Tuesday, August 30, 2005

Corporate Governance in the US and Europe: Where Are We Now? by Tom Kirchmaier, Geoffrey Owen, Jeremy Grant

SSRN-Corporate Governance in the US and Europe: Where Are We Now? by Tom Kirchmaier, Geoffrey Owen, Jeremy Grant:

This one is long but very interesting! It is really a book more than a paper.
It is "based on a conference organised by the London School of Economics and New York University, held in London on November 4th and 5th, 2004.

The conference brought together academics and practitioners from both sides of the Atlantic to review recent developments in corporate governance, focusing in particular on the lessons to be learnt from the stock market boom-and-bust and from the corporate scandals that came to light in 2001 and 2002."
It contains many interesting insights!

A very quick "look about":
* "Why is corporate governance important? Corporate governance can be defined as
the set of control mechanisms and institutions which protect the suppliers of capital to a company, particularly suppliers of equity capital, the shareholders, who have only residual protection after all other claimants have been satisfied. Product market competition provides an incentive for managers to deploy capital efficiently, but only effective corporate governance can ensure that interests of shareholders are protected."

* "In Europe, and to a lesser extent in Japan, additional pressure to make these changes came from the growing influence of American institutional investors as shareholders in European companies. Then came the stock market crash, followed by Enron, WorldCom and other corporate scandals. The US model of corporate governance lost much of its appeal, especially in those Continental countries where the concept of shareholder value maximisation did not fit easily with long-established habits and attitudes."

* "Comparisons are often made between Anglo-American capitalism and the rest,
and it is true that the US and the UK do share some common features which distinguish them from most Continental European countries and Japan. But such generalisations obscure important differences on both sides of the divide. For example, British institutional investors tend to be more interventionist than their American counterparts."
Fascinating material done well! Definitely I^3!

Kirchmaier, Tom, Owen, Geoffrey and Grant, Jeremy, "Corporate Governance in the US and Europe: Where Are We Now?" (April 2005). http://ssrn.com/abstract=708461

The New York Times Dealbook

The beginning of a semester is always a good time to put in a free plug for the NY Times DealBook. In many ways it is the best source of online business news I am found.

It is a daily newsletter that gives summaries and links to news from a multitude of sources (NY Times and not). HIGHLY RECOMMENDED! and FREE!

The New York Times> E-mail Preferences> Dealbook

Sarbanes-Oxley after Three Years by Larry Ribstein

SSRN-Sarbanes-Oxley after Three Years by Larry Ribstein:

I am sure many of you have been wondering whether Sarbanes-Oxley has been successful or not. I know that I have been! Unfortunately, it is a very difficult thing to test. While the costs are relatively easy to measure, the benefits are not. Moreover, even like any regulation, the passage is anticipated and thus normal event studies get muddied.

So with that in mind (and a good dictionary in hand) I present to you Larry Ribstein's look at the Sarbanes-Oxley Act after three years.

Ribstein presents a very interesting history (why and how it came about) and summary (what it contains) of SOX. He then reviews the literature on the Act. This literature review can be summarized with the following quote:
"The finance studies on the effect of SOX have been accompanied by data on the costs of SOX that have fueled mounting doubt about the ActÂ’s cost-effectiveness."
Ribstein's conclusion stems from this literature review:
"In general, the costs have been significant and the benefits elusive."
Overall the paper makes several good points, and concludes with his recommendations for future legislation, however, I was left wanting more empirical evidence but I guess that will have to wait.

However, it was a good read and the history/summary section would be great for class use!

Ribstein, Larry E., "Sarbanes-Oxley after Three Years" (June 20, 2005). U Illinois Law & Economics Research Paper No. LE05-016. http://ssrn.com/abstract=746884

BTW I am not kidding about needing a good dictionary. ;)

NYSE and ArcaEx Merger Update

NYSE and ArcaEx to Merge-- Writing in Financial Engineering News, Cynthia Harrington updates us on the NYSE and ArcaEx merger. While not exactly news, the report does have some interesting updates and would make excellent out of text book reading for any Instititions (or Money and Banking) class.

Highlight: Figure 1. It shows the amazing drop in average spreads since 1994. WOW! As late as 2000 the average spread was still 22 cents on the NYSE!

Monday, August 29, 2005

SSRN-Core Finance Trends in the Top MBA Programs in 2005 by Kent Womack, Ying Zhang

SSRN-Core Finance Trends in the Top MBA Programs in 2005 by Kent Womack, Ying Zhang:

Following Friday's mention of the DeAngelo, DeAngelo, and Zimmerman paper that looks at what is wrong with MBA programs at some universities, I was sent the following paper by Womack and Zhang. They survey MBA programs to see what trends exist.

The good news? More finance!
"Five of the nineteen schools responding have increased hours spent in the finance core substantially, compared to results of our earlier survey in 2001."
The bad news (at least for students): fewer electives:
"The recent survey results, however, suggest in general that most other schools seem to be migrating in the other direction, towards more required course hours."
The paper is full of many really cool things. Fot instance focusing on finance:
  1. "Principles of Corporate Finance by Brealey, Meyers, and Allen (BMA) and
    Corporate Finance by Ross, Westerfield, Jaffe (RWJ), were used by 8 and 6 schools this
    year respectively, and remain the prevailing main textbook choices by most schools."
  2. “Average outside class hours expected per session”. The mean for all schools
    responding is 4.2 hours, with a wide range of 2 to 8 hours."
  3. "...programs continue to spend significant amount of time (on average, 9% of in-class time) on Present Value and other primary background topics. Diverse professional backgrounds and entry mathematic proficiency levels demandfinance professors “level the playing field” before teaching other challenging topics."
VERY Interesting for anyone in an MBA program!

The is available from SSRN as well as from Womack's web site.

Womack, Kent L. and Zhang, Ying N., "Core Finance Trends in the Top MBA Programs in 2005" . http://ssrn.com/abstract=760604

Saturday, August 27, 2005

The Fed's "meeting" in Jackson Hole

If you have not been watching the annual Central Bank meeting (sponsored by Kansas City Fed) taking place in on in Jackson Hole, you have missed a great deal.

A few highlights:

The NY Times reports on Greenspan's own comments:
"Fed chairman implicitly took aim at both the torrid run-up in housing prices and at the broader willingness of investors to bid up the prices of stocks and bonds and accept relatively low rates of return.

Both trends reflect what Mr. Greenspan said was the increased willingness of investors to accept low "risk premiums, a willingness based on a complacent assumption that the low interest rates, low inflation and strong growth of recent years are likely to be permanent."

The Seattle Times furthers these comments:
"Greenspan, however, said people shouldn't count on that paper wealth, which can evaporate if economic conditions deteriorate rapidly.

"What they perceive as newly abundant liquidity can readily disappear," he said. "Any onset of increased investor caution" could cause home and stock prices to drop, he noted.""

While the London Times is a bit harsher saying that the US is heading for house price crash:
"In a pre-retirement speech to fellow central bankers at Jackson Hole, Wyoming, Mr Greenspan said that people were investing in houses as if they were a one-way bet, not allowing for the risk of price falls. He said “history had not dealt kindly” with investors who kept ignoring risks."...."Mr Greenspan’s comments were reminiscent of his 1996 inveighing against “irrational exuberance” on the stock market...."

Much time has also been spent on looking back at Greenspan's reign and looking ahead to who will be the next chairperson when he retires in January. For instance, Reuters reports on Robert Rubin's comments:
"Former U.S. Treasury Secretary Robert Rubin, lavish in his praise for Federal Reserve Chairman Alan Greenspan, said Friday his successor should be market savvy because large problems may lie ahead...."Looking forward, our loss over recent years of the fragile political coalescence around fiscal discipline, our currently projected 10-year fiscal deficits...our extremely low personal savings rate and high levels of personal debt, all suggest that the next Fed Chairman could face -- at some point in the future, there's no way of knowing whether it is years out or sooner -- an even greater need for the understanding and experience to deal with serious market difficulties""
And the conference is not even over yet!

Friday, August 26, 2005

What's Really Wrong With U.S. Business Schools? by Harry DeAngelo, Linda DeAngelo, Jerold Zimmerman

What's Really Wrong With U.S. Business Schools? by Harry DeAngelo, Linda DeAngelo, Jerold Zimmerman:

Wow, it sounds bad. I am very glad I chose a small university (St. Bonaventure). However, the choice leads me to not really comment on the paper since being at a small university removes me from many (but not all) of the problems cited in the paper. Moreover, I do not feel I can add any value to what the authors say.

Rather I will only give you the abstract and link.

"U.S. business schools are locked in a dysfunctional competition for media rankings that diverts resources from long-term knowledge creation, which earned them global pre-eminence, into short-term strategies aimed at improving their rankings. MBA curricula are distorted by 'quick fix, look good' packaging changes designed to influence rankings criteria, at the expense of giving students a rigorous, conceptual framework that will serve them well over their entire careers. Research, undergraduate education, and Ph.D. programs suffer as faculty time is diverted to almost continuous MBA curriculum changes, strategic planning exercises, and public relations efforts. Unless they wake up to the dangers of dysfunctional rankings competition, U.S. business schools are destined to lose their dominant global position and become a classic case study of how myopic decision-making begets institutional mediocrity."


DeAngelo, Harry, DeAngelo, Linda and Zimmerman, Jerold L., "What's Really Wrong With U.S. Business Schools?" (July 2005). http://ssrn.com/abstract=766404

Mmm, maybe I can use paper this as an excuse to skip some meetings. (uh, if my Dean or Chairman is reading this, I am kidding! I would never skip a meeting!!!! ;) )

Measuring the True Cost of Active Management by Mutual Funds by Ross Miller

SSRN-Measuring the True Cost of Active Management by Mutual Funds by Ross Miller:

Yet another WOW paper!

Miller decomposes mutual fund returns into an active portion and a passive portion. He then shows that the fees are for the active portion are much higher than most investors would suspect.

Longer version:

It is well known that actively managed funds are highly correlated with market indices. What Miller does in this paper is to break funds down into a passive index plus an actively managed portions. He then looks at expenses for the funds and then using a sort of weighted average tries to allocate them to the active and the passive portions of the fund.

When this is done, the reported fees for actively managed funds (which are reported for the whole fund but theoretically stem largely from from largely from the active portion, are much higher than a combination of indices and leveraged "market neutral" investments would suggest.

In Miller's words:
"Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in "closet"” or "shadow" indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index."
Of course that active funds are highly correlated with market indicies is not new. We've known that for a long time (at least since Sharpe's 1992 Portfolio Management paper). What Miller now does however is to attempt to uncover how this impacts the true benfits of active management as well as what investors are paying for this actmanagementment.

Probably the best way to understand the idea is with an example from the paper:
"Consider, for purposes of illustration, the Fidelity Magellan Fund at the end of 2004. Based on monthly data from the preceding three years, an investor could have replicated the risk and return characteristics of the fund (including its R2 of 99%) by placing 90.87% of his or her assets in an index fund that tracks the S&P 500 and the remaining 9.13% in an appropriately chosen marketneutral investment. In this new portfolio, 99% of the variance of this portfolio is explained by the index and we can leverage it in a way that Magellan'’s beta and variance are also replicated. If we then take 18 basis points as the expense ratio for the passive component of Magellan (the same ratio as the version of Vanguard'’s S&P 500 index fund marketed to individual investors), Magellan might be seen as "“overcharging"” investors by 52 basis points on the passive component of its portfolio. If we were to assess those 52 basis points against the 9.13% of the portfolio that is actively managed, we would find that annual expenses account for 5.87% of those funds."
See, I told you it deserved a WOW!

Miller, Ross M., "Measuring the True Cost of Active Management by Mutual Funds" (June 2005). http://ssrn.com/abstract=746926

Thursday, August 25, 2005

SSRN-Who Monitors the Mutual Fund Manager, New or Old Shareholders? by Woodrow Johnson

Who Monitors the Mutual Fund Manager, New or Old Shareholders? by Woodrow Johnson:

Johnson looks at the behavior of mutual fund investors to determine whether shareholders who have held the shares for longer behave differently than new shareholders. He finds that there are differences in behavior. Specifically he finds little relation between fund performace and selling behavior of existing shareholders.

From the paper:
"The main premise of the paper is that transactions from shareholders who monitor the fund's manager are correlated with returns. The first stage of the analysis compares buys with sells to see whether shareholders sell poor returns with the same vigilance they buy good returns."
Like virtually everyone who has looked at it, the author finds that net inflows increase after periods (even very short periods) of good returns. What sets this paper apart is that the data set allows Johnson to decompose these cash flows into buys and sells.

He finds that "buys" come from both new and existing shareholders with new shareholders investing more in dollar terms but existing shareholders involved in more transactions (and yes he does control for automatic investments). This difference is consistent with diversification theory.

"Sells," however, do not appear to be as closely tied to performance. Thus positive net inflows following good performance appear to be driven by increased inflows and not decreased outflows.

Again in the author's words:
"In a manner consistent with positive-feedback trading, they buy more after periods of high fund returns but less after periods the fund underperforms its benchmark index. Old shareholders generate the majority of the buy transactions|even after excluding automatic transactions and fund distributions, but new shareholders are responsible for the majority of the fund's inflow."

"Outflow is remarkably constant across all levels of fund returns: shareholders neither increase their sells during periods of poor returns nor decrease their sells during periods of good returns. These results suggest that the risk of losing assets from old shareholders does not incentivize the fund manager to work hard."
That deserves a WOW! Great paper! A definite I^3 paper!

Johnson, Woodrow T., "Who Monitors the Mutual Fund Manager, New or Old Shareholders?" (April 28, 2005). http://ssrn.com/abstract=712825

One comment: While I loved the paper as it now is, there may be much more to it than appears at face value.

If we are to simplify the conclusion down to its bare essence we get that existing (old) shareholders are not as good of monitors as new shareholders. The application of this idea to corporate finance could be HUGE.

For instance, do longer tenured shareholders lead to different forms (or levels) of executive pay? Different capital structure? Other agency costs problems? And if so, do corporate governance infrastructures vary with the tenure of shareholders?

So many questions, so little time.

Again be sure to read the Johnson paper!

Wednesday, August 24, 2005

India's turn in the spotlight

It is always fascinating to notice how reading something makes you more aware of other articles on the same topic. Given that I recently finished ristening to Thomas Friedman's The World is Flat (which I HIGHLY recommend! One of best books I have read this year!) it should be of little surprise that yesterday I blogged an article on China and today it is India's turn.

In the past 24 hours I have received emails from both McKinsey Quarterly and Knowledge@Wharton that contained coverage on India. While neither is per se a finance piece, each publication has many ties to finance (venture capital, investments, international finance, free trade, globalization), but is largely aimed at a broader audience than just those interested in finance.

The very short version of the series of articles is that foreign investment in India is increasing but it is no where near the level of in China. Moreover, India is now creating more higher level skilled jobs and not just the data entry etc. jobs. This shift (which was widely expected) will most likely create a larger middle class and help the millions of poor get hope for the future and at least some economic foothold for the present.

Of course, this shift will not be well received by those who feel threatened by the changing business environment. So look out for more talk of protectionismcoming from the so-called developed world --especially in times of economic slowdown.

A few direct links:

Knowledge@Wharton's special section on India: What is Driving India's Rise in R&D
McKinsey Quarterly's interview with India's prime minister, Dr. Manmohan Singh.

One quote from the interview:

"Manmohan Singh: 'If I have any message, it is that it is our ambition to integrate our country into the evolving global economy. We accept the logic of globalization. We recognize that globalization offers us enormous opportunities in the race to leapfrog in development processes. It also obliges us to set in motion processes which would minimize its risks.

I think, overall, India is today on the move. The economic reforms that our salvation lies in —operating an open society, political system, an open economy, economic system--—this has widespread support.' "

Do Online MBAs Make the Grade?

Are online MBAs as good as in-person MBAs?

I am sure many of you have been asked (or have asked yourself) this question before.
BusinessWeek tries to answer with a very qualified "yes". Why? Because a few bad apples are spoiling things for the rest of us.

Do Online MBAs Make the Grade?:
"Many of the online MBA programs are well-regarded and offer a way for busy people...to get advanced education without having to sidetrack a career for a year or two. But, as in many growing fields, cautions abound. Concerns about 'diploma mills,' or substandard institutions without proper accreditation that offer degrees with little or no serious work, are growing.
While I do question the first clause in the next paragraph, but the warning is well heeded.
'There are now more fake online MBA programs in the U.S. than real ones,' says Vicky Phillips, founder and CEO of GetEducated.com, a Web site that evaluates accredited online degree programs and educates consumers about them. 'It's an area that's ripe for consumer fraud.' "

Tuesday, August 23, 2005

Podcasts: a new tool for teaching?

I hestitate to put this online so soon as I am not totally satisfied with the quality yet, but as the internet generally (and blogs more specifically) are about sharing information and ideas, I figured I would put this out there and see what others think and seek comments/help.

As many of you know podcasts are the new 'hot thing" on the internet. They are essentially online radio shows made available to anyone with computer access.

Some of you in fact maybe familiar with RadioEconomics (by Dr. James Reese) which is one of the first true economic podcasts. (be sure to check out my interview ;) )

While doing a podcast for finance definitely intrigues me, I think a better use of the technology for me may be in conjunction with the FinanceProfessor.com blog and website. For example, in the weeks to come, I may be posting an occasional interview, author discussion, or guest lecturer etc. Thus the podcast technology (essentially making MP3 files readily available) will complement the existing tools and lead to more sharing or info and more learning.

However, what I am really excited about is using the technology for teaching my current students. For instance I plan on making available weekly reviews (about 5-10 minutes each) for each course I teach. This should not only help those studets that learn better auditorily but should also help all students review the material when it is still fresh and in a one on one manner without me having to have never ending office hours and without the students having to come to office hours. I think this could be huge!

I MAY (depending on the approval of my Dean and Chairperson) make class lectures available to the students as well. I currently make the lecturers available on CDs and given bandwidth and copyright problems, that may stay the same.

Here are a few brief examples of how this will be used in my classes. Remember these are for undergraduates so I do not have every author referenced and annotated (that is what website and Blog are for).
  1. How we will use Podcasts
  2. Welcome to Finance 301--Introduction to Corporate Finance
  3. Welcome to Finance 401--Advanced Corporate Finance
  4. Introduction to Market Efficiency
I would love to hear how others are using this technology or even just ideas on how I can try to use it better.

If you do want to keep up to date with all of my "podcasts--and yes you can use RSS readers to do so), my "pod" stored here. I warn you it is sort of awkward, but if you page down, you can see the RSS and mRSS feeds as well as the links to the individual "shows". (and yes the music is legit--I paid for royalty free music that I could use in podcasts.)

Oh and of course, if any of you want to use the material for your own classes, feel free.

China's Financial System

Allen, Qian, and Qian
give a fascinating look at China's Financial System. The auhtors do an excellent job both explaining what exists and hypothesizing as to what will happen in the future as a result of current conditions.

Some highlights: The paper comes to 4 broad conclusions. In the authors' words:
  1. "...the current financial system is dominated by a large but inefficient banking sector, and reducing the amount of non-performing loans among the major banks to normal levels is the most important objective for reforming the financial system in the short run."
  2. "... despite the fast growth of the stock market, its role of resource allocation in the economy has been both limited and ineffective. Further development of China’s financial markets is the most important long-term objective."
  3. "...the most successful part of the financial system, in terms of supporting the growth of the overall economy, is a non-standard sector that consists of alternative financing channels, governance mechanisms, coalitions, and institutions."
  4. "... in order to sustain stable economic growth, China should aim to prevent and halt damaging financial crises, including a banking sector crisis, a real estate or stock market crash, and a “twin crisis” in the currency market and banking sector.""
With respect to the stock market reform, Allen Qian, and Qian have several specific ideas:
""...the regulatory environment should be improved; in particular, corporate and
trading laws and legal protection of investors, as well as institutions governing the enforcement of contracts should be further developed. Second, the large blocks of shares held by various government entities in listed companies (including state-owned banks) should be reduced by announcing and carrying out a plan to sell them off slowly over time. Third, more professionals such as accountants, investment bankers, and (business) lawyers, should be trained. Fourth,
domestic financial intermediaries that act as institutional investors should be encouraged, as they will play a critical role in improving the efficiency of the markets and strengthening the corporate governance of listed firms. Finally, new financial products and markets should be developed."
A definite "must read". I warn you the paper is long (over 100 pages in total), but it has many good points and is well worth reading!

Franklin Allen, Jun Qian, and Meijun Qian. "China’s Financial System: Past, Present, and Future", Wharton Financial Instititions working paper (available online at http://fic.wharton.upenn.edu/fic/papers/05/p0517.html accessed 8/22/2005)
(also part of a book entitled China’s Financial System: Past, Present, and Future.)

Monday, August 22, 2005

Chinese Walls in German Banks

Yes, I confess, I picked this one for its title, but upon reading it, the paper turned out to be interesting!

Chinese Walls in German Banks by Lehar and Randl.

The short version? Chinese Walls leak not just in the US but in Germany. This leakage results in affiliated analysts having superior information.

A slightly longer version:

Chinese Walls are supposed to exist. We have seen that time and again in the US. Of course, they leak. This has lead to many changes in regulation. However, it now appears that these walls don't just leak in the United States.

Looking at German Banks, Lehar and Randl find that the walls leak there as well.

A few "look-ins":
  • "Officially, banks must establish a Chinese Wall around the research department for two reasons: first, to ensure that analysts do not incorporate confidential insider information in their reports, and second to shield analysts to allow them to work independently."
  • The authors "confirm two kinds of leakages through Chinese Walls. First, forecasts from banks owning equity stakes convey superior information. Second, ...evidence of conflicts of interest, resulting in reports with a positive bias."
  • "affiliated analysts are, on average, more optimistic than their independent counter-
    parts...[and] possess superior information compared to the average analyst"
  • "The main contribution of our paper is to document for the first time that bias and increased precision of affiliated analysts are the result of a clear strategy in analysts’ long term behavior. Analysts take advantage of their superior information about firms with close ties to the bank and they seem to balance the goals of having a good track record with the conflicts of interest resulting from the banks’ other business."
See, there is more to the paper than a cool name!

Lehar, Alfred and Otto Randl, "Chinese Walls in German Banks", University of Vienna Working Paper, http://www.bwl.univie.ac.at/bwl/fiwi3/members/lehar/analysts.pdf. Accessed on August 22, 2005.

Corruption, Firm Governance, and the Cost of Capital

Garmaise and Liu present a model that has several important implications in their paper
Corruption, Firm Governance, and the Cost of Capital.

In the paper they
"develop a model of a firm owned by shareholders and administered by managers who may be either honest or dishonest. When managers have an informational advantage but shareholders retain control, dishonest managers can make false reports that distort investment and thereby reduce firm cash flows. When dishonest managers have privileged access to both information and control, firm value is further reduced and profits are diminished especially in the worst states of the world."
Put another way, Garmaise and Liu separate managerial advantages into informational and control measures. Where managers have information (but not control) advantages, managers' ability to take advantage of the informational advantages are limited. However, where the manager has both informational and control advantages, investors have little ability to limit managerial actions.

The authors take this idea and model the relationships in several steps. They begin off with the assumptions that
"Managers have a preference for large projects and empire-building. They therefore have an incentive to misreport the private signal they alone receive, neglecting to inform the shareholders of bad news. "
However, in the
"information model, shareholders retain control of the firm, and they design an optimal investment policy that reflects the potential for false reporting on the part of management....[the result is that] managerial deception leads to investment distortions, but they are not correlated with market outcomes."
So if investors still have control, systematic risk will not increase.

The authors then look at what happens if managers have both informational and control advantages.
"...managers set the investment level, basing it on the report they make to shareholders. Dishonest managers hide bad outcomes and therefore set the investment level consistently too high. Since shareholders do not have control, they cannot adjust the firm'’s investment downward to reflect the possibility of signal falsification."
So far nothing really new. However, the authors then go on to investigate the implications of the informational and control advantages.
"In the control model, however, the overinvestment selected by dishonest managers essentially gives the shareholders a more levered claim on the market; ex ante overinvestment is ex post beneficial when the market outcome is good and ex post destructive when the market outcome is poor. Since the extent of overinvestment increases with the proportion of dishonest managers, we show that the firmÂ’s beta is increasing in this proportion."
Which deserves a wow. But the paper is not done yet. The authors next look at this empirically across countries and find that the empirical evidence fits the model.
"We find that corruption increases firm betas substantially, controlling for industry, leverage and per capita GDP. For example, increasing the degree of a countryÂ’s corruption from the level of Canada to that of South Korea would increase the industry-adjusted beta of firms by 0.35."
Predictably, in countries where stong "anti-director" rights, dishonesty has less of an impact on the systematic risk.
"dishonesty has a stronger effect on firm betas in countries with weak antidirector rights, and this is what we find empirically. In countries with very strong antidirector rights corruption has no effect on beta, but when rights are moderate or weak, corruption substantially increases beta."
A definite I^3 paper! (interesting, informative, and important)

Mark J. Garmaise and Jun Liu, "Corruption, Firm Governance, and the Cost of Capital" (February 28, 2005). Finance. Paper 1-05. http://repositories.cdlib.org/anderson/fin/1-05

I was just told that the paper is also available through SSRN.

Friday, August 19, 2005

Corporate Governance in Cyberspace - A Blueprint for Virtual Shareholder Meetings by Dirk Zetzsche

SSRN-Corporate Governance in Cyberspace - A Blueprint for Virtual Shareholder Meetings by Dirk Zetzsche:

This article "analyses the rules regarding the internet-based exercise of shareholder rights for public corporations incorporated in Canada, France, Germany, the U.S. (DelGCL & RMBCA), the UK and Switzerland"

A few highlights:
  1. "...this paper asserts that the transition from the traditional shareholder meeting, which is based on physical attendance of shareholders, towards a virtual shareholder meeting that fits the needs of the digital age is still incomplete."
  2. "Under the traditional doctrine, shareholder meetings fulfill three purposes: Dissemination of information; communication between shareholders and management and among shareholders; voting."
  3. "the current regimes of the internet-based exercise of shareholder rights merely replicate some of the above functions of traditional shareholder meetings"
Put simply, web-based shareholder meetings are not living up to their potential. For instance, the author suggests that shareholder voting could be done easily digitally. This lowered cost of voting would be anticipated to give shareholders more opportunities to vote on company matters and to monitor management.

In Zetzche's words:
"Achieving an efficient regime on virtual shareholder participation requires adjustments to traditional procedures. This paper argues in favor of a virtual shareholder meeting that (1) is freed from the time and place restrictions provided by traditional corporate law doctrine, (2) integrates the functions of analyst and institutional investor meetings, and (3) replicates the face-to-face accountability of managers, which is associated with traditional shareholder meetings."
and later, he gives some of the implications of this new paradigm:
"In a world of continuous disclosure and continuous buy/hold/sell decisions of market participants, more frequent opportunities for voting – a quasi-continuous-
voting - will bring management'’s activities more in line with shareholder interests and with market reactions, and thus improve market efficiency....communication with management and among shareholders, organized over an independently organized, publicly accessible chat-board on the company'’s website, will take place all-year-long; and voting will be exercised in the period after management has informed all shareholders in the shareholder conference. This design of internet-based exercise of shareholder rights will (1) improve corporate decision-making, (2) require management to follow shareholder interests to a greater extent than today, and (3) help align capital-market reactions with shareholder decision-making (i.e. voting)."
I agree to a point. However, given that the technology for this format is currently available and yet firms are not taking advantage of the technology suggests that this change may not be immediately forthcoming. More importantly, shareholders will have to demand this new format as managers have little incentive to increase shareholder monitoring.

I do think however that the increased number of shareholder votes is a likely consequence of such a change and that could have interesting ramifications. For instance, Zetzche hints at some of these in the following paragragh:
"Efficient voting is commonly said to be hampered by the high costs of exercising shareholder rights (as compared to the less costly alternative of selling), collective action problems, and limited shareholder influence on certain subject matters. The situation in which shareholders find themselves has been termed picturesquely as the shareholders "rational apathy". It is one of the driving forces behind the "Wall Street Rule"–--the traditional approach of institutional investors to either vote with management, or sell...."
Definitely thought-provoking!

Zetzsche, Dirk A., "Corporate Governance in Cyberspace - A Blueprint for Virtual Shareholder Meetings" (June 19, 2005). CBC-RPS No. 0011 http://ssrn.com/abstract=747347

FWIW this is a law paper, but remember some of the best new ideas in any field come from outside the field, so don't hold that against it--well except for the gazillion footnotes ;)

Thursday, August 18, 2005

SSRN-Who Gains More by Trading - Individuals or Institutions? by Granit San

SSRN-Who Gains More by Trading - Individuals or Institutions? by Granit San:

Wow, if proven true this could change some things!

San finds that individuals outperform institutions when it comes to trading! So much for individuals as noise traders!

A quick peek inside:
* "individuals buy low and sell high, and that they realize superior gains by selling"
* "findings suggest that due to holding winners too long institutions mistime the momentum cycles and gain less than individuals."
*"in the late 1990s bubble, [individuals] gain about 2% per month more than institutions by buying"


San, Granit, "Who Gains More by Trading - Individuals or Institutions?" (June 2005). http://ssrn.com/abstract=687415

To buy or to build?

Margsiri, Mello, and Ruckles provide a thoughtful article that models the "grow vs buy" decision.

SSRN-To Build or to Buy: Internal vs. External Growth by Worawat Margsiri, Antonio Mello, Martin Ruckes: "This paper relates growth via acquisitions to the characteristics of the possibility to grow organically"

As in most modeling papers, this should come with the standard warning that "while the conclusions laid forth in this paper are fairly straight forwards, some of the math may be more than the typcial undergraduate student (current or past) is ready to handle."

But do not dispair, I will leave the gritty details to the paper itself.

The main points:
  • There is a direct connection between the ability to grow and the price the firm would be willing to pay for an acquisition. This "important connection between the two growth
    strategies [has] organic growth..[as] the firm’s fall-back strategy and therefore has a significant impact on both the acquisition strategy as well as the acquisition price." Which is pretty intuitive: if you have have no good growth prospects, you are more willing to do an acquisition."
  • "when the growth asset is associated with a high level of volatility, firms favor growth via acquisition in order to avoid the costly time delay between the investment and the generation of revenues."
  • "a higher profitability of the opportunity to grow organically speeds up the acquisition. Since a higher value of the organic growth option leadsto a lower acquisition price, early acquisitions are profitable compared to the status quo."
  • "When a relatively high integration expense leads to a high acquisition threshold, the declining value of the outside option draws this threshold down to a lower asset value."
See that wasn't that bad. There really is a great deal more to the paper and I recommend it if you have some time (it took me a while to get through it) and you are of that temperment.

Margsiri, Worawat, Mello, Antonio S. and Ruckes, Martin E., "To Build or to Buy: Internal vs. External Growth" (March 15, 2005). http://ssrn.com/abstract=687413

BTW If you are still confused, let's talk baseball.

For the first point, you are the GM of a major league team. You have a great catching prospect in the minors. Therefore you are less likely to acquire a free-agent catcher.

For the second point, let's take this example a bit further. Suppose you not only have a great catcher in the minors, but also a great pitching propect. Since the the volatility of pitching careers is higher than that of catching careers (stated without proof), ceteris paribus you would be more willing to sign a free agent pitcher than a free agent catcher.

One more, ok. Consider the last point. A trouble-maker has higher "integration costs". Thus even if you admire the ability of the player, you are not willing to pay as much for him.


Wednesday, August 17, 2005

A Discrete-Continuous Choice Model of Climate Change Impacts on Energy by Erin Mansur, Robert Mendelsohn, Wendy Morrison

This may not be strictly finance, but it is something that I have often wondered (but never investigated): if global warming happens, what will be the net effect on energy consumption?

I would imagine that people will use more electricity for air conditioning and probably drive more, but will this be offset by lower heating expenditures?

Mansur, Mendelsohn, and Morrison say no. In fact they predict that energy usage will go up.

SSRN-A Discrete-Continuous Choice Model of Climate Change Impacts on Energy by Erin Mansur, Robert Mendelsohn, Wendy Morrison: "The model implies that warming will increase American energy expenditures, resulting in welfare damages that increase as temperatures rise."

And now back to your regularly scheduled programming.

Banks and Credit Derivatives

Minton, Stulz, and Williamson have an important look at banks' usage of credit derivatives. The short version? Very few banks are using them! In 2003, only about 6% of banks with over $1B in assets report using this form of derivatives. Consistent with what we have seen on other derviatve usage, these banks tend to be much larger than average. Best guess as for the low usage? Transaction costs driven by moral hazard and adverse selection costs.

Slightly longer version of the paper

Minton, Stulz, and Williamson begin by documenting that the credit derivative market (measured by notional principle) has grown in recent years. Regulators (and even Alan Greenspan himself) have claimed that this reduces the risks that banks face. The paper investigates banks' use of credit derivatives and find that as of 2003, few banks were using credit derivatives. Those banks that were using the derivatives tended to be larger and have a greater need for the risk reduction.

In the words of the paper's authors:

"...net buyers of protection have higher levels of risk than other banks: they have lower capital ratios, lower balances of liquid assets, a higher ratio of risk-based assets to total assets, and a higherfraction of non-performing assets than the non-users of credit derivatives."
Why the limited use? Transaction costs undoubtedly play a role. Like in other derivatives "know-how" can be expensive to obtain and this largely fixed cost may explain a portion of the limited use. However, the very nature of credit derivatives also makes them prone to moral hazard and adverse selection costs. (Tried another way, banks typcially know more about the borrowers (and are often in a better position to monitor), than do derivative market participants. This results in less liquidity (higher transaction costs) for the very loans that would make the most sense to hedge.)

Again in the authors' words:

"These adverse selection and moral hazard problems make the market for credit derivatives illiquid for singlename protection precisely for the credit risks that banks would often want to hedge with such protection. The positive coefficient estimates on C&I loan and foreign loan shares in a bank’s loan portfolio are consistent with the hypothesis that banks are more likely to hedge with credit derivatives if they havemore loans to credits for which the credit derivatives market is more liquid."

So what does this all mean? The conclusion hints that the benefits of credit derivatives may be overstated but apparently teh cost of hedging in papers is lower than in the credit derivative market as the paper ends covering both sides of the debate:

"To the extent that credit derivatives make it easier for banks to maximize their value with less capital, they do not increase the soundness of banks as much as their purchases of credit derivatives would imply. However, if credit derivatives enable banks to save capital, they ultimately reduce the cost of loans for bank customers and make banks morecompetitive with the capital markets for the provision of loans."

Not only are few banks using the derivatives to hedge, the exact loans that the banks would want to hedge are the most expensive to do. This really should not be surprising. What is more surprising is that these costs are so high as to prevent the use of the derivatives. Going forward in time, it will be interesting to see if this remains the case or if as the market develops, new ways evolve to lower the costs which would allow more effective hedging with credit derivatives. Stay Tuned.

Minton, Bernadette A, Rene Stulz, and Rohan Williamson. "How much do banks use credit derivatives to reduce risk?", Ohio State working paper, http://www.cob.ohio-state.edu/fin/dice/papers/2005/2005-17.pdf, accessed 8/17/05

Tuesday, August 16, 2005

CareerJournal | Retirement Plans - Retirement Planning - Pension Plans

CareerJournal | Retirement Plans - Retirement Planning - Pension Plans

This past Sunday the Buffalo News ran an article by the Wall Street Journal's Kelly Greene on the problem facing many retirees who expected their expenses to drop more than they have. The short version of the article was that because of more traveling, more consumer spending, and higher energy bills, post retirement expenses are often more then expected. Thus, old rules of thumb that suggest 50% to 75% of preretirement expenses be the norm for retirement planning may be too conservative.

Unfortunately I can not find the article online. However, I did find many other articles by Greene and others on the WSJ CareerJournal retirement page. It is highly recommended!

A few articles that I found particularly interesting include a look at Nolan Ryan's retirement, an article on advice from recent retirees saying to start planning now!, and an article showing that when portfolios drop many retirees go back to work.

Note: they are not all new (indeed some are 4 years old), but the advice and pointers they give are largely timeless.

The Gambler's Fallacy and the Hot Hand: Empirical Data from Casinos

The Gambler's Fallacy and the Hot Hand: Empirical Data from Casinos
Moneyscience.org points to the paper by Croson and Sundali (in the Journal of Risk and Uncertainty) who use video from a casino to document the existence of both a gambler's fallacy (the idea is that because some event has not happened in a while it is "due" and the hot hands fallacy (I am on a roll, so I will remain lucky).

A few "look-ins":
  • "The gambler'’s fallacy is a belief in negative autocorrelation of a non-autocorrelated random sequence."
  • "In contrast, the hot hand is a belief in positive autocorrelation of a non-autocorrelated random sequence"
  • "someone can believe both in the gambler'’s fallacy (that after three coin flips of heads tails is due) and the hot hand (that after three correct guesses they will be more likely to correctly guess the next outcome of the coin toss). These biases are believed by psychologists to stem from the same source, (the representative heuristic) as discussed below and formalized in Rabin (2002) and Mullainathan (2002)."
So what are the implications to the finance world? In the authors' words:
"it has been argued that the disposition effect in finance (the tendency of investors to sell stocks that have appreciated and hold stocks that have lost value) is caused by gambler'’s fallacy beliefs....Other evidence demonstrates that consumers'’ mutual fund purchases depend strongly on past performance of particular fund managers (Sirri and Tufano, 1998), even though the data suggest that performance of mutual fund managers is serially uncorrelated (e.g. Cahart, 1997). Thus, individuals are presumably making investment decisions based upon the belief that particular funds or fund managers are "“hot." ”"
So what does this mean to the average investor? That (s)he should be aware of the fallacies and be careful to avoid falling into their traps. The best way to do this is to remain rational about investing, which of course is easier said than done. ;)

Cite for paper:
Rachel Croson, James Sundali, The Gambler'’s Fallacy and the Hot Hand: Empirical Data from Casinos, Journal of Risk and Uncertainty, Volume 30, Issue 3, May 2005, Pages 195 - 209

Thanks again to MoneyScience for pointing this article out!

As antecdotal evidence of these fallacies I often use my own experience at my family's small chain of grocery stores. It is amazing to see certain customers (and a few employees) continually put money into the instant lottery machine as they say "I have put in $20 without a winner, the next one has to be a winner." Alternatively I have seen people give money to another person to put it in saying "you are always luckier than I am at this." Uh, ok...

Monday, August 15, 2005

Market timing and capital structure

Jay Ritter and Ronbing Huang give us more evidence that firms do time security issuance.

From their paper:
"publicly traded U.S. firms fund a much larger proportion of their financing deficit with external equity when the cost of equity capital is low. Small growth firms rely heavily on debt financing, and only resort to equity markets when the cost of equity is low."
It is also important to note that Ritter and Huang report that their is a slow adjustment process so that firms can deviate from their "target" ratio for a long time:
"Contrary to the findings of some recent papers, firms adjust very slowly toward target leverage, and past securities issues have long-lasting effects on capital structure"
Good stuff!

As an aside, I was just putting together my class notes for the fall semester on capital structure. Fortunately this paper does not lead to a change :) .

In fact how do I teach capital structure? I explain the traditional tradeoff theory, the pecking order theory, and then say, on top of these is the growing evidence that while managers consider these financing theories at least in part, market timing also plays a large role. Moreover market timing muddies the water since it can hide the impact of other factors that drive capital structure.

This paper by Ritter and Huang now fit in that "growing evidence" category.

Jay Ritter and Ronbing Huang. "Testing the Market Timing Theory of Capital Structure" Working paper, August 15, 2005.

'Do you Expect Me to Pander to the Students?' The Cold Reality of Warmth in Teaching by Robert Bruner

Robert Bruner has a really good piece on teaching. He discusses the ability to bring "warmth" to the finance classroom.

Do you Expect Me to Pander to the Students?' The Cold Reality of Warmth in Teaching by Robert Bruner

A quick intro:

"It is entirely possible to be warm and a tough teacher; to be warm and teach a dry technical subject; and to be warm even when you don’t feel like it. The effective teacher uses warmth as a stylistic tactic to promote student learning"
"Good teaching starts with a student-centered perspective. To gain this perspective requires direct engagement with students. Warmth, as a style, helps the engagement and thus the learning process."

Good reminders!

Bruner, Robert F., "'Do you Expect Me to Pander to the Students?' The Cold Reality of Warmth in Teaching" (June 2005). http://ssrn.com/abstract=754504

It's all relative!

Everything is relative.

Yeah we knew that, but there is a new study out that suggests even happiness is realtive. It is being widely reported today, but I do think it has a big impact in finance. Short version: everything is realtive.

Obviously this is not new. Indeed there was quite a bit on it Gregg Easterbrook's Progress Paradox.

Scotsman.com News - UK - Happiness is besting Joneses: "MONEY can buy you happiness - but only if you are richer than your neighbours, according to the results of research released yesterday.

Sociologists found that it was not strictly true to say that being well-off will not make a person happy.

But it depends on whether a person is able to 'keep up with the Joneses'"

"Glen Firebaugh, from Pennsylvania State University, who led the study, said: "We find, with and without controls, that the higher the income of others in one's age group, the lower one's happiness."

This could be used to look at financial implications in the areas of

1. Executive compensation
2. Globalization
3. Pay equity
4. Investor behavior
5. Trade

Thursday, August 11, 2005

Dollar Cost Averaging passes the test!

In Dollar Cost Averaging Brennan, Li, and Torous presents evidence that dollar cost averaging (investing equal amounts whether the market is up or down) actually works! In their words:
"evidence supports the view that the individual investors who follow this strategy in purchasing individual stocks to add to an existing portfolio are better off than if they followed the 'rational' strategies traditionally recommended by academics"
The short version of the paper is that while dollar cost averaging (DCA) may offer lower returns, it also lowers the risk. Consequentally, it seems that it does have an important roll to play in finance.

Again in their own words:
"We find, first, that, for an investor who is purchasing a diversified investment portfolio of common stocks represented by the CRSP value-weighted or equal-weighted indices, the DCA strategy, carried out over implementation periods of from one to six years, outperforms the lump sum investment strategy for all except the most risk tolerant investors. This seems to be due to the lower level ofrisk associated with the DCA strategy."
Yet another reason to use automatic investment plans!

As an aside, I love the paper's introduction:
"Practical or tacit knowledge typically precedes scientific knowledge. Crops were rotated long before the chemical basis of the practice was understood. Men learned to fly before aeronautics was well understood. Extracts of willow were described by Hippocrates as a pain remedy well before Bayer first synthesized aspirin....Therefore, given the relatively brief period of scientific study of financial markets, and the controversy that surrounds the interpretation of many of the findings, it is not surprising to find that a good deal of financial practice is stillgoverned by pre-scientific heuristics or maxims"

Michael J. Brennan, Feifei Li, and Walt Torous, "Dollar Cost Averaging" (June 24, 2005). Finance. Paper 17-05.

FPA Journal - Focus: Finding Career Paths

The Journal of Financial Planning has a cool article that is really a "roundtable" on what it is like to work as a Financial Planner. It really should be required reading for anyone considering gettting into the field!
FPA Journal - Focus: Finding Career Paths: "New planners and veterans alike voiced strong opinions on career opportunities and obstacles in the planning profession. While some respondents lamented that 'pioneering don't pay' in terms of hitting an early, successful career stride, others boasted that they are trading in their covered wagon for the latest Lexus."

Wednesday, August 10, 2005

Change is Good or the Disposition Effect Among Mutual Fund Managers by Anna Scherbina, Li Jin

Previous research has shown that individual investors often hold on to losing stocks for too long. It has largely been assumed that this is because individuals are reluctant to admit their mistakes. Empirically this has been shown by many including Odean 1998.

There is some, although less persuasive evidence that professional money managers are less likely to make this financial error.

Short Version:
Scherbina and Jin examine whether Mutual Fund managers exhibit such reluctance. Their finding? The managers, like the individual investors, hold on to losers too long. Their evidence? When new fund managers take over, they are more apt to sell off the losers and start fresh.

Longer Version:
SSRN-Change is Good or the Disposition Effect Among Mutual Fund Managers by Anna Scherbina, Li Jin:
"We document that mutual fund managers exhibit the disposition bias, or the tendency to hold on too long to poorly performing stocks. This bias arises because of the psychological unwillingness to admit past mistakes. We show that new fund managers, who are emotionally unattached to their predecessors' decisions, sell the momentum losers they have inherited more readily than continuing fund managers."
Some key factoids:
  • The authors only look at those funds where the complete manager team is replaced.
  • The sample is amazing! It goes from 1924 to the present and covers over 30,000 managerial changes.
  • "Consistent with the hypothesis of the disposition effect, in the quarter immediately after the new manager takes over, the median sale of the stocks in the losing decile is -100%, while the median stock sale (averaged over the continuing managers) is only -16.75%."
Their conclusion?
"mutual fund managers, much like individual investors are subject to the disposition bias. In order to document the effect, we go to the root of the bias and show that new managers, who are not likely to be attached to past portfolio decisions, make more rationaltrading choices."
While I think this is sort of what would have been expected, it is a victory for behavioral finance.

And interesting to boot! ;)

Scherbina, Anna and Jin, Li, "Change is Good or the Disposition Effect Among Mutual Fund Managers" (February 25, 2005). EFA 2005 Moscow Meetings Paper. http://ssrn.com/abstract=676970

Mmm, I wonder if the same happens when teams make coaching changes?

ISLAMIC MORTGAGES: Faith, finance forge new path

Kim Norris of the Detroit Free Press presents an interesting look at Islamic Mortgages. Islamic mortgages are different than traditional mortgages since many Muslims believe interest is wrong.

ISLAMIC MORTGAGES: Faith, finance forge new path: "In Islamic mortgages, an intermediary such as a bank buys the property, and the homeowner eventually obtains the home through a lease-to-own arrangement."

A few interesting tidbits from the article:
"The biggest barrier to developing so-called Islamic financing in the United States is the absence of a secondary market for these products. Typically when banks loan money for houses, they sell those loans to investors who profit by collecting the principle and interest.

Ranzini said University Bank must hang onto the Islamic mortgages it writes as well as title to the homes. That limits the volume of loans a bank can make."

Home insurance can also a be problem for the "borrowers" since they technically do not own the home. In the article Norris writes of a Muslim couple who experienced this problem:
"some problems when they tried to buy homeowners insurance -- something necessary to obtain a mortgage. Insurers would not recognize the Islamic mortgage as a standard mortgage. Instead, they insisted that since the trust owned the house, Solaiman and Metzger were only eligible for renters' insurance."
This may be changing however since in Michigan at least, the "Office of Financial and Insurance Services...OFIS issued a clarification saying that Islamic mortgages qualified for homeowners insurance just as a traditional mortgage does."

Ironically, what the article does not say is that the mere presence of insurance can be problematic for the most fundamentalist of Muslims. From Islam.org:
"Our scholars are not in agreement whether insurance is permissible (Halal) or prohibited (Haram). Since insurance as it is being practised now did not exist during the Prophet's time, Ijtihad is used to determine whether it is permissible or otherwise. As the scholars are not in agreement as to whether insurance is permissible or prohibited, they are also not in agreement as to reasons for its prohibition."
Total disclosure here. I was consulted by Kim Norris for her article. Among the topics we discussed were that the idea of that interest being bad is not new or unique to Islam. Christians had the same debate about 900 years ago.

From Newschool.edu (I highly recommend reading it!!!):
"Although clerics had been prohibited from lending at interest at least since the 4th Century, the ban was not extended to laymen until much later. In 1139, the Second Lateran Council denied all sacraments to unrepentant usurers and, in an 1142 decree, condemnedany payment greater than the capital that was lent."
Interestingly (no pun intended) Christians decided that interest was fine so long as it was not punitive (hence the term usury). It will be interesting to see (and unfortunately it will probably be after any of our lifetimes) whether Muslims decide likewise.

I have tried to understand why any religion would not allow any interest and I can not. I realize there are scripture readings (in many religions--see Wikipedia) against it, but I confess I do not understand the logic behind them. The ability to borrow (i.e. access to capital) can be amazingly beneficial and while equity might be better in some regards, limiting supply seems an interesting way of making helping the poor. Indeed, it could be said that religions would want to increase this access to money to help lift the poor from poverty.

The only explanation that makes sense to me is that debt can become a burden (too much of a good thing) and can lead to short-term thinking. But that is more an indictment of excessive debt. So maybe we should be against predatory lending and not all lending.

I would love some help on this one.

BTW Don't forget to check out the Detroit Free Press' article!

Also one of the best articles I have ever found on current trends in Islamic Finance is still available at Dinar Standard. A Great read!

Tuesday, August 09, 2005

Optimism and Economic Choice by Manju Puri, David Robinson

Puri and Robinson give us a new look at the old idea that optimism matters.

They identify optimists by looking at people's self-reported life expectancy. The findings are that not only do optimists work harder, but they buy more individual stock than their more pessimistic peers. .

SSRN-Optimism and Economic Choice by Manju Puri, David Robinson:

Short version:
"Optimists are more likely to believe that future economic conditions will improve. Self-employed respondents are more optimistic than regular wage earners. In general, more optimistic people work harder and anticipate longer age-adjusted work careers. They are more likely to remarry, conditional on divorce. In addition, they tilt their investment portfolios more toward individual stocks"

Longer version:

While I am usually quite interested in optimism research both in finance (e.g. Barber and O'Dean's work on excessive confidence leading to increased trading) and outside of finance (e.g. recovery from surgery etc), I confess I had not much seen much of the work cited. For instance:
"Gervais and Goldstein (2004) model how overconfidence in one's own ability leads to excessive effort, resolving moral hazard problems in teams. Rigotti, Ryan, and Vaithianathan(2004) develop a model in which optimists are more likely to embrace occupations with ambiguous returns, leading optimists to naturally choose entrepreneurship."
Puri and Robertson use self-reported life expectancy to proxy for optimism. That is, if the person expects to live for a longer time than actuarial tables suggest, that person is labeled an optimist. This rather simple labeling proves to be quite powerful.

For instance the authors report that:
"Our measure of optimism correlates with beliefs about future economic conditions. Respondents who report that they think economic conditions will improve over the next five years are statistically much more optimistic according to our measure than respondents who think conditions will stay the same or deteriorate."
And later:
"we findthat more optimistic people (regardless of their employment status) seem to view work more favorably: they work longer hours, they anticipate longer age-adjusted work careers, and they are more likely to think that they will never retire."
Which is all interesting, but I am not sure if I could include it in a FinanceProfessor blog (it would probably need to show up on my RandomTopics2 blog) but there is some pure finance in the paper:
"Optimists are more likely to own individual stocks, and they own a larger fraction of their equity wealth in individual stocks. Thus, they appear to be stock-pickers. This suggests that our measure of optimism captures the idea that optimists place greater weight on more positive outcomes than pessimists do. However, there is no evidence that more optimistic people tilt their portfolios more toward equity per se."
Very interesting.

Puri, Manju and Robinson, David T., "Optimism and Economic Choice" (May 2005). http://ssrn.com/abstract=686240

Do Investors Reinvest Dividends and Tender Offer Proceeds? by Elias Rantapuska

SSRN-Do Investors Reinvest Dividends and Tender Offer Proceeds? by Elias Rantapuska

Short answer: Not really.

Rantapuska asks two interesting questions:
  1. Are dividends and the proceeds from tender offers really reinvested?
  2. Are the proceeds from cash flows from tender offers treated differently than those from dividends.
Using data from Finland, the author finds that a relatively small percentage of the proceeds are immediately reinvested and that investors do appear to treat dividends differently from tender proceeds.

In Rantapuska's own words:
"analyses show that households reinvest probably less than 1% and under no circumstances more than 8.1% of the dividends within two weeks of the payment. Institutions other than mutual funds are not reinvesting either. There is also strong evidence on investors being more likely to reinvest proceeds from tender offers than dividends. This result holds even when I control for the identity of the investor, size of the cash flow, and the extraordinary nature of tender offer proceeds payment. This result can be understood in terms of mental accounting: investors label corporate cash-disbursements to mental accounts of capital assets and dividend income and are more prone to reinvest the former."
Pretty interesting. And yet more evidence that DRIP programs (both for mutual funds and individual stocks) are probably a good idea.

The mental accounting idea is also intriguing. Purely economic investors would treat cash as cash regardless of its source.

Rantapuska, Elias Henrikki, "Do Investors Reinvest Dividends and Tender Offer Proceeds?" (July 25, 2005). EFA 2005 Moscow Meetings, Forthcoming http://ssrn.com/abstract=675981

Monday, August 08, 2005

Socially Responsible Investors

I hate it when the WSJ "scoops" me, but that is where I found out about this paper. It is by Bollen and Cohen.

Socially Responsible Investing has been studied a great deal. Most of the work has looks at whether investors receive lower returns as a result of the SR criteria. Financial theory suggests that the more constraints placed on a portfolio, the lower the returns should be. (To put it another way, the addition of a constraint should make investors worse off when measure by risk and return). Somewhat surprisingly, the research on this has been very mixed.

Bollen and Cohen might have a partial explanation. They examine the behavior of SR investors. The results? SR investors appear to be more patient. This trait reduces transactions and (if theory is correct) should increase returns.

From the paper:

"following negative returns, cash outflows from SR funds are indeed smaller than cash outflows from a matched set of conventional funds, suggesting that investors derive utility from the SR attribute. Following positive returns, however, cash inflows to SR mutual unds are larger than cash inflows to conventional funds. An explanation for this asymmetry is that SR investors perceive the SR attribute as a luxury good which is more affordable when their level of wealth is sufficient."

Two quick points:

1. It is possible that the reason previous researchers have not been able to find a SRI penalty is that the lower returns due to the self-imposed constraint is offset by the higher net returns stemming from lower transaction costs and greater planning horizon provided by the higher cash flow predictability.

2. That SRI is seen as a luxury good is a cool finding. If pushed this is consistent with the view that improving economies could be expected to improve the same aspects that SRI investors are concerned with. (for instance firms in trouble worry less about the environment than firms "doing well").


Bollen and Cohen, Working paper, Vanderbilt University. Downloaded 8/8/05

Friday, August 05, 2005

SSRN-Options and the Bubble by Robert Battalio, Paul Schultz

Time to rewrite my class notes.....Like many people I have been telling my classes that at least a portion of the reason that Internet stocks were allowed to get so overpriced during the so-called bubble was that short-sale restrictions prevented investors from shorting the shares to drive down prices.

However, in their Options and the Bubble paper Robert Battalio and Paul Schultz show that even if there were short sale restrictions, the option market was efficient enough to allow investors to circumvent the short restrictions.

Unlike Ofek and Richardson (2003), Battalio and Schultz
"find few cases when synthetic and actual share prices diverge enough to appear to create arbitrage profits from short-selling. Indeed, the option and stock prices track each other so closely that we conclude short sale restrictions did not seem to have an important impact on Internet stocks." [emphasis mine]
They do this by showing that
"short sales of synthetic shares, formed by buying puts and writing
calls, are a viable alternative to selling actual shares short. For Internet stocks during the sample period, the expected proceeds from a synthetic short sale averaged about 99.5% of the expected proceeds from the short sale of actual shares. Even the hard-to-borrow stocks in our sample could be easily sold short synthetically, yielding proceeds that were on average only 0.6% less than the proceeds of an actual short-sale...."
Additionally, the option market was not just along for the ride, but a significant amount of information was being discovered via option markets. In the authors' words:
"We find that price discovery did take place in the options market during our
sample period. Moreover, we find that a larger portion of price discovery took place in the options market on days when the stock price declined."
So if we can't blame short sales restrictions, what caused the bubble? The authors conclude that investors simply did not know that the prices were too high:
"it was not obvious to them that Internet stocks were too high. They were trying to value companies in a new industry with unprecedented levels of recent growth. We academics, along with reporters and regulators, have the unfair advantage of hindsight."
Yet another very cool paper!!!

Battalio, Robert H. and Schultz, Paul H., "Options and the Bubble" (March 2004). AFA 2005 Philadelphia Meetings; EFA 2004 Maastricht Meetings Paper No. 3081. http://ssrn.com/abstract=558543

BTW Yes I realize this is not the newest paper, but I just found it when doing class notes for the upcoming semester. So I decided that since I had not seen it before, maybe some of you had not either.

Reputation Effects in Trading on the New York Stock Exchange by Andrew Ellul, Robert Jennings, Robert Battalio

Reputation matters. Once again we see that reputation and relationships matter. This papers presents evidence that trading costs on the NYSE are, in part, a function of the interpersonal relationships of floor traders.

SSRN-Reputation Effects in Trading on the New York Stock Exchange by Andrew Ellul, Robert Jennings, Robert Battalio: "reputation plays an important role in the liquidity provision process on the floor of the NYSE."

How cool of a study is this? Ellul, Jennings, and Battalio investigate trading costs on the NYSE following relocation of the specialist's post.

As the authors state, they have identified a "natural experiment". This occurs when specialists are moved but are not followed by the floor brokers who trade with the specialist. If relationships and reputation matter, then trading costs should increase (at least temporarily) following the move.

And the results? Sure enough, following the specialists' moves, trading costs increased. Interestingly, since the parties often knew of a pending move prior to the actual move, the importance of the relationship decreased before the actual move (consider game theory predictions as you get closer to the end of the game).

A few brief "look-ins":

*"we find evidence of statistically increased relative effective spreads for
relocating stocks versus their controls starting around event day -35 and ending after event day +45" p16.

* "With few exceptions, starting 45 days before the switch and continuing 35 days after the switch, the relocating stocks with high adverse selection have relative effective spreads that are higher than their controls"

In most cases the floor brokers did not follow the specialists to the new location. However, in some cases the brokers did move. Using regression analysis the authors find that "moving brokers enjoy significantly lower (statistically and economically) effective spreads than non-moving brokers. This advantage is particularly strong in stocks where the adverse selection problem is more severe." p. 26.

Which again suggests that repuation and relationships do impact trading costs. Why? The most logical explanation is that trust lowers the adverse selection cost of trading.

Very cool!

Ellul, Andrew, Jennings, Robert H. and Battalio, Robert H., "Reputation Effects in Trading on the New York Stock Exchange" (March 2005). http://ssrn.com/abstract=684091

Do Managers Influence their Pay? Evidence from Stock Price Reversals Around Executive Option Grants by M.P. Narayanan, Hasan Seyhun

SSRN-Do Managers Influence their Pay? Evidence from Stock Price Reversals Around Executive Option Grants by M.P. Narayanan, Hasan Seyhun: "Consistent with the hypothesis that managers influence their pay, the reversals are positively related to grant size and the seniority of the manager, and negatively related to the firm size. "

The size of this reversal is staggering.
"The market-adjusted return for the 90 days preceding the grant date is about −3.6% and the return for the 90 days following the grant date is about 9.4%. In small firms, the 90-day post-grant date average abnormal rise in stock price is about 17%. These patterns are significantly larger than any that has been documented in previous literature."
I saw this and, while surprised by the size, held off reading the rest of the article because I feared it was the same old thing on the topic: namely that managers do influence their pay by issuing bad news prior to option grant dates and good news after (see Yermack 1997). Well, that part was found again. BUT, what is cool about this paper is that the Narayanan and Seyhun propose that the price reversals that are found around option grant dates might not be merely because of the timing of news releases, but the selection of historic dates to use as the option grant date.

From the paper:
"consistent with the back-date method of influencing the grant date stock price comes from the relationship between stock price reversals on the grant date and reporting lags....for most of our sample period, Section 16(a) of the Securities and Exchange Act requires that option grants be disclosed within 10 days of the month following the month of the grant. About two-thirds of the awards in our database are reported after this deadline. We define the number of days elapsed between the grant date and the reporting date the “reporting lag.” If indeed in some cases the grant date is set on a back-date basis, the reporting period is extended automatically by an amount equal to the elapsed time between the reported grant date and the date on which the grant decision was made. Therefore, if the stock return reversals of Figure 1 are caused partly by awards being given on a back-date basis, the reversals should be more pronounced (i.e., the drop before and the rise after the grant date should both be steeper) in those cases where the reporting lag is greater. This is exactly what we find."
Why the interpretation of back-dating? Because of the striking change of direction around the date is almost too much to believe:
"if managers attempt to drive the share price down before the grant date by selling shares of the firm that they own and then release favorable earnings information after the grant date, it will be most likely in violation of the anti-fraud provisions of the Securities and Exchange Act of 1934 [Section 10(b)-5]. For these reasons, it appears farfetched that managers are influencing the stock price with such precision to obtain options at a reduced exercise price."
With that in mind, the authors look for (and find) evidence that is consistent with backdating. For instance, the reversal is greater for larger grants, grants to more senior management, and that there is no abnormal return when the actual grant is announced.

Interesting stuff!

Narayanan, M.P. and Seyhun, Hasan Nejat, "Do Managers Influence their Pay? Evidence from Stock Price Reversals Around Executive Option Grants" (January 2005). http://ssrn.com/abstract=649804

Thursday, August 04, 2005

They're back!

The US Treasury announced that the 30-year T bond will be making a return. (get it? I couldn't resist ;) )

"Treasury is re-introducing regular semi-annual auctions of the 30-year nominal security beginning with a bond that will mature on February 15, 2036." Treasury Press Release

From the Seattle Times:

"It is good because it will help the U.S. government finance its huge deficit and debt at longer terms, even as the baby boom prepares to retire. It is good because it would offer investors, such as big pension funds and insurance companies in particular, a safe, longer-run option in which to park their large portfolios.

It is bad because it means that there is much a bigger deficit, and debt, to finance even as the baby boom prepares to retire."

Don't Worry About China. Learn From It. - New York Times

Don't Worry About China. Learn From It. - New York Times: While there is a debate about the actual size of the Chinese economy, very few really have a grasp on the actual size.

From the article:
"range of estimates, but generally the gross domestic product of China in the year 2004 is estimated to be substantially less than $2 trillion. That would roughly make it one-sixth the size of the United States economy. Yet China has nearly five times the population of the United States. That means the per capita G.D.P. of China is about one-thirtieth the per capita G.D.P. of the United States"

This is totally not meant as a cut against anyone, but it is always useful to keep relative positions in mind. While China's economy is growing very quickly, don't forget it has a long ways to go. As the author Ben Stein points out, it is something often forgotten in the media.

Wednesday, August 03, 2005

The McKinsey Quarterly: Sizing the emerging global labor market

Thomas Friedman's Flat World meet academia. McKinsey Quarterly reports on the impact outsourcing will have on the global economy.

Short Version:
Outsourcing is here to stay, will continue to grow as more jobs can be digitized, this will increase per capita income in developing economies without "major discontinuities in overall levels of employment and wages in developed countries."

Of course that last statement is both macro in view (i.e. overall levels may not be impacted, but there will be individual winners and losers) and slightly optimistic.


The McKinsey Quarterly: Sizing the emerging global labor market

Tuesday, August 02, 2005

FinanceProfessor.com trivia

I had a request for my old trivia page that had been taken off the website. So here it is. I had not looked at it in years. Some are pretty interesting.
FinanceProfessor.com trivia

For instance:
#34. Ronald Reagan was the first president to visit the NYSE
#36. Arnold Schwarzenegger was a finance major
#41. The Founder of Merrill Lynch (Charles Merrill) played semi-pro baseball prior to coming to Wall Street. The Lynch in the name is from Edward Lynch who was a soda fountain salesman
#68. The slowest day is NYSE history was March 16, 1830, when only 31 shares changed hands

some of them are really dated, but still interesting.

Monday, August 01, 2005

Low-Carb Pioneer Atkins Files Chapter 11

Projecting sales is difficult. Indeed, it is probably the hardest part of valuation and it can have large implications if we are wrong. Therefore, it is covered in virtually all investment and corporate finance classes at least to some degree. Well we now there is a new example to use: Atkins Nutritionals.

As the low carb diet fad cooled, not only have grocery stores left with unsold product, but Atkins Nutritionals itself has found itself in financial trouble. Atkins Nutritionals after having projected the sales to grow significantly had increased their capacity in part with increased debt. When sales suffered, so did the firm's financial health and has now lead to Atkins filing for bankruptcy.

AOL News - Low-Carb Pioneer Atkins Files Chapter 11: "The company started by the late nutrition guru Dr. Robert C. Atkins to promote a low-carb lifestyle has filed for bankruptcy court protection, a further sign of the waning popularity of the diet"

I know this will be used as in class example in my classes. It should spur an interesting discussion as many students will have experience with the diet and therefore better understand the difficulty in predicting sales. With luck, the discussion will also include coverage of why firms facing greater business uncertainty opt for less debt in their capital structure.

Other links: CNN, Bloomberg (which also has a useful timeline), and the NY Times

RadioEconomics interview

As I warned/promised you last week, here is the RadioEconomics' interview I did. I just listened to it. I definitely did not break any new ground, but it does give a background on FinanceProfessor.com as well as some of the synergy between the site, the blogs, my research, and my classes.

Radio Economics

be sure to listen to some of the other interviews as well. Especially the Becker and Posner one!