Robert Merton

Robert Merton is a professor of finance at the Harvard Business School and the 1997 winner of the Nobel Prize in economics for his work on pricing models for options and derivatives.  Professor Merton is past President of the American Finance Association, a member of the National Academy of Sciences, and a fellow of the American Academy of Arts and Sciences.

Dan Richards interviewed Professor Merton on January 4 at the annual meeting of the American Economic Association in Atlanta, GA. This interview is one of a series that Dan conducted at that conference, and we will provide links to videos of his other interviews. Dan is president of Toronto-based Strategic Imperatives.

You received your Nobel Prize for your work in the field of derivatives.  This is a very a hot topic these days.  Let’s begin by defining exactly what we mean by derivatives.

The name “derivative” is almost self-explanatory.  A derivative security is a financial contract that derives its value and characteristics from the value or price of an underlying security.  For example, a call option on a stock is a derivative, where you have the right to buy a stock at a given price.  It derives its value from the underlying stock.

However, there are many instruments and securities that derive their value at some level from something else, which are not very useful to refer to as derivatives.  The way I like to think of it is that derivatives are financial instruments whose role is to allow efficient and effective transfer of risk, rather than transfer of value.  These tools vary and include futures, swaps and options.

They are all designed to allow the transfer of risk more efficiently without the transfer of value.  That’s what they are principally used for.

What many people call derivatives are structured products, many of which are opaque – including structured mortgage products.  If you call those derivatives, then you have to call the debt and shares of every company a derivative.  That is the sense in which it could become absurd.

How far back do derivatives go, as we understand them today?

It depends on how you want to measure that.  Some people say biblical times. You can clearly document their use in the 17th-century Holland, when Amsterdam was the center of the Western financial world.  Derivatives were front-and-center on various stock exchanges.  There was much more trading and volume in derivatives than in the financial stocks themselves.

When you read about those times – and I don’t know whether this is a good thing or a depressing thing – the same issues as what we are talking about today were talked about then: volatility, front-running and too much trading.  They really do go back a long, long time.

In more modern times, we have had futures markets and options market, but the big change in recent times was in the early 1970s, when there was an explosion of development in the derivatives market, particularly in the financial space.