Research articles for the 2019-08-12

A Proposal for Multi-asset Generalised Variance Swaps
Subhojit Biswas,Diganta Mukherjee

This paper proposes swaps on two important new measures of generalized variance, namely the maximum eigen-value and trace of the covariance matrix of the assets involved. We price these generalized variance swaps for financial markets with Markov-modulated volatilities. We consider multiple assets in the portfolio for theoretical purpose and demonstrate our approach with numerical examples taking three stocks in the portfolio. The resultsobtained in this paper have important implications for the commodity sector where such swaps would be useful for hedging risk

Acquisitions and Funding Conditions
Becher, David,Jensen, Tyler,Liu, Tingting
We find evidence that aggregate funding conditions play an instrumental role in mergers and acquisitions. Funding conditions impact the benefits, participants and the number of deals transacted. Specifically, when funding is favorable, the merger market is especially active and small, financially-constrained firms participate heavily. These same firms, however, are largely shutout of the deal market when funding is tight. Furthermore, investors view deals during favorable environments as relatively attractive, particularly if the deals are initiated by small bidders. In contrast, deals transacted by large firms during easy-money periods are viewed as value-destroying, which we document to be linked to the presence of agency costs.

An Instantaneous Market Volatility Estimation
Danyliv, Oleh,Bland, Bruce
Working on different aspects of algorithmic trading we empirically discovered a new market invariant. It links together the volatility of the instrument with its traded volume, the average spread and the volume in the order book. The invariant has been tested on different markets and different asset classes. In all cases we did not find significant violation of the invariant. The formula for the invariant was used for the volatility estimation, which we called the instantaneous volatility. Quantitative comparison showed that it reproduces realised volatility better than one-day-ahead GARCH (1,1) prediction. Because of the short-term prediction nature, the instantaneous volatility could be used by algo developers, volatility traders and other market professionals.

Anomalous Diffusions in Option Prices: Connecting Trade Duration and the Volatility Term Structure
Jacquier, Antoine (Jack),Torricelli, Lorenzo
Anomalous diffusions arise as scaling limits of continuous-time random walks (CTRWs) whose innovation times are distributed according to a power law. The impact of a non-exponential waiting time does not vanish with time and leads to different distribution spread rates compared to standard models. In financial modelling this has been used to accommodate for random trade duration in the tick-by-tick price process. We show here that anomalous diffusions are able to reproduce the market behaviour of the implied volatility more consistently than usual Levy or stochastic volatility models.We focus on two distinct classes of underlying asset models, one with independent price innovations and waiting times, and one allowing dependence between these two components. These two models capture the well-known paradigm according to which shorter trade duration is associated with higher return impact of individual trades. We fully describe these processes in a semimartingale setting leading no-arbitrage pricing formulae, and study their statistical properties. We observe that skewness and kurtosis of the asset returns do not tend to zero as time goes by. We also characterize the large-maturity asymptotics of Call option prices, and find that the convergence rate is slower than in standard Levy regimes, which in turn yields a declining implied volatility term structure and a slower decay of the skew.

Are International Banks Different? Evidence on Bank Performance and Strategy
Bertay, Ata Can,Demirgüç-Kunt, Asli,Huizinga, Harry
This paper provides evidence on how bank performance and strategies vary with the degree of bank internationalization, using data for 113 countries over 2000-15. Over this period, bank internationalization is associated with lower valuations and lower returns on equity. However, developing country banks that internationalized seem to have fared better than their high-income counterparts. Following the crisis, international banks were revalued particularly if they had stable funding in the form of deposits and if they had more generous deposit insurance coverage. Furthermore, for international banks headquartered in developing countries, our results indicate that bank internationalization reduces the cyclicality of their domestic credit growth with respect to home country gross domestic product growth, smoothing local downturns. In contrast, if the international bank is from a high-income country investing in a developing country, its lending is relatively procyclical, which can be destabilizing.

Behaving Optimally in Solar Renewable Energy Certificate Markets
Arvind Shrivats,Sebastian Jaimungal

SREC markets are a relatively novel market-based system to incentivize the production of energy from solar means. A regulator imposes a floor on the amount of energy each regulated firm must generate from solar power in a given period and provides them with certificates for each generated MWh. Firms offset these certificates against the floor and pay a penalty for any lacking certificates. Certificates are tradable assets, allowing firms to purchase/sell them freely. In this work, we formulate a stochastic control problem for generating and trading in SREC markets from a regulated firm's perspective. We account for generation and trading costs, the impact both have on SREC prices, provide a characterization of the optimal strategy, and develop a numerical algorithm to solve this control problem. Through numerical experiments, we explore how a firm who acts optimally behaves under various conditions. We find that an optimal firm's generation and trading behaviour can be separated into various regimes, based on the marginal benefit of obtaining an additional SREC, and validate our theoretical characterization of the optimal strategy. We also conduct parameter sensitivity experiments and conduct comparisons of the optimal strategy to other candidate strategies.

CEO Educational Background and Acquisition Targets Selection
Wang, Ye (Emma),Yin, Sirui
Using hand-collected CEO education data of 3574 CEOs over the period of 2000 to 2015, we document that CEOs are significantly more likely to acquire targets that are headquartered in those states where the CEOs received their undergraduate and graduate degrees. Education-state deals are larger, have higher completion rates, and exist with both public and private targets. Acquirers pay a lower target premium for education-state deals and the cumulative abnormal announcement returns are positive. The combined evidence suggests that education-state acquisitions are more likely to be driven by bidder CEO's information advantage toward firms headquartered in the education state.

Complexity of ECB Communication and Financial Market Trading
Hayo, Bernd,Henseler, Kai,Rapp, Marc Steffen
We examine how the verbal complexity of ECB communications affects financial market trading based on high-frequency data from European stock index futures trading. Studying the 34 events between May 2009 and June 2017, during which the ECB Governing Council press conferences covered unconventional monetary policy measures, and using the Flesch-Kincaid Grade Level to measure the verbal complexity of introductory statements to the press conferences, we find that more complex communications are associated with a lower level of contemporaneous trading. Increasing complexity of introductory statements leads to a temporal shift of trading activity towards the subsequent Q&A session, which suggests that Q&A sessions facilitate market participants’ information processing.

Determinants of Good Governance Practices: The Role of Board Independence
Melón-Izco, Álvaro,Ruiz-Cabestre, Francisco J.,Ruiz-Olalla, Carmen
This study contributes to broadening our knowledge of the corporate governance of firms. In particular, we consider board independence as a fundamental variable in the explanation of good governance practices. For this purpose, we analyse the Annual Corporate Governance Reports of the Spanish listed companies on the Continuous Market of the Madrid Stock Exchange during the period 2010-2016. The results for all companies reveal that firm size, ownership dispersion and board independence have a positive relationship with good practices, and the relationship between board independence and good governance practices is moderated by ownership dispersion. When we distinguish between firms that comply with board independence recommendation and those that do not, however, the results differ substantially, in terms of sign, magnitude and significance level. This highlights the importance of board independence in explaining good governance practices.

Distortion or Cash Flow Management? Understanding Credit Facilities in Private Equity Funds
Schillinger, Pierre,Braun, Reiner,Cornel, Jeroen
Credit facilities in private equity, often referred to as “subscription lines” (SL), have become a topic of interest, sparking debates not only among researchers but also among practitioners. In this paper, we are the first to analyze their potential thoroughly by quantifying the impact on both final fund performance and fund rankings. In addition, we are the first to academically describe and explain the key terms of SL in detail. Based on our simulations, we find that standard SL have moderate effects on final fund performance as well as fund rankings and constitute mainly a cash flow management tool. However, if used more extensively, SL have the potential to increase time-sensitive return measures substantially and can thereby also alter fund rankings. Consequently, if not properly understood by investors, extended SL could distort future fundraising outcomes. In addition, the higher reported performance may mislead investors with regard to the BO industry’s true skill and return opportunities.

Does Business Strategy Affect Dividend Payout Policies?
Akindayomi, Akinloye,Amin, Md Ruhul
Purpose: The purpose of this study is to investigate whether corporate dividend payout policies of non-financial and non-utilities US public firms are affected by business strategy over the period from 1992 to 2017.Empirical methodology: We use a comprehensive measure of business strategy based on Miles and Snow’s (1978, 2003) theoretical framework, following Bentley et al. (2013). Based on Miles and Snow’s (1978, 2003) theoretical framework, we account for two endpoints (prospectors and defenders) of the business strategy continuum. To test our empirical predictions, we use fixed-effect regression models.Findings: Firms following an innovation-oriented business strategy (prospectors) tend to pay less dividend than firms following a cost-effective business strategy (defender). We provide evidence of a link between business strategy and corporate dividend payout policies. Especially, compared with defenders, prospectors are likely to delay in dividend initiation process and hold a current level of dividend payment. We argue that this cross-sectional difference in dividend payment is attributed to a higher degree of operating cash flow volatility. We also show that this difference is subject to financial constraint, stock market liquidity, and tax uncertainty.Contribution: We show a link that helps investors’ ability to predict the expected dividend. We contribute to work on business strategy and its impact on corporate finance: corporate financial reporting, tax planning practices, and corporate social responsibility among others.

Does Institutional Trading Affect Underwriting
Anand, Amber,Irvine, Paul J.,Liu, Tingting
This paper investigates the impact of institutional trading on SEO lead underwriter choice. We measure the trading intensity of the lead investment bank in several different ways and find that bank trading has a significant effect on underwriter choice. A bank that concentrates its trading in particular stocks has an improved probability of earning the underwriting mandate in those stocks. We also find that the trading intensity of the lead bank has a significant effect on SEO underpricing and the composition of the underwriting syndicate. We attribute these results to the fact that banks that are large and active traders in an issuer’s stock have a competitive advantage in accessing the current shareholder base. For smaller banks, we show that concentrating the bank’s own trading in the issuer’s stock produces similar effects.

Economic Integration and the Currency and Equity Markets Nexus
Aftab, Muhammad,Ahmad, Rubi,Ismail, Izlin,Phylaktis, Kate
The paper examines the impact of economic integration on the relationship between the currency and equity markets for a group of Asian emerging economies using both linear and non- linear frameworks. We first derive the dynamic conditional correlations between the two markets and then examine the impact of economic integration on their relationship. Our main results are: (i) there is a negative correlation between real exchange rate changes and equity return differentials for all countries apart from China, which becomes deeper during the GFC for some of the countries; (ii) economic integration, both real and financial, has an asymmetric impact on the relationship between the two markets both in the short-run and in the long-run; and (iii) applying a linear framework does not bring out the impact of financial integration.

Equity Portfolio Diversification With High Frequency Data
Alexeev, Vitali,Dungey, Mardi H.
Investors wishing to achieve a particular level of diversification may be misled on how many stocks to hold in a portfolio by assessing the portfolio risk at different data frequencies. High frequency intradaily data provide better estimates of volatility, which translate to more accurate assessment of portfolio risk. Using 5-minute, daily and weekly data on S&P500 constituents for the period from 2003 to 2011 we find that for an average investor wishing to diversify away 85% (90%) of the risk, equally weighted portfolios of 7 (10) stocks will suffice, irrespective of the data frequency used or the time period considered. However, to assure investors of a desired level of diversification 90% of the time (in contrast to on average), using low frequency data results in an exaggerated number of stocks in a portfolio when compared with the recommendation based on 5-minute data. This difference is magnified during periods when financial markets are in distress, as much as doubling during the 2007-2009 financial crisis.

Exchange Rate Risk Exposure and the Value of European Firms
Parlapiano, Fabio,Alexeev, Vitali,Dungey, Mardi H.
This paper presents a new assessment of the exposure of European firms to exchange rate fluctuations which takes into account the potential common drivers of exchange rates and equity market conditions. Using monthly data for European firms from 1999 to 2011 we assess the impact of unexpected fluctuations in the USD, JPY, GBP and CHF against the Euro, and show that the proportion of firms subject to exchange rate risk is considerably larger when estimation accounts for potential common drivers and firm specific factors than otherwise. Firm exposure to exchange rate risk is affected by the level of international involvement, industry, firm size and country of origin. European firms with largely domestic operations reveal the greatest vulnerability to unexpected exchange rate movements, suggesting an opportunity to improve risk management for these companies.

Factors Affecting the Value-Relevance of Capitalized Exploration and Evaluation Expenditures Under IFRS 6
Ferguson, Andrew,Kean, Stephen ,Pündrich, Gabriel
This study examines factors affecting the value-relevance of financial and non-financial disclosure in the context of the long contentious International Financial Reporting Standards (IFRS 6). Relative to the capitalization of R&D expenditures, IFRS 6 follows a far less restrictive approach, delaying the requirement for probable future economic benefits in settings of high uncertainty. We compare the value-relevance of this asset with that of non-financial information commonly reported by mining firms, namely mineral resource estimates. We report evidence that investors utilize non-financial information to assess the value-relevance of financial information, initially focusing on whichever information is timelier. We do not find evidence that investors prefer conservative reporting practices in a setting with high uncertainty; rather we provide evidence that investors interpret the capitalization decision as a signal of project viability. This finding is of particular relevance to the ongoing Intangible Assets project being conducted by the International Accounting Standards Board (IASB).

Failure and Success in Mergers and Acquisitions
Renneboog, Luc,Vansteenkiste, Cara
This paper provides an overview of the academic literature on the market for corporate control, and focuses specifically on firms’ performance around and after a takeover. Despite the aggregate M&A market amounting to several trillions USD on an annual basis, acquiring firms often underperform relative to non-acquiring firms, especially in public takeovers. Although hundreds of academic studies have investigated the deal- and firm-level factors associated with M&A announcement returns, short-run returns are often not sustained in the long run. Moreover, the wide variety of performance measures and heterogeneity in sample sizes complicates the drawing of accurate and unambiguous conclusions. In this light, our survey compiles the recent literature and aims to identify the areas of research for which short-run returns predict (or fail to predict) long-run performance. We find that post-takeover deal performance is affected by key determinants including serial acquisitions, CEO overconfidence, acquirer-target relatedness and complementarity, and shareholder intervention in the form of voting or activism.

Fast Training Algorithms for Deep Convolutional Fuzzy Systems with Application to Stock Index Prediction
Li-Xin Wang

A deep convolutional fuzzy system (DCFS) on a high-dimensional input space is a multi-layer connection of many low-dimensional fuzzy systems, where the input variables to the low-dimensional fuzzy systems are selected through a moving window across the input spaces of the layers. To design the DCFS based on input-output data pairs, we propose a bottom-up layer-by-layer scheme. Specifically, by viewing each of the first-layer fuzzy systems as a weak estimator of the output based only on a very small portion of the input variables, we design these fuzzy systems using the WM Method. After the first-layer fuzzy systems are designed, we pass the data through the first layer to form a new data set and design the second-layer fuzzy systems based on this new data set in the same way as designing the first-layer fuzzy systems. Repeating this process layer-by-layer we design the whole DCFS. We also propose a DCFS with parameter sharing to save memory and computation. We apply the DCFS models to predict a synthetic chaotic plus random time-series and the real Hang Seng Index of the Hong Kong stock market.

Financial Reporting Frequency and the Allocation of Investor Attention
De George, Emmanuel T.,Phan, Minh,Stoumbos, Robert C.
This study examines whether and how one firm’s choice of reporting frequency affects other firms. Using a setting where both semi-annual and quarterly reporting are allowed, we find that firms lose investor attention when more of their peers choose to report quarterly instead of semi-annually, and that such loss of attention is associated with a decrease in market value and in market liquidity. In additional analyses, we also examine a mandatory change in reporting frequency, and corroborate our main findings that firms lose attention when their peers report more frequently. Overall our evidence suggests that reporting frequency choices affect other firms by changing the allocation of investor attention and, in particular, that firms are negatively impacted when their peers choose to adopt a higher reporting frequency.

Firm Reputation and the Cost of Bank Debt
Wang, Ye (Emma)
This paper examines whether firm reputation impacts borrowing costs and thus investment. Using unique data from Fortune’s Most Admired Companies surveys, I find that more reputable borrowers enjoy lower borrowing costs and better loan contract terms: Relative to otherwise similar firms’ loans, Most Admired firms’ bank loans cost 26.7% less, have 11.8% fewer financial covenants, and are 5.4% less likely to be secured with collateral. My identification strategy is based on propensity score matching, a regression discontinuity design, and clean reputation measures removing the impact of prior financial performance. Operating performance increases more than expected after being recognized as a Most Admired Company, consistent with this reputation proxy containing important information on borrower credit risk. Last, firms increase capital expenditures and R&D after receiving the Most Admired designation, consistent with reputable firms exploiting their lower cost of capital and with reputation having real effects of firms’ investment policies.

Forecasting Recovery Rates on Non-Performing Loans with Machine Learning
Bellotti, Anthony,Brigo, Damiano,Gambetti, Paolo,Vrins, Frédéric D.
We compare the performances of a wide set of regression techniques and machine learning algorithms for predicting recovery rates on non-performing loans, using a private database from a European debt collection agency. We find that rule-based algorithms such as Cubist, boosted trees and random forests perform significantly better than other approaches. In addition to loan contract specificities, the predictors referring to the bank recovery process -- prior to the portfolio's sale to the debt collector -- are also proven to strongly enhance forecasting performances. These variables, derived from the time-series of contacts to defaulted clients and clients' reimbursements to the bank, help all algorithms to better identify debtors with different repayment ability and/or commitment, and in general with different recovery potential.

Government Guarantees and the Risk-Taking of Financial Institutions: Evidence from a Regulatory Experiment
Atanasova, Christina V.,Li, Mingxin,Mugerman, Yevgeny,Rastan, Mehrdad
The potential dark side of government guarantees, introduced to mitigate concerns about financial stability during economic downturns, is that they may create incentives for excessive risk-taking. In a low-interest rate environment, this effect maybe even stronger as financial institutions try to "reach for yield". In this paper, we use the 2008 introduction of unlimited deposit insurance for all credit unions in the province of British Columbia, Canada, to examine the effect of government guarantees on financial institutions' earnings uncertainty. We find that the policy change resulted in an economically and statistically significant decrease in earnings uncertainty. In addition, although deposits grew following the policy change, lending did not increase and instead capitalization ratios improved. Overall, our results suggest that the provincial government guarantee boosted depositor confidence and increased the flow of funds to the insured financial institutions. We do not find support for the risk-taking hypothesis but instead show that risk-management improved following the policy change. Finally, the effect of the policy change was stronger for smaller, more levered credit unions as well as those with fewer members and smaller market share.

Horizontal Industry Relationships and Return Predictability
Schlag, Christian,Zeng, Kailin
It has been documented that vertical customer-supplier links between industries are the basis for strong cross-sectional stock return predictability (Menzly and Ozbas (2010)). We show that robust predictability also arises from horizontal links between industries, i.e., from the fact that industries are competitors or offer products, which are substitutes for each other. These horizontally linked industries exhibit positively correlated fundamentals. The signal derived from this type of connectedness is the basis for significant alpha in sorted portfolio strategies, and informed investors take the related information into account when they form their portfolios. We thus provide evidence of return predictability based on a new type of economic links between industries not captured in previous studies.

Investor Attention Allocation and Portfolio Performance: What Information Does It Pay to Pay Attention To?
Davydov, Denis,Khrashchevskyi, Ian,Peltomäki, Jarkko
We explore a unique dataset on individual investors’ online trading accounts to examine the determinants of their attention allocation and its relation to portfolio performance. In particular, we investigate what individual characteristics affect investor attentiveness and what type of information drives investment performance. We find distinct differences in investors’ attentiveness and provide evidence that paying attention has differential impact on performance depending on the type of information. Portfolio monitoring and attention to financial literacy are positively related to performance, while attention to analytical information is detrimental to performance. Attention to technical analysis is also negatively related to performance for actively trading investors, but it is positively related to trading for other investors. Overall, our results provide additional evidence to suggest that attention to financial literacy rather than analytical information is the key for investment success.

Is the Financial System Sufficiently Resilient: A Research Programme and Policy Agenda
Tucker, Paul
FocusThe paper discusses why the financial system is not as resilient as policymakers currently claim - despite extensive regulatory reforms from a very weak starting point.ContributionThe paper discusses different policy strategies for making some of the debt of some banks "information-insensitive", so that they it would be treated as safe in all but the most stressed circumstances. For the current prudential strategy, which is centred on minimum equity requirements, the paper argues that central banks and other agencies should start publishing annual staff reports on where regulatory and supervisory policy has been surreptitiously tightened or loosened.FindingsThe paper aims to spark and contribute to the debate on the second phase of stability reforms that will be needed. It sets out an alternative policy strategy based on 100% liquidity cover for the short-term debt of banks (and shadow banks), and for the creditor hierarchy of operating banks and holding companies. In this proposal, the haircut policy of central banks would become the key instrument in determining bank equity requirements and the terms on which they could borrow in secured money markets. As such, this strategy would operationalise the theoretical and empirical work of Bengt Holmström and Gary Gorton.

Losers Distribution, With Applications to Financial Inclusion: Lightning Can Strike Twice, but It May Not Strike at All
Edwards, John H. Y.
In this paper I develop the new “Losers Distribution" and use it to build a financial instrument which partially solves the problem of financial exclusion. I design compensated lotteries that can mobilize and circulate the savings of people who do not participate in formal financial markets. The lottery which I propose entirely avoids problems of information asymmetry, default risk, and ethnic and gender discrimination in lending. I use the losers distribution to set lottery ticket prices so that only the financially excluded participate and to calculate the subsidy needed to sustain the lottery. I show that the lottery subsidy rate is low when compared to the subsidies of typical microfinance programs about the world.

Market Efficiency and Inefficiency: An Overview on the Adaptive Market Hypothesis
, Nang Biak Sing,Rajkumar, Giridhari
Academic research and financial trader during the past 50 years are unable to come to consent whether the capital market are efficient or not.The inconclusive and mixed result of the market efficiency and inefficiency gave the birth of new theories that reconcile the two schools of thought in a natural and satisfying conclusive manner. The theory called Adaptive market hypothesis (AMH) was propounded by Andrew Lo in 2004. The present paper explored the various literatures related to the efficient market hypothesis and had identified the various findings of the studies conducted. The paper aimed to identify the existing gap related to the study of the market efficiency by exploring the related literatures. The paper scrutinized the controversial EMH and explored the related literatures and has come out with the existing gap in understanding the market efficiency.

Measuring Contagion Risk in International Banking
Avdjiev, Stefan,Giudici, Paolo,Spelta, Alessandro
We propose a distress measure for national banking systems that incorporates not only banks' CDS spreads, but also how they interact with the rest of the global financial system via multiple linkage types. The measure is based on a tensor decomposition method that extracts an adjacency matrix from a multi-layer network, measured using banks' foreign exposures obtained from the BIS international banking statistics. Based on this adjacency matrix, we develop a new network centrality measure that can be interpreted in terms of a banking system's credit risk or funding risk.

Migrant Gender and the Venture Funding Impact of Remittances to Developing Countries
Cummings, Michael,Vaaler, Paul M.
There is substantial research on how women differ from men as new business (venture) founders, but little on how women may differ from men as venture funders. We respond with theory and evidence from an unconventional context: migrant remittances to developing countries. Analyses of remittances to 48 developing countries from 2001-2010 indicate that: 1) remittances increase home-country venture funding availability more when they come from diasporas with higher percentages of women; and 2) such gender-related effects are magnified for remittances to poorer developing countries where there is less gender inequality in employment opportunity and greater need for remittance-based venture investing.

Portfolio Optimization managing Value at Risk under heavy tail distribution
Subhojit Biswas,Mrinal K.Ghosh,Diganta Mukherjee

We consider an investor, whose portfolio consists of a single risky asset and a risk free asset, who wants to maximize his expected utility of the portfolio subject to managing the Value at Risk (VaR) assuming a heavy tailed distribution of the stock prices return. We use a stochastic maximum principle to formulate the dynamic optimisation problem. The equations which we obtain does not have any explicit analytical solution, so we look for accurate approximations to estimate the value function and optimal strategy. As our calibration strategy is non-parametric in nature, no prior knowledge on the form of the distribution function is needed. We also provide detailed empirical illustration using real life data. Our results show close concordance with financial intuition.We expect that our results will add to the arsenal of the high frequency traders.

Portfolio optimization while controlling Value at Risk, when returns are heavy tailed
Subhojit Biswas,Diganta Mukherjee

We consider an investor, whose portfolio consists of a single risky asset and a risk free asset, who wants to maximize his expected utility of the portfolio subject to the Value at Risk assuming a heavy tail distribution of the stock prices return. We use Markov Decision Process and dynamic programming principle to get the optimal strategies and the value function which maximize the expected utility for parametric as well as non parametric distributions. Due to lack of explicit solution in the non parametric case, we use numerical integration for optimization

Portfolio optimization with two coherent risk measures
Tahsin Deniz Aktürk,Çağın Ararat

We provide analytical results for a static portfolio optimization problem with two coherent risk measures. The use of two risk measures is motivated by joint decision-making for portfolio selection where the risk perception of the portfolio manager is of primary concern, hence, it appears in the objective function, and the risk perception of an external authority needs to be taken into account as well, which appears in the form of a risk constraint. The problem covers the risk minimization problem with an expected return constraint and the expected return maximization problem with a risk constraint, as special cases. For the general case of an arbitrary joint distribution for the asset returns, under certain conditions, we characterize the optimal portfolio as the optimal Lagrange multiplier associated to an equality-constrained dual problem. Then, we consider the special case of Gaussian returns for which it is possible to identify all cases where an optimal solution exists and to give an explicit formula for the optimal portfolio whenever it exists.

Price Equations with Symmetric Supply/Demand; Implications for Fat Tails
Caginalp, Carey,Caginalp, Gunduz
Implementing a set of microeconomic criteria, we develop price dynamics equations using a function of demand/supply with key symmetry properties. The function of demand/supply can be linear or nonlinear. The type of function determines the nature of the tail of the distribution based on the randomness in the supply and demand. For example, if supply and demand are normally distributed, and the function is assumed to be linear, then the density of relative price change has behavior xâˆ'2 for large x (i.e., large deviations). The exponent approaches âˆ'1 if the function of supply and demand involves a large exponent. The falloff is exponential, i.e., e-x, if the function of supply and demand is logarithmic.

Pricing American Options by Exercise Rate Optimization
Christian Bayer,Raúl Tempone,Sören Wolfers

We present a novel method for the numerical pricing of American options based on Monte Carlo simulation and the optimization of exercise strategies. Previous solutions to this problem either explicitly or implicitly determine so-called optimal exercise regions, which consist of points in time and space at which a given option is exercised. In contrast, our method determines the exercise rates of randomized exercise strategies. We show that the supremum of the corresponding stochastic optimization problem provides the correct option price. By integrating analytically over the random exercise decision, we obtain an objective function that is differentiable with respect to perturbations of the exercise rate even for finitely many sample paths. The global optimum of this function can be approached gradually when starting from a constant exercise rate.

Numerical experiments on vanilla put options in the multivariate Black-Scholes model and a preliminary theoretical analysis underline the efficiency of our method, both with respect to the number of time-discretization steps and the required number of degrees of freedom in the parametrization of the exercise rates. Finally, we demonstrate the flexibility of our method through numerical experiments on max call options in the classical Black-Scholes model, and vanilla put options in both the Heston model and the non-Markovian rough Bergomi model.

Robust Dynamic Portfolio Choice Based on Out-Of-Sample Performance
Schüssler, Rainer Alexander
We introduce a novel dynamic portfolio choice method. The focus is on robust out-of-sample performance rather than on optimal in-sample performance. We therefore devise a strategy that rigorously tackles the problem of estimation error. The method involves defining a discrete set of single-period portfolio allocation policies (candidate portfolio strategies) that accommodate time-varying predictability of individual assets and choosing between them at portfolio revision dates based on bootstrapped out-of-sample portfolio returns. We apply the method to dynamic investment problems in futures trading, strategic asset allocation and a cross-sectional momentum strategy.

Robustness in the Optimization of Risk Measures
Paul Embrechts,Alexander Schied,Ruodu Wang

We study issues of robustness in the context of Quantitative Risk Management and Optimization. Depending on the underlying objectives, we develop a general methodology for determining whether a given risk measurement related optimization problem is robust. Motivated by practical issues from financial regulation, we give special attention to the two most widely used risk measures in the industry, Value-at-Risk (VaR) and Expected Shortfall (ES). We discover that for many simple representative optimization problems, VaR generally leads to non-robust optimizers whereas ES generally leads to robust ones. Our results thus shed light from a new angle on the ongoing discussion about the comparative advantages of VaR and ES in banking and insurance regulation. Our notion of robustness is conceptually different from the field of robust optimization, to which some interesting links are discovered.

Role of Cross Currency Swap Markets in Funding and Investment Decisions
Brophy, Thomas,Herrala, Niko,Jurado, Raquel,Katsalirou, Irene,Le Quéau, Léa,lizarazo, christian,O’Donnell, Seamus
A US dollar funding premium in the EUR/USD cross currency swap market has been in existence since 2008. Whilst there are many reasons behind this dislocation, since 2014 the divergence in monetary policy between the euro area and the United States has played a growing role. This paper aims at exploring and gaining more insight into the role the Eurosystem’s Expanded Asset purchase Programme (APP) has had in guiding investment and funding decisions and its influence on the cross currency basis. The downward pressure on yields, exerted by the APP, has made euro assets less attractive and has led investors to search for yield abroad. At the same time, the decline in yields and tighter credit spreads have attracted US corporate issuers to the euro market in search of cheaper funding costs. These cross-border flows from issuers and investors have played a strong role in driving the US dollar funding premium. The purpose of this study is to gauge whether these changing trends in cross-border flows have implications for the implementation of the Eurosystem’s APP. Beyond the structural increase in the US dollar funding premium described above, a cyclical component has led to an amplification of the premium over balance sheet reporting dates, due to new bank regulations. This paper also analyses the behaviour of euro area banks in cross currency swap markets over balance sheet reporting dates, using the money market statistical reporting (MMSR) dataset in order to discern whether the increase in the US dollar funding premium at these specific points in time has an adverse impact on the transmission of monetary policy.

Sampling Distributions of Optimal Portfolio Weights and Characteristics in Low and Large Dimensions
Taras Bodnar,Holger Dette,Nestor Parolya,Erik Thorsén

Optimal portfolio selection problems are determined by the (unknown) parameters of the data generating process. If an investor want to realise the position suggested by the optimal portfolios he/she needs to estimate the unknown parameters and to account the parameter uncertainty into the decision process. Most often, the parameters of interest are the population mean vector and the population covariance matrix of the asset return distribution. In this paper we characterise the exact sampling distribution of the estimated optimal portfolio weights and their characteristics by deriving their sampling distribution which is present in terms of a stochastic representation. This approach possesses several advantages, like (i) it determines the sampling distribution of the estimated optimal portfolio weights by expressions which could be used to draw samples from this distribution efficiently; (ii) the application of the derived stochastic representation provides an easy way to obtain the asymptotic approximation of the sampling distribution. The later property is used to show that the high-dimensional asymptotic distribution of optimal portfolio weights is a multivariate normal and to determine its parameters. Moreover, a consistent estimator of optimal portfolio weights and their characteristics is derived under the high-dimensional settings. Via an extensive simulation study, we investigate the finite-sample performance of the derived asymptotic approximation and study its robustness to the violation of the model assumptions used in the derivation of the theoretical results.

Stochastic integration with respect to arbitrary collections of continuous semimartingales and applications to Mathematical Finance
Constantinos Kardaras

Stochastic integrals are defined with respect to a collection $P = (P_i; \, i \in I)$ of continuous semimartingales, imposing no assumptions on the index set $I$ and the subspace of $\mathbb{R}^I$ where $P$ takes values. The integrals are constructed though finite-dimensional approximation, identifying the appropriate local geometry that allows extension to infinite dimensions. For local martingale integrators, the resulting space $\mathsf{S} (P)$ of stochastic integrals has an operational characterisation via a corresponding set of integrands $\mathsf{R} (C)$, constructed with only reference the covariation structure $C$ of $P$. This bijection between $\mathsf{R} (C)$ and the (closed in the semimartingale topology) set $\mathsf{S} (P)$ extends to families of continuous semimartingale integrators for which the drift process of $P$ belongs to $\mathsf{R} (C)$. In the context of infinite-asset models in Mathematical Finance, the latter structural condition is equivalent to a certain natural form of market viability. The enriched class of wealth processes via extended stochastic integrals leads to exact analogues of optional decomposition and hedging duality as the finite-asset case. A corresponding characterisation of market completeness in this setting is provided.

Strong and Weak Equilibria for Time-Inconsistent Stochastic Control in Continuous Time
Yu-Jui Huang,Zhou Zhou

A new definition of continuous-time equilibrium controls is introduced. As opposed to the standard definition, which involves a derivative-type operation, the new definition parallels how a discrete-time equilibrium is defined, and allows for unambiguous economic interpretation. The terms "strong equilibria" and "weak equilibria" are coined for controls under the new and the standard definitions, respectively. When the state process is a time-homogeneous continuous-time Markov chain, a careful asymptotic analysis gives complete characterizations of weak and strong equilibria. Thanks to Kakutani-Fan's fixed-point theorem, general existence of weak and strong equilibria is also established, under additional compactness assumption. Our theoretic results are applied to a two-state model under non-exponential discounting. In particular, we demonstrate explicitly that there can be incentive to deviate from a weak equilibrium, which justifies the need for strong equilibria. Our analysis also provides new results for the existence and characterization of discrete-time equilibria under infinite horizon.

The Behavior of Credit-Rating Agencies During the Recent Global Financial Crisis
Spina, Joel
Referring to the role credit-rating agencies played in the most recent global financial crisis, the Financial Crisis Inquiry Commission â€" FCIC concluded that “… the failures of credit rating agencies were essential cogs in the wheel of financial destruction.” The reasons for such failures include changes in technology, the rapid transformation of market structure, volume of business and complexity of financial instruments to be rated by these entities. These changes started in the late 1990s and culminated in the 2000 â€" 2007 period, but the consequences of such failures have pervaded global markets until recently. In addition to describing trends and circumstances surrounding these agencies during the global financial crisis, this study analyzes behavioral themes that intervened in the events and influenced the development of undesirable outcomes to the agencies and their clients.

The Likelihood of Divorce and the Riskiness of Financial Decisions
Stark, Oded,Szczygielski, Krzysztof
We link causally the riskiness of men's management of their finances with the probability of their experiencing a divorce. Our point of departure is that when comparing single men to married men, the former manage their finances in a more aggressive (that is, riskier) manner. Assuming that single men believe that low relative wealth has a negative effect on their standing in the marriage market and that they care about their standing in that market more than married men do, we find that a stronger distaste for low relative wealth translates into reduced relative risk aversion and, consequently, into riskier financial behavior.With this relationship in place we show how this difference varies depending on the "background" likelihood of divorce and, hence, on the likelihood of re-entry into the marriage market: married men in environments that are more prone to divorce exhibit risk-taking behavior that is more similar to that of single men than married men in environments that are little prone to divorce. We offer a theoretical contribution that helps inform and interpret empirical observations and regularities and can serve as a guide for follow-up empirical work, having established and identified the direction of causality.

Top performing stocks recommendation strategy for portfolio
Kartikay Gupta,Niladri Chatterjee

Stock return forecasting is of utmost importance in the business world. This has been the favourite topic of research for many academicians since decades. Recently, regularization techniques have reported to tremendously increase the forecast accuracy of the simple regression model. Still, this model cannot incorporate the effect of things like a major natural disaster, large foreign influence, etc. in its prediction. Such things affect the whole stock market and are very unpredictable. Thus, it is more important to recommend top stocks rather than predicting exact stock returns. The present paper modifies the regression task to output value for each stock which is more suitable for ranking the stocks by expected returns. Two large datasets consisting of altogether 1205 companies listed at Indian exchanges were used for experimentation. Five different metrics were used for evaluating the different models. Results were also analysed subjectively through plots. The results showed the superiority of the proposed techniques.

Unintended Consequences of Unemployment Insurance Benefits: The Role of Banks
Arslan, Yavuz,Degerli, Ahmet,Kabas, Gazi
Many countries provide unemployment insurance (UI) to reduce individuals' income risk and to moderate fluctuations in the economy. However, to the extent that these policies are successful, they would be expected to reduce precautionary savings and hence bank deposits--households' main saving instrument. In this paper, we study this reduced incentive to save and uncover a novel distortionary mechanism through which UI policies affect the economy. In particular, we show that, when UI benefits become more generous, bank deposits fall. Since deposits are the main stable funding source for banks, this fall in deposits squeezes bank commercial lending, which in turn reduces corporate investment.

Unique Fundamental Dynamics of Target-zone Exchange Rates
Lo, Chi-Fai,Hui, Cho-Hoi,Liu, Chi-Hei
We have provided a rigorous derivation of the asymmetric mean-reverting fundamental dynamics proposed by Lo and coworkers (2015) for target-zone exchange rates, and have shown that the proposed fundamental dynamics is the unique choice and described by the Rayleigh process. By analogy, such a fundamental can be treated as a one-dimensional overdamped Brownian particle moving in a logarithmic-harmonic potential well. In addition, we have demonstrated that the predicted exchange rate distributions can take several different shapes, which may correspond to possible realignments and widely different (marginal and intra-marginal) intervention policies. The shapes of these distributions represent the predicted distributions discussed in previous theoretical models which only generate one or two shapes. Moreover, we have succeeded in performing explicit calibration of the proposed fundamental dynamics, thus confirming the validity of our model. Unlike the Krugman model, our model is capable of explaining the empirical observations that the exchange rate dynamics is sticky near the edges of the band, and that both positive and negative interest rate differentials can appear in the entire target zone.

Using Portfolio Theory to Design Better Exams
Ardjmand, Ehsan,Stowe, David L.,Stowe, John D.
The mathematics behind many psychometric measures is similar to the mathematics in portfolio theory. Faculty often build exams based on judgment and experience and only use psychometric tools after an exam is administered. An obvious question is, can portfolio optimization models be used to design exams with desirable psychometric outcomes and content coverage? Although underlying variables (stock returns versus exam question scores) differ fundamentally, a portfolio approach to exam development can be used. The objective functions and underlying constraints will differ, but many faculty can readily apply the principles of portfolio theory to design more optimal exams. In this paper we contrast the objectives and mechanics of portfolio and exam development and use an integer programming model to develop the optimal set of exam questions given a realistic example.

When Is the Client King? Evidence from Affiliated-Analyst Recommendations in China’s Split-Share Reform
Chan, Kam C.,Jiang, Xuanyu,Wu, Donghui,Xu, Nianhang,Zeng, Hong
China’s split-share reform of 2005 (the Reform) converts the previously restricted shares held by founding shareholders to shares tradable on the open market. Against this backdrop, we study how underwriter-affiliated analysts and firms’ large shareholders interact in the event of the latter’s sales of restricted shares. We document that recommendations made by affiliated analysts are significantly more optimistic when firms’ large shareholders plan to sell their restricted shares. This optimism, however, is associated with negative post-sale stock returns, suggesting large shareholders profit from share sales. Furthermore, large shareholders sell more restricted shares through the affiliated brokerages for which analysts have issued more optimistic recommendations and firms under their control are more likely to appoint such brokerages as lead underwriters when they refinance in the future. The affiliated analysts also conduct more site visits to the firms after the share sales, thereby improving their earnings-forecast accuracy. Our analysis shows how conflicts of interest by financial intermediaries arise following the Reform and lead to large shareholders’ extraction of rents from public investors.