We Produce Thecal Matter

Some are just better at piling it.

My Students Are Getting Their CFA Level 1 Results

For the first time, I have five students who sat for the CFA Level 1 Exam. Today's the day results are given out.

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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Is There Predictive Power In The Option-Implied Volatility Smirk?

Apparently, the answer is yes. Xiaoyan Zhang (of Cornell), Rui Zhao (of Blackrock Inc.), and Yuhang Xing (of Rice University) recently conducted a study titled "What Does Individual Option Volatility Smirk Tell Us about Future Equity Returns?" Here's their abstract (emphasis mine):

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.

Basically, they calculate the "volatility smirk" (the difference between the implied volatility for At-The-Money (ATM) calls and Out-of-The-Money (OTM) puts) for individual stocks. They then sort firms into portfolios based on deciles of the smirk, and compare returns for the various portfolios (or for "hedge portfolios" constructed by shorting the "high smirk" decile and going long the "low smirk" decile) . The logic for this approach is the hypothesis that informed traders with negative news will choose to buy OTM puts, thereby causing a divergence in the IV of the puts vs for the call.

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

Dan Ariely - Predictably Irrational At Google Authors

Here's a video of Dan Ariely (author of "Predictably Irrational") in his recent talk for the Google Authors program. Ariely has written a fascinating book about some of the cognitive and behavioral biases that most of us exhibit. If you listen carefully, you'll find that he even gives a hint about how to increase your student evaluations.

Finance: 0% Politically Correct

Inside Higher Education just highlighted some research done by Neil Gross, a sociology professor at Harvard, and Solon Simmons, a sociology professor at George Mason University. Here's the "punch line" from the summary:

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).

In addition, the five disciplines next least likely to be politically correct were Biology(2%), Computer Science (3%), Accounting (4%), Marketing (4.5%), and Economics (4.7%). All in all, these numbers aren't surprising: I can't imagine what a politically correct approach tom teaching finance would entail (maybe an NPV of a project that differs based on the race, gender, or class of the project manager?).

Read IHE's summary here, and get the original article here.

HT: Marginal Revolution, who I'm less politically correct than.

Extension Risk and Mortgage Backed Securities

I'll probably be teaching Fixed Income class next year when a colleague goes on sabbatical. I'll try as much as possible to tie the class in with the CFA curriculum. One of the big topics in the Level 2 CFA Fixed Income material is the issue of extension and contraction risk for mortgage backed securities (MBS).

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.

Your Daily Dose of Patriotism

I'm a big Muppets fan, so I thought this was hilarious. My favorite part is around 1:12 (I always had a soft spot for Animal...).

HT: Neal Boortz

Once Again, The Movie Critics And I Disagree

The Unknown Mother-In-Law has a cottage on a lake in northern Vermont (Unknown Wife's father built it years ago). I'm not much for the place, and had a lot of work to do. So, the rest of the Unknown Family went up there for about a week, and I get to be a bachelor.

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.

Tony Snow - Passed Far Too Young.

Tony Snow passed away this past week, and his funeral was today. He was one of the good ones, and I'll miss him. From what I've seen of him and what I've read, he seemed like one of the good ones - a very happy warrior in his job, an extremely loving family man, and a devout Catholic.

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

You're gotta love an ad that uses old Godzilla footage to slam PE firms - if just for the sheer shlock factor (say that three times fast...).

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.