Liar's Poker

Kevin Lewis

January 14, 2010

Danger on the Exchange: How Counterparty Risk Was Managed on the Paris Bourse in the Nineteenth Century

Angelo Riva & Eugene White
NBER Working Paper, January 2010

Over the course of the nineteenth century, the struggles of Paris Bourse to manage counterparty risk revealed the awkward choices that face derivatives exchanges. Shortly after it was founded, the stock exchange, primarily a forward market, instituted a mutual guarantee fund to prevent broker failures from snowballing into a general liquidity crisis. The creation of the fund then forced the Bourse to search for mechanisms to control moral hazard. To study the determinants of broker failures, we collected new individual data on defaulting brokers and describe the evolving regulatory regime. To identify the factors behind the annual number of broker failures we use negative binominal regressions. To explain individual brokers' duration in office, we employ a proportional hazard model, while logit regressions examine the causes of individual broker failures. In addition to declines in asset prices and trading volume, the moral hazard from the mutual guarantee fund contributed to brokers' defaulting on their obligations. The Bourse faced a conundrum; when it finally imposed a tight regulatory regime that limited risk, trading began to migrate off the exchange to less regulated markets.


The Value of the Floor

Daniel Weaver & Xing Zhou
Rutgers Working Paper, May 2009

Existing theoretical literature suggests that floor trading has discernable benefits over electronic trading. In particular floor relationships lead to a reduction in asymmetric information and hence lower spreads. The ability of floor brokers to participate in incoming order flow without revealing their supply and demand curves increases total liquidity and dampens liquidity shocks leading to lower volatility. We develop hypotheses and test them on a sample of stocks that switch from floor trading to an electronic system with fairly identical rules and pre-trade transparency. We find strong support for existing theory and our hypotheses. In particular asymmetric information and volatility are significantly higher on the electronic system. This leads to an increase in investor transaction costs which dwarfs the operational cost advantages of the electronic systems. Our results are robust to test involving samples that control for company specific factors and market wide trends.


Metaphors used by venture capitalists: Darwinism, architecture and myth

Mark Cannice & Arthur Bell
Venture Capital, January 2010, Pages 1-20

In this paper we develop a catalog of metaphor families that Silicon Valley venture capitalists use in their public communications. In establishing this preliminary catalog we aim to provide additional insight into the venture capitalist perspective and also lay the foundation for the development of a grounded cultural model of Silicon Valley venture capitalists. To develop this catalog we surveyed on average 30 venture capitalists each quarter from Q1 2004 to Q1 2009. We analyzed these 21 qualitative datasets, coding and categorizing more than 10,000 words of direct venture capitalists' communications. We found that VC communications fall into 14 dominant metaphor families (e.g. Darwinism, physics, religion, etc.). We contribute to the literature on venture capital by establishing a catalog of predominant VC metaphor families as an initial step toward a grounded cultural model of venture capital. This catalog may also provide further context for related studies on VC decision-making and an additional tool for stakeholders of the venture capital industry in better interpreting VC communications.


Mad Money stock recommendations: Market reaction and performance

Terrill Keasler & Chris McNeil
Journal of Economics and Finance, January 2010, Pages 1-22

We examine the stock recommendations of Jim Cramer televised on CNBC's Mad Money, and document significant market reactions (i.e., announcement returns and volume) to Cramer's recommendations, particularly for small capitalization stocks. The following findings indicate that the announcement returns are primarily due to price pressure from uninformed trading as opposed to the recommendations providing new value related information: announcement returns reverse following buy recommendations; bid-ask spreads temporarily decline; and there is no evidence of positive longer-term abnormal returns. One implication, when considered in combination with other works, is that investors should be cautious in following stock recommendations announced in the mass-media.


Security Analyst Networks, Performance and Career Outcomes

Joanne Horton & George Serafeim
Harvard Working Paper, December 2009

Using a sample of 42,376 board directors and 10,508 security analysts we construct a social network, mapping the connections between analysts and directors, between directors, and between analysts. We use social capital theory and techniques developed in social network analysis to measure the analyst's level of connectedness and investigate whether these connections provide any information advantage to the analyst. We find that better-connected (better-networked) analysts make more accurate, timely, and bold forecasts. Moreover, analysts with better network positions are less likely to lose their job, suggesting that these analysts are more valuable to their brokerage houses. We do not find evidence that analyst innate forecasting ability predicts an analyst's future network position. In contrast, past forecast optimism has a positive association with building a better network of connections.


The Economics of Open Air Markets

John List
NBER Working Paper, October 2009

Despite their current prevalence and historical significance, little is known about the economics of open air markets. This paper uses open air markets as a natural laboratory to provide initial insights into the underlying operation of such markets. Using data on thousands of individual transactions gathered from May 2005- August 2008, I report several insights. First, the natural pricing and allocation mechanism in open air markets is capable of approaching full efficiency, even in quite austere conditions. Yet, a second result highlights the fragility of this finding: allowance of explicit seller communication frustrates market efficiency in a broad array of situations. Making use of insights gained from a "mole" in the marketplace, a third set of results revolves around economic questions pertaining to collusive arrangements that are otherwise quite difficult to investigate. Overall, I find data patterns that are consistent with certain theoretical predictions, as the evidence suggests that i) cheating rates increase as the coalition is expanded, ii) sellers cheat less when they have collusive arrangements in several spatially differentiated markets, and iii) sellers cheat more when they are experiencing periods of abnormally high profits. These results follow from a combination of insights gained from building a bridge between the lab and the naturally-occurring environment. By doing so, the study showcases that in developing a deeper understanding of economic science, it is desirable to take advantage of the myriad settings in which economic phenomena present themselves.


Regulate OTC Derivatives by Deregulating Them

Lynn Stout
Regulation, Fall 2009, Pages 30-41

As a result of the current financial crisis, there have been many calls for strict new regulation of over-the-counter financial derivatives. This paper proposes, instead, that we return to the now-voided common law on derivatives and consider them non-legally enforceable gambling contracts except when one of the parties can prove a bona fide hedging purpose. Doing this would not outlaw derivatives, but would instead require the rise of private institutions to enforce and control them, and would discourage their use for wild speculation.


Computational Complexity and Information Asymmetry in Financial Products

Sanjeev Arora, Boaz Barak, Markus Brunnermeier & Rong Ge
Princeton Working Paper, October 2009

Traditional economics argues that financial derivatives, like CDOs and CDSs, ameliorate the negative costs imposed by asymmetric information. This is because securitization via derivatives allows the informed party to find buyers for less information-sensitive part of the cash flow stream of an asset (e.g., a mortgage) and retain the remainder. In this paper we show that this viewpoint may need to be revised once computational complexity is brought into the picture. Using methods from theoretical computer science this paper shows that derivatives can actually amplify the costs of asymmetric information instead of reducing them. Note that computational complexity is only a small departure from full rationality since even highly sophisticated investors are boundedly rational due to a lack of requisite computational resources.


The performance of emerging hedge funds and managers

Rajesh Aggarwal & Philippe Jorion
Journal of Financial Economics, forthcoming

This paper provides the first systematic analysis of performance patterns for emerging funds and managers in the hedge fund industry. Emerging funds and managers have particularly strong financialnext term incentives to create investment performance and, because of their size, may be more nimble than established ones. Performance measurement, however, needs to control for the usual biases afflicting hedge fund databases. After adjusting for such biases and using a novel event time approach, we find strong evidence of outperformance during the first two to three years of existence. Each additional year of age decreases performance by 42 basis points, on average. Cross-sectionally, early performance by individual funds is quite persistent, with early strong performance lasting for up to five years.


Labor Regulations and European Private Equity

Ant Bozkaya & William Kerr
NBER Working Paper, December 2009

European nations substitute between employment protection regulations and labor market expenditures (e.g., unemployment insurance benefits) for providing worker insurance. Employment regulations more directly tax firms making frequent labor adjustments than other labor insurance mechanisms. Venture capital and private equity investors are especially sensitive to these labor adjustment costs. Nations favoring labor expenditures as the mechanism for providing worker insurance developed stronger private equity markets in high volatility sectors over 1990-2004. These patterns are further evident in US investments into Europe. In this context, policy mechanisms are more important than the overall insurance level provided.

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