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The Evolution of Financial Technology

01/28/2011 9:00 AM Kresge
Andrew W. Lo, Harris & Harris Group Professor, Director, MIT Laboratory for Financial Engineering; John C. Cox, Nomura Professor of Finance, MIT Sloan School of Management; Robert C. Merton, Ph.D. '70, MIT Sloan School of Management Distinguished Professor of Finance; Stewart C. Myers, Robert C. Merton (1970) Professor of Financial Economics,; MIT Sloan School of Management ; Stephen A. Ross, Franco Modigliani Professor of Financial Economics,; MIT Sloan School of Management; Myron S. Scholes, Frank E. Buck Professor of Finance, Emeritus,; Graduate School of Business, Stanford University

Description: An unmistakable glow of nostalgia rises from this reunion of "five of the founding fathers of modern finance," in the words of Andrew Lo. The speakers reminisce about their start in economics, and their professional lives at MIT, a decades"long era of intense collaboration and creativity that both transformed the academic field and the landscape of real"world finance.

This group of scholars believes they owe much to luck in finding their lives in financial economics. A sympathetic Stanford professor directed Stewart C. Myers to the right doctoral program, at precisely the moment when "big ideas were flowering" in the discipline: efficient markets, agency costs, and most important to Myers, new theories about valuation. A call came from MIT to join the faculty, and Myers began his critical work around the principles of corporate finance, which turned out to have great practical applications. Says Myers, "It's really good to go out in the world now and talk to CFOs actually using this stuff."

Raised in a Canadian family that traded in gold, Myron Scholes was interested in "how things were valued," but it was a summer job as a computer programmer for university researchers that set his career path. Assisting Franco Modigliani and Merton Miller, Scholes found infectious their "joy of getting results, and asking the next questions." He came to MIT in 1968, and became fascinated with options, insurance and distributions of portfolios. He met Fischer Black his first summer, which led to the first of many intellectually profitable partnerships, some of which continue to this day.

Among other twists of fate, a switch in grad school from applied mathematics to economics, and the good sense of MIT to offer him a fellowship (following rejections by eight other schools) brought Robert Merton to Cambridge. After taking Paul Samuelson's mathematical economics course, "the rest was history," says Merton. "I lived in his office from the end of that class on." He was hired at graduation by the Sloan School, and joined a "very small group, with no senior faculty. It was like all these kids and nobody to look after them." They designed courses, did research, "had a blast. The research flowed so fast for us and the students; there was not enough time to do it all. That doesn't happen often." Merton's work was also stimulated by the economic catastrophes of the 1970s, which fed an intense drive to put research around better markets mechanisms into practice.

"I can't remember a time when I didn't want to be a professor, and economics seemed special," says John C. Cox. In the mid"1970s, the pathbreaking work of Merton, Black, and Scholes offered "plenty of low"lying plums to be picked in the orchard. It seemed like a golden age for capital market theory, so much to do." The group he joined at MIT has evolved, and the programs expanded, but Cox "has enjoyed every minute" of the past 30 years.

Stephen A. Ross discovered he loved a certain kind of math while taking a course in game theory and linear programming to fulfill his Caltech humanities requirement. But it wasn't until he attended a mathematical economics seminar focused on MIT work that he realized he was interested in finance. "It was the most fascinating stuff I'd ever heard." He especially liked the "science" of it, "that theory and data had to relate in some way."

Ross defends financial engineering and its applications in the wake of the financial crisis. "Derivatives did what they were supposed to do. They spread the risk. The problem is the people who took on the risk didn't like the fact they lost money." Scholes wonders about rules that "let 1.5 million contracts go due in the derivatives swap market instantaneously for settlement. It sounds nuts to me." Says Myers, "It's true that modern finance is a powerful tool and can be misused, but it's not a reason to discard the tool. It's a reason to use it better."

About the Speaker(s): Andrew Lo's research interests include the empirical validation and implementation of financial asset pricing models; the pricing of options and other derivative securities; financial engineering and risk management; trading technology and market microstructure; statistics, econometrics, and stochastic processes; computer algorithms and numerical methods; financial visualization; nonlinear models of stock and bond returns; hedge"fund risk and return dynamics and risk transparency; and, most recently, evolutionary and neurobiological models of individual risk preferences and financial markets.

He has published numerous articles in finance and economics journals, and is a co"author of The Econometrics of Financial Markets and A Non"Random Walk Down Wall Street, and author of Hedge Funds: An Analytic Perspective. He is currently an associate editor of the Financial Analysts Journal, the Journal of Portfolio Management, the Journal of Computational Finance, and Statistica Sinica.

Lo is a former governor of the Boston Stock Exchange, and currently a research associate of the National Bureau of Economic Research, a member of the NASD's Economic Advisory Board, and founder and chief scientific officer of AlphaSimplex Group, LLC, a quantitative investment management company based in Cambridge, Massachusetts.

Lo received his Ph.D. in economics from Harvard University in 1984, and taught at the University of Pennsylvania's Wharton School 1984 to 1988.

Host(s): Office of the President, MIT150 Inventional Wisdom

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