Thursday, July 31, 2008
Tuesday, July 29, 2008
My Students Are Getting Their CFA Level 1 Results
So far, three have reported in, and two of those passed. Well done, lads.
I have a bet with my Dean that three of the five will pass. So, I need one more out of the two remaining...
update: It's now three out of four (the 4th, who didn;t make it was in the top band of those that failed, so he should make it in December). I guess that means the Dean owes me dinner. Since the overall passing rate is 35%, our initial group of Level 1 test takers have done very well.
Note: if you want to calculate a rough estimate for your score, here's a link to a scoring calculator someone hacked together.
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Monday, July 28, 2008
Is There Predictive Power In The Option-Implied Volatility Smirk?
The shape of the volatility smirks has significant cross-sectional predictive power for future equity returns. Stocks exhibiting the steepest smirks in their traded options underperform stocks with the least pronounced volatility smirks in their options by around 15% per year on a risk-adjusted basis. This predictability persists for at least six months, and firms with steepest volatility smirks are those experiencing the worst earnings shocks in the following quarter. The results are consistent with the notion that informed traders with negative news prefer to buy out-of-the-money put options, and that the equity market is slow in incorporating the information embedded in volatility smirks.
All in all, a pretty cool paper showing how information flows across markets. Given some work I'm doing with options data, I found it to be particularly timely.
Read the whole thing here.
HT: CXO Advisory Group
Friday, July 25, 2008
Dan Ariely - Predictably Irrational At Google Authors
Finance: 0% Politically Correct
Humanities and social science fields tend to have higher politically correct rankings, while professional and science disciplines do not. The table that follows is in order of political correctness. Psychology is the only field where a majority of professors are politically correct. Four fields — finance, management information, mechanical engineering and electrical engineering — had no one who was politically correct (emphasis mine).
Read IHE's summary here, and get the original article here.
HT: Marginal Revolution, who I'm less politically correct than.
Thursday, July 24, 2008
Extension Risk and Mortgage Backed Securities
In case you're not familiar with the terms, contraction risk is the risk that repayments of principal on the mortgages underlying the MBS will be higher than expected, thereby resulting in a lower than expected maturity on the security. Extension risk is the opposite (lower than expected repayments, and a stretching of the MBS security's maturity.
Accrued Interest just put up a great piece on the topic. In short, it talks about how the problems in the mortgage markets will result in extension risk being higher than expected. The general drop in the real estate market has resulting in people having lower than expected equity in their homes (in some cases, they're "upside down", with home values lower than the outstanding balance). In addition, lenders have become very skittish about lending with less than 20% equity. So, there will be less refinancing activity than in predicted in most pricing models. As a result, there'll be a lengthening in the average maturity of the typical MBS (i.e. more extension risk).
Read the whole thing here.
Tuesday, July 22, 2008
Friday, July 18, 2008
Once Again, The Movie Critics And I Disagree
In addition to cylcling when I want (no need to coordinate dinner with the family) and putting in a lot of time at work, I get to see all the guy movies that Unknown Wife doesn't care for.
Last night it was Hancock. The critics were of two minds about the film, but I loved it. First, it's Wil Smith at his best - both as a Bad Boy and his "sweet" side. Second, it's a pretty good "hero" story. And third, what he does to two prisoners was just hilarious (yeah, I know - it was crude. So sue me - I'm a guy). So, the general rule follows - what ever a critic says is almost useless to me as far as determining whether or not I'll like a movie.
Thursday, July 17, 2008
Tony Snow - Passed Far Too Young.
Many people saw him as the White House Press Secretary or heard his talk show, but he also was an accomplished musician. His band (Beats Working) actually got to play with Skunk Baxter of the Doobie Brothers and Ian Anderson of Jethro Tull (now THAT's cool!).
Our thoughts and prayers go out to his wife and three children.
I Didn't Know Godzilla Managed A Private Equity Fund
I was curious about the McCain reference in the video (it seemed to come out of nowhere). Then I checked and found out that the ad was paid for by the Service Employees International Union. Like most other unions, they're big Obama supporters. In fact, they were just mentioned in Wednesday's Wall Street Journal (unfortunately, I can't find a link to the piece just yet).
It's a pretty interesting mishmash of messages with a populist slant. It starts off with the obligatory gas pump picture (the economy is hard, and it's the fault of the eeeeeevil buyout firms) , and then shifts to say that there's a group of people who make millions and slash jobs. And worse yet, /sarcasm on/ they get tax breaks for doing it! /sarcasm off/
So, I guess the message to take from this is that gas prices are high, the economy is tanking, and it's all the fault of buyout firms with tax breaks.
But at least it was educational - I didn't realize John McCain and people at PE firms could breathe fire. That alone would be enough to get them my vote (if just for the coolness factor). Hey - if the Presidential campaign doesn't work out and McCain gets tired of the Senate, he could get a job in commercials.
Wednesday, July 16, 2008
What Effect Does Professor Quality Have on Student Performance?
- Students self-select into professors classes. So, better students might choose to take harder professor, while weaker ones might choose "softball" ones. Or alternately, grade-conscious students might select into classes of "easy graders"
- Performance in a class is typically based on an exam that scored by the same professor teaching the class. This means that the professor can increase easily increase (or decrease) scores by "teaching to the test" or simply by inflating/deflating them directly
- Student evaluations are subject to a number of biases, including the physical attractiveness of the instructor (oh well, I'm screwed...). In addition, they're endogenous with respect to expected grades.
So, "higher quality" professors result in better long-term performance for their students. But at the same time, their students get lower grades in the foundations courses. This could be a result of lower quality instructors "teaching to the test", or of better instructors teaching in a way that's geared more towards follow-on classes at the expense of focusing on the intro materials (those ar tow ways of saying the same thing, BTW).It is difficult to measure teaching quality at the post-secondary level because students typically self-select" their coursework and their professors. Despite this, student evaluations of professors are widely used in faculty promotion and tenure decisions. We exploit the random assignment of college students to professors in a large body of required coursework to examine how professor quality affects student achievement. Introductory course professors significantly affect student achievement in contemporaneous and follow-on related courses, but the effects are quite heterogeneous across subjects. Students of professors who as a group perform well in the initial mathematics course perform significantly worse in follow-on related math, science, and engineering courses. We find that the academic rank, teaching experience, and terminal degree status of mathematics and science professors are negatively correlated with contemporaneous student achievement, but positively related to follow-on course achievement. Across all subjects, student evaluations of professors are positive predictors of contemporaneous course achievement, but are poor predictors of follow-on course achievement.
If you don't have access to NBER, you can read an ungated version of the paper here.
HT: Kids Prefer Cheese
Monday, July 14, 2008
Do PE Firms Manage Portfolio Firms, or Just Manipulate Balance Sheets?
Or do they?
A couple of reports by accounting firm Ernst & Young over the last two years give some indications otherwise. According to a summary of last year's report published in the Wall Street Journal's Deal Journal:
Ernst & Young found that the average enterprise value of the companies studied in both Europe and U.S. jumped more than 80% from the time they were acquired. The growth in enterprise value was driven in part by the fact that private-equity-owned companies achieved faster profit growth, two-thirds of which came from business expansion — while a third in Europe — and 23% came from cost reductions.
What does that mean for jobs? The study found that employment was at the same or higher level at the time of exit in 80% of U.S. buyouts and 60% of European buyouts. In the United Kingdom, France and Germany, where fears that the industry will slash jobs has spurred strong opposition and scathing criticism, employment at businesses owned by private-equity firms rose 5% annually. That compares to 3% for equivalent publicly traded companies.
I'd take the result with at least a little grain of salt, though. One reason is that the report was done on "successful" PE deals - those companies taken private that were eventually brought public again in a subsequent IPO. These are likely to be the ones with the biggest increases in market value, and the ones that had the best overall performance (unsuccessful portfolio companies don't get taken back public down the road). So, the results most likely overstate the performance of LBO firms....companies being sold off by private-equity firms increased in enterprise value at an annual compound rate of 24% during the time they were in a PE firm’s portfolio, double the rate of comparable publicly traded companies. Buyout firms also increased the earnings before interest, taxes, depreciation and amortization of these portfolio companies 33% faster than their publicly traded counterparts did. Finally, these companies had productivity levels 33% higher than publicly traded company benchmarks.
The out performance wasn’t confined to a specific geographic region or particular industry. Private-equity-owned businesses outperformed their publicly traded counterparts in almost every sector and market as well.
Second, there's a big agency problem inherent with the report. E&Y did this report for the PE industry. Since they get a significant amount of fees from doing transactions advisory work (due diligence, forensic accounting, etc...), they have a vested interest in keeping their client companies (i.e. the PE firms) happy. So, there are some biases that could be present in the report (What, the accounting firm could be biased, I'm shocked. Shocked, I say!).
Read Deal Journal's article on last year's report here and on this year's report here.
So what does this mean? That in at least SOME cases, PE firms create value by making substantive operational changes that increase the quality of the portfolio company's business. In other words, they're not "just" restructuring the right hand side of the balance sheet.
Looks like another piece for class...
Labels: Private Equity
Tuesday, July 08, 2008
Saturday, July 05, 2008
Cash Flows, Earnings Quality, and Stock Returns
When investors fixate on current earnings, they commit a cognitive error and fail to fully value the information contained in accruals and cash flows. Extending the accrual anomaly documented by Sloan , we identify significant excess returns from a cash flow-based trading strategy. The market consistently underestimates the transitory nature of accruals and the long-term persistence of cash flows. We find that the accrual anomaly derives from the poor performance of high accrual firms, which are more likely to manage earnings. Combining the accrual and cash flow information also reveals that investors misvalue the quality of earnings. Contrary to Fama , these anomalies are robust to the three-factor model with equally or value-weighted portfolio returns.
The paper was published in the Journal of Psychology and Financial Markets in 2000, but you can get an ungated version here.
Friday, July 04, 2008
Happy Independence Day
A happy July 4th to all the Financial Rounds readers out there.
Start by reading the Declaration of Independence here. Then, to get a good feel for the costs born by the Signers of the Declaration, read this (there are a number of versions of it floating around the Internet, and it's been attributed originally to Paul Harvey, but this one is as good as any).
Finally go spend time with family, friends, grill some meat, and light off some fireworks. And if there's apple pie (See above) or baseball involved, so much the better.
As for the Unknown Family, I'm going for a "quick" 20 mile bike ride, followed by our spending the day spent at a family friend's house. We'll have all the essentials - a passel of kids, a grill with lots of critters to cook, various fruit, potato, and pasta salads, a hot tub to hang out in, and fireworks at the park just down the street.
update: the ride went well, Unknown Son was feeling well enough to play with the other kids for about 2 1/2 hours straight in the hot tub (it quickly became the "kiddie pool, so we didn't fire it up above merely warm), and there was plenty of food to be had. The little man is over his recent bout of chemo-induced nausea and vomiting of the recent post, but he still got tired out quickly. So, we left early (we anticipated this, so we took separate cars) and we're now settling in for a little Tom and Jerry action before bed (we believe in a classical education in the Unknown Household - Tom and Jerry, the Three Stooges, Bugs Bunny, etc...).
I suspect Unknown Daughter and Unknown wife will show up around 11 or so. So a happy 4th once again to all.
Thursday, July 03, 2008
Fun With Nausea
By the afternoon, he was back up to code, and we came home. Unfortunately, we had another incident later on at home. Without going into too many details, let's just say that our plans to get a new couch (our old one is about 10 years old) have now been accelerated...
Ah well, "stuff" happens (sometimes figuratively, and sometimes literally).
Tuesday, July 01, 2008
Investor Sentiment and Stock Returns
They construct an index of sentiment based on factors like share turnover on the NYSE, the dividend premium, the volume and first-day returns from IPOs, discounts on closed-end funds, and the equity share of news issues. Here's the conclusions section from their paper (normally I post the abstract, but this section gives a better feel for their results):
The paper is downloadable from SSRN here.Investor sentiment affects the cross-section of stock returns. For practitioners, the main takeaway is that the cross-section of future stock returns varies with beginning-of-period investor sentiment. The patterns are intuitive and consistent with economic theory. When sentiment is high, stocks that are prone to speculation and difficult to arbitrage, namely stocks of young, small, unprofitable, non-dividend-paying, highly volatile, distressed, and extreme growth firms, tend to earn relatively lower subsequent returns. When sentiment is low, the reverse mostly holds. Most strikingly, several characteristics that exhibit no unconditional predictive power actually exhibit predictive power once we condition on beginning-of-period investor sentiment. These results suggest there is much to be done in terms of understanding more about investor sentiment and its effects.
HT: CXO Advisory Group