Though his research covers many areas of finance theory and economics,
Merton's work on option valuation is perhaps his most influential. Prior
to 1973, when Black and Scholes published their landmark formula, determining
the value of stock options was extremely risky and difficult due to
the nature of options, which are essentially agreements that give investors
the right to either buy or sell an asset at some fixed time in the future.
The challenge of an option is to predict its value at that distant time;
before the BlackScholes formula was introduced, those investing in
options determined a risk premium to hedge against major financial losses.
The BlackScholes formula showed that risk premiums are not necessary
for investment in stock options because such premiums are already factored
into the prices of stocks. Merton used his background in mathematics
to generalize the formula by relaxing certain restrictions and assumptions
set by Black and Scholes, such as the rather unlikely assumption that
the stock will pay no dividends. By altering the formula, Merton allowed
it to apply to other financial matters, such as mortgages and student
loans.

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