Research articles for the 2019-03-24

A Case Study of Climate Change and Flooding in Bangladesh Floods in the World Floods in Asia (Presentation Slides)
Lemenkova, Polina
The presentation describes problem of flooding in Bangladesh: Among the countries that are the worst affected by climate change. Frequent natural disasters, loss of life, damage to infrastructure and economic assets, impacts on lives and livelihoods. Floods, tropical cyclones, storm surges and droughts are likely to become more frequent and severe in the coming years. Bangladesh lies in the delta of three of the largest rivers in the world â€" the Brahmaputra, the Ganges and the Meghna.

A Machine Learning approach to Risk Minimisation in Electricity Markets with Coregionalized Sparse Gaussian Processes
Daniel Poh,Stephen Roberts,Martin Tegnér

The non-storability of electricity makes it unique among commodity assets, and it is an important driver of its price behaviour in secondary financial markets. The instantaneous and continuous matching of power supply with demand is a key factor explaining its volatility. During periods of high demand, costlier generation capabilities are utilised since electricity cannot be stored---this has the impact of driving prices up very quickly. Furthermore, the non-storability also complicates physical hedging. Owing to this, the problem of joint price-quantity risk in electricity markets is a commonly studied theme.

To this end, we investigate the use of coregionalized (or multi-task) sparse Gaussian processes (GPs) for risk management in the context of power markets. GPs provide a versatile and elegant non-parametric approach for regression and time-series modelling. However, GPs scale poorly with the amount of training data due to a cubic complexity. These considerations suggest that knowledge transfer between price and load is vital for effective hedging, and that a computationally efficient method is required.

To gauge the performance of our model, we use an average-load strategy as comparator. The latter is a robust approach commonly used by industry. If the spot and load are uncorrelated and Gaussian, then hedging with the expected load will result in the minimum variance position.

The main contribution of our work is twofold. Firstly, in developing a multi-task sparse GP-based approach for hedging. Secondly, in demonstrating that our model-based strategy outperforms the comparator, and can thus be employed for effective hedging in electricity markets.

Asymptotics for volatility derivatives in multi-factor rough volatility models
Chloe Lacombe,Aitor Muguruza,Henry Stone

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.

Digital Banking: A Roadmap to Curb the Cancer of Corruption
Fernandes, Divya J.,Crasta, Shawna J.,Hans, V. Basil
Living in the technological era, we see that traditional banking is driving us towards the cancer of corruption and it is incomprehensible. Corruption in the Indian banking system has slightly lowered since the launching of the Digital India Campaign. When the government of India made its first move (i.e., demonetization) to curb corruption the outcome was it disrupted the lives of innocent people, as a positive consequence it gave an immediate boost to e-transactions. In the present scenario, people are extensively using e-transaction because of the benefits/returns that they derive from them. In this context, banks must stimulate their customers to use digital banking systems. Thus in India, Digital banking could be a roadmap that curbs corruption to a certain measure.In this research paper, we have attempted to find out as to how Digital Banking helps to curb Corruption in India. The paper also highlights the objectives and functions of Digital Banking and how it contributes to the development of the nation. This research paper further explores the issues and the challenges faced in e-transactions. Finally, the paper examines and draws out a conclusion.

Growth, Industrial Externality, Prospect Dynamics and Well-being on Markets
Emmanuel Chauvet

Functions or 'functionings' enable to give a structure to any economic activity whether they are used to describe a good or a service that is exchanged on a market or they constitute the capability of an agent to provide the labor market with specific work and skills. That structure encompasses the basic law of supply and demand and the conditions of growth within a transaction and of the inflation control. Functional requirements can be followed from the design of a product to the delivery of a solution to a customer needs with different levels of externalities while value is created integrating organizational and technical constraints whereas a budget is allocated to the various entities of the firm involved in the production. Entering the market through that structure leads to designing basic equations of its dynamics and to finding canonical solutions out of particular equilibria. This approach enables to tackle behavioral foundations of Prospect Theory within a generalization of its probability weighting function turned into an operator which applies to Western, Educated, Industrialized, Rich, and Democratic societies as well as to the poorest ones. The nature of reality and well-being appears then as closely related to the relative satisfaction reached on the market, as it can be conceived by an agent, according to business cycles. This reality being the result of the complementary systems that govern human mind as structured by rational psychologists.

High-Frequency Trading and Price Informativeness
Gider, Jasmin,Schmickler, Simon,Westheide, Christian
We study how the informativeness of stock prices changes with the presence of high-frequency trading (HFT). Our estimate is based on the staggered start of HFT participation in a panel of international exchanges. With HFT presence, market prices are a less reliable predictor of future cash flows and investment, even more so for longer horizons. Further, firm-level idiosyncratic volatility decreases, and the holdings and trades by institutional investors deviate less from the market-capitalization weighted portfolio as a benchmark. Our results document that the informativeness of prices decreases subsequent to the start of HFT. These findings are consistent with theoretical models of HFTs' ability to anticipate informed order flow, resulting in decreased incentives to acquire fundamental information.

Mid-price estimation for European corporate bonds: a particle filtering approach
Olivier Guéant,Jiang Pu

In most illiquid markets, there is no obvious proxy for the market price of an asset. The European corporate bond market is an archetypal example of such an illiquid market where mid-prices can only be estimated with a statistical model. In this OTC market, dealers / market makers only have access, indeed, to partial information about the market. In real time, they know the price associated with their trades on the dealer-to-dealer (D2D) and dealer-to-client (D2C) markets, they know the result of the requests for quotes (RFQ) they answered, and they have access to composite prices (e.g., Bloomberg CBBT). This paper presents a Bayesian method for estimating the mid-price of corporate bonds by using the real-time information available to a dealer. This method relies on recent ideas coming from the particle filtering / sequential Monte-Carlo literature.

Optimal Dividend Distribution Under Drawdown and Ratcheting Constraints on Dividend Rates
Bahman Angoshtari,Erhan Bayraktar,Virginia R. Young

We consider the optimal dividend problem under a habit formation constraint that prevents the dividend rate to fall below a certain proportion of its historical maximum, the so-called drawdown constraint. This is an extension of the optimal Duesenberry's ratcheting consumption problem, studied by Dybvig (1995) [Review of Economic Studies 62(2), 287-313], in which consumption is assumed to be nondecreasing. Our problem differs from Dybvig's also in that the time of ruin could be finite in our setting, whereas ruin was impossible in Dybvig's work. We formulate our problem as a stochastic control problem with the objective of maximizing the expected discounted utility of the dividend stream until bankruptcy, in which risk preferences are embodied by power utility. We semi-explicitly solve the corresponding Hamilton-Jacobi-Bellman variational inequality, which is a nonlinear free-boundary problem. The optimal (excess) dividend rate $c^*_t$ - as a function of the company's current surplus $X_t$ and its historical running maximum of the (excess) dividend rate $z_t$ - is as follows: There are constants $0 < w_{\alpha} < w_0 < w^*$ such that (1) for $0 < X_t \le w_{\alpha} z_t$, it is optimal to pay dividends at the lowest rate $\alpha z_t$, (2) for $w_{\alpha} z_t < X_t < w_0 z_t$, it is optimal to distribute dividends at an intermediate rate $c^*_t \in (\alpha z_t, z_t)$, (3) for $w_0 z_t < X_t < w^* z_t$, it is optimal to distribute dividends at the historical peak rate $z_t$, (4) for $X_t > w^* z_t$, it is optimal to increase the dividend rate above $z_t$, and (5) it is optimal to increase $z_t$ via singular control as needed to keep $X_t \le w^* z_t$. Because, the maximum (excess) dividend rate will eventually be proportional to the running maximum of the surplus, "mountains will have to move" before we increase the dividend rate beyond its historical maximum.

Optimal Dynamic Basis Trading
Bahman Angoshtari,Tim Leung

We study the problem of dynamically trading a futures contract and its underlying asset under a stochastic basis model. The basis evolution is modeled by a stopped scaled Brownian bridge to account for non-convergence of the basis at maturity. The optimal trading strategies are determined from a utility maximization problem under hyperbolic absolute risk aversion (HARA) risk preferences. By analyzing the associated Hamilton-Jacobi-Bellman equation, we derive the exact conditions under which the equation admits a solution and solve the utility maximization explicitly. A series of numerical examples are provided to illustrate the optimal strategies and examine the effects of model parameters.

Option Implied Dependence
Bernard, Carole,Bondarenko, Oleg,Vanduffel, Steven
We propose a novel model-free approach to infer a joint risk-neutral dependence among several assets. The dependence can be estimated when traded options are available on individual assets as well as on their index. In the empirical application, we implement our approach using options on the S&P 500 index and its nine sectors. We find that option-implied dependence is highly non-normal and time-varying. Using the estimated dependence, we then study the correlation risk conditional on the market going down or up. We find that the risk premium for the down correlation is strongly negative, whereas it is positive for the up correlation. These findings are consistent with the economic intuition that the investors are particularly concerned with the loss of diversification when financial markets fall. As a result, they are willing to pay a considerable premium to hedge against increases in correlation during turbulent times. However, the investors actually prefer high correlation when markets rally.

Risk-based optimal portfolio of an insurer with regime switching and noisy memory
Rodwell Kufakunesu,Calisto Guambe,Lesedi Mabitsela

In this paper, we consider a risk-based optimal investment problem of an insurer in a regime-switching jump diffusion model with noisy memory. Using the model uncertainty modeling, we formulate the investment problem as a zero-sum, stochastic differential delay game between the insurer and the market, with a convex risk measure of the terminal surplus and the Brownian delay surplus over a period $[T-\varrho,T]$. Then, by the BSDE approach, the game problem is solved. Finally, we derive analytical solutions of the game problem, for a particular case of a quadratic penalty function and a numerical example is considered.

Short-term at-the-money asymptotics under stochastic volatility models
Omar El Euch,Masaaki Fukasawa,Jim Gatheral,Mathieu Rosenbaum

A small-time Edgeworth expansion of the density of an asset price is given under a general stochastic volatility model, from which asymptotic expansions of put option prices and at-the-money implied volatilities follow. A limit theorem for at-the-money implied volatility skew and curvature is also given as a corollary. The rough Bergomi model is treated as an example.

Simultaneous Analyst Coverage and the Reduction of the Risk-Arb Spread
Hossain, Md Miran,Jansen, Ben,Taylor, Jon
Research on mergers and hedge funds find that the risk arbitrage spread has contracted. This paper investigates the role financial analysts have on risk arbitrage by comparing mergers where a single analyst covers both the target and the acquirer prior to the deal announcement. We find that simultaneous coverage increases as a percent of M&A deals and that deals with simultaneous analyst coverage have a lower risk-arb spread. We additionally find that these deals have a lower takeover premium and longer time to completion. Overall, results suggest that simultaneous analyst coverage has reduced the risk-arb spread.

Stability results for martingale representations: the general case
Antonis Papapantoleon,Dylan Possamai,Alexandros Saplaouras

In this paper, we obtain stability results for martingale representations in a very general framework. More specifically, we consider a sequence of martingales each adapted to its own filtration, and a sequence of random variables measurable with respect to those filtrations. We assume that the terminal values of the martingales and the associated filtrations converge in the extended sense, and that the limiting martingale is quasi--left--continuous and admits the predictable representation property. Then, we prove that each component in the martingale representation of the sequence converges to the corresponding component of the martingale representation of the limiting random variable relative to the limiting filtration, under the Skorokhod topology. This extends in several directions earlier contributions in the literature, and has applications to stability results for backward SDEs with jumps and to discretisation schemes for stochastic systems.

The Countercyclical Capital Buffer and the Composition of Bank Lending
Auer, Raphael,Ongena, Steven
Do macroprudential regulations on residential lending influence commercial lending behavior too? To answer this question, we identify the compositional changes in banks’ supply of credit using the variation in their holdings of residential mortgages on which extra capital requirements were uniformly imposed by the countercyclical capital buffer (CCyB) introduced in Switzerland in 2012. We find that the CCyB’s introduction led to higher growth in commercial lending, in particular to small firms, although this was unrelated to conditions in regional housing markets. The interest rates and fees charged to these firms concurrently increased. We rationalize these findings in a model featuring both private and firm-specific collateral. The corresponding imperfect substitutability between private and commercial credit for the entrepreneur’s relationship bank is then shown to give rise to the compositional patterns we empirically document. The surprising finding of our theoretical analysis however is that in terms of optimal policy design, such spillovers do not undermine the motive for sectorally differentiated equity requirements, but in contrast, actually provide a rational for such regulatory differentiation.

The Effect of Ownership Structure on Intellectual Capital Efficiency: Evidence from Borsa Istanbul
Nassar, Sedeaq,Ashour, Mahmoud,Tan, Ömer Faruk, Külah, Sezer
This study examined the effect of ownership structure on intellectual capital efficiency of listed firms on Borsa Istanbul. Data covering the 2005-2015 period is gathered from the FINNET database and companies’ financial statements to compute VAIC, and from the ISO500 website to obtain the ownership structures of the companies. The ownership structure is divided into five different categories; government, family, institutional, individual, and foreign, while the efficiency of intellectual capital is measured using Public’s model Value Added Intellectual Coefficient (VAIC). This measure is composed of three main components, Human Capital Efficiency (HCE), Structural Capital Efficiency (SCE), and Capital Employed Efficiency (CEE). In general, we find that family and foreign ownership structures have a significant negative impact on intellectual capital efficiency, while government, institutional, and individual ownership structures have a negative impact on intellectual capital efficiency. It seems that in this setting, all ownership structures have a negative impact on intellectual capital.

The Environment of the Białowieza National Park and Sudety Mountains (Presentation Slides)
Lemenkova, Polina
The research focus is Bialowieza, a World Heritage Site located in north east-central Poland. Presentation discusses some environmental and geographical issues of this unique region of Europe.

Unravelling the forces underlying urban industrial agglomeration
Neave O'Clery,Samuel Heroy,Francois Hulot,Mariano Beguerisse-Diaz

As early as the 1920's Marshall suggested that firms co-locate in cities to reduce the costs of moving goods, people, and ideas. These 'forces of agglomeration' have given rise, for example, to the high tech clusters of San Francisco and Boston, and the automobile cluster in Detroit. Yet, despite its importance for city planners and industrial policy-makers, until recently there has been little success in estimating the relative importance of each Marshallian channel to the location decisions of firms.

Here we explore a burgeoning literature that aims to exploit the co-location patterns of industries in cities in order to disentangle the relationship between industry co-agglomeration and customer/supplier, labour and idea sharing. Building on previous approaches that focus on across- and between-industry estimates, we propose a network-based method to estimate the relative importance of each Marshallian channel at a meso scale. Specifically, we use a community detection technique to construct a hierarchical decomposition of the full set of industries into clusters based on co-agglomeration patterns, and show that these industry clusters exhibit distinct patterns in terms of their relative reliance on individual Marshallian channels.