Research articles for the 2019-04-30

A General Method for Valuing Complex Capital Structures
Borochin, Paul,Kopeliovich, Yaacov,Shea, Kevin
We develop a numerical method based on the Cox et al. (1979) binomial tree option valuation approach to value complex capital structures with finite heterogeneous debt maturities, preferred and common stock, and warrants. This approach can also accommodate common bond market features such as convertibility and prepayment options, as well as sinking fund provisions, that have not been possible to model analytically in the prior capital structure valuation literature. We illustrate the application of this approach using data from a real firm’s capital structure

A Quantum Model of Supply and Demand
Orrell, David
One of the most iconic and influential graphics in economics is the figure showing supply and demand as two lines sloping in opposite directions, with the point at which they intersect representing the equilibrium price which perfectly balances supply and demand. The figure, which dates back to the nineteenth century, can be seen as a graphical representation of Adam Smith’s invisible hand, which is said to guide prices to their optimal level, and features in nearly every introductory textbook. However this figure suffers from a number of basic drawbacks. One is that it doesn’t represent a dynamical view of market forces, so it isn’t clear how prices converge on an equilibrium. Another is that it views supply and demand as deterministic, when in fact they are intrinsically uncertain in nature. This paper addresses these issues by using the quantum formalism to model supply and demand as, not a cross, but a probabilistic wave. The approach is used to derive from first principles a technique for modelling asset price changes using a harmonic oscillator, that has been previously used and empirically tested in quantum finance. The method is demonstrated for a simple system, and applications in other areas of economics are discussed.

Accounting Changes, Asset Substitution, and Debt Contracting
Darrough, Masako N.,Deng, Mingcherng
This paper examines whether firms benefit, in debt contracting, from committing to incorporate future GAAP changes (referred to as rolling GAAP) or not to incorporate any future changes (referred to as frozen GAAP). We show that informative future accounting changes do not necessarily improve efficiency of debt contracts. We develop a parsimonious model to examine the interplay between a firm's investment decisions made ex ante and the accounting information revealed ex post the rule change. A firm borrows fund and makes investment decisions (project selection and effort choice) before a regulator may change accounting rules, which enable the creditor to observe an accounting signal about the project state. The firm rationally anticipates such a signal and tailors investment decisions accordingly. For example, if the firm knows that a bad project state is likely to be revealed, it will select a more risky technology and exacerbate asset substitution. In such a case, accounting changes might reduce the overall efficiency of debt contracting by distorting the firm's ex ante investment decisions. If asset substitution is sufficiently severe, accounting changes unambiguously reduce the firm's expected payoff and the efficiency of debt contracting, even though they might reduce information asymmetry between the lender and the borrower. Under such a scenario, a firm would prefer not to incorporate future accounting changes.

An Empirical Analysis of Key Audit Matters in the Financial Industry
Loew, Edgar,Mollenhauer, Tim
One outcome of the financial crises with regard to financial statements and their audits has been that both, the European Union and the International Auditing and Assurance Standards Board came out with amendments to their legislations. Hence, the regulators focused on the information gap between the auditor and the stakeholders of financial reports. To close that gap, the implementation of Key Audit Matters (KAM) within the section of the independent auditor´s report became mandatory. 2017 marks the first year in which KAM for all European public interest entities (PIE) can be observed. Based on previous literature and few academic studies the following working paper focuses on KAM within European Banks. Basis of the sample are those significant supervised European Banks that are governed by the European Central Bank (ECB), disclosed by the list of supervised entities published by the ECB as of 1st of January 2018. Reported KAM topics are tested on influential factors for KAM such as bank size and complexity, success, earnings management, region or audit company. Furthermore, text similarities are checked, as one of the goals of the new auditor reports was to individualise the reports. This study therefore, provides a deep insight into both, the most relevant topics auditors are dealing with in European Banks and bank specific dependencies and their influence on KAM.

Analysis of Sharī‘ah Based Equity Screenings: Developing a Sharī‘ah-Compliant Index for Qatar Stock Exchange
Kahf, Monzer,Al-Hajjaji, Eman Mohammed
Although, any amount or portion of Haram is not permissible in Sharī‘ah. An exception has been addressed on the basis of the Sharī‘ah-established maxim of “necessities call for relaxation of prohibition.” This allows investing in companies that engage in some non-permissible transactions (mixed companies) to a certain tolerable extent, provided that the financial outcomes of these transactions are purified by giving the part that is not-permissible to charity. Identifying mixed companies that Muslims can invest in is done by using specific Sharī‘ah screening criteria that exclude out of the universe of all listed companies in a specific market those companies with returns emanating from non-permissible activities beyond certain threshold limits. This paper identifies the screening criteria used by seven Islamic indices, compares and contrasts between them and tries to examine whether it is time to have an Islamic index with no tolerance to non-permissible activities using Qatar as a case study. It is found that there exists a number of differences among Islamic indices which have impact on the Muslim investors level of freedom through their impact on the universe of Halal equity assets. It is also found that an Islamic index with zero-tolerance to non-permissible activities may be constructed for Qatar Stock Exchange without losing much of freedom of choice in this market. A comparison between the proposed zero-tolerance index and the already existing Al Rayan Islamic index shows that there are no differences in their respective behaviors. This indicates that having companies that do some non-permissible activities and having non-permissible income in the “Islamic basket” of listed companies is not necessary in Qatar. This paper consists of five sections. The first section provides an introduction to the presented topic. The methods that are used for Sharī‘ah investment screening are discussed in section two. The third section includes a comparison of the screening criteria that are currently used by major index providers. The creation of an Islamic index with Zero-tolerance in Qatar Stock Exchange is illustrated in section four. The last section consists of conclusions and recommendations.

Bank Geographic Diversification and Corporate Innovation: Evidence from the Lending Channel
Deng, Saiying,Mao, Connie X.,Xia, Cong
By integrating the staggered interstate bank deregulation into a gravity model, we construct a time-varying bank-specific instrument for geographic diversification and investigate its impact on corporate innovation via the lending channel. We find that bank geographic diversification boosts both the quantity and quality of innovation, enables firms to expand innovation scope beyond core businesses, and enhances the economic value of innovation. Such effects are more pronounced in marginal firms. We identify relaxing debt covenants and alleviating borrowers’ financial constraints as the two channels. Geographically diversified banks also enhance the innovation capability of borrowing firms via technology spillover from peer firms.

Bessel-like birth-death process
Vygintas Gontis,Aleksejus Kononovicius

We do consider models of the population or opinion dynamics which result in non-linear stochastic differential equations (SDEs) exhibiting spurious long-range memory. In this context, the correspondence between the description of birth-death processes as continuous-time Markov chains and continuous SDEs is of high importance for the alternatives of modeling. We propose and generalize Bessel-like birth-death process having clear representation by SDEs. The new process helps to integrate alternatives of description and to derive equations for the probability density function (PDF) of burst and inter-burst duration of the proposed continuous time birth-death processes. This PDF might be used to discriminate between spurious memory and true long-range memory in complex systems exhibiting continuing fluctuations.

Curriculum Learning in Deep Neural Networks for Financial Forecasting
Allison Koenecke,Amita Gajewar

For any financial organization, computing accurate quarterly forecasts for various products is one of the most critical operations. As the granularity at which forecasts are needed increases, traditional statistical time series models may not scale well. We apply deep neural networks in the forecasting domain by experimenting with techniques from Natural Language Processing (Encoder-Decoder LSTMs) and Computer Vision (Dilated CNNs), as well as incorporating transfer learning. A novel contribution of this paper is the application of curriculum learning to neural network models built for time series forecasting. We illustrate the performance of our models using Microsoft's revenue data corresponding to Enterprise, and Small, Medium & Corporate products, spanning approximately 60 regions across the globe for 8 different business segments, and totaling in the order of tens of billions of USD. We compare our models' performance to the ensemble model of traditional statistics and machine learning techniques currently used by Microsoft Finance. With this in-production model as a baseline, our experiments yield an approximately 30% improvement in overall accuracy on test data. We find that our curriculum learning LSTM-based model performs best, showing that it is reasonable to implement our proposed methods without overfitting on medium-sized data.

Designing Call Auction Institutions to Eliminate Price Bubbles: Is English Dutch the Best?
Deck, Cary A.,Servátka, Maroš,Tucker, Steven James
The bubble and burst pattern in asset market experiments is among the most replicable results in experimental economics. Numerous studies have searched for means to reduce this mispricing. Using controlled laboratory experiments, we compare mispricing in standard double auction markets to prices in two clock auctions. The double Dutch auction, shown to be more efficient than the double auction in commodity market experiments, does not eliminate bubbles. However, the English Dutch auction does yield prices reflective of underlying fundamentals and succeeds in taming bubbles even with inexperienced traders in the common declining fundamental value environment.

Determinants of Tangible Long-Lived Asset Impairments under US GAAP and IFRS
Gordon, Elizabeth A.,Hsu, Hsiao-Tang
This paper explores determinants of tangible long-lived asset impairments under US GAAP and IFRS. Using a sample covering 26 countries, we document that US GAAP impairments are more related to macroeconomic factors consistent with the built-in delay in reporting impairments under two-step impairment testing and measuring the impairment loss at fair value. IFRS impairments are more associated with firm-specific factors consistent with measuring the impairment at value-in-use and a one-step impairment test. Results also indicate US GAAP impairments are more associated with reporting incentives, except for having private debt. Further, when enforcement is low, impairments are less (more) associated with economic factors (reporting incentives) for IFRS reporters.

Economic Consequences of IFRS Adoption: The Role of Changes in Disclosure Quality
Li, Bin,Siciliano, Gianfranco,Venkatachalam, Mohan
This study adopts a two-step approach to highlight the disclosure quality channel that drives economic consequences of IFRS adoption. In the first step, we document the impact of the IFRS mandate on changes in disclosure quality proxied by the granularity of line-item disclosure in financial statements. We find that IFRS-adopting firms provide more disaggregated information upon IFRS adoption, such as more granular disclosure of intangible assets and long-term investments on the Balance Sheet and greater disaggregation of depreciation and operating income items on the Income Statement. In the second step, we link the observed disclosure changes to the benefits and costs of IFRS adoption. We show that greater disaggregated information due to IFRS adoption enhances market liquidity and decreases information asymmetry, but does not affect audit fees differentially. Thus, the cost-benefit tradeoff of IFRS adoption is neither uniform across all IFRS-adopting countries nor across IFRS-adopters within each country.

Efficient Numerical Pricing of American Call Options Using Symmetry Arguments
Stentoft, Lars
This paper demonstrates that it is possible to improve significantly on the estimated call prices obtained with the regression and simulation based Least-Squares Monte-Carlo method of Longstaff & Schwartz (2001) by using put-call symmetry. Results show that the symmetric method performs much better on average than the regular pricing method for a large sample of options with characteristics of relevance in real life applications, is the best method for most of the options, never performs poorly and, as a result, is extremely efficient compared to the optimal but unfeasible method that picks the method with the smallest Root Mean Squared Error (RMSE). A simple classification method is proposed that, by optimally selecting among estimates from the symmetric method with a reasonably small order used in the polynomial approximation, achieves a relative efficiency of more than 98%. The relative importance of using the symmetric method increases with option maturity and with asset volatility. Using the symmetric method to price, for example, real options, many of which are call options with long maturities on volatile assets, for example energy, could therefore improve the estimates significantly by decreasing their Bias and RMSE by orders of magnitude.

Extreme Downside Risk and Market Turbulence.
Harris, Richard D. F.,Nguyen, Linh,Stoja, Evarist
We investigate the dynamics of the relationship between returns and extreme downside risk in different states of the market by combining the framework of Bali, Demirtas, and Levy (2009) with a Markov switching mechanism. We show that the risk-return relationship identified by Bali, Demirtas, and Levy (2009) is highly significant in the low volatility state but disappears during periods of market turbulence. This is puzzling since it is during such periods that downside risk should be most prominent. We show that the absence of the risk-return relationship in the high volatility state is due to leverage and volatility feedback effects arising from increased persistence in volatility. To better filter out these effects, we propose a simple modification that yields a positive tail risk-return relationship in all states of market volatility.

Force Majeure Events And Stock Market Reactions In Ukraine
Caporale, Guglielmo Maria,Plastun, Oleksiy,Makarenko, Inna
This paper examines reactions in the Ukrainian stock market to force majeure events, which are divided into four groups: economic force majeure, social force majeure and terrorist acts, natural and technological disasters. More specifically, using daily data for the main Ukrainian stock market index (namely PFTS) over the period 01.01.1997-31.12.2018 this study investigates whether or not force majeure events create (temporary) inefficiencies and there exist profitable trading strategies based on exploiting them. For this purpose cumulative abnormal returns and trading simulation approaches are used in addition to Student’s t-tests. The results suggest that the Ukrainian stock market absorbs new information rather fast. Negative returns in most cases are observed only on the day of the event. The only exception is technological disasters, the market needing up to ten days to react fully in this case. Despite the presence of a detectable pattern in price behaviour after force majeure events (namely, a price decrease on the day of the event) no profitable trading strategies based on it are found as their outcomes do not differ from those generated by random trading.

Globalizimi i Tregjeve Financiare (Financial Markets' Globalization)
Pjetri, Fabian,Bylo, Ardita
Albanian Abstract: Globalizmi tashmë përbën një realitet të ri. Shpërndarja e pabarabartë e burimeve natyrore bën që të gjitha vendet e botës të jenë gjithmonë e më të ndërvarura ndaj prodhimeve dhe shërbimeve që ofrohen nga vëndet e tjera, të cilat ato vetë nuk i zotërojnë dhe për pasojë nuk mund ti prodhojnë. Ai nxit levizshmërinë e madhe të njerëzve nga njeri vend në një vend tjetër dhe kjo bën që të kemi një ndërthurje të kulturave nëpërmjet përshtatjes kulturore dhe sociale të tyre. Një rol tepër të rëndësishëm në globalizimin e vendeve luajnë edhe emigrantët, të cilët kontribuojnë si në nivelin ekonomik të vendeve pritëse të tyre, por edhe të vendeve përkatëse nga ata vijnë po ashtu dhe në nivelin social, kulturor. Globalizmi si dukuri është shndërruar në një dukuri komplekse që përfshin të gjitha sferat e jetës së njerezve dhe të shteteve në të gjithë botën. Përfitimet e kësaj dukurie janë universal dhe të shumëllojshme duke nisur me përfitimet politike, ekonomike, sociale, kulturore, teknologjike, shkëmbimit të eksperiencave në të gjitha aspektet, difuzioni si dukuri brenda së cilës përfshihet në çdo nivel bashkëveprimi, mundësi në shfrytëzimin e të gjitha të mirave dhe shërbimeve të ofruara, ristrukturimin e jetës, hapja e rrugës për veprimtari të cilat ende nuk janë eksploruar.English Abstract: Globalization is a phenomenon with great impact on the overall economy, social and political situation, during the last decades of the twentieth century. It represents a new reality and reflects a development that goes beyond the notion of global markets. It implies a so called "world without borders", but it can not be treated as a process with a well known starting point. In fact, there is no an exact definition.The natural resources unequal allocation becomes a reason for all countries to be dependent on products and services offered by the ones that can produce them. It urges people mobility from one country to another and brings a mixture of cultures among adaptation. The benefits of this process are universal and various through exchanges in different fields. Diffusion can occur in every level of interaction. In this way there is an opportunity to restructure life, to use all the goods and services offered, and to open the way to activities that have not yet been explored.

Halloween Effect in Developed Stock Markets: A US Perspective
Plastun, Oleksiy,Sibande, Xolani,Gupta, Rangan,Wohar, Mark E.
In this paper, we conduct a comprehensive investigation of the Halloween effect evolution in the US stock market over its entire history. We employ various statistical techniques (average analysis, Student’s t-test, ANOVA, and the Mann-Whitney test) and the trading simulation approach to analyse the evolution of the Halloween effect. The results suggest that in the US stock market the Halloween effect became more persistent since the middle of the 20th century. Despite the decline in its prevalence since that time, nowadays it is still present in the US stock market and provides opportunities to build a trading strategy which can beat the market. These results are well in line with other developed stock markets. Therefore, in the main, our results are inconsistent with the Efficient Market Hypothesis.

Infrastructure Investment â€" the Emergent PPP Equity Market
Whitfield, Dexter,SMYTH, Stewart
Increasingly governments are looking to private sector actors to invest in infrastructure projects. An emergent mechanism for such investment is the market in PPP equity. This is an aspect of PPPs that has to date had little empirical attention. This paper reports on the size and scope of the market in PPP equity sales within the UK. In the process, the nature of PPP projects and the existing rationales for the policy are critiqued. The paper concludes by laying out a number of potential research agendas focused on PPP equity sales including a call for reassessing theoretical perspectives.

Market Frictions, Arbitrage, and the Capitalization of Amenities
Ouazad, Amine,Rancière, Romain G.
The price-amenity arbitrage is a cornerstone of spatial economics, as the response of land and house prices to shifts in the quality of local amenities and public goods is typically used to reveal households' willingness to pay for amenities. With informational, time, and cash constraints, households' ability to arbitrage across locations with different amenities (demographics, crime, education, housing) depends on their ability to compare locations and to finance the swap of houses. Arbitrageurs with deep pockets and better search and matching technology can take advantage of price dispersions and unexploited trade opportunities. We develop a disaggregated search and matching model of the housing market with endogenously bargained prices, identified on transaction-level data from the universe of deeds for 6,400+ neighborhoods of the Chicago metropolitan area, matched with school-level test scores and geocoded criminal offenses. Price-amenity gradients reflect preferences and the capitalization of trading opportunities, which are arbitraged away in the frictionless limit. Thus the time-variation in hedonic pricing coefficients partly reflects the time variation in search and credit frictions. Our model is able to explain that, between the peak of the housing boom and its trough, the sign of the price-amenity gradient flipped, due to the decline in trading opportunities in lower-amenity neighborhoods and due to the lower capitalization of trading opportunities in house prices.

Method of Payment in Mergers and Acquisitions: The Case of Saudi Arabia
Zakaria, Nadisah,Kamaludin, Kamilah,AlKhalifa, Alya
This study examines the long-run share performance of acquirer’ companies listed on the Saudi Arabia Stock Exchange (Tadawul) from 1st January 2000 to 31st August 2017. Using the buy-and-hold abnormal return method, the present study finds that the acquirer companies’ shares for the cash payment method continues to outperform their counterparts of non-cash payment against the equal- weighted and value-weighted indexes. The presence of abnormal return opportunities that may be exploited by investors in the three-year holding period following the completion of M&A events might provide valuable insight to individual and institutional investors. As there is no national evidence on share performances of acquirer’s companies over the long-run period, the present findings add to a growing body of M&A literature.

Micro-Equity for Microenterprises
de Mel, Suresh,McKenzie, David J.,Woodruff, Christopher
Many microenterprises in developing countries have high returns to capital, but also face risky revenue streams. In principle, equity offers several advantages over debt when financing investments of this nature, but the use of equity in practice has been largely limited to investments in much larger firms. We develop a model contract to make self-liquidating, quasi-equity investments in microenterprises. Our contract has three key parameters that can be used to shift risk between the entrepreneur and the investor, resulting in a continuum of contracts ranging from a debt-like contract that shifts little risk from the entrepreneur to a pure revenue-sharing contract in which the investor absorbs much more of the risk. We discuss implementation choices, and then provide lessons from a proof-of-concept carried out by an investment partner, KGC Equity, which made nine investments averaging $3,800 in Sri Lankan microenterprises. This pilot demonstrates that our contract structure can work in practice, but also highlights the difficulties of micro-equity investments in an environment with weak contract enforcement.

On Comparing Asset Pricing Models
Chib, Siddhartha,Zeng, Xiaming,Zhao, Lingxiao
We revisit the framework of Barillas and Shanken (2018) (BS henceforth) to point out that the Bayesian marginal likelihood based model comparison method in that paper is unsound. We show that in this comparison of asset pricing models, the priors on the nuisance parameters across models must satisfy a certain change of variable property for densities that is violated by the off-the-shelf Jeffreys priors used in the BS method. Hence, the BS "marginal likelihoods" are non-comparable across models and cannot be used to locate the (traded) risk factors. We conduct extensive simulation exercises in two designs: one with 8 potential pricing factors and a second with 12 factors, in each case matching the factors to real world factors that arise in this setting. As expected, the BS method performs unsatisfactorily, even when epic (and practically unattainable) sample sizes of .12 and 1.2 million are used to conduct the model comparisons. In a notable advance, we derive a new class of improper priors on the nuisance parameters, starting from a single improper prior, which leads to valid marginal likelihoods, and valid model comparisons. The empirical performance of our marginal likelihoods is substantially better, opening doors to reliable Bayesian work on which factors are risk factors in asset pricing models.

On the martingale property in the rough Bergomi model
Paul Gassiat

We consider a class of fractional stochastic volatility models (including the so-called rough Bergomi model), where the volatility is a superlinear function of a fractional Gaussian process. We show that the stock price is a true martingale if and only if the correlation $\rho$ between the driving Brownian motions of the stock and the volatility is nonpositive. We also show that for each $\rho<0$ and $m> \frac{1}{{1-\rho^2}}$, the $m$-th moment of the stock price is infinite at each positive time.

Price Overreactions in the Forex and Trading Strategies
Caporale, Guglielmo Maria,Plastun, Oleksiy
This paper explores price overreactions in the FOREX by using both daily and intraday data on the EURUSD, USDJPY, USDCAD, AUDUSD and EURJPY exchange rates over the period 01.01.2008-31.12.2018. It applies a dynamic trigger approach to detect overreactions and then various statistical methods, including cumulative abnormal returns analysis, to test the following hypotheses: the intraday behaviour of hourly returns on overreaction days is different from that on normal days (H1), there are detectable patterns in intraday price dynamics on overreaction days (H2) and on the following days (H3). The results suggest that there are statistically significant differences between intraday dynamics on overreaction and normal days respectively; also, prices tend to change in the direction of the overreaction during the overreaction day, but move in the opposite direction on the following day. Finally, there exist trading strategies that generate abnormal profits by exploiting the detected anomalies, which can be seen as evidence of market inefficiency.

Production Efficiency of Firms with Mergers and Acquisitions in India
Saraswathy, Beena
Most often, the competition authorities approve combinations based on the tradeoff between the expected efficiency gains and the likely effect on market power creation. However, the realities may be different from the expected synergy creation since merger regulations are ex ante in nature. The present study is an attempt to understand how far the expected efficiency gains are actually achieved by the firms entering into consolidation in India, which experienced large number of mergers and acquisitions especially after the economic reforms of 1990s. Specifically, we have examined the technical efficiency of the firms involved in mergers and acquisitions, separately for cross-border and domestic deals.

Prospective strict no-arbitrage and the fundamental theorem of asset pricing under transaction costs
Christoph Kühn,Alexander Molitor

In discrete time markets with proportional transaction costs, Schachermayer (2004) shows that robust no-arbitrage is equivalent to the existence of a strictly consistent price system.

In this paper, we introduce the concept of prospective strict no-arbitrage that is a variant of the strict no-arbitrage property from Kabanov, R\'asonyi, and Stricker (2002). The prospective strict no-arbitrage condition is slightly weaker than robust no-arbitrage, and it implies that the set of portfolios attainable from zero initial endowment is closed in probability. A weak version of prospective strict no-arbitrage turns out to be equivalent to the existence of a consistent price system. In contrast to the fundamental theorem of asset pricing of Schachermayer (2004), the consistent frictionless prices may lie on the boundary of the bid-ask spread.

On the technical level, a crucial difference to Schachermayer (2004) and Kabanov-R\'asonyi-Stricker (2003) is that we prove closedness without having at hand that the null-strategies form a linear space.

Pure Gold for Economic Freedom: A Supranational Medium of Exchange to End American Monetary Hegemony as the World’s Main Reserve Currency
Taskinsoy, John
Before the invention of money (coin, paper, or digital) there was barter trading, a form of exchange without the use of a monetary medium. The evolution of money has kept pace with the evolution of humans. Money was not invented solely for transaction purposes; it was created to quantify wealth (i.e. bookkeeping of resources by bureaucrats) and functioned as a sign of power (i.e. aristocrats used it in social contracts between royals and servants). Throughout the human history, money has served as an important link (social relationship) between lenders and borrowers, contractors and workers. Facilitating exchange has evolved from barter to bimetallism (silver and gold), monometallic (gold), and paper (fiat) to gold as the basis of currencies. The emergence of fiat money was not to replace barter even though Adam Smith (1776) described barter trade as primitive in his seminal book titled in short “The Wealth of Nations”. The classical gold standard emerged as a true global standard in the late 19th century but lasted only about three decades, it collapsed bouts of unprecedented shocks of World War I. The interwar gold exchange standard was very brief which suffered similar flaws known as the Triffin dilemma. The inherent flaws of the gold standard and Bretton Woods made the U.S. more susceptible to the inevitable convertibility crisis; in reaction, the U.S. policies accelerated inflation, this in turn caused the system’s demise. The current ailing international monetary system is going to face the same predicament of the last generation regimes unless serious reforms are made.

Real Risk or Paper Risk? Mis-Measured Factors, Granular Measurement Errors, and Empirical Asset Pricing Tests
Byun, Sung Je,Schmidt, Lawrence
Given that the size distribution of publicly traded firms has fat tails, large idiosyncratic returns on large stocks can have nontrivial effects on the returns of value-weighted portfolios. We study effects of "granular measurement errors" -- which are present when the law of large numbers fails and idiosyncratic returns are not fully diversified away -- on standard empirical asset pricing tests. We construct an empirical proxy for the granular measurement error and demonstrate that it contributes substantially to the observed volatility of the CRSP value-weighted index and other market proxies. Unpriced granular measurement errors lead to downward-biased estimates of the intertemporal risk-return relationship, generate biased estimates of systematic risk exposures in cross-sectional asset pricing tests. After making simple corrections to eliminate the effects of granular measurement errors, we find much stronger evidence of an intertemporal risk-return relationship for the market index. In the cross section, betas for most portfolios -- especially portfolios of small stocks -- are severely biased downwards. After correcting estimated betas for the granular residual, the size anomaly disappears, and we find evidence of an expected return-beta relationship consistent with basic CAPM/APT theory. Finally, we use instrumental variables estimates to provide direct evidence that the granular residual is less informative about current and future real activity, suggesting an economic rationale for it having a lower or even zero risk price.

Risk measures and progressive enlargement of filtration: a BSDE approach
Alessandro Calvia,Emanuela Rosazza Gianin

We consider dynamic risk measures induced by Backward Stochastic Differential Equations (BSDE) in enlargement of filtration setting. On a fixed probability space, we are given a standard Brownian motion and a pair of random variables $(\tau, \zeta) \in (0,+\infty) \times E$, with $E \subset \mathbb{R}^m$, that enlarge the reference filtration, i.e., the one generated by the Brownian motion. These random variables can be interpreted financially as a default time and an associated mark. After introducing a BSDE driven by the Brownian motion and the random measure associated to $(\tau, \zeta)$, we define the dynamic risk measure $(\rho_t)_{t \in [0,T]}$, for a fixed time $T > 0$, induced by its solution. We prove that $(\rho_t)_{t \in [0,T]}$ can be decomposed in a pair of risk measures, acting before and after $\tau$ and we characterize its properties giving suitable assumptions on the driver of the BSDE. Furthermore, we prove an inequality satisfied by the penalty term associated to the robust representation of $(\rho_t)_{t \in [0,T]}$ and we provide an explicit example of such kind of dynamic risk measures, along with its decomposition.

Securitización e inversiones extranjeras: control del riesgo de ciertas inversiones para la seguridad nacional del Estado (Securitization and Foreign Investment: Screening of Foreign Investment on National Security Grounds)
Esplugues, Carlos
Spanish Abstract: El aumento constante de las inversiones extranjeras durante las últimas décadas ha venido acompañado de un cambio en sus parámetros. El origen de las inversiones varía, como lo hace su naturaleza y destino. La posibilidad de que sectores clave de la economía del Estado receptor acaben en manos de inversores extranjeros, en ocasiones pertenecientes o controlados por un Estado extranjero, es vista con prevención en muchos países y acentúa la creciente oposición al libre comercio y a la inversión extranjera. La limitada respuesta â€" ex post â€" ofrecida por el marco normativo internacional lleva a los Estados a diseñar respuestas ex ante, dirigidas a controlar ciertas inversiones que por su origen, condición o destino pueden resultar potencialmente riesgosas para su seguridad nacional.English Abstract: Foreign investment has increased steadily during the last decades. This fact has come accompanied by a change in some of its basic traits: its origin, its nature or its destination have also varied overtime. Today, when free trade and foreign investment are increasingly subject to criticisms in many places, the possibility for key sectors of the economy of the State to be controlled or owned by foreign investors, in many cases sovereign investors, is approached with prevention in many countries of the world. The limited â€" ex post â€" response provided by the international legal framework on investment forces States to explore new instruments to control foreign investment proposals that may endanger their national security due to its origin, nature or destination, among others.

Supervised Machine Learning for Eliciting Individual Reservation Values
John A. Clithero,Jae Joon Lee,Joshua Tasoff

Direct elicitation, guided by theory, is the standard method for eliciting individual-level latent variables. We present an alternative approach, supervised machine learning (SML), and apply it to measuring individual valuations for goods. We find that the approach is superior for predicting out-of-sample individual purchases relative to a canonical direct-elicitation approach, the Becker-DeGroot-Marschak (BDM) method. The BDM is imprecise and systematically biased by understating valuations. We characterize the performance of SML using a variety of estimation methods and data. The simulation results suggest that prices set by SML would increase revenue by 22% over the BDM, using the same data.

Systematic Extreme Downside Risk
Harris, Richard D. F.,Nguyen, Linh,Stoja, Evarist
We propose new systematic tail risk measures constructed using two different approaches. The first is a non-parametric measure that captures the tendency of a stock to crash at the same time as the market, while the second is based on the sensitivity of stock returns to innovations in market crash risk. Both tail risk measures are associated with a significantly positive risk premium after controlling for other measures of downside risk, including downside beta, coskewness and cokurtosis. Using the new measures, we examine the relevance for investors of the tail risk premium over different horizons.

Testing Derivatives Pricing Models under Higher-Order Moment Swaps
Doffou, Ako
This paper aims to test three parametric models in pricing and hedging higher-order moment swaps. Using vanilla option prices from the volatility surface of the Euro Stoxx 50 Index, the paper shows that the pricing accuracy of these models is very satisfactory under four different pricing error functions. The result is that taking a position in a third moment swap considerably improves the performance of the standard hedge of a variance swap based on a static position in the log-contract and a dynamic trading strategy. The position in the third moment swap is taken by running a Monte Carlo simulation.

Testing Margin of Conservatism for Scarce AIRB Data
Wiehler, Stephan
Since the go-live of the Basel II Regime in 2007, banks calculating Risk Weighted Assets under an (Advanced) Internal Rating Based Approach (AIRB) face the challenge to proof data robustness for parameter estimation approval (PD, LGD, CCF) from supervisory authorities. The question of how much margin of conservatism (MoC) is adequate is mostly discussed on a case by case basis and practitioners from banks and supervisors often enter an intense dialogue about how much the final suggested value should be above e.g. the sample mean. The most recent EBA guideline on PD and LGD estimation requires objective thresholds to judge model and parameter stability. This article introduces a testing procedure to structure the data robustness assessment. It employs the idea of checking how additional hypothetical but realistic observations would impact the proposed value based on the available observable sample. It should help practitioners to structure the discussion around MoC with internal validation units and supervisors. The test is applied to LGD data to illustrate the concept.

The Cross-Section of Currency Appreciation Rates
Maio, Paulo F.,Barroso, Pedro
We compute a cross-sectional variance decomposition for the average appreciation rate of foreign currencies. The cross-sectional dispersion in average nominal exchange rate growth is due to predictability of interest rate spreads among non-G10 currencies. However, among G10 currencies, we have an opposite pattern with cross-sectional return predictability playing the dominant role. The importance of the return channel among the G10 currencies is even stronger for real appreciation rates. By decomposing the cross-sectional return channel, pricing errors outweigh currency risk premia in terms of explaining nominal currency appreciation among G10 currencies. These results suggest important differences between G10 and other currencies.

The Hitchhiker's Guide to the Risk-Neutral Galaxy
Santean, Nicolae
The initial reason for writing this essay was to provide the background and a derivation of the IR quanto adjustment, as a mean of expressing the Hull-White dynamics of foreign currency interest rates under a domestic risk-neutral measure. However, one thing led to another, and the essay ended up including three different applications of the change of measure (or, Girsanov Theorem); namely, quanto adjustment, stock price dynamics under the risk-neutral measure, and pricing IR derivatives under the T-forward measure. The presented approach is neither meant to be original nor mathematically rigorous: it just aims at building an intuition of the employed methodology, hence facilitating a quick understanding of change of measure technique and some of its important applications. It is structured as a “user manual” and targets an audience with little background on the matter.

The Macroprudential Policy Framework Needs to Be Global
Lopez, Claude,Bruni, Franco
Basell III was a direct answer to the 2008 financial crisis. Now 10 years after the crisis, it is time to assess its timeliness and make the necessary adjustments so it becomes truly global. In this policy brief, we first clarify the goals of macroprudential policy before highlighting the main challenges that home and host countries may run into when global financial institutions lend beyond their home countries. We then suggest to focus on four priorities to address these vulnerabilities: (i) An adaptable and flexible global framework, (ii) The generalization of international standards and best practices, (iii) A stronger global data depository, (iv) Regulatory and monitoring cooperation.

The Origin and the Resolution of Nonuniqueness in Linear Rational Expectations
John G. Thistle

The nonuniqueness of rational expectations is explained: in the stochastic, discrete-time, linear, constant-coefficients case, the associated free parameters are coefficients that determine the public's most immediate reactions to shocks. The requirement of model-consistency may leave these parameters completely free, yet when their values are appropriately specified, a unique solution is determined. In a broad class of models, the requirement of least-square forecast errors determines the parameter values, and therefore defines a unique solution. This approach is independent of dynamical stability, and generally does not suppress model dynamics.

Application to a standard New Keynesian example shows that the traditional solution suppresses precisely those dynamics that arise from rational expectations. The uncovering of those dynamics reveals their incompatibility with the new I-S equation and the expectational Phillips curve.

The Resolution of Systemically Important Financial Institutions: Lessons from Fannie and Freddie
Calabria, Mark A.
There was perhaps no issue of greater importance to the financial regulatory reforms of 2010 than the resolution, without taxpayer assistance, of large financial institutions. The rescue of firms such as AIG shocked the public conscience and provided the political force behind the passage of the Dodd-Frank Act. Such is reflected in the fact that Titles I and II of Dodd-Frank relate to the identification and resolution of large financial entities. How the tools established in Titles I and II are implemented are paramount to the success of Dodd-Frank. This paper attempts to gauge the likely success of these tools via the lens of similar tools created for the resolution of the housing government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac.An additional purpose of this paper is to provide some additional “legislative history” to the resolution mechanisms contained in the Housing and Economic Recovery Act of 2008 (HERA), which established a resolution framework for the GSEs similar to that ultimately created in Title II of Dodd-Frank. The intent is to inform current debates over the resolution of systemically important financial institutions by revisiting how such issues were debated and agreed upon in HERA.

The Seniority Structure of Sovereign Debt
Schlegl, Matthias,Trebesch, Christoph,Wright, Mark L. J.
Sovereign governments owe debt to many foreign creditors and can choose which creditors to favor when making payments. This paper documents the de facto seniority structure of sovereign debt using new data on defaults (missed payments or arrears) and creditor losses in debt restructuring (haircuts). We overturn conventional wisdom by showing that official bilateral (government-to-government) debt is junior, or at least not senior, to private sovereign debt such as bank loans and bonds. Private creditors are typically paid first and lose less than bilateral official creditors. We confirm that multilateral institutions like the IMF and World Bank are senior creditors.

The Transmission Channels of Unconventional Monetary Policy: Evidence from a Change in Collateral Requirements in France
Delatte, Anne Laure,Imbs, Jean M.,Garg, Pranav
Using a bank-firm level credit registry combined with firm-level balance sheet data we establish the presence of heterogeneity in the effects of unconventional monetary policy transmission. We examine the consequences of a loosening in the collateral eligibility requirement for credit refinancing in France. The policy was designed to affect bank lending positively. We expect a linear increase in lending and an additional increase in loans to firms with newly acceptable rating. We find a large heterogeneity of the monetary policy transmission including the unexpected reduction of lending by the banks benefiting the most from the policy. These are small, risk-averse banks whose foremost concern after the recession was to strengthen their balance sheets. Banks least affected by the policy respond with a reduction in credit to low risk borrowers in reaction to the change in the market structure. Last we document heterogenous effects of the policy on firms depending on their size.

Utilizing Digital Tools for the Surveillance of the US Mortgage Market
Chang, Li,Koss, Richard
The US mortgage market is of paramount economic and financial importance. While the causes of the Global Financial Crisis (GFC) remain a subject of vigorous debate, lax lending standards and opacity surrounding innovations in securitization are often cited as central issues. A decade following the Global Financial Crisis, we have demonstrated that digital tools have been developed in the mortgage space that have the potential to allow investors to form a clear view of the investment risks and opportunities, and policymakers to design regulations with a complete view of the behavior of all participants: borrowers, underwriters, servicers and investors. While big data tools have been around for an extended period, it is only recently that advanced techniques have come to the market that allow for more cost-effective analysis. The latest enhancement is the application of AI to this data to unify the information across disparate data sets. We have seen demonstrations of the power of these techniques in analyzing business models for financial institutions, and for informing policymakers about the implications of their decisions across broad categories of actors in this market. Looking ahead, the analysis performed here can be extended by matching loans across time as well as between different data sets, and through applications to different markets and countries.

Volatility Forecasts for the RTS Stock Index: Option-Implied Volatility Versus Alternative Methods
Caporale, Guglielmo Maria,Teterkina, Daria
This paper compares volatility forecasts for the RTS Index (the main index for the Russian stock market) generated by alternative models, specifically option-implied volatility forecasts based on the Black-Scholes model, ARCH/GARCH-type model forecasts, and forecasts combining those two using a mixing strategy based either on a simple average or a weighted average with the weights being determined according to two different criteria (either minimizing the errors or maximizing the information content). Various forecasting performance tests are carried out which suggest that both implied volatility and combination methods using a simple average outperform ARCH/GARCH-type models in terms of forecasting accuracy.

rTSR: When Do Relative Performance Metrics Capture Relative Performance?
Ma, Paul,Shin, Jee-Eun,Wang, Charles C. Y.
Relative total shareholder returns (rTSR) has become the predominant metric to isolate managers' idiosyncratic performance. Among firms that explicitly use rTSR in relative performance contracts, 60% ― those that choose specific peers as benchmarks ― select rTSR metrics that do a remarkable job of filtering out the systematic component of returns in adherence to the informativeness principle. However, firms that choose index-based benchmarks retain substantial systematic noise in their rTSR metrics. We document that the selection of noisy benchmarks is associated with compensation consultants' preferences, which are uncorrelated with observable firm attributes. Firms with weak governance are more likely to choose indexes, not because of opportunism, but because they do not adequately scrutinize outside experts' advice. Collectively, our findings provide a new explanation for why some executives are evaluated based on systematic noise, and novel evidence on how compensation consultants can impact firms.