Is ICE hot or cold?

Ok, so the joke was really bad, I couldn't resist! (not that I tired...lol)...

Latest News and Financial Information | Reuters.com: "Energy and commodities exchange IntercontinentalExchange Inc., owner of Europe's biggest energy bourse, may raise up to $115 million in an initial public offering of stock, "

As we have often seen, it is not only industrial corporations that go public, more and more often financial markets themselves are selling shares to the public.

Interestingly, even in the ICE's IPO plans, we see some suggestion of market timing:

"ICE, launched in 2000 primarily as an Internet-based platform for trading U.S. power and gas, is hoping to capitalise on rising interest from investors and hedge funds in energy markets, which have lately yielded better returns than other asset classes."


Some other NYMEX news (gee can you guess we are doing derivatives in class next ;) )

The same Reuters article pointed out the ICE is facing competition in Europe (Ireland and now England) from the NYMEX as the NYMEX takes its open outcry market to fill the void left when ICE went to all electronic trading. (As an aside to those of you who went with the Finance Club to the NYMEX this past fall may remember them explaining this reason as why so many of them were "going to Ireland.") Well now that there will sooon be a bigger void in outcry trading, The NYMEX announced they would also open trading in London.

The NYMEX has recently formed a joint venture to open the Dubai Exchange "which aims to offer the world's only benchmark sour crude futures contract, probably will trade in both open-outcry and electronic environments, Nymex officials said."

OK, enough market talk about ICE, I am getting cold! :)

SSRN-Sharpening Sharpe Ratios by William Goetzmann, Jonathan Ingersoll, Matthew Spiegel, Ivo Welch

SSRN-Sharpening Sharpe Ratios by William Goetzmann, Jonathan Ingersoll, Matthew Spiegel, Ivo Welch

Measuring fund manager performance is not as easy as it sounds. Sure you know the basic measures: Sharpe Ratio, Treynor measure, and Jensen's alpha.

Sharpe: (Return-Risk Free)/ Standard Deviation
Treynor: ( Return-Risk Free)/ Beta)
Jensen's Alpha: Return = RF + Beta (Market Risk Premium) + Alpha

But each measure has its problems. For instance as far back as the early 1980s, financial economists (including Henricksson and Merton 1981) showed that the Sharpe Ratio could be a poor measure in the presence of "non-linear payoffs".

There really has been no good solution to this. Indeed in Robert Strong's Portfolio Construction, Management, and Construction Text, he concludes a discussion on the topic with a true, but unsatisfying statement:

"We have numerous analytical tools and we have a brain; we should use both in evaluating the performance of a portfolio."

In Sharpening Sharpe Ratios, William Goetzmann, Jonathan Ingersoll, Matthew Spiegel, and Ivo Welch discuss the problems of the traditional performance appraisal methods and show that this is particulary troubling with the widespread use of derivatives (because their payoffs are inherently non-linear).

The paper then shows how these biases can be "gamed" by fund managers using options to take advantage of the limitations of the Sharpe Ratio. Once this is established, the authors develop a "manipulation-free" measure.

While on simplicity grounds alone, I doubt the new measure will be a big hit in undergrad classes, it definitely addresses the key attributes that a new measure should have. To understand the derivation, I recommend you read the paper. :) I tried to copy the equation in (equation 30) but I could not paste it and have top get to class now...sorry...

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Suggested Citation

Goetzmann, William N., Ingersoll, Jonathan E., Spiegel, Matthew I. and Welch, Ivo, "Sharpening Sharpe Ratios" (November 2004). Yale ICF Working Paper No. 02-08; AFA 2003 Washington, DC Meetings. http://ssrn.com/abstract=302815

A look at IPO price stabilization by Lewellen

Katharina Lewellen provides is an interesting look at price stabilization in the IPO market.

Price stabilization is the practice of investment bankers going into the secondary market to support the price of newly issued shares. There has been much debate in the academic literature as to the rationale and the extent of this practice. For instance, is it a reward to institutional investors as some previous researchers (e.g. Chowdry and Nanda 1996) suggest? Or a means of helping the syndicate sell shares? Or some combo of each? One problem with these studies is that there is little publicly available data on the stabilization activities.

In her forthcoming JF article, Lewellen sheds light on this practice using a proprietary data set from the NASDAQ. She finds

"that underwriters accumulate large inventories of cold IPOs on the first day of trading, consistent with price support. Stock prices are extremely rigid at and below the offer price, in the sense that it requires large selling pressure to induce a price decline. For example, if a stock opens the first day at the offer price, marketmakers repurchase, on average, 6.0% of shares offered before they allow the bid to drop. The corresponding number is 2.1% for IPOs that open below the offer price, and only 0.4% for stocks that open above the offer price.

What is weird however is that once stabilization ends, the stock prices do not seem to fall. This suggests that, as investment bankers claim, stabilization is only a temporary support to allow the market to develop. (or as the author points out, it cold also be that the investment bankers have inside information and only support those stocks that in fact are not overpriced.)

Previous papers have suggested that stabilization is partially a substitute for underpricing as a means of handling information asymmetries. It is somewhat surprising therefore when Lewellen finds little support for this:

"A natural empirical implication is that, other things equal, stocks with more information asymmetries should exhibit more underpricing or stronger price support. I do not find support for this hypothesis. Instead, price support appears strongest for IPOs that are less risky,... and for IPOs underwritten by larger, more
reputable underwriters. A story that is consistent with these findings is that while underwriters avoid stabilizing risky IPOs, large underwriters absorb inventory risk better and, hence, stabilize more strongly. However, Aggarwal (2000) finds that underwriters usually oversell the issue and begin the first day of trading with a short position.....Alternatively, large underwriters may be more willing to support overpriced IPOs to protect their reputation with investors.

Consistent with the reputation hypothesis, I find that underwriters stabilize less
extensively on days when the stock market is doing poorly, that is, when the weak IPO performance can be attributed to market-wide events outside the underwriter’s control."

Another surprising finding is that investment banks with large retail operations tend to engage in more stabilization. This runs counter to previous papers. Lewellen offers several explanations:

"First, retail banks might value price support because it allows them to discriminate among investors: A promise to repurchase weak IPOs can be targeted to specific investors. Second, Hanley, Kumar, and Seguin (1993) suggest that underwriters
support prices to disguise weak offerings from initial investors. If such tactics indeed take place, they are probably targeted at unsophisticated investors, and therefore may be favored by retail banks. Third, it is possible that retail banks suffer larger reputational damage from ex post overpriced IPOs."

Definitely an interesting and important paper!

The forthcoming JF version of the paper is available for a short time. A previous version is available from SSRN.

Rodney Paul at Forbes.com: Ten Betting Tips For March Madness

Forbes.com: Ten Betting Tips For March Madness

Rodney Paul is in Forbes again. This time for his comments on betting on the NCAA basketball tourney. SHort version: market is pretty efficient. But don't take my word for it, watch the video--No it is not of him.

I am convinced that NCAA pools can tell us quite a bit about stock market investing. For instance, if we acknowledge the existence of the value anomaly, then one explanation is that these out of favor stocks are boring and you miss picking the bragging rights of being able to talk about them. The same holds true with pools. Picking the top seed yields the highest expected number correct, but you miss the excitement of picking the Vermonts and Bucknells.

Want a much better explanation of this idea and how it is impacts financial markets? William Bernstein (yes the author) does a great job in his INEPT model.

Signs of spring and market efficiency!

Sure signs of Spring: spring training, seeing robins, March Madness, now finance articles about baseball! (ok, so the last one is a stretch).

Hakes and Sauer (yes the same Skip Sauer who has the excellent Sports Economist Blog) have an interesting paper that looks at the premise of Michael Lewis' Moneyball book. WHat makes the paper interesting is what it says about markets in general.

For those of you who have not read Moneyball (I highly recommend it by the way), the basic story is about whether stats and computers can be used to effectively take advantage of inefficiencies in the baseball player market. It is centered around the Oakland A's GM Billy Beane who was an early adaptor of the technological/statistical approach) and very succesful at building the A's into a winning organization for millions less than other teams.

The paper's findings? "support Lewis's argument that the valuation of different skills was inefficient in the early part of this period, and that this was profitably exploited by managers with the ability to generate and interpret statistical knowledge. This knowledge became increasingly dispersed across baseball teams during this period. Consistent with Lewis's story and economic reasoning, the spread of this knowledge is associated with the market correcting the original mis-pricing. "

So how does this matter from an efficient markets perspective? It shows that markets do evolve and learn. This suggests that occasionally (with new technology--either electronic, mathmatical, operational, or financial) it may be possible to earn abnormal returns but that the success will quickly be copied and the abnormal returns will likely disappear. Given that financial markets have low barriers to entry and hence many participants, this can explain why financial markets are so difficult to beat.

Suggested Citation: Hakes, Jahn Karl and Sauer, Raymond D. "Skip", "An Economic Evaluation of the Moneyball Hypothesis" (November 3, 2004). http://ssrn.com/abstract=618401

Air Grasso??

New York Post Online Edition: business: "Former New York Stock Exchange chairman Dick Grasso turned the Big Board's corporate jet into Air Grasso."

It seems like it is 2003 all over again: not only is Worldcom front and center , Eliot Spitzer is investigating firms, and Richard Grasso is back in the news.

Why? There is now evidence that he used the NYSE's corporate jet as his family's own jet. FWIW the family seemed to be partial to Miami.

How did this come to light now? "Grasso's alleged use of the NYSE jet for personal reasons came up when Attorney General Eliot Spitzer asked Grasso to turn over his tax returns for the years 1995 through 2003.

Spitzer is trying to determine how much Grasso earned during those years, both from the NYSE and other sources, such as Grasso's time spent on the Board of Home Depot."

A quick look at the Bernie Ebbers case

Of course there is just a ton of coverage on the Bernie Ebbers' conviction today. If you have somehow missed it: He was found guilty on all charges and faces up to 85 years in jail (although USAToday reports 25 years is more likely.

Some interesting quotes from various sources:

USAToday:

• "John Coffee, an expert in securities law at Columbia University. "But the 'CEO as dupe' defense did not sell. Ultimately, the jury did not believe Ebbers."
  

NY Times:

• "The jury clearly concluded that the testimony of Mr. Sullivan was more credible than that of Mr. Ebbers, even though the jurors did not fully believe Mr. Sullivan either, according to Peter Nulty, the father of Sarah Nulty, juror No. 10. Mr. Nulty posted his daughter's views of the jury's deliberations at estrong.com, a financial newsletter's Web site, last night, writing that "no one on the jury trusted the testimony of the prosecution's star witness."

CNN: On Ken Lay and the others who have to stand trial in coming months

• "Clearly any one of these individuals is looking at these trials and this verdict and thinking 'My god. What is going to happen to me?'" said Stanley Twardy, a former U.S. attorney in Connecticut who is now a partner in Day, Berry & Howard."

Why do firms go public?

In a piece of fortuitous timing given that last night in class we began a section on raising capital and IPOs, today's NY Times DealBook mentions two firms that are selling shares so that the firms' current owners can cash out a portion of their shares.

1. From the NY Post: "National Lampoon Inc., the media company that cast comedian John Belushi as an irreverent fraternity boy in "Animal House" in 1978, is planning an $8 million stock sale designed to raise its profile on Wall Street and finance the buyout of a former owner." As an aside, the hope to list shares on the American and Pacific exchanges.
2. And from the Guardian: "Stead & Simpson, the British shoe seller that can trace its lineage back 171 years, is considering a return to the London stock market as its main shareholder looks for an exit."

This is not to say that a desire to cash out is the only reason firms go public, but it is one other reason.

Where have you been?

Sorry for the infrequent posts of late. I made and gave out 4 tests last week. Coupled with three papers in various states of completeness, I just have been a bit short on time. But the tests are done (and graded), one of the papers is 99.9% done, and I should be back to a more normal schedule later today. (I hope :) ) Sorry for any inconvenience!

jim

A Non-Technical Introduction to Brownian Motion by Don Chance

A Non-Technical Introduction to Brownian Motion

Wow--I wish I had had this during the Financial Econometrics class at Penn State. I was quite lost for the better part of the semester in that one! I have since made some sense of it, but the description from Financial Engineering News by Don Chance is a nice review and description! Definitely recommended!

Accounting games: How Banks Pretty Up The Profit Picture

Commentary: How Banks Pretty Up The Profit Picture

Need another example of why cash flow matters more than accounting numbers? BusinessWeek and the Financial Accounting Blog provide us with examples of how banks can play with their loan loss reserves to "manage" their earnings.

FRB: Testimony, Greenspan --Economic outlook and current fiscal issues-- March 2, 2005

Network television executives must hate me. I almost never see anything on their networks except sports, but I am watching Cspan at 1:40 AM. Why? Because Alan Greenspan is talking! Most of his talk (and definitely the Q&A session that followed his remarks) focused on social security reform.

Short version? The economy is strong but deficits (including budget, social security, and Medicare) pose significant threats.

FRB: Testimony, Greenspan --Economic outlook and current fiscal issues-- March 2, 2005:

"I fear that we may have already committed more physical resources to the baby-boom generation in its retirement years than our economy has the capacity to deliver. If existing promises need to be changed, those changes should be made sooner rather than later. We owe future retirees as much time as possible to adjust their plans for work, saving, and retirement spending. They need to ensure that their personal resources, along with what they expect to receive from the government, will be sufficient to meet their retirement goals.

Addressing the government's own imbalances will require scrutiny of both spending and taxes. However, tax increases of sufficient dimension to deal with our looming fiscal problems arguably pose significant risks to economic growth and the revenue base."

Well said!

A daily review of the Wall Street Journal (European version) and The Financial Times

Review of the Financial Press

Don't have time to read both the WSJ and the FT? Then I have a free solution! Vincent Colot summarizes some of the most interesting articles from both the Wall Street Journal Europe and the Financial Times. It is updated every morning.

Oh yeah, it is in French. Can't read French? Google's translation service does a manageable job.

SSRN-Psychological Barriers in Gold Prices? by Raj Aggarwal, Brian Lucey

The momentum for behavioral finance continues with a look at the importance of barrier prices in the Gold Market.

SSRN-Psychological Barriers in Gold Prices? by Raj Aggarwal, Brian Lucey

Aggarwal and Lucey "[present] evidence of psychological barriers in gold prices. [They] document that prices in round numbers act as barriers with important effects on the conditional mean and variance of the gold price series around psychological barriers."

At the risk of making some authors (who claim that these barriers are merely equilibrium outcomes) upset, the actual price of a security should not matter. For instance why is 10,000 any different than 10,040; the price should move through each with the same ease. However, most practioners claim that this is not the case.

In Aggarwal and Lucey's words:

"If gold markets are rational and efficient, we should not expect to see any psychological price barriers. However, significant numbers of commentators attribute particular levels of the gold bullion price as being ‘barriers’ or ‘support levels’ or in some other manner as being intrinsically more ‘important’ than other price levels."

Existing research has largely focused on equities and have found that there is some empirical existence for such psychological barriers.

"(see (R. G. Donaldson & Kim, 1993), (R. Glen Donaldson, 1990a, 1990b)) a variety of equity markets (not, however the Nikkei or the Wiltshire indices) are shown to deviate from this [uniform distribution] assumption"

Looking at the gold market by using both tests of uniformity and looking for barrier prices, Aggrawal and Lucey find:

"psychological barriers at the 100’s digits (price levels such as $200, $300 etc) do exist in daily gold prices....We find some significant evidence of changes in conditional
means around psychological barriers. However, we document very strong evidence of changes in the variances of returns in the vicinity of and when crossing psychological price barriers in gold markets.

VERY INTERESTING!

Suggested Citation

Aggarwal, Raj and Lucey, Brian M., "Psychological Barriers in Gold Prices?" (January 2005). Institute for International Integration Studies Discussion Paper No. 53. http://ssrn.com/abstract=669761