Research articles for the 2019-05-16

A Flexible Regime Switching Model for Asset Returns
Paolella, Marc S.,Polak, Pawel,Walker, Patrick S.
A non-Gaussian multivariate regime switching dynamic correlation model for financial asset returns is proposed. It incorporates the multivariate generalized hyperbolic law for the conditional distribution of returns. All model parameters are estimated consistently using a new two-stage expectation-maximization algorithm that also allows for incorporation of shrinkage estimation via quasi-Bayesian priors. It is shown that use of Markov switching correlation dynamics not only leads to highly accurate risk forecasts, but also potentially reduces the regulatory capital requirements during periods of distress. In terms of portfolio performance, the new regime switching model delivers consistently higher Sharpe ratios and smaller losses than the equally weighted portfolio and all competing models. Finally, the regime forecasts are employed in a dynamic risk control strategy that avoids most losses during the financial crisis and vastly improves risk-adjusted returns.

Analysis of Credit Culture in the Zimbabwean Banking Sector
Bonga, Wellington Garikai,Chirenje, Givemore,Mugayi, Providence
This paper is motivated by high levels of non-performing loans in the Zimbabwean banking sector since dollarization in 2009. Banks are well known for their function of providing liquidity in the economy. Normal loan awarding require credit analysis. Credit analysis is undertaken to assess the possibility of the paying back of borrowed funds by the borrowers. Despite, the condition of credit analysis in place in banks, there is continued increase in levels of non-performing loans. The study seeks to analyse the credit culture of banks in Zimbabwe. The study employs a questionnaire approach to determine the level of credit culture employed in the banking sector. Using 188 responses from an electronic survey comprising of 17 questions including demographics, the study managed to explore various issues linked to credit culture of the Zimbabwean banking sector. Credit culture has been found to be below optimal level despite the fact that many respondents indicated that credit risk management is critical. Corporate governance issues have been identified as lacking in the sector, hence aiding to poor credit culture. Internal and external factors have been identified as defining poor credit culture in the sector. Poor credit framework in banks, nepotism and insider loans, political influence are some factors leading to poor credit culture. The study concludes by suggesting proper reforms in the banking sector to grant them autonomy from politics, development of proper credit framework to be followed, effective credit analysis, ongoing lender training among other measures. Good credit culture should be promoted to ensure a viable banking sector and hence promoting economic growth. Loan default is strongly linked to poor credit analysis and improper loan allocation, and this should be dealt with by encouraging good corporate governance and maintaining a good credit culture, hence avoiding NPLs.

At the Mercy of the Common Noise: Blow-ups in a Conditional McKean--Vlasov Problem
Sean Ledger,Andreas Sojmark

We extend a model of positive feedback and contagion in large mean-field systems by introducing a common source of noise driven by Brownian motion. Although the dynamics in the model are continuous, the feedback effect can lead to jump discontinuities in the solutions, which we refer to as `blow-ups'. We prove existence of solutions to the corresponding conditional McKean--Vlasov equation, by realising them as suitable limit points of the finite-dimensional particle system, and we show that the pathwise realisation of the common noise can both trigger and prevent blow-ups.

Distributed Ledger and Blockchain Technology: Framework and Use Cases
Kim, Seoyoung,Sarin, Atulya
Since its first widespread implementation in 2009, distributed ledgers in general, and blockchain technology in particular, have rapidly become a part of the FinTech vernacular. In this paper, we provide an overview of the history of trade settlement and discuss this nascent technology that may now transform traditional methods of verifying and settling transactions. In so doing, we discuss current and potential use cases of this technology and provide a business-oriented framework for proper as well as improper implementations and applications of blockchains and distributed ledgers.

Dynamic model of firms competitive interaction on the market with taxation
Oleg Malafeyev,Eduard Abramyan,Andrey Shulga

In this article three models of firms interaction on the market are described. One of these models is described by using a differential equation and by Lotka-Volterra model, where the equation has a different form. Also, there are models of non-competing and competing firms. The article presents an algorithm for solving the interaction of competing firms in taxation and the calculation of a compromise point. Besides, the article presents a compromise between the interests of a state and an enterprise.

Financial Deepening, Terms of Trade Shocks and Growth in Low-Income Countries Countries
Kpodar, Kangni,Le Goff, Maëlan,Singh, Raju Jan
This paper contributes to the literature by looking at the possible relevance of the structure of the financial systemâ€"whether financial intermediation is performed through banks or marketsâ€"for macroeconomic volatility, against the backdrop of increased policy attention on strengthening growth resilience. With low-income countries (LICs) being the most vulnerable to large and frequent terms of trade shocks, the paper focuses on a sample of 38 LICs over the period 1978-2012 and finds that banking sector development acts as a shock-absorber in poor countries, dampening the transmission of terms of trade shocks to growth volatility. Expanding the sample to 121 developing countries confirms this result, although this role of shock-absorber fades away as economies grow richer. Stock market development, by contrast, appears neither to be a shock-absorber nor a shock-amplifier for most economies. These findings are consistent across a range of econometric estimators, including fixed effect, system GMM and local projection estimates.

Improving Regression-based Event Study Analysis Using a Topological Machine-learning Method
Takashi Yamashita,Ryozo Miura

This paper introduces a new correction scheme to a conventional regression-based event study method: a topological machine-learning approach with a self-organizing map (SOM).We use this new scheme to analyze a major market event in Japan and find that the factors of abnormal stock returns can be easily can be easily identified and the event-cluster can be depicted.We also find that a conventional event study method involves an empirical analysis mechanism that tends to derive bias due to its mechanism, typically in an event-clustered market situation. We explain our new correction scheme and apply it to an event in the Japanese market --- the holding disclosure of the Government Pension Investment Fund (GPIF) on July 31, 2015.

Interdependence of sectors of economic activities for world countries from the reduced Google matrix analysis of WTO data
Célestin Coquidé,José Lages,Dima L. Shepelyansky

We apply the recently developed reduced Google matrix algorithm for the analysis of the OECD-WTO world network of economic activities. This approach allows to determine interdependences and interactions of economy sectors of several countries, including China, Russia and USA, properly taking into account the influence of all other world countries and their economic activities. Within this analysis we also obtain the sensitivity of economy sectors and EU countries to petroleum activity sector. We show that this approach takes into account multiplicity of network links with economy interactions between countries and activity sectors thus providing more rich information compared to the usual export-import analysis.

Mean-Variance Portfolio Rebalancing with Transaction Costs
Dybvig, Philip H.,Pezzo, Luca
Transaction costs can make it unprofitable to rebalance all the way to the ideal portfolio. A single-period mean-variance theory allows a full solution for many securities with possibly correlated returns, and makes the economics of trading with transaction costs very clear, informing us about theory and practice. As in continuous time models, there is a non-trading region within which trading does not pay. With only variable costs, any trading is to the boundary of the non-trading region, while fixed or mixed costs induce trading to the interior. The exact solution for an arbitrary number of assets and covariance structure is easy to compute (exactly by hand for a small problem). The results nicely complement the continuous-time models for special cases or with approximate numerical solutions. One application shows how to improve on traditional symmetric futures overlay strategies.

Medical Malpractice Reform: What Works and What Doesn’t
Viscusi, W. Kip
Concerns with medical malpractice liability costs have been a principal factor leading states to adopt a series of tort liability reforms. Medical malpractice premiums have been declining, creating less of a cost-based impetus for additional reforms. The most consistent empirical evidence indicating statistically significant effects of medical malpractice reforms has been for caps on non-economic damages. Damages caps reduce insurance losses and foster insurer profitability, consistent with the objective of caps. The impacts of caps are greatest for insurance companies that otherwise would have experienced the greatest losses in the state. However, caps may reduce payouts to plaintiffs, potentially reducing the funds available to cover economic losses and attorney fees. A more recent medical malpractice reform, apology laws, may have a counterproductive effect by encouraging apologies that have the unintended consequence of increasing litigation and damages payments. There is also evidence that medical malpractice reforms affect the delivery of medical care and the supply of physicians, but these effects are not as prominent as the impacts on payouts. Medical malpractice liability remains an inefficient way to transfer funds to injured patients. The share of litigation and defense expenses relative to costs remains high. The early offer reform proposal is one approach that is directed at reducing these costs.

Options to Receive Employment Gratuity
Reason Machete

Employment gratuity is the money companies typically give to their employees at the end of their contracts as a legal requirement. Like pension, it is a form of retirement plan and is often given as an alternative to a pension plan. Nonetheless, there is now a new pattern whereby companies give their employees the option to receive their gratuity at various stages before the end of their contracts. In Botswana, for instance, some companies give their employees an option to receive their gratuity on a monthly basis rather than having them wait for a year or more. Many employees find this option attractive, but is it economically sound? This paper sheds light on this question, highlighting the need for analytically informed decisions. It quantifies the economic benefits of the tax relief provided by government relative to investing the monthly-received funds in a risk-free savings account or in helping repay a loan. The principles and methods used herein can be adapted and applied to different circumstances.

Playing with ghosts in a Dynkin game
Tiziano De Angelis,Erik Ekström

We study a class of optimal stopping games (Dynkin games) of preemption type, with uncertainty about the existence of competitors. The set-up is well-suited to model, for example, real options in the context of investors who do not want to publicly reveal their interest in a certain business opportunity. We show that there exists a Nash equilibrium in randomized stopping times which is described explicitly in terms of the corresponding one-player game.

Portfolio Optimization in Fractional and Rough Heston Models
Nicole Bäuerle,Sascha Desmettre

We consider a fractional version of the Heston volatility model which is inspired by [16]. Within this model we treat portfolio optimization problems for power utility functions. Using a suitable representation of the fractional part, followed by a reasonable approximation we show that it is possible to cast the problem into the classical stochastic control framework. This approach is generic for fractional processes. We derive explicit solutions and obtain as a by-product the Laplace transform of the integrated volatility. In order to get rid of some undesirable features we introduce a new model for the rough path scenario which is based on the Marchaud fractional derivative. We provide a numerical study to underline our results.

Predicting Cryptocurrency Defaults
Grobys, Klaus,Sapkota, Niranjan
We examine all available 146 Proof-of-Work based cryptocurrencies that started trading prior to the end of 2014 and track their performance until December 2018. We find that about 60% of those cryptocurrencies were eventually in default. The substantial sums of money involved mean those bankruptcies will have an enormous societal impact. Employing cryptocurrency-specific data, we estimate a model based on linear discriminant analysis to predict such defaults. Our model is capable of explaining 87% of cryptocurrency bankruptcies after only one month of trading and could serve as a screening tool for investors keen to boost overall portfolio performance and avoid investing in unreliable cryptocurrencies.

Quality in the Selection of REITs
Hughes, Bill,Kedrowski, Sean,Jivraj, Farouk,Abramczyk, Andrew
Quality real estate has historically offered an attractive return, but that return sits behind high barriers to entry. Physical property is costly to own and illiquid to trade. Publicly listed real estate investment trusts (REITs) were conceived as a means for shareholders to own property in a more divisible and tradable way. Over time, REIT shares have grown into a more than trillion dollar market. Historically, REIT shares have tracked long term real estate returns while also outperforming the stock market. They have combined bond-like regular payouts with the capital appreciation aspects of ordinary stocks. As such, they offer a long-term diversification benefit versus other traditional asset classes. However, REIT investing comes with two specific risk characteristics. One: an asymmetric risk profile, i.e. stable revenue and an absence of windfall profit possibilities limit the reward for taking incremental risk. Two: a high debt burden relative to companies in other sectors. In this paper, we investigate quality-based characteristics that can improve the risk-return profile of REIT investing. Specifically, we study portfolios of REITs formed based on four characteristics: profitability, leverage, valuation and yield. We find that a portfolio that removes low quality REITs has historically outperformed the broad REIT benchmark. We highlight an approach of using these four characteristics to build a broad, statistically robust REIT portfolio, with each characteristic being additive to the REIT selection process. Importantly, the approach is based on fundamental real estate investment principles.

Rent Extraction by Super-Priority Lenders
Eckbo, B. Espen,Li, Kai,Wang, Wei
We present strong evidence of supra-competitive pricing of debtor-in-possession (DIP) loans to firms filing for Chapter 11 bankruptcy. Fully collateralized and with super-priority and strong covenants, DIP loans have near-zero default risk. Nonetheless, their spreads and fees exceed those of even junk-rated loans, adding billions to the borrowing costs of Chapter 11 firms. There is also no evidence that the increasing involvement of hedge funds and private equity funds in providing DIP financing has mitigated rent extraction by lenders in this market. Junior claimants often contest DIP-loan terms in court - but apparently to little avail.

Risk and Return in International Corporate Bond Markets
Bekaert, Geert,De Santis, Roberto A.
We investigate risk and return in the major corporate bond markets of the developed world. We find that average returns increase with maturity and ratings class (where ratings go from high to low) and that this pattern is fit well by a global CAPM model, where the market consists out of equity, sovereign and corporate bonds. Nonetheless, we strongly reject “asset class integration,” finding a model which separates the market portfolio into its three components to fit much more of the corporate bond return variation. The corporate bond factor receives much higher exposure than suggested by its relative market capitalization. We also strongly reject “international market integration”; local factors contribute substantially more to the variation of corporate bond returns than do global factors, and a “local” three-factor model explains more than 80% of the return variation for 59 of 63 portfolios examined. The factor exposures show intuitive patterns; for example, the corporate bond factor betas increase steeply as ratings worsen. Our results are robust to the use of hedged versus unhedged returns and also show up in a panel regression at the CUSIP level.

SeLFIES for Portugal - An Innovative Pan European Retirement Solution
Merton, Robert C.,Muralidhar, Arun,Ferreira, Rui Seybert P
With a rapidly aging population, Portugal faces some serious pension challenges including a Social Security system which is under pressure, and pension benefits gradually approaching levels that will require individuals to supplement Social Security with private savings. In addition, Portugal has a low rate of financial literacy and hence transferring the responsibility of retirement planning to the general population runs a major risk of many individuals retiring poor. While some attempts have been made to create private pension plans, they have not had the level of acceptance as has been the case in some of the Anglo-Saxon countries. This paper argues that the government of Portugal could issue a new form of Sovereign Contingent Debt Instrument (SCDI) that can address the growing retirement challenge and achieve other goals as well. SeLFIES (Standard-of-Living indexed, Forward-starting Income-only Securities) are a new type of bond that greatly simplify retirement planning to the level of basic financial literacy and can not only address retirement security, but also improve the government’s debt financing and funding for infrastructure. Finally, since Portugal is part of the EU, the demand for these new bond instruments could be Euro-wide thereby providing both a Pan European solution and additional benefits to the Portuguese government in reducing its overall financing cost.

Search Frictions and Idiosyncratic Price Dispersion in the US Housing Market
Kotova, Nadia,Zhang, Anthony Lee
This paper studies the sources of idiosyncratic house price dispersion. We construct a search-and-bargaining model of the housing market, which predicts that idiosyncratic price dispersion should be positively correlated with time-on-market and negatively correlated with house prices and sales volume. Using a methodology which combines repeat-sales and hedonic approaches, we measure idiosyncratic price dispersion across locations and over time. We show that idiosyncratic price dispersion is countercyclical and seasonal, and that it is associated with prices, sales volume, and time-on-market in the directions predicted by our model, cross-sectionally as well as in panel regressions.

Tax Avoidance and the Real Effect of Tax-Risk Disclosures
McClure, Charles
I study the financial reporting effect of tax-risk disclosures (“FIN 48”) on tax avoidance. To isolate this effect from other factors that influence tax avoidance, I build a dynamic structural model in which a firm chooses a set of tax-saving projects in each period to maximize shareholder value. In this model, the firm trades off the tax savings with the financial-reporting costs, tax authority scrutiny, and operational frictions imposed by tax avoidance that reduce pre-tax income. I find that the FIN 48 disclosure increases effective tax rates by 2.8 percentage points relative to when firms can immediately recognize all of the tax savings on the income statement. I also find that average operational frictions from tax avoidance decrease pre-tax earnings by 7.4%. The magnitude of these frictions suggest they have a large impact on firms' tax planning and can explain the “undersheltering puzzle."

The Effect of Capital Gains Tax Policy Changes on Long-Term Investments
He, Eric,Jacob, Martin,Vashishtha, Rahul,Venkatachalam, Mohan
Pressure from short-horizon investors can hurt investments in innovative, long-run value increasing projects. We explore the efficacy of a commonly proposed tax-based policy tool to mitigate this problem: imposition of greater taxes on short-term capital gains relative to long-term capital gains. Using a panel of 30 OECD countries and 21 capital gains tax shocks over 1991-2006, we find that rewarding longer-term ownership through lower capital gains taxes results in an increase in corporate innovation. The evidence should be of interest to lawmakers and regulators and also adds to our understanding of the real effects of taxation of investor trading activity.

The Leland-Toft Optimal Capital Structure Model Under Poisson Observations
Palmowski, Zbigniew,Pérez, José-Luis,Surya, Budhi,Yamazaki, Kazutoshi
We revisit the optimal capital structure model with endogenous bankruptcy first studied by Leland (1994) and Leland and Toft (1996). Differently from the standard case, where shareholders observe continuously the asset value and bankruptcy is executed instantaneously without delay, we assume that the information of the asset value is updated only at intervals, modeled by the jump times of an independent Poisson process. Under the spectrally negative Levy model, we obtain the optimal bankruptcy strategy and the corresponding capital structure. A series of numerical studies are given to analyze the sensitivity of observation frequency on the optimal solutions, the optimal leverage and the credit spreads.

The Political Economy of Relationship Banking
Loncarski, Igor,Marinc, Matej
In the aftermath of the global financial crisis, banks need to reevaluate their position in light of profound changes in the economic, social, and political landscape. On the one hand, we emphasize the benefits of relationship banking, which establishes close contact with bank customers. Through a long-term orientation, relationship banking aligns incentives and supports the long-term needs of bank customers, leading to reduced inequality and greater firm innovation. On the other hand, the interaction between politics and relationship banking can have dark sides. First, with new borders arising and competition in banking affected, relationship banking might be particularly prone to political interference. Second, a shock to the relationship bank can be transmitted to its borrowers. We analyze how relationship banking can overcome its drawbacks.

The Role of Entrepreneurial Empowerment in the Relationship between Islamic Microfinance and Well-Being of Clients: A View from a Service Provider
Usman, A. S. ,Tasmin, Rosmaini,Ahmad Baharul-Ulum, Zatul Karamah
Islamic microfinance has been reported as appropriate in improving the living conditions of the poor. However, little is known about the contribution of entrepreneurial empowerment in achieving such success. The objective of this study is to examine the mediating role of entrepreneurial empowerment in the relationship between Islamic microfinance and well-being of clients. A sample of 291 respondents was selected randomly from the operational staff of Amanah Ikhtiar Malaysia in east-coast states of Malaysia. Structural Equation Modelling was used as the statistical procedure to analyse the data. The results supported three hypotheses, which confirmed that Islamic microfinance has positive relationship with entrepreneurial empowerment. However, three hypotheses were rejected on the relationship between Islamic microfinance and clients’ well-being, suggesting that Islamic microfinance does not improve the clients’ well-being. The seventh hypothesis was also supported, which indicates a full mediation role of entrepreneurial empowerment. The unique finding of the study is that, entrepreneurial empowerment is the underlying factor for the success of Islamic microfinance. To enable generalisation of this finding, further study is recommended in other Muslim countries.

The professional trader's paradox
Andrea Berdondini

In this article, I will present a paradox whose purpose is to draw your attention to an important topic in finance, concerning the non-independence of the financial returns (non-ergodic hypothesis). In this paradox, we have two people sitting at a table separated by a black sheet so that they cannot see each other and are playing the following game: the person we call A flip a coin and the person we'll call B tries to guess the outcome of the coin flip. At the end of the game, both people are asked to estimate the compound probability of the result obtained. The two people give two different answers, one estimates the events as independent and the other one considers the events as dependent therefore they calculate the conditional probability differently. This paradox show how the erroneous estimation of conditional probability implies a strong distortion of the forecasting skill that can lead us to bear excessive risks.

Unconventional Exchange: Methods for Statistical Analysis of Virtual Goods
Oliver James Scholten,Peter Cowling,Kenneth A. Hawick,James Alfred Walker

Hyperinflation and price volatility in virtual economies has the potential to reduce player satisfaction and decrease developer revenue. This paper describes intuitive analytical methods for monitoring volatility and inflation in virtual economies, with worked examples on the increasingly popular multiplayer game Old School Runescape. Analytical methods drawn from mainstream financial literature are outlined and applied in order to present a high level overview of virtual economic activity of 3467 price series over 180 trading days. Six-monthly volume data for the top 100 most traded items is also used both for monitoring and value estimation, giving a conservative estimate of exchange trading volume of over {\pounds}60m in real value. Our worked examples show results from a well functioning virtual economy to act as a benchmark for future work. This work contributes to the growing field of virtual economics and game development, describing how data transformations and statistical tests can be used to improve virtual economic design and analysis, with applications in real-time monitoring systems.

Why Are Commercial Loan Rates So Sticky? The Effect of Private Information on Loan Spreads
Demiroglu, Cem,James, Christopher M.,Velioglu, Guner
Past studies find that commercial loan spreads are “sticky,” in the sense that they do not fully respond to changes in market rates or observable firm credit risk characteristics. In this paper, we provide evidence that stickiness arises, in part, because the intensity of bank screening based on private soft information varies with changes in credit market conditions and observable firm credit risk characteristics. Our analysis demonstrates that stickiness in loan spreads does not necessarily indicate loan mispricing and may arise even in the absence of credit rationing, bank information monopolies, or behavioral biases in loan contracting.