Research articles for the 2019-03-05

A Score-Driven Conditional Correlation Model for Noisy and Asynchronous Data: an Application to High-Frequency Covariance Dynamics
Giuseppe Buccheri,Giacomo Bormetti,Fulvio Corsi,Fabrizio Lillo

The analysis of the intraday dynamics of correlations among high-frequency returns is challenging due to the presence of asynchronous trading and market microstructure noise. Both effects may lead to significant data reduction and may severely underestimate correlations if traditional methods for low-frequency data are employed. We propose to model intraday log-prices through a multivariate local-level model with score-driven covariance matrices and to treat asynchronicity as a missing value problem. The main advantages of this approach are: (i) all available data are used when filtering correlations, (ii) market microstructure noise is taken into account, (iii) estimation is performed through standard maximum likelihood methods. Our empirical analysis, performed on 1-second NYSE data, shows that opening hours are dominated by idiosyncratic risk and that a market factor progressively emerges in the second part of the day. The method can be used as a nowcasting tool for high-frequency data, allowing to study the real-time response of covariances to macro-news announcements and to build intraday portfolios with very short optimization horizons.

Asymptotic Expansion as Prior Knowledge in Deep Learning Method for high dimensional BSDEs
Masaaki Fujii,Akihiko Takahashi,Masayuki Takahashi

We demonstrate that the use of asymptotic expansion as prior knowledge in the "deep BSDE solver", which is a deep learning method for high dimensional BSDEs proposed by Weinan E, Han & Jentzen (2017), drastically reduces the loss function and accelerates the speed of convergence. We illustrate the technique and its implications by using Bergman's model with different lending and borrowing rates as a typical model for FVA as well as a class of solvable BSDEs with quadratic growth drivers. We also present an extension of the deep BSDE solver for reflected BSDEs representing American option prices.

Big Data and Firm Dynamics
Farboodi, Maryam,Mihet, Roxana,Philippon, Thomas,Veldkamp, Laura
We study a model where firms accumulate data as a valuable intangible asset. Data accumulation affects firms’ dynamics. It increases the skewness of the firm size distribution as large firms generate more data and invest more in active experimentation. On the other hand, small data-savvy firms can overtake more traditional incumbents, provided they can finance their initial money-losing growth. Our model can be used to estimate the market and social value of data.

Cross-shareholding networks and stock price synchronicity: Evidence from China
Fenghua Wen,Yujie Yuan,Wei-Xing Zhou

This paper investigates the effect of cross-shareholding on stock price synchronicity, as a measure of price informativeness, of the listed firms in the Chinese stock market. We gauge firms' levels of cross-shareholdings in terms of centrality in the cross-shareholding network. It is confirmed that it is through a noise-reducing process that cross-shareholding promotes price synchronicity and reduces price delay. More importantly, this effect on price informativeness is pronounced for large firms and in the periods of market downturns. Overall, our analyses provide insights into the relation between the ownership structure and price informativeness.

Digital Financial Services (FINTECH) in Latin America
Clavijo, Sergio,Vera, Nelson,Beltran, Daniel,Londoño, Juan Diego
This document assesses the degree of disruptive power of the application of cutting-edge technologies to financial services at a global level (a phenomenon known as Fintech). From there, we analyze the implications that this trend is having on the development of the banking system, with particular focus on the case of Latin America.In this field, digital platforms are competing vigorously, although large technology companies have clear advantages (most regarding user data) should they decide to enter Fintech full-on. It is worth mentioning the specific business approaches of Google (Artificial Intelligence), Amazon (cloud computing-Big Data), Apple (cellular connectivity), Microsoft (corporate applications and cloud computing) and Facebook (Big Data management in social networks). In parallel, massive transactional systems of P2P payment systems and the so-called "digital-wallets" (Paypal, Wechat-Tencent and even WhatsApp) are growing as important alternatives within the context of financial markets, representing a source of tension for the traditional banking business. The conclusion is that the traditional banking industry perceives latent competitive threats from this Fintech revolution. That is why it has awakened in recent years with waves of acquisitions-alliances with Fintech startups (improving their human capital in the process), in order to achieve better provision of technological services through the so-called "internal innovation hubs" (although they are also using outsourcing models for particular aspects of the business model).This paper also reports the results of a bank-survey on the development of Fintech-Digital Banking in Latin America. Being aware of Fintech´s competitive threats, the surveyed banks are reacting through strategies of: i) alliances with Fintech companies (36% of the sample); ii) "organic" innovation within banks (29% of the sample), where many entities have implemented their own internal "digital laboratories" or "innovation hubs"; iii) outsourcing of digital services to Fintech companies (21% of the sample); and iv) acquisition of Fintech companies (9%). In addition, results suggest that the region shows favorable elements of development in digital banking supply, although there are persistent lags of adoption of those digital banking services on the demand side (where most users still prefer traditional banking channels such as physical offices).Regarding prospective challenges for the development of digital banking in Latin America, the survey established concerns in key areas pertaining to: i) changes in the current regulatory framework; ii) the recurring theme of cybersecurity; and iii) overcoming cultural resistance within the banks themselves. Finally, surveyed banks project that, during the next five years, traditional banking and startups will end up “slicing” the industry in different niches of the market, while 34% think that their reactive innovation strategies will be enough to maintain their banking leadership. This document also presents the details of the countries´ individual results (Colombia, Paraguay, Perú, Ecuador, México and Argentina).

Do Investors Turn a Blind Eye to Risk-Factor Disclosures by State-Controlled Firms?
Chen, Feng,Yao, Yi,Zhao, Mei
We examine investor responses to risk-factor disclosures in Initial Public Offerings (IPO) prospectuses in China, which is characterized as a state-controlled economy. In such an economy, state-controlled firms receive various preferential treatments from the government, resulting in lower operating and bankruptcy risks compared to non-state-controlled firms. Consistent with the theoretical conjecture that more risk-factor disclosures reduce cost of equity, our results indicate that, high-quality risk-factor disclosures are associated with less IPO underpricing and lower post-IPO stock return volatility among non-state-controlled IPO firms. However, we find an insignificant association between risk-factor disclosure quality and IPO underpricing (or post-IPO stock return volatility) among state-controlled firms. Our findings suggest that state-offered implicit insurance becomes the predominant consideration when investors value IPO shares of state-controlled firms, thereby weakening the investor demand for high-quality risk-factor disclosures. Our study highlights the importance of considering the state control effect, which renders the high-quality risk disclosures ineffective for state-controlled firms in economies with significant government involvement.

Elusive Longer-Run Impacts of Head Start: Replications Within and Across Cohorts
Remy J.-C. Pages,Dylan J. Lukes,Drew H. Bailey,Greg J. Duncan

Using an additional decade of CNLSY data, this study replicated and extended Deming's (2009) evaluation of Head Start's life-cycle skill formation impacts in three ways. Extending the measurement interval for Deming's adulthood outcomes, we found no statistically significant impacts on earnings and mixed evidence on other adult outcomes. Applying Deming's sibling comparison framework to more recent birth cohorts born to CNLSY mothers revealed mostly negative Head Start impacts. Combining all cohorts shows generally null impacts on school-age and early adulthood outcomes.

Entrepreneurial Incentives and the Role of Initial Coin Offerings
Garratt, Rodney,van Oordt, Maarten R.C.
Initial coin offerings (ICOs) are a new mode of financing start-ups that saw an explosion in popularity in 2017, but declined in popularity in the second half of 2018 as regulatory pressure, instances of fraud and reports of poor performance began to undermine their reputation. We examine whether ICOs are a passing fad or a worthwhile form of financing with beneficial economic properties. We do so by examining how financing a start-up through an ICO changes the incentives of an entrepreneur relative to debt and venture capital financing. Depending on market characteristics, an ICO can result in a better or worse alignment of the interests of the entrepreneur and the investors compared to conventional modes of financing. Notably, an ICO can be the only form of financing that induces optimal effort and hence maximizes the net present value of the start-up and there are projects that should not take place at all unless they can be financed through an ICO.

Externalities in Knowledge Production: Evidence from a Randomized Field Experiment
Marit Hinnosaar,Toomas Hinnosaar,Michael Kummer,Olga Slivko

Are there positive or negative externalities in knowledge production? Do current contributions to knowledge production increase or decrease the future growth of knowledge? We use a randomized field experiment, which added relevant content to some pages in Wikipedia while leaving similar pages unchanged. We find that the addition of content has a negligible impact on the subsequent long-run growth of content. Our results have implications for information seeding and incentivizing contributions, implying that additional content does not generate sizable externalities by inspiring nor discouraging future contributions.

Finance in Economic Growth: Eating the Family Cow
Temin, Peter
The American economy changed rapidly in the last half-century. The National Income and Product Accounts (NIPA) were designed before these changes started. They have stretched to accommodate new and growing service activities, but they are still organized for an industrial economy. It is hard to fit finance into the measurement of national product and of economic growth, and similar problems bedevil efforts to include other intangible investments as well. I describe how our current accounts deal with these problems, and I argue that existing NIPA data fail to describe the future path of growth in our new economy because they lack output data on financial, human and social capital investments. They fail to show that the United States is consuming its capital stock now and will suffer later, rather like killing the family cow to have a steak dinner.

Fit and Proper Assessments within the Single Supervisory Mechanism
Busch, Danny,Teubner, Annick
A fit and proper management body and fit and proper key function holders are key drivers of good governance. The banks are primary responsible for ensuring this, while the assessment by the ECB and national competent authorities have the aim to ensure that banks comply with the requirements regarding robust governance arrangements and the suitability requirements. Over the past years convergence of fit and proper assessments within the SSM has been achieved on the one hand through harmonisation of the rules laid down in CRD IV and the EBA Guidelines on suitability, and on the other hand through consistent application of these rules. Nevertheless, there is still a wide variety of national practices regarding fit and proper assessments, due to the fact that there are limits to convergence in this area. These relate to:(1) the transposition of and the level of harmonisation by CRD IV; (2) the limits to harmonisation through the EBA guidelines on suitability; and (3) the requirement for the ECB to apply national law. With every step towards more harmonisation and consistency, the existing national variations will become more obvious and underline the need for more harmonisation.

Implementing a financial derivative as smart contract
Christian Fries,Peter Kohl-Landgraf,Björn Paffen,Stefanie Weddigen,Luca Del Re,Wilfried Schütte,David Bacher,Rebecca Declara,Daniel Eichsteller,Florian Weichand,Michael Streubel

In this note we describe the application of existing smart contract technologies with the aim to construct a new digital representation of a financial derivative contract. We compare several existing DLT based technologies. We provide a detailed description of two separate prototypes which are able to be executed on a centralized and on a DLT platform respectively. Beyond that we highlight some insights on legal aspects as well as on common integration challenges regarding existing process and system landscapes. For a further introductory note and motivation on the theoretical concept we refer to . A very detailed methodological overview of the concept of a smart derivative contract can be found in doi:10.2139/ssrn.3163074.

Influence of petroleum and gas trade on EU economies from the reduced Google matrix analysis of UN COMTRADE data
Célestin Coquidé,Leonardo Ermann,José Lages,D.L. Shepelyansky

Using the United Nations COMTRADE database we apply the reduced Google matrix (REGOMAX) algorithm to analyze the multiproduct world trade in years 2004-2016. Our approach allows to determine the trade balance sensitivity of a group of countries to a specific product price increase from a specific exporting country taking into account all direct and indirect trade pathways via all world countries exchanging 61 UN COMTRADE identified trade products. On the basis of this approach we present the influence of trade in petroleum and gas products from Russia, USA, Saudi Arabia and Norway determining the sensitivity of each EU country. We show that the REGOMAX approach provides a new and more detailed analysis of trade influence propagation comparing to the usual approach based on export and import flows.

Initial Coin Offerings (ICOs): Economics and Regulation
Klöhn, Lars,Parhofer, Nicolas,Resas, Daniel
Initial Coin Offerings (or Token Sales) are currently the “hottest game in town” in capital markets law. The discussion revolves around two core questions: Do token sales fall within the scope of existing EU capital markets legislation and do they warrant specific regulation? We will try to answer the first question while building a foundation for discussing the second question. To provide a complete picture, we examine the key economics of ICO-financed projects, their up- and downsides for investors and draw a comparison to regulatory activities both in the US and Switzerland.

Looking Forward to Backward-Looking Rates: A Modeling Framework for Term Rates Replacing LIBOR
Lyashenko, Andrei,Mercurio, Fabio
In this paper, we define and model forward risk-free term rates, which appear in the payoff definition of derivatives, and possibly cash instruments, based on the new interest-rate benchmarks that will be replacing IBORs globally. We show that the classical interest rate modeling framework can be naturally extended to describe the evolution of both the forward-looking (IBOR-like) and backward-looking (setting-in-arrears) term rates using the same stochastic process. In particular, we show that the extension of the popular LIBOR Market Model (LMM) to the backward-looking rates completes the model by providing additional information about the rate dynamics not accessible in the LMM.

MAR’s Jar? Information Quality
Patel, Jatine,Ringe, Wolf-Georg
If regulation is to improve the quality and efficiency of information in financial markets, its ability to separate abusive conduct from non-abusive is critical. It is critical because the speed and accuracy of algorithmic trading can exploit the error margin such that the costs of the current form of regulating market abuse outweigh its benefits.This article focuses on the European Union’s Market Abuse Regulation (“MAR”), and notes that MAR’s approach seems to have significantly reduced the information quality of innovative public companies’ securities markets. This is because of MAR’s error and administrative costs. Indeed, as we show through several difference-in-differences analyses, its current method of regulators and courts deciding what information is ‘false or misleading’ and what effect that information has on markets seems harmful for innovative businesses - because of how it affects the quality of information that is available to their markets. MAR, it seems, has the potential to negatively affect market integrity and consequently corporate governance, and investor protection. This is increasingly concerning because of the potential of algorithmic trading. We explain however, why the right kind of regulatory competition can assist us in both learning about how to manage manipulation issues, and matching the right regulation to investors and investments.Historically the debate about whether to ‘regulate’ insider trading and market manipulation has been robust. Perhaps the debate should focus on how to regulate.

Multiple Barrier-Crossings of an Ornstein-Uhlenbeck Diffusion in Consecutive Periods
Jiang, Yupeng,Macrina, Andrea,Peters, Gareth
We investigate the joint distribution and the multivariate survival functions for the maxima of an Ornstein-Uhlenbeck (OU) process in consecutive time-intervals. A PDE method, along- side an eigenfunction expansion is adopted, with which we are able to calculate the distribution and the survival functions for the maxima of a homogeneous OU-process in a single interval. By a deterministic time-change and a parameter translation, this result can be extended to an inhomogeneous OU-process. Moreover, we derive a general formula for the joint distribution and the survival functions for the maxima of a continuous Markov process in consecutive periods. With these results, one can obtain semi-analytical expressions for the joint distribution and the multivariate survival functions for the consecutive maxima of an OU-process with piecewise constant parameter functions. The joint distribution and the survival functions can be evaluated numerically by an iterated quadrature scheme, which can be implemented efficiently by matrix multiplications. Moreover, we show that the computation can be further simplified to the product of single quadratures if the filtration is enlarged with additional conditions. Such results may be used for the modelling of heat waves and related risk management challenges.

Multiscale Features of Cross Correlation of Price and Trading Volume
Jamshid Ardalankia,Mohammad Osoolian,Emmanuel Haven,G.Reza Jafari

Price without transaction makes no sense. Trading volume authenticates its corresponding price, so there is mutual information and entanglement between price and volume. On the other hand, we are curious about scaling features of this entanglement and need to know how structures in different scales translate information. So, markets are faced with a variety of dimensions of price and trading volume. Investment size (volume), price-wise expectations (gain/loss), and time-wise expectations (time-scale) differ from one investor to another. This study, by applying the MF-DXA method, demonstrates that price and trading volume and their coupling contain power law information and are multifractal in the markets we investigated. Also, the resultant correlation coefficients present scaling behaviors which are totally significant in the investigated time-scales and they decrease with increasing time-scales. Meanwhile, considering developed markets, the price-volume coupling is more dominated by trading volume rather than price. This domination increases price validity. We can confirm that in a developed market, traders, with a certain price, are more rational and show their enthusiasm to price by applying trading volume. This approach for emerging markets is weak. As a whole, in emerging markets, market behavior is guided by a phenomenon other than volume.

New Evidence on the Portfolio Balance Approach to Currency Returns
Cavusoglu, Nevin,Goldberg, Michael D.,Stillwagon, Joshua
This paper re-examines the empirical performance of the portfolio balance approach to currency returns. It considers the implications of two alternative specifications of preferences: one based on expected utility theory and the other on prospect theory. It also uses survey data to estimate models of ex-ante rather than ex-post returns. The empirical analysis relies on the co-integrated VAR framework, which is well suited for testing competing models and dealing with unit roots. Like earlier studies, we find little support for the expected utility theory model. By contrast, the prospect theory model’s predictions are largely borne out in the data, including those about sign reversals. We find the strongest support for a hybrid model that incorporates the risk factors of both portfolio balance specifications.

Optimal Learning under Robustness and Time-Consistency
Larry G. Epstein,Shaolin Ji

We model learning in a continuous-time Brownian setting where there is prior ambiguity. The associated model of preference values robustness and is time-consistent. It is applied to study optimal learning when the choice between actions can be postponed, at a per-unit-time cost, in order to observe a signal that provides information about an unknown parameter. The corresponding optimal stopping problem is solved in closed-form, with a focus on two specific settings: Ellsberg's two-urn thought experiment expanded to allow learning before the choice of bets, and a robust version of the classical problem of sequential testing of two simple hypotheses about the unknown drift of a Wiener process. In both cases, the link between robustness and the demand for learning is studied.

Over-the-Counter Market Liquidity and Securities Lending
Foley-Fisher, Nathan,Gissler, Stefan,Verani, Stephane
This paper studies how over-the-counter market liquidity is affected by securities lending. We combine micro-data on corporate bond market trades with securities lending transactions and individual corporate bond holdings by U.S. insurance companies. Applying a difference-in-differences empirical strategy, we show that the shutdown of AIG's securities lending program in 2008 caused a statistically and economically significant reduction in the market liquidity of corporate bonds predominantly held by AIG. We also show that an important mechanism behind the decrease in corporate bond liquidity was a shift towards relatively small trades among a greater number of dealers in the interdealer market.

Regular Dividends and Flexible Payouts: UK Evidence
Armitage, Seth,Gallagher, Ronan
We study payout by UK listed companies during 1993-2016. Regular dividends remain the dominant channel; they are not disappearing, nor becoming less flexible. At the same time, use of special dividends and especially repurchases has grown, and these methods make total payout substantially more flexible and more sensitive to earnings than regular dividends on their own. There is little evidence that special dividends or repurchases are replacing regular dividends. The role of regular and special dividends remains larger in the UK than in the USA, and the role of repurchases is smaller.

The Heat Is on: A Framework for Measuring Financial Stress Under Disruptive Energy Transition Scenarios
Vermeulen, Robert,Schets, Edo,Lohuis, Melanie,Kölbl, Barbara,Jansen, David-Jan,Heeringa, Willem
This paper presents a comprehensive framework for analyzing financial stress under scenarios with a disruptive transition to a low-carbon economy. This stress testing framework is designed to be readily applied by macroprudential supervisors or financial institutions. First, we construct stress scenarios using two dimensions: climate policy and energy technology. Then, we rely on various modeling approaches to derive macroeconomic and industry-specific implications. These approaches include a novel methodology for capturing industry-specific transition risks. Third, we disaggregate EUR 2.3 trillion in assets of more than 80 Dutch financial institutions by industry. Finally, our calculations show that financial losses can be sizeable, as portfolio values can decline by up to 11%. These outcomes suggest that climate-transition risks warrant close and timely attention from a financial stability perspective.

The Knightian Uncertainty Hypothesis: Unforeseeable Change and Muth’s Consistency Constraint in Modeling Aggregate Outcomes
Frydman, Roman,Johansen, Soren,Rahbek, Anders,Tabor, Morten
This paper introduces the Knightian Uncertainty Hypothesis (KUH), a new approach to macroeconomics and finance theory. KUH rests on a novel mathematical framework that characterizes both measurable and Knightian uncertainty about economic outcomes. Relying on this framework and John Muth’s pathbreaking hypothesis, KUH represents participants’ forecasts to be consistent with both uncertainties. KUH thus enables models of aggregate outcomes that:1) are premised on market participants’ rationality, and 2) yet accord a role to both fundamental and psychological (and other non-fundamental) factors in driving outcomes. The paper also suggests how a KUH model’s quantitative predictions can be confronted with time series data.

The Pink Balance Sheet: An Easy Way to Teach Capital Structure Basics
Livingston, Lynda
Students of corporate finance must learn the basics of capital structure theory. However, most textbook discussions are confusing and include too many equations. We present a simple model of tax-related capital structure basics that incorporates only three components: a market-value balance sheet, colors that represent risk, and one equation. Students mastering the pink balance sheet should be able to remember easily the various implications of basic capital structure models, including beta relationships such as the Hamada equation.

Time consistency for scalar multivariate risk measures
Zachary Feinstein,Birgit Rudloff

In this paper we present results on dynamic multivariate scalar risk measures, which arise in markets with transaction costs and systemic risk. Dual representations of such risk measures are presented. These are then used to obtain the main results of this paper on time consistency; namely, an equivalent recursive formulation of multivariate scalar risk measures to multiportfolio time consistency. We are motivated to study time consistency of multivariate scalar risk measures as the superhedging risk measure in markets with transaction costs (with a single eligible asset) (Jouini and Kallal (1995), Roux and Zastawniak (2016), Loehne and Rudloff (2014)) does not satisfy the usual scalar concept of time consistency. In fact, as demonstrated in (Feinstein and Rudloff (2018)), scalar risk measures with the same scalarization weight at all times would not be time consistent in general. The deduced recursive relation for the scalarizations of multiportfolio time consistent set-valued risk measures provided in this paper requires consideration of the entire family of scalarizations. In this way we develop a direct notion of a "moving scalarization" for scalar time consistency that corroborates recent research on scalarizations of dynamic multi-objective problems (Karnam, Ma, and Zhang (2017), Kovacova and Rudloff (2018)).

k-price auctions and Combination auctions
Martin Mihelich,Yan Shu

We provide an exact analytical solution of the Nash equilibrium for $k$- price auctions. We also introduce a new type of auction and demonstrate that it has fair solutions other than the second price auctions, therefore paving the way for replacing second price auctions.