Masters of Finance: Stephen Ross

Summary

In this interview, Richard Warrell engages with Steve Ross, a pioneer in modern finance. Ross shares his journey from Boston to Caltech, his time at Harvard studying economics, and his eventual shift to finance at Wharton. He discusses his influential work on the Arbitrage Pricing Theory (APT), risk-neutral pricing, and the binomial model. Ross also reflects on his corporate board experiences and his current research interests, including Social Security and the role of contracts in financial markets.

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Q & A

What was Steve Ross's background before entering the field of finance?

Steve Ross grew up in Boston, with a mother who was a homemaker and a father who was a self-made chemical engineer. He was a good student and had a strong interest in science, which led him to attend Caltech.

Why did Steve Ross choose to attend Caltech?

Ross wanted to get as far away from Boston as possible and was attracted to California's culture, including the Beach Boys and the general atmosphere. Additionally, a representative from Caltech gave an impressive pitch at his high school, emphasizing the institution's strengths in science.

Who were some of the influential professors Steve Ross encountered at Caltech?

At Caltech, Steve Ross was notably influenced by Richard Feynman, a Nobel laureate in physics, whom he had for several physics courses and a cosmology seminar.

What was the turning point for Steve Ross to study economics?

During his senior year at Caltech, Ross took a course in game theory and linear programming to fulfill his humanities requirement. This course sparked his interest in economics.

How did Steve Ross transition from studying economics to finance?

Ross transitioned into finance after attending seminars at Wharton, where he found the topics discussed in finance seminars fascinating, especially those by Richard Roll and Fischer Black.

What was the significance of the paper Steve Ross wrote about the principal-agent problem?

The paper on the principal-agent problem was significant as it was one of the early discussions on incentives in economics and finance. It predated a similar paper by Jensen and Meckling and contributed to foundational concepts in corporate finance.

Can you explain the Arbitrage Pricing Theory (APT) that Steve Ross developed?

The Arbitrage Pricing Theory (APT) is a multi-factor asset pricing model that Ross developed to make the mathematics consistent with economic intuitions. It suggests that asset prices are driven by a number of macroeconomic factors and is based on the principle of no-arbitrage.

What was the inspiration behind Steve Ross's work on risk-neutral pricing?

Ross and John Cox's work on risk-neutral pricing was inspired by the realization that if there's no arbitrage opportunity, then individual risk preferences should not affect option prices. This led them to the concept of pricing derivatives using risk-neutral probabilities.

How did the binomial model contribute to option pricing?

The binomial model, developed in collaboration with Mark Rubinstein and John Cox, simplified option pricing by demonstrating that it works due to the basic principle of no-arbitrage between two possible outcomes, rather than continuous time mathematics.

What is Tobin's Q and how did Steve Ross use it in his research?

Tobin's Q is the ratio of a firm's market value to the replacement cost of its assets. Ross used it to analyze intangible assets of companies, particularly those investing heavily in R&D and advertising.

What are some of the key takeaways from Steve Ross's experience serving on boards of directors?

Ross found serving on boards to be a great opportunity to influence strategy and learn from a diverse set of talents. However, he noted a shift in focus from strategic discussions to regulatory and legal issues over time.

What are the current research interests of Steve Ross?

Ross's current research interests include studying the efficiency of markets, the financial aspects of Social Security and other government entitlement programs, and the role of contracts in financial markets.