Most of you here are familiar with the Black-Scholes formula since it’s imbued in every possible textbook of corporate finance 101 under the sections of option pricing. The infamous black-scholes-merton formula was created by Nobel laureates (now unfortunately also blamed for the credit crunch) who used advanced calculus to build a closed form solutions on how to price options which are widely traded on the CBOE today. But most of you don’t know that the science behind options was created over 70 years before it came to practice by a man name Bachelier.
Louis Bachelier was born in Le Havre in 1870, and after education at secondary school in Caen he lost both his parents and had to enter the family business. It was during this period that he seems to have become familiar with the workings of financial markets. In 1900 at Sorbonne, Bachelier defended his thesis Théorie de la Spéculation(Theory of speculation) before Henri Poincaré (the famous mathematician who created the millennium problem labeled as the Poincare Conjecture). Although the concepts are now proudly celebrated as one of the greatest inventions in financial economics of all time, they didn’t impress Henri and he gave it less than a top mark, and called it not qualified to receive the highest honors. But he did mention it as ‘very interesting and original’.
Bachelier had hit upon two of the most important concepts of modern finance -- the random walk of securities prices and the pricing of market volatility over time. Five years later in 1905,Albert Einstein used the same diffusion equation to show that the random walk of small particles colliding with even smaller particles helps explain the atomic structure. Einstein was almost universally credited with a mathematical methodology that Bachelier had developed in his thesis and applied to derivatives markets.
In 1926 Bachelier tried to get back into the society of elite mathematicians, but was turned down on account of a critical report from Paul Lévy (1886-1971), then a professor at the prestigious École Polytechnique. However, Levy, a few years later, was apparently surprised to find other mathematicians citing Bachelier's work, so in 1931, Levy wrote a letter of apology to Bachelier and they were reconciled. But unfortunately, the tragedy behind the process was that regardless of their reconciliation, it was too late to fix the perceived problems around Bachelier’s work, and he failed to continue to build upon his work to advance what we know today as financial engineering.
Even with these sophisticated models at hand, we still are faced with the reality that even the best formulas to incorporate past and present conditions can’t predict the future. What Wall Street doesn’t understand is that regardless of whatever tools that mathematicians build, it’s how they are used that matter at the end.
I’ll leave it up to you to decide whether tools Bachelier built were used for good or bad, but as far as remembering mathematicians goes, Bachelier was a significant hero.
