Research articles for the 2019-04-23

A Conceptual Framework to Test the ESG Portfolio-Level Performance Hypothesis
Merz, Thomas
The core motivation for this research is to provide more clarity over the investment merits of environmental, social and government (ESG) portfolios and to reduce uncertainty for financial market participants by helping them to correctly price ESG information for their capital allocation decision. This clarification is ultimately needed as world-wide initiatives have channelled significant amounts of resources towards government supported projects, all assuming there is a causal and positive link between a company’s level of sustainability and its portfolio-level ESG performance. Based on the large body of literature we develop a theoretically well supported and novel conceptional framework to reliably test the strongly advocated superior ESG performance claim. By incorporating three bodies of theory, our framework enables a new ESG asset pricing hypothesis which combines the latest scholarly findings from corporate social responsibility (CSR) performance theory, ESG investor theory and ESG asset pricing theory. In stark contrast to the long history of inconclusive scholarly outcomes, our approach opens a new pathway to overcome the intense debate in which competing interests negotiate over empirical facts. Empirical research building on this novel model is expected to yield highly conclusive outcomes which will potentially allow to close the current gap in the ESG performance literature.

Are Firms with Female CEOs More Environmentally Friendly?
Wang, Zigan,Yu, Luping
In this paper, we document a previously unknown benefit of women’s role in firm management: the enhancement of environmental protection. Through a panel data analysis, we find that firms with female CEOs produce less air and water pollution and greenhouse gas emissions, and receive fewer environmental penalties, compared to firms with male CEOs. Our difference-in-differences analysis shows that firms also reduce air and water toxic releases, greenhouse gas emissions, and receive fewer environmental penalties after experiencing a male-to-female CEO transition. Moreover, firms demonstrate higher awareness of environmental protection, reflected in their 10-K filings, when being led by female CEOs.

Are Item 1A Risk Factors Priced?
Ross, Landon
Public companies report “the most significant factors that make” their common stock ”speculative or risky” in section “Item 1A. Risk Factors” of their annual filings. This paper uses textual analysis to estimate common risks from Item 1A texts and study these risks’ effect on public companies stock returns. I find the textual relevance of common Item 1A risks to the cross-section of firms’ Item 1A texts predicts the cross-section of expected stock returns. A factor portfolio aggregating information about returns from fifty individual Item 1A risks has an average monthly return of 0.97% and a risk adjusted return of 1.06%. Factor portfolios for nineteen individual Item 1A risks have significant average returns. Eighteen individual Item 1A risks provide independent information about stock returns.

Bayesian Trading Cost Analysis and Ranking of Broker Algorithms
Vladimir Markov

We present a formulation of the transaction cost analysis (TCA) in the Bayesian framework for the primary purpose of comparing broker algorithms using standardized benchmarks. Our formulation allows effective calculation of the expected value of trading benchmarks with only a finite sample of data relevant to practical applications. We discuss the nature of distribution of implementation shortfall, volume-weighted average price, participation-weighted price and short-term reversion benchmarks. Our model takes into account fat tails, skewness of the distributions and heteroscedasticity of benchmarks. The proposed framework allows the use of hierarchical models to transfer approximate knowledge from a large aggregated sample of observations to a smaller sample of a particular algorithm.

Best Portfolio Management Strategies For Synthetic and Real Assets
Jarosław Gruszka,Janusz Szwabiński

Managing investment portfolios is an old and well know problem in financial mathematics and engineering as well as in econometrics. In this paper, various strategies of building such portfolios are analysed in different market conditions. A special attention is given to several realisations of a so called balanced portfolio, which is rooted in the natural "buy-low-sell-high" principle. Results show that there is no universal strategy, because they perform differently in different circumstances (e.g. for varying transaction costs). Moreover, the planned time of investment may also have a significant impact on the profitability of certain strategies. All methods have been tested with both simulated trajectories and real data from the Polish stock market.

Bitcoin Spreads Like a Virus
Peterson, Timothy
We illustrate, by way of example, that Bitcoin’s long-term price is non-random and can be modeled as a function of the logistic growth of number of users n over time. Using observed data for both Facebook and Bitcoin, we derive the relationships between price, number of users, and time, and show that the resulting market capitalizations likely follow a Gompertz sigmoid growth function. This function, historically used to describe the growth of biological organisms like bacteria, tumors, and viruses, likely has some application to network economics. We conclude that the long-term growth rate in users has considerable effect on the long-term price of bitcoin.

Can Regulation on Loan-Loss-Provisions for Credit Risk Affect the Mortgage Market? Evidence from Administrative Data in Chile
Calani, Mauricio
We argue that financial institutions responded by raising their acceptable borrowing standards on borrowers, enhancing the quality of their portfolio, but also contracting their supply of mortgage credit. We reach this conclusion by developing a stylized imperfect information model which we use to guide our empirical analysis. We conclude that the loan-to-value (LTV) ratio was 2.8% lower for the mean borrower, and 9.8% lower for the median borrower, because of the regulation. Our paper contributes to the literature on the evaluation of macro-prudential policies, which has mainly exploited cross-country evidence. In turn, our analysis narrows down to one particular policy in the mortgage market, and dissects its effects by exploiting unique administrative tax data on the census of all real estate transactions in Chilean territory, in the period 2012-2016.

Common Stock Returns Are Not Equity Returns
Ross, Chase P.,Ross, Landon,Ross, Sharon Y.
U.S. companies hold cash on their balance sheets, and the share of assets held in cash varies across companies and over time. A firm’s cash holdings is an implicit holding in a low-return asset, which pushes down a firm’s common stock return, and investors should thus hedge out the cash on the balance sheets when calculating equity returns. Failing to do so has implications for portfolio formation and optimization, asset pricing models, and trading strategy performance. We show that neglecting to consider cash holdings results in biases in portfolio optimization, factor creation, and the cross-sectional asset pricing. We decompose common stock market betas into components, which depend on the portfolio’s cash holding, the return on cash, and the portfolio’s cash-hedged equity return. We create a cash-hedged market factor and show this better explains the cross-sectional variation in portfolio returns than the standard market factor. Finally, we show the implications of creating and using cash-hedged factors and test assets. Cash-hedged factors and portfolios increase Sharpe ratios of factors across the board, and motivate the creation of new factor based on cash-holdings of firms.

Copula estimation for nonsynchronous financial data
Arnab Chakrabarti,Rituparna Sen

Copula is a powerful tool to model multivariate data. Due to its several merits Copula modelling has become one of the most widely used methods to model financial data. We discuss the problem of modelling intraday financial data through Copula. The problem originates due to the nonsynchronous nature of intraday financial data whereas to estimate the Copula, we need synchronous observations. We show that this problem may lead to serious underestimation of the Copula parameter. We propose a modification to obtain a consistent estimator in case of Elliptical Copula or to reduce the bias significantly in case of general copulas.

Dividend Policy, Signaling Theory: A Literature Review
Taleb, Lotfi
With imperfect market hypothesis, it is widely accepted that announcements of dividend payouts affect firm value. An explanation has been proposed with the cash flow signaling theory and the dividend information content hypothesis. This original explanation, was developed in theoretical models by Bhattacharaya (1979), John and Williams (1985) and Miller and Rock (1985). All these authors argue that since managers possess more information about the firm's cash flow than do individuals outside the firm and they have incentives to convey that information to investors in order to inform the true value of the firm. This paper aims at providing the reader with a comprehensive understanding of dividend policy by reviewing the main theories and empirical findings under this signaling hypothesis.

Financial Literacy and Precautionary Insurance
Kubitza, Christian,Hofmann, Annette,Steinorth, Petra
This paper studies insurance demand when individuals exhibit limited financial literacy. Financially illiterate individuals are uncertain about the payout of complex insurance contracts. We show that a trade off between second-order and third-order risk preferences drives insurance demand. Sufficiently prudent individuals increase insurance demand with more complex contracts, while the effect is reversed for less prudent individuals. Under reasonable conditions, a positive level of contract complexity exists in competitive market equilibrium. We quantify the welfare loss from financial illiteracy, which amounts to 1-3% of wealth under reasonable assumptions. We provide a novel rationale for individual decision-making under risk with financially illiterate consumers and discuss implications for welfare and consumer protection.

First Impressions and Analyst Forecast Bias
Hirshleifer, David A.,Lourie, Ben,Ruchti, Thomas,Truong, Phong
We present evidence that equity analysts suffer from a first impression bias in forecasting future firm performance. If a firm does particularly well (poorly) in the year before an analyst follows it, the analyst tends to make optimistic (pessimistic) forecasts of its future performance relative to other analysts covering the same firm at the same time. Negative first impressions have a stronger effect than positive ones. Analysts with more negative first impressions of a firm tend to terminate their coverage earlier than analysts with positive first impressions. We find similar effects of first impressions on analyst price targets and recommendations. Finally, we find that the stock market adjusts for analyst first impression bias.

Flow-Induced Trades and Asset Pricing Factors
Huang, Shiyang,Song, Yang,Xiang, Hong
We show that mutual funds’ flow-induced trades significantly influence returns and co-movement among 50 well-known asset pricing factors (anomalies). Mutual fund investors are ignorant about both systematic and idiosyncratic risks when allocating capital among funds. We measure the non-fundamental demand shocks to each factor by aggregating mutual funds’ flow-induced trading of individual stocks underlying the factor. We show that flow-induced demand shifts largely determine factor return dynamics and that the expected (co)variance of flow-induced trades of factors strongly forecasts factor return (co)variance. Our results indicate that these factors are heavily exposed to flow-driven “noise trader” risk, which we further show is significantly priced. The flow-driven effects on factor return dynamics can partially explain factor momentum and underperformance of large-sized mutual funds relative to small funds.

Intermediated Implementation
Anqi Li,Yiqing Xing

We examine problems of "intermediated implementation." An example is sales, whereby retailers compete through offering consumption bundles to consumers with hidden tastes, whereas a manufacturer with a potentially different goal than retailers' can regulate only the sold goods but not the charged prices by legal barriers. We study how the manufacturer can implement through retailers any incentive compatible and individually rational social choice rule for consumers. We demonstrate the effectiveness of per-unit fee schedules and distribution regulations, which hinges on whether retailers have private or interdependent values. We formulate problems of this kind and give applications to taxation and healthcare.

Loss Aversion and Market Crashes
Ouzan, Samuel
This study proposes a rational expectation equilibrium model of crashes in an economy with information asymmetry and loss averse speculators. We obtain a state-dependent linear optimal trading strategy, which makes the equilibrium price tractable for the first time in such an economy. The model predicts nonlinear market depth and the fact that small shocks to fundamentals (e.g., supply or informational shocks) can cause abrupt price movements. We demonstrate that short-sale constraints intensify asset price collapses relative to upward movements. The model also generates contagion between uncorrelated assets. These results reflect the main puzzling features observed during market crashes, namely abrupt and asymmetric price movements, not driven by major news events, coupled with a spillover effect between unrelated markets.

Necessary and Sufficient Conditions for Existence and Uniqueness of Recursive Utilities
Jaroslav Borovicka,John Stachurski

We study existence, uniqueness and computability of solutions for a class of discrete time recursive utilities models. By combining two streams of the recent literature on recursive preferences---one that analyzes principal eigenvalues of valuation operators and another that exploits the theory of monotone concave operators---we obtain conditions that are both necessary and sufficient for existence and uniqueness of solutions. We also show that the natural iterative algorithm is convergent if and only if a solution exists. Consumption processes are allowed to be nonstationary.

Network-Based Financial Forecasting: A Statistical and Economic Analysis
Baitinger, Eduard
One of the main challenges facing researchers and industry professionals for decades is the successful prediction of asset returns. This paper enriches this endeavor by an in-depth analysis of topological metrics of correlation networks applied to financial forecasting. While academic research often focuses on statistical performance metrics, industry professionals are more interested in the economic value-added of competing forecasting approaches. Since statistical significance does not automatically imply economic significance, this article devotes attention to both types of performance metrics. We show that the benchmark mean model is indeed difficult to beat when it comes to statistical performance metrics. However, considering economic metrics, network-based predictors generate a clear value-added, which also applies to the multi risky asset allocation dimension.

New Funds, Familiar Fears: Are Interaction Risks in Exchange Traded Funds Making Markets Less Stable?
Clements, Ryan
Exchange traded funds (ETF) are creating a common link between main street, pension funds, and major Wall Street institutions. An ETF is an investment product that tracks an underlying index or basket of assets (like securities, bonds or commodities). ETFs are widely seen as superior to mutual funds because of low costs and intra-day secondary market trading. Since the global financial crisis (GFC), ETFs have attracted a substantial amount of retail and institutional assets. Recent estimates peg the U.S. ETF market at $3.4 trillion â€" remarkable growth considering pre-crisis levels of just over $500 billion. These products (which are continually expanding in variety) are expected to house a sizeable share of American retirement savings for the foreseeable future and they give the average investor instant diversification at a low cost, and the option to buy and sell, with a single click of the mouse, on a national stock exchange like the NYSE. ETFs are also a preferred vehicle for institutional investors, and technology-driven developments like high-frequency traders and algorithmic wealth management platforms (robo-advisers). And yet, ETFs present a potentially worrisome paradox. They offer the benefit of near-perfect liquidity â€" the ability for investors to buy or sell quickly with low transaction costs (which is why they are viewed as the next-generation successor to the mutual fund â€" perhaps the single most important investment vehicle in the history of U.S. financial markets); but this liquidity could prove illusory when it matters most â€" during a stock market crash or a full-blown financial crisis. Liquidity isn’t the only concern in this rapidly expanding market. The article’s central claim is that ETFs aren’t a neutral (or solely positive) development; however, their potentially destabilizing impact isn’t obvious because it involves “interaction risks” between intermediaries in a complex operating structure. The purpose of the article is to illuminate these “interaction risks” and it does so in a unique way by showing that three such risks â€" illusions of liquidity, investor herding, and information inefficiencies â€" were also present (and opaque) in the GFC. It is impossible to predict how (or when) a new crisis will arrive, yet the growing size and future projections of ETFs as an asset class, how they increase the connection between main street and Wall Street (like mortgage securitizations in the past), the opaque “interaction risks” giving rise to potential instabilities, and the long-term uncertainty that passive investing will have on the economy make ETFs a vastly understudied segment of consumer finance and financial regulation worthy of heightened attention.

Optimal investment strategy for DC pension plans with stochastic force of mortality
Yongjie Wang

This paper studies an optimal portfolio problem for a DC pension plan considering both interest rate risk and longevity risk. In the accumulation phase, plan members pay constant contributions continuously into the pension fund. We assume that the evolution of mortality rate of all the plan members can be described by the same stochastic process and a representative member is chosen to study the problem. At retirement time, the pension fund is used to purchase a lifetime annuity and a minimum guarantee is required by the representative member. To hedge the longevity risk, we introduce a mortality-linked security, i.e. a longevity bond, into the financial market. The pension manager makes investment decisions for the benefit and on behalf of the representative pension member whose objective is to maximize his expected utility of the terminal surplus between the final fund level and the minimum guarantee. To solve the initial constrained non-self-financing optimization problem, we transform it to an unconstrained self-financing problem by replicating the future contributions and the minimum guarantee. By applying dynamic programming method, analytical solutions to the equivalent optimization problem are derived and optimal investment strategies to the original problem are obtained by simple calculations. The numerical applications reveal that the longevity risk has an important impact on the investment strategies and show evidence that mortality-linked securities could provide an efficient way to hedge the longevity risk.

Optimal valuation of American callable credit default swaps under drawdown
Zbigniew Palmowski,Budhi Surya

This paper discusses the valuation of credit default swaps, where default is announced when the reference asset price has gone below certain level from the last record maximum, also known as the high-water mark or drawdown. We assume that the protection buyer pays premium at fixed rate when the asset price is above a pre-specified level and continuously pays whenever the price increases. This payment scheme is in favour of the buyer as she only pays the premium when the market is in good condition for the protection against financial downturn. Under this framework, we look at an embedded option which gives the issuer an opportunity to call back the contract to a new one with reduced premium payment rate and slightly lower default coverage subject to paying a certain cost. We assume that the buyer is risk neutral investor trying to maximize the expected monetary value of the option over a class of stopping time. We discuss optimal solution to the stopping problem when the source of uncertainty of the asset price is modelled by L\'evy process with only downward jumps. Using recent development in excursion theory of L\'evy process, the results are given explicitly in terms of scale function of the L\'evy process. Furthermore, the value function of the stopping problem is shown to satisfy continuous and smooth pasting conditions regardless of regularity of the sample paths of the L\'evy process. Optimality and uniqueness of the solution are established using martingale approach for drawdown process and convexity of the scale function under Esscher transform of measure. Some numerical examples are discussed to illustrate the main results.

Risk Mitigation by Institutional Participants in the Secondary Market: Evidence from Foreign Rule 144A Debt Market
Huang, Alan Guoming,Kalimipalli, Madhu,Nayak , Subhankar,Ramchand, Latha
We study secondary market trades of debt issues by foreign firms in the U.S. under SEC Rule 144A, a unique market where the counterparties are qualified institutional buyers (QIBs). We find that even though the secondary yield spreads of foreign 144A debt issues are larger than comparable public debt issues by foreign and domestic firms in the U.S., the incremental impact of common risks â€" namely, credit, illiquidity, governance, and familiarity risks â€" on spreads are lower for foreign 144A issues compared to various control samples. Our finding is consistent with the notion that institutional participants, namely QIBs, play a specialized role in mitigating risk exposures in the foreign 144A secondary market.

Sovereign Credit Ratings under Fiscal Uncertainty
Hantzsche, Arno
This paper studies the response of credit rating agencies to an increase in uncertainty about a government's fiscal position. To that end, a measure of the uncertainty around official forecasts of the public budget deficit is constructed that is comparable across time and a range of advanced economies. To estimate the effect of fiscal uncertainty on sovereign credit ratings, an empirical framework is developed that accounts for the high stability of ratings over time. Results suggest that fiscal uncertainty increases the predictive power of a model of rating changes and can explain why sovereign ratings are often changed more frequently during crises.

The 7 Reasons Most Econometric Investments Fail
Lopez de Prado, Marcos
This presentation reviews the main reasons why investment strategies discovered through econometric methods fail. As a solution, it proposes the modernization of the statistical methods used by financial firms and academic authors.This material is part of Cornell University's ORIE 5256 graduate course at the School of Engineering.

The Decision Making of a Financial Psychopath
Shank, Corey A.,Dupoyet, Brice V.,Durand, Robert B. B.,Patterson, Fernando
We examine the relationship between psychopathic personality traits and financial risk and time preferences using a sample of 118 business majors. We find that Finance majors score significantly higher on machiavellian egocentricity and lower fearlessness than other majors, including other business majors. Additionally, we find that the global trait of psychopathy has a positive association with the linearity of the cumulative prospective utility function. Furthermore, the secondary trait of self-centered impulsivity is statistically significant in all models of financial risk preferences determinants under Cumulative Prospect Theory. The aforementioned results show that certain psychopathic personality traits are related to more rational financial decision making. Alternatively, other aspects of psychopathy are associated with impulsive, less rational decision making. Superficially, we find that self-centered impulsivity and stress immunity are related to a higher time-preference discount rate under quasi-hyperbolic time preferences.

The Role of CAT Bonds in an International Multi-Asset Portfolio: Diversifier, Hedge, or Safe Haven?
Drobetz, Wolfgang,Schröder, Henning,Tegtmeier, Lars
We examine whether CAT bonds can serve as a hedge or a safe haven for global stock, bond, real estate, commodity, private equity, and infrastructure markets. Our results indicate that CAT bonds are a poor hedge, but they act as an effective diversifier against all asset classes under investigation. Moreover, CAT bonds can serve as a strong safe haven against extreme price drops of stocks only during the post-crisis period.

Tick Size Change and Market Quality in the U.S. Treasury Market
Fleming, Michael J.,Nguyen, Giang,Ruela, Francisco
This paper studies a recent tick size reduction in the U.S. Treasury securities market and identifies its effects on the market’s liquidity and price efficiency. Employing difference-indifference regressions, we find that the bid-ask spread narrows significantly after the change, even for large trades, and that trading volume increases. Market depth declines markedly at the inside tier and across the book, but cumulative depth close to the top of the book changes little or even increases slightly. Furthermore, the smaller tick size enables prices to adjust more easily to information and better reflect true value, resulting in greater price efficiency. Price informativeness remains largely similar before and after, suggesting that the reduction in trading costs does not result in increased information acquisition. However, there is clear evidence of an information shift from the futures market toward the smaller-tick-size cash market. Overall, we conclude that the tick size reduction improves market quality.