Friday, November 26, 2004

More evidence that governance matters

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

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

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

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

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

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

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

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

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

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

Thursday, November 25, 2004

A look around at a few blogs

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

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

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

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

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

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

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

Happy reading!

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

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

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

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

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

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

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

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

Wednesday, November 24, 2004

The value of hedging revisited...

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

Put your thinking caps on for this one!

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

Longer version:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Friday, November 19, 2004

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

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

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

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

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

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

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

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

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

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

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

Wednesday, November 17, 2004

Impact of Baby boomers from Porterba

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

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

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

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

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

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

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

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

Right angles in event studies are good :)

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

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

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

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

Immediately following the announcement, the stock prices jumped.

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

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

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

Tuesday, November 16, 2004

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

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

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

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

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

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

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

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

Friday, November 12, 2004

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

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

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

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

In the authors’ words:

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

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

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

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

In their conclusion, the authors summarize the findings:

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

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

Alternative sites/cites:

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

From the AFA program:

And from Mark Flannery’s web site:

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

Alti finds Market Timing's leverage impact is largely transitory

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

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

We will go alphabetically and begin with Alti.

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

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

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

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

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

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

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

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

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

When a crisis really is a crisis

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

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

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

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

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

Longer version:

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

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

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

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

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

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

Interesting piece!

The paper is also available through SSRN.

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

Thursday, November 11, 2004

Michael Brennan on the Stock Market Bubble

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

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

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

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

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

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

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

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

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

2. Agency Problems in the production and sale of information

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

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

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

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

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

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

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

Wednesday, November 10, 2004

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

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

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

Short version:

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

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

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

The Pecking Order--Dead or Alive?

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

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

Well we may have a "momentum changer"!

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

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

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

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

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

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

This paper is also available through FEN.

Monday, November 08, 2004

The Sports Economist--Sports, Globalization, and Protectionism

The Sports Economist has an interesting article looking at global competition in sports. The basic idea is that competition has become global. As Skip Sauer (the Sports Economist and Clemson Economics professor) writes:

Over the past century, the scale of sporting competition has increasingly moved from the local to the national and international stage. The great Brazilian soccer players no longer play in their home country, but for top teams in Europe. The best American talent plays there as well. Asian and European players now dot the landscape in American baseball, basketball, and hockey (should they ever get started again).

Now the astute reader might say, gee that is the same thing that has happened in business. No longer can you just be the best in your own small town, but rather competition has become global. This is true not only for manufacturing but even retailing. (EX. Wal Mart will very soon become a global retailer!)

Change does come with this increased globalization. For instance, in the business world, less efficient businesses do go out of business and there is a shift in how the work force is allocated. Similarly, in sports some long standing rivalries are no longer played. Again quoting the SportsEconomist:
The consequence of this form of globalization is that traditional, local-based competition faces serious challenges. This scenario has been played out before. Competition in intercollegiate athletics has become competition not so much against your local or regional rivals, but competition to gain a share of attention on the national stage, in a national market. The result: conference
expansion beyond a regional footprint has been the trend for the past thirty years or so.
The analogy between sports and business does not end there however. In each some do not like the increased competing and the changes that are being forced onto participants. While thankfully we do not see terrorists trying to block large conferences, there are some protectionism that tries to block the move towards globalization.
European soccer has to come to grips with these forces as well. UEFA currently mandates that its member clubs compete in domestic competitions. This rule precludes countries like Ireland and Switzerland from generating enough support
to field a team that can compete with the best on the continent.
And like protectionism in business, the loser is the consumer who no longer can watch the best players, but rather is entertained with watered down "local" competition.

I urge you read the whole article, it is worth the time!

Friday, November 05, 2004

Ljunqvist and Wilhelm: Prospect theory and IPOs

In trying to explain IPO underpricing, Loughran and Ritter (2002, RFS) suggested that CEOs may not be concerned about leaving money on the table in IPOs because the losses are netted against the rises in stock price in the secondary market.

Ljunqvist and Wilhelm now test this and find that it seems to hold. How do they do this?

From my class notes:
"Let's talk about grocery stores for a while.
Q. Why do stores try to keep their customers happy?
A. Happy customers are less likely to go to the competition."

If you follow that, you have the idea behind the Ljunqvist and Wilhelm paper. They examine when firms change investment bankers following IPOs. They find that when the CEO wealth increases significantly in the IPO process (and hence presumably the CEO is a 'happy customer'), the firm is more likely to stick with the same underwriter, even if there was significant underpricing in the IPO.

In more technical language, the idea that the CEO is less concerned about what is left on the table because (s)he is making money anyways is essentially prospect theory.

Prospect theory is the idea that how we are thinking about something affects our decision making and our utility from various events. The idea was is generally credited to Daniel Kahneman and Amos Tversky in 1979 (thanks Wikipedia!)

Thus, the idea is that even if you did not sell the firm for as much as you could have in the IPO process (you left money on the table), you are not upset because you made money on the deal--true not as much as you could have, but more than you did have).

In the authors' words:
"In contrast to Krigman, Shaw, and Womack (2001), we find that IPO firms are more likely to switch underwriters after the IPO when our behavioral proxies suggest that they were dissatisfied with the IPO underwriter’s performance. This difference arises because we measure dissatisfaction along the lines of Loughran and Ritter (2002) rather than focusing on underpricing. The finding by Krigman,Shaw, and Womack of significantly less underpricing among firms switching underwriters does not persist when we include the behavioral proxies for decision-maker satisfaction.
From the investment bankers' perspective, it pays to keep the customers happy. Not only are happy customers less likely to change companies, but they are also willing to pay higher prices!

"...underwriters appear to benefit from behavioral biases in the sense that they extract higher fees for subsequent transactions involving satisfied decision-makers. Thus, satisfaction with the IPO outcome is associated with both a reduced likelihood of switching underwriters after the IPO and paying higher fees for SEO underwriting services."

Yeah I know this one reviewed before, but since I will be using it in class I figured I would check on it again and if I found it interesting the second time, maybe some of you will too! And additionally, the review is a bit longer than it was before and the paper is slightly different.

FTR I guess I was not the only one who liked it, the paper is now accepted in the Journal of Finance. :) Congrats!

House Cleaning

When I started I envisioned it largely as a repository of summary articles. Well things changed some, but in my mind at least, the heart of the page is still the summary section (of which I sort of include the newsletters).

That said, a lack of time has often intervened, but finally I got around to partially updating the short summaries for Corporate Finance. It does not yet have the more recent blog entries (I will get to that next week?) but I think you will like what is done. Next comes the Investment Summaries--Stay tuned.

Also while my FinanceClass blog is really aimed at my own students, today's guest lecture by Anthony Annunziato was so good that it may interest others of you.

It was 90% Finance and 10% life. So even if you do not particularly care what he said about finance, hearing from a man who ran one day and was paralyzed the next is moving. He was in 6 different hospitals for 17 weeks! He is now back healthy and working as an energy trader. But he definitely reminds us that there is more to life than account balances.

Tuesday, November 02, 2004

Iowa Electronic Markets ~ Current Markets: 2004 US Presidential Winner Takes All Market

Iowa Electronic Markets ~ Current Markets: 2004 US Presidential Winner Takes All Market

For many reasons polls can be biased and inaccurate. For instance: do you answer your phone? I rarely do unless I know who is calling. Or do you tell the pollster what you thing they want to hear? Many do.

However, people are much less likely to lie if there is money at stake, so it is worthwhile to see what the markets telling us about the US presidential election?

No, I am not talking about the stock markets, the bond markets, or even the currency markets, but the political markets and the betting markets!

The most famous of the political markets is the Iowa Electronic Market. It has been around for years and has done a good job at predicting winners. Right now it has Bush ahead but barely.

Betting markets such as off-shore Casinos have also entered this year's election process. At many of these you can bet on not only who is going to win, but even who is going to win various states.

MSNBC did a story (including a video) on these betting sites two weeks ago:

"'The odds on our site react to the latest news event immediately, and so in terms of the reliability of our election data we think we are way ahead of the opinion polls which only tend to survey a few thousand people,' said Mike Knesevitch, a spokesperson for" has complied a list of the various betting markets that are quoting odds. It is fascinating to watch them move as news changes etc. For most of the day the line has been moving towards Kerry.

Now be forewarned, liquidity is not great at all of these so there is some noise in the predictions, but at the end of the day, my money is still on the efficiency of the financial markets.

Jim Garven has done a much more thorough study of the political markets on a state by state basis and as of the last post on his blog thinks the markets are now saying a Kerry victory. But again it is so close it is very hard to say.

An other site that has had predictions on the election is:

Also as a reminder, before you go jumping form windows or moving because your candidate lost, remember, John Nofsinger's finding that stock market performance is essentially the same for Republican and Democratic presidencies.

Monday, November 01, 2004

Commercial banking and Investment banking-Yasuda

In a forthcoming Journal of Finance article, Yasuda adds significantly to our understanding of the relationships between corporate borrower, commercial bankers, and investment bankers.

It is rare that an abstract summarizes a paper's findings as well as this one, so I will let the abstract give his findings:
"[Commercial] bank relationships have positive and significant effects on a firm’s underwriter choice, over and above their effects on fees. This result is sharply stronger for junk-bond issuers and first-time issuers. I also find that there is a significant fee discount when there are relationships between firms and commercial banks. Finally, I find that serving as arranger of past loan transactions has the strongest effect on underwriter choice, whereas serving merely as participant has no effect."
While the findings are in the abstract, the implications and interpretations are really what matters and for these, you have to read the paper.

Noteworthy points:
  1. Commercial banks made quick progress in gaining market share from investment bankers: "Between 1993 and 1996, the top ten investment banks’ collective
    market share was 11 percentage points less than it had been between 1985 and 1988
    (from 87% to 76%) while the top five commercial banks collectively accounted for 13% of
    corporate-bond underwriting." This success stems from both lowering fees and relationships with the borrowing firms.
  2. The data includes over 1,500 firms from 1993-1997 and also has their bank relationships.
  3. Not surprisingly, existing bank relationships are most important where information asymmetries are most important: low rated firms.
  4. Fees are lower when there is already an existing relationship in place: "there is a significant fee discount when there are relationships between the firms and commercial banks."
  5. <>Just because a bank is in the syndicate for one loan does not necessarily increase odds of being selected to underwrite another loan in the future. However, the closer the relationship between firm and bank, the more likely the bank will be selected in the future to underwrite a loan. In other words, there are relationships and then there are relationships.
    "This finding supports the view that only top-tier members of syndicates are engaged in information production about the borrower firms, while lower-tier members are merely invited by arranger banks forrisk-sharing purposes and do not gain any informational advantage about the firms."

Point #4 deserves further mention as previous studies have found that commercial banks could get a better price for issuing debt from firms with whom there was an existing relationship. As Yasuda points out it could be hypothesized that the bank would try to capture this better price through higher fees. This does not appear to be the case, which suggests that "commercial banks are not at an absolute competitive advantage over investments banks."

So why the lower fees? Probably because the information costs are lower at firms where there is an existing relationship. And this cost savings is being passed on to the issuing firm.

A great read!

Yasuda's paper is forthcoming in the Journal of Finance.

An earlier version is available on SSRN.

As an unpaid endorsement, I want to say that The Journal of Finance is probably my favorite Journal. Sure there are others that are close (obviously JFE), but the ability to constantly find really insightful papers sets the Journal of Finance above the rest. It should come with a warning however: Reading many interesting Finance papers available, is habit forming and may be the cause of a very messy desk! lol...

Trends in Corporate Governance--Hermalin

In a forthcoming Journal of Finance article, Hermalin does a great job of showing how the various trends we see in corporate governance may be linked.

Some of the trends that are investigated include more "diligent boards", more outsiders being hired as CEOs, shorter tenures as CEO, and of course more CEO pay.

In the author's own words:
If regulatory and other pressures are leading to, say, more diligent boards of directors, what else should we expect to see as consequences? Furthermore, how do the various trends in governance relate to each other? What trends may plausibly be causing other trends? What covariance in trends may simply be spurious? The purpose of this paper is to develop a theoretical framework from which to answer such questions. This framework allows one, for instance, to trace through the consequences of pushing for greater representation of outsiders on boards for matters such as who gets hired as Chief Executive Officer (CEO), how long he might be expected to serve, and how much he might expect to be paid.
Using modeling that may be above the level of an undergraduate class, Hermalin shows that many of these trends may be connected. For instance, consider the trends of more diligent boards, more outside hires, and shorter turnover as CEO. He shows that these are likely linked.

How? Suppose boards are more diligent (the reason could be regulation or as a result of past "Enrons" or merely because of sun spot activity--in other words the reason for this increased diligence is immaterial). What would be some fo the consequences of this increased board diligence?

Hermalin points out that boards play the biggest role in the hiring and firing of CEOs so the paper is focused on this.

If CEO hiring decisions are considered using option theory, outside applicants have an advantage. Why? More is unknown about the outsider than the insider applicant. Thus, there is a higher variance on the ability of the outsider. Coupled with the ability to remove the CEO for poor performance (capping the downside), this leads to an increased expected value of hiring the outsider as CEO. (Which is a really cool insight!)

So if the board is already monitoring the CEO (i.e. more dilegence by Boards), then this is a relatively cheap option to exercise. So with increased monitoring, we should expect to see more outside CEO hires and of course more CEOs being fired (i.e. shorter tenures).

As evidence of this, the author points out that we should see more independent boards hiring more outsiders:
"Given the perceived wisdom that outside directors are more independent or otherwise more inclined to monitor, this suggests that the tendency to hire external candidates increases with the proportion of outside directors on the board. This prediction is consistent with the empirical findings of Borokhovich et al. (1996) and Dahya and McConnell (2001), who find evidence in support of this hypothesis using U.S. and U.K. data, respectively."

Additionally, since CEOs do not like to be monitored, closer monitoring by boards may partially explain the higher CEO pay levels we are seeing.

Now of course, there are alternative explanations for many of these trends and even some contradictory evidence (for example, more institutional ownership and stronger boards being associated with LOWER CEO pay). In section VI of the paper the author comments on these other explanations and concludes that they are all missing some important part of the story. Which I find not totally convincing, but it is still a great paper!

Overall, one of those papers that opens you up to a new way of thinking about things. And that may be the best compliment an academic paper can receive!

The paper is currently available on the Journal of Finance site, but will be removed once it goes to print.