For those who still persist in believing that my books are not as interesting or as informative as Harry Potter or Lord of the Rings, I beg to differ. We, in finance, are not bothered with magic or trinkets - we have models and indeed (to coin a phrase) one model, one model to rule them all - the Black Scholes option pricing model.
Why is the Black Scholes model so crucial in modern finance? Isn't the BS model jsut a mathematical over-indulgence flashed around by academics to impress and at best a rather technical beast that answers the question: what's an option worth? Options are often seen in terms of financial options on stocks, currencies or swaps. However BS and their co-worker Robert Merton realised the wider significance of their model. What they had developed was a general approach to valuing future alternatives.
In finance, decision making is expressed in terms of current choices or future choices. Until BS published their paper in 1973 we had a model for the former where the alternatives are immediate. For very short run decisions (i.e., where the consequences are also immediate) we match of revenues against relevant costs to get the decision contribution. Where the consequences are somewhat longer term we use the net present value model which is the same thing except future revenues and costs are discounted to a present value.
Where there is the potential to delay choosing what to do, the net present value model begins to creak. Throw in uncertainty as well as risk and the NPV model can no longer cope. This is where the BS model comes in - its tells us the value we can attach to alternatives which we can choose between at some future date. Indeed, if we reduce the exercise time to zero, the BS model reduces to the net present value of the alternatives ahead of us - the so called 'intrinsic value' of the choice available to us. Where the time to choose is extended then the model brings in some key attributes of the decision the NPV model ignores: the financial benefits potentially available to us,the riskiness of those benefits, the scale of our investment and the time we have before we need to commit.
So in an important sense, the option valuation concept whether in the form of the original BS model or the 'n' variants developed over the years, is the heart of modern finance. With it we can value firms, investment projects, intangibles, and of course those nasty derivatives which nobody (i.e., politicians, journalists and, sadly, too many accountants) can understand.
ps: the attached young lady disturbed my post lunch snooze in an Alaskan estuary. The other photographers in my party had disappeared rather quickly but I, being rather slow to wake up, and up to my neck in waders with camera at water level, was somewhat surprised to see her eyeballing me from just a few short yards distance. 'Hello' she said 'have you seen any nice salmon?' 'Sadly no' I replied, but as she started to turn away I thought I would pop the obvious question: 'what do you think of the state of the financial markets'. Her reply.....you've guessed it! But anyway, here she is.