The first topic in my corporate finance class – starting in, alas, not very many weeks – is valuation and market efficiency.
This is a law school class, and the approach to valuation is not technical; it is mostly just a description of why it is important, in the context of a survey class that is usually a follow-on to business associations and precedes more specialized upper level business law classes. I am using Professor Bratton’s text, which I like very much, although it covers a whole year – and more – worth of material. So we don’t deal with M&A and many other things that this very comprehensive text addresses. For many law students, though, this is the first introduction to risk – the first introduction to finance, but risk in particular – as well as to financial markets and institutions. They have dealt with it in various ways in the first year, but only indirectly, mediated by the traditional legal doctrines of tort, contract, etc.
Students ask me what level of sophistication I am aiming for in this kind of upper level survey course. My current, and revisable, answer is that at a very minimum, I think they need the kind of sophistication that appellate judges bring to their opinions, to be able to read and understand those opinions, and to be able to have a start on writing briefs to judges on these issues. At least to be able to read the opinions on these topics offered by generalist appellate judges. Is that the right standard for upper level law students, often with no exposure to economics or business other than law school, in a midtier law school?
(Update: Commenters have made many very helpful suggestions, thanks! I can also see that I want to do a separate post, perhaps as I fine-tune my corporate finance class syllabus, just on the pedagogy of teaching finance to law students.)
I wrestle with this a lot, as I’m sure corporate finance law professors often do. I worry that I dumb it down too much – I’ve concluded, for example, but not without trying for years, that actually working through numerical present value problems with 80 students coming from completely different preps for this stuff is just hopeless. Half of them had it years ago and the other half are scared witless by numbers. But is that putting too little on law students? My younger brother had a corporate finance class in law school conducted largely on Excel. He could model more sophisticated option pricing than I will ever hope to do – on the other hand, he did not know what the term ‘indenture’ referred to when he had finished the class and was charmingly curious about why ‘covenants’ were so important in bonds contracts (I exaggerate, but not by much).
Perhaps unsurprisingly, my brother sounded very much like the private equity manager I was chatting with at a Christmas party in 2008 – I asked, I read these qualitatively complicated covenants in bond contracts that only have an effect at bad moments, and I am really interested in how, at the fundamental analysis level – not simply referring to some presumed market proxy – one would go about putting a value on these things. He laughed and said, until last year, we assumed they never applied and never tried to value them, except maybe in some generic, completely unsystematic way – we assumed either that it didn’t matter or else that it was already priced in somehow. Anyway, he said, you’re the lawyer, you guys write them, you’re the only ones who would know what they mean well enough to describe the consequences – you do the valuation. I told him that seemed weird and maybe even unnatural.
But was he right that no one priced these legal breakdown contingencies in, or or simply indulging Xmas party chat? Heck if I know these days. I have this sneaking feeling that what I will tell students in August will not be exactly, and with the same enthusiasm (see below), as I expressed myself on the subject of the efficient market hypothesis a decade ago.
So the textbook starts with valuation and then the efficient market hypothesis which, of course, is a matter much on many minds at the moment and not just mine. I like starting there; I used to start in the most traditional way, with concepts of equity, but in a world in which I am trying to emphasize to students that finance is more than just capital raising in the traditional sense, this works far better. (I like the Bratton book a lot.)
Meanwhile, I have been taking the summer opportunity to review the recent literature on EMH, both the academic literature and the writing aimed at a more general audience, in order to have a good basis on which to situate students to the current state of debate. Even just sticking with careful textbook writers like Professor Bratton – rather than some of the more breathless tomes in the popular books – I am struck by how much more cautious this 2007-08 edition is with regards to EMH. I have a broad selection of texts and standard books on the topic sitting on my shelves, multiple editions going back to the 1980s, and looking back over different editions of A Random Walk, various corporate finance texts for both business schools and law schools, etc., there is an (unsurprising) amount of pull-back.
Here’s my question. I’m thinking of proposing a review essay of recent books on efficient markets for a general book review. It is a general review, and the editor worries that I intend to drive general readers crazy with ‘jargon and jumble’ (I quote; but surely perish the thought, moi?). I might assign some book in the list to students in the class, as well. If the topic is not the economy generally, not the recession, not the financial crisis as such – but efficient market theory, specifically, what books would you suggest I feature in a review? They have to be recent, last nine months, certainly not more than a year.
Because the list I have below is mostly critical of efficient market theory, I would be quite interested to see the most current defense of it to the general reader, in as strong terms as anyone is willing to go. One can go to the Fama/French blog, I guess, and I will point students there, but for review purposes, I’d like to find a book.
On my list already is Justin Fox’s excellent The Myth of the Rational Market. I am also considering George Cooper, The Origin of Financial Crises. Are there others for the general reader but specifically on market efficiency? I might include George Akerloff and Robert Shiller, Animal Spirits, because though it is directly about behavioral finance, its implications are about rational market efficiency. For that matter, the Economist of July 18, 2009 has an excellent briefing, “Efficiency and beyond,” something I will certainly assign to students. I am also thinking about Dick Posner’s A Failure of Capitalism – but it is probably too much about the financial crisis rather than about efficient markets as such.
(Update: I should add how much I admire the late Peter Bernstein’s books. Someone mentioned Capital Ideas and Capital Ideas Evolving – they are very interesting, but a little bit hard for the uninitiated. The book that will really stand out over time by Bernstein, I think, is his Against the Gods: The Story of Risk. I reviewed it in the 1990s in the Times Literary Supplement, free download at the link, along with a good, somewhat sophisticated book on derivatives by the then editor of Risk magazine, Leverage: A Sword that Cuts Both Ways (aptly named).)
My own, first introduction to EMH was in the early 1980s, in law school, with a well-known corporate finance law professor. He was, even (or perhaps especially) way back then, perhaps too smitten with the idea in a purely deductive form – both the versions noted by Shiller, and with good reason much noted on econ blogs these days, viz., (a) no free lunch and no easy pickings and (b) the price is really, truly, genuinely right. I had come straight from philosophy with a fair amount of attention to the problems of skepticism, so I bravely raised my hand and said … this seems to me a little bit like Candide’s version of Leibniz, things are necessarily for the best in the best of all possible worlds.
He fixed me with a stare and said wiltingly (something very much like), perhaps you should actually understand it before you do a little one-line take-down. He was quite right; I was doing the (lazy) law student’s favorite intellectual move, which is to avoid having to understand something on its terms, and instead reframe it, preferably critically, in terms that already make sense to you. The former approach requires learning the apparatus in which the proposition is framed; the latter essentially reduces it to a metaphor, which might be brilliant and insightful but is always, so to speak, from ‘outside’ the frame in which it is derived.
But it was also true that the version of the thesis I learned auditing business school classes was much more cautious, and defended far more inductively, than what I was taught in law school. I did eventually learn it from the inside out. What I said by referring to Candide – deductive optimism – of course has always been made as a point against strongly deductive versions of EMH, made by practically everyone in some form or other, and I just didn’t know it. I didn’t really understand the true importance of “inside” versus “outside” understanding until I went into tax law and found out that to advise a client, it was not enough to do the Tax Law of Immanent Critique. That was the moment (naturally!) I knew I wanted to be a professor.
So what recent books on this should I propose to review? Suggestions welcomed. And any thoughts on the pedagogy of corporate finance for law students also very welcome. And of course anything you like on EMH.