Research articles for the 2019-07-17

A Systems Analysis of WEF Global Risks 2007~2017
Evans, John R.,Wang, Xingzhuo
The World Economic Forum (WEF) has been producing reports since 2006 based on what are perceived by respondents to their survey as the major risks facing the world. This paper extends the work of Evans et al (2017) that analysed the WEF 2014 risks and considers the WEF Global Risks over the period 2007~2017. We conclude that consistent with Evans et al (2017), whilst there is evidence that the WEF Global Risks over the period 2007~2017 can be reduced to a simpler number of common characteristics, there is not a great deal of consistency over time, i.e., the perceived global risks are evolving across time and this is consistent with evidence of a transition occurring in the global financial system over the 2007~2017 period. The result may also be partly due to changes in the respondents to the WEF Global Risk surveys over time. We have also concluded that the major risks are from the “unknown” and “unknowable” categories that require careful consideration as to appropriate risk management approaches.

A model-free backward and forward nonlinear PDEs for implied volatility
Peter Carr,Andrey Itkin,Sasha Stoikov

We derive a backward and forward nonlinear PDEs that govern the implied volatility of a contingent claim whenever the latter is well-defined. This would include at least any contingent claim written on a positive stock price whose payoff at a possibly random time is convex. We also discuss suitable initial and boundary conditions for those PDEs. Finally, we demonstrate how to solve them numerically by using an iterative finite-difference approach.

Air Pollution, Affect, and Forecasting Bias: Evidence from Chinese Financial Analysts
Dong, Rui,Fisman, Raymond J.,Wang, Yongxiang,Xu, Nianhang
We document a negative relation between air pollution during corporate site visits by investment analysts and subsequent earnings forecasts. After accounting for analyst, weather , and firm characteristics, an extreme worsening of air quality from “good/excellent” to “severely polluted” is associated with a more than 1 percentage point lower profit forecast, relative to realized profits. We explore heterogeneity in the pollution-forecast relation to understand better the underlying mechanism. Pollution only affects forecasts that are announced in the weeks immediately following a visit, indicating that mood likely plays a role, and the effect of pollution is less pronounced when analysts from different brokerages visit on the same date, suggesting a debiasing effect of multiple perspectives. Finally, there is suggestive evidence of adaptability to environmental circumstances â€" forecasts from analysts based in high pollution cities are relatively unaffected by site visit pollution.

Analysis of CDS Spread Fluctuations with an Application to the Negative Basis Arbitrage
Egami, Masahiko,Kevkhishvili, Rusudan
In this article, we first construct the empirical measure of spread (EMS) to capture the dynamics of quoted CDS spreads. It is the measure of creditworthiness of a company derived from the asset model in Egami and Kevkhishvili [2017]. We then use the information provided by the EMS to derive a refined negative CDS-bond basis trading strategy. Our contributions are twofold. By analyzing the period encompassing the global financial crisis, we find that the EMS is a forward-looking or leading indicator and can explain the movement of near future CDS spreads (20 or 30 days ahead). We then demonstrate that this feature of the EMS is present in non-crisis periods as well and is useful in negative basis arbitrage trading. Specifically, we set up a finite-horizon optimal stopping problem for an investor who uses CDS contracts to hedge a long position in a zero-coupon bond. Using this problem, we provide a trading tool for the investor and show that the information obtained from the EMS can enhance the gain from negative CDS-bond basis arbitrage.

Back to the Futures: When Short Selling is Banned
Jiang, George J.,Shimizu, Yoshiki,Strong, Cuyler
We examine the effect of single-stock futures (SSFs) trading on the price discovery and market quality of underlying stocks during the 2008 short-selling ban. We find a significant increase in SSFs trading volume for banned stocks during the ban period. In addition, we show that the contribution of SSFs trading to underlying stock price discovery also increased significantly. Moreover, we find that SSFs trading helped mitigate the negative effect of the short-selling ban on market quality. Given that SSFs trading in US still lags behind other markets, our findings project an increasingly important role of SSFs in the US financial market.

Benchmarking Operational Risk Stress Testing Models
Curti, Filippo,Migueis, Marco,Stewart, Rob T
The Federal Reserve's Comprehensive Capital Analysis and Review (CCAR) requires large bank holding companies (BHCs) to project losses under stress scenarios. In this paper, we propose multiple benchmarks for operational loss projections and document the industry distribution relative to these benchmarks. The proposed benchmarks link BHCs' loss projections with both financial characteristics and metrics of historical loss experience. These benchmarks capture different measures of exposure and together provide a comprehensive view of the reasonability of model outcomes. Furthermore, we employ several approaches to assess the conservatism of BHCs' stress loss projections and our estimates for the conservatism of loss projections for the median bank range from the 90th percentile to above the 99th percentile of the operational loss distribution.

Building Diversified Portfolios that Outperform Out-of-Sample
Lopez de Prado, Marcos
This paper introduces the Hierarchical Risk Parity (HRP) approach. HRP portfolios address three major concerns of quadratic optimizers in general and Markowitz’s CLA in particular: Instability, concentration and underperformance.HRP applies modern mathematics (graph theory and machine learning techniques) to build a diversified portfolio based on the information contained in the covariance matrix. However, unlike quadratic optimizers, HRP does not require the invertibility of the covariance matrix. In fact, HRP can compute a portfolio on an ill-degenerated or even a singular covariance matrix, an impossible feat for quadratic optimizers. Monte Carlo experiments show that HRP delivers lower out-of-sample variance than CLA, even though minimum-variance is CLA’s optimization objective. HRP also produces less risky portfolios out-of-sample compared to traditional risk parity methods.A presentation can be found at

CEO Compensation and Risk of Turnover: Evidence from CEO Divorce
Mohseni, Mahdi
Contrary to the entrenchment view of executive compensation, I find that CEOs with more control over the firm, proxied by higher equity ownership, have smaller compensation packages and are less likely to have severance contracts. Despite lower pay, these CEOs have longer tenure and their boards’ replacement decisions are less sensitive to their performance, which is consistent with the view that there is a trade-off between pay and dismissal risk. To mitigate endogeneity concerns, I use divorce as an exogenous negative shock to CEO equity ownership, and find that following a divorce, turnover risk goes up and pay increases significantly.

Can Transparency Exacerbate Adverse Selection? Evidence from Annuity Markets
Fajnzylber, Eduardo,Willington, Manuel,Pizarro, Matias
Upon retirement, Chilean workers must choose between two pension products: a longevity-insured life annuity or a programmed withdrawal. In the latter case, benefits tend to decrease over time but in the event of an early death the remaining balance is paid as survivorship benefits or inheritance. The retiree faces a trade-off between longevity insurance and greater inheritance. Comparing longevity outcomes of Chilean retirees, we show robust evidence of adverse selection: longevity is positively correlated with annuitization in general and, among annuitants, negatively correlated with choosing front-loaded contracts or contracts with guaranteed periods. Our results also show that the introduction in 2004 of an electronic annuity market â€"meant to increase transparency and competitionâ€" increased the level of adverse selection. Finally, in an attempt to disentangle the effects of adverse selection from moral hazard, we estimate instrumental variable binary choice models, finding negligible evidence of an insurance-induced behavioral change.

Central Banks and Regulation of Cryptocurrencies
Nabilou, Hossein,Prüm, André
This paper explores the interface between central banks and cryptocurrencies. Focusing on the European Central Bank (ECB), it identifies the potential threats that the rise of cryptocurrencies would pose to the basic and ancillary tasks of the ECB, in particular, its monetary policy operations and the exercise of its supervisory functions over credit institutions and payment systems. The paper finds that cryptocurrencies can potentially have both direct â€" through their potential impact on the price stability and monetary policy, and central banks’ monopoly over issuing base money â€" and indirect effects on central banks, mainly through the institutions and systems that fall under the ECB’s scope of competence.To address the challenges posed by cryptocurrencies, the ECB may take both legal (including supervisory and oversight) measures and non-legal (or technical) measures. With respect to technical measures, the ECB - to the extent falling within the scope of its competence - may focus on improving the efficiency of existing payment systems and addressing the existing frictions in market infrastructures to indirectly affect the cryptocurrency markets. Alternatively, it can venture into issuing Central Bank Digital Currency (CBDC). Regarding legal measures, central banks could envisage regulating cryptocurrencies either directly or indirectly. However, as the most significant potential impact of cryptocurrencies on central banks is likely to be indirect through the impact of cryptocurrencies on the banking and payment systems, and given the limitations on the ECB’s mandate and its regulatory and supervisory tools, it is apposite for the ECB to consider using indirect strategies and tools to influence cryptocurrency markets. This indirect approach can be implemented through the ECB’s existing supervisory and oversight powers over the banking and payment systems. This paper specifies the direct and indirect measures and assesses their merits in addressing the concerns about cryptocurrencies.

Common Ownership, Common Information Environment?
Jang, In Ji,Mohseni, Mahdi,Roychowdhury, Sugata,Sletten, Ewa
We examine the influence of common ownership on commonalities in the information environment. Specifically, we study commonalities in financial statements and in the actions of key agents such as financial analysts and firm managers who contribute and respond to the information environment. Using a differences-in-differences research design centered on the mergers of financial institutions, we find that an increase in common ownership leads to increased comparability of financial statements issued by commonly owned firms. An increase in common ownership also leads to higher likelihood of filing restatements, as greater comparability and potentially greater correlation of economic fundamentals uncover inconsistencies, errors and irregularities in reporting, particularly in the presence of shared auditors. In addition, common ownership leads to more shared coverage by financial analysts. Analysts’ earnings expectations become more correlated across peer firms, but analysts are also more likely to revise their expectations when peer firms issue earnings guidance. Finally, we shed light on the real consequences of such changes in the information environment. Managers become more likely to use the information captured in peer firms’ stock price when making investment decisions following an increase in common ownership.

Comparative Company Law 2018
Hopt, Klaus J.
Comparative company law is at once very old and very modern. It is very old because ever since companies and company laws first existed, trade has not stopped at the frontiers of countries and states. The persons concerned, practitioners as well as rule-makers, had to look beyond their own city, country, rules, and laws. This became even more true after the rise of the public company and the early company acts in the first half of the nineteenth century. Ever since, company lawmakers have profited from comparison. But comparative company law is also very modern. Most comparative work has focused on the main areas of private law, such as contract and torts, rather than company law. Internationally acknowledged standard treatises on comparative company law took a very long time to emerge. Company law and comparative company law work remained a task for professionals. The few academics who joined in this work tended also to be practitioners (such as outside counsel, arbitrators, or advisers to legislators), who were less interested in theory and doctrine.This changed only fairly recently with the spread of 1930s US securities regulation into Europe, the company law harmonization efforts of the European Community since the late 1950s, and most recently, in the 1990s, with the rise of the corporate governance movement, an international bandwagon that started in the United States and the United Kingdom, swooped over to Continental Europe and Japan, and has since permeated practically all industrialized countries. Corporate governance covers core company law, particularly the board and more recently also the shareholders and other stakeholders like employees. But it reaches well beyond classical company law into other areas of law, in particular capital market law, that is, securities regulation and most recently bank regulation; into other forms of rulemaking, in particular self-regulation and codes; and into disciplines other than law, in particular economics. In stark contrast to traditional company law, corporate governance, as it is presently studied and practised, is essentially international and interdisciplinary. It follows that comparative company law today is to a considerable degree part of comparative corporate governance, though casebooks and case-based books on corporate law are now available.

Confidence Collapse in a Multi-Household, Self-Reflexive DSGE Model
Federico Guglielmo Morelli,Michael Benzaquen,Marco Tarzia,Jean-Philippe Bouchaud

We investigate a multi-household DSGE model in which past aggregate consumption impacts the confidence, and therefore consumption propensity, of individual households. We find that such a minimal setup is extremely rich, and leads to a variety of realistic output dynamics: high output with no crises; high output with increased volatility and deep, short lived recessions; alternation of high and low output states where relatively mild drop in economic conditions can lead to a temporary confidence collapse and steep decline in economic activity. The crisis probability depends exponentially on the parameters of the model, which means that markets cannot efficiently price the associated risk premium. We conclude by stressing that within our framework, {\it narratives} become an important monetary policy tool, that can help steering the economy back on track.

Credit Risk Modeling With Jointly Spanned and Unspanned Interest Rate and Unspanned Bei Rate: A Macro-Finance Approach
Ticciati, Marco
We estimate a multifactor model which jointly considers the effect of interest rates and the effect of BEI rates on default rates of banks. At first we estimate a Gaussian three factor interest rate model and a Gaussian three factor inflation rate model on bootstrapped interest rates and ZCIS respectively. Afterwards, we introduce the results on the default rate term structure model to evaluate the effect of interest rates and inflation rates on default rates. Furthermore, following the recent developement in affine term structure model, we allow inflation rates to have an unspanned relation with default rates. This choice makes economic sense as the inflation rate is not present in the bootstrapping procedure of forward risk neutral default rates from CDS spread. Furthermore we allow also the interest rates to have both a spanned and an unspanned relation with default rates. The model is trained in a sample with positive interest rates and tested in a sample with negative interest rates. We check the robustness of the model by comparing the results with the performance of alternative model specifications. We see that the model with unspanned variables has a worse performance than alternative models where the unspanned relation is not present.

Currency Cops: The Law of Bank Supervision
Menand, Lev
A series of statutory provisions codified at Title 12 of the U.S. Code empower special government officials known as supervisors to examine banks and tell bankers what to do, not just when bankers break bright-line rules, but whenever supervisors believe bankers are engaged in “unsafe and unsound practices.” Despite the unusually broad scope of these provisions, academic treatments of them are quite shallow. This Article provides a new scholarly account of bank supervision, resurrecting the lost history of supervisory law and recovering the original meaning of the terms “unsafe” and “unsound.” It argues that legislators gave government officials the power to control various aspects of bank operations because they understood banks to be government instrumentalities augmenting the money supply on behalf of the state. And it shows that supervisors’ mandate â€" to prevent unsafe and unsound banking â€" is a monetary one. The standard authorizes supervisors to address practices that jeopardize the bank money system by undermining a bank’s ability to redeem its monetary liabilities (e.g., bank notes and deposits) in base money (e.g., cash) on demand. In recent decades, scholars and practitioners have lost sight of this meaning, obscuring the monetary nature of bank liabilities and reducing safety and soundness to a vague platitude. Policymakers have permitted unsupervised nonbanks to issue competing money liabilities and banks to monetize volatile and complex “nonmonetary” assets. The 2008 crisis was due largely to these errors. As these flaws in the monetary architecture have not yet been fully rectified, further reforms are in order.

Do Minimum Wage Increases Benefit Intended Households? Evidence from the Performance of Residential Leases
Agarwal, Sumit,Ambrose, Brent W.,Diop, Moussa
Prior studies debating the effects of changes to the minimum wage concentrate on impacts on household income and spending or employment. We extend this debate by examining the impact of changes to the minimum wage on expenses associated with shelter, a previously unexplored area. Increases in state minimum wages significantly reduce the incidence of renters defaulting on their lease contracts by 1.29 percentage points over three months, relative to similar renters who did not experience an increase in the minimum wage. This represents 25.7% fewer defaults post treatment in treated states. To put this into perspective, a 1% increase in minimum wage translates into a 2.6% decrease in rental default. This evidence is consistent with wage increases having an immediate impact on relaxing renter budget constraints. However, this effect slowly decreases over time as landlords react to wage increases by increasing rents. Our analysis is based on a unique data set that tracks household rental payments.

Does Intergenerational Mobility Increase Corporate Profits?
Albertus, James F.,Smolyansky, Michael
We find that firms located in areas with higher intergenerational mobility are more profitable. Building off the work of Chetty and Hendren (2018a and 2018b) â€" who provide measures of intergenerational mobility for all commuting zones (essentially, metropolitan areas) within the U.S. â€" we are the first to show the positive link between intergenerational mobility and corporate profitability. Our regressions compare firms within the same industry at the same point in time and fully control for time-varying state-level shocks. As such, our findings cannot be explained by either differences in industry composition across localities or by variation in state-level economic conditions; nor can our results be explained by differences in firm characteristics or by local economic conditions. Rather, we present evidence for a human-capital-based explanation: areas with higher mobility do a better job in unlocking people’s innate talents, which in turn has a positive effect on the performance of firms headquartered in these locations. Our results therefore show that greater equality of opportunity is associated with increased corporate profitability.

Does the Pension System’s Income Statement Really Matter? A Proposal for An NDC Scheme with Disability and Minimum Pension Benefits
Garvey, Anne M.,Ventura-Marco, Manuel,Vidal-Meliá, Carlos
This paper develops a full accounting model for monitoring the solvency of a notional defined contribution (NDC) pension scheme with disability and minimum pension benefits. Using the annual report of the Swedish pension system as a benchmark (TSPS, 2018), we extend the “Swedish” actuarial balance developed by Pérez-Salamero et al. (2017) by adding an income statement that fully explains the reasons behind the changes in the system’s solvency by type of benefit. In line with the reference model, assets and liabilities are measured at present value at each reporting date, and changes in present value are reported in each period as income or expenses and are included on the income statement. Our proposed model is a step forward because it also incorporates into the income statement changes in disability pensions, the value of changes in the discount rate and the explicit recognition of non-contributory rights (NCRs). This accounting framework integrates both the contributory and social aspects of public pensions and discloses the real cost of the disability contingency and the redistribution through minimum pensions. The paper contains a numerical example consisting of an income statement for a (fictional) already-functioning system to illustrate the main differences between the Swedish NDC scheme and our model. Mathematical details are presented in a comprehensive technical appendix.

Dynkin games with Poisson random intervention times
Gechun Liang,Haodong Sun

This paper introduces a new class of Dynkin games, where the two players are allowed to make their stopping decisions at a sequence of exogenous Poisson arrival times. The value function and the associated optimal stopping strategy are characterized by the solution of a backward stochastic differential equation. The paper further applies the model to study the optimal conversion and calling strategies of convertible bonds, and their asymptotics when the Poisson intensity goes to infinity.

False Hopes and Blind Beliefs: How Political Connections Affect China's Corporate Bond Market
Schweizer, Denis,Walker, Thomas John,Zhang, Aoran
This paper explores whether and how political connections affect the market for corporate bonds issued by privately owned enterprises (POEs) in China. We test two competing theories â€" the zero-default myth and the borrower channel theory â€" that predict how political connections affect the likelihood of bond issuance, refinancing costs, the market reaction to a bond issue announcement, and firms’ post-issue performance. Using a sample of Chinese POEs from 2007 to 2016, we show that â€" in line with the zero-default myth theory â€" politically connected POEs are more likely to issue corporate bonds as a debt financing instrument than their non-connected counterparts. They also achieve lower coupon rates (i.e., lower refinancing costs), despite exhibiting lower overall performance after bond issuance. We find that investors react positively to corporate bond-issuing announcements if the issuing firm is politically connected. At the same time, our research indicates that politically connected bond-issuing POEs in China have weaker corporate governance and a surprisingly higher default probability than non-connected issuers.

Federal Reserve Structure, Economic Ideas, and Monetary and Financial Policy
Bordo, Michael D.,Prescott, Edward S.
The decentralized structure of the Federal Reserve System is evaluated as a mechanism for generating and processing new ideas on monetary and financial policy. The role of the Reserve Banks starting in the 1960s is emphasized. The introduction of monetarism in the 1960s, rational expectations in the 1970s, credibility in the 1980s, transparency, and other monetary policy ideas by Reserve Banks into the Federal Reserve System is documented. Contributions by Reserve Banks to policy on bank structure, bank regulation, and lender of last resort are also discussed. We argue that the Reserve Banks were willing to support and develop new ideas due to internal reforms to the FOMC that Chairman William McChesney Martin implemented in the 1950s. Furthermore, the Reserve Banks were able to succeed at this because of their private-public governance structure, a structure set up in 1913 for a highly decentralized Federal Reserve System, but which survived the centralization of the System in the Banking Act of 1935. We argue that this role of the Reserve Banks is an important benefit of the Federal Reserve’s decentralized structure and contributes to better policy by allowing for more competition in ideas and reducing groupthink.

Firm Value and Government Commitment to Combating Climate Change
Berkman, Henk,Jona, Jonathan,Soderstrom, Naomi S.
We examine the impact of government commitment to combating climate change on firm value in relation to a firm’s climate risk exposure. We identify major recent regulatory events around climate change that are not fully predicted, including the surprise election of Donald Trump to President of the US and the Paris Climate Change agreement. We predict opposite changes in value for polluting firms (with a high score on climate risk exposure) relative to non-polluting firms (with a low score on climate risk exposure) in reaction to these regulatory changes. We find that around the surprise election of Donald Trump, the market value of firms with high climate risk increases relative to the value of firms with low climate risk, and they find the exact opposite results around the Paris Climate Change agreement, which represents an increased commitment to combating climate change.

Gaussian Process Regression for Pricing Variable Annuities with Stochastic Volatility and Interest Rate
Ludovic Goudenège,Andrea Molent,Antonino Zanette

In this paper we investigate price and Greeks computation of a Guaranteed Minimum Withdrawal Benefit (GMWB) Variable Annuity (VA) when both stochastic volatility and stochastic interest rate are considered together in the Heston Hull-White model. Specifically, we employ an improved version of the Hybrid Tree-PDE (HPDE) approach introduced by Briani et al.. Such a numerical method turns out to be particularly suitable to handle the long maturity of GMWB products and to solve the dynamic control problem due to computing the optimal withdrawal strategy. Then, in order to speed up the computation, we employ Gaussian Process Regression (GPR). Starting from observed prices previously computed for some known combinations of model parameters, it is possible to approximate the whole price function on a defined domain. The regression algorithm consists of algorithm training and evaluation. The first step is the most time demanding, but it needs to be performed only once, while the latter is very fast and it requires to be performed only when predicting the target function. The developed method, as well as for the calculation of prices and Greeks, can also be employed to compute the no-arbitrage fee, which is a common practice in the Variable Annuities sector. Numerical experiments show that the accuracy of the values estimated by GPR is high, while the computational cost is much lower than the one required by a direct calculation by HPDE. Finally, we stress out that the analysis is carried out for a GMWB annuity but it could be generalized to other insurance products.

IFRS Adoption and CEO Compensation: Evidence from Listed Banks in Nigeria
Ojeka, Stephen,Adegboye, Alex,Adetula, Dorcas,Adegboye, Kofo,Udoh, Inemesit
The study investigates the influence of International Financial Reporting Standards adoption, using accounting performance measure, to determine the CEO pay in listed banks in Nigeria. The audited annual financial statements of listed banks in Nigeria covering the period of 2009â€"2015 are analyzed. Fixed effect model, viz panel data analysis is adopted to establish the findings. The findings indicate that adoption of IFRS in Nigeria results in an inverse relationship with accounting performance in determining the CEO compensation after controlling for firm and corporate governance mechanism. However, the adoption of IFRS shows significant positive influence on the CEO pay. This result has policy implication, which encourages the regulatory agencies like Central Bank of Nigeria to monitor the compliance of all banks in Nigeria to the IFRS adoption.

Innovating Banks and Local Lending
Bostandzic, Denefa,Weiss, Gregor N. F.
We study the effects of financial and technological innovation by banks on local competition for deposits and credit supply. Banks that innovate increase their local market power by gaining deposits in a zero sum game at the expense of local non-innovating competitors. Innovative banks make use of both the additional liquidity as well as process innovations itselves and expand aggregate local mortgage lending. Banks allocate their additional funding efficiently with loan performance improving for banks that innovate. We employ two instrumental variable approaches that relate the number of patents awarded to a bank holding company to the human capital available to the bank as well as to the leniency of patent examiners to identify the causal effect of bank innovation on deposits and lending.

Macroprudential Policy: Results from a Tabletop Exercise
Duffy, Denise J.,Haubrich, Joseph G.,Kovner, Anna,Musatov, Alex,Prescott, Edward S.,Rosen, Richard J.,Tallarini, Thomas D.,Vardoulakis, Alexandros,Yang, Emily,Zlate, Andrei
This paper presents a tabletop exercise designed to analyze macroprudential policy. Several senior Federal Reserve officials were presented with a hypothetical economy as of 2020:Q2 in which commercial real estate and nonfinancial debt valuations were very high. After analyzing the economy and discussing the use of monetary and macroprudential policy tools, participants were then presented with a hypothetical negative shock to commercial real estate valuations that occurred in the second half of 2020. Participants then discussed the use of the tools during an incipient downturn. Some of the findings of the exercise were that during an asset boom, there were limits to the effectiveness of U.S. macroprudential tools in controlling narrow risks and that changes to the fed funds rate may not always simultaneously meet macroeconomic and financial stability goals. Some other findings were that during a downturn, it would be desirable to use high-frequency indicators for deciding when to release the countercyclical capital buffer (CCyB) and that tensions exist between microprudential and macroprudential goals when using the CCyB and the stress test.

Mixed Signals: Investment Distortions with Adverse Selection
Darst, Matthew,Refayet, Ehraz
We study how adverse selection distorts equilibrium investment allocations in a Walrasian credit market with two-sided heterogeneity. Representative investor and partial equilibrium economies are special cases where investment allocations are distorted above perfect information allocations. By contrast, the general setting features a pecuniary externality that leads to trade and investment allocations below perfect information levels. The degree of heterogeneity between informed agents' type governs the direction of the distortion. Moreover, contracts that complete markets dampen the impact of pecuniary externalities and change equilibrium distortions. Implications for empirical design in credit market studies and financial stability are discussed.

Modelling Transaction Costs When Trades May Be Crowded: A Bayesian Network Using Partially Observable Orders Imbalance
Briere, Marie,Lehalle, Charles‐Albert,Nefedova, Tamara,Raboun, Amine
Using a large database of US institutional investors’ trades in the equity market, this paper explores the effect of simultaneous executions on trading cost. We design a Bayesian network modelling the inter-dependencies between investors’ transaction costs, stock characteristics (bid-ask spread, turnover and volatility), meta-order attributes (side and size of the trade) and market pressure during execution, measured by the net order flow imbalance of investors meta-orders. Unlike standard machine learning algorithms, Bayesian networks are able to account for explicit inter-dependencies between variables. They also prove to be robust to missing values, as they are able to restore their most probable value given the state of the world. Order flow imbalance being only partially observable (on a subset of trades or with a delay), we show how to design a Bayesian network to infer its distribution and how to use this information to estimate transaction costs. Our model provides better predictions than standard (OLS) models. The forecasting error is smaller and decreases with the investors' order size, as large orders are more informative on the aggregate order flow imbalance R2 increases out-of-sample from -0.17% to 2.39% for the smallest to the largest decile of order size). Finally, we show that the accuracy of transaction costs forecasts depends heavily on stock volatility, with a coefficient of 0.78.

On the Stability of Portfolio Selection Models
Cesarone, Francesco,Mottura, Carlo,Ricci, Jacopo Maria,Tardella, Fabio
One of the main issues in portfolio selection models consists in assessing the effect of the estimation errors of the parameters required by the models on the quality of the selected portfolios. Several studies have been devoted to this topic for the minimum variance and for several other minimum risk models. However, no sensitivity analysis seems to have been reported for the recent popular Risk Parity diversification approach, nor for other portfolio selection models requiring maximum gain-risk ratios.Based on artificial and real-world data, we provide here empirical evidence showing that the Risk Parity model is always the most stable one in all the cases analyzed. Furthermore, the minimum risk models are typically more stable than the maximum gain-risk models, with the minimum variance model often being the preferable one.

Predicting Earnings Surprises
Snow, Derek
Nonlinear classification models, using just pricing and earnings information, can with great success predict future earnings surprises. Surprises that deviates 15% or more can be predicted with 71% accuracy. These predictions can be used to earn abnormal profits. A machine learning regression model that incorporates pricing, analyst forecasts and earnings information provides a better forecast of future earnings per share than consensus analyst forecasts and mechanical time-series models; with errors as much as 46% lower than analysts over certain periods. The machine learning model uses signal-processed and earnings-related variables. Some of these variables have been noted in past research to be related to analyst bias. The machine learning model in effect corrects for analyst mistakes and biases by incorporating these variables into a nonlinear prediction model that lowers the overall forecast error for all periods concerned. Machine learning models aid the identification of analyst biases by identifying variables that are important in predicting earnings over and above analysts' consensus forecast.

Reach for Yield by U.S. Public Pension Funds
Lu, Lina,Pritsker, Matthew,Zlate, Andrei,Anadu, Kenechukwu,Bohn, James
This paper studies whether U.S. public pension funds reach for yield by taking more investment risk in a low interest rate environment. To study funds’ risk-taking behavior, we first present a simple theoretical model relating risk-taking to the level of risk-free rates, to their underfunding, and to the fiscal condition of their state sponsors. The theory identifies two distinct channels through which interest rates and other factors may affect risk-taking: by altering plans’ funding ratios, and by changing risk premia. The theory also shows the effect of state finances on funds’ risk-taking depends on incentives to shift risk to state debt holders. To study the determinants of risk-taking empirically, we create a new methodology for inferring funds’ risk from limited public information on their annual returns and portfolio weights for the interval 2002-2016. In order to better measure the extent of underfunding, we revalue funds’ liabilities using discount rates that better reflect their risk. We find that funds on average took more risk when risk-free rates and funding ratios were lower, which is consistent with both the funding ratio and the risk premia channels. Consistent with risk-shifting, we also find more risk-taking for funds affiliated with state or municipal sponsors with weaker public finances. We estimate that up to one-third of the funds’ total risk was related to underfunding and low interest rates at the end of our sample period.

Reach for Yield by U.S. Public Pension Funds
Lu, Lina,Pritsker, Matt,Zlate, Andrei,Anadu, Kenechukwu,Bohn, James
This paper studies whether U.S. public pension funds reach for yield by taking more investment risk in a low interest rate environment. To study funds' risk-taking behavior, we first present a simple theoretical model relating risk-taking to the level of risk-free rates, to their underfunding, and to the fiscal condition of their state sponsors. The theory identifies two distinct channels through which interest rates and other factors may affect risk-taking: by altering plans' funding ratios, and by changing risk premia. The theory also shows the effect of state finances on funds' risk-taking depends on incentives to shift risk to state debt holders. To study the determinants of risk-taking empirically, we create a new methodology for inferring funds' risk from limited public information on their annual returns and portfolio weights for the interval 2002-2016. In order to better measure the extent of underfunding, we revalue funds' liabilities using discount rate s that better reflect their risk. We find that funds on average took more risk when risk-free rates and funding ratios were lower, which is consistent with both the funding ratio and the risk-premia channels. Consistent with risk-shifting, we also find more risk-taking for funds affiliated with state or municipal sponsors with weaker public finances. We estimate that up to one-third of the funds' total risk was related to underfunding and low interest rates at the end of our sample period.

Self Organizing Supply Chains for Micro-Prediction: Present and Future uses of the ROAR Protocol
Peter Cotton

A multi-agent system is trialed as a means of crowd-sourcing inexpensive but high quality streams of predictions. Each agent is a microservice embodying statistical models and endowed with economic self-interest. The ability to fork and modify simple agents is granted to a large number of employees in a firm and empirical lessons are reported. We suggest that one plausible trajectory for this project is the creation of a Prediction Web.

Smart Beta: The Good, the Bad and the Muddy
White, James,Haghani, Victor
This note describes the background of Factor investing in its Smart Beta form, and discusses the reasons Factor investing has become a popular investing style. We also discuss a number of reasons for skepticism regarding forward-looking expected returns.

Stress Testing Effects on Portfolio Similarities Among Large Us Banks
Bräuning, Falk,Fillat, Jose L.
We use an expansive regulatory loan-level dataset to analyze how the portfolios of the largest US banks have evolved since 2011. In particular, we analyze how the commercial and industrial and commercial real estate loan portfolios have changed in response to stress-testing requirements stipulated in the 2010 Dodd-Frank Act. We find that the largest US banks, which are subject to stress testing, have become more similar since the current form of the stress testing was implemented in 2011. We also find that banks with poor stress test results tend to adjust their portfolios in a way that makes them more similar to the portfolios of banks that performed well in the stress testing. In general, stress testing has resulted in more diversified bank portfolios in terms of sectoral and regional distributions. However, we also find that all the large US banks diversified in a similar way, creating a more concentrated systemic portfolio in the aggregate.

The Effect of Unconventional Monetary Policy on Cross‐Border Bank Loans: Evidence from an Emerging Market
Alper, Koray,Altunok, Fatih,Çapacıoğlu, Tanju,Ongena, Steven
We analyze the impact of quantitative easing by the Federal Reserve, European Central Bank and Bank of England on cross‐border credit flows. Relying on comprehensive loan‐level data, we find that Fed QE strongly boosts cross‐border credit granted to Turkish banks by banks located in the US, Euro Area and UK, while ECB and BoE QEs work only moderately through banks in the EA and UK, respectively. In general QE works at short maturities across bank locations and loan currencies, more strongly for weaker lenders and borrowers, and may have resulted in maturity mismatches in Turkish banks searching for yield.

The Exchange of Flow Toxicity
Easley, David,Lopez de Prado, Marcos,O'Hara, Maureen
Flow toxicity can be measured in terms of the probability that a liquidity provider is adversely selected by informed traders. In previous papers we introduced the concept of Volume-synchronized Probability of Informed Trading (the VPIN* metric), and provided a robust estimation procedure. In this study, we discuss the asymmetric impact that an incorrect estimation of the VPIN metric has on a market maker’s performance. This asymmetry may be part of the explanation for the evaporation of liquidity witnessed on May 6th 2010. To mitigate that undesirable behavior, we present the specifications of a VPIN contract, which could be used to hedge against the risk of higher than expected levels of toxicity, as well as to monitor such risk. Among other applications, it would also work as an execution benchmark, and a price discovery mechanism, since it allows for the externalization of market participants’ views of future toxicity.

The Impact of Credit Risk Mispricing on Mortgage Lending During the Subprime Boom
Kahn, James,Kay, Benjamin
We provide new evidence that credit supply shifts contributed to the U.S. subprime mortgage boom and bust. We collect original data on both government and private mortgage insurance premiums from 1999-2016, and document that prior to 2008, premiums did not vary across loans with widely different observable characteristics that we show were predictors of default risk. Then, using a set of post-crisis insurance premiums to fit a model of default behavior, and allowing for time-varying expectations about house price appreciation, we quantify the mispricing of default risk in premiums prior to 2008. We show that the flat premium structure, which necessarily resulted in safer mortgages cross-subsidizing riskier ones, produced substantial adverse selection. Government insurance maintained an even flatter premium structure even post-crisis, and consequently also suffered from adverse selection. But after 2008 it reduced its exposure to default risk through a combination of hi gher premiums and rationing at the extensive margin.

The Norway Model
Chambers, David,Dimson, Elroy,Ilmanen, Antti
The Norwegian Government Pension Fund Global was recently ranked the largest fund on the planet. It is also highly rated for its professional, low-cost, transparent, and socially responsible approach to asset management. Investment professionals increasingly refer to Norway as a model for managing financial assets. We present and evaluate the strategies followed by the Fund, review long-term performance, and describe how it responded to the financial crisis. We conclude with some lessons that investors can draw from Norway’s approach to asset management, contrasting the Norway Model with the Yale Model.

The cyclicality of loan loss provisions under three different accounting models: the United Kingdom, Spain, and Brazil
A. M. B. Araujo,P. R. B. Lustosa

A controversy involving loan loss provisions in banks concerns their relationship with the business cycle. While international accounting standards for recognizing provisions (incurred loss model) would presumably be pro-cyclical, accentuating the effects of the current economic cycle, an alternative model, the expected loss model, has countercyclical characteristics, acting as a buffer against economic imbalances caused by expansionary or contractionary phases in the economy. In Brazil, a mixed accounting model exists, whose behavior is not known to be pro-cyclical or countercyclical. The aim of this research is to analyze the behavior of these accounting models in relation to the business cycle, using an econometric model consisting of financial and macroeconomic variables. The study allowed us to identify the impact of credit risk behavior, earnings management, capital management, Gross Domestic Product (GDP) behavior, and the behavior of the unemployment rate on provisions in countries that use different accounting models. Data from commercial banks in the United Kingdom (incurred loss), in Spain (expected loss), and in Brazil (mixed model) were used, covering the period from 2001 to 2012. Despite the accounting models of the three countries being formed by very different rules regarding possible effects on the business cycles, the results revealed a pro-cyclical behavior of provisions in each country, indicating that when GDP grows, provisions tend to fall and vice versa. The results also revealed other factors influencing the behavior of loan loss provisions, such as earning management.

Time Variation in the News-Returns Relationship
Glasserman, Paul,Li, Fulin,Mamaysky, Harry
We find that the well-documented underreaction of stock prices to news exhibits substantial time variation, and we use this time variation to investigate the nature of the underreaction. The risk-bearing capacity of financial intermediaries and the degree of passive ownership of stocks are important conditioning variables for how contemporaneous and future prices respond to news. Once we control for likely institutional trading motives, we find the surprising result that stock prices overreact to news. Changing informativeness of news explains a portion but not all of the time variation in the news-returns relationship. The particular association of entropy, a text-based measure of news informativeness, with the news-returns relationship supports our interpretation that strategic institutional trading induces persistent price moves in response to news.

Using Patent Capital to Estimate Tobin's q
Woeppel, Michael
I develop a new proxy for Tobin's q that incorporates patent capital. This proxy, which I call PI (physical plus intangible) q, explains between 30% and 87% more of the variation in firm-level investment than two commonly-used proxies for q. PI q's relative outperformance is stronger in industries and time periods with more intangible capital. When using PI q, (i) the elasticity of investment with respect to q, which previous work has found to be puzzlingly low, is higher; and (ii) the positive investment-cash flow relation among young firms and small firms, which has been interpreted as evidence of financing constraints, mostly disappears. Overall, my results provide new evidence supporting the q theory of investment.

Variable Annuities: Underlying Risks and Sensitivities
Chahboun, Imad,Hoover, Nathaniel
This paper presents a quantitative model designed to understand the sensitivity of variable annuity (VA) contracts to market and actuarial assumptions and how these sensitivities make them a potentially important source of risk to insurance companies during times of stress. VA contracts often include long dated guarantees of market performance that expose the insurer to multiple nondiversifiable risks. Our modeling framework employs a Monte Carlo simulation of asset returns and policyholder behavior to derive fair prices for variable annuities in a risk neutral framework and to estimate sensitivities of reserve requirements under a real-world probability measure. Simulated economic scenarios are applied to four hypothetical insurance company VA portfolios to assess the sensitivity of portfolio pricing and reserve levels to portfolio characteristics, modelling choices, and underlying economic assumptions. Additionally, a deterministic stress scenario, modeled on Japan beginning in the mid-90s, is used to estimate the potential impact of a severe, but plausible, economic environment on the four hypothetical portfolios. The main findings of this exercise are: (1) interactions between market risk modeling assumptions and policyholder behavior modeling assumptions can significantly impact the estimated costs of providing guarantees, (2) estimated VA prices and reserve requirements are sensitive to market price discontinuities and multiple shocks to asset prices, (3) VA prices are very sensitive to assumptions related to interest rates, asset returns, and policyholder behavior, and (4) a drawn-out period of low interest rates and asset underperformance, even if not accompanied by dramatic equity losses, is likely to result in significant losses in VA portfolios.

When Trading Options is Not the Only Option: The Effects of Single-Stock Futures Trading on Options Market Quality
Jiang, George J.,Shimizu, Yoshiki,Strong, Cuyler
The literature documents that the short selling ban during the financial crisis led to a significant deterioration of options market quality, measured by bid-ask spreads and put-call parity violations. We examine the impact of single-stock futures (SSFs) trading on option market quality. We find a reduction in options trading volume during the ban period for banned stocks with SSFs trading. However, we show that these stocks had significantly narrower option bid-ask spreads relative to optionality and were less likely to have violations of put-call parity than those without SSFs during the ban period. Our results suggest that SSFs trading served as a substitute for options trading when the short selling ban was in effect. Moreover, SSFs trading improves options market quality in the face of short selling constraints.

Who Bears the Brunt? The Impact of Banking Crises on Younger and Older Workers
Van Dijk, Mathijs A.,van Dalen, Hendrik P.,Hyde, Martin
How do young and old workers fare on the labor market when a banking crisis occurs? Using data on 41 banking crises in 38 developed countries over 1990-2014, we examine how banking crises affect the labor market position of workers from five different age groups (including 65 years and older) and whether employment protection legislation shields workers from unemployment. Results show that unemployment increases across the board in the aftermath of banking crises, but much more so for younger workers. The labor force participation of older women increases significantly in the medium run, whereas older men withdraw from the labor market. Countries with strong employment protection legislation shield workers from the impact of banking crises in the short run, but show signs of increases in unemployment rates for young and middle-aged workers in the medium run.