FF on duration, term structure and immunization

Great post on the Fama French blog about long term bonds.

Call options and insider trading

My students know that options provide leverage. You don't have to exercise the option to profit, you just need to hold a call option while the stock price goes up. Your gain will be from the increase in the value of the option. My students also should know that insider trading is the practice of making trades based on private information.

So knowing all this, if you knew that HP was about to launch a takeover of 3COM, what would you do? Answer: buy calls on 3COM of course.* Turns out that's what a lot of people did.



*assuming you were willing to risk breaking the law.

Fama and French on portfolio optimization and the equity premium.

Fama and French talk about how to figure out the equity premium to use in a portfolio optimization problem. Excellent stuff and required reading for any finance MBA students!

Moral hazard and health care

Moral hazard is the term generally given to a situation where an individual does something that they normally would not do if they bore all the risk. There are many cases of moral hazard: For example, banks that lever up and take excessive risks but have implicit government guarantees are engaging in moral hazard.

The new health care plan that is making its way through the house prevents insurers from denying coverage based on a pre-existing condition. This is a great idea, but with it comes a moral hazard problem. Healthy people have the incentive to not get insurance until they get sick. Then they are guaranteed that they will be accepted into a plan. This doesn't just include the currently uninsured either. I have health insurance, but maybe I should drop my coverage and wait until I get really sick before reinstating it? I could save a huge amount. The economist, Martin Feldstein talks about the problem here.

The writers of the bill thought of this problem. Well sort of. They decided to impose a tax penalty on anyone who didn't get insurance. Brilliant! Except that the penalty is significantly less than the actual cost of insurance, so the problem does not go away.

I don't really want to get political here, but it seems to me that the problem with politicians is that they didn't take enough (or any) economics in school. In fact, if they had just read the book "Freakonomics" they would have seen an example of a very similar situation. I don't recall the exact details, but the basic story recounted in the book was that a day care center had a problem with parents being late to pick up their kids. To try to discourage this behavior, the day care center imposed a fine for each 30 minutes that the parents were late. The problem was that the fine was too low - well below the actual cost of child care. So instead of discouraging the behavior, more parents chose to be late and just pay the fine.

The solution to the health care moral hazard is simple. Make the penalty as much as the cost of insurance and force the non-insurers into a plan.

HT: Greg Mankiw's blog

More on bank capital ratios

In my MBA class last night we watched "The Trillion Dollar Bet" about Long Term Capital Mgmt. I believe that a large part of LTCM's problem was not the bets they were taking but the leverage that they were using. The recent financial meltdown has, again been in large part due to excessive leverage.

Which brings us to the question of banks being too big to fail. Here's another blog arguing that we need capital ratios that increase with size. Very large banks that become too big to fail should hold very large amounts of capital.

For more discussion, see my recent post about about how implicit and explicit government guarantees encourage excessive leverage.

Bank capital structure

The Economist has a nice article applying Modigliani and Miller's capital structure theory to the capital structure of banks. M&M said that in the absence of taxes and bankruptcy costs capital structure should not matter.

But banks are different - because large banks are too big to fail, the presence of bankruptcy costs don't matter. Furthermore, as banks benefit from very low debt costs (due to deposit insurance), their optimal capital structure is frequently very high.

In reality, large banks are more risky because of the risk they transfer to outsiders (tax payers) and therefore they should hold more capital than equivalent banks of a smaller size. But of course the banks don't want to hold more equity capital as equity is expensive relative to deposits.

The article is well worth a read.

Another bubble coming?

Newsweek has a great article looking at whether we are in an "echo bubble". The takeaway: we are still in for a rough ride.

Is market efficiency the culprit?

Eugene Fama argues that market efficiency was not the reason for the financial crisis in this excellent posting on his blog.

Home buyer's credits

Jack Hough of Smartmoney doesn't like the proposed extension of the home buyers credit. Neither do I. I am not sure that I fully agree with all his points, but the first two are on target. A home buyer credit will have the effect of raising prices. I doubt very much that it will have significant stimulus effect.

May I suggest a better use for the money. If you want to stimulate the economy and increase employment, use the credit instead to reduce payroll taxes. You'll distribute the stimulus money evenly across the economy instead of just to a) new home buyers or b) people who want to trade their clunker for a prius.

Its always harder to dig out of the hole

As the Wall Street Journal discusses today, you need larger returns to get back to where you were before your portfolio suffered a loss.

The math is simple. Start with $100. Loose 50%. You've now got $50. To get back to $100 you need a 100% return.

Of course, you can get back quicker if you save more.