Contact: Bob Nelson For immediate release
(212) 854-6580 October 15, 1997
Merton, Engineering Alumnus and Sociologist's Son,
Wins 1997 Nobel in Economics
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 1903 Metallurgical Engineer degree 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 Chu, his professor for a course in heat
transfer, noting that 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 Chu, now Fu Foundation
Professor of Applied Mathematics.
"It's gratifying to know that Columbia's engineering school provided the
grounding that saw Robert C. Merton through a career in advanced mathematics
and economics," said Zvi Galil, dean of engineering. "That he solved his first
partial differential equation at Columbia, and decided to keep solving them, is a
wonderful inspiration to our engineering students and faculty."
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. Farmers may
sell their wheat on the futures market before the first seed is planted if they expect
prices to drop, or market traders may buy options in a certain stock if they expect
its price to rise.
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. Researchers knew they needed to
come up with something superior, and there was a strong sense that a
theoretically satisfactory solution was possible."
Merton's key insight was that 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
capital so invested must earn should equal that of risk-free Treasury bonds. The
investor's risk aversion then drops out of the analysis, leaving only price volatility
as the immediate determinant of the call option's value.
Pricing the call option then simply becomes a matter of 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.
The pricing model has found wide applicability in investment decision-
making and is now also used to value insurance contracts and to depreciate
physical assets. "If you go to any commercial bank or investment bank or trading
firm, you will see Black-Scholes there on a daily basis," Sundaresan said. "The
insight is in fact the basis for just about every pricing model."
Said Merton: "Myron Scholes and I had that sense that it would be very
useful. Every time we thought about it, there were new applications, and our
graduate students were like kids in a candy store, because there were almost
more applications to work out than there was time to do it."
Merton's current research is focused on developing finance theory in the
areas of capital markets and financial institutions. He has written extensively on
portfolio choice, capital asset pricing, risky corporate debt, loan guarantees and
other complex derivative securities. He 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.
On learning of his son's Nobel, Robert K. Merton raced up to Cambridge to
be with his son. Merton founded the sociology of science, and his wife, Harriet
Zuckerman, vice president of the Mellon Foundation, professor emerita of
sociology at Columbia and the Nobel winner's stepmother, is an expert in how the
Nobel can affect its recipients. Often they experience a loss of productivity once
increasing public demands are made of them, and Merton passed on to his son
what Zuckerman had learned.
But 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."