Research articles for the 2019-09-27

A Managed Volatility Investment Strategy for Pooled Annuity Products
Li, Shuanglan,Labit Hardy, Héloïse,Sherris, Michael,Villegas, Andres
Pooled annuity products, where the participants share systematic and idiosyncratic mortality risks as well as investment returns and risk, provide an attractive and effective alternative to traditional guaranteed life annuity products. While longevity risk sharing in pooled annuities has received recent attention, incorporating investment risk beyond fixed interest returns is relatively unexplored. Incorporating equity investments has the potential to increase expected annuity payments at the expense of higher variability. We propose and assess a strategy for incorporating equity investments along with managed-volatility for pooled annuity funds. We show how the managed volatility strategy improves investment performance, while reducing pooled annuity income volatility and downside risk, as well as an investment strategy that reduces exposure to investment risk over time. We quantify the impact of pool size when equity investments are included, showing how these products are viable with relatively small pool sizes.

A Non-Elliptical Orthogonal GARCH Model for Portfolio Selection under Transaction Costs
Paolella, Marc S.,Polak, Pawel,Walker, Patrick S.
Covariance matrix forecasts for portfolio optimization have to balance sensitivity to new data points with stability in order to avoid excessive rebalancing. To achieve this, a new robust orthogonal GARCH model for a multivariate set of non-Gaussian asset returns is proposed. The conditional return distribution is multivariate generalized hyperbolic and the dispersion matrix dynamics are driven by the leading factors in a principle component decomposition. Each of these leading factors is endowed with a univariate GARCH structure, while the remaining eigenvalues are kept constant over time. Joint maximum likelihood estimation of all model parameters is performed via an expectation maximization algorithm, and is applicable in high dimensions. The new model generates realistic correlation forecasts even for large asset universes and captures rising pairwise correlations in periods of market distress better than numerous competing models. Moreover, it leads to improved forecasts of an eigenvalue-based financial systemic risk indicator. Crucially, it generates portfolios with much lower turnover and superior risk-adjusted returns net of transaction costs, outperforming the equally weighted strategy even under high transaction fees.

Attention and Biases: Evidence from Tax-Inattentive Investors
Birru, Justin,Chague, Fernando,De-Losso, Rodrigo,Giovannetti, Bruno
We provide evidence of investor inattention to a very simple and well-known tax-exemption opportunity in the Brazilian stock market. Attentive and inattentive investors are similar along the dimensions of portfolio size and number of trades, but inattentive investors exhibit stronger behavioral biases and worse trading performance. The results hold even among high-activity investors who trade large volumes. The results are consistent with inattention being a common cause of behavioral biases.

Can CoCo-Bonds Mitigate Systemic Risk?
Kund, Arndt-Gerrit,Petras, Matthias
After the 2007 financial crises, the idea of contingent convertible (CoCo) capital was revived and manifold proposed as a means to stabilize individual banks, and hence the entire banking system. The purpose of this paper is to empirically test, whether CoCo-bonds indeed improve the stability of the banking system and reduce systemic risk. Using the broadly applied SRISK metric, we obtain contradicting results, based on the classification of the CoCo-bond as debt or equity. We remedy this short-coming by proposing an adjustment to the original SRISK formula that now correctly accounts for CoCo-bonds. Using empirical tests, we show that the undue disparity has been solved by our adjustment, and that CoCo-bonds reduce systemic risk.

Collusion, Price Dispersion, and Fringe Competition
de Roos, Nicolas,Smirnov, Vladimir
We study the optimal behaviour of a cartel faced with fringe competition and imperfectly attentive consumers. Intertemporal price dispersion obfuscates consumer price comparison which aids the cartel through two channels: it reduces the effectiveness of free riding by the fringe; and it relaxes the cartel’s internal incentive constraints. Our theory explains the survival of a price-setting cartel in a homogeneous product market, provides a collusive rationale for sales and Edgeworth cycles, and characterises the cartel's manipulation of its fringe rival through a double cut-off rule.

Discount-Rate Uncertainty and Cost-Benefit Analysis: Should Long-Lived Projects Be Treated Differently?
Guthrie, Graeme
Evaluating the benefits of investment projects related to climate change is complicated by the uncertainty surrounding key model inputs, especially the discount rate. There is widespread agreement that discount-rate uncertainty requires relaxing the threshold needed to justify investment (typically by using a relatively low discount rate), and that a larger adjustment is appropriate for projects with longer lives. Relaxing the investment test like this is advocated because overestimating the actual discount rate causes bigger valuation errors than underestimating the actual discount rate by the same amount. However, this intuition also applies to the option to wait and reevaluate investment in the future. We find that incorporating investment-timing flexibility reduces â€" and in some practically relevant situations reverses â€" the adjustment needed to allow for discount-rate uncertainty. In particular, when the discount rate is low and uncertainty is high, increases in discount-rate uncertainty can lead to tougher (not easier) investment tests. These results are obtained by modifying a standard investment-timing model to incorporate discount-rate uncertainty, including situations where the distribution of possible discount rates is unknown.

Does the Financial Reporting for Income Tax Expense Affect Financial Reporting Quality? Evidence from the Timeliness of Goodwill Impairments
King, Zachary,Lynch, Dan,Stomberg, Bridget,Utke, Steven
Goodwill impairments are an important signal of expected future cash flows, yet their timing is subject to managers’ discretion. U.S. GAAP requires firms to test all goodwill for impairment but tax laws worldwide do not always allow goodwill deductions. As such, financial reporting tax benefits partially offset the negative GAAP earnings effect of impairments only for tax-amortizable goodwill and not for impairments of non-tax-amortizable goodwill. Holding the size of the impairment constant, the GAAP net income effect is therefore more negative for impairments of non-tax-amortizable goodwill than impairments of tax-amortizable goodwill. We predict and find that impairments of tax-amortizable goodwill are 16 to 20 percent less likely to be delayed than impairments of non-tax-amortizable goodwill. We also find impairments of tax-amortizable goodwill are more delayed when firms record valuation allowances that negate financial reporting tax benefits. Our findings suggest financial reporting for taxes potentially distort the timeliness of goodwill impairments.

Integration Among US Banks
Anand, Abhinav,Cotter, John
We define and measure integration among a sample of 357 US banks over 25 years from 1993 to 2017 and show that the median US bank's integration has increased significantly post-2005. During the great recession and the Eurozone crisis, integration levels among US banks display a significant rise over and above their trend. We nd that bank size is the most economically and statistically significant characteristic in explaining integration levels. Size and the equity ratio show positive association with bank integration while the net interest margin and combined tier 1 and tier 2 capital ratio influence bank integration negatively. For regulators, abnormally high integration levels indicate warning signs of potential distress in the banking sector.

Intraday Disclosure Timing Deviations and Their Implications for Financial Reporting
Tucker, Jenny Wu,Wang, Angie
A firm makes several financial reporting and disclosure decisions in a short period of time. Seemingly unrelated decisions may be correlated because of stability in management traits or the continuation of a firm’s accounting information system. We find that firms with greater deviations from their earnings-announcement intraday timing patterns during a fiscal year tend to report larger magnitudes of discretionary accruals for that year and are more likely to subsequently restate that year’s accounting information due to intentional errors. In addition, we find that firms with more timing deviations are more likely to receive auditors’ reports of internal control weaknesses. Moreover, we find that firms with inconsistent intraday timing have significantly lower subsequent stock returns than firms with consistent intraday timing. Overall, our findings suggest that a firm’s intraday disclosure timing deviations during a fiscal year are a telltale sign of the quality of its subsequent financial reporting for that year and that this signal is not fully utilized by investors.

Political Momentum
Bonaparte, Yosef
We show that stock prices underreact when there is a political event, reflected in higher momentum returns. We conjecture that political news crowds out stock news cause investors to underreact to firm specific news. We examine momentum returns following general election day, and find 8.8% increase in momentum portfolio return across the following days in November. Our channel to identify higher momentum after elections encompasses both rational and behavioral parts. The rational part is due to political uncertainty around elections and the behavioral part is due to investors’ distraction. Using Google trend data, we posit that investors change their news priorities to focus more on political news, and so some stock news slips under the radar. In sum, momentum strategies outperform during election cycles because investors’ distraction to stock market news.

Predicting Returns Out of Sample: A Naïve Model Averaging Approach
Chen, Huafeng (Jason),Jiang, Liang,Liu, Weiwei
The seminal paper by Goyal and Welch (2008) shows that variables that can forecast market returns in sample do not beat historical averages in forecasting market returns out of sample (i.e., the out-of-sample R2s are mostly negative). We reexamine this issue and present four findings: (i) A naïve model averaging (NMA) method, by equally weighting the ordinary least squares (OLS) out-of-sample forecasts and the historical means, produces positive out-of-sample R2s for the variables that are significant in sample. (ii) The NMA method is helpful even after we impose additional restrictions, as in Campbell and Thompson (2008). When constructing composition forecasts based on multiple forecasting variables, our method of using historical means information is also useful relative to the method in Rapach, Strauss, and Zhou (2010). (iii) The Bayesian model averaging (BMA) approach fails to perform better than the NMA method. (iv) Declining return predictability does not explain the performance of the NMA method, which might be better explained by model misspecification.

Shadow Banking: Kill It or Save It? Experiences from Taiwan and China
Lin, Hong-Jen
Shadow banking is important in financial systems. Its businesses have increased rapidly in the US. It also contributes to the fast economic growth but it also causes high financial risk in China. This paper reviews the literature in the shadow banking and lists it pros and cons. Then the policy implication and a concise history of the shadow banking in Taiwan are discussed. We can learn from the experience of Taiwan and scrutinize the current policies and regulations in China. Further the paper predicts the future trend according to economic theories and historical events.

The Consequences to Directors of Deploying Poison Pills
Johnson, William C.,Karpoff, Jonathan M.,Wittry, Michael D.
We examine the labor market consequences for directors who adopt poison pills. Directors who become associated with pill adoption experience significant decreases in vote margins and increases in termination rates across all their directorships. They also experience a decrease in the likelihood of new board appointments. Firms have positive abnormal stock price reactions when pill-associated directors die or depart their boards, compared to zero abnormal returns for other directors. Further tests indicate that these adverse consequences accrue primarily to directors involved in the adoption of pills at seasoned firms and not at young firms. We conclude that directors who become associated with poison pill adoption suffer a decrease in the value of their services, and that the director labor market thus plays an important role in firms’ governance.

The Market Reaction to Green Bond Issuance: Evidence from China
Wang, Jiazhen,Chen, Xin,Li, Xiaoxia,Yu, Jing,Zhong, Rui
This paper provides the first evidence of the debt and stock market reaction to corporate green bond issuance in the simultaneously largest developing economy and largest emerging debt market, China. Utilizing a most comprehensive sample of Chinese green bonds, we document a pricing premium of corporate green bonds relative to conventional bonds. The economic magnitude of the Chinese green bond pricing premium is greatly larger than that of an international green bond documented in prior studies. The pricing premium of corporate green bonds is most pronounced for new issues from high corporate social responsibility (CSR) issuers and underwriters. Given there is no public governance of green bonds, this finding implies the importance of issuer and underwriter social reputation in certifying environment-sensitive bonds in emerging markets. Further analysis reveals positive announcement stock returns for green bond new issues, consistent with the stakeholder value maximization theory that corporate engagement in sustainable financing practice increases firm value in a long run and thus is favored by shareholders.

The Reverse Agency Problem in the Age of Compliance
Eckstein, Asaf,Parchomovsky, Gideon
The agency problem, the idea that corporate directors and officers are motivated to prioritize their self-interest over the interest of their corporation, has had long-lasting impact on corporate law theory and practice. In recent years, however, as federal agencies have stepped up enforcement efforts against corporations, a new problem that is the mirror image of the agency problem has surfaced â€" the reverse agency problem. The surge in criminal investigations against corporations, combined with the rising popularity of settlement mechanisms including Pretrial Diversion Agreements (PDAs), and corporate plea agreements, has led corporations to sacrifice directors and officers in order to reach settlements with law enforcement authorities as expeditiously as possible.While such settlements are in the best interest of companies and shareholders, they have devastating effects for individual directors and officers. When settling through agreements, suspect companies usually attribute wrongdoing to a large group of directors and managers, without distinguishing among guilty and innocent individuals, and surrender all their information. As a result, directors and officers implicated in settlements may suffer severe reputational loss and face legal battles brought by corporations. Furthermore, the wrongdoing attributed to directors and officers in settlements expose them to derivative lawsuits for breach of their fiduciary duties. Unfortunately, extant law does not provide directors and officers with a means to prove their innocence or clear their name. In fact, it does not even give them a voice in the negotiations leading to the drafting of settlements. Thus, it dooms many directors and officers who have done no wrong to live with the mark of Cain and endure the economic consequences thereof.To remedy the plight of individual directors and officers, we suggest three possible legal reforms. The first seeks to amplify the voice of individual corporate officers in settlement negotiations by giving them a right to a hearing prior to the finalization of a settlement. The second is to give directors and officers implicated in settlements the right to bring an action for a declaratory judgment that could clear their name and preempt derivative actions against them. The third solution is to recognize a horizontal fiduciary duty between directors and officers, thereby allowing innocent directors and officers the right to sue their guilty colleagues for breaching such duty.

The Rise and Fall of the Carry Trade: Links to Exchange Rate Predictability
Filippou, Ilias,Rapach, David,Taylor, Mark P.,Zhou, Guofu
We investigate out-of-sample exchange rate predictability in a high-dimensional panel predictive regression model that includes numerous country characteristics and their interactions with a variety of global variables. To avoid the overfitting problem that plagues conventional estimation of high-dimensional models, we estimate the panel predictive regression model via the elastic net, a machine learning technique based on penalized regression. The elastic net forecasts significantly outperform the no-change benchmark forecast that has proven difficult to beat in the literature. Out-of-sample exchange rate predictability becomes considerably stronger starting in the fall of 2008 during the worst stage of the global financial crisis. We show that exchange rate predictability can substantially improve the performance of conventional carry trade strategies: a smart carry portfolio that incorporates the information in the elastic net forecasts avoids the crash experienced by a conventional carry portfolio in late 2008 and markedly improves portfolio performance thereafter.

The Way People Lie in Markets
Tergiman, Chloe,Villeval, Marie Claire
In a finitely repeated game with asymmetric information, we experimentally study how reputation and standard market mechanisms change the nature of fraudulent announcements by experts. While some lies can be detected ex post by investors, other lies remain deniable. Lying behavior suggests that individuals care more about the consequences of being caught, rather than the act of lying per se. Allowing for reputation reduces the frequency of lies that can be detected but has no impact on deniable lies: individuals simply hide their lies better and fraud persists. Competition without reputation increases risky lies and never protects investment.

Time-Varying Risk Aversion: Evidence from Near-Miss Accidents
Shum, Matthew,Xin, Yi
We present evidence consistent with time-varying risk preferences among automobile drivers. Exploiting a unique dataset of agents’ high-frequency driving behavior collected by a mobile phone application, we show that driving behavior changes after driving mishaps. Following “near-miss” accidents (measured by hard brakes or hard turns), drivers drive more conservatively, which is consistent with increased risk aversion following such mishaps. In a preferred specification, a near-miss triggers a reduction in driving distance of 8.12 kilometers, in-car cellphone use by 88.80%, and highway use by 34.88%. Calibration results indicate that such changes in behavior are consistent with an increase in risk aver- sion of 104.05â€"288.98% and a reduction in annual insurance cost of 2.98â€"87.82 Yuan per person, which is about 0.05â€"1.54% of the average car insurance premium.