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Professor Arvind Krishnamurthy

Professor Arvind Krishnamurthy

Kellogg professor wins Smith Breeden Prize

Arvind Krishnamurthy’s timely paper reveals the disastrous consequences of fear in the marketplace – and how the Fed can help

By Rachel Farrell

1/13/2009 - Arvind Krishnamurthy, the Harold Stuart Professor of Finance, has received one of the finance field’s top honors: the first-place 2008 Smith Breeden Prize.

The prestigious prize is bestowed annually on the top paper published in The Journal of Finance in any area, excluding corporate finance. In addition to the first-place prize, two distinguished prizes are awarded by the journal’s associate editors.

Krishnamurthy’s paper, “Collective Risk Management in a Flight-to-Quality Episode,” was co-authored with Ricardo J. Caballero, the Ford International Professor of Economics at the Massachusetts Institute of Technology. Their prize-winning paper examines the causes and consequences of “flight-to-quality” episodes, when fear in the marketplace provokes investors to drop high-risk investments in favor of those that are safer and lower-risk.

Flight-to-quality episodes tend to be sparked by unusual events — such as the terrorist attacks of Sept. 11, 2001 or the current recession — or untested financial innovations, and may result in capital immobility and liquidity hoarding. In certain extreme episodes, a “lender of last resort,” such as the Fed, needs to inject liquidity into the market to restore its equilibrium.

Krishnamurthy and Caballero began work on the project in 2005, before the current economic crisis developed. They observed at the time that many previous crises, including the 1987 stock market crash and the 1998 collapse of Long-Term Capital Management, seemed to suggest “some new dynamic in the marketplace that investors were grappling to understand as the crisis was playing out,” Krishnamurthy said.

“In short, during the crisis investors were ‘uncertain’ about an important aspect of the financial world,” Krishnamurthy added. “We wanted to study how investors’ uncertainty could play a role in magnifying a financial crisis, perhaps leading to a panic, and how a central bank should act to stabilize this panic.”

Krishnamurthy and Caballero’s work has received widespread attention in light of the current economic crisis, and has been cited by the Chicago Federal Reserve and its president, Charles Evans in papers and speeches over the past year.

“We hope that after reading our paper, people have a clearer idea of how investors’ uncertainty worsens a crisis,” Krishnamurthy said. “In the current crisis, the uncertainty element has been recognized to have played an important role.”

A member of the Kellogg faculty since 1998, Krishnamurthy is a finance and economics expert who specializes in areas such as banking and financial institutions, emerging markets, monetary policy and money markets and liquidity. He received his Ph.D. in financial economics from MIT in 1998.

Previous Kellogg winners of the Smith Breeden Prize include Andrea Eisfeldt, associate professor of finance; Mitchell Petersen, the Glen Vasel Professor of Finance; Robert McDonald, the Erwin P. Nemmers Professor of Finance; Deborah Lucas, the Donald C. Clark/HSBC Professor in Consumer Finance; and Artur Raviv, the Alan E. Peterson Professor of Finance. Former Kellogg School professors Todd Pulvino and Kent Daniel are two-time recipients of the award.