Additional background material on the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 1997. The Royal Swedish Academy of Sciences has decided to award the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 1997, to Professor Robert C. Merton , Harvard University, and Professor Myron S. Scholes , Stanford University for a new method to determine the value of derivatives.
Risk management is essential in a modern market economy.
Financial markets enable firms and households to select an appropriate level of risk in their transactions, by redistributing risks towards other agents who are willing and able to assume them. As an example, a firm might decide to engage in copper mining after determining that the metal to be extracted can be sold in advance at the futures market for copper. The risk of future movements in the copper price is thereby transferred from the owner of the mine to the buyer of the contract. An importing British firm that anticipates making a large payment in US dollars can hedge against the one-sided risk of large losses due to a future depreciation of sterling by buying call options for dollars on the market for foreign currency options. Effective risk management requires that such instruments be correctly priced.