Encyclopedia of Finance Part 21 pot

Chapter 39 ACCOUNTING SCANDALS AND IMPLICATIONS FOR DIRECTORS: LESSONS FROM ENRON PEARL TAN, Nanyang Technological University, Singapore GILLIAN YEO, Nanyang Technological University, Singapore Abstract We analyze the Enron case to identify the risk factors that potentially led to its collapse and specific issues relating to its aggressive accounting and highlight the lessons for independent directors. In Enron, the interactions between external stimuli, strategies, corporate culture, and risk exposures possibly created an explosive situation that eventually led to its demise. Much of the post-Enron reforms have been directed towards regulating the roles and responsibilities of executive directors and auditors. However, the role of independent directors has received relatively lesser attention. Independent directors should analyze the risks of their companies and understand the pressures that arise from market conditions and firm-specific policies and incentive structures. They also need to close the information gap between executive directors and themselves. A post-Enron era also requires independent directors to change their focus. Traditionally, independent directors have to strike a difficult balance between maximizing returns and minimizing risks. Independent directors may now have to focus on the management of risks, the design and functioning of an effective corporate governance infrastructure, and the moderation of the power bases of dominant executives. Practically, they may also have to reduce the number of independent director appointments to enable them to focus more effectively on a fewer companies. Keywords: corporate governance; independent directors; risks; incentives; accounting scandals; special purpose entity; hedging; volatility; Sarbanes– Oxley Act; audit committee 39.1. Introduction The recent spate of accounting scandals raises serious concerns about the opportunistic use of accounting procedures and policies to camouflage fundamental problems in companies. The series of corporate collapses also highlight the failure of corporate governance mechanisms to prevent and detect accounting irregularities. The convergence of several factors, including competitive pressures, conflicts of interest, lack of market discipline, and inherent limitations of accounting standards resulted in an explosive situation whereby managers use aggressive accounting practices to pre- sent financial statements that do not reflect economic reality. In this essay, we analyze the Enron case with the objective of determining the risk factors that potentially led to its collapse and specific issues relating to its aggressive accounting and highlight the lessons to be learnt for corporate governance from the perspective of an independent director. 39.2. The Competitive Environment and Incentives for Aggressive Accounting Enron was formed as a result of merger of two companies in 1985. The merger was funded by debt and pressure had existed from the start for the new company to reduce its debt burden. At about the same time, deregulation of the natural energy industry exposed Enron to substantial operating and price risks arising from the increase in gas supply and volatility in spot prices. However, deregulation also increased opportunities for more flexible and innovative contracts to be drawn up between the producer and buyers. To survive, Enron had to capitalize on these opportunities and became a primary market player through its development of the idea of a Gas Bank. Under this scheme, Enron facilitated the market for energy contracts by buying gas from suppliers and selling to buyers. In acting as an intermediary, Enron guaranteed both the supply and the price, and assumed the related risks in return for transaction fees. Innovations were subsequently extended to markets for basic metals, pulp and paper, and broadband products. Its diversification strategy also included investments in other countries in South America, Europe, and Asia. The business and geographical diversification created new risks for Enron. Its heavy investment in projects such as broadband network assets would pay off only in the long term. However, an immediate debt burden from these acquisitions placed pressure on Enron’s balance sheet that was already weighed down by existing debt (Powers et al., 2002). 1 Although Enron began as an operator of energy-related assets, by the end of the 1990s, the firm had divested a significant portion of its physical assets in what is known as an ‘‘asset light strategy’’ (Permanent Subcommittee on Investiga- tions of the Committee of Governmental Affairs, 2002) 2 and was primarily focused on its trading and financial activities relating to physical energy commodities. Effectively, the company was trans- formed from a natural gas supplier into an energy trader and intermediary. It offered specialist services in price risk management strategies and market-making activities. Its dominance in the market for energy contracts gave Enron a first-mover advantage in exploiting information economies of scale. However, the lucrative profits it enjoyed attracted other entrants to the industry and Enron’s profit margins began to erode by the end of 2000. Further, as a trader, Enron was compelled to maintain an investment grade rating in order to lower its counter-party risk. Against this backdrop of competitive pressures, Enron’s senior management developed incentive schemes that turned the firm environment into a highly competitive internal market place. An internal ranking system administered by the company’s Performance Review Committee became a means of allocating bonus points and determining dismissals. The entire process was described as a ‘‘blood sport’’ (Chaffin and Fidler, 2002) and for- mer employees believed that the basis for reward was largely determined by whether a deal could be reported as revenue or earnings rather than commitment to the company’s core values of Respect, Integrity, Communication, and Excellence. Enron’s annual incentive awards and the long-term incentive grants are closely tied to company performance measures and stock prices. The annual incentive bonus was pegged to a percentage of recurring after-tax profit, while its long-term incentive grants provided for accelerated vesting provided Enron achieved performance targets linked to com- pounded growth in earnings-per-share and cumulative shareholder returns. 3 A Senate report on the Enron collapse concluded that Enron’s Board of Directors approved lavish and excessive executive compensation and failed to stem the ‘‘cumulative cash drain’’ arising from its incentive schemes. 4 Hence, Enron appeared to react to risk by creating an environment that generated new risk exposures through its business strategies and reward system that focused on short-term results. Figure 39.1 summarizesthe competitivepressures atEnron. 644 ENCYCLOPEDIA OF FINANCE 39.3. Aggressive Accounting Practices Enron’s accounting practices resulted in removing the liabilities of its balance sheet, improving prof- itability, and reducing profit volatility. These de- sired accounting effects were achieved through structuring numerous complex and ‘‘innovative’’ transactions. Many of these transactions involved dealing with special purpose entities that Enron set up in partnership with related parties. The investigating Senate Committee described these practices as ‘‘high-risk accounting.’’ The manner in which certain transactions were reported was deemed to be at variance with their true economic substance. The main question that underlies these practices relates to the issue of whether Enron had retained the risks that were purportedly transferred to the special purpose entities. 39.3.1. Effectiveness of ‘‘Hedging’’ Transactions An example included the entering into transactions that were purported to hedge the volatility of its ‘‘marked to market’’ investments. The hedging transactions were entered into between Enron and a special purpose entity (SPE). 5 A hedge is effective only if a loss suffered by a hedged party is transferred out to an outside party. In its first hedging transaction, Enron transferred its own stock to the SPE in exchange for a note. The intention of the hedge was to transfer losses to the SPE, through the exercise of an option, should the stock price of a profitable ‘‘merchant’’ investment decline. The SPE purported to take on the risk of price volatility of the investment and to compensate Enron for the loss on its investments. However, cash was available to the SPE only if the latter sold the Enron stock. Since the SPE was financed by Enron’s stock, the transaction was effectively a self-hedging arrangement as the creditworthiness of the SPE was tied to Enron’s fortunes. When Enron’s stock fell in value in late 2000 and early 2001, the SPE faced a liquidity crisis and could not honor its obligations under the option. Hence, the ‘‘hedge’’ was ineffective because the counter-party’s risk was inextricably inter- twined with Enron’s risk and the hedge did not constitute a true economic hedge. 39.3.2. Control and Risks Relating to Unconsolidated Entities There are two broad approaches in accounting for an SPE. If an SPE is controlled by an investing company, the assets and liabilities of the SPE are consolidated entirely on to the investing company’s balance sheet. Alternatively, if it is not under the investing company’s control, it is treated as an investment in a separate entity, with off- balance sheet treatment of the SPE’s assets and liabilities. Under applicable accounting rules in the United States, an SPE could receive off-balance-sheet treatment only if independent third- party investors contributed at least 3 percent of the SPE’s capital. Some of Enron’s dealings raised serious questions about whether this rule was effectively met. For example, from 1997 to 2001, Enron did not consolidate an SPE called Chewco. In 1997, Enron Strategy Change in focus from production to trading Diversification Consequences Price risks and volatility Operating risks from new businesses Financial risks from increased debt burden pressure to maintain investment grade credit rating Corporate culture Competitive Profit-driven Short-term focus Stimuli Deregulation of the natural energy industry Debt burden incurred during the merger that resulted in Enron Figure 39.1. Competitive pressures at Enron ACCOUNTING SCANDALS AND IMPLICATIONS FOR DIRECTORS: LESSONS FROM ENRON 645 and the California Public Employees’ Retirement System (CalPERS) were joint venture partners in an off-balance sheet investment vehicle called Joint Energy Development Limited Partnership (JEDI). To enable CalPERS to cash out its investment in JEDI in order to invest in a larger Enron venture, Andrew Fastow, the then Chief Financial Officer at Enron, and others at Enron formed an SPE called Chewco to buy CalPERS’ interest in JEDI. Thus, Enron was able to continue accounting for JEDI as an off-balance-sheet entity on the basis that the holdings by Enron staff members and related parties constitute outside capital at risk. According to SEC investigations, 6 Fastow, secretly controlled Chewco. Hence, a serious question arose as to whether Enron, through a related party, had effective control over major operating and financial policies of Chewco. Further, Enron and its related SPEs provided guarantees and cash collateral on bank funding to Chewco, indicating that equity at risk was effectively borne by Enron rather than independent third parties. In Novem- ber 2001, both Enron and its auditors, Andersen, concluded that Chewco was an SPE without suffi- cient outside equity and should have been consolidated. The retroactive consolidation of Chewco from 1997 through 2001 had an astounding effect on the financial statements. Profits decreased by a total of $405 million over the period of restatement and additional debt of $711 million was recognized on the balance sheet in 1997. 7 39.4. The Role of Corporate Governance Theoretically, Enron had in place an impressive array of corporate governance mechanisms. Out- side directors were well respected and highly quali- fied individuals in the fields of accounting, finance, and law. The Board of Directors had several com- mittees to review various aspects of the company’s policies and operations. There was separation of the offices of the Chairman and Chief Executive Officer. The external auditors were a Big Five accounting firm. However, following the company’s massive financial collapse, serious doubts arose as to the effectiveness of these institutional arrangements. The Senate Investigating Commit- tee found that the Enron’s Board failed to safe- guard Enron shareholders and contributed to the collapse of the company by allowing Enron to engage in high-risk accounting, inappropriate con- flict of interest transactions, extensive undisclosed off-balance-sheet activities, and excessive executive compensation. 8 Further, the Board was also found to have failed to ensure the independence of the company’s external auditor, Andersen who provided internal audit and consulting services as well. 9 Many valuable lessons can be learnt from the Enron case to prevent the derailing of the effective functioning of governance mechanisms. We focus our discussion on the role of independent directors. Much of the post-Enron reforms have been directed towards regulating the roles and responsibilities of executive directors and auditors. However, the role of independent directors has received relatively less attention than that of other corporate governance agents. We discuss below some implications of the Enron collapse on the role of independent directors. (i) What is the primary role of independent directors? The multiple roles that independent directors have to undertake require them to strike a difficult balance between maximizing returns and minimizing risks. Their purview is wide, ranging from activities that have a ‘‘profit’’ focus to others that have a ‘‘defensive’’ focus. Independent directors potentially find themselves in an identity crisis. For example, if an independent director has to operate within an Enron-type environment, the director is confronted with an aggressive risk-taking internal environment. The question arises as to whether the independent director should act as a thorn in the managers’ flesh or go with the flow of an aggressive managerial style for the sake of profit maximization? The lesson from Enron is very clear that it does not pay to sacrifice the defensive role when risk 646 ENCYCLOPEDIA OF FINANCE factors are overwhelming and the long-run survival of the company is at stake. While post-Enron legislation such as the Sarbanes–Oxley Act of 2002 is primarily directed towards establishing mandates for insiders, audit committee board members and external auditors, much less is said about the responsibilities of independent directors per se. However, the implicit responsibilities of independent directors are clearly reinforced by laws that impose fiduciary duties on directors to act in good faith, with reasonable care, and in the best interest of the corporation and its shareholders. The Conference Board also reiterates directors’ role to monitor management and to ensure their ethical and legal compliance (The Conference Board, 2003). 10 Hence, independent directors owe a primary duty of care to outside investors. Their priority should be towards establishing and ensuring a corporate environment and infrastructure wherein managerial stewardship is executed without com- promising the long-run interests of the firm and its stakeholders. They, more than anyone else, are best placed to limit the excesses of a dominant Chief Executive. (ii) Independent directors have to bridge the information gap between executive directors and themselves. The Conference Board emphasizes that directors need to understand, among other things, the business strategies they approve, the risks and vulnerabilities arising from the strategies, growth opportunities, debt levels, and company’s capital allocation of the companies under their purview. 11 Following the Enron experience, independent directors are well ad- vised to understand the internal dynamics, managerial incentives, and power bases within the corporate environment and to adopt a healthy skepticism of strategies that potentially advance managerial interests over that of external investors. They should be keenly aware of the threats posed by dominant Chief Executive Officers and key personnel and the risks of opportunistic managerial behaviour. (iii) Greater commitment in terms of time and effort are expected of independent directors to meet the governance objective. Independ- ent directors must take a proactive role in governance and not rely solely on external auditors, legal counsel, or key executives to provide them the necessary assurance. For example, when the Enron Board was asked why they moved so quickly in their approval of an unusual hedging transaction, the re- sponse was that the company had obtained a fairness opinion from an outside accounting firm. 12 On another proposal, the Board relied on the company’s legal counsel to advise if anything was amiss on a particular memoran- dum. Had the directors reviewed the memo- randum for themselves, they would have noted that key company executives were involved in the arrangement that gave rise to conflicts of interest. 13 Interviewed Board members told the investigating Senate Sub- committee members that they assumed that the then Chief Executive Officer had actively reviewed and approved the fairness of the unusual business proposals and the compensation controls. 14 Enron’s directors were also found to have knowingly allowed Enron’s use of ‘‘high-risk’’ accounting without enforcing restraint. 15 Hence, the Senate Report under- scores the principle that evidence of a suspect transaction or activity that is known to a director must be questioned and examined diligently and thoroughly, regardless of the views of other experts. The implications for independent directors are enormous. The days when an independent director held several of such appointments concurrently are likely to be over. Independent directors may have to be selective in choosing appointments so as not to spread themselves too thinly. They must also be prepared to commit resources and time and change the mindset that their appointment is a ‘‘part- time’’ one. They may also have to assess the risks of companies to determine if they are willing to ACCOUNTING SCANDALS AND IMPLICATIONS FOR DIRECTORS: LESSONS FROM ENRON 647 undertake the fiduciary responsibility of monitor- ing such a company. 39.5. Conclusion The Enron case has painful lessons for the business community. A seemingly successful company was apparently derailed through the use of highly risky transactions and aggressive accounting that tem- porarily boosted profits and reduced debt. The question arises as to why the corporate guardians of Enron did not prevent these transactions from occurring. Following Enron and other accounting scandals, a re-examination needs to be carried out of the role and responsibilities of independent directors. This paper suggests that significantly greater challenges are posed to independent directors in a post-Enron world to understand more of the risks, accounting practices, and managerial op- portunism existing in the companies under their purview and to take a more proactive role in governance, which inevitably requires a substantial commitment of their time and resources. NOTES 1. Hereinafter referred to as the ‘‘Powers Report.’’ 2. Hereinafter referred to as the ‘‘Senate Report,’’ p. 7. 3. Proxy Statement Pursuant to Section 14(a) of the Securities Exchange Act of 1934, 2 March 2001, EDGARPlus(R). 4. The Senate Report, p. 3. 5. Details of the hedging transactions are found in The Powers’ Report, pp. 13–15. 6. Securities and Exchange Commission, Liti gation Release 17762, 2 October 2002. 7. The Powers’ Report, p. 42. 8. The Senate Report, p. 11. 9. The Senate Report, p. 54. 10. Hereinafter referred to as The Conf erence Board Report. 11. The Conference Board Report, p. 9. 12. The Senate Report, p. 27. 13. The Senate Report, p. 28. 14. The Senate Report, pp. 30–31. 15. The Senate Report, pp. 14–24. REFERENCES Chaffin, J. and Fidler, S. (2002). ‘‘The Enron Collapse.’’ Financial Times, London, 9: 30. Permanent Subcommittee on Investigations of the Committee of Governmental Affairs.(2002). United States Senate, The Role of the Board of Directors in Enron’s Collapse Report, 107–170. Powers, Jr. W.C. , Troubh, R.S., and Winokur, Jr. H.R. (2002). ‘‘R eport of investigation by the special inves- tigative committee of the board of directors of enron Corp.’’ Securities an d Exchange Commission. (2002). ‘‘Litiga- tion Release No. 17762.’’ The Conference Board (2003). ‘‘Commission on public trust and private enterprise.’’ 648 ENCYCLOPEDIA OF FINANCE Chapter 40 AGENT-BASED MODELS OF FINANCIAL MARKETS NICHOLAS S. P. TAY, University of San Francisco, USA Abstract This paper introduces the agent-based modeling methodology and points out the strengths of this method over traditional analytical methods of neoclassical economics. In addition, the various design issues that will be encountered in the design of an agent-based financial market are discussed. Keywords: agent-based models; computer simulation; bounded rationality; heterogeneous agents; learning; co-evolution; complex adaptive system; artificial intelligence; neural networks; classifiers; genetic algorithms; genetic programming 40.1. Introduction The sort of phenomena that are interesting in finance and yet difficult to investigate analytically involve the complex interactions among many self-interested heterogeneous boundedly rational agents acting within the constraints imposed by either formal or informal institutions or author- ities. To outrival their opponents, each and every agent must continually evolve to adapt to changes that may arise either from exogenous perturba- tions to the environment or endogenous transitions caused by agents changing their strategies or modifying their behaviors as they learn more about the behaviors of the other agents and the environment they reside in. A good example of such complex adaptive systems is the stock market. A natural way to study a complex adaptive system like the stock market is to use an agent-based model which entails simulating the stock market on a computer from the bottom up with a large number of interacting heterogeneous boundedly rational artificial agents that are created to mimic the traders in the stock market. Once the environment of the stock market and the behaviors of the agents are specified and the initial state of the model is set, the dynamics of the model from the initial state forward will be driven entirely by agent–agent interactions, and not by some exogenously determined systems of equations. Hence, if any macroscopic regularity emerges from the model, it must be a product of the endogenous repeated local interactions of the autonomous agents and the overall institutional constraints. This is the spirit of the agent-based modeling approach. What makes the agent-based modeling methodology particularly appealing? To begin with, analytical tractability is not an issue since this approach relies on computer simulations to understand the complex model. Quite the reverse, it is inconceivable how one could obtain closed form solutions of a model as complex as the stock market without first diluting drastically the au- thenticity of the model. Although analytically tractable heterogeneous agent rational expect- ations models have been around, the complexity and realism that are captured in agent-based models are beyond the reach of those analytical models. For instance, consider the problem that a decision maker faces when the outcome is contingent on the decisions to be made by all the participating heterogeneous decision makers, each with their own unique preferences and quirks and private information that are not directly observable by the other decision makers. This decision problem is inherently ill defined and cannot be solved through mathematical deduction or analytical modeling. In real life, when confronted with such an ill-defined situation, decision makers often rely on the rules of thumb that they have distilled from years and years of experience to guide them in their decision-making. This decision making process is formally known as inductive reasoning and it can be captured naturally with the agent- based approach by running computer simulations of a large number of interacting artificial agents who make decisions using rules of thumb that they distill from their repeated interactions with each other. The ability to build more realistic models with the agent-based method often allows agent-based models to reveal a much richer set of behaviors that are embedded in a system which may other- wise be overlooked by traditional equation-based models. For instance, Parunak et al. (1998) in comparing the differences between equation- based modeling and agent-based modeling of a supply network have found that equation-based model fails to produce many of the rich effects, such as memory effect of backlogged orders, tran- sition effects, or the amplification of order vari- ation, which are observed in an agent-based model of the same supply network. In addition, various agent-based models (Farmer and Joshi, 2000; Johnson et al., 2001; LeBaron et al., 1999; Tay and Linn, 2001) have been successful in accounting for real financial markets phenomena such as market crashes, mean reversion, relatively high level of trading, technical trading, excess volatility, and volatility clustering. These are phenomena that analytical representative agent models of financial markets have tolled to explain without much success. Another serious shortcoming of analytical representative agent models of financial markets is that by design these models do not specify the dynamic process that will need to happen in order to arrive at the equilibrium or equilibria that are characterized in these models. Consequently, for models that produce multiple equilibria, it is un- clear which equilibrium among the multiple equilibria agents would converge on. In contrast, the events that unfold in a computer simulation of an agent-based model are completely transparent, and can be recorded hence providing the modeler a means to go back in the time line of evolution to understand how certain equilibrium or other global regularities came into existence. The agent-based methodology therefore offers important advantages over the traditional analytical tools of neoclassical economics as it allows a researcher to obtain more germane results. Need- less to say, the use of computer simulations as a tool for studying complex models has only became feasible in recent years because of the availability of fast and cheap computing power. Although the agent-based modeling methodology is still in its infancy, there is already a considerable lit- erature on agent-based models. Leigh Tesfatsion at the Iowa State University maintains a website at http:==www.econ.iastate.edu=tesfatsi=ace.htm to facilitate access to the extensive resources related to the agent-based modeling methodology, and to keep researchers in this field abreast of the latest developments. In the introductory remarks on her website, Tesfatsion observes that agent-based research may generally be organized according to one of the following four research objectives: (1) empirical understanding, (2) normative understanding, (3) qualitative insight and theory generation, and (4) methodological advancement. The first objective focuses on seeking answers that are established on the repeated interactions of agents to explain the emergence of global regularities in agent-based models. Some examples of global regularities in financial markets are mean reversion and volatility clustering. Researchers in this group are interested 650 ENCYCLOPEDIA OF FINANCE in understanding if certain types of observed global regularities can be attributed to certain types of agent-based worlds. The second objective concerns using agent-based models as laboratories to aid in the discovery and design of good economic policies or good institutional structures. Researchers with this objective in mind are interested in using agent- based models to evaluate whether certain economic policies or institutional designs and pro- cesses will promote socially desirable outcomes over time among agents that are driven solely by their self interests. Tesfatsion phrased the third objective as ‘‘How can the full potentiality of economic systems be better understood through a better understanding of their complete phase portraits (equilibria plus basins of attraction)?’’ Unlike analytical models, the causal mechanisms in agent-based models are not direct and are very difficult to discern because of the complex nature of the interactions among the agents and between the agents and the environment. The goal here is to use the phase portraits as a means to enrich our understanding of the causal mechanism in these systems. The fourth objective addresses issues related to improving the methods and tools used by agent-based researchers. For someone who is just starting out in this line of research, it is worthwhile to begin by reading ‘‘A Guide for Newcomers to Agent-based Modeling in the Social Sciences’’ by Axelrod and Tesfatsion which is available on the homepage of Tesfatsion’s website. In addition, it is beneficial to read the survey articles written by Hommes (2004), Duffy (2004), LeBaron et al. (1999), LeBaron (2000, 2004a), and Tesfatsion (2002) and a book by Batten (2000) that provides an overview of agent-based models and offers some historical perspectives of this methodology. The next section discusses the design issues that will be encountered in the design of an agent-based model. This discussion benefited greatly from the insights that LeBaron has provided in his excellent overviews of the various design issues (LeBaron, 2000, 2001c, 2004a). 40.2. Design Considerations A typical agent-based model is made up of a set of autonomous agents that encapsulate the behaviors of the various individuals in a system we are interested in studying and the investigation involves simulating on a computer the interactions of these agents over time. Accordingly, there are two important design considerations in the development of an agent-based model – the design of the agents and the design of the environment. How naive or sophisticated the agents should be modeled really depends on the objective of the research. For instance, if the research objective is to understand how certain market structures affect the allocative efficiency of a market independent of the intelligence of the agents as in Gode and Sunder (1993), then one can simply model the agents as naive ‘‘zero intelligence’’ agents. Zero intelligence agents are agents that are not capable of formulating strategies or learning from their experience; hence their behaviors will be completely random. Gode and Sunder populated their double auction market with zero intelligence agents that are designed to submit their bids and asks at random over a predefined range and remarkably they discover that zero intelligence agents when subjected to a budget constraint are able to allocate the assets in the market at over 97 percent efficiency. The lesson to be learned here is that not all macroscopic regularities that emerge from agent-based models are necessarily consequences of the actions taken by the agents as they evolve and learn from their interactions. In this case, the high level of allocative efficiency that is attained in a double auction market is due to the unique structure of the market itself. However, in many agent-based models, the objective is to investigate the outcome of the interactions among many heterogeneous agents that are designed to mimic their counterparts in the real world. In these models, the key design issues related to the design of the agents are the agents’ preferences and their decision-making behaviors. AGENT-BASED MODELS OF FINANCIAL MARKETS 651 Agents could have either myopic or intertemporal preferences. The latter is more realistic but will make the model much more complex. As we have alluded to earlier, the decision problem that the agents face is usually ill defined, and thus cannot be solved by deductive reasoning. A reasonable solution is to assume that the agents rely on inductive reasoning to arrive at a decision (see Arthur, 1994, 1999; Rescher, 1980). Inductive reasoning or induction is a means for finding the best available answers to questions that transcend the information at hand. In real life, we often have to draw conclusions based upon incomplete information. In these instances, logical deduction fails because the information we have in hand leaves gaps in our reasoning. In order to complete our reasoning, we fill those gaps in the least risky, minimally problematic way, as determined by plausible best-fit considerations. Consequently, the conclusions we draw using induction are suggested by the data at hand rather than logically deduced from them. Inductive reasoning follows a two-step process: possibility elaboration and possibility reduction. The first step involves creating a spectrum of plausible alternatives based on our experience and the information available. In the second step, these alternatives are tested to see how well they answer the question at hand or how well they connect the existing incomplete premises to explain the data observed. The alternative offering the ‘‘best fit’’ is then accepted as a viable explanation. Subse- quently, when new information becomes available or when the underlying premises change, the fit of the current alternative may degrade. When this happens a better alternative will take over. How can inductive reasoning be implemented in an agent-based financial market model? Arthur (1994, 1999) envisions inductive reasoning in a financial market, taking place as follows. Initially, each agent in the market creates a multitude of decision-making rules (this corresponds to the possibility elaboration step discussed above). Next, the decision-making rules are simultaneously tested for their effectiveness based on some criteria. Finally, effective decision-making rules are retained and acted upon in buying and selling decisions. Conversely, unreliable rules are dropped (this corresponds to the possibility reduction step). The rules that are dropped are then replaced with new ones in the first step and the process is carried out repeatedly to model how individuals learn inductively in a constantly evolving financial market. Some examples of criteria that have been used for appraising the effectiveness of the decision rules includes utility maximization, wealth maximization, and forecast errors minimization. Once a decision has been made on a criterion for evaluat- ing the decision-making rules, the next task is to decide the length of historical data to be used in computing the criterion. Although many agent- based models tend to allow the agents to adopt identical history length, this is not necessary. It is in fact more realistic to permit agents in the same model to adopt different history length as in LeBaron (2001a,b). To take the modeling to the next step, decision will have to be made concerning what the decision making rules look like and how they are to be generated in the models? One possibility is to model the decision-making rules after actual trading strategies used in real financial markets. The benefit of this approach is that the results are likely to be tractable and precise and it will also shed light on the interaction among these actual trading strategies. However, this approach does not allow the agents any flexibility in modifying the strategies or developing new strategies. This could impose ad hoc restrictions on the model’s dynamics. Some common tools that have been employed to allow the agents more degrees of freedom in structuring and manipulating the decision making rules as they learn are artificial neural networks (LeBaron, 2001a), genetic programming (Chen and Yeh, 2001), and classifiers that are evolved with genetic algorithms (LeBaron et al., 1999). Even with these artificial intelligence tools, the modeler will need to predefine a set of information variables and functional forms to be used in the 652 ENCYCLOPEDIA OF FINANCE [...]... downside of this approach is that the design of the agent-based model is much more complicated as many details at the institutional as well as the agent level will need to be clearly specified But, this is inevitable if the objective is to simulate realistic market microstructure behavior To sum up, there are many design questions that need to be addressed in the development of an 654 ENCYCLOPEDIA OF FINANCE. .. (2001) ‘‘Application of multi agent games to the prediction of financial time-series.’’ Physica A, (299): 222–227 LeBaron, B., Arthur, W.B., and Palmer, R (1999) ‘‘Time series properties of an artificial stock market.’’ Journal of Economic Dynamics and Control, 23:(9,10), 1487–1516 LeBaron, B (2000) ‘‘Agent-based computational finance: suggested readings and early research.’’ Journal of Economic Dynamics... traders.’’ Journal of Political Economy, 101: 119–137 Grossman, S.J (1976) ‘‘On the efficiency of competitive stock markets where traders have diverse information.’’ Journal of Finance, 31(2), 573 Hommes, C.H (2006) ‘‘Heterogeneous agent models in economics and finance. ’’ In K.L Judd and L Tesfatsion (eds.) Handbook of Computational Economics Volume 2: Agent-Based Computational Economics, Handbooks in Economics... Berlin: Springer-Verlag Rescher, N (1980) Induction: An essay on the Justification of Inductive Reasoning Pittsburgh: University of Pittsburgh Press Tay, N.S.P and Linn, S.C (2001) ‘‘Fuzzy inductive reasoning, expectation formation and the behavior of security prices.’’ Journal of Economic Dynamics and Control, 25(3,4): 321 361 Tesfatsion, L (2002) ‘‘Agent-based computational economics: growing economies... Handbook of Computational Economics Volume 2: Agent-Based Computational Economics, Handbooks in Economics Series Amsterdam: Elsevier North-Holland Farmer, J.D and Joshi, S (2000) ‘‘The price dynamics of common trading strategies.’’ Santa Fe Institute Working Paper 00-12-069, Santa Fe, New Mexico Gode, D.K and Sunder, S (1993) ‘‘Allocative efficiency of markets with zero intelligence traders.’’ Journal of. .. agent-based markets to be cleared analytically each period A critical advantage of this design is that it avoids having to deal with the difficult issue of explicitly modeling the decision-making behaviors of the risk-adverse market maker Unfortunately, this advantage is also a serious shortcoming in that this is not a realistic picture of what is happening in real markets that trade continuously and are rarely... shoe fit all?’’ Technical Report Ottawa, CA: Bank of Canada Batten, D.F (2000) Discovering artificial economics: How agents learn and economies evolve Boulder, CO: Westview Press Chen, S.-H and Yeh, C.-H (2001) ‘‘Evolving traders and the business school with genetic programming: a new architecture of the agent-based artificial stock market.’’ Journal of Economic Dynamics and Control, 25: 363–394 Duffy,... cleared LeBaron (2004a) observes that most of the agent-based models employ one of the following four designs for trading mechanism The simplest trading mechanism is one that allows mutually beneficial trades to be consummated between agents that meet at random Though this trading mechanism is quite simple, it bears some resemblance to the trades conducted on the floor of the Chicago futures and options exchanges... own experiences or from the collective experience of all the agents in the model The latter is known as ‘‘social learning.’’ We will turn our attention next to the design of the financial market environment Most agentbased models simplify the environment to a market with one risky asset and one risk-free asset Clearly, this is an oversimplification of actual financial markets, but there are good reasons... announced beforehand by a market maker The market maker then appraises the aggregate of the orders submitted by the agents, and adjusts next period price by a fixed fraction of the excess demand or supply according to ptþ1 ¼ pt þ a(D(pt ) À S( pt )) Granted that this adaptive price process may be a more reasonable model of how prices adjust in real markets, the problem with this mechanism is that it does . fields of accounting, finance, and law. The Board of Directors had several com- mittees to review various aspects of the company’s policies and operations. There was separation of the offices of. of an aggressive managerial style for the sake of profit maximization? The lesson from Enron is very clear that it does not pay to sacrifice the defensive role when risk 646 ENCYCLOPEDIA OF FINANCE factors. consolidation of Chewco from 1997 through 2001 had an astounding effect on the financial statements. Profits decreased by a total of $405 million over the period of restatement and additional debt of $711

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