ppauper - You've also got to remember that, at least in the US, there was no secondary market in options before Black Scholes -The market as we recognize it may not have existed but options have traded actively on stocks long before CBOE et al and for commodities before that.The old standard/popular stock option contracts included strips and straps which are ratio combinations of puts and calls.A few people I have worked with cut their deriv teeth trading these in the US and they were actively traded in Italy until quite recently.One of the interesting things is that though B&S was widely recognized as important at the time - it was years before the methodology became dominant outside the US - apparently O'Connor brought 'discipline' to the UK LTOM or whatever it was called in the 1980s. Until then it was all rule of thumb and experience.

Black Scholes original paper submitted for publication derived the Black-Scholes PDE from the CAPM model. Apparently, the PDE had been sitting on Black's board for a while, until Scholes took the PDE to a former physics professor or something (which told him about the connection to the heat equation). However, this paper never got published because of the rocket science math involved and, in general, nobody understood why stock prices would behave in a geometric brownian motion fashion. In fact, there was no reason for returns to be normally distributed.Merton great contribution to the BS model was the development of the self-financing portfolio, and a trading strategy (the hedge) that replicated the value of the option. It was this insight into the BS model which got the seminal BS paper printed (at least this is what my finance professor tells me). I don't remember the exact line of arguement, but it pretty much comes down to geometric brownian motion precludes arbitrage.

This is not quite correct. Merton, Black and Scholes were all working on this problem together and independently from 1969 to 1973 (by which time the basic results had been published in peer-reviewed journals). Merton and Scholes were faculty members at MIT and Black worked for AD Little but came by the meetings. Of course, others were involved as well, including Paul Samuelson.All three published versions of the formula in working papers, and Merton in lecture notes, before 1973. All three published peer-reviewed papers that showed some of the results. But the seminal paper was:Black, Fischer, and Myron S. Scholes. "The Pricing of Options and Corporate Liabilities." Journal of Political Economy 81 (May/June 1973): 637-654. This does not use CAPM. You are thinking of: Black, Fischer, and Myron S. Scholes. "The Valuation of Option Contracts and a Test of Market Efficiency." Journal of Finance 27 (May 1972): 399-418. Which shows how the model is consistent with CAPM, but is not major paper. It's true that Merton got into print first with:Merton, Robert C. "Theory of Rational Option Pricing." Bell Journal of Economics and Management Science 4, no. 1 (spring 1973): 141-183.but this is a much simpler paper. When this was accepted, the Journal of Political Economy reconsidered their earlier rejection of the Black-Scholes paper (also Eugene Fama and others suggested changes in the paper and lobbied for acceptance). There is no argument among the three men (or the surviving two men) about priority and credit. All worked together, shared ideas and made important independent contributions.The story of the physics professor and the heat equation is also not quite right. It's true that M, B and S couldn't solve the partial differential equation at first. It's also true that at a seminar, someone pointed out the similarity to the physics heat equation, but this person has never been identified. It's certainly possible it was a physics professor or (in the more common version) a physics graduate student. But the equation had already been solved by then, although the analogy allowed a cleaner derivation of the solution.

I guess the editors and referees would say that the paper won the Nobel Prize due to the corrections they forced. And they probably brag to their students about how they rejected Black-Scholes, just a people will brag about encounters with celebrities in which they made fools of themselves.But the embarassment really should be felt by the field of finance at the time. It was a moribund field, with all the important creative work being done by outsiders and young iconoclasts. Like dinosaur paleontology in 1980 and psychology in 1950 the field was entrenched with sterile thinking.

If you look at it as a pure probability problem, a call option would be equal to E(S-K|S>K), which would be a reasonable first guess at an option valuation algorithm. Thus the 'only' novel insight from M, B and S is that you use the risk-free interest rate in the discounting *and* mean growth rate. Since the bid-ask spreads were so large in '72, not knowing these parameters exactly was a second order concern at the time. While we should appreciate the rigorous foundations of option pricing formulas, it is a self-serving intellectual fantasy to suppose that without academics such as Merton and Scholes the option market would have been still born.