1932

Abstract

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.

Loading

Article metrics loading...

/content/journals/10.1146/annurev-financial-011019-040506
2019-12-26
2024-03-29
Loading full text...

Full text loading...

/deliver/fulltext/financial/11/1/annurev-financial-011019-040506.html?itemId=/content/journals/10.1146/annurev-financial-011019-040506&mimeType=html&fmt=ahah

Literature Cited

  1. Arrow KJ. 1953. Le rôle des valeurs boursières pour la répartition la meilleure des risques. Transl. The role of securities in the optimal allocation of risk-bearing Chicago: Cowles Comm. Res. Econ., Univ. Chic.
    [Google Scholar]
  2. Arrow KJ. 1970. Essays in the Theory of Risk-Bearing Amsterdam: North-Holland
  3. Bernstein PL. 1992. Capital Ideas: The Improbable Origins of Modern Wall Street Hoboken, NJ: John Wiley & Sons
  4. Black F. 1989. How we came up with the option formula. J. Portfolio Manag. 15:24–8
    [Google Scholar]
  5. Black F, Scholes M. 1973. The pricing of options and corporate liabilities. J. Political Econ. 81:3637–35
    [Google Scholar]
  6. Bodie Z. 2011. Mismatch risk, government guarantees, and financial instability: the case of the U.S. pension system. Int. J. Central Bank. 8:S1273–83
    [Google Scholar]
  7. Bodie Z, Merton RC. 1993. Pension benefit guarantees in the United States: a functional analysis. Future of Pensions in the United States ed. R Schmitt, pp. 194–246. Philadelphia: Univ. Pa. Press, 2nd ed..
    [Google Scholar]
  8. Bodie Z, Merton RC, Cleeton D 2010. Financial Economics Upper Saddle River, NJ: Prentice Hall
  9. Bodie Z, Ruffino D, Treussard J 2008. Contingent claims analysis and life-cycle finance. Am. Econ. Rev. 98:2291–96
    [Google Scholar]
  10. Breeden D. 1979. An intertemporal asset pricing model with stochastic consumption and investment opportunities. J. Financ. Econ. 7:3265–96
    [Google Scholar]
  11. Breeden D, Litzenberger R. 1978. Prices of state-contingent claims implicit in option prices. J. Bus. 51:4621–51
    [Google Scholar]
  12. Cox J, Ingersoll J, Ross S 1985. A theory of the term structure of interest rates. Econometrica 53:2385–407
    [Google Scholar]
  13. Crane D, Froot KA, Mason SP, Perold A, Merton RC et al. 1995. The Global Financial System: A Functional Perspective Boston: Harvard Bus. School Press
  14. Draghi M, Giavazzi F, Merton RC 2003. Transparency, Risk Management and International Financial Fragility Iss. 9806 Geneva: Int. Cent. Monet. Bank Stud. 69 pp.
  15. Fama E. 1965. The behavior of stock prices. J. Bus. 1965:34–105
    [Google Scholar]
  16. Fisher I. 1930. The Theory of Interest New York: The Macmillan Co.
  17. Fisher L, Lorie J. 1964. Rates of return on investments in common stocks. J. Bus. 1964:1–24
    [Google Scholar]
  18. Gray DF, Bodie Z, Merton RC 2007. Contingent claims approach to measuring and managing sovereign risk. J. Invest. Manag. 5:45–28
    [Google Scholar]
  19. Hakansson N. 1976. The purchasing power fund: a new kind of financial intermediary. Financ. Anal. J. 32:649–59
    [Google Scholar]
  20. Ingersoll JE. 1976. A theoretical and empirical investigation of the dual purpose funds: an application of contingent-claims analysis. J. Financ. Econ. 3:1–283–123
    [Google Scholar]
  21. Jensen MC. 1968. The performance of mutual funds in the period 1945–64. J. Finance 1968:487–616
    [Google Scholar]
  22. Khandani AE, Lo AW, Merton RC 2013. Systemic risk and the refinancing ratchet effect. J. Financ. Econ. 108:29–45
    [Google Scholar]
  23. Kritzman M. 2018. An interview with Nobel Laureate Robert C. Merton. Financ. Anal. J. 74:112–20
    [Google Scholar]
  24. Lintner J. 1965. The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. Rev. Econ. Stat. 1965:13–37
    [Google Scholar]
  25. Lo AW, Merton RC 2009. Annu. Rev. Financ. Econ.1.
  26. Markowitz H. 1952. Portfolio selection. J. Financ. 1952:77–91
    [Google Scholar]
  27. Markowitz H. 1959. Portfolio Selection: Efficient Diversification of Investment New York: Wiley
  28. Mason SP, Merton RC, Perold A, Tufano P 1995. Cases in Financial Engineering: Applied Studies of Financial Innovation Englewood Cliffs: Prentice Hall
  29. Merton RC. 1969. Lifetime portfolio selection under uncertainty: the continuous-time case. Rev. Econ. Stat. 51:3247–57
    [Google Scholar]
  30. Merton RC. 1970. Analytical optimal control theory as applied to stochastic and non-stochastic economics PhD Thesis, Mass. Inst. Technol., Dept. Econ.
  31. Merton RC. 1971. Optimum consumption and portfolio rules in a continuous-time model. J. Econ. Theor. 3:4373–413 see Merton (1970), chapter I, Merton (1990d), chapter 15
    [Google Scholar]
  32. Merton RC. 1973a. An intertemporal capital asset pricing model. Econometrica 41:5867–87
    [Google Scholar]
  33. Merton RC. 1973b. Theory of rational option pricing. Bell J. Econ. Manag. Sci. 4:1141–83 see Merton (1990d), chapter 8
    [Google Scholar]
  34. Merton RC. 1973c. An intertemporal capital asset pricing model. Econometrica 41:5867–87
    [Google Scholar]
  35. Merton RC. 1974. On the pricing of corporate debt: the risk structure of interest rates. J. Financ. 29:2449–70 see Merton (1990d), chapter 12
    [Google Scholar]
  36. Merton RC. 1975. Theory of finance from the perspective of continuous time. J. Financ. Quant. Anal. 10:659–74
    [Google Scholar]
  37. Merton RC. 1982. On the microeconomic theory of investment under uncertainty. Handbook of Mathematical Economics 2 K Arrow, M Intriligator, pp. 601–69. Amsterdam: North-Holland
    [Google Scholar]
  38. Merton RC. 1989. On the application of the continuous-time theory of finance to financial intermediation and insurance. Geneva Pap. Risk Insur. 14:52225–26; see Merton (1990d), chapter 14
    [Google Scholar]
  39. Merton RC. 1990a. A dynamic general equilibrium model of the asset market and its application to the pricing of the capital structure of the firm. See Merton (1990d), chapter 11
  40. Merton RC. 1990b. Capital market theory and the pricing of financial securities. Handbook of Monetary Economics B Friedman, F Hahn, pp. 497–581. Amsterdam: North-Holland
    [Google Scholar]
  41. Merton RC. 1990c. An intertemporal capital asset pricing model. See Merton 1990d
  42. Merton RC. 1990d. Continuous-Time Finance Malden, MA: Blackwell
  43. Merton RC. 1993. Operation and regulation in financial intermediation: a functional perspective. Operation and Regulation of Financial Markets P Englund, pp. 4–67. Stockholm: Econ. Council
    [Google Scholar]
  44. Merton RC. 1995. A functional perspective of financial intermediation. Financ. Manag. 24:223–41
    [Google Scholar]
  45. Merton RC. 1998. Applications of option-pricing theory: twenty-five years later. Am. Econ. Rev. 88:3323–49
    [Google Scholar]
  46. Merton RC. 2002. Future possibilities in finance theory and finance practice. Mathematical Finance—Bachelier Congress 2000 H Geman, D Madan, S Pliska, T Vorst, pp. 47–73 Berlin: Springer-Verlag
    [Google Scholar]
  47. Merton RC. 2007a. Risk is not an add-on. Capital Ideas Evolving ed. PL Bernstein, pp. 47–57 Hoboken, NJ: John Wiley & Sons
    [Google Scholar]
  48. Merton RC. 2007b. The future of retirement planning. The Future of Life-Cycle Saving and Investing Z Bodie, D McLeavey, LB Siegel 5–14 New York: Res. Found. CFA Inst.
    [Google Scholar]
  49. Merton RC. 2014. The crisis in retirement planning. Harvard Bus. Rev. July-Aug. 3–10
    [Google Scholar]
  50. Merton RC. 2018. Solving global challenges using finance science: past and future Lecture presented at the China Int. Conf. Financ., Tianjin, China, July 10–13
  51. Merton RC, Billio M, Getmansky M, Gray D, Lo AW et al. 2013. On a new approach for analyzing and managing macrofinancial risks. Financ. Anal. J. 69:222–33
    [Google Scholar]
  52. Merton RC, Bodie Z. 1992. On the management of financial guarantees. Financ. Manag. 21:87–109
    [Google Scholar]
  53. Merton RC, Bodie Z. 1993. Deposit insurance reform: a functional approach. Carnegie-Rochester Conf. Ser. Public Policy 38:1–34
    [Google Scholar]
  54. Merton RC, Bodie Z. 1995a. A conceptual framework for analyzing the financial environment. See Crane et al. (1995), chapter 1
  55. Merton RC, Bodie Z. 1995b. Financial infrastructure and public policy: a functional perspective. See Crane et al. (1995), chapter 8
  56. Merton RC, Bodie Z. 2002. International pension swaps. J. Pension Econ. Financ. 1:77–83
    [Google Scholar]
  57. Merton RC, Bodie Z. 2005. Design of financial systems: towards a synthesis of function and structure. J. Invest. Manag. 3:11–23
    [Google Scholar]
  58. Merton RC, Muralidhar A. 2017. Time for retirement ‘SeLFIES’. Invest. Pensions Eur. April 3–4
    [Google Scholar]
  59. Merton RC, Tufano P. 1998. The Global Financial System Project. The Intellectual Venture Capitalist: John H. McArthur and the Work of the Harvard Business School, 1980–1995 TK McCraw, JL Cruikshank 67–98 Boston: Harvard Bus. School Press
    [Google Scholar]
  60. Modigliani F, Miller MH. 1958. The cost of capital, corporation finance and the theory of investment. Am. Econ. Rev. 1958:261–97
    [Google Scholar]
  61. Mossin J. 1966. Equilibrium in a capital asset market. Econometrica 1966:768–83
    [Google Scholar]
  62. R. Swed. Acad. Sci 1997. The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1997 Press Release, Oct. 14. https://www.nobelprize.org/prizes/economic-sciences/1997/summary/
  63. Rubinstein M. 2006. A History of the Theory of Investments Hoboken, NJ: Wiley
  64. Samuelson PA. 1965. Proof that properly anticipated prices fluctuate randomly. Ind. Manag. Rev. 1965:41–49
    [Google Scholar]
  65. Samuelson PA. 1969. Lifetime portfolio selection by dynamic stochastic programming. Rev. Econ. Stat. 51:3239–46
    [Google Scholar]
  66. Samuelson PA, Merton RC. 1969. A complete model of warrant pricing that maximizes utility. Ind. Manag. Rev. 10:17–46
    [Google Scholar]
  67. Scholes MS. 1998. Derivatives in a dynamic environment. Am. Econ. Rev. 88:3350–70
    [Google Scholar]
  68. Sharpe WF. 1964. Capital asset prices: a theory of market equilibrium under conditions of risk. J. Finance 19:425–42
    [Google Scholar]
  69. Tobin J. 1958. Liquidity preference as behavior towards risk. Rev. Econ. Stud. 1958:68–85
    [Google Scholar]
  70. Treynor J. 1962. Toward a theory of market value of risky assets SSRN Work. Pap. http://ssrn.com/abstract=628187
  71. Vasicek O. 1977. An equilibrium characterization of the term structure. J. Financ. Econ. 5:2177–88
    [Google Scholar]
  72. Wilson JP, Campbell L. 2016. Financial functional analysis: a conceptual framework for understanding the changing financial system. J. Econ. Methodol. 23:4413–31
    [Google Scholar]
/content/journals/10.1146/annurev-financial-011019-040506
Loading
  • Article Type: Review Article
This is a required field
Please enter a valid email address
Approval was a Success
Invalid data
An Error Occurred
Approval was partially successful, following selected items could not be processed due to error