Research articles for the 2019-03-07
A New Empirical Perspective on the Minimum Variance Portfolio
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This study examines the market level determinants of the portfolio construction process behind minimum variance investing. I show that the minimum variance portfolio (MVP) weight composition will be similar to that of equally weighted portfolio (1/N portfolio) if the ratio of idiosyncratic volatility relative to total return volatility is high and the number of securities in the portfolio is large.
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This study examines the market level determinants of the portfolio construction process behind minimum variance investing. I show that the minimum variance portfolio (MVP) weight composition will be similar to that of equally weighted portfolio (1/N portfolio) if the ratio of idiosyncratic volatility relative to total return volatility is high and the number of securities in the portfolio is large.
A New Time-Varying Asymmetric Copula Analysis of the EU Sovereign Debt Crisis
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This paper considers the time-varying asymmetric correlation between the stock and government bond price returns of the five peripheral EU countries during the EU sovereign crisis. To this end this paper proposes a new asymmetric copula using the split-normal distribution. The time-varying correlation coefficients are estimated by the particle filter method in the state-space framework. It finds a strong asymmetry in the early stage of the crisis, namely positive lower-tail correlation and negative upper-tail correlation of the stock-bond distribution, which the other copulas cannot express. It also finds that the signs of the correlations changed from negative to positive in the crisis.
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This paper considers the time-varying asymmetric correlation between the stock and government bond price returns of the five peripheral EU countries during the EU sovereign crisis. To this end this paper proposes a new asymmetric copula using the split-normal distribution. The time-varying correlation coefficients are estimated by the particle filter method in the state-space framework. It finds a strong asymmetry in the early stage of the crisis, namely positive lower-tail correlation and negative upper-tail correlation of the stock-bond distribution, which the other copulas cannot express. It also finds that the signs of the correlations changed from negative to positive in the crisis.
Asymptotics for volatility derivatives in multi-factor rough volatility models
arXiv
arXiv
We present small-time implied volatility asymptotics for Realised Variance (RV) and VIX options for a number of (rough) stochastic volatility models via large deviations principle. We provide numerical results along with efficient and robust numerical recipes to compute the rate function; the backbone of our theoretical framework. Based on our results, we further develop approximation schemes for the density of RV, which in turn allows to express the volatility swap in close-form. Lastly, we investigate different constructions of multi-factor models and how each of them affects the convexity of the implied volatility smile. Interestingly, we identify the class of models that generate non-linear smiles around-the-money.
At Your Service! Liquidity Provision and Risk Management in 19th Century France
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This paper uses a historical study to show a solution to the trade-off faced by central banks between providing liquidity to a broad group of financial intermediaries and the risk that this easy access may fuel moral hazard. In late 19th century the Bank of France operated a very wide discount window and used a variety of risk management techniques to effectively subdue risk-taking behaviors and to protect its balance sheet from taking any loss. This allowed agents to monetize a very diverse set of capital while limiting the risk of bail-out. We show that this effectively helped the central bank to stabilize the economy from the consequences of negative income shocks.
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This paper uses a historical study to show a solution to the trade-off faced by central banks between providing liquidity to a broad group of financial intermediaries and the risk that this easy access may fuel moral hazard. In late 19th century the Bank of France operated a very wide discount window and used a variety of risk management techniques to effectively subdue risk-taking behaviors and to protect its balance sheet from taking any loss. This allowed agents to monetize a very diverse set of capital while limiting the risk of bail-out. We show that this effectively helped the central bank to stabilize the economy from the consequences of negative income shocks.
Autoencoder Asset Pricing Models
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We propose a new latent factor conditional asset pricing model. Like Kelly, Pruitt, and Su (2019), our model allows for latent factors and factor exposures that depend on covariates such as asset characteristics. But, unlike the linearity assumption of KPS, we model factor exposures as a flexible nonlinear function of covariates. Our model retrofits the workhorse unsupervised dimension reduction device from the machine learning literature - autoencoder neural networks - to incorporate information from covariates along with returns themselves. This delivers estimates of nonlinear conditional exposures and the associated latent factors. Furthermore, our machine learning framework imposes the economic restriction of no-arbitrage. Our autoencoder asset pricing model delivers out-of-sample pricing errors that are far smaller (and generally insignificant) compared to other leading factor models.
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We propose a new latent factor conditional asset pricing model. Like Kelly, Pruitt, and Su (2019), our model allows for latent factors and factor exposures that depend on covariates such as asset characteristics. But, unlike the linearity assumption of KPS, we model factor exposures as a flexible nonlinear function of covariates. Our model retrofits the workhorse unsupervised dimension reduction device from the machine learning literature - autoencoder neural networks - to incorporate information from covariates along with returns themselves. This delivers estimates of nonlinear conditional exposures and the associated latent factors. Furthermore, our machine learning framework imposes the economic restriction of no-arbitrage. Our autoencoder asset pricing model delivers out-of-sample pricing errors that are far smaller (and generally insignificant) compared to other leading factor models.
Beyond Beholden
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Corporate law has long been concerned with director independence. In controlled companies, the conventional wisdom focuses on “beholdenness†as the main threat to independence. The prevailing theory argues that directors might feel pressured to reciprocate a past kindness from the controlling shareholder or fear retaliation. This Article argues that this conventional narrative is troublingly incomplete. I show that directors are also influenced by the prospect of rewards, or patronage, from the controller.This Article is the first to identify controlling shareholder patronage as a systemic phenomenon and to explore how anticipation of future patronage can affect director behavior. It presents an original empirical study on professional relationships between directors who are nominally independent and the controlling shareholders of their firms. My findings reveal that these relationships are far more pervasive than is usually recognized. In fact, some controlling shareholders regularly re-appoint cooperative “independent†directors to senior positions and directorships at other firms under their control. From a director’s perspective, this pattern of behavior means that the potential upside of getting along with the controlling shareholder is significant. I further demonstrate that the likelihood of patronage from the controlling shareholder depends on two factors: the controlling shareholder’s base of controlled entities and the concentration of its decision-making authority. Together, these factors provide an analytic framework for assessing which controllers have greater potential to create conflicts of interest. Disaggregating controlling shareholders in this way opens up opportunities and new challenges for how we define independence, analyze decisions made by putatively independent directors, and judge the utility of independent directors as a safeguard against controller opportunism.
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Corporate law has long been concerned with director independence. In controlled companies, the conventional wisdom focuses on “beholdenness†as the main threat to independence. The prevailing theory argues that directors might feel pressured to reciprocate a past kindness from the controlling shareholder or fear retaliation. This Article argues that this conventional narrative is troublingly incomplete. I show that directors are also influenced by the prospect of rewards, or patronage, from the controller.This Article is the first to identify controlling shareholder patronage as a systemic phenomenon and to explore how anticipation of future patronage can affect director behavior. It presents an original empirical study on professional relationships between directors who are nominally independent and the controlling shareholders of their firms. My findings reveal that these relationships are far more pervasive than is usually recognized. In fact, some controlling shareholders regularly re-appoint cooperative “independent†directors to senior positions and directorships at other firms under their control. From a director’s perspective, this pattern of behavior means that the potential upside of getting along with the controlling shareholder is significant. I further demonstrate that the likelihood of patronage from the controlling shareholder depends on two factors: the controlling shareholder’s base of controlled entities and the concentration of its decision-making authority. Together, these factors provide an analytic framework for assessing which controllers have greater potential to create conflicts of interest. Disaggregating controlling shareholders in this way opens up opportunities and new challenges for how we define independence, analyze decisions made by putatively independent directors, and judge the utility of independent directors as a safeguard against controller opportunism.
Beyond LIBOR: A Primer on the New Benchmark Rates
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The transition from a reference rate regime centred on interbank offered rates (IBORs) to one based on a new set of overnight risk-free rates (RFRs) is an important paradigm shift for markets. This special feature provides an overview of RFR benchmarks, and compares some of their key characteristics with those of existing benchmarks. While the new RFRs can serve as robust and credible overnight reference rates rooted in transactions in liquid markets, they do so at the expense of not capturing banks' marginal term funding costs. Hence, there is a possibility that, under the new normal, multiple rates may coexist, fulfilling different purposes and market needs.
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The transition from a reference rate regime centred on interbank offered rates (IBORs) to one based on a new set of overnight risk-free rates (RFRs) is an important paradigm shift for markets. This special feature provides an overview of RFR benchmarks, and compares some of their key characteristics with those of existing benchmarks. While the new RFRs can serve as robust and credible overnight reference rates rooted in transactions in liquid markets, they do so at the expense of not capturing banks' marginal term funding costs. Hence, there is a possibility that, under the new normal, multiple rates may coexist, fulfilling different purposes and market needs.
Choosing to Disagree in Financial Markets
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The rational expectations paradigm restricts the subjective beliefs of investors to align with the objective distribution. We relax this constraint and analyze how investors optimally choose their subjective beliefs about the information contained in their private signals and in prices. We show that investors systematically choose to deviate from rational expectations. In any symmetric equilibrium, investors optimally exhibit overconfidence in their private information but dismiss the information in prices. However, when aggregate risk aversion is sufficiently low, symmetric equilibria do not exist. Instead, there arises an asymmetric equilibrium in which investors endogenously separate into (i) fundamental investors, who also ignore the information in prices, and (ii) “technical†traders, who overweight the information in prices. Relative to the corresponding rational expectations equilibrium, these equilibria feature higher (i) return volatility, (ii) price informativeness, (iii) trading volume, and (iv) return predictability. Finally, such deviations by informed investors improve the welfare of liquidity traders under the objective distribution.
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The rational expectations paradigm restricts the subjective beliefs of investors to align with the objective distribution. We relax this constraint and analyze how investors optimally choose their subjective beliefs about the information contained in their private signals and in prices. We show that investors systematically choose to deviate from rational expectations. In any symmetric equilibrium, investors optimally exhibit overconfidence in their private information but dismiss the information in prices. However, when aggregate risk aversion is sufficiently low, symmetric equilibria do not exist. Instead, there arises an asymmetric equilibrium in which investors endogenously separate into (i) fundamental investors, who also ignore the information in prices, and (ii) “technical†traders, who overweight the information in prices. Relative to the corresponding rational expectations equilibrium, these equilibria feature higher (i) return volatility, (ii) price informativeness, (iii) trading volume, and (iv) return predictability. Finally, such deviations by informed investors improve the welfare of liquidity traders under the objective distribution.
Demand for and Supply of Trade Credit in Africa
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With African firms highly rationed out of credit markets, trade credit has become an important source of financing. Yet, not much is known about the drivers of trade credit demand and supply in the continent. This study fills this research gap by estimating trade credit demand and supply for a panel of listed firms in 19 African countries over a period of 29 years. Using dynamic and static structural equation modelling, the study finds short-term leverage, firm size and past experience in trade credit as simultaneous determinants of trade credit demand and supply. The study further finds turnover (inverse relationship) as the unique determinant of trade credit supply, and cash flows (inverse effect), raw material inventories (inverse effect) and investment in current assets (positive effect) as the peculiar determinants of trade credit demand. These determinants are robust to the control for endogeneity and non-separability, and to the inclusion of lagged value of the dependent variables, industrial classification and time dummies. These findings have important implications for trade credit policy in Africa.
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With African firms highly rationed out of credit markets, trade credit has become an important source of financing. Yet, not much is known about the drivers of trade credit demand and supply in the continent. This study fills this research gap by estimating trade credit demand and supply for a panel of listed firms in 19 African countries over a period of 29 years. Using dynamic and static structural equation modelling, the study finds short-term leverage, firm size and past experience in trade credit as simultaneous determinants of trade credit demand and supply. The study further finds turnover (inverse relationship) as the unique determinant of trade credit supply, and cash flows (inverse effect), raw material inventories (inverse effect) and investment in current assets (positive effect) as the peculiar determinants of trade credit demand. These determinants are robust to the control for endogeneity and non-separability, and to the inclusion of lagged value of the dependent variables, industrial classification and time dummies. These findings have important implications for trade credit policy in Africa.
Emerging Markets' Reliance on Foreign Bank Credit
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This article examines the importance of foreign banks in the provision of credit to emerging market borrowers. It documents this along two dimensions: the share of total credit provided and the concentration of claims from different foreign banking systems. The share of credit from foreign banks in total credit to emerging market economies has fallen since the Great Financial Crisis, but still stands at 15-20% on average, with the remainder provided by domestic banks or non-bank creditors. On the other hand, concentration in the market share of foreign creditor banking systems has risen. The official sector tends to be less reliant on foreign banks for credit, but more concentrated in its foreign banking system creditors than the private sector.
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This article examines the importance of foreign banks in the provision of credit to emerging market borrowers. It documents this along two dimensions: the share of total credit provided and the concentration of claims from different foreign banking systems. The share of credit from foreign banks in total credit to emerging market economies has fallen since the Great Financial Crisis, but still stands at 15-20% on average, with the remainder provided by domestic banks or non-bank creditors. On the other hand, concentration in the market share of foreign creditor banking systems has risen. The official sector tends to be less reliant on foreign banks for credit, but more concentrated in its foreign banking system creditors than the private sector.
Entrepreneurship, Institutions, and Economic Growth: Does the Level of Development Matter?
arXiv
arXiv
Entrepreneurship is often touted for its ability to generate economic growth. Through the creative-destructive process, entrepreneurs are often able to innovate and outperform incumbent organizations, all of which is supposed to lead to higher employment and economic growth. Although some empirical evidence supports this logic, it has also been the subject of recent criticisms. Specifically, entrepreneurship does not lead to growth in developing countries; it only does in more developed countries with higher income levels. Using Global Entrepreneurship Monitor data for a panel of 83 countries from 2002 to 2014, we examine the contribution of entrepreneurship towards economic growth. Our evidence validates earlier studies findings but also exposes previously undiscovered findings. That is, we find that entrepreneurship encourages economic growth but not in developing countries. In addition, our evidence finds that the institutional environment of the country, as measured by GEM Entrepreneurial Framework Conditions, only contributes to economic growth in more developed countries but not in developing countries. These findings have important policy implications. Namely, our evidence contradicts policy proposals that suggest entrepreneurship and the adoption of pro-market institutions that support it to encourage economic growth in developing countries. Our evidence suggests these policy proposals will be unlikely to generate the economic growth desired.
Financial Portfolios based on Tsallis Relative Entropy as the Risk Measure
arXiv
arXiv
Earlier studies have shown that stock market distributions can be well described by distributions derived from Tsallis entropy, which is a generalization of Shannon entropy to non-extensive systems. In this paper, Tsallis relative entropy (TRE), which is the generalization of Kullback-Leibler relative entropy (KLRE) to non-extensive systems, is investigated as a possible risk measure in constructing risk optimal portfolios whose returns beat market returns. Portfolios are constructed by binning the risk values and allocating the stocks to bins according to their risk values. The average return in excess of market returns for each bin is calculated to get the risk-return patterns of the portfolios. The results are compared with those from three other risk measures: 1) the commonly used 'beta' of the Capital Asset Pricing Model (CAPM), 2) Kullback-Leibler relative entropy, and 3) the relative standard deviation. Tests carried out for both long (~18 years) and shorter terms (~9 years), which include the dot-com bubble and the 2008 crash periods, show that a linear fit can be obtained for the risk-excess return profiles of all four risk measures. However, in all cases, the profiles from Tsallis relative entropy show a more consistent behavior in terms of both goodness of fit and the variation of returns with risk, than the other three risk measures.
Financial Statement Change and Equity Risk
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While financial statement analysis is a rich tool, there is no widely used holistic measure of the amount of change in corporate financial statements. Statistical decomposition analysis has been employed as an index of the amount of change, but has fallen into disuse because it does not allow negative accounting numbers. As a remedy, this paper suggests three distance measures adapted from cluster analysis that avoid this critical data limitation. We successfully apply these proposed distance measures to explain the total and systematic risk of stock returns (in the CAPM and Fama-French model), corporate bond ratings, and corporate distress.
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While financial statement analysis is a rich tool, there is no widely used holistic measure of the amount of change in corporate financial statements. Statistical decomposition analysis has been employed as an index of the amount of change, but has fallen into disuse because it does not allow negative accounting numbers. As a remedy, this paper suggests three distance measures adapted from cluster analysis that avoid this critical data limitation. We successfully apply these proposed distance measures to explain the total and systematic risk of stock returns (in the CAPM and Fama-French model), corporate bond ratings, and corporate distress.
Funding New Ventures with Digital Tokens: Due Diligence and Token Tradability
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We study funding mechanisms for new ventures based on cryptographic tokens enabled by blockchain technology, such as initial coin offerings (ICOs). The infrastructure built around blockchain allows for efficient trading of these tokens. Thus the due diligence process can be crowdsourced beyond the potential early adopters, as favorable assessments of the venture can be leveraged with speculative token purchases exceeding the buyer's individual demand. We develop a model for an entrepreneur considering digital tokens to finance a new venture, focusing on token tradability and broader crowdsourcing of due diligence. We then compare funding via digital tokens with funding from traditional financing sources like venture capital as well as with pre-sale crowdfunding with non-tradable rewards.We find that tradable digital tokens are more attractive when there is higher uncertainty about market demand, which is frequently the case when developing applications of new technologies, such as blockchain-based platforms. In such cases crowdsourcing due diligence benefits from the information contained in the private valuations of the early potential adopters. Token tradability leverages that information and increases the amount that can be financed, thus enabling new ventures with higher development costs. The increased funding comes at the cost of a lower digital token price and lower total profit for the entrepreneur, but may still be preferable to the alternatives, if such alternatives are available at all. This work makes a contribution to the emerging literatures on digital cryptographic tokens and on crowdfunding new ventures.
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We study funding mechanisms for new ventures based on cryptographic tokens enabled by blockchain technology, such as initial coin offerings (ICOs). The infrastructure built around blockchain allows for efficient trading of these tokens. Thus the due diligence process can be crowdsourced beyond the potential early adopters, as favorable assessments of the venture can be leveraged with speculative token purchases exceeding the buyer's individual demand. We develop a model for an entrepreneur considering digital tokens to finance a new venture, focusing on token tradability and broader crowdsourcing of due diligence. We then compare funding via digital tokens with funding from traditional financing sources like venture capital as well as with pre-sale crowdfunding with non-tradable rewards.We find that tradable digital tokens are more attractive when there is higher uncertainty about market demand, which is frequently the case when developing applications of new technologies, such as blockchain-based platforms. In such cases crowdsourcing due diligence benefits from the information contained in the private valuations of the early potential adopters. Token tradability leverages that information and increases the amount that can be financed, thus enabling new ventures with higher development costs. The increased funding comes at the cost of a lower digital token price and lower total profit for the entrepreneur, but may still be preferable to the alternatives, if such alternatives are available at all. This work makes a contribution to the emerging literatures on digital cryptographic tokens and on crowdfunding new ventures.
Growth Opportunity Bias
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Growth opportunity bias (GOB), measured as the difference between market and fundamental values of a firm’s growth opportunity, has an ability to predict future stock returns. In the portfolio sort, low-GOB firms earn higher returns than high-GOB firms, which is unexplained by the common asset pricing models. Cross-sectional regression results also confirm GOB’s power in predicting stock returns. Given the inability of the risk-based methods in explaining the GOB premium, we turn to behavioral approaches to gain a better understanding of the anomaly. We find that the GOB premium is more pronounced when investor sentiment is high or when limits-to-arbitrage is severe, which suggests that the GOB is more likely to capture behavioral biases than systematic risk.
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Growth opportunity bias (GOB), measured as the difference between market and fundamental values of a firm’s growth opportunity, has an ability to predict future stock returns. In the portfolio sort, low-GOB firms earn higher returns than high-GOB firms, which is unexplained by the common asset pricing models. Cross-sectional regression results also confirm GOB’s power in predicting stock returns. Given the inability of the risk-based methods in explaining the GOB premium, we turn to behavioral approaches to gain a better understanding of the anomaly. We find that the GOB premium is more pronounced when investor sentiment is high or when limits-to-arbitrage is severe, which suggests that the GOB is more likely to capture behavioral biases than systematic risk.
High-order compact finite difference scheme for option pricing in stochastic volatility with contemporaneous jump models
arXiv
arXiv
We extend the scheme developed in B. D\"uring, A. Pitkin, "High-order compact finite difference scheme for option pricing in stochastic volatility jump models", 2019, to the so-called stochastic volatility with contemporaneous jumps (SVCJ) model, derived by Duffie, Pan and Singleton. The performance of the scheme is assessed through a number of numerical experiments, using comparisons against a standard second-order central difference scheme. We observe that the new high-order compact scheme achieves fourth order convergence and discuss the effects on efficiency and computation time.
Host-Country Financial Development and Multinational Activity
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This paper evaluates the influence of host-country financial conditions on the global operations of multinational firms. Using detailed U.S. data, we establish that financial development in a country is associated with relatively more entry by multinational affiliates, as well as with higher aggregate affiliate sales to the local market, back to the U.S. and to third destinations, with these effects being more pronounced in financially more vulnerable sectors. At the level of individual affiliates, by contrast, these forces are associated with relatively lower local sales and higher return and third-country sales. Yet at both aggregate and affiliate levels, the share of local sales in total sales is smaller, while the shares of U.S. and third-country sales are both bigger. These empirical regularities hold when using fixed effects to account for unobserved differences across country-years, sectors, and parent firms. We show theoretically that these patterns are consistent with host-country financial development affecting multinationals' incentives for horizontal, vertical and platform FDI through two channels: a financing effect that induces affiliate entry and expansion by improving their access to external finance, and a competition effect that reorients affiliate sales away from the local market due to increased entry by credit-constrained domestic firms.
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This paper evaluates the influence of host-country financial conditions on the global operations of multinational firms. Using detailed U.S. data, we establish that financial development in a country is associated with relatively more entry by multinational affiliates, as well as with higher aggregate affiliate sales to the local market, back to the U.S. and to third destinations, with these effects being more pronounced in financially more vulnerable sectors. At the level of individual affiliates, by contrast, these forces are associated with relatively lower local sales and higher return and third-country sales. Yet at both aggregate and affiliate levels, the share of local sales in total sales is smaller, while the shares of U.S. and third-country sales are both bigger. These empirical regularities hold when using fixed effects to account for unobserved differences across country-years, sectors, and parent firms. We show theoretically that these patterns are consistent with host-country financial development affecting multinationals' incentives for horizontal, vertical and platform FDI through two channels: a financing effect that induces affiliate entry and expansion by improving their access to external finance, and a competition effect that reorients affiliate sales away from the local market due to increased entry by credit-constrained domestic firms.
How Do Insurance Companies Manage Reserves? Evidence from Reserve Manipulation Across Lines of Business and Accident Years
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We study the question of how insurance companies manipulate reserves. Specifically, we investigate how managerial incentives affect insurers’ reserving practice across lines of business (LOBs) and accident years (AYs). As the tax discount factor assigned by the tax authority varies across LOBs and AYs, insurers with stronger tax saving incentives will be more likely to manipulate reserves across both LOBs and AYs. As the RBC regime specifies different industry worst case factors across LOBs, insurers with stronger incentives to increase their RBC ratio will be more likely to manipulate reserves across LOBs. In terms of income smoothing incentives, only the overall level (and not the composition) of reserves is of consequence, thus we predict that there will be no similar systematic patterns in reserves manipulation by insurers based on income smoothing incentives. By using a Firm-LOB-Year sample, we find that both tax incentives and RBC incentives can not only affect the level of reserve errors (REs), but also the composition of REs. These results help us identify how managerial incentives impact insurers’ reserving behavior.
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We study the question of how insurance companies manipulate reserves. Specifically, we investigate how managerial incentives affect insurers’ reserving practice across lines of business (LOBs) and accident years (AYs). As the tax discount factor assigned by the tax authority varies across LOBs and AYs, insurers with stronger tax saving incentives will be more likely to manipulate reserves across both LOBs and AYs. As the RBC regime specifies different industry worst case factors across LOBs, insurers with stronger incentives to increase their RBC ratio will be more likely to manipulate reserves across LOBs. In terms of income smoothing incentives, only the overall level (and not the composition) of reserves is of consequence, thus we predict that there will be no similar systematic patterns in reserves manipulation by insurers based on income smoothing incentives. By using a Firm-LOB-Year sample, we find that both tax incentives and RBC incentives can not only affect the level of reserve errors (REs), but also the composition of REs. These results help us identify how managerial incentives impact insurers’ reserving behavior.
Impact of Financial Regulations: Insights from an Online Repository of Studies
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The BIS is launching a public, online and interactive repository of studies on the effects of financial regulations, called FRAME. The purpose of this repository is to keep track of, organise, standardise and disseminate the latest findings. FRAME currently covers 83 studies and 139 quantitative impact estimates from 15 countries or groups of countries, offering a new and comprehensive perspective on what the literature has been able to document to date, and where gaps exist. We observe a high degree of heterogeneity across impact estimates, notably in terms of the effects of capital regulation on loan growth: while on average the estimated effect is that more capital leads to more lending, there are large differences across studies. A meta-analysis shows that an important driver of these differences is whether the underlying study incorporates second-round effects.
SSRN
The BIS is launching a public, online and interactive repository of studies on the effects of financial regulations, called FRAME. The purpose of this repository is to keep track of, organise, standardise and disseminate the latest findings. FRAME currently covers 83 studies and 139 quantitative impact estimates from 15 countries or groups of countries, offering a new and comprehensive perspective on what the literature has been able to document to date, and where gaps exist. We observe a high degree of heterogeneity across impact estimates, notably in terms of the effects of capital regulation on loan growth: while on average the estimated effect is that more capital leads to more lending, there are large differences across studies. A meta-analysis shows that an important driver of these differences is whether the underlying study incorporates second-round effects.
Information Asymmetry, Line of Credit and Term Loan Pricing
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The information asymmetry between the borrower and the lender is a well-studied issue in the credit contracts. Various mechanisms (credit rationing, short-term debt, relationship banking, collateralization) have been discussed in the literature to reduce the asymmetry. This paper examines the role of credit line in reducing the information asymmetry through better risk profiling of the borrower. A two period model followed by empirical evidence shows the information effect of credit line on term loan pricing. The empirical findings show that the presence of credit line correlates with better term loan pricing while the discontinuation of it correlates with the deterioration of term loan pricing. The interrelation of information asymmetry and contract stringency ascertains the efficacy of credit line contract in reducing information asymmetry. The paper further shows that the information effect from the LoC to term loan pricing is not incorporated in the loan rating, is not due to miscalculation of the cost of borrowing, is independent of whether the LoC and term loan has a shared lead arranger, stays significant in the presence of relationship loans, and not captured in the credit line utilization.
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The information asymmetry between the borrower and the lender is a well-studied issue in the credit contracts. Various mechanisms (credit rationing, short-term debt, relationship banking, collateralization) have been discussed in the literature to reduce the asymmetry. This paper examines the role of credit line in reducing the information asymmetry through better risk profiling of the borrower. A two period model followed by empirical evidence shows the information effect of credit line on term loan pricing. The empirical findings show that the presence of credit line correlates with better term loan pricing while the discontinuation of it correlates with the deterioration of term loan pricing. The interrelation of information asymmetry and contract stringency ascertains the efficacy of credit line contract in reducing information asymmetry. The paper further shows that the information effect from the LoC to term loan pricing is not incorporated in the loan rating, is not due to miscalculation of the cost of borrowing, is independent of whether the LoC and term loan has a shared lead arranger, stays significant in the presence of relationship loans, and not captured in the credit line utilization.
LA SUSPENSIÃ"N DE DERECHOS POLÃTICOS DEL SOCIO HASTA QUE LAS AUTORIDADES DE COMPETENCIA O DE REGULACIÃ"N SECTORIAL AUTORICEN LAS ADQUISICIONES A TRAVÉS DE OPA (The Suspension of Shareholder’s Political Rights Until the Competition or Regulatory Authorities Authorize the Acquisitions Through a Takeover Bid )
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Spanish Abstract: Análisis la regla de suspensión del derecho de voto de las acciones sobre el umbral que obliga a una sociedad cotizada a lanzar una Oferta Pública de Adquisición (OPA). Esta regla es el mecanismo de enlace y de coordinación de la legislación sobre el mercado de valores (y regulación de las OPAs) y el sistema de control de concentraciones (nacional y de la UE) asà como los controles previstos en la regulación sectorial de determinadas industrias. Se examinan el ámbito de la suspensión (OPAs comprendidas en la norma, acciones afectadas y derechos), asà como el eventual levantamiento de la suspensión por las autoridades de defensa de la competencia cuando sea indispensable para la protección del valor de la inversión.English Abstract: Analysis of rule suspending the voting right of those shares over the threshold that obliges a Spanish listed company to launch a public tender bid. This rule is the liaison and coordination mechanism of the securities markets legislation (and takeover regulation) and the merger review system (national and EU) as well as the controls foreseen in sectoral regulation for some industries. The scope of the suspension (bids covered, affected shares and rights) is examined, as well as the lifting of the suspension by the competition authorities when it would be essential for the protection of the value of the investment.
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Spanish Abstract: Análisis la regla de suspensión del derecho de voto de las acciones sobre el umbral que obliga a una sociedad cotizada a lanzar una Oferta Pública de Adquisición (OPA). Esta regla es el mecanismo de enlace y de coordinación de la legislación sobre el mercado de valores (y regulación de las OPAs) y el sistema de control de concentraciones (nacional y de la UE) asà como los controles previstos en la regulación sectorial de determinadas industrias. Se examinan el ámbito de la suspensión (OPAs comprendidas en la norma, acciones afectadas y derechos), asà como el eventual levantamiento de la suspensión por las autoridades de defensa de la competencia cuando sea indispensable para la protección del valor de la inversión.English Abstract: Analysis of rule suspending the voting right of those shares over the threshold that obliges a Spanish listed company to launch a public tender bid. This rule is the liaison and coordination mechanism of the securities markets legislation (and takeover regulation) and the merger review system (national and EU) as well as the controls foreseen in sectoral regulation for some industries. The scope of the suspension (bids covered, affected shares and rights) is examined, as well as the lifting of the suspension by the competition authorities when it would be essential for the protection of the value of the investment.
Liquidity, Volume, and Volatility
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We examine the relation between liquidity, volume, and volatility using a comprehensive sample of U.S. stocks in the post-decimalization period. For large stocks, effective spread and volume are positively related in the time series even after controlling for volatility, contrary to most theoretical predictions. This relation is mostly driven by the systematic component of volume. In contrast, for small stocks the evidence matches the predictions of standard adverse selection models. We show that the volatility of order imbalances can reconcile our puzzling finding with standard intuition. Order imbalance volatility is strongly associated with spreads both in the time series and cross-section and makes the relation between spread, volume, and volatility close to what is predicted by invariance theories. We develop a continuous-time inventory model to explain our empirical findings. Evidence from intraday patterns and other liquidity measures (price impact and depth) support our interpretation.
SSRN
We examine the relation between liquidity, volume, and volatility using a comprehensive sample of U.S. stocks in the post-decimalization period. For large stocks, effective spread and volume are positively related in the time series even after controlling for volatility, contrary to most theoretical predictions. This relation is mostly driven by the systematic component of volume. In contrast, for small stocks the evidence matches the predictions of standard adverse selection models. We show that the volatility of order imbalances can reconcile our puzzling finding with standard intuition. Order imbalance volatility is strongly associated with spreads both in the time series and cross-section and makes the relation between spread, volume, and volatility close to what is predicted by invariance theories. We develop a continuous-time inventory model to explain our empirical findings. Evidence from intraday patterns and other liquidity measures (price impact and depth) support our interpretation.
Moral Hazard in VC Syndicates
SSRN
Syndicates are good but not always. A number of studies have looked into the benefits of syndication and enumerated the various factors that lead to the positive outcome. There are few studies that allude to the negative side of syndication. Adding to the latter string of papers, this paper analyzes the interaction among VC partners using partnership model and derives conditions that lead to inferior performance of the venture funded by the syndicate. Syndications with large number of partners, entering the later rounds of financing, already overseeing big portfolio of investments do not add expected value to the ventures and render rather inferior performance. The empirical findings support the theoretical claims.
SSRN
Syndicates are good but not always. A number of studies have looked into the benefits of syndication and enumerated the various factors that lead to the positive outcome. There are few studies that allude to the negative side of syndication. Adding to the latter string of papers, this paper analyzes the interaction among VC partners using partnership model and derives conditions that lead to inferior performance of the venture funded by the syndicate. Syndications with large number of partners, entering the later rounds of financing, already overseeing big portfolio of investments do not add expected value to the ventures and render rather inferior performance. The empirical findings support the theoretical claims.
On the support of extremal martingale measures with given marginals: the countable case
arXiv
arXiv
We investigate the supports of extremal martingale measures with pre-specified marginals in a two-period setting. First, we establish in full generality the equivalence between the extremality of a given measure $Q$ and the denseness in $L^1(Q)$ of a suitable linear subspace, which can be seen in a financial context as the set of all semi-static trading strategies. Moreover, when the supports of both marginals are countable, we focus on the slightly stronger notion of weak exact predictable representation property (henceforth, WEP) and provide two combinatorial sufficient conditions, called "2-link property" and "full erasability", on how the points in the supports are linked to each other for granting extremality. When the support of the first marginal is a finite set, we give a necessary and sufficient condition for the WEP to hold in terms of the new concepts of $2$-net and deadlock. Finally, we study the relation between cycles and extremality.
Passive Asset Management, Securities Lending and Stock Prices
SSRN
How does the shift to passive investments affect securities prices? We propose and analyze a security lending channel in which passive funds serve as primary providers of lendable shares to make short selling possible. We show that stocks with high level of passive ownership exhibit greater supply of lendable shares which results in larger short positions, lower lending fees and longer durations of security loans. The effect of passive investors on security lending is significantly larger than the effect of other lenders such as actively managed funds and other institutional asset managers. Consistent with the literature on short-sale constraints, we find that constrained stocks with more passive ownership exhibit lower cross-autocorrelations with negative market returns and more negative skewness in stock returns. To mitigate identification concerns, we confirm our main findings using Russell index reconstitution that generates quasi-random variation in passive ownership. Our study suggests that passive investors make market prices more efficient by relaxing short-sale constraints.
SSRN
How does the shift to passive investments affect securities prices? We propose and analyze a security lending channel in which passive funds serve as primary providers of lendable shares to make short selling possible. We show that stocks with high level of passive ownership exhibit greater supply of lendable shares which results in larger short positions, lower lending fees and longer durations of security loans. The effect of passive investors on security lending is significantly larger than the effect of other lenders such as actively managed funds and other institutional asset managers. Consistent with the literature on short-sale constraints, we find that constrained stocks with more passive ownership exhibit lower cross-autocorrelations with negative market returns and more negative skewness in stock returns. To mitigate identification concerns, we confirm our main findings using Russell index reconstitution that generates quasi-random variation in passive ownership. Our study suggests that passive investors make market prices more efficient by relaxing short-sale constraints.
Pay to Play
SSRN
Supervisors struggle to solve two problems at banks: first, how to induce banks to configure compensation so as to control, rather than compound risk; and second, how to ensure that banks can raise so-called “gone-concern capital†in amounts sufficient to recapitalise the bank, if it were to enter resolution, without causing contagion to other institutions or sectors. We suggest that banks could solve both problems via a single measure. We call this “pay to playâ€.The concrete proposal is to pay bonus to managers, especially senior executives, in a the form of write-down bonds that qualify as loss-absorbing capacity under TLAC and MREL requirements. Such bonds will require senior managers to bear first loss. This will sensitise management to loss and make banks safer and sounder.
SSRN
Supervisors struggle to solve two problems at banks: first, how to induce banks to configure compensation so as to control, rather than compound risk; and second, how to ensure that banks can raise so-called “gone-concern capital†in amounts sufficient to recapitalise the bank, if it were to enter resolution, without causing contagion to other institutions or sectors. We suggest that banks could solve both problems via a single measure. We call this “pay to playâ€.The concrete proposal is to pay bonus to managers, especially senior executives, in a the form of write-down bonds that qualify as loss-absorbing capacity under TLAC and MREL requirements. Such bonds will require senior managers to bear first loss. This will sensitise management to loss and make banks safer and sounder.
Price Formation of FICC Research Following MiFID II Unbundling Rules
SSRN
Traditionally, full-service broker/dealers catering to institutional investors have bundled trade execution with investment research. Since 2018, new market regulation forces broker/dealers to unbundle and to sell research separately. We present a stylized model in which a monopolist FICC research provider faces a linear demand function and picks an appropriate price schedule. We show that it is important to initiate the price discovery process with a low price. We also show that some broker/deals will not be able to find a regulatory compliant price/quantity solution because their research-production fixed cost is too high compared to the research demand function they face.
SSRN
Traditionally, full-service broker/dealers catering to institutional investors have bundled trade execution with investment research. Since 2018, new market regulation forces broker/dealers to unbundle and to sell research separately. We present a stylized model in which a monopolist FICC research provider faces a linear demand function and picks an appropriate price schedule. We show that it is important to initiate the price discovery process with a low price. We also show that some broker/deals will not be able to find a regulatory compliant price/quantity solution because their research-production fixed cost is too high compared to the research demand function they face.
Real Options Applied to Infrastructure Investments: A Volatility-Free Framework Based on Closed-Form Expressions
SSRN
We derive closed-form expressions to price European calls and puts assuming the cash flows of the underlying asset or project are normally distributed. This approach has important advantages in the context of real options applied to infrastructure projects when compared to the Black-Scholes equation. First, it fits naturally with the way engineers and project managers evaluate projects, that is, based on cash flow estimates, and not on return estimates. And second, it does not require to estimate the volatility of geometric (not arithmetic) returns, a concept alien to project management. Two examples, an option to expand and an option to abandon, demonstrate the usefulness of this approach. A third example demonstrates the shortcomings of the Black-Scholes equation when applied to real assets.
SSRN
We derive closed-form expressions to price European calls and puts assuming the cash flows of the underlying asset or project are normally distributed. This approach has important advantages in the context of real options applied to infrastructure projects when compared to the Black-Scholes equation. First, it fits naturally with the way engineers and project managers evaluate projects, that is, based on cash flow estimates, and not on return estimates. And second, it does not require to estimate the volatility of geometric (not arithmetic) returns, a concept alien to project management. Two examples, an option to expand and an option to abandon, demonstrate the usefulness of this approach. A third example demonstrates the shortcomings of the Black-Scholes equation when applied to real assets.
Shadow Banks, Leverage Risks and Asset Prices
SSRN
Trust companies generate the dynamics of the leverage cycle in intermediating less regulated credit to financial markets in China. We find that the leverage factor constructed from trust companies can explain the time series and cross-section of multiple asset returns. In contrast, the leverage factor derived from securities companies does not possess the same power, although these companies are the legitimate financing sources of leveraged investment. Our results provide new evidence that the financial innovations created by shadow banks significantly magnify leverage in a less sophisticated financial market, which not only affects financial fragility but also determines asset prices.
SSRN
Trust companies generate the dynamics of the leverage cycle in intermediating less regulated credit to financial markets in China. We find that the leverage factor constructed from trust companies can explain the time series and cross-section of multiple asset returns. In contrast, the leverage factor derived from securities companies does not possess the same power, although these companies are the legitimate financing sources of leveraged investment. Our results provide new evidence that the financial innovations created by shadow banks significantly magnify leverage in a less sophisticated financial market, which not only affects financial fragility but also determines asset prices.
Sovereign Credit Rating Determinants Under Financial Crises
SSRN
This paper empirically examines the determinants of sovereign credit ratings using panel data on a sample of 86 countries for 1993â€"2013. It further investigates whether the countries' average credit rating differs by region and for crisis and noncrisis periods, and how the bursting of the dot-com bubble, the Asian crisis, and the 2008 international financial crisis affected the average rating of each region. The estimation results reveal that macroeconomic, external, government, and qualitative factors importantly affect sovereign credit ratings, and that average ratings differ across all geographical regions except for North America and the Eurozone. While the recent crisis reduced the average rating across all regions, the dot-com bubble burst had no effect, the Asian crisis affected only the average rating of Asian countries, and the downgrade resulting from the 2008 crisis was larger in the Eurozone.
SSRN
This paper empirically examines the determinants of sovereign credit ratings using panel data on a sample of 86 countries for 1993â€"2013. It further investigates whether the countries' average credit rating differs by region and for crisis and noncrisis periods, and how the bursting of the dot-com bubble, the Asian crisis, and the 2008 international financial crisis affected the average rating of each region. The estimation results reveal that macroeconomic, external, government, and qualitative factors importantly affect sovereign credit ratings, and that average ratings differ across all geographical regions except for North America and the Eurozone. While the recent crisis reduced the average rating across all regions, the dot-com bubble burst had no effect, the Asian crisis affected only the average rating of Asian countries, and the downgrade resulting from the 2008 crisis was larger in the Eurozone.
Stock Liquidity and Investment Efficiency: Evidence from the Split-Share Structure Reform in China
SSRN
Using the split-share structure reform in China as a quasi-natural experiment, we examine the effect of stock liquidity on investment efficiency. Consistent with feedback and incentive theories, investment efficiency of Chinese firms increases after the reform but only for under-investing firms. When stock liquidity increases, compared to under-investing firms, over-investing firms face a reduction in institutional shareholding and witness no increase in takeover risk; thus, those firms face lower pressure to make optimal investments. Our findings further substantiate the real effects of financial markets and add evidence to the consequences of the Chinese structural reform initiatives.
SSRN
Using the split-share structure reform in China as a quasi-natural experiment, we examine the effect of stock liquidity on investment efficiency. Consistent with feedback and incentive theories, investment efficiency of Chinese firms increases after the reform but only for under-investing firms. When stock liquidity increases, compared to under-investing firms, over-investing firms face a reduction in institutional shareholding and witness no increase in takeover risk; thus, those firms face lower pressure to make optimal investments. Our findings further substantiate the real effects of financial markets and add evidence to the consequences of the Chinese structural reform initiatives.
Technology Adoption and Access to Credit Via Mobile Phones
SSRN
We study the effect of mobile phone coverage on technology adoption and access to credit by Indian farmers. Our units of observation are 10-by-10 km cells for which we observe the evolution of mobile phone coverage, land use and agricultural inputs between 1997 and 2012. Our empirical strategy exploits variation in the construction of mobile-phone towers under a large government program aimed at increasing mobile coverage in rural areas. In particular, we compare cells covered by new towers with similar cells where new towers were proposed but eventually not realized. We find that areas receiving mobile phone coverage experience faster adoption of high-yielding varieties of seeds, and higher increase in access to credit by small farmers. To explore how mobile phones can reduce farmers' information gap on new technologies and facilitate access to credit we analyze the content of 1.4 million geo-localized calls to a major call center for agricultural advice.
SSRN
We study the effect of mobile phone coverage on technology adoption and access to credit by Indian farmers. Our units of observation are 10-by-10 km cells for which we observe the evolution of mobile phone coverage, land use and agricultural inputs between 1997 and 2012. Our empirical strategy exploits variation in the construction of mobile-phone towers under a large government program aimed at increasing mobile coverage in rural areas. In particular, we compare cells covered by new towers with similar cells where new towers were proposed but eventually not realized. We find that areas receiving mobile phone coverage experience faster adoption of high-yielding varieties of seeds, and higher increase in access to credit by small farmers. To explore how mobile phones can reduce farmers' information gap on new technologies and facilitate access to credit we analyze the content of 1.4 million geo-localized calls to a major call center for agricultural advice.
The Impact of Financial Knowledge on the Allocation of Household Assets - Evidence from China
SSRN
This paper studies the impact of family finance knowledge on household asset allocation through China Household Financial Survey Data (CHFS). The study found that the increase in family financial knowledge will significantly increase the diversity of household asset allocation and promote more family participation in financial markets. This conclusion is still significant after being subdivided into money market and capital market. In addition, this paper also finds that household purchase of self-owned housing has a significant crowding out effect on its investment financial market. The increase in education level and risk appetite will increase the diversification of household asset allocation, and the ability of households from rural areas in China to take risks is lower, its assets are mostly deployed in the lower risk currency market.
SSRN
This paper studies the impact of family finance knowledge on household asset allocation through China Household Financial Survey Data (CHFS). The study found that the increase in family financial knowledge will significantly increase the diversity of household asset allocation and promote more family participation in financial markets. This conclusion is still significant after being subdivided into money market and capital market. In addition, this paper also finds that household purchase of self-owned housing has a significant crowding out effect on its investment financial market. The increase in education level and risk appetite will increase the diversification of household asset allocation, and the ability of households from rural areas in China to take risks is lower, its assets are mostly deployed in the lower risk currency market.
The Intangibles Song in Takeover Announcements: Good Tempo, Hollow Tune
SSRN
Mergers and acquisitions are often motivated by the intention of creating value from intangible assets. We develop a novel word list of intangibles and apply it to takeover announcements. Deals presented with more "intangibles talk" complete more quickly. However, the value of these deals to the acquirer is questionable: One standard deviation more in intangibles talk results in 0.45 percentage points lower abnormal announcement returns of bidders. Agency problems explain little of these results. Instead, payment mode choices and insider trades suggest that intangibles talk reflects managerial overoptimism. Overall, takeover announcements can provide important information regarding the quality of deals.
SSRN
Mergers and acquisitions are often motivated by the intention of creating value from intangible assets. We develop a novel word list of intangibles and apply it to takeover announcements. Deals presented with more "intangibles talk" complete more quickly. However, the value of these deals to the acquirer is questionable: One standard deviation more in intangibles talk results in 0.45 percentage points lower abnormal announcement returns of bidders. Agency problems explain little of these results. Instead, payment mode choices and insider trades suggest that intangibles talk reflects managerial overoptimism. Overall, takeover announcements can provide important information regarding the quality of deals.
The Interdependence of Hierarchical Institutions: Federal Regulation, Job Creation, and the Moderating Effect of State Economic Freedom
arXiv
arXiv
Regulation is commonly viewed as a hindrance to entrepreneurship, but heterogeneity in the effects of regulation is rarely explored. We focus on regional variation in the effects of national-level regulations by developing a theory of hierarchical institutional interdependence. Using the political science theory of market-preserving federalism, we argue that regional economic freedom attenuates the negative influence of national regulation on net job creation. Using U.S. data, we find that regulation destroys jobs on net, but regional economic freedom moderates this effect. In regions with average economic freedom, a one percent increase in regulation results in 14 fewer jobs created on net. However, a standard deviation increase in economic freedom attenuates this relationship by four fewer jobs. Interestingly, this moderation accrues strictly to older firms; regulation usually harms young firm job creation, and economic freedom does not attenuate this relationship.
The Interplay Between Bond Analysts and Equity Analysts in Information Provision
SSRN
We explore the interplay between sell-side bond analysts and equity analysts in information provision. We use plausibly exogenous variation in equity analyst coverage to show that bond analysts actively react to the reduction in equity analyst coverage by initiating coverage, issuing more reports, and issuing reports with more pages and larger sizes. Moreover, these reports also have a larger market impact. These effects are more pronounced for firms with less existing bond analyst coverage and firms with management earnings guidance. Overall, our results suggest that bond analysts can causally influence and shape firms’ information environment.
SSRN
We explore the interplay between sell-side bond analysts and equity analysts in information provision. We use plausibly exogenous variation in equity analyst coverage to show that bond analysts actively react to the reduction in equity analyst coverage by initiating coverage, issuing more reports, and issuing reports with more pages and larger sizes. Moreover, these reports also have a larger market impact. These effects are more pronounced for firms with less existing bond analyst coverage and firms with management earnings guidance. Overall, our results suggest that bond analysts can causally influence and shape firms’ information environment.
The Real Effects of Financial Protectionism
SSRN
This paper analyzes the effect of government support for banks, such as recapitalizations on financial integration and firm outcomes. Using data on European syndicated lending, results show that bailout banks increase their home bias in lending by 24.6% more than non-bailout banks. In turn, discriminated foreign firms can only imperfectly substitute this fall in lending by switching banks or issuing corporate bonds. Thus, the negative loan supply effect translates into lower sales and employment growth for foreign firms. In addition, government support distorts credit allocation in the home market by shifting lending to larger, safer and less innovative firms. Moreover, I document that politicians gain influence over banks by transferring control rights to the government as part of the support scheme. These results suggest that locating bank resolution within the European Banking Union at the national level discourages international economic activity, distorts credit towards less productive firms and harms growth.
SSRN
This paper analyzes the effect of government support for banks, such as recapitalizations on financial integration and firm outcomes. Using data on European syndicated lending, results show that bailout banks increase their home bias in lending by 24.6% more than non-bailout banks. In turn, discriminated foreign firms can only imperfectly substitute this fall in lending by switching banks or issuing corporate bonds. Thus, the negative loan supply effect translates into lower sales and employment growth for foreign firms. In addition, government support distorts credit allocation in the home market by shifting lending to larger, safer and less innovative firms. Moreover, I document that politicians gain influence over banks by transferring control rights to the government as part of the support scheme. These results suggest that locating bank resolution within the European Banking Union at the national level discourages international economic activity, distorts credit towards less productive firms and harms growth.
The Sound of Many Funds Rebalancing
SSRN
This paper proposes that computational complexity generates noise. In modern financial markets, it is common to find the same asset held for completely different reasons by funds following a wide variety of threshold-based trading rules. Under these conditions, we show that it can be computationally infeasible to predict how these various trading rules will interact with one another. Formally, we prove that it is NP hard to predict the sign of the net demand coming from a large interacting mass of funds at a rate better than chance. Thus, market participants will treat these demand shocks as random noise even if they are fully rational. This noise-generating mechanism can produce noise in a wide range of markets and also predicts how noise will vary across assets. We verify this prediction empirically using data on the exchange-traded fund (ETF) market.
SSRN
This paper proposes that computational complexity generates noise. In modern financial markets, it is common to find the same asset held for completely different reasons by funds following a wide variety of threshold-based trading rules. Under these conditions, we show that it can be computationally infeasible to predict how these various trading rules will interact with one another. Formally, we prove that it is NP hard to predict the sign of the net demand coming from a large interacting mass of funds at a rate better than chance. Thus, market participants will treat these demand shocks as random noise even if they are fully rational. This noise-generating mechanism can produce noise in a wide range of markets and also predicts how noise will vary across assets. We verify this prediction empirically using data on the exchange-traded fund (ETF) market.
Transform Analysis for Markov Processes and Applications: An Operator-based Approach
SSRN
We establish a novel duality relationship between continuous and discrete non-negative additive functionals of stochastic (not necessarily Markovian) processes and their right inverses. For general Markov processes, we further extend and develop a theoretical and computational framework for the transform analysis via an operator-based approach, i.e. through the infinitestimal generators. More precisely, we characterize the joint double transforms of additive functionals of Markov processes and the terminal values in both discrete and continuous time. In particular, under the continuous-time Markov chain (CTMC) setting, we obtain single Laplace transforms for continuous/discrete additive functionals and their inverses. Lastly, we discuss the potential applications of the proposed transform methodology in various contextual areas in finance and queuing theory within operations research.
SSRN
We establish a novel duality relationship between continuous and discrete non-negative additive functionals of stochastic (not necessarily Markovian) processes and their right inverses. For general Markov processes, we further extend and develop a theoretical and computational framework for the transform analysis via an operator-based approach, i.e. through the infinitestimal generators. More precisely, we characterize the joint double transforms of additive functionals of Markov processes and the terminal values in both discrete and continuous time. In particular, under the continuous-time Markov chain (CTMC) setting, we obtain single Laplace transforms for continuous/discrete additive functionals and their inverses. Lastly, we discuss the potential applications of the proposed transform methodology in various contextual areas in finance and queuing theory within operations research.
Valuation Effects of Overconfident CEOs on Corporate Diversification and Refocusing Decisions
SSRN
This study presents a theoretical model that links chief executive officer (CEO) overconfidence to the value loss of corporate diversification. Consistent with the model’s prediction, the findings show that diversified firms run by overconfident CEOs experience value loss compared to diversified firms run by their rational counterparts. Empirically, the value loss is economically significant and ranges between 12.5% and 14.1%. In addition, the model predicts heightened corporate refocusing activity by overconfident CEOs who pursued diversified investments in the past once realized returns fail to match initial expectations. The empirical odds of corporate refocusing decisions are 67% to 98% higher when past diversifications are undertaken by overconfident rather than rational CEOs. Another prediction of the model is that overconfident CEOs exhibit preference for diversified investments, especially in the presence of ample internal funds. This prediction is also strongly supported by the data. Overall, this study proposes CEO overconfidence as a unified and consistent explanation of why firms pursue value-destructive corporate diversification policies and later adopt refocusing policies aiming to restore value.
SSRN
This study presents a theoretical model that links chief executive officer (CEO) overconfidence to the value loss of corporate diversification. Consistent with the model’s prediction, the findings show that diversified firms run by overconfident CEOs experience value loss compared to diversified firms run by their rational counterparts. Empirically, the value loss is economically significant and ranges between 12.5% and 14.1%. In addition, the model predicts heightened corporate refocusing activity by overconfident CEOs who pursued diversified investments in the past once realized returns fail to match initial expectations. The empirical odds of corporate refocusing decisions are 67% to 98% higher when past diversifications are undertaken by overconfident rather than rational CEOs. Another prediction of the model is that overconfident CEOs exhibit preference for diversified investments, especially in the presence of ample internal funds. This prediction is also strongly supported by the data. Overall, this study proposes CEO overconfidence as a unified and consistent explanation of why firms pursue value-destructive corporate diversification policies and later adopt refocusing policies aiming to restore value.
What Do Mutual Fund Investors Really Care About?
SSRN
Rational investors should account for risk factor exposure when allocating capital to mutual funds. Two recent influential studies use mutual fund flows to test whether investors distinguish between performance driven by managers' skill and systematic risk factors. Both studies found that investors use the Capital Asset Pricing Model (CAPM), and one concluded that the CAPM is the "closest to the true asset pricing model." We re-examine these results and show that, in fact, fund flow data are most consistent with investors relying blindly on fund rankings (specifically, Morningstar ratings) and chasing recent returns. We find no evidence that investors account for any of the common systematic risk factors when allocating capital among mutual funds.
SSRN
Rational investors should account for risk factor exposure when allocating capital to mutual funds. Two recent influential studies use mutual fund flows to test whether investors distinguish between performance driven by managers' skill and systematic risk factors. Both studies found that investors use the Capital Asset Pricing Model (CAPM), and one concluded that the CAPM is the "closest to the true asset pricing model." We re-examine these results and show that, in fact, fund flow data are most consistent with investors relying blindly on fund rankings (specifically, Morningstar ratings) and chasing recent returns. We find no evidence that investors account for any of the common systematic risk factors when allocating capital among mutual funds.
