Quant Corner Robert Merton Merton model for valuing corporate debt

‚robert merton, who’s best known for his academic work in developing option-pricing models, published his first scholarly paper on a topic far removed from finance: Gulliver’s Travels. While an undergraduate at Columbia University in New York, he wrote a piece for a literature class that analyzed the physical impossibility of a flying island as described in Jonathan Swift’s classic work. Merton, who majored in engineering mathematics at Columbia, says his English instructor proposed that they publish the paper as coauthors. “I asked myself, ‘What did he do?’” Merton says. He submitted “The ‘Motionless’ Motion of Swift’s Flying Island” by himself to the Journal of the History of Ideas, which published it in 1966. Merton got a D in the class. Merton, now a professor of finance at Harvard Business School in Boston, won the Nobel Memorial Prize in Economic Sciences in 1997 along with Myron Scholes for their development of the optionpricing model that many quants refer to as BlackMerton-Scholes. Merton played an instrumental role in discovering the Black-Scholes model, supplying the crucial arbitrage argument that underpins its logic. In January 1973, Merton was the first to publish the differential equation that became known as the Black-Scholes equation in a paper called “Continuous-Time Speculative Processes.” Black and Scholes published their full article on the model later that year. At about the same time, he developed the Merton model, a method of valuing a corporate bond based on default probability using a form of the Black-Scholes equation. The high-profile defaults of companies such as Enron Corp. and WorldCom Inc. and the rapid growth in the credit derivatives market have prompted a boom in interest in the Merton model among credit analysts. In addition to his teaching responsibilities at Harvard, Merton is now chief science officer at Integrated Finance Ltd., a New York–based investment bank he cofounded in December 2002. The firm closed its IFL Continuum Fund in June, according to Beth Burrus, a managing director of Integrated Finance. The fund, which concentrated on fixed-income securities, had collected $30 million since its start in March and was managed by Peter Hancock. Integrated Finance also has an $80 million emerging-market hedge fund run by José Luis Daza. Merton, 62, received his pre-doctorate training in the hard sciences. He earned a bachelor’s degree at Columbia and then a master’s degree in applied mathematics at California Institute of Technology in Pasadena. Merton credits his time in the master’s program at Caltech with helping him make the transition from passive learning to an active, self-directed education. “They would just throw you in a lab, and you would play around,” he says. He also spent his early-morning hours before class trading convertible bonds and warrants, which give the holder the right to buy the underlying stock, in the over-thecounter market. He says he became increasingly interested in finance and impressed by the idea, which was common at the time, that macroeconomic theory could solve many of the world’s economic problems. He decided to apply to doctoral programs in economics after he completed his master’s degree.