Research articles for the 2019-10-20

A New Approach to Forecast Market Interest Rates Through the CIR Model
Orlando, Giuseppe,Mininni, Rosa Maria,Bufalo, Michele
The purpose of this study is to suggest a new framework that we call the CIR#, which allows forecasting interest rates from observed financial market data even when rates are negative. In doing so, we have the objective is to maintain the market volatility structure as well as the analytical tractability of the original CIR model.javascript:void(0);

Client-Paid Research: Analyst Reports and Information Asymmetry
Xiao, Kerry
Sell-side research is a common source of corporate fundamental information, but most of the research is exclusively distributed to paying clients. In this study, I investigate whether the client-paid research exacerbates the information asymmetry between institutional investors and retail investors. I document that the increase of bid-ask spread on report days is positively associated with the quantity and the length of analyst reports. Looking into payment methods, I find that compared to analysts compensated by bundled brokerage commissions, analysts compensated by direct charges for research produce longer reports and are more likely to issue soft reports (i.e. without quantitative summary measures). As these reports create greater information advantages for paying clients, the more coverage from direct-paid analysts, the higher information asymmetry is. In short, the way to pay for research determines the amount and the exclusivity of analyst research, shaping the equitability of firms’ information environment.

Healthy... Distress... Default
Zura Kakushadze

We discuss a simple, exactly solvable model of stochastic stock dynamics that incorporates regime switching between healthy and distressed regimes. Using this model, which is analytically tractable, we discuss a way of extracting expected returns for stocks from realized CDS spreads, essentially, the CDS market sentiment about future stock returns. This alpha/signal could be useful in a cross-sectional (statistical arbitrage) context for equities trading.

Interest Rates Calibration with a CIR Model
Orlando, Giuseppe,Mininni, Rosa Maria,Bufalo, Michele
The purpose of this paper is to model interest rates from observed financial market data through a new approach to the Coxâ€"Ingersollâ€"Ross (CIR) model. This model is popular among financial institutions mainly because it is a rather simple (uni-factorial) and better model than the former Vasicek framework. However, there are a number of issues in describing interest rate dynamics within the CIR framework on which focus should be placed. Therefore, a new methodology has been proposed that allows forecasting future expected interest rates from observed financial market data by preserving the structure of the original CIR model, even with negative interest rates. The performance of the new approach, tested on monthly-recorded interest rates data, provides a good fit to current data for different term structures.

Management Team Incentive Heterogeneity and Stock Price Crash Risk
Li, Yiwei,Zeng, Yeqin
Research into group decision-making suggests that any optimal managerial compensation incentive design should incorporate synergistic interrelationships among top executives within a firm. This paper investigates whether the equity incentive structure of a management team affects firm-level stock price crash risk. Using a large sample of S&P 1500 firms over the period 1994--2015, we find that the average of top five executives' equity-based incentive ratios is positively related to future crash risk. However, the positive relation is moderated by management team incentive heterogeneity, measured by the Gini coefficient of top five executives' equity incentive ratios. The impact of management team incentive heterogeneity on crash risk is more pronounced when the firms have weaker internal corporate governance, less institutional investor monitoring, and higher financial leverage. Our main results are robust to the two-stage least squares identification method, alternative measures of crash risk, and alternative measures of management team incentive heterogeneity. Overall, our findings highlight the important role of management team incentive heterogeneity as an internal corporate governance mechanism.

Optimal implementation delay of taxation with trade-off for L\'{e}vy risk Processes
Wenyuan Wang,Xueyuan Wu,Cheng Chi

In this paper we consider two problems on optimal implementation delay of taxation with trade-off for spectrally negative L\'{e}vy insurance risk processes. In the first case, we assume that an insurance company starts to pay tax when its surplus reaches a certain level $b$ and at the termination time of the business there is a terminal value incurred to the company. The total expected discounted value of tax payments plus the terminal value is maximized to obtain the optimal implementation level $b^*$. In the second case, the company still pays tax subject to an implementation level $a$ but with capital injections to prevent bankruptcy. The total expected discounted value of tax payments minus the capital injection costs is maximized to obtain the optimal implementation level $a^*$. Numerical examples are also given to illustrate the main results in this paper.

Option Pricing in a Regime Switching Jump Diffusion Model
Anindya Goswami,Omkar Manjarekar,Anjana R

This paper presents the solution to a European option pricing problem by considering a regime-switching jump diffusion model of the underlying financial asset price dynamics. The regimes are assumed to be the results of an observed pure jump process, driving the values of interest rate and volatility coefficient. The pure jump process is assumed to be a semi-Markov process on finite state space. This consideration helps to incorporate a specific type of memory influence in the asset price. Under this model assumption, the locally risk minimizing price of the European type path-independent options is found. The F\"{o}llmer-Schweizer decomposition is adopted to show that the option price satisfies an evolution problem, as a function of time, stock price, market regime, and the stagnancy period. To be more precise, the evolution problem involves a linear, parabolic, degenerate and non-local system of integro-partial differential equations. We have established existence and uniqueness of classical solution to the evolution problem in an appropriate class.

Pleonexia and Politics over Professionalism: Collapsing Cooperative Banks
Sapovadia, Vrajlal K.
The Cooperative movement in India has its own status, role and impact in the socio-economic development, especially for providing organizational and financial support to give impetus to income generating activities for weaker sections, such as small and marginal farmers, artisans, weavers, landless agriculture labours, fisherman and urban poor (Sapovadia, 2004). Cooperative banks and credit cooperative society played important role in socio-economic development of India. Administrative restrictions were imposed by Reserve Bank of India on one of the leading cooperative bank operating in western India (September 2019). Another cooperative bank failed in 2001 shadowed several small cooperative banks. Recent directives issued by Reserve Bank of India (RBI) on Punjab and Maharshtra Cooperative Bank (PMC) exposed undercurrent in urban cooperative banks. This paper investigates reasons of cooperative bank failures.

Pricing and Hedging Performance on Pegged FX Markets Based on a Regime Switching Model
Samuel Drapeau,Yunbo Zhang

This paper investigates the hedging performance of pegged foreign exchange market in a regime switching (RS) model introduced in a recent paper by Drapeau, Wang and Wang (2019). We compare two prices, an exact solution and first order approximation and provide the bounds for the error. We provide exact RS delta, approximated RS delta as well as mean variance hedging strategies for this specific model and compare their performance. To improve the efficiency of the pricing and calibration procedure, the Fourier approach of this regime-switching model is developed in our work. It turns out that: 1 -- the calibration of the volatility surface with this regime switching model outperforms on real data the classical SABR model; 2 -- the Fourier approach is significantly faster than the direct approach; 3 -- in terms of hedging, the approximated RS delta hedge is a viable alternative to the exact RS delta hedge while significantly faster.

Real Effects of PCAOB International Inspections
Shroff, Nemit
This paper examines the effect of the Public Company Accounting Oversight Board (PCAOB) international inspection program on companies’ financing and investing decisions. Estimates from difference-in-differences regressions suggest that companies respond to their auditor receiving a ‘deficiency-free’ inspection report by issuing additional external capital amounting to 1.4% of assets and increasing investment by 0.5% of assets. These effects are larger for (i) financially constrained companies and (ii) companies located in countries where there is no audit regulator or the audit regulator does not conduct inspections. Further, the effect on financing decisions is stronger in countries with (i) low corruption, (ii) strong rule of law, and (iii) high regulatory quality. Descriptive evidence suggests that inspections increase the use of financial covenants in debt contracts, which is likely one of the mechanisms through which inspections generate real effects. This paper documents the value of PCAOB inspections in mitigating financing frictions for non-U.S. companies.

The Valuation of Collateral in Bank Lending
Luck, Stephan,Santos, João A. C.
Researchers' attempts to identify the valuation of collateral has been hampered by data limitations. We overcome this challenge by comparing spreads on loans originated by the same bank, to the same firm, at the same origination date, but with different types of collateral. We find that securing a loan reduces borrowing costs for firms by 17 basis points. The price effect varies across different types of collateral, with marketable securities and real estate being the most valuable types of collateral. Our results show that collateral is especially valuable for small and medium-sized firms, riskier firms, credit lines, and longer-term loans, thus adding support to the moral hazard-based theories of collateral. Further, we unveil supporting evidence for the microfoundation of the collateral channel: the value of and the propensity to pledge real estate collateral is sensitive to changes in local housing prices.