Baker Library: About the Merton Exhibit


Option Pricing in Theory & Practice: The Nobel Prize Research of Robert C. Merton
About the Exhibit
*Introduction* *Prelude to the Option Pricing Model* *The Formula*	*The Spread and Adoption of Option Pricing Models* *The Significance and Consequences of Financial Models*


Introduction In October 1997, the Royal Swedish Academy of Sciences announced that the Nobel Prize in Economic Sciences was to be awarded to Professor Robert C. Merton, Harvard University, and Professor Myron S. Scholes, Stanford University, "for a new method to determine the value of derivatives." Robert Merton is the 35th Harvard University faculty member - and the first from the Graduate School of Business Administration - to be awarded a Nobel Prize. To celebrate both an extraordinary honor and a remarkable man, the Baker Library presents an exhibition exploring the context in which Professor Robert Merton conducted his Nobel Prize research, from his early influences and investigations as a young doctoral student more than twenty-five years ago to the impact and growth of his groundbreaking work in the current academic and financial communities. The Black-Scholes option pricing model established the everyday use of mathematical models as essential tools in the world of finance, both in the classroom and on the trading floor. The model offers a methodology to predict the seemingly unpredictable by using the lessons of complex mathematics and probability theory to forecast stock valuations, making it possible to successfully manage risk in the financial market. In less than thirty years it has changed the course of economic theory and financial practice. With the option pricing model firmly in place, Merton's research as a member of the Harvard Business School faculty continues to evolve as he turns his attention to new analyses of the financial system.


Prelude to the Option Pricing Model The work of Robert Merton, Fischer Black and Myron Scholes is the culmination of a series of discoveries and theories spanning the twentieth century. From Louis Bachelier, an obscure French mathematician who wrote at the turn of the century, through the contributions of scholars such as Harry Markowitz, John Lintner, William Sharpe, Eugene Fama, Franco Modigliani, and Merton Miller, the quest to apply the lessons of probability theory to the stock market has been a key focus of twentieth-century American finance. As a doctoral student at the Massachusetts Institute of Technology in the late '60s, Merton was able to both draw on the tradition preceding him and begin establishing new foundations in economics through his working relationship with Paul Samuelson. Perhaps more than any other economist to date, Paul Samuelson is credited with ushering in the modern era of mathematical economic analysis incorporating formal probability theory and optimization methods.


The Formula In 1970, Robert Merton joined Myron Scholes at the Sloan School of Management, becoming the sixth member of the finance faculty. It was in this small group that the complex theories of option pricing and corporate liability valuation were developed and expanded upon. Though Fischer Black was not a member of the MIT faculty, he was a frequent visitor and valuable participant in the discussions held there. Over the next several years, these three economists both independently and collaboratively created option pricing theory. Early empirical tests of what became known as the Black-Scholes formula were published in 1972. The theoretical account finally appeared in 1973, after several attempts to find a journal willing to accept the article. Merton was closely involved in the work leading up to these publications and his own extensions of the formula appeared in print in the spring of 1973.


The Spread and Adoption of Option Pricing Models News of an elegant and practical solution to the pricing of options and other derivatives spread quickly among receptive audiences. The Black and Scholes working papers, along with Merton's own handwritten notes and derivations of the formula, were required reading for students in Merton's finance classes long before they were published. An equally eager audience of financial advisors, portfolio managers and securities traders awaited the option pricing model. In the same year that Merton published his article on option pricing theory (1973), the Chicago Board Options Exchange opened and provided the perfect testing ground for the practical implementation of the Black-Scholes model. Within six months of the original publication of the Black-Scholes formula, it had become so widely used by traders at the CBOE that Texas Instruments produced a handheld calculator pre-programmed to produce Black-Scholes option prices and hedge ratios.


The Significance and Consequences of Financial Models In addition to being awarded the Nobel Prize, Robert Merton's contributions to financial economics have been celebrated frequently over the past quarter century in both the academic and finance communities. He has received honorary degrees from several universities, both in the United States and abroad, as well as numerous accolades from institutions in the financial world. Robert Merton's many honors include acknowledgments by the broader and more distant academic and scientific communities. In addition to being a Fellow of the American Academy of Arts and Sciences, he was elected as a member of the National Academy of Sciences in 1993. In May 1998 Robert Merton was appointed the first John and Natty McArthur University Professor. First created by the President and Fellows in 1935, the University Professorships, Harvard's most distinguished professorial post, are intended for "individuals of distinction...working on the frontiers of knowledge, and in such a way as to cross conventional boundaries of the specialities." The receipt of the Nobel Prize represents both the evolution of an idea and the beginning of endless new avenues for research that have been made possible by the work of Robert Merton, Myron Scholes, and Fischer Black. We join in celebrating the achievements of Robert Merton and the future he has made possible with the combination of theoretical and practical traditions in finance and economics.


Lenders to the exhibition: Cabot Science Library, Harvard University Carliss Y. Baldwin Chicago Board Options Exchange, Incorporated Francis Loeb Library, Graduate School of Design, Harvard University HBS Communications Office Stanford University News Service MIT Museum Gene Wright Sincere thanks is due to Professor Robert C. Merton, who not only loaned many pieces but also generously gave his time and his thoughts in the preparation of the exhibition. It has been an honor and a privilege to work with Professor Merton on this project.

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