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Sergio Rebelo

Professor Sergio Rebelo, above, is a leading scholar on international finance, while Professor Robert McDonald, below, has produced the influential text Derivatives Markets.  All Photos © Nathan Mandell

  Robert McDonald

Ahead of the market

Collegiality and intellectual depth define Kellogg School's Finance Department

By Rebecca Lindell

With all eyes on the financial markets in recent months, Kellogg School finance professors have found themselves on center stage.

The New York Times, Wall Street Journal, Washington Post, "Good Morning America," CNBC and National Public Radio are among the media outlets tapping the school's faculty for their insights on the economic meltdown. And with good reason: these scholars have spent years studying the very issues underlying the ongoing banking crisis.

"It's a very unsettling time, but in some ways, it perfectly highlights the strength of our department," says Janice Eberly, the John L. and Helen Kellogg Professor of Finance and former chair of the department. "People here have been doing research in this area for years, raising red flags about risk. Now they're in the exciting, albeit sometimes uncomfortable, position of being right."

Those in the spotlight include professors Deborah Lucas and Robert McDonald. They have worked to identify the risks associated with government's implied guarantee to back up Fannie Mae and Freddie Mac, which together assumed all of the credit risk for about half of the $8 trillion U.S. residential mortgage market.

"Their hybrid government-private status, and the perception that they are too big to fail, make them a potentially large, but largely unaccounted for, risk to the federal government," Lucas and McDonald wrote in 2006 — two years before the institutions were placed into conservatorship.

The professors noted the difficulty of measuring the size and risk of that mortgage liability, but stressed the importance of doing so to determine appropriate regulation of the institutions.

"Their expectation that the government would step in turned out to be right," Eberly observes. "If you have that expectation, you are implicitly giving the government a liability. The market thinks the government has made a promise. The question is how big is that promise?"

The pair used an option-pricing model to put a value on that implied guarantee, which in 2007 they pegged at about $20 billion. "That estimate was an average out of a lot of possible outcomes, in some cases worse, in other cases better," says McDonald, the Erwin P. Nemmers Professor of Finance.

Paola Sapienza  

Professor Paola Sapienza has produced insights into the global gender gap in math and shown how cultural bias can affect economic exchange.


Lucas, the Donald C. Clark/HSBC Professor of Consumer Finance, has long studied risk in government-insured financial institutions. Her past work as chief economist for the Congressional Budget Office and senior staff economist for the Council of Economic Advisers has given her a firsthand look at the issues behind the current crisis.

 "She's been working for years to bring modern finance tools to bear on government budgeting and risk assessment," McDonald says. "She pinpointed this years ago as an extremely important topic."

Lucas and McDonald are not the only Kellogg professors doing timely research. Professor Jonathan Parker has examined the effectiveness of economic stimulus packages, including the one passed earlier this year, and the impact of tax rebates on the economy. Arvind Krishnamurthy, the Harold Stuart Professor of Finance, and Associate Professor Annette Vissing-Jorgensen are also steps ahead of the news, studying how central bank policy can help stabilize liquidity in financial markets.

"These aren't topics that came up yesterday," Eberly says. "This faculty has had a longstanding interest and intellectual foundation for thinking about these issues."

The Kellogg Finance Department is one of the school's largest, with three dozen professors whose expertise ranges from corporate finance and banking to asset pricing and derivatives to macroeconomic policy and even neurofinance.

They find each other's work fascinating.

"We run into each other in the hall; we eat lunch regularly together; we talk about research and what's going on in the market on a daily basis," says Robert Korajczyk, the Harry G. Guthmann Professor of Finance and director of the Zell Center for Risk Research. "Not every department in academia has that kind of culture."

This collegiality opens new horizons for all and promotes prize-winning research that breaks new ground. Nine of his colleagues, Korajczyk notes, are recipients of the Smith Breeden Prize, the prestigious Journal of Finance's top research award. Four others have claimed the Review of Financial Studies' Michael Brennan Award, a similarly notable honor.

"It's a very active department," Korajczyk observes. "A lot of good work is getting done here."

That includes the efforts of Paola Sapienza, associate professor of finance, to investigate the alleged global gender gap in math skills. After analyzing data on more than 276,000 children in 40 countries, Sapienza argued in an article co-authored for the journal Science that the gap is a product of girls' unequal access to resources and educational opportunities.

Assistant Professor Camelia Kuhnen, is another pioneer. Using data from MRI scans, Kuhnen has explored the neural basis for financial decision-making. Her findings suggest that distinct neural circuits promote different types of financial choices and that over-activation of those circuits can lead to investing mistakes.

Other Kellogg trailblazers include Torben Andersen, the Nathan S. and Mary P. Sharp Professor of Finance, who is exploring the use of large sets of high-frequency data for volatility forecasting, portfolio choice and risk management; and Sergio Rebelo, the Tokai Bank Professor of International Finance, who has studied gains from diversification in the carry trade and the optimal moment to abandon a fixed exchange rate.

The school's support for finance research is augmented the Zell Center. And the costs can be significant: Kuhnen, for example, needs to buy time on MRI machines to collect the experimentation results for her research, while Sapienza has had to hire "armies of research assistants" to study the assessments of hundreds of thousands of children, Korajczyk says.

"Without that flow of funds, we wouldn't be producing as much research as we do," Korajczyk says. "Rather than spending our time looking for money, we can spend it doing research."

It all adds up to a unique community of scholars with the resources to push the boundaries of the finance field.

"I feel fortunate to have such interesting and energetic colleagues," McDonald says. "It's an extremely collegial and supportive department, and I think you'll hear that from anyone who works here."

Next: Chain reaction

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