Research articles for the 2019-03-23
Bilateral Risk Sharing with Heterogeneous Beliefs and Exposure Constraints
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This paper studies bilateral risk sharing under no aggregate uncertainty, where one agent has Expected-Utility preferences and the other agent has Rank-Dependent Utility preferences with a general probability distortion function. We impose exogenous constraints on the risk exposure for both agents, and we allow for any type or level of belief heterogeneity. We show that Pareto-optimal risk-sharing contracts can be obtained via a constrained utility maximization under a participation constraint of the other agent. This allows us to give an explicit characterization of optimal risk-sharing contracts. In particular, we show that an optimal contract is a monotone function of the likelihood ratio, where the latter is obtained from Lebesgue's Decomposition Theorem.
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This paper studies bilateral risk sharing under no aggregate uncertainty, where one agent has Expected-Utility preferences and the other agent has Rank-Dependent Utility preferences with a general probability distortion function. We impose exogenous constraints on the risk exposure for both agents, and we allow for any type or level of belief heterogeneity. We show that Pareto-optimal risk-sharing contracts can be obtained via a constrained utility maximization under a participation constraint of the other agent. This allows us to give an explicit characterization of optimal risk-sharing contracts. In particular, we show that an optimal contract is a monotone function of the likelihood ratio, where the latter is obtained from Lebesgue's Decomposition Theorem.
Can the Open Market React to Stock Repurchases Announcement Correctly?
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In this study, we explore the market reaction to the announcement of stock repurchase plans, and the mutual influence between the actual fulfillment rate of stock repurchase plans and the degree of earnings management. From the perspective of earnings management behavior, this paper also analyzes the actual fulfillment rate, and discusses the information asymmetry, firms may carry out earnings management before stock repurchases, to mislead the investors into believing the prettified financial statements, to induce the investors to invest, and convey false signals to the market. The empirical results demonstrate that the cumulative abnormal return (CAR) resulting from true signals is higher than that resulting from false signals. Further, the phenomenon is more significant in the hi-tech industry than in traditional industries, and the firms with Purpose 3 (support the stock prices to maintain firm credit and shareholders' equity), a significant, positive abnormal return is observed on the day before and the day after the announcement day. In bullish periods, abnormal returns are not significant; in bearish periods, a significant, positive abnormal return is observed. These findings are applicable not only to the research samples but also to the samples when the extreme values are removed. Therefore, the empirical results are still robust.
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In this study, we explore the market reaction to the announcement of stock repurchase plans, and the mutual influence between the actual fulfillment rate of stock repurchase plans and the degree of earnings management. From the perspective of earnings management behavior, this paper also analyzes the actual fulfillment rate, and discusses the information asymmetry, firms may carry out earnings management before stock repurchases, to mislead the investors into believing the prettified financial statements, to induce the investors to invest, and convey false signals to the market. The empirical results demonstrate that the cumulative abnormal return (CAR) resulting from true signals is higher than that resulting from false signals. Further, the phenomenon is more significant in the hi-tech industry than in traditional industries, and the firms with Purpose 3 (support the stock prices to maintain firm credit and shareholders' equity), a significant, positive abnormal return is observed on the day before and the day after the announcement day. In bullish periods, abnormal returns are not significant; in bearish periods, a significant, positive abnormal return is observed. These findings are applicable not only to the research samples but also to the samples when the extreme values are removed. Therefore, the empirical results are still robust.
Comparison of the European and the U.S. Unregulated Stock Markets Designed for SMES
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This paper examines the state of small and medium enterprises (SMEs) in European and U.S. unregulated stock markets. The analysis compares the performance of both markets, using the weekly adjusted closing index prices of Euronext all share index, NYSE AMEX Composite Index, and the OTCM ADR Index for the 2013-2017 period. ADF, EGARCH, and ARCH tests were performed on the collected time series data, to measure and forecast index price volatility, risk and return. The results show a high level of price volatility in some periods; but a permanent effect of shocks was not observed in the long term for all the analyzed indexes. Negative shocks cause more volatility than positive shocks. However, an overall result shows that, the Euronext all share index, despite slight declines, displays an upward trend and relatively higher returns with less risk, than the NYSE AMEX Composite Index, and the OTCM ADR Index. This results reflects the better performance of the European unregulated market, compare to its U.S. counterparts.
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This paper examines the state of small and medium enterprises (SMEs) in European and U.S. unregulated stock markets. The analysis compares the performance of both markets, using the weekly adjusted closing index prices of Euronext all share index, NYSE AMEX Composite Index, and the OTCM ADR Index for the 2013-2017 period. ADF, EGARCH, and ARCH tests were performed on the collected time series data, to measure and forecast index price volatility, risk and return. The results show a high level of price volatility in some periods; but a permanent effect of shocks was not observed in the long term for all the analyzed indexes. Negative shocks cause more volatility than positive shocks. However, an overall result shows that, the Euronext all share index, despite slight declines, displays an upward trend and relatively higher returns with less risk, than the NYSE AMEX Composite Index, and the OTCM ADR Index. This results reflects the better performance of the European unregulated market, compare to its U.S. counterparts.
Derivatives Markets and Managed Money: Implications for Price Discovery
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Derivatives markets determination of commodities prices should largely be based on production and utilization of the underlying commodity. Certainly, government programs designed to impact production or utilization including expectations associated with those programs, as well as, weather, geopolitical issues, related commodity dynamics, terrorism, etc. could potentially impact prices. Derivatives markets participants such as producers, merchants, warehousers, processors and end users play a fundamental role of providing liquidity through their management of risk. Of increasing significance is managed money. Hedge funds, commodities index contracts, and commodity Exchange Traded Funds (ETFs) are types of managed money that look to commodity derivatives markets to speculate. This research project utilizes panel data, commodities prices and Commodities Futures Trading Commission (CFTC) data on Commitment of Traders (COT) to isolate the impact that managed money has on commodities prices. To this end we employ regression analysis to analyze various periods of time to test our hypothesis that the flow of managed money into and out of commodities derivatives markets creates price changes not consistent with production and utilization.
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Derivatives markets determination of commodities prices should largely be based on production and utilization of the underlying commodity. Certainly, government programs designed to impact production or utilization including expectations associated with those programs, as well as, weather, geopolitical issues, related commodity dynamics, terrorism, etc. could potentially impact prices. Derivatives markets participants such as producers, merchants, warehousers, processors and end users play a fundamental role of providing liquidity through their management of risk. Of increasing significance is managed money. Hedge funds, commodities index contracts, and commodity Exchange Traded Funds (ETFs) are types of managed money that look to commodity derivatives markets to speculate. This research project utilizes panel data, commodities prices and Commodities Futures Trading Commission (CFTC) data on Commitment of Traders (COT) to isolate the impact that managed money has on commodities prices. To this end we employ regression analysis to analyze various periods of time to test our hypothesis that the flow of managed money into and out of commodities derivatives markets creates price changes not consistent with production and utilization.
Dynamics Between Exchange Rates and Stock Prices: Evidence From Developed and Emerging Markets
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This study examines the long- and short-run dynamics between exchange rates and stock prices by using cointegration methodology and multivariate Granger causality tests. We apply the analysis to six countries, including: Japan, United Kingdom, Hong Kong, China, India and Brazil over the period December 2007 to May 2013. The evidence suggests that the global financial crisis 2007-2009 is an important determinant of the link between the domestic stock and foreign exchange markets. The exchange rate is negatively related to the domestic stock market for emerging countries but positively for developed countries for entire sample and during the crisis. However, this relationship became positive for all countries after the crisis, except United Kingdom. The finding also indicates that the exchange rate movements contain some significant information to forecast the stock returns of these markets.
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This study examines the long- and short-run dynamics between exchange rates and stock prices by using cointegration methodology and multivariate Granger causality tests. We apply the analysis to six countries, including: Japan, United Kingdom, Hong Kong, China, India and Brazil over the period December 2007 to May 2013. The evidence suggests that the global financial crisis 2007-2009 is an important determinant of the link between the domestic stock and foreign exchange markets. The exchange rate is negatively related to the domestic stock market for emerging countries but positively for developed countries for entire sample and during the crisis. However, this relationship became positive for all countries after the crisis, except United Kingdom. The finding also indicates that the exchange rate movements contain some significant information to forecast the stock returns of these markets.
Evidence on the Impact of the Troubled Assets Relief Program on Stock Returns
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In response to the global financial crisis which began in 2008, the US government launched the Troubled Assets Relief Program (TARP), the largest government bailout in US history. TARP was controversial and publicly unpopular. This article examines the market responses to the TARP-related events as reflected in stock returns. Our empirical strategy permits a counterfactual interpretation of the data and provides empirical evidence to answer the question “what would have happened to those banks that did in fact receive bailout funds if they had not received the bailout.†We find that the market responded favorably to the announcement of TARP, which suggests that the bailout program launch helped restore investors’ confidence in the financial system. However, the market reacted negatively to the receipt of TARP bailout funds. Hence, instead of ensuring certification, receiving bailouts generated an adverse market signal. Our empirical evidence suggests that TARP receipt rather than the announcement by banks to accept TARP funds was essential.
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In response to the global financial crisis which began in 2008, the US government launched the Troubled Assets Relief Program (TARP), the largest government bailout in US history. TARP was controversial and publicly unpopular. This article examines the market responses to the TARP-related events as reflected in stock returns. Our empirical strategy permits a counterfactual interpretation of the data and provides empirical evidence to answer the question “what would have happened to those banks that did in fact receive bailout funds if they had not received the bailout.†We find that the market responded favorably to the announcement of TARP, which suggests that the bailout program launch helped restore investors’ confidence in the financial system. However, the market reacted negatively to the receipt of TARP bailout funds. Hence, instead of ensuring certification, receiving bailouts generated an adverse market signal. Our empirical evidence suggests that TARP receipt rather than the announcement by banks to accept TARP funds was essential.
Expectations in the Cross Section: Stock Price Reactions to the Information and Bias in Analyst-Expected Returns
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This paper provides evidence that the market does not efficiently incorporate expected 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 five (one) 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 returns drift an additional one percentage point 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.
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This paper provides evidence that the market does not efficiently incorporate expected 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 five (one) 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 returns drift an additional one percentage point 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 Psychology and Sustainable Finance
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Although significant attention has been paid to the incorporation of sustainability criteria into investment decisions, these remain far from a mainstream practice. Starting with the view that the notion of “doing good while doing well†is inconsistent, this paper argues that this paradigm warrants a behavioral foundation. To this end, I propose a theoretical model of preferences for sustainable investing; sketch the empirical and experimental evidence regarding investor psychology as a determinant of sustainable investing; suggest an array of fundamental behavioral parameters that have yet to be explored; and outline ways for leveraging insights from behavioral economics to nudge investors towards sustainability.
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Although significant attention has been paid to the incorporation of sustainability criteria into investment decisions, these remain far from a mainstream practice. Starting with the view that the notion of “doing good while doing well†is inconsistent, this paper argues that this paradigm warrants a behavioral foundation. To this end, I propose a theoretical model of preferences for sustainable investing; sketch the empirical and experimental evidence regarding investor psychology as a determinant of sustainable investing; suggest an array of fundamental behavioral parameters that have yet to be explored; and outline ways for leveraging insights from behavioral economics to nudge investors towards sustainability.
Risk and Return Determinants of US Insurers
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This paper identifies the risk and risk-adjusted return determinants of US insurers. We find that the significant firm-specific determinants for risk and risk-adjusted return vary slightly for the risk proxy and risk-adjusted return proxy used, and the types of insurers. We find that in general, profitability, leverage, types of management compensation are significantly related to both total risk and systematic risk; in addition, size is positively related to systematic risk. Profitability and incentive pay are significant determinants for total-risk-adjusted return. Size is significantly negatively related to systematic-riskadjusted return. In addition to size, profitability and leverage are significant determinants for systematicrisk-adjusted return for Life insurers.
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This paper identifies the risk and risk-adjusted return determinants of US insurers. We find that the significant firm-specific determinants for risk and risk-adjusted return vary slightly for the risk proxy and risk-adjusted return proxy used, and the types of insurers. We find that in general, profitability, leverage, types of management compensation are significantly related to both total risk and systematic risk; in addition, size is positively related to systematic risk. Profitability and incentive pay are significant determinants for total-risk-adjusted return. Size is significantly negatively related to systematic-riskadjusted return. In addition to size, profitability and leverage are significant determinants for systematicrisk-adjusted return for Life insurers.
Systemic Portfolio Diversification
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We study the implications of fire-sale externalities on balance sheet composition. Banks select their asset holdings to minimize expected execution costs triggered by the need to comply with regulatory leverage requirements. We show that if banks disregard the price impact caused by other banks' liquidation actions, they hold an excessively diversified portfolio. Banks seek systemic diversification when they account for the negative externalities imposed by other banks' liquidation actions. Social costs can be reduced by a tax on portfolio overlap, or by enforcing policies which mandate the split of a bank into smaller institutions with heterogeneous leverage ratios.
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We study the implications of fire-sale externalities on balance sheet composition. Banks select their asset holdings to minimize expected execution costs triggered by the need to comply with regulatory leverage requirements. We show that if banks disregard the price impact caused by other banks' liquidation actions, they hold an excessively diversified portfolio. Banks seek systemic diversification when they account for the negative externalities imposed by other banks' liquidation actions. Social costs can be reduced by a tax on portfolio overlap, or by enforcing policies which mandate the split of a bank into smaller institutions with heterogeneous leverage ratios.
The Transactional Asset Pricing Approach (TAPA): A Non-Technical Summary of the TAPA Framework for Valuing Illiquid Income-Producing Assets
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Ever since A. Marshall brought about the neoclassical synthesis in Economics and I. Fisher developed theories of capital valuation and interest in the early part of 20th c,, valuation theory has not been static. A particular spurt of activity has been observed in the 1950-1960th when the theory of pricing financial assets has been elaborated starting from works by H. Markovitz W.Sharpe , J.Lintner, as well as Modigliani & Miller. All these works were exploring the brave new world of big financial data, the crunching which has suddenly become possible by then newly introduced computer technology, therefore, predicating a valuation theory on distributional statistical concepts of average returns and standard deviations, in the framework of the market efficiency assumption and the homogeneity of market participant expectations. This has allowed to frame the standard valuation toolkit of the Modern Portfolio theory (MPT) â€" which Financial and Business assets valuers (as well as sometimes even Property valuers!) subsequently borrowed for their practical work. After this process of borrowing from the MPT valuation thinking has become assimilated to the actual valuation practicesin 1980s and 1990s, the fact that the underlying pricing models perform poorly even in the context of efficient public capital markets is often overlooked, or the need to hedge the theory with the protective belt of untenable highly abstract assumptions arises. The Transactional Asset Pricing Approach (TAPA) may offer a way out of this cul-de-sac in the development of valuation theory for the world of assets with less-than-perfect liquidity, i,e the majority of real assets participating in economic exchanges. This Paper provides a non-technical outline of the analytical vision underlying TAPA and summarizes major formulaic and theoretical findings obtainable under TAPA.
SSRN
Ever since A. Marshall brought about the neoclassical synthesis in Economics and I. Fisher developed theories of capital valuation and interest in the early part of 20th c,, valuation theory has not been static. A particular spurt of activity has been observed in the 1950-1960th when the theory of pricing financial assets has been elaborated starting from works by H. Markovitz W.Sharpe , J.Lintner, as well as Modigliani & Miller. All these works were exploring the brave new world of big financial data, the crunching which has suddenly become possible by then newly introduced computer technology, therefore, predicating a valuation theory on distributional statistical concepts of average returns and standard deviations, in the framework of the market efficiency assumption and the homogeneity of market participant expectations. This has allowed to frame the standard valuation toolkit of the Modern Portfolio theory (MPT) â€" which Financial and Business assets valuers (as well as sometimes even Property valuers!) subsequently borrowed for their practical work. After this process of borrowing from the MPT valuation thinking has become assimilated to the actual valuation practicesin 1980s and 1990s, the fact that the underlying pricing models perform poorly even in the context of efficient public capital markets is often overlooked, or the need to hedge the theory with the protective belt of untenable highly abstract assumptions arises. The Transactional Asset Pricing Approach (TAPA) may offer a way out of this cul-de-sac in the development of valuation theory for the world of assets with less-than-perfect liquidity, i,e the majority of real assets participating in economic exchanges. This Paper provides a non-technical outline of the analytical vision underlying TAPA and summarizes major formulaic and theoretical findings obtainable under TAPA.
