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The Father of
Financial Engineering
Paul Samuelson’s research on pricing warrants helped lay the groundwork for derivatives to grow
into a trillion-dollar industry. By PETER CARR
P
aul a. samuelson helped chart the
course of 20th-century economics. He
has published more than 550 scientific
papers. His 1948 textbook, Economics,
now in its 18th edition, introduced generations of
college students to economics. And he has won
prizes ranging from the 1947 John Bates Clark
Medal for the most significant contribution to eco-
nomics by an American under 40 to the 1970 Nobel
Memorial Prize in Economic Sciences. “He has in
fact simply rewritten considerable parts of eco-
nomic theory,” the Royal Swedish Academy of Sci-
ences said in presenting the prize.
Today, at 92, Samuelson continues to
‘I’m never sure of the write for a wide audience as well as for
academics. His output includes a
more than 10 million monthly column that’s syndicated to
people who are exposed newspapers, including one in Japan
to that, whether there with 10 million readers. “I’m never sure
of the more than 10 million people who
are more than 10 of are exposed to that, whether there are
them who understand more than 10 of them who understand
my nuances,’ my nuances,” he says in a December
interview at his office at Massachusetts
Samuelson says. Institute of Technology in Cambridge.
Samuelson’s December column is
about financial engineering, a field that the MIT
Institute Professor Emeritus is often credited with
creating. “I helped train at MIT a generation of
financial engineers,” he writes. “Maybe I should
feel like Dr. Frankenstein, who created a poten­
tially fabulous robot but, alas, one that turned
out to be a monster.”
The derivatives market today is huge. At the end of
June, the notional value of over-the-counter deriva-
tives was $516 trillion, according to the Basel, Swit-
zerland–based Bank for International Settlements,
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the bank for central banks. Financial engineering
was supposed to reduce risk. Samuelson says his cre-
ation’s dark side comes because derivatives lend
themselves to “nontransparency and tremendous
overleveraging.”
Samuelson’s ideas about financial engineering
date to the 1940s. “I became interested in deriva-
tives, in puts and calls, immediately after World
War II,” he says. Puts and calls were then sold by
dealers based in small offices off Wall Street in New
York. “I assure you this was not the high-rent dis-
trict,” Samuelson says. Put options grant the right
but not the obligation to sell the underlying secu­
rity at a set price on or before a fixed date. Call
options similarly grant the right to buy.
To do his research, Samuelson would go to New
York and talk to the dealers. Once, the late Herbert
Filer, head of the Puts and Calls Brokers and Deal-
ers Association, a trade group, asked Samuelson
what he was doing. “I’m trying to advance the sci-
ence of modern finance in understanding options,
derivatives,” Samuelson says he told Filer.
“It’s hopeless!” Filer said. “You have to have
a European kind of mind to understand it.”
Samuelson took his revenge when he published
his results in the 1960s. He gave the name European
options to the simplest kind: options that can be ex-
­ercised only at maturity. For the more-complicated
case of options that can be exercised at any time
before maturity, he used the term American options.
In the 1950s, Samuelson became the first econo-
mist to recognize the importance of a dissertation
written by mathematician Louis Bachelier in 1900
at the Sorbonne. The thesis, “Théorie de la spécula-
tion,” said that the price of an asset underlying an
option could be modeled as a Brownian motion, also
known as a continuous random walk. Just as a
jason grow
drunken sailor is equally likely to wander left or
right, Bachelier assumed that financial assets are
photo/illo credit here

Samuelson began his

research into derivatives
in the 1940s.

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priced so that they’re equally likely to rise or fall by
the same amount. Samuelson also spotted the flaw
in Bachelier’s main assumption. Since Bachelier pre-
sumed that the size of each price change is indepen-
dent of the price level, a run of bad luck could lead to
negative prices—an impossibility for stocks.
Samuelson proposed that price
changes should instead be proportion-
Paul Samuelson al to the level of the asset price. Under
Rational Theory of Warrant Pricing Samuelson’s geometric Brownian
motion, even an infinite stream of bad
Education luck would leave the price positive.
Attended the University of Chicago.
“On Jan. 2, 1932, I guess the Although an astronomer named
mathematical bottom of the Great M.F.M. Osborne at the U.S. Naval
Depression, I walked into the Research Laboratory in Washington in
economics classroom, and I was born,”
Samuelson says. Earned a bachelor’s 1959 published this idea before Samu-
degree from Chicago in 1935. Was a elson, both authors are generally given
member of the Society of Fellows at credit for proposing this stochastic
Harvard University, where he earned
a master’s in 1936 and a Ph.D. in 1941. process, which is the benchmark
against which all subsequent pro­
Career posals have been evaluated.
Began teaching in 1940 at
Massachusetts Institute of Technology, In 1965, Samuelson published
where he is Institute Professor two papers in the same issue of an
Emeritus in economics. Received the MIT journal called Industrial Man-
Nobel Memorial Prize in Economic
Sciences in 1970. The first five volumes agement Review. The first one, “Proof
of The Collected Scientific Papers of That Properly Anticipated Prices
Paul Samuelson (MIT Press) run to Fluctuate Randomly,” proved that in
4,834 pages and cover his work
through 1986. an informationally efficient and fric-
tionless market, futures prices would
personal follow a martingale, once the effects
Age 92. Born in Gary, Indiana.
Married, with six children and of the market’s aversion to risk have
15 grandchildren. been accounted for. The defining
property of a martingale is that the
conditional expectation of the next value, given the
current and preceding values, is the current value.
A martingale is a weaker concept than a random
walk, as it implies zero correlation between incre-
ments rather than independence. For a martingale,
squared price changes or returns can be serially cor-
related. In contrast, applying any function to the
increments of a random walk results in random vari-
ables that remain independent. Samuelson’s 1965
paper appears to be the first application of the prob-
abilistic concept of a martingale in finance.
The other paper by Samuelson in the spring 1965
issue of the journal is called “Rational Theory of
Warrant Pricing.” The paper includes an appendix
written by Henry McKean, now of New York Univer-
sity, whom Samuelson refers to in the December
interview as a “hotshot mathematical probabilist.”
The practice of including appendices written by
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others is unorthodox, and the paper stands as a tes-
tament to how mathematically rigorous economics
had become under Samuelson’s influence. Robert
Merton, a Nobel Prize–winning student of Samuel-
son’s, refers to McKean’s appendix in the 1965 paper
as “formidable.”
“Rational Theory of Warrant Pricing” contains
most of the elements of the standard theory of
option pricing as used today. As Merton points out,
the importance of Samuelson’s paper became appar-
ent only after subsequent publications in 1973 by
Fischer Black, Myron Scholes and Merton himself.
Samuelson set out to derive the relationship that
would pertain in economic equilibrium between
the value of a warrant and the price of its underlying
stock. A warrant differs from a call option mainly in
that it’s written by the issuer of the stock. Samuel-
son’s interest in warrants over options came from
the fact that in 1965, warrant prices were listed
while puts and calls traded only over the counter. In
his paper, Samuelson considered two types of war-
rants: those that can be exercised only at their expi-
ry, European; and those that can be exercised at any
time up to their expiry, American.
since the price of the stock underlying a war-
rant trades in a spot market, Samuelson under-
stood that this price would not be a martingale for
two reasons. First, unlike futures, the stock has a
carrying cost given by the difference between the
interest rate and the dividend yield. While Samuel-
son’s paper never explicitly makes assumptions on
interest rates, he does make clear that he’s allowing
for the possibility of dividends’ being paid continu-
ously such that the dividend yield is constant. The
second reason that a spot price wouldn’t evolve as
a martingale is that the spot price is risky and, as
such, the expected growth rate of the stock reflects
a risk premium. While not modeling this risk pre-
mium directly, Samuelson places a strong con-
straint on the sum of the stock’s carrying cost and
the stock’s risk premium by requiring that the
expected growth rate in the underlying stock price
is a nonnegative constant he calls α. He similarly
assumes that the expected growth rate of the over-
lying warrant price is a second constant he calls β.
Since models are by definition an abstraction
of reality, modelers always make assumptions,
explicitly or implicitly, that specify these abstrac-
tions. Good modelers state all of their assumptions
and ensure that these assumptions don’t contra-
dict one another.
As a modeler without peer, Samuelson explicitly
states that his two assumptions are that the stock’s
mean growth rate is constant at α ≥ 0 and that the
warrant’s mean growth rate is constant at β ≥ α.
From the title of his paper, it’s clear that Samuelson
is also assuming that investors are rational, and it’s
safe to presume that he’s also assuming that mar-
kets are in equilibrium.
However, Samuelson doesn’t explicitly assume
that interest rates are constant or that investors can
trade continuously as Black, Scholes and Merton
later assumed. Had he made these assumptions,
then you could show that his two assumptions con-
tradict each other in general.
For example, if α is constant, then the mean
growth rate for a finite-lived warrant can be shown
to depend nontrivially on the contemporaneous
stock price and time. Interestingly, when α is con-
stant, then under constant interest rates, continu-
ous trading opportunities and no arbitrage, the
mean growth rate of a perpetual warrant can be
shown to be constant. Had Samuelson explored the
implications of the ability to trade continuously
for perpetual warrants, it seems plausible that he
would have discovered that the perpetual warrant
value depends on neither α nor β. The proof of this
result is straightforward, as shown below.
In his paper, Samuelson assumed that the war-
rant price has a mean growth rate at least as large as
that of the stock—that is, β ≥ α. He considers the
two logical subcases β = α and β > α separately.
He shows that when β = α ≥ 0, American war-
rants have the same value as European warrants
and hence there’s no early exercise premium. He
also shows that as time to maturity becomes infi-
nite, this common value converges to the underly-
ing stock price, regardless of the strike price of the
warrant. He takes this property as a rejection of the
possibility that β = α and goes on to consider the
case where β > α ≥ 0. For this case, he shows that
the early exercise premium is positive.
samuelson recognizes the existence of a cri­ti­-
cal boundary situated above the strike price of
the American warrant. For finite-lived warrants,
this boundary depends nontrivially on time and
inhibits the development of a closed-form formula,
a mathematical expression that depends only on
the inputs to the problem. As a result, Samuelson
outlines a numerical method by which finite-lived
American warrant prices and this boundary can be
approxi­mated. In contrast to the case of finite-lived
warrants, the critical boundary is independent
of time for a perpetual American war-
rant. As a result, McKean derives closed- ‘Rational Theory of
form formulas for both this boundary
and for the value of a perpetual Ameri- Warrant Pricing’
can warrant. contains most of the
The McKean result is interesting elements of the standard
from a methodological viewpoint
because it shows just how tantalizingly theory of option pricing
close the two authors were in 1965 to as used today.
the stunning result published in 1973
that when investors can trade continuously, deriva-
tive security prices are independent of the expected
growth rate of the underlying asset—that is, α.
Let’s now review this development using modern
notation and concepts. Samuelson assumed that
under the real-world probability measure, the
stock price S follows geometric Brownian motion:
dSt
= αdt + σdBt , t ≥ 0,
St
where σ denotes the stock’s constant volatility and
B is a standard Brownian motion. The last term on
the right side of the equation is the differential of
an Itô integral.
Now assume that a risk-free asset exists and that
the risk-free rate is constant at r ∈ R+. Consider a
portfolio of stock and the riskless asset that’s con-
tinuously rebalanced so that a constant proportion
p ∈ R of the wealth is kept in the stock. Assume
that the stock’s dividend yield is constant at q > 0,
and assume that dividends are reinvested into the
stock under this fixed-mix trading strategy. It
would have been well known to portfolio theorists
in the 1960s that, letting Wt denote the wealth at
time t of this portfolio, wealth also follows geomet-
ric Brownian motion under this simple fixed-mix
strategy. In terms of the Itô calculus that was devel-
oped by Kyoto University probabilist Kiyoshi Itô
and introduced to finance by Merton, the wealth
solves the stochastic differential equation:
dWt
= [r + p(α + q − r)]dt + pσdBt , t ≥ 0.
Wt
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��
The unique solution of this stochastic differen- �2
r − q − σ 2 /2 r − q − σ 2 /2 2r
tial equation is: p+ ≡ − + + .
σ2 σ2 σ2
2 2
Wt = W0 e[r+p(α+q−r)−p σ /2]t+pσBt
, t ≥ 0. (1) With this choice of p, (3) simplifies to:
� �p+
Likewise, the solution of the stochastic differen- Wt = W0 SS0t , t ≥ 0.
tial equation describing the stock price process is:
Consider a perpetual warrant with strike K that
2
St = S0 e(α−σ /2)t+σBt
, t ≥ 0. must be exercised when the stock price hits a barrier
b. At�the first
�p+ passage time, the wealth would be
Raising this expression to the power p implies: W0 Sb0 . Replication occurs if we equate this
wealth to the payoff:
2
Stp = S0p ep(α−σ /2)t+pσBt
, t ≥ 0. (2) � �p+
b
W 0 = b − K.
S0
Comparing (1) and (2), we have:
� �p Solving for W0 gives the initial cost of creating this
2
Wt = W0 e[pq+(1−p)(r+pσ /2)]t St
S0 , t ≥ 0. (3) warrant: � �p+
S0
W0 = (b − K) . (4)
b
Thus, when the wealth of a self-financing trading
strategy is expressed relative to the contemporane- Samuelson and McKean point out that optimizing
ous stock price, the mean growth rate of the stock the fixed boundary warrant value over all possible
is irrelevant. This is an extremely important result, boundaries results in the value of an American war-
and it was shown later by Yaacov Bergman at the rant. They also point out that this can be captured
University of California, Berkeley, in a by the high-contact condition equating the slope in
Samuelson and 1981 working paper that the irrele- S to one. Choosing b in this way leads to the opti-
McKean point out vance still holds when the proportion mal boundary:
p+
p depends on the stock price and time.
that optimizing Note that this irrelevance has nothing
b∗ =
p+ − 1
K.

the fixed boundary to do with eliminating variance in a Replacing b in (4) with b∗ leads to the desired
warrant value over all hedge portfolio; the result holds true closed-form solution.
even if derivatives don’t exist. Further- In retrospect, the Samuelson-McKean paper
boundaries results more, the above irrelevance holds was a near miss. To this day, Samuelson is dubious
in the value of an under price jumps and stochastic vola- about the efficacy of the standard model and in par-
American warrant. tility where perfect hedges don’t exist. ticular the assumption that volatility is constant.
Continuing with our fixed-mix The late Black shared this skepticism. By now, most
strategy, suppose we try to have the wealth process practitioners are inured to the constant volatility
be the replication cost of a perpetual warrant. As assumption. The model has stimulated a plethora
Samuelson points out, time t wouldn’t enter the of new products. This brave new world is not with-
cost function, and hence we choose p so that the out its detractors.
coefficient of t in (3) vanishes: In his December column, Samuelson writes that
financial engineering is like the science that can
pq + (1 − p)(r + pσ 2 /2) = 0. help mankind or create atomic bombs. “Under
proper regulation and with optimal transparency,
The quadratic function of p on the left has two it can spread risk efficiently and in that sense
roots, and it’s easily shown that one is negative and reduce intrinsic riskiness,” he writes. “But sans
the other is greater than one. The perpetual war- transparency and lacking understanding of the
rant has zero value at zero stock price, so we can arithmetic of cancerous leveraging, maybe it intro-
discard the negative root. The positive root is: duces into modern finance new fragility?” ≤

Peter Carr heads Bloomberg’s Quantitative Financial

Research Group in New York. pcarr4@bloomberg.net

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