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MIT Alumnus, Nobel Prize Winner Merton Discusses Use of Derivatives for Markets

By Brian Loux

NEWS EDITOR

Nobel Laureate Robert C. Merton PhD ’70 discussed future uses of financial derivatives Monday night in 10-250.

The Harvard professor of economics returned to MIT after a long absence, receiving his PhD in economics at MIT and then serving on the Finance faculty at the Sloan School of Management until 1988.

“I was pleased to see that I could find 10-250 without any help,” he said.

“Merton laid the foundation of the rapid growth of derivative markets in the past 10 years,” said Undergraduate Economics Association Treasurer Jason R. Broeder ’02, who introduced him to the crowd.

Enron failed to manage pensions

Merton’s talk was heavily technical, focusing almost entirely on future uses of derivatives in markets.

In finance, derivatives are essentially contracts requiring the seller to pay a certain amount of money, based on some other economic parameter, at a future time. One person may sell these contracts with the hope that a stock or commodity’s price will never rise high enough for the buyer to make a profit, allowing the seller to make money without spending capital beforehand. This can allow business to manage risks more effectively than with traditional securities trading, as it allows you to “do it on a large scale with a razor thin cost,” Merton said.

It does, however, come with a great risk. Poor management of these risks led to Enron’s inability to pay off their pensions, Merton said. A large portion of employee pensions were based in derivative markets, and when the financial managers of the company guessed wrong on which contracts to make, the company was soon out millions.

In cases like this, Merton attributed problems with increased reliance on computer models and the scarcity of expertise to oversee the manipulation of the models. “Tools that serve well to transfer risks can, as a [result of their complexity], disguise failure from the most diligent of detectors,” he said.

He was not deterred by “individual” faults of some financial engineers. “There have been faulty financial engineering cases just as there have been in bridges, planes, and silicon chips,” he said.

Expanding derivative possibilities

In fact, Merton said he felt “excited” about the possibility of expanding the derivatives markets. “Once you measure risk well, it is almost irresistible to want to manage it,” he said.

One of Merton’s more interesting ideas involved derivatives for national markets. Using the example of Taiwan, Merton said that the country could use ‘swap derivatives,’ or contracts in which two or more parties split whatever profits are earned, on large scale industries in order to diversify its “national portfolio.” Therefore, should the electronics industry be hurt one year, the country would not collapse because it would receive profits from other foreign industries in which it invested.

In regard to future trends, Merton said that the key role of financial engineering will become production services. “Traditionally, retirement involved no decisions for the employee ... now there are much more, like 401(k)s and investments,” he said.

Merton argued that the current limits of accounting fail to distinguish levels of risk in an account and an investor’s human capital, or how sensitive an investor is to certain markets. “It is time for the next generation of risk models to find their way into life-minded investing.”

Reflecting upon the advances in financial science in the past decades and what they could promise for the future, he mentioned the importance of universities in helping advance markets. “What has happened in the past is not possible without the Black-Scholes model, which was developed entirely in an academic community,” he said.

Nobel Prize work started at MIT

Merton began his career at MIT as a doctoral student under the tutelage of Institute Professor Emeritus Paul A. Samuelson, who is credited with making the department one of the best in the nation.

Merton won the Nobel Prize for Economics in 1997 along with Martin Scholes for their derivative pricing formula. The two began collaboration in 1970 along with Fischer Black on option pricing theory, creating the Black-Scholes derivative pricing model. Merton’s work was published in 1972 after brief difficulties in finding a publisher, and his theoretical account appeared in print in 1973. Their work was soon realized to have incredible potential and applicability to a number of fields of study. He authored or co-authored seven books and wrote over twenty papers.

Merton took the time to answer individual questions after he finished his hour talk. The crowd received him very warmly and many students were eager to speak with the Nobel winner one-on-one.

“It was good to hear his perspective on how financial engineering will play a role in the future, as his thoughts carry a lot of weight,” Broeder said.

Around 200 people attended the talk.

Jonathan Wang contributed to the reporting of this story.