SEAS Latest Nobel Laureate: Robert C. Merton

By Bob Nelson
Senior Science Writer

Robert C. Merton, Class of 1966.

The latest Nobel laureate in economics has some fond memories of his undergraduate days at Columbia.

"I had terrific training,'' said Robert C. Merton. "I was in engineering mathematics, a small program that allowed me the freedom to take lots of different courses, including graduate courses, in various parts of the University. That's what so attracted me. And so I took accounting in General Studies, and mathematical sociology with the late Paul Lazarsfeld in the graduate school, and of course Contemporary Civilization in the College, and lots of mathematics everywhere, along with engineering courses in plasma physics, fluid dynamics and electrical engineering.

"In fact, I didn't realize until I arrived for orientation that there was any difference between the college and engineering. So I switched from Columbia College to the engineering school two days after I arrived.''

Merton, a 1966 alumnus of Columbia's Fu Foundation School of Engineering and Applied Science and son of renowned Columbia sociologist Robert K. Merton, will share the 1997 Nobel Prize in Economics for his work in options pricing. "It's such a signal honor, how could you not be thrilled and happy?'' he said.

He is the 57th Nobel laureate who taught or studied at Columbia, and the third Nobelist to graduate from the engineering school. Irving Langmuir, who earned a degree in metallurgical engineering in 1903 and was awarded an honorary doctorate in 1925 from Columbia, won the 1932 Nobel Prize in Chemistry for his work in surface chemistry. And Edward C. Kendall, a 1908 B.S. in engineering and a 1910 Ph.D., was awarded the 1950 Nobel in Physiology or Medicine for his investigations of the adrenal cortex and isolation of cortisone.

In the preface to his book, Continuous-Time Finance, published in 1990 and revised in 1992, the younger Merton lauded Columbia's engineering school. "With its small and flexible program and fine faculty, Columbia was a great place for an undergraduate to explore mathematics and its applications. It was there I first became intrigued with stochastic processes and optimal control theory.''

He inscribed the volume to John (Chia-Kun) Chu, his professor for a course in heat transfer, noting that Prof. Chu introduced him to his first partial differential equation and to much advanced mathematics. "He really did learn how to apply mathematics to real life, and apparently he liked the course sufficiently that he discussed with his father what he had learned,'' said Dr. Chu, now Fu Foundation Professor of Applied Mathematics.

Merton's advisor was Morton Friedman, now vice dean and professor of civil engineering. "I had created a program in the civil engineering department called engineering mathematics, and it attracted some really brilliant kids,'' Friedman said. "Merton was one of them.''

Merton, the George Fisher Baker Professor of Business Administration at the Harvard Business School, will share the prize with Myron S. Scholes, professor emeritus at Stanford's Graduate School of Business, for work they did with the late Fischer Black in the early 1970s at the Massachusetts Institute of Technology. The two economists will formally receive the prize in Stockholm in December and will share a cash award of $1 million.

After receiving his engineering degree from Columbia, Merton went on, with John Chu's encouragement, to graduate study at CalTech, where he received an M.S. in applied mathematics in 1967.

"Because of all the extra courses I took at Columbia, I finished my course work in first year, but realized I wasn't interested in doing a typical engineering science thesis,'' Merton said. "Instead, I thought, maybe I could bring mathematics to bear in economics. To the chagrin of everyone, my family and my advisers at CalTech, I applied to graduate programs in economics. They all turned me down, except MIT, which gave me a full fellowship. They had probably the number one or two economics department in the country at the time, so it was an easy decision.

''Born in New York in 1944, Merton had always had a keen interest in markets and trading. He bought his first share of stock at the age of 10. "Mathematics was for him a language from the very early years,'' said Robert K. Merton, now University Professor Emeritus at Columbia. "He certainly did not get that from me. But he liked solving problems, and he liked it even better if those problems involved the world.''

The younger Merton became a research assistant to famed economist Paul Samuelson at MIT, and discovered they shared an interest in applying mathematics to problems involving time and uncertainty, exemplified by financial markets. He earned the Ph.D. in economics in 1970, then taught at MIT's Sloan School of Management until 1988, when he joined the faculty of Harvard Business School.

Meanwhile, Fischer Black, a mathematician with Arthur D. Little consultants in Boston, met Myron Scholes, a professor at MIT, and discovered they shared a fascination with options pricing, then an arcane, theoretical subject. Merton was already working on the problem. Both groups published their results in 1973, but the Black and Scholes paper credited Merton for key elements of their work. Merton has also extended the Black-Scholes model and suggested several other applications of its approach that make it useful in almost every area of finance, a fact noted by the Nobel committee.

A call option allows, but does not require, an investor to purchase an asset, such as stocks, bonds or commodities, for a given price within a given period of time. Options and other financial derivatives, so named because their value is derived from that of other assets, allow investors who anticipate payments or revenues to hedge against losses or insure profits at certain levels.

No satisfactory way to value an option existed until the Black-Scholes model. "You had to either come up with the estimate of return on the stock, or say something on how risk-averse the investor is,'' said Suresh Sundaresan, Chase Manhattan Bank Foundation Professor of Financial Institutions at Columbia's Graduate School of Business. "Neither is easy to come up with, so there was a sense of unease about these models.''

Merton's key insight was the value of a call or buy option could be replicated by continuously balancing a portfolio that included both the stock in question and options to sell it. Any changes in stock price are compensated by changes in the price of the sell option, so the portfolio is risk-free and the rate that invested capital must earn should equal that of risk-free Treasury bonds. The investor's risk aversion drops out of the analysis, leaving only price volatility as the immediate determinant of the call option's value.

Pricing the call option is reached by subtracting the expected cost of exercising the option from the expected stock or commodity price at the time the option is exercised. Both terms can be calculated by solving a partial differential equation. The formula assigns a higher price to the option if the share price is higher today, if the stock or commodity price is more volatile and if interest rates in general are higher.

Merton's current research is focused on developing finance theory in the areas of capital markets and financial institutions.

On learning of his son's Nobel, Robert K. Merton raced up to Cambridge to be with him. Merton is happy and proud for his son. "We know the prize represents the judgment of his most knowing peers,'' the elder Merton said. "In the world of learning, there isn't a more demanding judgment.''

Has the father influenced the son? "I'd answer that by telling you that for the last 30 years, we have pretty much talked every day,'' Robert C. Merton said. "And often many times a day.''