moneyscience.org : Islamic mortgage market to expand

From Moneyscience.org
moneyscience.org : Islamic mortgage market to expand

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

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

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

Financial history/trivia from the 1700s

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

From their abstract:

"conflicting nature of the existing evidence on the pecking order theory is due to the difference between financing practices of large and small firms, and the skewness of the firm size distribution. The theory performs poorly for small firms because they have low debt capacities that are quickly exhausted, forcing them to issue equity. The pecking order theory performs satisfactorily for large firms, firms with rated debt, and when the impact of debt capacity is accounted for"

The authors explain that some of the difficulty in previous studies has been brought about by the treatment of firm size.

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

In their current paper Agca and Mozumdar break the firms into deciles based on size and then examine firm financing behavior. The conclusion?

"We find that working with nonnormalized numbers yields results that are in line with the conventional notions about corporate financing practices. Furthermore, sorting firms into size deciles, we find that the debt-deficit sensitivity coefficients and R2 values are low for small firms, as in Frank and Goyal (2003), while they are high for large firms, as in Shyam-Sunder and Myers(1999)."

So size does matters. Or as the authors state:

"Why does the pecking order theory perform so differently for large and small firms? Our analysis shows that this is due to different factors assuming primacy in the two cases. How much a firm borrows depends on how much it can borrow (its debt capacity), as well as how much it wants to borrow. The observed debt level is the lower of the two. The pecking order theory focuses on the latter, and largely ignores the former."

Or in the vernacular: the pecking order works when there are not other constraints (such as debt capacity) in the way.

An I^3 paper for sure!

Cite:

Agca, Senay and Mozumdar, Abon, "Firm Size, Debt Capacity, and Corporate Financing Choices" (December 2004). http://ssrn.com/abstract=687369

Free Money Finance: Carnival of Personal Finance #6

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

Some Financial history/trivia from the 1600s

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

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

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

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

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

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

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

7. In 1690 commodity rice futures were selling in Japan

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

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

10. The London Stock Exchange was started in 1698
    

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

Volume and returns

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

From their paper:

Their key finding:

"There is on average a positive relation between past returns and turnover in our sample of countries. Using a trivariate Vector Autogression (VAR) of market return, market volatility, and turnover with weekly data from 1993 through 2003, we find that a positive shock to returns leads to a significant increase in volume after ten weeks in 24 countries and to a significant decrease in no country. The economic magnitude of the return-turnover relation is large; a one standard deviation shock to returnsleads to a 0.46 standard deviation increase in turnover on average after ten weeks."

In other words, people trade more in up markets than in down markets. While this fact is well known to any stock broker, it is interesting to see that the same realtion holds across most countries and that it appears that it is more concentrated for individual investors and in countries with less developed markets.

Again from the paper:

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

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

The NFL Draft and Market Efficiency

NFL and Finance by Massey & Thaler

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

From their abstract:

"Using archival data on draft-day trades, player performance and compensation, we compare the market value of draft picks with the historical value of drafted players. We find that top draft picks are overvalued in a manner that is inconsistent with rational expectations and efficient markets and consistent with psychological research. "

The short version of their paper is that they examine the relative worth of various draft postions and then compare what they teams pay for the pick with what they get from the pick in on field performance. To get at this, the authors must first construct a price for draft position schedule based off of trades:

"For example, a team might give up the 4th pick and get the 10th pick and the 21st pick in return. In aggregate, such trades reveal the market value of draft picks. We can compare these market values to the surplus value (to the team) of the players chosen with the draft picks. We define surplus value as the player'’s performance value--estimated from the labor market for NFL veterans-- less his compensation. In the example just mentioned, if the market for draft picks is rational then the surplus value of the player taken with the 4th pick should equal (onaverage) the combined surplus value of the players taken with picks 10 and 21."

The high price for higher picks (the article goes into detail of the Giants' acquisitionion of Eli Manning from the Chargers) suggests that there must be a large drop-off in quality since the price of signing the players also drops with position. Again in the authors' words: "both in terms
of pick value and monetary cost, the market prices imply that performance must be highly predictable."

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

Massey and Thaler:

"Our findings suggest the biases we had anticipated are actually even stronger than we had guessed. We expected to find that early picks were overpriced, and that the surplus values of picks would decline less steeply than the market values. Instead we have found that the surplus value of the picks during the first round actually increases throughout the round: the players selected with the final pick in the first round on average produces more surplus to his team than than the first pick, and costs one quarter the price!"

While I loved the paper, I do have a few reservations. The author attempt to address the first one but with only partial success. They investigate the "Michael Vick factor". That is the idea that even though his on field performance may not be great, he brings people into the stands. They investigate this by looking subsequentent contracts and find that it is only on field performance that matters.

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

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

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

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


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


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

The Value of Financial Flexibility by Andrea Gamba, Alexander Triantis

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


Gamba and Triantis look at the relationship between financial flexibility and Investment flexibility. Not surprisingly, they find the two are related.

"We find that firms with greater investment flexibility derive less value from financial flexibility, indicating that these two dimensions of flexibility are substitutes to some degree....we demonstrate that firms that face financing frictions should simultaneously borrow and lend, and we examine the nature of the dynamic debt and liquidity policies and the value associated with corporate liquidity."

Translated for the less financially savvy of you: firms that can "time" their investments need less flexibility on the financial side of the balance sheet. Additionally, they find that if there are significant market frictions to raising new capital, then cash and financial flexibility in general are good.

A look-in:

"The effect of financial flexibility on firm value can, however, be quite significant
when investment flexibility is low, when there is significant upside for growth, and when high volatility in the firmÂ’s profitability makes it more difficult to maintain stable internal cash reserves. Firms in such circumstances would be appropriate targets for acquisitions by companies having large internal cash reserves, and our analysis allows us to gauge the magnitude of value creation through such transactions. We also find that having more reversible capital adds even more value to the firm when its financial flexibility is lower. Thus, investment and financial flexibility appear to be substitutes to some extent."

While not unexpected (it has been taught for years), it is an important contribution on the interrelationships between the left hand side and the right hand side of the balance sheet.

VERY COOL!

cite

Gamba, Andrea and Triantis, Alexander J., "The Value of Financial Flexibility" (May 2005). EFA 2005 Moscow Meetings http://ssrn.com/abstract=677086

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

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

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

They "present new evidence on the time-varying behavior of stock prices using a completely new and unique dataset of historical stock returns from the Brussels Stock Exchange that has never been studied before. To the best of our knowledge, this is probably the most comprehensive and accurately constructed historical index representing more 1500 different common stocks during the period 1832-1914. The excessive use of the CRSP return data in examining predictability and the data mining risks involved, render this independent return database a adequate out-of-sample test for different asset pricing anomalies identified in the literature."

With this cool data set, their key finding is that:

"Contrary to Fama and French (1988) and Poterba and Summers (1988), our results show that stock prices do not contain autoregressive stationary components but instead resemble a random walk. Capital appreciation returns exhibit stronger time-varying behavior than total returns. Belgian stock returns demonstrate strongly significant seasonality in January notwithstanding the absence of taxes. Moreover, long horizon mean reversion is present, however, completely concentrated in January."

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

The authors:

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

Interesting.

Cite:

Annaert, Jan and Van Hyfte, Wim, "Long Horizon Mean Reversion for the Brussels Stock Exchange: Evidence for the 19th Century" (December 20, 2004). EFA 2005 Moscow Meetings http://ssrn.com/abstract=676006

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

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

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

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

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

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

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

Radio Economics

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

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

Radio Economics

You can listen on your IPOD or on any computer.

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

Speaking of Freakonomics

FYI: From Freakonomics

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

Moodgrapher: The World according to LiveJournal

Moodgrapher: The World according to LiveJournal

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

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

Corporate Governance Mechanisms and Corporate Cash Holdings by Yuanto Kusnadi

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

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

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

In fact, I will take from my dissertation to set the Kusnadi paper up:

Two theories have been used to explain cash'’s role in decision making. The first, and more widely accepted is an agency costs theory. This agency theory, which is often called the “free cash flow problem” (Jensen (1986)), holds that excess cash is detrimental to shareholders because managers will waste it through overinvestment and diversifying acquisitions or use it as a tool to entrench themselves and to block takeovers (Harford 1998)....The alternative view is that cash holdings are good because they allow firms to avoid the transaction costs, mispricing, and delays involved in a security issuance. This second position, called the market friction theory, is widely cited by managers as the reason for holding large cash positions.

Since 1998 (the time of my dissertation), numerous papers have been published that suggest that there is truth in both views.

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

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

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

First the view that cash is good (i.e. there are real market frictions that can be avoided if firms hold more cash):

"size, market-to-book ratio (a proxy for investment opportunities) and capital expenditures (a proxy for investment) are positively related to cash holdings."

Then the bad side (i.e. holding cash is to the benefit of managers and nto to shareholders):

"On the other hand, cash holdings decreases in leverage, tangibility, and a dividend
dummy. As for our governance variables, we demonstrate that firms characterized by largeboards, boards that are dominated by insiders, and low non-management controlling ownership tend to hold higher cash balances. Our findings lend further support to the importance of corporate governance mechanisms in the determination of corporate cash holdings as documented by Dittmar et al. (2003)."

To which I would add, that this once again demonstrates that there is no simple answer to the question of whether cash is good or bad. Like most things, cash can be good or bad, depending on firm specific factors. This firm specificness (which leads to the endogeniety problem) is one of the key factors that make finance so difficult for some people to grasp: there is rarely a single answer.

A worthwhile read!

Cite:

Kusnadi, Yuanto, "Corporate Governance Mechanisms and Corporate Cash Holdings" (November 2004). EFA 2005 Moscow Meetings Paper. http://ssrn.com/abstract=675462