By 1974, Brodsky began feeling restless at Model, Roland and sought to create his own identity, apart from his father. He made an unusual move, going to the American Stock Exchange. "In those days,” he says, "I was like a freak in a way—nobody had ever come to the Amex from a firm. People usually did the reverse.”
Weighing his options
Brodsky took a position as a government relations lawyer, but didn't stay in that role for long. A few months into his tenure, the Amex's board of governors looked with increasing interest at the business model of the CBOE. While the stock markets were in the tank—the Amex was trading less than a million shares a day—equity options were starting to pick up steam. "The Amex was concerned that the CBOE, by having options on, say, IBM, would take away their customers, who tended to be more speculative. Why buy a $3 stock on a company you've never heard of, when you could buy a call option on IBM at $3 a share? So all of a sudden, there was a mad dash to create a new option market to compete with the CBOE.”
Brodsky, having written the paper on the CBOE's rules a year earlier, was deemed an options expert and was tapped to run the project. It was a massive undertaking. The biggest obstacle: in-fighting among the Amex membership and staff. "Many people at the Amex resented the idea that we were trying to get into the options business,” he remembers. "It was looked at as a fringe business, highly speculative, and people who had been at the Amex a long time didn't want to do that kind of stuff.”
The Securities and Exchange Commission didn't help matters, delaying the Amex's application for more than a year. The regulator demanded that the Amex and the CBOE create a common clearing organization. The two reluctantly agreed, creating the Options Clearing Corp., which has cleared every U.S. exchange-traded option since.
|"At the time, someone said to me, ‘What's a nice guy like you doing in options?' as if I had really made a wrong turn down an alley.”
The Amex kicked off options trading in 1975, and slowly built its business. Shaking popular misperceptions was difficult at first. "At the time,” Brodsky remembers, "someone said to me, ‘What's a nice guy like you doing in options?' as if I had really made a wrong turn down an alley.”
By 1982, however, things had changed. Brodsky had built a stellar options business at the Amex, along with a reputation as a visionary in the new field of equity derivatives. The Chicago Mercantile Exchange, known by many at the time as a place to buy pork bellies, came calling with an intriguing proposition. It was preparing to begin trading futures contracts on the Standard & Poor's 500—and eventually options on those futures—and it needed to find someone with experience in equity derivatives to develop the project and manage a growing staff. The exchange offered Brodsky a job as chief operating officer. At 38, Brodsky found it too great to pass up.
Looking to the futures
The story of the Merc's wild success with the S&P futures program is legend by now, and Brodsky was a big part of the product's success. By 1985 he had become president and CEO of the Merc—a post he held until February 1997. During those years, the exchange enjoyed more success than it had, perhaps, in all its years before. Nowhere were the exchange's accomplishments more stunning than in equity derivatives. "I'm proud of the fact that while I was there we really grew stock indices,” he says. "We added the Nikkei index and the Nasdaq—I negotiated that with the National Association of Securities Dealers—which is now the second biggest stock index. And we had a great relationship with S&P—we did the S&P 500 and the mid-cap.”
In 1985, the market was abuzz with concerns about dramatic stock market volatility surrounding the so-called triple witching date, when quarterly futures, stock options and index options are settled. Triple witching had produced huge and unmanageable swings in the markets since the early 1980s, spooking investors. "It was creating a lot of problems with retail customers and companies,” he says, "because their stock would move four points at the bell.” Brodsky here functioned as the consummate point man, using his connections at the NYSE—including Robert Birnbaum, the NYSE's president, who had worked with Brodsky at the Amex, and Richard Grasso, then the executive vice president of the NYSE—to refashion the rules. Brodsky's solution: to settle the stock index futures at the opening of trading, allowing the NYSE to deal with the imbalances during the course of the trading day.
Brodsky's negotiating skills were called on again in the wake of the 1987 crash, one of the darkest periods in the Merc's history. Derivatives exchanges were routinely blamed for the crash, and a number of voices were calling for 50 percent margin requirements on futures, a requirement that would have crippled the Chicago exchanges forever.
Brodsky and Wayne Luthringshausen, chairman of the Options Clearing Corp., led the push for cross-margining in equity derivatives between the CBOE and the Merc. Brodsky's experience with the OCC—he had been on its board for seven years while at the Amex—was a crucial bridge in the two exchanges' efforts to hammer out an agreement. "We were able to work through all the legal thickets to get this done,” he says. "It now saves the industry millions in capital and margins each day.”
Brodsky's considerable success at the Merc bred contentment. But in late 1996, the CBOE approached him with an offer to replace Duke Chapman as chairman and CEO. Brodsky couldn't resist. "I really loved the options business and the equity business,” he says. "Although there were stock index futures at the Merc, they accounted for probably 20–25 percent of the business. At the CBOE, equity products were 100 percent of the business. I also loved the securities business itself—the sheer size of it. The number of brokers in our business compared to the number of brokers in the futures business is probably 25 times greater.”
Celebrating the CBOE's 25th anniversary in April 1998 was one of Brodsky's most enjoyable tasks. Among his favorite guests: Arthur Levitt, chairman of the SEC and former chairman of the Amex during Brodsky's tenure; Robert Rubin, then-U.S. Treasury secretary and a member of the CBOE's first board of directors; and Philip Purcell, chairman and CEO of Morgan Stanley Dean Witter, the massive broker-dealer whose voracious appetite for equity options has helped fuel the industry's stunning growth.
|"I feel vindicated that these little brochures and booklets we wrote in longhand are now textbooks and have become a standard part of investment training that people get in the universities.”
But with electronic upstarts such as the International Securities Exchange—which received SEC approval last month—on the horizon, Brodsky had his work cut out for him in his early days at the CBOE. In the last year alone, the CBOE has initiated multiple listings, capturing market share from its rivals; transformed itself from a market-maker system to a designated primary market-maker system; cut customer fees; and drastically beefed up its electronic trading capabilities. The result: daily trading volume has doubled. "We saw the ISE coming, and we felt we'd be better off practicing for the big game on a playing field where we felt we were extremely strong as a way of honing our skills for even more competition,” he says. "Overall, we're quite pleased with the results.”
The options business clearly has come a long way. "The ways derivatives are being used today exceed the wildest expectations of the industry's pioneers,” says Brodsky. "Their use by individual and institutional investors as well as major dealers has created enormous opportunities for people to own and manage large stock positions that, without derivatives, would have been impossible—or prohibitive—to hold. Equity derivatives have had a dramatic and lasting impact on capital formation as we know it.”
Brodsky's work in the early days has clearly paid off. "I feel to a large extent vindicated that all this pioneering work we did years ago has paid off. These little brochures and booklets we wrote in longhand are now textbooks and have become a standard part of investment training that people get in the universities,” he beams.
The results of his work may be gratifying, but for Brodsky, the journey was the best part.
Every once in a while, a student finds a teacher who seems to know everything there is to know about the subject at hand. Mark Rubinstein never met such a person, so he set out to become that person. The same restless intellect that compelled him to spend hours in the dusty library stacks of some of the finest schools in the country eventually drew him to the roller-coaster ride that is the derivatives business. Along the way, he's amassed more nuts-and-bolts knowledge of how options markets work than just about anyone alive.
Rubinstein grew up in Washington state and attended the prestigious Lakeside School in Seattle. At a young age, he was captivated by the process of intellectual inquiry—a result Rubinstein credits to his father, who constantly challenged him to work through philosophical problems logically and systematically. Lakeside nurtured his curiosity, encouraging the youngster to learn simply for learning's sake.
Everything went downhill, he says, when he shuffled off to Harvard at 18 to study economics. "Harvard was disappointing,” he says. "There were wonderful professors, and you could attend smashing lectures, but there was little one-on-one attention.” His main complaint about the economics curriculum: his professors "assumed students didn't know any mathematics, and tried to explain everything in words,” he recalls. "I had a lot of trouble with that. Harvard wasn't very useful, I'm afraid.”
Not that his grade point average reflected his troubles. Rubinstein graduated magna cum laude in 1966, then bolted for his beloved West Coast, where he has remained ever since. He enrolled in the MBA program at Stanford, and briefly toyed with the idea of joining his father's business. But in 1968, Rubinstein saw that many new graduates were finding themselves on airplanes headed for Vietnam, so he decided to move to Los Angeles and pick up his Ph.D. in finance at the University of California at Los Angeles.
His decision to go to UCLA was a mixed blessing. "I didn't know it at the time,” he says, "but the places to be in the early 1970s were the University of Chicago and the Massachusetts Institute of Technology. UCLA was kind of a backwater.” Before long, Rubinstein recalls, he found that he knew just as much as many of his professors—and sometimes more. During his third year, in fact, he taught a high-level Ph.D. course to other Ph.D. students, earning a reputation on the West Coast as the guy who knew everything. But his stunning academic development wasn't merely the result of intellectual firepower.
|"It turned out that you could understand a discrete model without having to understand the mathematics.”
"At UCLA,” he says, "I decided to develop a complete bibliography of finance. I started in 1900, and noted 2,500 items from 36 journals. I organized them by topic and tried to see how things related to each other, and then I started to read them. I looked at all of them, read 500 very carefully and maybe 100 a few times. I was one of the few Ph.D. students who didn't wait to see what was assigned before diving in.”
His status as a walking compendium of finance theory helped him secure a teaching job at the University of California at Berkeley after graduating from UCLA in 1971. Apart from a brief stint as a visiting professor at the University of Washington in 1975, he's been at Berkeley ever since.
A model professor
Rubinstein's UCLA experience helped him in another important respect: while all the hotshots at Chicago and MIT were thinking in terms of mean-variance analysis, Rubinstein focused his approach to finance around a concept he'd kept with him since his days as an economics student: state-contingent prices. Also known as risk-neutral probabilities and Martingale measures, the state-contingent approach required that you be able to know what the price is today of a dollar in a given state in the future.
"I remember reading a paper in the 1970s complaining that the state-contingent-claim approach, while conceptually of some merit, was practically uninteresting, because how are you ever going to know what the price is today of a dollar in a given state in the future? Instead, it said, we should measure means, variances and covariances, which were the bases for the Capital Asset Pricing Model and mean-variance portfolio selection at that time. But it turned out that as time went on, it finally became practical to measure state-contingent prices, and that was because of options and derivatives. That's one of the reasons I got interested in derivatives. I saw that they were a way to measure state-contingent prices.”
In 1976, Rubinstein published his favorite paper, "The Valuation of Uncertain Income Streams and the Pricing of Options,” which showed how the Capital Asset Pricing Model as most people knew it was related to option-pricing models. "That relationship in discrete time hadn't been shown,” he recalls. "I was able to tie together two important lines of research in finance.” That same year, he taught what may have been the first university course on options in the United States.
Rubinstein then decided to write a book, and asked John Cox, a professor at Stanford, to collaborate. The book, finally published in 1985 as Options Markets, became the standard text used at top business schools. But by that time, Cox and Rubinstein had already changed the derivatives world.
As a side project, Rubinstein and Cox, along with Stephen Ross (now at MIT), published in 1979 a paper called "Option Pricing: A Simplified Approach,” which has turned out to be the most important paper written on options since the legendary Black-Scholes and Merton papers. It took the fancy mathematics of the Black-Scholes-Merton model and simplified things, offering something called the Binomial Option Pricing Model. "It showed in a very simple way the basic economics that underlay option-pricing theory,” Rubinstein says, "in a mathematically unadorned fashion.”
The model turns away from the continuous-time approach of Black, Scholes and Merton, with its numerous differential equations, and toward a discrete approach based on the simplest modeling of uncertainty, in which only two outcomes are possible before an investor can revise his portfolio (hence, the approach is binomial). "It turned out that you could understand a discrete model that would get you arbitrarily close on your computer to whatever Black-Scholes-Merton would say, quite easily, without having to understand the mathematics of actually going to the limit,” says Rubinstein. The result: a vastly more accessible model for options traders to use in the trenches.
Another benefit of the Cox-Ross-Rubinstein model was that, whereas Black-Scholes-Merton applied only to European-style options with no early exercise, the new model worked for American-style options as well. Since all the products traded at the Chicago Board Options Exchange at the time were American-style, the benefits of a model that could price them accurately were enormous—and undoubtedly helped fuel the options boom of the 1980s.
The business world awaits
Rubinstein made his first foray into the options business in 1976, becoming a market-maker at the Pacific Exchange the day it opened its doors. Around this time, a Berkeley colleague named Hayne Leyland approached him with a radical idea: to use options hedging strategies to hedge the portfolios of large financial institutions, via a system that looked remarkably similar to insurance. It was simply delta hedging writ large—instead of hedging a single equity, they would hedge an entire portfolio.
After some considerable tweaking, a company called Leyland O'Brien Rubinstein Associates was created in 1981 to sell portfolio insurance to financial institutions with large portfolios. "We didn't guarantee anything,” says Rubinstein. "We told our customers we'd do the best we could—this is our strategy, this is how it worked in the past. Originally, no one believed us. They thought it was a miracle—how could we give them most of the upside capture of investing in the Standard & Poor's 500 but take away the chance they'd lose? We said we could do that, more or less.”
For the better part of six years, they were right. By 1986, the company was managing $6 billion directly and $54 billion indirectly (some customers simply licensed LOR's software, paying the firm a small percentage of assets under management by the software). Some 30 competitors quickly flooded the market with similar products, and portfolio insurance was all the rage.
"I liked it because we weren't making claims we couldn't back up, and because it really was an extension of finance theory,” says Rubinstein. "We were trying to move the world away from static asset allocation, or the Capital Asset Pricing Model view of things, where you trade off the variance and mean of your portfolio without thinking to yourself, ‘If I can revise my position in the future, should I do something different today?' Our approach systematically considered the fact that you could change your portfolio tomorrow in determining what your decision today would be. That was really multiperiod portfolio selection, which I was very much into in my research at the time.”
|"Our customers thought it was a miracle—how could we give them most of the upside capture of investing in the S&P 500 but take away the chance they'd lose? We said we could do that, more or less.”
But the business crashed with a thud in October 1987, when a plummeting stock market caused unprecedented volatility in the equity derivatives markets. As stocks fell, holders of portfolio insurance flooded the derivatives exchanges trying to sell, short-circuiting the strategy. Many even began to wonder aloud whether portfolio insurance had caused the stock market crash, which caused the product to fall quickly out of favor among fund managers.
By 1989, Rubinstein was onto his next project, tweaking his concept of portfolio insurance at a company called Supershare Services Corp., which he cofounded. He tried to create a suite of listed contracts to replicate portfolio insurance. But the Securities and Exchange Commission was slow to approve the contracts. By the time approval finally came, the American Stock Exchange had developed its own version of the products, called Standard & Poor's Depositary Receipts, which quickly became the most successful derivatives traded at the Amex.
Rubinstein's experience in the business world wasn't what he had hoped it would be, but it hasn't derailed his academic career one bit. He's been a tenured professor at Berkeley since 1976, and continues to publish compelling work on derivatives at a breakneck pace—including some 15 titles in the last decade. In 1994, he wrote one of his favorite papers, "Implied Binomial Trees,” which, along with two other papers written independently around the same time, caused a stir in academic circles. In 1998 he published a textbook called Derivatives: a PowerPlus Picture Book, on his fascinating web site, www.in-the-money.com. Nowadays he's taking up the glove thrown down by behavioral finance. He's working on a paper called "Rational Markets: Yes or No?” which argues that puzzling market phenomena such as the overwhelmingly poor performance of stocks on Mondays since the Great Depression can be consistent with prices set in rational markets.
For Mark Rubinstein, finding the answers to such questions is a labor of love.
|Making the Derivatives World Safer
|Patrick de Saint-Aignan
There's perhaps no better example of the globalization of the derivatives business than Patrick de Saint-Aignan. Born and schooled in Paris before coming to the United States in the 1970s, Saint-Aignan has held senior posts at Morgan Stanley in New York, Paris and London, and was at the forefront of the firm's global swaps and risk management effortsa resume that alone would warrant Hall of Fame consideration. But his contributions to the field also include a critical role in the formation of the International Swaps and Derivatives Association, the organization that brought derivatives to the level of respectability in the financial world.
Saint-Aignan was born in Paris in 1948, just as the Marshall Plan was starting to help rebuild war-ravaged Western Europe. After secondary and university studies in his home city, he bounded off to the United States to study finance in Harvard's MBA program. In 1974, the ink had barely dried on his degree when he joined Morgan Stanley's corporate finance department in New York. Except for a three-month period in the 1980s, he has remained at Morgan Stanley ever since.
Saint-Aignan was among the first to work in the nascent eurobond market—setting the stage for a career in interest rate derivatives. "[The year] 1974 was disastrous in the eurobond market,” he recalls. "There were no more than 15 deals completed. An issue size of $25 million to $50 million was standard. The conventional avenue to funding, bank loans, was far more common.”
But the market's lean times were short-lived. In 1975 and 1976, eurobonds took off like a rocket, as more and more U.S. companies found it attractive to borrow overseas. In 1975, Saint-Aignan moved back to Paris to work in a small joint venture between Morgan Stanley and Morgan Guaranty Trust specializing in eurobonds. The office represented all of Morgan Stanley's European capabilities; its paltry staff numbered 30.
By 1977, eurobonds were even hotter, and financial institutions were increasingly choosing London as the center of activity. Saint-Aignan transferred to London, where he stayed for six months before returning to New York. Finally, he was able to give his passport a rest. In 1980, he joined Morgan Stanley's capital markets group, initially focusing on private placements and public debt issues. Things were about to change dramatically for Saint-Aignan—and for the financial world as a whole.
In 1981, the massive currency swap between the World Bank and IBM made headlines in the financial press, but capital markets players looked at the transaction as a one-of-a-kind deal. A year later, however, interest rate swaps began popping up more regularly. Saint-Aignan was intrigued by the new products and became one of the first players on the scene, ascending to the newly created role of swaps product manager in 1982. The products were thinly traded among a handful of banks and securities firms. The learning curve was steep enough within the market; outsiders viewed the products skeptically.
"Nobody knew at that time, or expected, that this product would shine among all other products and become so large,” recalls Saint-Aignan. "There was a significant comprehension gap, to put it mildly. It was the fringe of the capital markets, and its use initially was only focused on achieving lower funding costs for borrowers. Most people were simply using underlying financing with a swap to create an attractive funding package that could not have been achieved by direct borrowing in the desired currency or the desired tenor at the time.”
|"Nobody knew that swaps would shine among all other products and become so large. There was a significant comprehension gap, to put it mildly.”
Saint-Aignan helped build Morgan Stanley's swap business from the ground up, initially acting as the sole member of the New York swaps team. His most immediate challenge was to create a demand for the product. "First, people needed to understand the product itself, then its potential uses,” he says. "Eventually, people came to view swaps as a way to provide attractive investment returns. Later it got more generalized, obviously, as a risk management instrument, but it took many years. In the early days, we were preaching in the desert.”
At first, Morgan Stanley acted solely as an agent in the market, bringing together counterparties and structuring deals that fit everyone's requirements. "Putting everything together at the right time to achieve the respective clients' objectives was a fairly demanding discipline,” says Saint-Aignan. "It was a challenge because, if you're matching the needs of one client with the off-setting needs of another, those two needs have to come together at the same time. There was no room for saying, ‘Well, it works for one side today, but not for the other side, so we'll take one side and warehouse the position and then we'll be able to meet the other client's need tomorrow.' Our challenge was in getting all the stars and planets in the right alignment for a deal to be possible.”
But other firms, such as Citibank and Salomon, were taking another approach: They were acting as principals in swap transactions, assuming positions with certain counterparties and laying some off with others. Saint-Aignan realized that this was where the future lay for big investment banks. Unfortunately, his superiors at Morgan Stanley would not commit the private firm's then-scarce capital. By 1984, his fledgling swaps operation consisted of only 10 people. An offer from Merrill Lynch to run its growing swaps group—which was taking the "warehouse approach” and growing rapidly—enticed Saint-Aignan to leave in June 1984.
Evidently his exodus was a deep blow to Morgan Stanley. Three months later, the company decided to follow the warehouse model, and Saint-Aignan came back to run a newly integrated global operation. "I returned because I was always in love with Morgan Stanley,” he says. "And I had so many years invested in the firm, it made sense for me to go back.”
The new group was organized on a global basis, with main centers in New York, London and Tokyo. The company started to act as a principal on a one-off, as-necessary basis. But before long, Morgan Stanley had built a major swaps book. "At the time the focus was very much on being a customer-facilitation business, not one where you took directional interest rate risk,” he says. "The idea was risk mitigation, risk management. What we learned while managing our book was really the basis of sound risk management, and if we were able to do it for ourselves, we thought we could help our clients do it as well.”
Saint-Aignan grew increasingly cognizant of the need for transparency and standardization in derivatives markets. In 1985, he addressed these issues in an unusual meeting in Palm Springs, Fla. It would change derivatives forever.
The Palm Beach conference consisted of fewer than 15 people representing a handful of firms looking for a way to standardize swaps agreements. Because the burgeoning swaps business brought together securities firms as well as commercial banks from around the world, no single regulatory body or industry group could circumscribe all of the market's players. At the time, nonstandard contracts from such diverse players created more than a little uncertainty in the swaps markets.
"People were using different forms of confirmation and different forms of swap agreements, on the basis of ‘My document is better than your document.' Anybody with a little bit of foresight realized this was not the way to develop the market. The best thing to do was to develop the best standard form of agreement, with sufficient flexibility so that individual situations could be accommodated.”
|"People were using different confirms and swap agreements, on the basis of ‘My document is better than your document.' This was not the way to develop the market.”
Before long the group had a name, the International Swap Dealers Association (which eventually became the International Swaps and Derivatives Association), and by the next year had hammered out the first ISDA master agreement. Saint-Aignan sat on ISDA's board from its inception until 1991, and served as chairman from 1987–88. Under his leadership, the organization accomplished many things. Aside from increasing standardization, ISDA lobbied Congress to improve the legal standing of netting in the U.S. bankruptcy code. "If netting certainty wasn't achieved,” says Saint-Aignan, "there was a chance that a judge in bankruptcy court could cherry-pick the contracts, basically saying ‘I'm not going to recognize the contracts where I owe something, and I will recognize the transactions where I'm owed something.'” Thanks to ISDA's intensive lobbying, Congress amended the bankruptcy code to allow for netting, and other jurisdictions around the world followed suit. "Today, swaps are quite safe in virtually all jurisdictions,” he says proudly.
Risk manager supreme
In its early years, ISDA also created the ISDA survey, which provided invaluable information on the market's size and composition. ISDA's standardization and education efforts fit in perfectly with Saint-Aignan's dedication to improving market transparency. At Morgan Stanley, he recalls, "It wasn't good enough for us to feel we were running our activity on a well-managed basis. The swaps business wasn't a naturally transparent activity. It takes understanding, and books become quite complex. The whole management-reporting end of it is critically important—how you measure and report the risk. Achieving a degree of transparency so that senior managers were comfortable that the activity was prudently managed was an important undertaking and a big internal challenge.”
It was a challenge for which Saint-Aignan was well-suited. After passing on the business to his teammates and taking charge of the firm's debt capital markets group from 1991–93, Saint-Aignan began to focus more on risk management. From 1993–95, he went back overseas to head the Paris office, serving as president of Morgan Stanley SA. In 1995, he moved back to New York, to serve as head of firm-wide risk management. His experience at the forefront of the derivatives and risk management revolutions made him a natural choice for the position.
During that period he spent quite a bit of time working on the Group of 30's global derivatives study, a seminal document in derivatives history produced in 1993 with Dennis Weatherstone and other industry leaders. The report was designed to be an educational tool to explain derivatives to a larger financial audience. It was designed to serve as a blueprint to show how dealers and end-users should manage risk, and to introduce the concept of value-at-risk to a wide audience. As co-chairman of the working group, Saint-Aignan played an integral role in the formulation of the study's revelatory recommendations.
Last January, Saint-Aignan cut back his full-time schedule to spend more time with his family. He now serves as an advisory director and consultant to the firm—a role that allows him to focus on the areas that still captivate him, like risk management. He represents Morgan Stanley on the Counterparty Risk Management Policy Group, a private-sector group chaired by Gerald Corrigan that seeks to draw lessons from the Long-Term Capital Management crisis and the market upheavals of autumn 1998.
For Saint-Aignan, it's a continuation of a theme: making the world safer for swaps.
|Oldrich Alfons Vasicek
Oldrich Alfons Vasicek is perhaps the most unlikely member of the Derivatives Hall of Fame. That he ended up studying derivatives at all can be chalked up to pure happenstance. Had events occurred differently in his early years, Vasicek might well have spent his career studying nuclear physics or marine biology rather than default probabilities. The derivatives world is fortunate things turned out the way they did.
Vasicek, now 58, was born in Prague, Czechoslovakia, and was drawn to mathematics at an early age. His father, a lawyer, had suffered through the vastly different but equally onerous political systems of Nazism and Communism, and believed his children should choose careers in the physical sciences, which were less vulnerable to political crosscurrents.
At his father's urging, Oldrich studied nuclear physics at the Czech Technical University, but never lost his passion for mathematics. When the university introduced a new degree program in pure mathematics for selected students, Oldrich jumped at the chance. In 1964, he earned a master's degree in math.
Immediately after graduating, he enrolled at Charles University in Prague to pursue a Ph.D. in probability theory. He earned his diploma four years later, just as Soviet tanks rolled into Prague to restore order to an unraveling government. Within five days of the invasion, Vasicek and his wife, a physician, boarded a train leaving the country.
|"You cannot imagine how revolutionary an idea an index fund was at the time. They said, ‘You mean you want to buy all the dogs along with the good stocks?'”
Vasicek made his way to San Francisco in late 1968 and started to look for a job. Stanford University's biology department was looking for a mathematician to do spectral analysis of dolphins' sounds, but passed on Vasicek. Wells Fargo Bank, which needed a research analyst in its management science department, quickly nabbed Vasicek for the post in January 1969. In the coming decade, the derivatives explosion would reshape finance. Vasicek, still a financial neophyte, would be at the epicenter of the changes.
In the early 1970s, Wells Fargo's management science department began organizing annual conferences that brought select academicians together with half a dozen bankers to discuss various cutting-edge topics in finance. The 1970 affair featured two young turks named Fischer Black and Myron Scholes, who had just begun thinking about the problem of valuing equity options. Their effect on Vasicek was immediate. "It was like being in heaven, being exposed to all of these new ideas and these people,” he recalls. Later conferences brought Merton Miller, Franco Modigliani and Robert Merton, who introduced his continuous time equation before it was published.
The conferences awakened in Vasicek a passion for finance he never knew he had. By the early 1970s, he was working with Black, Scholes, William Sharpe and others to develop for Wells Fargo a radical new investment vehicle known as an index fund. "You cannot imagine how revolutionary an idea it was at the time,” Vasicek recalls. "The basic plan was to form a capitalization-weighted stock market fund. The whole bank went up in arms. The security analyst division was aghast. They said, ‘You mean you want to buy all the dogs along with the good stocks? You're not going to do fundamental analysis of stocks to see which ones are good and which are bad?' We said, ‘No, the market's already doing that.'” After two years of in-fighting, the team was encouraged to resign. "The bank just couldn't comprehend the idea, because nobody else was doing this,” Vasicek says.
Vasicek headed east to take a teaching job at the University of Rochester. After two upstate New York winters, he went back to California, this time as a visiting professor at the University of California at Berkeley. In 1977, he wrote a paper that would change the face of finance. In "An Equilibrium Characterization of the Term Structure,” published in the Journal of Financial Economics, Vasicek first traced the relationship between the term structure of interest rates and the pricing of bonds. The paper examined how interest rates affect prices of riskless bonds, such as Treasuries. It asked how bonds of different maturities are related to each other, what kind of stochastic processes derived them, and what kind of conditions have to hold across the whole bond market, for all maturities, so that it stays in equilibrium.
"That was, at the time, kind of a novel thing,” Vasicek says modestly. "When I was working on it, the theory available for stocks was the Capital Asset Pricing Model. Somehow, it wasn't perceived as being applicable to bonds—they didn't seem to have any beta. The bond question was hard to get hold of. Then the idea that illuminated my thinking was the consideration that the pricing of longer bonds must in some way be related to what the short rate would do over the tenure of the bond. Now it seems fairly obvious, but it surely wasn't at the time.”
The basic assumption of the theory: that the pricing of, say, a five-year bond is a function of the short rate—or, more accurately, today's probability assessment of the behavior of the short rate—over the next five years. "This was something to build on,” he says. "You simply need to specify what type of stochastic processes you're dealing with. The mathematical implementation was easy; the idea was the hardest part—that the short rate over that span is what should determine the price of the long bond.”
The idea caught on instantly. Within a few years, dozens of articles were popping up in journals that took the concept further. Now, in one form another, anybody who buys, sells, prices or structures an interest rate derivative is using some version of Vasicek's model.
Credit is due
Despite such success—or maybe because of it—Vasicek realized his heart wasn't in teaching. He needed to be on the front lines all the time, focusing his considerable mathematical powers on the furthest reaches of finance theory. In 1978, Vasicek left Berkeley to become a consultant, eventually ending up at Gifford Fong Associates, where he became a senior research associate in 1980, specializing in mathematical approaches to the newest exotic products in the rapidly growing derivatives markets.
After several years in that role, he left to become a partner in a new company, Diversified Corporate Finance, together with John McQuown, who had first hired Vasicek at Wells Fargo in 1969. The company was built with a groundbreaking mission: to pool bank loans to improve asset diversification. The concept was, by today's standards, quite simple: banks would contribute their loans to a massive pool of diverse loans in exchange for a share of the entire pool. "They were entirely off-balance-sheet transactions,” Vasicek says. "In effect, they were the first credit derivatives.” But banks were afraid to take the plunge.
|"Valuing the debt of a company from knowing its equity and derivative asset pricing sounds natural now. But in the mid-1980s, people were absolutely laughing at us.”
Meanwhile, Vasicek was working on some theoretical questions relating to credit. While at DCF, he created a proprietary credit valuation model to help banks evaluate the loans they were contributing to the pool and evaluate the pool itself. The model, later published under the title "Credit Valuation” in several publications, is based on the assumption that credit valuation should not be a subjective judgment of an individual credit analyst, but rather should be inferred objectively from the characteristics of the firm and the firm's share price.
"It sounds extremely natural now, valuing the debt of a company from knowing its equity and derivative asset pricing,” says Vasicek. "We take it for granted. But in the mid-1980s they were absolutely laughing at us.” The theoretical underpinning for the model went back to Black and Scholes, who argued in the 1970s that the stock of a firm is simply a call on the firm's assets. When Vasicek tried to apply that thinking to credit, he was met with tremendous resistance.
"Prospective clients said you value credit by knowing the corporate customer, working with him, analyzing, going to visit, having him visit you, studying the financial statements. It was a completely nonanalytical approach, based on the relationship with the client and on experience. We proposed that the stock market in effect does all that—that it's the aggregate judgment of hundreds of thousands of investors, with the bottom line of their evaluation expressed as the price at which they're willing to buy and sell the stock. If we could succeed in extracting the information from the stock and converting it to the valuation of the credit, we'd capitalize on all this information. In fact, unless the bank credit officer knows something that the market does not know, it should be a superior gauge. You'd have to know more than the aggregate of market participants to arrive at a superior valuation.”
Vasicek was so sure of his revelation that DCF hired a retired former bank credit officer to soothe potential clients. To no avail: the company folded in 1989.
But Vasicek moved forward. After the failure of DCF, he cofounded KMV Corp. with McQuown and Steve Kealhofer, a former Berkeley professor who had also worked at DCF. The new firm beefed up its credit capabilities. In addition to portfolio risk management systems, KMV offers explicit default probabilities from one year to five years for 20,000 companies worldwide. Whereas most portfolio managers used agency ratings to gauge expected losses, KMV offered a quantitative measure—which, among other things, also helped banks price loans and make lending decisions. While Vasicek's pioneering use of quantitative methods in credit analysis would prove instrumental to the credit derivatives boom of the 1990s, demand for KMV's services was nonexistent in the beginning. It took two years for the company to sign up its first client, Bank of America.
Once Bank of America signed on, however, business snowballed. One client led to two, then five, then 10, and before long KMV could count 35 of the world's 50 biggest banks as clients. KMV now models portfolios with combined assets of several trillion dollars.
Nowadays, Vasicek is spending much of his time developing pricing mechanisms for credit derivatives. "You need to know the complete probability distribution of the potential losses in the underlying portfolio before you can fully structure or write, say, a collateralized bond obligation,” he says.
Thanks to Oldrich Vasicek, this is no longer such a difficult proposition.