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Finance in Action

01/28/2011 10:45 AM Kresge
Stewart C. Myers, Robert C. Merton (1970) Professor of Financial Economics,; MIT Sloan School of Management ; Douglas T. Breeden, '72, William W. Priest, Jr. Professor of Finance, Fuqua School of Business, Duke University; Eugene Flood, PhD '84, President and CEO, Smith Breeden Associates ; Bennett W. Golub, '72 SM '82 PhD '84 , Co"Founder and Vice Chairman, BlackRock ; Robert A. Jarrow, PhD '79, Ronald P. and Susan E. Lynch Professor of Investment Management, The Johnson School, Cornell University; Judy C. Lewent, SM '72, Former Executive Vice President & Chief Financial Officer,; Merck & Co., Inc

Description: Stewart Myers introduces the panelists as distinguished academics and practitioners who share not only their status as MIT alums, but also their innovative application of finance theory to entrepreneurship. "They were in the middle of the action," says Myers.

Douglas Breeden "grew up in the chicken business" so it is unsurprising that his financial path began with a classroom exercise for forecasting egg futures. His career moved eventually to analyzing the virtues of mortgage products. Models to estimate risks in asset"backed securities and their expected profits are very sensitive to such complex influences as interest rates, prepayment rates, and ominously rising loan"to"value ratios, he notes.

Breeden observes that a slight perturbation in one of these factors can have a major impact on a prediction, or even reverse the direction of the economic result. "This is why smart people have a hard time making money with these securities," he comments. Breeden says the theories are great, yet so are the challenges of applying them. He appeals for "a little bit of sympathy for the financial application people."

Eugene Flood emphasizes "structure" as the sine qua non to define problems and achieve results throughout a large organization. Involvement in areas ranging from international finance to proprietary trading to human resources taught him "how to think of the firm as a whole." Thanks to this broad exposure within the investment business, Flood recognizes that a comprehensive, integrated approach goes far toward success of the enterprise. He forms multidisciplinary teams and stresses a consistent philosophy, supported by "constructive debate" and active reinforcement of ideas by management.

On systemic risk, Flood cautions "we can get very good at pulling problems apart," but we cannot overlook the iterative, progressive effects of shifting one thing "and that affects something else and that affects something else" In keeping with his holistic view of business operations, he advises taking account of "everything that moves when one thing starts to change."

Bennett Golub recounts the inception of financial engineering in the traditional sense of engineering a physical object. In 1985, while at a major investment bank, he used CAD"CAM software to design new types of mortgage"backed securities. "We would grind it out, studying all the parameters, tuning these things up, and calibrating them precisely to what the different investors wanted, trying to extract arbitrage in the process." After a few years, he continues, "Instead of making money the old"fashioned way -- earning it -- people discovered you could obfuscate," that is, hide the risk. "You could get people to pay you for things that they probably shouldn't." That led in turn to "what we call risk managementKnow what you own and understand how it behaves."

Golub acknowledges that the financially engineered models that kept him ahead of clients "had challenges along the way. From the beginning, I always tried to think about having some humility in the analytics," he admits.

As a financial mathematician, Robert Jarrow creates and implements models to manage interest rate and credit risks. He constructed a "reduced form model" to address defaults across the business cycle. Because credit rating agencies were among the largest users of earlier flawed models, and "many other financial institutions depended upon them to get the risk measures right," the economy suffered a disastrous cascade. He maintains faith nonetheless, saying "I believe financial engineering models are the solution" but we need better education on how to use them for risk management.

Jarrow now studies how hedging techniques should respond to asset price bubbles, and "how to include a realistic financial sector in a macroeconomic model." He aims to develop tools that take account of actual conditions, unlike existing idealized models.

Judy Lewent brought sophisticated theories and analytical methods learned at MIT to key facets of the pharmaceutical industry. For instance, Lewent describes, in Merck's global activities "we had a very robust framework to understand where our foreign currency risks were and what aspects of those we needed to hedgeto minimize the volatility." This knowledge helped management allocate resources with reasonable certainty and stability.

Lewent used Monte Carlo simulations to evaluate the company's portfolio, and to examine the questions: "How do you think about what the right level of R&D spending is, and are you returning the cost of capital to your shareholders?" She put game theory into practice "to help us with a specific pricing decision for a new product launch." She also applied her MIT training to determine the feasibility of mergers and acquisitions; investigate the most efficient corporate capital structure; and reduce financial risk, enabling Merck to go forward when it became necessary to withdraw a major medicine from the market. Lewent declares, "Theory is great but it really does apply directly to practice."

About the Speaker(s): Stewart C. Myers is past president of the American Finance Association and elected Fellow of the Financial Management Association. Myers co"authored the leading graduate"level textbook on corporate finance, Principles of Corporate Finance, now in its 10th edition. He is a Research Associate of the National Bureau of Economic Research and is active as a financial consultant, advising major corporations on mergers and acquisitions, capital investment decisions, methods of financing, measurement of the cost of capital, and various valuation issues. He is also a Principal of The Brattle Group, Inc. and a Director of Entergy Corporation.

Myers has appeared as an expert witness in many major cases and regulatory proceedings involving estimation of the cost of capital, the analysis of profitability and value, intellectual property, the determination of damages, and various tax issues. His work has spanned a wide range of industries, including oil and gas pipelines, telecommunications, oil production, railroads, pharmaceuticals, insurance, and banking and financial services.

Host(s): Office of the President, MIT150 Inventional Wisdom

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MIT World — special events and lectures

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