Saturday, April 30, 2005

Weaker IPOs May Be Good for Stocks

This recent Wall Street Journal Weaker IPOs May Be Good for Stocks: (note: online subscription required) highlights an interesting pattern - that overall stock market returns are weaker in the time period following hot IPO markets and stronger following weak IPO markets.

This makes sense if you believe in an "overvaluation" story - IPOs are more attractive when valuations are high. So, if markets are getting overheated, subsequent returns are likely to be low. I'd suspect that there's a similar pattern for seasoned equity issues (SEOs), which might even be stronger - it's much easier to time an SEO than an IPO.

"Which merger deals draw lawsuits?"

Lawyers, like everyone else, mazimize utility. In their case, mazimized utility often equates directly to maximized $$ (insert joke here). Overlawyered links to an article in Forbes magazine that asks the question "Which merger deals draw lawsuits?". The not so surprising answer is:

"The ones that are sure to generate big fees, of course." University of Arizona law professor Elliott Weiss and New York University economist Lawrence White studied lawsuits filed in Delaware Chancery Court over mergers of Delaware companies between 1999 and 2001. Of 564 mergers, 104 attracted lawsuits, and there was a pattern: the deals sued over "were among the largest, often involved all-cash offers and in more than half the cases the acquiring company owned stock in the firm it was buying." As it happens, "Delaware law subjects cash takeovers and buyouts by controlling shareholders to much tougher scrutiny than most stock-swap mergers" and in such deals acquirers frequently anticipate negotiations with independent directors, and thus enter a somewhat lower initial bid to leave scope for concessions. It is common, however, for the lawyers who sue to wait for the deal price to rise and then claim credit for having made that happen, thus entitling them to compensation: "according to the study, they sought and got fees averaging $1,800 an hour in the cases where the price rose." The authors "conclude that in many cases lawyers are 'exploiting their "license to litigate" primarily to enrich themselves.'" (Daniel Fisher, "Free Riders", Feb. 14).

The Weiss and White paper can be downloaded free from the SSRN here. Here's a few joice parts from the abstract:

...We offer two broad alternative hypotheses as to what drives merger-related class actions in Delaware: a "shareholder champion" hypothesis, and a "self-interested litigator" hypothesis...

...The pattern that we observe is redolent of a pattern of opportunistic filings, of a lawyer-driven process rather than a true client-driven process: systematic behavior with respect to which mergers were challenged; early and frequent complaints filed; a very high percentage of dismissed cases never reached a judgment on the merits; the absence of a single case that has been decided in favor of the plaintiffs on the merits; settlements tending to reflect free riding by plaintiffs' attorneys; plaintiffs' attorneys failing to challenge special negotiating committees' decisions or competing offers; attorneys with "real" clients and from outside the "traditional" Delaware plaintiffs' bar who were far more vigorous in their litigation efforts; no settlements overturned by the Delaware courts; plaintiffs' attorneys' fee awards in settlements usually paid by defendants and not out of common funds, and largely unchallenged; and plaintiffs' attorneys' fees representing a strikingly low percentage of claimed recoveries (but attractive on an hourly basis), which may well indicate that the attorneys added little value to the recoveries.
The paper's pretty substantal and dense, but worth a look.

School Mistakes Huge Burrito for a Weapon - Yahoo! News

And now, for something completely different:

"CLOVIS, N.M. - A call about a possible weapon at a middle school
prompted police to put armed officers on rooftops, close nearby streets
and lock down the school. All over a giant burrito."

Someone called authorities Thursday after seeing a boy carrying something long and wrapped into Marshall Junior High.

The drama ended two hours later when the suspicious item was identified as a 30-inch burrito filled with steak, guacamole, lettuce, salsa and jalapenos and wrapped inside tin foil and a white T-shirt.

click here for the whole article.

It's got to be tough for comedy writers. Like Malcolm Muggeridge (British satirist and Theologian) once said, "You work so hard to put real people into ridiculous situations in your pieces, and then they go and do something far more ridiculous than you could ever have imagined"

Economics for the Citizen (Part 1) by Walter Williams -- Capitalism Magazine

Walter Williams is known to many from his often over-the-top guest hosting appearance on the Rush Limbaugh radio show. However, when he's not writing newspaper columns or doing Limbaugh's show, he teaches at George Mason University in Virginia. He put together a series of lectures on economics (available free from Capitalism Magazine) for the average citizen, and they're definitely worth a read. I'd preface this by this snippet from Williams:

Professor Armen Alchian, a very distinguished economist, used to give me a hard time in class. But one day, we were having a friendly chat during our department's weekly faculty/graduate student coffee hour, and he said, "Williams, the true test of whether someone understands his subject is whether he can explain it to someone who doesn't know a darn thing about it."
Here's a link to the first one (you can find links to the others on the right hand sidebar in the article).

Economics for the Citizen (Part 1) by Walter Williams

Friday, April 29, 2005

This Is Just Wrong, But I Want It!

Stephen Bainbridge provides this link to a story about exploding toads. I know: it's crass, disgusting, and will probably bring down the wrath of the PETA crowd. But, I'm in Bainbridge' camp - I want to see the video.

Thursday, April 28, 2005

Bubbles and Economists

Why do bubbles exist? If markets are efficient (and frictionless), they shouldn't. In this case, if investors perceive an overvaluation, they'd short the stock and drive its price back to fundamentally sound levels. And yet, bubbles exist.

This NYT article, "Economists Try To Explain Why Bubbles Happen" gives a pretty good explanation for some of the major theories why we have bubbles:
  • The reluctance of sophisticated investors (like mutual funds) to short sell for fear of offending clients
  • The willingness to buy into a bubble if you think the bubble is going to continue to grow for a while. This is also known in real estate as the "greater fool" approach (you don't mind buying an overpriced asset if you can find an even bigger fool to sell it to in the future).
  • Regulatory frictions
It closes with some analysis of hedge fund transactions during the recent tech stock bubble.

Click here for the whole article.

Wednesday, April 27, 2005

Should Financial Disclosures Be Mandatory?

This post from Don Boudreaux at Cafe Hayek examines whether a firm should be forced to disclose whether they outsource (off-shore?) their call centers. It gives a pretty good "slippery-slope" argument against the idea. Before I get to their argument, let me give one of my own:

Back at a previous school, the main classroom for the College of Business was next to a certain well-known coffee chain. So, I'd often run into students while getting my daily (or twice or thrice daily, depending on the day) StarCrack.

Once, I overheard two accounting students debating some accounting rule change that mandated a higher level of discolosure for all companies. They went back and forth as to why the regulation was a good thing or not. Most aggreed that it was. Then, they made the mistake of asking me what I thought (one of them was a previous student who recognized me). My view was that (above some minimal level), companies should be free to choose how much financial information they disclose. Here was my argument:

  • How much detail a company provides is observable at least to reasonably sophisticated investors
  • If a company chooses not to disclose much information, a rational assumption would be that the company has something to hide
  • So, the amount of disclosure serves as a signal of firm quality (in fact, even choosing not to disclose reveals information).
I don't know if they got it, but they at least humored me, since I'm supposed to know about theese things.

As for Don BeauDreaus's argument:

I answered by pointing out that requiring firms to reveal the physical location of their employees isnt really full disclosure. Its fuller disclosure, but it's far from full disclosure. And this distinction is relevant. There remain oodles of information about each company and its employees that is not explicitly revealed in the absence of legislation but which might well be relevant to some callers.

Here are some other things that many American consumers no doubt care about and that firms probably would not not reveal unless forced by government to do so:

- an employee's sexual orientation

- an employee's religious beliefs

- an employee's political beliefs

- an employees attitudes toward controversial matters such as abortion, euthanasia, and the death penalty

So why stop with requiring firms to reveal their employees
physical whereabouts? Why not also require firms explicitly to reveal to customers information on all of the above matters?

Click here for the whole piece.

This Week's Carnival of The Capitalists

This week's COTC is up at Peaktalk.

Protect Yourself From Identity Theft (From Fortune)

As more and more of our data becomes computerized, identity becomes more and more of a problem. Just recently, hackers broke into Lexis-Nexis and lifted information on over 300,000 people. In fact, the Unknown Brother In Law was a victim a few years back. This article in Fortune Magazine "Protect Yourself From Identity Theft" lists a baker's dozen ways to protect yourself.

A while back, I taught a personal finance class. I used to have a regular feature called the Scam OF The Day where I highlighted a different way people could cheat your. Many involve nothing more complicated than getting you to reveal personal information on bank accounts, credit cards, etc...

Here are some of the suggestions from the article:

  • Never give out personal information to strangers - whether it's an email, or a phone call.
  • Get your free copy of your credit reports annually
  • Consider a "fraud alert" service with the three major credit agencies
  • Check you bank and credit card statements monthly
  • Make sure your computer has UPDATED virus protection software
  • Keep Windows updated - set your system to automatically download the updates
  • Install a firewall
Click here for the whole article.

Another good suggestion is to take all the paperwork out of your wallet and photocopy it. Make copies of both sides of social security cards, credit cards, etc... and keep it in a safe place. That way, if you lose your wallet, you know exactly what's been lost.

Tuesday, April 26, 2005

The Economics of Gilligan's Island

I don't usually teach Money and Banking. But, if I did, I'd definitely use this piece to illustrate the role of money in society. David Tufte at Voluntary Exchange gives us this link to The Monetary Economics of Thurston Howell III. To quote Glenn Reynolds, "heh".

Or should that be, "Simply smashing, Lovey"?

The (Good) Unintended Consequences of SOX

The unintended consequences of Sarbanes Oxlex might not be all bad. We've all heard how the increased costs of compliance drive more firms private (or keep them from going public in the first place). Jeff Cornwall at Entrepreneurial Mind has some interesting thoughts on some good things that could result from this:

...One outcome that I hope for is that this growth in privately held firms will allow more CEOs to take ethics and values more seriously in how they grow and build their firms.

One stumbling block for public companies being more ethical has been the responsibility to the public financial markets to maximize returns. Those CEOs who do not, particularly in small cap companies can find themselves out of work if they miss quarterly financial expectations of the market.

Private businesses are in a better position to look at a broader array of criteria for what defines success, be it job creation, work environment and so forth. Entrepreneurs and the other shareholders define the rules and can set their own definitions for effectiveness in their companies. Profits remain the primary goal, but private companies can place this goal within a context of ethical and moral considerations that address other stakeholders and broader considerations.

I hadn't thought of that. I guees that's why he teaches Entrepreneurship and I teach Finance.

SOxing It To Small Businesses (From TCS)

I firmly believe that the total effects of Sarbanes Oxley won't be known for quite a few years. We seem to hear new stories and articles daily on how it's caused big enough headaches for public firms that many are considering going private (and causing others to delay going public). Well, here's some more:

In his Tech central column SOXing It To Small Businesses, Steve Bainbridge details some of the costs associated with section 404, which mandates that firms include disclosures of their firms' internal controls in their annual reports. He writes:

Study after study confirms that Section 404 has imposed huge costs on American business:

  • By one estimate, some companies will incur 20,000 staff hours to comply with Section 404, something the SEC estimated would take only 383 staff hours.
  • A Financial Executives International survey of 321 companies found that firms with greater than $5 billion in revenues spend an average of $4.7 million per year just to implement SOX section 404.
  • A survey by Foley & Lardner found that the average cost of being public for a company with annual revenue under $1 billion increased by $1.6 million -- 130% -- after SOC went into force.
He also notes that the burden of increased SOX-related costs are borne disproportionally by small firms:

Finally, the Foley & Lardner study found that these costs are disproportionately borne by smaller public firms. That finding is confirmed by data from a study by three University of Georgia economists, who found that post-SOX director compensation increases have been much worse at small firms:

There is also strong evidence that SOX has imposed disproportionate burdens on small firms. For example, small firms paid $5.91 to non-employee directors on every $1,000 in sales in the pre-SOX period, which increased to $9.76 on every $1000 in sales in the post-SOX period. In contrast, large firms incurred 13 cents in director cash compensation per $1,000 in sales in the Pre-SOX period, which increased only to 15 cents in the Post-SOX period.

Monday, April 25, 2005

Dear Economist (i.e. Dear Abby For Economists)

Patri Friedman at Catallarchy brings us a link to "Dear Abby for Economists" (Tim Harford's the Financial Times' "Dear Economist" columns).

The column answers readers' questions in the style of Dear Abby, but by using insights from classical economics. Where else can you get advice on whether or not to share a mean that uses the Coase Theorem?

Blogging's been light due to my being away at a conference this last week, but I'm back now and ready to blog.

Saturday, April 23, 2005

Share Buybacks (From the Economist)

Share buybacks have been on the rise recently. This article in the Economist, "A valuable alternative to empire building" list some good issues and questions for class discussion:

Have corporate bosses run out of more productive things to do with their money? With the world in its third year of solid, if slowing, growth, are buybacks a sad reflection on threadbare late-cycle capitalism? Is there perhaps skulduggery afoot, with bosses trying to jack up earnings per share and share prices so that their own stock-based compensation schemes are worth more? Or do buybacks in fact create more value for shareholders than letting bosses keep the money to squander on misguided acquisitions?

Companies buy back their shares for three main reasons: they think their firm is undervalued and want to tell the market so; they want to have enough shares in hand to satisfy employees exercising their stock options without having to “dilute” current owners or see their balance sheet become too skewed towards equity; or they don’t see any more profitable investment opportunities and want to hand back the unusable cash to shareholders. This last is particularly persuasive when interest rates are low and cash represents a dead weight on the balance sheet.

It also references work by Vermaelen and Peyer (available free from SSRN) that supports the undervaluation/signalling view of repurchases. This paper finds that the market reaction to a repurchase announcement is more positive for low market-to-book firms, particularly when the repurchase is explained by management as being done due to unvervaluation.

Vermaelen and Urs Peyer

Monday, April 18, 2005

Prediction Markets And Betting Odds On The Next Pope

As the conclave of cardinals begins, a lot of people are wondering who's going to be the next Pope. I've linked to articles recently that talk about prediction markets, and I regularly use TradeSports to show my classes how markets process information.

Tradesports trades a number of contracts whose payoffs are based on papal election outcomes. Based on the latest trades, the conservative German Cardinal, John Ratzinger seems to be the current favorite, followed by the Nigerian Cardinal, Francis Arinze.

However, since the voting by the cardinals is held under maximum secrecy, I'm doubtful as to the ability of prediction markets to provide useful information in this case.

But, it's still fun to watch.

Sunday, April 17, 2005

Do Rich Voters Really Vote Democrat? (from Marginal Revolution)

Alex Tabarrok (at Marginal Revolution) provides an interesting example of the "ecological fallacy". He mentions a very nice blog called Statistical Modeling, Causal Inference, and Social Science, done by Andrew Gelman, a professor in the Departments of Statistics and Political Science at Columbia University (definitely a new one on my own list). This latest post examines the supposed finding from the last election that low-income voters surprisingly seemed to vote Republican, while high-income voters went Democrat:

A recent post looks at the difference between red and blue states and red and blue individuals. We all know that in the recent election poorer states tended to vote Republican while richer states tended to vote Democrat. On the basis of the famous maps many people jumped to the conclusion that poorer individuals were voting Republican (Nascar Republicans) while richer individuals were voting Democrat (trust fund Democrats). But the inference is a fallacy, the ecological fallacy. In fact, high-income individuals, as opposed to high-income states, vote Republican with greater likelihood than low-income individuals (the effect is not huge and it may be declining but it is significant).
Click here for the whole article.

Within states, higher income counties vote republican, but when you pool the data across states, the reverse seems true. It's a great example of the weird (and incorrect) inferences you can come up with when you try to analyze data with pooled samples.

Very nice.

Friday, April 15, 2005

Have Identity Thieves Been Spying On your Wi-Fi

David Kirkpatrick has an interesting (and unsettling) article in Fortune Magazine, titled "Identity Thieves Spying on Your WiFi?" where he thinks someone has been tampering with his computer files.

Every time I boot up my laptop at home in my suburban neighborhood, it registers no fewer than three other networks. One of them hasn't bothered to encrypt his network, so if mine goes down, I use his. The other night, I took out my laptop, drove around the block and found almost a dozen networks, of which 4 were unencrypted.

So, check yours to make sure you haven't left yourself wide open.

More on Bankruptcy Reform (from Asymmetrical Information)

Megan McArdale has been in her cave the last few days preparing some salvos on personal bankruptcy reform. She poked her head out today, and makes a couple of excellent posts (looks like it's six more weeks of bankruptcy issues ;0):

The Economics of Bankruptcy provides a link to an excellent post by William Sjostrom over at Atlantic Blog. It discusses the problems of moral hazard and adverse selection that have to be considered when analyzing the economics of the credit markets.

In Who's To Blame For Bankruptcy, she frames the issue in terms of tempters (the credit car compoanies) versus temptees (the borrowers). IMHO, the best lines are:

...those opposing bankruptcy tried to have it both ways: "people going into bankruptcy are desperate, not deadbeats" and "it's the credit card company's fault anyway for lending them too much money".

But these cannot both be true. If people really needed the money, to put food on the table or shoes on the kids, then it's hard to argue that they would have been somehow better off without the credit cards. And if they spent the money on things they didn't need, well then surely most of the responsibility has to lie on their shoulders?

Mark Kleiman gets around this problem by arguing that you've got two villains here--the tempters and the tempted--and it's unfair to punish only the tempted. Fair enough, except that I don't exactly understand how requiring people to fulfil contracts they've undertaken is "punishment".

...The other problem with saying we shouldn't punish the temptee unless we also punish the tempter is, of course, that none of the people making this argument have any interest in punishing the temptee.
Finally, in How Much Bankruptcy Fraud Is There, she provides a pointer to a summary of a study that examines the likely frequency of fraudulent filings (the study estimates that the number is significantly more than the oft-cited 10% number).

Wednesday, April 13, 2005

What Documents Should I Keep

Since I'm in the middle of tax season (looks like I'll be filing for another extension this year), I've been thinking about what documents to keep and what to toss. Not surprisingly, the Unknown Wife and I have opposite views: she keeps EVERYTHING, and I tend to toss things I shouldn't . It's another example of what someone once said, "If you marry someone exactly like yourself, one of you is extra".

The Motley Fool has a nice piece on what documents you should have. It's not the usual "what to put in a safe-deposit box" list. It talks about things like living wills and so on. There are a few things I should probably get on (after tax season).

Click here for the article

Tuesday, April 12, 2005

Congratulations to David Tufte

Congratulations to David Tufte over at VoluntaryXchange. He just received tenure. He had it before at another university, so there probably wasn't that much doubt, but it's still a big deal. Well done.

How To Improve Your Credit Score

The Motley Fool is almost always a good source of information about personal finance. This article "The Score Is Falling! The Score Is Falling!" explains the factors that go into your credit score. They also give a few good examples of how common actions would affect your score. Here are a few highlights. For an individual with a score in the low 700s:

  • If you've had some late payments, paying all your bills for a month could raise your score by 20 point;
  • Forgetting to pay all your bills for a month could cause a drop from around 700 to as low as 582;
  • Going on a spending bender and maxing out your cards could cause a 70 point drop
  • Transferring a large chunk of credit card debt to a lower-interest card (no effect, since the total amount of debt is the same).
Definitely worth a read. A related Fool article "That's Gonna Leave a Mark"presents some strategies to help you mess up an otherwise good credit record because of an unusual event (hey, stuff happens).

Saturday, April 09, 2005

A Harvard Economist Should Know That There's No Free "Lunch" (or Even Manure)

We should have expected this - An economist should know that there's no such thing as a free lunch. However, Harvard University's Ernest E. Monrad Professor of Economics Martin Weitzman, recently got caught trying to steal a load of horse manure. I know, it's too easy, since folks outside the university view a lot of us faculty as being full of (well, you know...).

Click here to read the whole thing.

Something about this story seems to have tickled a few funnybones Imagine that). Among the blogs mentioning it are (with the best lines):

Truck and Barter: "An Ivy League economics professor, of all people, should know that a market economy is based on the principal of paying for goods and services."

The Liberal Order: "Obviously Weitzman calculated the costs and benefits of his actions and chose the option that maximized his utility"

Market Power:"I have one question. Why would Weitzman go out and find his own sh**? Isn't that what graduate assistants are for?"

Division Of Labor: "Where one Harvard economist allegedly gets the crap he spreads"

The Emirates Economist: "Why did he have to travel to a horse farm to find material that could be found at Harvard?"

All Intensive Purposes: "Perhaps his opening bid was too low."

My first thought was that Weitzman was confused between inputs and outputs.

Feel free to post your own line (snarky is better!)

Why Professors Act The Way They Do

Most studies show that the typical university is, shall we say, a bit left of the American public. Within a University, the Business School tend to be among the most conservative, and the finance (and accounting) departments are usually the most conservative in the Business School. However, even in my department, I'd say that the majority tend to be liberal with an occasional spicing of libertarian tendencies.

David Tufte at VoluntaryXchange has a great post explaining why the university political climate tends to be this way. He writes:

Here's five thougtful links about why - on average - professors hold the poltical views they do.

It all starts with an op-ed piece entitled "An Academic Question" in the New York Times by future Nobel Prize winner Paul Krugman. He points out that:'s Republican Party - increasingly dominated by people who believe truth should be determined by revelation, not research - doesn't respect science, or scholarship in general. It shouldn't be surprising that scholars have returned the favor by losing respect for the Republican Party.

I work with a lot of academics who take the idea of revelation through faith very seriously, and while I don't side with their religion, I can't see Krugman's claim as anything other than blinkered bigotry. Important blinkered bigotry though, because Krugman has the guts to say in print what a lot of academics use for an intellectual crutch to save themselves the trouble of engagement with the other side.

Click here for the whole piece.

Friday, April 08, 2005

Free Wireless

A year or so, several restuarants had talked about providing free WI-FI access to their customers. In fact, before it wend out of business, I used to frequent my favorite coffee shop (not Starbucks) mostly because of the free wireless. Lately, I've been going to Panera's - in the middle of the afternoon, it's usually not crowded, and their connection is pretty good. The coffees not bad, either. It seems like I'm not the only blogger there - the folks at Truck and Barter use it too.

I notice a lot of the "notebook crowd" there, typing and caffeinating away. I've talked about this in class - the WIFI requires some fixed costs, but not much in the way of marginal costs. It provides positive externalities, because it increases sales of coffee (which is pretty high margin) and other foodstuffs.

Thursday, April 07, 2005

Markets constantly evolve in the ways they allow participants to share risk. In recent years, hedge funds have exploded in popularity. A bit less recently (the last 15 years or so), asset-backed securities started becoming more and more popular. These innovations typically result in benefits to companies seeking financing. This from an article in the New York Times, titled Return Hungry Investors Snap Up Riskier Loans:

Corporate loans were once tightly held by banks. But over the last decade or so, the riskiest form of the business, known as leveraged lending, has been transformed to an actively traded market. Besides hedge funds, other large buyers of these loans now include managers of pools of loans known as collateralized loan obligations, which are sold to insurance companies and the like.
Click here for the whole article.

What impressed me about the process is that this loan market used to be primarily bank-driven. The securitization process allows the originator to "sell off" the risk to other investors (like hedge funds). Hence, they have more capital to lend. It's a pretty interesting process.

SEC Approves Trade-Through Rule

The SEC just approved changes prohibiting trade-throughs, which occur when an order to buy or sell stock bypasses the market displaying the best price to another market with a worse price.

IMHO, the regulation is a bad one because of the accelerated pace at which transactions occur in today's market. In my understanding (full disclosure: I'm a corporate finance guy, not a microstructure expert), large investors focus on "effective price" rather than quoted price. So, an investor with an order for, say, 10,000 shares might prefer to execute the whole order at $50.01 rather than be forced to execture a portion at $50 first. In the second case, if the stock trades frequently (Microsoft often has a dozen or more stroc transactions in a second), by the time a portion of the order is executed at the $50 price, the second quote may be filled, and the price could have moven upward.

For a good and non-technical explanation of this argument, read this recent letter to the Wall Street Journal by Charles Schwab, titled "May We Trade Through". He says is as well as I've heard yet.

Wednesday, April 06, 2005

Manipulating Prediction Markets

A reader (Alex) followed up on a recent post on prediction markets with the following interesting question:

Does this have an impact on accuracy of betting markets?

It’s interesting is that "market" corrected itself relatively quickly, but lower volume market (Iowa) could be more susceptible to someone willing to take large (short-term) loss.

It's true that lower volume markets like the Iowa Electronic Markets are more susceptible to manipulation, because of a concept we finance nerds call "depth". This is a measure of how much a trade of a given amount moves prices. Lower volume markets have less depth, so it takes a smaller trade to move prices.

Manipulators by definition make betting markets less predictive. The reason that these markets are normally good at aggregating information about beliefs is that profit-maximizing investors have incentives to trade on their beliefs. For a contract that pays off $1 if an event occurs (like, for instance the “Bush gets elected” contract), it’s pretty easy to show mathematically that a rational individual would be willing to pay an amount equal to the probability that the event will occur. In other words, if you believed that Bush had a 45% chance of winning, you’d be willing to pay $0.45 for the contract that pays off a dollar if Bush wins.

If market players are motivated by making profits, and the price of the contract is below their assessed “fair” price (in the above example, assume that it was $0.40), they’d be willing to buy the contract. As they buy the contract, the price goes up. It will go up until there is no more perceived mispricing (i.e. until the price is at $0.45).

However, a person might be willing to trade at prices they don’t think are accurate. The article gives an example of a “speculative attack”, where someone puts in an order at an obviously low price in hopes of causing a selling panic. If successful, they will wait until the other sellers drive the price down and then purchase shares on the cheap. Their hope is that they can make more money on the cheaply bought shares than they lost on the unrealistic earlier “triggering” trades.

Another possibility (also mentioned in the article) is that someone wanted to create the perception that Bush was unlikely to win. So, they sold the contract to drive the price down in the hopes that people who watch this market start saying “look at what people are saying with their money – Bush has no chance of winning”. Since prophesies are often self-fulfilling in the world of politics, it could conceivably started a negative buzz that helped torpedo perceptions about Bush’s chances.

In a market like the Iowa Electronic Markets, a relatively small trade can move prices quickly. Likewise, an individual could give money to other operatives (the limit to the amount than can be played on the Iowa Market is $500) and also have them trade to magnify the effect.

Unfortunately, unless someone was willing to keep selling (note: they can do this even if they themselves don’t own the contract by executing what’s called a short sale), the price would quickly rebound, since other investors would perceive the contract as being underpriced. Therefore, the other participants would start buying, until the market is back in equilibrium (i.e. the price is back to “fair levels).

So, speculators or manipulators can make the contract temporarily mispriced, but markets quickly correct. The one case where this might fail is if an individual was willing to keep throwing money away for non-profit making reasons. I’m sure, for instance, that Soros probably has enough spare change in his couch to corner the whole Iowa Electronic Market, so it’s definitely possible. As to how likely, I’ll leave that up to the conspiracy theorists. Besides, I’m running late – I have a black helicopter to catch.

The College Debauchery Index (From Motley Fool)

At the beginning of my Principles of Finance Class, I usually solicit questions from my students (i.e. what questions about the world of finance would you like to get the answers to in this course?). Invariably, at least one asks "What's the Dow Jones Average?", or "What's the S&P?" So, I usually spend at least part of an early class on the meaning of a stock index. Now, thanks to the folks at the Motley Fool, Ihave a new favorite index to show my students: The College Debauchery Index:
If there's a group of people who know more about debauchery, I haven't met 'em. Have you folks seen those Girls Gone Wild videos? Heavens to Betsy... I mean, I've only seen the ads, of course, but there's enough there to convince me that the weekend behavior of today's college kids makes yesteryear's Animal House antics look like a church supper.

So props to a well-organized group of college students who have stepped away from the keg and tap to analyze this behavior and model an appropriate stock portfolio based on the results. Behold the glory that is the College Debauchery Index.

Click here for the whole article.

Tuesday, April 05, 2005

More On The Costs Of Sarbanes-Oxley

In the next installment of the ongoing saga on how Sarbanes-Oxley makes being a public company prohibitively costly, we have two items (one anectdotal, and the other from a summary from Red Herring):

In the first Steve Bainbridge (at send us to this article by Amity Shlaes detailing how the owners of Sungard engineered an $11.3 billion deal to take the company private.

In the second, Jeff CornWall at The Entrepreneurial Mind points us to an article from Red Herring that indicates only 10 venture-capital backed companies filed IPOs in the first quarter of 2005. However, buyouts are continuing at their usual pace.
Stay tuned - I'm betting we'll hear more and more of these reports shortly.

Brad DeLong on Marxism and Exploitation of Workers

This is a Brad Delong recently received this email:

From: "XXXX"
To: delong@econ.Berkeley.EDU
Subject: Communism
Date: Mon, 4 Apr 2005 14:22:30 -0700
Thread-Index: AcU5XGg0e/rUmG6pRfqAi7kFYayhrA==

I was wondering if I could borrow some of your insights on Economics.... I have taken Transitional Economics and have a healthy background (for an undergrad) of the “Economics of Shortage” and decision making under socialist constraints.

However, reading Das Kapital and other things, I am seeing a different interpretation of how an item is valued, and the value of labor verses what I have been taught in traditional classes and I need more understanding. What is the “value” of a product, or of labor? Marx argues that exploitation in capitalism is structural, because the basis of making a “good deal” is paying someone four dollars for something worth five. To be a capitalist means you have to exploit the true value of their labor for what you’re willing to pay them for it.

I was hoping to get your insights into how products and labor are valued, and what you think of exploitation in capitalism. Any help you can provide would be greatly appreciated, even if it is a referral to other books or anything. Thank you in advance.


He answers the email by way of this example (click on the link for the whole thing). He concludes:

...Marx's labor-theory-of-value-schema makes no distinctions between profits on capital that have their origins in luck, theft, and choosing the right parents on the one hand; and profits on capital that have their origins in sacrifice, industriousness, or flashes of genius on the other. They are all, to Marx, "exploitation," "unjust enrichment," "extraction of surplus value." They are all, to Marx, signs of evil. But in this particular example the proprietors are, in reality, not evil. The proprietors are, in reality, public benefactors. The effect of their savings and investment is to raise not just their own incomes (after an extended period of sacrifice) but everyone else's incomes as well.

Thus the labor theory of value category of "exploitation" does not map onto what either ordinary language or our moral intuitions call "exploitation."
definitely worth a read.

Legal Finance (From Overlawyered)

Overlawyered brings us this story on "legal finance".

The mushrooming "legal finance" industry offers to advance injury claimants cash on the barrel, to be repaid only if their suits are successful. Some firms have charged effective interest rates exceeding 100 percent a year, but the business generally operates beyond the reach of moneylending laws and has mostly escaped the sort of hostile attention that has been directed at say, the payday loan industry and its alleged "predatory lending". That may be changing, however. New York Attorney General Eliot Spitzer (who says he gets only unflattering attention in this space?) has reached settlements calling for clearer disclosure of fees from at least ten litigation-cash-advance firms, including one based in New Jersey which billed a client $19,000 for a cash advance of $3,000 two and a half years earlier, later accepting a smaller sum. (Joseph P. Fried, "Waiting To Settle a Lawsuit? Beware of Cash Advances", New York Times, Apr. 4). For a glimpse of how the business sometimes works, see Barbara Ross, "Costly trip for Zongo family", New York Daily News, Feb. 14.

There are similarities between these contracts and "payday" loans or (loans in sub-sub-prime markets), but these loans are more like option contracts than anything else. They are paid off only if the plaintiff in the lawsuit wins. So, calculating the interest rate on the loan based only on the cases where the contract gets paid off drastically overstates the return the lender is getting.

Sources For Bond Price and Trade Data

This New York Times article, "A Few Tools For Do-It-Yourself Bond Trading" mentions some excellent sources for bond data. Of these,, a Web site run by the Bond Market Association is definitely worth a look. On their website, you'll find:
  • A good section on "bond basics"
  • News about bonds and bond markets
  • Data on recent trades and prices
  • Coverage of all major markets (corporate, federal government, municiple)
The Web makes bringing real world data into the classroom easy (particularly if you have a net hookup and a projector in the room).

VCs are Flush with Cash (From The Entrepreneurial Mind)

This in from Jeff Cornwall at The Entrepreneurial Mind:

Venture Capitalists were busy raising money in 2004 and have some very full pockets of cash. The phenomenon is known as overhang, and you can read about it here.

More cash means more deals and probably a little bit looser purse strings with the investments they are willing to take. Good times are ahead for high potential ventures looking for money!

Looking at the article linked above, of the $82.6 billion raised in 2000, a fifth has yet to be invested. So, the VCs have the equivalent of a free-cash flow problem - they have more available investable resources than they have good investments. My guess is that this will result in their investing in some start-ups that they wouldn't have taken otherwise. For a corporation, this would be the equivalent of taking on negative-NPV projects. That's good for the startups, but bad for those investing in the VCs funds.

Bernanke On Implementing Monetary Policy

Brad Delong give us this link to Ben Bernanke talking about how monetary policy is actually conducted:

FRB: Speech, Bernanke--Implementing Monetary Policy--March 30, 2005: at the Redefining Investment Strategy Education Symposium, Dayton, Ohio March 30, 2005

Among the most important of my duties at the Federal Reserve is serving on the Federal Open Market Committee (FOMC), the body that makes U.S. monetary policy. Nineteen men and women--the seven members of the Board of Governors and the Presidents of the twelve Reserve Banks--gather in Washington eight times each year to participate in FOMC deliberations on the course of monetary policy. If necessary, the FOMC can also convene by conference call between regularly scheduled meetings. The FOMC's decisions are guided by the dual mandate given to the Federal Reserve by the Congress, which enjoins the Committee to use its powers to pursue both price stability and maximum sustainable employment.

Click here for the whole article.

This article is a must read for anyone that's even vaguely interested in the economy as a whole and/or the role of central bankers. I'll definitely give it to my next Markets and Institutions class.

Monday, April 04, 2005

The Feynman-Tufte Principle (From The new Economist)

Richard Feynman was a fascinating figure - Nobel prize winning physicist, member of the Manhattan Project, drummer in a Brazilian street band, and amateur safe-cracker in his spare time. To many finance professors and practitioners, he's also known for developing a solution to a 3rd order partial differential equation that Black and Scholes used to solve the option pricing problem. He was particulary admired for his way of illustrating phsics concepts through what are now known as "Feynman Diagrams". The New Economist.

Edward Tufte is also know for his work on the visual display of information. It turns out that he also was a fan of Feynman. The New Eonomist writes:

Many economists would - or certainly should - be familiar with the pathbreaking work of Edward Tufte on the visual display of information. hence my interest in a short piece by Michael Shermer in the April 2005 issue of Scientific American on the Feynman-Tufte Principle (permanent version here). It's short, but insightful:

Tufte codified the design process into six principles: "(1) documenting the sources and characteristics of the data, (2) insistently enforcing appropriate comparisons, (3) demonstrating mechanisms of cause and effect, (4) expressing those mechanisms quantitatively, (5) recognizing the inherently multivariate nature of analytic problems, (6) inspecting and evaluating alternative explanations." In brief, "information displays should be documentary, comparative, causal and explanatory, quantified, multivariate, exploratory, skeptical."

Click here for the whole article.

Odds On The Next Pope

As difficult as it's been, I've tried not to make any comments on the recent passing of either Terry Schiavo or Pope John. However, I just can't pass up a good finance angle.

I've used prediction (betting) markets in my class for years as a tool to explain how markets process information. These contracts traded in these markets are very simple - a contract based on a given event (i.e. Bush gets elected president or UNC wins the NCAA tournament) pays off $1 if the event occurs and $0 if it doesn't (in econ-speak, it's an Arrow-Debreu security). So, the "fair price" of the security would be the probability of the event occurring. Prediction markets have been useful tools for aggregating information.

Tyler Cowen at Marginal Revolution brings us the following roundup of betting markets related to the papal succession:

Try here, here, and here, with the latter offering discussion as well. Thanks to the ever-keen Naunihal Singh for the pointer.

Addendum: Here are odds by country, thanks to Paul N for the pointer.

Update: welcome to all the visitors from - come on in, make yourselves comfortable, and have a look around.

Economics In One Lesson

From Lynn Kiesling at Knowledge Problem:

Henry Hazlitt's seminal text Economics in One Lesson is now fully available online. It's a clear, straightforward articulation of basic economic principles.Thanks to the Foundation for Economic Education for doing so, and to Mahalanobis for the tip.

If you've never seen this book, take this opportunity and download it.

This Week's Carnival Of The Capitalists

This week's Carnival of the Capitalists is up, and brought to you by Gordon Smith at Law & Entrepreneurship News.

Sunday, April 03, 2005

Information Asymmetry and Dating

The gang at Marginal Revolution has a category of posts they title "Markets in Everything" (warning: their taste in examples sometimes is a bit "out there", so be warned). Here's the latest: can pop over to and find out whether your prospective date is anything close to what the profile suggests.

TrueDater, not to be confused with, is a database of reviews written by people who met through online personals. It's like, only instead of books, you're reviewing people. More specifically, you are reviewing their ability to represent themselves online.

Here is the story; the prescient Michelle Boardman suggested this idea some time ago.

Addendum: Here is a sample review.

Luckily, I've been together with the Unknown Wife for almost 15 years, so I don't have to deal with stuff like this. That's why, in relationship, I'm a firm believer in a "long-term buy and hold" strategy" (I did my asset selection, paid my price, and I plan on keeping my portfolio just where it is). In fact, when I get nostalgic for my single days, it's usually because I forget that they weren't all that great. Without going into too much detail, let's just say that there was a lot of search costs and adverse selection going on...

NYT Interview With Michael Jensen

Michael Jensen is one of the icons of modern finance. In addition to writing many of the most cited pieces in corporate finance he also was one of the founders of the Social Science Research Network. He was recently intereviewed in this New York Times Article (titled "An Early Advocate of Stock Options Debunks Himself") by Claudia Deutsch. It's fairly long, so I won't reproduce it here. However, it touches on a wide variety of interesting and relevent topics, including:
  • The perverse incentives arising from option-based and stock-based compensation as it's currently used
  • The agency costs of overvalued equity
  • Using indexed options (options that are adjusted for cost of capital or peer-group performance)
  • Whether options should be expensed
It's worth a look (as is just about anything written by Jensen).

Premium Callable Bonds and Interest Rate Risk

Here's a good NYT article on premium callable bonds, titled "It's Name Is a Mouthful, SO Just Call It a Rate Shield". It begins:

After months of false alerts, longer-term interest rates may finally be moving up in earnest. If the trend continues, fixed-income investors who have not prepared will be taught an ugly lesson: as yields rise, prices fall and the value of a bond portfolio declines.

But there are ways to minimize the pain. The most common moves are to sell longer-term bonds and to hold cash or shorter-term securities, which won't be hurt as badly as their cousins with longer maturities. Some portfolio managers also use futures contracts to hedge against rate increases.

But professionals are also using a less known way to cushion a bond portfolio: by buying premium callable bonds.
The article is a good one to use when discussing duration (a measure of how far off in the future the cash flows from a financial security are on average). Duration is a measure of a bond's price sensitivity to interest rates, because the present values of distant cash flows are affected by changes in interest rates more than are the present values of cash flows that are closer in time to the present. Premium callable bonds have lower duration for a number of reasons:

  1. The bond are selling at a premium becuse they pay a coupon rate that is higher than the rate on bond that sells at par. So, since a bond's cash flows consist of coupon payments and a lump sum at the end, a premium bond has relatively more of its cash flow in the form of coupon payments (which occur before maturity).
  2. Since the bond is at a premium, it is more likely to be called. So, the "term" if the bond is likeley to be much shorter, resulting in a shorter duration.
The article then concludes with a few scenarious where a premium callable bond has some increased risks.

Saturday, April 02, 2005

Different Opinions, or Evil?

Jane Galt at Asymmetrical Information gives some good advice on how to approach & deal with those who hold different opinions than your own:

Absolutely outstanding post by Stuart Buck about one of my pet peeves, the common belief that people who disagree with you are amoral lackwits, rather than putting different relative weights on principles we mostly all cherish:
People often accuse their opponents of being hypocrites when, in fact, they ma simply have been balancing competing principles. We all do this constantly. And the mere fact that someone reaches a different balance than you, or that they decline to treat one principle alone as being absolute, does not prove that they are being hypocritical.
Click here for the whole article.

Excellent advice - people I disagree may be misguided or illogical, but they aren't necessarily evil. Once you start demonizing your opponents, you're no longer discussing things in order to win them over, but instead in order to reinforce your own beliefs.

Updated Blog Roll

There are a number of blogs I check on a regular basis. - I just hadn't gotten around to updating the blogroll. Now I have - I've just added about a dozen new ones. Check them out, and see if anything tickles your fancy.

If you have any suggestions on links I should add (whether to your blog or to those you frequent), email me and let me know.

One Billion Lnks

From the Folks at Crooked Timber:
I wasn’t watching it tick over, and I missed the party but Technorati just passed 1 billion links, of which this blog accounts for 311.
Click here for the whole (albeit short) post.

Editorial comment: Crooked Timber is one of my favorite blogs. They usually have a point of vies that's very different (and often diametrically opposed) to mine, but that's what makes it fun. If you haven't already, consider adding them to your "regular read" list.

Along those lines, if you haven't already done so, check out Bloglines. It's a good way to keep up on your blog reading without spending all day. My current subscription list contains over 50 sources, and I can usually check it for new posts in about 2 minutes.

An Insider Looks at The Tribe

To those not in "The Tribe", academia can be a strange place. To those in it, it can be even stranger. Tyler Cowen at Marginal Revolution the latest edution of Econ Journal Watch. While he mentions the tribute to Thomas Schelling, there's another article in the same journal, titled "The Ph.D. Circle In Academic Economics" (click on the page link in the table of contents) that's also a great read. It goes at great lengths into how the "market for ideas" among economists is very different than the market for just about anything else. These types of analyses are typical conversation for colleagues of mine, but we don't say it as well as this article. The section titled "If Waiters Were Like Economists" is particularly good:

Do the thought experiment. You arrive on a planet on which the market for waiters is like our market for academic economists. This otherworldly market exhibits the following features:

  • Each waiter job is controlled by a collection of other waiters, a Waiter Department.
  • Each Waiter Department spends money with very slight regard for the preferences of restaurant customers. Indeed, much of the money comes from coercive extractions from extraneous parties.
  • There are 200 Waiter Departments, but they all form an encompassing mono-centric cultural pyramid. Each Waiter Department gets whatever prestige and revenue-base it commands principally by adhering to the accustomed standards of the encompassing club.
  • Each Waiter Department produces the new young waiters, whom it tries to place as high up in the pyramid as possible.
  • Non-waiters are deemed unqualified to criticize the standards and practices of the encompassing Waiter club. Outsiders are ignored.
  • Waiters at departments at the top of the pyramid set the tone for the entire club.
  • Waiters carry on political discourse with restaurant customers.
  • Moreover, waiters at the top departments rub shoulders with political elites and power-holders. Sometimes, the top Waiters are appointed to positions of influence and power. Many aspire to be or imagine themselves to be part of society’s governing set. Their governing-set standing depends on playing according to the rules of conventional political culture. One of those rules is that one must accept the idea that society is an organization and government is the manager of that organization. One must affirm a basic faith in democratic political processes. One must observe that the appointed managers are like us, smart, socially-concerned people who can master the contours of society’s unknowability well enough to regulate social affairs beneficially. One must refrain from saying anything that might imply that much of what the government does is fundamentally a sham and a menace. As a result, among the top 50 Waiter Departments there is no voice or vitality for abolitionism.
It explains a lot, and should be read by anyone considering a Ph.D. in finance or economics.

Friday, April 01, 2005

The Plagiarist And The Comedian

A college student goes on the internet and asks a stranger (Nate Kushner at A Week Of Kindness) to write a paper for her. Unfortunately for (and unbeknownst to) her, he's a comedian with some free time on his hands who doesn't like plagiarists. So, he strings her along and then turns her in. The story that follows is either poetic justice or the makings of a new urban legend.

Make sure you read the comments too. They're split between "good for you - she git what she deserved" and "that was WAAAAY too harsh".

Since I just had to deal with three cheaters on my last exam, you can guess what side I'm on.

Compensation, Governance, and Fraud

This from The Atlantic (by way of Jane Galt at Asymmetrical Information):

Corporate scandals often happen at the most successful firms—or at least at firms where the appearance of success breeds a megalomaniac CEO, reams of stock options, overoptimistic goals, and gaga recommendations from Wall Street equity analysts. This is the conclusion of a Boston Consulting Group study that analyzes the companies responsible for twenty-five of the largest corporate frauds since 1996. Compared with their clean competitors, "fraud firms" offered their CEOs eight times as much stock-based pay and set corporate performance targets 250 percent higher. Other factors associated with executive malfeasance were inflated stock prices and attention from the press (before their downfalls, fraud-firm CEOs were three times as likely to be quoted in the media as their competitors). Moreover, two interesting insights emerged. First, good corporate governance—of the sort mandated by post-bubble regulations—may have done little to prevent fraud. Enron's board, for instance, was rated among the nation's five best-governed in 2000. Second, while crooked execs may have fooled analysts, the media, and the public, the market sniffed them out. The median fraud firm lost 40 percent of its value in the year before its actions came to light. (One wonders who was selling …)

—"Corporate Governance Revisited: How Greed and Ego Can Destroy Companies and the Lessons to Be Learned," Kees Cools, Boston Consulting Group [This item is unavailable online.]

There have been a number of academic studies that are closely related to this news. They examine factors related to earnings restatements (rather than fraud), but the two events are pretty closely related):

1) Palmrose, Richardson and Wu that examined what factors predict earnings restatements :

...firms restating earnings have high market expectations for future earnings growth and have higher levels of outstanding debt. We also find that a primary motivation for the earnings manipulation is the desire to attract external financing at a lower cost. Furthermore, our evidence suggests that restating firms have been attempting to maintain a string of consecutive positive earnings growth and consecutive positive quarterly earnings surprises. Together, our evidence is consistent with capital market pressures acting as a motivating factor for companies to adopt aggressive accounting policies.
Click here for a copy of the working paper from the SSRN.

2) A paper by Agrawal and Chadha in the Journal of Law and Economics:

... We find that several key governance characteristics are unrelated to the probability of a company restating earnings. These include the independence of boards and audit committees, and the provision of non-audit services by outside auditors. We find that the probability of restatement is lower in companies whose boards or audit committees have an independent director with financial expertise; it is higher in companies where the CEO belongs to the founding family.
The article isn't available online, but an earlier version (also on the SSRN) can be found here.

The first piece is consistent with executives having incentives to manipulate earnings to enhance corporate "reputation" (if we construe the term "reputation" broadly to include the need to be able to attract funds at a reasonable price). In particular, firms more likely to need external financing (i.e. higher growth firms) are more likely to manipulate their earnings.

The second piece board governance matters in constraining earnings manipulation, but that the simple "is the board independent" measure is not the best way to capture how well the board is governing. It's more important that the board members be "smart". Other words, the key seems to be the presence of a "sophisticated" independent director (one with financial expertise). Several years ago (pre-SOX), ther was a study that found that the typical independent director spends less than three hours a week on board-related duties. Given this relatively short time commitment, it's tough to do any effective monitoring unless you really know what you're doing.