Research articles for the 2019-07-19

An Investigation of Tracking Errors of Leveraged and Inverse Etfs in Taiwan
Huang, Han-Ching,Tsai, Lin Jiun
The purpose of this paper is to investigate the tracking error of leveraged and inverse ETFs. Single-day tracking performances of the Taiwan 50 Bull 2X ETF and Taiwan 50 Bear -1X ETF were tested to investigate whether there are structural changes of tracking performances during the bull and bear markets. The result shows that single-day performances of the two ETFs are significantly different from their targets. The positive and negative effects of single-day performance are asymmetric. When the market moves from bull to bear, there is a structural change in the two ETFs’ returns. Nonetheless, there is a structural change only in Taiwan 50 Bear -1X ETF returns when the market moves from bear to bull.

Back to the Real Economy: The Effects of Risk Perception Shocks on the Term Premium and Bank Lending
Bluwstein, Kristina,Yung, Julieta
We develop a dynamic stochastic general equilibrium framework that can account for important macroeconomic and financial moments, given Epstein-Zin preferences, heterogeneous banking and third-order approximation methods that yield a time-varying term premium that feeds back to the real economy. A risk perception shock increases term premia, lowers output, and reduces short-term credit in the private sector in response to higher loan rates and constrained borrowers, as banks rebalance their portfolios. A ‘bad’ credit boom, driven by investors mispricing risk, leads to a more severe recession and is less supportive of economic growth than a ‘good’ credit boom based on fundamentals.

Bank Profitability, Leverage Constraints, and Risk-Taking
Martynova, Natalya,Ratnovski, Lev,Vlahu, Razvan
Traditional theory suggests that higher bank profitability (or franchise value) dissuades bank risk-taking. We highlight an opposite effect: higher profitability loosens bank borrowing constraints. This enables profitable banks to take risk on a larger scale, inducing risk-taking. This effect is more pronounced when bank leverage constraints are looser, or when new investments can be financed with senior funding (such as repos). The model's predictions are consistent with some notable cross-sectional patterns of bank risk-taking in the run-up to the 2008 crisis.

Banks' Holdings of Risky Sovereign Bonds in the Absence of the Nexus: Yield Seeking with Central Bank Funding or De-Risking?
Frey, Rainer,Weth, Mark Andreas
For the largest 55 German banks, we detect the presence of countercyclical yield seeking in the form of acquisition of high-yielding periphery bonds in the period from Q1 2008 to Q2 2011. This investment strategy is pursued by banks not subject to a bailout, banks characterised by high capitalisation, banks that rely on short-term wholesale funding, and trading banks. In the subsequent period up to 2014, these banks switched to a procyclical divestment strategy resulting in the sale of risky assets. Following the launch of the public sector purchase programme (PSPP) in 2015, a clear investment pattern can no longer be identified. Unlike existing evidence for banks domiciled in vulnerable countries, we find that the recourse to central bank finance is rather limited and does not affect the risk-taking behaviour of banks in the non-stressed country Germany. Yield-seeking strategies were predominantly pursued by healthy banks in Germany. This contrasts with the increases in domestic sovereign holdings in vulnerable countries which can be primarily regarded as the result of moral suasion or, for weakly capitalised banks, a kind of "indirect" moral suasion or "home-biased" gambling for resurrection.

Credit Default Swaps and Corporate Bond Trading
Czech, Robert
Using regulatory data on CDS holdings and corporate bond transactions, I provide evidence for a liquidity spillover effect from CDS to bond markets. Bond trading volumes are larger for investors with CDS positions written on the debt issuer, in particular around rating downgrades. I use a quasi-natural experiment to validate these findings. I also provide causal evidence that CDS mark-to-market losses lead to fire sales in the bond market. I instrument for the prevalence of mark-to-market losses with the fraction of non-centrally cleared CDS contracts of an individual counterparty. The monthly corporate bond sell volumes of investors exposed to large mark-to-market losses are three times higher than those of unexposed counterparties. Returns decrease by more than 100 bps for bonds sold by exposed investors, compared to same-issuer bonds sold by unexposed investors. My findings underline the risk of a liquidity spiral in the credit market.

Global Downside Risk and Equity Returns
Atilgan, Yigit,Bali, Turan G.,Demirtas, K. Ozgur,Gunaydin, A. Doruk
This paper reexamines the relation between various downside risk measures and future equity returns in a global context that spans 26 developed markets. We find that there is no significantly positive relation between systematic downside risk and the cross-section of equity returns, and in fact, this relation is mostly negative. Moreover, stock-specific risk measures such as lower partial moment or extreme left tail risk measures such as value-at-risk and expected shortfall have a negative predictive relation with future equity returns. These negative relations are weaker but still observable for value-weighted portfolios. Focusing on additional test assets indicates a significantly negative relation between downside risk and future returns at the portfolio level whereas this relation is flat at the equity index level.

Insider Trading, Macroeconomic Risk and Network Theory
Romano, Alessandro
A company insider possessing material nonpublic information can profit by trading in the stocks of her company. Moreover, since in an interconnected economy shocks propagate from one firm to another, she can also profit by trading in stocks of connected firms (e.g. suppliers and customers). In this article, I will show that these “network trades” create a moral hazard problem because they allow insiders to profit from risk-creation. In particular, by investing in a riskier project an insider produces larger fluctuations in the stock price of her company and of the connected firms. She can then use her privileged position to obtain early information on the direction of these fluctuations and then profit by engaging in network trades. Most importantly, the insights from network theory reveal that risk creation is more profitable for insiders that operate in industries that have a larger impact on macroeconomic risk, and hence network trades can play a key role in increasing the overall level of risk to which the economy is exposed. Given the severity of the 2007-2009 crisis, this insight offers a new and powerful rationale for regulating trades made by insiders on private material information. In particular, I advocate a reform divided in two steps: In a first phase, disclosure of network trades should be mandated to investigate whether they are a pervasive phenomenon and whether they produce abnormal returns for the insiders. In a second phase, if the data suggests that network trades are indeed pervasive and lead to abnormal profits, the following reforms should be implemented: (i) network trades on private material information should be banned, at least in the most central sectors; (ii) the rule requiring insiders to disgorge short-term profits when trading in the stocks of their corporation should also be extended to network trades.

Interest Rate Risk in the Banking Book: Management with Discrete-time Affine â„š Term Structure Models
Bloechlinger, Andreas
I present an analytical valuation model for the management of fixed-income instruments traded in imperfectly competitive markets, like non-maturity deposits and credit card loans in the banking book, inter alia, to stabilize the profit margin. Banking book instruments contain embedded options such as withdrawal rights, discretionary pricing and zero-based floors. Analytical solutions speed up computation time to calculate valuations, earnings and risk measures like closed-form expressions for margin spreads, hedge ratios and parameter sensitivities to derive management actions. Asymptotically, according to martingale central limit theorems and thanks to the long-term nature of the banking book, Gaussian approximations can be applied.

Investor Relations and IPO Performance
Chahine, Salim,Colak, Gonul,Hasan, Iftekhar,Mazboudi, Mohamad
We analyze the value of investor relations (IR) strategies to IPO firms. We find that firms that are less visible and have inexperienced management tend to hire IR consultants prior to the issue date. IR consultants help create positive news coverage before an IPO event as reflected in a more optimistic tone of published media. Their presence is associated with higher underpricing at the IPO date but with lower long-run returns. IR-backed IPOs also exhibit disproportionately higher insiders-related agency problems, as IR-induced higher underpricing tends to occur primarily in IPOs where underwriter and venture capitalist agency conflicts are more severe. These findings suggest that the IR programs of IPO firm are mostly short-term oriented and tend to facilitate the ulterior motives of some insiders (underwriters and venture capitalists) targeting higher first-day returns.

Modelling the Distribution of Mortgage Debt
Levina, Iren,Sturrock, Robert,Varadi, Alexandra,Wallis, Gavin
This paper presents an approach to modelling the flow and the stock of mortgage debt, using loanâ€'level data. Our approach allows us to consider different macroeconomic scenarios for the housing market, lenders’ and borrowers’ behaviour, and different calibrations of macroprudential policy interventions in a consistent way. This, in turn, allows us to take a forward-looking view about potential risks stemming from the distribution of mortgage debt, as well as assess the impact of potential macroprudential policies in a forwardâ€'looking manner.

Non-Concave Utility Maximization without the Concavification Principle
Dai, Min,Kou, Steven,Qian, Shuaijie,Wan, Xiangwei
The problems of non-concave utility maximization appear in many areas of finance and economics, such as in behavior economics, incentive schemes, aspiration utility, and goal-reaching problems. Existing literature solves these problems using the concavification principle. We provide a framework for solving non-concave utility maximization problems, where the concavification principle may not hold and the utility functions can be discontinuous. In particular, we find that adding bounded portfolio constraints, which makes the concavification principle invalid, can significantly affect economic insights in the existing literature. Theoretically, we give a new definition of viscosity solution and show that a monotone, stable, and consistent finite difference scheme converges to the solution of the utility maximization problem.

On Buybacks, Dilutions, Dividends, and the Pricing of Stock-Based Claims
Backwell, Alex,McWalter, Thomas,Ritchken, Peter H.
We develop a structural model of the firm that allows after-interest cash to be directed to dividends, buybacks or some combination thereof. We study the effects of dilutions and buybacks on the value of the firm's claimants and on options written on the stock. We distinguish between options on equity and options on individual shares and value both types. We examine employee stock options and establish how their value changes in accordance with changing payout policies. Our model allows us to quantify and analyze the wealth transfer that occurs from shareholders to holders of employee stock-based contingent claims.

Security Design and Credit Rating Risk in the CLO Market
Vink, Dennis,Nawas, Mike,van Breemen, Vivian
In this paper, we empirically explore the effect of the complexity of a security’s design on hypotheses relating to credit rating shopping and rating catering in the collateralized loan obligation (CLO) market in the period before and after the global financial crisis in 2007. We find that complexity of a CLO’s design is an important factor in explaining the likelihood that market participants display behaviors consistent with either rating shopping or rating catering. In the period prior to 2007, we observe for more complex CLOs a higher incidence of dual-rated tranches, which are more likely to have been catered by credit rating agencies to match each other. Conversely, in the period after 2007, for CLOs, it is more likely that issuers shopped for ratings, in particular opting for a single credit rating by Moody’s, not by S&P. Furthermore, contrary to what market participants might expect, investors do not value dual ratings more than single ratings in the determination of the offering yield at issuance. Looking at the explanatory power of credit ratings for a dual rated CLO, the degree to which investors increase their reliance on credit ratings depends to a large extent on the disclosure of an S&P rating, not Moody’s. This suggests that investors recognize credit rating risk by agency in pricing CLOs. In sum, the policy implication is that, to effectively regulate CLOs, the regulatory environment ought to differentiate between complex and non-complex CLOs.

Sorting, Selection, and Announcement Returns in Takeover Markets
Kawakami, Kei
We present a competitive model of takeovers that explains two robust features of the data: target premia and size-dependent bidder returns. Takeovers are driven by complementarity between two factors, non-tradeable "skill" and a tradeable "project". Firms are heterogeneous in both dimensions. After characterizing a condition under which positive assortative matching (PAM) of skill and projects occurs, we show that announcement returns identify stock market investorsípre-deal information about the firms. The two robust features are consistent with PAM if stock market investors know (i) only skill of firms or (ii) only stand-alone values of firms, before the deal announcements.

Stress Testing the German Mortgage Market
Barasinska, Nataliya,Haenle, Philipp,Koban, Anne,Schmidt, Alexander
This paper presents a framework for estimating losses in the residential real estate mortgage portfolios of German banks. We develop an EL model where LGD estimates are based on current collateral values and PD dynamics are estimated using a structural PVAR approach. We confirm empirically that foreclosure rates are rising with the unemployment rate and are inversely related to house price inflation. Being consistent with our expectation that strategic defaults do not play a central role given the full personal liability of German households, the results give broad support for the double-trigger hypothesis of mortgage defaults. In order to analyse the possible credit losses stemming from residential mortgage lending we then use the model to run a top-down stress test and simulate losses on the individual bank level for the years from 2018 to 2020 for the whole German banking sector. Our results show that loss rates in the residential mortgage portfolios of German banks do increase significantly in an adverse economic environment. The estimated expected losses are widely distributed in the banking system leading, on average, to a 0.4 percentage points reduction in the CET1 ratio over the simulation period.

System-Wide Stress Simulation
Aikman, David,Chichkanov, Pavel,Douglas, Graeme,Georgiev, Yordan,Howat, James,King, Benjamin
We present a model for assessing how the UK’s system of market-based finance â€" an increasingly important source of credit to the real economy since the financial crisis â€" might behave under stress. The core of this model is a set of representative agents, which correspond to key sectors of the UK’s financial system. These agents interact in asset, funding (repo), and derivatives markets and face a range of solvency and liquidity constraints on their behaviour. Our model generates ‘tipping points’ such that, if shocks are large, or if headroom relative to constraints is small, lower asset prices can cause solvency/liquidity constraints to bind, resulting in forced deleveraging and large endogenous illiquidity premia. We illustrate such an outcome via a stress scenario in which a deteriorating corporate sector outlook coincides with tighter leverage limits at key intermediaries. Our findings highlight the key role played by broker-dealers, commercial banks, investment funds and life insurers in shaping these dynamics.

The Effect of Tax Avoidance on Capital Structure Choices
Lee, Yoojin,Shevlin, Terry J.,Venkat, Aruhn
In this study, we examine whether tax avoidance affects firm-level external financing choices. We hypothesize that firms marginally choose equity over debt because tax avoidance generates incremental cash flows but is likely risky. Consequently, we predict that tax avoidance induces a relative price increase in debt relative to equity. Our results are consistent with tax avoidance inducing firms to choose equity over debt. Importantly, our theory and results are distinct from the effects of marginal tax rates on capital structure (e.g., Modigliani and Miller 1963) and we control for marginal tax rates in all specifications. From an identification standpoint, we use path analyses, a plausibly exogenous 9th Circuit decision and cross-sectional tests to support our main results. To our knowledge, our study is the first to examine the relationship between capital structure decisions and tax avoidance.

Who Trusts Insurance? Empirical Evidence from Seven Industrialised Countries
Courbage, Christophe,Nicolas, Christina
While the importance of trust in insurance is widely recognised, surprisingly, existing literature on the determinants of trust in insurance remains scarce. This paper investigates the determinants of trust in insurance in seven industrialised countries in Europe, North America and Asia using data from a recent insurance industry survey. We find that trust in insurance is higher among females, younger individuals, and less educated people. On the contrary, people who are more insurance literate have higher trust in insurance. Our findings also show that experiences with insurance are one of the most important determinants of trust in insurance, with the negative effect of a bad experience being more pronounced than the positive effect of a good experience. Finally, access to information related to insurance through the internet deters trust in insurance, while access to information through newspapers and magazines promotes it.

Why Me? The Saga of Public Sector Banks under Prompt Corrective Action
Kaur, Navneet,Kaur, Parneet
This study explores Income and funding strategies of banks under Prompt Corrective action (PCA) and it also compares the Technical, Pure technical and scale efficiency of these banks with Public sector banks not under PCA and Private sector banks. This study found that PCA banks earn higher non-interest income and have higher borrowings than Non-PCA Public sector banks and are as efficient or inefficient as Non PCA-public sector banks. However, PCA banks are bigger in size and have lower Technical but higher Pure Technical and scale efficiencies than Private sector banks. This study highlights the concern of Dr. Viral V Acharya, regarding the unfinished agenda of restoring Public Sector banks’ health in India (R.K. Talwar Memorial Lecture) and not just the banks under PCA.

Why so Negative? Belief Formation in Boom and Bust Markets
Kieren, Pascal,Müller-Dethard, Jan,Weber, Martin
What determines investors’ risk-taking across macroeconomic cycles? Researchers have proposed rational expectations models that introduce countercyclical risk aversion to generate the empirically observed time-variation in risk-taking. In this study, we test whether systematic deviations from rational expectations can cause the same observed investment pattern without assuming unstable preferences. We let subjects form beliefs in an environment with exclusively positive (boom) or negative (bust) numbers, followed by an independent investment task. Those subjects who learned in the negative domain form overly pessimistic beliefs and invest significantly less in an unrelated ambiguous investment option. However, similar investment patterns cannot be observed for an unrelated risky investment option, where expectations are fixed. The proposed mechanism presents an alternative explanation for time-varying risk-taking and provides new implications for both theory and policy makers.