Research articles for the 2019-03-25

A Study of How Pursuit of Wealth Rank Distorts Risk Preferences
Rtischev, Dimitry
We theoretically explore the risk-taking behavior of two unequally-endowed risk-neutral agents who are presented with opportunities to play lotteries. We find that if the agents consider rank in the wealth distribution more important than wealth itself, then their risk preferences are distorted in a way that lowers their expected income, raises inequality and increases wealth-rank mobility. In equilibrium, the rich agent avoids some positive expected return lotteries and both agents gamble on some negative expected return lotteries. We simulate and graph equilibrium strategies to visualize how trying to get richer differs from trying to be richer than someone else.

Can Brands Circumvent Marketing Regulations? Exploiting Umbrella Branding in Financial Markets
Lu, Yan,Mitra, Debanjan,Musto, David K.,Ray, Sugata
Governments often regulate marketing activities to ensure marketers do not misinform consumers and obtain ‘unfair’ advantages. Yet, ample research finds such regulations may be ineffective since marketers are able to circumvent them. We examine if umbrella branding, a marketing strategy of multiple products sharing a common brand, can be used to circumvent marketing regulations on a given product. Specifically, in the asset management industry, we examine if hedge funds, faced with a comprehensive marketing ban, benefited from the advertising by their umbrella brand mutual fund affiliates and, if so, whether the hedge funds exploited this effect. We find higher advertising by mutual fund affiliates leads to a significant increase in sales of umbrella brand hedge funds and that hedge funds’ circumstances in a trailing period impact the likelihood of advertising by their umbrella brand mutual fund affiliates. More important, using the 2012 JOBS Act that removed hedge funds’ marketing restrictions as a natural experiment, we find that hedge funds’ trailing circumstances had significantly less impact on umbrella branded mutual fund advertising after the passage of the JOBS Act. These findings are consistent with hedge funds using umbrella branding to circumvent the marketing ban.

Consumer Characteristics With Regard to Choosing Between Fixed and Adjustable Interest Rates in Mortgage Contracts
Penczar, Marta
The main purpose of the article is to analyse the most important borrower characteristics determining preferences in the choice of the interest rate formula in mortgage contracts. Based on the PFSA statistics, the portfolio of newly-issued mortgages in 2016 was analysed to identify a group of consumers corresponding to the borrower characteristics who, in the light of European and global research, would be willing or obliged to choose a fixed interest rate.The conducted research shows that in Poland, the scale of the fixed interest rate choice in mortgage contracts is insignificant and represents only 0.2% of total mortgage debt. The analysis allows to identify a group of Polish consumers who should be given an option to choose a fixed rate when signing a mortgage contract.The size of the target group that should get acquainted with the offer of fixed-rate mortgages varies in Poland, depending on the chosen borrower characteristics.On the basis of the research, however, it can be incurred that in about 20% of the concluded contracts, there should be an option to choose the interest rate formula.

Consumption smoothing in the working-class households of interwar Japan
Kota Ogasawara

I analyze Osaka factory worker households in the early 1920s, whether idiosyncratic income shocks were shared efficiently, and which consumption categories were robust to shocks. While the null hypothesis of full risk-sharing of total expenditures was rejected, factory workers maintained their households, in that they paid for essential expenditures (rent, utilities, and commutation) during economic hardship. Additionally, children's education expenditures were possibly robust to idiosyncratic income shocks. The results suggest that temporary income is statistically significantly increased if disposable income drops due to idiosyncratic shocks. Historical documents suggest microfinancial lending and saving institutions helped mitigate risk-based vulnerabilities.

Corporate Bond VIX
Chen, Steven Shu-Hsiu,Doshi, Hitesh,Seo, Sang Byung
We construct a model-free volatility index for the corporate bond market, the CBVIX. This measure calculates the risk-neutral expectation of future 1-month volatility on a 5-year aggregate corporate bond index. Although options on corporate bonds do not generally trade, we show that it is possible to replicate call and put options on our synthetic corporate bond index using CDX options. The resulting CBVIX enables us to estimate the corporate bond variance risk premium, which robustly predicts future bond and equity returns. Additional model-free option-based analyses reveal the usefulness of CDX options in understanding various aspects of the corporate bond market.

Costly Private Learning and Informed Trading: Evidence from Mutual Funds in China
Xu, David Xiaoyu
Given multiple sources of information, how does cost of a private signal affect sophisticated investors' learning and trading? Mutual fund industry in China provides a unique empirical setting. I measure information acquisition and its cost with fund manager site visits and travel time between office addresses. Consistent with specialized learning under short sale constraint, visit decision positively correlates with existing information, which confounds causal estimation. To disentangle information costs from prior, I exploit within-firm-by-time variation in pairwise connection of high-speed rail lines. My results demonstrate that exogenous travel time reduction has sizable positive impact on site visits and investment profits.

DeepLOB: Deep Convolutional Neural Networks for Limit Order Books
Zihao Zhang,Stefan Zohren,Stephen Roberts

We develop a large-scale deep learning model to predict price movements from limit order book (LOB) data of cash equities. The architecture utilises convolutional filters to capture the spatial structure of the limit order books as well as LSTM modules to capture longer time dependencies. The proposed network outperforms all existing state-of-the-art algorithms on the benchmark LOB dataset [1]. In a more realistic setting, we test our model by using one year market quotes from the London Stock Exchange and the model delivers a remarkably stable out-of-sample prediction accuracy for a variety of instruments. Importantly, our model translates well to instruments which were not part of the training set, indicating the model's ability to extract universal features. In order to better understand these features and to go beyond a "black box'' model, we perform a sensitivity analysis to understand the rationale behind the model predictions and reveal the components of LOBs that are most relevant. The ability to extract robust features which translate well to other instruments is an important property of our model which has many other applications.

Do Firms Respond to Peer Disclosures? Evidence from Disclosures of Clinical Trial Results
Capkun, Vedran,Lou, Yun,Wang, Yin
We examine whether a firm’s decision to disclose non-financial proprietary information depends on peer disclosures of similar information. Using a sample of 5,035 unique clinical trials by U.S. pharmaceutical firms over the 2007-2014 period, we find that the firm is less likely to disclose its own clinical trial results if peers have published clinical trial results pertaining to the same medical condition. Conditional on disclosing clinical trial results, the firm is also less likely to disclose the trial results on time when peers have disclosed their clinical trial results. Our cross-sectional tests suggest that proprietary costs of disclosure play an important role in the relation between peer disclosures and the firm’s own disclosure. In particular, the negative relation is more pronounced when proprietary costs of disclosure are higher. Taken together, our findings provide new evidence on the interplay between peer and own disclosures of non-financial proprietary information.

Do Labor Conditions Matter in Loan Contracting? Evidence from Labor Specificity
Chen, Yangyang,Ng, Jeffrey,Wang, Chong
The labor specificity of a firm refers to the extent to which the firm’s workers have general or specific skills. In this paper, we examine how loan contracts terms are affected by borrowers’ labor specificity. We find that the loan contracts of borrowers with greater labor specificity are associated with tighter loan conditions in terms of higher loan spreads, smaller loan size, and a larger number of loan covenants. These findings suggest that lenders, with asymmetric payoff functions, are concerned about cost stickiness arising from labor specificity. In further analyses, we find that the positive relation between labor specificity and tightness in loan terms is stronger for firms that rely more on labor, have less redeployable capital assets, and when banks face less competition. In further analysis of the cost stickiness channel, we also document that labor specificity contributes to a firm’s cost stickiness. Overall, our paper provides new insight into how the nature of the borrower’s labor force impacts loan contracting.

Do Speed Bumps Curb Speed Investment? Evidence from a Pilot Experiment
Khapko, Mariana,Zoican, Marius
Exchanges implement intentional trade delays to limit the harmful impact of low-latency trading. Do such "speed bumps" curb investment in fast trading technology? Data is scarce since trading technologies are proprietary. We build an experimental trading platform where participants face speed bumps and can invest in fast trading and private signal technologies. A pilot experiment study with financial markets students suggests that the introduction of a speed bump reduces investment in low-latency technology by 22%. However, conditional on implementation, a one standard-deviation longer speed bump increases investment in low-latency technology by 11%, as fast speculators compete with each other.

Does Statistical Significance Help to Evaluate Predictive Performance of Competing Models?
Bulut, Levent
In Monte Carlo experiment with simulated data, we show that as a point forecast criterion, the Clark and West's (2006) unconditional test of mean squared prediction errors does not reflect the relative performance of a superior model over a relatively weaker one. The simulation results show that even though the mean squared prediction errors of a constructed superior model is far below a weaker alternative, the Clark- West test does not reflect this in their test statistics. Therefore, studies that use this statistic in testing the predictive accuracy of alternative exchange rate models, stock return predictability, inflation forecasting, and unemployment forecasting should not weight too much on the magnitude of the statistically significant Clark-West tests statistics.

Dynamic Risk Factors and the Intertemporal Capital Asset Pricing
Swan, Tina T
This paper proposes an affine interest rate model of dynamic risk factors and the intertemporal capital asset pricing. The nominal pricing kernel is built on a yield-surface of federal bonds, inflation rates, and market indexes. The beta values of derivative or portfolio in the system are determined by finding correlations between asset returns and pricing kernel innovations from data. We present the calibrations of intertemporal capital asset returns to the market data with the numerical fitting. The model is tested using market return, short rate, inflation, term spread, and produces the cross-sectional evidence that the value stocks have higher loadings on the cash-flow and discount-rate shocks than do growth stocks. We infer the discount-rate shocks and the cash-flow shocks, and find that the value stocks are riskier than the growth ones in findings on volatility shocks, which verifies and supports the Campbell's return decomposition.

Dynamic intertemporal utility optimization by means of Riccati transformation of Hamilton-Jacobi Bellman equation
Sona Kilianova,Daniel Sevcovic

In this paper we investigate a dynamic stochastic portfolio optimization problem involving both the expected terminal utility and intertemporal utility maximization. We solve the problem by means of a solution to a fully nonlinear evolutionary Hamilton-Jacobi-Bellman (HJB) equation. We propose the so-called Riccati method for transformation of the fully nonlinear HJB equation into a quasi-linear parabolic equation with non-local terms involving the intertemporal utility function. As a numerical method we propose a semi-implicit scheme in time based on a finite volume approximation in the spatial variable. By analyzing an explicit traveling wave solution we show that the numerical method is of the second experimental order of convergence. As a practical application we compute optimal strategies for a portfolio investment problem motivated by market financial data of German DAX 30 Index and show the effect of considering intertemporal utility on optimal portfolio selection.

Dynamics of Value-Tracking in Financial Markets
Nicholas CL Beale,Richard M Gunton,Kutlwano L Bashe,Heather S Battey,Robert S MacKay

The efficiency of a modern economy depends on what we call the Value-Tracking Hypothesis: that market prices of key assets broadly track some underlying value. This can be expected if a sufficient weight of market participants are valuation-based traders, buying and selling an asset when its price is, respectively, below and above their well-informed private valuations. Such tracking will never be perfect, and we propose a natural unit of tracking error, the 'deciblack'. We then use a simple model to show how large tracking errors can arise if enough market participants are not valuation-based traders, regardless of how much information the valuation-based traders have. We find a threshold above which value-tracking breaks down without any changes in the underlying value of the asset. Because financial markets are increasingly dominated by non-valuation-based traders, assessing how much valuation-based investing is required for reasonable value tracking is of urgent practical interest.

Hedge Fund Performance: What Do We Know?
Joenväärä, Juha,Kauppila, Mikko,Kosowski, Robert,Tolonen, Pekka
This paper proposes a novel database merging approach and re-examines the fundamental questions regarding hedge fund performance. Before drawing conclusions about fund performance, we form an aggregate database by exploiting all available information across and within seven commercial databases so that widest possible data coverage is obtained and the effect of data biases is mitigated. Average performance is significantly lower but more persistent when these conclusions are inferred from aggregate database than from some of the individual commercial databases. Although hedge funds deliver performance persistence, an average fund or industry as a whole do not deliver significant risk-adjusted net-of-fee returns while the gross-of-fee returns remain significantly positive. Consistent with previous literature, we find a significant association between fund-characteristics related to share restrictions as well as compensation structure and risk-adjusted returns.

International Stock Market Co-Movements and Politics-Related Risks
Pagliardi, Giovanni,Poncet, Patrice
We investigate the determinants of international stock market co-movements, shedding light on the relevance of politics-related factors. We propose a new characterization for the link connecting politics and financial markets, disentangling two different components: political risk and economic policy risk. We uncover the surprisingly low correlation between the two variables, and show they are priced differently by the market. We implement a pairs trading strategy, in the spirit of Gatev et al. (2006), which loads on international stock market co-movements. Exclusively relying on hard macro-data proves not to be sufficient to explain the statistically significant and economically large returns generated by the strategy. We show how to increase the abnormal returns (alphas) generated by the strategy by exploiting shorter-time co-movements. We document the utmost relevance of political risk, which explains and predicts returns driven by both short-term and long-run correlations. Our analysis also unveils the relevance of confidence factors, especially foreign investors' confidence, which should therefore be accounted for when assessing the co-variation of international stock market prices.

Is Gold a Safe Haven? International Evidence Revisited
Bulut, Levent,Rizvanoghlu, Islam
The literature has not settled down on safe haven property of gold in emerging and developing countries. Therefore, in this study, we revisit the international evidence on hedging and safe haven role of gold for 34 emerging and developing countries with a span of daily data covering January 2000 â€" November 2018. We employ GARCH-copula approach to estimate lower-tail extreme dependencies of the joint distribution of gold and equity returns. We also introduce a new definition for strong safe haven property of an asset. Our findings indicate that while gold serves as a hedge instrument for all countries in our sample, we got evidence of weak safe haven property for gold, for domestic investors, only in 18 countries, and a strong safe haven asset only in six countries.

Microstructure in the Machine Age
Easley, David,de Prado, Marcos Lopez,O'Hara, Maureen,Zhang, Zhibai
We demonstrate how a machine learning algorithm can be applied to predict and explain modern market microstructure phenomena. We investigate the efficacy of various microstructure measures and show that they continue to provide insights into price dynamics in current complex markets. Some microstructure features with apparent high explanatory power exhibit low predictive power, and vice versa. We also find that some microstructure-based measures are useful for out-of-sample prediction of various market statistics, leading to questions about the efficiency of markets. Our results are derived using 87 of the most liquid futures contracts across all asset classes.

Modern Asset Theory: A Framework for Successful Active Management
Corry Bedwell,Ryan Guttridge

Active management is a term that has many meanings and we have found the defining characteristics needed for success as an "active manager" elusive within the literature. In this paper we offer a set of criteria that defines an active manager and his success. In order to facilitate this, we introduce several definitions, which lead to a logically coherent evaluation framework. We expand on the definitions of these six key concepts: Introduce a specific concept of Ruin, Assets, Risk, Discount rate, Margin of safety, and Optimization.

Through these definitions a strong defense of active management emerges. Furthermore, to the extent one chooses to limit the definitions we offer, our framework reduces to that of Modern Portfolio Theory. Overall, we have aimed to construct a robust expansion of a framework for active management, one that has been found wanting in the current literature.

Multi-period investment strategies under Cumulative Prospect Theory
Liurui Deng,Traian A. Pirvu

In this article, inspired by Shi, et al. we investigate the optimal portfolio selection with one risk-free asset and one risky asset in a multiple period setting under cumulative prospect theory (CPT). Compared with their study, our novelty is that we consider a stochastic benchmark, and portfolio constraints. We test the sensitivity of the optimal CPT-investment strategies to different model parameters by performing a numerical analysis.

Optimal Trading with a Trailing Stop
Tim Leung,Hongzhong Zhang

Trailing stop is a popular stop-loss trading strategy by which the investor will sell the asset once its price experiences a pre-specified percentage drawdown. In this paper, we study the problem of timing buy and then sell an asset subject to a trailing stop. Under a general linear diffusion framework, we study an optimal double stopping problem with a random path-dependent maturity. Specifically, we first derive the optimal liquidation strategy prior to a given trailing stop, and prove the optimality of using a sell limit order in conjunction with the trailing stop. Our analytic results for the liquidation problem is then used to solve for the optimal strategy to acquire the asset and simultaneously initiate the trailing stop. The method of solution also lends itself to an efficient numerical method for computing the the optimal acquisition and liquidation regions. For illustration, we implement an example and conduct a sensitivity analysis under the exponential Ornstein-Uhlenbeck model.

Portfolio optimization with two coherent risk measures
Tahsin Deniz Aktürk,Çağın Ararat

We provide a closed-form analytical solution to a static portfolio optimization problem with two coherent risk measures. The use of two risk measures is motivated by joint decision-making for portfolio selection where the risk perception of the portfolio manager is of primary concern, hence, it appears in the objective function, and the risk perception of an external authority needs to be taken into account as well, which appears in the form of a risk constraint. The problem covers the risk minimization problem with an expected return constraint and the expected return maximization problem with a risk constraint, as special cases. We also consider a variant of the problem with size and magnitude constraints which we formulate using binary variables. In this case, only numerical solutions are possible.

Quantitative Easing and Excess Reserves
Jouvanceau, Valentin
What are the impacts of a flush of interest-bearing excess reserves to the real economy? Surprisingly, the theoretical literature remains silent about this question. We address this issue in a new Keynesian model with various financial frictions and reserve requirements in the balance sheet of bankers. Modeling QE by the supply of excess reserves, allow for endogenous changes in the relative supply of financial assets. We find that this mechanism is crucial to identify and disentangle between the portfolio balance, the credit and the asset prices channels of QE. Further, we demonstrate that the macroeconomic effects of QE are rather weak and mainly transmitted through the asset prices channel.

Relative Performance Evaluation and the Timing of Earnings Release
Gong, Guojin,Li, Laura Yue,Yin, Huifang
Relative performance evaluation (RPE) compensates managers on their relative performance against a peer group. Since observing more peers’ performance allows managers to better estimate the performance level required to achieve RPE targets, we conjecture that releasing earnings later than peers facilitates managers to achieve targets by exploiting last-minute reporting discretion. Empirical evidence is consistent with our conjecture. Further, managers tend to select peers that release earnings more timely and delay own firms’ earnings releases to be later than peers’ after RPE adoption. Our evidence suggests strategic timing of earnings release and discretionary reporting in response to relative performance evaluation.

Skill and Fees in Active Management
Stambaugh, Robert F.
Greater skill of active investment managers can mean less fee revenue in equilibrium. Although more-skilled managers receive more revenue than less-skilled managers, greater skill for active managers overall can imply less revenue for their industry. Greater skill allows managers to identify mispriced securities more accurately and thereby make better portfolio choices. Greater skill also means, however, that active management corrects prices better and thus reduces managers’ return opportunities. The latter effect can outweigh managers’ better portfolio choices in a general equilibrium. Investors then rationally allocate less to active funds and more to index funds if active management is more skilled.

Strategic Adjustment of Capital Structure: Evidence from S&P 500 Index Additions
Hong, Eunpyo,Hwang, Min,Lee, Jiyoon
We examine the capital structure of firms that are newly added to the S&P 500 index. Leverage gradually decreases during the two-year pre-addition period and then increases during the two-year post-addition period, resulting in a U-shaped trend. This trend is more pronounced in financially weak firms and firms facing intense competition for index addition. This U-shaped leverage trend also exists among firms that compete for addition to the index but not among similar firms that do not compete for addition. The sharp shift in the direction of the leverage trend after addition is attributable mainly to increases in debt issuance and cannot be explained by mechanical mean reversion of leverage or changes in the cost of capital. The overall results are consistent with firms' strategically reducing leverage to improve financial health prior to index revisions. The post-addition reversion of leverage suggests that the pre-addition-period improvement in financial health is temporary, and is consistent with the existence of a target capital structure.

The Conditional CAPM Revisited: Evidence from High-Frequency Betas
Hollstein, Fabian,Prokopczuk, Marcel,Wese Simen, Chardin
When using high-frequency data, the conditional CAPM can explain asset-pricing anomalies. Using conditional betas based on daily data, the model works reasonably well for a recent sample period. However, it fails to explain the size anomaly as well as 3 out of 6 of the anomaly component excess returns. Using high-frequency betas, the conditional CAPM is able to explain the size, value, and momentum anomalies. We further show that high-frequency betas provide more accurate predictions of future betas than those based on daily data. This result holds for both the time-series and the cross-sectional dimensions.

The impact of renewable energy forecasts on intraday electricity prices
Sergei Kulakov,Florian Ziel

The shift to renewable power is accelerating at a growing pace. Contemporary energy markets undergo profound structural changes. Forecasts as to the wind and solar supply become critically important. This paper studies the impact of these forecasts on electricity market prices. We develop an intraday price model based on day-ahead auction data and errors in wind and solar power prognostications. The model manipulates empirical supply and demand curves recorded in the German EPEX SPOT SE to produce the prices. The obtained results show that forecast errors exert a non-linear impact on intraday prices. Moreover, additional wind and solar power capacities induce non-linear changes in intraday price volatility. Economical and policy implications of these findings are elaborated upon.

금융위기 ì‹œ 예금보험제도의 역할에 관한 연구: 2008ë…„ 아이슬란ë"œ 사례를 ì¤'심으로(A Study on the Role of Deposit Insurance System During the Financial Crisis: Focusing on the Iceland Case in 2008)
Lee, Jinho,Jung, Hyunjae,Gwon, Eunji
Korean Abstract: 본 연구ëŠ" 금융위기 ì‹œ 예금보험제도의 개혁을 통해 시장의 신뢰를 확보하고 금융시장의 안정을 되찾은 아이슬란ë"œ 사례를 ì¤'심으로 금융위기 ì‹œ 예금보험제도의 역할을 고찰하고 동제도의 수정적용이 금융시스템의 안정에 기여할 수 있음을 제언하였다. 글로벌 금융위기를 겪으며 전세계적으로 예금보호한도의 전액보호조치와 우선변제권을 동시에 도입한 사례ëŠ" 아이슬란ë"œê°€ 유일하다. 아이슬란ë"œëŠ" 금융위기 직후 êµ­ë‚´ 예금을 동결하고 예금보호한도를 전액보호로 전환함과 동시에 파산은행의 파산채권에 대하여 예금자 우선변제제도를 도입함으로써 êµ­ë‚´ 예금자를 보호하고 금융시장의 안정을 도모할 수 있었다. IMF와 같이 최종대부자가 제시한 강력한 구조조정안을 자국 금융소비자 보호를 최우선하여 수정반영한 아이슬란ë"œ 사례ëŠ" 시사하ëŠ" ë°"ê°€ 크다. 특히 최근 저축은행 사태 ë"±ì„ 겪은 우리나라 예금보험기구ëŠ" 명시적인 예금보험제도의 역할을 재조명하ëŠ" 데 있어 예금자를 포함한 금융소비자 보호의 ì¤'ìš"성을 논의의 ì¤'심에 포함할 í•„ìš"ê°€ 있다고 하겠다.English Abstract: This study examined the role of the deposit insurance system in the financial crisis, focusing on the case of Iceland, where the market confidence was secured and the financial market was restored through the reform of the deposit insurance system during the financial crisis, and this reform is believed to contribute to the financial stability. Iceland is the only country that introduced both the full protection of deposit insurance coverage and the depositor preference at the same time during the global financial crisis. Iceland could freeze domestic deposits shortly after the financial crisis, convert the deposit insurance coverage to full protection, as well as protect depositors and stabilize the financial market by introducing depositors’ preference for bankruptcy of depository financial institutions. This has a great meaning in that Iceland corrected the strong restructuring proposals of the final lenders, such as IMF, to the financial consumer protection of their own countries. In particular, the Korea Deposit Insurance Corporation, which has suffered from recent savings banking problems, needs to include the importance of the financial consumer and depositors protection at the center of the discussion when reexamining the role of the explicit deposit insurance system.