Thursday, June 30, 2005

History of Wall Street

In response to the historic stock price mention in the last post, I received a link to this History of Wall Street

BTW a bit of trivia: Most of you know that the NYSE was basically started with the Buttonwood Agreement. What type of tree is a buttonwood?

Yes, the Sycamore. The nickname was earned because of the seeds that look like buttons.

A few links
Ohio State Forestry, TreeTotem (which suggests that Plato taught under a Buttonwood tree!), Eastern Tennessee Arboretum, and finally the USDA.

Old stock data from Will Goetzmann's Home Page

I am trying to review a stock split paper (I strated it yesterday and never finished) and SSRN was down, so I figured I would Google it. And what a treat! Will Goetzmann has links to many sources of old (as in from the 1800s!) stock data as well as his own papers and many other cool sites.

Will Goetzmann's Home Page
Will Goetzmann's Home Page

I already have a paper in mind. If anyone is interested in the American Civil War and is would like to be a co-author, let me know.

Wednesday, June 29, 2005

Trading Halts: new evidence from Istanbul

Bildik gives us a interesting look at trading halts. While the data and the halts he looks at are from the from the Istanbul stock market, most of what he writes is similar worldwide.

Trading halt papers are always interesting and often controversial. This controversy comes in part from the underlying controversies surrounding the halts themselves.

"The stated purpose of trading halts is to allow investors an opportunity to react to new information and to facilitate the orderly emergence of a new equilibrium price. It aims to ensure that all investors have fair access to market information when material information comes to the market or any drastic change occurs."

Sounds good right? The problem is that much of the academic literature questions how useful these halts really are. In Bildik's words "opponents argue that halts are an unnecessary barrier to price discovery and do not prevent an increase in volatility following the halts."

Bildik investigates trading halts on the Istanbul Stock Exchange. After a GREAT literature review and a brief description of some microstructure difference between the NYSE and the Istanbul Stock Exchange, he finds that
"return, volume and volatility tend to return to their non-halt period averages in a short period of time after trading is resumed. Most of the information is absorbed by the prices within fifteen minutes (most completely in an hour) following the resume of trading after the halt. In general, results are robust to the time-of-the-halt and the duration of haltÂ’s effects. Halts clearly do not prevent the stock price reaching its equilibrium or spread the volatility out longer periods, it otherwise would have been."
Clearly? Maybe, I am not totally convinced, but ok.

Some other interesting findings:
* "...consistent to previous studies, the reaction of investors to the negative announcements is not only stronger than that of positive news but also lasts longer, which generates short-term under-reaction in returns. Restrictions on short sale, disposition effect, and positive abnormal returns in the pre-halt period seem to be an explanation for this"

* "Even though the duration of halts on the ISE is shorter than on developed
stock markets, the market seems to respond to the new information quicker or at least as quickly as it does in more developed US markets due to a different market microstructure, such as fully computerized trading, price discovery mechanisms based on continuous trading, the non-existence of monopolist specialists, restrictions on order cancellation during trading, investor characteristics and the small size of the market."
While these are all interesting, I may offer the finding that individual investors are still at an informational advantage as the most important finding:
" of the most striking findings of this study are the differences of trading
behavior of individuals, mutual funds, and brokerage houses around trading halts: mutual funds and brokerage houses take the price advantage of the information release ahead of the individual investors by having better timing in trading after the halt since they constantly watch the market. Similar to day traders, institutional investors systematically buy and sell at more favorable prices than non-institutional or individual investors around halts by using this advantage. However, halts facilitate the dissemination of valuable information during the halt period to the large number of investors, and give them a chance to react to the new announcement; halts cannot completely prevent institutional investors and day traders from
exploiting their natural advantage as a result of their professional activity. Obviously, if the trading halts did not exist, the advantage...would have been bigger since there were less informed individual investors...."
So, at least while halts do not totally protect the individual investor, they appear to provide some protection.

Interesting paper. Definitely recommend the lit review!

Bildik, Recep , "Trading Halts and the Advantage of Institutional Investors: Evidence from the Istanbul Stock Exchange" (December 1, 2004).

As an aside, I confess my views on trading halts have softened somewhat. While in school, I had been opposed to them on the grounds they did not really do what they were intended. However, in the past year or so, several conversations with NYSE regulators have persuaded me of at least some benefits (largely with limit orders) that accrue to small investors. (For example, if you had a limit order at 21, and the price were allowed to go up gradually, your trade would execute at 21, whereas if the true price is $25 and this is the price that the stock reopens at, then your trade would be executed at the higher price). Of course this is reversed if you are buying, BUT since there are probably more limit sells than limit buys (at least I would imagine there are), on net, the halt may protect individual investors.

Tuesday, June 28, 2005

The New York Times Deal Book

The New York Times > Member Center > Deal Book

The NY Times Deal Book is by far my favorite business news newsletter. It is so great. It gives a look at all of the major stories and links to them. For instance, among the many stories in today's newsletter were stories on:

The gives us an update on the Japanese banking sector:

I"t has taken Japan nearly 15 years to restructure the big banks that helped set off a vicious cycle of asset inflation in the 1980s that left the country mired in deflation."

The Guardian reports in the PartyGaming IPO.

"The quartet of two Indian computer engineers plus an American former porn entrepreneur and her husband will now collect a combined £1bn in cash and retain stakes collectively worth £3.5bn."

USAToday points out that "Over the objections of several former commissioners and his Senate overseers, Donaldson is pressing ahead with plans to re-approve a controversial rule adopted in 2004 that would force mutual funds to hire independent chairmen. The rule was nullified last week when a federal appeals court said the SEC violated the Administrative Procedure Act by not addressing the question of how much the rule would cost mutual fund companies.

Donaldson, who championed the rule throughout his 28-month tenure as SEC chair,..."

and those are only a few of the very good and very useful articles.

I definitely recommend signing up for DealBook!

Monday, June 27, 2005

Is growth good for shareholders?

I love articles that turn the conventional wisdom on its head (and I held this view long prior to ristening to Freakonomics), but that said, this one surprised me. What is more, in doing looking at growth and returns, Ritter offers valuable insights into what matters in forecasting expected returns.

Jay Ritter finds that shareholder returns are negatively correlated with economic growth.
In his words:
"... does economic growth benefit stockholders? This article argues on both theoretical and empirical grounds that the answer is no. Empirically, there is a cross-sectional correlation of –0.37 for the compounded real return on equities and the compounded growth rate of real per capita GDP for 16 countries over the 1900-2002 period."

"I am not arguing that economic growth is bad. There is ample evidence that people who live in countries with higher incomes have longer life spans, lower infant mortality, etc. Real wages are higher. But although consumers and workers may benefit from economic growth, the owners of capital do not necessarily benefit."
"This article argues that limited historical data on stock returns are not a constraint, since these data are irrelevant for estimating future returns, whether in emerging markets or developed countries. This point has been made before, although possibly not as explicitly, in Fama and French (2002) and Siegel (2002), among other places. Of greater originality, this article argues that not only is the past irrelevant, but to a large extent knowledge of the future real growth rate for an economy is also irrelevant."

"I argue that only three pieces of information are needed for estimating future equity returns. The first is the current P/E ratio, although earnings must be smoothed to adjust for business cycle fluctuations. The second is the fraction of corporate profits that will be paid out to shareholders via share repurchases and dividends, rather than accruing to managers or blockholders when corporate governance problems exist. The third is the probability of catastrophic loss, i.e., the chance that “normal” profits are a biased measure of expected profits because of “default” due to hyperinflation, revolution, nuclear war, etc. This third point is the
survivorship bias issue, applied to the future."
A few other highlights:
*"I believe that the large stock price effects associated with recessions are partly due to higher risk aversion at the bottom of a recession, but also due partly to an irrational overreaction."
He argues that while some claim the high returns experienced in the US are the result of a survivorship bias, this claim is probably overstated. For this argument he points out that 1. in 1900 most people were positive on the devolped world, 2. most of the developed world economies today are the same as they were in 1900 (with a few exceptions), and 3. no convincing evidence exists to suggest that the market's risk premium (i.e. the return above the so-called risk free rate) can be expalined through a survivorship bias hypothesis. Why? because the so-called "risk free rate" may increase in response to systematic risk factors.

It is for this third point that Ritter offers one of my favorite lines from any finance paper:
* "Third, even if survivorship bias is important in explaining realized stock returns, it is not clear that survivorship bias should affect the equity risk premium, since bond and T-bill investors suffer just as much from devastation as equity holders do. In the 1950s and 1960s, when it might plausibly be argued that a nuclear war involving the U.S. and the Soviet Union had a significant probability of occurring in future decades, real rates of interest on U.S. government bonds were very low, suggesting that investors had no significant desire for immediate consumption before they were incinerated." (italics are mine)
So why are returns negatively correlated with economic performance?
* "Why is there a negative correlation between real returns and real per capita income growth? ....Siegel (1998) hypothesizes, that part of the negative correlation between real stock returns and per capita GDP growth is because high growth was impounded into prices at the start of the period."
*"optimistic investors will bid up stock prices, lowering the dividend yield."
*"One reason that GDP growth does not necessarily translate into high returns for minority stockholders is that managers may expropriate profits via sweetheart deals, tunneling, etc."
So what does matter? Ritter concludes with what many may deem the most important part of the paper:
"What...does predict future equity returns? The answer is simple: the current
earnings yield. The major adjustment that needs to be made is to smooth earnings for the effects of business cycles. Economic growth doesn’t matter. As a first approximation, the return on existing shares will equal the earnings yield on these shares, subject to the caveats that expropriation by insiders or catastrophic market meltdowns will prevent minority shareholders from receiving future earnings."

If the earnings yield is the real cost of equity capital, does this mean that the textbooks are wrong to say that the E/P ratio of a company is not its cost of equity capital? The answer is yes and no. A company can rationally be expected to earn above- or below-normal ROE for a period of time (economic profits), so in general it is incorrect to state that a firm’s cost of equity capital is its earnings yield. But for the market as a whole, above- and below-normal rates of profit growth largely cancel out, so in fact the market’s smoothed earnings yield is the expected real return on the market."

An definite I^3 paper. Well worth your time!

(for the uninitiated: I^3 = Interesting, Informative, Important)

Ritter, Jay R., "Economic Growth and Equity Returns" (November 1, 2004).
Although I question the date, as it says it was last edited on June 24, 2005.

Governance and CEO Turnover: Do Something or Do the Right Thing? by Raymond Fisman, Rakesh Khurana, Matthew Rhodes-Kropf

SSRN-Governance and CEO Turnover: Do Something or Do the Right Thing? by Raymond Fisman, Rakesh Khurana, Matthew Rhodes-Kropf

Conventional wisdom suggests that replacing a manager if the stock price is falling is good. Along the same lines we often view (and teach) that managerial entrenchment is bad. However, maybe that is too simplistic of view. Entrenchment can play a positive role in reducing unwarranted managerial firings.

Fisman, Khrurana, and Rhodes-Kropf
suggest that in the absence of entrenchment, sometimes managers will be replaced too quickly. In their words, their paper "explores whether, in caving in to shareholder demands, boards act in the best interests of shareholders or simply respond to their whims: Do they do just do something, or do they do the right thing?"

In this light, entrenchment is not all bad as it can protect managers from whimsical boards.

A longer description of the basis of this paper:
"...the recent uproar over accountability to shareholders has raised the possibility that shareholders may agitate for CEO dismissal in response to short-run per-formance changes, even when these changes are beyond the CEO's control. For example, arecent report on CEO turnover by the consulting firm, Booz, Allen, and Hamilton states that "In the U.S., investors apparently want CEOs to share the pain of poor returns. Although this reaction is not surprising, it is irrational...This conclusion is one of several this year that raise uncomfortable questions about the relationship between boards and management, for it indicates that directors are highly responsive to shareholder pressure about share prices, even if management is not solely responsible for the performance.""
So is entrenchment good? Yes and No. That is, while completely entrenched managers may not look out for shareholders, some degree of entrenchment may be good to prevent needless (and costly) managerial firings.

To test for this the authors look for empirical differences (largely operating performances) between so-called entrenched and less entrenched manegrs. Again in their words:
"Interestingly, the two contrasting views on entrenchment generate a number of overlapping predictions, namely: (1) post-firing firm performance improvements are greater for entrenched CEOs (2) entrenched CEOs are fired less frequently (3) market reaction is more positive for the firing of entrenched CEOs. We find strong support in the data for each of these predictions. We also consider two situations where the views make contrasting predictions: (1) the relationship between governance and pre-firing returns of dismissed CEOs, and (2) the subsequent performance of retained CEOs where there had recently been poor corporate performance.The results of these further tests lean in favor of the `misguided shareholder' view."

Kisman, Raymond, Khurana, Rakesh and Rhodes-Kropf, Matthew, "Governance and CEO Turnover: Do Something or Do the Right Thing?" (January 2005).

As a sports analogy to this, let me offer the firing of a coach. If we fire a coach just for the sake of doing something, we may increase uncertainty which can lead to worse performance in the future (to say nothing of the direct cost of the firing and hiring). So some entrenchment may be good. On the other hand, a policy of never replacing an underperforming coach would worsen incentives (and likely team performance as well)
(Mmm, I wonder if Steinbrenner is reading).

Thomas Friedman and Energy Independence

To those of you who have read, or are reading/ristening to The World is Flat, you will be very interested in this. It is an interview with Thomas Friedman. While it is largely a gloom and doom piece about the need for an energy program (possibly with good reason), there are some interesting tidbits.

For instance: he calls for the creation of an "energy Axis" between the West, India, and China to develop alternative energy and become independent of Middle East oil within ten years.

And of course the World is Flat view shines through throughout as he calls for more science education.

NPR : Thomas Friedman and Energy Independence

Friday, June 24, 2005

SSRN-Reconciling Efficient Markets with Behavioral Finance: The Adaptive Markets Hypothesis by Andrew Lo

I will write more about this one later. But I just found it and it is a definite keeper!

SSRN-Reconciling Efficient Markets with Behavioral Finance: The Adaptive Markets Hypothesis by Andrew Lo

Super short version from abstract:

"The battle between proponents of the Efficient Markets Hypothesis and champions of behavioral finance has never been more pitched, and there is little consensus as to which side is winning or what the implications are for investment management and consulting. In this article, I review the case for and against the Efficient Markets Hypothesis, and describe a new framework - the Adaptive Markets Hypothesis - in which the traditional models of modern financial economics can co-exist alongside behavioral models in an intellectually consistent manner. Based on evolutionary principles, the Adaptive Markets Hypothesis implies that the degree of market efficiency is related to environmental factors characterizing market ecology such as the number of competitors in the market, the magnitude of profit opportunities available, and the adaptability of the market participants."

Investments and Life Insurance are not independent decisions

SSRN-Human Capital, Asset Allocation, and Life Insurance by Roger Ibbotson, Peng Chen, Moshe Milevsky, Xingnong Zhu: "Human Capital, Asset Allocation, and Life Insurance"

Executive Summary (Don't you think that sounds better than abstract?)
You should look at life insurance as another asset in your portfolio.

Ibbotson, Chen, Milevsky, and Zhu tell us that we can not make investment and life insurance decisions independently.

In the authors' words:
"Life insurance has long been used to hedge against mortality risk. Typically, the greater the value of human capital, the more life insurance the family demands. Intuitively, human capital not only affects the optimal asset allocation, but also the optimal life insurance demand. However, these two important financial decisions—the demand for life insurance and the optimal asset allocation—have consistently been analyzed separately in theory and practice."
and later
"We develop a unified model to provide practical guidelines for developing the optimal asset allocation and life insurance decisions for individual investors in their pre-retirement years (accumulation stage)."

Chart 1 (which I can not copy) is an excellent visual description.

Ibbotson, Roger G., Chen, Peng, Milevsky, Moshe Arye and Zhu, Xingnong, "Human Capital, Asset Allocation, and Life Insurance" (May 2005). Yale ICF Working Paper No. 05-11.

Thursday, June 23, 2005

Conflicts of Interest, Regulations, and Stock Recommendations by Leonardo Madureira

Does regulation change behavior? That is the question that Madureira asks. To examine this question Madureira examines whether regulations on sell-side research recommendations changed following the "increased scrutiny of their equity research business regarding conflicts of interest driven by investment bank relationships."

And the answer? Yes. Behavior (at least in the short run has changed.)

SSRN-Conflicts of Interest, Regulations, and Stock Recommendations by Leonardo Madureira

Some highlights:

The paper investigates "changes in the behavior of brokerage houses through recommendations they issued for US common stocks between July 1995 and December 2003"

The author summarizes the paper:
"Prior to the new regulations, brokerage houses disproportionately issued upbeat (strong buy and buy) recommendations-- with sell recommendations being virtually absent from the sample....However, the period after regulations were adopted reveals significant changes in these distributions. Every brokerage house started issuing more hold and pessimistic (underperform or sell) recommendations and less
optimistic (strong buy and buy) ones, but the big difference is in the cross-sectional dimension. Big 10 brokerage houses now issue pessimistic recommendations much more aggressively. "
An important aspect of this is whether the recommendations matter. The author replies, yes they do matter (shock) and that prior to these changes, investors were somewhat tricked by the recommendations. From the paper:
"there is evidence that heterogeneous investors use sell-side research
differently (Boni and Womack (2002b, 2003b), Malmendier and Shanthikumar (2004)), with retail investors acting naively by failing to adjust for clear biases in analystsÂ’ stock recommendations. That conflicts of interest matter highlights the importance of investigating the impact of regulations specifically designed to cope with them."
It is duly noted (in a footnote) that this appears to conflict with the findings of Agrawal and Chen who find that investors could see through the conflicts and hence discounted biased recommendations.

Another interesting piece (which may weaken the claim that investors were duped) is that there was no initial reaction to the new ratings. Again from the paper:
"Analysis of market reactions to recommendations when the new regulations took effect indicates that investors were initially dismissive of the increase in pessimistic recommendations by the big 10 brokerage houses. Returns associated with recommendations during the adoption of new ratings systems-- when the new patterns of more balanced distribution were achieved--— do not show the usual pattern of positive (negative) event and future returns associated with optimistic
(pessimistic) recommendations."

Cool paper.

Madureira, Leonardo, "Conflicts of Interest, Regulations, and Stock Recommendations" (November 2004).

Wednesday, June 22, 2005

Publishing Advice from the Marginal Revolution

As Paul Harvey would say: "This is closed circuit for the academics"

The Marginal Revolution blog has some good advice on how to get articles published. And yes reading the list may smart a bit.

Ouch! But I guess that is the intent of any spur.

FTR: I am not endorsing all of these views, but do appreciate them none-the-less.

As an aside, the Marginal Revolution also had an intriguing look at grade inflation a few days ago. I can not quite convince myself that grade inflation is not bad for students in the long run.

Reputation matters-a lot!

In light of the recent Tyco trial and this week's sentencing of the Rigases, it might behoove us to remember that the market, and not the SEC or the courts, is the real disciplinarian. The market penalty (as measured by the drop in value of the firm) is much greater than the out of pocket fine imposed by the legal and regulatory system.

Until recently we have only had antectodal evidence of this (for example Enron and Salomon Brothers were the two examples I generally used in class), but a new paper by Karpoff, Lee, and Martin changes that.

They "examine the consequences to individuals and firms involved in Securities and Exchange Commission (SEC) and Department of Justice (DOJ) enforcement actions for financial misrepresentation....from 1978 through 2002."

Their findings are amazingly strong and set aside the conventional wisdom that white collar crime goes unpunished. For instance:
"A total of 501 individuals were indicted on criminal charges. Of these indictments, only three of the 341 individuals whose trials concluded by June 30, 2004 were acquitted. Sentencing information is available for 210 of the concluded cases. These 210 cases led 190 individuals to be incarcerated for an average of 4.2 years and probation or supervised release for 90 individuals (not mutually exclusive arrangements).

(iii) Total monetary penalties [exceeded] $13.3 billion"
However, what is even more remarkable is the penalty paid by the firms' investors:
"The average one-day abnormal return upon the first announcement of federal involvement in a financial reporting investigation is -13.09%. This is in addition to an average loss of 25.24% associated with the prior announcement of the event ? such as an accounting restatement or change in auditor ? that triggers the investigation. Altogether, over $157 billion in shareholder value vanished when the reporting improprieties of the corporations were exposed."
Wow! That is huge! Definitely deserving of an I^3 award!


Karpoff, Jonathan M., Lee, Dale Scott and Martin, Gerald, "The Cost of Cooking the Books" (December 17, 2004).

Tuesday, June 21, 2005

Ten Money Blogs Everyone Should Read from Yahoo! Finance Special Edition

Yeah, I am really biased on this. A #6? will have to work on that ;)

Yahoo! Finance Special Edition: Welcome to the Blogosphere

Another charity opportunity!

Just what you wanted! Another chance to give money to a great charity.

I have decided to ride in Roswell Park 100K this weekend. THe money goes to help fight cancer.

So if you want to give, click through the below link. THANKS!
Roswell Park Alliance Foundation:

The Risk Return Tradeoff in the Long-Run: 1836-2003 by Christian Lundblad

SSRN-The Risk Return Tradeoff in the Long-Run: 1836-2003 by Christian Lundblad

Lundblad looks at US stock data from 1836 and finds sure enough that risk and return are related. SHOCK!

Key quote:
"I obtain a positive and significant relationship between the expected market return and conditional market volatility regardless of how the model is specified."

Whew. Risk and return are related. Not that I ever really doubted it, but sometimes in a weak moment and when papers suggest that there is only weak evidence of a relationship, some of you doubt it. Well doubt no more! lol...While I make fun of the expected finding, it is important to verify and the history on the data set (see section 3) alone makes it worthwhile to read! I should warn you, it is not the historian's standard fare, but rather quite mathematical.

Lundblad, Christian T., "The Risk Return Tradeoff in the Long-Run: 1836-2003" (October 2004).

SSRN-All that Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors by Brad Barber, Terrance Ode

Ladies and gentlemen, we have now have more proof of what you may have long suspected: that investors do buy stocks that are in the news at a greater rate than other stocks.

If you remember, this idea was mentioned back when we were talking about the NCAA basketball tournement. It ws suggested that trying to pick winners (rather than going with the favorite) was in part because of the glamour of being able to brag about your picks. Similarly, this was seen as being nearly identical to William Berenstein's INEPT model whereby investors buy glamourous and "sexy" stocks so that they can brag about owning them.

Well now Barber and Odean have the evidence we have been lacking to support these theories:

SSRN-All that Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors by Brad Barber, Terrance Odean

Some highlights:
"In this paper, we test the hypotheses that (1) the buying behavior of individual investors is more heavily influenced by attention than is their selling behavior and that (2) the buying behavior of individual investors is more heavily influenced by attention than is the buying behavior of professional investors. We also develop a model based on the assumption that attention influences buying more than selling and we test the asset pricing predictions of our model. These predictions are (1) that stocks heavily purchased by attention-based investors will subsequently underperform stocks heavily sold by those investors and (2) that this underperformance will be greatest following periods of high attention."

"Since we cannot measure the daily attention paid to stocks directly, we do so indirectly. We focus on three observable measures that are likely to be associated with attention grabbing events: news, unusual trading volume, and extreme returns."

"As predicted, individual investors tend to be net buyers on high attention days. For
example, investors at the large discount brokerage make nearly twice as many purchases as sales of stocks experiencing unusually high trading volume (e.g, the highest five percent) and nearly twice as many purchases as sales of stocks with an extremely poor return (lowest 5 percent) the previous day. The buying behavior of the professionals is least influenced by attention."

"...we find that individual investors display attention based
buying behavior. They are net buyers on high volume days, net buyers following both extremely negative and extremely positive one-day returns, and net buyers when stocks are in the news....The institutional investors in our sample—especially the value strategy investors—do not display attention-based buying."

"Our theoretical model....predicts that when investors are most influenced by
attention, the stocks they buy will subsequently underperform those they sell. We find strong empirical support for this prediction.

AnotherI^3 paper!

Barber, Brad M. and Odean, Terrance, "All that Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors" (January 2005). EFA 2005 Moscow Meetings Paper.

Future of Archipelago boss hangs on judge's ruling

Who is going to head thecombined NYSE-Acheipelago? Well officially it appears that there will be co-presidents, but that may change depending on a court ruling:

Future of Archipelago boss hangs on judge's ruling: "Putnam, chief executive of Archipelago, stands to become a co-president of the NYSE if the deal closes. But he also stands accused of cheating a former business partner out of a stake in a brokerage in the mid-1990s that evolved into Archipelago, an electronic exchange with a current market value of $1.6 billion."

Thanks to FL for the tip on this one. I had totally missed it.

Monday, June 20, 2005

Adelphia founder sentenced to 15 years - Yahoo! News

Adelphia founder sentenced to 15 years - Yahoo! News: "John Rigas, founder of cable operator Adelphia Communications Corp. (Other OTC:ADELQ - news), was sentenced on Monday to a lower-than-expected 15 years in federal prison for concealing loans and stealing millions from the company.

The sentence for his son, Timothy Rigas, is expected later on Monday"

While it may be "lower-than-expected" in some circles, most locals did not believe he would get any time.

A Consumption-Based Explanation of Expected Returns (one of my favorite sites!) pointed out this gem that links stock returns and consumption. It is forthcoming in the Journal of Finance.

Yogo: A Consumption-Based Explanation of Expected Returns

In the author's words:
"This paper proposes a simple consumption-based explanation of both the cross-sectional variation in expected stock returns and the countercyclical variation in the equity premium."
"In the language of finance, the main findings can be summarized as follows. When
utility is nonseparable in nondurable and durable consumption, optimal portfolio allocation implies a linear factor model in nondurable and durable consumption growth. The risk price for durable consumption is positive, provided that the elasticity of substitution between nondurable and durable goods is higher than the EIS. First, small stocks and value stocks have higher durable consumption betas than big stocks and growth stocks. Simply put, the returns on small stocks and value stocks are more procyclical, explaining their high average returns. Second, the covariance of stock returns with durable consumption growth is higher at business cycle troughs than at peaks. The equity premium is therefore countercyclical because the quantity of risk, measured by the conditional covariance of returns with durable consumption growth, is countercyclical."

Read the whole paper here. Remember, since it is a Journal of Finance link, it will not last long!

Saturday, June 18, 2005

A look around at a few blogs

I have not done one of these look around pieces in a while, so why not?

Freakonomics has an update on the discussion from the book on real estate agents. If you have not read/ristened to the book, in the book Levitt points out a study that finds that real estate agents behave differently when selling their own homes than when they are selling homes for clients. SHOCK! It now seems that the National Association of Realtors is upset. (SHOCK!)^2

Cafe Hayek directs us to a great Thomas Sowell article on Free trade and the Smoot-Hawley tariff.

The Marginal Revolution has an interesting article on musician Shayan, who is selling shares in himself. Uh, ok. At what point will the SEC halt it?

SportsEconomist has a cool piece on public vs. private financing of stadiums. Short version public financing is generally not good. The Sports Economist

FreeMoney Finance points to an article about the difficulty that Muslim homebuyers face when it comes to mortgages. (if you want more on this, check out my Islamic Finance Page.)

PFblog reports that there are now an estimated 7.7 million millionaires. (warning, you have to look through all the ads to find the story!)

Kimsnider's Investment Intelligence touts the benefits of laddered bond portfolios.

time to bike....

Friday, June 17, 2005

BBC NEWS | Business | Tyco two guilty of stealing $150m

CEO fraud may decrease somewhat after this verdict!

BBC NEWS | Business | Tyco two guilty of stealing $150m

"Former Tyco chief executive Dennis Kozlowski and finance chief Mark Swartz have been found guilty of stealing over $150m (£82m) from the US manufacturer.

They used the cash to fund opulent lifestyles, splashing out on expensive jewellery, luxury apartments and giant $2m Mediterranean parties.

It was the pair's second trial. The first collapsed after a juror received a threatening phone call and letter.

Kozlowski and Swartz could now face prison sentences of up to 25 years. "

SSRN-Irrational Diversification: An Experimental Examination of the Diversification Heuristic by Thierry Post, Guido Baltussen

While I am not always a fan of experimental economics (or finance in this case), this one is interesting and it gets to whether people diversify rationally or not.

SSRN-Irrational Diversification: An Experimental Examination of the Diversification Heuristic by Thierry Post, Guido Baltussen

Short version: people do an OK job, but not optimal and how the diversification topic is framed, influences how people diversify. In other words, they tend to ignore how assets work with rest of the portfolio and focus more on how they work in isolation.

From their conclusion:

* "we conviningly reject the simple 1/n rule. Only a few subjects select an even allocation across all lotteries. A large majority of sugjects focus on a subset of the lotteries. Further, the subsets chosen are consistent with the idea that the subjects exclude the individual choice alternatives that are unfavourable when held in isolation"

"emphasizing the diversification benefits...leads to better choices."

SSRN-Systemic Risk and Hedge Funds by Nicholas Tung Chan, Mila Getmansky, Shane Haas, Andrew Lo

Continuing the discussion on Hedge Funds and their regulation, Chan, Getmanksy, Haas, and Lo have some important contributions to make. Their paper Systemic Risk and Hedge Funds by Nicholas Tung Chan, Mila Getmansky, Shane Haas, Andrew Lo (which is being presented at the 2005 EFA conference paints a picture of banks being exposed to the hedge fund industry and the hedge fund industry being quite exposed to a series of risks. Together these factors are seen as increasing systematic risk.

Longer review:

Some quotes from their paper (which btw is 110 pages long):
* "innovations in the banking industry have coincided with the rapid growth
of hedge funds, unregulated and opaque investment partnerships that engage in a variety of active investment strategies, often yielding double-digit returns and commensurate risks. Currently estimated at over $1 trillion in size, the hedge fund industry has a symbiotic relationship with the banking sector, providing an attractive outlet for bank capital, investment management services for banking clients, and fees for brokerage services, credit, and other banking functions. Moreover, many banks now operate proprietary trading units which are
organized much like hedge funds. As a result, the risk exposures of the hedge-fund industry may have a material impact on the banking sector, resulting in new sources of systemic risks. And although many hedge funds engage in hedged strategies --—where market swings are partially or completely offset through strategically balanced long and short positions in various securities--—such funds often have other risk exposures such as volatility risk, credit risk, and liquidity risk."
The authors identify two themes:
"We argue that the risk/reward profile for most alternative investments differ in important ways from more traditional investments, and such differences may have potentially important implications for systemic risk, as we experienced during the aftermath of the default of Russian government debt in August 1998 when Long Term Capital Management and many other hedge funds suffered catastrophic
losses over the course of a few weeks, creating significant stress on the global financial system and a number of substantial financial institutions. Two major themes emerged from that set of events: the importance of liquidity and leverage, and the capriciousness of correlations among instruments and portfolios that are supposedly uncorrelated. These are the two main themes of this study, and both are intimately related to the dynamic nature of hedge-fund investment strategies and risk exposures."

The authors go on to explain that because of the dynamic nature of hedge funds, there currently exists no single measure of risk and that the benefits of diversification (as shown through standard Mean-Variance diagrams) may be distorted by changing correlations. Moreover, with the exposure to "tail risk" included, it is often difficult to guage the actual risk to return performance. After providing an example of this, they argue that investors do not fully appreciate this risk:
"The track record in Tables 2 and 3 seems much less impressive in light of the simple strategy on which it is based, and few investors would pay hedge-fund-type fees for such a fund. However, given the secrecy surrounding most hedge-fund strategies, and the broad discretion that managers are given by the typical hedge-fund offering memorandum, it is difficult for investors to detect this type of behavior without resorting to more sophisticated risk analytics that can capture dynamic risk exposures."
I really can not do the paper justice without going into too much detail (did I mention the 110 pages?), but I will share their conclusions:
"...Therefore, we cannot determine the magnitude of current systemic risk exposures with any degree of accuracy. However, based on the analytics developed in this study, there are a few tentative inferences that we can draw.

1. The hedge-fund industry has grown tremendously over the last few years.... These massive fund inflows have had a material impact on hedge-fund
returns and risks in recent years, as evidenced by changes in correlations, reduced
performance, increased illiquidity...and increased mean and median liquidation probabilities for hedge funds in 2004.

2. The banking sector is exposed to hedge-fund risks, especially smaller institutions, but the largest banks are also exposed through proprietary trading activities, credit arrangements and structured products, and prime brokerage services.

3. The risks facing hedge funds are nonlinear and more complex than those facing traditional asset classes....

4. ....Recent measurements suggest that we may be entering a challenging period. This, coupled with the recent uptrend in the weighted autocorrelation ρ∗t , and the increased mean and median liquidation probabilities for hedge funds in 2004 from our logit model implies that systemic risk is increasing.

We hasten to qualify our tentative conclusions by emphasizing the speculative nature of these inferences, and hope that our analysis spurs additional research and data collection to refine both the analytics and the empirical measurement of systemic risk in the hedge-fund industry."
Wow. Well done. Whether you agree or disagree with their conclusions, after looking over their work (this entry took about three times as long as a "typical blog entry"--did I mention it is 100 pages?), I am sure you will acknowledge the importance of the questions they raise.

a definite I^3 paper! (interesting, informative, and important)


Chan, Nicholas Tung, Getmansky, Mila, Haas, Shane M. and Lo, Andrew W., "Systemic Risk and Hedge Funds" (February 22, 2005).

Thursday, June 16, 2005

To regulate or not? A look at Hedge funds

The decision to regulate or not regulate hedge funds is a tough one. On one hand is the view that more regulation is needed since the funds have grown so large and often take large risks. The big fear in this camp that a "blow-up" could lead to major market declines. (Sort of the LTCM scenario).

On the other hand is the view that by their very nature hedge funds are difficult to regulate and regulation would lower returns and the nations that regulate would lose hedge funds to those nations that do not regulate. For instance, it has been reported that an amazing 80% of hedge funds are already registered in the Cayman Islands and "the rate of hedge fund formation continues in Cayman at a rapid rate."

The difficulty of regulation acknowledged, US Treasury Secretary John Snow met with German officials as discussed increased Hedge fund regulation:

Latest News and Financial Information |
"U.S. Treasury Secretary John Snow and German Finance Minister Hans Eichel agreed on Thursday that hedge funds bear close scrutiny but avoided saying whether they agreed tougher regulatory oversight was required.

At a brief meeting with reporters after a one-on-one session between the two, Eichel said: 'We both agree we need transparency. Whether we need more regulation, we could look at later on.'"

I am on the fence about this. Having spoken with many in the fund industry over the past year about this topic, and generally being in favor of fewer regulations, I am slightly biased towards letting hedge funds be and hoping that the increased number of hedge funds diversifies the market.

However, if pushed off the fence, I think my opposition to information asymmetries would trump my distaste for regulation and I would be pro-limited regulation.

Why? Investors should be allowed to know what they are investing in. Of course, this will take away some competitive advantages, and some funds may leave the country, but many would not. Currently with reporting problems, survivorship issues, and a "black-box" mentality that exists, there is reason to distrust what the industry is saying.

Moreover, even with increased regulation, all is not lost for the hedge fund industry. Reduced asymmetries will also increase the number of investors willing to invest. (As an analogy consider food manufacturers who are required to disclose nutritional information--and yes to extend this I realize that restaurants are not required to disclose, but given my choice, I always try to pick those that voluntarily do disclose.)

As a final point, as the minimum investments drop for some funds, the SEC will have a much stronger case for regulation as it is supposed to look out for the smaller investors.

Interestingly (and I swear it is true), I wrote this entry without wanting to be biased by what others thought. I then decided to do a web search to see what others (particularly in academia) were saying. It appears at least some others are falling on the same side of the fence:
""Originally, I was opposed to the requirement that they be registered as investment advisors," says Marshall E. Blume, professor of financial management and finance at Wharton. "But I'm not so opposed anymore. I think there are some shenanigans going on, particularly with respect to the pricing of the assets that they hold. Some of these are really exotic [securities] for which there is no market. And there are incentives for the managers to make a lot of money real quick.""

I definitely recommend the Knowledge (i.e. Wharton publication) on this issue!

Wednesday, June 15, 2005

The future of text books?

Megginson and Smart Introdcution to Corporate Finance--Companion Site

Wow. I think we may have a glimpse into the future of text books with this one. It is the new Introduction to Corporate Finance by William Megginson and Scott Smart.

From videos for most topics, to interviews, to powerpoint, to a student study guide, to excel help...just a total integration of a text and a web site! Well done!

At St. Bonaventure we have adopted the text for the fall semester and the book actually has made me excited to be teaching an introductory course! It is that good!!

BTW Before I get accused of selling out, let me say I get zero for this plug. I have met each author at conferences but do not really know either of them. And like any first edition book there may be some errors, but that said, this is the future of college text books!

Check out some of the online material here
. More material is available with book purchase.

Monday, June 13, 2005

SSRN-Research Roundtable Discussion: The Diversification Discount by Belen Villalonga

I finished up a paper today so it is time to start a new one. In doing preliminary research for the new paper, I stumbled upon this roundtable on the Diversification Discount. It is excellent! Very interesting. And yes it is two years old, but still well worth your time!

SSRN-Research Roundtable Discussion: The Diversification Discount by Belen Villalonga: " Villalonga, Belen, 'Research Roundtable Discussion: The Diversification Discount' (April 24, 2003).

Thursday, June 09, 2005

Brad DeLong's Website: An Historical Document: Long-Term Capital Management CEO John Meriwether Asks for Money

If this is real, it will definitely be discussed in class. However, I am not sure if it is. A letter from John Meriwether during the collapse of LTCM.

Brad DeLong's Website: An Historical Document: Long-Term Capital Management CEO John Meriwether Asks for Money

Thanks to MoneyScience and Brad Delong for pointing it out.

Tuesday, June 07, 2005

Public offer vs private placement

Have you ever wondered why some firms issue convertible debt privately whereas other firms choose to issue their debt publicly? Well wonder no more! Devrim Yaman has answered at least the majority of our questions in her Bquest article. Information story explains public vs private choice

and the answer? Where information asymmetry problems are great, firms choose private placements. Which is what I think we would have suspected, but now we also have some empirical evidence.

The main finding:

"Our sample consists of 78 private and 229 public placements of convertible bonds issued by industrial firms between 1983 and 2002. The results show that the primary determinant of the placement choice for convertible debt is a firmÂ’s information asymmetry problems. We find that firms with higher levels of information asymmetry are more likely to choose private placements. This result is consistent with the argument that investors in private placements establish closer relations with the issuing firm and can, therefore, value the firm more accurately. This result also indicates that the commitment of better informed investors in private placements signal favorable information to the market."

Link to paper.

Monkeys, risk aversion, game theory, inflation, and more

Steven Levitt on monkeys and investors:

Monkey Business - New York Times: "...economics is increasingly being recognized as a science whose statistical tools can be put to work on nearly any aspect of modern life. That's because economics is in essence the study of incentives, and how people -- perhaps even monkeys -- respond to those incentives. A quick scan of the current literature reveals that top economists are studying subjects like prostitution, rock 'n' roll, baseball cards and media bias."

So why not monkeys!?!? Sure enough, researchers are teaching mokeys to use money. Really! And much more. For example what happens when people (err, monkeys) don't cooperate? (they get punished), when they are too cooperative? (they get less food), and even when there are wealth effects or inflation (they are not always rational). Amazing stuff.

From the NY Times:
"...were fairly cooperative but still showed a healthy amount of self-interest: over repeated encounters with fellow monkeys, the typical tamarin pulled the lever about 40 percent of the time. Then Hauser and Chen heightened the drama. They conditioned one tamarin to always pull the lever (thus creating an altruistic stooge) and another to never pull the lever (thus creating a selfish jerk). The stooge and the jerk were then sent to play the game with the other tamarins. The stooge blithely pulled her lever over and over, never failing to dump a marshmallow into the other monkey's cage. Initially, the other monkeys responded in kind, pulling their own levers 50 percent of the time. But once they figured out that their partner was a pushover...their rate of reciprocation dropped to 30 percent -- lower than the original average rate. The selfish jerk, meanwhile, was punished even worse. Once her reputation was established, whenever she was led into the experimenting chamber, the other tamarins ''would just go nuts,'' Chen recalls. ''They'd throw their feces at the wall, walk into the corner and sit on their hands, kind of sulk.''

* or even better in discussing what happens when the reward is risky (i.e. the monkey may either win a grape or lose a grape. (expected payoff was identical). It turns out that monkeys favored gambling to win, rather than to not lose. This is similar to people.

"In similar experiments, it turns out that humans tend to make the same type of irrational decision at a nearly identical rate...The data generated by the capuchin monkeys, Chen says, ''make them statistically indistinguishable from most stock-market investors.'"

I do not know whether to laugh or to be worried that the monkeys are as intelligent as the average investor! ;)

As an aside, Steven Levitt is good. He is smart, interesting, and I would suppose (I do not know him) he may even be a nice guy. But his PR person must really be something! Not only does Levitt teach at Chicago, but he also has a best-selling book (Freakonomics), he has a blog, he was also on C-span this weekend, and he writes a column for the NY Times.

Roger Lowenstein on hedge funds

Seeking Alpha
and point out a great article on Hedge Funds by Roger Lowenstein (yes, the author of When Genius Fails etc).
Very interesting....I would comment on it, but seeking Alpha already has so I will link to those comments:
Seeking Alpha: Roger Lowenstein on hedge funds

a quick quote:
"It's a good time to be a financial-disaster writer. Disasters abound, and even when they don't, people are eager for your opinion on when the next bubble is going to pop. Scarcely a day goes by without a warning of some dire calamity -- in the dollar, in housing values, in pension funds. The way people crave financial info, we must be the best-informed, most economically literate society ever"

"Almost by definition, the spark for such calamities is unforeseeable. This explains our vigilance. What is less appreciated is that excessive, or inappropriate, vigilance also exacts a price. It does so in several ways. People who insulate their portfolios against phantom risks pay a toll, just as they paid to protect their computers against Y2K."

Read the full article from the New York Times

Friday, June 03, 2005

A list of finance blogs

I was recently asked what blogs I try to follow. So I decided to make a list of the finance/economics blogs I have in my readers.
List of Blogs Enjoy!

George Mikan and Executive Compensation

George Mikan the NBA Hall of Fame Center died this week. Absolute all reports of the man that I have read say he was nothing but a great guy.

For instance: Yahoo! Sports - NBA - Shaq offers to pay for Mikan's funeral: "Mikan died Wednesday night at a rehabilitation center in Scottsdale, Ariz., following a long fight with diabetes and kidney ailments. He was 80....`He was a great man. We had many, many conversations,'' O'Neal said. ``Very nice to me. I know what he was and I know what he did.''

So why do I bring him up now? Because of an old Business Week article from maybe 10 years ago--I'll try to track it down at some point. The article was on executive compensation and discussed why Shaq (then at the LA Lakers) got paid more (in real terms) than Mikan used to as the star of the Minneapolis Lakers of an earlier epoch.

Of course there were many reasons for the pay differential (free agency, better marketing, etc), but a key reason identified in the article was technology: many times more people can now watch a game on TV and now on the internet than could attend a game of the Minneapolis Lakers in Mikan's day.

The same idea holds true for executive compensation. Technology has multiplied the impact of a manager's actions. We see that as corporate hierarchies have been flattened. Whereas before the impact of a single manager might directly impact only a handful of employees, today the same decision may directly affect thousands. Hence, the marginal productivity has increased. So it is one reason that executive pay has increased.

This is not to say that technology is the only cause of the pay increase, but it is an important reason why executive pay has increased faster than the pay of typcial employees.

Wednesday, June 01, 2005

A look at the Andersen Verdict

First the news announcement:

From the NY Times:
"WASHINGTON, May 31 - With a brief, pointed and unanimous opinion, the Supreme Court on Tuesday overturned Arthur Andersen's conviction for shredding Enron accounting documents as that company was collapsing in one of the nation's biggest corporate scandals."
From The BBC:
"Chief Justice William H Rehnquist said the instructions were too vague for the jurors to decide correctly whether Andersen had obstructed justice."

While much has been being made of the Supreme Court's ruling, it will have little affect on the company.

From the New York Times:
Justices Reject Auditor Verdict in Enron Scandal - New York Times:
"But the decision represents little more than a Pyrrhic victory for Andersen, which lost its clients after being indicted on obstruction of justice charges and has no chance of returning as a viable enterprise. The accounting firm has shrunk from 28,000 employees in the United States to a skeleton crew of 200"

Much evidence suggests that the auditors' reputation was destroyed before the court verdict (see Chaney-Philipich (2002), Callen-Morel, Godbey-Mahar (2004) and many others who both found that Andersen audited firms suffered as Andersen's reputation fall in the aftermath of the Enron debacle.

For instance from Godbey-Mahar paper (in Research in Finance 2004):
"Both long-term and short-term event-studies were used to examine the effects on implied volatility, of events that were deemed as damaging to Andersen'’s reputation. The results of all of the tests yield strong evidence that ....that auditor reputation plays an important role in reducing information asymmetries between investors and the audited firm."
Which is to say, while we can feel bad that the jury supposedly got the case wrong, it is unlikely to have made much difference. Even prior to the trial, most firms had dropped Andersen as their auditor and the market was penalizing firms who used Andersen.

What does matter however is how this ruling will affect future cases. Again from the NY Times:
" truth the Supreme Court's judgment simply underscores the significance of a rule in white-collar cases: a jury cannot properly convict without first being required to conclude that a defendant had intended to engage in wrongdoing."