Fall 2004 Finance 4366 Weblog

The Blogosphere Just Got A Whole Lot Smarter

According to Inter Alia, the blogosphere just got a whole lot smarter, since "Nobel-prize-winning economist Becker and federal circuit judge Posner have made their introductory post and will be blogging over here."

Why is this such an important development?  As Tyler Cowen notes, "If Posner were a law school, his citation index would put him in or close to the top ten.  And Becker just gave up his Business Week column a few months ago.  He is also the most widely cited living economist, not to mention that Nobel Prize."

Richard Posner is one everyone's short list to get appointed as a Supreme Court justice.  That may be wishful thinking.  As we learned from the (non)confirmation hearings for Robert Bork back in 1987, the problem with being a prolific scholar is that by leaving such an enormous paper trail, it provides all the more ammunition that political opponents can fire at the prospective nominee.  Perhaps the most distinguishing characteristic of post-Bork nominees who have been confirmed to the bench (including Anthony Kennedy (1988), Clarence Thomas (1991), Ruth Bader Ginsburg (1993), and Stephen Breyer (1994)) is their comparatively thin vitas.

George Will's perspective on political bias in academia

Six days after I blogged about political bias in our nation's colleges and universities, George Will published an interesting essay about this topic that I encourage all of you to read, entitled "The Left's last paradise."

Some practical strategies for becoming gainfully employed!

I highly recommend two articles which have appeared recently on CollegeJournal:

1. "It's Never Too Early To Start Your Job Hunt"
2. "Up Next For Seniors: Compose a Resume"

Political bias in the groves of academe!

Today's OpinionJournal features a very interesting and insightful article by John Fund entitled "High Bias".  The basic premise of Fund's article is that political bias is alive and well in academia.  Specifically, Fund claims that there is a "...lack of intellectual diversity on university campuses, whose faculties are overwhelmingly liberal." 

Fund cites several studies which document the lack of intellectual diversity in academia.  For example, one of the newest studies on this topic (by Swedish sociologist Charlotta Stern and Santa Clara University economist Daniel Klein) finds that in a random national sample of 1,678 responses from university professors, Democratic professors outnumber Republicans 3 to 1 in economics. 28 to 1 in sociology and 30 to 1 in anthropology.  A particularly noteworthy quote comes from Robert Brandon, a Duke University philosophy professor, who offers a theory as to why conservatives are an endangered species on college and university campuses: "We try to hire the best, smartest people available. If, as John Stuart Mill said, stupid people are generally conservative, then there are lots of conservatives we will never hire. Mill's analysis may go some way towards explaining the power of the Republican Party in our society and the relative scarcity of Republicans in academia."

Against grade inflation - How to counter declining rigor in US university courses.

I am attaching a copy of a very interesting editorial about grade inflation at private universities.  This appeared recently in Nature (October 14, 2004 issue). 

======================================= 

Call it Moore's law of US higher education: the quantity and quality of work that undergraduates must do to get top grades halves every decade. This is an exaggeration, of course, but many readers will recognize the sentiment. Is it just the jaded perception of cynical academics? On the contrary: the evidence suggests that there is a real problem of grade inflation in degree courses, especially at private universities. And the assessment of teachers by students, as well as parents' demands that they get what they think they've paid for, are making the problem worse.

Course evaluations were intended to give the instructor feedback about how well he or she was doing. But they rapidly became a favored tool of deans, tenure and promotion committees because they were quantifiable. Now there is an implicit understanding that if instructors give good grades, they will not be judged too severely by students. New faculty often grade more harshly than other members of the department, only to be 'punished' by students. Deans who believe that this doesn't happen are deluding themselves.

Also worrying is the idea - particularly evident at costly private universities - that students and their parents believe they are paying for a degree that will lead to a good job, rather than for a good education that will help them to think independently. The pressure on teachers to appease demanding students and parents by awarding high grades is obvious.

The consequences are all too clear. Anecdotal evidence suggests that there is a general unwarranted upward creep in grades (http://ctl.stanford.edu/Tomprof/postings/444.html). More objectively, the fact that graduate schools rely for admission criteria almost exclusively on the results of standardized tests, rather than on universities' individual grading, points to a systematic failure to ensure that grading standards are being maintained.

What to do? More universities should focus seriously on improving the instructional abilities of their faculty in programs - mandatory for new instructors - to videotape classes and analyze them with the faculty member to highlight strengths and weaknesses. And evaluations should take note of thoughtful individual comments by students, rather than relying on scores, or be abandoned.

What's Behind Edward C. Prescott's Nobel Prize?

Last month Edward C. Prescott and Finn E. Kydland won the 2004 Nobel Prize in Economic Sciences for two important papers they coauthored that advanced the field of "dynamic macroeconomics". As the Royal Swedish Academy of Sciences put it, Prescott and Kydland's work "has not only transformed economic research, but has also profoundly influenced the practice of economic policy in general, and monetary policy in particular." The Knowledge@Wharton website has an excellent article which explains the importance of Prescott's research to issues that confront our society today.  The title of the article is: "What's Behind Edward C. Prescott's Nobel Prize?"

Pension Guarantor's Deficit Doubles

"Struggling under a cascade of bankruptcy filings in the airline and steel industries, the government's pension insurance agency (aka the Pension Benefit Guaranty Corporation, or PBGC) said yesterday that its deficit has more than doubled in the past year -- to $23.3 billion," according to The Washington Post. In "How to Reduce the Cost of Federal Pension Insurance," Richard A. Ippolito, former chief economist at the PBGC, warns that the agency is poised for a taxpayer bailout similar to the 1980s savings and loan crisis. He recommends transforming the PBGC into a private insurance program that sets premiums according to the amount of risk plan sponsors add to the program.

Compensating the Victims of 9/11

Dr. Martin F. Grace makes some very insightful comments concerning Rand's just released study entitled "Compensating the Victims of 9/11".  Dr. Grace links to Figure 2 of the Rand study, which shows how compensation is distributed according to who (e.g., charity, government, private insurers) paid what to whom (e.g., civilians and emergency responders killed or seriously injured during the attacks on the twin towers), and he notes that charity picked up 7% of the tab, private insurers paid 51% of total losses, and the government picked up the remainder. 

An obvious public policy implication is whether ex post victim compensation by charity and government may "crowd out" private insurance.  As Dr. Grace notes, "public policy should be designed to encourage people to have more insurance rather than rely upon prospective government payments."  I made similar points two months ago concerning the effect of public disaster relief on the risk management incentives of firms and individuals.  The prospect of public disaster relief creates a serious moral hazard problem by reducing consumers' demand for private insurance, which in turn incentivizes them to underinvest in loss prevention and mitigation.

Outsourcing debate

For a highly literate, non-emotional, fact/science-based perspective on the outsourcing debate, go no further than today's Econoblog entry entitled "The Rise of Outsourcing"!

Social Security Reform

Following up on Dr. Seward's RMI@Baylor posting entitled "Social Security Reform: When will it come?", there are a couple of Social Security-related articles appearing in the blogosphere which are definitely worth a read.  For starters, check out Alex Tabarrok's posting on marginalrevolution.com entitled "The Social Security Inversion".  The basic premise of this article is that current (and past) retirees have gotten the best deal from Social Security; indeed, many of them did far better than they could have done in any other investment (Tabarrok cites the (spectacular) example of the first known Social Security recipent, Ida May Fuller, who received a nominal payoff equal to 925 times her total contribution into the system).   Unfortunately (as both Seward and Tabarrok point out), for today's workers and their children, Social Security (as it is currently configured) is a raw deal; even if the Social Security system does not become insolvent, current workers will receive a very poor return on their "investment".

The second article appears in yesterday's online version of the Wall Street Journal.  Entitled "Social Security: What's Next", this article provides both liberal and conservative views concerning reforming the Social Security system.

Erratum...

The 2:1 Kerry advantage indicated on Tuesday evening at 5 p.m. on Tradesports.com was apparently driven by market participants acting on faulty data (specifically, faulty exit polling).  Even though the media networks have not yet (as of 2:30 a.m. on Thursday, November 3) called the election, the only "Bush wins" state contracts that are still trading are Iowa ($97), Nevada ($95), Ohio ($95), New Mexico ($90), Wisconsin ($5.70), Minnesota ($1.20), New Hampshire ($0.50), and Michigan ($0.10).  Assuming that Iowa, Nevada, Ohio, and New Mexico go to Bush and Wisconsin, Minnesota, New Hampshire and Michigan go to Kerry, the "most likely" final Electoral College tally should be 286 for Bush and 252 for Kerry.

Hopefully this will be my last blog entry today about prediction markets...

As of 5:00 p.m. this evening, the prediction markets data suggest that the odds now favor a Kerry victory, with the Republican Party maintaining control of both houses of Congress.  As late as 2 p.m. today, the market was still pricing a marginally higher probability of a Bush victory; the PRESIDENT.GWBUSH2004 contract was selling at the time for $55, and the BUSH.OHIO and BUSH.FLORIDA contracts were selling for similar prices.  However, the market dynamics changed significantly starting around 2:30 p.m., with the release of exit polling data which appeared to favor Kerry.  As of 5:00 p.m., the last trade on the PRESIDENT.GWBUSH2004 contract occurred at a price of $32.20, whereas the last trade on the PRESIDENT.KERRY2004 contract occurred at a price of $67.60, and BUSH.OHIO and BUSH.FLORIDA were selling for $39 and $43 respectively.  Although PRESIDENT.GWBUSH2004 is selling off and PRESIDENT.KERRY2004 is rallying, the HOUSE.GOP.2004 contract (which pays off $100 in the event that Republicans maintain control of the US House of Representatives) is selling for $90 and the SENATE.GOP.2004 contract (Republicans maintain control of the US Senate) is selling for $86.80.

While it may be a bit premature to call the election, as I noted earlier it would appear that the most likely outcome at this point is a Kerry presidency coupled with a GOP controlled Congress.

The latest prediction markets story

Based upon the pricing this morning (at 9:30 a.m. CST) of the state by state contracts, I am projecting a "most likely" 272-266 Bush win today.  This assumes that Bush wins Florida ($54) and Ohio ($55), but loses Iowa (the latter contract is currently priced at $50).  If Bush picks up Iowa, it will be 279-259.

The most sane polling-based website I have found is www.realclearpolitics.com.  (I call this a "sane" site because it averages polling results, whereas many other websites (e.g., http://www.electoral-vote.com) simply allocate votes in a given state based upon the latest poll in that state.)  There, you'll find an electoral college map of the United States, which currently has Bush leading Kerry 227-203.  The "toss-up" states are New Hampshire (4 electoral votes), Pennsylvania (21 electoral college votes), Ohio (20 electoral college votes), Florida (27 electoral college votes, Wisconsin (10 electoral college votes), Minnesota (10 electoral college votes), Iowa (7 electoral college votes), and New Mexico (5 electoral college votes).  The prediction markets result reported above assumes that Kerry picks up New Hampshire ($33.70), Pennsylvania ($22), Wisconsin ($42), Minnesota ($21.50), and Iowa, whereas Florida, Ohio, and New Mexico ($59.80) go to Bush.

What are the prediction markets saying on the eve of the election?

As of 8:30 a.m. this morning, the PRESIDENT.GWBUSH2004 contract was trading for $56, whereas the PRESIDENT.KERRY2004 contract was trading for $43.60.  If you look "under the hood" at the state-specific "Bush Wins" contracts, it would appear that Ohio ($52), Iowa ($54.20), and Wisconsin ($42) are the most "in play" at this point in time.  The lowest price "Bush Wins" contract going for Bush at this point is Florida (at $61.50), and the lowest price "Bush Wins" contract going for Kerry at this point is New Hampshire (at $33).  If Bush wins Ohio and Iowa, while Kerry wins Wisconsin, the Electoral College total would be 279-259 in favor of Bush.  Furthermore, the BUSH.ELECTORALVOTES contract is currently pricing a 276-262 margin in favor of Bush.  If you look at page 7 of my "Decision Making under Risk and Uncertainty, part 2" lecture note (which we covered during our class session on September 14), I was predicting an Electoral College margin then of 278-260 in favor of Bush.

While I expect Bush to win reelection on the basis of the prediction markets' estimates, the election would appear to be quite close, and could really go either way.  However, regardless of whether Bush or Kerry win, it appears that the GOP will continue to retain control of Congress.  Currently, the HOUSE.GOP.2004 contract is selling for $95, whereas the SENATE.GOP.2004 contract is selling for $84.50.  These prices are not far off earlier all-time high's set for both contracts. 

One final point - if you haven't already voted, please be sure to vote on Tuesday (although I do not recommend missing class because it will be a particularly important lecture)!

Some Canadian Flu Shot Alternatives

Earlier this month, I wrote about the impact of the tort system on flu vaccine availability in the United States.  Interestingly, travel companies are now bundling flu vaccination with vacation opportunities in Canada.  Fodor's has an interesting story about the "Flu-Shot Ferry", a round trip between Seattle and British Columbia selling for $105 with the flu shot included.  The same story also links to an interesting Boston Globe article entitled "Business brisk as Americans stream to Canada for flu shots" which talks about the Flu-Shot Ferry as well as other flu vaccination/vacation opportunities available throughout Canada, such as a weekend plane trip from New York to Montreal.

Prediction markets assessment of the Presidential Election

Today's Wall Street Journal article entitled "For Math Whizzes, The Election Means A Quadrillion Options" provides an overview of the various quantitative techniques being employed by geeks all over the country who typically are tenured college professors who probably have too much time on their hands.  Notwithstanding the barrage of criticism which has been leveled at the prediction markets (e.g., one commentator has described the Iowa Electronic Exchange Market as "college students playing with their lunch money", and others have offered even more unflattering comments which will not be repeated here), I remain a fan and am looking forward to how the realized election results line up with these markets' predictions.

Speaking of the prediction markets, the prices on the state-specific "Bush win" contracts offered on tradesports.com suggest that Bush currently (as of 10 a.m. on October 26) has a 19 electoral college vote advantage over Kerry; specifically, 253 to 234.  The basis for this assessment involved allocating electoral college votes to Bush in states with "Bush win" contract prices exceeding $60, and to Kerry in states with "Bush win" contract prices less than $40.  In my opinion, the states which are really in play are those with "Bush win" contract prices between $40 and $60.  There are five states which fit this criterion: Wisconsin, Ohio, New Mexico, New Hampshire, and Minnesota.  The following table lists the current prices for Bush contracts in these states, along with the number of electoral college votes which each state owns:

If Bush holds onto the states with contract prices exceeding $60, a win in Ohio would put him over the top.  If Bush does not win Ohio, he can still be reelected by taking Wisconsin, New Mexico, and New Hampshire.  Kerry on the other hand, will not likely win the election without taking Ohio.  Of course, various other permutations are possible.  The prediction markets data suggest the possibility of a 269-269 tie in the electoral college, which would happen if Kerry wins Ohio, New Hampshire and Minnesota, while losing Wisconsin and New Mexico to Bush.

Certainly the quantitative models are interesting, and as indicated by the Wall Street Journal article referenced above, suggest that the election may very well be somewhat of a toss-up.  However, there is probably no predictive indicator which has been as consistently accurate as the Weekly Reader poll.  Since 1956, Weekly Reader students in grades 1-12 have correctly picked the president.  As noted on the Weekly Reader website, "President Bush was a strong winner in the student poll; the only state Senator Kerry won was Maryland. Senator Kerry was also in a statistical dead heat with President Bush in New York, Massachusetts, Washington, D.C. and Vermont. President Bush won most grades, although Senator Kerry did win among tenth-graders."  Also, results by grade are shown on the Weekly Reader website, in case if you are interested.

PBS Program about the Stock Market Crash of 1929

This evening on KWBU, a one hour PBS program entitled "The Crash of 1929" will be airing, starting at 8 p.m.  The PBS home page for this program is located at http://www.pbs.org/wgbh/amex/crash/gallery/index.html.  There, you can obtain much more detailed information about this program, including information such as a Film Description, Program Transcript, suggestions concerning Further Reading, etc.

Daily Times Series of Closing Prices for the PRESIDENT.GWBUSH2004 and PRESIDENT.KERRY2004 Futures Contracts

Today, the Tradesports website made high, low, and closing daily price data available for the PRESIDENT.GWBUSH2004 and PRESIDENT.KERRY2004 futures contracts.  Below, I provide the graph of daily closing prices for the period August 11, 2004 (which is the first day that the Kerry contract started trading) through October 20, 2004.

Who's Behind the Bush-Futures Attacks

Spencer Elliott brought an interesting article to my attention today about "attacks" on the Tradesports futures market over the past months, and speculation about who's doing it.  The article is entitled "Who's Behind the Bush-Futures Attacks?  Although you should not take this as "investment" advice, I do think that the author's idea of entering orders to purchase Bush futures contracts at absurdly low prices (near $0) does make some sense!

Important WSJ article about and video interviews with some of the leading academic thinkers in finance

I highly recommend a page 1 article from today's Wall Street Journal entitled "As Two Economists Debate Markets, the Tide Shifts".  This article provides a very clear explanation of the intellectual history of finance during the past forty years, and how academic scholarship has evolved to embrace a hybrid of the efficient market theory and behavioral finance theory.

I also highly recommend two video interviews featuring Eugene Fama (who is Robert R. McCormick Distinguished Service Professor of Finance, Graduate School of Business, University of Chicago and the founder of the efficient market hypothesis) and Ken French (who is Heidt Professor of Finance, Tuck School of Business, Dartmouth College and a frequent research collaborator with Fama).  In my opinion, it is not a question of if, but rather a question of when Fama will be awared the Nobel Prize in Economics.

"Infectious Politics" - article about the flu vaccine shortage in today's Wall Street Journal

In today's Wall Street Journal, there is a very interesting and insightful article entitled "Infectious Politics" that explains why flu vaccines in particular and vaccines for infectious diseases generally are in such short supply in the United States.  The contributing factors appear to involve a combination of price controls, regulation and tort lawyers.  Of course, I made the latter point (concerning tort) the other day in my blog entry entitled "Impact of the tort system on flu vaccine availability in the United States".

http://www.electoral-vote.com/

I recommend the website http://www.electoral-vote.com/.  It provides a state-by-state breakdown of electoral college vote allocations based upon current polling data, and as of this morning it has Bush leading Kerry 284 to 228, with Iowa (7 votes), New Jersey (15 votes) and New Hampshire (4 votes) too close to call.  This assessment lines up well with what the prediction markets have been saying, and it respresents the midpoint of my prediction market-based 95% confidence interval, which puts the minimum number of electoral votes for Bush at 278 and the maximum number at 289.  The state-by-state breakdown of electoral college vote allocations is also available as an Excel spreadsheet.

Prediction markets - who won the Nobel Prize?

In my entry this past Saturday afternoon entitled "Prediction markets - who will win the Nobel Prize?", I noted that the prediction market for economics scholarship had Edward Prescott (Minneapolis Fed/Arizona State University) in the lead, followed by Robert Barro (Harvard University/Hoover Institution) and Paul Krugman (Princeton).  It is interesting to note that while the prediction market was "right" about Prescott (the Royal Swedish Academy of Sciences announced today that Prescott is one of two winners of the 2004 Nobel Prize in Economic Science; see today's Bloomberg's article), the market was "wrong" about Norweigan scholar Finn E. Kydland, who was cited today as a co-recipient of the 2004 Prize along with Prescott.  Apparently, a contract had been offered on Kydland, but was never traded and consequently expired due to a result of lack of investor interest!

By the way, I highly recommend Dartmouth Professor Andrew Samwick's essay entitled "In Praise of Finn Kydland and Edward Prescott" which explains the significance of the research for which Kydland and Prescott were cited. 

Prediction markets - who will win the Nobel Prize?

Not only do we have prediction markets for politics; there are also prediction markets for economic scholarship; specifically, who will win the Nobel prize in economics (to be announced this coming Monday)?  The current leaders are Edward Prescott (Minneapolis Fed/Arizona State University), Robert Barro (Harvard University/Hoover Institution), and Paul Krugman (Princeton).  It will be interesting to see how accurately these markets predict outcomes!

Impact of the tort system on flu vaccine availability in the United States

It is well known that the U.S. tort system undermines incentives for U.S. pharmaceutical corporations to bring innovative, yet risky drugs to market.  This is particularly apparent in the case of vaccines against infectious diseases, where the "tort tax" is by far and away the most significant cost component in the manufacturing and distribution of vaccines.  With this in mind, it is interesting to consider the consequences for the United States of today's decision by the UK's Medicines and Healthcare Products Regulatory Agency (MHRA) to suspend Chiron Corporation's (NASDAQ:CHIR) license to manufacture influenza virus vaccine in its Liverpool facility, which in turn will prevent the company from releasing any of the product during the 2004-2005 influenza season.  This doesn't seem like it should be that big of a deal until one considers the fact that the United States was counting on U.S.-based Chiron Corporation to provide roughly 1/2 of its total flu vaccine for the upcoming flu season.  Now that Chiron is out of the picture, the only supply source for flu vaccine for the entire United States is a French company called Aventis Corporation (NYSE:AVE), and Aventis has made it quite clear that it cannot possibly scale its manufacturing to meet the needs of the United States during the upcoming flu season. (Fortunately for Baylor University students, faculty and staff, Baylor was prescient enough this past spring to contract with Aventis to provide an adequate vaccine supply this fall for the Baylor community).

Needless to say, it seems pathetic that only two (one U.S., the other French) corporations are willing to accept the risk of being sued for products liability by marketing flu vaccines in the United States.  Unfortunately, this situation has created a serious capacity constraint which in turn has given rise to a potentially serious public health problem for the United States which is now looming.  According to the Centers for Disease Control in Atlanta, GA, influenza typically accounts for as many as 140,000 hospitalizations and 40,000 deaths annually in the United States.  Since these are the statistics which obtain under more "normal" (adequately supplied) flu vaccine scenarios, one can only wonder how many more thousands of people will likely die during the upcoming flu season because the highly dysfunctional US tort liability system has persuaded most companies to not bother with trying to compete in the market for flu vaccines!

Catastrophe risk summary and recommended reading

Here is a summary of the various articles I have written concerning public policy in the context of the disastrous hurricane season suffered by the state of Florida:

• 09.07.04: Financial Implications of Hurricanes - This article provides some insight concerning the evolution of public policy in the post-Andrew world.  Because of persistent regulatory suppression of insurance rates, economic theory suggests that over time, product quality will likely deteriorate and insurers can be expected to exit the market (see Harrington (1992)).  For all practical purposes, this is what has occurred in the Florida homeowners insurance market.  Clearly, there has been a shifting of risk away from private insurers and toward government and policyholders. What has resulted is a rather ad hoc set of risk sharing arrangements which no one particularly likes and very few people understand.
• 09.08.04: Catastrophes and Moral Hazard: The Case of Florida Windstorm Risk - This article explains why public disaster relief, however well intentioned, may make matters worse in the long term by undermining incentives for firms and individuals to select "economically efficient" levels of private insurance and loss mitigation.
• 09.09.04: The double deductible problem in Florida - Here, you will find my "proposal" concerning policy regulation reform; i.e., why not offer consumers a choice between the status quo policy form and an alternative policy form that enables consumers to insure against aggregate losses? This is a workable reform, assuming that the rate suppression problem can also be properly addressed.
• 09.10.04: Reinsurance reinstatement option - This article discusses an important contractual issue that is looming in the market for catastrophe reinsurance which may end up being considerably more significant economically than the "double deductible" problem (i.e., given the amount of catastrophe exposure this season, this important aspect of "fine print" may result in quite a few insolvencies).
• 09.17.04: More on double deductibles - This article argues that in order to "fix" the Florida insurance market, regulatory reform needs to address pricing issues as well as policy forms. Specifically, 1) the rate suppression problem needs to be properly addressed so that rates accurately reflect the expected cost of risk, and 2) consumers ought to have a broader set of choices concerning policy forms.

For people who are interested in reading more about public policy as it pertains to catastrophe risk, I highly recommend two books: 1) Catastrophe Insurance: Consumer Demand, Markets, and Regulation, and 2) When All Else Fails: Government As the Ultimate Risk Manager. Finally, I also highly recommend Martin Grace's weblog.

As Bush Goes, So Goes Market

Yesterday (Monday, September 20, 2004), E. S. Browning (Staff Reporter of the Wall Street Journal) wrote a very interesting article entitled "As Bush Goes, So Goes Market".  He basically makes many of the same points which I made on Saturday, September 11 in my entry entitled "Update on the relationship between stock market returns and presidential futures returns"; i.e., that the presidential futures contracts appear to be pointing to a Bush victory this coming November, and that the stock market appears to be responding favorably.  Or does the direction of causality move in the opposite direction?; i.e., as the stock market improves, this implies that investors are more confident about the economy's future prospects which which in turn improves the electoral prospects of the incumbent president (as reflected in futures prices).  Professors Naveen Khanna and Jennifer Brooke Marietta-Westberg (both finance professors at Michigan State University) make the latter (rather compelling) argument in their paper entitled "Is it 'Kerry up, Market Down' or 'Market Down, Kerry up?' Correlation versus Causation".

Ivan May Take Wind Out of Alfa's Sails

According to an article appearing in today's Wall Street Journal, Insurers note that the industry's losses from Hurricane Ivan, the latest of three major storms to hit the Southeastern U.S. in the last month, could be higher than for the other two huge storms, since Ivan will make landfall west of Florida.  Alabama and the neighboring Gulf Coast states do not have a state-sponsored reinsurance program like Florida so that insurers will have to cover more of the losses from the latest hurricane.  Alfa Insurance Group, a small insurer, has a 20 percent market share of Alabama's homeowners and auto insurance markets, more than twice the share of Allstate Corp and only a little less than that of State Farm.   Alfa could have to pay a large percentage of the initially estimated insured losses of $4 billion to $10 billion from Hurricane Ivan.

Kerry Economic Policy

Today's Wall Street Journal features an article by John Kerry entitled "My Economic Policy".  After spending a fair amount of time during yesterday's lecture analyzing financial market and futures market reactions to the Bush and Kerry political campaigns, I highly recommend reading this article.  Now that Senator Kerry has laid his cards out on the table, it will be interesting to see whether President Bush follows up with his own article in the Journal.

Should the Terrorism Risk Insurance Act (TRIA) be allowed to expire as scheduled at the end of 2005?

A new study has found that if the Terrorism Risk Insurance Act (TRIA) is allowed to expire as scheduled at the end of 2005, it will have negative consequences on the U.S. economy.  Glenn Hubbard, former chairman of the White House Council of Economic Advisors, urged Congress to extend the Act, arguing that without the federal terrorism insurance backstop the potential drag on the gross domestic product (GDP) could be $53 billion, 0.4 percent of the GDP.  The study also found that failure to extend TRIA could reduce job growth by 326,000 and household net worth by $512 billion.  The study was funded by the American Insurance Association, The Financial Services Roundtable, the National Association of Mutual Insurance Companies, the National Council on Compensation insurance, the Property Casualty Insurers Association of America and the Reinsurance Association of America.

Hedge Funds Bet On Catastrophe Reinsurance

According to an article appearing in today's Wall Street Journal, hedge funds are making increasing use of privately negotiated transactions allowing reinsurance companies to manage their exposure to such natural catastrophes as Hurricane Ivan, which is now moving toward the U.S. Gulf Coast.  The leading hedge funds in this market include Citadel Investment Group LLC of Chicago; Nephila Capital Ltd. of Hamilton, Bermuda, and CooperNeff Advisors Inc., a unit of the French bank BNP Paribas.  Greg Hagood, a Nephila Capital partner, says that the fund has focused on reinsurance catastrophe coverage since he cofounded the firm, part of insurance broker Willis Group Holdings Ltd., with Frank Majors in 1997.  Hagood says that the market, which can produce large returns for hedge funds, is attracting many investors.  A hedge fund typically offers to pay $10 million to a reinsurer when it faces a particular level of catastrophic losses, charging as much as $3 million for a one-year contract or less for a single threat such as Hurricane Ivan.

Investors Who Bet On Storms, Disasters Gauge Trade Winds

From today's Wall Street Journal, be sure to check out the article entitled "Investors Who Bet On Storms, Disasters Gauge Trade Winds".  This article provides a very interesting discussion of an important form of "alternative risk transfer" known as catastrophe, or "cat," bonds.  This is considered alternative risk transfer because the more traditional way to finance the cost of catastrophes has been to rely upon insurance and reinsurance markets.  In a nutshell, by purchasing cat bonds, investors receive a relatively high interest rate (usually at a substantial premium above the London Interbank Offer Rate (LIBOR) in exchange for assuming some of the risk of paying claims in the event of catastrophic losses.  Depending upon the severity of the catastrophe, it is possible for investors to lose their principal and/or interest payments if a storm triggers losses at and exceeding an amount set when the bonds are sold. The investors' money is then used to help pay for insurance claims.

According to Moody's, roughly $1 billion in cat bonds were issued per year for several years leading up to 2003, typically involving 4-6 separate bond issues.  During 2003, a total of $1.5 billion was raised involving 13 separate bond issues.  Cat bond issuers typically include insurance companies who are seeking alternatives to traditional reinsurance, as well as nonfinancial corporations whose capital assets are significantly exposed to risks of natural and man-made (i.e., terrorism) risks.  USAA (insurer based in San Antonio) is one of the important innovators in the cat bond market, as is Disney.

New Study Debunks Link Among Winning College Athletic Programs and Increases in Donations and Quality of Applicants

According to a newly published study commissioned by the Knight Foundation Commission on Intercollegiate Athletics, success in big-time athletics has little if any effect on a college's alumni donations or on the academic quality of its applicants. You can read about this study in a September 8, 2004 Austin American Statesman article entitled "New Knight Commission study says athletic success has little to do with alumni contributions". The study, entitled "Challenging the Myth: A Review of the Links Among College Athletic Success, Student Quality, and Donations", was written by Robert H. Frank, who is the Henrietta Johnson Louis Professor of Management and Professor of Economics at Cornell University's Johnson Graduate School of Management.

Update on the relationship between stock market returns and presidential futures returns

In an earlier post entitled "Kerry Up, Markets Down? A Regression Analysis", I reported the results of the following regression equation:

(1) r_S&P500,t = a + br_Kerry,t + e_t,

where r_S&P500,t = daily return on the S&P 500, r_Kerry,t = daily return on the Kerry Futures contract, a = intercept, b = slope; and e_t= error term.  I was motivated to estimate this regression equation after reading a Wall Street Journal article entitled "Kerry Up, Markets Down" which claimed that "...when Kerry's political fortunes rise, the stock market tanks."  The evidence presented in this article for this conjecture did not seem all that robust; specifically, it was based upon graphically comparing 5 day moving averages of Kerry Futures Contract prices (available from the Iowa Electronic Markets website) with 5 day moving averages of the S&P 500 index.  A more convincing analysis is possible by running this very simple regression equation given in (1) above. I found that while there is statistically significant inverse relationship, the economic significance of the effect is rather negligible; specifically, a 1 percent change in the value of the Kerry Futures contract is associated with a -0.0389% change in the value of the S&P500 index.

It struck me that if Kerry was "bad" for the stock market, it would be interesting to find out whether Bush was "good" for the stock market, so I decided to reestimate regression equation (1) and also run a similar regression (given by equation (2) below) on the Bush Futures contract. 

(2) r_S&P500,t = a + br_Bush,t + e_t,

where r_Bush,t represents the return on the Bush Futures contract.  For both contracts, I used realized daily returns from the period June 2, 2004 through September 9, 2004, resulting in 69 daily observations for the futures contract and stock market returns. 

The "new" Kerry results are given in the following table:

Compared with the original regression results from August based upon 47 daily observations from the period June 2, 2004 through August 10, 2004, there has hardly been any change in the parameter values.  The correlation between daily returns on the Kerry Futures contract and daily returns on the S&P 500 index is -0.225, and although this inverse relationship is statistically significant (as indicated by the low "P-value" in the table above), it is not economically significant, since it implies that a 1 percent change in the value of the Kerry Futures contract is associated on average with a -0.03789% change in the value of the S&P500 index. 

Next, let's turn our attention to the parameter estimates for regression equation (2), which relates stock market returns to Bush Futures contract returns.  There, we find the following:

Reinsurance reinstatement option

With the entire furor over the so-called "double deductible" problem in Florida, a contractual issue is looming in the market for catastrophe reinsurance which may be much more significant economically. Insurers writing property insurance routinely purchase reinsurance coverage for the purpose of limiting their catastrophe exposures. When insurers purchase reinsurance, they must decide whether to pay extra for an option which automatically reinstates coverage after an insured event occurs. The default reinsurance contract pays for one insured event, and then the coverage disappears unless the insurer has purchased the option to reinstate. Insurers can select how many reinstatements they wish to have. Typically, the cost to reinstate coverage is roughly half the cost of the original reinsurance premium. For example, suppose a reinsurer quotes $100 for the default reinsurance contract which does not reinstate. Then the reinsurer might quote a price of $110 for a contract which reinstates once, $120 for a contract which reinstates twice, etc. Whenever reinstatement occurs, the reinsurer would charge the insurer an additional $50 premium.

Since it is rare that multiple hurricanes strike the same properties, many insurers will prefer to purchase the default reinsurance contract and retain the risk of a subsequent catastrophe. Unfortunately, this is likely to be the most popular strategy for the smaller, less solvent companies for two reasons: 1) since the "option to default" conveyed by the legal rule of limited liability is more valuable for such firms, smaller, less solvent insurers are likely to reinsure less than larger, moresolvent insurers by not purchasing the reinstatement option, and 2) by foregoing the purchase of the reinstatement option,this results in significant reinsurance premium savings. Furthermore, given the dynamics of the Florida insurance market (where, for a variety of reasons, many of the worst risks are covered by such companies), we may be looking at a much worse insolvency scenario for the Florida insurance industry than we might have otherwise expected.

I wish to thank my good friend and colleague, Dr. Richard Derrig, for pointing this problem out to me.

The double deductible problem in Florida

In a statistical sense, the probability that the same property is damaged by multiple hurricanes is surely a rare event.  However, this is a situation which many property owners in Florida now face.  The print media is filled these days with examples of policyholders whose properties have sustained separate damages from Hurricanes Charlie and Frances who will likely have to pay two deductibles.  Hopefully this won't become an n deductible problem; obviously whether n will be greater than or equal to two will depend upon how the rest of the hurricane season plays out.

While one cannot help but be sympathetic toward people who face such financial hardships, it is also important to think through this issue in a logical fashion. Under most property insurance contracts, claims and deductible payments are related to a specific insured event.  The insurance policy promises to make the property owner whole after an insured event occurs (where being made whole is defined as paying the difference between the property damage related to the insured event and the deductible).  Even if a policyholder suffers the misfortune of multiple (e.g., 2, 3, ..., n) different hurricanes affecting the same property, contractually these represent multiple insured events, not one.  Consequently, n deductibles apply.  Similarly, a person who has the misfortune of being involved in multiple car accidents is not afforded the option of treating multiple accidents as one event; in fact, these are multiple events and each event has its own claim settlement process.

A useful way to think about the double deductible problem is to relate it conceptually to the World Trade Center controversy.  In that case, there was one insured event; specifically, a coordinated strike by terrorists on the two buildings.  Although it could be (and certainly was) argued that were two insured events, the court's decision to treat it as one event appropriately came down to a question of policy language, which is why the "one event" position eventually prevailed in that case.  In the case of Florida homeowners insurance, multiple deductibles follow as a logical consequence of (state regulated) homeowners insurance policy forms which require separate claims and deductibles for damage on separately named storms.  From a contractual standpoint, Hurricanes Charles and Frances were clearly two different insured events, so two deductibles (or three if Ivan also ends up hitting the same property) would seem appropriate and consistent with standard policy form contract language and legal principles of insurance.

In all likelihood, the state of Florida will end up considering various regulatory reforms once this hurricane season is over.  Even Florida governor Jeb Bush has weighed in on this issue, suggesting that the double deductible is something that might need to be changed because of the financial hardship that this creates for many property owners.  In my view, a constructive approach would involve giving consumers the option to choose between a policy based upon the current policy form, and an alternative policy that would enable consumers to insure against aggregate losses.  Contractually, the latter policy type would closely resemble a typical health insurance contract which has a "stop loss" provision built in for aggregate losses.  Since the alternative policy would provide consumers with the opportunity of insuring against paying multiple deductibles, consumers could expect to pay more for the alternative policy than for the current policy.  Besides offering consumers greater choice, such a policy reform would improve market efficiency.  So long as these contracts are fairly priced, chances are that the worse-than-average risks would tend to gravitate toward the stop loss policy, whereas the better-than-average risks would tend to gravitate toward the current policy form.

Catastrophes and moral hazard: The Case of Florida Windstorm Risk

An important public policy aspect of catastrophes such as hurricanes, floods, earthquakes and terrorist actions is the effect of public disaster relief on the incentives of private firms and individuals to make prudent risk management decisions.  Typically, economists are most worried by the possibility that public disaster relief, however well intentioned, may make matters worse in the long term by undermining incentives for firms and individuals to select economically efficient levels of private insurance and loss mitigation. 

A useful way to think about this problem is to consider what optimal risk management and insurance decisions might look like in a world without public disaster relief, and compare these decisions with the decisions that are likely to be made in a world with public disaster relief.  Since consumers fully internalize the costs and benefits of risk management and insurance decisions in the former case, but do not in the latter, the prospect of public disaster relief reduces consumers' demand for private insurance and incentivizes consumers to underinvest in loss mitigation.  This is a classic example of the so-called "moral hazard" problem.   Moral hazard refers to the tendency for insured consumers to change their behavior in ways that increase the probability and/or size of claims.  It is an important issue whenever risk sharing occurs and the price at which risk is transferred is distorted in some fashion; e.g., in the form of subsidized insurance provided after the fact by public entities such as FEMA.

Forecasted paths of Hurricanes Frances and Ivan

After blogging earlier this evening about the financial implications of hurricanes, I was blown away by the National Hurricane Center's forecasted paths for Frances and Ivan.  Also, it is hard to beat NASA's picture of Frances, circa September 5, 2004.

Financial Implications of Hurricanes

Fortunately, the severity of damage from Hurricane Frances will likely be much less severe than what was anticipated in the later part of last week.  Then, forecasters were bandying about Andrew/911 level estimates; e.g., $20-$50 billion.  The three most prominent insurance risk management companies, AIR Worldwide, Risk Management Solutions and EQECAT, now estimate that insured losses from the storm will likely range from $2 billion to $10 billion, which still aren't exactly "chump change".  Combined with Charley's insured losses of $7 billion, this is turning out to be a rather expensive hurricane season for the insurance industry.

The worst hurricane (in terms of total property damage and insured losses) was Hurricane Andrew, a Category 4 hurricane which hit Florida in August 1992.  Andrew caused $20.3 billion in losses for insurers (in today's dollars) and caused a dozen insurance carriers to go bankrupt.  Andrew set in motion fundamental changes in the way that the insurance business is conducted in Florida.  Consider the following examples of private sector innovation:

• Insurers (e.g., USAA) have begun to experiment with insurance securitization, where catastrophe risks are shared in capital markets rather than in the reinsurance markets. 
• Companies doing business in Florida have begun to set up separately capitalized subsidiaries which theoretically could fail without taking their parents down (e.g., Allstate has such a subsidiary, called "Allstate Floridian").  This strategy enables insurers to create financial firewalls between their Florida companies and the rest of their business organizations, thereby limiting the financial consequences of rate suppression and the risk of insolvency which would otherwise have to be borne by the parent company.

Furthermore, other mechanisms have been put in place which causes consumers and the state government to share more of the catastrophe risk.  Consider the following:

• Florida Hurricane Cat Fund. After Andrew, Florida created a risk pool which provides catastrophe reinsurance for companies writing homeowners insurance policies in the state of Florida. Allstate will only pay out $425 million for Charley-related losses because the fund pays 90% of Allstate's losses in excess of $305 million; thus Charley was a manageable loss for Allstate.  In comparison, Allstate's net exposure to Andrew resulted in a $2.5 billion loss (in 1992 dollars) Similarly, State Farm is expected to pay out $200 million for Charley-related losses, compared with $3.7 billion for Andrew-related losses.  Similar stories apply for other major insurers with significant Florida exposure; e.g., companies such as Nationwide, St. Paul Travelers, CNA, The Hartford, etc.).
• Insurer of Last Resort: Citizens Property Insurance Corporation. Because insurance price regulations have generally suppressed rates below their true costs, this has provided insurers with incentives to "cherry pick"; i.e., select the best risks, and refuse to cover higher risk properties.  Many of these higher risk properties have been picked up by the state-run Citizens Property Insurance Corp., created by the Florida Legislature in 2002 as an insurer of last resort. Interestingly, Citizens Property Insurance Corp. has become so "successful" that it currently insures 800,000 coastal homes that private insurers refuse to fully cover.  
• Higher deductibles mean that consumers pay a higher proportion of claims. Some homeowners pay anywhere from 2-5% of windstorm losses, vs. the less than 1% typical for fire damage. Pre-Andrew, deductibles were typically specified in terms of absolute dollar amounts rather than percentages.

It will be interesting to see how this hurricane season plays out.  To date, the damages have been very manageable for the insurance industry.  However, if we have many more storms like Charley and Frances, this may have significant pricing and coverage implications for property insurance markets throughout the United States.  Historically, the capital shocks from major catastrophes such as Andrew and 911 caused insurance rates and reinsurance rates to rise and coverage levels to fall.  This is to be expected, since capital shocks result in capacity constraints in these markets, which in turn result in higher rates and lower coverage.

Kerry up, markets down? A regression analysis

In the August 11, 2004 issue of the Wall Street Journal, an article by Eric Engen (resident scholar at the American Enterprise Institute) entitled "Kerry Up, Markets Down" appeared which makes the following claim: "...Sen. Kerry has promised to repeal a significant portion of (the Bush) tax cuts if elected, including the tax rate reductions on dividend and capital gain income. With the growth rate of the economy high but slowing somewhat, there are signs that this promise is rattling financial markets. The evidence suggests that when Sen.Kerry's political fortunes rise, the stock market tanks." Steve Forbes, editor in chief of Forbes and former (Republican) presidential candidate, weighed in with a similar opinion piece (entitled "The Rubinian Candidate") in today's Wall Street Journal.

Mr. Engen's analysis is based upon graphically comparing 5 day moving averages of the 2004 US Presidential "Winner Takes All" Kerry Futures Contract Prices with 5 day moving averages of the S&P 500 index. While it appears that the two time series move in opposite directions, a more convincing analysis requires determining whether what seems visually apparent is statistically significant. Experimental evidence shows that people tend to see order even when the charts they are looking at consist of randomly generated numbers. Therefore, I computed daily returns on the S&P 500 andthe Kerry Futures contract and regressed stock returns on Kerry Futures contract returns for the period June 2, 2004 through August 9, 2004. I selected this period because the datasource (the Iowa Electronic Markets database) has a continuous price history on the Kerry Futures contract which began on June 1, 2004.

The regression equation that I estimated is specified as follows:

r_S&P500,t = a + br_Kerry,t + e_t,

where r_S&P500,t = daily return on theS&P 500, r_Kerry,t = daily return on the Kerry Futures contract, a = intercept, b =slope; and e_t= error term.

Let's look first at the question of statistical significance. Whether a particular independent variable is statistically significant depends upon the P-value associated with its regression coefficient. A regression coefficient's P-value indicates the probability of "Type 1" error. Type 1 error occurs whenever one concludes that a relationship exists when in fact it does not. Furthermore, one must differentiate between "1 tail" and "2 tail" tests. The P-values listed here are for 2 tail tests, meaning that the "null" hypotheses we are trying to reject are a = 0 and b = 0. In the case of Engen's theory, since the null hypothesis we are trying to reject is that b is non-negative, a 1 tail test is more appropriate. Consequently, based upon these test statistics, we would conclude that a is not statistically different from 0, and that the negative relationship between returns on the Kerry Futures contract and the S&P500 index is statistically significant (at the 7.66%/2 = 3.83% level). Technically, the 1 tail P-value of 3.83% suggests that the probability of committing Type 1 error (i.e., concluding that a negative relationship exists when in fact it does not) is very small.

Next, consider the economic significance of the effect. Even though it is statistically significant, the actual magnitude of the effect is quite small. Specifically, on average, a 1 percent change in the value of the Kerry Futures contract is associated with a -0.0389% change in the value of the S&P500 index. Based upon this result, I would have to conclude that Mr. Engen's basis thesis (that when Sen. Kerry's political fortunes rise, the stock market "tanks") does not represent a particularly fair characterization of this relationship. There is an inverse relationship, but the economic significance of the effect is rather negligible.

Political "Futures" Markets II

The idea of relying upon futures markets prices to forecast future events has an interesting history. Nearly 20 years ago, Richard Roll published a paper in the American Economic Review entitled "Orange Juice and Weather" which showed, among other things, that the futures market in orange juice concentrate is a better predictor of Florida weather than the National Weather Service. Since the only way one can earn excess profits in a speculative market is to gain an informational advantage over the competition, traders are strongly motivated to try to do just that. As I noted in my previous blog entry about political "futures" markets (see 'Political "futures" markets I'), if markets are informationally efficient, it follows that market prices represent unbiased forecasts concerning future events. Technically, this means that on average, the market's estimate of the average value of the event in question is likely to be quite accurate. Consequently, I believe that political "futures" markets are more reliable indicators of the odds of a Bush or Kerry win than surveys conducted by the various media companies. With this in mind, it is interesting to observe what the political futures markets are telling us. As Alex Tabarrok notes, the market prediction of a Bush victory has hit an all-time low; I just checked the tradesports.com website, and today's closing price for the PRESIDENT.GWBUSH2004 futures contract (George W. Bush is re-elected as United States President) is $49.60, which indicates that the election today is quite literally a tossup (note: since the tradesports contracts pay off $100 if a predefined event occurs and $0 otherwise, the reported price is essentially a probability measure). However, it does appear that regardless of which party wins the presidential election, the House and Senate will most likely have Republican majorities. This is evident because today's closing price for the SENATE.GOP.2004 futures contract (Republicans maintain control of the US Senate in 2004 Election) is $76.50, whereas today's closing price for the HOUSE.GOP.2004 futures contract (Republicans maintain control of the House in 2004 Election) is $87.

Effect of Tax Rules on Dividend Policy

Tyler Cowen asks some rather interesting questions concerning Microsoft's decision to declare a $3 per share "special dividend" (since Microsoft has more than 10 billion shares outstanding, this translates into more than $32 billion in cash, thus representing the largest corporate dividend payment in history). Specifically, 1) would these dividends have happened without the Bush tax cuts, and 2) does Microsoft fear that Kerry will win and raise taxes on dividends? Professor Cowen's answers to these questions are "maybe not" and "probably" respectively. The Wall Street Journal corroborates Professor Cowen by noting that "...the company was clearly concerned with the possibility that John Kerry might be elected President and carry out his promise to return dividends to their former status as ordinary income (thus raising the dividend tax back to the nearly 40% Clinton-era top rate from today's 15%).

That dividend policy is sensitive to tax rules is empirically borne out by a new working paper authored by Raj Chetty and Emmanuel Saez entitled "Do Dividend Payments Respond to Taxes? Preliminary Evidence from the 2003 Dividend Tax Cut". Chetty and Saez note "The individual income tax burden on dividends was lowered sharply in 2003 from a maximum rate of 35% to 15%, creating a unique opportunity to analyze the effects of dividend taxes on dividend payments by U.S. corporations." They find, among other things, that 1) the fraction of publicly traded firms paying dividends began to increase in 2003 after having declined continuously for more than two decades, and 2) firms that were already paying dividends prior to 2003 raised their dividend payments significantly after the tax cut became law.

A long standing theorem in finance is that any time a firm's shareholders can find more highly valued uses of capital than the firm, then excess cash should be returned to shareholders. Indeed, the Washington Post quotes Wharton finance professor Jeremy Siegel as saying that "Cash that's just sitting around gets discounted". However, this theorem implicitly assumes that there are no tax asymmetries. The most famous tax asymmetry in corporate finance is that debt related income is only taxed at the personal level, whereas equity related income is taxed at both the corporate and personal levels. At the margin, this tax asymmetry compels firms to be more highly leveraged than they otherwise might be, and also causes firms to avoid generating cash distributions for their shareholders. Another important tax asymmetry which existed until last year was that cash distributions through share buybacks were more tax-efficient transactions than cash distributions through dividend payments. While the 2003 dividend tax reform doesn't address the double taxation issue, it does significantly reduce the tax penalty for cash distributions to shareholders. Furthermore, the tax code is now neutral about the form of equity-related cash distributions, whereas before it favored share buybacks over dividend payments.

On the impact of high fuel prices on airline profitability and the propensity to hedge risk

On the impact of high fuel prices on airline profitability and the propensity to hedge risk

Lately, there have been a slew of articles concerning the impact of high fuel prices on airline profitability. A common statistic which is being bandied about in the news media is that for every $1 increase in fuel costs, airline industry costs increase by $425 million. Indeed, it has become fashionable lately for airline executives to not only blame high fuel prices for their lack of profitability, but also to argue for the "need" for government intervention. As a case in point, consider the following quotes (taken from a June 3, 2004 Washington Post article entitled "Airlines Find Fuel Prices Tough to Swallow"):

1. "'The price of oil has taken our profitability hopes away from us," said Gordon M. Bethune, Continental Airlines Inc.'s chairman and chief executive. "The government ought to recognize that this is pretty serious.'"

2. "United Airlines blamed high fuel costs for its operating loss in April. If prices had been lower, the airline would have reported a profit during the month, said Jake Brace, chief financial officer of UAL Corp., which owns United Airlines."

After reading quotes such as these, one would think that the airline industry is powerless to do anything about fuel prices, and that the government may be their only "hope". Of course, this is complete nonsense. Firms are in the business of taking and managing risk; after all, this is how they earn profit. Corporate risk management theory makes a compelling case for the notion that firms should hedge or insure "incidental" risks (which are risks that they cannot control, such as commodity prices), and retain "core" risks (which are risks that they are in a position to favorably influence). In the case of the airline industry, the price of jet fuel is clearly an "incidental" risk and therefore it represents the type of risk which ought to be transferred. On the other hand, passenger safety and security represent examples of "core" risks which the firm presumably has a comparative advantage in managing.

In light of these considerations, it is interesting to look under the hood at actual airline industry hedging practices. Casual empiricism reveals that the propensity to hedge tends to be positively related to profitability and inversely related to the risk of default. In other words, the more profitable, less financially troubled airlines (e.g., companies such as Southwest Airlines, Air Tran and Jet Blue) tend to aggressively hedge jet fuel prices, whereas the less profitable, more financially troubled airlines (e.g., Continental, Delta, Northwest, American and United) either do limited hedging or none whatsoever. Southwest Airlines is 80 percent hedged for the remainder of 2004 with prices capped below $24 per barrel, 80 percent hedged for 2005 with prices capped at $25 per barrel and 45 percent hedged for 2006 with prices capped at $28 per barrel. Compare Southwest's policy with the policies followed by Northwest Airlines (only 7% of its 2004 fuel needs are hedged at $37 per barrel and none of its 2005 fuel needs), American Airlines (no hedging), and United Airlines (no hedging). During the second quarter of 2004, Southwest Airlines' net income for the second quarter of 2004 was $113 million, $90 million of which was attributable to the lower jet fuel prices afforded by their hedging program. In contrast, American and United are expected to pay $700 million and $750 million respectively in additional fuel costs during 2004.

These data beg an obvious question; specifically why is there such a glaring disparity in terms of the risk management strategies of these companies? Digging a bit deeper, it is important to note the risk bearing incentive effects related to corporate limited liability, and how this affects corporate investment decision making. Finance theory suggests that when firms are financially distressed (as is the case with many airline companies), limited liability gives rise to various moral hazard problems. Among other things, firms that are close to going bankrupt often fall prey to perverse risk bearing and investment incentives; specifically, they tend to underinvest as well as take on too much risk. Since limited liability creates an asymmetry in terms of the impact of risk bearing on shareholders; i.e., shareholders are shielded from downside risk and exposed to upside risk, this will often compel financially distressed firms to adopt risk management strategies which wouldn't be considered by financially sound firms. Basically, if you find yourself up against the wall, you may prefer not to hedge risk. If you lose, your losses are limited, but if you win, your gains are unlimited. The prospect of a government bailout further exacerbates this moral hazard and makes it even less likely that a financially troubled airline will be inclined to hedge.

In the case of the airline industry, the unprofitable and financially troubled firms consequently have greater incentive to take on incidental risks than profitable companies. Fuel price risk is clearly symmetric; while an increase in price reduces profitability, a price decrease enhances profitability. By rolling the dice and remaining largely unhedged, companies like Northwest, American, and United will benefit if fuel prices fall (indeed, as investments these companies' stocks basically represent highly speculative, leveraged plays on future fuel prices). However, if prices rise, these companies have other risk management mechanisms at their disposal; specifically, bankruptcy protection and the possibility of government loan guarantees. Since these companies do not have to put much of their own money at risk, the costs of hedging likely outweigh the benefits. The reverse is true for profitable companies that are not likely to go bankrupt (such as Southwest Airlines). For these companies, the "option to default" is deeply out of the money, as is the prospect of a government bailout. Since their own money is at risk, they are more likely to adopt prudent business practices (including hedging incidental risks)

In closing, I would like to point out that there have been some academic studies done on this very topic; I would point the reader to a working paper by David Carter, Daniel Rogers and Betty Simkins entitled "Does Fuel Hedging Make Economic Sense? The Case of the U.S. Airline Industry". These same authors have also recently written an interesting case study of Southwest Airlines entitled "Fuel Hedging in the Airline Industry: The Case of Southwest Airlines".

Political "futures" markets I

An important aspect of the theory of finance is the notion that market prices reflect unbiased estimates by market participants concerning future events. Since we are now "full swing" into a political season, it is interesting to see how markets view the upcoming presidential election in the United States.

The first known implementation of real-money futures markets for outcomes of political elections was created by faculty members at the University of Iowa's Tippie College of Business. Their initiative is commonly known as the Iowa Electronic Markets (aka IEM). Currently, the following contracts are being offered at IEM:

2004 U.S. Democratic Convention Market
2004 U.S. Presidential Election Vote Share Market
2004 U.S. Presidential Election Winner Takes All Market
2004 U.S. Congressional Control Market
2004 U.S. House Control Market
2004 U.S. Senate Control Market
 
For readers who are interested in seeing current price quotes for the IEM political markets, go to http://128.255.244.60/quotes.

Another interesting example of political futures markets can be found at tradesports.com, a Dublin, Ireland website which became famous during 2003 for offering futures contracts on whether Saddam Hussein would remain in power in Iraq. The tradesports.comcontracts are defined as "all or nothing" futures contracts which pay off $100 if a predefined event occurs and $0 otherwise. Consequently, the price is essentially a probability measure. The set of contract offerings at tradesports.com is much broader than what is currently being offered at IEM. For a list of current price quotes, go to the tradesports.com website, click on the "All Events" tab, and then click on "Politics", which is located under the "Current Contracts" column.