Research articles for the 2019-04-11

(Martingale) Optimal Transport And Anomaly Detection With Neural Networks: A Primal-dual Algorithm
Pierre Henry-Labordere

In this paper, we introduce a primal-dual algorithm for solving (martingale) optimal transportation problems, with cost functions satisfying the twist condition, close to the one that has been used recently for training generative adversarial networks. As some additional applications, we consider anomaly detection and automatic generation of financial data.

Bank Capital Forbearance
Martynova, Natalya,Perotti, Enrico C.,Suarez, Javier
We analyze the strategic interaction between undercapitalized banks and a supervisor who may intervene by preventive recapitalization. Supervisory forbearance emerges because of a commitment problem, reinforced by fiscal costs and constrained capacity. Private incentives to comply are lower when supervisors have lower credibility, especially for highly levered banks. Less credible supervisors (facing higher cost of intervention) end up intervening more banks, yet producing higher forbearance and systemic costs of bank distress. Importantly, when public intervention capacity is constrained, private recapitalization decisions become strategic complements, leading to equilibria with extremely high forbearance and high systemic costs of bank failure.

Delegated Monitoring, Institutional Ownership, and Corporate Misconduct Spillovers
Lel, Ugur,Qin, Zhongling
Is corporate misconduct costly only to stakeholders of fraudulent firms? We show that idiosyncratic events such as lawsuits and earnings restatements have spillover implications for the broader economy. Upon the revelation of corporate misconduct in their portfolios, institutional investors experience significant discount in the total market value of their portfolios excluding firms engaged in misconduct, creating a negative externality that averages $39.4 billion of losses per year. This negative spillover increases with stronger ownership links to fraud firms, when more long-term investors hold such firms’ shares, and when the institutional investor should provide higher common ownership incentives to such firms, all of which lend support to a failed monitor theory. On the other hand, stock picking and flow price pressure do not explain our results. In equity markets characterized by institutional cross-holdings, we highlight the spillovers to idiosyncratic monitoring failures.

Der Schutz von Geschäftsmethoden und andere patentrechtliche Fragestellungen im Lichte der aktuellen Finanzmarktkrise (The Protection of Business Methods and Other Patent Law Issues in View of the Current Financial Market Crisis)
Straus, Joseph,Klopschinski, Simon
German Abstract: Der Aufsatz untersucht die Patentierbarkeit von Geschäftsmethoden, insbesondere Finanzinnovationen, in Europa und den USA im Lichte der Finanzmarktkrise von 2007.English Abstract: The paper analyses the patentability of business methods, in particular financial innovations, in Europe and in the USA in view of the financial market crisis of 2007.

Determinants of Home Bias: Evidence From European Equity Funds
Maier, Moritz,Scholz, Hendrik
This paper analyzes determinants of home bias in equity funds based on monthly holdings data using panel and quantile regressions. We investigate 699 equity funds, domiciled in fifteen European countries, that broadly invested in European stocks from January 2003 to December 2016. More than ninety percent of our sample funds show, on average, a home bias. In addition, the home bias across funds is quite stable over time. Analyzing the determinants of this home bias, our empirical results from panel regressions indicate that macroeconomic development, stock market development and fund-specific characteristics have, on average, a significant influence on the home bias of individual funds. Applying quantile regressions, we find the effects of several determinants, such as real growth in the gross domestic product, past excess return of the domestic stock market or number of stocks held by funds to be clearly related to the funds’ level of home bias. Further analyses of subportfolios of funds show that informational advantages do not seem to be a reason for the observed home bias.

Earnings Volatility, Ambiguity, and Crisis-Period Stock Returns
Ahmed, Anwer S.,McMartin, Andrew Stephen,Safdar, Irfan
Financial crises are typically marked by substantial increases in ambiguity where prices appear to decouple from fundamentals. Consistent with ambiguity-based asset pricing theories, we find that ambiguity concerns are more severe for firms with higher pre-crisis earnings volatility, causing investors to demand a higher ambiguity premium for such firms. While there is no relation between earnings volatility and stock returns under normal conditions, there is a significant negative relation between crisis-period stock returns and prior earnings volatility. In other words, during economic turmoil, investors punish stocks whose past earnings volatility was higher despite that they do not perceive these stocks to be riskier under stable economic conditions. Our findings indicate that a firm’s past earnings volatility predicts its stock price performance during crisis periods. We also find that this relation is stronger in firms with low institutional ownership and low analyst-following, consistent with ambiguity concerns being more important for firms with a greater proportion of unsophisticated investors. Our results are robust to controlling for firm-level characteristics as well as industry-fixed effects. Our evidence suggests that earnings stability helps mitigate ambiguity-concerns during a financial crisis.

Feature Engineering for Mid-Price Prediction Forecasting with Deep Learning
Adamantios Ntakaris,Giorgio Mirone,Juho Kanniainen,Moncef Gabbouj,Alexandros Iosifidis

Mid-price movement prediction based on limit order book (LOB) data is a challenging task due to the complexity and dynamics of the LOB. So far, there have been very limited attempts for extracting relevant features based on LOB data. In this paper, we address this problem by designing a new set of handcrafted features and performing an extensive experimental evaluation on both liquid and illiquid stocks. More specifically, we implement a new set of econometrical features that capture statistical properties of the underlying securities for the task of mid-price prediction. Moreover, we develop a new experimental protocol for online learning that treats the task as a multi-objective optimization problem and predicts i) the direction of the next price movement and ii) the number of order book events that occur until the change takes place. In order to predict the mid-price movement, the features are fed into nine different deep learning models based on multi-layer perceptrons (MLP), convolutional neural networks (CNN) and long short-term memory (LSTM) neural networks. The performance of the proposed method is then evaluated on liquid and illiquid stocks, which are based on TotalView-ITCH US and Nordic stocks, respectively. For some stocks, results suggest that the correct choice of a feature set and a model can lead to the successful prediction of how long it takes to have a stock price movement.

How Does the Strength of Monetary Policy Transmission Depend on Real Economic Activity?
Sapriza, Horacio,Temesvary, Judit
We study the relationship between the strength of the bank credit channel (BCC) of monetary policy and real GDP growth in the United States using quarterly commercial bank level data between 1986 and 2008. We find that the BCC was significantly stronger during periods of low economic growth. Monetary policy is more effective through this channel in spurring economic activity during periods of low growth, rather than in cooling the economy when growth is high. Furthermore, we find that the BCC operated through a broader range of loan categories and banks than previously documented, underscoring this channel’s economic relevance.

Impact of Corporate (Bonus Issue) Action on Stocks in India
Nagendra, M ,, Prof. M Suresh Babu
Bonus issue is the one of the corporate action where companies issue the stocks to existing shareholders at a free of cost. Bonus announcement or proportion of the bonus may stimulate the investors to buy or sell of the shares before and after of ex-bonus issue date and this may cause the abnormal returns in the stock around ex-bonus issue date. In this paper tries to understand the abnormal returns around ex-bonus issue by using companies which declared ex-bonus issue in the year 2017 in India. Researcher has selected 9 companies randomly from the companies which declared ex-bonus issue in the year 2017 to test the abnormal returns around ex-bonus issue and used event study and t test used to test the significance of bonus issue impact on share price.

Impacts of Financial Literacy on the Loan Decisions of Financially Excluded Households in the People's Republic of China
Lyons, Angela C.,Grable, John,Zeng, Ting
Financial literacy is a key tool being used to bring economically vulnerable populations into the financial mainstream. Data from the 2013 China Household Finance Survey (CHFS) were used to investigate the impacts of various dimensions of financial literacy on the use of bank and non-bank loans among rural, illiterate, and migrant populations in the People’s Republic of China. The findings show that the most vulnerable groups may be less likely to benefit from financial literacy, especially when it comes to usage of formal bank loans. Other factors such as those related to social networks and infrastructure may matter more than financial literacy. Results were found to vary across measures of financial literacy and financial inclusion. The findings suggest that barriers to access likely need to be overcome so that financial literacy can be more effective. The current study provides important insights for policy makers and international organizations designing national strategies to improve financial inclusion via financial literacy, especially for populations that have been traditionally excluded. Researchers are encouraged to reexamine previous definitions and measures of financial literacy and inclusion to develop a better understanding of the relationship between the two dimensions.

Mind the Conversion Risk: A Theoretical Assessment of Contingent Convertible Bonds
Le Quang, Gaëtan
We develop a theoretical model to assess the merits of principal-write down contingent convertible (CoCo) bonds. The conversion risk is the key feature of CoCo bonds. Because of this conversion risk, CoCo bonds are hard to price and an equilibrium price does not necessarily exist. In our model, for such a price to exist, the bank needs to hold a minimum amount of equity and/or the expected return associated with its asset portfolio needs to be large enough. When an equilibrium price exists, it is a decreasing function in the amount of equity held by the bank. Well-capitalized banks can thus issue CoCo bonds at a lower price than least-capitalized banks. This is the reason why CoCo bonds are to be thought of more as a complement to equity than as a substitute. In addition, because of the conversion risk, self-fulfilling panics may occur in the CoCo bonds' market. We indeed define a game between CoCo bonds' holders and the Central Bank that allows us to exhibit situations where a panic occurs in the CoCo bonds' market. Using the global game technique, we show that the probability of crisis can be expressed as a function of the return associated with the asset portfolio of the bank. The probability of crisis is shown to be sensitive to the precision of the information available to CoCo bonds' holders. Taken together, our results call for cautiousness when assessing the relevance of regulatory requirements in CoCo bonds, especially concerning their systemic impact.

Mitigating Fire Sales with Contracts: Theory and Evidence
Vuillemey, Guillaume
Fire sales are a source of severe market inefficiencies. In this paper, I show theoretically that fire sales resulting from coordination failures can be eliminated via private contracting between investors. The contract has two main features: (i) parties pre-commit to buy assets at above-market prices and (ii) free-riding is penalized. This contract can be implemented as a central clearing counterparty (CCP), and explains important features of actual CCP design. I then study the first historical event during which a CCP played an active role in mitigating fire sales, the wool crisis of 1900 in France. The conditions under which the CCP organized coordination between investors to avoid fires sales are consistent with those implied by the model.

On the Valuation of Equity Options with Dividend-Protection Features
Vong, Ghislain
This note describes the various techniques used to protect the writer of an equity option against the risk of dividend uncertainty. We first explicitly formulate the PnL tracking error in presence of dividend misspecification. We then describe various ways to offset the dividend risk: for vanilla options practitioners usually adjust the strike and notional across an ex-div date. We justify this approximation. We then introduce an alternative way that does not require a change in the strike and that involves an extra exchange of cash flow across the ex-div date.

Optimal excess-of-loss reinsurance for stochastic factor risk models
Matteo Brachetta,Claudia Ceci

We study the optimal excess-of-loss reinsurance problem when both the intensity of the claims arrival process and the claim size distribution are influenced by an exogenous stochastic factor. We assume that the insurer's surplus is governed by a marked point process with dual-predictable projection affected by an environmental factor and that the insurance company can borrow and invest money at a constant real-valued risk-free interest rate $r$. Our model allows for stochastic risk premia, which take into account risk fluctuations. Using stochastic control theory based on the Hamilton-Jacobi-Bellman equation, we analyze the optimal reinsurance strategy under the criterion of maximizing the expected exponential utility of the terminal wealth. A verification theorem for the value function in terms of classical solutions of a backward partial differential equation is provided. Finally, some numerical results are discussed.

Pricing under Fairness Concerns
Erik Eyster,Kristof Madarasz,Pascal Michaillat

This paper proposes a theory of pricing consistent with two well-documented patterns: customers care about fairness, and firms take these concerns into account when they set prices. The theory assumes that customers find a price unfair when it carries a high markup over cost, and that customers dislike unfair prices. Since markups are not observable, customers must extract them from prices. The theory assumes that customers infer less than rationally: when a price rises after an increase in marginal cost, customers partially misattribute the higher price to a higher markup---which they find unfair. Firms anticipate this response and trim their price increases, which reduces the passthrough of marginal costs into prices below one: prices are somewhat rigid. Embedded in a New Keynesian model---as a replacement of Calvo pricing---our theory produces monetary nonneutrality. When monetary policy loosens and inflation rises, customers misperceive markups as higher and feel unfairly treated; firms mitigate the perceived unfairness of prices by reducing their markups, which in general equilibrium leads to higher output.

Returns to Community Lending
Chakraborty, Indraneel,Chhaochharia, Vidhi,Hai, Rong,Vatsa, Prithu
For forty years, at a large scale, the Community Reinvestment Act (CRA) has encouraged U.S. banks to lend to lower income neighborhoods. We estimate costs and benefits of providing incentives to privately-owned banks to reduce poverty. Regarding costs, to comply with CRA, rather than lend more overall, banks perfectly substitute away from small business lending to other income groups. Regarding benefits, 0.5% of the population is lifted out of poverty per year through the CRA small-business lending channel. The incidence of the act is on smaller banks who lend more and face higher loan losses. Large banks show no effects.

Size-Adapted Bond Liquidity Measures and Their Asset Pricing Implications
Reichenbacher, Michael,Schuster, Philipp
We develop a new class of transaction costs measures for the bond market. Standard liquidity measures suffer from the combination of two effects. First, transaction costs in OTC bond markets depend strongly on trade size. Second, many bonds are traded only scarcely with differing trading volumes over time and in the cross-section. As a result, a change in the average transaction costs often indicates a change in the average trade size and not a change in liquidity. Our new measures eliminate this idiosyncratic dependence on trade size. We employ them to reevaluate the asset pricing implications of corporate bond liquidity effects. Compared to standard measures, we can explain a much larger part of yield spread variations. Furthermore, the new measures uncover the joint pricing of liquidity level and corporate bond market liquidity risk in the cross-section of U.S. corporate bonds.

Stochastic Comparative Statics in Markov Decision Processes
Bar Light

In multi-period stochastic optimization problems, the future optimal decision is a random variable whose distribution depends on the parameters of the optimization problem. We analyze how the expected value of this random variable changes as a function of the dynamic optimization parameters in the context of Markov decision processes. We call this analysis stochastic comparative statics. We derive both comparative statics results and stochastic comparative statics results showing how the current and future optimal decisions change in response to changes in the single-period payoff function, the discount factor, the initial state of the system, and the transition probability function. We apply our results to various models from the economics and operations research literature, including investment theory, dynamic pricing models, controlled random walks, and comparisons of stationary distributions.

Terrorist Attacks and Investor Risk Preference: Evidence from Mutual Fund Flows
Wang, Yan Albert,Young, Michael
Using a comprehensive list of terrorist attacks over three decades, we find that aggregate investor risk aversion inversely relates to terrorist activity in the United States. A one standard deviation increase in the number of attacks each month leads to a $75.09 million drop in aggregate flows to equity funds and a $56.81 million increase to government bond funds. Tests on alternative channels further suggest that the shift in aggregate risk aversion is driven mainly by an emotional shock rather than changes in wealth or the outside environment. We also investigate possible alternate explanations for reduced flows to risky assets. Our evidence is consistent with a fear-induced increase in aggregate risk aversion.

Theory of Cryptocurrency Interest Rates
Dorje C. Brody,Lane P. Hughston,Bernhard K. Meister

A term structure model in which the short rate is zero is developed as a candidate for a theory of cryptocurrency interest rates. The price processes of crypto discount bonds are worked out, along with expressions for the instantaneous forward rates and the prices of interest-rate derivatives. The model admits functional degrees of freedom that can be calibrated to the initial yield curve and other market data. Our analysis suggests that strict local martingales can be used for modelling the pricing kernels associated with virtual currencies based on distributed ledger technologies.

U.S. Presidential Cycles and the Foreign Exchange Market
Ashour, Samar,Rakowski, David A.,Sarkar, Salil K.
We examine the association between the foreign exchange rate of the US dollar and US presidential cycles. Results show that Republican presidencies tend to start with a strong dollar, which then depreciates over the course of the presidency. In contrast, Democratic presidencies tend to begin with a weak dollar that then appreciates. These patterns result in an apparent presidential effect in US foreign exchange rates, the direction of which depends on whether exchange rates are measured by levels or by returns.

Understanding consumer demand for new transport technologies and services, and implications for the future of mobility
Akshay Vij

The transport sector is witnessing unprecedented levels of disruption. Privately owned cars that operate on internal combustion engines have been the dominant modes of passenger transport for much of the last century. However, recent advances in transport technologies and services, such as the development of autonomous vehicles, the emergence of shared mobility services, and the commercialization of alternative fuel vehicle technologies, promise to revolutionise how humans travel. The implications are profound: some have predicted the end of private car dependent Western societies, others have portended greater suburbanization than has ever been observed before. If transport systems are to fulfil current and future needs of different subpopulations, and satisfy short and long-term societal objectives, it is imperative that we comprehend the many factors that shape individual behaviour. This chapter introduces the technologies and services most likely to disrupt prevailing practices in the transport sector. We review past studies that have examined current and future demand for these new technologies and services, and their likely short and long-term impacts on extant mobility patterns. We conclude with a summary of what these new technologies and services might mean for the future of mobility.