CHICAGO - The links between the financial derivatives markets and the University of Chicago were forged some 25 years ago when the school's Nobel Prize-winning economist, Milton Friedman, wanted to take a chance on his negative view of the British welfare system.
Prof. Friedman wanted to short-sell the pound, but his banker laughed at the request to broker a transaction, according to Merton Miller, the well- known finance professor at the school.
"Milton got very indignant, and he wrote a letter to some newspapers asking, 'Why is it that an American citizen can't sell the pound short?'," Prof. Miller said. "Leo Melamed of the Chicago Mercantile Exchange saw the letter and said he had been thinking along the same lines."
Since then, the faculty and students at the University of Chicago have forged strong ties with not only the futures exchanges, but also with the over-the-counter derivatives markets. So close are the ties that in some circles the university is referred to as the mecca of the industry.
Chicago is home to three of the largest futures and options exchanges in the world, and the school mirrors the no-holds-barred thinking that dominates the trading pits.
"We are free-market fanatics," said Prof. Miller, who won the Nobel Prize in 1990 for the work he and economist Franco Modigliani prepared on the principles of leverage and the cost of capital. "I always say the Board of Trade practices what we preach."
A key element of a free market is risk taking, and that's something the school takes very seriously when hiring faculty members, said John Huizinga, deputy dean of its graduate school of business.
For example, Prof. Miller's views on leverage were at first highly controversial, Prof. Huizinga said.
Likewise, when the school gave the late Fisher Black his first teaching job with tenure, he was working on an ground-breaking option pricing model with Myron Scholes. It was clear to the faculty that Prof. Black 'was somebody we wanted to take a chance on," Prof. Huizinga said. "We hire faculty from a variety of places, but typically we are looking for extremely bright people who are willing to challenge conventional wisdom."
But new ideas like option-pricing models and the "M&M" principles developed by Prof. Miller and Prof. Modigliani must meet the test of public opinion.
One such test is the university's raucous workshops, which draw teachers and students from across the nation.
"Anybody with good ideas is anxious to bring them to Chicago," Prof. Huizinga said. But that doesn't mean such ideas get a free ride, he said. "The culture of this place is to attack the work," he said, and the workshops force presenters to look critically at their research and modify their methods accordingly.
These days, the results of the research are reaching the ears and minds of Wall Street and LaSalle Street, the heart of Chicago's financial district, faster than ever.
Mark Brickell, managing director with J.P. Morgan Securities Inc. in New York, who earned an MBA at the university, said the growth of the derivatives markets has been aided by the rising speed of communications and the falling costs of technology. But the fundamental reason for the rapid transfer of ideas into commercial practice is basic free market economics, he said.
"The race for competitive advantage among people in this business often leads us to create stronger ties with professors and others on campus," he said. "That way we can put their new ideas to use faster than our competitors."
Todd Petzel, executive vice president of business development for the Chicago Mercantile Exchange, said the school's focus on practical applications helps ensure that the exchange doesn't become complacent.
It is remarkable how meeting people "without a narrow focus on your business ... opens up wide horizons," said Mr. Petzel, who also teaches classes on futures, forwards, options, and swaps at the university part- time. "I don't think we can stay reasonably current in meeting the needs of our customers if we are not staying current in reading of research in the finance area."
In the same way, links to the commercial market prevent the school from getting lazy.
Prof. Miller is currently an outside director at the Merc, following stints on the board of the Board of Trade. In fact, the school's ties with the Board of Trade date back to Edward Levy, the dean of Chicago's law school and later its president. And James Lorie, finance professor emeritus, was involved in establishing the Chicago Board Options Exchange.
"If you have priceless resource" like Chicago's financial district, "you have to be a pretty brain-dead economist not to go down there and study about how these markets work," said Prof. Miller.
A place in a financial hub is part of the equation, but another part - perhaps equally important - not being in the national hub, New York.
Jose Scheinkman, a professor of economics at the school and former risk management analyst at Goldman, Sachs & Co., sees a sort of frontier attitude at the school that leads people there to find new ways to look at subjects.
"The University of Chicago schools evolved into free thinkers because they were not in the center of things," he says.