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Jul 26, 201112:00 AMMad @ Mgmt

with Walter Simson

Summer shorts

Summer shorts
This week I had hoped to be on a beach. Not sure if that’s going to happen, but here are two beach-appropriate short reads. Please consume while wearing flip-flops:


I. Capping CAPM


A Google search on the Capital Asset Pricing Model returns over 1.2 million hits. This model, taught in finance courses as “Cap-em,” indicates that the expected rate of return of a security is the risk-free rate PLUS beta times the difference between the market rate of return and the risk-free rate. Beta is the variability of pricing of the asset:


Ra = Rf + ß(Rm-Rf)


In other words, a security is priced based on the risk-free rate plus the expected variability of returns over the risk-free rate.


In millions of texts, the risk-free rate is the U.S. government security of the appropriate term, say 10 years.


And millions of students instinctively understood the risk-free portion of the formula, but struggled with the concept of beta and risk. How do you calculate beta? If beta is a calculated variability, what is the appropriate time period to use for the variability?


Interestingly, with the publication of Nassim Nicholas Taleb’s The Black Swan: The Impact of the Highly Improbable, we began to see that our understanding of variability, and therefore risk, was limited to our own preferred time horizons. We tend to view risk as what we have experienced recently. If house prices tended to go up recently, the risk of them going down, to us, appears small.


Taleb showed us that “black swan” events (nuclear accidents, tsunamis, market crashes, political upheavals) are more likely than our own limited experience has led us to believe. Markets had been underpricing the risks of these events in securities.


And now, zealots in Congress have taught us a new CAPM message: that the risk-free rate is not risk-free, and that the U.S.’ full faith and credit can be taken hostage.


Millions of textbooks will have to be rewritten, and we as a country will be infinitely poorer for it. Because when all the securities-holders in the world are not sure what the price of their asset is based on, markets will lose value, probably dramatically and perhaps permanently.


Just ask the black swan.


II. Accounting for Murdoch


The questioning of Rupert and James Murdoch, chairman and CEO and deputy chief operating officer, respectively, of the family-controlled News Corp., could have used a little business discipline.


Rupert made it sound as if the whole enterprise was an amalgamation of people that he trusted but should not have. If one believes this story line, one could have felt sorry for the man.


First, product. If the editorial product has consistency and (ahem) integrity, there should be policies and procedures regarding the role of the editor. The editor is the quality assurance officer for editorial.


What do those policies determine to be the level of investigation the editor pursues in any story? Fact-checking? Source identification?


What about keeping notes and source documents for later follow-up and, as appears inevitable in Great Britain, defense of libel suits?


Investigators should focus on the policies, procedures, notes, and documents – or perhaps the lack of them.


The second is accounting. What are the approved expense levels for each executive? What are the controls, over all material expenditures? (And $3.2 million in out-of-court settlements is certainly material.) How is it that someone can demand a check from accounting and simply say that it is for James? If that is true, as reported, there would certainly appear to be a lack of financial control in the company – except by family members.


The board of directors has a fiduciary (that is, protective) duty to News Corp. shareholders. They, and the appropriate financial authorities, should be investigating to find the answers to these questions.

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