Research articles for the 2019-08-16
Bold Stock Recommendations: Informative or Worthless?
SSRN
We select a small set of recommendations that lie in the upper and lower tail of the empirical distribution of divergences between a recommendation, and the consensus over the window (-30, -1)-days prior to that recommendation. We classify these extremely divergent recommendations as bold, and then subdivide them into informative bold recommendations that lead other analysts (leading-bold) and those that are ignored by other analysts (contra-bold) based on the consensus change in the thirty days after the announcement. We focus on the information conveyed to the market by these bold, leading-bold, and contra-bold recommendations through their effects on Cumulative Abnormal Returns (CAR). We find that bold recommendations are not anticipated by market participants (CAR’s are negative before a bold buy and positive before a bold sell). The next finding is that the market responds strongly to both leading and contra bold recommendations over the (0, +4) window and that these reactions are stronger than that to non-bold recommendations. In contrast, over the longer (0, +30)-day window, leading-bold recommendations earn additional returns whereas contra-bold ones reverse significantly due to lack of confirmation. The overall pattern is one of rational market reaction both in the short and long windows. We support the rationality of the market reaction by showing that the percentage of leading-bold recommendations exceeds that of contra-bold recommendations, and that these two types of recommendations cannot be separated using observable analyst characteristics such as experience or brokerage size.
SSRN
We select a small set of recommendations that lie in the upper and lower tail of the empirical distribution of divergences between a recommendation, and the consensus over the window (-30, -1)-days prior to that recommendation. We classify these extremely divergent recommendations as bold, and then subdivide them into informative bold recommendations that lead other analysts (leading-bold) and those that are ignored by other analysts (contra-bold) based on the consensus change in the thirty days after the announcement. We focus on the information conveyed to the market by these bold, leading-bold, and contra-bold recommendations through their effects on Cumulative Abnormal Returns (CAR). We find that bold recommendations are not anticipated by market participants (CAR’s are negative before a bold buy and positive before a bold sell). The next finding is that the market responds strongly to both leading and contra bold recommendations over the (0, +4) window and that these reactions are stronger than that to non-bold recommendations. In contrast, over the longer (0, +30)-day window, leading-bold recommendations earn additional returns whereas contra-bold ones reverse significantly due to lack of confirmation. The overall pattern is one of rational market reaction both in the short and long windows. We support the rationality of the market reaction by showing that the percentage of leading-bold recommendations exceeds that of contra-bold recommendations, and that these two types of recommendations cannot be separated using observable analyst characteristics such as experience or brokerage size.
Corporate Innovation, Likelihood to be Acquired, and Takeover Premiums
SSRN
We analyze the effect of a firm’s innovation activities on its likelihood to be acquired and the takeover premium using a large sample of M&A transactions. We show that firms with larger innovation outputs and R&D investments are more likely to be acquired, receive unsolicited bids, and receive multiple bids. The takeover premium increases with the target firm’s innovation output, and this positive relation is stronger when there are more competing bidders, when acquiring firms’ product markets are competitive, and when technological proximity is lower in the acquiring firms’ industry. Both the acquirer’s cumulative abnormal return around the announcement date and post-acquisition operating performance are positively related to the target firm’s innovation output and R&D spending.
SSRN
We analyze the effect of a firm’s innovation activities on its likelihood to be acquired and the takeover premium using a large sample of M&A transactions. We show that firms with larger innovation outputs and R&D investments are more likely to be acquired, receive unsolicited bids, and receive multiple bids. The takeover premium increases with the target firm’s innovation output, and this positive relation is stronger when there are more competing bidders, when acquiring firms’ product markets are competitive, and when technological proximity is lower in the acquiring firms’ industry. Both the acquirer’s cumulative abnormal return around the announcement date and post-acquisition operating performance are positively related to the target firm’s innovation output and R&D spending.
Do U.S. Firms Innovate to Escape Neck-and-Neck Competition?
SSRN
Yes, when product-market competition is measured explicitly by a firm’s neck-and-neckness with its competitive rivals. Using an identification strategy where major reductions in U.S. import tariffs act as exogenous shocks to competition, we show that these shocks differentially incentivized U.S. manufacturing firms to escape competition. Firms facing more neck-and-neck competition generated more patents and patent citations. They took an exploitative strategy in innovation and pursued higher-valued innovation. Difference-in-differences tests further reveal explicit channels in which the escape-competition effect occurs: it occurs among firms that had high potential for product differentiation, faced high product market threats, and adopted conservative financial policies.
SSRN
Yes, when product-market competition is measured explicitly by a firm’s neck-and-neckness with its competitive rivals. Using an identification strategy where major reductions in U.S. import tariffs act as exogenous shocks to competition, we show that these shocks differentially incentivized U.S. manufacturing firms to escape competition. Firms facing more neck-and-neck competition generated more patents and patent citations. They took an exploitative strategy in innovation and pursued higher-valued innovation. Difference-in-differences tests further reveal explicit channels in which the escape-competition effect occurs: it occurs among firms that had high potential for product differentiation, faced high product market threats, and adopted conservative financial policies.
GDPR and the Localness of Venture Investment
SSRN
We examine how investors' tendency to prefer investing in local ventures interacts with the effects of the General Data Protection Regulation (GDPR) on venture investment in the European Union (EU). Using five-year investment data in EU and US ventures, we demonstrate that GDPR's enactment and rollout differentially affect investors as a function of their proximity to ventures. Specifically, we show that GDPR's rollout in 2018 has a negative effect on EU venture investment and the effects are higher when ventures and lead investors are not in the same country or union. The relationship manifests in the number of deals per month and in the amount invested per deal, and is particularly pronounced for newer and data-related ventures. We further show that GDPR's enactment in 2016 exhibits similar effects but only with respect to lead investors that invest across different industries.
SSRN
We examine how investors' tendency to prefer investing in local ventures interacts with the effects of the General Data Protection Regulation (GDPR) on venture investment in the European Union (EU). Using five-year investment data in EU and US ventures, we demonstrate that GDPR's enactment and rollout differentially affect investors as a function of their proximity to ventures. Specifically, we show that GDPR's rollout in 2018 has a negative effect on EU venture investment and the effects are higher when ventures and lead investors are not in the same country or union. The relationship manifests in the number of deals per month and in the amount invested per deal, and is particularly pronounced for newer and data-related ventures. We further show that GDPR's enactment in 2016 exhibits similar effects but only with respect to lead investors that invest across different industries.
High-Frequency Trading with Fractional Brownian Motion
SSRN
In the high-frequency limit, conditional expected increments of fractional Brownian motion converge to a white noise, shedding their dependence on the path history and the forecasting horizon, and making dynamic optimization problems tractable. We find an explicit formula for locally mean-variance optimal strategies and their performance for an asset price that follows fractional Brownian motion. Without trading costs, risk-adjusted profits are linear in the trading horizon and rise asymmetrically as the Hurst exponent departs from Brownian motion, remaining finite as the exponent reaches zero while diverging as it approaches one. Trading costs penalize numerous portfolio updates from short-lived signals, leading to a finite trading frequency, which can be chosen so that the effect of trading costs is arbitrarily small, depending on the required speed of convergence to the high-frequency limit.
SSRN
In the high-frequency limit, conditional expected increments of fractional Brownian motion converge to a white noise, shedding their dependence on the path history and the forecasting horizon, and making dynamic optimization problems tractable. We find an explicit formula for locally mean-variance optimal strategies and their performance for an asset price that follows fractional Brownian motion. Without trading costs, risk-adjusted profits are linear in the trading horizon and rise asymmetrically as the Hurst exponent departs from Brownian motion, remaining finite as the exponent reaches zero while diverging as it approaches one. Trading costs penalize numerous portfolio updates from short-lived signals, leading to a finite trading frequency, which can be chosen so that the effect of trading costs is arbitrarily small, depending on the required speed of convergence to the high-frequency limit.
Investment Company Disclosures: Qualities, Content & Compliance
SSRN
Operating company disclosures are a poor proxy to understand investment company disclosures. Despite sharing governance structures and mandatory disclosure regimes, there are important differences between operating and investment companies that permeate disclosure content and uses. But to date, these differences have been ignored. There is no academic attention paid to the text of investment company disclosures. To combat this, we first establish the need to study investment companies in their own right. Second, we develop and deploy text mining tools to examine the content and compliance of 140,000 investment company summary prospectuses filed between 2010-2018. We find that disclosure length is growing and is driven by risk sections that have nearly doubled in size over the last decade. We also find high occurrences of specific risk disclosures such as liquidity, market, interest rate, and derivatives in our sample. While investment companies comply with check the box regulations, they do not comply with suggested lengths or readability, and a fraction of funds do not comply with specific derivative disclosure obligations. Beyond compliance, investment company disclosures are an unmined stockpile of market insights and risk assessments from the market’s most sophisticated and dominant investors. This paper is the first in a series to introduce and test tools to unlock the black box of investment company disclosures.
SSRN
Operating company disclosures are a poor proxy to understand investment company disclosures. Despite sharing governance structures and mandatory disclosure regimes, there are important differences between operating and investment companies that permeate disclosure content and uses. But to date, these differences have been ignored. There is no academic attention paid to the text of investment company disclosures. To combat this, we first establish the need to study investment companies in their own right. Second, we develop and deploy text mining tools to examine the content and compliance of 140,000 investment company summary prospectuses filed between 2010-2018. We find that disclosure length is growing and is driven by risk sections that have nearly doubled in size over the last decade. We also find high occurrences of specific risk disclosures such as liquidity, market, interest rate, and derivatives in our sample. While investment companies comply with check the box regulations, they do not comply with suggested lengths or readability, and a fraction of funds do not comply with specific derivative disclosure obligations. Beyond compliance, investment company disclosures are an unmined stockpile of market insights and risk assessments from the market’s most sophisticated and dominant investors. This paper is the first in a series to introduce and test tools to unlock the black box of investment company disclosures.
Monetary Policy Transmission and the Impact on Financial Markets, Inflation and the Real Economy
SSRN
The relationship between macroeconomic variables and asset prices varies over time. Recent research points to monetary policy as an important driver of this dynamic relationship. On the one hand, most central banks pursue a mandate that takes into account expected inflation and some measure of the expected output gap. On the other hand, realized inflation and output gap are influenced by monetary policy. The main part of this paper provides an overview of the most important transmission channels of conventional and unconventional monetary policy (and their potential impact on asset prices). The current environment of low to zero interest rates challenges the traditional transmission of monetary policy. However, recent academic research suggests that the central bank is not armless in such an environment. Unconventional monetary policy has been adopted by most developed markets central banks since the start of the Great Financial crisis. This paper also reviews potential limits and side-effects of such policies. Finally, some policy implications of tapering are presented.
SSRN
The relationship between macroeconomic variables and asset prices varies over time. Recent research points to monetary policy as an important driver of this dynamic relationship. On the one hand, most central banks pursue a mandate that takes into account expected inflation and some measure of the expected output gap. On the other hand, realized inflation and output gap are influenced by monetary policy. The main part of this paper provides an overview of the most important transmission channels of conventional and unconventional monetary policy (and their potential impact on asset prices). The current environment of low to zero interest rates challenges the traditional transmission of monetary policy. However, recent academic research suggests that the central bank is not armless in such an environment. Unconventional monetary policy has been adopted by most developed markets central banks since the start of the Great Financial crisis. This paper also reviews potential limits and side-effects of such policies. Finally, some policy implications of tapering are presented.
Risk Parity is Not Short Volatility (Not That There's Anything Wrong with Short Volatility)
SSRN
There have been increasingly frequent claims that risk parity strategies are hiding an implicit short volatility exposure or behave as though they are short volatility. In order to test the veracity of these claims, we simulate stylized versions of three-asset-class (equity, fixed income, and commodities) risk parity and short volatility strategies, and we compare the trading behavior and returns of each. We conclude that the two strategies’ similarities are overstated, and we find no empirical evidence to support the claimed hidden exposure. Even with conservative assumptions designed to heighten the similarity of the two strategies, their trades are uncorrelated (or even slightly negative correlated) at almost any horizon. Though their returns are moderately correlated, the correlation is explained by common exposure to equities and bonds, not by common exposure to gamma or other forms of convexity. Controlling for these static underlying exposures, we find that the returns of the two strategies are almost orthogonal, with short volatility explaining less than one percent of the total variance of risk parity returns. We extend our analysis to consider equity and fixed income asset classes in isolation, where we observe very similar results.
SSRN
There have been increasingly frequent claims that risk parity strategies are hiding an implicit short volatility exposure or behave as though they are short volatility. In order to test the veracity of these claims, we simulate stylized versions of three-asset-class (equity, fixed income, and commodities) risk parity and short volatility strategies, and we compare the trading behavior and returns of each. We conclude that the two strategies’ similarities are overstated, and we find no empirical evidence to support the claimed hidden exposure. Even with conservative assumptions designed to heighten the similarity of the two strategies, their trades are uncorrelated (or even slightly negative correlated) at almost any horizon. Though their returns are moderately correlated, the correlation is explained by common exposure to equities and bonds, not by common exposure to gamma or other forms of convexity. Controlling for these static underlying exposures, we find that the returns of the two strategies are almost orthogonal, with short volatility explaining less than one percent of the total variance of risk parity returns. We extend our analysis to consider equity and fixed income asset classes in isolation, where we observe very similar results.
Robust Statistical Arbitrage Strategies
SSRN
We investigate statistical arbitrage strategies when there is ambiguity about the underlying financial model. Pricing measures are assumed to be martingale measures calibrated to prices of liquidly traded options, whereas the set of admissible physical measures is not necessarily implied from market data. Our investigations rely on the mathematical characterization of statistical arbitrage, which was originally introduced by Bondarenko in 2003. In contrast to pure arbitrage strategies, statistical arbitrage strategies are not entirely risk-free, but the notion allows to identify strategies which are profitable on average, given the outcome of a specific sigma-algebra. Besides a characterization of robust statistical arbitrage, we also provide a super-/sub-replication theorem for the construction of statistical arbitrage strategies based on path-dependent options. In particular, we show that the range of statistical arbitrage-free prices is, in general, much tighter than the range of arbitrage-free prices.
SSRN
We investigate statistical arbitrage strategies when there is ambiguity about the underlying financial model. Pricing measures are assumed to be martingale measures calibrated to prices of liquidly traded options, whereas the set of admissible physical measures is not necessarily implied from market data. Our investigations rely on the mathematical characterization of statistical arbitrage, which was originally introduced by Bondarenko in 2003. In contrast to pure arbitrage strategies, statistical arbitrage strategies are not entirely risk-free, but the notion allows to identify strategies which are profitable on average, given the outcome of a specific sigma-algebra. Besides a characterization of robust statistical arbitrage, we also provide a super-/sub-replication theorem for the construction of statistical arbitrage strategies based on path-dependent options. In particular, we show that the range of statistical arbitrage-free prices is, in general, much tighter than the range of arbitrage-free prices.
Short Sellers and Long-Run Management Forecasts
SSRN
We examine how short sellers affect long-run management forecasts using a natural experiment (Regulation SHO) that relaxes short-selling constraints on a group of randomly selected firms (referred to as pilot firms). We find that compared to other firms, the pilot firms issue more long-run good news forecasts but do not change the frequency of long-run bad news forecasts. The increase in good news forecasts is greater when the pilot firms have higher quality forecasts, greater uncertainty about firm value, or higher manager equity incentives. Overall, these results and the results of additional analyses indicate that the reduction in short-selling constraints and the increase in short-selling threat induce managers to enhance disclosures through more long-run good news forecasts to discourage short sellers.
SSRN
We examine how short sellers affect long-run management forecasts using a natural experiment (Regulation SHO) that relaxes short-selling constraints on a group of randomly selected firms (referred to as pilot firms). We find that compared to other firms, the pilot firms issue more long-run good news forecasts but do not change the frequency of long-run bad news forecasts. The increase in good news forecasts is greater when the pilot firms have higher quality forecasts, greater uncertainty about firm value, or higher manager equity incentives. Overall, these results and the results of additional analyses indicate that the reduction in short-selling constraints and the increase in short-selling threat induce managers to enhance disclosures through more long-run good news forecasts to discourage short sellers.
Short Squeeze Uncertainty and Skewness
SSRN
Short squeezes often lead to sudden, large increases in stock prices. We show that uncertainty about the likelihood of a short squeeze is a proxy for skewness-seeking investors, and they use call options in their quest. In particular, these investors are willing to pay a premium for the upside potential of these lottery-like securities, as is the case for other lottery-like securities identified in the literature. In addition, high short squeeze uncertainty causes deviations from the putâ€"call parity condition in the direction dictated by the overpricing of the call options.
SSRN
Short squeezes often lead to sudden, large increases in stock prices. We show that uncertainty about the likelihood of a short squeeze is a proxy for skewness-seeking investors, and they use call options in their quest. In particular, these investors are willing to pay a premium for the upside potential of these lottery-like securities, as is the case for other lottery-like securities identified in the literature. In addition, high short squeeze uncertainty causes deviations from the putâ€"call parity condition in the direction dictated by the overpricing of the call options.
Spillover and Profitability of Intraday Herding on Cross-listed Stocks
SSRN
Companies are cross-listed on multiple exchanges in different countries to take advantage of different market features. Due to difference in time zones, it is normally quite impossible to take advantage of instantaneous information spillover from market to market to generate abnormal return. Situations can be different if the cross-listed firms are traded in markets within the same country and in the same time zone, but with different legislative regimes and levels of sophistication. Focusing on investors’ herd behavior and using hourly data, this paper finds evidence of cross market information spillover in herding formation and abnormal returns in cross-listed stocks in China's Shanghai, Shenzhen and Hong Kong markets. More importantly, we find that investors can make excess returns upon observing herding by buying and holding Hong Kong’s small and median stocks in industrials sector cross-listed in Shenzhen market especially in the morning and the end of the trading day.
SSRN
Companies are cross-listed on multiple exchanges in different countries to take advantage of different market features. Due to difference in time zones, it is normally quite impossible to take advantage of instantaneous information spillover from market to market to generate abnormal return. Situations can be different if the cross-listed firms are traded in markets within the same country and in the same time zone, but with different legislative regimes and levels of sophistication. Focusing on investors’ herd behavior and using hourly data, this paper finds evidence of cross market information spillover in herding formation and abnormal returns in cross-listed stocks in China's Shanghai, Shenzhen and Hong Kong markets. More importantly, we find that investors can make excess returns upon observing herding by buying and holding Hong Kong’s small and median stocks in industrials sector cross-listed in Shenzhen market especially in the morning and the end of the trading day.
The Real-Time Impact of ECB Press Conferences on Financial Markets
SSRN
We present a new methodology to trace the information flow of communication events: Using the captions of press conference webcasts and textual analysis tools we fully automatically create timestamps for the different information content which can then be used to study the respective real-time impact on financial markets. Applying our approach to the press conferences of the European Central Bank we find that the ECB’s announcements of non-standard monetary policy measures first further increased the pre-ECB drift (as documented by Ulrich et al., 2017) by 20% before equity prices start to drop. Over 50% of this fall is realized during the ECB’s economic analysis, partly due to information about the real economy and partly due to inflation news. We relate the former to news about the course of the European sovereign debt crisis. The results are especially pronounced for the banking and insurance sector as well as the GIIPS countries in our sample.
SSRN
We present a new methodology to trace the information flow of communication events: Using the captions of press conference webcasts and textual analysis tools we fully automatically create timestamps for the different information content which can then be used to study the respective real-time impact on financial markets. Applying our approach to the press conferences of the European Central Bank we find that the ECB’s announcements of non-standard monetary policy measures first further increased the pre-ECB drift (as documented by Ulrich et al., 2017) by 20% before equity prices start to drop. Over 50% of this fall is realized during the ECB’s economic analysis, partly due to information about the real economy and partly due to inflation news. We relate the former to news about the course of the European sovereign debt crisis. The results are especially pronounced for the banking and insurance sector as well as the GIIPS countries in our sample.
What Moves Equity Markets? A Term Structure Decomposition for Stock Returns
SSRN
Several papers decompose stock returns into cash flow and discount rate news to study equity market fluctuations. This paper develops and explores an alternative decomposition for stock returns based on the idea that equity volatility must come from variation in the present value of short- and long-term dividends. I find that (i) more than 60% of equity volatility comes from dividends with maturities beyond 20 years and (ii) most of the return volatility associated with short-term dividends comes from cash flow shocks while discount rate news are mainly responsible for return volatility linked to long-term dividends.
SSRN
Several papers decompose stock returns into cash flow and discount rate news to study equity market fluctuations. This paper develops and explores an alternative decomposition for stock returns based on the idea that equity volatility must come from variation in the present value of short- and long-term dividends. I find that (i) more than 60% of equity volatility comes from dividends with maturities beyond 20 years and (ii) most of the return volatility associated with short-term dividends comes from cash flow shocks while discount rate news are mainly responsible for return volatility linked to long-term dividends.
