RICHARD ROLL: Good afternoon. I am Richard Roll, and I would like to welcome you on behalf of the American Finance Association to the latest interview with one of the founding contributors to modern finance. I am happy to say that the interview today will be with Steve Ross, who is my long time friend, co-author and a prolific writer. He has contributed to the literature by writing at least a hundred papers on finance, not to mention quite a few books. And in his spare time, he has also found time to work in the real world. He has been on the board of directors for a number of large public corporations including General Eeinsurance and, I hate to mention it, Freddy Mac. He has also served on the Board for TIAA-CREF and some others. Steve has also been an investment manager, running money for pension funds and foundations. And, he has been a consultant for a number of investment banks and other large corporations.

So Steve is not just a person who has contributed to the theoretical and empirical literature of finance, but he has also had a lot of impact on the real world. Some of his papers have had a big impact too. So I’d like to welcome you, Steve, to this interview.

STEPHEN ROSS: Thank you.

RICHARD ROLL: We will talk about the papers as we go along, but before we do that, tell me about some background. Your parents, where you were born, what you did between the time you were born and now.

STEPHEN ROSS: Well, unfortunately it’s been a long time, so it may take a long time. I grew up in Boston. My mom was a stay at home mom. My dad was a chemical engineer, and a really great guy. He had to put himself through night school to become a chemical engineer, and he was the first in his family to go to college. I grew up in a suburb in Boston, Brookline, and that was a great place to grow up. I feel that to some extent whatever I have, I owe to those two people.

RICHARD ROLL: Were they immigrants?

STEPHEN ROSS: No they were the second generation.

RICHARD ROLL: They were from Russia originally, right?

STEPHEN ROSS: Yes, originally from Russia.

RICHARD ROLL: So your name used to be Rossincoski or something like that?

STEPHEN ROSS: No, actually it’s always been Ross.

RICHARD ROLL: It’s always been Ross. There are Russian Rosses?

STEPHEN ROSS: No, actually the name is Scottish. It is an apocraful story, which I actually have some background for. An itinerant sewing machine salesman from Edinborough came to Minsk and married a nice Jewish girl.

RICHARD ROLL: He stayed?

STEPHEN ROSS: He stayed for a brief enough time to do some damage.

RICHARD ROLL: Okay, and then you went high school and where?

STEPHEN ROSS: I went to high school in Brookline at Brookline High.

RICHARD ROLL: How did you do in school?

STEPHEN ROSS: I was a pretty good student. My sister was a better student. She is seven years older than I am, and I remember that for years when I would go to the first class they would ask, "Oh are you Linda Ross’ little brother?" I’d say yes, and they’d say. "Gee I hope you’re as smart as your sister was." But she was a good student, and Brookline was a great school to go to. Smart kids and just a terrific place to go to school.

RICHARD ROLL: What about other interests? Were you a sport’s fan?

STEPHEN ROSS: I liked sports, but I had no capacity whatsoever to do it. It was always disappointing. I remember that, I guess it was in the eighth grade, I was a point guard on the basketball team, and I was also on the junior high swimming team. But that was it. My athletic pursuits ceased after that.

RICHARD ROLL: After you graduated from high school you went to Cal Tech right?

STEPHEN ROSS: I did.

RICHARD ROLL: How did a kid from Boston end up in Pasadena?

STEPHEN ROSS: I wanted to get as far away as possible. I liked the Beach Boys. I liked all the stuff going on in California. It sounded like a great place to be. But I think the real reason was a guy came out. That was the early stages of when colleges and universities began to recruit from broader geographic areas. This fellow came from Pasadena to my high school in Boston. He gave a pitch about Cal Tech, and it was an extraordinary pitch. To this day I really am very fond of Cal Tech. I’m on the board now at Cal Tech. So I love the place. He just said this is the best place in the world to study science, and that’s what I really cared about, science and stuff. He said "You've got to go there." Then I went to my MIT interview, and the guy said "Where else did you apply." I said I applied to Cal Tech, and he said "Oh, if you get in there, you should go."

RICHARD ROLL: The guy from MIT said that?

STEPHEN ROSS: From MIT said that. So I asked "Does that mean I’m not getting into MIT?" He said, "No you’ll get into MIT, but, Cal Tech’s the best place in the world."

RICHARD ROLL: I remember you told me one time about a story when you first got to Cal Tech. You had scored third in the national math exam or something like that. And the guy next to you was …

STEPHEN ROSS: Well, they had this little thing like a boot camp. They said look to your left, look to your right, one of you won’t be here four years from now. So I decided to talk to the kid on my left and the kid on my right. The kid on my left had won the national math exam, and the kid on my right had been number two, or something like that. I was first in New England and had done well, but I thought if one of the three of us isn’t going to make it, it’s going to be me.

RICHARD ROLL: Were you studying physics at Cal Tech?

STEPHEN ROSS: I had decided to major in physics, yeah.

RICHARD ROLL: Did you rank among these three guys have anything to do with you changing to economics?

STEPHEN ROSS: It didn't because the other two guys flunked out.

RICHARD ROLL: Oh, they flunked out. Okay.

STEPHEN ROSS: They found other things that were more interesting I guess. But I loved physics. I just didn’t like the math.

RICHARD ROLL: You didn’t like the math?

STEPHEN ROSS: I think the math was kind of boring because all the problems were differential equations, and you had to solve them all with numerical techniques. You will appreciate this. That was back, if I remember right, when the Cal Tech computer, which was one of the largest in the world at the time, had 48K memory. It sat on a drum in nitrogen, and you had to wear special gloves to go in and look at it. All your programming was done with little paper cards. We had to do all that stuff, and I remember every problem had no closed form solution. So every problem had to be solved numerically. You got very cunning at figuring out how to do it with this computer that was so limited in its capacity.

RICHARD ROLL: So who were some of the professors at Cal Tech that you remember the most?

STEPHEN ROSS: Richard Feynman was there. I had him for four years. I had him for freshman physics, and sophomore physics. I also had him for s seminar is cosmology in my junior year, and in my senior year I attended his theoretical physics workshop. To this day he’s the smartest guy I ever met.

RICHARD ROLL: Really?

STEPHEN ROSS: I know a lot of smart people in universities and I never met anyone as smart as him.

RICHARD ROLL: Yeah, well he’s a legend, and Murray Gellmann was there too. I don’t know if you--

STEPHEN ROSS: He was pretty good, but I’ll tell you a funny story. The first class we had as freshmen was Feynman teaching physics. Every kid in the room thinks he's the smartest kid in the world, and the world is just waiting to find out. About fifteen minutes into this class, there’s this hum in the room that you can almost see, and the kid next to me turns to me and says "This guy is really smart." Everyone in the room knew the guy at the front was smarter than any of us. The second class was Linus Pauling teaching chemistry. We all thought, he’s no Fineman. Education really is wasted on the young, I think.

RICHARD ROLL: After Cal Tech you went directly to Harvard?

STEPHEN ROSS: I went directly to Harvard.

RICHARD ROLL: In economics?

STEPHEN ROSS: In economics. I was interested, and I asked where you could study game theory. Only in Cal Tech could you fulfill your senior year humanities requirement by taking a course on Game Theory and Linear Programming. So that is how I fulfilled my humanities requirement. It was really fascinating, and I said "This is what I want to do." I like the math much better than I did boundary value problems, and much better than differential equations.

RICHARD ROLL: Tell us about Harvard. You were a research assistant for some famous economist right?

STEPHEN ROSS: I don’t remember. I don’t think so.

RICHARD ROLL: Well some German guy?

STEPHEN ROSS: Gottfried Haberler?

RICHARD ROLL: Gottfried Haberler, yeah.

STEPHEN ROSS: But I couldn’t be his research assistant because I was scared of his dog. He had this huge German shepherd in his office. You’d go in the thing would growl this massive growl toward you. But I remember Harvard then, you can speak about it now because it’s a very different place. But Bob Barrow came from Cal Tech with me, and Peter Clark came from Cal Tech with me. The three of us went to Harvard. I heard that someone asked Bob once about what it was like being at Harvard. He said I’m from Harvard, so I’m self taught. Because, it was just a wasteland, I thought, for economics.

RICHARD ROLL: But you did pretty well.

STEPHEN ROSS: I did well, but I switched over and started to work with Howard Raffia on decision theory and statistics.

RICHARD ROLL: Was he in the business school?

STEPHEN ROSS: He was in the business school, but he taught a course that you could take jointly with the both. That was my last year. Then I had the great fortune of Ken Arrow coming, and I was his assistant. He asked if I would TA for him, and that is when I discovered the real genius of economics.

RICHARD ROLL: After you graduated from Harvard, you went to Wharton, and you started writing papers in trade theory and stuff like that.

STEPHEN ROSS: General equilibrium, growth theory, trade theory, theory of trade. Stuff like that.

RICHARD ROLL: Then you wrote, I guess what was your first paper in finance, about the principle-agent problem.

STEPHEN ROSS: Yeah. Some people think that’s finance. Some people think it’s economics. But, should I tell you stories about this stuff?

RICHARD ROLL: Sure.

STEPHEN ROSS: Well, so I write this paper on the principle agent problem, and I thought it was kind of an interesting paper. I got the idea when I was a graduate student, and I had this car to sell. It was really a bad piece of work and--

RICHARD ROLL: A lemon?

STEPHEN ROSS: A lemon. And this gal came to buy the car. She was twenty, or nineteen, or something like that. And they had a law in Massachusetts that if you are not twenty one and you buy a car and you don’t like it, you can give it back to the seller within six months. I was sort of afraid of that. But she said "My boyfriend can buy it, and he’s twenty-one." I said "Okay." But then it started to occur to me that maybe the courts would look right through that and say, "Well the boyfriend is just acting for her." At Harvard at the time, you could pay ten bucks and see a local lawyer. They offered their services, and they’d give you advice. So I went into this guy and he said, "It’s fine. You can sell it to the boyfriend." I said couldn’t they think he was her agent or something. He said, "Oh yeah, agent and principle. Apparently they had talked about this in the law. That was the best ten bucks I ever paid.

So I wrote the paper when I was at Wharton, and Wharton had a very good group of strong young professors at the time. Cowshell was there, Bob Pollack was there, and a variety of others who for the purpose of this story will remain unnamed. And after I published this paper, one of them came up to me and said, "Steve, you know, we think you have some potential, but you’re going to have to do some serious work. Not stuff like this." So I was kind of at sea.

RICHARD ROLL: That paper predated the paper by Jensen and Meckling. Did they get their idea from your paper?

STEPHEN ROSS: Well, that’s for them to tell you. I don’t know. I mean it was an idea that was around.

RICHARD ROLL: Well, the idea is in the bible. If you talk to some rabbis they’ll tell you that the principle agent is discussed in Leviticus, or something like that. So it’s nothing new.

STEPHEN ROSS: It’s also in the Talmud. It has a long religious and historical tradition. I certainly didn’t invent the idea. I thought what was interesting about the idea was the whole question of incentives. If you’re my agent, how do I motivate you to do what I would do if I had the information and the capacities that you have as my agent?

RICHARD ROLL: How many papers have followed your paper in agency theory would you guess?

STEPHEN ROSS: I don’t know, hundreds and hundreds.

RICHARD ROLL: Hundreds and hundreds. That’s a whole field in itself now.

STEPHEN ROSS: Well, I don’t want to lay claim to having done all of that. There are a lot of other folks who’ve done great work.

RICHARD ROLL: But your paper was probably the first paper in the modern finance literature about that. But you were an economics department at Wharton, and you didn’t really work in finance until you started this, I guess. So how did you switch over to finance?

STEPHEN ROSS: It’s not well known, but all of the social sciences at the University of Pennsylvania were in the Wharton school. So political science, sociology and economics, were part of the Wharton school. It wasn’t even a non-traditional business school that had an economics department. All of economics at the university was in the Wharton school. I thought that was wonderful. It led to a lot of interaction across things. But as is my want, I grew bored with the purer theory of international trade and general equilibrium, and I just needed some contact with reality. I just had the feeling that some how or other there wasn’t any real empirical significance to what I was doing. It didn’t feel like science. It felt more like puzzles.

So I asked around to see what seminars I should go to and what should I do. Someone said we should go to the labor seminar. I didn’t like that at all. Someone mentioned the econometric seminar, and I knew about that. I actually taught econometrics the Wharton. Then someone said I should go to the finance seminar. So I’m in the finance seminar, and the first guy was this young guy from Carnegie named Richard Roll.

RICHARD ROLL: Oh.

STEPHEN ROSS: He was talking about the term structure of interest rates. This was the very first seminar I ever heard in finance, and I thought gee, this stuff is really fascinating. I didn’t fully understand what you were saying, but I thought it was really interesting. So I resolved to be a regular participant. I went next week, and they had this guy Fischer Black talking about the Black-Scholes model.

RICHARD ROLL: Just your no names in there.

STEPHEN ROSS: Yeah. So I thought to myself, I had been trained in Baysian analysis by Howard Raffia, and I concluded that was the average quality in finance. It turned out to be a disappointing rest of the year. But I was hooked right from that moment. First you, then him, and I said that’s what I really want to do.

RICHARD ROLL: So after that happened, you turned to arbitrage pricing theory?

STEPHEN ROSS: Well, I decided to study finance.

RICHARD ROLL: So Steve you started being interested in finance. You started reading finance, and then did that lead to the APT?

STEPHEN ROSS: Well I first approached some people in finance and told them that I was very interested in it. I told people in the economics department I was very interesting, and I think I had this line that’s passed around. When I told a senior professor that I was really interested in finance, he said to me, finance is to economics as osteopathy is to medicine. I subsequently told him they have given six Nobel prizes in Osteopathy. But I started to study it. I want to figure out what it was all about, and there was all this talk about the cos