# Research articles for the 2019-06-17

arXiv

An explicit martingale representation for random variables described as a functional of a Levy process will be given. The Clark-Ocone theorem shows that integrands appeared in a martingale representation are given by conditional expectations of Malliavin derivatives. Our goal is to extend it to random variables which are not Malliavin differentiable. To this end, we make use of Ito's formula, instead of Malliavin calculus. As an application to mathematical finance, we shall give an explicit representation of locally risk-minimizing strategy of digital options for exponential Levy models. Since the payoff of digital options is described by an indicator function, we also discuss the Malliavin differentiability of indicator functions with respect to Levy processes.

SSRN

Safe and liquid assets like Treasuries are not a cash substitute. However, dealer banks may transform Treasuries into a money-like financial asset, i.e., a repurchase agreement collateralized with Treasuries. The ratio of Treasuries useable as repo collateral by dealer banks over demand for money-like financial assets by institutional investors is a statistically and economically significant determinant of spreads in both money and bond markets beyond conventional determinants. The ratio captures a risk premium for the illiquidity of the dealer system that is due to the time-varying market liquidity of repo collateral.

arXiv

The asymptotic distribution of the Markowitz portfolio is derived, for the general case (assuming fourth moments of returns exist), and for the case of multivariate normal returns. The derivation allows for inference which is robust to heteroskedasticity and autocorrelation of moments up to order four. As a side effect, one can estimate the proportion of error in the Markowitz portfolio due to mis-estimation of the covariance matrix. A likelihood ratio test is given which generalizes Dempster's Covariance Selection test to allow inference on linear combinations of the precision matrix and the Markowitz portfolio. Extensions of the main method to deal with hedged portfolios, conditional heteroskedasticity, conditional expectation, and constrained estimation are given. It is shown that the Hotelling-Lawley statistic generalizes the (squared) Sharpe ratio under the conditional expectation model. Asymptotic distributions of all four of the common `MGLH' statistics are found, assuming random covariates. Examples are given demonstrating the possible uses of these results.

SSRN

Exploiting staggered interstate banking deregulation as exogenous shocks to bank geographic expansion, we examine the causal effect of geographic diversification on systemic risk. Using the gravity-deregulation approach developed in Goetz, Laeven, and Levine (2013, 2016), we find that bank geographic diversification leads to higher systemic risk measured by the change in conditional value at risk (Î"CoVaR) and financial integration (Logistic(R2)). Furthermore, we document that geographic diversification affects systemic risk via its impact on asset similarity. The impact of geographic diversification on systemic risk is stronger in BHCs located in states comoving less with the U.S. aggregate economy.

SSRN

This paper discusses new research into the causes and consequences of historical banking crises around the world. Although much of our understanding about why banking crises occur and how to prevent them is based on our study of banking crises of the past, we know surprisingly little about many historical crises (Baron, Verner, and Xiong, 2019), in part because of a lack of quantitative measures of their causes and aftermath. This paper highlights limitations with narrative chronologies of banking crises and showcases the uses of historical micro-level data, such as bank equity returns and individual bank balance sheet, in reconstructing the global history of banking crises.

SSRN

This paper examines two prominent approaches to design efficient mechanisms for debt renegotiation with dispersed bondholders: debt exchange offers that promise enhanced liquidation rights to a restricted number of tendering bondholders (favored under U.S. law), and collective action clauses that allow to alter core bond terms after a majority vote (favored under U.K. law). We use a dynamic contingent claims model with a debt overhang problem, where both hold-out and hold-in problems are present. We show that the former leads to a more efficient mitigation of the debt overhang problem than the latter. Dispersed debt is desirable, as exchange offers also achieve a larger and more efficient debt reduction relative to debt held by a single creditor.

arXiv

In this paper, we study a semi-martingale optimal transport problem and its application to the calibration of Local-Stochastic Volatility (LSV) models. Rather than considering the classical constraints on marginal distributions at initial and final time, we optimise our cost function given the prices of a finite number of European options. We formulate the problem as a convex optimisation problem, for which we provide a dual formulation. We then solve numerically the dual problem, which involves a fully nonlinear Hamilton--Jacobi--Bellman equation. The method is tested by calibrating a Heston-like LSV model with simulated data.

SSRN

We suggest that the Commissionâ€™s recommendations can be made â€˜organisation readyâ€™ if the ethical culture is developed in a way that is consistent with internationally recognized human rights norms. Human rights remove some of the subjective element from ethics and replace it with internationally agreed standards ready to be incorporated into thoughtful governance and corporate decision making processes. We suggest that this model can help build valuable social capital so organisations are seen to be self-regulating ethical conduct beyond governmental controls.

SSRN

Interest rate instruments are typically priced by creating a non-arbitrage replicating portfolio in a risk-neutral framework. Bespoke instruments with timing, quanto and other adjustments often present arbitrage opportunities, particularly in complete markets where the difference can be monetized. To eliminate arbitrage opportunities we are required to adjust bespoke instrument prices appropriately, such adjustments are typically non-linear and described as convexity adjustments.We review convexity adjustments firstly using a linear rate model and then consider a more advanced static replication approach. We outline and derive the analytical formulae for Libor and Swap Rate adjustments in a single and multi-curve environment, providing examples and case studies for Libor In-Arrears, CMS Caplet, Floorlet and Swaplet adjustments in particular. In this paper we aim to review convexity adjustments with extensive reference to popular market literature to make what is traditionally an opaque subject more transparent and heuristic.

SSRN

This paper investigates the relation between credit risk and stock return for publicly traded firms in the Pakistan Stock Exchange (PSX) over the period 2000-2017. Using credit ratings as a proxy for credit risk, we find that this relation is negative in Pakistan, as low-rated stocks (i.e., those with high credit risk) earn lower returns than high-rated stocks (i.e., those with low credit risk) do. An additional analysis using Altmanâ€™s Z-score as a proxy for credit risk confirms the negative relation between credit risk and stock return. In seeking to determine whether this negative relation arises from other anomalies, we discover that stock return is positively related to firm size in Pakistan, so a reverse size effect is present. However, the negative credit risk-return relation in Pakistan persists after controlling for the reverse size effect as well as the momentum and liquidity effects. This study provides evidence that the default-risk anomaly holds in a frontier stock market that lacks adequate information infrastructures and faces high levels of political and economic uncertainty.

arXiv

In this paper we derive a generic decomposition of the option pricing formula for models with finite activity jumps in the underlying asset price process (SVJ models). This is an extension of the well-known result by Alos (2012) for Heston (1993) SV model. Moreover, explicit approximation formulas for option prices are introduced for a popular class of SVJ models - models utilizing a variance process postulated by Heston (1993). In particular, we inspect in detail the approximation formula for the Bates (1996) model with log-normal jump sizes and we provide a numerical comparison with the industry standard - Fourier transform pricing methodology. For this model, we also reformulate the approximation formula in terms of implied volatilities. The main advantages of the introduced pricing approximations are twofold. Firstly, we are able to significantly improve computation efficiency (while preserving reasonable approximation errors) and secondly, the formula can provide an intuition on the volatility smile behaviour under a specific SVJ model.

arXiv

The research presented in this article provides an alternative option pricing approach for a class of rough fractional stochastic volatility models. These models are increasingly popular between academics and practitioners due to their surprising consistency with financial markets. However, they bring several challenges alongside. Most noticeably, even simple non-linear financial derivatives as vanilla European options are typically priced by means of Monte-Carlo (MC) simulations which are more computationally demanding than similar MC schemes for standard stochastic volatility models.

In this paper, we provide a proof of the prediction law for general Gaussian Volterra processes. The prediction law is then utilized to obtain an adapted projection of the future squared volatility -- a cornerstone of the proposed pricing approximation. Firstly, a decomposition formula for European option prices under general Volterra volatility models is introduced. Then we focus on particular models with rough fractional volatility and we derive an explicit semi-closed approximation formula. Numerical properties of the approximation for a popular model -- the rBergomi model -- are studied and we propose a hybrid calibration scheme which combines the approximation formula alongside MC simulations. This scheme can significantly speed up the calibration to financial markets as illustrated on a set of AAPL options.

arXiv

We analyze what can be learned from tests for p-hacking based on distributions of t-statistics and p-values across multiple studies. We analytically characterize restrictions on these distributions that conform with the absence of p-hacking. This forms a testable null hypothesis and suggests statistical tests for p-hacking. We extend our results to p-hacking when there is also publication bias, and also consider what types of distributions arise under the alternative hypothesis that researchers engage in p-hacking. We show that the power of statistical tests for detecting p-hacking is low even if p-hacking is quite prevalent.

SSRN

We find that Treasury futures volume contains information about future economic and financial market conditions. Short-term and long-term volumes are economically different: A relatively higher volume in short-term (long-term) Treasury futures is counter-cyclical (pro-cyclical), preceding worse (better) economic and financial conditions. Further, we construct a single factor from futures volumes of different maturities that forecasts the performances of Treasury securities and the corporate debt and equity markets, as well as macroeconomic conditions. Our results are consistent with the notion that futures volumes from different market segments reflect differences in beliefs and contain different information about future financial and economic activity.

arXiv

We study population behavior when choice is hard because considering alternatives is costly. To simplify their choice problem, individuals may pay attention to only a subset of available alternatives. We design and implement a novel online experiment that exogenously varies choice sets and consideration costs for a large sample of individuals. We provide a theoretical and statistical framework that allows us to test random consideration at the population level. Within this framework, we compare competing models of random consideration. We find that the standard random utility model fails to explain the population behavior. However, our results suggest that a model of random consideration with logit attention and heterogeneous preferences provides a good explanation for the population behavior. Finally, we find that the random consideration rule that subjects use is different for different consideration costs while preferences are not. We observe that the higher the consideration cost the further behavior is from the full-consideration benchmark, which supports the hypothesis that hard choices have a substantial negative impact on welfare via limited consideration.

SSRN

Based on a General Dynamic Factor Model with infinite-dimensional factor space, we develop a new estimation and forecasting procedures for conditional covariance matrices in high-dimensional time series. The performance of our approach is evaluated via Monte Carlo experiments, outperforming many alternative methods. The new procedure is used to construct minimum variance portfolios for a high-dimensional panel of assets. The results are shown to achieve better out-of-sample portfolio performance than alternative existing procedures.

SSRN

Valuation adjustments are nowadays a common practice to include credit and liquidity effects in option pricing. Funding costs arising from collateral procedures, hedging strategies and taxes are added to option prices to take into account the production cost of financial contracts so that a profitability analysis can be reliably assessed. In particular, when dealing with linear products, we need a precise evaluation of such contributions since bid-ask spreads may be very tight. In this paper we start from a general pricing framework inclusive of valuation adjustments to derive simple evaluation formulae for the relevant case of total return equity swaps when stock lending and borrowing is adopted as hedging strategy.

arXiv

Information transfer between time series is calculated by using the asymmetric information-theoretic measure known as transfer entropy. Geweke's autoregressive formulation of Granger causality is used to find linear transfer entropy, and Schreiber's general, non-parametric, information-theoretic formulation is used to detect non-linear transfer entropy.

We first validate these measures against synthetic data. Then we apply these measures to detect causality between social sentiment and cryptocurrency prices. We perform significance tests by comparing the information transfer against a null hypothesis, determined via shuffled time series, and calculate the Z-score. We also investigate different approaches for partitioning in nonparametric density estimation which can improve the significance of results.

Using these techniques on sentiment and price data over a 48-month period to August 2018, for four major cryptocurrencies, namely bitcoin (BTC), ripple (XRP), litecoin (LTC) and ethereum (ETH), we detect significant information transfer, on hourly timescales, in directions of both sentiment to price and of price to sentiment. We report the scale of non-linear causality to be an order of magnitude greater than linear causality.

SSRN

Pichhadze (2010) introduced the Market Oriented Blockholder Model (MOBM) as properly describing the ownership pattern in the American equity markets. Under the model, the emerging blockholder in the American equity markets is the institutional investor (II). This poses a challenge to the shareholder primacy literature, which argues that IIs (i) have interests that coincide with the interests of the shareholder body in the public firm, (ii) promote dispersed ownership, and (iii) crusade shareholder interests domestically and internationally. I show that (i) the position of IIs as blockholders creates a paradox for both the literature and the law, (ii) IIs have interests that do not coincide with those of other shareholders, and (iii) failure to recognize these observation vis-Ã -vis IIs or the MOBM may result in the introduction of a systemic risk into the financial system.

SSRN

This appendix contains supplemental tests discussed in the main text of "The Effects of Common Ownership on Customer-Supplier Relationships."Found here: https://ssrn.com/abstract=2873199

SSRN

The investment literature has long acknowledged the time- and frequency-varying dynamics of the relationship between investment, Tobin's Q and cash flow. In this paper, we use continuous wavelet tools to estimate and assess the relationship between these variables simultaneously at different frequencies and over time. We find that i) Q and cash flow are complementary sources of information for investment, the former being more important for firms' investment decisions in the medium-to-long run and the latter at business cycles frequencies; and ii) investment-Q sensitivity declines over time at all frequencies, while investment-cash flow sensitivity declines at business cycles frequencies but remains largely stable over the medium-to-long run.

SSRN

I develop a model of asset markets where asset sellers may sell an illiquid asset for money because they are in need of liquidity. Asset sellers also possess private information about the quality of the illiquid asset. I show that sellers with high quality assets signal the quality through partial retention of the asset, but only if the amount of liquidity they need is relatively low. If the liquidity needs are relatively high, however, sellers with high quality assets offer the same price and sell the same quantity as other sellers. I show this result has important implications on the flight to safety episodes, fire sales and market freezes that frequently happen during financial crises.

arXiv

We study long-run selection and treatment effects of a health insurance subsidy in Ghana, where mandates are not enforceable. We randomly provide different levels of subsidy (1/3, 2/3, and full), with follow-up surveys seven months and three years after the initial intervention. We find that a one-time subsidy promotes and sustains insurance enrollment for all treatment groups, but long-run health care service utilization increases only for the partial subsidy groups. We find evidence that selection explains this pattern: those who were enrolled due to the subsidy, especially the partial subsidy, are more ill and have greater health care utilization.

arXiv

In this paper long-run risk sensitive optimisation problem is studied with dyadic impulse control applied to continuous-time Feller-Markov process. In contrast to the existing literature, focus is put on unbounded and non-uniformly ergodic case by adapting the weight norm approach. In particular, it is shown how to combine geometric drift with local minorisation property in order to extend local span-contraction approach when the process as well as the linked reward/cost functions are unbounded. For any predefined risk-aversion parameter, the existence of solution to suitable Bellman equation is shown and linked to the underlying stochastic control problem. For completeness, examples of uncontrolled processes that satisfy the geometric drift assumption are provided.

SSRN

We extend the double-well potential process to a three-parameter version in order to model intraday price dynamics, with a focus on the intraday momentum and reversal. The proposed process has a parsimonious form of three parameters controlling momentum, reversal, and volatility respectively. By using different combinations of parameter values, the process can accommodate two different intraday patterns: i) there is no new information and intraday price undertakes mean-reverting pattern due to â€œnoise tradersâ€; ii) there is new information released and the intraday price experiences a momentum possibly followed by a reversal due to overreaction. Estimation methods are developed under both long-span asymptotics and in-fill asymptotics along with a simulation study for the finite sample properties. An empirical illustration is provided by using three intraday-frequencies data of Apple Inc.

arXiv

The pricing of financial derivatives, which requires massive calculations and close-to-real-time operations under many trading and arbitrage scenarios, were largely infeasible in the past. However, with the advancement of modern computing, the efficiency has substantially improved. In this work, we propose and design a multi-path option pricing approach via autoregression (AR) process and Monte Carlo Simulations (MCS). Our approach learns and incorporates the price characteristics into AR process, and re-generates the price paths for options. We apply our approach to price weekly options underlying Taiwan Stock Exchange Capitalization Weighted Stock Index (TAIEX) and compare the results with prior practiced models, e.g., Black-Scholes-Merton and Binomial Tree. The results show that our approach is comparable with prior practiced models.

SSRN

In this article, we analyze the possibility to do well, while doing good from a passive portfolio management strategy. In this analysis, we distinguish the regions Europe and the US and refer to the stock price data of composites from the most important indices in these regions. Based on these, we design portfolios that mimic a typical index, and compare their performance in terms of risk, ESG and return. All strategies proposed are passive and thus, not affected by management skills or fees. We show, that there are significant differences across the regions which can only partly be explained by the Fama French factors. We find that there is no significant difference between an ESG based strategy and the naive one in terms of returns or sharpe ratios, whereas a clear outperformance in the ESG value is evident. From this, it can be concluded, that socially responsible investors are willing to pay for the impact of the portfolio, as in opposite to the naive strategy transaction costs have to be paid. Comparing the ESG based strategy to the value weighted strategy that is used for most indices, we observe no significant ESG difference but a significant superior performance of the ESG based portfolio, arguing in favor of the ESG strategy being preferable to all investors - not only the social ones.

arXiv

In this paper, we introduce and develop the theory of semimartingale optimal transport in a path dependent setting. Instead of the classical constraints on marginal distributions, we consider a general framework of path dependent constraints. Duality results are established, representing the solution in terms of path dependent partial differential equations (PPDEs). Moreover, we provide a localisation result, which reduces the dimensionality of the solution by identifying appropriate state variables based on the constraints and the cost function. Our technique is then applied to the exact calibration of volatility models to the prices of general path dependent derivatives.

SSRN

The preference of German households for cash payments is well known. I document this preference using payment information from individual transactions of a panel of up to 18,000 households, covering the years 2009 till 2015. Accounting notably for household fixed effects, I show that over these seven years preferences for card payments have hardly increased, despite the fact that virtually all German household have access to a debit card (the girocard), which comes free of charge with their current account and which is accepted by virtually all retailers of fast-moving consumer goods (i.e., grocery retailers and drugstores in my household panel). However, zooming in on transactions with high denomination, I also document pronounced differences in household preferences, which I show to be stable over time. The particular institutional environment, i.e., the identical access of all households to girocard payments, allows me to rule out common explanations for such heterogeneity.

SSRN

We find that product market differentiation is an economically meaningful and robust predictor of accounting fraud. Controlling for traditional measures of competition and large tariff reductions does not influence this finding. Thus, product differentiation appears to capture a unique relation between competition and fraud, which we posit is driven by the firm's external information environment. To help establish identification, we exploit product similarities with rivals issuing IPOs, as well as cross-sectional variation in firm complexity, institutional ownership, analyst coverage, and financial statement comparability. Our analysis suggests that lower product differentiation enhances external monitoring, which disciplines manager reporting behavior.

SSRN

This is the first study that analyzes the Bank of Japan's (BOJ) dual bond-purchase program consisting of both fixed-amount and fixed-rate (i.e., unlimited-amount) operations since 2016. This Yield Curve Control (YCC) regime as part of the BOJ's Quantitative and Qualitative Easing exhibits similarities to the Fed's bond-price support regime during WWII. Bond yields became stationary processes across the entire yield curve under the YCC regime. The decomposition of bond yields reveals that both trend and cyclical components became stable and less volatile. As a result, international correlations decreased between JGBs and other government bonds. These results suggest that the BOJ's monetary policy is considered credible. However, interest rates other than JGB yields were not completely controlled as evidenced by an increased spread between 10-year swap rates and JGB yields after the largest fixed-rate operation on July 30, 2018.

arXiv

Stochastic gradient descent in continuous time (SGDCT) provides a computationally efficient method for the statistical learning of continuous-time models, which are widely used in science, engineering, and finance. The SGDCT algorithm follows a (noisy) descent direction along a continuous stream of data. The parameter updates occur in continuous time and satisfy a stochastic differential equation. This paper analyzes the asymptotic convergence rate of the SGDCT algorithm by proving a central limit theorem (CLT) for strongly convex objective functions and, under slightly stronger conditions, for non-convex objective functions as well. An $L^{p}$ convergence rate is also proven for the algorithm in the strongly convex case. The mathematical analysis lies at the intersection of stochastic analysis and statistical learning.

SSRN

I study the effect of a blockholder who sits on the board of directors on debt contracting. This is a unique setting to study countervailing agency conflicts, as theory suggests that blockholder-directors can simultaneously mitigate owner-manager conflicts and exacerbate shareholder-debtholder conflicts. My evidence provides support for the notion that outside blockholders on the board reduce the interest rate attached to the loan. The evidence is stronger for blockholder-directors with longer investment horizons and when owner-manager conflicts are more severe. My research examines how lenders respond to a significant agency tension and suggests that a blockholder on the board has the potential to reduce the firmâ€™s burden in borrowing.

SSRN

This study examines the change of returns on common stocks around the time exchange-traded derivatives (options and futures) are listed on those stocks. It also analyses the impact of derivative introductions on market completeness. Two emergent markets are considered: India and Taiwan. We propose the use of event study based on GLS regression to test market completeness hypothesis. The evidence indicates that option and future introductions have a positive impact on the underlying stock returns. This effect is either transitory (Taiwan) or persistent until the 10th-day post listing (India). The market completeness hypothesis does not explain the price effect. We also find a significant increase in volume in the three days after the derivative introductions. Finally, the argument explaining the price reaction depends on the market and the way exchanges choose new underlying.

SSRN

For years, the insurance industry was essentially about mathematical quantification and financial transformation of physical risks. But our world has become more interconnected with the advent of the internet, blockchain etc.: as a consequence, cyber risk is expanding rapidly. Here, Prof. W. Jean Kwon looks at how the insurance industry will adapt to the â€œcyber-physicalâ€ world order. These ideas were presented by the author at the 8th World Pensions Forum, held in Brussels, 23 & 24 May 2019.

SSRN

Stocks of firms with cash flows concentrated in the short-term (i.e., short duration stocks) pay a large premium over long duration stocks. I empirically demonstrate this premium: (i) is long-lived and strong even among large firms; (ii) subsumes the value and profitability premia; and (iii) exposes investors to variation in expected returns, especially in times when the premium is high. These facts are consistent with an intertemporal model in which the marginal (long-term) investor dislikes expected return declines as they lead to lower expected wealth growth. The model also captures the positive relation between risk premia and bond duration.

SSRN

We examine the relationship between the tone of mandatory disclosure and bank risk insolvency to determine whether and how qualitative information, through the manager tone, may reveal about bank stability. Using text analysis and context-specific text dictionaries of Loughran and McDonald, we find that qualitative information collected in negative tone contribute to explain the bank risk insolvency lowering distance to default. In addition, we find that a frame of communication of relevant information rich of negative words and expressing uncertainty let transpire about bank stability. This finding suggests that qualitative information could be used to detect through the managerial tone in the communication between bank, market and supervisor.

SSRN

We find that a US equity tail risk factor constructed from out-of-the-money S&P 500 put option prices explains the cross-sectional variation of currency excess returns. Currencies highly exposed to this factor offer a low currency risk premium because they appreciate when US tail risk increases. In a reduced-form model, we show that country-specific tail risk factors are priced in the cross section of currency returns only if they contain a global risk component. Motivated by the intuition from the model and by our empirical results, we construct a novel proxy for a global tail risk factor by buying currencies with high US equity tail beta and shorting currencies with low US tail beta. This factor, along with the dollar risk factor, explains a large portion of the cross-sectional variation in the currency carry and momentum portfolios and outperforms other models widely used in the literature.

SSRN

This paper investigates the impact of unbundling on sell side research production under the context of MiFID II. We provide evidence that unbundling causes a decrease in analyst coverage. Such a drop does not come from small or mid-cap firms, but concentrates on large firms. Furthermore, we find evidence of improvement in coverage quality. Our evidence suggests a competition channel driving the results. Redundant analysts drop out (extensive margin). Analysts who stay have stronger incentives to produce high-quality research (intensive margin). The channel helps to explain the simultaneous decrease in coverage quantity and increase in coverage quality.

arXiv

We propose two variants of the Smith-Wilson method for practical application in the insurance industry. Our first variant relaxes the Smith-Wilson energy and can be used to incorporate less reliable market data with a certain weight rather than disregarding it completely. This is particularly useful for deriving yield curves in the IFRS 17 accounting regime, where there is a mandate to incorporate all available market data.

A second variant incorporates the requirement to reach the ultimate forward rate at a prescribed term into the problem formulation. This provides a natural way to fulfil the Solvency II convergence requirement and is more elegant than the current methodology adapting the term-scale parameter to control convergence.

SSRN

This paper investigates the relationship between volatility and liquidity on the German electricity futures market based on high-frequency intraday prices. We estimate volatility by the time-weighted realized variance acknowledging that empirical intraday prices are not equally spaced in time. Empirical evidence suggests that volatility of electricity futures decreases as time approaches maturity, while coincidently liquidity increases. Established continuous-time stochastic models for electricity futures prices involve a growing volatility function in time and are thus not able to capture our empirical findings a priori. We demonstrate that incorporating increasing liquidity into the established models is key to model the decreasing volatility evolution.