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Conditional Performance Evaluation

Conditional performance evaluation refers to the measurement of performance of a managed portfolio taking into account the information that was available to investors at the time the returns were generated. An example of an unconditional measure is Jensen’s alpha based on the capital asset pricing model (CAPM). Unconditional measures may assign superior performance to managers who form dynamic strategies using publicly available information.

Since any investor could have done the same (because the information is public) it is undesirable to label this as superior performance. In addition the distribution of returns on assets which managers invest in is known to change as the public information changes.

Recent empirical work has found that incorporating public information variables such as dividend yields and interest rates is important in explaining expected returns. Conditional performance evaluation brings these insights to the portfolio performance problem.

They find that conditional models seem to have more power to detect persistence of performance relative to unconditional models. In a recent paper Chen and Knez (1996) extend the theory of performance evaluation to the case of general asset pricing models.

Farnsworth et al. (1996) empirically investigate several conditional and unconditional formulations of mt+1 including a SDF version of the CAPM, various versions of multifactor models where the factors are specified to be economic variables, the enumerative portfolio of Long (1990), and a primitive efficient SDF which is the payoff on a portfolio which is constructed to be mean–variance efficient (this case is also examined in Chen and Knez, 1996). Their results showed that inference based on the SDF formulation of the CAPM differ from those obtained using Jensen’s alpha approach even though the same market index was used.

Whether these results show that the SDF framework is superior is still an open question. Future research should try to determine if SDF models are better at pricing portfolios which are known to use only public information. If they do not then another reason must be found for the difference. It does appear that inclusion of conditioning information sharpens inferences on performance. Future work may help determine what information specifically should be included in order to perform conditional performance evaluation.


Resources for Conditional Performance Evaluation:

Chen, Z. & Knez, P. J. (1996). Portfolio performance measurement: theory and applications. Review of Financial Studies, 9, 511–55.

Christopherson, J. A., Ferson, W. E. & Glassman, D. A. (1996). Conditioning manager alphas on economic information: another look at the persistence of performance. University of Washington. Working paper.

Farnsworth, H. K., Ferson, W. E., Jackson, D., Todd, S. & Yomtov, B. (1996). Conditional Performance Evaluation. University of Washington. Working paper.

Ferson, W. E. & Schadt, R. W. (1996). Measuring fund strategy and performance in changing economic conditions. Journal of Finance, 51, 425–62.



Because of their separate legal status, a parent company and its subsidiaries keep independent accounts and prepare separate financial statements. However, investors are interested in the financial performance of the combined group and so this is reported as thegroup’s “consolidated” or “group” financial statements, which present the financial accounts as if they were from a single company.

Companies within a group often do business with one another. Raw materials and finished goods may be bought and sold between companies in a group; cash may also be lent by the parent company in order to finance operations or capital investments. These transactions appear in the financial accounts of both parties but need to be eliminated in the consolidated accounts; if not, then the combined companies would appear to have been carrying on more business than was actually the case.

In forming the consolidated accounts, these transactions would be entered for elimination on a work sheet in some fashion, such as the following:

Notes payable (subsidiary) US$1m.
Notes receivable (parent) US$1m.

to eliminate inter-company receivable and payable. A parent company need not own 100 percent of a subsidiary in order to maintain control of it. In acquiring a new subsidiary company, the parent need only obtain more than half of the voting stock of the acquired company. The parent then has what is called a majority interest while the other owners have a minority interest. Elimination in the consolidated accounts is then carried out in proportion to ownership.

If a subsidiary is formed by acquisition, this can be treated in the stockholders’ books by two alternative accounting methods, called purchase and pooling of interests. The purchase method requires the assets of the acquired company to be reported in the books of the acquiring company at their fair market value. The price actually paid will often be greater than the fair market value of the assets of the acquired company, since the value of the company lies in its trading capability not simply in the resale value of its fixed assets.

Therefore, the financial accounting quantity called goodwill is created, equal to the excess of the purchase price over the sum of the fair market values of the assets acquired. Goodwill can be amortized over a period of years (this does not mean that the tax authorities in a particular country will allow tax deductions on these amortization expenses). In contrast, using pooling of interests, no goodwill is created and the assets of both companies are combined in new books at the same values as recorded in their separate books; the total recorded assets and the total equity are unchanged.

It is useful to know what differences arise from the use of these alternative financial accounting treatments. In purchase accounting, amortization of goodwill reduces income shown on the stockholders’ books. Also, the assets of the acquired company are put on the stockholders’ books at the fair market value. Depreciation expense is increased, again lowering the income reported compared with pooling. However, the cash flows on acquisition are not affected by the choice of financial accounting method chosen and so neither the net present value of the acquisition nor taxes are affected.



News of a bankruptcy could affect the trading positions and equity values of other companies in the same industry simply because a lack of information encourages the presumption that the circumstances of the bankrupt firm apply more generally. This phenomenon is referred to as contagion. Other examples of initializing news events and possible contagious consequences include the impact of the closure of an insolvent bank on the operations and market value of other banks and the effect that the debt-servicing difficulties of a sovereign borrower might have on (1) banks with loan exposures to similar countries and (2) lender perceptions of the creditworthiness of similar countries and therefore the spreads and/or ceilings on loans that they are prepared to offer.

Although contagion is often implicitly linked to irrationality it may turn out to be beneficially rational, for example where news of a bankruptcy provides an early warning of problems that are common to an industry as a whole. The alternative situation is sometimes referred to as “pure” contagion, the wider consequences of which might include the instabilities of inefficient markets, including perhaps crisis proportion failures of confidence, and lost opportunities for portfolio diversifications because of increasing event dependence, i.e. systematicity.

As may be anticipated from the qualifications surrounding these definitions, evidence of contagion can only be tested subject to a variety of conditions. These include, first, in the case of pure contagion, news of an event that is independent of what is happening elsewhere.

Second, its effects can only be measured after having separated out what would otherwise have happened. For example, the “normal” behavior of the equity value of companies or banks could come from some appropriate first-stage regression, the residuals of which can then be used to test for the effects of contagion by means of a second regression.

Third, it may be that there is a need to take account of the ways in which these effects (1) change as a situation evolves, e.g. as a result of a slow release of more and more information and (2) depend on other factors (such as the degree of imperfect competition in an industry, since other firms could benefit from a bankruptcy, or the size of a bank, because regulatory authorities are less likely to allow large banks to go to the wall).

Perhaps somewhat surprisingly, given the many instances in the literature of a temptation to presume that contagion is nothing unusual, most empirical studies have found against it having any substantial or lasting effect. There is also considerable evidence that it has become increasingly less likely as a result of better provision of information flows specific to individual companies, banks, and countries as well as other changes that help markets to adjust prices more quickly and reliably, such as, in the wake of the crisis following Mexico’s 1982 problems, secondary markets for sovereign debt.

Examples of statistical studies relating to banking, industry and sovereign loans can be seen in Aharony and Swary (1983), Lang and Stulz (1992), and Musumeci and Sinkey (1990), while Park (1991) reviews evidence of how US bank panics over the period 1873–1933 from being a “mysterious” market irrationality, were increasingly subdued by the provision of more and more bank-specific information.


Resources for Contagion:

Aharony, J. & Swary, I. (1983). Contagion effects of bank failures: evidence from capital markets. Journal of Business, 56, 305–22. Lang, L. H. P. & Stulz, R. M. (1992).
Contagion and competitive intra-industry effects of bankruptcy announcements. Journal of Financial Economics, 32, 45–60.

Musumeci, J. J. & Sinkey, J. F. (1990). The international debt crisis, investor contagion, and bank security returns in 1987: the Brazilian experience. Journal of Money, Credit, and Banking, 22, 209–20.

Park, S. (1991). Bank failure contagion in historical perspective. Journal of Monetary
Economics, 28, 271–86.


Contingent Claims

In layman’s language, a contingent-claims market can be understood by comparing it with betting in a horse race. The state of the world corresponds to how the various horses will lace, and a claim corresponds to a bet that a horse will win. If your horse comes in, you get paid in proportion to the number of tickets you purchased. But ex ante you do not know hich state of the world will occur. The only way to guarantee payment in all states of the world is to bet on all the horses.

The state-preference model is an alternative way of modeling decision under uncertainty. Consumers trade contingent claims, which are rights to consumption, if and only if a particular state of the world occurs. In the insurance case, in one state of the world the consumer suffers a loss and in the other, she or he does not; however, ex ante he does not know which state will occur, but wants to be sure to have consumption goods available in each state.

In a corporate context Deman (1994) identified basically two theories of takeovers: (1) agency theory, and (2) incomplete contingentclaims market. The latter theory hypothesizes that takeovers result from the lack of a complete state-contingent claims market. The main argument can be summarized briefly. If complete state-contingent claims markets exist, then shareholders’ valuations of any state distribution of returns are identical (because of one price for every state-contingent claim) and hence, they agree on a value-maximizing production plan. However, in the absence of complete-state contingent claims markets, any change in technologies (i.e. a change in the state distribution of payoffs) is not, in general, valued identically by all shareholders. Thus, majority support for such a change in plan may be lacking. Takeover is a contingent contract which enables a simultaneous change in technologies and portfolio holdings.
Merton (1990) describes some commercial examples of contingent claims which include: futures and options contracts based on commodities, stock indices, interest rates, and exchange rates, etc. Other examples are Arrow–Debreu (AW) securities, which play a crucial role in general equilibrium theory (GE), and options. Under AW conditions, the pricing of contingent claims is closely related to the optimal solutions to portfolio planning problems.

Thus, contingent claims analysis (CCA) plays a central role in achieving its results by integrating the option-pricing theory with the optimal portfolio planning problem of agents under uncertainty.

One of the salient features of CCA is that many of its valuation formulae are by and large or completely independent of agents’ preferences and expected returns, which are some times referred to as risk neutral valuation relationships. Contributions to CCA have adopted both continuous and multiperiod discrete time models. However, most of them are dominated by continuous time, using a wide range of sophisticated mathematical techniques of stochastic calculus and martingale theory. There are several other facets of contingent claims, such as 71

The option price theory of Black and Scholes (1973), and Merton (1977), general equilibrium and pricing by arbitrage illustrated in Cox et al. (1981), and transaction costs in Harrison and

Kreps (1979). CCA, from its origin in option pricing and valuation of corporate liabilities, has become one of the most powerful analysis tools of intertemporal GE theory under uncertainty.

Resources for Contingent Claims:

Black, F. & Scholes, M. S. (1973). The pricing of options and corporate liabilities. Journal of Political Economy, 81, 637–59.

Cox, J. C., Ingersoll, J. E. & Ross, S. A. (1981). The relationship between forward prices and future prices. Journal of Financial Economics, 9, 321–46.

Deman, S. (1994). The theory of corporate takeover bids: a subgame perfect approach. Managerial Decision Economics, Special Issue on Aspects of Corporate Governance, 15, 383–97.

Harrison, J. M. & Kreps, D. M. (1979). Martingale and arbitrage in multi-period securities markets. Journal of Economic Theory, 20, 381–408.

Merton, R. C. (1977). On the pricing of contingent claims and the Modigliani–Miller theorem. Journal of Financial Economics, 5, 241–49.

Merton, R. C. (1990). Continuous-time finance. Cambridge, MA: Basil Blackwell.

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