Research articles for the 2019-02-28

A novel dynamic asset allocation system using Feature Saliency Hidden Markov models for smart beta investing
Elizabeth Fons,Paula Dawson,Jeffrey Yau,Xiao-jun Zeng,John Keane

The financial crisis of 2008 generated interest in more transparent, rules-based strategies for portfolio construction, with Smart beta strategies emerging as a trend among institutional investors. While they perform well in the long run, these strategies often suffer from severe short-term drawdown (peak-to-trough decline) with fluctuating performance across cycles. To address cyclicality and underperformance, we build a dynamic asset allocation system using Hidden Markov Models (HMMs). We test our system across multiple combinations of smart beta strategies and the resulting portfolios show an improvement in risk-adjusted returns, especially on more return oriented portfolios (up to 50$\%$ in excess of market annually). In addition, we propose a novel smart beta allocation system based on the Feature Saliency HMM (FSHMM) algorithm that performs feature selection simultaneously with the training of the HMM, to improve regime identification. We evaluate our systematic trading system with real life assets using MSCI indices; further, the results (up to 60$\%$ in excess of market annually) show model performance improvement with respect to portfolios built using full feature HMMs.

A numerical scheme for the quantile hedging problem
Cyril Bénézet,Jean-François Chassagneux,Christoph Reisinger

We consider the numerical approximation of the quantile hedging price in a non-linear market. In a Markovian framework, we propose a numerical method based on a Piecewise Constant Policy Timestepping (PCPT) scheme coupled with a monotone finite difference approximation. We prove the convergence of our algorithm combining BSDE arguments with the Barles & Jakobsen and Barles & Souganidis approaches for non-linear equations. In a numerical section, we illustrate the efficiency of our scheme by considering a financial example in a market with imperfections.

Characterizing Cryptocurrency market with Levy's stable distributions
Shinji Kakinaka,Ken Umeno

Recent emergence of cryptocurrencies such as Bitcoin and Ethereum has posed possible alternatives to global payments as well as financial assets around the globe, making investors and financial regulators aware of the importance to modeling them properly. The Levy's stable distribution is one of the attractive distribution that well describes the fat tails and scaling phenomena in economic systems. In this paper, we show that the behaviors of price fluctuations in cryptocurrency markets can also be characterized by a Levy's stable distribution under certain conditions of time intervals ranging from 30 minutes to 4 hours. The arguments are developed under the theoretical background of the General Central Limit Theorem (GCLT) and quantitative valuation defined as a distance function using the Parseval's relation. Our approach can generally be extended for further analysis of statistical properties and applications for financial modeling.

Climate Change and Agriculture: Subsistence Farmers' Response to Extreme Heat
Fernando M. Aragón,Francisco Oteiza,Juan Pablo Rud

This paper examines how subsistence farmers respond to extreme heat. Using micro-data from Peruvian households, we find that high temperatures reduce agricultural productivity, increase area planted, and change crop mix. These findings are consistent with farmers using input adjustments as a short-term mechanism to attenuate the effect of extreme heat on output. This response seems to complement other coping strategies, such as selling livestock, but exacerbates the drop in yields, a standard measure of agricultural productivity. Using our estimates, we show that accounting for land adjustments is important to quantify damages associated with climate change.

Corporate Sustainability: Do Executives and Investors Care? An Empirical Study
Amba, Sekhar Muni
This research examines the association between corporate sustainability reporting ESG score and firm’s financial performance, Executive compensation. Empirical analysis is performed on firms listed on S&P 500 and S&P/TSX firms. Regression method is used to test the impact of ESG score of a year on next years’ ROE and Executive compensation. Empirical evidence suggests that ESG scores of an year has an impact on ROE of the following year during the period of investigation 2011 to 2015, whereas ESG scores showed similar impact on Executive compensation from the year 2013 onwards suggesting executive compensation is tied to corporate sustainability performance.

Correlation Patterns in Foreign Exchange Markets
Lasko Basnarkov,Viktor Stojkoski,Zoran Utkovski,Ljupco Kocarev

The value of an asset in a financial market is given in terms of another asset known as numeraire. The dynamics of the value is non-stationary and hence, to quantify the relationships between different assets, one requires convenient measures such as the means and covariances of the respective log returns. Here, we develop transformation equations for these means and covariances when one changes the numeraire. The results are verified by a thorough empirical analysis capturing the dynamics of numerous assets in a foreign exchange market. We show that the partial correlations between pairs of assets are invariant under the change of the numeraire. This observable quantifies the relationship between two assets, while the influence of the rest is removed. As such the partial correlations uncover intriguing observations which may not be easily noticed in the ordinary correlation analysis.

Digesting Anomalies in Emerging European Markets: A Comparison of Factor Pricing Models
Zaremba, Adam,Czapkiewicz, Anna
This study compares the performance of four popular factor pricing modelsâ€"the capital asset-pricing model (Sharpe, 1964), the three-factor model of Fama and French (1993), the four-factor model of Carhart (1997), and the five-factor model of Fama and French (2015a)â€"testing their explanatory power over a broad range of cross-sectional return patterns in emerging European markets. We identify, classify, and replicate 100 anomalies documented in the financial literature. Only 20 (32) of the capitalization-weighted (equal-weighted) anomaly portfolios are significantly profitable. We show that the five-factor model best explains the returns of anomaly portfolios and verify its superiority over the other models.

Do Style Momentum Strategies Produce Abnormal Returns: Evidence from Index Investing
Liu, Zugang,Wang, Jia
In this study, we investigate the return enhancement ability of style momentum strategy: a strategy that switches between value and growth styles based on previous performance. We explore the variation in abnormal returns of long-only and long-short momentum strategies using various style based indexes (Russell value/growth indexes, Fama-French value/growth indexes, and MSCI value/growth indexes) where value and growth stocks are classified using different criteria. Our results show that the performance of style momentum does vary across different index families. We first find that in general the long-only strategies create significant positive abnormal returns whereas the long-short strategies do not. Second, for a fixed formation period, abnormal returns of the strategies tend to decrease when the length of holding periods increase. Third, abnormal returns are stronger and more significant when rotating within large cap value and growth indexes while abnormal returns are weaker and inconsistent when rotating within small cap value and growth indexes. Fourth, strategies based on rotating across all market cap levels do not generate consistently significant positive abnormal returns for Russell indexes or Fama-French indexes but they do for MSCI indexes. Fifth, individual stock momentum only explains a very small portion of the returns of style moment strategies

Financial series prediction using Attention LSTM
Sangyeon Kim,Myungjoo Kang

Financial time series prediction, especially with machine learning techniques, is an extensive field of study. In recent times, deep learning methods (especially time series analysis) have performed outstandingly for various industrial problems, with better prediction than machine learning methods. Moreover, many researchers have used deep learning methods to predict financial time series with various models in recent years. In this paper, we will compare various deep learning models, such as multilayer perceptron (MLP), one-dimensional convolutional neural networks (1D CNN), stacked long short-term memory (stacked LSTM), attention networks, and weighted attention networks for financial time series prediction. In particular, attention LSTM is not only used for prediction, but also for visualizing intermediate outputs to analyze the reason of prediction; therefore, we will show an example for understanding the model prediction intuitively with attention vectors. In addition, we focus on time and factors, which lead to an easy understanding of why certain trends are predicted when accessing a given time series table. We also modify the loss functions of the attention models with weighted categorical cross entropy; our proposed model produces a 0.76 hit ratio, which is superior to those of other methods for predicting the trends of the KOSPI 200.

From Az\'ema supermartingales of finite honest times to optional semimartingales of class-($\Sigma$)
Libo Li

Given a finite honest time, we derive representations for the additive and multiplicative decomposition of it's Az\'ema supermartingale in terms of optional supermartingales and its running supremum. We then extend the notion of semimartingales of class-$(\Sigma)$ to optional semimartingales with jumps in its finite variation part, allowing one to establish formulas similar to the Madan-Roynette-Yor option pricing formulas for larger class of processes.

From Glosten-Milgrom to the whole limit order book and applications to financial regulation
Weibing Huang,Mathieu Rosenbaum,Pamela Saliba

We build an agent-based model for the order book with three types of market participants: informed trader, noise trader and competitive market makers. Using a Glosten-Milgrom like approach, we are able to deduce the whole limit order book (bid-ask spread and volume available at each price) from the interactions between the different agents. More precisely, we obtain a link between efficient price dynamic, proportion of trades due to the noise trader, traded volume, bid-ask spread and equilibrium limit order book state. With this model, we provide a relevant tool for regulators and market platforms. We show for example that it allows us to forecast consequences of a tick size change on the microstructure of an asset. It also enables us to value quantitatively the queue position of a limit order in the book.

Has Regulatory Capital Made Banks Safer? Skin in the Game vs Moral Hazard
Dautović, Ernest
The paper evaluates the impact of macroprudential capital regulation on bank capital, risk taking behaviour, and solvency. The identification relies on the policy change in bank-level capital requirements across systemically important banks in Europe. A one percentage point hike in capital requirements leads to an average CET1 capital increase of 13 percent and no evidence of reduction in assets. The increase in capital comes at a cost. The paper documents robust evidence on the existence of substitution effects toward riskier assets. The risk taking behavior is predominantly driven by large and less profitable banks: large wholesale funded banks show less risk taking, and large banks relying on internal ratings based approach successfully disguise their risk taking. In terms of overall impact on solvency, the higher risk taking crowds-out the positive effect of increased capital.

Limits to Arbitrage, Investor Sentiment, and Factor Returns in International Government Bond Markets
Zaremba, Adam,Szczygielski, Jan
The perspective of behavioral finance is that anomalies in the cross-section of returns are driven by mispricing that arises from investor irrationality that cannot be easily arbitraged away. In this study, we examine the implications of this for international government bond markets. Using data for 25 countries for the years 1992â€"2015, we replicate multiple factor strategies that represent four major return drivers: defensive (low-risk), carry, value and momentum. We investigate the relationships between the performance of these strategies and market-wide measures of limits to arbitrage and investor sentiment. We find that the defensive strategy performs best during tight arbitrage conditions whereas severe limits to arbitrage negatively affect momentum profits.

Long and Short Memory in the Risk-Neutral Pricing Process
Kim, Young Shin,Jiang, Danling,Stoyanov, Stoyan V.
The paper proposes a semimartingale approximation to a fractional Levy processes that is capable of capturing long and short memory in the stochastic process together with fat tails. We use the semimartingale process in option pricing and empirically compare its performance to other option pricing models including a stochastic volatility Levy process. We contribute to the empirical literature by being the first to report the implied Hurst index computed from observed option prices using the Levy process model. Calibrating the implied Hurst index of S&P500 option prices in a period that covers the 2008 financial crisis, we find that the risk neutral measure is characterized by a short memory in turbulent markets and a long memory in calm markets.

Nothing Lasts Forever (And Everywhere): Fundamental Indexation at the Global Level
Zaremba, Adam,Miziołek, Tomasz
Fundamental indexation is commonly employed to form portfolios of stocks, but can we also use it to form portfolios of countries? The authors investigate whether fundamental weighting can be applied to enhance the profits from international diversification. To this end, they form and evaluate fundamental indexation strategies within an up-to-date sample of equity benchmarks covering 71 countries for the years 1995â€"2017. The fundamentally weighted portfolios indeed outperform capitalization-weighted indexes, but significant benefits are largely limited to emerging and frontier markets and almost disappear from the post-2007 period. The abnormal returns result from additional exposure to country-level value and size effects, which have delivered disappointing performance in the past decade.

Optimal Financial Contracting and Risk-Shifting
Han, DongJoon
I study optimal financial contracting in the presence of two capital market frictions. When cash flow realizations are not verifiable, firms have an incentive to divert cash by under-reporting. Second, when firms' project choices are not verifiable, they may have an incentive to choose riskier projects ex-post than desired by their financiers. Using an optimal contracting framework, I show these two frictions are intricately linked: to address the cash-diversion problem, an optimal contract resembles a debt contract, which in turn causes the asset-substitution problem. The effects of such an endogenous asset-substitution problem on the firm'’s financing costs, and thus the implications for welfare, depend on the market structure: the cost for public debt increases, but it decreases for private debt. Strikingly, however, regardless of the market structure, the asset-substitution problem leads to a more efficient risk-profile choice.

Option Pricing with Heavy-Tailed Distributions of Logarithmic Returns
Lasko Basnarkov,Viktor Stojkoski,Zoran Utkovski,Ljupco Kocarev

A growing body of literature suggests that heavy tailed distributions represent an adequate model for the observations of log returns of stocks. Motivated by these findings, here we develop a discrete time framework for pricing of European options. Probability density functions of log returns for different periods are conveniently taken to be convolutions of the Student's t-distribution with three degrees of freedom. The supports of these distributions are truncated in order to obtain finite values for the options. Within this framework, options with different strikes and maturities for one stock rely on a single parameter - the standard deviation of the Student's t-distribution for unit period. We provide a study which shows that the distribution support width has weak influence on the option prices for certain range of values of the width. It is furthermore shown that such family of truncated distributions approximately satisfies the no-arbitrage principle and the put-call parity. The relevance of the pricing procedure is empirically verified by obtaining remarkably good match of the numerically computed values by our scheme to real market data.

Performance Persistence of Government Bond Factor Premia
Zaremba, Adam
This study investigates the momentum effect in factor premia in international government bond markets. The investigations are based on a range of fixed-income factor strategies related to volatility, credit risk, value, and momentum that are tested in a sample of data from 25 countries for the years 1992â€"2016. We demonstrate a strong and robust long-run performance persistence in the returns on factor portfolios of government bonds. Furthermore, our results support the view that the momentum in factor premia is driven by cross-sectional differences in expected returns on various factors rather than by behavioral overreaction.

Rentabilidad de los Fondos de Inversión en España, 2003-2018 (Return of Mutual Funds in Spain, 2003-2018)
Fernandez, Pablo,Fernández Acín, Juan,Martinez, Mar
Spanish Abstract: La rentabilidad media de los fondos de inversión en España en los últimos 15 años (2,39%) fue inferior a la inversión en bonos del estado español a 15 años (4,55%) y a la inversión en el IBEX 35 (5,33%). 69 fondos de los 642 con 15 años tuvieron una rentabilidad superior a la de los bonos del estado a 15 años y 45 a la del IBEX 35. 17 tuvieron rentabilidad negativa. El fondo más rentable proporcionó en los últimos 15 años a sus partícipes una rentabilidad total del 282% (promedio 9,35%) y el menos rentable del -59% (promedio -5,8%). English Abstract: The average return on investment funds in Spain in the last 15 years (2.39%) was lower than investment in government bonds to 15 years (4.55%) and investment in the IBEX 35 (5.33%). 69 of the 642 funds with 15 years had a higher return than 15-year government bonds . The most profitable fund provided in the last 15 years to its investors a total return of 282% (average 9.35%) and the least profitable of -59% (average -5.8%).

Return Seasonalities in Government Bonds and Macroeconomic Risk
Mikutowski, Mateusz,Karathanasopoulos, Andreas,Zaremba, Adam
We present a novel explanation of the cross-sectional seasonality anomaly in government bond returns. The macroeconomic risk premia may accrue unevenly during the calendar year, and the pattern may be transferred to government bond prices. We decompose the seasonality strategy payoffs into predicted and unexpected components. The seasonality effect plays a role only for the predicted component, linking the sources of the phenomenon with macroeconomic risk factors.

Seasonality in the Cross Section of Factor Premia
Zaremba, Adam
This study examines the seasonality effect in the cross section of factor premia representing a broad set of stock market strategies. Using cross-sectional and time-series tests, we investigated the cross-sectional seasonality of market, value, size, momentum, quality, and low-risk premia within a sample of 24 international equity markets for the years 1986â€"2016. We provide convincing evidence that the factors with the highest (lowest) mean returns in the same calendar months in the past continue to overperform (underperform) in seven of the studied countries: Denmark, Finland, France, Israel, Spain, Sweden, and the United States. Furthermore, when the factors in multiple countries are considered, the past same-month returns display strong predictive power for future size and low-risk premia.

Sectoral Credit Cycles and Systemic Risk in the United States
Ferrari, Stijn,Rovira Kaltwasser, Pablo
This paper studies the properties and systemic risk implications of sectoral credit cycles for the United States over the period 1960Q1 â€" 2017Q3. The analysis shows that the credit cycle in the United States was indeed characterised by systemically relevant sector-specific boom/bust cycles during our sample period. Sectoral credit exuberance, with the exception of consumer credit, generally does not lead to broader credit exuberance within a period of one year. Taken together, these findings indicate that it may be useful to act upon sectoral credit cycles rather than on broad-based credit developments. Regarding the systemic relevance of sector-specific boom/bust cycles, the results indicate that CRE is the most systemic credit segment: exuberance in the sector-specific component of the CRE credit-to-GDP gap tends to be followed by a surge in financial stress and borrower delinquencies. Exuberance in the residential mortgage sector may also lead to financial stress and tends to be followed by a moderate rise in borrower delinquency rates. For sufficiently large shocks to C&I credit, there has been an increase in the aggregate credit risk at commercial banks in the United States, albeit not as strong as following sector-specific shocks to RRE and CRE mortgages. Finally, losses following a period of exuberance in sectoral credit developments are not necessarily limited to the exuberant credit segments. In particular, exuberance in CRE and RRE mortgage credit tends to raise delinquency rates in credit segments beyond real estate.

Taiwan and U.S. Equity Market Interdependence and Contagion: Evidence from Four-Factor Model
Li, Chun An,Lee, Min-Ching,Huang, Chin-Sheng
A four-factor model is used to measure the interdependence’s co-movement and crisis’ contagion effect on portfolio returns of 23 Taiwanese industries during tranquil and the U.S. subprime mortgage crisis periods. By incorporating the control variables of economic and financial fundamentals, we deconstruct the relevance of returns on industrial assets’ channels. The empirical results show that the co-movement effect on Taiwan’s industrial portfolios returns are affected by “global,” “regional,” and “domestic” factors. Additionally, in the subprime mortgage crisis period, the contagion effect of Taiwan’s industrial portfolios returns was affected by the domestic and crisis factor. Based on our empirical study, the transmission of Taiwan’s industrial portfolio returns channel is significantly impacted by the instrument variables of interest rate, trade integration, political stability, and government budgets of the economy fundamentals.

The Effect of Institutional Ownership on Firm Performance: The Case of U.S. Listed Shipping Companies
Tsouknidis, Dimitris A.
This paper examines the relationship between institutional ownership and firm performance for US listed shipping companies using quarterly 13F reports of institutional holdings over the period 2002 to 2016. Traditionally, public shipping companies exhibit a large concentration of ownership as specific individuals and families hold large percentages of the total shares outstanding. However, institutional investors also hold a substantial percentage of ownership of U.S. listed shipping firms, whose effects on firm performance have not been examined previously in the literature. Results reveal a negative relationship between the percentage of institutional ownership and firm performance, which is primarily attributed to non-strategic rather than strategic institutional investors. This result survives a set of panel data estimators which take into account the presence of dynamic endogeneity in the relationship examined.

The Effects of Macroeconomic, Fiscal and Monetary Policy Announcements on Sovereign Bond Spreads: An Event Study from the EMU
Afonso, Antonio,Jalles, João Tovar,Kazemi, Mina
We assess the impact of announcements corresponding to different fiscal and monetary policy measures on the 10-year sovereign bond yield spreads (relative to Germany) of the 10 EMU countries during the period 01:1999 - 07:2016. Implementing pooled and country-fixed effects OLS regressions, we find that the European Commission’s (EC) releases of the excessive deficit procedure significantly affect the yield spreads. The EC releases of higher debt and better budget balance forecasts contribute to the rise and the decline of spreads, respectively. Moreover, we find that the announcements of the ECB’s key interest rates together with the longer-term refinancing operations (LTROs) and the first covered bond purchase programme (CBPP1) negatively affect sovereign yield spreads in our sample of EMU countries.

The Social Value of Asymmetric Information Revisited
He, Xuezhong,Shi, Lei,Tolotti, Marco
In contrary to previous literature, we show in the Grossman-Stiglitz model of noisy rational expectation that the social value of asymmetric information can be improved with more informative prices when being informed is uncertain. Investors always benefit from a privately payoff-relevant information, but they have to pay more to increase the probability of observing the information. In equilibrium, this trade-off can lead to high-risk, high return investments. Consequently the marginal expected utility gain from observing the information is not completely washed out by the cost of information acquisition, which leads to Pareto-optimal equilibrium and improves investors' welfare.

Three Different Ways Synchronization Can Cause Contagion in Financial Markets
Naji Massad,Jørgen Vitting Andersen

We introduce tools to capture the dynamics of three different pathways, in which the synchronization of human decision-making could lead to turbulent periods and contagion phenomena in financial markets. The first pathway is caused when stock market indices, seen as a set of coupled integrate-and-fire oscillators, synchronize in frequency. The integrate-and-fire dynamics happens due to change blindness, a trait in human decision-making where people have the tendency to ignore small changes, but take action when a large change happens. The second pathway happens due to feedback mechanisms between market performance and the use of certain (decoupled) trading strategies. The third pathway occurs through the effects of communication and its impact on human decision-making. A model is introduced in which financial market performance has an impact on decision-making through communication between people. Conversely, the sentiment created via communication has an impact on financial market performance. The methodologies used are: agent based modeling, models of integrate-and-fire oscillators, and communication models of human decision-making

Understanding China’s Evolving Credit Risk Maze
Anderson, Ronald W.
This paper analyses factors that account for credit risk in the Chinese market for bonds issued by non-financial enterprises. By exploring a data set of covering monthly observations of individual corporate and enterprise bonds a number of important structural features of the market are seen to account for cross sectional and time series variations of yield spreads. The analysis sheds light on the issue of implicit government guarantees. The results suggest that steps taken by Chinese authorities to restructure local public finance are concentrating such guarantees to a few segments and are bringing greater financial discipline to other segments of the market.