By Ken Gewertz

Gazette Staff

Robert C. Merton, a Business School professor whose work on evaluating risk has changed the nature of financial markets worldwide, has won the Nobel Prize in Economics.

Merton, 53, the George Fisher Baker Professor of Business Administration, shares the $1 million prize with Myron S. Scholes of Stanford University. Merton joins more than 30 Harvard faculty members who have won a Nobel Prize. The announcement was made Tuesday morning.

"Robert Merton has been an innovative leader in the field of economic valuations, and in improving the capacity to manage financial risk," said President Neil L. Rudenstine. "This is a well-deserved honor for an outstanding member of our faculty whose work has had a major impact on modern financial markets."

Business School Dean Kim Clark said that Merton is "a highly valued member of our faculty who has made and continues to make fundamental contributions to finance and economics. His work not only wields remarkable influence on modern financial theory, but also has important implications for the character and performance of the global financial system. Bob's is a voice of leadership that speaks at once to the academy and the world of practice."

At a press conference at the Business School on Tuesday, Merton said that he learned he had won the prize when he answered the phone at 5:45 that morning and heard someone identifying himself as a representative of the Royal Swedish Academy of Sciences say, "We have something interesting to tell you . . ."

"I was in shock," Merton said. "I'm very touched and deeply honored, but I still can't believe it's really happened."

Looking trim and dapper, his red hair brushed back in crisp waves from his beaming face, Merton faced rows of reporters, banks of TV cameras, and flurries of firing strobe lights, and calmly strove to put his complicated and abstract theory into accessible terms.

Merton said that his interest in risk evaluation began when he was a graduate student in applied mathematics at the California Institute of Technology and would visit a local brokerage every morning between 6:30 and 9:30 to trade securities. Later, when he came to M.I.T. to study economics under Nobel Laureate Paul Samuelson, it struck him that his early morning activity could be placed on a scholarly footing.

"I realized that what I'd been doing could be a field of economics," he said.

Merton's research focuses on evaluating the financial risk associated with derivatives. He began working in this area in the late 1960s and early 1970s, later joining forces with co-prize-winner Scholes, who had been moving in a similar direction in collaboration with the late Fischer Black.

A derivative is a financial instrument connected to a stock. One form of derivative, for example, is a stock option, which gives a purchaser the right to buy a stock at a particular price.

Investors use derivatives to hedge their portfolios against the effects of sudden shifts in the market. Merton's work provides them with a formula for evaluating derivatives with greater precision. In fact, using Merton's formula, it is possible to construct a portfolio that is virtually risk-free.

Merton said that since his theory was introduced, financial managers have realized that it could be applied to a wide range of contractual agreements, covering the prepayment of mortgages, the evaluation of student loan guarantees, the choice of energy alternatives, and many others.

Merton said that "it was an enormous kick to discover that this highly mathematical and abstract theory that I played with for the sheer enjoyment of it actually had a practical use."

The theory has not only proved useful to financial managers, it has actually helped to change the nature of financial investment.

"The formula allows managers to evaluate innovative financial instruments with greater confidence," Merton said. "In fact, a lot of these instruments would not exist today because managers wouldn't have the confidence to put them on the market."

Merton's work has helped to bring about an explosion in the derivatives market worldwide, a development which some have criticized as leading to greater instability. For example, the 1994 bankruptcy of Orange County, Calif., as well as the 1995 collapse of Barings Bank were both brought about through trade in derivatives.

But Merton said that, on the whole, the increase in derivatives trading has been beneficial. Derivatives serve as a form of sophisticated "adapters," he said, linking economic systems together and helping to bring about a unified world economy. They have also brought about vast reductions in costs by connecting these systems with more efficient technologies.

"All of us are naturally fascinated with pathology, with what can go wrong, but we must look at the whole. Derivatives have opened up multiple channels of financial flows, and there is less risk with that than with a single channel," he said.

Asked what he plans to do with his half-million-dollar share of the prize money, Merton replied:

"Someone might doubt my financial prowess if I confess that I haven't really thought about it. It is very pleasant, however."

Merton joined the Business School faculty in 1988. He is the author of Continuous-Time Finance (1990, revised edition 1992) and the co-author of Casebook in Financial Engineering: Applied Studies of Financial Innovation (1995) and The Global Financial System: A Functional Perspective (1995).