Research articles for the 2019-06-02

A simple and efficient numerical method for pricing discretely monitored early-exercise options
Min Huang,Guo Luo

We present a simple, fast, and accurate method for pricing a variety of discretely monitored options in the Black-Scholes framework, including autocallable structured products, single and double barrier options, and Bermudan options. The method is based on a quadrature technique, and it employs only elementary calculations and a fixed one-dimensional uniform grid. The convergence rate is $O(1/N^4)$ and the complexity is $O(MN\log N)$, where $N$ is the number of grid points and $M$ is the number of observation dates.

Capital Flows: The Role of Bank and Nonbank Balance Sheets
Hashimoto, Yuko,Krogstrup, Signe
This paper assesses the role of bank and nonbank financial institutions' balance sheet foreign exposures and risk management practices in driving capital flow responses to global risk. Using a unique and previously unexplored dataset on domestic and cross border balance sheet positions of financial institutions collected by the IMF, we show that the response of overall capital flows to global risk shocks is associated with the on-balance sheet foreign exposures of nonbanks, but not with that of banks. A possible interpretation is that risk-averse and dynamically optimizing nonbanks reduce their foreign risk exposure when global risk perceptions increase, leading to capital flows, while banks tend to be hedged against these risks off balance sheet. In advanced countries, the findings suggest that nonbank portfolio adjustment to changing risk conditions may take place through derivatives transactions with banks, the hedging practices of which trigger bank related capital flows rather than portfolio flows.

Clusters of investors around Initial Public Offering
Margarita Baltakienė,Kęstutis Baltakys,Juho Kanniainen,Dino Pedreschi,Fabrizio Lillo

The complex networks approach has been gaining popularity in analysing investor behaviour and stock markets, but within this approach, initial public offerings (IPO) have barely been explored. We fill this gap in the literature by analysing investor clusters in the first two years after the IPO filing in the Helsinki Stock Exchange by using a statistically validated network method to infer investor links based on the co-occurrences of investors' trade timing for 14 IPO stocks. Our findings show that a rather large part of statistically similar network structures is persistent and general: they form in different securities' and persist in time for mature and IPO companies. We also find evidence of institutional herding that hints at the existence of an investor information network.

Conceptual Issues in Calibrating the Basel Iii Countercyclical Capital Buffer
Wezel, Torsten
This paper discusses issues in calibrating the countercyclical capital buffer (CCB) based on a sample of EU countries. It argues that the main indicator for buffer decisions under the Basel III framework, the credit-to-GDP gap, does not always work best in terms of covering bank loan losses that go beyond what could be expected from economic downturns. Instead, in the case of countries with short financial cycles and/or low financial deepening such as transition and developing economies, the Basel gap is shown to work best when computed with a low, smoothing factor and adjusted for the degree of financial deepening. The paper also analyzes issues in calibrating an appropriate size of the CCB and, using a loss function approach, points to a tradeoff between stability of the buffer size and cost efficiency considerations.

Cross-sectional Learning of Extremal Dependence among Financial Assets
Xing Yan,Qi Wu,Wen Zhang

We propose a novel probabilistic model to facilitate the learning of multivariate tail dependence of multiple financial assets. Our method allows one to construct from known random vectors, e.g., standard normal, sophisticated joint heavy-tailed random vectors featuring not only distinct marginal tail heaviness, but also flexible tail dependence structure. The novelty lies in that pairwise tail dependence between any two dimensions is modeled separately from their correlation, and can vary respectively according to its own parameter rather than the correlation parameter, which is an essential advantage over many commonly used methods such as multivariate $t$ or elliptical distribution. It is also intuitive to interpret, easy to track, and simple to sample comparing to the copula approach. We show its flexible tail dependence structure through simulation. Coupled with a GARCH model to eliminate serial dependence of each individual asset return series, we use this novel method to model and forecast multivariate conditional distribution of stock returns, and obtain notable performance improvements in multi-dimensional coverage tests. Besides, our empirical finding about the asymmetry of tails of the idiosyncratic component as well as the whole market is interesting and worth to be well studied in the future.

Crowdfunding Research Agenda: Semantic Analysis of the Media and Geography of Investments
Felipe, Israel ,Mendes-Da-Silva, Wesley,Gattaz, Cristiane
This paper proposes a current research agenda on crowdfunding from two different perspectives, mass media and geography. It is believed that these two elements must exert some kind of influence on the dynamics of the investments made in that market. Semantic analysis of mass news can be a useful tool for investors to assess their exposure to risk as well as help predict financial returns. Geography, on the other hand, can be used on the origin of the capital contributions and, therefore, present information on the location and regional characteristics of the investors.

Enabling Deep Negative Rates to Fight Recessions: A Guide
Agarwal, Ruchir,Kimball, Miles S.
The experience of the Great Recession and its aftermath revealed that a lower bound on interestrates can be a serious obstacle for fighting recessions. However, the zero lower bound is not a law of nature;it is a policy choice. The central message of this paper is that with readily available tools a central bank canenable deep negative rates whenever needed-thus maintaining the power of monetary policy in the futureto end recessions within a short time. This paper demonstrates that a subset of these tools can have a bigeffect in enabling deep negative rates with administratively small actions on the part of the central bank. Tothat end, we (i) survey approaches to enable deep negative rates discussed in the literature and present newapproaches; (ii) establish how a subset of these approaches allows enabling negative rates while remainingat a minimum distance from the current paper currency policy and minimizing the political costs; (iii) discusswhy standard transmission mechanisms from interest rates to aggregate demand are likely to remainunchanged in deep negative rate territory; and (iv) present communication tools that central banks can useboth now and in the event to facilitate broader political acceptance of negative interest rate policy at theonset of the next serious recession.

Fiscal Implications of Interest Rate Normalization in the United States
Bi, Huixin,Shen, Wenyi,Yang, Susan
This paper studies the main channels through which interest rate normalization has fiscalimplications in the United States. While unexpected inflation reduces the real value ofgovernment liabilities, a rising policy rate increases government financing needs because ofhigher interest payments and lower real bond prices. After an initial decline, the realgovernment debt burden rises even with higher tax revenues in an expansion. Given thecurrent net debt-to-GDP ratio at around 80 percent, interest rate normalization leads to anegligible increase in the sovereign default risk of the U.S. federal government, despite amuch higher federal debt-to-GDP ratio than the post-war historical average.

Household Debt, Consumption, and Monetary Policy in Australia
Loukoianova, Elena,Ching Wong, Yu,Hussiada, Ioana
This paper discusses the evolution of the household debt in Australia and finds that while higher-income and higher-wealth households tend to have higher debt, lower-income households may become more vulnerable to rising debt service over time. Then, the paper analyzes the impact of a monetary policy shock on households' current consumption and durable expenditures depending on the level of household debt. The results corroborate other work that households' response to monetary policy shocks depends on their debt and income levels. In particular, households with higher debt tend to reduce their current consumption and durable expenditures more than other households in response to a contractionary monetary policy shocks. However, households with low debt may not respond to monetary policy shocks, as they hold more interest-earning assets.

Indonesia's Public Wealth: A Balance Sheet Approach to Fiscal Policy Analysis
El Rayess, Majdeline,Halstead, Avril,Harris, Jason,Ralyea, John,Tieman, Alexander F.
Public sector balance sheets (PSBS) provide a framework for comprehensive and deepanalysis of fiscal risks and policies. To illustrate these benefits, this paper shows how PSBSanalysis can be applied to assess risks to Indonesia's public sector stemming from its publiccorporations. The paper also shows that the government's plans to finance a ramp-up inpublic investment with additional tax revenue increases both economic growth and publicwealth.

Labor Market Outcomes and Early Schooling: Evidence from School Entry Policies Using Exact Date of Birth
Pedro Cavalcante Oliveira,Daniel Duque

We use a rich, census-like Brazilian dataset containing information on spatial mobility, schooling, and income in which we can link children to parents to assess the impact of early education on several labor market outcomes. Brazilian public primary schools admit children up to one year younger than the national minimum age to enter school if their birthday is before an arbitrary threshold, causing an exogenous variation in schooling at adulthood. Using a Regression Discontinuity Design, we estimate one additional year of schooling increases labor income in 25.8% - almost twice as large as estimated using mincerian models. Around this cutoff there is also a gap of 9.6% on the probability of holding a college degree in adulthood, with which we estimate the college premium and find a 201% increase in labor income. We test the robustness of our estimates using placebo variables, alternative model specifcations and McCrary Density Tests.

Network effects in default clustering for large systems
Konstantinos Spiliopoulos,Jia Yang

We consider a large collection of dynamically interacting components defined on a weighted directed graph determining the impact of default of one component to another one. We prove a law of large numbers for the empirical measure capturing the evolution of the different components in the pool and from this we extract important information for quantities such as the loss rate in the overall pool as well as the mean impact on a given component from system wide defaults. A singular value decomposition of the adjacency matrix of the graph allows to coarse-grain the system by focusing on the highest eigenvalues which also correspond to the components with the highest contagion impact on the pool. Numerical simulations demonstrate the theoretical findings.

Not a Bank, Not a SIFI; Still Too Big to Fail
Couwenberg, Oscar,Lubben, Stephen J.
Many have wrestled with too big to fail firms, with the attention predominantly focused on banks, especially the so-called systemically important ones, i.e. SIFI’s (“Systematically Important Financial Institutions”). In this Article we look at too big to fail firms. We focus on cases of large firms that are not banks but were considered too big to fail when in financial distress. We look at a diverse set of multi-jurisdictional, internationally active and nationally very important large firms, analyze their outcomes and whether and in what way they were supported by their respective governments. This analysis reveals that all these firms can be categorized in one of four types of resolution frames: a standard bankruptcy procedure, a bankruptcy procedure with funding support from the state, an ad hoc solution and a full bailout by the government. We argue that only the first two types are needed for resolving financial distress, with the latter two inefficient. We provide arguments for the efficiency of the government support via the bankruptcy procedure in a jurisdiction and we discuss how this fits our cases. We conclude that for large firms the moral hazard associated with the too big to fail argument can be mitigated, but that it at least implies a bankruptcy procedure that is able to handle such large cases.

On Policy Evaluation with Aggregate Time-Series Shocks
Dmitry Arkhangelsky,Vasily Korovkin

In this paper we construct a parsimonious causal model that addresses multiple issues researchers face when trying to use aggregate time-series shocks for policy evaluation: (a) potential unobserved aggregate confounders, (b) availability of various unit-level characteristics, (c) time and unit-level heterogeneity in treatment effects. We develop a new estimation algorithm that uses insights from treatment effects, panel, and time-series literature. We construct a variance estimator that is robust to arbitrary clustering pattern across geographical units. We achieve this by considering a finite population framework, where potential outcomes are treated as fixed, and all randomness comes from the exogenous shocks. Finally, we illustrate our approach using data from a study on the causal relationship between foreign aid and conflict conducted in Nunn and Qian [2014].

Optimal Information Acquisition and Consumption Under Habit Formation Preference
Yue Yang,Xiang Yu

We consider a basic model of two-stage optimal decision making involving pure information learning beforehand and dynamic consumption afterwards: in stage-1 from initial time to a chosen stopping time, the individual investor has access to full market information and simply updates the underlying stock and mean-reverting drift processes by paying information costs; in stage-2 starting from the chosen stopping time, the investor terminates the costly information acquisition while the public stock prices are still available and free. Therefore, during stage-2, the investor starts the investment and consumption based on previous full information and the dynamic partial observations after the stopping time. Moreover, the investor adopts the habit formation preference, in which the past consumption affects his current decisions. Mathematically speaking, we formulate a composite optimal starting and control problem, in which the exterior problem is to determine the best time to initiate the investment-consumption decisions and the interior problem becomes a finite time stochastic control problem with partial information. The value function of the composite problem is characterized as the unique viscosity solution of some variational inequalities.

Pecking Order Incentives and Mandatory Management Forecasts
Ferguson, Andrew,Pündrich, Gabriel
This study investigates the effects of funding channel incentives on management forecasts. In this study, funding channel incentives refers to those arising from firms with no internal sources of funds following the approval of private debt loans. The setting (Australia) doesn’t have an information sensitive debt market able to be accessed by corporations. We examine a large sample of mandatory management forecasts of quarterly expenditure disclosed by mining companies around project finance approvals, where debt often enters the capital structure of the firm for the first time. We find project finance approval results in managers increasing overestimates of cash outflows or creating ‘budget slack’. We interpret this as evidence consistent with management signalling to equity markets lower risk of cost-overruns during the critical mine development and construction phase. Consistent with pecking order theory, we find that operating cash outflow overestimates increase following project finance approvals, where the equity channel becomes prioritised and is the remaining viable funding channel given the debt channel is already set in place. Our results show that managers are more likely to create budget slack to signal investors lower risks of cost overruns, which can be fatal for mining projects.

Pitching Research: Insights and Reflections from using a Web Portal in a Doctoral Course Exercise
Faff, Robert W.,Godfrey, Keith,Brosnan, Mark,Dorris, Alana,Orole, Felix,Salehudin, Imam,Wong, Charlane,Zhaunerchyk, Kate
Faff’s (2015, 2019) pitching research concept provides a simple 2-page template tool, with the aim of presenting a framework SO THAT a novice researcher can confidently and succinctly convey all the essential elements of a new research proposal to an academic expert. The “low technology” way of implementing the pitching research exercise is to create a pitch using a WORD version of the template. However, a web portal version is freely available at PitchMyResearch â€" and this provides a more “high tech”, “mobile friendly” way of completing the pitching task. The current paper explores user data (primarily, the sequence of completion and time spent on each item) extracted from the web portal, based on pitch exercises conducted in a PhD course at the University of Queensland.

Prudential Monetary Policy
Caballero, Ricardo J.,Simsek, Alp
Should monetary policy have a prudential dimension? That is, should interest rates be raised to rein in financial excesses during a boom? We theoretically investigate this issue using an aggregate demand model with asset price booms and financial speculation. In our model, monetary policy affects financial stability through its impact on asset prices. Our main result shows that, when macroprudential policy is imperfect, small doses of prudential monetary policy (PMP) can provide financial stability benefits that is equivalent to tightening leverage limits. PMP reduces asset prices during the boom, which softens the asset price crash when the economy transitions into a recession. This mitigates the recession because it supports high-valuation investors' balance sheets. An alternative intuition is that PMP raises the interest rate to create room for monetary policy to react to negative asset price shocks. The policy is most effective when speculation is high and leverage limits are neither too tight nor too slack.

Resolving New Keynesian Anomalies with Wealth in the Utility Function
Pascal Michaillat,Emmanuel Saez

The New Keynesian model makes several anomalous predictions at the zero lower bound: collapse of output and inflation, and implausibly large effects of forward guidance and government spending. To resolve these anomalies, we introduce wealth into the utility function. The justification is that wealth is a marker of social status, and people value social status. Since people save not only for future consumption but also to accrue social status, the Euler equation is modified. As a result, when the marginal utility of wealth is sufficiently large, the dynamical system representing the equilibrium at the zero lower bound becomes a source instead of a saddle---which resolves all the anomalies.

The Global Economic Recovery 10 Years after the 2008 Financial Crisis
Mrkaic, Mico,Nabar, Malhar,Chen, Wenjie
This paper takes stock of the global economic recovery a decade after the 2008 financial crisis. Output losses after the crisis appear to be persistent, irrespective of whether a country suffered a banking crisis in 2007-08. Sluggish investment was a key channel through which these losses registered, accompanied by long-lasting capital and total factor productivity shortfalls relative to precrisis trends. Policy choices preceding the crisis and in its immediate aftermath influenced postcrisis variation in output. Underscoring the importance of macroprudential policies and effective supervision, countries with greater financial vulnerabilities in the precrisis years suffered larger output losses after the crisis. Countries with stronger precrisis fiscal positions and those with more flexible exchange rate regimes experienced smaller losses. Unprecedented and exceptional policy actions taken after the crisis helped mitigate countries' postcrisis output losses.

The Network Effect in Credit Concentration Risk
Davide Cellai,Trevor Fitzpatrick

Measurement and management of credit concentration risk is critical for banks and relevant for micro-prudential requirements. While several methods exist for measuring credit concentration risk within institutions, the systemic effect of different institutions' exposures to the same counterparties has been less explored so far. In this paper, we propose a measure of the systemic credit concentration risk that arises because of common exposures between different institutions within a financial system. This approach is based on a network model that describes the effect of overlapping portfolios. We calculate this measure of systemic network concentration on a few data sets reporting exposures of financial institutions and show that typically the effect of common exposures is not fully contained by information at the level of single portfolio concentration. As a result, we show that an optimal solution that minimizes systemic risk is to be found in a balance between these two, typically different and rather divergent, effects. Using this network measure, we calculate the additional capital corresponding to the systemic risk arising from credit concentration interconnectedness. This adjustment is additional to both the original capital requirement from Basel II and the granularity adjustment of each portfolio. We also develop an approximated methodology to avoid double counting between the granularity adjustment and the common exposure adjustment. Although approximated, our common exposure adjustment is able to capture, with only two parameters, an aspect of systemic risk that goes beyond a view over single portfolios and analyzes the complexity of the interplay among (risk-adjusted) exposures.

The Valuation of Insurance Liabilities: A Framework Based on First Principles
Koch-Medina, Pablo
We describe a framework for the valuation of insurance liabilities that relies on first principles in finance theory. Key features of the economic value of liabilities are its market-consistency and the inclusion of the costs of financial frictions. We compare this framework to the Solvency II approach and highlight the differences.

Volatility-Managed Portfolios: True Market-Timing with a False Theory?
Guo, Shuxin,Liu, Qiang
The volatility-managed portfolio (VMP) offers an appealing market-timing strategy (Moreira and Muir, Journal of Finance, 2017). Unfortunately, an important theoretical result for VMP and the foundation of the paper’s empirical study, namely the arbitrariness of the constant c in the portfolio weight factor, seem questionable. We prove that the VMP alpha from a slightly modified theory isn’t guaranteed to be positive under any circumstance, casting doubt on the Moreira-Muir results. In a case with inferable positive Moreira-Muir alphas, our simulations show that statistically significant alphas are rare and volatility-managed portfolios frequently lose all investments, contradicting the Moreira-Muir theory.

You are Suffocating Me! Firm-Level Evidence on Crowding Out
Cevik, Serhan
Literature on whether government spending crowds out or crowds in the private sector is large, but still without an unambiguous conclusion. Using firm-level data from Ukraine, this paper provides a granular empirical investigation to disentangle the impact of state-owned enterprises (SOEs) on private firm investment in Ukraine-a large transition economy. Controlling for firm characteristics and systematic differences across sectors, the results indicate that the SOE concentration in a given sector has a statistically significant negative effect on private fixed capital formation, and that the impact of SOEs is stronger in those industries in which SOEs have a more dominant presence. These findings imply that private firms operating in sectors with a high level of SOE concentration invest systematically less than businesses that are not competing directly with SOEs.