For developing "a pioneering formula" for the pricing of stock derivatives that is used worldwide, Professors Robert C. Merton of Harvard University and Myron S. Scholes of Stanford University will take home the Nobel prize for economics, said the Royal Swedish Academy of Sciences Tuesday.
If you're in a mutual fund these days (and who isn't?), you're probably in derivatives, thanks to Merton and Sholes. The pair became a booming business by crafting a reliable pricing method and standardizing, as it were, the currency of the game.
But have they greened the financial landscape or legitimized market dynamite?
A derivative is a bet, called an "option," on the future performance of a stock. If you own a volatile stock, purchasing options on it can provide you with a hedge against a downturn or reserve you a great seat for an upturn; thus softening the risk of an investment.
Buying options without the stock to back it up, however, is speculative gambling, pure and simple, and the derivatives thruway is littered with some very fat corpses. Britain's Barings bank in 1995; Orange County in 1994. Today, bad derivatives investments have sent Pacific Rim economies reeling.
"Intelligently used, they serve a constructive purpose by reducing risk," says TIME Business correspondent Bernard Baumohl. "They protect you. But if they're bought foolishly or desperately, in the scramble for a windfall, they increase exposure. And you can pay the price."
The recent high-profile disasters — and in Asia, the chilling possibility of a domino effect brought on by one nation-sized default — have some thinking "junk bond" and demanding that the Federal Government step in with laws requiring companies to disclose the extent of their exposure in the derivatives market. Fund managers, along with Alan Greenspan, say that's a recipe for disaster: the market moves too quickly for a company's position to parse intelligently in a quarterly report. In other words: Once you give your money to a pro, you'll probably sleep easier not knowing what he does with it.