Research articles for the 2019-03-15

Attention, Social Interaction, and Investor Attraction to Lottery Stocks
Bali, Turan G.,Hirshleifer, David A.,Peng, Lin,Tang, Yi
We test the hypothesis that retail investors' attraction to lottery stocks induces overvaluation, and is amplified by high attention and social interactions. The lottery premium (negative abnormal returns) is stronger for high-retail-ownership stocksâ€"especially those that also have high analyst coverage, high latest absolute earnings surprises, or extreme recent positive returns. The premium is also larger for high-retail-ownership stocks headquartered in counties with high social interactions, proxied by headquarter population density or Facebook social connectivity. Google search activities in response to large extreme returns are also consistent with the role of attention in attracting investors to lottery stocks.

Banking Relationships and the Formation of Supply-Chain Relationships
Coiculescu, Gabriela
I study the effect of banking relationships on the formation of new supply-chain relationships. I find that common banking relationships between a firm and a potential supplier increase the probability that the potential supplier will be selected to start a new supply-chain relationship. The effect is driven by firms in low-innovation industries. However, when accounting for the endogeneity of supply-chain and banking relationships, using bank branch location as an instrument for common banking relationships, the effect of common banks is negative, suggesting that supply-chain partners avoid common lenders for fear that sensitive information might leak through the bank to the supply-chain partner.

Book Review. Marco Migliorelli (Ed.): New Cooperative Banking in Europe. Strategies for Adapting the Business Model Post Crisis
Ferri, Giovanni
The book “New Cooperative Banking in Europe. Strategies for Adapting the Business Model Post Crisis”, edited by Marco Migliorelli and published by Palgrave Macmillian in 2018, rigorously delves into the future of the European cooperative banking sector. Corroborated by up to date and hard to find information and data, the book addresses four major challenges pertaining to: i) the macroeconomic adversities; ii) the regulatory challenge; iii) the internal governance issues; and iv) the consequences of the digital revolution. The overarching question is: Can Europe afford to do away with its cooperative banks, or should the old continent find a manner to safeguard these banks which are deeply rooted in its tradition? Although some issues could have been investigated more in depth, the book stands out for its merits and serves as an important and timely reference on the topic.

Clustering Fosters Investment: Local Agglomeration and Household Portfolio Choice
Addoum, Jawad M.,Delikouras, Stefanos,Ke, Da,Korniotis, George M.
We investigate the impact of local agglomeration economies on household portfolio choice. Using detailed location and employment data from two U.S. household surveys, we document that individuals who work in locally agglomerated industries are more likely to invest in risky assets. This pattern cannot be explained by households sorting on latent factors, local employers' stock compensation and pension policies, or investors' local biases. Instead, the relation between local agglomeration and portfolio decisions is consistent with industry clusters enhancing human capital and in turn, raising workers' effective risk tolerance. Our findings highlight the role of geography in shaping household financial decisions.

Countercyclical Risks and Portfolio Choice Over the Life Cycle: Evidence and Theory
Shen, Jialu
I show that countercyclical earnings dynamics can have quantitatively important effects on saving and portfolio choice decisions over the life cycle. During expansions (recessions) when expected future earnings growth is high (low), households save less (more) and also invest a higher (lower) share of their financial wealth in the stock market. Negative skewness in the earnings process during recessions further reduces households' stock market exposure and consumption. These quantitative predictions are consistent with microeconometric evidence from the Panel Study of Income Dynamics and macroeconometric evidence from the Flow of Funds. Counterfactual simulations using the calibrated model generate wealth inequality dynamics similar to their empirical counterparts.

Does Accounting Measurement Impact Market Efficiency: A Laboratory Market Perspective
Barradale, Nigel J.,Goodson, Brian M.,Sooy, Matthew
Using laboratory markets where accounting regimes can be directly compared with equivalent economic parameters, we test whether and how two different accounting measurement bases â€" historical cost and mark-to-market â€" influence investor perceptions and asset mispricing. Results show that investors perceive otherwise equivalent assets differently by regime. In the mark-to-market regime investors perceive stronger links between performance and market price changes, and also perceive weaker links between performance and asset fundamentals. These perceptions correspond with greater market-level mispricing/bubbles in the mark-to-market regime. In supplemental analysis, we observe that investors in the market-to-market regime prefer information about future market prices but investors in the historical cost regime prefer information about future dividends. Our results suggest that accounting regimes can, on their own, contribute to price bubbles and their subsequent collapse.

Engineering Lemons
Vokata, Petra
Banks engineer and sell to U.S. households complex securities with attractive yields but negative returns. I document this in a sample of over 20,000 yield enhancement products (YEP), which became a $20 billion market after the post-crisis fall in interest rates. YEPs carry a significant downside risk and, according to regulators, are frequently missold to inexperienced investors. The products lose money both ex ante and ex post due to their largely hidden fees: on average, YEPs charge 7% in annual fees and subsequently lose 7% relative to risk-adjusted benchmarks. The fees remain large even after the SEC mandated disclosure of product values.

Expectations in the Cross Section: Stock Price Reactions to the Information and Bias in Analyst-Expected Returns
Loudis, Johnathan
Abstract returns implied by analyst price targets into prices. I use a novel decomposition to extract information and bias components from these analyst-expected returns and develop an asset pricing framework that helps interpret price reactions to each component. A one-standard-deviation increase in the information (bias) component is associated with a 5 (1) percentage point increase in announcement-month returns. The positive reaction to bias implies the market does not fully debias analyst-expected returns before incorporating them into prices. Prices overreact to bias and reverse their initial reaction within three to six months. Prices underreact to information and drift 20% beyond their initial reaction in the following 12 months. Announcement-window returns forecast future returns, which provides model-free evidence of underreaction, and that underreaction dominates overreaction. Trading against underreaction generates average monthly returns of 1.12% with a Sharpe ratio of 1.08, and the returns survive controlling for exposure to many standard factors.

Investor Memory
Gödker, Katrin,Jiao, Peiran,Smeets, Paul
How does memory shape individuals' financial decisions? We find experimental evidence of a self-serving memory bias, which distorts beliefs and drives investment choices. Subjects who previously invested in a risky stock are more likely to remember positive investment outcomes and less likely to remember negative outcomes. In contrast, subjects who did not invest but merely observed the investment outcomes do not have this memory bias. Importantly, subjects do not adjust their behavior to account for the fallibility of their memory. After investing, they form overly optimistic beliefs and re-invest in the stock even when doing so reduces their expected return. The memory bias we document is relevant for understanding how people form expectations from experiences in financial markets and, more generally, for understanding household financial decision-making.

Regulating Cryptocurrencies in New Zealand
Sims, Alexandra,Kariyawasam, Kanchana,Mayes, David G.
Cryptocurrencies, in particular bitcoin, have captured the public’s attention. It is hard to find a person who has not heard about bitcoin, albeit blockchain, the technology that the creators of bitcoin devised, is still a mystery to most. (Blockchain is just one form of distributed ledger technology (DLT). For the sake of simplicity the term blockchain is used throughout this report.) Prior to bitcoin, people who wanted to transfer value between themselves needed to do it face-to-face or rely on trusted third parties. Even transacting face-to-face often required the use of bank notes (cash) issued by central banks â€" and good luck trying to get someone in New Zealand to accept Moroccan dirham for a cup of coffee. Cryptocurrencies allow people to transfer value in seconds â€" if using a newer cryptocurrency than bitcoin â€" between themselves even if they are on opposite sides of the world without using third parties: something which conventional banking systems cannot do. Not only can value be transferred, but there are considerable cost savings: a blockchain is a shared tamper-proof ledger which means the parties do not need to reconcile their records. Conventional payment systems have not caught up with the internet age. We take it for granted that we can send digital files, such as photographs and documents, across the world in seconds. Moreover, the use of cryptocurrencies goes well beyond mere transfers of value; it can transform how we transact. The provision of goods and services, including the transfer of legal title and the payment, can be done in one transaction. So compelling are the opportunities that blockchain technology allows that large corporations are already using cryptocurrencies in their operations to move value around the world and central banks are actively working on creating central bank-issued cryptocurrencies, which we refer to as CBDCs. Fears of the dangers of technology are understandable, such as the ability for criminals to use cryptocurrencies to launder money and finance terror; however, any technology can be used for good and bad. If early humans had turned their backs on fire due to the very real risk of harm, none of us would be reading this report. Indeed, criminals are using the current banking and corporate/trusts systems more than cryptocurrencies. While cryptocurrencies are tolerated in New Zealand, as they are in most countries, in practice they are difficult to obtain and use. Many New Zealand cryptocurrency exchanges, where people can purchase cryptocurrencies with New Zealand dollars (fiat currency), find it difficult to obtain bank accounts, and when they do, the exchanges’ bank accounts are often closed down. Businesses find it extremely difficult to operate without bank accounts. In turn, consumers are potentially harmed if they purchase cryptocurrencies from overseas exchanges, which may not be subject to the same level of regulatory oversight as New Zealand exchanges. The risk increases if those cryptocurrencies are stored by the overseas exchanges. Businesses that want to receive and pay in cryptocurrencies also find it difficult to obtain and keep bank accounts in New Zealand. As a result, businesses, and the resulting economic activity, migrate to those countries that are actively fostering their blockchain ecosystem. New Zealand has an opportunity to be a blockchain and financial technology (fintech) hub, which would fit well with New Zealand’s perception as a nimble, agile and innovative country. However, for New Zealand to realise its potential, change is required. Recommendations: 1. The New Zealand Government should continue to allow cryptocurrencies to be traded as well as used for the payment of goods and services within and outside New Zealand. 2. New Zealand-based cryptocurrency exchanges should be encouraged, and clear and detailed guidance provided as to their anti-money laundering/counter-the funding of terrorism (AML/CFT) obligations by both the Department of Internal Affairs (DIA) and the Financial Markets Authority (FMA). That is, follow Australia’s example. 3. Greater advice and therefore protection should be provided to consumers on cryptocurrencies by the FMA, DIA and other organisations. 4. Cryptocurrency exchanges that comply with AML/CFT and other requirements must have access to bank accounts with New Zealand banks. 5. Merchants must be able to accept cryptocurrency payments by people or organisations for under NZD 100 or payments made through a New Zealand exchange (or an overseas exchange) that complies with AML/CFT requirements, without the merchants losing their bank accounts. 6. GST is removed from cryptocurrencies that are used for the payment of goods and services. 7. The Inland Revenue Department (IRD) clarifies other taxation rules around the use of cryptocurrencies. 8. The IRD should accept cryptocurrencies for the payment of taxes. 9. The Reserve Bank of New Zealand (RBNZ) should trial the creation and issuance of a New Zealand CBDC. 10. Although this point goes wider than merely cryptocurrencies, New Zealand should follow countries such as the United Kingdom (UK) and Australia, and create a regulatory sandbox and ensure that the regulators work alongside fintech companies.

The Financial Conglomerate Discount: Insights from Stock Return Skewness
Bressan, Silvia,Weissensteiner, Alex
Empirical evidence shows that diversified banks (i.e. financial conglomerates) trade at a discount compared to a matched portfolio of specialized stand-alone banks. While one strand of research explains this puzzle primarily with inefficiencies in the cash flow management, we analyze whether this evidence is due to expected returns which compensate investors for skewness exposure. Our empirical findings support this hypothesis. We implement different (co-)skewness measures proposed by the previous literature. We illustrate that diversified banks have asset returns with lower skewness, and, as a consequence of lower upside potential, investors demand for these stocks a higher discount or, vice versa, higher expected returns. Different robustness checks corroborate our main result.

The Good the Bad and the Trending: Microblogging Sentiment and Short Term Momentum
Hill-Kleespie, Austin
Over the past ten years microblogging services such as StockTwits and Twitter have become a popular way for users to express thoughts, opinions, and reactions in real time. This study explores the mechanism that connects the content of these posts to stock returns and theories of momentum at both the individual security level and in portfolios. Specifically I construct firm level measures of StockTwits sentiment using data from the StockTwits microblogging website to test theories of momentum from Daniel, Hirshleifer, and Subrahmanyam (1998) and Hong and Stein (1999). I find that trailing measures of sentiment have predictive power over future stock returns. Portfolios formed using StockTwits data have strong explanatory power over the daily momentum factor of Carhart (1997). These findings are consistent with Hong and Stein (1999) and also demonstrate that microblogging services provide an important new data set for testing asset pricing theories.

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 proposes 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 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) 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 Role of Stock Price Informativeness in Compensation Complexity
Bennett, Benjamin,Garvey, Gerald T.,Milbourn, Todd T.,Wang, Zexi
We study the effect of stock price informativeness (SPI) on executive compensation complexity. Using textual analysis of SEC proxy statements to construct compensation complexity measures for US public firms, we find strong evidence that higher SPI reduces pay complexity. We then use mutual fund redemption as an exogenous decrease in SPI to address endogeneity concerns. When fund flow pressure is high, pay includes more performance metrics, a greater number of vesting periods, and options with longer vesting periods. When stock prices convey information more effectively, executive pay is simpler.

The Unintended Consequences of Regulation: Evidence from China’s Interbank Market
Gu, Xian,Yun, Lu
In this paper we use evidence from China’s interbank market to examine the unanticipated consequences of regulation on the financial system. We find that banks tend to use newly introduced and lightly regulated financial instruments in the interbank market to get around regulation in the search for funds. Specifically, we find that banks which face greater competition have engaged more heavily in the issuance of interbank negotiable CDs and interbank wealth management products, especially when market rates are high. Moreover, these interbank activities are closely associated with banks’ proprietary trading, suggesting the potential risk of contagion in the financial system.

Unlevelling the Playing Field: The Investment Value and Capital Market Consequences of Alternative Data
Painter, Marcus
This paper documents the investment value of alternative data and examines how market participants react to the data's dissemination. Using satellite images of parking lots of US retailers, I find a long-short trading strategy based on growth in car count earns an alpha of 1.6% per month. I then show that, after the release of satellite data, hedge fund trades are more sensitive to growth in car count and are more profitable in affected stocks. Conversely, individual investor demand becomes less sensitive to growth in car count and less profitable in affected stocks. Further, the increase in information asymmetry between investors due to the availability of alternative data leads to a decrease in the liquidity of affected firms.

What's Wrong with Pittsburgh? Investor Composition and Trade Frequency in US Cities
Ghent, Andra C.
This paper documents differences in investor composition across US cities, shows that delegated investors have shorter holding periods, and shows that delegated investors are concentrated in cities with higher turnover. It then calibrates a search model with heterogeneity in liquidity preferences to interpret these facts. The model shows that heterogeneity in liquidity preferences makes some markets more liquid even when assets have identical cash flows. The calibration indicates that commercial real estate commands an illiquidity premium of two percentage points annually relative to a perfectly liquid asset with similar credit risk.

When Blockholders Meet Short Sellers: Two Forms of Governance
Wang, Michael,Yu, Jin
Using a natural experiment of short selling and a unique blockholder dataset from the U.S. market, this paper investigates how short selling affects blockholder governance. Although the size of blockholders is reduced with the high propensity for short selling, blockholders tend to raise more activism events, propose more activism goals to discipline managers, or provide suggestions for business operations. Further analyses reveal that blockholders that choose to stay in the firm with increasing short selling can improve the firm’s value. These detailed purposes of activism lead to better firm performance compared with other active blockholders that focus on investment goals.

When Investors Call for Climate Responsibility, How Do Mutual Funds Respond?
Ceccarelli, Marco,Ramelli, Stefano,Wagner, Alexander F.
In April 2018, the investment platform and financial advisor Morningstar introduced a new eco-label for mutual funds, the Low Carbon Designation (LCD). The unexpected release of this label induced responses by (1) investors and (2) mutual funds. First, investors flocked to funds labeled as Low Carbon. Through the end of 2018, such funds enjoyed a 3.1% increase in assets compared to otherwise similar funds. This effect was distinct from that of more generic sustainability ratings ("Globes"), and it reversed for funds that lost the label in August or November 2018. Second, managers of just-missing funds adjusted their holdings towards lower carbon risk and lower fossil fuel involvement, the two criteria used to assign the LCD. Both the rewards-for-LCD and the moving-towards-LCD effects are stronger for European funds, retail funds, funds with weak financial performance, and low-sustainability funds. Overall, the findings suggest that as investors become more sensitive to the topic of climate change, financial intermediaries also use existing investment vehicles to respond to the increasing demand for climate-conscious investment products.