Tuesday, May 28, 2013

The Capital Asset Pricing Model – “Understand markets on their own terms and not on our own”?

"Grau, theurer Freund, ist alle Theorie."
(Johann Wolfgang von Goethe, Faust)

The Abacus Journal has recently published a series of articles about the use of the Capital Asset Pricing Model (CAPM). Before summarizing the academic discussion, let's first understand what the CAPM is about:

With the CAPM you can calculate the price of a financial assets. If you buy a stock, you should get the rate that everyone gets who invests in stock markets (This is the risk-free rate.) plus a surplus which is a function of the risk involved with the specific company you invest in (This is the equity risk premium.).

This leads us right away to the CAPM formula:

k = rf + Beta * (km – rf)


k = the required rate of return on the financial asset = cost of equity
rf = the risk-free rate
Beta = the beta of the specific stock in question
km = the required rate of return for the market = the expected return of the market portfolio
Beta * (km – rf) = the equity risk premium

The CAPM is built on two main assumptions:

  • Investors act rationally.
  • Investors dispose of all important information about the financial assets in question.

The Abacus supplement discusses an article from Mike Dempsey who says:

In adhering to the CAPM we are choosing to encounter the market on our own terms of rationality, rather than the market’s.”

Dempsey's basic criticism is that the CAPM is built on rationality of markets although empirical evidence contradicts this assumption. In his view, markets can self-correct irrational reactions only in the long run. Dempsey is not convinced of post CAPM models, which simply add additional factors to the CAPM equation:

The identification of the correlation of a variable with asset returns is then presented as either an ‘anomaly’ or as the demonstration that the variable is ‘priced’ by the markets. This is what Black meant by saying that the exercise amounts to data mining.”

The reactions of the other authors to Dempsey's statements are mitigated:

  • D. J. Johnstone focuses on the debate whether an investment should be appreciated on the basis of mean-variance (MV) of its returns or on its subjective expected utility (SEU) for investors. The author criticizes that this debate is no more present in today's finance which is built on mean-variance.
  • Karen Benson and Robert Faff criticize Dempsey and call his work “greatly overstated” and “unduly ‘nihilistic’”. They argue that asset pricing is a long-term task and, therefore, the CAPM still useful. To counter contradictory empirical evidence, the authors argue that the CAPM cannot be tested at all. The reason is that one fundamental parameter of the CAPM is the market portfolio, which is, however, unobservable in practice. Any index which replaces the true market portfolio is, therefore, doomed to distort the results of the CAPM. The authors accept these shortcomings of the CAPM but argue that it is still preferable over no pricing model at all.
  • Henk Berkman says that the lack of empirical support for the CAPM does not make the model void. Rather, it “should be viewed as a necessary step in the normal scientific process resulting in a better understanding of asset pricing”.
  • Philip Brown and Terry Walter respond to the lack of empirical proof of the CAPM by stating that the CAPM is an ex ante concept and, thus, cannot be tested ex post. In addition, as the true market portfolio is not and may never be known, any empirical test of the model is, in the authors' view, necessarily flawed.
  • Charlier X. Cai, Iain Clacher, and Kevin Keasey agree with Mike Dempsey and call for understanding markets better: “We need to understand how markets actually behave rather than assuming they behave in a given way.” Their article includes pretty strong language such as “Through its assumptions of rationality and efficiency, academic finance has legitimated an emphasis on financial markets, unfettered profit and the ability of markets to self-regulate, and this has filtered through into government policy”.
  • Imad A. Moosa fully agrees with Mike Dempsey and says that “the model is theoretically bankrupt, empirically unsupported, and practically useless at best and misleading at worst”. “Excessive mathematization of economics and finance has resulted in work that has no relevance to reality.”
  • Graham Partington takes a pragmatic view. He emphasizes that the critics must consider what the CAPM is used for. Graham argues that discount rates are not critical to budgeting decisions. As a consequence, the job of the CAPM is of much less importance than usually thought which compensates for its insufficiencies. In addition, he points out that there is simply no alternative to the CAPM today.
  • Tom Smith and Kathleen Walsh say that “the CAPM is half-right and everything else is wrong”. As a matter of fact, since it is still very difficult to make abnormal returns from publicly available information, financial markets should still be considered efficient. Besides, the authors argue that the CAPM is actually not based on the market efficiency hypothesis. Instead, the model has its roots in the concepts of time value of money (A USD today is worth more than a USD tomorrow.), diversification (Diversification reduces risk.), and arbitrage (Same cash flow – same price).
  • As does Graham Partington, Avanidhar Subrahmanyam takes a pragmatic viewpoint. “He asks “What is the cost to practitioners to using the wrong model?” and “What is the alternative model?”

In short, the authors seem more or less to agree that the CAPM has serious shortcomings. But as we have nothing else, it will probably be still around for quite a while. As said Johann Wolfgang von Goethe in his Faust: “Es irrt der Mensch solange er strebt.”

You can download the Abacus supplement on the CAPM here.

Friday, May 24, 2013

US Department of Justice vs. S&P – Scheme to defraud or healthy work-place discussions?

Almost 6 years after the outbreak of the financial sub-prime crisis in the US, we are still searching for the culprit. The banks? The rating agencies? The investors? The Borrowers? The US Government? All of them?

Currently, the focus is again on rating agencies. In a recent complaint introduced against S&P, the US Department of Justice accuses S&P:

S&P, knowingly and with the intend to defraud, devised, participated in, and executed a scheme to defraud investors […].”

Naturally, the rating agency denies:

With much fanfare, a parade of senior officials congratulated one another for their efforts – the hundreds of subpoenas they had served, the thousands of hours their team had devoted to the case, the millions of documents they had read. Notwithstanding all the back-slapping, the Government’s Complaint fails to state a claim.”

Let's take a closer look at the arguments of the parties:

Claimant's Brief

Claimant's memorandum starts off describing what and how S&P has rated in the run-up to the sub-prime crisis:

Which laws has S&P violated, according to claimant?

First,there is United States Code (USC) 18 § 1341. If you want to crucify yourself, keep on reading the whole paragraph. If not, just have a look at the passages in red which capture the essentials:

Whoever, having devised or intending to devise any scheme or artifice to defraud, or for obtaining money or property by means of false or fraudulent pretenses, representations, or promises, or to sell, dispose of, loan, exchange, alter, give away, distribute, supply, or furnish or procure for unlawful use any counterfeit or spurious coin, obligation, security, or other article, or anything represented to be or intimated or held out to be such counterfeit or spurious article, for the purpose of executing such scheme or artifice or attempting so to do, places in any post office or authorized depository for mail matter, any matter or thing whatever to be sent or delivered by the Postal Service, or deposits or causes to be deposited any matter or thing whatever to be sent or delivered by any private or commercial interstate carrier, or takes or receives therefrom, any such matter or thing, or knowingly causes to be delivered by mail or such carrier according to the direction thereon, or at the place at which it is directed to be delivered by the person to whom it is addressed, any such matter or thing, shall be fined under this title or imprisoned not more than 20 years, or both.

Additionally, the US Department of Justice invokes USC 18 § 1343. This stipulation captures the same idea as above, but applies it to wire transfers instead of postal services.

Finally, the applicant accuses S&P of bank fraud under USC 18 § 1344. The clause reads as follows:

Whoever knowingly executes, or attempts to execute, a scheme or artifice to defraud a financial institution or to obtain any of the moneys […] owned by […] a financial institution […] shall be fined.”

How has S&P violated the USC? Claimant's argument goes like this:

  • S&P has promised to issue objective and up-to-date ratings, free from conflicts of interest.
  • S&P knew that its ratings were a major reason for investors to invest.
  • From September 2004 to October 2007, S&P saw the RMBS and CDO market gradually go down but did not adjust its ratings criteria and analytical models accordingly, in order to keep and grow its market-share.

S&P's status as a nationally recognized statistical rating organization (NRSRO) is of special importance for the the first two bullet points. As a matter of fact, this status required S&P to have internal policies and procedures to address and manage conflicts of interest on the one hand, and, on the other hand, allowed publicly regulated funds to invest in securities rated by S&P.

The third point of the argument is obviously the most interesting and, therefore, longest part of the complaint. The US Department tries to proof S&P's bad faith mainly by describing how S&P dealt internally with conflicts of interest and the declining sub-prime mortgage market:

  • Ratings of the underlying assets were simply taken at face value, logically leading to inflated ratings (and higher earnings for S&P), when the market went down.
  • In July 2004, S&P staff was asked to discuss a change of the ratings' criteria with clients before introducing it formally. In addition, “concerns with the objectivity, integrity, or validity of the criteria should [normally] only be communicated in person rather than by email.”
  • Loan data, underlying S&P's rating criteria, were not updated although S&P possessed better and more relevant data sets. (LEVELS 5.6 vs. LEVELS 6.0)
  • Striking conversations between rating analysts are also not missing in the complaint:
    Remember the dream of being able to defend the model with sound empirical research? […] If we are just going to make it up in order to rate deals, then quants are of precious little value.”
    Btw that deal is ridiculous … I know right … model def[initely] does not capture half of the … risk. … We should not be rating it … We rate every deal … it could be structured by cows and we would rate it … but there’s a lot of risk associated with it ... I personally don’t feel comfy signing off as a committee member.”

S&P's Response

S&P's response is very short, compared to claimant's brief.


On a purely legal side, S&P says that the above facts, even taken for granted, are not actionable as fraud. As a matter of fact, they reveal subjective statements (how employees should behave) rather than objective facts which are the only facts actionable under the cited USC stipulations.

In addition, it says that claimant's statements are too general and vague to constitute the basis for a fraud claim: “Courts have held that internal squabbles about appropriate rating methodology are insufficient to establish that a particular rating is “false” or “not believed” by the rating agency.”

Finally, S&P denies having acted with a specific intent to defraud. The firm differentiates between investors (who rely on S&P's ratings) and issuers (who pay for S&P's ratings) and says that the complaint mixes both by stating that S&P directed its fraud against investors who, nevertheless, were not the people paying for the ratings.


As regards the facts, S&P simply ensures that “any disagreements within S&P are evidence of the robust debate that does and should take place in any large and diverse work place – not evidence the entity was engaged in a scheme to defraud. […] Even taken as true for the purpose of this motion, they reveal a robust internal debate among S&P employees about the likely future performance of complex financial instruments at the beginning of what turned into a global economic tsunami.”


The complaint is interesting to read, namely the rating process is very well described. However, on the merits, I didn't find it convincing. Let's wait for the outcome of this trial.


Sunday, May 12, 2013

“Why nations fail” – A great book about the origins of economic prosperity

Daron Acemoglu and James A. Robinson have asked themselves the question “Why are some nations rich and some others poor?” Their short answer is “Inclusive political and economic institutions”.

The book is written very vividly and its clear language makes it accessible to both experts and nonprofessionals. Even though it is not exactly structured this way, the authors discuss three topics: Economic theories that cannot explain economic prosperity (1), theory proposed by the authors (2), and undermining historical references and contemporary examples (3).

(1) The geographic, cultural, and ignorance hypotheses cannot explain economic prosperity.

The geographic hypotheses says that poor countries are poor and rich countries are rich because of geographical differences. This belief doesn't withstand historical and current examples such as:
  • Most African countries are poor, Botswana is rich.
  • Singapore and Malaysia are significantly richer than their neighbors.
  • Regions at the border between Mexico and the United States (The authors offer the example of the divided city of Nogales.) share the same geographic patterns but their wealth bears no resemblance.
In addition, the geographical hypotheses cannot explain why the wealth of specific countries (Examples include China and Japan.) changes over time.

According to the cultural hypothesis, religion, beliefs, values, and ethics are linked to prosperity. “Some populations simply lack a good work ethic.”
The authors raise two main arguments against this hypothesis:
First, cultural patterns are oftentimes identical in frontier regions, although the economic performance of the states involved can differ substantially. Mexico and the USA as well as North and South Korea serve as examples here.
Second, by definition, cultural patterns change only slowly. As a consequence, they cannot explain rapid growth such as the development China experiences today.

Followers of the ignorance hypothesis say that poverty exists because some rulers simply don't know how to make their country rich.
Acemoglu and Robinson argue that ignorance can, at best, explain a small part of world inequality: “It’s not ignorance but oftentimes political strategy to sustain an undemocratic regime that is at the origin of wrong economic policies.”
In addition, the ignorance hypothesis can only explain poverty, not prosperity.

(2) Inclusive political and economic institutions make nations wealthy.

Acemoglu and Robinson argue that, to prosper in the long run, countries need inclusive economic and political institutions.

Inclusive economic institutions create a level playing field for and encourage every citizen to participate in economic activities. They are characterized by
  • secure private property rights,
  • an efficient legal system,
  • the availability of basic public services and infrastructure,
  • efficient markets and freedom of trade,
  • encouraging investment,
  • technological evolution,
  • and a high level of eduction.
    What matters most is that these institutions are available for everybody, not just for the elite of a country.

Most important for inclusive political institutions is a pluralistic society: Political power should be distributed widely and checks and balances among institutions should prevail. On the other hand, to dispose of political power at all, a state must be sufficiently centralized.

As opposed to inclusive institutions, extractive institutions are designed to extract income and wealth from a subset of society to benefit a different subset.

History shows that extractive institutions cannot create incentives for people to make their countries thrive in the long run. Also, they rarely exploit the talent pool of a society efficiently. Temporary economic growth is, however, possible under extractive institutions if they direct resources in the right direction, e.g. towards high-productivity activities. Ultimately, growth under extractive institutions is, nevertheless, doomed to slow down. The reason is that people under extractive institutions will not save, invest, or innovate, simply because they have no incentive to do so.

Why do not all countries in the world adopt inclusive institutions then? The reason is linked to the lack of innovation that arranges the elite of a country. Obviously, innovation leads to creative destruction. In other words, it replaces the old by the new and, thereby, creates winners and loosers and redistributes wealth. If you have power and money today, this is exactly what you want to avoid.

Over time, institutions can shift from inclusive to extractive and vice versa. Major historical events (“critical junctures”) play a major role here. In addition, political and economic institutions interact. For example, inclusive political institutions make the emergence and subsistence of inclusive economic institutions very likely (“virtuous circle”).

(3) Historical references and contemporary examples

To justify their above theory, the authors describe many relevant historical examples:

  • The consequences of a lack of political centralization are explained by a description of today's situation in countries such as Afghanistan, Columbia, Congo, Haiti, Nepal, Somalia, and Zimbabwe.
  • China today and the Soviet Union from 1928 until 1970 serve as examples to illustrate economic growth under extractive political institutions.
  • The break-down of the Roman empire and the economic decline of Venice in the 14th century illustrate how a shift from inclusive to extractive political institutions results in extractive economic institutions.
  • Two powerful stories describe the fear of creative destruction:
    The Roman emperor Tiberius killed the man who just showed him his invention of unbreakable glass instead of rewarding him because he feared the economic and social effects this invention might have.
    In 1589, William Lee presented his knitting machine to English Queen Elisabeth I and asked for a patent. Instead of obtaining it, the Queen responded “Thou aimest high, Master Lee. Consider thou what the invention could do to my poor subjects. It would assuredly bring to them ruin by depriving them of employment, thus making them beggars.”
  • Major critical junctures described in the book are the black death (and the related loss of the world's workforce) in the 14th century, the discovery and colonization of the Americas in the 14th century, the invention of the printing press by Johannes Gutenberg in Mainz in 1445, the French revolution in 1789, and the industrial revolution in England the 19th century.

The above list of examples is a personal choice; the book offers many other historical references.

What can I criticize? I found the book sometimes a bit repetitive. But that is definitely a minor aspect. Daron Acemoglu's and James A. Robinson's “Why nations fail” is, beyond any doubt, worth reading.

You can find a speech of one of the authors about the book here.

Thursday, May 2, 2013

EU AIFM Directive – Rationale, scope, and consequences of application

AIFM is a shortcut for “alternative investment funds manager”. The EU regulation, which shall be adopted by national European governments this summer, therefore addresses fund managers, not funds themselves. For example, structure and portfolio composition of AIF will remain regulated on a national level. This is, at least, what the directive explicitly promises. However, as you can imagine, the limits are blurry. For example, when the directive sets maximum levels of leverage for alternative investment funds (AIF) managed by AIFM, it also regulates indirectly AIF.

Following my recent post about UCITS, I will look, from an AIFM directive perspective, at three questions – Why does the EU regulate? (Rationale), When does the directive apply? (Scope of application), and What do you have to respect? (Consequences of application).


The AIFM directive pursues a triple rationale:

  • establish common requirements for AIFM and create an internal market for AIFM;
  • ban risks for financial markets in the EU;
  • ensure investor protection.

Scope of application

The AIFM directive will apply if AIFM manage AIF.

First, what is an alternative investment funds (AIF)?
Basically, the notion of AIF wants to cover any fund that is not covered by the EU UCITS directive. More specifically, your fund must answer two cumulative conditions: collective investment undertaking (A vehicle with a unique investor is not covered.) and defined investment policy. In other words, the AIFM directive will apply to you if you raise capital from a number of people to invest it for their benefit, applying a defined investment policy.
Pension funds, social security funds, employee participation or savings schemes, and securitization special purpose vehicles are, nevertheless, explicitly excluded from the directive's scope of application.
Some criteria explicitly don’t matter: The directive applies to both open-ended and closed-ended funds, to any legal form, and to listed and not listed funds.

Second, what is an alternative investment fund manager (AIFM)?
The notion refers to any entity managing AIF on a regular basis and which is not a supranational institution, national central bank, or national government. In addition, the fund manager must have some relationship with the EU: It can be an EU-AIFM, manage EU-AIF, or market AIF in the EU.

Consequences of application

Authorization of AIFM

To be authorized under the directive, an AIFM must have sufficient initial and subsequent capital from suitable shareholders, hire experienced employees to conducts its business, and either have its head office or be registered in an EU member state.

Once authorized in an EU member state, an AIFM can do business in any EU member state. This is called the harmonized passport system for EU and non-EU AIFM.

Operating Conditions for AIFM

Operating conditions for AIFM is a core regulation of the directive. They include general requirements, organizational requirements, delegation of AIFM functions, and depositary requirements.

General requirements can be seen as guidelines when interpreting other provisions of the directive.
For example, AIFM must
  • act honestly and with due skill, care, and diligence;
  • act in the best interest of investors and market integrity;
  • avoid or, if not avoidable, manage conflicts of interest;
  • treat all AIF investors fairly.
Risk management and operating activities must be carried out in different functions and hierarchies. In the same vein, AIFM are bound to set maximum levels of leverage for each AIF.
Finally, appropriate liquidity management systems must be in place and regular stress tests be conducted.

Organizational requirements refer to appropriate human an technical resources and proper and independent annual valuation of assets. The valuation function must be independent from portfolio management. Under specific conditions, it can be outsourced.

AIFM functions can be delegated and sub-delegated. However, this should not lead to “a de facto circumvention of the AIFM directive” or “turn the AIFM into a letter-box entity”. Even though an AIFM delegates some of its functions, it remains ultimately liable for the management of AIF.

Asset safe-keeping and asset management functions must be separated. This is where the depositary comes into play: He holds financial assets in custody, manages cash flows, ensures any sale, issue, re-purchase, redemption, and cancellation of AIF units or shares, ensures proper valuation of AIF units or shares, and applies AIF income. Depositary functions are usually exercised by a credit institution or investment firm. Exceptionally, other professionals such as notaries and lawyers might also be chosen. The depositary must belong to the EU member state of the AIF or, in case of a non-EU AIF, to the country of the AIFM. He can delegate his functions to a suitable third party if he remains ultimately liable.

Transparency Requirements

Transparency requirements ask AIFM to
  • disclose information on the leverage employed by an AIF if it is substantial;
  • pass special information to employees of companies controlled by an AIF;
  • prepare annual reports for each AIF;
  • communicate with potential investors on elements such as AIF investment strategy, liquidity risk management, fee structure, and depositary function;
  • report to administrative authorities.

Marketing of funds

Reading this section of the AIFM directive is definitely not funny. To guide you through the detailed stipulations, the following schema might help you:

A common trait of these marketing possibilities is the distinction between professional and retail investor. As a general rule, the directive allows distributing AIF units to professional investors only. However, individual EU member states can still admit marketing all or certain types of AIF to retail investors within their territory, provided the conditions for such distribution are stricter than those fixed by the AIFM directive for professional investors.