, Scholes commented that they do not “get rid of risk, but just move it around.”

The role of government, Scholes added, should be to anticipate shocks, watch for early warnings and act proactively, rather than reactively with tactics such as bailouts, which he says only perpetuate the boom-bust cycle. At the same time, he admitted that data to generate the models that could help in this effort were lacking. He expressed concern, though, that many policymakers and practitioners preferred reactive approaches because they tend to generate greater short-term returns, albeit at the expense of intermediate and longer-term prospects.

Scholes also outlined the strengths and limitations of key risk management tools, including diversification, reserves and insurance options. Each of these can help mitigate risk, but come with embedded costs, he said. For instance, building a cash reserve — “keeping your powder dry” against a crisis — helps reduce risk, he noted. But the challenge is knowing just how much to build this cushion. An additional problem, Scholes said, is that this risk management strategy is static, not dynamic.

Indeed, Scholes, now the chairman of Platinum Grove Asset Management and a professor emeritus at Stanford University, pointed out that the entire economic system has become less flexible in recent years, increasing the potential risk to the economy.

Scholes went on to discuss the differences between Bayesian inference models and information theory — two competing theories of how people make sense of the world, including the marketplace. The main friction between the camps, he said, involves a difference in focus: the Bayesian framework emphasizes the typical event, while information theory concentrates on unusual occurrences. Each frame has ramifications for economic modeling, Scholes said.

“We don’t really know what world we’re in. Is the tiger tamed or simply fed and sleepy?” Scholes asked, referring figuratively to systemic risk. “If he’s tamed, then we don’t care if it’s walking around.”

After his lecture, which was sponsored by the Zell Center for Risk Research, Scholes gave a guest lecture on risk management in hedge funds to Kellogg students in the Asset Management Practicum.

“Myron Scholes is justly famous for his pathbreaking work on option pricing and derivatives … but his work is extremely varied,” said Robert Korajczyk, the Harry G. Guthmann Professor of Finance, as he welcomed the speaker to the class.

Scholes’ seminal work, written in collaboration with Fischer Black, includes a 1973 Journal of Political Economy paper titled “The Pricing of Options and Corporate Liabilities,” which introduced the famous pricing model.