Research articles for the 2019-10-07

A Crash Course on the Euro Crisis
Brunnermeier, Markus K.,Reis, Ricardo
The financial crises of the last twenty years brought new economic concepts into classroom discussions. This article introduces undergraduate students and teachers to seven of these models: (i) misallocation of capital inflows, (ii) modern and shadow banks, (iii) strategic complementarities and amplification, (iv) debt contracts and the distinction between solvency and liquidity, (v) the diabolic loop, (vi) regional flights to safety, and (vii) unconventional monetary policy. We apply each of them to provide a full account of the euro crisis of 2010-12.

A Supply and Demand Approach to Equity Pricing
Betermier, Sebastien,Calvet, Laurent E.,Jo, Evan
This paper presents a frictionless neoclassical model of financial markets in which firm sizes, stock returns, and the pricing kernel are all endogenously determined. The model parsimoniously specifies the supply and demand of financial capital allocated to each firm and provides general equilibrium sizes and returns in closed form. We show that the interaction of supply and demand can coherently explain a large number of asset pricing facts. The equilibrium security market line is flatter than the CAPM predicts and can be nonlinear or downward-sloping. The model also generates the size, profitability, investment growth, value, asymmetric volatility, betting-against-beta, and betting-against-correlation anomalies, while also fitting the cross-section of firm characteristics.

A tale of two sentiment scales: Disentangling short-run and long-run components in multivariate sentiment dynamics
Danilo Vassallo,Giacomo Bormetti,Fabrizio Lillo

We propose a novel approach to sentiment data filtering for a portfolio of assets. In our framework, a dynamic factor model drives the evolution of the observed sentiment and allows to identify two distinct components: a long-term component, modeled as a random walk, and a short-term component driven by a stationary VAR(1) process. Our model encompasses alternative approaches available in literature and can be readily estimated by means of Kalman filtering and expectation maximization. This feature makes it convenient when the cross-sectional dimension of the sentiment increases. By applying the model to a portfolio of Dow Jones stocks, we find that the long term component co-integrates with the market principal factor, while the short term one captures transient swings of the market associated with the idiosyncratic components and captures the correlation structure of returns. Finally, using quantile regressions, we assess the significance of the contemporaneous and lagged explanatory power of sentiment on returns finding strong statistical evidence when extreme returns, especially negative ones, are considered.

A theorem of Kalman and minimal state-space realization of Vector Autoregressive Models
Du Nguyen

We introduce a concept of $autoregressive$ (AR)state-space realization that could be applied to all transfer functions $\boldsymbol{T}(L)$ with $\boldsymbol{T}(0)$ invertible. We show that a theorem of Kalman implies each Vector Autoregressive model (with exogenous variables) has a minimal $AR$-state-space realization of form $\boldsymbol{y}_t = \sum_{i=1}^p\boldsymbol{H}\boldsymbol{F}^{i-1}\boldsymbol{G}\boldsymbol{x}_{t-i}+\boldsymbol{\epsilon}_t$ where $\boldsymbol{F}$ is a nilpotent Jordan matrix and $\boldsymbol{H}, \boldsymbol{G}$ satisfy certain rank conditions. The case $VARX(1)$ corresponds to reduced-rank regression. Similar to that case, for a fixed Jordan form $\boldsymbol{F}$, $\boldsymbol{H}$ could be estimated by least square as a function of $\boldsymbol{G}$. The likelihood function is a determinant ratio generalizing the Rayleigh quotient. It is unchanged if $\boldsymbol{G}$ is replaced by $\boldsymbol{S}\boldsymbol{G}$ for an invertible matrix $\boldsymbol{S}$ commuting with $\boldsymbol{F}$. Using this invariant property, the search space for maximum likelihood estimate could be constrained to equivalent classes of matrices satisfying a number of orthogonal relations, extending the results in reduced-rank analysis. Our results could be considered a multi-lag canonical-correlation-analysis. The method considered here provides a solution in the general case to the polynomial product regression model of Velu et. al. We provide estimation examples. We also explore how the estimates vary with different Jordan matrix configurations and discuss methods to select a configuration. Our approach could provide an important dimensional reduction technique with potential applications in time series analysis and linear system identification. In the appendix, we link the reduced configuration space of $\boldsymbol{G}$ with a geometric object called a vector bundle.

An Experiment on Network Density and Sequential Learning
Krishna Dasaratha,Kevin He

We conduct a sequential social-learning experiment where subjects take turns guessing a hidden state based on private signals and the guesses of a subset of their predecessors. A network determines the observable predecessors, and we compare subjects' accuracy on sparse and dense networks. Accuracy gains from social learning are twice as large on sparse networks compared to dense networks. Models of naive inference where agents ignore correlation between observations predict this comparative static in network density, while the finding is difficult to reconcile with rational-learning models.

Bank Intermediation Activity in a Low Interest Rate Environment
Borio, Claudio E. V.,Brei, Michael,Gambacorta, Leonardo
This paper investigates how the prolonged period of low interest rates affects bank intermediation activity. We use data for 113 large international banks headquartered in 14 major advanced economies during the period 1994â??2015. We find that low interest rates induce banks to shift their activities from interest-generating to fee-related and trading activities. This rebalancing is stronger for low capitalised banks. Banks also moderately adjust their funding structure, away from short-term market funding towards deposits. We observe a concomitant decline in the risk-weighted asset ratio and a reduction in loan-loss provisions, which is consistent with signs of evergreening.

Business Cycles and Currency Returns
Colacito, Ric,Sarno, Lucio,Riddiough, Steven
We find a strong link between currency excess returns and the relative strength of the business cycle. Buying currencies of strong economies and selling currencies of weak economies generates high returns both in the cross section and time series of countries. These returns

Can Risk Be Shared Across Investor Cohorts? Evidence from a Popular Savings Product
Hombert, Johan,Lyonnet, Victor
This paper shows how one of the most popular savings products in Europe -- life insurance financial products -- shares market risk across investor cohorts. Insurers smooth returns by varying reserves that offset fluctuations in asset returns. Reserves are passed on between successive investor cohorts, causing redistribution across cohorts. Using regulatory and survey data on the 1.4 trillion euro French market, we estimate this redistribution to be quantitatively large: 1.4% of savings value per year on average, or 0.8% of GDP. These findings challenge a large theoretical literature that assumes inter-cohort risk sharing is impossible. We develop and provide evidence for a model in which the elasticity of investor demand to predictable returns determines the amount of risk sharing that is possible. The evidence is consistent with low elasticity, sustaining inter-cohort risk sharing despite predictable returns. Demand elasticity is higher for investors with a larger investment amount, suggesting that low investor sophistication enables inter-cohort risk sharing.

Characteristic-Sorted Portfolios: Estimation and Inference
Matias D. Cattaneo,Richard K. Crump,Max H. Farrell,Ernst Schaumburg

Portfolio sorting is ubiquitous in the empirical finance literature, where it has been widely used to identify pricing anomalies. Despite its popularity, little attention has been paid to the statistical properties of the procedure. We develop a general framework for portfolio sorting by casting it as a nonparametric estimator. We present valid asymptotic inference methods and a valid mean square error expansion of the estimator leading to an optimal choice for the number of portfolios. In practical settings, the optimal choice may be much larger than the standard choices of 5 or 10. To illustrate the relevance of our results, we revisit the size and momentum anomalies.

Commodity Option Pricing Efficiency Before Black Scholes Merton
Chambers, David
It is often thought that the arrival of the Black Scholes Merton (BSM) model of option pricing in the early 1970s allowed traders to understand how to price and value options with greater precision. Yet, our study suggests that interwar commodity option traders may have been able to intuit 'fair' value and to adjust their prices to changes in the market environment well before the advent of this innovative model. A scarcity of historical price data has limited empirical tests of option price efficiency well before BSM to prior studies of stock options in the 1870s and the early twentieth century which reach contrasting findings. This study deals with option pricing in a different market â?? commodities â?? during the interwar period. We conclude that option prices were closer to their BSM theoretical values than suggested by prior studies. Institutional differences between interwar commodity options market and stock option markets in the 1870s and the early twentieth century may partly account for this result. Furthermore, we find that interwar option prices were no more mispriced and were as sensitive to changes in volatility â?? the key valuation parameter in the BSM model â?? as in modern times.

Constrained Credit Networks
Geoffrey Ramseyer,Ashish Goel,David Mazieres

The Credit Network is a model for transactions across a network of agents based on bilateral trust between agents. Credit Networks capture many aspects of traditional currencies as well as new virtual currencies and payment mechanisms. In a credit network, if an agent defaults, every other node that trusted it is vulnerable to loss. Alternatively, in a cryptocurrency context, securing a payment channel requires putting capital into escrow to guarantee against default. In this paper, we introduce constraints that bound the total amount of loss that the rest of the network can suffer if an agent (or a set of agents) were to default. We show that these constraints preserve two important aspects of credit networks. The first is route independence: if there are multiple trust-paths over which a transaction can clear, then it does not matter which one is used. The second pertains to liquidity (i.e. the fraction of transactions that succeed): given a symmetric transaction matrix, any achievable vector of net "credit balances" of the agents is equally likely. This technical property allows us to extend the original analysis of liquidity in credit networks to the constrained case. Surprisingly, aggregate borrowing constraints greatly simplify the analysis and achieve the optimal tradeoff between liquidity and the number of trust-edges.

Cross-Border Asset Pledgeability for Enhanced Financial Stability
Choi, Gongpil
Even with the sizable FX holdings and good credit ratings of its top assets, Asia remains vulnerable to various shocks. This paper highlights the limited cross-border asset pledgeability as a significant factor for the lingering vulnerability in Asia. The dichotomy in asset holdings between pledgeable FX and non-pledgeable domestic assets in major economies in Asia has been the source of increasing stabilization costs as well as weakened market momentum in the region. Specifically, the peculiar feature of asset holdings in Asia reflects seriously deficient cross-border asset pledgeability that is left unaddressed. Asset pledgeability contributes toward financial stability via three channels: capital market development by recognizing the role of collateral, increased shock absorption capacity via collateral management, and the newly activated safe asset provision. Therefore, it is important to go beyond the usual market development strategy and expand the overall asset pledgeability in the region that has remained unduly depressed.

Cryptocurrencies, Currency Competition, and the Impossible Trinity
Benigno, Pierpaolo,Schilling, Linda Marlene,Uhlig, Harald
We analyze a two-country economy with complete markets, featuring two national currencies as well as a global (crypto)currency. If the global currency is used in both countries, the national nominal interest rates must be equal and the exchange rate between the national currencies is a risk- adjusted martingale. We call this result Crypto-Enforced Monetary Policy Synchronization (CEMPS). Deviating from interest equality risks approaching the zero lower bound or the abandonment of the national currency. If the global currency is backed by interest-bearing assets, additional and tight restrictions on monetary policy arise. Thus, the classic Impossible Trinity becomes even less reconcilable.

Distracted Institutional Investors and Audit Risk
Wu, Hai,Yang , Jingyu,Yu, Yangxin
We use a newly developed institutional investor distraction measure (Kempf, Manconi, & Spalt, 2016) to examine whether auditors charge higher audit fees and exert higher efforts when their clients’ institutional investors temporarily reduce their monitoring activities. We find that audit fees and audit report lags increase significantly during periods when institutional investors are distracted. This effect is stronger when dedicated institutional investors are distracted. We further show that the positive association between the investor distraction measure and audit risk measures declines in the post-Sarbanesâ€"Oxley Act period. Collectively, our results suggest that institutional shareholders monitoring activities benefits auditors by reducing audit risks. This paper also shows that the negative effect of investors’ limited attentions on corporate monitoring can to some extent be mitigated by auditors.

Estimating the volatility of Bitcoin using GARCH models
Samuel Asante Gyamerah

In this paper, an application of three GARCH-type models (sGARCH, iGARCH, and tGARCH) with Student t-distribution, Generalized Error distribution (GED), and Normal Inverse Gaussian (NIG) distribution are examined. The new development allows for the modeling of volatility clustering effects, the leptokurtic and the skewed distributions in the return series of Bitcoin. Comparative to the two distributions, the normal inverse Gaussian distribution captured adequately the fat tails and skewness in all the GARCH type models. The tGARCH model was the best model as it described the asymmetric occurrence of shocks in the Bitcoin market. That is, the response of investors to the same amount of good and bad news are distinct. From the empirical results, it can be concluded that tGARCH-NIG was the best model to estimate the volatility in the return series of Bitcoin. Generally, it would be optimal to use the NIG distribution in GARCH type models since time series of most cryptocurrency are leptokurtic.

Family Ownership and Antitrust Violations
Amore, Mario Daniele,Marzano, Riccardo
We study how family ownership shapes the firms' likelihood of being involved in antitrust indictments. Using data from Italy, we show that family firms are significantly less likely than other firms to commit antitrust violations. To achieve identification, we exploit a law change that made it easier to transfer family control. Studying the mechanisms at play, we find that family firms are especially less likely to commit antitrust violations when they feature a more prominent size relative to the city where they are located, which magnifies reputational concerns. Next, we show that family firms involved in antitrust violations appoint more family members in top executive positions in the aftermath of the indictment. Moreover, these firms invest less and curb equity financing as compared to nonfamily firms. Collectively, our findings suggest that family control wards off reputational damages but, at the same time, it weakens the ability to expand in order to keep up with fiercer competition following the dismantlement of the anticompetitive practice.

Finance and Carbon Emissions
De Haas, Ralph,Popov, Alexander A.
We study the relation between financial structure and carbon emissions in a large panel of countries and industries. For given levels of

Financial Frictions and the Wealth Distribution
Fernández-Villaverde, Jesús,Hurtado, Samuel,, Galo Nuno
This paper investigates how, in a heterogeneous agents model with financial frictions, idiosyncratic individual shocks interact with exogenous aggregate shocks to generate time-varying levels of leverage and endogenous aggregate risk. To do so, we show how such a model can be efficiently computed, despite its substantial nonlinearities, using tools from machine learning. We also illustrate how the model can be structurally estimated with a likelihood function, using tools from inference with diffusions. We document, first, the strong nonlinearities created by financial frictions. Second, we report the existence of multiple stochastic steady states with properties that differ from the deterministic steady state along important dimensions. Third, we illustrate how the generalized impulse response functions of the model are highly state-dependent. In particular, we find that the recovery after a negative aggregate shock is more sluggish when the economy is more leveraged. Fourth, we prove that wealth heterogeneity matters in this economy because of the asymmetric responses of household consumption decisions to aggregate shocks.

Fiscal Distress and Banking Performance: The Role of Macroprudential Regulation
Balfoussia, Hiona,Dellas, Harris,Papageorgiou, Dimitris
Fiscal fragility can undermine a government's ability to honor its bank deposit insurance pledge and induces a positive correlation between sovereign default risk and financial (bank) default risk. We show that this positive relation is reversed if bank capital requirements in fiscally weak countries are allowed to adjust optimally. The resulting higher requirements buttress the banking system and support higher output and welfare relative to the case where macroprudential policy does not vary with the degree of fiscal stress. Fiscal tenuousness also exacerbates the effects of other risk shocks. Nonetheless, the economy's response can be mitigated if macroprudential policy is adjusted optimally. Our analysis implies that, on the basis of fiscal strength, fiscally weak countries would favor and fiscally strong countries would object to banking union.

Growth, Industrial Externality, Prospect Dynamics and Well-being on Markets
Emmanuel Chauvet

Functions or 'functionings' enable to give a structure to any economic activity whether they are used to describe a good or a service that is exchanged on a market or they constitute the capability of an agent to provide the labor market with specific work and skills. That structure encompasses the basic law of supply and demand and the conditions of growth within a transaction and of the inflation control. Functional requirements can be followed from the design of a product to the delivery of a solution to a customer needs with different levels of externalities while value is created integrating organizational and technical constraints whereas a budget is allocated to the various entities of the firm involved in the production. Entering the market through that structure leads to designing basic equations of its dynamics and to finding canonical solutions out of particular equilibria. This approach enables to tackle behavioral foundations of Prospect Theory within a generalization of its probability weighting function turned into an operator which applies to Western, Educated, Industrialized, Rich, and Democratic societies as well as to the poorest ones. The nature of reality and well-being appears then as closely related to the relative satisfaction reached on the market, as it can be conceived by an agent, according to business cycles. This reality being the result of the complementary systems that govern human mind as structured by rational psychologists.

Harmonizing the EU Regulation in the Banking Union
Kudrna, Zdenek,Riekmann, Sonja Puntscher
The European Central Bank strives to harmonize over 160 national options and discretions (O&Ds) that contribute to the fragmentation of the banking union’s regulatory framework. National authorities seem prepared to accept it, despite previously insisting on the inclusion of all O&Ds into the EU legislation. We analyze a sample of O&D choices and their correspondence to cleavages pertinent to the political economy of EU banking. We find that the 11 post-communist member states use O&Ds more stringently to protect capital and liquidity in the local subsidiaries of foreign-own banks, which may complicate their potential opt-in to the banking union.

Heterogeneity in Decentralized Asset Markets
Hugonnier, Julien,Lester, Benjamin R.,Weill, Pierre-Olivier
We study a search and bargaining model of asset markets in which investors' heterogeneous

Hierarchical PCA and Applications to Portfolio Management
Marco Avellaneda

It is widely known that the common risk-factors derived from PCA beyond the first eigenportfolio are generally difficult to interpret and thus to use in practical portfolio management. We explore a alternative approach (HPCA) which makes strong use of the partition of the market into sectors. We show that this approach leads to no loss of information with respect to PCA in the case of equities (constituents of the S&P 500) and also that the associated common factors admit simple interpretations. The model can also be used in markets in which the sectors have asynchronous price information, such as single-name credit default swaps, generalizing the works of Cont and Kan (2011) and Ivanov (2016).

Hierarchical PCA and Applications to Portfolio Management
Avellaneda, Marco
It is widely known that the common risk-factors derived from PCA beyond the first eigenportfolio are generally difficult to interpret and thus to use in practical portfolio management. We explore a alternative approach (HPCA) which makes strong use of the partition of the market into sectors. We show that this approach leads to no loss of information with respect to PCA in the case of equities (constituents of the S&P 500) and also that the associated common factors admit simple interpretations. The model can also be used in markets in which the sectors have asynchronous price information, such as single-name credit default swaps, generalizing the works of Cont and Kan (2011) and Ivanov (2016).

Intermediary-Based Equity Term Structure
Li, Kai,Xu, Chenjie
New empirical facts show that equity term premium is counter-cyclical, while the term structure of equity yield is pro-cyclical and switches sign between expansions and recessions. We decompose the term structure of equity yield into an equity term premium and a mean reversion component about the expected changes in future yields to understand this seemingly contradictive evidence. Although the first component is counter-cyclical, we show the second mean reversion component dominantly drives the pro-cyclical fluctuations of the overall equity yield curve. We propose a financial intermediary-based asset pricing model to quantitatively account for both facts simultaneously. In our model, the mean reversion component is endogenously driven by the time-varying tightness of the intermediaries' leverage constraint. We demonstrate that the cyclical pattern of equity term structure imposes a strong discipline on the speed of mean reversion of discount rate for any standard asset pricing models. In the standard calibration of long-run risks model Bansal and Yaron (2004) and habit model Campbell and Cochrane (1999), the mean reversion speed of discount rate is too slow to account for a negative correlation between equity yield curve and equity term premium.

Internal Auditor Turnover, Financial Reporting Quality, and Audit Risk Assessment
Bills, Kenneth L.,Huang, Hua‐Wei,Lin, Yi-Hung,Wood, David A.
Internal audit serves a valuable monitoring role inside of companies; yet, we understand relatively little about factors that affect internal audit’s ability to monitor financial reporting. We study one factor â€" how turnover of the chief audit executive (CAE) position influences financial reporting quality and audit risk assessment. Using data from Taiwan where companies are required to disclose when and why CAEs change position, we find that a CAE turnover event is associated with a significant increase in the odds of a financial statement misstatement and an increase in discretionary accruals. Furthermore, we find that the relation only holds for firms with forced CAE changes (i.e., demotions, dismissals, or resignations) and not for unforced changes (i.e., lateral moves in the company, promotions, retirements, etc.). We exclude observations with contemporaneous CEO, CFO, or auditor switches and control for changes in signing audit partners. Results are robust to a generalized difference-in-difference design that includes both year and company fixed effects. We corroborate these findings by examining external auditors’ response to CAE turnover and find that external auditors charge higher fees the year there is a CAE change. The results provide evidence of the important monitoring role of internal auditing, and especially of the critical role the CAE plays in the internal audit function.

Macroprudential Policy with Leakages
Bengui, Julien,Bianchi, Javier
The outreach of macroprudential policies is likely limited in practice by imperfect regulation enforcement, whether due to shadow banking, regulatory arbitrage, or other regulation circumvention schemes. We study how such concerns affect the design of optimal regulatory policy in a workhorse model in which pecuniary externalities call for macroprudential taxes on debt, but with the addition of a novel constraint that financial regulators lack the ability to enforce taxes on a subset of agents. While regulated agents reduce risk taking in response to debt taxes, unregulated agents react to the safer environment by taking on more risk. These leakages do undermine the effectiveness of macruprudential taxes, yet they do not necessarily call for weaker interventions. Quantitatively, we find that a well-designed macroprudential policy that accounts for leakages remains successful at mitigating the vulnerability to financial crises.

Microfinance Cuban Style: The New Financial Framework for the Cuban Non-State Sector
Vidal Alejandro, Pavel,Viswanath, P.V.
The Cuban economic system and, along with it, the Cuban financial system has been changing since the coming to power of Raul Castro. In this paper, we analyze some of the changes in the Cuban financial system and the goals of the government in implementing these changes. Using the results of a survey of non-state businesses, we look at the microfinance sector â€" the provision of financial services to the small and medium enterprises in the non-state sector â€" from two perspectives: first, the nature of the new credit regulations and bank policies and how they accomplish the evaluation of credit to a hitherto non-existent sector; and second, how do these small business clients view their relationship with their lender state banks. We look at Cuban finance from the perspective of a socialist economy in transition and compare it to microfinance elsewhere, particularly in China and India.

Microfoundations of Discounting
Alexander Adamou,Yonatan Berman,Diomides Mavroyiannis,Ole Peters

An important question in economics is how people choose between different payments in the future. The classical normative model predicts that a decision maker discounts a later payment relative to an earlier one by an exponential function of the time between them. Descriptive models use non-exponential functions to fit observed behavioral phenomena, such as preference reversal. Here we propose a model of discounting, consistent with standard axioms of choice, in which decision makers maximize the growth rate of their wealth. Four specifications of the model produce four forms of discounting -- no discounting, exponential, hyperbolic, and a hybrid of exponential and hyperbolic -- two of which predict preference reversal. Our model requires no assumption of behavioral bias or payment risk.

Modelling Currency Crises in Nigeria: An Application of Logit Model
Omotosho, Babatunde
Currency crises inflict significant social and economic costs on economies that have suffered its occurrence. Thus, statistical models have been developed over the years to construct reliable early warning systems as part of strategies for preventing or reducing the devastating effects of such crises. To the knowledge of this study, no recent work has been done in this regard with respect to Nigeria, especially following the 2008/09 global financial crisis. Using a logit model, this paper estimates the probabilities of currency crises in Nigeria as a logistic function of selected macroeconomic variables. Particularly, it provides answer to the question of whether real exchange rate misalignment propels currency crises. The empirical investigation used quarterly data for the period 2000Q1 to 2012Q4. Model results show that the likelihood of currency crisis in Nigeria increases when the real exchange rate is misaligned; the exchange rate is volatile; oil price declines; debt/GDP ratio increases; and the current account balance to GDP ratio declines. Real exchange rate misalignment has overarching influence on the tendency for currency crash during the estimation period. The paper therefore recommends regular assessments of the value of the Naira exchange rate vis-à-vis its equilibrium level with a view to implementing appropriate policy responses to arrest or avoid prolonged and substantial misalignment. Since all the variables entered the equation in their one period lag, the estimated model constitutes a reliable early warning system to policy makers on the likelihood of impending currency crisis in the country.

Money Runs
Donaldson, Jason Roderick,Piacentino, Giorgia
We develop a model in which, as in practice, bank debt is both a financial security used to raise funds and a kind of money used to facilitate trade. This dual role of bank debt provides a new rationale for why banks do what they do. In the model, banks endogenously perform the essential functions of real-world banks: they transform liquidity, transform maturity, pool assets, and have dispersed depositors. Moreover, they make their debt redeemable on demand. Thus, they are endogenously fragile. We show novel effects of narrow banking, suspension of convertibility, and some other policies.

Near-Rational Equilibria in Heterogeneous-Agent Models: A Verification Method
Kogan, Leonid,Mitra, Indrajit
We propose a simulation-based procedure for evaluating approximation accuracy of numerical solutions of general equilibrium models with heterogeneous agents. We measure the approximation accuracy by the magnitude of the welfare loss suffered by agents from following sub-optimal policies. Our procedure allows agents to have knowledge of the future paths of the economy under suitably imposed costs of foresight. This method is general, straightforward to implement, and can be used in conjunction with various solution algorithms. We illustrate our method in two contexts: the incomplete-markets model of Krusell and Smith (1998) and the heterogeneous firm model of Khan and Thomas (2008).

No-arbitrage with multiple-priors in discrete time
Romain Blanchard,Laurence Carassus

In a discrete time and multiple-priors setting, we propose a new characterisation of the condition of quasi-sure no-arbitrage which has become a standard assumption. This characterisation shows that it is indeed a well-chosen condition being equivalent to several previously used alternative notions of no-arbitrage and allowing the proof of important results in mathematical finance. We also revisit the so-called geometric and quantitative no-arbitrage conditions and explicit two important examples where all these concepts are illustrated.

Optimal Convergence Trading with Unobservable Pricing Errors
Sühan Altay,Katia Colaneri,Zehra Eksi

We study a dynamic portfolio optimization problem related to convergence trading, which is an investment strategy that exploits temporary mispricing by simultaneously buying relatively underpriced assets and selling short relatively overpriced ones with the expectation that their prices converge in the future. We build on the model of Liu and Timmermann (2013) and extend it by incorporating unobservable Markov-modulated pricing errors into the price dynamics of two co-integrated assets. We characterize the optimal portfolio strategies in full and partial information settings both under the assumption of unrestricted and beta-neutral strategies. By using the innovations approach, we provide the filtering equation that is essential for solving the optimization problem under partial information. Finally, in order to illustrate the model capabilities, we provide an example with a two-state Markov chain.

Optimal Dividend Strategy for An Insurance Group with Contagious Default Risk
Zhuo Jin,Huafu Liao,Yue Yang,Xiang Yu

This paper studies the optimal dividend for a multi-line insurance group, in which each subsidiary runs a product line and is exposed to some external credit default risk. The external default contagion is considered in the sense that one default event can affect the default probabilities of all surviving subsidiaries. The total dividend problem is formulated for the insurance group and we reveal for the first time that the optimal singular dividend strategy is still of the barrier type. Furthermore, we show that the optimal barrier for each subsidiary is modulated by the current default state, namely how many and which subsidiaries have defaulted will determine the dividend threshold for each surviving subsidiary. These interesting conclusions are based on our analysis of the associated recursive system of Hamilton-Jacobi-Bellman variational inequalities (HJBVIs), which is new to the literature. The existence of the classical solution is established and the rigorous proof of the verification theorem is provided. For the case of two subsidiaries, the value function and optimal barriers for each subsidiary are explicitly constructed. Some numerical examples are also presented to illustrate the economic insights.

Ownership, Wealth, and Risk Taking: Evidence on Private Equity Fund Managers
Bienz, Carsten,Thorburn, Karin S.,Walz, Uwe
We examine the incentive effects of private equity (PE) professionals' ownership in the funds they manage. In a simple model, we show that managers select less risky firms and use more debt financing the higher their ownership. We test these predictions for a sample of PE funds in Norway, where the professionals' private wealth is public. Consistent with the model, firm risk decreases and leverage increases with the manager's ownership in the fund, but largely only when scaled with her wealth. Moreover, the higher the ownership, the smaller is each individual investment, increasing fund diversification. Our results suggest that wealth is of first order importance when designing incentive contracts requiring PE fund managers to coinvest.

Pathwise superhedging on prediction sets
Daniel Bartl,Michael Kupper,Ariel Neufeld

In this paper we provide a pricing-hedging duality for the model-independent superhedging price with respect to a prediction set $\Xi\subseteq C[0,T]$, where the superhedging property needs to hold pathwise, but only for paths lying in $\Xi$. For any Borel measurable claim $\xi$ which is bounded from below, the superhedging price coincides with the supremum over all pricing functionals $\mathbb{E}_{\mathbb{Q}}[\xi]$ with respect to martingale measures $\mathbb{Q}$ concentrated on the prediction set $\Xi$. This allows to include beliefs in future paths of the price process expressed by the set $\Xi$, while eliminating all those which are seen as impossible. Moreover, we provide several examples to justify our setup.

Q&A on Financial Machine Learning (Course Materials)
Lopez de Prado, Marcos
Machine learning (ML) is changing virtually every aspect of our lives. Today ML algorithms accomplish tasks that until recently only expert humans could perform. As it relates to finance, this is the most exciting time to adopt a disruptive technology that will transform how everyone invests for generations.

Racial Disparities in Debt Collection
Jessica LaVoice,Domonkos F. Vamossy

A distinct set of disadvantages experienced by black Americans increases their likelihood of experiencing negative financial shocks, decreases their ability to mitigate the impact of such shocks, and ultimately results in debt collection cases being far more common in black neighborhoods than in non-black neighborhoods. In this paper, we create a novel dataset that links debt collection court cases with information from credit reports to document the disparity in debt collection judgments across black and non-black neighborhoods and to explore potential mechanisms that could be driving this judgment gap. We find that majority black neighborhoods experience approximately 40% more judgments than non-black neighborhoods, even after controlling for differences in median incomes, median credit scores, and default rates. The racial disparity in judgments cannot be explained by differences in debt characteristics across black and non-black neighborhoods, nor can it be explained by differences in attorney representation, the share of contested judgments, or differences in neighborhood lending institutions.

Real Effects of Markets on Politics: Evidence from U.S. Presidential Elections
Crane, Alan D.,Koch, Andrew,Lin, Leming
We explore the electoral implications of stock market fluctuations. Analyzing the outcome of presidential elections at the county level from 1992 to 2016, we find that the market return directly influences U.S. presidential elections, but with significant heterogeneous effects among constituents. Counties with high stock market participation are more likely to vote for the incumbent party when the stock market has performed well since the previous election relative to low participation counties. Our results are robust to controlling for various aggregate and local shocks and various model specifications. The effect of the stock market on voting is weaker in partisan and Republican leaning counties and in battleground states, and is not driven by differential voter turnout. Overall, our finding provides evidence on the effect of the stock market on politics and a novel channel through which stock market fluctuations could be transmitted into the real economy.

Redistributive Growth
Döttling, Robin,Perotti, Enrico C.
We study long term effects of the technological shift to intangible capital, whose creation relies on the commitment of skilled human capital in firm production. Humancapital cannot be owned, so firms need less financing. Human capital cannot be credibly committed so firms need to reward it by deferred compensation, diluting future profits. As human capital income is not tradeable, total investable assets fall. The general equilibrium effect is a gradual fall in interest rates and a re-allocation of excess savings into rising valuations of existing assets such as real estate. The concomitant rise in house prices and wage inequality leads to higher household leverage.

Resolving asset pricing puzzles with price impact
Xiao Chen,Jin Hyuk Choi,Kasper Larsen,Duane J. Seppi

We solve in closed-form a Nash equilibrium model in which a finite number of exponential investors trade continuously with price-impact over a finite time horizon. By comparing our continuous-time Nash equilibrium model to the otherwise identical competitive Radner equilibrium model, we show that our Nash equilibrium model with price-impact can simultaneously help resolve the interest rate puzzle, the equity premium puzzle, and the stock volatility puzzle.

Search Complementarities, Aggregate Fluctuations, and Fiscal Policy
Fernández-Villaverde, Jesús,Mandelman, Federico,Yu, Yang,Zanetti, Francesco
We develop a quantitative business cycle model with search complementarities in the inter-firm matching process that entails a multiplicity of equilibria. An active static equilibrium with strong joint venture formation, large output, and low unemployment can coexist with a passive static equilibrium with low joint venture formation, low output, and high unemployment. Changes in fundamentals move the system between the two static equilibria, generating large and persistent business cycle fluctuations. The volatility of shocks is important for the selection and duration of each static equilibrium. Sufficiently adverse shocks in periods of low macroeconomic volatility trigger severe and protracted downturns. The magnitude of government intervention is critical to foster economic recovery in the passive static equilibrium, while it plays a limited role in the active static equilibrium.

Stock Market's Assessment of Monetary Policy Transmission: The Cash Flow Effect
Gürkaynak, Refet S.,Lee, Sang Seok,Karasoy Can, Gokce
We show that firm liability structure and associated cash flow matter for firm behavior, and that financial market participants price stocks accordingly. Looking at firm level stock price changes around monetary policy announcements, we find that firms that have more cash flow exposure see their stock prices affected more. The stock price reaction depends on the maturity and type of debt issued by the firm, and the forward guidance provided by the Fed. This effect has remained intact during the ZLB period. Importantly, we show that the effect is not a rule of thumb behavior outcome and that the marginal stock market participant actually studies and reacts to the liability structure of firm balance

Swing Pricing and Fragility in Open-End Mutual Funds
Jin, Dunhong,Kacperczyk, Marcin T.,Kahraman, Bige,Suntheim, Felix
How to prevent runs on open-end mutual funds? In recent years, markets have observed an innovation that changed the way open-end funds are priced. Alternative pricing rules (known as swing pricing) adjust funds' net asset values to pass on funds' trading costs to transacting shareholders. Using unique data on investor transactions in U.K. corporate bond funds, we show that swing pricing eliminates the first-mover advantage arising from the traditional pricing rule and significantly reduces redemptions during stress periods. The stabilizing effect is internalized particularly by institutional investors and investors with longer investment horizons. The positive impact of alternative pricing rules on fund flows reverses in calm periods when costs associated with higher tracking error dominate the pricing effect.

Technology Adoption and Access to Credit Via Mobile Phones
Gupta, Apoorv,Ponticelli, Jacopo,Tesei, Andrea
Farmers in developing countries often lack access to timely and reliable information about modern technologies that are essential to improve agricultural productivity. The recent diffusion of mobile phones has the potential to overcome these barriers by making information available to those previously unconnected. In this paper we study the effect of mobile phone network expansion in rural India on adoption of high yielding variety seeds and chemical fertilizers. Our empirical strategy exploits geographical variation in the construction of mobile phone towers under a large government program targeting areas without existing coverage. To explore the role of mobile phones in mitigating information frictions we analyze the content of 1.4 million phone calls made by farmers to a major call center for agricultural advice. Farmers seek advice on which seed varieties and fertilizers better meet their needs and how to use them. We find that areas receiving mobile phone coverage experience higher adoption of these technologies. We also observe that farmers are often unaware of the eligibility criteria and loan terms offered by subsidized credit programs. Consistently, we find that areas receiving mobile phone coverage experience higher take-up of agricultural credit.

The Aggregate and Distributional Effects of Financial Globalization: Evidence from Macro and Sectoral Data
Furceri, Davide,Loungani, Prakash,Ostry, Jonathan D.
We take a fresh look at the aggregate and distributional effects of policies to liberalize international capital flows-financial globalization. Both country- and industry-level results suggest that such policies have led on average to limited output gains while contributing to significant increases in inequality. The country-level results are based on 228 capital account liberalization episodes spanning 149 advanced and developing economies from 1970 to the present. Difference-in-difference estimation using industry-level data for 23 advanced economies suggests that liberalization episodes reduce the share of labor income, particularly for industries with higher external financial dependence, higher natural propensity to use layoffs to adjust to idiosyncratic shocks, and higher elasticity of substitution between capital and labor.

The Countercyclical Capital Buffer and the Composition of Bank Lending
Auer, Raphael,Ongena, Steven
Do macroprudential regulations on residential lending influence commercial lending behavior too? To answer this question, we identify the compositional changes in banks' supply of credit using the variation in their holdings of residential mortgages on which extra capital requirements were uniformly imposed by the countercyclical capital buffer (CCyB) introduced in Switzerland in 2012. We find that the CCyB's introduction led to higher growth in commercial lending although this was unrelated to conditions in regional housing markets. Interest rates and fees charged to the firms concurrently increased. We rationalize these findings in a model featuring both private and firm-specific collateral.

The Dollar During the Great Recession: Us Monetary Policy Signaling and the Flight to Safety
Stavrakeva, Vania,Tang, Jenny
Conventional wisdom holds that lowering a home country's interest rate relative

The FOMC Risk Shift
Kroencke, Tim Alexander,Schmeling, Maik,Schrimpf, Andreas
A large share of stock returns around FOMC meetings is driven by shocks that are uncorrelated with news about risk-free rates but seem closely related to changes in investors' perception of risk. These "FOMC risk shifts" can only partly be traced to fundamental news. However, FOMC risk shifts are accompanied by sizeable shifts in fund flows reminiscent of "risk on/off" modes and strong price pressure, which accounts for up to half of returns. Our results highlight the role of investor heterogeneity as an important factor to understanding the short-term dynamics of stock returns in response to monetary policy news.

The Role of Due Diligence in Crowdfunding Platforms
Cumming, Douglas J.,Johan, Sofia,Zhang, Yelin
Crowdfunding platform due diligence comprises background checks, site visits, credit checks, cross-checks, account monitoring, and third party proof on funding projects. We evaluate the factors associated with platforms’ compliance expenses, and their due diligence application. We find that due diligence is related to legislation requirement, platform size, and type or complexity of crowdfunding campaigns. In addition, we find that platforms applying due diligence provide more services to project issuers and funders. Furthermore, due diligence is associated with higher percentage of successful campaigns, more fund contributors, and larger amount of capital raised on platforms. Our analyses are supported by platform-level data, covering the period 2014-2017.

The Role of External Regulators in Mergers and Acquisitions: Evidence from SEC Comment Letters
Liu, Tingting,Shu, Tao,Towery, Erin,Wang, Jasmine
This study examines the role of the Securities and Exchange Commission (SEC) in improving information transparency for mergers and acquisitions (M&As) involving publicly traded firms. Using hand-collected M&A comment letter data, we document that the SEC issues comment letters on M&A filings for 31 percent of the deals announced between 2005 and 2017. We find that the SEC is more likely to issue a comment letter when deal characteristics suggest greater risk to target firm shareholder welfare, target firms have weaker corporate governance, or target firms have weaker pre-transaction financial reporting quality. Further, we examine the real effects of SEC comment letters on deal outcomes and provide evidence that while the SEC comment letter process increases deal duration, it improves the likelihood of deal completion and increases the probability of positive deal price revision. We address concerns of endogeneity using entropy balancing, an Impact Threshold of a Confounding Variable (ITCV) analysis, and an instrumental variable approach. Overall, our paper suggests the SEC’s comment letter review process protects M&A shareholders by improving information transparency.

The Value of Intermediation in the Stock Market
Di Maggio, Marco,Egan, Mark,Franzoni, Francesco A.
Brokers continue to play a critical role in intermediating institutional stock market transactions. More than half of all institutional investor order flow is still executed by high-touch (non-electronic) brokers. Despite the continued importance of brokers, we have limited information on what drives investors' choices among them. We develop and estimate an empirical model of broker choice that allows us to quantitatively examine each investor's' responsiveness to execution costs and access to research and order flow information. Studying over 300 million institutional trades, we find that investor demand is relatively inelastic with respect to commissions and that investors are willing to pay a premium for access to top research analysts and order-flow information. There is substantial heterogeneity across investors. Relative to other investors, hedge funds tend to be more price insensitive, place less value on sell-side research, and place more value on order-flow information. Furthermore, using trader-level data, we find that investors are more likely to trade with traders who are located physically closer and are less likely to trade with traders that have misbehaved in the past. Lastly, we use our empirical model to investigate the unbundling of equity research and execution services related to the MiFID II regulations. While under-reporting for the average firm is relatively small (4%), we find that the bundling of execution and research allows some institutional investors to under-report management fees by up to 15%.

The War Next Door and the Reds are Coming: the Spanish Civil War and the Portuguese Stock Market
Leitão, Diogo,Marques Pereira, Jaime,Pereira dos Santos, João,Tavares, José
The Spanish Civil War (July 1936 to April 1939) was a key event that paved the way for World War II, unfolding with unprecedented violence and uncertainty over the its outcome. In this paper, we analyze the impact of the events of the Spanish Civil War on the Portuguese stock returns. Portugal is a particularly interesting case for analysis given its geographical exposure and historical ties to Spain as well as its political ties to the Nationalist side. Unlike previous studies of stock market responses to World War II outcomes, in our period of analysis the world at large was at peace, allowing for a clearer attribution of causation. We examine investors' reactions to news from the Spanish War using a panel of weekly returns for firms listed on the Lisbon Stock market, after classifying a series of important developments of the Spanish Civil War, classified according to its nature - military or political, and which contender emerged as favored - the Republicans, on the left, or the Nationalists, on the right. We run dynamic specifications with firm and month fixed effects, controlling for the reference interest rate in London, and events in Portugal. Our results reveal that Spanish Civil War events affect returns negatively, especially events that are military in nature. When we break down our sample into overseas firms â?? those whose most significant assets were located in Africa - and non-overseas firms, the latter present more significant effects from the event variables, especially from the Pro-Republican military events. Our findings are robust to the different specifications and suggest that both general uncertainty and partisan preferences affect Portuguese returns.

Threats to Central Bank Independence: High-Frequency Identification with Twitter
Bianchi, Francesco,Kind, Thilo,Kung, Howard
This paper presents market-based evidence that President Trump influences expectations about monetary policy. The main estimates use tick-by-tick fed funds futures data and a large collection of Trump tweets criticizing the conduct of monetary policy. These collected tweets consistently advocate that the Fed lowers interest rates. Identification in our high-frequency event study exploits a small time window around the precise time stamp for each tweet. The average effect of these tweets on the expected fed funds rate is strongly statistically significant and negative, with a cumulative effect of around negative 10 bps. Therefore, we provide evidence that market participants believe that the Fed will succumb to the political pressure, which poses a significant threat to central bank independence.

Trading Strategies and Market Color: The Benefits of Friendship with Quantitative Analysts and Financial Engineers
Ravi Kashyap

This paper acts as a collection of various trading strategies and useful pieces of market information that might help to implement such strategies. This list is meant to be comprehensive (though by no means exhaustive) and hence we only provide pointers and give further sources to explore each strategy further. To set the stage for this exploration, we consider the factors that determine good and bad trades, the notions of market efficiency, the real prospect amidst the seemingly high expectations of homogeneous expectations from human beings and the catch-22 connotations that arise while comprehending the true meaning of rational investing. We can broadly classify trading ideas and client market color material into Delta-One and Derivative strategies since this acts as a natural categorization that depends on the expertise of the various trading desks that will implement these strategies. For each strategy, we will have a core idea and we will present different flavors of this central theme to demonstrate that we can easily cater to the varying risk appetites, regional preferences, asset management styles, investment philosophies, liability constraints, investment horizons, notional trading size, trading frequency and other preferences of different market participants.

As an illustrative example, we consider in detail an investment strategy, titled "The Bounce Basket", designed for someone to express a bullish view on the market by allowing them to take long positions on securities that would benefit the most from a rally in the markets. The central idea of this theme is to identity securities from a regional perspective that are heavily shorted and yet are fundamentally sound with at least a minimum buy rating from a consensus of stock analysts covering the securities.

Trading and Shareholder Voting
Levit, Doron,Malenko, Nadya,Maug, Ernst G.
We study shareholder voting in a model in which trading affects the composition of the shareholder base. In this model, trading and voting are complementary, which gives rise to self-fulfilling expectations about proposal acceptance. We show three main results. First, increasing liquidity and trading opportunities may reduce prices and welfare, because it allows shareholders with more extreme preferences to accumulate large positions and impose their views on more moderate shareholders through voting. Second, prices and welfare can move in opposite directions, which suggests that the former is an invalid proxy for the latter. Third, delegation of the decision to a board of directors may strictly improve shareholder value. However, the optimal board is generally biased, should not be representative of current shareholders, and may not always garner voting support from the majority of shareholders.

Uncertainty-Induced Reallocations and Growth
Bansal, Ravi,Croce, Mariano (Max) Massimiliano,Kiao, Wenxi,Rosen, Samuel
Focusing on both micro and aggregate U.S. data, we show the existence of a significant link

Under-Utilized Capacity of Resources, Rising Unemployment and Low House Hold Savings: Bottleneck to South Asia’s Growth
Sapovadia, Vrajlal K.
Nine major world economies and few South Asian economies are slowing. South-east Asia is more vulnerable to economic downturn than it was during the global financial crisis one decade ago, according to analysts at global management consultancy Bain & Co. Greater exposure to a slowing China - and other structural economic shifts - have left most ASEAN markets in a more perilous position than before, according to a report released in September 2019. Bain partner Thomas Olsen, who co-authored the report, told The Business Times over the phone that the next downturn will likely be broad-based and not limited to an acute financial crash, as it is set to be "more typical economic correction at the end of a cycle". Heather Long argues that many of the countries slowing down or in recession have a common problem, that they are heavily dependent on selling goods overseas. And this is not a good time to have an export-driven economy. India’s GDP growth in first quarter in fiscal 2019-20 was reported 5%, lowest in past six years. This paper attempts to investigate the most critical factors that impede the growth. We noticed that under-utilization of resources is very common in emerging economies.The objective is to suggest emerging South Asian economies the most pressing policy measures that can boost economy by optimum utilization of resources.

Wealth Transfer Through Private Placements? Evidence From China
Lin, Jing,Zheng, Steven Xiaofan,Zhou, Mingshan
We examine private issuance of public equity (PIPE) in China, and our results suggest that PIPE investors benefit from the price manipulation before and after issuance. These investors tend to cash out after lockup expiration and make large profits. We also find evidence that the trading of PIPE investors after lockup expiration is informed. Tests about the abnormal returns in the three years after lockup expiration suggest that at least part of the benefits PIPE investors receive come from wealth transfer from outside investors. Overall, PIPE issuers in China seem to use an opaque mechanism to compensate PIPE investors.

What is Mutual Fund Flow?
Cumming, Douglas J.,Johan, Sofia,Zhang, Yelin
Distinguishing between switches, pre-authorized contributions, systematic withdrawal plans, reinvestments, and distributions, we find that different types of fund flow exhibit distinct characteristics to retail fund flow with respect to fund fees and past performance. We argue that the positive correlation between retail fund inflow and switch-out reflects information asymmetry between incoming investors and current unitholders. This information asymmetry is more common when fund series are sold through dealers or brokers. We further show that this information asymmetry, attributed to biased purchase advice, is negatively associated with fund performance. A large sample of proprietary data from 2003â€"2014 support our findings, including but not limited to results from funds that invest only in the US, and funds that invest worldwide.