Wednesday, May 31, 2006

Dividends and Capital Structure

Hold on to your seats folks, this one gets exciting! Definitely I^3!

It starts off so easy: Are dividend policy and capital structure related? And if so how?

Surprisingly for two topics that have been central to corporate finance for decades, we still really do not have very good explanations to either. A new paper by Faulkender, Milbourn, and Thackor attempts to solve both problems with a new theory that suggests not only are dividends and debt related, and tied to investor uncertainty. Moreover, it appears the theory actually fits the data!

Super short version: When managers and shareholders agree on the things stock prices rise. Moreover, debt levels and dividend payout ratios drop. This key insight is shown both theoretically and empirically.

Longer version: While often studied, capital structure and dividend policy have many unanswered questions and none of our models fit the evidence very well.Hence the need to new thinking on the matter and that is what by Faulkender, Milbourn, and Thackor have brought to the table (computer screen?) in Does Corporate Performance Determine Capital Structure and Dividend Policy?

A few quick look-ins:
“..troubling is the fact that existing theories also do not explain why some firms never pay dividends whereas others consistently do, why the payment of dividends seems dependent on the firm’s stock price, and why there seem to be correlations between firms’ capital structure and dividend policy...We are thus left without a theory of dividends that squares well with these stylized facts. The evidence on capital structure is even more troubling.”
“In this paper, we address this question by developing a fresh approach with a simple model that departs from the usual agency and signaling stories. We assume that the manager wishes to maximize a weighted average of the stock prices at the initial and terminal points in time. At the initial point in time he raises the funds needed for a future project with either debt or equity, and thereby determines the firm’s capital structure. Moreover, he also decides how large a dividend to promise to pay at the next point in time. At the time that the manager makes his financial policy choices, he is aware that investors may not agree with his future project choice… project-choice disagreement arises solely from potentially different beliefs about project value rather than agency or private information problems.

* Their main point:
“higher agreement between the manager and the investors implies a higher stock price, so the model predicts leverage and dividend payout ratios to be inversely related to the firm’s stock price.
After theoretically modeling the problems, the authors empirically test their predictions and find strong support. Again in their words:
"We find that firms for which there is greater agreement (i.e., lower analyst forecast dispersion and greater performance-based compensation) have significantly less debt in their capital structure – as measured by either market or book leverage, or interest coverage – and pay out a significantly smaller fraction of the earnings in the form of dividends, measured using both the dividend payout ratio and the dividend yield.”
Good stuff!!

You probably do want to read the whole thing on this one (indeed the literature review (disguised in the introduction) is excellent and is definitely understandable for even undergraduates!)

Cite: Faulkender, Michael W., Milbourn, Todd T. and Thakor, Anjan V., "Does Corporate Performance Determine Capital Structure and Dividend Policy?" (
March 9, 2006). Available at SSRN:

Tuesday, May 30, 2006

Has IPO underpricing decreased over time?

Continuing with the “history and finance” theme that seems to have arisen of late, Chambers and Dimson examine IPOs from the London Stock Exchange from 1914 to the present. Interestingly, and counter to what standard financial theory might have predicted, they find no reduction in IPO underpricing in the more recent periods of increased regulation and decreased information asymmetries.

In their words:

In examining how underpricing changed over time, we consider whether improvements in investor protection and underwriting have resulted in lower underpricing over the course of the last century….investors were considerably better protected after 1945 due to substantial reforms in company law, accounting standards and the LSE’s own rules. Similarly, reputable banks committed themselves to underwriting IPOs after 1945.

Based upon a narrowing of information gaps and the benefits of certification, we would expect both these improvements…to moderate the level of underpricing over time. However, the main finding of this paper is that underpricing rose after the middle of the century when shifts in IPO risk composition, changes in issue method and underwriter reputation are taken into account.”

Why? The authors hypothesize:

“Possible reasons for this puzzle include the decline in competition from provincial stock exchanges, the market power of investment banks, and the deployment of underpricing as an anti-takeover device, which led to more heterogeneous investors and an exacerbated winner’s curse. Each of these offers an avenue for further research.”

See, I told you it is not what theory would have expected.

BTW the history reported in the paper is fascinating as well. For instance:

“…the large initial premia of Initial Public Offerings (IPOs) had been pointed out as early as 1929 (The Economist, 27 July 1929).”

Cite: Chambers, David and Dimson, Elroy, "Better Regulation and Underwriter Reputation have done Nothing for IPO Underpricing over the 20th Century: Empirical Evidence from IPOs on the London Stock Exchange" (April 14, 2006). Available at SSRN:

Hedge Fund pay

$130,000,000. That is how much the 25th and 26th highest paid hedge fund managers made last year. The top spot? James Simon of Renaissance Technologies made about $1.5 billion (yes with a "b")!

From USAToday:
"In rising to the top of what amounts to a who's who list of the secretive hedge fund world, Simons, of Renaissance Technologies, unseated 2004's top earner and first-ever billion-dollar man, Edward Lampert of ESL Investments, who is best known for buying Kmart and masterminding the blockbuster deal to buy Sears. Lampert's earnings dipped to an estimated $425 million last year, down from $1.0 billion in 2004.

"These are staggering numbers," said Alpha editor Michael Peltz in announcing its fifth-annual list of Top 25 earners. "It took $130 million to make the list.""

From NY Times: (NY Times graph on hedge fund pay)

"The magic behind the money is the compensation structure of a hedge fund. Hedge funds, lightly regulated private investment pools for institutions and wealthy individuals, typically charge investors 2 percent of the money under management and a performance fee that generally starts at 20 percent of gains.

The stars often make a lot more than this "2 and 20" compensation setup. According to Alpha's list, Mr. Simons charges a 5 percent management fee and takes 44 percent of gains; Steven A. Cohen, of SAC Capital Advisors, charges a management fee of 1 to 3 percent and 44 percent of gains; and Paul Tudor Jones II, whose Tudor Investment Corporation has never had a down year since its founding in 1980, charges 4 percent of assets under management and a 23 percent fee."


"Hedge Funds are hot. With inflows from pension funds and university endowments, they are becoming more mainstream, making hedge fund managers better paid in 2005 than ever before. The top 26 earners brought home more than $130 million, and two earned over $1 billion."

For perspective the average CEO of an S&P 500 firm made about $11.75 Million last year while a mutual fund manager made about $400,000. Is it any wonder why mutual fund managers have been so ready to start their own hedge fund?

While some of this so-called "pay" is a return on investment, the sheer size of the pay when coupled with a lack of transparency that shrouds the hedge fund industry does hint of potential trouble. Remember the accounting games that have arose in the corporate sector due in part to misaligned incentives and information asymmetries. In the hedge fund world, we can only guess as to what may be happening.

Friday, May 26, 2006

Recent graduates and Money

This AM NPR had an interesting(short) piece on the finances of recent college graduates. Didn't have much new, but you might be interested.

Short version: you can save more than you think!

Thursday, May 25, 2006

Enron Trial Results: guilty

From CBS Marketwatch:
HOUSTON (MarketWatch) - A jury of eight women and four men threw the book at former Enron founder and former Chief Executive Kenneth Lay Thursday, finding him guilty on all six counts of fraud and conspiracy.
The jury also found Lay's protégé, former Enron Chief Executive Jeffrey Skilling, guilty on 19 counts of fraud, but acquitted him on 9 counts of insider trading regarding shares he sold while the company unraveled.
The verdict is the culmination of a high-profile 108-day trial that took Enron's top executives to task for what federal prosecutors said was a deliberate effort to hide the company's foundering finances from investors.
From the Houston Chronicle:

A federal jury convicted former Enron chiefs Ken Lay on all counts and Jeff Skilling on most counts today, marking the climax of one of the most notorious corporate scandals in U.S. history and nearly ensuring prison time for two of Houston's best-known executives.

The jury heard 16 weeks of testimony and arguments and made its announcement early on its sixth day of deliberations. The eight-woman, four-man panel found Lay guilty of all six counts. They convicted Skilling on 19 of the 28 counts against him.

U.S. District Judge Sim Lake set a sentencing date of Sept. 11.

BTW the Chronicle has probably the most complete coverage of all things Enron.

Wednesday, May 24, 2006

Thomas Friedman on Google Video

Long time followers of know I am a big fan of Thomas Friedman. From his early books to The World is Flat and most of his NY Times articles, I think I have read everything he has written. I may not agree with everything, but at least I have read it (or more aptly ristened to it) and agreed with MOST of it.

Thus, I was excited when I found the following from Google Video (one of my new favorite sites).

From Charlie Rose (actually with guest host John Doerr): On energy and much more. He also talks about entrepreneurship, a gas tax, geo-green, globalization (a little), and even a bit on social responsibility and incentives. And much more. (BTW the link says 99 cents, but I think that is to buy, I watched it for free) (from May 22, 2006):

For all Google Video on Thomas Friedman check out this search.

Two recent purchases turn out to be great "investments"

No, just because the blog is now "listed" on TheMoneyBlogs (check it out, it is pretty cool!), I am not going to start giving stock predictions. Rather these are investments in learning!

1.Advances in Behavioral Finance Volume II edited by Richard Thaler. Just get it. Yeah I have read many of the articles in the text before, so what. Context matters and Thaler does a wonderful job of putting the articles in just the right context to get a better understanding of the field. Indeed, the preface plus chapter 1 (Survey of Behavioral Finance by Nicholas Barberis and Thaler) are worth the price of admission! (BTW Volume I was also good. I reread it (skimmed it) a few months ago and it did serve a good reminder of the key papers from the field.)

2. The DVD of Enron: The Smartest Guys in the Room. Yeah it might be a tad slanted against Enron from the start, but it is very entertaining (I rode my indoor trainer while watching it and ended up doing an extra 30 minutes!) and informative. (I especially loved the audio from California.) Very well done, even a pretty cool soundtrack! Maybe the first time I have liked a movie better than the book.

Tuesday, May 23, 2006

Do managers backdate options?

Do managers backdate options? It sure seems that way.

From Reuters:
"A U.S. government probe into stock option grants for executives widened on Tuesday with more technology companies being called on to explain the way these grants are awarded.

The investigation focuses on whether companies are giving executives backdated options after a run-up in the stock. Backdated securities are priced at a value before a rally, which boosts their returns."

From NPR:

" The Securities and Exchange Commission (SEC) is reportedly examining the timing of stock option awards by corporations." (BTW this is included to you can listen to it--has several professors speaking on it.)

From the LA Times:

""The stock-option game is supposed to confer the potential for profit, but also some risk," said John Freeman, a professor of business ethics at the University of South Carolina Law School who was a special counsel to the SEC during the 1970s. "When in essence the executives are betting on yesterday's horse races, knowing the outcome, there's no risk whatever.""

What does past academic research have to say on this? Most of the evidence suggests that backdating probably does occur.

For years there have been papers showing that managers tend to announce bad news prior to option grants and even time the grants prior to price run ups (see Yermack 1997) it has only been more recently that researchers have noticed that the price appreciation was not merely due to firm specific factors (which managers may be able to control and time) but also market wide factors (i.e. the stock market goes up after option grants).

Last year a paper by Narayanan and Seyhun suggested that this may be the result of backdating the option grants. More recently two papers by Collins, Gong, and Li (a) and (b) find further evidence that backdating is (or at least was) happening and that unscheduled grant dates (where this can occur) tend to be found more commonly at firms whose management has relatively more control over their board of directors.

Stay tuned!!

* A quick comment to any manager who may have done this: Why bother? Why risk it all cheating for a few extra dollars? (Indeed it reminds me of the Adelphia case where the firm outsourced snow plowing to a Rigas owned firm. It just doesn't seem worth it.)

*As an aside, once again this shows that finance and accounting go hand in hand as Collins, Gong, and Li are accounting professors!

How and WHY does inclusion in an index affect stock prices

It is well known that when a stock gets added to an index, the stock price jumps. This has been known for at least as long as the mid 1980s (Harris and Gurel 1986 JF). However the "why" has been the question ever since.

Some alternative hypotheses that have been examined include
  1. "Certification" by the company running the index (for instance, for the Standard and Poors 500, Standard and Poors MIGHT pick stocks that are expected to go up in the future--although S&P do not claim to do so).
  2. Increased liquidity
  3. Reduced information costs and/or better monitoring (since more analysts may follow the stock)
  4. Some investors must be made aware of the stock (Merton's Shadow Cost idea)
After the initial stock price jump was found, further research has shown that the price appreciation on inclusion is greater (and more permanent) than the price decline when the price falls. Which is consistent with the shadow cost hypotheses but still leaves the question of certification in play.

Now Jay Dayha in his paper "Playing Footsy with the FTSE 100 index" offers further insights by studying the FTSE. The fact that the FTSE is used is what really separates this paper.

Why? Becasue inclusion into the FTSE is more or less an automatic process (100 of the 110 largest stocks on London Stock Exchange). Thus, there is no certification going on.

Dayha's findings? There is a positive and permanent stock price jump on inclusion (about 1.86% on announcement and over 5% from announcement to inclusion). For deletions, there is only a temporary price drop.
"FTSE 100 Index additions reveal a permanent positive stock price response, whilst deletions are associated with a negative response, which is fully reversed over a 120 day-period after news of index removal. These results are consistent to those reported by Chen, Noronha and Singhal (2005), hereafter CNS (2005), on stock price effects to S&P 500 Index changes"
Why the price jump? It may be that firms in, or recently removed from, the index are under greater monitoring. In the author's words:
"...additions are associated with significant improvements in both realized and expected earnings (consistent with DMOY (2003)), and reduced information asymmetry as measured by a change in press coverage and Merton’s shadow cost (consistent with CNS (2005))."

"...deletions are not associated with a symmetric reduction in expected earnings or increase in information asymmetry. In fact, index deletions reveal a significant increase in realized and forecast earnings."

However, this price jump may have an economic rationale. Namely increased monitoring and better information.
"...It would appear that investors place increased scrutiny on the managers of firms added to and removed from the FTSE 100 Index."

Additionally, it fits well with Merton's shadow cost idea--namely that investors must be made aware of the stock. This awareness occurs upon inclusion. Deletion does not affect the awareness factor so the price should not be expected to drop back to its previous (pre-inclusion) level.

What is interesting (and really cool) about the paper is that the author then breaks down this price jump into component factors. For instance:
"...0.33 percent of the permanent stock price effect to index additions can be attributed to a change in future eps forecasts and a further 0.19 percent to changes in investor awareness (i.e., change in press coverage and shadow cost). Thus, the permanent stock price effect to index additions of 1.63 percent diminishes to an insignificant level after information effects have been stripped away."
Which deserves a wow! VEry cool. Definitely will find its way into class!!

Cite: Dahya, Jay, "Playing Footsy with the FTSE 100 Index" (January 11, 2006). Available at SSRN:

Monday, May 22, 2006

Is Corporate Social responsibility good for shareholders?

Corporate Social Responsibility as a Conflict between Shareholders

Main point of paper: Barnea and Rubin ask the tough and important question of whether Corporate Social Responsibilty (CSR) is value increasing or whether it is an agency cost problem whereby managers and others accrue benefits at the expense of shareholders.

They find that firms with "higher insiders ownership and leverage are negatively related to the firm’s social rating." This is largely consistent (although by no means the final word) with a view that "insiders...may seek to over-invest in CSR for their private benefit to the extent that doing so improves their reputations as good global citizens."

Longer Summary:

Barnea and Rubin begin by stating Corporate Social Responsiblity (CSR) is a very hot topic but we do not know to the extent that it benefits shareholders. This paper investigates this by examining the CSR ratings on approximately 3000 firms.

They key finding is that CSR ratings are negatively related to the percentage of insider ownership. This is tested in several ways. For instance from their probit analysis (OLS on if the firm passes the CSR screen or not), they report:
"The most striking result in our analysis is that the coefficients of insider ownership and leverage are negative and significant at the 1% level across all specifications. On the other hand, the coefficients of institutional ownership are insignificant with inconsistent signs."
The paper also points out that while some CSR spending may be good, too much may be bad. In their words:
"A key argument in our analysis is that the relation between CSR expenditure and firm value is non-monotonic. When CSR expenditure is low, we expect that it should contribute positively to firm value, for example, by increasing the productivity of employees or by avoiding reputational or pollution-related costs and fines. But at some point...the marginal effect of an additional dollar of CSR expenditure must decrease shareholder wealth as there is no limit to the amount that a firm can transfer
to its stakeholders."
This is tested with a piecewise regression. The results are as expected. Again in Barnea and Rubin's words:
"The analysis suggests that at low levels of insider ownership (up to 25%), there is no relation between insider ownership and CSR, while at levels above 25%, the relation is negative and highly significant. This suggests that only levels of ownership above 25% align insiders with other shareholders as only then do insiders bear a significant amount of the costs involved with CSR. On the other hand, lower levels of ownership do not help to mitigate a potential CSR conflict."
The paper also tests whether capital structure influences CSR. The logic behind the use of leverage is that debt payments may help control agency cost problems through both less available cash at managers' discretion and additional monitors. Like above, they find that firms with more debt are rated lower on CSR.

Overall a very interesting and important paper! I^3

Comments: First of all let me say again that I really liked the paper and the analysis and I agree with their findings. Moreover the paper adds much to our understanding of this very important question.

However, I would like to at least suggest some alternative interpretations (and be sure to read my admission of a slight bias below).

* To the extent that higher insider ownership means concentrated holdings by investors, it could be that CSR spending lower due to the increase in risk that the spending necessary to improve CSR ratings would entail.

* Higher leveraged firms tend to be less profitable. This has at least two implications:
  • The levered firm may not have the necessary resources to make this expenditures (especially to the degree that management ownership and size are tied together AND there are fixed costs of issuances.)
  • The deductions allowed on the CSR expenses (think of it as a donation) are not as valuable. This tax shield is thereby reduced.
An imperfect solution to this might be to use Q-values to proxy for agency costs rather than leverage.

Overall a definite must read!!! Highly recommended!

Cite: Barnea, Amir and Rubin, Amir, "Corporate Social Responsibility as a Conflict Between Shareholders" (March 10, 2006). Available at SSRN:

Disclaimer: Because of my ties to both a private University as well as the work I do with BonaServes I am at least partially dependent on donations, and hence not a totally disinterested party.

Friday, May 19, 2006

NY Times: S.E.C. Eases Audit Rules but Rejects Exemptions

Small firms and even academic researchers (see for instance Linck, Netter, and Yang 2005) have noted that the costs of Sarbannes-Oaxley compliance are higher for small companies. In part as a response to the complaints, the SEC tried to make things easier.

From the NY Times:
"The Securities and Exchange Commission moved yesterday to make audit rules that have angered many companies easier and less expensive to apply. But despite political pressure, the commission said smaller companies would eventually have to comply with rules governing their internal controls."

*"...The cost of compliance for smaller companies has been the prime exhibit in political arguments that provisions of the Sarbanes-Oxley Act of 2002 should be scaled back, and a bill to exempt most companies from the rules was introduced in Congress hours before the commission made its announcement."

*"The S.E.C. statement came as the Public Company Accounting Oversight Board announced plans to change the auditing standard involved, with the aim of making the rules clearer and permitting audits to be done more efficiently."

Stay tuned.

Huge bill for public retirees hits soon

Just on the outside chance that things are too good for you today, I will give you something to worry about. To put it bluntly, this is not good. Talk about an off balance sheet liability!! Wow.

From USAToday

"Taxpayers will soon get a surprise bill that could exceed $1 trillion for the cost of paying future medical benefits for state and local workers who retire.

Retiree medical costs are the biggest long-term challenge that state and local governments face. By comparison, state and local pensions have an unfunded liability of about $500 billion.

State and local governments have set aside $2.5 trillion to help pay pension benefits for 19 million civil servants and 7 million retirees. But they have set aside almost nothing to pay for retiree medical benefits. (Emphasis is mine. How can this be???)

"Taxpayers will revolt when they realize the enormous cost of this," Minnesota State Auditor Pat Anderson says. She says the financial burdens on local governments will be so great they will put pressure on the federal government to nationalize health care, which she opposes.

New accounting rules require that governments, starting next year, put a price tag on the value of medical benefits promised to civil servants when they retire. New York City's liability, for example, approaches $50 billion. The city's total budget last year was $53 billion.

Well then. I guess corporations are not the only group having trouble with retiree benefits.

Wednesday, May 17, 2006

Hedge fund follow-up

Two additional articles that you might enjoy on hedge funds (see yesterday's entry)

1. From GreenTrader(via

How to Set Up Your Own Hedge Fund:
"Traders and money managers often dream about one day running their own hedge fund, managing large sums of money, and competing head to head with the world's top traders. For many, though, this dream remains unfulfilled, because they do not know where to begin and do not want to squander their resources “reinventing the wheel.”
and later:
"The first step toward setting up a hedge fund is getting a better grasp of what exactly a hedge fund is. Hedge funds often are compared to registered investment companies, unregistered investment pools, venture capital funds, private equity funds, and commodity pools....Unlike a mutual fund, a hedge fund is not registered as an investment company under the Investment Company Act and interest in the fund is not sold in a registered public offering. Hedge funds can trade in a wider range of assets than a mutual fund. Portfolios of hedge funds may include fixed income securities, currencies, exchange-traded futures, over-the-counter derivatives, futures contracts, commodity options and other non-securities investments."
Read the entire thing here. It goes on to show also who is an accredited investor (and hence can invest in hedge funds). Good stuff!

2. The second "item" is from Fed Chairman Bernanke's speech on systemic risk and hedge funds. A rather long "look-in":
"The primary mechanism for regulating excessive leverage and other aspects of risk-taking in a market economy is the discipline provided by creditors, counterparties, and investors. In the LTCM episode, unfortunately, market discipline broke down....

The Working Group's central policy recommendation was that regulators and supervisors should foster an environment in which market discipline--in particular, counterparty risk management--constrains excessive leverage and risk-taking. Effective market discipline requires that counterparties and creditors obtain sufficient information to reliably assess clients' risk profiles and that they have systems to monitor and limit exposures to levels commensurate with each client's riskiness and creditworthiness....

For various reasons, however, creditors may not fully internalize the costs of systemic financial problems; and time and competition may dull memory and undermine risk-management discipline. The Working Group concluded, accordingly, that supervisors and regulators should ensure that banks and broker-dealers implement the systems and policies necessary to strengthen and maintain market discipline, making several specific recommendations to that effect. The Working Group's recommendations on this point have largely been followed....

An alternative policy response that the Working Group considered, but did not recommend, was direct regulation of hedge funds. Direct regulation may be justified when market discipline is ineffective at constraining excessive leverage and risk-taking but, in the case of hedge funds, the reasonable presumption is that market discipline can work. Investors, creditors, and counterparties have significant incentives to rein in hedge funds' risk-taking. Moreover, direct regulation would impose costs in the form of moral hazard, the likely loss of private market discipline, and possible limits on funds' ability to provide market liquidity.

The speech was given yesterday.

Finance Reading List

I was asked for a "summer reading list" for finance classes so here you go: ten (non technical) finance/economics books I would recommend.

1. The World is Flat by Thomas Friedman. It has been talked about everywhere (even the SBU graduation speaker mentioned it by name) but it is definitely worth the read! Probably my favorite of the bunch. Read what I wrote about it previously.

2. The Wisdom of Crowds by Jame Surowiecki. Great. Tells you more about market efficiency (and the lack thereof) than several classes could.

3. Random Walk Down Wall Street-by Burton Malkiel. A must read classic!

4. Against the Gods--Peter Bernstein. I remember my first reaction to this book was--Wow! It makes risk management not only interesting but fun!

5. The End of Poverty by Jeff Sachs. It is about ending extreme poverty. I really liked it! An important read that covers strategies to fight poverty from China to India to Africa. Also has an interesting economic history of the world. Introduction is by Bono.

6. Heard on the Street: Quantitative Questions from Wall Street Job Interviews--even if you are not interviewing, this one is interesting and somewhat fun! EVERY business school should have this one!

7. Barbarians at the Gate--Yeah, it's outdated. Yeah, it reads like a novel. Yeah, I like it and still use some of the examples.

8. Freakonomics--by Steven Levitt and Stepham Dubner. It is an interesting and fast read. Levitt is always a worthwhile read.

9. Fooled by Randomness by Nassim Nicholas Taleb. I hate to admit it but I think about this book during almost every sporting event I watch. It may not be the best written book on the list (and I have to agree with the Amazon review, he does come across as arrogant) but it is still definitely a VERY worthwhile read.

10. Worry Free Investing by Zvi Bodie. Basic idea: invest in bonds and options. Might be a tad text-bookish, but such a great idea. I hope more people do it!

Well there you have it. Ten Finance books to read this summer ;) No doubt I have forgotten many others as well, but here are a few to whet your appetite.

Maybe someday soon I will list ten non finance books again.

Ancient Finance from HBS

The HBS Working Knowledge site has an interesting article by William Goetzmann on financial instruments back in the time of the Romans and Greeks. For instance on checks:
"...bankers' checks written in Greek on papyri appeared in ancient Egypt as far back as 250 B.C. Papyri preserved well in Egypt thanks to its arid climate, but Goetzmann thinks it's safe to say such checks changed hands throughout the Mediterranean world.

"So the whole tradition of bank checks predates the current era and has its roots at least in Hellenistic Greek times," he says."

VERY interesting! Great for a money and banking class!

I may have to buy his book The Origins of Value as well. Although I have been told "no more Big books."

Tuesday, May 16, 2006

Fed's Patrick M. Parkinson on Hedge Funds

Let's see what the Fed's Patrick Peterson who is the Deputy Director of the Division of Research and Statistics had to say to the Subcommittee on Securities and Investment, Committee on Banking, Housing, and Urban Affairs, U.S. Senate

Some highlights:

* "In my remarks today, I will discuss the increasing importance of that role, the public policy issues associated with it, and what the Federal Reserve has been doing to address concerns about potential systemic risks from hedge funds’ activities."

*" The role that hedge funds are playing in capital markets cannot be quantified with any precision. A fundamental problem is that the definition of a hedge fund is imprecise, and distinctions between hedge funds and other types of funds are increasingly arbitrary....
Although several databases on hedge funds are compiled by private vendors, they cover only the hedge funds that voluntarily provide data.1 Consequently, the data are not comprehensive. Furthermore, because the funds that choose to report may not be representative of the total population of hedge funds, generalizations based on these databases may be misleading. Data collected by the Securities and Exchange Commission (SEC) from registered advisers to hedge funds are not comprehensive either. The primary purpose of registration is to protect investors by discouraging hedge fund fraud. The SEC does not require an adviser to a hedge fund, regardless of how large it is, to register if the fund does not permit investors to redeem their interests within two years of purchasing them.2 "

* "Even if a fund is included in a private database or its adviser is registered with the SEC, the information available is quite limited. "

* "
Although the role of hedge funds in the capital markets cannot be precisely quantified, the growing importance of that role is clear. Total assets under management are usually reported to exceed $1 trillion.4 Furthermore, hedge funds can leverage those assets through borrowing money and through their use of derivatives, short positions, and structured securities. Their market impact is further magnified by the extremely active trading of some hedge funds."

* " Hedge funds and their investment advisers historically were exempt from most provisions of the federal securities laws.8 Those laws effectively allow only institutions and relatively wealthy individuals to invest in hedge funds. Such investors arguably are in a position to protect themselves from the risks associated with hedge funds.9 However, in recent years hedge funds reportedly have been marketed increasingly to a less wealthy clientele. Furthermore, pension funds, many of whose beneficiaries are not wealthy, have increased investments in hedge funds"

It goes on and is very interesting but I have included too much already and will leave the rest to you.

(As an aside to professors, students seem very interested in this discussion and I highly recommend bringing it into the classroom! I do so after discussing the importance of hedge funds and discussing Long Term Capital Management.)

The Bogle Blog!

John Bogle is truly one of my heros. I really do not think his impact on the small investor can be overstated. He has been a long-time advocate for lower transaction costs and less frequent trading. And this from the founder and long-time leader of Vanguard.

From his bio on
"In 2004, TIME magazine named Mr. Bogle as one of the world's 100 most powerful and influential people, and Institutional Investor presented him with its Lifetime Achievement Award. In 1999, FORTUNE designated him as one of the investment industry's four "Giants of the 20th Century." In the same year, he received the Woodrow Wilson Award from Princeton University for "distinguished achievement in the nation's service." In 1997, he was named one of the "Financial Leaders of the 20th Century" in Leadership in Financial Services (Macmillan Press Ltd., 1997).
So why the excitement today? Barry from the FinancialPage sent the good news that John Bogle is starting his own blog! The Bogle Blog. It will definitely be a MUST READ!! It even has the text of his speeches etc.

From Bogle's entry from yesterday (May 15):
"The Bogle Blog. Can you believe it? A few months ago I barely knew what on earth a “blog” was, and now here I am blogging. I’m excited, however, about the opportunities this new website will offer me, and hope that what you find here keeps you coming back to check in."
I for one am sure I will be checking in regularly!

Thanks again to Barry at the FinancialPage!

Monday, May 15, 2006

When are behavioral biases most pronounced

When do Investors Exhibit Stronger Behavioral Biases? by Alok Kumar.

To get a quick understanding of this paper, ask yourself the following question: when do biases (financial or otherwise) play a large role in decision making?

Your answer probably includes "in areas where there is much subjectivity" or "in gray areas". Why? Because you can not readily prove the opinion wrong.

For example, why do most drivers feel they are "above average"? Probably because there is no easily identified (and readily available) measure of driving abilities, thus everyone is more or less allowed to think what they want and hence they are all "above average". (The reverse is true in track and field where an abundance of hard-fast (pun intended) data allows instant evidence of one's relative standing.)

Kumar ingeniously takes the above logic and applies it to financial markets. In the author's own words:
"In particular, how does value ambiguity (or information uncertainty) influence the strength of investors’ behavioral biases? Are investors more likely to make mistakes in settings with greater uncertainty or do stocks that are more difficult-to-value attract a clientele that exhibits stronger behavioral biases?"
This idea in and of itself is not new, but the empirical testing of this idea is and that is exactly what Kumar does! And sure enough, he finds that investors behave as behavioral finance would predict.

From the paper:
"Consistent with the theoretical predictions, I find that investor overconfidence is higher for stocks which are more difficult to value. Additionally, I find that higher market-wide (or economy-wide) uncertainty (higher mean stock volatility, higher unemploymentrate, etc.) induces greater overconfidence among individual investors."
He goes and and finds that several other biases are also more prevalent (for instance disposition bias) when uncertainty is high.

People will definitely be talking about this one! I^3! (for the new readers, I^3 is Interesting, Important, and Informative)

Kumar, Alok, "When do Investors Exhibit Stronger Behavioral Biases?" (June 2005). Available at SSRN:

To add my two cents to this: These findings suggest that biases are always there, but to varying degrees. It would thus be interesting to see some of the recent behavorial finance literature re-examined over different time periods to see how much the results may change. Stay tuned!

The NYSE and Competition

Competing with the NYSE by William Brown, Harold Mulherin, and Marc Weidenmier.

No, this is not on the impact of ECNs (Electronic Communication Networks) on the NYSE. Rather, it is a fascinating look back to competition from the Consolidated Stock Exchange NYSE's cheif rival from 1885 to 1926.

Some of the cool points of the paper

1. The NYSE has faced major competition--at its peak the Consolidated Stock Exchange had about 60% of the NYSE volume.

2. The NYSE fought hard (in courts) to prevent member frims from trading with the Consolidated exchange and to prevent others (Consolidated) from using their ticker information. They even went as far as to prevent any communication between the two exchanges (see Appendix NY Times Feb. 27. 1891)

3. NYSE spreads narrowed for shares that were traded on the Consolidated Exchange but not for other shares.

Very interesting!!!

Brown, William O., Mulherin, J. Harold and Weidenmier, Marc, "Competing with the NYSE" (March 2006). Claremont Colleges Economics Department Paper Available at SSRN:

Are real estate commissions going to go the way of stock commissions?

Battling the 6 percent realtor commission - May 1, 2006:
"The 6% real estate commission has been under assault awhile, but the hits just
keep coming - and are getting more sophisticated. Three Internet upstarts are the latest to take a shot"
That the internet is shaking up the Real Estate business is obviously no surprise. What is surprising is that it has taken so long. Be sure to check out the sites listed on the CNN page. It is amazing how much detail they have! You can see how much home prices vary even within relatively small areas.
Of course, Steve Levitt, who has railed against the 6% commission, must be happy!

Friday, May 12, 2006

The role of learning in M&A

What better way to kick off "summer" than with a really cool paper from Aktas, de Bodt, and Roll?

Short version: The paper confirms the now well known finding that Cumulative Abnormal Returns (CARs) drop with subsequent takeover announcements. The authors proceed to separate takeovers that are done by "rational CEOs" and those that are done by "hubris infected" CEOs. Both groups do show learning in subsequent takeovers (for instance taking over larger firms and with less time between deals), but the hubris group is doing takeovers less often.

Longer version: Aktas, de Bodt, and Roll show once again that when firms do multiple takeovers, the market has correctly forecasted the likelihood of these deals and thus the market reaction to the deal announcement is muted. This finding is consistent with Schipper and Thompson's 1983 JFE article.

What is interesting is that this is true for "rational" CEOs (who have their CARs decrease towards zero) as well as "hubris infected" CEOs (who have their CARS increase towards zero).

A key to the paper is the sample definition. The authors break the overall sample of deals into a rational and a hubris-infected sample (I love the name!). The actual sample selection will no doubt be somewhat controversial (although any definition of a hubris sample would likely suffer the same fate). The authors create the hubris sample by ranking firms in decreasing order of the CAR of their first deal. Thus by definition if a deal results in a large positive CAR, it was rational. (and yes this first deal is then ignored for subsequent analysis).

Key findings:

1. The subsequent CARs are closer to zero for both sub-samples.

2. Learning does play a significant role (as evidenced by subsequent deals being larger and coming closer together. This is true for both sub-samples.

3. The "Hubris-infected" group has its time between deals decrease but at a slower rate than the "rational" group.

A very thought-provoking paper. Definitely recommended reading!

Nihat Aktas, Eric de Bodt, and Richard Roll. 2006. Hubris, Learning, and M&A Decisions: Empirical Evidence. UCLA working paper

BTW: I was good and did not mention the "Cars" and the "new" Cars (with Todd Rundgren replacing Rik Ocasek) even once, until now.

Expropriation: a way NOT to build an economy

My note to all national leaders who have not had economics or finance classes.

It may be tempting. It may even look like a great idea: a way of making up for past injustices (real and imagined). But expropriation is almost never a good means of building an economy.

Why not? As Aguiar, Amador, and Gopinath write "...[the] threat of expropriation depresses investment, prolonging downturns."

What news spurs this economic truism? Bolivia is at it again. From Bloomberg:
"Bolivian President Evo Morales said he will extend his nationalization of private property to include agricultural estates and ruled out any compensation for oil companies whose assets the government took over May 1"
As the Austrian Foreign minister Ursala Plassnik added: "We need legal security and confidence because these are the core topics for investors."

Interestingly (think nexus of contracts), government officials may have incentives behind their apparent economic madness. In a World Bank 2002 working paper Keefer and Knack write that in the presence of "insecure property rights" firms may have an incentive to pay off politicians. ("Pay-off are my words not their's. They use: "Rent-seeking is best seen as that portion of predictable government taxes that are retained by government officials for their own uses.")

If lower foriegn investment was not enough reason to not threaten expropriation, Keefer and Knack also write that insecure property rights could lead to lower government investments as well.

Thursday, May 11, 2006

High School Economics--some really good examples!

This is pretty cool. It is designed for High Schools, but many of the items can be used in college AND even if not, it is useful to know what knowledge incoming freshmen posses. Oh and it is always useful to watch great teachers!

Resource: The Economics Classroom: A Workshop for Grade 9-12 Teachers:
"Video workshop for teachers provides a solid foundation for teaching the concepts covered in high school economics courses. Topics range from personal finance to global economic theories. In addition to defining economics concepts and outlining modern economic theory"
There are some really cool videos of lessons. Yes you have to subscribe, but it is free. Go ahead, you will get some good ideas!

Financial Research Association call for papers


Call for Papers The 2006 Financial Research Association Meeting
December 16 and 17, 2006 Las Vegas, Nevada

"The program committee of the Financial Research Association seeks finance papers of general interest to the profession....The selection process is extremely competitive. Last year’s program represented 7% of submissions."

Want to succeed? Better be prepared to work hard!

While it is "pure finance", it is both interesting and important and from time to time it is important to take a step back and think about learning. That is why, in this time of many graduations (and the NFL draft ;) ), this post will appear on this larger blog and not just my class blog. Indeed it may be the most important lesson we can learn! Namely, that success is hard and that talent alone will not get you very far.

From the NY Times (by Stephen Dubner and Steven Levitt)
"Anders Ericsson, a...psychology professor at Florida State the ringleader of what might be called the Expert Performance Movement, a loose coalition of scholars trying to answer an important and seemingly primordial question: When someone is very good at a given thing, what is it that actually makes him good?

Their work, compiled in the "Cambridge Handbook of Expertise and Expert Performance," a 900-page academic book that will be published next month, makes a rather startling assertion: the trait we commonly call talent is highly performers -- whether in memory or surgery, ballet or computer programming --— are nearly always made, not born."
Which may not what you wanted to hear as you begin your careers (or even your summer "break") but is, in some ways encouraging.

Saturday, May 06, 2006

Berkshire Hathaway's annual meeting

Two reasons for this entry:
1. I love to follow Warren Buffett's Berkshire Hathaway's annual meetings.
2. The WSj is having a 10 day free online trial. - Reporters' Notebook: Wisteria Lane, Omaha:
"The annual shareholder gathering at Berkshire Hathaway's headquarters in Omaha on Saturday, often called 'Woodstock for Capitalists,' included bling, a merger deal and appearances by the 'Desperate Housewives' cast.Here are dispatches from the meeting."
For another look at it, here is the intro from the Houston Chronicle:
"Billionaire Warren Buffett greeted thousands of his faithful followers Saturday at the Berkshire Hathaway Inc. annual meeting, likely to face questions on everything from his successor to his company's latest acquisition.

Company officials predicted a record crowd of more than 20,000 people...University of Kansas junior Luiza Loureiro got in line for the meeting at 1:30 a.m. and said two or three other people were already there....[she] said she came so early because she wanted a chance to ask Buffett about Latin American investments and her finance professor offers extra credit to students who ask a question during the meeting."

Thursday, May 04, 2006

Louis Rukeyser, Television Host, Dies at 73 - New York Times

I always liked his show. :(

Louis Rukeyser, Television Host, Dies at 73 - New York Times:
"Louis Rukeyser, the exquisitely tailored and pun-loving television host who helped millions of Americans believe that they could get rich in the stock market, or at least begin to understand it, died yesterday at his home in Greenwich, Conn. He was 73.
AN interesting point in the article:

"Wall Street Week" was broadcast for the first time on Nov. 20, 1970.... The Dow Jones Industrial Average was then languishing, and the population of American mutual funds numbered a scant 323."

Is risk aversion an instinct? Monkeys may hold the answer

ScienceDaily: New Study Finds Similarities Between Monkey Business And Human Business:
"As part of the study, the researchers presented capuchin monkeys with two payoff-identical gambles: one in which a good outcome was framed as a bonus, and the other in which bad outcomes were emphasized as losses. Like humans, the monkeys displayed a strong preference for the first option, and like humans, the monkeys seemed to weigh the losses more heavily than comparable gains.
'Our results suggest that loss-averse behavior is a very general feature of economic choice,' explain the authors. 'Given our capuchins' inexperience with trade and gambles, these results suggest that loss-aversion extends beyond humans, and may be innate rather than learned.'"
The paper by Chen, Lakshminarayanan, and Santos is in the JPE. A working paper copy is available through SSRN.

Cite: Chen, Keith, Lakshminarayanan, Venkat and Santos, Laurie, "The Evolution of Our Preferences: Evidence from Capuchin Monkey Trading Behavior" (June 2005). Cowles Foundation Discussion Paper No. 1524 Available at SSRN:

Wednesday, May 03, 2006

Free Financial Spreadsheet templates!!

Free Excel Spreadsheets

This collection (which is simly awesome) is from Matt Evans. Great Job!!

Thanks to MoneyScience for pointing it out!!

Update on NASDAQ-LSE

This one sure has legs. It has been going on seemingly forever.

Nasdaq increases stake in the LSE:
"Former takeover suitor Nasdaq Stock Market Inc. revealed Wednesday that it has increased its stake in the London Stock Exchange PLC to 18.9 percent....The purchases are the second major move by Nasdaq to increase its share of the bourse -- Europe's oldest and largest -- since it abruptly dropped a 2.4 billion pound (US$4.4 billion; euro3.7 billion) bid in March."

"Nasdaq dropped its takeover bid without explanation on March 30 and, under British takeover laws, must wait six months from that date before making another bid -- unless the LSE backs a revised offer or another buyer emerges"

FEN interview with Jack Treynor

This one should not be missed. FEN has an interview (text) with Jack Treynor (yeah that Jack Treynor, the person who helped devlop CAPM) .
"Jack Treynor is one of the river gods of finance. He helped develop the Capital Asset Pricing Model, which relates risk and expected return, in the early 1960s and spearheaded the field of performance measurement for investment funds. Over the decades Treynor’s reputation as a fearless, maverick thinker who clears his own path into topics that catch his interest has become legendary. Treynor developed a version of what became the Capital Asset Pricing Model in 1962, before the 1964 publication of William Sharpe’s paper laying out what became the CAPM. Treynor never published his paper. John Lintner, an economist at Harvard Business School, published a version of the CAPM in 1965. "

Monday, May 01, 2006

NPR : Q&A: What's Behind High Gas Prices?

Given that every single media outlet seems to be focuisig on price if gas, I found this interesting: it even has some real numbers!

NPR : Q&A: What's Behind High Gas Prices?:
"If a gallon of gasoline costs $2.90 (this week's average, according to the Energy Department), crude oil accounts for about $1.60. The cost of crude oil on the futures market has risen about 33 percent in the last year....Refining costs add another 64 cents or so to a gallon of gasoline. Refining margins have increased from a few years ago, and are especially high this spring, because many refineries are currently shut down for seasonal maintenance."
and later:
"Big oil companies are making most of their money by producing crude oil. They invested in oil fields when prices were much lower, with the expectation that they could break even at, say, $25 per barrel. Since the market price is now more than $70 a barrel, the extra money is gravy....they can no more control those prices than a farmer can dictate what he gets for a bushel of corn...f oil companies could control the price of crude oil, they would not have allowed the price to fall to $10 a barrel as it did in 1998."