It is rare to meet your heroes. I wouldn’t exactly describe Professor Robert C. Merton as one of my heroes – I’m not sure I have any heroes actually – but he is somebody I admire greatly. He is probably the most distinguished financial economist in the world today. He won the Nobel prize (*) for economics in 1997 along with Myron Scholes for their work on option pricing. What is widely known as the Black-Scholes option pricing model is better known in the academic world as Black-Scholes-Merton, because Merton put rigorous financial underpinnings under what was a brilliant but incomplete work of theory. Among many contributions he is the author of a classic analysis of credit risk (the “Merton model”). As he told me this week, the BSM model of pricing equity options was adopted by the markets in just two years; the Merton model took twenty years.
Merton is one of pioneers of modern mathematical finance, based on continuous time models. Unfortunately for struggling economics students, there has been a gradual escalation in the maths you need to do financial economics. It started with discrete time deterministic optimisation models, which were used in WW2 for targeting, then moved to continuous deterministic models (optimal control models that help you aim missiles and run machine tools). Now you have to cope with stochastic continuous time models, which requires a knowledge of stochastic calculus, something of a challenge for most students. Merton, building on the pioneering work of his PhD supervisor the great Paul Samuelson, was the leading developer of the current state of the art in mathematical finance.
Samuelson mentions in one of his reflections on his career that he saw the logic of what became the BSM option pricing model when he was working on the pricing of warrants (which are equity call options). Unlike many academics, Samuelson actually invested in the markets and set up an investment firm. Partly because of this experience, he was sceptical about the central assumption of BSM, which is the idea that you can continuously hedge a portfolio. So he left the final stage of the analysis and the Nobel prizes to Black (who died), Scholes and Merton. Samuelson did of course have his own Nobel.
Merton did his PhD at MIT many years ago and was a faculty member at the Sloan School for nearly 20 years, then moved to Harvard for a little over 20 years. He retired from Harvard in 2010 and returned to MIT. He now teaches on the MIT Master of Finance degree (which they, like us, abbreviate to MFin). I was lucky to meet Prof Merton at MIT this week, having attended one of his lectures on “Functional and Strategic Finance”. We had a long chat afterwards. He is very committed to the MIT MFin as a way of educating the world of financial practice. He hopes that bright and well trained graduates will move into positions of influence and leadership and help raise the quality of financial analysis and decision making. Of course this is just what we aim for in the Cambridge MFin and Prof Merton was pleased that another university has the same goal.
The Cambridge and MIT MFins are not directly in competition, because their course is mainly pre-experience and ours is post-experience. So we have a friendly and constructive relationship. And we share a common goal of getting MFin degrees recognised as something different from and intellectually more focused than MBAs, especially in the US. It is proving a long struggle. But it’s of some comfort to know that Prof Merton is on our side.
(*) Officially The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel