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Robert C. Merton and the Science of Finance of Science the and Merton C BRIEF / ROBERT C. MERTON AND THE SCIENCE OF FINANCE CFA INSTITUTE RESEARCH FOUNDATION / BRIEF ROBERT C. MERTON AND THE SCIENCE OF FINANCE A COLLECTION LUIS GARCIA-FEIJÓO, CFA, CIPM, LAURENCE B. SIEGEL, AND TIMOTHY R. KOHN, EDITORS GARCIA-FEIJÓO, SIEGEL, AND KOHN ROBERT C. MERTON AND THE SCIENCE OF FINANCE A Collection Luis Garcia-Feijóo, CFA, CIPM, Laurence B. Siegel, and Timothy R. Kohn, Editors Statement of Purpose CFA Institute Research Foundation is a not-for- profit organization established to promote the development and dissemination of relevant research for investment practitioners worldwide. Neither CFA Institute Research Foundation, CFA Institute, nor the publication’s edi- torial staff is responsible for facts and opinions presented in this publication. This publication reflects the views of the author(s) and does not represent the official views of CFA Institute Research Foundation. CFA®, Chartered Financial Analyst®, and GIPS® are just a few of the trademarks owned by CFA Institute. To view a list of CFA Institute trademarks and the Guide for the Use of CFA Institute Marks, please visit our website at www.cfainstitute.org. © 2020 CFA Institute Research Foundation. All rights reserved. Updated July 2020 to include “Robert C. Merton’s Seminal Insights, Revisited” by Robert A. Jarrow No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the copyright holder. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Cover photo credit: fanjianhua / Moment / Getty Images ISBN 978-1-944960-99-5 Luis Garcia-Feijóo, CFA, CIPM Florida Atlantic University and CFA Institute Research Foundation Laurence B. Siegel CFA Institute Research Foundation Timothy R. Kohn Dimensional Fund Advisors ROBERT C. MERTON AND THE SCIENCE OF FINANCE A Collection CONTENTS Foreword: Robert C. Merton and His Impact on the Science of Finance .................................. vii David Booth Introduction ........................................................................................................................ 1 Luis Garcia-Feijóo, CFA, CIPM, and Laurence B. Siegel Robert C. Merton and the Science of Finance ........................................................................ 3 Zvi Bodie Robert K. Merton, Robert C. Merton, Functional Social Science, and Finance ......................... 11 Harriet Zuckerman Trust and the Functional Perspective .................................................................................... 21 Richard Thakor The Relationship between Economics and Finance ................................................................. 25 James Poterba Robert Merton’s Impact on Retirement Security: Finance Science, SeLFIES, and the MMM Plan .......................................................................................................... 32 Arun Muralidhar Panel ................................................................................................................................... 46 Zvi Bodie, Carliss Baldwin, Deborah Lucas, Peter Tufano, and André Perold Developing a Theory of Convertible Securities ...................................................................... 56 Marti Subrahmanyam What Would Bob Merton Say or Do? .................................................................................... 59 André Perold Robert C. Merton’s Seminal Insights, Revisited ...................................................................... 63 Robert A. Jarrow Robert C. Merton: The First Financial Engineer ..................................................................... 69 Andrew W. Lo This publication qualifies for 4 PL credits under the guidelines of the CFA Institute Professional Learning Program. FOREWORD: ROBERT C. MERTON AND HIS IMPACT ON THE SCIENCE OF FINANCE David Booth Dimensional Fund Advisors Dimensional Fund Advisors was proud to models laid the foundation for an entirely cosponsor the 2019 MIT symposium honor- new branch of finance that revolutionized the ing Robert C. Merton that is faithfully summa- way financial firms manage risk. We endorse rized in this CFA Institute Research Foundation and share his belief that best practice is not publication. good enough; we must all continually inno- vate to improve outcomes for our clients and Dimensional is dedicated to translating aca- investors—and for future generations. demic research into practical investment solu- tions. Since 2010, Bob has been our resident The speeches in this volume make abundantly scientist working on retirement income solu- clear that Bob has had a profound impact both tions. His effort to link science and the practice as a financial science pioneer and as a teacher of finance was groundbreaking when he started and mentor. And I can attest, based on my years his career, and today, he remains committed to as his colleague, that his influence as a friend is the power of ideas and putting them to work to no less profound. solve real challenges. It is easy to think of Bob Merton as the father of financial engineering. His continuous-time CFA Institute Research Foundation | vii INTRODUCTION Luis Garcia-Feijóo, CFA, CIPM, and Laurence B. Siegel Robert C. Merton, winner of the 1997 Nobel which can be found at https://www.youtube. Prize in economics, is one of the most influ- com/watch?v=zLYlMi83o5Y. ential scholars in the history of financial eco- nomics. His work on continuous-time finance, The brief begins with an overview of Merton’s option pricing, financial services firms, and work and career, authored by Zvi Bodie. It retirement security is central to the current then presents edited transcripts of some of the state of knowledge. speeches and panel discussions that took place at the symposium. The authors of these pieces On August 5 and 6, 2019, MIT hosted a sym- graciously contributed their time following posium in honor of Merton’s 75th birthday. The the conference to make this brief possible.1 idea for this symposium originated with several Professor Bodie organized and put some struc- of Merton’s former students, whose careers ture into the conference by asking the present- were shaped by his influence. Realizing that he ers to focus on a specific aspect of Merton’s was about to turn 75 on July 31, 2019, Zvi Bodie work so that summed across the presenters, the took the initiative to organize a celebratory sym- audience would gain a full picture of Merton’s posium with a steering committee consisting of influence while avoiding repetition. The presen- Eric Rosenfeld, Leonid Kogan, and Andrew Lo tations illustrate the impact that Merton had, as well as Professor Bodie. They invited for- and continues to have, on the profession not mer students and colleagues to prepare papers only as an author but also as a teacher, mentor, and presentations explaining the influence that and adviser to financial practice. Merton had on their ideas, careers, and lives. Some readers may not know that Merton’s Every one of the people invited to make a pre- father, Robert K. Merton, was one of the most sentation accepted enthusiastically. The MIT important sociologists of the last half of the 20th finance department, represented by Kelly Nixon, century. As Harriet Zuckerman, who is the elder coordinated the logistics, and Dimensional Merton’s widow as well as a sociologist of great Fund Advisors (DFA) and Convexity Wines accomplishment, mentions in her presentation, jointly funded the event. We thank David Booth he is the originator of the concept of role mod- and Tim Kohn at DFA, and Chi-fu Huang, John els, of unanticipated consequences, and of self- Meriwether, and Eric Rosenberg at Convexity fulfilling prophecies, just to give a few examples. Wines for their generosity and support. His ideas on functions laid the foundation for the younger Merton and Zvi Bodie’s work on the Roughly a hundred people—former students, functional perspective of the financial system. colleagues, and Merton’s family—gathered at MIT for the symposium. The result was an intel- 1This brief includes selected conference presentations. We lectually stimulating and heartwarming event are grateful to everyone who presented, including those that is summarized in this brief. There is also whose excellent presentations are not available for inclu- a complete set of videos of the entire event, sion herein. CFA Institute Research Foundation | 1 INTRODUctiON Robert C. Merton’s current interests include the article, Subrahmanyam and coauthors show the- role of trust in financial markets, a classic topic oretically that the optimal contract between an that regained relevance following the global finan- entrepreneur and a financier takes the form of a cial crisis. Richard Thakor, a professor of econom- convertible security, as it is common in practice, ics and psychology at the University of Minnesota but in their model they do not assume informa- Carlson School of Management, describes his and tion asymmetry, contrary to existing models. He Merton’s recent theoretical work on trust. Thakor notes that today, it is nearly impossible to develop explains that the combination of their model
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