Friday, August 25, 2006

Economics Humor

No, it is not from this site devoted to economics humor, but a true story!

Yesterday I joined a group of cyclists for a 50 miler in the local state park.

During summer months the park charges $7.00(?) per car from 10:00-4:30. Our ride started at 4:00 pm so for those doing the entire ride (there were shorter options), we were expected to pay the $7.00.

While no one wants to pay, I figure that any park (and especially one of this size and grandeur--it is the largest in NY State) needs money to operate and given the utility I get from the park (remember for much of year they do not charge anything), when I do pay, I definitely fell that I still have a positive consumer surplus (another good economic word!)

Notice the important fact that only cars must pay--if you come in on foot (or bike) you do not need to pay. Oh and did I mention that there is a parking area just outside of the park.

Sure enough, several of our group yesterday made the purely rational decision of parking their vehicles and riding their bikes into the park, thus avoiding the fees.

Which is the classic "free rider problem". (

Thursday, August 24, 2006

well well well

Monitoring might work ;)

First go back a ways and read this from two weeks ago. A look in:
"...earlier this week Sharesleuth made their first publication coming out harshly against Xethanol(XNL). Sharesleuth claims that the firm is dramatically overvalued and that its reported leadership position in the field of ethanol production is largely just hype."
And now from Sharesleuth:

"Xethanol Corp. has replaced Christopher d’Arnaud-Taylor as chief executive officer."
and while Sharesleuth is still asking for more, this is pretty fast for a board to move. Again, stay tuned.

Common Investment Mistakes

Could almost be called "Behavioral Finance in Practice" by the Wall Street Journal's Jonathan Clements from MoneyWeb:

Some look-ins:
  • ""People tend to buy the investments they wish they had bought last year," says Terrance Odean, a finance professor at the University of California at Berkeley. "Partly, people simply extrapolate the past trend. But also, people feel that the markets are more predictable than they really are."
If we were rational, we would grow leery as an investment rises in price, because we are now paying more for the same investment. Instead, however, we are drawn to hot stocks and hot mutual funds, because we assume that the future will look like the immediate past."
  • "Rather than accepting that market conditions have changed, home sellers today are often fixated on the price they paid or the price they could have gotten at the market peak. Indeed, whether it is real estate or stocks, folks like to "get even, then get out."

    This, of course, is partly about making money. But it is also about avoiding regret"
  • "According to the Commerce Department's Bureau of Economic Analysis, the U.S. savings rate turned negative over the three months through June 2005 and it has remained that way ever since.

    Partly, this reflects our struggle with self-control. Instead of rationally socking away money on a regular basis, we prefer to spend today and put off saving until tomorrow.

    I suspect the negative savings rate, however, is also driven by our overconfidence"

As always Clements offers some good advice in a readable fashion.

Does friendliness trump independence?


SUPER Quick version: if the threat of monitoring causes managers to withhold information, the advising aspect of a board is impaired and the firm suffers. A solution may be a portion of the board that advises and a portion that monitors, which while often unweildy is exactly what happens in many European nations.

From the University of Queenland's Newsletter:
"Research by UQ Business School's Professor Renée Adams [and Daniel Ferreira] suggests that increasing the independence of boards may not be so good for shareholders.
and later:
"She said the research showed that emphasising director independence may have adverse consequences in the sole board system but would "unambiguously" enhance shareholder value in a dual board system.

“By delegating monitoring roles to audit and remuneration committees, a sole board takes on the nature of a dual board. Thus, our results imply that emphasising independence of committee members is likely to result in good outcomes for shareholders,” Professor Adams said.

“But, when a management-friendly board is optimal, one should expect other governance mechanisms to pick up the slack.” "

The abstract from SSRN:
" This paper analyzes the consequences of the board's dual role as an advisor as well as a monitor of management. As a result of this dual role, the CEO faces a trade-off in disclosing information to the board. On the one hand, if he reveals his information, he gets better advice. On the other hand, a more informed board will monitor him more intensively. Since an independent board is a tougher monitor, the CEO may be reluctant to share information with it. Thus, our model shows that management-friendly boards can be optimal...."

Look for it in a forthcoming Journal of Finance!

Adams, Renee B. and Ferreira, Daniel, "A Theory of Friendly Boards" . Journal of Finance, Forthcoming Available at SSRN: or DOI: 10.2139/ssrn.453960

Tuesday, August 22, 2006

Are CEOs overpaid?

Yeah, I know I said I would go a while before posting, but Rich forwarded this to me and I think many of you will be interested. It is from MSNBC/Newsweek:

A few look-ins:
*"Ogling executive pay is the spectator sport of business. The catcalls from the stands have gotten louder as new studies throw out eye-popping statistics about how rich CEOs are getting, while the rest of us worry about keeping our jobs out of China. One such: the U.S.-based Institute for Policy Studies notes that CEOs made 142 times more than the average worker in 1994—and 431 times more in 2004."

*"Democratic Congressman Barney Frank is proposing a Protection Against Executive Compensation Abuse Act, which would limit tax deductions for companies that pay executives more than 25 times the lowest paid worker. But even as the drumbeat for reform grows louder, some new research is questioning just how out of proportion these megapackages really are—and whether more regulation is the best way to scale them down.First, there's the issue of metrics....[the article then shows that using medians reduced the average CEO to average worker pay multple to 187].

*Xavier Gabaix of MIT and Augustin Landier of NYU say that since 1980 the pay of CEOs has risen in lock step with the market capitalization of their companies: both are up 500 percent.

*"Good governance still plays some part in determining pay—the researchers say that CEOs can garner 10 to 20 percent more by going to a firm with a weak board. And cultural mores play some role, too; many of the Japanese firms studied were as big as American firms, but executives were paid less and changed jobs less often."

*"...nearly all firms are moving toward heavier reliance on bonuses. The average dollar amount of bonuses has doubled in the last three years, as they make up a growing proportion of pay...."

Interesting article and an easy read so it is perfect for the final "lazy, hazy, crazy days of summer."

Thanks Rich!

A "before-semester time-out"

Hi everyone...

I haven't written about "non finance things" in a while and figured before classes would be a good time to say hello and let you know that this week will not have many posts.

Things are going well on this end. Busy, but that is a good thing right? ;) However, like most things busyness is good only in moderation.

Why? Hhave you ever fell way behind and started to feel you could not catch up? Be it in racing, school work, or just your daily chores? Isn't it an awful feeling? always feeling guilty something is not being done, but almost powerless to get any more done.

For me, that was much of the last school year. I want to avoid that feeling this year and with classes starting this coming week, I am going to take the opportunity to catch up on as much as possible. I have two papers I have to review for editors and would like to put finishing touches on one of my own papers. Additionally I need to do syllabi etc for classes.

Rather than promise too much and deliver too little, I think I will take off this week from blogging on FinanceProfessor.

Now of course that may change and I may put up some short articles, but longer reviews will have to wait until I get caught up on things. I just do not want to start what promises to be a busy semester already way behind.

And in the mean time, enjoy the last days of break! Summer goes way too fast, take some time to enjoy it! Go for a hike, stop at the local farmers' market, or just "take some time to smell the flowers."

Speaking of nature and fun things, why not check out some of my favorite pictures from Flickr. There is no finance content and they were not taken by me, but they are really cool. I can not help but get in a good mood whenever I look at them.

Thanks and I'll be back to blogging in a week (or less!).


Thursday, August 17, 2006

Should you hold multiple mutual funds?

Should you hold multiple equity funds? Yes!

One of the more frequently asked questions from family and friends is whether there is any advantage to holding multiple mutual funds or whether a single fund yields the same diversification benefits.

Fortunately Louton and Saroglu shine some light on this question in their working paper "Individual Investors' Asset Allocation and Number of Mutual Fund Holdings."

Using simulations, they investigate various asset allocation schemes along with the number of funds held in equities, bonds, and cash. They find that holding multiple funds (especially in equity) does reduce risk (as measured by standard deviation of terminal wealth) significantly

The authors also report that the benefits of multiple funds are, as expected, greatest when there are multiple equity funds. In fact, a suggested strategy that comes out of this work is to diversify more heavily within equity funds (where there is great dispersion and lower correlations) and less (if at all) within cash and bond funds.

Some look-ins:
  • "The results....for each scenario for investment horizons of 5 and 7 years. Regardless of asset allocation weights and investment horizons, holding 18 funds in the portfolio instead of the minimum possible 3 funds as dictated by the choice of 3 asset classes enables the investor to reduce the standard deviation of terminal wealth by about 55%."
  • "...the average terminal wealth level at the end of each investment horizon
    remains the same as the number of funds in the portfolio increases"
  • "holding multiple funds in the dominant asset class together with one fund in each other asset class results in similar diversification benefits compared to holding multiple fund portfolios with equal number of funds in each asset class. These findings confirm the intuition that management style differences are less significant for bond and money market mutual funds...."
Of course this does ignore costs of accounting for various funds etc, but a reduction of risk of this magnitude seems to be well worth a few extra mailings.

BTW The best recap of the paper is found in table 3.

This will be presented at the FMAs in Salt Lake City (Thursday October 12).

Wednesday, August 16, 2006

Executive compensation around the world

Executive compensation is always a hot and interesting topic and this paper by Bryan, Nash, and Patel (all from Wake Forest) is no exception!

SUPER short recap:
  1. Pay varies with institutional factors and protections from country to country.
  2. As a general rule, if agency costs are high then firms pay with more equity.
  3. Large firms use more equity compensation than do small firms.
  4. There does not appear to be the great convergence that has been predicted.
  5. Agency costs of debt apparently matter less internationally than in US.

Slightly longer recap:

Bryan, Nash, and Patel (RNP) use a sample of 256 firms with ADRs from 36 countries for the years 1996-2004 to find that both macro/institutional (e.g. legal protections) and micro (growth opportunities, agency costs) affect pay.

The authors point out a possible bias in their sample creation:
"A trade-off for obtaining this accounting consistency is that our sample is made up
entirely of ADR-issuing firms. ADR issuers are commonly thought to be larger, more
established firms."
But believe that the tradeoff is necessary:
"feel that the data availability, coverage, and consistency provided by our ADR
sample outweigh any potential selection bias."
Some highlights from the paper:
"firms use more equity-based compensation in countries that provide strong protection of shareholder rights or have English common-law legal origins. Similarly, firms in countries with strong enforcement of the rule of law use more equity-based compensation.

In addition to these institutional determinants, we find some evidence that the relative use of equity-based compensation is also affected by the firmÂ’s agency costs of debt and equity. The data indicate that non-U.S. firms with higher growth opportunities (and the resultant larger agency costs of equity) use relatively more equity-based compensation. We also find that larger firms and firms with lower free cash flow use more equity-based compensation."
Contrary to prior hypotheses, the authors do not find that pay practices in different countries are quickly converging:
"We find that despite the increasing globalization of financial markets, the compensation structures of U.S. and non-U.S. firms generally remain very different during the 1996-2004 period"
While they generally do find the expected institutional (my 'macro') and agency cost (my 'micro') relations, the authors found limited evidence that the agency costs of debt are a driver in the way executives are paid internationally. These costs (for instance underinvestment and asset substitution) appear not to have as greatly of impact pay internationally as they do in the US. Why? RNP hypothesize it is because of greater creditor protections in many nations. Again in their words:
"Relating back to our institutional argument, it may be that the more creditor-centric orientation of most non-U.S. financial markets inoculates non-U.S. firms against threats posed by the agency problems of debt. That is, outside of the U.S., the mitigation of stockholder/bondholder conflicts may be a lesser concern when firms design managerial compensation contracts."

Good stuff...Really interesting! Oh sure a bigger sample etc would be nice, but this is a good first look at what is happening internationally. Will definitely find its way into the classroom!

BTW this is the first of many papers that we will be looking at from the upcoming FMA meetings.

FMA reminder

Probably my favorite finance conference is the FMA annual meeting. This year it is in Salt Lake City from October 11-14.

Over the next couple of months I will give some greater emphasis to papers from conference.

The program and registration information is available here.

Tuesday, August 15, 2006

Why Smart People make Big Money Mistakes

If you have any interest in behavioral finance or if you are looking for simple examples for class, I would definitely recommend "Why Smart People make Big Money Mistakes" by Gary Belsky and Thomas Gilovich.

I bought it for the examples and it has proven to be a very quick, easy, yet informative and fun read!

For instance it deals with problems people have figuring out odds (the example
is instantly memorable and informative:

* Is a shy, meek, yet helpful person more likely to be a librarian or in sales? Are you sure? Be careful. Why? Because there are about 75 times as many people in sales as there are librarians!

Virtually every page is made up of such great examples.

Another example?

*Ok, suppose you are going to a sporting event and lose your ticket. Do you buy a new ticket? What if you had lost money instead of a ticket (and assuming you could resell your ticket). Do you go then?

True it breaks little new ground, but isn't it fun just to sit back and enjoy finance?

Monday, August 14, 2006

How do you say? Stock returns and pronunciation

How people decide things is a fascinating topic. Recent work from marketing, psychology, and even finance is now suggesting that we may not know as much as we thought we did on how people make decisions.

For instance, how do you decide what cereal to buy? or what team to root for? or what stock to buy?

Atler and Oppenheimer (psychologists) contribute to this investigation with a paper that investigates whether the pronunciation of a stock symbol impacts the returns. They report that the pronunciation does matter.
"The ease of pronouncing the name of a company and its stock ticker symbol influences how well that stock performs in the days immediately after its initial public offering"
Why? Good question. It could be that information costs are lower for easy to remember firms, it could be that easy to pronounce symbols are given to "better" firms, or it could be that investors make decisions in a manner that traditional financial economists would call "irrational".

First the press release from Princeton (the paper is available for $10 from NSF):
"A new study of initial public offerings (IPOs) on two major American stock exchanges shows that people are more likely to purchase newly offered stocks that have easily pronounced names than those that do not, according to Princeton's Adam Alter and Danny Oppenheimer..."
This idea came from a classroom experiment:
"The two researchers were initially looking for a different effect when they stumbled upon the relationship between ease of pronounceability and performance. They asked a group of students to estimate how well a series of fabricated stocks would perform based only on the stocks' names.

"We gave them the list of company names and essentially asked, 'How well do you think the stock would perform?'" Oppenheimer said. "At the time, we were primarily interested in studying whether we could manipulate how people interpret the feeling that information is easy to process. We weren't trying to study markets or companies initially; stocks were just an interesting domain of inquiry."

However, the relationship was very strong -- regardless of Alter and Oppenheimer's attempts to manipulate students' interpretations, the students still believed that the easily pronounceable stocks would perform best."

Interesting to say the least. But I do have some questions and am looking forward to reading the actual paper! (Via a free interlibrary loan, not $10).

NOTE: Several of the links I have found on this seemingly use the term stock symbol and name interchangeably. It appears the actual paper used both, which begs the question of whether there were differences. This could be important for at least a couple of reasons: if it were company name, then one might suspect that at least part of the return difference (probably better measured using Q ratios) would come from consumers being able to remember the name (hence the importance of pronunciation might be lower for firms that market to other businesses (B2B) than to consumers (B2C). If it were only because of symbols, it is possible that easy to pronounce symbols (names etc) are given away in a way that signals firm quality.

One of the best links I have seen on this is from RedHerring.

(Thanks to JB for pointing this article out and to JG for suggesting the B2B and B2C distinctions!)

Monkey pay? Monkey do

Financial Rounds points out a really really cool article that shows for the zillionth time that economics works.

The blog entry is a review of a paper by Boyle who examines issues within academia. Now it has become my trademark to mention whenever pay issues come up that there are two key points to every pay issue: the form of pay and the level of pay. Form of pay is what creates incentives, whereas the level of pay determines the pool of candidates for the job.

It is this paper, Boyle largely examines the level of pay. What makes the paper is that in New Zealand university pay is independent of field. Thus in areas where the market rate is higher, the New Zealand schools lose the better employees to other schools whereas in fields where the market rate is lower, they get a better selection of candidates (and by extension employees).

The Unknown Professor (at FinancialRounds) summarizes it perfectly:
"In New Zealand, faculty receive the same salary regardless of their academic discipline (with a few exceptions - the medical and dental fields). So, a high-quality researcher in finance would give up a lot to go to New Zealand as an academic, since academic finance salaries are higher elsewhere. In contrast, an English professor considering a position in New Zealand has lower opportunity costs, since English professor salaries are relatively low outside of New Zealand."
Boyle introduces the main points very succiently:
"Even if non-financial phenomena such as pride and enjoyment are important motivators, the insights of personnel economics and efficiency wage theories suggest that there are still good reasons for believing that low remuneration should have an adverse effect on average worker quality.
  • First, there is a sorting effect: offering low remuneration discourages applications from high-ability workers.....
  • Second, there is an incentive effect: for given worker ability, high remuneration motivates greater effort due to the greater competition for such positions and hence the greater threat of termination in the event of under-performance....
  • Third, there is an appreciation effect: low pay may make workers feel less valued"
The findings? Again in Boyle's own words:
"more valuable opportunities have a significantly adverse effect on discipline research quality; on average, a one standard deviation increase in the average difference between US and NZ salaries lowers a discipline's average quality score by about 13%. A higher salary shortfall also reduces the percentage of high grades achieved by a discipline, and increases the number of low grades."
In other words, by and large labor markets do work. Of course, there are exceptions (people willing to accept less pay to be near family, work more flexible hours, or whatever), but by and large, if people are paid a below market rate, the employees will not be as "good" as if they were paid more.

Or as Boyle so aptly puts it: "paying peanuts attracts mainly monkeys"

Too informal for you? Ok, another Boyle quote: "pay levels do matter in determining the available pool of quality workers." (which says it better, but is not nearly as much fun).

Cite of paper:
Boyle, Glenn, "Pay Peanuts and Get Monkeys? Evidence from Academia" (August 2006). Available at SSRN:

Saturday, August 12, 2006

Finance, Literature, Science, History, and more

This is good! Using non finance examples to get finance across.

From Reuters:
"Economics may be called the dismal science, but that doesn't mean that anyone who writes about it or its sibling, investment, has to be dull.

How about '60s rockers Crosby, Stills & Nash to illustrate the need for a rebalancing of global financial fundamentals?

Or a population explosion among jellyfish off the coast of Namibia as a proxy for institutional investors fleeing risk?

Maybe, if you are a history buff, you would prefer linking a major U.S. civil war battle to the renewed rise of yields on 10-year government debt?"

for instance:

"The U.S. Civil War Battle of Bull Run ... took place in July, the Pamplona bull run takes place in July and the bond markets have had their own July bull run," investment bank Calyon noted recently.


"Analysts also regularly try for a bit of color or humor in their daily market reports.

On Bastille Day, July 14, for example, Kit Juckes, Royal Bank of Scotland's head of bond and currency strategy, said investors should expect a tough day for stocks and bonds but a better one for the dollar.

But he only got there after first treating readers to the entire first verse of France's national anthem."

Gee, making finance fun, how original ;) .

Of course it does have a academic basis as well. For instance Rodney Paul and I once wrote a paper about teaching finance using football. Not only do these non traditional examples stand out, they are also fun AND they help people without strong finance backgrounds understand what is happening.

Thanks to Rich (yes that Rich) for the headsup on this one!

Thursday, August 10, 2006

Cramer Vs Chimp

FinancialRounds pointed this out, but if you missed it, go watch it NOW! If for no other reason you will be humming the music for the rest of the day! lol...

Consumer Confidence and Stock Returns

Every week it seems some news agency is reporting consumer confidence numbers. For instance from ABC News:
" Consumer confidence is showing strain. Faced with the highest gas prices since Hurricane Katrina, soft job growth, and a cooling economy, it has slipped to its lowest level in seven weeks.

The ABC News/Washington Post Consumer Comfort Index stands at -12 on its scale of +100 to -100 this week, inching out of the -9 to -11 range at which it has hovered since late June."

The traditional interpretation is that consumers will not spend as much if they lack confidence. Thus the economy will slow down. But that said, there is still some debate as to whether the numbers really mean much.

Lemmon and Portniaguina
(L&P) join a long list of researchers who have tried to determine exactly how this sentiment measure matters. Specifically L&P examine whether confidence numbers can be used to further explain stock returns.

Why so many looks at the same thing? One reason is because the results are often contradictory. For instance some researchers (Lee, Shleifer, and Thaler 1991) find that the closed end fund discount can be described by investor sentiment, whereas others do not (Doukas and Milonas 2002).

What sets the L&P paper apar is that the authors break down confidence into (my terms) justified confidence and unjustified confidence. The unjustified confidence is interpreted as investor sentiment. (how cool is that?!)

How is this done? In the authors' words:
"First, we regress consumer confidence on a set of macroeconomic variables. Although the regression has a high R2 (around 0.6 – 0.8 depending on the specific confidence index), a substantial portion of confidence remains unexplained. We treat the residual from this regression as our measure of excessive sentiment (optimism or pessimism) unwarranted by fundamentals."
And now a theoretical time-out:
  • The majority of financial researchers and professionals hold that small traders are more prone to bouts of excessive optimism (and pessism) than are institutional traders.
  • Research has shown that individual traders impact small stocks more than large stocks (in large part due to liquidity differences).
Putting these two things together leads to the prediction that returns on small stocks should be more susecptible to sentiment swings. Namely, that if over optimism exists, small stocks will be over priced relative to large stocks.

Empirical findings:

Lemmon and Portniaguina find that their "excessive sentiment"measure can be used to describe stock returns.
"Consistent with the view that investor sentiment affects stock prices, we find that the pricing errors of small stocks exhibit larger time variation than those of large stocks and are higher following quarters of low sentiment. Thus we report evidence that investors appear to overvalue small stocks relative to large stocks during periods when consumer confidence is high, and vice versa"
Which is a really cool finding!

Want another cool finding? Try this one on for size:
"in the post-1977 period [where individual share ownership has increased], the sentiment measure based on consumner confidence exhibits strong ability to forecast the size premium"

Want still more? OK. The paper gives us even more:
"We find that, after controlling for time variation in beta, quarters of high investor optimism are followed by lower returns on dividend non-paying stocks, stocks with low earnings growth, stocks with low sales growth, and stocks with low institutional ownership. The results based on institutional ownership provide some additional evidence that is consistent with the idea that
individual investor sentiment is an important determinant of mispricing in stocks where arbitrage may be more limited"

Which deserves a WOW. A definite I^3 paper! (Important, Interesting, and Insightful!)

BTW I am currently ristening to Confidence by Rosebeth Kanter. So I might be hyper- sensitive to the idea that confidence matters....or maybe it goes back to middle school when after a particularly bad basketball game my mom made me a wall hanging with the CW Longenecker poem "If you think you are beaten you are" on it.

Sharesleuth and Xethanol

By now many of you probably have heard of Mark Cuban's It has been widely reported (see Financial Rounds, Cuban's own BlogMaverick, and Gary Weiss's blog).

If you have not seen the site, go and see for yourself!

What is it? From ShareSleuth itself:
"Call it journalism. Call it investigative blogging. Call it what you will.

More than 13,000 companies are listed on U.S. stock exchanges. Analysts for brokerages and independent research firms track fewer than half of them. Overburdened examiners at the Securities and Exchange Commission review only a fraction of the filings that come their way.

If you’ve spent any time digging through muck and rot in the lower reaches of the stock market, you know that many investment opportunities are not what they seem, and that some companies are the creation of predators and pretenders. aims to create a new line of defense by using investigative journalism techniques and a worldwide network of amateur and professional stock detectives to identify suspect companies."

What makes this particularly interesting is that they are also going to trade on their analysis prior to publishing. Essentially this plan gives Cuban both the incentive to find information as well as a soapbox on which to shout the findings to the world.

This has sparked a mild controversy (see Gary Weiss, as well as comments on Cuban's BlogMaverick) in spite of the disclosure of what they are doing (i.e. trading on it), which is not journalism.

Anyways, earlier this week Sharesleuth made their first publication coming out harshly against Xethanol(XNL). Sharesleuth claims that the firm is dramatically overvalued and that its reported leadership position in the field of ethanol production is largely just hype. The stock price has been falling for sometime prior to the publciation, so the direct effect is difficult to guage, but as Financial Rounds reported, it fell by 12% on the first day after Sharesleuth's publication. It has since fallen even further and as I write this it is down about 20% and about a third since Friday.

So far so good. However, what makes this even more interesting (or controversial if you prefer) is that Cuban had shorted the shares not in the days leading up to publication, but back in May! (again this is perfectly legal, as it is disclosed, but still interesting). Moreover he said he would like to short more but has been unable to borrow more shares to short.

"I am short 10,000 shares of Xethanol. I would like to short more, but I haven’t been able to borrow any more. I am currently in the money on the shares.

I am also short approximately 25,000 shares of UTEK because of its relationship to Xethanol. I have tried to short more, but have been unable to borrow the stock."

It will be very interesting to watch what firms are listed in coming months and whether the trades are made just prior to the announcement or months before. Stay tuned.

Ideas for class usage:
  1. Discuss the fact that many stocks do not have analysts and what this might imply for market efficiency as well as risk premiums.
  2. Ask whether Cuban's trading would this be a problem if the positions were not disclosed? (for instance if a WSJ reporter traded prior to publication--see the Winans' case).
  3. The speed of reaction to the Sharesleuth article.
  4. The long-run impact (do managers behave more in shareholder interest etc) on XNL.
  5. The role of the financial media as monitors and conflicts.
  6. How short selling works and how the lack of shares to short can lead to mispricing (see Lamont and Thaler, and Lamont).

Interesting podcast from Jeremy Siegel

Knowledge@Whatron has a podcast interview with Jeremy Siegel on recent news ranging from the Fed's decsion to not raise rates to the Middle East to the Alaskan Pipeline.

A quick example:

"Knowledge@Wharton: After 17 consecutive interest rate hikes, the Federal Reserve decided on August 8 not to raise the federal funds rate. Joining us to discuss this recent decision is Jeremy Siegel, professor of finance at the Wharton School. Professor Siegel, thank you so much for joining us here.

After two years, the Federal Reserve Committee has decided, in a 9-to-1 vote, to leave the Federal funds rate unchanged at 5.25%. In your estimation, was that a prudent decision?

Siegel: Yes. That was the right decision. After last Friday's employment report showed considerable softness, the market moved to the expectation that the Fed would pause. It's very important in central banking that you meet the expectation of the market. "
BTW the transcript is also available for those who would prefer to read the interview.

Wednesday, August 09, 2006

Adam Smith and Behavioral Finance

Harvard Business Schools "Working Knowledge" has a fascinating look at Adam Smith and Behavioral Finance/Economics.

Super short version: Smith's early writings (pre Wealth of Nations) laid much of the ground work for what we now call Behavioral Finance.

A few look-ins:

  • "The Theory of Moral Sentiments [TMS]... caught the attention of Harvard Business School professor Nava Ashraf and coauthors Colin Camerer and George Loewenstein....the authors find that Smith's insights from 1759 can contribute to modern thinking on everything from our fascination with celebrity to the theory of loss aversion. In fact, says Ashraf, Moral Sentiments presages the emerging field of behavioral economics."
  • " TMS, he describes the psychological factors that underlie human decision making, motivation, and interaction, which of course have strong implications for what drives consumption and savings decisions, worker productivity and effort, and market exchange"
  • "Smith believed that much of human behavior was under the influence of the "passions"—emotions such as fear and anger, and drives such as hunger and sex—but these passions were moderated by an internal "voice of reason," which he called an "impartial spectator.""
  • "Economics has had success as a field of scientific inquiry because it's been able to develop tractable models with strong predictive capacity; in other words, it simplifies the complex phenomena of human decision-making, interaction, and exchange into its barest form and makes predictions based on those. Of course, this has meant that economists have often had to sacrifice realism for tractability. Only recently has the field of economics advanced enough to have the tools to reincorporate the factors that Smith and others had always felt were important in human interaction: our caring about each other and about fairness, our difficulties with aligning our long-term interests with short-term pulls, etc."
Great stuff! It makes me want to read the Theory of Moral Sentiments!!

The journal article on which this interview is based is available here.

Monday, August 07, 2006

Clearing mail box

Ok, I am back...Went to Virginia (and West Virginia) for a bike ride. Wow, what a ride. Supposedly the hilliest Century east of the Rockies. Not sure if it is or is not, but it is hard and hilly! Over 13,400 feet of climbing with 9 named climbs. Great fun!

I will get back to seriously posting finance stuff either later tonight or tomorrow, but a few articles that were sent to me (either by email or RSS reader) I thought you might be interested in.

From the Detroit FreePress:
"Index funds simply track a market index, such as the Standard & Poor's 500. Weighting by market cap poses problems. As a stock rises in price, it becomes a larger part of the index. The index can then become larded with overpriced stocks. At the same time, it underweights undervalued stocks.

Jeremy Siegel, a finance professor at the University of Pennsylvania's Wharton School, has proposed "fundamentally weighted indexes," which would weigh stocks by some factor other than market cap. For example, an index could be weighted by the total amount a company pays out in dividends. This would reflect the companies' earnings and financial strength"

Financial Rounds has an interesting piece on Sarbannes-Oxley and IPOs. Short version, MAYBE (and I agree with the Unknown Professor that this is HIGHLY debateable), SOX is a reason why some firms are doing IPOs internationally.

The FinancialPage
examines mutual fund fees around the world. Interesting not only because there are differences (so much for law of one price) but also where the differences occur.

Thursday, August 03, 2006

Derivatives shown to increase volatility

Well Fischer Black is right again. Or at least that is the conclusion of a new paper by Bhamra and Uppal. They model a market with and without "non redundant derivatives" and find that derivatives do lead to increased return volatility.

A few look-ins at their largely theoretical paper:

* "Our main result is to show that introducing a new derivative security that improves risk
sharing leads to an increase in the volatility of the stock market of stock returns is higher in the economy with improved risk sharing if the discount rate is countercyclical, because the change in the discount rate magnifies the effect on stock returns of a shock to dividends; this condition is satisfied if the average prudence in the economy is not too large."

* The logic behind their conclusion is that:
"In the economy without the derivative, agents cannot share risk at all, and so the distribution of wealth across agents changes only deterministically. Consequently, the discount rate is deterministic, and so there is no excess volatility over and above fundamental volatility. But with the introduction of a non-redundant derivative risk sharing is possible, and hence, the discount rate is stochastic."
Interesting. And I confess it does make sense. Even though it may take a second reading to convince me of all of it.

Cite: Bhamra, Harjoat Singh and Uppal , Raman, "The Effect of Introducing a Non-Redundant Derivative on the Volatility of Stock-Market Returns" (March 14, 2006). Sauder School of Business Working Paper Available at SSRN:

Does initial success breed overconfidence and fraud? has an interesting article that looks at fraud throughout the last several decades. A common trait in many of the cases? The company had been doing very well, then competition came along, and pretty soon troubles began.

Bright ideas gone bust can lead to corporate fraud:
"For type-A executives who have introduced landmark changes to their industries, it's a thin line between innovation and fraud.

'There's always an element of Greek tragedy to these scandals, because they start off with someone having a real insight,' says Alan Webber, who co-founded FastCompany magazine. 'Then arrogance sets in. It's a natural instinct. Once you're the smartest guy in the room, you believe your own press clippings, drink your own bathwater. If you have one good idea, you think every idea is going to be terrific.'"
And later in the same article:
"Sometimes, executives commit fraud to please the boss, who's unwilling to accept the fact that his brilliant idea isn't that profitable.

Josh Lerner, a professor at Harvard Business School, says that in many cases of corporate accounting fraud, "it wasn't that the company was totally fraudulent as much as that you had a hard-charging CEO who was so focused on success above everything else."

Compounding the problem is the tendency among investors, once they've been shown an innovation that's profitable, to believe future pronouncements from the CEO."

FTR, this also has several good examples for class discussions.

Tuesday, August 01, 2006 on one impact of back dating

Gee, I ad not thought of this impact:

"Lost amid the swirl of media attention, however, is what backdating, or other practices, such as re-pricing, might mean if you happen to be one of the people who holds those options.

In much the same way that backdating is now prompting some companies to restate, corporate tinkering with options can damage the personal equivalent of a financial statement: your tax return."

Why is this a problem?

"The board's action makes the option a non-qualified stock option because the exercise price does not equal the fair market value of the stock at the date of the grant.

Non-qualified stock options require tax payment at the ordinary income rate for the difference between the grant price and the price at which the option is exercised (the gain). Non-qualified stock options do not meet the criteria to be treated as an incentive stock option, which has a tax benefit of having the options taxed at the lower capital gains tax rate."