Research articles for the 2019-05-17
A Note on Building Proxy Volatility Cubes
SSRN
In this note, we introduce a simple approach for building volatility cubes of an interest-rate index based on the existing volatility cube of another index. Our approach can be formulated as a specific linear factor model, but it is dynamical in nature, and has the advantage of simple, explicit formulas for the ATM implied volatility and skew. As an example, we will construct SOFR volatility smiles from LIBOR-based ones.
SSRN
In this note, we introduce a simple approach for building volatility cubes of an interest-rate index based on the existing volatility cube of another index. Our approach can be formulated as a specific linear factor model, but it is dynamical in nature, and has the advantage of simple, explicit formulas for the ATM implied volatility and skew. As an example, we will construct SOFR volatility smiles from LIBOR-based ones.
Busy Boards and Corporate Earnings Management: An International Analysis
SSRN
Examining a set of firms from 46 countries, we explore whether busy independent directors, CEOs and audit committees effectively monitor corporate financial reporting. We find that firms with a higher proportion of busy independent directors or busy CEOs more extensively manage their earnings. Further, we discover that firms with a higher percentage of busy independent audit committee members have poorer financial reporting quality. This finding is consistent with the board and the audit committee monitoring the firm’s financial reporting while CEOs influence the reporting process itself. We determine that the adverse effect of board busyness on a firm’s earnings reporting quality is more pronounced in non-U.S. firms. We also discover that investor protection levels and national culture influence a firm’s earnings management.
SSRN
Examining a set of firms from 46 countries, we explore whether busy independent directors, CEOs and audit committees effectively monitor corporate financial reporting. We find that firms with a higher proportion of busy independent directors or busy CEOs more extensively manage their earnings. Further, we discover that firms with a higher percentage of busy independent audit committee members have poorer financial reporting quality. This finding is consistent with the board and the audit committee monitoring the firm’s financial reporting while CEOs influence the reporting process itself. We determine that the adverse effect of board busyness on a firm’s earnings reporting quality is more pronounced in non-U.S. firms. We also discover that investor protection levels and national culture influence a firm’s earnings management.
CSR Disclosure, Analyst Forecasts and Firm Value: Evidence from Financial Restatements
SSRN
This study examines the changes in CSR disclosure and the impacts of CSR disclosure on analyst forecasts and firm value during financial restatements. Our results reveal that restating firms substantively improve their CSR disclosure quality via a change of disclosure tone, report readability, and the sustainability-related word usage following a restatement. We also find that the improvement is stronger in restating firms with low CSR disclosure quality. Further, we find that in the post-restatement period analysts’ forecast revisions are faster for firms with prior CSR reporting, and despite the downward post-restatement revision, analyst forecasts are still optimistically biased for restating firms with CSR disclosure. Moreover, restating firms with CSR disclosure are associated with smaller forecast errors and less dispersion than restating firms that do not engage in CSR reporting. Finally, we report that restating firms with CSR disclosure suffer less value losses from the restatement, consistent with the view that CSR reporting helps to repair reputation damage and protect firm value.
SSRN
This study examines the changes in CSR disclosure and the impacts of CSR disclosure on analyst forecasts and firm value during financial restatements. Our results reveal that restating firms substantively improve their CSR disclosure quality via a change of disclosure tone, report readability, and the sustainability-related word usage following a restatement. We also find that the improvement is stronger in restating firms with low CSR disclosure quality. Further, we find that in the post-restatement period analysts’ forecast revisions are faster for firms with prior CSR reporting, and despite the downward post-restatement revision, analyst forecasts are still optimistically biased for restating firms with CSR disclosure. Moreover, restating firms with CSR disclosure are associated with smaller forecast errors and less dispersion than restating firms that do not engage in CSR reporting. Finally, we report that restating firms with CSR disclosure suffer less value losses from the restatement, consistent with the view that CSR reporting helps to repair reputation damage and protect firm value.
Capital and Earnings Management: Evidence from Alternative Banking Business Models
SSRN
This paper examines whether institutional characteristics distinguishing Islamic from conventional banks lead to distinctive capital and earnings management behavior through the use of loan loss provisions. In our sample countries, the two banking sectors operate under different regulatory frameworks: conventional banks currently apply the “incurred†loan loss model until 2018 whereas Islamic banks mandatorily adopt an “expected†loan loss model. Our results provide significant evidence of capital and earnings management practices via loan loss provisions in conventional banks. This finding is more prominent for large and loss-generating banks. By contrast, Islamic banks tend not to use loan loss provisions in either capital or earnings management, irrespective of the bank’s size, earnings profile, or the structure of their loan loss model. This difference may be attributed to the constrained business model of Islamic banking, strict governance, and ethical orientation.
SSRN
This paper examines whether institutional characteristics distinguishing Islamic from conventional banks lead to distinctive capital and earnings management behavior through the use of loan loss provisions. In our sample countries, the two banking sectors operate under different regulatory frameworks: conventional banks currently apply the “incurred†loan loss model until 2018 whereas Islamic banks mandatorily adopt an “expected†loan loss model. Our results provide significant evidence of capital and earnings management practices via loan loss provisions in conventional banks. This finding is more prominent for large and loss-generating banks. By contrast, Islamic banks tend not to use loan loss provisions in either capital or earnings management, irrespective of the bank’s size, earnings profile, or the structure of their loan loss model. This difference may be attributed to the constrained business model of Islamic banking, strict governance, and ethical orientation.
Communication Within Banking Organizations and Small Business Lending
SSRN
We investigate how communication within banks affects small business lending. Using travel time between a bank’s headquarters and its branches to proxy for the costs of communicating soft information, we exploit shocks to these travel times to evaluate the impact of within bank communication costs on small business loans. Consistent with Stein’s (2002) model of the transmission of soft information across a bank’s hierarchies, we find that reducing headquarters-branch travel time boosts small business lending in the branch’s county. Several extensions suggest that new airline routes facilitate the transmission of soft information, boosting small firm lending.
SSRN
We investigate how communication within banks affects small business lending. Using travel time between a bank’s headquarters and its branches to proxy for the costs of communicating soft information, we exploit shocks to these travel times to evaluate the impact of within bank communication costs on small business loans. Consistent with Stein’s (2002) model of the transmission of soft information across a bank’s hierarchies, we find that reducing headquarters-branch travel time boosts small business lending in the branch’s county. Several extensions suggest that new airline routes facilitate the transmission of soft information, boosting small firm lending.
Components of Other Comprehensive Income Increase Uncertainty and Reduce Analyst Forecasting Ability
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This study examines the relationship between components of OCI and analysts’ forecasting behaviour, being forecast accuracy, analyst following and herding. The findings show that cash flow hedge (CFH) and foreign currency (FCX) elements are negatively associated with forecast accuracy and herding. We also find that available for sale (AFS) amounts are positively associated with forecast accuracy, herding and analyst following. Together with prior evidence, our findings provide empirical evidence that some OCI items (CFH and FCX) may increase uncertainty and make it more difficult for analysts to predict net income, and other OCI items (AFS) may be used by management to smooth net income, making net income less volatile and easier to predict. These results suggest that market participants benefit from more transparent OCI disclosures.
SSRN
This study examines the relationship between components of OCI and analysts’ forecasting behaviour, being forecast accuracy, analyst following and herding. The findings show that cash flow hedge (CFH) and foreign currency (FCX) elements are negatively associated with forecast accuracy and herding. We also find that available for sale (AFS) amounts are positively associated with forecast accuracy, herding and analyst following. Together with prior evidence, our findings provide empirical evidence that some OCI items (CFH and FCX) may increase uncertainty and make it more difficult for analysts to predict net income, and other OCI items (AFS) may be used by management to smooth net income, making net income less volatile and easier to predict. These results suggest that market participants benefit from more transparent OCI disclosures.
Constructing Tax Efficient Withdrawal Strategies for Retirees with Traditional 401(k)/IRAs, Roth 401(k)/IRAs, and Taxable Accounts
SSRN
We construct an algorithm for United States retirees that computes individualized tax-efficient annual withdrawals from IRAs/401(k)s, Roth IRAs/Roth 401(k)s, and taxable accounts. Our algorithm applies a new approach that generates an individualized strategy that results in consistent improvements over non-individualized withdrawal strategies currently advocated by financial institutions and academics. Among other results, we quantifiably demonstrate why retirees should avoid, not seek, dividend producing stocks in their taxable accounts. Our model, which can work to optimize either portfolio longevity or the bequest to an heir, accommodates many salient tax code features, including dividends, different taxable lots, conversions, and required minimum distributions.
SSRN
We construct an algorithm for United States retirees that computes individualized tax-efficient annual withdrawals from IRAs/401(k)s, Roth IRAs/Roth 401(k)s, and taxable accounts. Our algorithm applies a new approach that generates an individualized strategy that results in consistent improvements over non-individualized withdrawal strategies currently advocated by financial institutions and academics. Among other results, we quantifiably demonstrate why retirees should avoid, not seek, dividend producing stocks in their taxable accounts. Our model, which can work to optimize either portfolio longevity or the bequest to an heir, accommodates many salient tax code features, including dividends, different taxable lots, conversions, and required minimum distributions.
Corporate Tax-Rate and Tax-Base Avoidance Trends of U.S. Domestic and U.S. Multinational Firms
SSRN
Recent empirical evidence suggests that domestic firms avoid taxes at least to the same extent as multinational firms. We extend this finding by developing an approach to estimate the average statutory tax rate from publicly available data that implicitly weights all statutory tax rates a firm is exposed to by the corresponding taxable income. Based on this new approach we decompose tax avoidance into two separate components: tax-rate avoidance and tax-base avoidance. We find that U.S. multinational firms make substantial use of tax-rate avoidance, for instance, their foreign average statutory tax rates decrease from 1988 by 0.6 percentage points each year to around 16 percent in 2014. U.S. domestic firms by definition do not take advantage of low tax rates in non-U.S. countries, however, we find that U.S. domestic firms make substantial use of tax-base avoidance and are more effective in tax-base avoidance than U.S. multinational firms. Overall, our findings on tax-rate and tax-base avoidance of U.S. multinational and domestic firms explain the recent evidence that effective tax rates of domestic firms are at least as low as effective tax rates of multinational firms and substantiate existing doubts that multinational firms, in particular, are the most aggressive tax avoiders.
SSRN
Recent empirical evidence suggests that domestic firms avoid taxes at least to the same extent as multinational firms. We extend this finding by developing an approach to estimate the average statutory tax rate from publicly available data that implicitly weights all statutory tax rates a firm is exposed to by the corresponding taxable income. Based on this new approach we decompose tax avoidance into two separate components: tax-rate avoidance and tax-base avoidance. We find that U.S. multinational firms make substantial use of tax-rate avoidance, for instance, their foreign average statutory tax rates decrease from 1988 by 0.6 percentage points each year to around 16 percent in 2014. U.S. domestic firms by definition do not take advantage of low tax rates in non-U.S. countries, however, we find that U.S. domestic firms make substantial use of tax-base avoidance and are more effective in tax-base avoidance than U.S. multinational firms. Overall, our findings on tax-rate and tax-base avoidance of U.S. multinational and domestic firms explain the recent evidence that effective tax rates of domestic firms are at least as low as effective tax rates of multinational firms and substantiate existing doubts that multinational firms, in particular, are the most aggressive tax avoiders.
Dissecting the Effect of Financial Constraints on Small Firms
SSRN
We use the Great Recession as a laboratory to dissect the implications of financial constraints in small firms. We exploit firm-level requirements for eligibility to a credit guarantee scheme launched in the UK during 2009 as an exogenous determinant of financial access during the crisis. Using a difference-in-difference methodology, we show that eligible firms relatively increased their borrowing, employment, sales, profits, and survival, but disinvested as much as non-eligible businesses. The results show that employment can be more sensitive to financial constraints than fixed assets, likely because fixed assets can be pledged as collateral, whereas employees cannot.
SSRN
We use the Great Recession as a laboratory to dissect the implications of financial constraints in small firms. We exploit firm-level requirements for eligibility to a credit guarantee scheme launched in the UK during 2009 as an exogenous determinant of financial access during the crisis. Using a difference-in-difference methodology, we show that eligible firms relatively increased their borrowing, employment, sales, profits, and survival, but disinvested as much as non-eligible businesses. The results show that employment can be more sensitive to financial constraints than fixed assets, likely because fixed assets can be pledged as collateral, whereas employees cannot.
Does Gender Diversity in the Boardroom Matter? Evidence from CEO Inside Debt Compensation
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We show gender diverse boards offer compensation packages that incentivize CEOs to adopt strategies that lower risk and promote long-term firm survival. Appointment (exogenous departure) of independent female directors is followed by higher (lower) CEO pension compensation. Instrumental variable tests, exploiting geographic variation in supply of female directors, suggest effects are causal. Consistent with greater incentive alignment with bondholders, announcements of female director appointments are associated with decreases in yield spreads. We find no evidence of wealth transfer from equity investors to bondholders: Stock prices of firms, especially those with high-yield debt, react positively when female director appointments are announced.
SSRN
We show gender diverse boards offer compensation packages that incentivize CEOs to adopt strategies that lower risk and promote long-term firm survival. Appointment (exogenous departure) of independent female directors is followed by higher (lower) CEO pension compensation. Instrumental variable tests, exploiting geographic variation in supply of female directors, suggest effects are causal. Consistent with greater incentive alignment with bondholders, announcements of female director appointments are associated with decreases in yield spreads. We find no evidence of wealth transfer from equity investors to bondholders: Stock prices of firms, especially those with high-yield debt, react positively when female director appointments are announced.
Dynamic Linkages Among U.S. Real Estate Sectors Before and After the Housing Crisis
SSRN
This study explores the dynamic nature of linkages among seven key real estate sectors which include residential, health, lodging-resort, storage, office, retail and industrial. Long-run results reveal evidence of increased integration and contagion across the real estate sectors in the wake of the housing crisis. Short-run analyses suggest bi-directional causality and indicate the shocks to one real estate sector have a much more severe and persistent impact on other real estate sectors during the post-crisis period in comparison to the pre-crisis period. Finally, ripple effects are observed across the real estate sectors with shocks emanating from the "dominant" residential sector and spilling over to other real estate sectors.
SSRN
This study explores the dynamic nature of linkages among seven key real estate sectors which include residential, health, lodging-resort, storage, office, retail and industrial. Long-run results reveal evidence of increased integration and contagion across the real estate sectors in the wake of the housing crisis. Short-run analyses suggest bi-directional causality and indicate the shocks to one real estate sector have a much more severe and persistent impact on other real estate sectors during the post-crisis period in comparison to the pre-crisis period. Finally, ripple effects are observed across the real estate sectors with shocks emanating from the "dominant" residential sector and spilling over to other real estate sectors.
Gauge Invariant Lattice Quantum Field Theory: Implications for Statistical Properties in High Frequency Financial Markets
SSRN
We report on initial studies of a quantum field theory defined on a lattice with multi-ladder geometry and the dilation group as a local gauge symmetry. The model is relevant in the cross-disciplinary area of econophysics. A corresponding proposal by Ilinski aimed at gauge modeling in non-equilibrium pricing is implemented in a numerical simulation. We arrive at a probability distribution of relative gains which matches the high frequency historical data of the NASDAQ stock exchange index.
SSRN
We report on initial studies of a quantum field theory defined on a lattice with multi-ladder geometry and the dilation group as a local gauge symmetry. The model is relevant in the cross-disciplinary area of econophysics. A corresponding proposal by Ilinski aimed at gauge modeling in non-equilibrium pricing is implemented in a numerical simulation. We arrive at a probability distribution of relative gains which matches the high frequency historical data of the NASDAQ stock exchange index.
Housing Boom, Mortgage Default and Agency Friction
SSRN
The paper develops a quantitative framework to understand the dynamics of US house and mortgage markets before and after the Great Recession. I document two facts that jointly seem puzzling in the mortgage credit boom from 2001 to 2007: (1) mortgage risk increased, but (2) the mortgage risk premium decreased. Besides the mortgage risk component in the premium, other time-varying factors must reduce the risk premium in the boom episode. I introduce and calibrate the lending conditions and the mortgage risk as the aggregate shocks to capture time series change in the supply and the demand of mortgage credit. The shocks generate time-varying liquidity and default premiums in the mortgage risk premium respectively. Using a general equilibrium model with borrowers, depositors and intermediaries, I quantify the contribution of aggregate risks to the boom-bust dynamics. I find that the income channel alone cannot generate strong movement in the risk premium under plausible size of shocks, while lending relaxation is essential to explain the mortgage credit boom and the decreasing risk premium. An intermediary is subject to a moral hazard problem whose leverage ratio thus cannot exceed an endogenous cap. The optimal leverage is pro-cyclical and amplifies aggregate shocks through the news effect; bad news of future funding liquidity can hamper today's intermediation and increase the risk premium.
SSRN
The paper develops a quantitative framework to understand the dynamics of US house and mortgage markets before and after the Great Recession. I document two facts that jointly seem puzzling in the mortgage credit boom from 2001 to 2007: (1) mortgage risk increased, but (2) the mortgage risk premium decreased. Besides the mortgage risk component in the premium, other time-varying factors must reduce the risk premium in the boom episode. I introduce and calibrate the lending conditions and the mortgage risk as the aggregate shocks to capture time series change in the supply and the demand of mortgage credit. The shocks generate time-varying liquidity and default premiums in the mortgage risk premium respectively. Using a general equilibrium model with borrowers, depositors and intermediaries, I quantify the contribution of aggregate risks to the boom-bust dynamics. I find that the income channel alone cannot generate strong movement in the risk premium under plausible size of shocks, while lending relaxation is essential to explain the mortgage credit boom and the decreasing risk premium. An intermediary is subject to a moral hazard problem whose leverage ratio thus cannot exceed an endogenous cap. The optimal leverage is pro-cyclical and amplifies aggregate shocks through the news effect; bad news of future funding liquidity can hamper today's intermediation and increase the risk premium.
How Big are the Ambiguity-Based Premiums on Mortgage Insurance?
SSRN
This paper studies how ambiguity aversion affects the pricing of mortgage insurance (MI). We consider pricing-kernel ambiguity arising from market incompleteness. This ambiguity model is applied to a standard framework of MI-ML (mortgage loan) structural pricing. Our quantitative results show that insurers' ambiguity aversion generates substantial positive effects of MI premium. Ambiguity impacts are highly sensitive to loan-to-value ratio, ambiguity magnitude, and the tightness of information constraints. By using the U.S. city-level housing and mortgage data, we estimate that, on average, ambiguity aversion increases MI premium rate by 77% (46 bps), and explains about 60%-90% of pricing errors.
SSRN
This paper studies how ambiguity aversion affects the pricing of mortgage insurance (MI). We consider pricing-kernel ambiguity arising from market incompleteness. This ambiguity model is applied to a standard framework of MI-ML (mortgage loan) structural pricing. Our quantitative results show that insurers' ambiguity aversion generates substantial positive effects of MI premium. Ambiguity impacts are highly sensitive to loan-to-value ratio, ambiguity magnitude, and the tightness of information constraints. By using the U.S. city-level housing and mortgage data, we estimate that, on average, ambiguity aversion increases MI premium rate by 77% (46 bps), and explains about 60%-90% of pricing errors.
Litigation Risk and Firm Performance: A Mediation Effect via Debt Financing
SSRN
Manuscript Type: EmpiricalResearch Question/Issue: The objective of this study is to investigate how litigation risk influences firm financial performance. Specifically, we attempt to explore four important research questions: Does litigation risk affect firm performance? Does the concurrence of litigation risk and internal control of governance improve firm performance? Does the concurrence of litigation risk and analyst following improve firm performance? Does debt financing mediate the impact of litigation risk on firm performance?Research Findings/Insights: Our results indicate that a large monetary amount of a claim in litigation is negatively associated with firm performance, while internal governance and analyst following offset the negative impact of litigation risk. We further examine debt financing as a mediator in the relationship between litigation risk and firm performance, and find that litigation risk negatively affects firm performance through excessive leverage, increased cost of debt, reduced bank borrowing and trade credit.Theoretical/Academic Implications: This study offers empirical evidence that enhances understanding of the causes underlying the association between a firm’s litigation risk and its performance through testing the mediation effect of debt financing.Practitioner/Policy Implications: The findings assist firm management to review litigation risks, have better understanding of the economic mechanisms of litigation risk, and promote risk control to regulate their own behaviour. The findings also reveal that financial analyst can correct the adverse effects of litigation risk, and that debt financing has a mediation effect on the relationship between litigation risk and firm performance.
SSRN
Manuscript Type: EmpiricalResearch Question/Issue: The objective of this study is to investigate how litigation risk influences firm financial performance. Specifically, we attempt to explore four important research questions: Does litigation risk affect firm performance? Does the concurrence of litigation risk and internal control of governance improve firm performance? Does the concurrence of litigation risk and analyst following improve firm performance? Does debt financing mediate the impact of litigation risk on firm performance?Research Findings/Insights: Our results indicate that a large monetary amount of a claim in litigation is negatively associated with firm performance, while internal governance and analyst following offset the negative impact of litigation risk. We further examine debt financing as a mediator in the relationship between litigation risk and firm performance, and find that litigation risk negatively affects firm performance through excessive leverage, increased cost of debt, reduced bank borrowing and trade credit.Theoretical/Academic Implications: This study offers empirical evidence that enhances understanding of the causes underlying the association between a firm’s litigation risk and its performance through testing the mediation effect of debt financing.Practitioner/Policy Implications: The findings assist firm management to review litigation risks, have better understanding of the economic mechanisms of litigation risk, and promote risk control to regulate their own behaviour. The findings also reveal that financial analyst can correct the adverse effects of litigation risk, and that debt financing has a mediation effect on the relationship between litigation risk and firm performance.
Making Equity Crowdfunding Work for the Unaccredited Crowd
SSRN
This article summarizes why the crowdfunding exemption is important, explains how its expected costs are problematic, and proposes ways to mitigate those costs without sacrificing investor protection.
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This article summarizes why the crowdfunding exemption is important, explains how its expected costs are problematic, and proposes ways to mitigate those costs without sacrificing investor protection.
Market Stability with Machine Learning Agents
SSRN
We consider the effect of adaptive model selection and regularization by agents on price volatility and market stability in a simple agent-based model of a financial market. The agents base their trading behavior on forecasts of future returns, which they update adaptively and asynchronously through a process of model selection, estimation, and prediction. The addition of model selection and regularization methods to the traders' learning algorithm is shown to reduce but not eliminate overfitting and resulting excess volatility. Our results accord well with the empirical "sparse signals" and "pockets of predictability" findings of Chinco, Clark-Joseph and Ye (2019) and Farmer, Schmidt and Timmermann (2019), but stand in contrast to, for example, the model validation framework of Cho and Kasa (2015).
SSRN
We consider the effect of adaptive model selection and regularization by agents on price volatility and market stability in a simple agent-based model of a financial market. The agents base their trading behavior on forecasts of future returns, which they update adaptively and asynchronously through a process of model selection, estimation, and prediction. The addition of model selection and regularization methods to the traders' learning algorithm is shown to reduce but not eliminate overfitting and resulting excess volatility. Our results accord well with the empirical "sparse signals" and "pockets of predictability" findings of Chinco, Clark-Joseph and Ye (2019) and Farmer, Schmidt and Timmermann (2019), but stand in contrast to, for example, the model validation framework of Cho and Kasa (2015).
Measuring Long-Term Tail Risk: Evaluating the Performance of the Square-Root-of-Time Rule
SSRN
This paper focuses on risk over long time horizons and within extreme percentiles, which have attracted considerable recent interest in numerous subfields of finance. Value at risk (VaR) aggregates several components of asset risk into a single quantitative measurement and is commonly used in tail risk management. Due to realistic data limits, many practitioners might use the square-root-of-time rule (SRTR) to compute long-term VaR. However, serial dependence and heavy-tailedness can bias the SRTR. This paper addresses two deficiencies of the study by Wang et al. (2011), who propose the modified-SRTR (MSRTR) to partially correct the serial dependence and use subsampling estimation as the benchmark to verify the performance of MSRTR. First, we investigate the validity of the subsampling approach through numerical simulations. Second, to reduce the heavy-tailedness bias, we propose a new MSRTR approach (MSRTR) in light of the Central Limit Theorem (CLT). In the empirical study, 28 country-level exchange-traded funds (ETFs) from 2010 to 2015 are considered to estimate the 30-day VaR. After modifying both serial dependence and heavy-tailedness, our approach reduces the bias from 26.46% to 5.97%, on average, compared to the SRTR. We also provide a backtesting analysis to verify the robustness of the MSRTR. This new approach should be considered when estimating long-term VaR using short-term VaR.
SSRN
This paper focuses on risk over long time horizons and within extreme percentiles, which have attracted considerable recent interest in numerous subfields of finance. Value at risk (VaR) aggregates several components of asset risk into a single quantitative measurement and is commonly used in tail risk management. Due to realistic data limits, many practitioners might use the square-root-of-time rule (SRTR) to compute long-term VaR. However, serial dependence and heavy-tailedness can bias the SRTR. This paper addresses two deficiencies of the study by Wang et al. (2011), who propose the modified-SRTR (MSRTR) to partially correct the serial dependence and use subsampling estimation as the benchmark to verify the performance of MSRTR. First, we investigate the validity of the subsampling approach through numerical simulations. Second, to reduce the heavy-tailedness bias, we propose a new MSRTR approach (MSRTR) in light of the Central Limit Theorem (CLT). In the empirical study, 28 country-level exchange-traded funds (ETFs) from 2010 to 2015 are considered to estimate the 30-day VaR. After modifying both serial dependence and heavy-tailedness, our approach reduces the bias from 26.46% to 5.97%, on average, compared to the SRTR. We also provide a backtesting analysis to verify the robustness of the MSRTR. This new approach should be considered when estimating long-term VaR using short-term VaR.
Productivity growth and finance: The role of intangible assets - a sector level analysis
RePEC
Investment in intangible assets has become an increasingly important driver of productivity growth in OECD countries. Facing stronger informational asymmetries and harder to value collateral, intangible investment is subject to more severe financial constraints and relies more on internal rather than external capital. To test the hypothesis that the availability of finance, and financial development in particular, is more important for productivity growth in sectors that are intensive in intangible assets, an empirical analysis is carried over a panel of 32 countries and 30 industries, from 1990 to 2014. Overall, results confirm that the impact of financial development on labour productivity is not uniform across sectors. It varies based on country-specific institutional settings and sector-specific characteristics such as the intangible asset intensity, financial structure and external financial dependence. Policies and institutional settings may relax financial constraints by: i) altering the overall composition of finance; ii) encouraging competition and iii) strengthening the legal environment in which businesses operate.
RePEC
Investment in intangible assets has become an increasingly important driver of productivity growth in OECD countries. Facing stronger informational asymmetries and harder to value collateral, intangible investment is subject to more severe financial constraints and relies more on internal rather than external capital. To test the hypothesis that the availability of finance, and financial development in particular, is more important for productivity growth in sectors that are intensive in intangible assets, an empirical analysis is carried over a panel of 32 countries and 30 industries, from 1990 to 2014. Overall, results confirm that the impact of financial development on labour productivity is not uniform across sectors. It varies based on country-specific institutional settings and sector-specific characteristics such as the intangible asset intensity, financial structure and external financial dependence. Policies and institutional settings may relax financial constraints by: i) altering the overall composition of finance; ii) encouraging competition and iii) strengthening the legal environment in which businesses operate.
Responsible Public Cryptocurrency Protocol Development
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Cryptocurrencies have entered the economy as alternative money, speculation objects, and as utility tokens for digital platforms. Cryptocurrencies are based on cryptography-based asset disposals broadcasted peer-to-peer to be validated in a decentralized way according to consented protocols. In a public cryptocurrency, the protocol development itself is also decentralized. This paper discusses the influence of protocol developers on the risks associated with a cryptocurrency and addresses the protocol developers' responsibility for these risks. Both the forward-looking responsibility to mitigate risk and the backward-looking responsibility for harm are discussed. It is found that protocol developers lack sufficient forward-looking responsibility. The regulation of a cryptocurrency's broader financial ecosystem and backward-looking responsibility may remedy insufficient forward-looking responsibility. However, backward-looking responsibility, in particular as legal liability, is insufficient to cover the broad range of possible harms flowing from the risks. Policies to improve responsibility are discussed.
SSRN
Cryptocurrencies have entered the economy as alternative money, speculation objects, and as utility tokens for digital platforms. Cryptocurrencies are based on cryptography-based asset disposals broadcasted peer-to-peer to be validated in a decentralized way according to consented protocols. In a public cryptocurrency, the protocol development itself is also decentralized. This paper discusses the influence of protocol developers on the risks associated with a cryptocurrency and addresses the protocol developers' responsibility for these risks. Both the forward-looking responsibility to mitigate risk and the backward-looking responsibility for harm are discussed. It is found that protocol developers lack sufficient forward-looking responsibility. The regulation of a cryptocurrency's broader financial ecosystem and backward-looking responsibility may remedy insufficient forward-looking responsibility. However, backward-looking responsibility, in particular as legal liability, is insufficient to cover the broad range of possible harms flowing from the risks. Policies to improve responsibility are discussed.
Sensitivity of Emerging Market Bond Fund Flows to US Monetary Stance and Global Risk Aversion
SSRN
This note ranks the sensitivities of emerging market economies’ (EMEs’) bond fund flows to changes in the US monetary stance and global risk aversion. Based on the sensitivities, we draw heat maps to indicate the economies that are more likely to suffer large outflows. We find that bond fund flows have become more sensitive to changes in the US monetary stance and global risk aversion since the global financial crisis, possibly attributable to an increasing participation of global investors in the EME bond markets through mutual funds. Some emerging Asian economies, such as Hong Kong, Korea and Singapore, are found to be more resilient in times of market stress and demonstrate lower outflow persistence, which may reflect that global investors are able to differentiate among emerging economies based on their fundamentals. Our results also show that persistence is relatively high for bond fund inflows to emerging Asian economies, suggesting that policymakers should be vigilant about the risk of large inflows.
SSRN
This note ranks the sensitivities of emerging market economies’ (EMEs’) bond fund flows to changes in the US monetary stance and global risk aversion. Based on the sensitivities, we draw heat maps to indicate the economies that are more likely to suffer large outflows. We find that bond fund flows have become more sensitive to changes in the US monetary stance and global risk aversion since the global financial crisis, possibly attributable to an increasing participation of global investors in the EME bond markets through mutual funds. Some emerging Asian economies, such as Hong Kong, Korea and Singapore, are found to be more resilient in times of market stress and demonstrate lower outflow persistence, which may reflect that global investors are able to differentiate among emerging economies based on their fundamentals. Our results also show that persistence is relatively high for bond fund inflows to emerging Asian economies, suggesting that policymakers should be vigilant about the risk of large inflows.
The Effect of Female Directors on Firm Performance: Evidence From the Great Recession
SSRN
Empirical evidence suggests that the effect of board gender diversity on firm performance remains inconclusive. We argue that, during the times of crisis, firms likely need more monitoring and different advice than they normally do, thereby highlighting the role of female directors, who bring new ideas and different perspectives to the table. Consistent with this argument, the results show that the presence of female directors on the board significantly improved firm performance during the Great Recession of 2008, but such benefits from board gender diversity are not found outside the crisis period. In particular, during the Great Recession, an increase in the percentage of female directors by one standard deviation raised the return on assets (ROA) by 8.41%. Several robustness checks confirm the results, including an instrumental-variable analysis and a dynamic panel generalized method of moments (GMM). There is also evidence that the beneficial role of female directors during the crisis is not sufficiently reflected in the stock markets.
SSRN
Empirical evidence suggests that the effect of board gender diversity on firm performance remains inconclusive. We argue that, during the times of crisis, firms likely need more monitoring and different advice than they normally do, thereby highlighting the role of female directors, who bring new ideas and different perspectives to the table. Consistent with this argument, the results show that the presence of female directors on the board significantly improved firm performance during the Great Recession of 2008, but such benefits from board gender diversity are not found outside the crisis period. In particular, during the Great Recession, an increase in the percentage of female directors by one standard deviation raised the return on assets (ROA) by 8.41%. Several robustness checks confirm the results, including an instrumental-variable analysis and a dynamic panel generalized method of moments (GMM). There is also evidence that the beneficial role of female directors during the crisis is not sufficiently reflected in the stock markets.
The Effect of Institutional Ownership on Firm Compensation: A Regression Discontinuity Design
SSRN
In this paper we study the causal effect of institutional ownership on public firms' compensation to executives and board members, using a regression discontinuity design to exploit the natural experiment created by Russell index. Firms around the Russell 1000/2000 index cutoff are randomly placed above or below it, creating exogenous changes in institutional ownership due to passive investor's index tracking behavior. Since the Russell indexes are market-cap weighted, the firms moving from the bottom of Russell 1000 index to Russell 2000 index will receive more inflow of institutional money. With such RDD analysis, we find increase in institutional ownership caused the executive's cash bonus and stock award to decrease significantly, and we observe decrease in board member's compensation as well. Additional evidence suggests such decrease is caused by passive investors. Such empirical evidence is consistent with the understanding of firm compensation in a principle-agent model, that an increase in institutional ownership decreases monitoring cost, which gives rise to a decrease in performance based compensation.
SSRN
In this paper we study the causal effect of institutional ownership on public firms' compensation to executives and board members, using a regression discontinuity design to exploit the natural experiment created by Russell index. Firms around the Russell 1000/2000 index cutoff are randomly placed above or below it, creating exogenous changes in institutional ownership due to passive investor's index tracking behavior. Since the Russell indexes are market-cap weighted, the firms moving from the bottom of Russell 1000 index to Russell 2000 index will receive more inflow of institutional money. With such RDD analysis, we find increase in institutional ownership caused the executive's cash bonus and stock award to decrease significantly, and we observe decrease in board member's compensation as well. Additional evidence suggests such decrease is caused by passive investors. Such empirical evidence is consistent with the understanding of firm compensation in a principle-agent model, that an increase in institutional ownership decreases monitoring cost, which gives rise to a decrease in performance based compensation.
The Farce of Fake Regulation: Royal Commission Exposed Australia
SSRN
The revelations from the Hayne Royal Commission (HRC, 2019), limited though they were by the terms of reference, have come as a shock to most people, including Australian politicians, officials, academics and the media. Their expressed shock indicates a high degree of ignorance about the Australian financial system. For decades, the public was led to believe that Australia has the best financial system in world, being one of the few countries to have avoided a recession in the global financial crisis (GFC).This complacent view was contradicted by the HRC and this fact needs to be understood and explained. The HRC Final Report lacks an explanation for its major finding that the regulators had failed to enforce the law. The report merely recommended the regulators be more active, when it did not discover why the regulators had been so passive in the past. This paper provides detailed explanations for the observed failure to regulate based on published research, new or old empirical evidence and industry insider experience.
SSRN
The revelations from the Hayne Royal Commission (HRC, 2019), limited though they were by the terms of reference, have come as a shock to most people, including Australian politicians, officials, academics and the media. Their expressed shock indicates a high degree of ignorance about the Australian financial system. For decades, the public was led to believe that Australia has the best financial system in world, being one of the few countries to have avoided a recession in the global financial crisis (GFC).This complacent view was contradicted by the HRC and this fact needs to be understood and explained. The HRC Final Report lacks an explanation for its major finding that the regulators had failed to enforce the law. The report merely recommended the regulators be more active, when it did not discover why the regulators had been so passive in the past. This paper provides detailed explanations for the observed failure to regulate based on published research, new or old empirical evidence and industry insider experience.
This Time Is Different, but It Will End the Same Way: Unrecognized Secular Changes in the Bond Market since the 2008 Crisis That May Precipitate the Next Crisis
SSRN
The US bond market had over $42.39 trillion of outstanding debt at the end of the third quarter of 2018, eclipsing the US stock market’s approximately $30 trillion in market capitalization. The sheer size of the bond market provides ample opportunities, as well as risks, for institutional investors. Some of these risks escape investors’ radar because of the nature of fixed-income securities: low transparency, illiquidity, and over-the-counter (OTC) trading. In this paper, we present our concerns regarding five secular changes brought up by the over-regulation of the marketplace after the financial crisis of 2008 and investors’ persistent thirst for yield. Further, while painful lessons were gleaned after the punishing 2008 financial crisis, we present empirical evidence that suggests that many sectors, such as the auto loans and collateralized loan obligations, that were largely unscathed by this crisis may be at risk in the next downturn. This paper is based on original data sources and academic research. The authors are in continuing dialogue with other experts that may further the research, and welcome interested parties to get in contact.
SSRN
The US bond market had over $42.39 trillion of outstanding debt at the end of the third quarter of 2018, eclipsing the US stock market’s approximately $30 trillion in market capitalization. The sheer size of the bond market provides ample opportunities, as well as risks, for institutional investors. Some of these risks escape investors’ radar because of the nature of fixed-income securities: low transparency, illiquidity, and over-the-counter (OTC) trading. In this paper, we present our concerns regarding five secular changes brought up by the over-regulation of the marketplace after the financial crisis of 2008 and investors’ persistent thirst for yield. Further, while painful lessons were gleaned after the punishing 2008 financial crisis, we present empirical evidence that suggests that many sectors, such as the auto loans and collateralized loan obligations, that were largely unscathed by this crisis may be at risk in the next downturn. This paper is based on original data sources and academic research. The authors are in continuing dialogue with other experts that may further the research, and welcome interested parties to get in contact.
Too Much of a Good Thing? Corporate Social Responsibility and the Takeover Market
SSRN
We examine the relation between corporate social responsibility (CSR) and firm value using the takeover market as an experimental setting. Greater CSR is generally associated with reduced takeover likelihood and higher returns to targets, suggesting that CSR benefits target shareholders. However, there are limits to the benefits of CSR as these effects reverse for targets with high levels of CSR (around the 80th percentile). Our results are robust to several endogeneity checks and are evident in sub-samples where CSR is arguably an important factor in mergers. Consistent with this evidence, targets moderate extreme CSR scores after a failed takeover attempt.
SSRN
We examine the relation between corporate social responsibility (CSR) and firm value using the takeover market as an experimental setting. Greater CSR is generally associated with reduced takeover likelihood and higher returns to targets, suggesting that CSR benefits target shareholders. However, there are limits to the benefits of CSR as these effects reverse for targets with high levels of CSR (around the 80th percentile). Our results are robust to several endogeneity checks and are evident in sub-samples where CSR is arguably an important factor in mergers. Consistent with this evidence, targets moderate extreme CSR scores after a failed takeover attempt.
Trends Everywhere
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We provide new out-of-sample evidence on trend-following investing by studying its performance for 82 securities not previously examined and 16 long-short equity factors. Specifically, we study the performance of time series momentum for emerging market equity index futures, fixed income swaps, emerging market currencies, exotic commodity futures, credit default swap indices, volatility futures, and long-short equity factors. We find that time series momentum has worked across these asset classes and across several trend horizons. We examine the co-movement of trends across asset classes and factors, the performance during different market environments, and discuss the implications for investors.
SSRN
We provide new out-of-sample evidence on trend-following investing by studying its performance for 82 securities not previously examined and 16 long-short equity factors. Specifically, we study the performance of time series momentum for emerging market equity index futures, fixed income swaps, emerging market currencies, exotic commodity futures, credit default swap indices, volatility futures, and long-short equity factors. We find that time series momentum has worked across these asset classes and across several trend horizons. We examine the co-movement of trends across asset classes and factors, the performance during different market environments, and discuss the implications for investors.
Unfair 'Fair Value' in Illiquid Markets: Excessive Spillover Effects in Times of Crisis
SSRN
The paper investigates the effects of mark-to-market write-downs by financial institutions on market prices and volumes, as well as the prominent role that illiquidity plays in exacerbating the direct and spillover effects of exit valuation on equity and credit default swaps markets. Using a hand-collected database of write-down announcements made during and after the credit crisis (from January 1, 2007 through June 30, 2010), we find that firms that write down assets in accordance with mark-to-market rules experience significant abnormal negative stock returns and spikes in the premiums of credit default swaps written on their obligations. Equally noteworthy, we find that similar firms without write-downs exhibited sympathetic and significant negative abnormal returns and positive premiums at the same time as the write-down firms. We find that the effects of information spillovers associated with write-downs during the financial crisis go beyond normal information transfer expected from asset fundamentals and may have contributed to adverse consequences of the crisis.
SSRN
The paper investigates the effects of mark-to-market write-downs by financial institutions on market prices and volumes, as well as the prominent role that illiquidity plays in exacerbating the direct and spillover effects of exit valuation on equity and credit default swaps markets. Using a hand-collected database of write-down announcements made during and after the credit crisis (from January 1, 2007 through June 30, 2010), we find that firms that write down assets in accordance with mark-to-market rules experience significant abnormal negative stock returns and spikes in the premiums of credit default swaps written on their obligations. Equally noteworthy, we find that similar firms without write-downs exhibited sympathetic and significant negative abnormal returns and positive premiums at the same time as the write-down firms. We find that the effects of information spillovers associated with write-downs during the financial crisis go beyond normal information transfer expected from asset fundamentals and may have contributed to adverse consequences of the crisis.
Venturenomics: Adjusting for Three Standard Practices May Reduce Venture-Backed Company Pre-Money Valuations by 90%
SSRN
This Article illustrates how pre-money valuations of venture capital-backed companies may be overstated by 10X.This is because venture capital math (VC Math) ignores the economic impact of three standard practices. First, VC Math treats a company’s unissued (and even non-existing) stock options as outstanding shares of stock. Second, VC Math ignores the fact that much of a company’s common stock, and options to purchase common stock, have not yet been earned. Third, VC Math values a share of common stock and a share of convertible preferred stock equally, despite the fact that convertible preferred stock was intentionally created to be worth more.
SSRN
This Article illustrates how pre-money valuations of venture capital-backed companies may be overstated by 10X.This is because venture capital math (VC Math) ignores the economic impact of three standard practices. First, VC Math treats a company’s unissued (and even non-existing) stock options as outstanding shares of stock. Second, VC Math ignores the fact that much of a company’s common stock, and options to purchase common stock, have not yet been earned. Third, VC Math values a share of common stock and a share of convertible preferred stock equally, despite the fact that convertible preferred stock was intentionally created to be worth more.
What’s in Your Wallet (and What Should the Law Do About It?)
SSRN
In traditional markets, firms can charge prices that are significantly elevated relative to their costs only if there is a market failure. However, this is not true in a two-sided market (like Amazon, Uber, and Mastercard), where firms often subsidize one side of the market and generate revenue from the other. This means consideration of one side of the market in isolation is problematic. The Court embraced this view in Ohio v. American Express, requiring that anticompetitive harm on one side of a two-sided market be weighed against benefits on the other side. Legal scholars denounce this decision, which, practically, will make it much more difficult to wield antitrust as a tool to rein in two-sided markets. This inability is concerning as two-sided markets are growing in importance. Furthermore, the pricing structures used by platforms can be regressive, with those least well-off subsidizing their affluent and financially-sophisticated counterparts. In this Article, I argue that consumer protection, rather than antitrust, is best suited to tame two-sided markets. Consumer protection authority allows for intervention on the grounds that platform users create unavoidable externalities for all consumers. The Consumer Financial Protection Bureau (“CFPBâ€) has broad power to curtail “unfair, abusive, and deceptive practices.†This authority can be used to restrict practices that decrease consumer welfare, like the anti-steering rules at issue in Ohio v. American Express.
SSRN
In traditional markets, firms can charge prices that are significantly elevated relative to their costs only if there is a market failure. However, this is not true in a two-sided market (like Amazon, Uber, and Mastercard), where firms often subsidize one side of the market and generate revenue from the other. This means consideration of one side of the market in isolation is problematic. The Court embraced this view in Ohio v. American Express, requiring that anticompetitive harm on one side of a two-sided market be weighed against benefits on the other side. Legal scholars denounce this decision, which, practically, will make it much more difficult to wield antitrust as a tool to rein in two-sided markets. This inability is concerning as two-sided markets are growing in importance. Furthermore, the pricing structures used by platforms can be regressive, with those least well-off subsidizing their affluent and financially-sophisticated counterparts. In this Article, I argue that consumer protection, rather than antitrust, is best suited to tame two-sided markets. Consumer protection authority allows for intervention on the grounds that platform users create unavoidable externalities for all consumers. The Consumer Financial Protection Bureau (“CFPBâ€) has broad power to curtail “unfair, abusive, and deceptive practices.†This authority can be used to restrict practices that decrease consumer welfare, like the anti-steering rules at issue in Ohio v. American Express.
When Factor Timing Makes Sense
SSRN
In this paper we investigate when it makes sense for portfolio managers to implement factor timing in their quantitative investing, that is we outline necessary circumstances under which the benefits of factor timing (measured by the improvement in Sharpe ratio and the skewness of the returns) outweighs the challenges associated with development and implementation of factor timing. In particular, we mathematically show that factor timing for a single strategy does not yield substantial improvements unless either (1) the Sharpe ratio of the strategy is orders of magnitude different across states, or (2) the signal used for factor timing can accurately predict when the strategy will deliver negative returns (and the portfolio manager is willing to go short the strategy at that time). On the other hand, using simulation, we provide evidence that for a multi-factor portfolio (containing more than 10 factors) allocating risk based on instantaneous correlations between the factors at the beginning of each time period improves performance above the passive approach of allocating risk based on the long-term factor correlations.
SSRN
In this paper we investigate when it makes sense for portfolio managers to implement factor timing in their quantitative investing, that is we outline necessary circumstances under which the benefits of factor timing (measured by the improvement in Sharpe ratio and the skewness of the returns) outweighs the challenges associated with development and implementation of factor timing. In particular, we mathematically show that factor timing for a single strategy does not yield substantial improvements unless either (1) the Sharpe ratio of the strategy is orders of magnitude different across states, or (2) the signal used for factor timing can accurately predict when the strategy will deliver negative returns (and the portfolio manager is willing to go short the strategy at that time). On the other hand, using simulation, we provide evidence that for a multi-factor portfolio (containing more than 10 factors) allocating risk based on instantaneous correlations between the factors at the beginning of each time period improves performance above the passive approach of allocating risk based on the long-term factor correlations.
