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

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

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

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

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


From the BBC:

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

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

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

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

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

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

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

"The equally weighted performance of the funds that existed at the end of the sample period had a compound annual return of 16.64% net fees. Including dead funds reduced this return to 13.90%. Excluding backfill further reduced the return to 9.06%, net of fees."

So the returns are lower than many believed. That does not mean that the returns are not good relative to other investments. The authors therefore try to break this return down to determine "the average amount of hedge fund returns that come from long-term beta exposures versus the hedge fund value-added alpha."

They find that alphas are positive and significant:

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

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

Conclusion:

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

In the author's words:

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

Which might just explain some of their popularity ;)

Definitely another of those I^3 papers!

Cite:

Ibbotson, Roger G. and Chen, Peng, "Sources of Hedge Fund Returns: Alphas, Betas, and Costs" (June 2005). Yale ICF Working Paper No. 05-17. http://ssrn.com/abstract=733264

Social Norms versus Standards of Accounting by Shyam Sunder

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

SSRN-Social Norms versus Standards of Accounting by Shyam Sunder

A few highlights from the paper:

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

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

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

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


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

Cite:
Sunder, Shyam, "Social Norms versus Standards of Accounting" (May 2005). Yale ICF Working Paper No. 05-14. http://ssrn.com/abstract=725821

Commanding Heights: Home | on PBS

Commanding Heights: Home | on PBS

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

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

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

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

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

Longer review:

Given investors chase hot returns and managers are often dimissed for poor performance, fund managers face pressure to increase returns in the short run.
In Li's words:

"fund managers face large incentives to perform in the short run. Such incentives largely come in the form of increased fund inflow and thus asset under management on the upside, and firing on the downside."

The author examines this by looking at mutual fund holdings and returns and by creating measures of investor "short-termism."

And the findings? Jin finds that

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

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

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

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

"Further tests of causality suggest that fund manager investment
short-termism is caused by investor short horizon, but not the other way round."

The potential consequences of these findings are huge. Again in the author's words:

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

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

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

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

Cite:

Jin, Li, "How Does Investor Short-termism Affect Mutual Fund Manager Short-termism" (February 27, 2005). EFA 2005 Moscow Meetings Paper. http://ssrn.com/abstract=675262

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

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

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

Short Version:

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

Score one more paper for behavioral finance.

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

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

Cite:

Edmans, Alex J., Garcia, Diego and Norli, Oyvind, "Football and Stock Returns" (May 2005). EFA 2005 Moscow Meetings http://ssrn.com/abstract=677103

The World is Flat (or at least flatter)

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

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

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

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

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

NPR : Home Owners Increasingly Betting on Interest-Only Loans

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

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

NPR : Home Owners Increasingly Betting on Interest-Only Loans

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


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

Call for papers

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

Call for papers

The 2005 Financial Research Association Meeting

December 17 and 18, 2005

Aladdin Resort and Casino

Las Vegas, Nevada

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

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

Paper submissions should be emailed in PDF to FRA@bc.edu by August 31.

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

Yet another interesting paper from the EFA Moscow Meetings!

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

Using a "proprietary database of lending activity from a large institutional investor" the authors examine

• Whether shorting impacts future returns?
• If shorting is important, is it "short supply" or "short demand"?
• Is shorting influenced by private? or public information?
• Is there a profitable trading rule that can be made off of shorts?
  

Their findings:

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

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

c. Private information drives shorting. This is important because, as pointed out in the paper,

"Ideally one would like to know if shorting indicators have explanatory power abstracting from public information (signaling the potential importance of market frictions), or if they are simply correlated with underlying movements in publicinformation flow."

And they find that private information seems to be more important.

d. The authors find that by following their strategy (that is when demand for shorts is high, sell), one would be presumed to beat the market on a

"net of shorting costs [basis], the investor still makes over 8% per year. Also, the Sharpe Ratio of the strategy is about 3 times that of the market and HML. Thus, indirect shorting costs (e.g., recall risk) and other indirect costs would have to be substantial to subsume this return."

Interesting to say the least!

Cite:

Cohen, Lauren H., Diether, Karl and Malloy, Christopher J., "Supply and Demand Shifts in the Shorting Market" (June 4, 2005). EFA 2005 Moscow Meetings Paper. http://ssrn.com/abstract=672381

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

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

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

The authors stress the difference between pure information costs and the ability of investors to handle information (the capacity side). This allows for the following

"evidence suggests that the degree of diversification only slightly improved over the last decade, in spite of a large drop in (fixed and proportional) transaction and information costs. While the ease of access and the speed of dissemination of financial information have dramatically improved over the last
decade, the processing capacity of the investor has not."

(A note to my own students: in class we have always combined these two into a broad information cost catergory).

Following along in this discussion:

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

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

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

"If investors concentrate their portfolios because they have informational advantages, then concentrated portfolios should outperform diversified ones (corollary 3). In contrast, if transaction costs or behavioral biases are responsible, then concentrated portfolios should offer no advantage"

The authors point out that there is evidence to support this:

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

The paper also write that their model can partially explain the problems with CAPM:

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

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

Cite:

Van Nieuwerburgh, Stijn and Veldkamp, Laura, "Information Acquisition and Portfolio Under-Diversification" (March 2005). EFA 2005 Moscow Meetings http://ssrn.com/abstract=619362

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

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

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

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

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

We now more empirical evidence that supports this liquidity view:

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

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

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

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

cite:

Dhar, Ravi, Goetzmann, William N. and Zhu, Ning, "The Impact of Clientele Changes: Evidence from Stock Splits" (August 2004). EFA 2005 Moscow Meetings http://ssrn.com/abstract=410104