Friday, April 29, 2005

Plagiarism Resource Site Windows Software Page

End of semesters often mean term papers. Here are a few source of anti-plagirism software that might make your job a tad easier.

From the University of Virginia Plagiarism Resource Site Windows Software Page

From the University of Washington

Another site that discusses many free sources for both teacher and student.

This is not to say I have had a problem lately, but it is always better to be prepared for these things.

My note to students: always give credit to those sources you use!

NYSE, Nasdaq mergers seen changing landscape

NYSE, Nasdaq mergers seen changing landscape - Banks - Financial - Financial Services - IPOs - M&A - Markets/Exchanges - Market News

A follow-up on last week's the announcements of the NYSE and NAsdaq.

"By Steve Gelsi, MarketWatch
Last Update: 2:30 PM ET April 28, 2005

NEW YORK (MarketWatch) -- With the financial markets business weighing the New York Stock Exchange's planned $3 billion combination with Archipelago, as well as the Nasdaq's pending $1.9 billion purchase of Instinet, specialty companies and many others are reassessing their roles in an increasingly electronic trading world."

Short version: much change is on the horizon. Indeed the future of the trading floor is by no means a foregone conclusion.

Some highlights:

* "You're looking at an environment where everything is in play," said Chris Nagy, managing director of order routing for Ameritrade (AMTD: news, chart, profile) . "Everyone is posturing to be a leader in this new market structure.""

*"The Nasdaq and the NYSE will finally catch up to innovation in the industry after electronic communication networks and other players led the way in recent years"

*"Meanwhile, the fate of the NYSE-Archipelago deal is under fire as board member Kenneth Langone attempts to pick up support for a rival plan to buy the Big Board. See full story"

*"Ingrid Werner, professor of the Fisher School of Business at Ohio State University, said questions remain about the role of NYSE's two surviving independent specialist firms...[and added] Overall, the NYSE's move illustrates the advantages of demutualization to increase transparency, raise capital for technological improvements and increase the speed the process for future changes, according to Werner."

Read the entire article here.

Thanks MarkP for the heads up on this one!

Thursday, April 28, 2005

NPR : Post-Scandal Regulations Boost Accounting Industry

For the accountants among us :)

NPR : Post-Scandal Regulations Boost Accounting Industry: "All Things Considered, April 27, 2005 "The accounting scandals of the past few years produced a regulatory crackdown known as Sarbanes-Oxley, which has made audits much tougher and restricted who can be on a company board. Many companies hate the new rules, but they've been a boon for the accounting industry. "

Wednesday, April 27, 2005 | Environmental economics | Environmental economics
As Matt S. points out: "IRR and NPV pop up in the strangest of places." Actually not strange at all! Just in areas where the average non-finance person would not expect them.

Short version: NPV and IRR can (and should) be used to evaluate environmental decisions as well. the problem however is that these costs and especially benefits are often difficult to quantify.

Slightly longer version:
The World Bank (at least since 1991) has used NPV and IRR to study the environmental impact of its decisions. While finding the true cost and benefit of environmental questions is notoriously difficult, it is something that must be done.

From "A Review of the Valuation of Environmental Costs and Benefits in World Bank Projects" by Silva and Pagiola. (Take a look at the boxes for nice summaries!)
"If a project activity causes environmental damage, that damage needs to be included in the economic analysis of the project together with the activity’s benefits and any other damages. To do otherwise would be to make the activity appear artificially more attractive than it is. Likewise, if additional costs are incurred to avoid such damage, those costs need to be included in the project costs considered in the economic analysis."
From the Economist article:
"The turning point for this way of looking at things was in 1997. In that year, the city government of New York realised that changing agricultural practices meant it would need to act to preserve the quality of the city's drinking water. One way to have done this would have been to install new water-filtration plants, but that would have cost $4 billion-6 billion up front, together with annual running costs of $250m. Instead, the government is paying to preserve the rural nature of the Catskill Mountains from which New York gets most of its water. It is spending $250m on buying land to prevent development, and paying farmers $100m a year to minimise water pollution."
Actually I am including this in the blog not because it is new per se, but because
  1. it is so interesting and thought provoking
  2. it could be used to motivate those who are less inclined towards finance to see the importance of NPV and IRR calculations--indeed I plan on using it in my Finance 301 class in the fall!
  3. if all of the environmental costs and benefits were included, the world would be a better place.

Thanks for the heads up on this one Matt! (BTW Matt is a former JMU student who is about to take off on a several month around the world adventure!)

Texas Finance Festival

From Michael Jensen:
"In cooperation with Baylor University, FEN announces
the 2005 7th Annual Texas Finance Festival abstracting journal.
This abstracting journal, available to all subscribers at no charge,
contains abstracts of the festival papers with links to the
full text in the SSRN eLibrary."

"HOW TO SUBSCRIBE You can subscribe to the 7th Annual Texas Finance
Festival abstracting journal by clicking on the following link:"

The purpose of this abstracting journal is to provide
a data warehouse for all abstracts and papers presented at
the festival and to facilitate their distribution to the financial
profession as a whole. Abstracts of the papers will also be published
in subject-specific journals within the FEN Network and,
where appropriate, in the journals of our sister networks."

Conference URL:

PAPERS AT SSRN The following URL will allow you to browse all FEN 7th
Annual Texas Finance Festival Abstracts in the SSRN database as
they are submitted. You may wish to bookmark it in your
browser. "

Michael C. Jensen

Adelphia, Deloitte, and the Rigases all agree to make payments

Deloitte Settles Adelphia Case for $50 Million - -

Well there is some closure at least. After about 3 years, the Adelphia case may be over! In a move seen as both an attempt to stay out of Jail and to clear the way for a pending takeover, the Rigases, Adelphia itself, and the former Auditors all agreed to pay into a fund to help compensate victims of the fraud.

The Rigases agreed to turn over about $1.5 Billion of assets to Adelphia which in turn will pay about half ($715 million) into the fund. Additionally Deloitte agreed to pay $50 million (including a $25 Million fine) for not catching the fraud and for insufficient safeguards against the fraud.

Some of the highlights of the case:


"The Rigas family, which founded the now-bankrupt cable giant, will forfeit 95 percent of its assets — totaling more than $1.5 billion — under a settlement with the U.S. Attorney's office for the Southern District of New York and the SEC. Those assets — including cable systems valued at $700 million to $900 million and bonds valued at $567 million — will be turned over to Adelphia. Upon emerging from bankruptcy, the company will then pay $715 million to create a fund to compensate victims of the fraud, according to the commission."

From the Boston Globe:

"The settlement should help clear the way for Adelphia's acquisition by Comcast Corp. and Time Warner Inc., the two largest US cable television companies, said Sanford C. Bernstein & Co. analyst Craig Moffett. Comcast and Time Warner said last week they would buy Adelphia for $17.6 billion in cash and stock, the biggest transaction in the industry in two years."

From CNN:
"Deloitte, one of the Big Four accounting firms, will pay a penalty of $25 million and another $25 million in a related administrative proceeding, the SEC said. The total will go into "a fund to compensate victims of Adelphia's fraud," it said."

From Marketwatch:
""What is especially troubling here is that Deloitte recognized the risk of fraud posed by this client at the outset," said Mark K. Schonfeld, director of the SEC's Northeast Regional Office, in a statement."

From the NYPost:
"Members of the Rigas clan, led by 80-year-old patriarch John Rigas were accused of siphoning more than $2.4 billion from the company to spend freely on real estate and other investments.

The elder Rigas and his son Timothy, 48, the ex-CFO, were convicted last summer of fraud and conspiracy and will be sentenced June 1. They could get leniency due to the pact,"

From the NY Times:
"In turning over their assets to Adelphia, the Rigases are giving up virtually all of their holdings. The settlement would leave the Rigases with about $79 million in assets."

And finally, here is what NPR had to say about it.

For those of you outside of the local area, Adelphia was headquartered in Coudersport PA (about 45 minutes from St. Bonaventure). Due to local interest (the Rigas were generous donors to SBU), Carol Fischer and I wrote 2 cases on Adelphia back in 2002 and 2003. Each was published but to be honest I can not remember where. I think one was under the name Philippe at Bquest and one was in the Journal of Accounting and Finance. It was more accounting based, but unfortunately I can not find an online version of it.

I do have a working copy version (before an editor told us to change the name) of the Finance oriented casethat I currently am using in my MBA classes.

Here are powerpoint slides from a presentation we put on based off of the paper.

Monday, April 25, 2005

What is the expected return on options? Zero? RF rate? Or something else?

FEN has a great article on some of the limitations of Black-Scholes World! It is by Ross Miller and it is definitely worth your time!!! It is both thought provoking and funny at once. A great combo!!!

Be Careful What You Model

A few quick highlights:

* "You have in your hand (or on your screen) an at-the-money call option with a year until it expires. Because you are in BSW, you know exactly what that option is worth at the present moment in time. Consider this: What is your expected rate of return on the option between now and the option’s expiration in one year?

An easy question, right? Think some more.

The typical profit-and-loss diagram for options, popularly known as the “hockey-stick,” assumes that the funds invested in options earn a zero return regardless of the time until expiration. According to this diagram, the absolute return from an option is simply the terminal payoff minus the current cost. The possibility that one might require a positive return to compensate for the opportunity cost of funds used to finance the option is either ignored for the sake of pedagogical simplicity or relegated to a footnote.

Zero is clearly the wrong answer, so what about the risk-free rate? That was the nearly unanimous answer to my informal, nonscientific survey and it is what Paul Wilmott appears to be saying (if I understand his notation) on the top of page 34 of the first volume of his magnum opus on quantitative finance.

This answer might be defensible, but it is not what BSW’s creators had in mind"

*The strange world in which every asset earns the risk-free rate of return for the life of the option is not Black-Scholes World, but a universe that I will dub Cox-Ross World (CRW) after the two economists, John Cox and Stephen Ross, who colonized this world in their 1976 Journal of Financial Economics article. (Cox and Ross explicitly refer to their theoretical construct as a “world.”) CRW is a degenerate neighborhood of Black-Scholes World in which risk-neutrality rules. What Cox and Ross recommend (and what Black and Scholes allude to in an unpublished early draft of their famous article) is that when you have a messy option it usually pays to visit CRW to find its value."

*"Take the collapse in spreads on risky debt. In a risk-neutral world, yield spreads are just wide enough to cover the expected capital losses from adverse credit events. While unquestionably much of the tightening over the past few years has come from good news on the credit front, there appears to be more going on – vanishing risk premia."

* "It is natural to wonder whether all of this is just another recipe for disaster whipped up in the financial engineers’ kitchens. Unfounded assumptions of option replicability (portfolio insurance in 1987) and market liquidity (LTCM in 1998) turned out to have a destabilizing effect on financial markets"


Friday, April 22, 2005

Nasdaq finalizes acquisition of Instinet

The market consolidation continues with the Nasdaq and Instinet finalizing their widely rumored deal on the heels of the NYSE Archipelago deal.

From Reuters (the previous majority owner of Instinet):
" As a condition of the deal, Reuters will sell Instinet's electronic trading network to Nasdaq."

Latest News and Financial Information |

From Bloomberg:

" Chicago-based Archipelago, the third-largest electronic market for U.S. stocks, had a 23.5 percent share of trading in Nasdaq-listed stocks in the first quarter. Instinet, which is scheduled to report first-quarter results on Monday, has had about 25 percent. Both electronic exchanges and electronic trading systems known as ECNs can trade Nasdaq stocks.

``Competition from ECNs and other electronic trading platforms has significantly reduced our market share in executions in Nasdaq-listed securities,'' Nasdaq said in a recent SEC filing. "

Thursday, April 21, 2005

NYSE to acquire Archipelago

Talk about major stories! The NYSE has announced plans to acquire the Archipelago stock market!

With the NYSE losing marketshare to ECNs, it has long been speculated as to what the Big Board's response would be. It appears that this is it!

From the NY Times:
"The New York Stock Exchange, whose shouting traders and frenzied activity have become a global symbol of capitalism, announced yesterday that it would acquire a leading electronic trading system in a deal that allows the exchange to become a public company but casts doubts on its 213-year-old system of auction trading.

The exchange will merge operations with Archipelago, one of the biggest electronic trading operators, to form the NYSE Group. The deal will give the holders of the exchange's 1,366 seats $400 million in cash and 70 percent of the shares of the combined publicly traded company.....

The merger is the most significant acknowledgement yet that the Big Board's traditional market, driven by human traders, may not be able to survive in an era increasingly dominated by instantaneous trades."

From the San Francisco Chronicle:

"By merging with Archipelago Holdings and morphing into a for-profit, publicly held company, it vastly increases its electronic trading capabilities at a time when its customers and regulators are demanding it.

It will add or expand trading opportunities in products like options, exchange-traded funds and Nasdaq stocks, thus increasing its slow-growing revenues, dominated by trading in NYSE-listed stocks.

It also gives NYSE members a new way to cash in on the value of their seats."

From Bloomberg:

"When New York Stock Exchange Chief Executive Officer John Thain arranged the takeover of Archipelago Holdings Inc., a nine-year-old electronic exchange, by the 212-year- old Big Board, he pulled ``a rabbit out of his hat.''

That's the view of William Harts, who worked for the NYSE's chief rival, the Nasdaq Stock Market Inc. In one stroke, the NYSE will be able to extend its operating hours, provide clients with options trading and access to Nasdaq-listed stocks, and cut about $200 million of expenses.

For the NYSE, the transaction is a ``a giant step toward eliminating their massive infrastructure costs by adopting Archipelago's technology....

The new entity plans to cut costs during the next two years by reducing staff and consolidating operations. Thain said he will preserve the NYSE's Wall Street trading floor, where specialists make markets in shares of some of the largest U.S. companies.

Thain said there would continue to be a role for floor traders. While the top few hundred of the NYSE's largest companies, such as General Electric Co. and International Business Machines Corp. trade seamlessly electronically, he said smaller companies benefit from human intervention.

``This is absolutely not the end of the floor,'' Thain said."

From the Washington Post:

"Thain and Archipelago chief executive Gerald D. Putnam, who would become co-president of the new company, said the combination would significantly improve the NYSE's competitive position in a long-fragmented business that appears to be quickly consolidating.

The Nasdaq Stock Market Inc., for instance, is widely expected to complete a deal soon to buy Instinet Group Inc., another large electronic trading network. Nasdaq also has long considered an initial public offering of its own but has not managed to complete a deal."

Interestingly, this past fall on our Finance Club trip to NYC we spoke with representatives at both NYSE and Nasdaq who had largely predicted more consolidation. On official in fact went as far as to imagine a world with a single market. While the regulations and governance of such a market causes some pause, the consolidation wave continues!

Is this a case of "If you can't beat them, join them?" Or is it being driven by economies of scale? or something else entirely? CBS Marketwatch has a very interesting series of interviews with analysts on the deal. Most are very favorable. Thus it is not surprising that
Archipelago shares jumped (about 68%) in the hours after the announcement.

Six Degrees of Separation: Examining Back Door Links between Directors and CEO Pay - Knowledge@Wharton

Six Degrees of Separation: Examining Back Door Links between Directors and CEO Pay - Knowledge@Wharton

Forget 6 degrees of Kevin Bacon. Now we can play the game for real and see how CEOs and their boards are connected and how the connection impacts executive pay!

Executive Compenstaion is always an interesting topic and Larker, RIchardson, Tuna, and Seary have made it more so! They look for connections between CEOs and Board members across "22,074 directors for 3,114 firms, we develop a measure of the "back door" distance between each pair of directors on a company's board."

And they find? Drum roll please.....
"CEOs at firms where there is a relatively short back door distance between inside and outside directors or between the CEO and the members of the compensation committee earn substantially higher levels of total compensation (after controlling for standard economic determinants and other personal characteristics of the CEO and the structure for board of directors). This statistical association is consistent with recent claims that the monitoring ability of the board is hampered by “cozy” and possibly difficult toobserve relationships between directors."
I hope I would be as generous as the authors in maintaining that this could be justifiable:
"There could be innocuous explanations for the extra compensation, he says. The network of links among directors acts as a mechanism to disseminate information, and part of the information may be that a director impressed by the work of a compensation consultant at one company simply takes the template over to another, Richardson says, adding that yet another plausible explanation for the compensation differential could be that directors who serve on multiple boards "inherently are of a higher quality," and therefore the companies where they are directors generate greater value, and that greater value is reflected in the CEO's compensation." From McKinsey Quarterly.
Yeah. Or for the more cynical: Boards pay their "friends" more.

Two cites:

McKinsey Quarterly or from SSRN

Yes it is a commercial, but actually quite interesting!

Not sure if you have seen this 4 page ad (in PDF format) for GE Lending or not, but it is quite interesting. It discusses capital structure for midsized firms. An area that does not get as much coverage from academics or many investment bankers.
recap_april05.pdf (application/pdf Object)

Some of the highlites for those who opt not to click through to the PDF file:

1. "As businesses grapple with such multiple challenges as an on-again and off-again economy and slowlyrising
interest rates, specialists from Wharton and GE Commercial Finance note that successful
organizations often exhibit an ability to quickly respond to market dynamics. With this in mind, they say
that debt financing is playing an increasingly important role in a company’s competitiveness. A responsive,
well-managed capital structure can add value and help a company to thrive while an inflexible, outdated
approach can drain a company’s cash flow, resulting in missed opportunities and restricted

2. "For John Percival, an adjunct professor of finance at Wharton, there’s really no distinction between a
good approach to financing and a good strategy. “There’s a common misperception that there’s a difference
between strategy and finance"

3. "if the firm’s fundamentals are sound and it has a solid asset base but is also weighed
down by fixed financing costs, it may be worthwhile to explore a debt restructuring. In such a situation, a
lender needs to take an active role—first to gain a deep understanding of the borrower’s operations and
needs, and then to structure a package that can address the strengths and weaknesses of the company.” "

4. "Current finance theory suggests that there is an optimal capital structure for a firm that finds the right balance
between the tax advantages of debt financing and the costs of financial distress that go along with too much
leverage, adds Wharton’s Percival."

Not bad for an advertisement!

Monday, April 18, 2005

Is risk increasing or decreasing?

IPO Vintage and the Rise of Idiosyncratic Risk by Jason Fink, Kristin Fink, Gustavo Grullon, James Weston

While well documented, increased risk (and in particular increased firm specific risk) has been a puzzle for researchers for quite some time. With improve transparency and deeper markets, one could speculate that risk should be decreasing, but researchers have not been finding this. For instance:
"recent studies by Campbell, Lettau, Malkiel, and Xu (2001) (henceforth CLMX), Malkiel and Xu (2003), Fama and French (2004), Wei and Zhang (2004), and Jin and Myers (2004) document that, over the past 30 years, U.S. public firms exhibit higher firm specific return volatility, more volatile income and earnings, lower returns on equity, and lower survival rates. The recurring theme in all these studies is that firm risk, however defined, has increased."
But now Fink, Fink, Grullon, and Weston may provide the explanation: firms are going public sooner. When the age of firms is controlled for, there does not appear to be an increase in systematic risk and in fact there may be a decrease!
"We argue that the rise in firm specific risk can be explained by the interaction
of two reinforcing factors: a dramatic increase in the number of new listings and a
simultaneous decline in the age of the firm at IPO."

"we find that after controlling for age and other measures of firm maturity (e.g., book-to-market, size, profitability, etc.), there is a negative trend in idiosyncratic risk."
Go ahead and read it! Interesting and a quick read! (and the Finks are at JMU (one of my favorite places) so you know it has to be good!!!!)

Suggested Citation
Fink, Jason, Fink, Kristin, Grullon, Gustavo and Weston, James Peter, "IPO Vintage and the Rise of Idiosyncratic Risk" (February 2005). 7th Annual Texas Finance Festival Paper.

Thursday, April 14, 2005

Do Fundamentals or Emotions Drive the Stock Market? - -

Do Fundamentals or Emotions Drive the Stock Market? - -

WELL DONE! Markets are not perfect, but they sure are pretty good. A few highlights:

* "We agree that behavioral finance offers some valuable insights — chief among them the idea that markets are not always right, since rational investors can't always correct for mispricing by irrational ones. But.... significant deviations from intrinsic value are rare, and markets usually revert rapidly to share prices commensurate with economic fundamentals. Therefore, managers should continue to use the tried-and-true analysis of a company's discounted cash flow to make their valuation decisions."

* "Behavioral-finance theory holds that markets might fail to reflect economic fundamentals under three conditions.." The three conditions are 1. Irrational Behavior 2 Systematic patterns of behavior and 3. Limits to Arbitrage."

* "Academics are still debating whether irrational investors alone can be blamed for the long-term-reversal and short-term-momentum patterns in returns. Some believe that long-term reversals result merely from incorrect measurements of a stock's risk premium, because investors ignore the risks associated with a company's size and market-to-capital ratio. (Eugene F. Fama and Kenneth R. French, "Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, 1996, Volume 51, Number 1, pp. 55–84.) These statistics could be a proxy for liquidity and distress risk."

There is more and I HIGHLY recommend you take a look! It is EXCELLENT! (BTW this was originally from McKinsey Quarterly.)

I wholeheartedly agree with the article and am comforted by how close this corresponds to what we do in class! :)

ABC News: Nestle CEO Faces Opposition on Added Title

Bucking the trend of breaking up the CEO and Chairman positions, Nestle is trying to "reward" the CEO with the dual titles.

ABC News: Nestle CEO Faces Opposition on Added Title: "The global food company says giving CEO Peter Brabeck a double mandate at the company's annual shareholder meeting Thursday is in the interest of its investors because it assures 'strategic continuity and long-term value."

Shareholders seem to be opposed to the idea:
"Five pension funds led by Ethos have proposed a vote at the shareholders' assembly to separate the two top jobs permanently."

Interestingly, Brickley, Coles, and Jarrell might agree with Nestle. Their paper "call[s] into question previous empirical work which suggests that firms with separate titles outperform firms with combined titles. We tentatively conclude that proponents of legislation to force separation of titles have overlooked important costs."

Tuesday, April 12, 2005

BusinessWeek Online: 2005 Executive Compensation Scoreboard

The 2005 Business Week Executive Compensation "scoreboard" is now online!
BusinessWeek Online: 2005 Executive Compensation Scoreboard

In the accompanying article, Louis Lavelle writes "BusinessWeek's 55th annual Executive Pay Scoreboard found that increases were moderated in 2004 by the continued impact of corporate reform, an ongoing shareholder revolt over astronomical pay levels, and pending accounting changes that are reining in the use of stock options. Our survey of 367 CEO pay packages showed that:

-- Total CEO pay was up smartly, to an average $9.6 million -- a 15% increase from $8.3 million in 2003. But that average was skewed by the outsize pay package of our most highly compensated CEO, Yahoo! Inc.'s (YHOO ) Terry Semel, who received a package worth $120 million made up almost entirely of options. Take him out of the mix and the average raise was 11.3%, not far off the rise in shareholder gains."

An important change in this year's scoreboard is that the options are valued using the Black Scholes formula rather than merely looking at exercise gains.
This will make "pay anomalies are now easier to detect, thanks to a new methodology that BusinessWeek began using this year. Instead of counting the windfalls from option exercises as part of the annual pay package, as we have in the past, we're counting the value of annual option grants. The values are calculated using the Black-Scholes formula...."

Another important trend was the increased use of restricted shares at the expense of option grants.

"In 2004 the 200 big companies tracked by New York pay consultants Pearl Meyer & Partners granted options equal to 2% of their outstanding shares, down from 2.7% in 2001. CEOs saw the stock option portion of their pay packages decline from 51% to 37% in just one year -- in part because grants of restricted stock increased"

Still not convinced you can teach ethics

Teaching ethics is hard and as the WSJ reports, colleges are not having an easy time of it.
CollegeJournal | MBA Track: "Three years after coming under attack for their M.B.A. graduates' involvement in the many corporate scandals, schools are still grappling with how to teach ethics more effectively."

How can you teach ethics? My best advice is to attempt to show why it really is in your best interests (i.e. think long term!) to act ethically and to show that the market is a harsh disciplinarian.

It would be interesting to see how many finance classes incorporate ethics. (if you know of any study on that, please send it along). My classes do discuss ethics, but not we do not devote an entire section to it, but rather bring it up whenever it seems appropriate. (for instance, dumping toxic wastes may seem a good short term solution, but in the long run, is really really stupid.)

Of course, the success of any ethics effort is debatable.

Monday, April 11, 2005

Who will replace Greenspan?

Rueters has an interesting article on who will replace Greenspan when the time comes. Preseason favorite? Ben BernankeLatest News and Financial Information |

Friday, April 08, 2005

Another look at Capital Structure and Market Timing

Market Timing with respect to capital structure changes is an interesting and controversial topic that combines capital structure theory with market efficiency theory. On one side of the aisle pure market efficiency proponents maintain there is no place for market timing as the current price is always right. The other side of the discussion is held by those who believe that capital structure tradeoff or pecking order theories are sufficiently robust to capture changes in capital structure.

Most recently is has appeared that the timing camp has been winning. Over the past few years much esearch has shown what the authors interpreted as market timing (that is, issue equity when stock prices are relatively high, issue debt when interest rates are low). For example Baker and Wurgler (2002), Flannery and Rangan (2004), and Alti (2004) all suggest that market timing does occur.

Now Hovakimian draws that interpretation into question. Namely he suggests that timing is less important than the persistent relation between market to book ratios and growth opportunities. Specifically: "These results are consistent with the hypothesis that the importance of historical weighted-average market-to-book is due to its association with current growth opportunities."

In other words:
"results also show that cross-sectional differences in market-to-book ratios of firms issuing and repurchasing debt and equity dwarf the changes in market-to-book experienced by these firms over time."
Interesting! I am not totally convinced that timing does not play a more important role than suggested here, but do (and always have) admit that timing is not the major determinant in capital structure decisions. However, I will be surprised if in the end we do not conclude that it does play a role.


Suggested Citation:
Hovakimian, Armen, "Are Observed Capital Structures Determined by Equity Market Timing?" (June 3, 2003). AFA 2005 Philadelphia Meetings.

Risk Free?

This is not my editorial comment, I just thought it was funny. President Bush was disparaging the safety of the IOU's held by the Social Security Trust.

The New York Times > Opinion > Editorial: Shameless Photo-Op

For the record, all bonds are just IOUs! And as for the credit worthiness of the debtor, let's hope we don't need to worry about that!It is the US!!! Maybe President Bush does not realize that those IOUs are largely assumed to be risk free!

"He posed next to a file cabinet that holds the $1.7 trillion in Treasury securities that make up the Social Security trust fund. He tossed off a comment to the effect that the bonds were not "real assets." Later, in a speech at a nearby university, he said: "There is no trust fund. Just i.o.u.'s that I saw firsthand.""

Thursday, April 07, 2005

SSRN-Do Analyst Conflicts Matter? Evidence from Stock Recommendations by Anup Agrawal, Mark Chen

SSRN-Do Analyst Conflicts Matter? Evidence from Stock Recommendations by Anup Agrawal, Mark Chen

Agrawal and Chen have a really cool paper that looks at conflicts of interest with investment bankers and their affiliated brokerages. They find sure enough that the conflicts of interest do influence recommendations. However, the authors also make a pretty convincing case that these conflicts and biased recommendations probably are known by investors and therefore the market place is not tricked.

I'll try to find some time to write more about this paper soon. It is definitely worth reading!

Suggested Citation
Agrawal, Anup and Chen, Mark, "Do Analyst Conflicts Matter? Evidence from Stock Recommendations" (March 2005).

Tuesday, April 05, 2005

SSRN-Portfolio Concentration and the Performance of Individual Investors by Zoran Ivkovich, Clemens Sialm, Scott Weisbenner

SSRN-Portfolio Concentration and the Performance of Individual Investors by Zoran Ivkovich, Clemens Sialm, Scott Weisbenner

It is always nice when research confirms what we had theorized. For instance Ivkovich, Sialm, and Weisbenner show that when investors take highly undiversified positions, they on average earn higher returns than when they are diversified. However before you scrap all diversification theory, these higher returns come at the expense of added risk.

Why would investors hold a "concentrated" portfolio? It could be because of fixed transaction costs or because of information advantages, or because of what collectively could be called behavioral reasons.
"There are a few key reasons why households might hold poorly diversified portfolios. First, a lack of diversification could be prompted by behavioral biases such as familiarity, overconfidence, or risk-loving behavior such as holding stocks in “entertainment accounts.” Second, individual investors might hold concentrated portfolios because they are able to identify stocks with high expected abnormal returns."
Overall the authors find that "Consistent with Odean (1999), we find that, on average, the stocks bought by individual investors underperform the stocks they sell by a wide margin."

However, when larger portfolios (over $25,000) are examined concentrated investors earn higher returns.
"Regardless of portfolio size, the purchases made by diversified households underperform the appropriate Fama and French (1992) benchmark portfolios based on size and book-to-market deciles by one to two percentage points in the year following the purchase....the purchases made by concentrated households with large portfolios do substantially better, exceeding the appropriate Fama and French benchmark portfolios by 1.3 percentage points for those with relatively large portfolios (i.e., $25,000 or more) and by 2.3 percentage points for those with the largest portfolios (i.e., at least $100,000)."
However, before you scrap diversification plans (A DEFINITE NO-NO in my book!), these added returns come at the cost of added risk. While acknowledging problems with the Sharpe Ratio, the authors find that "wealthy households holding highly concentrated portfolios perform significantly better than the wealthy households holding widely diversified portfolios, we also find that their levels of total risk are larger and the Sharpe ratios of their stock portfolios are lower."

So why would investors take on this added risk? While some argue behavioral reasons (see above), however, such a view would have predicted no higher returns for the concentrated investors. Thus given the higher returns, the best explanation seems to be that the investors have superior information for these stocks and are trying to take advantage of this information.
Consistent with the information explanation, the authors write that "The excess return associated with concentration is stronger for investments in local stocks and stocks that are not included in the S&P 500 Index (which tend to have less analyst coverage and national media attention), potentially reflecting concentrated investors’ ability to exploit information advantages. In sum, these findings are consistent with the hypothesis that skilled investors can exploit information asymmetries by concentrating their portfolios in the stocks about which they have particularly favorable information."

True. However, to get this excess return the concentrated investors (a term I like more than "skilled investors") do take on added risk. It is unclear whether they can earn an excess return on a risk adjusted basis.

VERY Interesting!

As an aside, does anyone else note the irony of a paper that essentially comes to the defense of investor rationality, resting on less than perfectly efficient markets.

Suggested citation:

Ivkovich, Zoran, Sialm, Clemens and Weisbenner, Scott J., "Portfolio Concentration and the Performance of Individual Investors" (February 2005).

Saturday, April 02, 2005

What is the role of the Fed with respect to asset price bubbles?

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There is always a debate as to the role of the Fed when it comes to asset "bubbles." For instance, the Fed was criticized by many after the internet bubble. What is the correct role? Hands off? Active interventionist?

Fed Governor Edward Gramlich gave his view to a "conference hosted at Princeton University." His view? Basically hands off:

"You've only got one funds' rate so you can't get into the business of targeting specific assets."

"Gramlich stressed that the Fed had a very specific task -- it is mandated by Congress to preserve price stability while seeking sustainable full employment -- and demanding that it tackle asset bubbles as well could undermine those goals. "If you worry about asset prices, that represents a trade-off with your primary objectives.""

That is true, but the counter argument can also be made. Namely that the role of the Fed is to assure stability in the Economy and that asset bubbles are often destabilizing. So the debate will continue to be waged.