Research articles for the 2019-09-14
Auditing Fair Value: Security-Level Evidence on Auditor Expertise
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In this paper, I study whether and how auditors develop domain-specific expertise in auditing difficult-to-audit fair value (FV) measurements. Specifically, by analyzing the dispersion in the FV estimates of the same security held by different insurance clients of the same auditor, I provide security-level evidence that auditors influence their clients’ FV measurements. Importantly, I find that auditors get better at estimating security FV when they observe multiple valuations of the same securities at different clients. I also find evidence that auditors use their built-up competency to curb insurance clients’ incentives to overstate the FV of securities stemming from their regulatory capital levels. Overall, these results shed light on the role of domain-specific expertise in the auditing process, suggesting that auditors develop such expertise through a specific learning mechanism that they apply to curb managerial incentives.
SSRN
In this paper, I study whether and how auditors develop domain-specific expertise in auditing difficult-to-audit fair value (FV) measurements. Specifically, by analyzing the dispersion in the FV estimates of the same security held by different insurance clients of the same auditor, I provide security-level evidence that auditors influence their clients’ FV measurements. Importantly, I find that auditors get better at estimating security FV when they observe multiple valuations of the same securities at different clients. I also find evidence that auditors use their built-up competency to curb insurance clients’ incentives to overstate the FV of securities stemming from their regulatory capital levels. Overall, these results shed light on the role of domain-specific expertise in the auditing process, suggesting that auditors develop such expertise through a specific learning mechanism that they apply to curb managerial incentives.
Capitalizing on Sustainability: Value of Going Green
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This paper investigates how corporate Environmental, Social, and Governance (ESG) actions affect firm value. By employing an event study around two 5-to-4 Supreme Court rulings and using portfolio-based approaches, we document that prices capitalize sustainability in the cross-section. When the Court awards broader regulatory authority to the EPA, polluting firms with the largest discrepancies vis-a-vis the new rules heralded by the Court exhibit the largest price responses. Conversely, when the Court narrows the regulatory limit of existing environmental law, polluting firms lose value. The announcement returns are more sensitive to the Court rulings for firms in regions with a higher level of social trust. More generally, a portfolio of firms improving their sustainability by adopting cleaner production practices earns alphas (4.43% annually for value-weighted returns) compared to firms which adopt more toxic practices and thereby reduce sustainability. Firms with greener production practices show positive earnings surprises, higher revenue and profitability, and more capital inflow from institutional investors with longer horizons. The abnormal returns are more pronounced among firms in regions with a high level of trust. In sum, we show that firms gain value when they go green.
SSRN
This paper investigates how corporate Environmental, Social, and Governance (ESG) actions affect firm value. By employing an event study around two 5-to-4 Supreme Court rulings and using portfolio-based approaches, we document that prices capitalize sustainability in the cross-section. When the Court awards broader regulatory authority to the EPA, polluting firms with the largest discrepancies vis-a-vis the new rules heralded by the Court exhibit the largest price responses. Conversely, when the Court narrows the regulatory limit of existing environmental law, polluting firms lose value. The announcement returns are more sensitive to the Court rulings for firms in regions with a higher level of social trust. More generally, a portfolio of firms improving their sustainability by adopting cleaner production practices earns alphas (4.43% annually for value-weighted returns) compared to firms which adopt more toxic practices and thereby reduce sustainability. Firms with greener production practices show positive earnings surprises, higher revenue and profitability, and more capital inflow from institutional investors with longer horizons. The abnormal returns are more pronounced among firms in regions with a high level of trust. In sum, we show that firms gain value when they go green.
Combination Portfolio: A Cocktail Therapy for Boosting Robustness
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In machine learning literature, the performance of prediction can be improved by combining multiple models together in some way, such combinations of models are sometimes called committees. In this manuscript, we propose a combination portfolio which first combines 200 mean-variance type risk diversification portfolios and 50 risk optimal portfolios of CVaR type, we then design a performance score to each and pick the best one’s weight vector to construct a portfolio to hold in the next period. Technically, the buy-and-hold back-testing procedure is rebalanced by iterating the process. Using several datasets of DJ components, 49 Fama-French industry portfolios, S&P500 and global ETF, the back-testing experiments demonstrate that the combination portfolio substantially improves the out-of-sample performance, measured by annualized Sharpe ratio, and outperforms others.
SSRN
In machine learning literature, the performance of prediction can be improved by combining multiple models together in some way, such combinations of models are sometimes called committees. In this manuscript, we propose a combination portfolio which first combines 200 mean-variance type risk diversification portfolios and 50 risk optimal portfolios of CVaR type, we then design a performance score to each and pick the best one’s weight vector to construct a portfolio to hold in the next period. Technically, the buy-and-hold back-testing procedure is rebalanced by iterating the process. Using several datasets of DJ components, 49 Fama-French industry portfolios, S&P500 and global ETF, the back-testing experiments demonstrate that the combination portfolio substantially improves the out-of-sample performance, measured by annualized Sharpe ratio, and outperforms others.
Common Holdings and Mutual Fund Performance
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This paper studies the relationship between U.S. mutual funds' common holdings and fund performance. In a network where funds are connected through portfolio overlap, degree centrality of each fund represents the level of similarity with peers. The results show that holdings similarity leads to lower abnormal fund returns. Further tests suggest that information asymmetry is a potential explanation for this relationship. The negative association between holdings similarity and fund performance widens in volatile markets. In uncertain times, mutual funds move towards their benchmark due to asset management constraints. This creates negative price pressure on commonly held assets. A portfolio based on stocks owned by low vs. high degree centrality funds yields abnormal returns of 7% per year. This paper provides new evidence of the informational advantage hypothesis as a driver of fund performance. It also highlights negative externalities of asset management contracts.
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This paper studies the relationship between U.S. mutual funds' common holdings and fund performance. In a network where funds are connected through portfolio overlap, degree centrality of each fund represents the level of similarity with peers. The results show that holdings similarity leads to lower abnormal fund returns. Further tests suggest that information asymmetry is a potential explanation for this relationship. The negative association between holdings similarity and fund performance widens in volatile markets. In uncertain times, mutual funds move towards their benchmark due to asset management constraints. This creates negative price pressure on commonly held assets. A portfolio based on stocks owned by low vs. high degree centrality funds yields abnormal returns of 7% per year. This paper provides new evidence of the informational advantage hypothesis as a driver of fund performance. It also highlights negative externalities of asset management contracts.
Contrasting Worldviews at Bank and Securities Market Regulators
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Bank and securities regulators operate with different attitudes about the appropriate regulation of financial institutions and markets. Bank regulators’ prudential oversight protects depositors from worrying about the repayment of their bank claims. In contrast, securities market regulators tend to presume that security markets (almost) always clear quickly at prices close to the asset’s fundamental value. These regulators seek to assure full disclosure of information, which facilitates active securities trading. In the United States, the SEC’s investor protection duties are tailored to the financial sophistication of individual investors.
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Bank and securities regulators operate with different attitudes about the appropriate regulation of financial institutions and markets. Bank regulators’ prudential oversight protects depositors from worrying about the repayment of their bank claims. In contrast, securities market regulators tend to presume that security markets (almost) always clear quickly at prices close to the asset’s fundamental value. These regulators seek to assure full disclosure of information, which facilitates active securities trading. In the United States, the SEC’s investor protection duties are tailored to the financial sophistication of individual investors.
Economics with Market Liquidity Risk
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For markets to work efficiently, buyers and sellers must be able to transact easily. People must have access to a marketplace such as a supermarket or a stock exchange with adequate liquidity. Further, people must have confidence that such a well-functioning marketplace will also exist in the future. Market liquidity risk is the risk that the market will function poorly in the future, handcuffing the “invisible hand†through which markets produce allocative efficiency. We discuss the effects of market liquidity risk on asset pricing, investment management, corporate finance, banking, financial crises, macroeconomics, monetary policy, fiscal policy, and other economic areas.
SSRN
For markets to work efficiently, buyers and sellers must be able to transact easily. People must have access to a marketplace such as a supermarket or a stock exchange with adequate liquidity. Further, people must have confidence that such a well-functioning marketplace will also exist in the future. Market liquidity risk is the risk that the market will function poorly in the future, handcuffing the “invisible hand†through which markets produce allocative efficiency. We discuss the effects of market liquidity risk on asset pricing, investment management, corporate finance, banking, financial crises, macroeconomics, monetary policy, fiscal policy, and other economic areas.
Electricity Futures Prices in an Emissions Constrained Economy: Evidence From European Power Markets
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We investigate the economic factors that drive electricity risk premia in the European emissions constrained economy. Our analysis is undertaken for monthly baseload electricity futures for delivery in the Nordic, French and British power markets. We find that electricity risk premia are significantly related to the volatility of electricity spot prices, demand and revenues, and the price volatility of the carbon dioxide (CO2) futures traded under the EU Emissions Trading Scheme (EU ETS). This finding has significant implications for the pricing of electricity futures since it highlights for the first time the role of carbon market uncertainties as a main determinant of the relationship between spot and futures electricity prices in Europe. Our results also suggest that for the electricity futures under scrutiny prices are determined rationally by risk-averse economic agents.
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We investigate the economic factors that drive electricity risk premia in the European emissions constrained economy. Our analysis is undertaken for monthly baseload electricity futures for delivery in the Nordic, French and British power markets. We find that electricity risk premia are significantly related to the volatility of electricity spot prices, demand and revenues, and the price volatility of the carbon dioxide (CO2) futures traded under the EU Emissions Trading Scheme (EU ETS). This finding has significant implications for the pricing of electricity futures since it highlights for the first time the role of carbon market uncertainties as a main determinant of the relationship between spot and futures electricity prices in Europe. Our results also suggest that for the electricity futures under scrutiny prices are determined rationally by risk-averse economic agents.
Nonlinearity Matters: The Stock Price â€" Trading Volume Relation Revisited
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We apply a practical two-step procedure to test for nonlinear information in the stock price -- trading volume relation. The approach draws upon the concept of transfer entropy and allows us to identify the dominant direction of the information transfer, which constitutes an improvement over (non-)linear Granger causality tests. We apply the procedure to a sample of more than 400 constituents of the S\&P 500 over an 18 years time period. The findings suggest a substantial amount of nonlinear information transfer across stocks after accounting for all linear correlation and volatility persistence in the bivariate system of calendar-adjusted log-returns and trading volume growth. For most stocks, information predominantly flows from returns to trading volume. Our results call into question the widespread practice of modelling this dynamic relation with linear models.
SSRN
We apply a practical two-step procedure to test for nonlinear information in the stock price -- trading volume relation. The approach draws upon the concept of transfer entropy and allows us to identify the dominant direction of the information transfer, which constitutes an improvement over (non-)linear Granger causality tests. We apply the procedure to a sample of more than 400 constituents of the S\&P 500 over an 18 years time period. The findings suggest a substantial amount of nonlinear information transfer across stocks after accounting for all linear correlation and volatility persistence in the bivariate system of calendar-adjusted log-returns and trading volume growth. For most stocks, information predominantly flows from returns to trading volume. Our results call into question the widespread practice of modelling this dynamic relation with linear models.
On the Notions of Equilibria for Time-Inconsistent Stopping Problems in Continuous Time
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A new notion of equilibrium, which we call strong equilibrium, is introduced for timeinconsistent stopping problems in continuous time. Compared to the existing notions introduced in Time-Consistent Stopping Under Decreasing Impatience and On Finding Equilibrium Stopping Times for Time-Inconsistent Markovian Problems, which in this paper are called mild equilibrium and weak equilibrium respectively, a strong equilibrium captures the idea of subgame perfect Nash equilibrium more accurately. When the state process is a continuous-time Markov chain and the discount function is log sub-additive, we show that an optimal mild equilibrium is always a strong equilibrium. Moreover, we provide a new iteration method that can directly construct an optimal mild equilibrium and thus also prove its existence.
SSRN
A new notion of equilibrium, which we call strong equilibrium, is introduced for timeinconsistent stopping problems in continuous time. Compared to the existing notions introduced in Time-Consistent Stopping Under Decreasing Impatience and On Finding Equilibrium Stopping Times for Time-Inconsistent Markovian Problems, which in this paper are called mild equilibrium and weak equilibrium respectively, a strong equilibrium captures the idea of subgame perfect Nash equilibrium more accurately. When the state process is a continuous-time Markov chain and the discount function is log sub-additive, we show that an optimal mild equilibrium is always a strong equilibrium. Moreover, we provide a new iteration method that can directly construct an optimal mild equilibrium and thus also prove its existence.
Residential Real Estate, Risk, Return and Diversification: Some Empirical Evidence
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This paper outlines and applies a methodology for estimating and examining the variation in risk and return for individual homes. This is important because most households own individual properties and the risk and return profile of each of these may differ. We use large data sets of home prices and rents for Sydney, Australia, from 2001-16, and estimate flexible smoothing spline hedonic models. These models are used to construct total returns - the sum of capital gains and the rental yield net of costs - for the homes in our data. We find that Sydney homes had, on average, both higher returns than shares and much lower risk. This gave them a far superior Sharpe ratio. Moreover, while we find that shares benefit to a greater extent from diversification than homes, the Sharpe ratio of a large portfolio of shares was still well below that of the average single home. Interestingly, we find that much of the variation in risk and return across properties can be explained by observable home characteristics. In particular houses had stronger returns than did apartments.
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This paper outlines and applies a methodology for estimating and examining the variation in risk and return for individual homes. This is important because most households own individual properties and the risk and return profile of each of these may differ. We use large data sets of home prices and rents for Sydney, Australia, from 2001-16, and estimate flexible smoothing spline hedonic models. These models are used to construct total returns - the sum of capital gains and the rental yield net of costs - for the homes in our data. We find that Sydney homes had, on average, both higher returns than shares and much lower risk. This gave them a far superior Sharpe ratio. Moreover, while we find that shares benefit to a greater extent from diversification than homes, the Sharpe ratio of a large portfolio of shares was still well below that of the average single home. Interestingly, we find that much of the variation in risk and return across properties can be explained by observable home characteristics. In particular houses had stronger returns than did apartments.
Risk-Managed Momentum Strategies
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We show that conditional skewness and kurtosis of the momentum strategy are highly time-varying, take extreme values and sometimes may not exist. The high negative skewness and high kurtosis arise since winners’ and losers’ skewness moves in opposite direction whereas kurtosis comoves. Moreover, momentum returns do not follow a random walk. Exploiting these observations we present strategies that manage momentum’s volatility by advanced volatility models in calm periods and downside risk in periods when a momentum crash is likely. Compared to the Realized Volatility managed momentum strategy frequently examined in the literature, our switching strategy exhibits higher returns, significantly reduces left tail risk and provides statistically significant utility gains for mean-variance investors, CRRA investors as well as loss averse investors.
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We show that conditional skewness and kurtosis of the momentum strategy are highly time-varying, take extreme values and sometimes may not exist. The high negative skewness and high kurtosis arise since winners’ and losers’ skewness moves in opposite direction whereas kurtosis comoves. Moreover, momentum returns do not follow a random walk. Exploiting these observations we present strategies that manage momentum’s volatility by advanced volatility models in calm periods and downside risk in periods when a momentum crash is likely. Compared to the Realized Volatility managed momentum strategy frequently examined in the literature, our switching strategy exhibits higher returns, significantly reduces left tail risk and provides statistically significant utility gains for mean-variance investors, CRRA investors as well as loss averse investors.
The Mitigating Effect of Governance Quality on the Finance-Renewable Energy-Growth Nexus: Some International Evidence
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This study analyzes the conditional effect of governance quality on the dynamics between financial development, renewable energy consumption, and economic growth in 123 countries from 1990 to 2017. We built composite indexes of financial development and governance quality through the principal component analysis (PCA) by using several financial variables and governance indicators. We employ the generalized method of moments (GMM) and the two-stage least squares (2SLS) techniques, but also the Granger non-causality in Dumitrescu and Hurlin (2012). First, the disaggregated analysis shows that renewable energy consumption,financial inclusion, financial efficiency, and financial stability have positive marginal effects on economic growth under a good governance quality, except for financial depth. These results differ across countries with different income levels. Second, the aggregated analysis confirms the positive marginal impact of financial development on growth only in low-income economies, whereas renewable energy consumption has positive marginal effects only in lower-middle-income and upper-middle-income economies. Finally, in most cases, the feedback hypothesisis confirmed between financial development and growth in all countries. Similarly, the bidirectional causality between renewable energy consumption and growth is also confirmed in lower-middle-income and low-income countries, exceptforhigh-income and upper-middle-income economies. Overall, governance quality has a threshold effect on the finance-renewable energy-growth nexus, which varies across countries. Thus, financial development and good governance quality are complementary driving forces for growth in most countries, except in upper-middle-income countries, whereas the complementary effect between renewable energy consumption and governance quality holds only in low-income and high-income countries. Accordingly, our study suggests more improvements in the governance quality in these countries, especially in the low-income and high-income countries to enhance the marginal impacts of financial development and renewable energy consumption on growth.
SSRN
This study analyzes the conditional effect of governance quality on the dynamics between financial development, renewable energy consumption, and economic growth in 123 countries from 1990 to 2017. We built composite indexes of financial development and governance quality through the principal component analysis (PCA) by using several financial variables and governance indicators. We employ the generalized method of moments (GMM) and the two-stage least squares (2SLS) techniques, but also the Granger non-causality in Dumitrescu and Hurlin (2012). First, the disaggregated analysis shows that renewable energy consumption,financial inclusion, financial efficiency, and financial stability have positive marginal effects on economic growth under a good governance quality, except for financial depth. These results differ across countries with different income levels. Second, the aggregated analysis confirms the positive marginal impact of financial development on growth only in low-income economies, whereas renewable energy consumption has positive marginal effects only in lower-middle-income and upper-middle-income economies. Finally, in most cases, the feedback hypothesisis confirmed between financial development and growth in all countries. Similarly, the bidirectional causality between renewable energy consumption and growth is also confirmed in lower-middle-income and low-income countries, exceptforhigh-income and upper-middle-income economies. Overall, governance quality has a threshold effect on the finance-renewable energy-growth nexus, which varies across countries. Thus, financial development and good governance quality are complementary driving forces for growth in most countries, except in upper-middle-income countries, whereas the complementary effect between renewable energy consumption and governance quality holds only in low-income and high-income countries. Accordingly, our study suggests more improvements in the governance quality in these countries, especially in the low-income and high-income countries to enhance the marginal impacts of financial development and renewable energy consumption on growth.
The Sustainability and Profitability of Bitcoin Mining: A Time-Varying Granger Causality Approach
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In this paper, we investigate the Granger causal relationships between Bitcoin mining, mining profitability and sustainability (the resultant energy consumption and electronic waste), where importantly we allow such relationships to varying over time. We consider three questions relevant to energy-usage, environmental and investors' perspectives. We find that increased mining difficulty not only has a significant effect on the power consumption used for Bitcoin mining from late 2018 to the middle of 2019 but also Granger causes the electronic waste generated from mining from January/February 2018 to April 2019. Moreover, we provide an explanation of why the deployment of massive computer power in mining for Bitcoin as the hash rate Granger causes miners' revenues during the entire sample period 2013-19.
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In this paper, we investigate the Granger causal relationships between Bitcoin mining, mining profitability and sustainability (the resultant energy consumption and electronic waste), where importantly we allow such relationships to varying over time. We consider three questions relevant to energy-usage, environmental and investors' perspectives. We find that increased mining difficulty not only has a significant effect on the power consumption used for Bitcoin mining from late 2018 to the middle of 2019 but also Granger causes the electronic waste generated from mining from January/February 2018 to April 2019. Moreover, we provide an explanation of why the deployment of massive computer power in mining for Bitcoin as the hash rate Granger causes miners' revenues during the entire sample period 2013-19.
