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Lunch with a Laureate: Robert Merton

04/26/2010 12:00 PM Museum
Robert C. Merton, Ph.D. '70, MIT Sloan School of Management Distinguished Professor of Finance

Description: As an MIT Museum audience peppers him with queries ranging from the barter system to development, trade relations, and the role of intuition in economics, Nobel Prize"winner Robert Merton pushes back against any assumptions that he might be a "renaissance man." He carefully steers listeners to his areas of expertise -- financial engineering and innovation, and risk management.

Merton starts with the breakthrough work that earned him his laurels, and which has recently stirred up controversy: derivatives. There are "no mysteries" to these financial instruments, insists Merton. They are neither complex nor threatening. Derivatives are "nothing more than insurance," coming into play when people exercise the right to buy or sell an asset or stock at a guaranteed price. Merton developed formulas for valuing such guarantees. These "tools of analysis" are now central to many areas of big finance, such as pricing corporate liabilities, student loan guarantee programs, and federal deposit insurance, and pop up in ordinary life as mortgages with the right to prepay, and car leases with a purchase option.

Merton relishes extending theory into the world of practice. He says, "I'm an engineer by nature; I like to solve problems." He's wrestling with two very big current projects: developing a new model for retirement that takes into account the uncertainties that unfold over 30"some years of a working life, and provides the desired standard of living when that working life ends; and improving the risk profiles of small, developing countries.

During give and take with the audience, Merton finds himself fending off some harsh questions around the role of derivatives in the current financial crisis, even suggestions that his contributions to economics have been discredited by the events of the past year or so. Merton declares that his models factored in the possibilities of such crises, and we should acknowledge that "rare events can occur." He does not view the avalanche of financial institution failures following the implosion of the housing market as evidence of flawed financial instruments so much as poor implementation. There is "no need to throw the paradigm out," he says. Beyond some of the "fools and knaves" complicit in the crisis, Merton sees structural problems, like senior managers, boards and government regulators "who did not understand what was going on." He concludes, "I do believe that what we had does not fundamentally have to be changed."

About the Speaker(s): Robert C. Merton earned a bachelor's degree in engineering mathematics from Columbia University, a master's degree in engineering mathematics from the California Institute of Technology, and a doctorate in economics from the Massachusetts Institute of Technology. He then served on the finance faculty of the MIT Sloan School of Management until 1988, when he moved to Harvard Business School.

Merton is a fellow of the American Association of Arts and Sciences, and a member of the National Academy of Sciences. He is also past president of the American Finance Association. He serves as co"editor of the Annual Review of Financial Economics and is a member of the MIT Sloan Finance Group Advisory Board, among many other appointments.

Merton was a founding principal of Long Term Capital Management, and is currently the developer of SmartNest, a pension management system that addresses deficiencies associated with traditional defined"benefit and defined"contribution plans.

Host(s): Office of the Provost, MIT Museum

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