Annual Review of Financial Economics - Volume 12, 2020

This is an edited version of a talk given at the Robert C. Merton 75th Birthday Celebration Conference held at MIT on August 5 and 6, 2019. A video of the talk is available at https://bit.ly/2nvITM6.

This article is one of a pair of articles published in this volume about Robert C. Merton's contributions to the science of financial economics. The other article in this pair is “Robert C. Merton and the Science of Finance” by Zvi Bodie.

Starting with his 1970 doctoral dissertation and continuing to today, Robert C. Merton has revolutionized the theory and practice of finance. In 1997, Merton shared a Nobel Prize in Economics “for a new method to determine the value of derivatives.” His contributions to the science of finance, however, go far beyond that. In this article I describe Merton's main contributions. They include the following:

• 1.   The introduction of continuous-time stochastic models (the Ito calculus) to the theory of household consumption and investment decisions. Merton's technique of dynamic hedging in continuous time provided a bridge between the theoretical complete-markets equilibrium model of Kenneth Arrow and the real world of personal financial planning and management.
• 2.   The derivation of the multifactor Intertemporal Capital Asset Pricing Model (ICAPM). The ICAPM generalizes the single-factor CAPM and explains why that model might fail to properly account for observed market excess returns. It also provides a theory to identify potential forward-looking risk premia for use in factor-based investment strategies. It is therefore both a positive and normative theory.
• 3.   The invention of Contingent Claims Analysis (CCA) as a generalization of option pricing theory. CCA applies the technique of dynamic replication to the valuation and risk management of a wide range of corporate and government liabilities. Merton's CCA model for the valuation and analysis of risky debt is known among scholars and practitioners alike as the Merton Model.
• 4.   The development of financial engineering, which employs CCA to design and produce new financial products. Merton was the first to apply CCA to analyze government guaranty programs such as deposit insurance, and to suggest improvements in the way those programs are managed. He and his students have applied his insights at both the micro and macro policy levels.
• 5.   And finally, the development of a theory of financial intermediation that explains and predicts how financial systems differ across countries and change over time. Merton has applied that theory, called functional and structural finance, to guide the design and regulation of financial systems at the levels of the firm, the industry, and the nation. He has also used it to propose reforms in pensions, sovereign wealth funds, and macrostabilization policy.

This article is one of a pair of articles published in this volume about Robert C. Merton's contributions to the science of financial economics. This article was originally published in Volume 11 of the Annual Review of Financial Economics. The other article in this pair is “Robert C. Merton: The First Financial Engineer” by Andrew W. Lo.

Short-term debt that can serve as a medium of exchange is designed to be information insensitive. No one should be tempted to acquire private information to gain an informational advantage in trading that could destabilize the value of the debt. Short-term debt minimizes the incentive to acquire information among all securities of equal value backed by the same underlying asset. Moreover, backing short-term debt with debt (i.e., using debt as collateral) minimizes information sensitivity across all types of collateral with equal value. These features are consistent with financial crises occurring periodically. In the information view adopted here, a financial crisis can occur when the collateral backing the short-term debt is thought to have lost enough value to raise doubts among the traders that some may acquire private information. In a crisis, there is a shift from information-insensitive to information-sensitive debt.

We assess the complicated reality of monetary policy transmission through mortgage markets by synthesizing the existing literature on the role of refinancing in policy implementation. After briefly reviewing mortgage market institutions in the USA and documenting refinance activity over time, we summarize the links between refinancing and consumption and describe the frictions impeding the refinancing channel. The review draws heavily on research emerging from the experience of the financial crisis of 2008–2009, as it highlights a combination of market, institutional, and policy-making factors that dulled the transmission mechanism. We conclude with a discussion of potential mortgage market innovations and the applicability of lessons learned to the ongoing stresses induced by the COVID-19 pandemic.

We provide a critical review of macroeconomic models used for monetary policy at central banks from a finance perspective. We review the history of monetary policy modeling, survey the core monetary models used by major central banks, and construct an illustrative model for those readers who are unfamiliar with the literature. Within this framework, we highlight several important limitations of current models and methods, including the fact that local-linearization approximations omit important nonlinear dynamics, yielding biased impulse-response analysis and parameter estimates. We also propose new features for the next generation of macrofinancial policy models, including a substantial role for the financial sector, the government balance sheet, and unconventional monetary policies; heterogeneity, reallocation, and redistribution effects;the macroeconomic impact of large nonlinear risk premium dynamics; time-varying uncertainty; financial sector and systemic risks; imperfect product market and markups; and further advances in solution, estimation, and evaluation methods for dynamic quantitative structural models.

Global activities of banks are a core manifestation of broader patterns of globalization of production, trade, and finance. This article reviews the extensive recent empirical and theoretical literature on global banking, emphasizing the careful empirical analyses that incorporate key dimensions of heterogeneity among borrowers and lenders, and across activities. The actions of globally active banks are consequential, with cost and benefit trade-offs that differ during their lifetimes and at times of stress. Both research and policymaking around global banking benefit from improved infrastructures around collection of and access to granular data and repositories of evaluation studies. Although overall positive contributions from welfare perspectives arise from the activities of global banks, these organizations require appropriately targeted policy frameworks and oversight.

The credit default swap (CDS) remains an important class of derivatives contract despite the declining activity in the single-name corporate market. I provide a quick introduction to the contracts, the pricing formula used to interpret the market premiums, the development in trading volumes, and some key insights that are important for understanding its role in markets. I then take a closer look at the CDS-bond basis and the role of trading and regulatory frictions. Finally, the European sovereign debt crisis brought back in focus the notion of a quanto spread, which I explain.

We review the literature on debt structure, which is a central element in a firm's capital structure. We first survey both theoretical and empirical research pertaining to debt characteristics—maturity and priority—and debt types—bank loans, corporate bonds, credit lines, commercial paper, and capital leases. We then present comprehensive empirical evidence on public US firms’ debt structure over the period 2002–2018, highlighting that more than three-quarters of US firms concentrate their borrowing in one debt type, and offer some suggestive explanations for the observed pattern. Finally, we discuss directions for future research, including a better understanding of debt structure choices by non-US firms and by private firms, the cross-sectional and temporal variations in debt structure, the corporate policy implications of firms’ debt structure choices, and the interaction between types of assets and debt structure.

This review addresses, from a unified perspective, the important role of conflicts of interest in various facets of asset management and advising, including managing individual portfolios, institutional asset management, and order routing. I use an agency framework to highlight the sources of the underlying incentive conflicts, the nature of efficient solutions, the role of the structure of compensation in mitigating (or creating) the agency problem, and the use of benchmarks as a solution. I also highlight several contemporary contexts in which conflicts of interest are important.

We review recent research into how firms navigate four complex decisions in corporate takeovers: (a) deal initiation, (b) pre-offer toehold acquisition, (c) the initial (public) offer price, and (d) the payment method. We focus the evidence on public targets and the theory on first-price or English (ascending-price) auctions with two competing bidders and a single (pivotal) seller. The evidence shows that nearly half of bids are initiated by the target (not a bidder). Notwithstanding the large offer premiums, only a small fraction of bidders acquire a target toehold prior to bidding. The first bid rarely attracts rival bidders, suggesting effective competition deterrence. Bid jumps are high, as predicted when bidding costs are large. Pre-bid stock price run-ups reflect rational market deal anticipation and are understood as such by the deal negotiators. Bidders select stock payment when concerned with adverse selection on the target side of the deal.

Life-cycle portfolio choice models capture the role of human capital, housing, borrowing constraints, background risk, and several other crucial ingredients for determining the savings and investment decisions of households. Over the last two decades, this literature has provided us with multiple insights regarding the asset allocation decisions of individual investors. This article provides a critical survey of this research and suggests directions for future research, namely incorporating additional forms of household heterogeneity.

Real interest rates have been persistently below historical norms over the past decade, leading economists and policy makers to view the equilibrium real interest rate as likely to be low for some time. Various definitions and approaches to estimating the equilibrium real interest rate are examined, including approaches based on the term structure of interest rates and small macroeconomic models. The individual country approaches common in the literature are extended to allow for global trend and cyclical factors. The analysis finds that global factors dominate the downward trend in the equilibrium interest rate across 13 advanced economies. A corollary of this finding is that the U.S. equilibrium rate can be informed by global developments and is recently lower than estimated in U.S.-only studies. The analysis also highlights how the common global trend confounds empirical assessments of the determinants of movements in the equilibrium rate and the need to better integrate term-structure and macroeconomic approaches.

There is sufficient evidence in the popular, legal, and financial literatures that informed options trading ahead of scheduled and unexpected corporate events is pervasive. In this review, we piece together the extant evidence on this topic into a cohesive picture, which includes abnormal activity ahead of announcements of earnings, mergers and acquisitions, as well as numerous other corporate events. We also discuss the more limited evidence on informed trading in other derivatives markets, such as credit default swaps. In addition, we characterize the impact and features of illegal insider trading and insider trading networks. We also provide a brief overview of the legal framework in the United States concerning legal and illegal insider trading to emphasize the challenges associated with identifying informed options trading. We end with our suggestions regarding future research opportunities in this broad topic.

Textual analysis, implemented at scale, has become an important addition to the methodological toolbox of finance. In this review, given the proliferation of papers now using this method, we first provide an updated survey of the literature while focusing on a few broad topics—social media, political bias, and detecting fraud. We do not attempt to survey the various statistical methods and instead initially focus on the construction and use of lexicons in finance. We then center the discussion on readability as an attribute frequently incorporated in contemporaneous research, arguing that its use begs the question of what we are measuring. Finally, we discuss how the literature might build on the intent of measuring readability to measure something more appropriate and more broadly relevant—complexity.

Technological innovation is critical to a country's economic development and a firm's long-term success. This article reviews the recent literature that links institutions and innovation. Specifically, we focus on five aspects of the linkage. First, we discuss the literature that explores how the culture of a society or a corporation influences the process, features, and outcomes of innovation activities. Second, we review papers that focus on the role of demographic characteristics in innovation. Third, we describe studies examining the relation between market development and firms’ incentives as well as their ability to engage in innovative investments. Fourth, we discuss the literature on how innovation is shaped by a nation's laws and policies. Finally, we review the academic papers regarding the effects of government regulations and policies on innovation activities. Overall, this article aims to provide a synthetic and evaluative review of recent academic research that links various aspects of institutions and innovation. We also provide our views on potential directions for future research in this area.