|THEORY & PRACTICE|
In a predawn phone call on October 14, the Royal Swedish Academy of Sciences informed HBS professor Robert C. Merton that he had won the 1997 Nobel Prize in Economics. Merton's work evaluating risk has changed the nature of financial markets worldwide. At 53, he is the second youngest economist ever to win the honor, which he shares with Myron S. Scholes of Stanford University.
Merton, the School's George Fisher Baker Professor of Business Administration, joins more than thirty Harvard University faculty members who have won a Nobel Prize. The news elicited an outpouring of praise for his accomplishment from both sides of the Charles. "Robert Merton has been an innovative leader in the field of economic valuations and in improving the capacity to manage financial risk," said Harvard President Neil L. Rudenstine. "This is a well-deserved honor for an outstanding member of our faculty whose work has had a major impact on modern financial markets."
"We are enormously proud that Bob Merton has received this honor," noted HBS Dean Kim B. Clark. "He has made and continues to make fundamental contributions to finance and economics. His work not only wields remarkable influence on modern financial theory but also has important implications for the character and performance of the global financial system. Bob's is a voice of leadership that speaks at once to the academy and the world of practice."
At a press conference at the Business School a few hours after the announcement, Merton told reporters, "I still can't believe it's really happened." Looking trim and dapper, his hair brushed back in crisp waves from his beaming face, Merton faced rows of reporters, banks of TV cameras, and flurries of firing strobe lights and calmly strove to put his complicated and abstract theory into accessible terms.
Merton's research focuses on evaluating the financial risk associated with derivatives. He said that his interest in risk evaluation began when he was a graduate student in applied mathematics at the California Institute of Technology and intensified in the late 1960s, when he went to MIT to study economics under Nobel Laureate Paul Samuelson. At MIT, he later joined forces with coÐprize-winner Scholes, who had been moving in a similar direction in collaboration with the late Fischer Black.
Investors use derivatives to hedge their portfolios against the effects of sudden shifts in the market. Merton's work provides them with a formula for evaluating derivatives with greater precision. In fact, using Merton's formula, it becomes possible to construct a portfolio that is virtually risk-free.
Merton said that since his theory was introduced, financial managers have realized that it could be applied to a wide range of contractual agreements, covering the prepayment of mortgages, the evaluation of student loan guarantees, the choice of energy alternatives, and many others. "It was an enormous kick to discover that this highly mathematical and abstract theory that I played with for the sheer enjoyment of it actually had a practical use," he observed. The theory has not only proved useful to financial managers, it has actually helped to change the nature of financial investment.
Merton's work has helped to bring about an explosion in the derivatives market worldwide, a development that some have criticized as leading to greater instability. But Merton said that, on the whole, the increase in derivatives trading has been beneficial. Derivatives serve as a form of sophisticated "adapters," he said, linking economic systems together and helping to bring about a unified world economy. They have also brought about vast reductions in costs by connecting these systems with more efficient technologies. "All of us are naturally fascinated with pathology, with what can go wrong, but we must look at the whole. Derivatives have opened up multiple channels of financial flows, and there is less risk with that than with a single channel," he said.
Later in the day, two of Merton's HBS colleagues offered their own assessments of his contributions to the field. Andre F. Perold, Sylvan C. Coleman Professor of Financial Management and chair of the School's Finance unit, noted, "Bob has pioneered the use of sophisticated stochastic calculus for pricing financial instruments and determining optimal dynamic investment strategies. He also has applied this technology toward understanding broad aspects of the financial system, such as household consumption, the creation of financial products intermediaries, and the management and regulation of financial institutions. The influence of his pathbreaking work is hard to overstate."
Carliss Y. Baldwin, the William L. White Professor of Business Administration at the School, commented, "Bob's methods have been applied to an enormously wide range of economic problems, ranging from pure theory to the very practical design of new financial securities. His generalization of Black and Scholes's valuation method made it possible to customize financial claims to suit the preferences of buyer and seller alike and to price those derivative claims directly. Thus Bob's theories are the analytical underpinning of the huge, global market for derivative securities, which has grown so dramatically over the last decade."
Merton joined the Harvard Business School faculty in 1988. From 1970 to 1988, he was a professor in the finance area at MIT's Sloan School of Management. He earned a Ph.D. in economics from MIT in 1970 and an MS in applied mathematics from the California Institute of Technology in 1967. He received a bachelor's degree in engineering mathematics from Columbia University in 1966.
He has served as president and director of the American Finance Association. Among Merton's awards are the Distinguished Scholar Award from the Eastern Finance Association; the Leo Melamed Prize from the University of Chicago; first prize in the Roger Murray Prize Competition of the Institute of Quantitative Research in Finance; the FORCE Award for Financial Innovation from Duke University; and the Financial Engineer of the Year Award from the International Association of Financial Engineers.
Merton is a fellow of both the American Academy of Arts and Sciences and the Econometric Society, and is a senior fellow of the International Association of Financial Engineers. He was elected a member of the National Academy of Sciences in 1993. Merton is a research associate of the National Bureau of Economic Research and a principal and one of the founders of Long Term Capital Management, L.P., a financial technology and proprietary trading firm.
He is the author of Continuous-Time Finance (1990, revised edition 1992) and the co-author of Casebook in Financial Engineering: Applied Studies of Financial Innovation (1995) and The Global Financial System: A Functional Perspective (1995).
(Portions of this report were taken from an article by Ken Gewertz that appeared in the October 16 edition of the Harvard University Gazette.)
"Economists are puzzle solvers..."
Two days after his Nobel Prize was announced, Professor Merton spoke with Bulletin editor Deborah Blagg in his Morgan Hall office, where imposing stacks of scholarly journals had been displaced temporarily by a garland of colorful balloons and numerous congratulatory floral bouquets.
Bulletin: What were you doing when you heard the news?
Merton: I was just about ready to leave for an early morning flight to New York. The phone rang in my apartment at about quarter to six. I could easily have been out the door. I answered the phone, and the secretary general of the Royal Swedish Academy introduced himself and said, "I have some interesting news for you."
Bulletin: Were you surprised?
Merton: I certainly was surprised, overwhelmed, and very happy. There are many people who have done remarkable work in this field. I am truly honored to have been chosen.
Bulletin: You have said that your father [Robert K. Merton, a National Medal of Science winner whose work in theoretical sociology at Columbia University has spanned fifty years] has been a strong influence in your life and your career. What did he say when you told him?
Merton: My father is the really serious academic in the family. He created the sociology of science; terms such as focus group, role model, and self-fulfilling prophecy are all familiar to us because of his work. He's 87 now, a university professor emeritus at Columbia, and a scholar at the Russell Sage Foundation. And we're very close; we've talked to each other every day for the last thirty years.
Anyway, when I called him in New York, he just was beside himself. When he later learned there would be a reception for me at HBS that day, he wanted to get to Boston as quickly as possible. He couldn't find a taxi to the airport outside his apartment, so he raced up a steep hill to Broadway, found a cab, and for the first time in his life he gave a driver a couple of extra bills with instructions to get him on the next shuttle at LaGuardia. He said his son had just won a Nobel Prize, and the cab driver made him spell the name Merton so that he'd have it right when he told the story.
Bulletin: Will your father be going to Stockholm with you when you accept the prize?
Merton: Yes, he'll be with me in December.
Bulletin: You mentioned how some of the concepts your father introduced have found their way into everyday vernacular. Are there applications of your own work that would be familiar to the average noneconomist?
Merton: In 1973, when the late Fischer Black, Myron Scholes, and I published the research recognized by this prize, option pricing was considered a fairly esoteric area. Myron and Fischer were working on a formula for option valuation. I looked at what they were doing and came up with an alternative - some say more robust - way to derive the formula that has since turned out to have very wide applicability. But at the time, the work only had direct implications for pricing over-the-counter options and some executive stock options.
The methodology we developed to solve that original problem, however, gave us an insight into solving a wide range of other problems. I think of the process of discerning other applications as a little bit like peeling an onion: once we gained the initial understanding, we began to see a whole world of possibilities open up. An option is a fundamental security now - whether linked to interest rates, stock indexes, currencies, commodities, or real estate. But that's only part of it. There are other financial things that have the same structure as an option and can thus be analyzed in the same way.
A home mortgage is a simple example of how our work is commonly applied. Most mortgages allow the homeowner the option to prepay the mortgage before its term is up. That option to prepay has a value, and banks need to know how much to charge for it up front. In order to determine that, they really need to be able to analyze what the chances are that the mortgage will be prepaid - in other words, what the risk is to them. What our analysis did, in addition to improving the means to price options, was to provide a way to measure risk exposure.
Bulletin: Why has the methodology been so widely used?
Merton: One answer is, simply, that it filled a need. It wasn't intellectual interest that made people want to apply it. In the 1970s, profit margins to options dealers were driven down, competition was going up, and options investors no longer could operate based on simple heuristics and guesswork. This theory enabled options transactors to take much bigger positions because they were hedged; they could be much more efficient, and they could control their risk much better.
If you look at the last 25 years of extraordinary financial innovation and institutional change - with structural changes in financial systems all over the world - it's easy to see why the ability to take financial securities and products, many of which never existed before, and analyze them both with respect to pricing and risk characteristics turned out to be a very powerful tool.
Bulletin: How do you present this theory to your students?
Merton: What the formula captures permeates many financial aspects of life. One way I present it in the classroom is to have the students design a security. We call it a squiggle. They ask, "What's a squiggle?" I say, "I don't know yet. You're going to design it for me." And in real time, they design the payoffs to the security.
Then I say, "Now, I'm going to show you how we price and analyze the risk of this just-created security." I take them through and apply the analysis, and boom - within a class session, we've worked out how this thing has to be priced. So they see that even with an instrument that never existed before they came into the classroom that day, the theory allows us to price it and measure its risk.
Bulletin: When did you first become interested in the field of economics?
Merton: I bought my first share of stock in General Motors (I've always been a car buff!) when I was ten. I can remember going with my dad to the stockbroker's and sitting there watching the NYSE and AMEX tapes, learning all the companies' symbols. And when I was in graduate school in applied mathematics at Cal Tech, I'd get up and go to the broker's at 6:30 (9:30 EST) to trade over-the-counter options and convertible bonds until I had to go to class at 9:00.
But it wasn't until I was contemplating the topic of my Ph.D. thesis that I started thinking about switching from applied math to economics. I had always been interested in financial markets, and I found myself thinking that unlike a career in applied math, where most of the work is pretty esoteric, if I could really make a breakthrough in economics, I might affect an awful lot of people.
So, much to the chagrin of both my family and my advisors at Cal Tech, I applied to a bunch of economics departments. Since I only had one undergraduate economics course on my transcript, all but one school turned me down.
Bulletin: MIT offered you a full fellowship?
Merton: Yes, and MIT had Paul Samuelson. My first semester there I took his course on mathematical economics and loved it. A paper I wrote for the course was later published, and Paul asked me to become his research assistant.
Working with him was critical to me, because he was one of the few economists at the time whose work really integrated sophisticated mathematics and financial economics. That real-world application of complex theory was very attractive to me, and when I realized that financial market problems could be a legitimate area for serious academic research, I was off and running.
One of the nice things about this award of the Nobel is that it further underscores the legitimacy of finance as a mainline field in economics. I get such a kick out of being able to bridge the highly mathematical world of formulas and the hands-on world of the markets.
Bulletin: Can you describe what it's like to work at this level of intellectual sophistication?
Merton: Economists are puzzle solvers, and some solve purely empirical puzzles, where you work long hours evaluating data one step at a time, trying every permutation, and after years of this, you hope to find something. That can be really fascinating and rewarding.
The research that I like best, however, typically starts out as theoretical and not empirical, but I always try to bring my financial common sense to bear on it. The art of theoretical model-building is to make good abstractions that also capture the essence of the world that you're trying to explain. That's the fun. That's the challenge. I've been doing this for close to thirty years, and I'm always excited when it really works. To have both intrinsic intellectual challenge and excitement and extrinsic application - it just doesn't get any better than that.
Bulletin: At 53, you are the second youngest economist ever to win a Nobel Prize. Where do you go from here?
Merton: In terms of research, for several years I have been working with colleagues in the HBS finance group on something called the Global Financial System Project. We are trying to understand the global financial system and the implications of institutional change.
Our conceptual framework to date is that because the institutions themselves are changing so dramatically - just look, for example, at the transformation of banks and insurance companies in the last couple of decades - we can't expect them to be our analytical anchors. Instead, we've decided to analyze the global financial system by looking at universal financial functions.
Bulletin: We spoke earlier of sophistication; this sounds like research based on very basic principles.
Merton: In a way, yes. All of us, whether we live now or a hundred years from now, in New York City or in Bali, are served by various financial functions as we go through life. We are born, we need to acquire shelter, we work, we borrow or lend money, we sell things, we retire, etc. Our group takes these functions as our unit of analysis and asks, "At any given time and place, with technology, geopolitical change, and a host of other variables factored in, what's the best way to structure an institution that performs those functions?"
The spirit of it is to try to devise a way of thinking about institutional change in an organized way in the global financial system. We're still at an early stage in this, but I'm finding it very exciting.
Bulletin: So you'll still have plenty to keep you busy when you come back from Sweden.
Merton: I have no thoughts of early retirement!
by Marco Iansiti
(Harvard Business School Press)
In the old days, coping with technological change was simple: you kept track of developments, tried to decide if they had legs, and implemented them when the market seemed ready. New technology fed into the product line in an orderly and linear way.
In his new book, Technology Integration: Making Critical Choices in a Dynamic World, HBS associate professor Marco Iansiti presents a detailed analysis of what has become a vital challenge in every cutting-edge industry: selecting from myriad emerging technologies that will enable a company to assemble seamless and reliable real-world products that can thrive in a demanding marketplace. IansitiÕs work provides a blueprint for the radical restructuring of corporate research and product development.
The ability to generate technology in the laboratory and develop it for practical application is no longer enough, Iansiti asserts. Firms must take control of the technology integration process from the very beginning, matching new technological possibilities to the appropriate applications in order to create products that make both business and technical sense. "Unless you have a targeted process that accumulates knowledge before the critical decisions need to be made," writes Iansiti, "youÕre going to run into all sorts of problems." Technology Integration provides an intensive guided tour that familiarizes the reader with this process at every level and stage.
Iansiti spent eight years studying more than a hundred development projects in four computing-related industries - particularly turbulent and complex environments in which making the right technology choices is essential for success. In comparing the effective and not-so-effective processes he observed, he has distilled the critical elements for success.
Iansiti points out that lessons drawn from the computer industry have broad applications. "This book offers examples that people in other environments can use and adapt to their own needs," he says. "It was exciting to see and document that organizations as large as IBM and Texas Instruments could acknowledge the need for new processes. People are interested in this work because it provides models for R&D as well examples of change." Technology Integration is required reading for those whose businesses develop products from new technologies.
by Robert Binstock
by Sumantra Ghoshal and Christopher A. Bartlett
In an economy of explosive global growth and rapid technological advancement, traditional corporate organizations and management techniques have become outmoded. Yet while many companies have responded to these changes with structural adaptations, few have achieved the much more fundamental organizational and managerial transformation required to succeed in this new environment. In their latest book, The Individualized Corporation: A Fundamentally New Approach to Management, Christopher A. Bartlett, MBA Class of 1966 Professor of Business Administration, and London Business School professor Sumantra Ghoshal describe an emerging kind of corporate form and management philosophy that is likely to serve as the paradigm for the next century.
In their groundbreaking analysis, the authors identify three core capabilities that distinguish what they call "the individualized corporation": the ability to inspire individual creativity and initiative; the ability to link pockets of expertise and entrepreneurial activity to embed learning within the organization; and the ability to continually renew the organization and its products. This new individualized corporation, they observe, requires a fundamentally different management approach that rejects the traditional "organization man" model in which employees are considered undifferentiated cogs in a machine. They argue that in an environment in which knowledge has replaced capital as the critical strategic resource, the core responsibility of management must now focus on attracting, developing, and retaining exceptional people and on creating an environment in which they are energized, motivated, and, above all, able to develop to be the best they can be.
Bartlett and Ghoshal profile several organizations that have successfully adopted this new approach, from large industrial giants such as 3M and Asea Brown Boveri, to newer high-tech firms such as Intel and Canon, to service-based organizations such as McKinsey and ISS. Describing how these entities transformed themselves by shifting from the traditional management doctrine based on strategy, structure, and systems, and embracing a new philosophy emphasizing purpose, process, and people, the authors draw valuable lessons for all managers who want to assure the vitality and success of their own companies in the coming years. Finally, Bartlett and Ghoshal consider the social role of corporations, arguing that their new paradigm is the best model for helping such organizations contribute to society.
Short Takes
A summary of selected new research by HBS faculty.
Firms and Flexibility
As job security and long-term relationships between corporations and their white-collar workers become relics of the past, what will link these two parties in the future? According to HBS assistant professor Jeffrey L. Bradach, a new model based on flexibility may connect employers and employees. "The growth of staffing agencies suggests that we may be witnessing a slow recasting of the economy's institutional matrix where people are emerging as bundles of skills, organizations as constellations of projects, and agencies as brokers, certifiers, and developers of talent," he writes.
In his working paper "Flexibility: The New Social Contract between Individuals and Firms?," Bradach studies independent contractors, companies that use their services, and staffing agencies that bring the two parties together. "I'm trying to illuminate how this new way of organizing white-collar employment is structured," he says.
Gathering data from four temporary staffing agencies that focus on managerial and professional talent, Bradach interviewed 26 skilled temporary workers serving as independent contractors and 17 of their company clients. He found that by using contractors, companies gain flexibility in the range of projects they may undertake. "Hiring outside contractors is a way for managers to access the talent they need to get the work done," says Bradach.
Independent contractors reported a greater sense of accomplishment, as well as more autonomy and control over their time when contracting out their skills than when permanently employed. "This group clearly chose contracting as a way of working. This is not work of last resort," Bradach notes. The arrangement, he says, may give rise to a new pattern of loyalty, where contractors are committed to projects instead of companies, and agencies provide some of the health and other employee benefits once supplied by corporations.
Bradach hopes to learn whether the flexibility model represents a lasting shift in how work is to be organized. "Does this imply a new social contract? If so, who will be the winners and losers?" he asks. Bradach will continue to study these issues in future work.
Coordinating Patient Care
With tight hospital budgets and shorter hospital stays the norm today, hospitals must not only improve the coordination of patient care within their walls, but they must also communicate with a host of outside institutions to ensure that patients receive the necessary follow-up treatment. HBS assistant professor Jody Hoffer Gittell and her coauthor, Leigh M. Weiss, a doctoral student at Harvard University, are examining organizational practices that improve the coordination of patient care by encouraging effective communication among care providers.
In their working paper, "Networks and Organization Design: A Framework for Improving the Coordination of Patient Care," Gittell and Weiss argue that organization design needs to be paired with analysis of informal networks to help hospitals build cross-functional and cross-organizational teams that coordinate patient care more effectively. "Given the diversity of skills and backgrounds of doctors, nurses, therapists, social workers, and technicians, and the speed at which patients move through their hospital stays, there is ample opportunity for miscommunication," explains Gittell.
In interviewing health-care providers and administrators from nine major urban hospitals about their organizational practices, Gittell and Weiss found that hospitals are actively attempting to coordinate care using four mechanisms: case management (oversight of a patient's care on a case-by-case basis, from start to finish); care paths (preplanned procedural menus for certain illnesses and conditions); information systems (allowing accessibility of a patient's records through a central system); and patient rounds (regular meetings by physicians, nurses, and other care providers to assess the progress of patients).
The authors argue that the way hospitals hold care providers accountable for cost and quality outcomes also influences whether they work as members of individual disciplines and organizations or as members of a team. Human resource practices such as employee selection and conflict resolution affect how well care providers work together, as well.
Gittell and Weiss are currently surveying managers, care providers, and patients to further develop and test hypotheses about patient-care coordination. They hope to identify organizational practices that will help hospitals ensure healthy results for patients within and beyond their walls.
by Judith Ross
Alumni may request copies of HBS working papers by calling (617) 495-6852.