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Conference in Honor of Hans R. Stoll’s Contributions to the Field of Finance

This year’s Financial Markets Research Center conference, held May 19^th-20^th, 2005, honored Hans R. Stoll for his many contributions to the theory and practice of finance. The conference was organized by Robert Whaley and Bill Christie on the occasion of Hans’s 65th birthday and 25th year at Vanderbilt.

The conference organizers: Whaley & Christie

This, the 18th annual conference of the Center, continued with its usual interface among academics, government regulators, and industry professionals, but its focus was broader and its participation wider than usual in recognition of Hans’s research on such diverse topics as derivatives, market microstructure, and international finance.

The program included people with whom Hans has interacted professionally during the past 40 years. From academia, there were classmates from the University of Chicago during his graduate school days, former colleagues from the Wharton School where Hans took his first academic position, collaborators from the times Hans was on leave and visiting the Federal Reserve, the Securities Exchange Commission, ESSEC, and Karlsruhe, and, finally, coauthors and colleagues from his 25 years at the Owen School. From industry, there were exchange officials, fund managers, consultants, and product strategists. The common thread running through the program is the influence that Hans has had on their careers and lives and vice versa.

The conference was sponsored by the Financial Markets Research Center and by a special grant from the New York Stock Exchange. Additional support was provided by the Hull Family Foundation and by Sanborn Kilcollin Partners, LLC.

Jim Bradford, the newly appointed dean of the Owen School and Bill Christie, Professor of Finance at the Owen School and one of the conference organizers, welcomed participants. The first session of the day dealt with Derivatives and was chaired by Duke Chapman, former chairman of the Chicago Board Options Exchange and one of the first members of the Center. Chapman commented on the changes in options trading since the crash of 1987 when he had recently become chairman of the CBOE. Mr. Chapman introduced Steve Figlewski, Professor at NYU and currently on leave at Citibank, where he is analyzing credit derivatives. Professor Figlewski provided evidence on the correlation between credit default swap spreads and other measures of credit risk, such as yield spreads and implied volatilities from equity options. Nick Bollen, Associate Professor at the Owen School, discussed Figlewski’s results and suggested that implied volatility of out-of-the-money puts might be a better indicator of credit risk than the implied volatilities of at-the-money puts.

Mr. Chapman next introduced Markus Brunnermeier, Assistant Professor of Economics at Princeton, who presented his paper, “Market Liquidity and Funding Liquidity,” (with Lasse Pedersen). Brunnermeier’s model provides an explanation of how liquidity suddenly dries up and what factors determine liquidity crises. Bernard Dumas, Professor at INSEAD, commented on the paper and noted that the dealer funding constraints in the model that produced the results may be artificial. He drew an analogy to the theory of forward exchange where artificial limits on arbitrage allowed forward rates to deviate from interest rate parity. The second commentator, Glenn Satty, Glenn Satty Ltd., provided a general commentary on derivatives and hedge funds. He noted that hedge funds can experience sudden liquidity crises, as in the Brunnermeier paper, because of high leverage. Lock-up restrictions by hedge funds spread the crisis as investors liquidate investments in those hedge funds not subject to lock-ups. The effect is likely to be that the liquidity crisis is transferred from the weak funds (with lock-up restrictions) to strong funds (without lock-up restrictions).

After a short break, participants returned for a panel discussion on Recent Advances in Corporate Finance, chaired by Alan Kraus, Professor of Finance at the University of British Columbia.

Alan Kraus introducing the panel

Professor Kraus introduced the first speaker, Thomas Ho, Thomas Ho Company, who presented his research paper, “Business Model: Capital Budgeting, Equity Valuation, and Returns Attribution.” The model contrasts a naive “bottoms up” NPV approach to capital budgeting in which each project is considered independently to a more realistic “top down” approach in which projects are viewed as options that may be exercised contingent on the company incurring a fixed cost to stay in business. Under this approach, projects must pay some of the cost of the option as well as the direct costs associated with the project. The next speaker, Tom Copeland, Head of the Monitor Corporate Finance Group, presented an option approach to corporate finance entitled, “A Theory of the Firm with Substitution between Real and Financial Options.”

He noted that corporate financial structure can be viewed as a three layer cake. The first layer is a primitive firm that operates with a given asset base and investment policy, where capital structure does not matter. The second layer is a firm that exploits real options – growth options or abandonment options. The third layer is a firm that retains options to adjust financial structure. He noted that real options and financial options interact to affect the optimal capital structure.

Tom Copeland describing the three layer capital structure cake

			The first part of the Thursday afternoon program was devoted to a session on market microstructure, chaired by Thomas Peterffy, Chairman of Interactive Brokers, and one of the founding supporters of the Financial Markets Research Center. Peterffy expressed concern about the anticompetitive effects of the recently announced mergers of the NYSE with Archipelago and of Nasdaq with Instinet. He then introduced the first speaker, Maureen O’Hara, Professor of Finance at Cornell, who presented her paper, “Down and Out in the Stock Market: The Law and Economics of the Delisting Process,” (with Macey and Pompilio). The research examines the causes and effects of delisting and questions the NYSE process for delisting firms. Erik Sirri, Professor of Finance at Babson College, and Paul Bennett, Chief Economist of the NYSE, commented on the paper. Bennett challenged some of the statements in the paper and noted that the process and purpose of delisting are clearly stated in the NYSE rules and are clearly carried out by NYSE staff. The second speaker in the microstructure session, Larry Harris, Professor of Finance at USC, presented his paper, “Corporate Bond Transparency and Transaction Costs,” (with Edwards and Piwowar). Harris and his colleagues find that estimated bid-ask spreads narrow when trades are reported in the TRACE system, after controlling for other factors affecting spreads. Paul Schultz, Professor of Finance at Notre Dame, commenting on the paper, expressed surprise that the TRACE requirement that trades be reported within 45 minutes has an observable beneficial effect. He urged greater transparency in the market. George Sofianos, Vice President at Goldman Sachs, commented on the contrast between bond markets, where percentage transaction costs decline with trade size, and equity markets, where percentage transaction costs increase with trade size. TRACE reporting had little effect on this pattern, he observed.After a break, the conference continued with a panel discussion on financial innovation chaired by Rick Kilcollin, cofounder of Sanborn Kilcollin Partners.

Members of the panel included William Brodsky, Chairman and CEO of the Chicago Board Options Exchange, Phil DeFeo, Chairman and CEO of the Pacific Exchange, Blair Hull, Chairman and CEO of Matlock Capital, and Richard Lindsey, President of Bear Stearns Securities Corporation. The panel commented on the changes in the financial landscape as electronic markets, such as the ECNs in stocks and the International Securities Exchange in options, have taken market share away from traditional exchanges.

Blair Hull, Bill Brodsky, Phil DeFeo and Rich Lindsey preparing to respond to a question about financial innovation

		Traditional option markets, such as the CBOE, have had a difficult time in adjusting because members were reluctant to switch to new technologies that would jeopardize their future. The Pacific Exchange has met these challenges by (1) selling its equities business to Archipelago, (2) demutualizing, and most recently (3) agreeing to sell the rest of its business to Archipelago. Other issues discussed were the appropriate structure for governing and regulating exchanges and the competitive effects of the NYSE/Archipelago and Nasdaq/Instinet mergers. Most of the panelists were of the opinion that competition in trading services would continue to be effective in spite of the reduction in the number of players.

Hans responded by thanking everyone for attending, and he denied all the allegations made by the previous speakers. He noted that success in the academic world can be assured by working with good co-authors. He thanked his co-authors – Alan Kraus, Tom Ho, Bob Whaley, Roger Huang, and Christian Schlag by presenting each of them with goblets inscribed with the references for their joint papers.

The conference resumed on Friday morning with a session on international finance chaired by Tony Santomero, President of the Federal Reserve Bank of Philadelphia. He introduced Roger Huang, Professor of Finance at Notre Dame University, who presented his paper, “Overseas Monitors and Emerging Financial Markets: Evidence from Foreign Investment Flows and Equity Ownership in Taiwan” (with Cheng-Yi Shiu). The research finds that stocks in emerging markets with high foreign ownership outperform other stocks, and this result is ascribed to the effective monitoring by foreign investors. Amar Gande, Assistant Professor of Finance at the Owen School, commented that perhaps factors other than monitoring, such as superior stock selection by foreigners, could explain the superior performance and suggested that it might be possible to measure the degree of monitoring directly.

Mr. Santomero next presided over a panel of three speakers on the topic, “Perspectives on International Finance.” The first speaker, Jack Lavery, Chairman of Lavery Consulting Group, spoke on the fragility and the imbalances in the current U.S. economy. While growth has been strong, such other factors as the domestic deficit are not as encouraging. Herbert Grubel, Professor of Economics Emeritus at Simon Fraser University and a former member of the Canadian Parliament, spoke in favor of large currency unions because, among other things, they result in better monetary policy and more efficient and liquid capital markets. He also commented on his recent trip to Shanghai and the dramatic developments he had observed there. Jim Klingler, Senior Vice President of Eclipse Capital Management, described his firm’s approach to investing in the currency market. He noted that fundamental factors alone do not provide good trading signals; they must be supplemented by technical indicators that measure the market’s sentiment.

The final session of the conference, on research directions in finance, was chaired by Jim Cochrane, former Senior Vice President at the NYSE and now affiliated with the Center for Corporate Governance at Vanderbilt. Cochrane did not introduce the panel members noting that these distinguished academics truly needed no introduction.

Jim Cochrane not introducing the panelists

Marshall Blume, Professor of Finance at the Wharton School, discussed the paradigm shift that occurred in finance in the late 1950’s and the 1960’s when the Modigliani-Miller propositions, efficient capital markets and the CAPM were introduced, reviewed the subsequent attacks on these propositions, and left the audience wondering if there would be a new paradigm that would reconcile the two streams of work. Gene Fama, Professor of Finance at the University of Chicago, and personally responsible for much of the seminal research in finance in the last 40 years, gave an overview of finance in the past four decades, while recognizing he was violating the panel’s charge to look toward future research directions.

Gene Fama speaking on the contributions of finance research

		He commented on the basic validity of the efficient markets hypothesis and remained unconvinced that behavioral finance provided a viable alternative explanation for the behavior of market prices. He expressed skepticism as to the contributions of corporate finance in explaining corporate behavior. Michael Jensen, Professor of Management, Emeritus, at Harvard, took a normative approach in his discussion of managerial incentives, managerial behavior, and management compensation. He gave a thoughtful review of his recent writings on appropriate managerial compensation, on the role of the stock market in diverting managers from their basic tasks, on the need to stop smoothing earnings, and on other issues. Steve Ross, Professor of Finance and Economics at MIT, commented on the debate between behavioral finance and efficient markets, coming down on the side of efficient markets. Many conference participants stayed around for the post conference activities – the Dewey Daane Invitational Tennis Tournament, a hike around Radnor Lake led by Ron Masulis, and a pig roast dinner at the Stoll’s. Some hardy souls retained sufficient energy to take a 30 mile bike trip down the Natchez Trace and back on Saturday morning.

Dewey Daane Invitational Tennis Tournament

On a warm and sunny Friday afternoon, a record turnout battled for the contents of the Daane Cup. Emerging victorious was Jim Klingler and taking second was Christoph Schenzler. Dewey Daane was unable to play because of a sore shoulder, but he had no trouble hoisting the contents of the cup and presenting them to the winner and runner-up.

List of Participants