Functional and Strategic Finance

Course Number 1460

Professor Robert C. Merton
Winter, 29 Sessions


This is a course organized around applying finance science and financial engineering in the design and management of global financial institutions, markets and the financial system. The approach is used to understand the dynamics of institutional change and the design of financial products and services. We also examine the needs of government as user, producer and overseer of the financial system, including the issues surrounding measuring and managing risks in financial crises. In the fast changing environment of the financial system, we try our hand at predicting where things will be in the impending future instead of focusing on where they are now. We will develop the necessary tools of derivative pricing and risk measurement, portfolio analysis and risk accounting, and performance measurement to analyze and implement concepts and new product ideas. We will apply these tools to analyze aspects of the financial crisis of 2008-2009.

The course focuses on a functional perspective in which institutions, markets and financial instruments are all considered tools of the financial engineer for implementing financial functions in the most effective manner at a given time and in a given geopolitical environment. The categories of institutions considered are governmental, private-sector, and family-based. Those considering whether to take the course are encouraged to look at "The Design of Financial Systems: Toward a Synthesis of Function and Structure," Robert C. Merton and Zvi Bodie , Journal of Investment Management 3, no. 1 (First Quarter 2005): 1-23 and Chapters 1 and 8 of Crane, D.B., K.A. Froot, S.P. Mason, A.F. Perold, R.C. Merton, Z. Bodie, E.R. Sirri, and P. Tufano, eds. The Global Financial System: A Functional Perspective. Harvard Business School Press, 1995.

Course Organization

The teaching structure for this course is different than the typical HBS course. Out of the 29 sessions, there will be approximately 4-5 formal case-study preparations. The balance of the classes will be hypothetical situations to analyze for class discussion and "interactive" lectures. The preparation material for interactive lecture classes will be readings and in some cases, a list of thought questions. Class participation on lecture days comes either from sharing your conclusions to the thought questions ("cold calls" happen here as they would on a case day) or from asking "good" questions…ones that either enrich the discussion or help you and the rest of the class understand better what is going on. Unlike a stereotypical case discussion, in interactive lecture discussions, asking substantive (not just clarifying) questions is strongly encouraged. The absolute amount of student airtime for class participation will be less than for a typical course. This reduced opportunity will be in part offset by written homework assignments that are included in measuring individual class participation, which will make up 45% of the final grade.

Career Perspective of the Course

Students pursuing careers in the financial-services industry and financial markets, including professional asset management (i.e., within investment counseling firms, insurance companies, mutual funds, hedge funds, etc.,), investment, merchant and commercial banking, institutional sales and trading, product design and internet advisory for personal financial services. The course is equally appropriate for students interested in pursuing public-sector careers particularly in central banks and ministries of finance in both developed and emerging countries.

Educational Objectives of the Course

The goal of the course is to help prepare students for a long-term career as a finance professional in the financial-service industry or in government. The course develops a conceptual framework and the analytical tools to support decision-making in 1) the development and delivery of those services to clients of a firm; 2) the design and management of the financial-service firm itself and 3) the design and oversight of a financial system. With the long-run horizon in mind, the emphasis is on topics and tools that are believed to have a long "shelf life" of usefulness even in a rapidly changing institutional and technology environment that characterizes the global financial system. It is thus more of a "big-issue" and "conceptual-tools" course. Nevertheless, the issues are addressed from a rigorous analytical framework and a comfort level with mathematical manipulations will be helpful. It is expected that the students will master the finance tools, so they can apply them in a wide range of design situations.