Robert C. Merton: Early Life and Education, Accomplishments, FAQs

Robert C. Merton is an American economist who won the 1997 Nobel Memorial Prize in Economic Sciences. Merton, along with Fisher Black and Myron Scholes, developed a method of determining the value of options, referred to as the Black-Scholes model. 

Merton also developed an intertemporal capital asset pricing model (CAPM) based on William Sharpe's capital asset pricing model. CAPM is a way of calculating anticipated investment returns based on the level of risk.

Early Life and Education

Merton was born in 1944 in New York City and grew up in Westchester County, New York. He has a Bachelor of Science in Engineering Mathematics from Columbia University, a Master of Science from the California Institute of Technology, and a doctorate from Massachusetts Institute of Technology (MIT), where he studied under Paul Samuelson, considered one of the most influential economists of the 20th century.

Merton continued at MIT as a professor, teaching there for nearly two decades, then teaching at Harvard University for another 20 years. He has since returned to MIT, where he is Professor Emeritus.

Notable Accomplishments

The Black-Scholes Model

Robert C. Merton is best known for the Black-Scholes model, also known as the Black-Scholes-Merton model. The Black-Scholes model is a model of price variation of financial instruments such as stocks. In one of the most important concepts in modern economic theory, Merton, along with his colleagues, developed the 1973 model.

Merton received the Nobel Prize in Economics in 1997 for his work on the Black-Scholes model. The model remains prevalent and influential. It is widely used today by investment bankers and hedge funds as the basis for hedging strategies. The Black-Scholes model is regarded as one of the best ways of determining the fair price of options.

The Black-Scholes model requires five input variables to complete the calculation. Inputs include the option's strike price, the current stock price, the time to expiration, the risk-free rate, and the volatility. Additionally, the model assumes stock prices follow a log-normal distribution because asset prices cannot be negative.

The model further posits there are no transaction costs or taxes, the risk-free interest rate is constant for all maturities, short selling of securities with the use of proceeds is permitted, and there are no riskless arbitrage opportunities. Contemporary models often differ, however, allowing for transaction costs and other variants.

Long-Term Capital Management

Long-Term Capital Management was a hedge fund founded by John Meriwether, who was a bond trader at Salomon Brothers and rose to become its vice-chairman. The fund's strategy was partly led by both Merton and Scholes, who were also principals of the fund, and was extremely levered.

With the financial crisis in Asia spreading and the economic issues of Russia devaluing its currency and not paying its debt in 1998, LTCM began to lose significant amounts of money and was on the brink of collapse.

To prevent a complete meltdown that would have significant ramifications across financial markets, 14 banks and brokerage firms invested $3.6 billion into the hedge fund to prevent its collapse. The Federal Reserve facilitated the process but did not invest any money.

LTCM was saved from collapse but the owners had to give up the bulk of their ownership and eventually closed down the firm and returned the $3.6 billion.

The Bottom Line

Robert C. Merton developed the Black-Scholes model, which is one of the most important financial tools used in investing. It is used by derivatives traders and investors, particularly those using options, to correctly price a derivatives option. The model greatly helps traders and investors hedge their securities with minimal risk.