Detecting Random Events

I have been teaching accounting and finance for many years. One issue that continues to amaze me is that students do not properly understand what randomness is and are unable to distinguish between a random set of events and a non-random set of events. Below are two sets of results from tossing a coin (H = heads, T = tails), one set is random, the other set is non-random.

Set 1	Set 2
H	H
H	T
T	T
H	H
H	T
H	H
T	T
H	T
T	H
T	T
H	H
H	T
T	T
H	T
H	H
T	H
T	T
H	H
T	T
H	H
T	T
T	H
T	T
T	H
H	H
T	H
T	T
T	H
T	T
H	T
H	H
T	H
T	T
T	H
H	T
H	H
H	T
T	H
T	T
T	H

Send me an email (see below) with your selection of which set is the random set and, if you can, tell me why it is random and the other set is non-random. No prizes, just a warm inner feeling. I will answer your emails and tell you if you are correct.


My email address is: andrew [dot] read [dot] canberra [at] gmail [dot] com (written this way to reduce the risk of spam).


The reason this inability to detect randomness is a concern is that naive (and perhaps professionals as well) investors can be conned by charlatans selling bogus charting and other technical analysis systems.

Robert McNamara - Driving Force in Government Financial Management Reform

Robert McNamara, former American Secretary of Defense died several days ago at the age of 93. Prior to becoming Secretary of Defense in the Kennedy and Johnson administrations he was President of Ford Motor Company. After leaving the US Cabinet he became President of the World Bank.

For accountants, McNamara is important for starting a reform process in public sector financial management which continues today. This reform process introduced corporate style financial management processes into government.

What to do with derivatives

This post is prompted by a corridor conversation today among accounting academics about the role of derivatives in the global financial crisis (GFC). The only thing we agreed upon was that we could not agree.

One of the more strident views expressed was that derivatives are evil and should be suppressed. I think this is too strong. I consider that derivatives are like guns and cars: extremely useful tools in the hands of careful operators but incredibly dangerous in the hands of irresponsible or unskilled users. To continue the simile, in the same way that we try to develop laws to keep guns and cars away from the unskilled and the reckless, we need laws to do the same for derivatives. Despite these laws, we still find guns and cars being used dangerously and I think we will find the same with derivatives - no matter how we legislate we will be unable to stop all abuses. The problem is to find that balance between sufficient regulation to prevent unbearable abuses but not so much regulation to inhibit their use for functions in which they are useful.

The regulation issues with derivatives are twofold: how to regulate the market and how to market participants disclose their exposure to derivatives to investors. These issues are much easier to address with exchange-traded derivatives than with over-the-counter (OTC) derivatives. In this diatribe, I will make the case for exchange-traded derivatives.

Exchange-traded derivatives are easier to regulate as there is a long history of financial market regulation which can (and has) been applied to derivatives markets to ensure they operate fairly. Further advantages of exchange-traded derivatives include:

• the marketability of contracts they generate allowing participants to close-out an open position immediately,
• the use of a clearing house to eliminate (effectively) counter-party risk, and
• the use of margin calls to prevent the development of large uncovered liabilities by participants.

Accounting for exchange-traded derivatives is also easier. As they are traded in a public market, the market value of the contracts can be observed and reported. As the terms of the contracts are publicly available, users are in a better position to assess the risks if the type of derivative is disclosed in the financial reports.

In contrast, OTC derivatives are harder to regulate as there does not have to be any central co-ordination for them. The customisation of OTC contracts make them harder to close-out by taking an opposite position. The lack of a clearing house increases counter-party risk (a major concern during the current GFC), and the possible lack of margin calls allows the accumulation of large uncovered liability positions on open contracts. As OTC exchanges occur in private, it may not be possible to observe and report market values. Finally, as the content of the contracts varies, it is more difficult for users to assess the risks associated with the contract.

These differences between OTC and exchange-traded derivatives provide an argument for differential regulation. This differential regulation can be used to encourage firms to use exchange-traded derivatives and to avoid OTC contracts. Such differential regulation is likely to lead to an expansion on the range of derivatives offered on financial markets but that would not be a bad outcome if there was a corresponding fall in the use of OTC derivatives.

Too Big to Fail

Why are we (taxpayers) paying so much money to bailout private companies? Because the failure of those companies would threaten the entire market and devastate society. This is the problem - we have allowed companies to become so large that their failure threatens society. Most of the very large companies have grown to that size through acquisition and merger, not from internal growth. However, when regulators like the ACCC consider acquisitions and mergers, they only consider anti-competition issues. This has to stop.

There are too many companies in Australia which are too big to allow them to fail. The reasons they cannot be allowed to fail include:

• They provide an essential service for the economy and there are insufficient competitors to absorb the business if the company failed - eg Telstra, Macquarie Airports
  
• Ordinary citizens would be harmed significantly by their failure - eg banks, insurance companies, superannuation funds
• Local economies would be devastated by the unemployment caused - eg car manufacturers, steel industry, mining industry
  

We are still seeing this corporate elephantiasis occurring. Westpac has merged with St George, the Commonwealth Bank has taken over Bank West. Last year, BHP Billiton was considering taking over Rio to create a mining colossus.

National industry and competition policy needs to specifically consider the risks to the economy of the failure of companies and to develop strategies to manage the risk. Ideally, companies would not be allowed to get so big that they threaten society. If that is unavoidable, adequate prudential regulation must exist to manage the risks. Where the size or the sensitivity of the company makes the existence of a government guarantee implicit (as we have seen with the banks), then that guarantee needs to be made explicit, companies must pay for it, and oversight systems created to manage the moral hazard implicit in these guarantees.

It is essential that we learn from Iceland. We cannot allow any company to get so big that the government cannot protect society from the risks of that company failing.

Defending Fair Value

Executives of financial institutions have been critical of fair value measurement in accounting. The standard setters are listening to these calls as can be seen in the announcement of FASB relaxing the requirements to write down impaired assets measured at fair value.

Weakening the rules on fair value measurement is a disservice to users of financial statements and destabilises financial markets. If users are kept in the dark about the magnitude of the losses then they will assume the worst - the law of adverse selection. Decisions made on less than the fullest information available are more likely to prove to be poor decisions in hindsight. Not only will this harm the individual decision maker but it will harm society by preventing the market from delivering the optimum distribution of resources.

Blaming accounting rules for their own mismanagement merely highlights that the views of the scoundrels managing some financial institutions are not worthy of consideration. There is nothing in the accounting which forced management to invest imprudently. The sincerity of these critics of fair value can be challenged if they did not criticise fair value measurement when rising asset prices was leading to the booking of profits (resulting in bonuses for management).

Managers of financial institutions have chosen to invest in instruments with volatile market values. The accounting reports should report on that volatility to allow users to properly assess risks. Refusing to report the losses in fair value prevents users from fully assessing the risks. The accounting reports should not allow managers to hide their ineptitude.

To misquote Samuel Johnson: blaming accounting is the last refuge of the scoundrel.

Hedging: An Irregular Verb

Irregular verbs are the bane of people learning a foreign language. I still shudder at the thought of learning irregular French verbs in high school.

For those with poor memories of their schooling, irregular verbs change in a unique manner as their usage changes. For example, the verb "to be" changes in the following pattern:

• I am
• You are
• He/she/it is
• We are
• You are
• They are

But enough of the English lesson. The TV series Yes Minister and its sequel Yes Prime Minister both created jokes out of irregular verbs. In these series, the Minister's principal private secretary, Bernard Woolley (played by Derek Fowlds) regularly invents irregular verb constructions for humorous impact. Following his lead, I am proposing a new irregular verb: "to hedge".

• I hedge
• You speculate
• He/she/it sells goods that do not belong to him/her/it
• We manage open positions
  
• You insure
• They go to jail for fraud

The problem with hedging is that it is frequently only the intent of the actor which distinguishes a hedging transaction from a speculative transaction - particularly in relation to an anticipated future commitment or receipt. This is a concern for accounting as gains and losses from hedge transactions are not recorded as part of operating income but gains and losses from speculation are. The difficulty of identifying the motive means that management can selectively choose whether to record gains or losses from derivatives transactions as part of income or not. The possibilities for gaming this should be obvious.

Accounting for Securitisation

Securitisation is one of the major scapegoats of the global financial crisis (GFC). The following slide show examines the features of securitisation, the accounting for securitisation, how that accounting influenced the GFC and, finally, the policy issues for regulators of accounting.

Global Financial Crisis And Securitisation

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