Wednesday, December 28, 2005

Enron chief accountant expected to plead guilty - report -

Well you knew someone would talk (first mover advantage--LOL)..

From Forbes:
Enron chief accountant expected to plead guilty - report - "he former chief accountant at Enron Corp is expected to plead guilty to one or more criminal charges related to the collapse of the energy company, the Wall Street Journal reported.

In its online edition, the newspaper cited sources familiar with the situation as saying attorneys for accountant Richard Causey have spoken to prosecutors in recent days about a plea agreement.

A plea agreement could have a major impact on the cases against his co-defendants, former chairman Kenneth Lay and former president Jeffrey Skilling.

The three men face fraud, conspiracy and other charges in relation to the alleged financial and accounting practices at the company. "

Tuesday, December 27, 2005

Text book prices too high? Hope is either here or coming soon!

Just had another of those "The World is Flat" moments.

I started working on my syllabi for the spring semester today and while cleaning off my desk I found an advertisement for FreeLoadPress. Have you heard of them? It is a very cool idea. I have not used their books, but am very tempted.

The basic idea is that they offer text books for free or next to free in return for sponsorship. For instance, a quick look shows that the online version of the text books are free and a printed copies costs less than $30. Sure the text does not have all the bells and whistles, but at first glance, it looks to have all of the important topics.

Has anyone used it? Any suggestions would be greatly appreciated.

This got me thinking "are there any open source finance textbooks?" So far, the answer appears to be "not yet" but they are coming.

Thursday, December 15, 2005 - More funds lower fees after scandal in 2003

YEAH!!! Fees and expenses eat away large portions of your "nest egg" over the long haul, so every cut is a good thing! - More funds lower fees after scandal in 2003: "Fund-tracker Lipper says 2,830 funds reduced their management fees in 2004, compared with 622 that did so in 2003.

Those fee reductions were not one-time cuts but contractual agreements with the funds' investment advisers, which manage the funds' assets.

The median stock fund charged investors 1.45% of assets for expenses in 2004, Lipper says, down from 1.50% in 2003" - Pension funds pin target on CEO pay - Pension funds pin target on CEO pay:
"Runaway CEO pay, a longtime pet peeve of shareholder activists and corporate governance experts, is about to take center stage in Washington, D.C.

At least that's the hope of 10 pension funds from the USA, Canada and Europe. In a confidential letter sent to the Securities and Exchange Commission on Nov. 30, representatives of the funds, which together manage almost $1 trillion, urged the SEC to look more closely at the pay for performance among top executives"
Interesting factoid:
"At 60 of the worst-performing companies in that group, which lost $769 billion in market value over the past five years, the aggregate pay for the top five executives of those 60 companies over the same period was $12 billion."

Which even after adjusting for risk seems a tad inconsistent with pay for performance.

What's the Return on Education? - New York Times

Want to include education in the "market portfolio"? It is not as easy as you would hope!

What's the Return on Education? - New York Times: "Economists have tried for decades to quantify the impact of education. They still don't have all the answers, but their work can shed some light on what Americans are getting for their investment."

Thought provoking article!

Taking a View: Corporate Speculation, Governance and Compensation by Christopher Geczy, Bernadette Minton, Catherine Schrand

SSRN-Taking a View: Corporate Speculation, Governance and Compensation

You know the standard class spiel:
"... identify your core business exposure, then find ways to hedge it by taking a derivatives position that moves in the opposite direction. In this way derivatives are not bets on market movements, but as an insurance policy against things outside the firm's control (i.e. macro risk factors."
The problem is that firms regularly ignore this advice and speculate by making bets as to which way the asset price will move beleiving that they have an ability to "beat the market".

Geczy, Minton, and Schrand examine this "market view" of derivative use and find that it can be tied to the poor governance and option based executive pay. Moreover, they report that current accounting standards do not allow outsiders to correctly judge how derivatives are being used.

A few "look-ins"

* "Taken together, these characteristics of speculators are consistent with the following scenario. Firms are motivated to use derivative instruments to hedge. Once the fixed costs of a derivatives operation are in place, however, some firms extend their derivatives program to include speculation. The firms that start speculating have (or believe they have) a comparative information advantage relative to the market such that they view speculation as a positive NPV activity."

* "The firm characteristics that measure incentives to increase convexity, however, are significantly associated with other proxies for potential risk-seeking activities of the sample firms –lower diversification and higher stock return volatility. Thus, while the sample firms that we identify as risk-seekers engage in other risk-seeking activities, they do not seem to consider actively taking positions in derivatives based on a market view as similarly risk-seeking."

* "Greater managerial power measured by the Gompers, Ishii, and Metrick (GIM, 2003) governance index is positively associated with frequent speculation. These results are particularly strong for firms that rely less on the market for corporate control as an ex post monitoring mechanism to prevent excessive risk-taking."

HOWEVER, these firms do not give managers' totally free reign:

"The speculating firms, however, have more frequent and scheduled reports of their activities to the Board of Directors, more sophisticated methods of and more frequent valuation, and stated policies that limit counterparty risk"

* "we show that market participants could not have discerned the activities of the frequent speculators from publicly available documents (e.g., 10-K filings). This result is not necessarily evidence of accounting fraud because speculation, as we have defined it, may not meet the requirements for reporting under generally accepted accounting principles (GAAP). Nonetheless, irrespective of whether we do not observe disclosure because the accounting rules do not require it or because firms are not implementing the rules properly, the end result is that the financial statements do not provide an accurate picture of the firm’s speculative activities."

Caveat: As the authors readily acknowledge, this is based on survey data, but the data has been used before AND the questions appear innocuous in the sense they do not readily "lead" the response. Morever, given the finding that accounting numbers are insufficient to find the usage, survey data may be all there is.

Wharton's Knowledge has a great summary of the article with interviews! "One quote from this article:
"Executives in charge of derivatives speculation tend to feel they have some unique insight into currency and interest-rate markets, even though their firm's main business may be entirely different, Geczy says. "They really believe they can make money. They feel like they can identify opportunities and/or trade with the advantage of low costs of leverage."
VERY Cool article! It will definitely be used in class!


The Role of Derivatvs in Corporate Finances: Are Firms Betting the Ranch?

Geczy, Christopher Charles, Minton, Bernadette A. and Schrand, Catherine M., "Taking a View: Corporate Speculation, Governance and Compensation" (November 2005).

Monday, December 12, 2005

Dilbert Comic Strip Archive - - The Official Dilbert Website by Scott Adams - Dilbert, Dogbert and Coworkers!

Yesterday's Dilbert comic strip acknowledges the importance of incentives and brings up the question of whether we should rewrite underwater options.

Which just happens to be a topic we will be covering this Friday in class.

Sunday, December 11, 2005

The Bonds That Fight the Monster Called Inflation - New York Times

Another interesting article NY Times article that is useful for introductory investment (or money and banking) classes.

The Bonds That Fight the Monster Called Inflation - New York Times:
"The I Bonds offer a two-part interest-rate mechanism. The first is a fixed rate for the life of the bond. That rate is now 1 percent, applying to all I Bonds issued in the six months that started Nov. 1. The second rate is linked to the Consumer Price Index for urban consumers. This rate is reset twice a year - on Nov. 1 and May 1 - according to changes in the C.P.I.-U. It is this feature that has made the I Bond especially attractive to many fixed-income investors....On Nov. 1, the Treasury Department increased the variable I Bond rate to 5.70 percent - based on the climb in the inflation index from March to September - giving it a total annualized earnings rate of 6.73 percent.

"....And the rate looks even better when you consider that many observers...think that the C.P.I. overstates the real level of inflation in the economy."

Giving Yourself a Tax Cut on Investments - New York Times

The NY Times has several good tips on lowering tax bite on your investments.

Giving Yourself a Tax Cut on Investments - New York Times: For instance:
"Every year in late November or December, mutual funds distribute to their shareholders the gains they realized by selling stocks that year."
"So-called tax-efficient funds, which manage money with taxes in mind, are also considered a relatively safe bet. But be sure to hold these investments outside a tax-advantaged account because they are already tax-efficient."

Friday, December 09, 2005 - 'Consensus estimate' may be from one analyst

USA Today ran an interesting look at analyst coverage. Many stocks have a surprisingly small analyst following. - 'Consensus estimate' may be from one analyst: "Currently, more than half the 8,416 public companies have no analyst coverage, says Ashwani Kaul, chief spokesman for Reuters Estimates. An additional 7% of publicly traded companies are covered by just one analyst.

Most of the single-covered stocks are small, with an average market value of $284 million, Kaul says. But the ranks still include some well-known companies such as 1-800-Contacts, A.T. Cross and Rocky Mountain Chocolate Factory."

As analysts play roles in reducing information asymmetries and even in control agency costs, the relative scarcity of analysts brings up interesting questions: how do returns vary with coverage? How about agency costs?

Wow has it been a while

I don't know whether to beg forgiveness or put up a white flag. It has so long. This semester has been very hard: much traveling, classes every day, plus helping to plan a large trip to the Gulf for the spring. But the semester is winding down, tonight's hotel has wireless internet, and I have had more than my share of planning for now, so I will turn my attention to finance. :)

Wednesday, November 30, 2005

Hands On USA : Thanksgiving video

Oops, this was supposed to go on My Randomtopics2 blog, sorry!!!

A Thanksgiving video is up. VERY good!!!

So many familiar faces!

But since I have you attention, why not consider coming down with us when we go back? Check out our plans here. It will be a GREAT trip!

Most corporate fraud found by luck: study - Yahoo! News

Most corporate fraud found by luck: study - Yahoo! News: "Despite tough regulations aimed at improving corporate governance, financial fraud is still on the rise around the world, and most is still detected by chance, a study from auditing firm PriceWaterhouseCoopers (PWC) showed on Tuesday"

"For the roughly one-third which said they could quantify the cost of the fraud, the total losses exceeded $2 billion, or an average of $1.7 million per company.

"Economic crime remains difficult to detect, despite everybody's best efforts to invest in internal controls," said Steven Skalak, Global Investigations Leader at PWC.

The survey showed that the most common methods of finding out about financial fraud were still accidental, like calls to hotlines or tips from whistle-blower employees."

Why am I not surprised? Because if people want to hide their dishonesty, it is often easy to do. In class I occassionally use the Adelphia case where I hand out the footnotes that let to the Rigas' downfall.

Knowing that there was a problem, most people (myself included)could not tell for sure which footnote was the "smoking gun."

Tuesday, November 29, 2005

Is Stock Picking Declining Around the World? by Utpal Bhattacharya, Neal Galpin

SSRN-Is Stock Picking Declining Around the World? by Utpal Bhattacharya, Neal Galpin:

Short version: Bhattacharya and Galpin examine the relative use of indexing vs. stock picking in various equity markets around the world. They find that indexing is increasing pretty much everywhere but especially in more developed markets. They also estimate that the "long run steady state" fraction of stock picking in US markets is 11% (it is now 24% down from 60% in the 1960s."

Longer version:
Bhattacharya and Galpin use an innovative method to measure the degree to which stock picking is used in an equity market. Based on this model, they then compare the relative percentage of stock picking (vs. Indexing) both using a cross sectional analysis as well as time series analysis.

The key idea behind the paper model is that if everyone indexes, then volume should be proportional to size of firm. In their words:
"The idea behind this measure is inspired by a theoretical insight in Lo and Wang (2000). They proved that, if the two-fund separation theorem holds, dollar turnover of a stock, which is defined as the dollar volume of shares traded divided by the dollar market capitalization of the stock, should be identical for all stocks.

An empirical implication of the above theoretical insight is that if every person in the world indexes between a risk-free portfolio and the market portfolio (or a value-weighted portfolio that is a proxy for the market portfolio), trading volume in stock i should be explained completely by the market capitalization of stock i."
Given this, the authors the essentially regress actual volume on capitalization (more technically they run the
"regression of log monthly stock volume (measured by number of shares traded in that month for stock i in a country) against the log of monthly shares outstanding (measured by number of shares outstanding in the beginning of the month for stock i). We run this regression for 43 countries, of which 21 are classified as developed markets and 22 are classified as emerging markets."
Most of the analysis begins in 1995, but for US stocks they go back into the early 1960s to yield valuable insights as to how markets have changed.


* "The first big result.... is that there is more stock picking in emerging markets than in developed markets." This is shown in figure 1 and table 1.

* "The second big result that Figure 1(a) illustrates is that, on an average, stock picking is declining around the world. The declines in stock picking are quite dramatic, especially in the emerging markets."

In their examination of US stocks, they find that there has been a dramatic decrease in stock picking:
"In the United States, the maximum fraction of volume explained by stock picking has secularly declined from a high of 60% in the 1960s to a low of 24% in the 2000s"
Additionally, stock picking is relatively more popular where theory would predict--
namely where information asymmetries are highest. Thus stock picking is more common in young firms, in industries where there is lower asymmetries, and (only somewhat surprisingly) where there are fewer analysts.

VERY cool!! I^3. Indeed their finding that stock picking is negatively related to analyst coverage is worth the price of admission!


Bhattacharya , Utpal and Galpin, Neal E., "Is Stock Picking Declining Around the World?" (November 2005).

By the way, Neal is a SBU grad, so I could be a tad biased ;) I tried not to be, but you can be the judge.

Class Classification: Investments

Please, Sir, I Want Some More - How Goldman Sachs is Carving Up its $11 Billion Money Pie

New York Magazine has an interesting look at Wall Street bonuses.

Please, Sir, I Want Some More - How Goldman Sachs is Carving Up its $11 Billion Money Pie: "The standard portion of net revenue (total revenue minus interest expense) earmarked for compensation at Wall Street firms stands at an astonishing 50 percent. That?s because talent is the most precious commodity on Wall Street; it?s what they sell, so it?s also what they have to pay for."

"With all senior managers of Goldman taking home a $600,000 salary, an equal split of 30 percent of $1.65 billion would be worth almost $2 million, pushing their pay into the neighborhood of $2.6 million."

I always hate these articles as they always remind me how little I make. Oh well. LOL

Monday, November 28, 2005

New Email Service

Once again you guys have come to the rescue!

I mentioned that many people had requested an emailed newsletter since they could not access blogspot from work. Jeff from MBA Depot suggested Feedblitz. It is great. It allows you sign up and receive emails of the most recent blog entries.

In their words:
"It's easy too! No gurus required. The basic service is free to all - no restrictions, no ads. Plus, you can subscribe to any blog or RSS feed by email with FeedBlitz, even if that blog does not use FeedBlitz itself."

You should notice a sign-up box on the right of the blog (at least in Firefox, it sometimes is near the bottom in Internet Explorer). All you have to do is to enter your email address and click on the link they provide for you in email! So easy!

here, I will replicate the box here as well:

Enter your Email

Powered by FeedBlitz

Hope this helps. I will still try to get the newsletter out, but this will be a useful alternative!

Sunday, November 27, 2005 : SmartMoney Interview: Nassim Taleb

If you have never read Fooled by Randomness, you owe yourself a present for the Holidays. found an interview with the aurthor Nassim Taleb. Good stuff.

Short version of the book: many traders are just lucky and they take way too many chances because they think they are good. : SmartMoney Interview: Nassim Taleb: "Good call TaylorTree for spotting this interview in SmartMoney and alerting me to a recent addition to Taleb's website, Quick Notes and Comments in the Old Style (not quite a blog). You might also be interested in this article from Fortune Magazine teaming Taleb with Mandelbrot. Quite a combination: How the Finance Gurus Get Risk All Wrong. "

Thursday, November 24, 2005

Writely - The Web Word Processor

Eric Briys did it again! The person who turned me onto blogging and the person behind Cyberlibris and the cyberlibris blog sent me a note today mentioning

I checked it out and wow! It is so cool. It is an online word processor that multiple people can use at the same time. It will be perfect for co-authoring papers etc. Indeed, you can pretty much make it a "wiki" world.

I have several uses (in and outside of finance) already ready to go.

Check it out. I bet you will be as excited as I am about it!!!

Tuesday, November 22, 2005

Update on things

Sorry I have been such a spotty poster of late. Between travel, tests, my own research, and other things (including a dog that got into macadamian nuts--a definite no-no!), I have not had much time.

just some quick updates on various topics:

1. Due to several requests (especially on the NYC trip) I will somehow be bringing back the newsletter yet again. It is such a pain to do, but there does seem to be a demand for it, so I will figure out a way. Look for it soon.

2. I am sure you will hear about it again from me, but if you can, get down and help out in the Gulf Coast region. It really was devastated and they can use our help. If you want, come with us. Bonaventure Responds is the name of our group that is going down over spring's midterm break (March 4-12, 2006). Even if you can only be there for a portion of the time, you will not regret it!

3. The Southern Finance Association meetings were ok. The resort was not ready for us and many people did stay away in the wake of Wilma, but there were several good papers presented.

more after class...

Wednesday, November 16, 2005

Gone for a few days

I am off to the Southern Finance Association meetings. I will be back on Friday. (yeah short trip). Depending on how much time is available and connection speed, I will try to give updates from the conference. But no guarantees.

Monday, November 14, 2005

Nasdaq to allow 1,2,3 letter symbols

Well, you can keep your phone number when you change carriers, so why not your ticker if you change markets?

Latest News and Financial Information |
"From Jan. 31, 2007 it will be able to support one-, two- and three-character stock symbols for Nasdaq-listed and NYSE-listed stocks, in addition to the four-character symbols it currently uses.

The single-character stock symbol carries a degree of prestige. It is held by NYSE-listed companies such as Ford Motor Co. (F.N: Quote, Profile, Research) and Citigroup Inc. (C.N: Quote, Profile, Research) .

Nasdaq, which competes agressively against the NYSE for listings, said the symbol that a market assigns to an issuer 'should be transferable to a competing market if that issuer chooses to switch...'"

Capital structure lesson

It worked!

Want to hear a class? Here is my finance 401 class lecture on capital structure. Some studnets actually asked me to put them online :)

This is a senior level course.

Take a listen ;)

Thursday, November 10, 2005

At the request of the authors

The post on abnormal returns accruing to elected officials was removed at the request of the authors.

Tuesday, November 08, 2005

Voting and Rationality

In much of the US today is Election day, so I will devote some time to politics and how it can be used to demonstrate finance (and economic) topics.

In the first of two blog entries dealing with politics, we will begin off with a seemingly simple question: Why vote?

It is a question that has pained economists for years. Why? The odds are very very high that you will not be the marginal voter (i.e. the election results would thus be the same whether or not you voted) and yet the cost of voting falls on the shoulders of the voter (no benefit, high cost).

So why vote? Writing in the NY Times, Stephen Dubner and Steven Levitt (who show good spelling diversification of their first names) examine the question and come to the conclusion that people vote so that they can be seen voting. I would take it a step further and suggest that this is only a portion of it. They also vote so they can feel good about what they did (or else why would so many absentee ballots be cast?), so while they may not feel AS good if no one sees them, they still feel better (to think of it in the form of a regression, it has a positive coefficient).

A couple of “look-ins” from their article:

“Why would an economist be embarrassed to be seen at the voting booth? Because voting exacts a cost - in time, effort, lost productivity - with no discernible payoff except perhaps some vague sense of having done your "civic duty." As the economist Patricia Funk wrote in a recent paper, "A rational individual should abstain from voting."”

They then examine a study of voting habits in Switzerland when voting by mail became allowed:

“Every eligible Swiss citizen began to automatically receive a ballot in the mail, which could then be completed and returned by mail…..Never again would any Swiss voter have to tromp to the polls during a rainstorm; the cost of casting a ballot had been lowered significantly. An economic model would therefore predict voter turnout to increase substantially….In fact, voter turnout often decreased….”


“It may be that the most valuable payoff of voting is simply being seen at the polling place by your friends or co-workers.”

Which is interesting in and of itself, but I think may have finance implications as well. Voting is a good example of how what we (if I can allow myself to be called an financial economist for a moment) often deem irrational behavior. But when viewed from a total utility point of view (“I feel better when I vote, so I vote”), It may be perfectly rational to vote.

This is not unlike my views of some behavioral finance hypotheses. From a strict risk and return perspective, investor behavior does often appear irrational, but investors, like voters, may gain some psychic satisfaction from their behavior. Thus from a perspective of utility maximization, the investor may still be acting perfectly rationally. Unfortuntely, this is MUCH more difficult to measure than risk and return.

Monday, November 07, 2005

How 1+1+1+1 Can Equal Less Than 4 - New York Times

This was in yesterday's NY Times. It is another supporting article for the diversification discount.

How 1 1 1 1 Can Equal Less Than 4 - New York Times:

"over the long haul, conglomerates, on average, perform worse in the stock market than the typical focused company. One likely cause is that they tend to do a poor job of allocating capital among their various divisions. Of course, if those units were separate publicly traded companies, the market itself would be making the allocation decisions. And it stands to reason that the overall market is a better administrator in this regard than the average corporate manager."

A study conducted by David S. Scharfstein, a finance professor at the Harvard Business School, offers evidence of inefficient capital allocation among widely diversified companies. Professor Scharfstein found that managers of conglomerates generally felt compelled to invest something in all of their divisions, regardless of the divisions' growth potential - a phenomenon that he calls intrafirm "socialism." Because of it, conglomerates tend to invest too much in divisions with low growth potential and too little in those with high potential."

"Professor Scharfstein's research was conducted for the National Bureau of Economic Research; a copy of his study is at [ssrn]."

Yet another example of a perfectly timed article. Just today in class we were speaking of the problems with internal capital markets!

International Calendar Effects

"December and January Effects around the Globe: Evidence from US and International Panel Data"

Salimi, Wang, Yakovlev, and Roychoudhury provide further evidence that the January and December effects. The authors describe these effects as:
"When investors do not sell winner stocks in December but postpone their sale to January so that capital gains will not be realized in the current fiscal year, the "winners" appreciate in December. This is called the December effect.

The January effect is the tendency of the stock market to rise between December 31 and the end of the first week in January. The January Effect occurs because many investors choose to sell some of their stock right before the end of the year in order to claim a capital loss for tax purposes."
While this has been exained before, this paper brings some more sophisticated mathmatical tools into play. And their findings?
"The general conclusions that can be drawn from our estimates are that there exist significant December and January effects, and the momentum (represented by cumulative returns), liquidity, and tax incentives are among significant factors affecting monthly returns in the US stock market."
Which supports the previous understanding perfectly.

Salimi, Wang, Yakovlev, and Roychoudhury. December and January Effects around the Globe: Evidence from US and International Panel Data. 2005, Working paper:

Why indexing is less controversial now

Joanthan Clements has long been one of my favorite WSJ writers and once again he nails it! In his most recent article (Nov. 6, 2005) he suggests that the reason indexing has finally caught on is because brokers and advisors no longer have as much of an incentive to fight it. - Getting Going: "Yet the widespread acceptance of indexing has come only in the past few years. Indeed, as recently as five years ago, I would be inundated with scornful phone calls, letters and emails whenever I recommended index funds. Today, I don't get that reaction"

Why? In his words:

"I think the acceptance of indexing has been driven by two key developments: The proliferation of exchange-traded index funds, often known as ETFs, and the emergence of fee-only financial advisers."

Brilliant! Read the article! In fact, if you are in my class, definitely read the article! But be forewarmed, the article will not stay online for long.

Friday, November 04, 2005

CFOs tell us what they think of SOX

Survery of CFOs on SOX

I will start this one with my standard discalaimer whenever I review a paper that is based on a survey data: be forewarned, survey data is often notoroiously inaccurate and biased. Thus, view the folloiwng with a good deal of skepticism.

The warning given, the paper itself is intersting. Peng, Dukes, and Bremer survey 1,312 CFOs who were in the Financial Executives International (FEI) database as of May 24th, 2005. Of course, the vast majority did not reply, but they did get 83 responses (6%).

So remembering the above disclaimer, How did the CFOs respond? Prett much as expected, they hate it! (which is exactly what I hear every time I speak with any of the CFOs I know.)

From the paper:
"...the approximate annual average cost of compliance to a company in our sample is estimated to be $1.77 million....More than 50% of the CFOs in our sample report that the cost estimate of compliance with the Act is between $500,000 and $3 million."
About 60% say that the costs of complainace outweigh the benefits.

Other interesting findings:
* "unlike Linck, Netter, and Yang (2005), we find that there is not any significant change in the following aspects of corporate governance practices due to the enactment of the Act since July 2002:"
There were some before/after differences however.

The paper reports that more firms are using independent audit committees and have more financial experts on the committee since teh adoption of the law. Moreover, more firms have adopted a code of ethics (80 of 83 repsonders said they do now, where only 57 did prior to SOX).

* The act has created jobs for accounting professionals: "The average number of staff that companies in our sample have to hire to deal with Section 404 compliance is 3.61 with the median value of five. The extreme cases are that two firms have to hire an additional 25 employees for Section 404 compliance."

What may be the most interesting however are the comments the authors received from CFOs. I will quote one to whet your appetite:
"“This Act was horribly overreaching. It is costly, and there is very little/absolutely no cost benefit relationship. The Act and, specifically, the Section 404 requirements, will do little, if anything, to deter the "crimes"/"irregularities" it was intended to deter/preclude. Management override is the biggest issue, and the Section 404 requirements hardly address that issue. It is a complete waste of time and money. PCAOB is ineffective, at best. Their "investigations" of the Big 4 firms is a joke, and the Big 4 firms don't know what to do or how to do it in complying with the Section 404 audits. They (the Big 4 firms) gouged "corporate America" in the purported "audits" of the control environments, using no/very little professional judgment in the conduct of their examinations. And I spent over 30 years with a Big 4 firm, including over 20 as a Partner.”"
uh, could you tell us what you really think?

Interesting article. It is still being revised and the authors have asked for comments, so if you have a few minutes, whay not send them your thoughts. And tell them you first saw the article here ;)


Who is Jay Cooke?

Looking for an unsung hero of the US Civil War? You could do much worse than picking Jay Cooke.

Jay Cooke was what we would now call an investment banker.. He had made quite the name for himself selling all types of securities but especially state bonds---his Pennsylvania and Texas bond sales are particularly interesting and could be the focus of a future entry just by themselves

Cooke did things differently than most bankers at the time. Whether by necessity or plan, he marketed his securities directly to the people. Additionally he played on not only their desire for a good deal, but their patriotism.

For instance, a typical advertisement that he ran in newspapers:

“…independent of any motives of patriotism, there is considerations of self-interest which may be considers in reference to this Loan. It is a six percent loan free of any taxation”

While his pre-war career had been successful, he should be most remembered for his work during the Civil War. Starting in 1862 (after the Union lost the Battle of Bull Run), he helped sell several large Federal bond offers that literally helped to win the war by allowing the North to outspend the South. This ability to spend seemingly endless amounts of money, was a major determining factor in the North's eventual victory.

The details of his sales are fascinating. His place in history is guaranteed for his paving the way for future generations of “war bonds” and helping to open the world of finance to a much broader audience—a fact that during the later 1800s the railroads would use to their advantage). To help make these bonds available to the general public, he made bonds available in with par values as low as $50 and instructed his network of offices to remain open well into the evening so that the “working man” could invest after work.

It should be noted that these were not just “plain vanilla” bonds. He was selling debt that was callable and had a longer maturity (up to 20 years) than most debt of the day.

But that is not all; he also ran what some consider to be the first “wire house” whereby his firm used telegraphs to sell securities throughout the North from their office in Washington.

And even after the actual fighting ended (a time when the Union needed millions of dollars to help rebuild) he kept at his original ways (which angered the more traditional bankers) and now gets credit for initiating price stabilization (a practice whereby the investment banking syndicate enters the secondary market and helps to stabilize the price of the security they just helped to sell to the public).

There is today a middle school named after Cooke in Philadelphia.

Source: Wall Street: a History From Its Beginnings to the Fall of Enron, by Charles R. Geisst, pp. 49-58.

Additional sources:

Thursday, November 03, 2005

FRB: Speech, Ferguson--Monetary Credibility, Inflation, and Economic Growth--November 3, 2005

Very useful for a money and Banking class!
FRB: Speech, Ferguson--Monetary Credibility, Inflation, and Economic Growth--November 3, 2005:
"By now it must be universally agreed that low and stable inflation is a primary and essential goal for monetary policy, in large part because we believe it brings stability to financial systems and fosters sustainable economic growth over the longer run. In pursuit of this goal, central banks can report some success. According to the latest World Economic Outlook from the International Monetary Fund (IMF), consumer price inflation in the advanced economies over the decade beginning in 1997 and ending next year looks set to come in at an average annual rate of less than 2 percent, down from 3-1/2 percent for the previous ten years. The IMF figures for the United States show a smaller but still substantial decline in headline inflation, from about 3-3/4 percent to 2-1/2 percent. The drop in inflation for the non-industrial economies has been more striking, with average inflation falling from double to single digits over the same time periods"

Leverage and Investment

Leverage and OVER investment--Yet another "ARGHHHH--why didn't I think of that!" paper

Showing that leverage leads to underinvestment is standard fare for any corporate finance class. Indeed, I had planned on doing it today. However, as Lyandres and Zhdanov point out, it might be better to say that leverage influences investment, but that the direction of the bias is firm-dependent (which once pointed out is very obvious, but I for one have not considered it!).

Super short version: The option to delay investment is only valuable for firms that will be around. Excessive leverage increases the likelihood of bankruptcy (where shareholders are likely to lose their claim) so levered firms will be biased to invest in projects earlier than a similar all-equity firm.

Longer version: Myers (1977) made an important contribution by showing that leverage can lead to underinvestment because shareholders will opt to not invest in projects if the firm is near bankruptcy and the results of the investment would accrue to debt holders. This idea was widely picked up on in the field and is now widely used to explain why growth firms have less debt than firms with "assets-in-place."

Lyandres and Zhdanov show that this underinvestment is only part of the story. Leverage can also lead to an "overinvestment" problem whereby firms speed-up their investment to realize teh gains prior to a potential bankruptcy.

In the authors' words:
"a firm may optimally delay an investment in a positive NPV project, if by waiting and making the investment at a future date, it is able to increase the value of the investment opportunity. In other words, the value of the option to wait must be taken into account when accessing the profitability of a project. However, when a firm is financially levered, its shareholders face the threat of bankruptcy. Upon bankruptcy, the control of the firm passes over to the debtholders. Hence, if bankruptcy happens, the shareholders lose the option to realize their investment opportunities. This is true regardless of whether bankruptcy is exogenous or endogenous. Thus, the presence of debt makes the option to wait less valuable, and forces the equityholders to speed up the investment, leading to a positive relation between the firm’s financial leverage and its investment intensity. Therefore, this overinvestment effect works in exactly the opposite direction from Myers’ (1977) underinvestment effect."
Which once pointed out is obvious. However, we owe the authors a debt for pointing this out to us! So from all of us, THANK-YOU!

Cite: Zhdanov, Alexi and Evgeny Lyandres, Underinvestment or Overinvestment? The effect of Debt Maturity on Investment, Southern Finance Meeting paper (Upload date: Nov 02, 2005).

Topic: Corporate, Leverage, Real Options

Higher moments and finance

Incorporating Higher Moments into Financial Data Analysis--James M. Sfiridis

Oh boy, here we go! Hold on tight and let's tag along for the ride. This could change some things!

Virtually everything we do with respect to risk and return centers on the assumption of normality (that is that the normal distribution correclt explains returns, or minimally the log of returns).

The problem is nearly perfectly laid out in the opening paragraph of the paper:
"There is ample empirical evidence that the distribution of short-term security returns, e.g., daily, weekly or monthly, is non-normal (Mandelbrot, 1963; Fama, 1965; Campbell, Lo and MacKinlay, 1997). Such data are inadequately described by linear models commonly used in financial economics that assume a normal data-generating process (DGP). For example, return outliers occur with much greater frequency than would be expected assuming normality, resulting in fat-tailed distributions described as leptokurtotic in the fourth moment. Additionally, returns may exhibit asymmetry, having the tendency for either positive or negative returns to persist for any number of reasons (Campbell, Lo and MacKinlay, 1997). This phenomenon of return “clustering” results in skewness in the third moment and has been studied by Conine and Tamarkin (1981) and Harvey and Siddique (2000)."
While I will leave the more rigorous math to the paper itself, but the basic idea is that author uses a Markov Chain Monte Carlo simulation to account for the higher moments needed to describe a non normal distribution. Using a simulation also allows for tests of whether these high moments matter.

The answer, in a word, is 'yes'.

In the paper's words:
"Bayesian sampling-based Markov chain Monte Carlo (MCMC) methods are used in this paper to estimate an extension of the normal model by using a modification of the normal likelihood function presented by Fernandez and Steele (1998), henceforth known as FS, that incorporates all four moments of the underlying return DGP."
Building on a great deal of past work in the field that examines higher moments, the author looks specifically at CAPM and equity risk premums.

The findings? I will allow Sfridis conclude:
"In this paper Bayesian-based Markov chain Monte Carlo (MCMC) analysis is used to estimate a non-normal likelihood function that effectively specifies the return DGP by the explicit incorporation of higher moments. The significant effect of higher moments on testing of the [Sharp-Lintner] CAPM has been illustrated. Results show that model testing requires incorporation of more complete return information as summarized by the higher statistical moments, leading to possibly contrary conclusions from those obtained under an assumption of normality. A second exercise considers specification of the non-normally distributed market risk premium. Incorporation of additional information contained in the higher moments can yield nearly equivalent point estimation to that from re-specification of the first two moments that implicitly account for excess skewness and kurtosis. However, a major advantage of accurately re-specifying the model is the greater precision of resulting parameter estimates."
Which definitely deserves a wow! While the temptation might be to overlook such a finding because of its complexity, it could be why so many of our theortcial models do not stand up to empirical tests. Which is obviously VERY important!

James Sfiridis, "Incorporating Higher Moments into Financial Data Analysis"
(Upload date: Aug 16, 2005)

Tuesday, November 01, 2005

Delaware Incorporation and Bonds

"Does Delaware Incorporation Affect Bondholder Wealth?"
by Francis, Hasan, John, and Waisman.

First the answer: Yes.

Bonds rarely spark the interest of stocks, but this one is sort of cool.

Francis, Hasan, John, and Waisman examine the interest rates spreads of corporate issues based on where companies are incorporated. They find that firms that are incorporated in Delaware pay a penalty (in the form of higher rates) for being under Delaware's corporate rules.

In their words:
"We find that Delaware incorporated firms are associated with higher yield spreads in comparison to non-Delaware firms. Specifically, on average, the difference between bond yields due to Delaware incorporation can be as high as 25 basis points when we compare Delaware to Ohio, Pennsylvania or Massachusetts incorporated companies, which are well known for antitakeover laws that protect managers"
This is consistent with the idea that takeovers can reduce bondholders' wealth and reiterates the view that how contracts are structured (and where!) does influence firm value.

The authors also examine equity returns around debt issues across different states of incorporation. They find that the state of incorporation also may be a factor in determining equity returns around debt issues. This response is attributed to lower costs of debt capital stemming from the reduced agancy cost of debt in these states. Again in their own words:
"stockholder wealth enhancement hypothesis contends that state antitakeover laws would benefit stockholders and increase the value of the firm by lowering the firm’s agency costs of debt. In general, the conflicting interests of bondholders and stockholders may cause two types of agency problems. First, a risk incentive (asset substitution) problem.....If bondholders anticipate this action on the part of stockholders, they demand a higher interest rate to account for the greater risk they encounter, and are willing to pay less for the bonds at the time of issuance, which leads to a reduced value of the firm (Kahan and Klausner, 1993). Second, an underinvestment problem occurs if the value of the firm’s investment opportunities is revealed to be less than the face value of the maturing debt plus the costs of undertaking the investment project (Myers, 1977).
Which is pretty standard for any corporate finance class, but the finding is then surprising.
"we find that, on average, firms incorporated in states with stronger takeover laws, such as Ohio, Pennsylvania and Massachusetts, experience positive abnormal stock returns around the announcement of bond issuance, whereas firms incorporated in states which offer relatively milder takeover restrictions, such as Delaware, experience significantly negative abnormal returns around the bond issuance event, consistent with the stockholder wealth enhancement hypothesis."
Their overall conclusion however:
"...although as far as shareholders are concerned, it is yet unclear whether Delaware wins a race to the top by addressing their rights or a race to the bottom by addressing the needs of management, as far as bondholders are concerned, Delaware ultimately wins a race to the bottom. These findings strongly suggest that it is important to look at the total effect of governance terms, including state laws, before drawing conclusions on regulatory and security design policies, and that it is important to evaluate these laws considering all majorcorporate stakeholders.

Bill Francis, Iftekhar Hasan, Kose John, and Maya Waisman.
"Does Delaware Incorporation Affect Bondholder Wealth?"
(Upload date: Aug 17, 2005).

Monday, October 31, 2005

Is long run IPO underperformance driven by lack of liquidity?

Is Long-run IPO underperformance driven by lack of liquidity?

What a roll! Maybe it is time to talk about momentum blogging! ;) Yet another cool paper!

Roychoudhury and Abbott tie long run underperformance of IPOs (See Ritter 1991 or Loughran and Ritter 1994) to a lack of liquidity (the Amihud and Mendelson 1986 idea).

In Roychoudhury and Abbott's own words:
"We construct portfolios of IPOs with positive and negative excess liquidity during the first year after IPO issue. While overall we find IPO underperformance in the long run, we show that positive and negative excess liquidity portfolios perform differently. We show that positive excess liquidity portfolio underperforms the negative excess liquidity portfolio during next few years. We show that the above effect holds for portfolios constructed in the event time and in calendar time, for equally weighted and value weighted portfolios, and for size or industry benchmarks....Our result has significant implications about the role of observed
liquidity as an indicator of future returns."
To dive in a bit deeper:

* The paper "support[s] the contention that portfolios of more liquid stocks on average provide investors with significantly lower returns than more illiquid stock portfolios even after adjusting for risk. We find IPOs underperform in the long run even after the accounting for liquidity, industry, size, market and year effects."

* The paper uses two measures of liquidity: the so-called standard "spread" based measure as well as a new measure Lambda which is based on turnover and price. Again in the authors' words (see the paper for a more detailed description!)
"lambda is a measure of the observed level of liquidity, with higher levels signifying that the current order flow in the market can absorb larger volumes of trading without impacting prices."
Cool paper! I can not wait to see what this does to other "anomalies" and even pricing models in general! (come on CAPM ;) )

"Revisiting Liquidity Underperformance: Excess liquidity Effect"
(Upload date: Oct 10, 2005) Saurav Roychoudhury and Ashok Bhardwaj Abbott.

Wednesday, October 26, 2005

SSRN-Corporate Governance and Acquirer Returns by Ronald Masulis, Cong Wang, Fei Xie

SSRN-Corporate Governance and Acquirer Returns by Ronald Masulis, Cong Wang, Fei Xie:

Some takeovers are good (value enhancing), others are bad (value destroying). Why the difference? One easy explanation is that managers often have incentives (such as empire building, hubris, pay tied to size, ego, diversification) to do a merger that is not in shareholders’ best interests. Masulis, Wang, and Xie examine this by looking at the returns to acquiring firms and relating these returns to the corporate governance in place at the firm.

To some degree the market for corporate control and corporate governance at the firm itself can force managers to look out for shareholders. Thus firms with anti-takeover provisions (ATP) in place make good candidates for areas where managers might be more tempted to do acquisitions that increase managerial well-being at the expense of shareholders.

Examining over 3000 acquisitions from 1990 to 2003, Masulis, Wang, and Xie find strong support for this hypothesis. In their words:

“More specifically, acquisition announcements made by firms with more ATPs in place generate lower abnormal bidder returns than those made by firms with fewer ATPs, and the difference is significant both statistically and economically. This result holds for all the corporate governance indices or subsets of ATPs we consider and it is robust to controlling for an array of other key corporate governance mechanisms, including product market competition, CEO equity incentives, institutional ownership, and board characteristics."

Simply put, this is more evidence that not only are antitakeover provisions bad for shareholders, but it shows a specific path by which these diminish shareholder wealth.

Not centent with just one important finding, the authors also look at other control or governance mechanisms on the premise that if ATPs lower returns, good governance measures will increase acquiring firms' returns. They also find support for this hypothesis:

"acquiring firms operating in more competitive industries experience higher abnormal announcement returns, as do acquirers that separate the positions of CEO and chairman of the board."

An I^3 paper! It definitely deserves a WOW!


Masulis, Ronald W., Wang, Cong and Xie, Fei, "Corporate Governance and Acquirer Returns" (August 22, 2005). AFA 2006 Boston Meetings Paper

Tuesday, October 25, 2005

SSRN-Strength of Analyst Coverage Following IPOs by Christopher James, Jason Karceski

James and Karceski report that firms who have poor IPO performance get more than just price stabilization in the after market. However, while price stabilization tends to end relatively quickly, the firms whose IPO did poorly also get longer term more favorable coverage in the period following their IPO. This supports the "booster shot" hypothesis.
"Firms with poor aftermarket performance are given higher target prices and are more likely to receive strong buy recommendations, especially by analysts affiliated with the lead underwriter. This favorable coverage is relatively short-lived, lasting for only the first one or two analyst reports, typically less than six months."
What is so cool about this finding is that James and Karceski do not find the same degree of positive recommendations for stocks that went up immediately after their IPO. This finding is important for it seemingly differentiates the momentum stories from the so-called "booster shot" explanation.
"Another alternative is that analysts pre-commit to provide more than a favorable recommendation. As suggested by Michaely and Womack (1999), analysts may commit to provide a "“booster shot"” by increasing the strength of their recommendation in the face of an unfavorable market response to the IPO. This argument suggests a negative relationship between strength of affiliated coverage and stock price performance."
The findings?
"Lead analysts post much higher relative target prices for IPO firms that
have non-positive initial returns and for firms that trade at or below the IPO offer price when coverage is initiated. For these broken deals, lead analyst target price ratios are on average more than 26 and 36 percentage points higher than target price ratios for firms with zero or negative initial returns or for firms with non-positive return to coverage."
To control for the "of course it is not a strong buy, it has already gone up" phenomena, the authors use a group of analysts that were not associated with the IPO. The authors find that analysts associated with lead underwriters are more positive on the stock (which is consistent with the booster shot hypothesis):
"Lead analysts are also more optimistic relative to other analysts in broken deals in their recommendations as well. The average lead analyst target price ratio for broken deals is 14 percentage points higher than the average target price ratio set by other analysts."
Interestingly the ranking of investment bankers seems to matter (or at least the ranking of their clientele).
"Virtually all (96%) of the 85 broken deals underwritten by a top-ranked underwriter received coverage. In contrast, only 53% of broken deals underwritten by less prestigious underwriters received coverage. The percentage of IPOs underwritten by top-ranked underwriters that receive coverage does not differ significantly by whether or not the IPO is a broken deal. In contrast, broken
deals underwritten by less prestigious underwriters are significantly less likely to receive coverage than successful IPOs underwritten by less prestigious underwriters (the t statistic is -3.68). Thus, one reason to use a top-rated underwriter appears to be a higher likelihood of analyst support if returns are poor in the aftermarket."
Very interesting.

James, Christopher M. and Karceski, Jason J., "Strength of Analyst Coverage Following IPOs" (February 28, 2005). AFA 2006 Boston Meetings Paper

Monday, October 24, 2005 - Money - Report: Bush Set To Name Bernanke As New Fed Chief

Seemingly a very good choice! - Money - Report: Bush Set To Name Bernanke As New Fed Chief: "We're expecting to hear later today who the White House wants to succeed Alan Greenspan as head of the Federal Reserve.

An announcement is expected at 1 p.m. EDT.

Greenspan has been expected to leave his post as the nation's top central banker at the end of January."

Do managers play games with R&D?

What an interesting paper!

As most anyone in industry will tell you, managers often play games with R&D spending. Whether it is for their own "pet projects" or to further some cause within the firm. Of course, this should not be surprising as no where are information assymetry probelms more severe than in R&D spending.

Bange, De Bondt, and Shrider
now provide empirical evidence of this game playing with respect to managers trying to "manage" earnings. This is because R&D expenditures (for which there is much discretion as to the timing) lower earnings.

The authors find
"find ample evidence suggesting that executives, on average, distort R&D investment decisions so that they may improve their chances of meeting analyst expectations."
This finding, which is based on firms with large R&D spending over the past two plus decades, is consistent with previous survey based work (for instance Graham, Harvey and Rajgopal’s (2004)).

VERY interesting and important work.

Bange, Mary M, Werner F.M. De Bondt, and David G. Shrider, FMA Working paper, 2005.

Good example of diversification discount

Cendant is giving us a near perfect example of the diversification discount. The basic idea is that firms sell for less when they are made up of multiple lines of business. This has been the a edbate as to whether this is real or whether we are measuring the wrong thing. For instance we do not see the firms' apart from the start.

That said, it appears that most now acknowledge the existence of a discount. Cendant, after denying it for years, is now talking about splitting itself up to remove the discount.

Independent Online Edition > Business News : app4: "Cendant Corporation, the US group that acquired ebookers last year, is considering breaking itself up to unlock the hidden value in its travel and property arms.

The move would be the culmination of its attempt to focus on its core businesses"

Thursday, October 20, 2005

Equity Risk Premium

It is not new, but we just covered it in class and I think many of you might be interested. It is a brief overview of the Equity Risk premium through time by Clark and Silva.

Short version: Expect the equity risk premium to be lower moving forward.

From the paper:
"Expectations for the long-run equity risk premium play an important role in asset allocation decisions because the policy asset mix between equity and fixed income depends on the tradeoff between expected return and risk. The higher the expected equity risk premium the more equity will be held in the portfolio. To give some perspective about what might be reasonable to expect in the future, we first show historical values for the U.S. equity risk premium. Second, we break the equity risk premium into its component parts and suggest some reasonable values for the components going forward. Finally, we present expectations from several other written sources."
I especially suggest you look at page two; the tables are excellent for class!

Wednesday, October 19, 2005

Monday, October 17, 2005

What a great site!

When I was gone I recieved a message from the authors of Corporate Finance by Vernimmen, Quiry, Le Fur, and Salvi.

The book, newsletter, and website are all very interesting and useful.

The book is 48 chapters (about 1000 pages) full of corporate finance. I have to agree with the authors "It is a book in which theory and practice are constantly set off against each other...."

I really like it. Especially the emphasis not so much on techniques ("which tend to shift and change over time."


Moreover, the authors also put out a monthly newsletter and have a web site that could stand alone as one of the best in the business.

Check it out!

Sunday, October 16, 2005

I'm back from Biloxi

Well that was quite a week! All I can say is that the destruction in the Gulf Coast region from Hurricane Katrina is awful. I went to Biloxi MS with a group from SBU. We worked with HandsonUSA.

I have uploaded many pictures and am in the process of posting essays on what it was like.

I would encourage you all to volunteer down there. If you are interested, a large group of us are going down over Spring Break (March 4 to March 12). Email me if interested.

I have several finance oriented posts almost ready. However, I also have much correcting to do, and school work must come first :( so it may be a day or two.


Thursday, October 06, 2005

Does a "no vote" matter?

Continuing our look at some papers from the FMA Meetings, Del Guercio, Wallis, and Woidtke give us a look at whether boards of directors actually listen to their voting shareholders and if they do hear shareholders, what the reaction is.

The answer may surprise you!

From the abstract:
"Overall, our findings support the argument that existing tools are insufficient to induce pro-shareholder change at highly resistant firms. In fact, firms targeted by vote no campaigns are more likely to add management friendly charter provisions and takeover defenses, suggesting that these firms feel threatened by the campaigns and negative publicity."

A bit more on the paper:

The basic issue that is investigated is whether no votes that lack a majority matter. The authors find that they do matter, but unfortunately, the votes actually may make things worse!
"in practice shareholders cannot legally remove a director that fails to act in their interests short of waging a costly proxy solicitation contest. Even a majority of shareholders ‘voting against’ a director would not result in his removal from the board because directors almost always run unopposed and only require a plurality of shareholder votes to be elected."
So what can shareholders do if the board candidate is running upopposed?

"While shareholders cannot technically vote against a director running unopposed,they do have the ability to withhold their vote from one or more directors up for election, and the right to publicly and privately encourage other shareholders to do the same. Thus, a substantial ‘withheld vote’ in a director election is another mechanism for shareholders to communicate their dissatisfaction. Some argue that a substantial withholding of the vote is enough of a public embarrassment to generate an immediate board response to shareholder concerns, and thus current tools are sufficient. The public spectacle associated with the recent annual meeting at Walt Disney Co is a case in point."
However, this paper finds that Disney was the exception and not the rule:
"Overall, our results provide little support that vote no campaigns are motivated by special interests, but do support the argument thatexisting tools are insufficient to induce pro-shareholder change at highly resistant firms."
Definitely an interesting finding. While it makes perfect sense, I had hoped that the negative publicity surrounding these events would have been enough of a "kick in the pants" to get boards to watch out for shareholders. Apparently the opposite is true. The "kick in the pants" is just enough to create a bunker mentality where the boards move further from shareholder interests.

Stay tuned, I predict more work in the area. The authors have brought up some interesting questions!

Del Guercio, Diane, Laura Wallis, and Tracie Woidtke. Do Board Members Pay Attention When Institutional Investors 'Just Vote No'?, (2005) FMA paper.

TradeSports Pays a fine to CFTC

Thanks to Chris Masse for pointing me to it this interesting story. TradeSports got fined for trading option contracts to US citizens without regulatory approval and oversight.

From the CFTC's press release:
"The U.S. Commodity Futures Trading Commission (CFTC) today announced the filing and simultaneous settlement of charges under the Commodity Exchange Act (CEA) that Trade Exchange Network Limited (TEN), a limited liability company based in Dublin, Ireland, solicited and accepted orders from U.S. residents for commodity option contracts that were not excepted or exempted from the Commission’s ban on options. TEN owns and operates an Internet-based trading platform that facilitates trading through its websites,, and"
The full statement.

By the way, Tradesports and other so-called decision markets are an excellent way to learn about how markets work. For instance how neew information gets incorporated into the price.

The American Academy of Accounting and Finance :: 2005 Annual Meeting

Katrina shut down New Orleans, so there is a new locale for the American Academy of Accounting and Finance annual conference.

Just announced:

"The American Academy of Accounting and Finance will hold its 12th annual meeting in St. Pete Beach, Florida, on December 8, 9, and 10, 2005."

For more information check out their website.

Tuesday, October 04, 2005

St. Bonaventure students join relief teams

This has almost no finance content, but it is about our finance club, so some of you might be interested. It is from the Olean Times Herald.

Bradford Publishing - HOME - 10/03/2005 - St. Bonaventure students join relief teams: "the St. Bonaventure Finance Club, along with members from Students in Free Enterprise, plan to take a trip to Mississippi during their mid-term break, scheduled from Thursday through Oct. 11.

The students, ... are traveling to Gulfport, Miss., in conjunction with HandsonUSA, "

Which partially explains the paucity of posts of late.

Cash Holdings and Governance

What better way to start our look at conference papers than by a paper on Cash Holdings and Corporate Governance by Jarrad Harford, Sattar A. Mansi, and William F. Maxwell that will be in the first session of the FMAs in Chicago.

Short Version:
The authors use a corporate Governance index to examine cash holdings by firms. They report evidence that firms with weaker governance waste the cash faster.

Longer Version:

Is cash good or bad? The correct answer is Yes. It is both. I'll be lazy and quote my dissertation:
"Two theories have been used to explain cash’s role decision making. The first, and more widely accepted model, is an agency costs theory. This agency theory, typically called the “free cash flow problem” and generally credited to Jensen (1986), holds that excess cash is detrimental to shareholders because managers will waste it through overinvestment and diversifying acquisitions. Not everyone believes this agency cost theory is a good explanation of reality. Skeptics claim that you cannot have too much of a good thing, and cash is a good thing because it allows firms to avoid the costs, mispricing, and delays involved in a security issuance. This second position, called the market friction theory is widely cited by managers as the reason for holding large cash positions. "
If you are like me and largely accept the agency cost explanation, then at first glance it may appear surprising that Harford, Mansi, and Maxwell find that firms with poor corporate governance (as measured by the the Investor Research Responsibility Center) have small cash reserves:
"We start with the hypothesis that stronger shareholder rights (weaker manager
rights) will lead to smaller cash holdings, all else equal. However, as noted above, we find the opposite."
Why is this the case? It appears that this finding is because the firms with weak governance spend the money faster!

Again in the author's words:
"...for a given set of firms with high levels of cash, all else equal, the firms with weaker shareholder rights will spend that cash morequickly. Our tests show that this spending is primarily on acquisitions."
That firms with higher agency problems spend the money faster would partially explain why some firms, who probably not coincidentally often have high insider ownership--and thus arguably less severe agency problems--Weis and Microsoft immediately come to mind) for years had consistently high levels of cash and yet did not appear to be adversely affected by their holdings.

A few other tidbits from the paper:

*"The results from the models using GIndex segmented into weak and strong governance firms, suggests that firms with strong management rights hold less cash but firms with strong shareholder rights do not hold more cash than the average firm, which indicates a non-linear relation between GIndex and cash holdings."

* The authors make a good attempt at controlling for the endogeniety problem:
"Although we find that the governance index is negatively related to cash holdings, the OLS regressions may not fully account for potential endogeneity in the sample. Modeling the relation between governance and cash holdings may be problematic if there is an endogenous feedback from cash holdings to governance. That is, cash holdings and the governance index are jointly determined....."
They control for this (at least partially) by using the Granger causality tests using lagged governance scores. The finding?
"We find that the governance index is statistically and significantly related, at the 5% confidence level, related to the future cash holdings of the firm. Firms with strong management rights (high GIndex) shed more cash from one period to the next overall our sample period."
* They also examine cash-rich and non cash-rich firms and report important differences that are tied to acquistion activity:
"For the high-cash sample...both weak and strong governance firms revert toward the normal level of cash for their industry. However, the weak governance firms revert significantly faster. For the increasing cash flow sample, we see that the stronger shareholder firms see an increase in their cash holdings. For the weak governance firm there is no increase in their cash holdings and the difference between firms based on their governance score is significant."
Interesting stuff!

Harford, Jarrad, Sattar A Mansi, and William F. Maxwell. Corporate Governance and Firm Cash Holdings, Working paper, 2005.

Also available on Harford's website.

Midwest Finance Association 2006 Annual Meeting

Speaking of conferences, I would be remiss if I did not mention the upcoming deadline for the Midwest Finance Association's annual meeting:

Midwest Finance Association 2006 Annual Meeting: "The Midwest Finance Association's 55th Annual Meeting will be held March 23 - 25, 2006 at the Chicago Marriott - Michigan Avenue in Chicago, Illinois.

The MFA Distinguished Scholar Lecture will be given by .Chicago Marriott - Michigan Avenue

Members and friends of the MFA are invited to submit papers to be considered for presentation at the 55th Annual Meeting. Papers on any topic related to financial economics, financial planning or financial education will be considered. In addition, there will be a symposium of foreign exchange markets. Papers accepted for the symposium will be considered for inclusion in a special issue of the 'International Review of Financial Analysis.' Click for more details. The paper submission deadline has been extended to October 28, 2005."

Finance Conferences: FMA and SFA

Finance conferences are great learning opportunities. Unfortunately the vast majority of people interested in finance do not get to experience these conferences since they are largely for academics.

So, I will try to bring the Financial Management Association and the Southern Finance Association's Annual meetings to you.

Each is an excellent conference and the programs are now online. Over the next few months I will try and review papers from each conference.

So even if you can not be there, you can experience some of the papers.

Monday, October 03, 2005

Busy Day

I may or may not get anything online today. Have to make out a test and finish correcting projects. I will try.

In the meantime, I suggest you check out two recent posts (or collections of posts) at FreeMoney Finance.

1. Is about monkeys investing (it really can not get much better than that!). Short version: Due to market efficiency (or thereabouts) indexing, while not perfect, is good way to invest.
2. A personal finance discussion of debt and how to reduce your debt. Carnival of Debt Reduction

I'll try to post something new material after class today, but no guarantees. Sort fo swamped right now!

Saturday, October 01, 2005

Hurricane Brings Miss. Real Estate Frenzy - Yahoo! News

This is one of those things I realize from an intellectual point of view I should be happy about, but that said, it still saddens me.

From Yahoo News (the AP)
"The Mississippi coast, wracked by Hurricane Katrina, is caught up in a real estate rush, as speculators and those looking to replace their own wrecked homes pinpoint broken and battered waterfront neighborhoods. In the weeks since the hurricane, prices of many homes — even damaged properties — have jumped 10 to 20 percent.

But what Katrina spared, the real estate rush now imperils. The arrival of speculators threatens what's left of bungalow neighborhoods that are among the Gulf's oldest communities, close-knit places of modest means where casino workers, fishermen and their families could still afford to live near the water."

Friday, September 30, 2005

Don't Let Your Portfolio Get Caught Speeding [ Commentary] September 28, 2005

What great timing! We just covered bonds this week in class. So if you are in my class, you better read this one. It reviews the types of bonds and what bonds add to your portfolio.

Don't Let Your Portfolio Get Caught Speeding [ Commentary] September 28, 2005:
"we tend to focus most of our time and energy on stocks, believing that equities are the best way to stay ahead of the erosive effects of inflation and build wealth over time. The staid fixed-income sector, on the other hand, is seldom mentioned with any enthusiasm. It's not that we don't appreciate what bonds have to offer. We discuss their merits from time to time and have even devoted a section of our Investing Basics center to a comprehensive profile of their ins and outs. For many, though, bonds are ...deependable, polite, never reckless ... in a word, boring."

Executive Stock Options and Earnings Management - A Theoretical and Empirical Analysis by Ohad Kadan, Jun Yang

Executive compensation has changed in the aftermath of the corporate governance "crisis" (where we saw Enron, Tyco, Adelphia, WorldCom and others fall precitously due to accounting scandals). One such change is a shift away from stock options. Microsoft is the classic example but many other firms have also scaled back option progams for restricted shares (share that can not be sold for some period).

The restricted shares are better than options view is summed up by the AFL-CIO in a WSJ piece from 2003:
The AFL-CIO has submitted shareholder resolutions at American Express Co. and five other businesses urging a ban on stock options for senior executives and greater use of restricted stock. Labor officials call performance-linked restricted stock "a better motivator of performance," says the AFL-CIO's Brandon Rees.
However, that is not the final word. Kadan and Yang suggest that restricted shares may actaully worsen the earnings management problem and be more costly than traditional option grants.

Executive Stock Options and Earnings Management - A Theoretical and Empirical Analysis

How? They begin by showing that restricted shares are really little more than option grants with a strike price of zero. They then
" that lowering the exercise price (increasing the moneyness) of options intensifies earnings management. Therefore, for the same number of grants, restricted stock induces more earnings management than stock options. Additionally, using numerical examples, we show that to induce the same level of effort, optimally-designed stock options induce less earnings management and cost less to the firm than restricted stock. "
Very interesting.

Here are some more "visual bites":
  • "Stock-based compensation, on one hand, motivates executives to take real actions to increase firm value. On the other hand, it induces executives to engage in earnings management, which is essentially the difference between the firm’s reported earnings and the economic earnings"
  • "lowering the exercise price makes the options more in-the-money, and hence the marginal benefit from an increased stock price is higher. For this reason, it is more likely that the cost of earnings management will be outweighed by the benefit from the boost in stock price. As an extreme case of stock options, restricted stock is always in-the-money regardless of the stock price.Consequently, restricted stock induces more earnings management than do stock options." --This is presented more rigorously as their second propostion (page 13): Both the expected earnings management and the expected cost of earnings management strictly decrease in the exercise price K, strictly increase in the number of ESO grants, and strictly decrease in the stringency of the accounting standards....Proposition 2 is the main theoretical result used in our empirical analysis. It implies that the more in-the-money the option is, the higher the extent of induced earnings management. Everything else being equal, stocks induce more earnings management than options."
So it is very possible that the change to restricted shares (ie. in the money options) may lead to further accounting problems. Kadan and Yang investigate this empirically using cross sectional regressions where they measure the effect of restricted share usage on distretionary accruals. Their findings fit existing theories very well!
" a larger amount of stock-based compensation in year t induces managers to lower the earnings in this year. Perhaps, during the grant year, managers manipulate earnings downwards in order to better the conditions of the grants (to lower the exercise price) or to save accruals for future vesting years....bonus payments induce more earnings management, which is consistent with prior research; see, for instance, Healy (1985).... In contrast, salary payments appear to mitigate earnings management, perhaps, due to the wealth effect. Interestingly, the CEOs with longer tenures tend to manipulate earnings more. Moreover, large firms tend to have more discretionary accruals consistent with the observation in Coffee (2003). Firms with more growth opportunities and lower current operating performance are engaged in more earnings management, in line with Larcker and Richardson (2004). Not surprisingly, firms with a higher stock return have less incentives to manipulate earnings"
Which deserves a WOW!

I^3! (a rarity for a paper that still has some parts undone!)


Kadan, Ohad and Yang, Jun, "Executive Stock Options and Earnings Management - A Theoretical and Empirical Analysis" (March 15, 2005). AFA 2006 Boston Meetings Paper

Thursday, September 29, 2005

FPA Journal - Post-Modern Portfolio Theory

What is risk? It pains me greatly that we do not have a better measure of it. I remember when I took my first finance class and was told that risk was measured by standard deviation and was immeditely put off. Why? Because how many people are worried about making too much money?

Ask a person on the street (Main Street or Wall Street) and they will tell you a closer description of risk than the average quant. Why? Because we (and I will throw myself into the quant catergory) generally use normality (and hence symmmetry) for any number of solid reasons, to describing risk, somewhere deep inside we realize that there has to be a better risk measure.

In the FPA Journal--The Journal of Financial Planning-- Swisher and Kasten analyze this problem in their paper entitled Post-Modern Portfolio Theory. While I am not convinced they have the solution, their paper does offer important thoughts on the topic of risk and risk management. Undoubtedly a recommended read!

A few sneak peeks:

* "The primary reason MPT produces inefficient portfolios (even though the whole point is supposedly the building of efficient portfolios) is simple: standard deviation is not risk. Risk is something else, and we need a better mathematical framework to describe it. The primary purpose of this paper is to describe that framework and suggest a use for it—the building of better portfolios through downside risk optimization (DRO). We define DRO as optimization of portfolio risk versus return using downside risk as the definition of risk instead of standard deviation."

* "Downside risk (DR) is a definition of risk derived from three sub-measures: downside frequency, mean downside deviation, and downside magnitude. Each of these measures is defined with reference to an investor-specific minimal acceptable return (MAR)."

* "
Portfolios created using MVO and DRO are often similar and the differences in absolute risk and return values small—diversification works regardless of how you measure it. Yet DRO seems to avoid the known errors of MVO and provide a more reliable tool for choosing the "best" portfolio."

For the quants here today:
"The perfect investment, as everyone knows, is positively skewed, leptokurtic, and has low semi-variance. But these moments about the mean of an investment's return probability distribution are at least partially incompatible since investment returns are non-Gaussian, and variance/semi-variance obviously loses its utility in non-mesokurtic (that is, non-Gaussian) skewed distributions."
*"Risk is the potential for a bad outcome. Losing money, underperforming, failing to meet financial goals—those are real-life human concerns. Yet this risk definition—potential for an undesirable outcome—is fuzzy. Hard to quantify mathematically. But just because a concept has no clear mathematical equivalent does not mean that we cannot create mathematical models to describe it."

* Possibly my favorite quote of the paper is the following:
"As Brian Rom and Kathleen Ferguson report: "It has long been recognized that investors do not view as risky those returns above the minimum they must earn in order to achieve their investment objectives. They believe that risk has to do with the bad outcomes...and that losses weigh more heavily than gains." Investors are worried about downside deviation, not upside deviation.

Markowitz himself said that "downside semi-variance"would build better portfolios than standard deviation. But as Sharpe notes, "in light of the formidable computational problems...he bases his analysis on the variance and standard deviation." Markowitz did not have a Dell laptop with a 60 Gb hard drive and Microsoft Excel in 1959."
Read the rest for yourself. You will be glad you did--do not shy away from it just because you fear math. The paper has the enviable quality of being both quantitative and readable!

Swisher, Pete and Gregory W. Kasten. Post-Modern Portfolio Theory. FPA Journal, September 2005.

Interesting trivia: Kasten is an MD!