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Showing posts from October, 2009

Damodaran on the Equity Risk Premium

The Equity Risk Premium is one of the central concepts of finance theory and practice. However, when we teach it in class (usually as part of the CAPM), we tend to do a lot of hand-waving and tell students to use historical ERPs. Aswath Damodaran of New York University has an excellent piece on SSRN titled "Equity Risk Premiums: Determinants, Estimation, and Implications" that's a must-read whether you're a professor, student, or practitioner. Here's the abstract:
Equity risk premiums are a central component of every risk and return model in finance and are a key input into estimating costs of equity and capital in both corporate finance and valuation. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. In the standard approach to estimating equity risk premiums, historical returns are used, with the difference in annual returns on stocks versus bonds over a long time period comprising the expected…

Some Thoughts on Buttonwood's Trifecta

Buttonwood’s column this week is typically thought-provoking. She starts with the observation that three major asset classes – stocks, bonds and gold – have all produced double-digit returns in the last three months. She then points out that this is not usual: indeed, it has only happened thrice in the past fifty years 1. And for good reason: the three asset classes have very different exposures to risk (equities are risky, bonds and gold are canonical safe havens) and to inflation (gold is a good inflation hedge, bonds are not, and equities lie somewhere in between). She describes various fundamental explanations (divisions in investor opinion; inefficient markets; central bank intervention; increasing risk appetites). And finally, she lays out her own explanation: liquidity.
Low interest rates are driving investors out of cash and into anything that offers either the prospect of capital gain or a yield that is higher than zero. Investors used to talk about a ‘Greenspan put’ th…

Some Thoughts on the Phillips Curve

Of all the economists, journalists and assorted financial industry participants who comment on the web – and there’s certainly no shortage of them – the one whose views align most closely with my own is James Hamilton of UC San Diego and Econbrowser. I find that I rarely disagree with him, whether it’s on macroeconomics, oil, securitization, financial markets, or anything else. So I was interested to see him make the case that ‘high levels of unemployment are a factor that will put downward pressure over the next two years’.

His argument is straightforward: he regresses historically realized inflation against unemployment, and also against lagged inflation (the latter is to account for expectations of inflation). He finds a statistically significant negative coefficient for the period from 1948 to 2007, validating the classical Phillips Curve relationship. Since unemployment is currently very high, inflation is (ceteris paribus) likely to be contained over the next few years.

My …

I'd Eat That

I just stopped by my favorite (on campus) coffee, bagel, and sandwich shoppe - I'm spending the afternoon grading exams that are due back tomorrow (groan).

Their latest sandwich offering is a Veggie Burger with Tomato, Onion, Provolone cheese, and Bacon. That's right - a veggie burger with bacon - probably the only way I'd eat one of those. Actually, it sounds pretty good. Bacon improves just about everything.

Talking With Practitioners

Unknown University recently had a function where they brought back a number of prominent alumni to talk about various topics. At dinner after the function, I ended up at a table with an MD from a major investment bank who manages about 10Billion overall in both traditional funds and alternative investments in the market where I'm currently doing some research. It was not by chance - I offered to lead a session that he was the main speacker for, and asked to be put at his table afterward.

So, at dinner (in between him checking his Blackberry every few minutes (dan - that is distracting), I got a chance to see whether my story about what I saw in my data passed the "sniff test" from someone who works in that market on a daily basis. Luckily, it did. Having topped that bar, we started talking about what sorts of things his firm has done in terms of research on the particular topic. So, it looks like I made a connection that could result in my getting some pretty scarc…

Best Headline Ever

I'm a big fan of satire. But sometimes reality comes out with something that's far funnier and more bizarre than anything I could have come up with (even during the 70s, which were very, very interesting). Here's a newspaper headline that I just can't get out of my mind:

One gay man, two lesbians, a three-legged cat and a poisoned curry plot.

From the Mail Online. Hey - brit tabloids just do this stuff better than us.

Occam's Razor vs. Occam's Professor

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I try not to be Occam's Professor - unless it's the right thing to do.

Jobless Recoveries and Asset Market Bubbles

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Asset markets around the world have rebounded quite substantially from their lows of earlier this year. As a result, attention has increasingly become focused on the Federal Reserve’s ‘exit strategy’1. Can the Fed raise interest rates, or even credibly threaten to do so, given the bleak state of the labor market? Some central bankers think so; here’s the Philly Fed’s Charles Plosser:
As the economy and financial markets improve, the Fed will need to exit from this period of extraordinarily low interest rates and large amounts of liquidity. We recognize the costs that significantly higher inflation and the ensuing loss of credibility will impose on the economy if we fail to act promptly, and perhaps aggressively, when the time comes to do so. The Fed will need courage because I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels.Others are more cautious, and would like to see a rebound in employment …

Williamson and Ostrom Win Nobel In Economics

The announcement just came in - The Nobel Prize in Economics (actually the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, to be precise) was awarded jointly to Elinor Ostrom(for her work on usage of common goods) and to Oliver Williamson(for his work on business as means of mitigating transactions costs). While I'm familiar with Williamson's work, I'm not with Ostrom's - so it looks like some reading is in order..
Click here for a list of past laureates.
In somewhat surprising related news, Obama was not awarded the prize (neither was Michael Moore or Timothy Geithner).

Obama Awarded Nobel Peace Prize

When I read this morning that Obama had been awarded the Nobel Peace Prize, I first thought it was a joke. Then, when I found out that it was real, I realized it was still a joke. Unfortunately, it was one that the prize committee played on themselves. They've definitely beclowned themselves - if I were to guess why they gave it to Obama, I'd have to say "Because he's not Bush").

I know, I know - this isn't a political blog (it's supposed to be about finance, or at least about being a finance professor). But some things cry out for comment.

Since it's Friday at 5:00, I guess it's time to call it a day. If the weather holds out, I'm trying a 100 kilometer ride tomorrow. Should be interesting - the course is not as hilly as the last ride. But, it might rain, in which case I'll stay home.

update: a reader just informed me that nominations had to be in by February 1st. So that means that Obama was nominated after eleven days in office.

Feedback in Financial Markets

In a previous post, I mentioned that bubbles were characterized by – indeed, defined by – positive feedback. This idea, and more generally, the importance of feedback in driving market dynamics, deserves a lot more ink. Here’s a first installment.

Classical economics is often concerned with analyzing various equilibrium outcomes (“comparative statics”). These outcomes are usually generated or maintained by some sort of negative feedback. The simplest example is that of security prices. Under the efficient markets hypothesis, each security has a fair price reflecting its ‘fundamental value’; furthermore, this fundamental value is known to market participants in aggregate. If the actual market price drops below this value, people step in to buy the security; if the price rises above it, people step in to sell. As a result of this negative feedback, the market price equilibriates to its natural or fundamental value.

Unfortunately markets do not always tend to equilibrium. Negative f…

The Christian Finance Faculty Association

Robert Brooks is a finance professor at the University of Alabama. He's trying to get a new organization (the Christian Finance Faculty Association) off the ground. Since it's a worthwhile endeavor (and one I'd be a part of if I were going), I thought I'd post some information about it.

Professor Brooks has scheduled an organizational meeting at the upcoming Financial Management Association meeting in Reno in a few weeks. Rather than retype everything, I'll just pass along the info that was forwarded to me (efficient AND lazy- now there's a combination. Unfortunately, I don't have the looks to go with it.)
The purpose of this email is to announce the formation of The Christian Finance Faculty Association. The first formal meeting will be held at the Nugget Hotel in Reno (Lake Tahoe) during the FMA meeting this year. The meeting will be held in the Alpine Room on Friday, October 23, 2009 from 7:00 to 9:00 AM.
The following are information items related t…

Nash Meets Feynman

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Those of you who haven't seen "A Beautiful Mind" might not get it. Butif you have (or if you know Nash's work), it's funny.

In case you didn't know, in addition to Richard Feynman being a Nobel-prize winning physicist, also found the Feynman-Kac solution to the third-order partial differential solution that Black and Scholes used in their option-pricing formula. So, he's actually about a Nobel-Prize winner and maybe a quarter (once on his own, and once for being useful to B&S.

A Funny Economist

It turns our Austan Goolsbee (U of Chicago Economics prof and member of President Obama's Council of Economic Advisors) is a pretty funny guy.

From what I recall, I'd gotten a couple of emails from him a while back (when he was just a normal mortal) regarding possible things to blog on. Of course, that could be just the Alzheimer's talking.

Regardless, he's a pretty funny guy - decent material (not fantastic, but he IS an Economics Prof, after all) and interesting delivery.

Now that I've mention you Austin - about MY stimulus package...