Following on from last week's post, I have been reading a paper in the Journal of Finance by Lyndon Moore and Steve Juh. In this paper, they look at derivative pricing on the Johannesburg Stock Exchange 60 years before the Black-Scholes (1973) formula. They find that long before the development of formal theory, investors had a very good intuitive grasp of option pricing. The implication of their paper is that the innovation of the Black-Scholes-Merton formula does explain the huge growth of the options markets since the 1970s.
As an undergraduate, I was taught about the failure of Herstatt Bank in 1974 and Herstatt risk. This bank was only the 35th largest bank in Germany at the time so why would anyone be interested in studying its failure? Herstatt failed because of its involvement in risky foreign exchange business. When it closed its doors on 26 June 1974, counterparty banks (mainly in New York) had not received dollars due to them because of time-zone differences - this is known as settlement risk. The cross-jurisdictional implications of its failure resulted in the Bank for International Settlements setting up the Basel Committee on Banking Supervision and Herstatt's failure was a key reason for the establishment of real-time gross settlements systems, which ensures that payments between two banks are executed in real time. The Bank of England's Ben Norman has an interesting post on Herstatt over at the Bank's new blog ( Bank Underground ). As well as giving an excellent overview of