The day I spent 5 hours with Robert Merton and everything was explained

Thanks to the Fisher College of Business, I met one of the of legends of Modern Finance – Robert C. Merton!!

Dr. Merton started by defining how he, Fisher Black, and Myron Scholes discovered valuation model of Options (Black Scholes Model). They started with Put option which he defined as a VALUE INSURANCE. The call option is derived from the put option by put call parity. It is the contract when you

buy an asset,

by borrowing money

and insuring the asset.

So, you pay just the insurance premium and have the complete upside of the asset with the insurance taking care of the downside!!

So, a call option is the sum of three functions:  f(asset) + f(leverage/loan) + f(premium for value insurance/put option)

He went on to talk about different types of option and their applications – information, market timing, HFT, Project Finance, Patents, Labour, Tenure, Training, HMO, Pay for view, Behavioral Dysfunction- Regret Insurance, Kenneth Arrow Risk, Option strategies, Butterfly, Digital, Real Options, Drug Discovery Phase, Movies, Public Policy, etc.

One of the most interesting was the Behavioral Dysfunction- Regret Insurance – Sometimes you lose money on a financial instrument (stocks for example) because you were emotionally attached to the stock and could not sell it at the exact price you wanted. The Lookback option gives you the right to sell the stock for the last 1 year(some time frame)’ s best price which takes away the regret from your sell.

He also talked about Long term capital management, subprime crisis and the recent financial regulation.

He also explained that financial innovations are based on models – and models are based on real historical cases and bounds to fail it times. Models depends on three things:

(1) Model

(2) User of the Model

(3) Application of the Model

So, when we evaluate financial models, we have to take the above three in consideration.

He finished by saying that innovation in financial instruments has been the best thing that has happened to society and with the increasing uncertainties, there will be a greater need for new financial instruments – which will be good for society.

The analogy he used was the 2 wheel drive vehicle and 4 wheel drive vehicle and winter in Ohio, which is snowy and cold. 4-wheel drive is safer than 2 wheel drive in winter. It was noted that after the innovation of the 4 wheel drive, the number of accidents increased. Later on, after doing a lot of research, it was found why the fatalities increased with the innovation of safe tool. The reason was that because of the innovation of 4 wheel drive, those people who once never went driving in the winter started doing so and though the innovation helped the society in giving access to increased travel, even in winter – it led to more accidents as people started taking more risk with the new tool.

New inventions leads to accidents(crisis) and crisis leads to new discoveries.

Meeting with Prof. Merton was really an inspirational experience!!

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For the uninitiated, Robert Merton is the Father of New Age Finance – Economics Noble Laureate 1997.
Known for
Black–Scholes model
ICAPM
Merton’s portfolio problem
Merton Model
Jarrow-Turnbull model
Long-Term Capital Management

http://en.wikipedia.org/wiki/Robert_C._Merton



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