Rajan expects the next revolution in finance theory to come from a better understanding of how managers make decisions. "The Modigliani-Miller theorem gave us a first-order good understanding," he says. "But a second-order understanding is exciting and important now. It's more important to understand how managers behave. The models we have are very crude right now."
Jeremy Stein: Reputational Matters
The seventh theorist in our survey is Jeremy Stein, a 40-year-old professor of economics at Harvard University. Stein has written on herd behavior and short-termism, laying out a theory of why managers concerned with their reputations may want to copy one another's decisions, ignoring their own information in the process. "It turns out," says Stein, "that the job market may be harsher in evaluating a manager who makes a mistake when his actions differ from those of the herd." He has also written extensively on corporate risk management, outlining how specific risk management strategies can be used to increase shareholder value.
Most recently, Stein has been working on the general topic of how internal capital markets allocate funds to different projects inside companies. This research is closely related to questions having to do with the pros and cons of diversification versus spin-offs. "For example," he says, "if there is a tendency toward socialism in the internal capital market, with weak divisions getting a more than efficient share of the company's overall capital budget, a spin-off that eliminates the cross-subsidization can be value-enhancing."
For Stein, the next revolution will come in behavioral finance, to which he has devoted more and more of his time and energy. "Behavioral finance is where there is the highest demand for good theory," says Stein. "If people succeed on that dimension, it will be one of the greatest successes of the next 10 or 15 years. I mean, what if markets aren't as efficient as we've been saying? What do we tell CFOs?"
Nikos Valance is a contributing editor of CFO.
More Stars of Finance
David Scharfstein, 40, MIT's Sloan School of Management. Scharfstein's research focuses on capital market frictions, which lead to less than efficient types and levels of investment; it has implications for risk management, pricing, and internal resource allocation. Scharfstein has also analyzed pricing strategy when companies are financially constrained. His recent research focuses on understanding why some firms are able to nourish innovative, entrepreneurial activity, while in other firms employees are prone to leave and take their innovative ideas and technologies with them.
Qiang Dai, 35, New York University's Stern School of Business. Dai's primary areas of research include term-structure modeling and fixed-income pricing, the expectations theory, and dynamic theories of portfolio choice and asset pricing. He has studied the empirical performance of a rich class of term-structure models, laying the foundation for applying such models to the analysis of economic theories of asset-return generation and macroeconomic behavior. Dai's current research centers in part on the determination of labor income and the valuation of human capital.
Rene M. Stulz, 48, Fisher School of Business, Ohio State University. Stulz has analyzed how total risk affects firm value and how risk management can be used to increase shareholder wealth. This research is widely referred to as the foundation for best practice in corporate risk management. Additional research by Stulz has shown that a firm's investment decisions have to take into account the impact of projects on total firm risk, and that a firm's optimal capital structure depends on the firm's ability to manage its total risk.
Steven Grenadier, 34, Stanford University, Graduate School of Business. Grenadier's research focuses on applying option-pricing theory to real investment analysis, or real-options theory. One area of application has been real estate investment analysis, with a focus on finding rational, structural explanations for real estate cycles. Grenadier has also analyzed firms' investment in technological innovations. His current research deals with combining real-options analysis with game theory, where he takes into account strategic interaction across firms.
Hersh Shefrin, 52, Santa Clara University, Department of Finance. Shefrin's specialty is behavioral finance. His recent book, Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing, examines the psychological factors that impel corporate executives to be overly optimistic when they develop capital budgets, to be reluctant to terminate losing projects, to overvalue the stock of their own companies, and to ignore negative information about companies they seek to take over. Shefrin's current research is concerned with the development of techniques to help corporate executives deal more effectively with psychologically induced errors.
Eduardo Schwartz, 60, Anderson Graduate School of Management, UCLA. Schwartz's past research has focused on different dimensions in asset and securities pricing. His more recent interests include interest-rate models, asset-allocation issues, evaluating natural-resource investments, pricing Internet companies, and the stochastic behavior of commodity prices. —N.V
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