01 Dec 1997

Merton's Economics Research Wins Nobel Prize


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.)


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