Volume 11, No. 2, Second Quarter 2013

Practitioner’s Digest • Vol. 11, No. 2

The “Practitioners Digest” emphasizes the practical significance of manuscripts featured in the “Insights” and “Articles” sections of the journal. Readers who are interested in extracting the practical value of an article, or who are simply looking for a summary, may look to this section.

Price Inflation and Wealth Transfer During the 2008 SEC Short-Sale Ban

by: Lawrence E. Harris, Ethan Namvar and Blake Phillips

We estimate that the ban on short-selling financial stocks imposed by the SEC in September 2008 led to price inflation of 10-12% in the banned stocks based on a factor-analytic model that extracts common valuation information from the prices of stocks that were not banned. This inflation reversed approximately two weeks after the ban for stocks with negative pre-ban performance. In contrast, similar magnitude price inflation was sustained following the ban for stocks with positive pre-ban performance, suggesting the ban was successful in stabilizing prices for these stocks. Cross-sectional analysis reveals that inflation was isolated to stocks without traded options, suggesting option markets provided a mechanism for traders to circumnavigate the ban. Further, we find that the level and change in short interest associated with the ban is unrelated to the level of inflation. These results suggest that price pressure associated with closing short positions at the start of the ban is unrelated to the noted price inflation. If prices were inflated, buyers paid more than they otherwise would have for the banned stocks during the period of the ban. We provide a conservative estimate of $2.3 to $4.9 billion for the resulting wealth transfer from buyers to sellers, depending on how post-ban reversal evidence is interpreted. Such transfers should interest policymakers concerned with maintaining fair markets.

When Sell-Side Analysts Meet High-Volatility Stocks: An Alternative Explanation for the Low-Volatility Puzzle

by: Jason C. Hsu, Hideaki Kudoh and Toru Yamada

Using a global equity dataset that includes emerging markets, we confirm that high-volatility stocks tend to deliver low average returns; this effect is robust to adjustments for country and style factors. We also show that sell-side analysts earnings growth forecasts for high-volatility stocks are more biased. It is well-known that sell-side analysts are predictably optimistic; however, the relationship between the degree of optimism and a stocks volatility has not been documented before. We hypothesize that analysts inflate earnings forecasts more aggressively for volatile stocks, in part because the inflation would be more difficult for investors to detect. Because investors are known to overreact to analyst forecasts (under-adjust to analyst bias), this contributes to systematic overvaluation and low returns for high-volatility stocks. Additionally, we find sell-side analysts research informative despite the biases; stocks that have high forward E/P ratios based on analyst earnings forecasts tend to outperform and produce significantly positive Fama-French alphas. This evidence rejects the cynical view of some in our industry that sell-side analysts are unskilled. More interestingly, we find high forward E/P stocks also exhibit high analyst bias, which supports an interpretation that analysts are more willing to inflate earnings forecasts for stocks that they believe are likely to deliver high returns or for which their inflated forecasts are likely to do no harm.

Approaches to Improving Bank Share Value Using Credit-Portfolio Management and Credit-Transfer Pricing

by: Jeffrey R. Bohn and Roger M. Stein

Prudent credit risk management within a bank requires that a number of agents within the firm communicate, agree and act in a concerted fashion to manage credit risk both at the individual exposure level and at the broader portfolio level. This can be challenging given the nature of credit portfolios. Even if highly diversified, credit portfolios display heavily skewed loss distributions that imply relatively long quiescent periods (during which losses are lower than their mathematical expectations and the benefits of risk management less visible) and occasional periods of much higher losses. This phenomenon makes it difficult to maintain focus on the impact of individual trades or loans on the longer-term risk of portfolio losses, particularly in large organizations. In this non-technical paper, which draws on and extends portions of Bohn and Stein (2009), we reflect on some of these challenges and discuss mechanisms, such as credit-transfer pricing, by which banks can better align the behaviors of underwriters, risk managers and senior managers within large institutions while also increasing the communications between these groups. This approach grew out of industry practice and is currently in use to varying degrees by a number of large banks worldwide. While many challenges still persist in its implementation, innovations in both extending credit and modeling credit continue to evolve to address them, making implementation more practically feasible.

Mutual Fund’s Net Economic Alpha: Definition and Evidence

by: Sharon Garyn-Tal and Beni Lauterbach

It is sometimes argued that existing methodologies for assessing mutual fund's performance are unfair, as fund's return is taken net of expenses and benchmark return is gross of expenses. Examining over 1000 U.S. non-specialized mutual funds in 2001-2009, we find that the abovementioned problem is minute - the net economic alpha, an alpha that accounts for the actual costs of investing in benchmarks via ETFs, yields similar fund's ranking and classification as the traditional methods. Also interesting, the average net economic alpha is only slightly negative, suggesting that the mutual funds industry is not inferior.

VarGamma Stress Tests

by: Kent Osband

Standard financial stress tests are ad hoc. They offer no guidance on how to select the target stress levels, how to adjust for randomness within crisis, or how to integrate the results with other risk measures. The VarGamma metric introduced by Osband (2013) offers an appealing alternative. It estimates a risk premium for crisis stress that can be added directly to the premium for ordinary risk. The use of cumulant generating functions for convolutions of variance-gamma distributions makes this analytically tractable. However, the general formula depends on unfamiliar parameters for the variance of extra crisis variance and the impact of variance on returns. This paper reformulates VarGamma crisis estimates using two more familiar parameters: the probability of crisis and the mean extra loss in crisis. The modeling assumptions are consistent with fat-tailed historical returns and near-ubiquitous option smiles. This opens new vistas for estimating fair market-implied risk premia at various levels of risk aversion.

The Dividend Decision

by: Jack L. Treynor

“Case Studies” presents a case pertinent to contemporary issues and events in investment management. Insightful and provocative questions are posed at the end of each case to challenge the reader. Each case is an invitation to the critical thinking and pragmatic problem solving that are so fundamental to the practice of investment management.

The Most Important Thing - Uncommon Sense for the Thoughtful Investor

by: Howard Marks • reviewed by: Javier Estrada

“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.