We could say that two events in 1973 changed financial markets.
- The CBOE (Chicago Board Options Exchange) starts trading.
- The Black-Scholes Model for pricing options (most simply the right to buy or sell a security at a future date) was published.
So yes, we had the CBOE and an options pricing model.
But it took the Texas Instruments (TI) SR-52 to bring the two together. Because the SR-52 was a programmable handheld calculator, the son of a CBOE trader was able to enter Black-Scholes. Quick to see the potential, TI then added a “Securities Analysis Module” which Dr. Scholes said was unauthorized. Disagreeing, Texas Instruments pointed out that the formula was in the public domain and that he could buy the calculator when he requested one.
Where are we going? To the impact of financial innovation.
In a paper that is six years old but still relevant, former Brookings economist Robert Litan used four key functions of finance to group financial innovations. To his list, we could add Black-Scholes and the capabilities of TI calculators.
You can see below that Dr. Litan correlates an innovation with productivity and the GDP.
Selected Financial Innovations and Their Impacts
Our Bottom Line: Production Possibilities
Through production possibilities frontiers, we can illustrate economic growth. With the frontier displaying the most that existing land, labor and capital can produce, the goal is to shift the curve to the right.
When a financial innovation like the SR-52 increased the potential of labor in options markets, we can hypothesize that it shifted the PP curve to the right.
A Production Possibility Frontier:
Updating Dr. Litan’s list, which financial innovations would you add?
My Sources: H/T to Timothy Taylor and his always interesting Conversable Economist for alerting me to the Andrew Lo paper which led me to the somewhat controversial Litan paper on financial innovation and to an original Black-Scholes paper. Please note that parts of today’s Bottom Line were previously published in an econlife post.