Saturday, July 30, 2005 : Islamic mortgage market to expand

From : Islamic mortgage market to expand

"The Islamic mortgage market is set to grow by 47% a year and could be worth £1.4bn by 2009, market research group Datamonitor has said. There is a growing demand from the UK's 1.8 million Muslims for mortgages that comply with Sharia law. The law forbids interest payments;"

While Islamic banking is growing rapidly in the UK, there does not appear to be much supply of Islmanic Banking in the US. Watch for it to start.

A few links:
Harvard's Islamic Project
My notes for International Finance on Islamic Finance (surprisingly they came up #6 on Google :) )

Friday, July 29, 2005

Financial history/trivia from the 1700s

I had so much fun with the 1600s, I decided to go on to the 1700s. Enjoy!

Some more financial history/trivia. This is from the 1700s. I think it is worthwhile to note how some things really do not chnage that much. Indeed that is a major reason why I love history so much.

  1. In 1703 England and Portugal reach an agreement to jointly lower tariffs in order to increase trade. (Methuen Treaty)

  2. In 1716 John Law (who was wanted for murder and had taken refuge in France) persuades the French Government to allow him to open the Banque Royale. His famous quote from this time: “ Wealth depends on commerce and commerce depends on circulation (of money).”

  3. By 1720 the South Sea Bubble collapsed. Shares fell nearly 70% in a course of a few months.

  4. In 1729 Benjamin Franklin publishes “A modern Enquiry into the Nature and Necessity of a Paper Currency.

  5. In 1733 Britain passed the Molasses Act. It raised taxes on molasses from Non-British West Indies. Liike most taxes, this tax resulted in changes in behavior. By 1763 approximately 80% of molasses was smuggled into the colonies.

  6. In 1765, the Stamp Act is enacted. It sets off protests centered in Boston. Most likely not coincidentally, Boston is suffering through a serious economic downturn.

  7. In 1773 Britain lowered taxes on tea shipped into Britain but not on that shipped into the colonies. This gave British tea exporters a virtual monopoly but angered colonialists. The Act ended up sparking the most famous tax revolt of all time: the Boston Tea Party. At the Tea Party, an estimated £9,650 (or roughly equivalent of the annual income of 200 common laborers) was destroyed.

  8. By 1775, a growing spirit of independence in the American Colonies leads to boycott of British goods. American imports from Britain drop an estimated 90%! Cite

  9. In 1789 Benjamin Franklin writes “Nothing is certain but death and taxes.” Incidentally, Franklin dies in 1790.

  10. In 1799 Britain imposed its first income tax. The tax was remarkable similar to current income taxes. It was for 10% for incomes over £200 but allowed deductions for “children, insurance, repairs to property, and tithes.”

Quotes, dates and events from The People's Chronology by James Trager. It is one of my all time favorites. Covers history from 3 million BC to the present in largely bullet form. It may have some mistakes, but it sure is interesting! Definitely recommended!

Thursday, July 28, 2005

SSRN-Firm Size, Debt Capacity, and Corporate Financing Choices by Senay Agca, Abon Mozumdar

Firm Size, Debt Capacity, and Corporate Financing Choices by Senay Agca, Abon Mozumdar:

Yet another paper on the pecking order! This one is by Agca and Mozumdar. You will definitely want to read it!

There is a large debate in the financial world as to whether Myers' and Majluf's pecking order holds. Their famous hypothesis states that firms want to use internally generated funds first, and then if they still have to issue new securities, they will issue safer (debt) first and only use equity as a last resort. However, the evidence on this has been mixed to say the least with some saying the Pecking order is alive and well, while others suggesting it is dead. In this paper Agca and Mozumdar report in on the "it's ALIVE!" side.

From their abstract:
"conflicting nature of the existing evidence on the pecking order theory is due to the difference between financing practices of large and small firms, and the skewness of the firm size distribution. The theory performs poorly for small firms because they have low debt capacities that are quickly exhausted, forcing them to issue equity. The pecking order theory performs satisfactorily for large firms, firms with rated debt, and when the impact of debt capacity is accounted for"
The authors explain that some of the difficulty in previous studies has been brought about by the treatment of firm size.

For instance, in possibly the most well known of the pecking order studies "Frank and Goyal (2003) normalize all variables by firm size and then use equally weighted averages. This increases the importance of small firms whose financing mix conforms poorly with the pecking order...." (here is a 2001 version of the Frank and Goyal paper)

In their current paper Agca and Mozumdar break the firms into deciles based on size and then examine firm financing behavior. The conclusion?
"We find that working with nonnormalized numbers yields results that are in line with the conventional notions about corporate financing practices. Furthermore, sorting firms into size deciles, we find that the debt-deficit sensitivity coefficients and R2 values are low for small firms, as in Frank and Goyal (2003), while they are high for large firms, as in Shyam-Sunder and Myers(1999)."
So size does matters. Or as the authors state:
"Why does the pecking order theory perform so differently for large and small firms? Our analysis shows that this is due to different factors assuming primacy in the two cases. How much a firm borrows depends on how much it can borrow (its debt capacity), as well as how much it wants to borrow. The observed debt level is the lower of the two. The pecking order theory focuses on the latter, and largely ignores the former."
Or in the vernacular: the pecking order works when there are not other constraints (such as debt capacity) in the way.

An I^3 paper for sure!


Agca, Senay and Mozumdar, Abon, "Firm Size, Debt Capacity, and Corporate Financing Choices" (December 2004).

Free Money Finance: Carnival of Personal Finance #6

While I often try not to make this too much of a personal finance page, I think this one deserves mention. It is Free Money Finance's "Carnival of Personal Finance." Many good tips and ideas! Free Money Finance: Carnival of Personal Finance #6

Some Financial history/trivia from the 1600s

Some Finance trivia for you. All from the 1600s.

  1. How profitable was the spice trade? VERY! If (and this is a big if) the ships made it back safely. In 1618 it was estimated that 3000 tons of spices were bought in what is now India and the surrounding area. The spices cost about £91,000. By the time they reached the eastern Mediterranean they were worth almost £800,000! So it is easy to see why trading companies were so important.

  2. In 1633 speculation in tulip bulbs was rampant in the Netherlands. It is reported that one "“collector"” (dare I say investor?) pays 1000 pounds of cheese, 12 sheep, a bed, and a suit for a single tulip bulb. (Online sources suggest that a single bulb cost upwards of $40,000.)
    In 1636 the tulip "“bubble"” burst.

  3. Talk about your weird financial contracts! In 1641 the Japanese threw out most European trading firms because on religious grounds. However, the Dutch East India Company have no missionaries and are allowed to stay on the conditions that "“company officers visit Edo once a year, turn somersaults in the street, spit on the Cross, and pay rent in peppercorns."”

  4. In 1642 the Massachusetts Colony initiated a usury law at 10%, in 1693 this rate was lowered to 6%.

  5. In 1656 shares of the Dutch East India Company "“plummet on the Amsterdam Exchange and many investors are ruined. Among them is Rembrandt van Rijn [yes that Rembrandt!] who is declared bankrupt." Mmm, diversification needed maybe?

  6. Lloyds of London was started as a means of sharing the risk of shipping. The company was started at Edward Lloyd's Coffee House.

  7. In 1690 commodity rice futures were selling in Japan

  8. In 1693 King William III of England raised money for the operation of the government by selling £1,000,000 of 10% annuities.

  9. The Bank of England was chartered in 1694. It was based loosely on the Bank of Amsterdam which got its start in 1609.

  10. The London Stock Exchange was started in 1698

Dates and events from The People's Chronology by James Trager. It is one of my all time favorites. Covers history from 3 million BC to the present in largely bullet form. It may have some mistakes, but it sure is interesting!

Wednesday, July 27, 2005

Volume and returns

Do investors trade more when stocks have performed well? John M. Griffin, Federico Nardari, and René M. Stulz report that investors do trade more following strong market performance.

From their paper:

Their key finding:
"There is on average a positive relation between past returns and turnover in our sample of countries. Using a trivariate Vector Autogression (VAR) of market return, market volatility, and turnover with weekly data from 1993 through 2003, we find that a positive shock to returns leads to a significant increase in volume after ten weeks in 24 countries and to a significant decrease in no country. The economic magnitude of the return-turnover relation is large; a one standard deviation shock to returnsleads to a 0.46 standard deviation increase in turnover on average after ten weeks."
In other words, people trade more in up markets than in down markets. While this fact is well known to any stock broker, it is interesting to see that the same realtion holds across most countries and that it appears that it is more concentrated for individual investors and in countries with less developed markets.

Again from the paper:
"The relation [between volume and returns] is more statistically and economically significant in countries with restrictions on short sales, where corruption is higher, and where the allocative efficiency of the stock market is weaker. The return-volume relation is also stronger for individual investors than for institutional or foreign investors."


John M. Griffin, Federico Nardari, and René M. Stulz. Do investors trade more when stocks have performed well? Evidence from 46 countries, Working Paper, downloaded 7/27/2005

The NFL Draft and Market Efficiency

NFL and Finance by Massey & Thaler

Massey and Thaler use football (the NFL) to demonstrate that markets may not be "rational."

From their abstract:
"Using archival data on draft-day trades, player performance and compensation, we compare the market value of draft picks with the historical value of drafted players. We find that top draft picks are overvalued in a manner that is inconsistent with rational expectations and efficient markets and consistent with psychological research. "
The short version of their paper is that they examine the relative worth of various draft postions and then compare what they teams pay for the pick with what they get from the pick in on field performance. To get at this, the authors must first construct a price for draft position schedule based off of trades:
"For example, a team might give up the 4th pick and get the 10th pick and the 21st pick in return. In aggregate, such trades reveal the market value of draft picks. We can compare these market values to the surplus value (to the team) of the players chosen with the draft picks. We define surplus value as the player'’s performance value--estimated from the labor market for NFL veterans-- less his compensation. In the example just mentioned, if the market for draft picks is rational then the surplus value of the player taken with the 4th pick should equal (onaverage) the combined surplus value of the players taken with picks 10 and 21."
The high price for higher picks (the article goes into detail of the Giants' acquisitionion of Eli Manning from the Chargers) suggests that there must be a large drop-off in quality since the price of signing the players also drops with position. Again in the authors' words: "both in terms
of pick value and monetary cost, the market prices imply that performance must be highly predictable."

Overall, the authors find that teams tend to overpay for the top picks. This of course this is similar to the Barber and O'Dean Glitter paper and Bernstein's Inept model in which exciting or glamorous assets tend to be overpriced.

Massey and Thaler:
"Our findings suggest the biases we had anticipated are actually even stronger than we had guessed. We expected to find that early picks were overpriced, and that the surplus values of picks would decline less steeply than the market values. Instead we have found that the surplus value of the picks during the first round actually increases throughout the round: the players selected with the final pick in the first round on average produces more surplus to his team than than the first pick, and costs one quarter the price!"
While I loved the paper, I do have a few reservations. The author attempt to address the first one but with only partial success. They investigate the "Michael Vick factor". That is the idea that even though his on field performance may not be great, he brings people into the stands. They investigate this by looking subsequentent contracts and find that it is only on field performance that matters.

However, it is possible that in trading up, the teams are willing to overpay because of the added excitement (and coverage) that the higher picks generate. Thus, in the early years the team sells more tickets. (This becomes particularly important for a GM that has a short contract).

My second thought on this is that higher picks presumably have a wider variance of performance. If you take the view that team is buying a real option, the wider the variance on performance, the more valuable the pick.

Interestingly, both of these factors could explain why Quaterbacks seem to be be picked higher in first round than performance might warrant.

But no matter how you look at it, the paper is very interesting and does draw into question whether the market for draft picks is rational. And I will definitely use it in class!

Cade Massey and Richard Thaler. The Loser'’s Curse:
Overconfidence vs. Market Efficiency in the National Football League Draft, Working paper. Downloaded 7/27/05.

Want another football paper? Try this one on using Football to teach finance.

Tuesday, July 26, 2005

The Value of Financial Flexibility by Andrea Gamba, Alexander Triantis

SSRN-The Value of Financial Flexibility by Andrea Gamba, Alexander Triantis:

Gamba and Triantis look at the relationship between financial flexibility and Investment flexibility. Not surprisingly, they find the two are related.
"We find that firms with greater investment flexibility derive less value from financial flexibility, indicating that these two dimensions of flexibility are substitutes to some degree....we demonstrate that firms that face financing frictions should simultaneously borrow and lend, and we examine the nature of the dynamic debt and liquidity policies and the value associated with corporate liquidity."
Translated for the less financially savvy of you: firms that can "time" their investments need less flexibility on the financial side of the balance sheet. Additionally, they find that if there are significant market frictions to raising new capital, then cash and financial flexibility in general are good.

A look-in:
"The effect of financial flexibility on firm value can, however, be quite significant
when investment flexibility is low, when there is significant upside for growth, and when high volatility in the firmÂ’s profitability makes it more difficult to maintain stable internal cash reserves. Firms in such circumstances would be appropriate targets for acquisitions by companies having large internal cash reserves, and our analysis allows us to gauge the magnitude of value creation through such transactions. We also find that having more reversible capital adds even more value to the firm when its financial flexibility is lower. Thus, investment and financial flexibility appear to be substitutes to some extent."
While not unexpected (it has been taught for years), it is an important contribution on the interrelationships between the left hand side and the right hand side of the balance sheet.



Gamba, Andrea and Triantis, Alexander J., "The Value of Financial Flexibility" (May 2005). EFA 2005 Moscow Meetings

SSRN-Long Horizon Mean Reversion for the Brussels Stock Exchange: Evidence for the 19th Century by Jan Annaert, Wim Van Hyfte

If people look at the same data over and over again, it should not be surprising that eventually people find things. Moreover, if different people look at the same data set, they are likely to find the same things. For this reason, it is always nice when there is an out of sample data set that can be used to verify the initial findings. Annaert and Van Hyfte provide us this opportunity.

SSRN-Long Horizon Mean Reversion for the Brussels Stock Exchange: Evidence for the 19th Century by Jan Annaert, Wim Van Hyfte
They "present new evidence on the time-varying behavior of stock prices using a completely new and unique dataset of historical stock returns from the Brussels Stock Exchange that has never been studied before. To the best of our knowledge, this is probably the most comprehensive and accurately constructed historical index representing more 1500 different common stocks during the period 1832-1914. The excessive use of the CRSP return data in examining predictability and the data mining risks involved, render this independent return database a adequate out-of-sample test for different asset pricing anomalies identified in the literature."
With this cool data set, their key finding is that:
"Contrary to Fama and French (1988) and Poterba and Summers (1988), our results show that stock prices do not contain autoregressive stationary components but instead resemble a random walk. Capital appreciation returns exhibit stronger time-varying behavior than total returns. Belgian stock returns demonstrate strongly significant seasonality in January notwithstanding the absence of taxes. Moreover, long horizon mean reversion is present, however, completely concentrated in January."

While this is all interesting, what will likely force me to redo my notes is that the January effect does NOT (at least at first glance) appear to be tied closely to taxes or the small firm effect!

The authors:
"did not find any official sources or records making reference to the Belgian government levying taxes on capital gains or dividends during that period. Second, our results show that larger rather than smaller companies achieve abnormal returns throughout the month of January disputing the tax-motivated size premium. Last, abnormal returns earned during January appear to be related to more fundamental factors like dividends rather than taxes as the month of July, another high dividend-yield month, is subject to the same effect. Further research on dividends and how asset prices respond to dividend information is required to examine these effects in more detail.


Annaert, Jan and Van Hyfte, Wim, "Long Horizon Mean Reversion for the Brussels Stock Exchange: Evidence for the 19th Century" (December 20, 2004). EFA 2005 Moscow Meetings

Who's Afraid of China Inc.? - New York Times

With all of the discussion of late about China and the Flat (or Not so flat) World, it is worthy to note that not all are looking forward to a "one world," Particularly, many are afraid of China.

This issue has come to a head of late with the attempted takeover of Chevron.

It is into this environment where NY Times runs their article on US-China business relations. I had to laugh at the description of a Wal-Mart with a military.

It should also be noted that contrary to the view that economists are pessimistic, the economists have the positive outlook!

Who's Afraid of China Inc.? - New York Times: "China is both an engine of economic globalization and an emerging military power. In symbolic shorthand, it is Wal-Mart with an army.

The two sides aren't neatly divided. But those who focus on economics tend to see partnership, cooperation and reasons for optimism despite tensions, while security experts are more pessimistic and anticipate strategic conflict as the likely future for two political systems that are so different."

Monday, July 25, 2005

Radio Economics

If you have not been introduced yet to podcasting (I would describe it as audio blogging), check our RadioEconomics.

Dr. James Reese of the University of South Carolina Upstate has started a cool site that plays interviews of various economists (and soon financeprofessors ;) as well.

Radio Economics

You can listen on your IPOD or on any computer.

Recent interviews include Skip Saur, James Hamilton, John Palmer, and others.

Friday, July 22, 2005

Speaking of Freakonomics

FYI: From Freakonomics

On July 26 at noon EDT, Levitt and Dubner will conduct a one-hour Microsoft online "live meeting," open to anyone.

Moodgrapher: The World according to LiveJournal

Moodgrapher: The World according to LiveJournal

Freakonomics is absolutely right on this one! A veritable plethora of paper ideas come out. I wonder if past data is publicly available.

Just a few ideas: Can we explain the weekend effect by looking at mood swings? Do people actually buy stock more when happy? Do credit spreads change as a result of mood swings? Can we time when we should sell a new issue?

Corporate Governance Mechanisms and Corporate Cash Holdings by Yuanto Kusnadi

Kusnadi gives us a look at cash holdings and corporate governance from Singapore.

SSRN-Corporate Governance Mechanisms and Corporate Cash Holdings by Yuanto Kusnadi:

Long time readers of my newsletter and/or blog know that my dissertation at Penn State was on High Cash firms. Consequentially, I still am interested in virtually any article on the behavior of firms with high cash.

In fact, I will take from my dissertation to set the Kusnadi paper up:
Two theories have been used to explain cash'’s role in decision making. The first, and more widely accepted is an agency costs theory. This agency theory, which is often called the “free cash flow problem” (Jensen (1986)), holds that excess cash is detrimental to shareholders because managers will waste it through overinvestment and diversifying acquisitions or use it as a tool to entrench themselves and to block takeovers (Harford 1998)....The alternative view is that cash holdings are good because they allow firms to avoid the transaction 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.
Since 1998 (the time of my dissertation), numerous papers have been published that suggest that there is truth in both views.

From Kusnadi: "Dittmar et al. (2003)..., Pinkowitz et al. (2003) and Guney et al. (2004)... find an inverse relationship between shareholder protection and cash holdings."

However, support for the market friction side of the fence can be found from "Mikkelson and Partch (2003) [who] argue that large cash holdings do not necessarily imply negative performance. They find that the operating performance of firms with large, persistent cash reserves is comparable to or even better than the performance of other matched firms."

So it appears cash is still an unsettled issue. Into this discussion comes a new paper by Kusnadi that looks at cash rich firms from Singapore. Maybe not surprisingly, the findings are consistent with both views of the cash (agency cost and market friction).

First the view that cash is good (i.e. there are real market frictions that can be avoided if firms hold more cash):
"size, market-to-book ratio (a proxy for investment opportunities) and capital expenditures (a proxy for investment) are positively related to cash holdings."
Then the bad side (i.e. holding cash is to the benefit of managers and nto to shareholders):
"On the other hand, cash holdings decreases in leverage, tangibility, and a dividend
dummy. As for our governance variables, we demonstrate that firms characterized by largeboards, boards that are dominated by insiders, and low non-management controlling ownership tend to hold higher cash balances. Our findings lend further support to the importance of corporate governance mechanisms in the determination of corporate cash holdings as documented by Dittmar et al. (2003)."
To which I would add, that this once again demonstrates that there is no simple answer to the question of whether cash is good or bad. Like most things, cash can be good or bad, depending on firm specific factors. This firm specificness (which leads to the endogeniety problem) is one of the key factors that make finance so difficult for some people to grasp: there is rarely a single answer.

A worthwhile read!


Kusnadi, Yuanto, "Corporate Governance Mechanisms and Corporate Cash Holdings" (November 2004). EFA 2005 Moscow Meetings Paper.

Aha...surprise helps learning

Cool first glance, there appears to be little (if any) finance content, but given that many of you are teachers, I think you might be interested.

Short version: The surprise "or aha" moment that comes about from something unexpected, improves recall of the material. So in class, if we can "create scenarios", find surprises, and not spoon feed the students too much, it may increase retention.

Penn State Live: "Twenty-five years ago, it was commonly thought that providing people with straightforward information that they could easily process was a key to learning facts effectively. Today, Penn State Abington researcher Ted Wills will tell you that this doesn't necessarily hold true. In fact, creating an 'aha' moment for the person processing the information could well be the key to better retention."

Thursday, July 21, 2005

Implied Volatility wins out again!

Ok, so it is sort of cheating to post work on which I am a co-author, but given I just spent the entire afternoon on the phone, I am short on time, so this will have to suffice.

SSRN-Forecasting Power of Implied Volatility: Evidence from Individual Equities by Jonathan Godbey, James Mahar:
1) implied volatility is a better forecaster of realized volatility than either historic volatility or GARCH models and 2) the information content of implied volatility significantly decreases with liquidity. "

The paper is interesting for several reasons. First and probably most importantly, we show that IV is still the best forecaster of future realized volatility. Secondly we find that the information content of implied volatilty does drop with volume. Previously this had been shown before for index options and for a small collection of firms, but to the best of our knowledge, not for a sample as large as ours. Finally, we show that the IVs derived from call prices is almost identical in information contect as that taken from put prices.


Godbey, Jonathan M. and Mahar, James W., "Forecasting Power of Implied Volatility: Evidence from Individual Equities" (July 14m 2005).

BTW I was going to wait until it had been "reviewed" but figured I would post it now.

BBC NEWS | Business | Warning signs for the funding of terror

The BBC documents some of the difficulties facing investigators who try to track terrorist funding. The short version is that there are MANY ways that are used to fund terrorists and many of the ways are not not easily traceable.

BBC NEWS | Business | Warning signs for the funding of terror: "Investigating the money trail of attacks such as the London bombings or 9/11 can be a frustratingly nebulous business."

China Says It Will No Longer Peg Its Currency to the U.S. Dollar - New York Times

China Says It Will No Longer Peg Its Currency to the U.S. Dollar - New York Times: "China said Thursday it will no longer peg its currency to the U.S. dollar but instead let it float in a tight band against a basket of foreign currencies"

From the BBC:

"In effect, this strengthens the yuan by 2.1%, to 8.11 to the dollar.

More importantly, this is seen as the first step in a complete liberalisation of the Chinese exchange rate, perhaps leading to a free float."

While I am sure there will be many who feel it is not enough, this is definitely a step in the right direction. Pegged (or fixed) currency regimes are rarely a good idea in that they create artificial advantages when the currency is undervalued and an unwarranted sense of security that can lead to economic instability (see Peso crisis and Asian Crisis) when the currency is overvalued.

Wednesday, July 20, 2005

SSRN-Sources of Hedge Fund Returns: Alphas, Betas, and Costs by Roger Ibbotson, Peng Chen

SSRN-Sources of Hedge Fund Returns: Alphas, Betas, and Costs by Roger Ibbotson, Peng Chen

With the growth of hedge funds in recent years, it is good that Ibbotson and Chen investigate whether these funds actually do as well as they often claim. And the answer? They do well, but not as well as claimed.

Some of the more serious problems in studying hedge funds are data related. Specifically, survivorship bias and the related backfilling of data lead to a bias in reported returns. Ibbotson and Chen investigate these problems using their data from 1995 to 2004 and as expected find that the problem is quite severe especially in smaller funds.

"The equally weighted performance of the funds that existed at the end of the sample period had a compound annual return of 16.64% net fees. Including dead funds reduced this return to 13.90%. Excluding backfill further reduced the return to 9.06%, net of fees."
So the returns are lower than many believed. That does not mean that the returns are not good relative to other investments. The authors therefore try to break this return down to determine "the average amount of hedge fund returns that come from long-term beta exposures versus the hedge fund value-added alpha."

They find that alphas are positive and significant:
"Note that the index of all the funds has an annual compound return of 9.1% over the period. This return was not as high as the S&P 500 return of 12.2%, but given the low betas on stocks (0.33) and bonds (–0.30), with a beta on cash of almost one (0.97), the alpha was a high 3.7% and statistically significant at the 5% level. Most catergories have low RSQs as well."

Interestingly, this alpha (which can be seen as abnormal return), is split almost evenly between fees to the fund and returns to the investors:


While the returns may not be as high as reported, they are still better than would be expected in a perfectly efficient market and the returns are not highly correlated with broader marketindicess.

In the author's words:
"Thus, our results confirm that hedge funds added alpha over the period, and also provided excellent diversification benefits to stock, bond, and cash portfolios."

Which might just explain some of their popularity ;)

Definitely another of those I^3 papers!


Ibbotson, Roger G. and Chen, Peng, "Sources of Hedge Fund Returns: Alphas, Betas, and Costs" (June 2005). Yale ICF Working Paper No. 05-17.

Monday, July 18, 2005

Social Norms versus Standards of Accounting by Shyam Sunder

I have not had many accounting articles of late. It has not been intentional (and definitely is not a commentary on their importance), but I just do not find as many that are strictly relevant to finance. However, that changed today as I was sent the following:

SSRN-Social Norms versus Standards of Accounting by Shyam Sunder

A few highlights from the paper:

*"Historically, norms of accounting played an important role in corporate financial reporting. Starting with the federal regulation of securities, accounting norms have been progressively replaced by written standards....[and]enforcement mechanisms, often supported by implicit or explicit power of the state to impose punishment. The spate of accounting and auditing failures of the recent years raise questions about the wisdom of this transition from norms to standards....It is possible that the pendulum of standardization in accounting may have swung too far, and it may be time to allow for a greater role for social norms in the practice of corporate financial reporting."

*"The monopoly rights given to the FASB in the U.S. (and the International Accounting Standards Board or IASB in the EU) deprived the economies, and their rule makers, from the benefits of experimentation with alternative rules and structures so their consequences could be observed in the field before deciding on which rules, if any, might be more efficient. Rule makers have little idea, ex ante, of the important consequences (e.g., the corporate cost of capital) of the alternatives they consider."

*"Given the deliberate and premeditated nature of financial fraud and misrepresentation (and other white color crimes), “clarifications” of the rules invite and facilitate evasion"

And my favorite!
*"Indeed the U.S. constitution—a document that covers the entire governance system for the republic—has less than 5,000 words. The United Kingdom has no written constitution. A great part of the governance of both countries depends on norms. Do accountants deal with greater stakes?"

BTW: I like the prescriptions called for as well, but will allow you to read those (pages 20 to 22 of paper)

Sunder, Shyam, "Social Norms versus Standards of Accounting" (May 2005). Yale ICF Working Paper No. 05-14.

Sunday, July 17, 2005

Commanding Heights: Home | on PBS

Commanding Heights: Home | on PBS

If you are teaching an International Finance Class, this one is a must. It it updated PBS show on globalization. I am not teaching International Finance this semester, but I might buy it anyway!

Thursday, July 14, 2005

How Does Investor Short-termism Affect Mutual Fund Manager Short-termism by Li Jin

SSRN-How Does Investor Short-termism Affect Mutual Fund Manager Short-termism by Li Jin: "How Does Investor Short-termism Affect Mutual Fund Manager Short-termism"

Do stock prices reflect all future cash flows or is the market myopic and looks too much at recent performance and near term cash flows? This is an enormously important question. Jin tries to answer it in the context of mutual fund investors. He finds that short term thinking is alive and well and can have important implications on efficiency.

Short Review:
We know that investors chase "hot funds" (see Sirri and Tufano-1998). But what are the implications of this (and other types of short-term thinking)? Li finds that short term thinking on the side of investors flows forward and leads to short term thinking by mutual fund managers. Of course, this is expected if the manager is under pressure to report strong results, but the paper is is an interesting look at this none-the-less.

Longer review:

Given investors chase hot returns and managers are often dimissed for poor performance, fund managers face pressure to increase returns in the short run.
In Li's words:
"fund managers face large incentives to perform in the short run. Such incentives largely come in the form of increased fund inflow and thus asset under management on the upside, and firing on the downside."
The author examines this by looking at mutual fund holdings and returns and by creating measures of investor "short-termism."

And the findings? Jin finds that

1. "Flow-to-performance sensitivity is...positively correlated with turnover....a measure of input short-termism, is positively correlated with turnover
and negatively correlated with the average remaining holding periods of fund
investments. All correlations are statistically significant at the 1% level."

2. Short-termism has increased over the past 40 years.

3. "Higher flow-to-performance sensitivity significantly decreases
average remaining holding period and significantly increases fund turnover"

4. The reason for the short-term thinking flows from the fund's investors who behave in a short-term manner.

"Further tests of causality suggest that fund manager investment
short-termism is caused by investor short horizon, but not the other way round."
The potential consequences of these findings are huge. Again in the author's words:

"Excessive fund manager focus on short horizon investments will likely affect asset prices, by inflating the price of the most liquid assets, which can be quickly resold without large price impact. On the other hand, long term investments could be the “neglected asset class” and thus might be less efficiently priced. "

Additionally, if investors (and institutions) are more short-term oriented, then there may be serious implications in the monitoring and corporate goverenance of firms.

"If institutions only invest for the short run, they might not have much interest to monitor management or participate in active governance.
Furthermore, corporate managers might react to the pressure of their
institutional investors by pursuing myopic investment decisions."

This finding will unfortunately give managers reason to doubt market efficiency and to argue that their "long-term" interests are different than the "myopic" stock market. Look for it to be used not only by mutual fund managers, but also any manager trying to increase entrenchment or argue for pet projects.


Jin, Li, "How Does Investor Short-termism Affect Mutual Fund Manager Short-termism" (February 27, 2005). EFA 2005 Moscow Meetings Paper.

SSRN-Football and Stock Returns by Alex Edmans, Diego Garcia, Oyvind Norli

First of all, I have to play ugly American and remind readers they are really talking about soccer and not real football ;) (I am kidding!!!)

SSRN-Football and Stock Returns by Alex Edmans, Diego Garcia, Oyvind Norli

Short Version:
"This paper investigates the stock market reaction to the outcome of international football competitions, such as the FIFA World Cup, a variable shown in psychological literature to have a dramatic effect on mood. We document an economically and statistically significant market decline after football losses. Daily stock returns are 39 basis points lower than average following a loss in a World Cup elimination match."
Score one more paper for behavioral finance.

ARGH....I wanted to do this one! Well actually what I want to do is to look at stock returns following World Series and Super Bowl Victories. Anyone interested and have access to CRSP? Give me an email.

BTW note this is different than the story in "my" (and I use that term loosely as my co-authors probably did more work on each than I) Endorsement paper and Nascar paper. In each of those the events had specific cash flow implications. The cash flow implications for this "football" (err, soccer) are much more tenuous.


Edmans, Alex J., Garcia, Diego and Norli, Oyvind, "Football and Stock Returns" (May 2005). EFA 2005 Moscow Meetings

The World is Flat (or at least flatter)

I do not know where to put this one. It is definitely economics and business, but I am not sure how to tie it to finance per se, so I will put it on my RandomTopics2 blog, but make a note of it and provide a link to it here. It is a discussion of the book The World is Flat by Thomas Friedman.

Whether or not you agree with everything in it, it is well worth your time to read (or risten) to the book!

Wednesday, July 13, 2005

St. Bonaventure University: SBU prof's site named one of top 10 finance blogs in the country

LOL...the SBU news got a hold of the blog story....probably a tad too flattering, but I do like the synergy section! I think that really is the key: doing the blog is both doing research and preparing for class!

St. Bonaventure University: SBU prof's site named one of top 10 finance blogs in the country

Tuesday, July 12, 2005

NPR : Home Owners Increasingly Betting on Interest-Only Loans

Only time will tell whether these interest only loans are more evidence of a real estate bubble, impatient buyers, or just a good example of financial innovation, but regardless, the link is interesting.

The short version is that Interest-Only loans are becoming increasingly popular. Moreover, they are not just popular for those who can not afford to pay the principle. There are of course downsides of these loans (especially if the market reverses its upward trends), but these loans do allow people to buy homes that otherwise may not be able. That said, I can only see a few isolated cases where I would ever recommend this type of financing--namely if you knwo your cash flows (earnings) will escalate quickly.

NPR : Home Owners Increasingly Betting on Interest-Only Loans

For more on the dangers of this type of loan (whatever you do, do not tell him it is a mortgage!!), check out the Really. It is by "Jack M. Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania, and Chairman of GHR Systems, Inc., a mortgage technology company."

BTW If you are teaching a class that deals with types of loans (Money and Banking, Financial Institutions, Introductory Finance, or Personal Finance come to mind), you will be interested in this audio presentation from NPR. It is definitely not too difficult for the students to understand!

Monday, July 11, 2005

Call for papers

Received this today. I have never been to this conference so I can not say much about it, but it is in Las Vegas in December. So it can not be all that bad!
Call for papers

The 2005 Financial Research Association Meeting

December 17 and 18, 2005

Aladdin Resort and Casino

Las Vegas, Nevada

The program committee of the Financial Research Association seeks finance papers of general interest to the profession. We specifically seek new papers that do not currently have a “revise-resubmit” journal decision.

The sessions will take place Saturday and Sunday, December 17 and 18. All papers will be presented by a discussant, after which the authors will have an opportunity to respond. A conference dinner will be held on Sunday evening, and a wine tasting will be held Saturday evening. The association will make an award to cover airfare, hotel, and registration, for the Ph.D. student who submits the best solo-authored paper, regardless of whether the paper is included on the program.

Paper submissions should be emailed in PDF to by August 31.

Saturday, July 09, 2005

Supply and Demand Shifts in the Shorting Market by Lauren Cohen, Karl Diether, Christopher Malloy

Yet another interesting paper from the EFA Moscow Meetings!

SSRN-Supply and Demand Shifts in the Shorting Market by Lauren Cohen, Karl Diether, Christopher Malloy

Using a "proprietary database of lending activity from a large institutional investor" the authors examine
  • Whether shorting impacts future returns?
  • If shorting is important, is it "short supply" or "short demand"?
  • Is shorting influenced by private? or public information?
  • Is there a profitable trading rule that can be made off of shorts?
Their findings:

a. Demand for shorting stocks seems to be a good predictor of future returns.

b. As a predictor, demand is more important than supply. " increase in shorting demand leads to a significant negative average abnormal return of 2.54% in the following month. Decreases in shorting supply play a more minor role."

c. Private information drives shorting. This is important because, as pointed out in the paper,
"Ideally one would like to know if shorting indicators have explanatory power abstracting from public information (signaling the potential importance of market frictions), or if they are simply correlated with underlying movements in publicinformation flow."
And they find that private information seems to be more important.

d. The authors find that by following their strategy (that is when demand for shorts is high, sell), one would be presumed to beat the market on a
"net of shorting costs [basis], the investor still makes over 8% per year. Also, the Sharpe Ratio of the strategy is about 3 times that of the market and HML. Thus, indirect shorting costs (e.g., recall risk) and other indirect costs would have to be substantial to subsume this return."
Interesting to say the least!


Cohen, Lauren H., Diether, Karl and Malloy, Christopher J., "Supply and Demand Shifts in the Shorting Market" (June 4, 2005). EFA 2005 Moscow Meetings Paper.

Friday, July 08, 2005

Information Acquisition and Portfolio Under-Diversification by Stijn Van Nieuwerburgh, Laura Veldkamp

SSRN-Information Acquisition and Portfolio Under-Diversification by Stijn Van Nieuwerburgh, Laura Veldkamp

Van Nieuwerburgh and Veldkamp (V&V) help us to understand the importance of information costs (as learning capacity) on portfolio decisions. They model the portfolio (diversification) aspect along with the learning (information) costs necessary to hold a diversified portfolio.

The authors stress the difference between pure information costs and the ability of investors to handle information (the capacity side). This allows for the following
"evidence suggests that the degree of diversification only slightly improved over the last decade, in spite of a large drop in (fixed and proportional) transaction and information costs. While the ease of access and the speed of dissemination of financial information have dramatically improved over the last
decade, the processing capacity of the investor has not."
(A note to my own students: in class we have always combined these two into a broad information cost catergory).

Following along in this discussion:

"The interaction of the information portfolio problem and the asset portfolio problem creates a trade-off between diversification and specialization through learning. The result is that investors hold some fraction of their assets in a well-diversified fund, about which they learn nothing, and hold the other fraction in a small set of highly-correlated assets that they specialize in learning about."

"For the investor with zero information capacity, it is optimal to hold a diversified portfolio; our theory collapses to the standard model. As the investor's information capacity increases, holding a perfectly diversified portfolio is still feasible, but no longer optimal...."

This "if-investors-are-concentrated-then-it-must-be-for-a-reason" idea is summed up as the following:

"If investors concentrate their portfolios because they have informational advantages, then concentrated portfolios should outperform diversified ones (corollary 3). In contrast, if transaction costs or behavioral biases are responsible, then concentrated portfolios should offer no advantage"
The authors point out that there is evidence to support this:

"Ivkovic, Sialm, Weisbenner (2004) find that concentrated investors outperform diversified ones by as much as 3% per year. This excess return is even higher for investments in local stocks, where natural informational asymmetries are most likely to be present." (I would also add Choe, Kho, and Stulz)

The paper also write that their model can partially explain the problems with CAPM:
"We find that the risk premium on an asset is low when its correlation with the risk factors that the economy learns about is high. Asset returns are also described by a CAPM; the CAPM that would hold if each investor had the average of all investors' signal precisions."

Definitely an interesting article! Especially for a largely theoretical paper ;)


Van Nieuwerburgh, Stijn and Veldkamp, Laura, "Information Acquisition and Portfolio Under-Diversification" (March 2005). EFA 2005 Moscow Meetings

Wednesday, July 06, 2005

The Impact of Clientele Changes: Evidence from Stock Splits by Ravi Dhar, William Goetzmann, Ning Zhu

SSRN-The Impact of Clientele Changes: Evidence from Stock Splits by Ravi Dhar, William Goetzmann, Ning Zhu (btw Shane Sheperd is also listed on the actual paper, but not on this link, not sure why, but Shane, I am not purposely not giving you credit!!!)

Ever since the first event study (Fama, French, Jensen, and Roll 1969), people have puzzled at stock splits. Why should splitting a stock matter? Is it a signal of good times ahead? Of a larger dividend? Often. But there are times when splits offer no signal.

Take for instance the the finding by Muscarella and Vetsuypens (1996). They look at splits of ADRs (American Depository Receipts) where the underlying stock did not split. This research design assured no signaling could take place. And sure enough, the ADRs still went up on the news of the split.

So most in the field came back to the view that liquidity mattered and that a lower stock price was affordable to more individual investors.

We now more empirical evidence that supports this liquidity view:

Individual investors are net buyers following stock splits. That is the key finding of this paper by Dhar, Sheperd, Goetzmann, and Zhu. They find:

"strong evidence that a change in investor clientele accompanies a stock split. Following the announcement of a split, individual investors increase their trading of the split stocks by more than 50 percent and also considerably increase their buying intensity. In contrast, our sample of professional traders reduces both their aggregate order flow and the ratio of buy orders to sell orders. Furthermore, less sophisticated individuals, such as investors in non-professional occupations or with lower incomes, comprise a larger fraction of individual investor ownership after stock splits, a phenomenon consistent with the contrast between individuals and institutions."

This is at least consistent with the view that liquidity increases and the firms gets a more diverse investor base following stock splits.

Which may lead to other interesting questions: for instance, if individual investors are worse at monitoring management, then there may be predictable changes following splits (for instance, CEO pay comes to mind immediately).


Dhar, Ravi, Goetzmann, William N. and Zhu, Ning, "The Impact of Clientele Changes: Evidence from Stock Splits" (August 2004). EFA 2005 Moscow Meetings