Thursday, December 30, 2004

Red Cross Red Crescent - Make a donation-(updated)

Red Cross Red Crescent - Make a donation

At some level this is not the correct use of this blog, but on another level if it helps, I am willing to break the rules. So this is getting posted on all of my blogs and on the Website itself (later tonight).

After seeing the total destruction caused by the tsunami, I decided to end my week "vacation" and post a link for people to donate.

To say the destruction is horrific is an understatement. Money will not make bring back the lives (estimated now at almost 80,000 and maybe 100,000 or even more!) but may help reduce some of the suffering and even prevent the feared epidemics that the deaths may cause.

CNN has complied a list of aid societies. If you do not want to give to the RedCross/Red Crescent, then pick another. But please give some :)

Added 12/30/04
I was just sent this list of places to donate from as well.

(And yes I am putting my money where my mouth (fingers?) is, and just donated $100.)

Thursday, December 23, 2004

It's a Wonderful Life

Review: It's a Wonderful Life

I almost forgot, since it is Christmas time many of you will be watching one of my favorite movies of all time: It's a Wonderful Life.

As a teaching tip: the run on Savings and Loan in the movie makes an excellent point of discussion in Money and Banking classes and/or Financial Institutions classes.

If you have not seen the movie, look for it on Christams Eve and/or buy a copy for youself.

The closest I will ever give to a lock guarantee is that you will like it. :)

Merry Christmas Mr Bailey! :)

Happy Holidays!!!!

Hi everyone.

I just wanted to wish you all a very very Merry Christmas and a Super happy and healthy New Year.

Thanks for all of the kind comments this past year and I look forward to seeing the site and the Blog grow even more in the coming year!

Again Happy Holidays!!


who will probably be posting more before Christmas, but no guarantees.

Wednesday, December 22, 2004

Updated IPO numbers from Jay Ritter--his so-called "Factoids"

In my book Jay Ritter is known as Mr. IPO. So when I saw that he updated his famous IPO database yesterday, I knew it would be the first entry today! So here you go:

Among the many highlights:
  1. 188 firms went public in the US in 2004.
  2. The firms raised nearly $33 Billion
  3. The firms left about $3.9 Billion (about 11.7%) "on the table"
  4. For the first time since 2000 a IPO doubled in value on the first day of trading. (Jed Oil) (table 5--which is fascinating--look at 1999 and 2000)
  5. The spreads stayed very close to 7% AGAIN (table 9)

BTW this link only has the tables, there is very little "paper" but that said, Mr. IPO does his usual fantastic job on IPOs. (stay tuned for more of his research)

More of Jay Ritter's working papers can be found on his web site.

Real Estate Derivatives

Real Estate Derivatives

I am excited about this one!!! The only thing I can say is what took so long?

A simple explanation of why derivatives exist is that they allow people (or firms) to transfer risk. That is, derivatives allow those who want to to assume more risk to speculate and those who want to reduce their risk to hedge.

Given that for most people the most valuable single asset that they own is in real estate. It is troubling that real estate is also one of the most difficult assets to hedge. You can not short sell, generally (and there are some exceptions--REITs etc.) you have very limited ability to diversify, and until now no traded derivatives to transfer the risk.

That may be changing. From the NY Times Dec. 12,2004:
"Macro Securities Research, a company affiliated with Robert J. Shiller, the Yale economist, has reached an agreement with the Chicago Mercantile Exchange to list pairs of derivative instruments that are essentially index funds linked to home prices in certain markets. One instrument in each pair will rise as its market index rises; the other will rise as the same index falls. That will let investors bet on the direction of housing prices. Similar, but less sensitive, vehicles are being offered by HedgeStreet, a firm in San Mateo, Calif., that offers small-scale derivatives speculation online. "
Quoting from the NY Times, the Montpelier Times Argus (quite the name for a newspaper!) has the following:

"Another set of derivative products linked to home prices was introduced in October by HedgeStreet, which specializes in online trading of pint-sized contracts it calls "hedgelets." Each is a yes-or-no wager that a housing index will be in a certain range on a given date within three months. After that period, the contracts expire, and losing bets are worthless. There are three residential property bets, representing percentage moves in an index whose level may be higher, lower or even with the recent trend in home price movements, for each of six cities: New York, Miami, Chicago, Los Angeles, San Francisco and San Diego.But the value of each contract is a paltry $10, and they are infrequently traded, at best, so unless you live in a matchbox, it would be difficult and very expensive to buy enough of them to provide a practical hedge."

Robert Shiller adds in the Daily Times of Pakistan

"Well-developed markets for real estate derivatives would allow homeowners to kick the gambling habit. A liquid, cash-settled futures market that is based on an index of home prices in a city would enable a homeowner living there to sell in a futures market to protect himself. If home prices fall sharply in that city, the drop in the value of the home would be offset by an increase in the value of the futures contract.

That is how advanced risk management works, as financial professionals know. But the tools needed to hedge such risks should be made available to everyone.

Attempts to set up derivatives markets for real estate have-so far-all met with only limited success. In May 2003, Goldman, Sachs & Co. began offering cash-settled covered warrants on house prices in the United Kingdom, based on the Halifax House Price Index and traded on the London Stock Exchange."

Shiller goes on to add that the real benefit for the home owner will be when these derivatives securities are made more user-friendly:

"Because even many financially sophisticated homeowners will find direct participation in derivative markets too daunting, the next stage in the development of real estate risk management will be to create suitable retail products. For example, the derivative markets should create an environment that encourages insurers to develop home equity insurance, which insures homeowners not just against a bust but also against drops in the market value of the home." Such insurance should be attractive to homeowners if it is offered as an add-on to their existing insurance policies."

Isn't that exiciting? and what great use of finance :) I am so proud :)

BTW I have to admit I had missed the NY Times article, I happened upon it when reading Michael Stastny's blog. Check it out!

Monday, December 20, 2004

Bad economics = bad tomatoes

I am somewhat hesitant to cross-post this, but it is such a great example of why I do not like government intervention that I think I will post it here as well.

A bit of background is necessary. My family owns 4 small grocery stores in Western New York State. As a means of helping out, I also publish a blog for the stores. This is a story from there:

I saw this on ABC News yesterday. What an outrage!! The short version:Joe Procacci is a Florida farmer/saleperson. He has "developed" a tomato that looks and tastes much like many heirloom tomatoes that home gardeners grow. He calls his tomato the UglyRipe. (from

The problem? The Florida Tomato Committee says the tomatoes can not be sold out of state because they look ugly and...the ugly tomatoes would hurt the reputation of other Florida Tomato growers:

"Growers complain that Procacci's UglyRipes could wreck the reputation of Florida tomatoes. To allow misshapen and blemished tomatoes could open the way for a flood of ugly tomatoes to hit the market, says Reggie Brown, the tomato committee's manager." Yahoo News

Uh, folks, let's apply some economics here. If there is demand for the ugly tomatoes becuase of their taste, my guess is that people would eat them! And just for the record, it's taste, not looks, that matters when it comes to tomatoes!

More than likely the real reason for the The Florida Tomato Commission's crackdown is that allowing the UgliRipes to sell would...put other farmers at a competitive disadvantage.

The loser in this? The non Florida consumer who can not buy what they want (better tasting tomatoes).

The firm has established a site to protest the rules .

Congratulations to SSRN

From the desk of Michael C. Jensen: "SSRN is a collaborative of over 800 scholars worldwide who contribute their services"

I am sure many of you saw this already, but if not, I would like to add my congratulations and thanks to all who work on and help SSRN. But of course I would like to add special thanks to Michael Jensen and Wayne Marr. Their idea has really revolutionized the way research is distributed. I can only imagine how difficult doing somehting like this blog would be without their efforts.

So thank you and congrats a your ten-year anniversary!!

From Micheal Jensen: "SSRN's objective is to provide worldwide distribution of research to authors and their readers and to facilitate communication among them at the lowest possible cost. In pursuit of this objective, we allow authors to upload papers without charge. And any paper an author uploads to SSRN is downloadable for free, worldwide. We allow publishers and other institutions to charge users for downloading papers while encouraging them to charge fees that are as low as possible. Our rule is that the price for such papers on SSRN must be equal to or below the lowest price that such papers are available anywhere on the web to non-subscribers. The vast majority of downloads of papers from the SSRN eLibrary are free. In addition, SSRN provides free subscriptions to all of our abstracting journals to users in developing countries on request."

Congrats and keep up the great work!

Sunday, December 19, 2004

Islamic Investing

Consistently one of the most popular pages on is the Islamic Finance page. One reason I beleive is that so few people understand what Islamic Finance is.

From the executive summary on FinanceProfessor Islamic Finance page:
"Islamic Finance is based on interpretations from the Qua ran. Its two central tenants are no interest can be earned on loans and socially responsible investing. The key difference from a financial perspective is the no-interest rule since the Islamic socially responsible investing paradigm is not much different than what other religions do."

Islamic finance, and the majority of all socially responsible investing (SRI), is different from "regular investing" that ignores social factors. SRI is based on the premise that by investng responsibly, we can improve the world. SRI has taken on many aspects: economic, environmental, social, and even whether the firm encourages gambling, drugs, or other so-called vices.

Many of the differences in Islamic Finance (especially Islamic banking) revolve around the no interest (no-riba) principle. For example, Islamic banks must take equity positions in homes rather than taking a traditional mortgage. Others examples include profit sharing plans, leasing, and repurchase plans. These allow the financial institution to make money while satisfying the no-interest principle.

While still a relatively small percentage of the overall financial market, Islamic Finance is a fascinating, important, and often overlooked area. Moreover, its importance will only increase as nations with large Islamic populations play a increasing role in world markets.

Therefore, I was quite excited when I received a link to AIF Investor Services. AIF is designed to help make Islamic Investment easier by not only explaining what Islamic Finance is, but also by rating firms (only a few at the present) on how well they abide by Islamic rules.

While making recommendations on for-profit firms is well beyond the scope of this blog, I can say I learned several things by reading their site and especially will recommend the FAQ page on Islamic Investing. It is good!

Saturday, December 18, 2004

Tax year trading and wash sales--Grinblatt and Keloharju

With the end of the year rapidly approaching it is a good time to consider taking any tax losses that you can to lower this year's tax bite. And guess what? You will not be the only one doing this!

Grinblatt and Keloharju provide us an interesting look at tax year trading in the Finish Stock Market in their upcoming JFE article.

After showing that many researchers have hypothesized the existence of a large number of wash sales (example Ritter 1988), the selling of losers in December and then buying them back had not been empirically documented.

Finland, lacking all wash sales restrictions and with a remarkable electronic database on the trades of all domestic
investors, provides an ideal environment for analyzing the relation between the turn of the year and wash sales.

And sure enough, the authors find that investors do sell shares, recognize the loss, then are more likely to again buy shares in the same firm.

In the authors words:

First, we analyze, on a daily basis, the proportion of stocks with gains that are realized and the proportion of stocks with losses that are realized in the 50 trading days around January 1 of the years 1996-2000. We show that the ratio of these two proportions, aggregated over all Finnish households,
decreases markedly in the last eight trading days of December and then exhibits an abrupt increase commencing on the first trading day of January.

We also show that the rate of repurchase is highly linked
to the turn of the year and the size of the capital loss. This supports Ritter's hypothesis that repurchases are tied to tax-motivated sales....

To explore the role of firm size in this trading pattern, we show that the timing of repurchase activity as a fraction of volume in small stocks has much more of a turn-of-the-year seasonal than the timing of repurchase activity for large stocks.

Isn't it cool when something we thought was there really is! And to make things even better they also found more evidence that supports the Keim's (1983 and 1989) explanation of why small firms outperform large firms in January.

The paper concludes with the requisite discussion of the extent to which these findings can be generalized to other countries. Their conclusion, to which I agree, is that while tax laws are different (for instance in the US you can not immediately buy back the same stock, but rather have to resort to buying back a close substitute if your intent is to lower taxes), the idea likely does hold.

From the JFE--remember this will be moved once the paper goes to press:

From SSRN: (this is an older working copy version of the paper)

Friday, December 17, 2004

Cool site alert!!! an absolutely cool site. I love it and so will you!

I found this site a few weeks ago when the founder Jacob Bettany emailed me. Wow. It is just a wealth of information! While it is advertised as a Quantitative Finance site, it has sections on everything from behavioral finance, to game theory, to jobs in Q-Fin, to a list of blogs, an interview with Joel Hasbrouck,to discussions, to you name it!

In their words:
[We are] an open-access resource for academics and practitioners working in finance and economics, physics, applied mathematics and computing. We aim to provide the single most comprehensive aggregated source for information in the broad field of quantitative finance.

Go check it out now!!! You will definitely like it!

Total disclosure: MoneyScience does have as its feature link today, but that do not hold that against them. You will love the site!

Where do inefficiencies exist? Where imperfections exist!

Efficiency does not mean perfection!

This came up in class the other day, so I figured even though the Ofek, Richardson, and Whitelaw paper itself has been around for a while (it has been accepted but has yet to be published at the JFE), I would do a quick recap of the discussion and add the links to the actual paper in question.

We were speaking about market efficiency, and suggesting that if markets were not efficient, the inefficiencies could be from two main sources: 1. True irrationality or 2. market imperfections such as a lack of liquidity, short sales constraints, poor information, etc.

While acknowledging group irrationality can develop, its existence is (IMO) quite rare and a function of a lack of differing views. Hence the more participants in a market, the less likely group irrationality will develop.

Market imperfections can be broadly classified as transactions costs (lack of information, a lack of liquidity, high trading costs, short sale restrictions etc). These imperfections allow any temporary mispricing to continue by raising the cost of arbitraging the errors away. Additionally, to the degree that the imperfections shrink the size of the market, transaction costs also help to allow the group “irrationality” mentioned above to both develop and to persist.

It should be noted that the existence of these conditions does not guarantee inefficiencies. And even if the conditions and inefficiencies do exist, it very well may be that the market is still better than any other allocation mechanism. (So relax, I am still a believer in largely efficient, albeit not perfect, markets.)

Rather than consider this question from the emotionally charged debate on market efficiency, consider the question to be: “if I had to look for inefficiencies, this is where I would look.”

In a forthcoming JFE article, Ofek, Richardson and Whitelaw investigate the idea that imperfections may limit arbitrage in conjunction with the put-call parity relationship. (Put call parity states that the put + stock = call + PV (strike) (remember: all positive at Park and Shop ;) ).

This put-call relationship should always hold in equilibrium. The authors find that it does not hold in the presence of short sale restrictions.

In their words:
…consistent with the theory of limited arbitrage, we find that the violations of the put-call parity no-arbitrage restriction are asymmetric in the direction of short sales restrictions. These violations persist even after incorporating shorting costs and/or extreme assumptions about transactions costs (i.e., all options transactions take place at ask and bid prices).

Need more “evidence”? I will ignore the preponderance of existing literature on the topic (ask if you want some more) and give you some “real time” research. I am currently working on a paper with Jonathan Godbey and Rodney Paul that looks at this idea along different lines. We look at the predictive ability of implied volatilities of equity options. While the paper is still a ways off (hopefully it will be done in January), preliminary results suggest fairly convincingly that the efficiency of the option market (as measured by the ability to forecast future volatility) is strongly tied to option liquidity. That is, for active options, implied volatility works well, for illiquid options, it does not.

So what this all mean? I will give the same conclusion that ended our class discussion:

“From a societal point of view, we should strive to reduce market imperfections and lower transactions costs: Reduce barriers to entry, end short sale restrictions, increase competition. Why? Because where there are significant imperfections, the market prices we see are less likely to be “correct” and consequently allocational efficiency is suspect.

...Are markets perfect? No. Are they pretty good? Yes. Are they better in some incidences than others? Yes. It is this last area where we may be able to do something. As an investor (and not just in financial securities), look for areas where you have a sustainable advantage. It is unlikely, although not impossible, that this is in the area of financial markets. In the financial markets, you can earn a very good return, but it is unlikely that actually beat the market on a risk adjusted basis. "

The Ofek, Richardson and Whitelaw paper is available at:
Forthcoming JFE version remember it will be taken down when the paper goes to print
FEN-SSRN (working copy version)

Finally, finals are finished

Sorry for the absence of late. I got behind on about every front I can imagine. I was behind in correcting, in research, on sleep, on laundry, at the store, on you just about anything you name. So I took about a week off from the blog.

But yesterday was our December graduation ceremony and all grades have been submitted. In the research front, I THINK we (me and various co-authors) should have three papers out by the end of the month.

So I will get back to updating the blogs and FinanceProfessor website later today.

To the graduates, congratulations and best of luck in the future! May I suggest you look over my notes from the last class I taught for Finance401. I think you will like them! They are sort of a graduation address.

And to everyone going on break: happy holidays!


Tuesday, December 07, 2004

McKinsey Quarterly Interview on Corporate Governance

What a GREAT article! It is a McKinsey Quarterly Interview with Jack Creighton.

Yes, it is an interview and not based on a large database of firms, but that said, it is still EXCELLENT!

Some of the highlights:

"I'd require companies to have two different individuals playing the CEO and board chair roles. To put it simply, this is a question of internal control. You don't have the same person writing the checks and processing accounts payable. We have checks and balances in the accounting department; why don't we have them at the executive level?

Business is also becoming more complicated and, as a result of Sarbanes-Oxley, more regulated. There is enough "CEO work" for a CEO to give up the chairman's role. Or to put it differently, I think those two roles, in a company of significant size, require more time than one person can supply."

The Quarterly: How else might a CEO benefit from having an independent chairman?
Jack Creighton: .... I really believe that some CEOs we've seen get the ax would not have been let go if there had been an independent chair to counsel that CEO, to pass on the board's negative thoughts and discussions in a nonaggressive, noncombative way. The chairperson could say, "You know, the board is concerned. I'm starting to see some groundswell here, and you need to take action."

"One thing you don't want is to have management begin thinking that the chairman is running the company. Officers and employees need to understand clearly that the nonexecutive chair functions primarily as a resource for the CEO, the board, and the company."

EXCELLENT STUFF!!! It is a fast, easy, and informative read! I highly recommend reading it!!

BTW If you do not subscribe to McKinsey Quarterly, you should! It is free and just a tremendous resource.

Monday, December 06, 2004

The high price of subsidies--From the Buffalo News

What is wrong with government subsidies? A great deal!

Deciding what projects to invest in is hard work. And often times we do make mistakes, but time and time again the evidence shows that free markets make the best decisions. (In class terminology, markets make the best allocation decisions and funnel the money to its highest valued use.)

However, all too often politicians can not help but to play the game as well--but not with their money, but with taxpayers money.

This is a classic agency cost problem whereby the politician gets benefits while each tax payer pays a small portion. This is problematic because it often leads to investments in projects that yield no reasonable chance of being profitable. To make matters worse, there is often no easy way to measure success (unlike the stock market), and the project often being popular in some sense or to some people, or for a short period of time.

The result? More money is spent on the project than should be—in class terms we invest in negative NPV projects.

The SportEconomist has long railed against subsidization. For instance he posted a great article on the lack of success Cleveland has had after they funded their Gund Arena. (But even in this instance, note the difficulty in measuring success.)

I would like to extend the disagreement with subsidization beyond just Sports complexes and teams. It is unclear why governments should be allowed to pick favorites in any business.

Recently Buffalo and the state of New York granted tax breaks to Bass Pro Shops to open a new store in Buffalo. That Bass is coming to Buffalo is great. There are few cities that need more jobs more than Buffalo. I just wish Bass had looked at the area, and concluded that it was a good place to locate a business and do so without government spending.

Why? Because by picking Bass, the government is paying for a new project. Who is paying for it? Among others are other retail stores that will now face increased competition.

Why play favorites? What about all of the already struggling businesses in Buffalo and elsewhere in New York State that did NOT get tax breaks? A better idea is to lower taxes to all so that businesses (and not just Bass) would willingly relocate to New York State.

But of course the temptation is great. From today's Buffalo News - The high price of subsidies: The "'silver bullet' projects sometimes are off target. Just as Buffalo officials are celebrating the Bass Pro announcement, Rochester leaders are figuring how to bounce back from a celebrated public-private partnership that fizzled in their city. Rochester, New York State and the federal government contributed an estimated $35 million toward a high-speed ferry project, for a terminal and for the vessel. The goal of that project was similar to Buffalo's Bass Pro deal - to spur development of a city's waterfront. But the debt-laden private operator of the Rochester-to-Toronto ferry halted the twice-a-day round-trip crossings in September, just three months after launching the service. Now, Rochester Mayor William Johnson Jr. wants the city to buy the ferry for an estimated $40 million, using the proceeds of government-backed bonds. Service would restart in April under the proposal."

While the examples of this type of subsidization are ubiquitous, maybe, just maybe, economic sense is entering the picture.

From the Buffalo News article:
"The National Taxpayers Union views cash grants and tax abatements differently. "Giving tax abatements isn't a great idea compared to cutting tax rates across
the board,...." "

and some areas may be finally making the right choice:
Last month in Syracuse, Onondaga County lawmakers said they did not like the idea of a public subsidy worth at least $20 million for a 350-room hotel next to the county's convention center. That has delayed the deal as county officials and the developer look for ways to reduce the subsidy.

In October, Philadelphia Mayor John F. Sweet recommended rejecting developers' plans to redevelop a 13-acre riverfront site at Penn's Landing. Two finalists each proposed plans that needed a public investment of as much as $100 million, and Street called that "too much, given our priorities, and simply doesn't seem likely to happen," according to the Philadelphia Inquirer.

Do these successes mean we will see markets return to their role as allocator of capital and politicans look for ways to make sure investors have the money to invest (i.e. cutting taxes). I doubt it. Politicians have too much at stake to give up their pet projects so easily; projects all too often financed with our money.

Friday, December 03, 2004

Was it a Bubble?

A two-for-one deal! Send your paper to a conference and it is automatically considered for publication in the RFS!

August 12-13, 2005

ISDEX, an authoritative and widely cited internet stock index, rose from 100 in January 1996 to 1100 in February 2000 – an incredible increase of about 1000% in four years – only to fall down to 600 in May 2000 – an incredible decrease of about 45% in four months. Amongst big rises and falls in the history of stock market prices, this episode ranks amongst the most spectacular. The RFS-IU conference focuses on these recent financial market bubbles. It aims to address the following three questions: a) Was it a bubble? (How do you define bubbles ex-ante? Can you even define bubbles ex-post?) b) What caused it? (Investors? Managers? Financial advisors? Government policies? Media? Academics?) c) Did it matter? (Any real effects?)

The answers to these three research questions touch upon all sub-disciplines of finance – asset pricing, corporate finance, market microstructure, behavioral finance, international finance, law and finance, and real estate finance.

PROGRAM COMMITTEE: Brad Barber, Utpal Bhattacharya, Joshua Coval, John Graham, Craig Holden, Robert Jennings, Steve Kaplan, Alan Kraus, Maureen O’Hara (chair), Thomas Noe, Jay Ritter, David Scharfstein, Matthew Spiegel, Xiaoyun Yu and Jiang Wang.

SUBMISSION: There is no charge for submission. The RFS will consider all the papers accepted for the conference as submissions to the RFS, and will waive the RFS submission fees for these papers. If a sufficient number of conference papers are accepted by the RFS after their usual rigorous refereeing process, the papers will be published in a RFS special issue. Authors who do not wish to have their papers submitted to the RFS if their papers are accepted for the conference should indicate so at the time of conference submission. Authors are invited to submit theoretical or empirical papers. Papers should be written in English and not have already been accepted for publication. Papers will be blindly reviewed by the program committee. The conference organizers will reimburse reasonable travel expenses and will provide meals and lodging for paper presenters, discussants and session chairs.

SUBMISSION DEADLINE: Please send three hard copies of your paper, with a separate title page and abstract, by April 30, 2005 to:

Utpal Bhattacharya or Xiaoyun Yu
The RFS-IU Conference
Kelley School of Business, Indiana University
1309 East Tenth Street
Bloomington, Indiana 47405

Sponsored by The Review of Financial Studies and The Finance Department of the Kelley School of Business, Indiana University, Bloomington, IN.

Cash is up, but so too are Buybacks and reports that cash holdings are up.
In a survey of more than 360 midsize and large nonfinancial companies, Treasury Strategies also found that more than half consider themselves net investors rather than net borrowers....In other words, they have more short-term investments than short-term debt outstanding.

On the plus side, it appears that managers are giving more of this cash back to investors rather than wasting it on negative NPV projects!

To confirm this, also reports that dividends and stock buybacks are up this year: "Many cash-rich companies are giving shareholders an early holiday gift by buying back shares and boosting dividends"

Continuing from

"Companies have been buying back their shares this year partly to offset the increase in outstanding shares that resulted from option exercises and other executive and employee incentive plans involving shares, thus avoiding heavy dilution for existing shareholders"

And at the same time, dividends are also quite popular:

"...nearly half of the companies in the S&P 500 have raised their dividends this year, according to USA Today, which cited Standard & Poor's. What's more, in 2004 at least 10 companies in the index started to pay a dividend for the first time.

Companies have also been aggressively increasing their dividends since last year, when President Bush cut the tax rate for dividend investors."

BTW in a totally unpaid endorsement, if you do not subscribe to's weekly newsletters, you are missing out on a great source of information! Highly recommended!!!

Thursday, December 02, 2004

Covered shorts: the long and short of it

The New York Times has an interesting article on covered shorts. That is the tactic where you are both long and short the same stock.

This is what The Perry Corporation, a New York-based hedge fund seems to have done by buying shares in Mylan Pharaceuticls while simultaneously shorting shares (or more technically having Bear Stearns and Goldman Sachs short the shares).

So if the shares go up, Perry makes money on the long position but loses on the short position. On the other hand if the shares go down, Perry will lose money on their stock position, but make it up on the short position.

Of course this begs the question, Why? Why incur the transaction costs etc for no gain. The short answer is that they now have voting rights without being exposed to price fluctuations.

These voting rights are especially valuable in this case since the firm whose stock is being bought and sold is King Pharaceuticals. King is involved in a drawn out proxy contest as they are being taken over by Mylan. This takeover has grown heated as Carl Icahn (a shareholder in Mylan) moved to block the deal.

Not surprisingly, Icahn and shareholder rights groups are not pleased with Perry's deal.

"If hedge funds or any other investors are permitted to dictate the outcome of corporate elections without having economic interest in the companies, then any semblance of corporate democracy we still have in our country would become a travesty"

Nell Minow of the Corporate Library:
"It undermines the whole concept of linking ownership and control. It is not illegal, but the question is, 'Should it be?' I say, 'Yes.' The vote should accompany some kind of underlying interest."

What is curious however is that the article also states that Perry hopes
"to profit from the spread between the price Mylan offered for King shares, $16.49, and King's actual share price, which closed yesterday at $12.42. If the deal is completed, Perry stands to make over $28 million, based on figures in a filing with the Securities and Exchange Commission on Tuesday."
Unfortunately the article does not say how this profit would be accomplished and (as stated above) the rest of the article says that Perry's has no economic interest in the deal. (mmm, well $28 million seems to be interesting to me. ;) )

So how did they accomplish getting voting rights and gaining if the stock price appreciates? Two strategies come to mind. Note: the article and the illustration do NOT suggest that this is possible, so this is pure speculation.
  • The short sale could be done via a limit order arrangement whereby the shares will only be sold in the event that the stock price goes below some price limit. This would prevent losses while allowing Perry to profit if the deal is done.
  • With derivatives. Perry may have puts on the shares at the current price. The put would be allowed to expire if the price appreciates.

Unfortunately, as the article says, the details are still fairly "opaque" so we may have to wait and see.

Wednesday, December 01, 2004

Personal Finance and variable annuities

One thing I wish we had at St. Bonaventure was a personal finance class. Maybe even not for credit, but I do think it would help many people after graduation. However, often there seems to be little demand for such a class and to offer it for credit is almost too much like training and not enough like "education".

My biggest advice with respect to personal can be summarized into a series of rules

FinanceProfessor's Top Ten Personal Finance Rules

  1. Invest as much as you can-Do it now!
  2. Invest on a regular basis! Set up automatic investments in your funds.
  3. Realize there are no "free lunches"
  4. Diversify! The basket is generally more important than the eggs!
  5. Think long-term and do not try to time the market
  6. Consider tax consequences and take advantage of tax-advantaged accounts
  7. Look for low transaction costs
  8. Save more than you think you need (a penny saved is a penny earned!)
  9. Compounding matters! Save early, save hard!
  10. Live within your means. Do not run up large credit card bills.

But this is far from a "do this, don't do this" prescription. I really do not (and probably will never) want to give that specific of advice. However, that often does not stop people from asking however. But I always do my best to refrain from answering. LOL.

That said, a good friend recently asked about variable annuities for his mother and for him I broke my silence and agreed that it made no sense (especially since it was already in a retirement account!)

Fortunately, she did not do it. Many people do not know much about variable annuities and hence fall prey to salespeople who have a vested interes in selling the high cost products. So I was really excited when I saw/heard this week's Kim Snider radio show. It had a very good discussion on variable annuities and the problems they can cause. You can listen to it here. Short version: you probably do not want a variable annuity!

As I said before when I mentioned her blog/show: "good stuff." :)

Reuter and Zutzewitz on the Bias in the financial press

SSRN-Do Ads Influence Editors? Advertising and Bias in the Financial Media by Jonathan Reuter, Eric W. Zitzewitz'

Super Short Review:

In a paper that will be presented in the American Finance Association's Annual Conference (AFA) this coming January, Reuter and Zitzewitz (R&Z) examine mutual fund recommendations from "major personal finance magazines (Money, Kiplinger's Personal Finance, and SmartMoney)."

The authors report that the magazines appear biased. (SHOCK!) In R&Z's words:

"...recommendations appear to be tied to mutual fund families that "have the past."

Fortunately, there is still some semblance of journalistic independence as The Wall Street Journal and New York Times appear to be free of this co-called "content bias".

BUT then the question---does the bias matter from an investment perspective? And the answer is no, or at least not much:

"so bias towards advertisers can be accommodated without significantly reducing readers' future returns. Interestingly, the recommendations of Consumer Reports, which does not accept advertising, have future returns comparable to or below those of the publications which accept do advertising."

As an aside, while the bias may not matter much from an investment recommendation perspective, the article should stir debate into the conflicts of interest that exist within the journalistic community. (Similar to that within audit firms and brokerage firms) It is not far fetched to imagine negative news stories being ignored or pulled if they involve an advertiser.

Suggested Citation:
Reuter, Jonathan and Zitzewitz, Eric W., "Do Ads Influence Editors? Advertising and Bias in the Financial Media" (October 31, 2004).

Mark Cuban's New Hedge Fund - Blog Maverick -

New Hedge Fund - Blog Maverick -

Mark Cuban is starting a Hedge fund that will gamble. Literally! Forget stocks, forget bonds, the money will be used to make bets.

(In case you do not know, Mark Cuban is the Billionaire owner of the Dallas Mavericks and former owner of

The article is great. It has so many interesting and thought provoking lines I really have to stress that you should read it. Some of the highlights:

On market efficiency:

"It's an idea whose time has come. I have bet on stocks long and short for about 15 years now. I've done very well. There has already been one hedge fund started based on my trading results. In those 15 years, I have learned that despite all the claims and books written about efficient markets, the trading of individual stocks are not efficient. There are always people trading on better or worse information. There are always people trading on emotion rather than logic. There are always people t rading on hopes of the big hit. What Peter Lynch would call the '10 Bagger'. They were gambling. Nothing more. Nothing less"
On SEC Enforcement:

"Unlike the stockmarket, you know the rules exactly. You know without question, the house is going to play by the rules. The gaming commission appears to actually enforce rules of play, unlike the SEC.""

On information

"When you think about betting on sports, there really is far better information about your local sports team than there is about any local business in your market. The local papers cover the team every day. The local TV station gives a report about every game. There are radio stations who cover them for hours at a time. That's far more information than you get about Tyco or Computer Associates or NFI."

On accounting games

"Public companies play so many games with their numbers it's ridiculous. Should they expense options or not? Per forma vs GAAP? One time write-offs? Buying company after company? Writing down inventories then reselling them?"

Some news coverage of this story includes:


I agree with the news articles that suggest this is a long shot at best of getting off the ground, but I personally hope it does. While he goes too far in my opinion with the inefficiency story, I do agree that gambling markets are very efficient and regulators appear to have an easier enforcement task.

One question I have is whether the NBA would allow him to do this? My bet is no. (Pun intended) But I sure would love to see the fight that he would put up if the NBA does tell him he can't do it! :)

Friday, November 26, 2004

More evidence that governance matters

Giannetti and Simonov find that some investors are more concerned with corporate governance than others.

Short version: Corporate governance does not affect all shareholders equally. Individual investors and this with no connection to the firm, are more apt to invest if the firm has a strong governance system. On the other hand, insiders apper to either not care or be more apt to invest if there is not a strong governance system in place.

Longer version: Giannetti and Simonov report more evidence that corporate governance does matter. Previous researchers have shown that those firms with strong governance have higher returns—for example see: Cremers and Vinay (2004) and Yermack (2004).

What is new in this paper is convincing evidence that corporate governance does not affect all investors equally. In fact, some investors (those with ties to the firm), may actually seek out poorly governed firms.
As G&S put it:
“We find that all categories of investors who generally enjoy only security benefits (domestic and foreign, institutional and small individual investors) are reluctant to invest in companies with weak corporate governance. In contrast, individuals who are well connected with the local financial community because they are board members or hold large blocks of at least some listed companies behave differently. They seem not to care about the expected extraction of private benefits and even prefer to invest in companies where there is more scope for it.”

(This would suggest that these investors are in a position to use their power to expropriate wealth form other investors).

The authors identify firms where the risk of poor expropriation is high by
1. using a ratio of control to cash flow rights of the main shareholder.
2. a control premium using “the difference between price paid for a control block and the price in the market after the sales announcement”
3. “a dummy variable proxying for the level of control entrenchment”

The authors then use these categories to assess the likelihood of various investor groups investing in the firm. As stated above, they find that investors with no ties to the firm are much more sensitive to the risk of expropriation.

Interestingly, this finding may also be able to help explain home country biases (the finding that investors invest more in their home nation than would appear economically justifiable) as foreign investors are particularly less apt to invest in firms with weak governance. Specifically, ‘a marginal increase in the control/cash flow ratio decreases the probability of investing in a firm by 1.37% for foreign individual investors…the effect is comparable for foreign financial institutions.” (page 16)

Giannetti, Mariassunta and Simonov, Andrei, "Which Investors Fear Expropriation? Evidence from Investors' Portfolio Choices" (June 2004). ECGI - Finance Working Paper No. 54/2004; EFA 2003 Annual Conference Paper No. 715.

© Mariassunta Giannetti and Andrei Simonov 2004. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including
© notice, is given to the source.

Thursday, November 25, 2004

A look around at a few blogs

Last week before going to the Southern Economics conference in New Orleans, I noticed the SportsEconomist (who I had the good fortune of meeting in New Orleans) did an blog reading by quickly discussing a few of the interesting stories he had been reading on other blogs (including FinanceProfessor :) . Well, I liked the idea so much, here is my version of the same.

Jeff Horton at Synergyfest has a summary of Malmendier and Tate's article showing that over-confident CEO's invest more (too much) in capital projects. How did I miss that article? I had never seen it but it definitely is an important one! One question: is it over confidence or stupidity that leads to the CEO holding onto options beyond the rational point of exercise. This is important as it is on this variable that over-confidence was defined.

Cyberlibris has a good article article on blogging in academia. It comes from a conference session on blogging and lists 11 key points out of the session and concludes that blogging is an excellent tool to use in academia. BTW I was totally set on posting a link to the article before I saw my name!!! In fact it was one of those "wow, how cool is that moments!"

And finally two articles from the Marginal Revolution
1. For Thanksgiving, a look back at the key economic decision that made the early colonialists (that is the so-called Pilgrims) succesful. Key point? Capitalism instead of Communism!

"When the Pilgrims first arrived at Plymouth rock they promptly set about creating a communist society. Of course, they were soon starving to death.

Fortunately, "after much debate of things," Governor William Bradford ended corn collectivism, decreeing that each family should keep the corn that it produced....[Ending corn collectivism] had very good success, for it made all hands very industrious, so as much more corn was planted than otherwise would have been by any means the Governor or any other could use...."

2. How can it be that while medical costs are increasing, the costs of laser eye surgery are falling?! Could it be because insurance often does not pay for laser surgery? You bet!

Happy reading!

NPR's Talk of the Nation on Social Security, equity ownership, and home ownership

NPR's Talk of the Nation had a very interesting segment on "ownership". It was advertised as being focused on President Bush's supposed plan to create 100% home ownership (it won't happen) in ten years. But it really is part of a larger move towards more ownership of equity, real estate and other assets.

Frank Luntz a Republican Pollster, Stephen Moore of the Cato Institute, and James Surowiecki (of the New Yorker and author of The Wisdom of Crowds) are guests.

About a third of the way into the show, the talk turns towards reforming social security.

Given his book on crowds and by extension markets, it is somewhat surprising that Surowiecki is not in favor of the major privatization of social security. Why? On both efficiency reasons (more accounts would lead to more transaction costs). Moreover, he fears that many need the safety net. Both valid points.

The debate on whether the current social security system redistributes wealth from the rich to the poor or from the poor to the rich, is particularly interesting. (FTR: if it is poor to rich, the reason is that poor people tend to have started work earlier and die sooner)

A very interesting and informative discussion! Highly recommended. Even if you do not agree with either side completely, hearing all sides is important.

While I tend to disagree in part with what Surowiecki with his view on this issue (although I must stress not completely since privatization in and by itself is not a cure-all), his book is the Wisdom of Crowds. It is excellent!

Wednesday, November 24, 2004

The value of hedging revisited...

Does Hedging with Derivatives REDUCE THE MARKET Risk Exposure by Bali, Hume, and Martell

Put your thinking caps on for this one!

Short version: Hedging, at least as it is currently being done, may not add to firm value.

Longer version:

In a Modigliani and Miller world nothing really matters. This includes dividend policy, capital structure, and hedging. Hedging is the idea that by buying or selling various assets (be them real (physical) or financial) in an attempt to lower the volatility of the firm.

However, when we leave the MM world, we largely have seen that hedging does matter. In fact, it is by now fairly standard to discuss hedging in advanced corporate finance classes. This discussion typically begins:

Teacher: If we consider a levered firm as a call option, you might ask, “why hedge?” Doesn’t hedging hurt shareholders (by reducing volatility)?"

The standard response (as well as the preponderance of academic research) says that hedging does in fact increase shareholder wealth.

How? The increase is often explained along contracting and information asymmetry lines. For instance from my class notes:
Firms might hedge because:

  1. Lower borrowing costs—Bondholders do not like risk. May be cheaper to hedge for firm than it is for Bondholders.
  2. Allows managers to worry about what they have control over and not things outside their control.
  3. Easier to monitor and to contract with management since you can tell what is their fault and what is not.
  4. Lower expected taxes—Because of progressive taxes.
  5. Reduce labor and payroll expenses since these undiversified stakeholders do not like risk.
  6. Less likely to have to go to capital markets in a “bad” time
  7. Operationally, it may make long term contracts easier to enter and customers will know you are going to be around.

These explanatoons had all been fairly well established in the financial literature. But then this paper from Bali, Hume, and Martell comes along and makes us rethink what we are teaching. It finds that firms are not doing what we had thought!!! and moreover, it may not matter!

Because of the large endogenity problem in derivative use (for example firms select when and if to hedge), the paper “introduces a bivariate econometric framework to consider the effects of changes in macroeconomic factors on market risk exposure simultaneously.”
Then (in what I think is a really cool part of the paper, the authors use a

“modified two-stage market model to include a firm’s risk exposure levels relative to returns in the first stage regression. In that stage, our model estimates an individual firm’s risk exposures:

(i) currency exposure is the sensitivity of the firm’s value as proxied by the firm’s stock return to the unanticipated change in an exchange rate index (currency beta);

(ii) interest-rate exposure is the sensitivity of the firm’s value to the unanticipated change in an interest rate index (interest rate beta);

(iii) commodity exposure is the sensitivity of the firm’s value to the unanticipated change in a commodity index (commodity beta).

In the second stage, the impact of hedging is tested by the hypotheses that currency, interest rate, and commodity
exposures are negatively related to derivatives use and positively related to the levels of a firm’s real operations....Real operations are proxies for a firm’s need to hedge and determine a firm’s exposure level.

So once this is done what do they find? Not what one might have thought!
For the univariate tests, the authors find that hedging rarely reduced exposure and in some cases actually increased the risk! (Which suggests that the firms may have been speculating—a definite no-no!).

Again in the author’s words:
"Our empirical findings do not generally support the hypothesis that derivatives positions offset risk movements….Further, the empirical results do not support a positive association between real operations and exposures.”

“Except for one year for interest rate exposure, there
is little evidence that derivatives use reduces risk exposures for the firms studied. There is some evidence that user firms are increasing risk exposure in the use of commodity derivatives.”

“To the extent that there is no change in market risk exposure, then this suggests that:

1) firms use other forms of risk management such as operational hedging from global diversification, or production management, or;

2) firms do not fully hedge the extent of the effect of exchange rate movements, or;

3) interest rate, exchange rate and commodity risks are economically insignificant relative to the firm’s return, or;

4) firms do not have an economic justification for derivatives hedging if they are large, diversified, and of good credit quality, except in special cases, or;

5) they use derivatives to facilitate internal contracting, or informational asymmetries."

Which simplified means that firms we expect to hedge, are not hedging (or at least did not from 1995-1998) and moreover are not hedging like we would have counseled. WHY? Maybe because the firms studied were large and the diversification and operational hedges available to the firms off-set the need to hedge using derivatives.

VERY INTERESTING!! I will be watching this one for paper updates etc.

BTW This may have been the most difficult paper I have summarized in a while. It was rather complex and to make this summary understandable for all, I left quite a bit out. I HIGHLY recommend you download and read the actual paper!!

Friday, November 19, 2004

SSRN-Are Busy Boards Effective Monitors? by Eliezer Fich, Anil Shivdasani

SSRN-Are Busy Boards Effective Monitors? by Eliezer Fich, Anil Shivdasani

The answer? No. That is the finding of Fich and Shivdasani who look at firms whose board members sit on multiple boards. The authors find that these firms trade at a discount relative to their peer firms. As Fich and Shivdasani put it:

"We show that firms where a majority of outside directors hold three or more board seats have significantly lower market-to-book ratios than firms where a majority of outside directors hold fewer than three board seats. Our findings differ from those reported by Ferris et al. (2003) who claim that busy boards are equally effective monitors than non-busy boards. We argue that methodological choices and the econometric specification of their tests lead to low statistical power for detecting the relation between performance and busy outside directors that we document. The negative relation between market-to-book ratios and busy outside directors is robust to a wide range of sensitivity tests."

If you are thinking about potential endogeneity problems (and you should be!) the authors beat you too it and have attempted to control for these problems. This did not change the original findings.

While this is interesting, perhaps even more interesting (and more convincing) are the findings that this lower market to book ratio is likely to be well deserved due to lower management monitoring (as measured by likelihood to replace incumbent management) and poor operating performance. The authors:
"We show that boards where the majority of outside directors hold three or more directorships are less likely to remove a CEO for poor performance. We confirm results of prior research that finds that independent boards are more likely to remove CEOs for poor performance than non-independent boards. We augment these findings by showing that this pattern holds largely when a majority of outside directors on the board are not deemed to be busy."
"Using panel-data regressions, we also find that an inverse relation holds between several accounting-based measures of operating performance and a majority of busy outside directors on the board."

Fich and Shivdasani also look at what happens when a "too busy" director leaves the board. Guess what! The stock price rises.

Need more proof? When an already too busy adds another board directorship to his/her resume, the stock prices of the other firms also drop.

VERY interesting! And if nothing else, a good reason to say no when you are asked to be on another board! Or committee for that matter ;)

Fich, Eliezer M. and Shivdasani, Anil, "Are Busy Boards Effective Monitors?" (October 2004). ECGI - Finance Working Paper No. 55/2004.

The authors also requested that the following be included:
© Eliezer M. Fich and Anil Shivdasani 2004. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

Wednesday, November 17, 2004

Impact of Baby boomers from Porterba

I was just sent this paper. It is by James Porterba. Given the recent post on the Geanakoplos, Magill, and Quinzii paper that concluded stock prices may be negatively impacted when baby boomers retire, I think this may give some further perspective to the issue.

Short version: Porterba concludes that not all assets will fall when the boomers retire and that past population booms have been met with only modest price changes.

In Porterba's words:
"The paper begins by discussing the theoretical basis for a link between population age structure and asset prices. Standard models suggest that equilibrium returns on financial assets will vary in response to changes in population age structure. While the direction of the effect of demographic changes is not controversial, the quantitative importance of such changes for financial markets is open to debate. The paper presents several strands of empirical evidence that bear on this issue.

First, it describes current age-specific patterns of asset holding in the United States, with the goal of understanding the age-wealth trajectory and how it may affect the future demand for financial assets....Aside from the automatic decline in the value of defined benefit pension assets as households age, however, other financial assets decline only gradually during retirement. When these data are used to project asset demands in light of the future age structure of the U.S. population, they do not show a sharp decline in asset demand between 2020 and 2050."

That said, I would still not plan on having as high of returns in the future as we have had over the past 20 years and maintain my view that those of us behind the boom generation should save more and plan on realizing lower returns and try to diversify into regions whose population is not aging as quickly as US and Europe.

But that said, the news is better than some fear. Very interesting paper and only time will tell!

The paper is available through SSRN and from Porterba's own site.

For the record, the person who sent it to me, found it on a site that I absolutely love and have linked to it since its inception.

Right angles in event studies are good :)

In running or biking I am not a fan of 90 degree angles, but in event studies, I love them! An abrupt (straight up or straight down-i.e. a right angle) price movement following an "event" suggests that the news was both unanticipated and the market quickly incorporated the new information.

A right angle going forward suggests that the market not only was quick about incorporating the news, but that investors correctly interpreted the news.

In this context let's take a fast look at the "surprise" merger of Kmart and Sears.'> Kmart, Sears to Merge in $11 Billion Deal: "Kmart, Sears to Merge in $11 Billion Deal "

Was it a surprise? It sure seems it! In yesterday's trading neither Kmart nor Sears experienced abnormal trading. In fact both had relatively low volume. So the announcement most likely took the whole market by surprise.

Immediately following the announcement, the stock prices jumped.

Now this happened before the NYSE is opened, so we will have to rely on price quotes from ECNs. According to Archipelago, Sears is up 21% while Kmart is up just over 10%. Which also suggests strongly that those trying to profitably trade on overnight information would have a difficult time doing so on the major exchanges where the stock price "open" at the higher price.

So the lesson? Right angles in event studies suggest semi-strong form market efficiency!

As an aside, years ago this horizontal merger (two firms in tea same industry) might have bumped up against significant regulatory pressure , but as the market shares of each firm has fallen, so too will serious pressure to block the deal as anticompetitive.

Tuesday, November 16, 2004

Salary Cap Football and Ratio analysis: what they teach us about markets

I am in a fantasy Salary Cap Football League through Yahoo. It is really fun and keeps me interested in all the teams.

But as much as I like picking the team, I think it is almost as fun to see how the market operates. For instance, earlier today I was researching various ratios that Yahoo provides for the players. These ratios include points/$. Since it is a salary cap league (example of hard rationing), this is trying to measure how much you get back (presuming the past repeats itself) for a dollar invested--sort in the spirit of a profitability index). I noticed that the Giants QB Kurt Warner was the highest ranked QB when on this scale. "Mmm...I wonder why, he is having a decent year, but not that great." So I look at what he is selling for: his value had dropped significantly.

Something must have happened. A few hours later I heard the sports news on the radio and find out that Warner had been benched and that Eli Manning was named this week's starter.

What does this have to do with financial markets? A great deal! First notice that market seems to be largely semi-strong form efficient. By the time I had heard about the benching, the price had already reacted.

Secondly, notice how the markets are forward looking. People will not pay for past performance. Ratios however, are historically based. This explains some of the large variation on ratios which are at least in part based on historical accounting numbers and explains why we can not blindly make decisions based off ratio analysis.

Now I must admit not only do I teach finance but also I am currently ristening to The Wisdom of Crowds by James Surowiecki, so I am a bit predisposed to see signs of market working. BTW the book is awesome so far! Many good examples for class!!!

BTW I have been really lucky in the league and am doing pretty well (check my stats and team out, my name is PlayingGM).

Friday, November 12, 2004

Flannery and Rangan: more proof of the trade-off model

Have you had your fill of capital structure papers yet? Of course you have not! You can never have too many! So here is yet another paper on capital structure (with a similar finding) is to be presented at the AFA meetings.

It is by Flannery and Rangan. In the paper entitled Partial Adjustment toward Target Capital Structures they show that firms do have targets for their capital structure and do behave in a manner that attempts to get their leverage ratios back to this target.

The paper begins by describing the pecking order and the trade-off theory of capital structure. As they correctly point out, in its strictest sense, the pecking order theory implies that firms do not have a target capital structure—a conclusion which seemingly flies in the face both surveys of executives (example Graham and Harvey 2001) and mounting evidence.

In the authors’ words:

“In a pecking order world, observed leverage reflects primarily a firm’s historic profitability and investment opportunities. Firms have no strong preference about their leverage ratios, and, a fortiori, no strong inclination to reverse leverage changes caused by financing needs or earnings growth.” (I confess I had to look up a fortiori to be sure ;) )

Flannery and Rangan proceed to investigate changes to firms’ capital structure that result from stock price changes but do so in a world where it is not costless to move back towards the targeted capital structure. (The inclusion of both market price induced changes and transaction costs into their adjustment model is i^3—insightful, interesting and important)

The authors examine an enormous data set of “all firms present in the Compustat Industrial Annual tapes between the years 1965 and 2001.” For each of these firms they winsorize the data (which is largely in the form of ratios) at 1% and 99% to reduce the impact of outliers and data errors. (BTW winsorize just means to set the values in the outer tails equal to the 1st and 99th percentiles. -this was corrected from initial posting)

Using a detailed regression analysis, the paper finds that firms do move back to their previous target. That is under levered firms lever up, while over leveraged firms reduce their leverage. Moreover, when the distance away from this target is studied, firms furthest away from the target move the most back towards it. (see figure 1). This is consistent with a world where there are transaction costs of rebalancing capital structures since for smaller deviations away from the target, it may not be worthwhile to make the costly adjustment.

In their conclusion, the authors summarize the findings:

<>“We find strong evidence that nonfinancial firms identified and pursued a target capital ratio during the last 35 years of the twentieth century. The evidence is equally strong across size classes and time periods. As earlier researchers have found, target debt ratios depend on well-accepted firm characteristics. Firms that are under- or over-leveraged by this measure soon adjust their book debt ratios to offset the observed gap. Unlike some recent studies, we estimate that firms return relatively quickly to their target leverage ratios when they are shocked away. The mean sample firm acts to close its (market) leverage gap at the rate of more than 30% per year. One might dispute whether a 30% annual adjustment speed is “slow” or “rapid”, but it is far from zero for U.S. nonfinancial firms.

Our results strongly support the tradeoff theory of firm capital structure and the relevance of costly (partial) adjustment toward target leverage. Indicators of the pecking order and market timing (à la Baker and Wurgler [2002]) theories carry statistically significant coefficients, but their economic effects are swamped by movements toward a leverage target that reflects firm-specific characteristics."
Very Interesting! Or as I said above, i^3! :)

Alternative sites/cites:

From SSRN: Flannery, Mark Jeffrey and Rangan, Kasturi P., "Partial Adjustment Toward Target Capital Structures" (May 3, 2004).

From the AFA program:

And from Mark Flannery’s web site:

BTW I just emailed both authors and have been told that modified version will be out within a few weeks. I will update the above links.

Alti finds Market Timing's leverage impact is largely transitory

Two for the price of one today! We have two papers today that both give us more evidence that suggests that firms do “time the market” with respect to capital issuance (and consequently capital structure), but that the firms try to get back to their targeted capital structure quite quickly.

What makes it interesting (and not repetitive) is that each paper (Flannery and Rangan and Alti) each get to this same conclusion from different starting points.

We will go alphabetically and begin with Alti.

In a paper that is to be presented at the American Finance Association meetings, Ayogan Alti looks at hot and cold IPO markets. As the names “hot” and “cold” suggest, he finds that firms do time the market. Not only do more firms issue during hot markets, but also the issuers raise more capital during the hot periods. (During hot periods Alt reports that firms raise 102% of previous assets whereas during cold period the firms only raise 67% of their pre-issuance assets.).

What is somewhat novel is Alti’s next finding: that this initial capital structure choice (less leverage in hot periods) is quite transitory. Firms revert back to some target capital structure relatively quickly. In his words:
"The IPO-year market timing effect on leverage has very low persistence. One year after the IPO, only about one half of the effect remains. Two years after the IPO, the hot-market effect is completely dead, never to revive again. Hence market timing appears to have only a short-term impact on capital structure. An analysis of financing activity in these two years reveals that hot-market firms follow an active policy of reversing the timing effect on leverage. Cold-market issuers are content with the leverage ratios they attain at the IPO"
This finding contradicts some previous literature (for instance Baker and Wurgler, JF 2002). Why the difference? Alti speculates that it is because previous work often used the market to book ratio as a measure of market timing. This can be problematic since the market to book ratio also proxies for growth opportunities available to the firm.

While previous authors recognize this flaw and attempt to control for it, “this control is likely to be very noisy.”

So what does this paper add to our knowledge? It adds more evidence that in spite of market efficiency claims that the price is always just a price and thus there is no good or bad time to issue, corporate managers believe they can time the market. They issue more equity when they feel the market is “hot”.

More importantly the paper shows that this capital structure impact of this market timing behavior is largely transitory. In the longer term, firms do seem to have a target (which is presumed to be an optimal) capital structure in mind. Which nicely jives with the trade-off theory of capital structure.

It shuld be noted, that this conclusion is very similar to that of Mayer and Sussman which we discussed a few days ago.

Alternative sites where this paper can be downloaded
(or cites if you prefer---pun intended ;) )

From SSRN:
Suggested Citation
Alti, Aydogan, "How Persistent is the Impact of Market Timing on Capital Structure?" (October 14, 2003). University of Texas at Austin Working Paper; 6th Annual Texas Finance Festival.

From his web site, and finally from the AFA program.

When a crisis really is a crisis

In a paper to be presented at the upcoming American Finance Association Meetings, Pasquariello asks the interesting question "
Are Financial Crises Indeed 'Crises?'

The question is interesting for several reasons and on multiple levels.

For starters, if it is a crisis and has economic repercussions, then we may want to invest more to prevent the crisis in the first place. On the other hand, if the currency crisis is a media induced frenzy with no lasting consequences, then we can learn to live with the so-called crisis.

From a different perspective (and this is really the main point of this paper), how the market handles and reacts to the "said-crisis" is interesting and yields insights into investors' thought processes, how the markets work, and the limits of market efficiency. In the author's own words:
"The word 'crisis' is instead suggestive of market breakdowns or failures, seemingly irrational behavior of investors and speculators, or inefficient allocation of resources and risks, hence, in short, of the occurrence of unusual,possibly irrational phenomena."

Conclusion? Pasquariello finds that they so called crises really are crises. As evidence he shows that the law of one price in the ADR market was violated much more frequently around these crisis periods.

Longer version:

With a great sense of timing, in this week's Tuesday Morning QB (easily my favorite read of the week! If you like football, you owe it to yourself to read it!) Gregg Easterbrook of the Brookings Institute suggests a general "word inflation:"

"Contemporary editorialists and politicians never speak of a "problem," they speak of a "crisis;" nowadays you hear the phrase "serious crisis" invoked because "crisis" is so overused the word has been hollow. Critics don't call movies or music "good" or "bad," everything is either "brilliant" or "terrible.""
So given that introduction by Easterbrook, it only makes sense to investigate whether economic crisis really are crisis. Pasquariello does this investigation by examining the trading of ADRs (American Depository Receipts).

The law of one price (that is that same assets must sell for the same price or else there is an arbitrage opportunity) dictates that the same shares must sell for the same price. If they do not sell for the same price, then there is a temporary "money machine: that arbitrager can make money by pushing the prices back to equilibrium.

The author finds that this law of one price generally holds in the ADR market (which is good for market efficiency adherents), but that this relationship tends to break down when the market (and investors) are stressed by the currency crisis.

Pasquariello also studies the relationship of ADR returns and global sources of risk. Here he finds: "evidence that, during recent episodes of financial turmoil (Mexico (1994), East Asia (1997), Russia (1998), Brazil (1999), and Argentina(2002)), those normal market conditions were in fact violated."
"Based on this evidence, we conclude that, during the various episodes of financial turmoil that took place over the last decade, the market for emerging ADRs was, on average, less efficient, more segmented, and relatively more sensitive to domestic sources of risk than during more tranquil times."

Or to translate 'academic speak' into the the vernacular: the market went 'wacky' during these times of turmoil. Which is another small knowck on teh perfection that some believe the market possesses.

Interesting piece!

The paper is also available through SSRN.

Suggested Citation
Pasquariello, Paolo, "Are Financial Crises Indeed 'Crises?' Evidence from the Emerging ADR Market" (March 1, 2004). EFA 2004 Maastricht Meetings Paper No. 2715.

Thursday, November 11, 2004

Michael Brennan on the Stock Market Bubble

Michael Brennan provides an interesting (and cutting) analysis of how the stock market climbed so high in the late 1990s. He writes that there was plenty of blame to go around and that even FinanceProfessors should take their share of the blame.

He begins by documenting the major bull market from 1980 to 2000:
"Between January 1980 and August 2000 American stock prices as measured by the S&P500 index rose by 1239%; over the same period the dividends on the shares underlying the index rose by only 188%, while the earnings rose by 254%."

The two main reasons that he cites for this run-up were the
"democratization of investment" and the change in conventional wisdom.
1. The "democratization of investment and change in conventional wisdom

These changes "led to an environment where "individuals with little or no experience of the stock market began to invest for the first time."

He attributes this rise in participation to changes in retirement plans (the "demise of the defined benefit plan" and to the "cult of equity."

This so-called cult was allowed to develop in part because "there was ...a general lack of objective discussion in the public marketplace of ideas about the elevated level of stock prices."

This lack of discussion he attributes to poor press coverage and financeprofessors who refused to speak out against the overvaluation.

Moreover, he claims that market efficiency theories from academia led many to be reluctant to publicly speak out against the price rise for the same professor often taught "the Price is right".

Additionally, published articles that showed that equities had out performed all other investments had become well-known by this time. These works were often cited as a means for being invested heavily in stocks even when their prices soared.

2. Agency Problems in the production and sale of information

Not only were investors and professionals over-confident, but there were also conflicts of interest keeping share prices high and investors in the dark as to the true health of companies. In Brennan's words:

"During the 1990's severe problems arose in the production of information at the firm level. This was exacerbated by deficiencies in accounting conventions, and by conflicts of interest faced by accountants and investment analysts. The result was that the underlying profitability of the corporate sector became overstated, causing investors to over-estimate, not just the current level of profits, but also their underlying rate of growth. In this circumstance, it is not surprising that stock prices rose above sustainable levels."
While showing some survey data as evidence that institutional investors were not tricked (that is they felt the stock market was over-valued), the author points out that equity allocations rose in spite of this belief that the stock market was too high. Why? In part because of an agency cost problem:

"...investment managers, whose greatest risk is the business risk of losing their clients, cannot afford to take bets based on long run outcomes, and consequently have incentives to ignore signs of overvaluation: it is better for them to lose their clients' money along with the crowd as the market goes down than to risk saving significantly worse returns than their competitors."
In other words, if the investment manger were wrong in the short run while everyone else is betting the stocks will still rise, (s)he might be replaced. On the other hand, if the fund manager were wrong when everyone else was also wrong, it is less likely to result in a firing.

While most of the article stresses that stock prices should not have risen as much as they did, there was at least one economically justifiable reasons for stock prices rising: a declining risk premium. In his words: "There is evidence that the risk premia in capital markets that might have been assessed by sophisticated investors were declining through the 1990's."

The article ends with a look into the future and a discussion of whether a bubble could happen again. He suggests that the regulatory changes to lessen conflicts of interest and increase transparency are steps in the right direction but that investors and journalists must learn more about finance and not to blindly invest with no expectation of a loss. He also calls on FinanceProfessors to be more vocal:
"Perhaps more important for the aggregate level of prices is a broader understanding among the public of the sources of value for stocks in general.....Greater sophistication on the part of financial journalists would assist in this process, as would the increased involvement of financial economists in the popular media."

A quick, informative, and interesting piece! It brings up many interesting ideas.

BTW in a stroke of uncanny timing, I will be taking part of Brennan's prescription this week. On Saturday I will be on The Kim Snider show on KRLD-AM News radio 1080 out of Dallas Texas. If you are in the area, listen in!

Wednesday, November 10, 2004

The McKinsey Quarterly: Internal rate of return: A cautionary tale

The McKinsey Quarterly: Internal rate of return: A cautionary tale

I was just preparing for class and came upon a great article from McKinsey Quarterly (published by Wharton) that gives some reasons why the Internal Rate of Return may not be all that it is cracked up to be.

Short version:

IRR may lead to the wrong investment decision more often than we thought! And to make matters worse, many who are using IRR, are not even aware of the flaws (and in particular the problems with the reinvestment rate assumptions!)

As the authors John C. Kelleher and Justin J. MacCormack state: "Our next surprise came when we reanalyzed some two dozen actual investments that one company made on the basis of attractive internal rates of return. If the IRR calculated to justify these investment decisions had been corrected for the measure's natural flaws, management's prioritization of its projects, as well as its view of their overall attractiveness, would have changed considerably."

BTW this is why I love the blog idea so much. Why share the information only with those in class, why not all past students, fellow professors, and just anyone who is interested in finance! And it si so easy. Technology creates such leverage!

The Pecking Order--Dead or Alive?

What a treat we have! It is by Colin Mayer and Oren Sussman. It is on the pecking order.

The last we visited the pecking order was January's newsletter:
Myers and Majuf's famous 1984 pecking order hypothesis attempts to describe how firms raise capital. The authors hypothesized that firms are driven by information asymmetries and transaction costs to use internally generated capital first before turning to more expensive sources of financing. Once
their internal sources are used, then firms will use debt (where the information asymmetry problem is less severe) first and then as a last resort will use equity.
Not surprisingly many researchers have investigated this hypothesis. For example, two recent papers have taken different tacks, but have each come to the same basic conclusion, namely that the pecking order hypothesis does not fit the evidence. The papers are (1) by Fama and French and (2) by Galpin. In brief, recent work has suggested that the pecking order is in trouble and as I concluded the piece in January by writing: "currently the pecking order does not work" camp has the momentum."

Well we may have a "momentum changer"!

Mayer and Sussman look at the pecking order by examining firm behavior around spending "spikes" and find that is does help explain firm finance activity, at least in the short run.

The logic behind there study is relatively simple but important: generally the firms ability to generate cash is at least as as its ability to find positive spending opportunities. Thus, internally generated cash is most often used. However, when there is a large expenditure, this changes and the firm must rely on external financing.

In the words of the authors:
"Most investments are thus undertaken by financially unconstrained firms that shed little light on the main body of corporate finance theory, which is developed on the assumption that firms are financially constrained. Indeed, most theoretical corporate finance relates to the financing of indivisible investment opportunities, i.e. projects undertaken by cash-poor entrepreneurs and companies.
So rather than look at all firms, look at those that may be "cash poor," hence firms making large investments. When this is done, the results change!

"We find that the spikes are predominantly financed with debt by large firms and by new equity by small loss-making firms."
Which is consistent with the pecking order!

Equally interestingly, however, the authors find evidence that firms do have some target capital structure in place and that managers do consider this as an optimal financing mix and try to return to it once the investment spike is financed.

There is clear evidence of capital structures reverting back to previous levels of leverage after an investment spike. The size of adjustments is very significant: large firms offset up to 70% of the disturbance to their capital structure over a five year period around the investment spikes.
So what does this all mean? It seems to point to a world where both the pecking order and the trade-off model have something to offer us. As Mayer and Sussman summarize:
"The pecking order provides a partial but not wholly accurate description of firms' behaviour in the short run while the trade-off theory holds in the long run. Neither the pecking order nor the trade-off theories on their own therefore are adequate descriptions of the data."
This paper is to be presented at the American Finance Association's (AFA) annual meeting which takes place in January. Be sure to look for it! You will like it!

This paper is also available through FEN.