What went wrong?

The Economist talks about "What went wrong" - basically a combination of leverage and perpetual optimism that financial assets could only go up.

Cramer...Cramer....Cramer

Cramer on CNN about his Bear Sterns comments. He's a bit more coherent this time, and as usual the interviewer gives him an easy pass.

Link here

But I still don't get it. He claims he was talking about someone having deposits at Bear Sterns. Since when was Bear Sterns a depository bank?

And in a related post, apparently Fox News Business Channel is playing off the Cramer gaff as a promotion tool.

They (Fox Business news) claims to be a "credible network". Personally I'll stick with the Colbert Report.

Executive compensation schemes

There is no doubt that you have to be smart to be a CEO. In fact, according to the WSJ, you have to be a math wiz just to understand a CEO's bonus compensation.

For example, for Adobe the bonus formula is:

"Target Bonus x Unit Multiplier x Individual Results."

But then comes the definition of unit multiplier. Adobe says it is:

Derived from aggregating the target bonus of all participants in the Executive Bonus Plan multiplied by the funding level determined under the funding matrix, and allocating a portion of the funding level to each business or functional unit of Adobe based on that unit's relative contribution to Adobe's success, and then dividing the allocated funding level by the aggregate target bonuses of participants working within each such unit.

(source WSJ)

Before this era of "transparency" I bet bonuses were just decided in a smoke filled room. Now that companies are expected to reveal their methods, they are opting to make the method as opaque as possible.

Bear Sterns worse than LTCM?

The Telegraph (UK paper) has an article arguing that the Bear collapse is worse than the LTCM failure.

The implosion of Bear Stearns is more dangerous.
A host of other banks, broker dealers, and hedge funds have played the same game, deploying massive leverage at the top of the credit bubble to eke out extra yield. Dozens of them are saddled with the same toxic debt - sub-prime property, credit cards, auto loans, and mountains of unsold paper from the merger boom.

Primarily because the rest of the economy is in bad shape and the risk on the damage spreading is much greater. We'll have to wait and see.

Delta hedging on AMEX

FinanceProfessor.com has a nice piece on a proposed rule change to allow delta hedging to be used to compute the appropriate stock hedges for option positions on AMEX.

Link Here

The rule change states:

All options contracts listed and traded on the Exchange are subject to position and exercise limits as set forth in Amex Rules 904 and 905. Position limits restrict the number of options contracts that an investor, or a group of investors acting in concert, may own or control in one particular option class or the security or securities that underlie that option class.

And

Over the past several years, the Exchange as well as the other self-regulatory organizations ("SROs") have increased in absolute terms the size of the options position and exercise limits as well as the size and scope of available exemptions for "hedged" positions. /6/ The exemptions for hedged positions generally require a one-to-one hedge (i.e., one stock option contract must be hedged by the number of shares covered by the options contract, typically 100 shares). In practice, however, many firms do not hedge their options positions in this way. Rather, these firms engage in what is known as "delta hedging," which varies the number of shares of the underlying security used to hedge an options position based upon the relative sensitivity of the value of the option contract to a change in the price of the underlying security. /7/ The Amex believes that delta hedging is widely accepted for net capital and risk management purposes.

Why is this interesting?

Well, as students of mine should know, once we have covered Black Scholes, the appropriate hedge for an option is not 1 share of stock per option, but depends on the delta of the option - that is the sensitivity of the option to the change in the stock price. A 1 for 1 hedge is really only applicable for very in the money options. For most options, the delta is less than 1, and thus a smaller hedge is required. Remember that over hedging is not a good thing.

Cramer: master of the double meaning

So the Bear Stearns collapse has been all over the news. But a slightly amusing side line is the Jim Cramer angle. Cramer as you probably know has a stock show on cable called "Mad Money". Its sort of like Wall Street Week meets Emeril but with more of the "Bammm!" and less of the analysis. Needless to say he is pretty popular. I think both Cramer and Emeril are very overrated.

So last week (March 11) Jim Cramer states that Bear is fine - no need to pull your money out....http://www.youtube.com/watch?v=gUkbdjetlY8. At that point the price was at about $60. Then by Friday the stock had collapsed to basically $2.

By this week, he's catching some heat for his comments. See the video here on financeprofessor's blog.
http://financeprofessorblog.blogspot.com/2008/03/more-news-on-jim-cramer.html

Ahhhh, but does Jim fess up and admit his mistake? Nooooo!!!

In a brilliant use of double meaning, he states that when he was asked "should I pull my money out of Bear?" his answer was referring to whether someone should remove their money from Bear's investment products, not Bear's stock. This is despite the fact that he posted a chart of Bear's stock on the screen.

Given that he had about 3 days to contact this answer I think he did pretty well. This must also mark the first time (on 3/11) that he gave advice about investing in an investment bank's investment products and not the bank itself.

Great stuff Jim. But perhaps you should consider a career in cooking.

Thanks to FinanceProfessor for the original link

The cost of active trading.

Finance Professor has a great link up here which talks about a new study by Ken French that argues that investors collectively spend $100bn trying to beat the market (and collectively failing). The original article is from Mark Hulbert's column on the NYTimes.

This is great stuff and pretty profound really. Fans on indexing should rejoice and can act smug in front of day traders!!! Of course active investors will argue that it doesn't apply to them - for an example see here.

For those of us who buy in to the idea of indexing, this study is not really a surprise, although I have to admit the dollar amount is pretty big!

Black Scholes - the root of all evil?

Last week, one of my MBA students handed me a copy of "Conde Naste Portfolio" which featured an article about the Black Scholes option pricing model. The article is also online and FinanceProfessor has a link to it here.

The article is pretty poor (although the magazine is very glossy!) First of all, it basically rehashes all the material in the PBS Nova TV special from a few years ago which looked at Black Scholes and the collapse of Long Term Capital Management. The Black Scholes Model was blamed for all the ills of the world back then. To make the topic more current, the author of the piece cites a Nicholas Taleb who has basically made a living trashing Black Scholes. People listen to this guy because back in 1987 he correctly bet that the market would crash. By his own admission, he hasn't been able to repeat that feat since - hmmmm. Anyhow, he has this to say about Black and Scholes:

"This is what I'm saying to Merton and Scholes," "You guys are just parasites. You're not bringing anything useful to the market. You are lecturing birds on how to fly. You're watching them fly. And then you're taking credit for it."

He also thinks that they should have the Nobel revoked.

I'm sorry Mr Taleb, but you are so far off base here, your comments barely dignify a response. The Black Scholes model is a model, and just that. It assumes that the risk input that you use is a reasonable estimation of the future risk of the security. If the security does something drastically different to what it has done in the past, then the model will misprice it. Garbage in, garbage out. If you use the model and don't recognize this, then you'll likely get burned.

Mr Taleb, don't go shooting the messengers (or in this case trashing the authors) of the model in such an unprofessional manner.