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Pre-modern derivative trading

A study of actual interwar commodity trades by John Maynard Keynes finds that pricing was as efficient as modern derivative trading using the Nobel Prize-winning BSM model developed a half-century later.

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One of the most important innovations in modern finance is the Black-Scholes-Merton (BSM) model of option pricing, developed in the early 1970s and recognised in 1997 by the Nobel Prize in Economics. It is often thought that before the 1970s traders had little idea how to accurately price options.

Yet a new Cambridge Judge Business School study that looks at the actual commodity option trades of the famed economist John Maynard Keynes between 1921 and 1931 suggests that traders in that interwar era may have been able to “intuit” what amounts to fair value and adjust their prices to the market environment – five decades before the modern BSM model.

“We find that interwar option prices were no more mispriced than in modern times and were as sensitive to changes in volatility – the key valuation parameter in the BSM model,” says the study just published in the journal Economic History Review. “Traders of tin and copper options in the 1920s transacted with Keynes via his broker at prices fairly close to their BSM theoretical values.”

Such interwar commodity options were “modestly” overpriced – “as in modern markets” – and responded systematically to market changes as reflected in volatility even though traders had no knowledge of the BSM model – whether for puts, calls, or straddles at-the-money (selling both a put and call option at the same strike price and expiration date), the study found.

Dr David Chambers
Dr David Chambers

The study – entitled “Commodity option pricing efficiency before Black, Scholes, and Merton” – is co-authored by Dr David Chambers, Reader in Finance and Academic Director of the Centre for Endowment Asset Management at Cambridge Judge, and Rasheed Saleuddin, Research Associate in Finance at the Centre for Endowment Asset Management. Dr David Chambers has also studied Keynes’ record as a private currency trader and art collector.

“What is fascinating is that the study suggests – and we can only speculate – that for the options traded by Keynes in copper and tin, market participants were intuitively taking into account the parameters of the BSM model, including volatility, without any knowledge of the model itself,” say the study’s co-authors. “Perhaps this is because these traders were able to estimate the relationships between the key elements of BSM and option prices, even without the benefit of the model. But we simply do not know.”

The new study hand-collected the actual prices paid to London Metal Exchange dealers by Cambridge-based economist Keynes in the over-the-counter market for short-dated options on metal futures from 1921 to 1931, based on Keynes’s detailed investment records – and then analysed how “fair” those prices were as judged by the BSM model.

The conclusion was that for Keynes’ trades, pricing errors (defined as the difference between traded prices and BSM-theoretical prices) averaged 15 per cent, which is at a similar level to those observed in modern options trading that actually uses the BSM model. Previous historical studies, based on South African mining stocks in the early 20th Century and US stock option pricing in the 1870s, found pricing errors at two to three times that level.

The study acknowledges that not every trader is as smart as the well-connected Keynes, so less sophisticated investors may not be the recipient of the same efficient pricing.

“We do not deny this possibility but at the same time we believe that this does not invalidate our test or weaken our results,” the study says. “What matters, whether in the 1920s or today, is whether trades between informed participants exhibit very little mispricing.”