Prof. Jayanth R. Varma's Financial Markets Blog

Last week FiveBooks carried an interview with well-known Einstein biographer, Walter Isaacson, reviewing his favourite five books on Einstein. Isaacson discusses a very interesting futures contract related to Einstein’s Nobel Prize:

This is a great piece of writing and of research about Einstein’s relationship with his first wife who served as his sounding-board in the miracle year of 1905 when he discovers special relativity and lays the groundwork for quantum theory. Mileva Maric was a physics student at Zurich Polytechnic, and when she and Einstein met they fell madly in love. ... When the passionate relationship exploded and Einstein wanted a divorce he couldn’t afford the money Maric wanted to raise their two boys. So Einstein says to her that one day he’ll win the Nobel Prize for his 1905 work and if she gives him a divorce he’ll give her the prize money when he wins. She takes a week to calculate the odds and consult other scientists, but she is a good scientist herself and she takes the bet. He didn’t win until 1921 but he did give her the money and she bought three apartment buildings in Zurich.

I was aware that Einstein gave the prize money to his first wife, but did not know that there was actually a futures contract (or more precisely a forward contract). Wikipedia has more details about the transaction. As I think carefully about it, this futures contract is actually quite hard to value:

First of all, we need the risk neutral probability (as of 1919) that Einstein’s work would win the Nobel Prize at all. This is a nontrivial task – those who think that this probability was close to one must keep in mind the fact that no Nobel Prize was ever awarded for relativity theory (Einstein’s prize was for his work on the photon).

There is a significant information asymmetry in assessing this probability because Einstein obviously knew more about his own work than anybody else.

To value the futures contract it is also necessary to estimate the expected time at which the prize would be awarded. Coase received the economics Nobel Prize six decades after his original work. Physicists do not usually have to wait that long, but in 1919, Einstein had already waited 14 years.

Mileva Maric would also have to worry about mortality risk because the Nobel Prize is not given posthumously. Her own mortality is less important because the money would probably have gone to a trust for the benefit of her children.

There is also the vexed issue of counterparty risk – during and after the First World War, it could not be taken for granted that the endowment of the Nobel Foundation would be preserved sufficiently well in real terms to ensure that the expected prize money could be paid out.

Finally, since the futures contract was clearly non-tradable, a significant liquidity discount would also have to be applied while doing the valuation.

Despite all these difficulties, the fact is that Mileva Maric was able to arrive at a reasonable valuation and conclude the negotiations. It is interesting to read that the information asymmetry was resolved not only by her own competence as a physicist, but also by consulting other scientists. This is similar to the use of rating agencies in debt markets.

In the real world, instruments do end up getting valued despite the theoretical difficulties involved. One of Einstein’s famous quotes is probably relevant here with suitable modifications: “God does not care about mathematical difficulties, he integrates empirically.”

Posted at 18:02 on Mon, 27 Dec 2010 View/Post Comments (8) permanent link



