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Investors of note: Robert C. Merton

November 10, 2022

reading time: 3 minutes

by Sidi Staub, LGT

Investors of note: Harry Markowitz

The Nobel Prize-winning economist who played a part in what almost became a global financial crisis.

During the 1980s, a new type of banker emerged on Wall Street that traditional investment bankers referred to as quants or eggheads. These scientists, who were increasingly being poached from universities, were often very talented mathematicians, economists and physicists. They revolutionized financial markets with their quantitative models and algorithms and paved the way for today’s computer-based investment and trading strategies.

Buying stocks at the age of eleven

One of these eggheads was Robert C. Merton, a brilliant young economist from New York. Merton, who initially studied applied mathematics, had been interested in money and finance since his childhood. By the age of eight, he had drawn up a household budget for his mother, and he bought his first stock at age eleven. While doing his master’s, he would go to his broker early each morning before class to trade stocks, convertible bonds and options. In 1970, after receiving his doctorate, Merton became a lecturer at the prestigious Massachusetts Institute of Technology (MIT). It was there that he met other eggheads, including Myron Scholes and Fischer Black, with whom he developed a new method for valuing stock options. This model, which became known as the Black-Scholes model, was the first equation for calculating the value of options, and fueled a boom in these financial instruments that continues to this day.

Nobel Prize for options model

In 1994, John W. Meriwether, a disgraced former head of bond trading at a major investment bank, founded a new breed of hedge fund, which he called Long-Term Capital Management, or LTCM. He brought Merton and Scholes on board as partners. The idea was to manage the fund using mathematical algorithms such as the Black-Scholes formula. In its early years, the fund was extremely successful and highly sought after by major investors and banks. Demand increased even further when Merton and Scholes received the Nobel Prize in 1997 for their formula for the valuation of options. By 1998, LTCM had entered into contracts for derivatives, swaps and other complex financial instruments, which according to one estimate were worth a total of one trillion dollars. The fund was largely financed with bank loans, and had grown to a volume that made it a potential threat to the entire financial system. In the fall of 1998, just one year after the two co-founders were awarded the Nobel Prize, LTCM recorded huge losses in the wake of the Asian and Russian crises, and due to a bad investment in Italian government bonds, which put the hedge fund at risk of collapsing. In order to prevent a larger financial crisis, a rescue package worth billions of dollars had to be put together with the help of the Federal Reserve.

Image remains intact

Whether it was the models and algorithms that were to blame for the fall of LTCM or simply poor risk management is still a matter of debate. But the affair had practically no impact on Merton’s image. He taught at Harvard University until 2010 and then returned to MIT as a highly decorated professor, where he continues to teach to this day as a Distinguished Professor of Finance. In an interview in 2010, he said that the 2008 financial crisis has shown the growing importance of understanding complicated financial instruments and models. Merton went on to say that while no bank can dispense with these instruments and models, it is important that they be used appropriately. The same probably would have been true for LTCM.

Portrait in Header Visual © Peter Boer / De Beeldunie / laif.

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