Research articles for the 2019-11-22
Accounting-based Compensation and Debt Contracts
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We examine how accounting-based compensation plans influence a firm’s contracts with its creditors. After granting long-term accounting-based compensation plans (LTAPs) to CEOs, firms pay lower spreads and have fewer restrictive covenants in new bank loans. Mechanisms leading to lower borrowing cost include improvements in debt repayment ability, reduced shareholder-debtholder conflicts, and reduced risk-taking incentives. Creditors view LTAPs as a substitute for monitoring, adjust covenant design based on LTAP features, and value plans with concave performance-payout functions and reasonable performance targets. A firm’s credit rating improves and CDS spread declines after LTAP grants, suggesting that LTAPs help reduce firms’ credit risk.
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We examine how accounting-based compensation plans influence a firm’s contracts with its creditors. After granting long-term accounting-based compensation plans (LTAPs) to CEOs, firms pay lower spreads and have fewer restrictive covenants in new bank loans. Mechanisms leading to lower borrowing cost include improvements in debt repayment ability, reduced shareholder-debtholder conflicts, and reduced risk-taking incentives. Creditors view LTAPs as a substitute for monitoring, adjust covenant design based on LTAP features, and value plans with concave performance-payout functions and reasonable performance targets. A firm’s credit rating improves and CDS spread declines after LTAP grants, suggesting that LTAPs help reduce firms’ credit risk.
Design Optimization Average-Based Algorithm
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This article introduces a metaheuristic algorithm to solve engineering design optimization problems. The algorithm is based on the concept of diversity and independence that is aggregated in the average design of a population of designs containing information dispersed through a variety of points, and on the concept of intensification represented by the best design. The algorithm is population-based, where the population individual designs are randomly generated. The population can be normally or uniformly generated. The algorithm may start either with points randomly generated or with a designer preferred trial guess. The algorithm is validated using standard classical unconstrained and constrained engineering optimum design test problems reported in the literature. The results presented indicate that the proposed algorithm is a very simple alternative to solve this kind of problems. They compare well with the analytical solutions and/or the best results achieved so far. Two constrained problem analytical solutions not found in the literature are presented in annex.
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This article introduces a metaheuristic algorithm to solve engineering design optimization problems. The algorithm is based on the concept of diversity and independence that is aggregated in the average design of a population of designs containing information dispersed through a variety of points, and on the concept of intensification represented by the best design. The algorithm is population-based, where the population individual designs are randomly generated. The population can be normally or uniformly generated. The algorithm may start either with points randomly generated or with a designer preferred trial guess. The algorithm is validated using standard classical unconstrained and constrained engineering optimum design test problems reported in the literature. The results presented indicate that the proposed algorithm is a very simple alternative to solve this kind of problems. They compare well with the analytical solutions and/or the best results achieved so far. Two constrained problem analytical solutions not found in the literature are presented in annex.
Financial Sophistication and Conflicts of Interest: Evidence from 401(k) Investment Menus
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We analyze the investment menus offered within 401(k) pension plans to the employees of the largest finance and non-finance firms. Within the sample of finance firms, we distinguish between finance firms that hire an external independent trustee and finance firms that serve also as a trustee of their own pension plan. We find that employees of finance firms with an external trustee invest less in sponsor equity and options affiliated with the trustee as compared to those of non-finance firms and of finance firms with an internal trustee. The changes of mutual funds on the investment menu offered by finance firms with an independent trustee are also more sensitive to past performance and their plan participants benefit from the removal of underperforming mutual funds. These findings suggest that greater financial sophistication among plan participants and the sponsoring company can improve the quality 401(k) menus, but only when it is accompanied with an independent governance structure.
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We analyze the investment menus offered within 401(k) pension plans to the employees of the largest finance and non-finance firms. Within the sample of finance firms, we distinguish between finance firms that hire an external independent trustee and finance firms that serve also as a trustee of their own pension plan. We find that employees of finance firms with an external trustee invest less in sponsor equity and options affiliated with the trustee as compared to those of non-finance firms and of finance firms with an internal trustee. The changes of mutual funds on the investment menu offered by finance firms with an independent trustee are also more sensitive to past performance and their plan participants benefit from the removal of underperforming mutual funds. These findings suggest that greater financial sophistication among plan participants and the sponsoring company can improve the quality 401(k) menus, but only when it is accompanied with an independent governance structure.
Institutional Trading around Firms’ Negative ESG Events
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Using institutional trades at transaction-level and firm’s negative ESG news releases, we find that institutional trading prior to the news is informative of the forthcoming news and that institutions are able to earn abnormal profits from those trades. Further analysis shows that institutions’ informativeness is less pronounced for firms with better existing CSR reputation, lower firm-level information asymmetry, and larger shareholder breadth. We also find evidence that some institutions forgo economic profits to trade for social reasons. Our results are robust to matched sample analysis, different forecasting horizons, and alternative measures of firm’s long-term CSR reputation.
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Using institutional trades at transaction-level and firm’s negative ESG news releases, we find that institutional trading prior to the news is informative of the forthcoming news and that institutions are able to earn abnormal profits from those trades. Further analysis shows that institutions’ informativeness is less pronounced for firms with better existing CSR reputation, lower firm-level information asymmetry, and larger shareholder breadth. We also find evidence that some institutions forgo economic profits to trade for social reasons. Our results are robust to matched sample analysis, different forecasting horizons, and alternative measures of firm’s long-term CSR reputation.
Labor Mobility and Capital Misallocation in the Mutual Fund Industry
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This paper studies how fund managers' mobility across mutual fund firms affects the efficiency in the allocation of capital across managers. To overcome the endogeneity of fund managers' mobility, I exploit exogenous shocks to managers' ability to change employer via state-level legislation changes increasing the enforceability of non-compete agreements. I find that these policy changes lead to a reduction by half of the propensity of fund managers to switch mutual fund firms along with an increase in capital misallocation across managers by roughly 30% as well as a decline in value added of managers by more than $110 million at the state level. These results suggest that the labor market for mutual fund managers is an important channel through which the mismatch between capital and skill is reduced.
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This paper studies how fund managers' mobility across mutual fund firms affects the efficiency in the allocation of capital across managers. To overcome the endogeneity of fund managers' mobility, I exploit exogenous shocks to managers' ability to change employer via state-level legislation changes increasing the enforceability of non-compete agreements. I find that these policy changes lead to a reduction by half of the propensity of fund managers to switch mutual fund firms along with an increase in capital misallocation across managers by roughly 30% as well as a decline in value added of managers by more than $110 million at the state level. These results suggest that the labor market for mutual fund managers is an important channel through which the mismatch between capital and skill is reduced.
Managerial Myopia and Cybersecurity
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Using a large sample of U.S. firms for the period 2005â€"2017, we provide evidence that managerial myopic actions contribute to corporate cybersecurity risk. Specifically, we show that abnormal cuts in discretionary expenditures, our proxy for myopic actions, are positively associated with the likelihood of data breaches. The association is largely driven by firms that appear to cut discretionary expenditures to meet short-term earnings targets. In addition, the association is stronger for firms with greater equity incentives, a high earnings response coefficient, low levels of institutional or block ownership, or large market shares.
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Using a large sample of U.S. firms for the period 2005â€"2017, we provide evidence that managerial myopic actions contribute to corporate cybersecurity risk. Specifically, we show that abnormal cuts in discretionary expenditures, our proxy for myopic actions, are positively associated with the likelihood of data breaches. The association is largely driven by firms that appear to cut discretionary expenditures to meet short-term earnings targets. In addition, the association is stronger for firms with greater equity incentives, a high earnings response coefficient, low levels of institutional or block ownership, or large market shares.
Networks for Alpha: Prime Broker Connections and Hedge Fund Manager Selection
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Using the setting of funds of hedge funds (FoFs), we show that prime brokers (PBs) help investors search for informed hedge fund managers. We find that FoFs overweight their investments in hedge funds serviced by their connected PBs. This PB bias is larger when the cost of hedge fund due diligence is higher relative to capital and when the FoF's management firm operates a larger hedge fund business with greater potential to generate prime brokerage revenues. We also show that FoFs select PB-connected hedge funds at an information advantage and that FoFs with a larger PB bias exhibit superior performance.
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Using the setting of funds of hedge funds (FoFs), we show that prime brokers (PBs) help investors search for informed hedge fund managers. We find that FoFs overweight their investments in hedge funds serviced by their connected PBs. This PB bias is larger when the cost of hedge fund due diligence is higher relative to capital and when the FoF's management firm operates a larger hedge fund business with greater potential to generate prime brokerage revenues. We also show that FoFs select PB-connected hedge funds at an information advantage and that FoFs with a larger PB bias exhibit superior performance.
Restructuring Argentina’s Sovereign Debts â€" Navigating the Legal Labyrinth
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In November 2019, roughly four years after Argentina finally settled the lawsuits from its previous crisis, the new left-wing administration finds itself between a rock and a hard place. Argentina is in a deep economic recession and owes significant sums to different types of creditors, including more than USD120 billion to international creditors and roughly USD45 billion to the IMF. Indeed, there are serious doubts about the sustainability of Argentina's debt and a debt restructuring seems, if one was to listen to financial market chatter or indeed the government itself, almost inevitable.This short essay provides an overview of the intricate challenges that Argentina would be facing in a potential restructuring of its sovereign debt obligations, with a focus on the legal aspects. First, relying on Bloomberg data as well as official statistics, I show which types of debt instrument Argentina has issued, including respective volumes. Second, the essay discusses some of the key legal obstacles when it comes to the (unilateral) restructuring. While a majority of Argentina's international sovereign bonds include so-called Collective Action Clauses (CACs), which ameliorate holdout inefficiencies, there are several series that include older, less effective CACs. Moreover, as this paper argues, the requirement in Argentina's newer bonds that a restructuring offer must be "uniformly applicable" raises complex transactional and design questions. I also identify some legal uncertainties under New York law with respect to the interpretation of the pari passu clause included in Argentina's bond prospectuses, which ought to be taken into account by the new administration.To be sure, modern sovereign bond restructurings rest on the basic premise of bondholder democracy. In other words, as long as a sufficient majority of creditors accepts a restructuring offer, most legal obstacles can be overcome. However, the entrance of specialized distressed-debt managers the market suggests that some investors will gamble for a better deal, or try to leverage their contractual rights against the country in a classic holdout manner. While Argentina certainly finds itself in a legally superior position compared to its last debt crisis, the country will soon have to sail straight into the choppy sea where all sorts of hazards lurk - some of which the country is all too familiar with.
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In November 2019, roughly four years after Argentina finally settled the lawsuits from its previous crisis, the new left-wing administration finds itself between a rock and a hard place. Argentina is in a deep economic recession and owes significant sums to different types of creditors, including more than USD120 billion to international creditors and roughly USD45 billion to the IMF. Indeed, there are serious doubts about the sustainability of Argentina's debt and a debt restructuring seems, if one was to listen to financial market chatter or indeed the government itself, almost inevitable.This short essay provides an overview of the intricate challenges that Argentina would be facing in a potential restructuring of its sovereign debt obligations, with a focus on the legal aspects. First, relying on Bloomberg data as well as official statistics, I show which types of debt instrument Argentina has issued, including respective volumes. Second, the essay discusses some of the key legal obstacles when it comes to the (unilateral) restructuring. While a majority of Argentina's international sovereign bonds include so-called Collective Action Clauses (CACs), which ameliorate holdout inefficiencies, there are several series that include older, less effective CACs. Moreover, as this paper argues, the requirement in Argentina's newer bonds that a restructuring offer must be "uniformly applicable" raises complex transactional and design questions. I also identify some legal uncertainties under New York law with respect to the interpretation of the pari passu clause included in Argentina's bond prospectuses, which ought to be taken into account by the new administration.To be sure, modern sovereign bond restructurings rest on the basic premise of bondholder democracy. In other words, as long as a sufficient majority of creditors accepts a restructuring offer, most legal obstacles can be overcome. However, the entrance of specialized distressed-debt managers the market suggests that some investors will gamble for a better deal, or try to leverage their contractual rights against the country in a classic holdout manner. While Argentina certainly finds itself in a legally superior position compared to its last debt crisis, the country will soon have to sail straight into the choppy sea where all sorts of hazards lurk - some of which the country is all too familiar with.
Squeezing the Shorts in Small Cap Stocks
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In the summer of 2018 the shares of New Concept Energy and Avalon Holdings increased more than 500% and then fell back down without any news or rumours about the companies. Using court documents we reconstruct the trades by an alleged manipulator, we analyze his strategic trading behavior and how the market reacted to his trades. We find that the market on average was not able to identify the alleged manipulator’s trades and that his trading costs were lower than those of the other market participants. Consistent with Allen and Gale (1992) we find that the manipulator exhibits the same behavior as informed investors in Collin-Dufresne and Fos (2015), Kacperczyk and Pagnotta (2018), Garriott and Riordan (2019). We argue that Regulation SHO mandatory settlement deadline easily binds for small-cap stocks, making manipulation in these stocks more likely.
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In the summer of 2018 the shares of New Concept Energy and Avalon Holdings increased more than 500% and then fell back down without any news or rumours about the companies. Using court documents we reconstruct the trades by an alleged manipulator, we analyze his strategic trading behavior and how the market reacted to his trades. We find that the market on average was not able to identify the alleged manipulator’s trades and that his trading costs were lower than those of the other market participants. Consistent with Allen and Gale (1992) we find that the manipulator exhibits the same behavior as informed investors in Collin-Dufresne and Fos (2015), Kacperczyk and Pagnotta (2018), Garriott and Riordan (2019). We argue that Regulation SHO mandatory settlement deadline easily binds for small-cap stocks, making manipulation in these stocks more likely.
Tests of the Stochastic Volatility with Jumps Model Driven by Moment Swaps
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This paper tests the pricing accuracy and the hedging performance of the stochastic volatility with random jumps model in markets extended to contain swap contracts whose payoffs depend on the realized higher moments of the state variable. Using a two-step iterative approach, latent model variables are first filtered and then used to estimate the model parameters. The tests on European options and variance swaps written on the S&P 500 index show superior pricing accuracies in-sample and out-of-sample and jump risk is priced. Hedging strategies involving higher-order moment swaps perform better across all moneyness and maturity classes.
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This paper tests the pricing accuracy and the hedging performance of the stochastic volatility with random jumps model in markets extended to contain swap contracts whose payoffs depend on the realized higher moments of the state variable. Using a two-step iterative approach, latent model variables are first filtered and then used to estimate the model parameters. The tests on European options and variance swaps written on the S&P 500 index show superior pricing accuracies in-sample and out-of-sample and jump risk is priced. Hedging strategies involving higher-order moment swaps perform better across all moneyness and maturity classes.
The Black Box of SEC Monitoring and Regulatory Spillover
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In spite of its focus on transparency, the SEC remains a black box. I peer into this black box by analyzing downloads of regulatory filings by SEC employees to provide granular evidence on how the SEC allocates its scarce monitoring resources. I document that SEC employees respond quickly to potential monitoring triggers and that this disclosure monitoring “spills over†among firms. That is, firms are subject to greater monitoring if the SEC has recently monitored the disclosures of their industry peers. Further, restatements and spikes in negative media coverage, whose timing is relatively exogenous with respect to internal SEC activities, both lead to large increases in SEC disclosure monitoring and subsequent spillover, ruling out scheduled industry sweeps as an alternative explanation. In addition, regulatory spillover is strongest when there is evidence of noncompliance and between firms that are assigned to the same regional or industry SEC office. These results suggest that knowledge spillovers allow SEC employees to reapply information obtained about individual firms to identify and monitor similar targets at a lower cost.
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In spite of its focus on transparency, the SEC remains a black box. I peer into this black box by analyzing downloads of regulatory filings by SEC employees to provide granular evidence on how the SEC allocates its scarce monitoring resources. I document that SEC employees respond quickly to potential monitoring triggers and that this disclosure monitoring “spills over†among firms. That is, firms are subject to greater monitoring if the SEC has recently monitored the disclosures of their industry peers. Further, restatements and spikes in negative media coverage, whose timing is relatively exogenous with respect to internal SEC activities, both lead to large increases in SEC disclosure monitoring and subsequent spillover, ruling out scheduled industry sweeps as an alternative explanation. In addition, regulatory spillover is strongest when there is evidence of noncompliance and between firms that are assigned to the same regional or industry SEC office. These results suggest that knowledge spillovers allow SEC employees to reapply information obtained about individual firms to identify and monitor similar targets at a lower cost.
The Business Environment: Economic Reforms in the Context of Institutional Shortcomings
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The existence of a well-functioning business environment is a key factor in the diversification of the economy, the efficient use of available resources and ensuring sustainable growth. The business environment, in its turn, should be regarded as a composite of conditions that incorporate quite complex components. If one or more of the composition components are not functioning appropriately, the result you will get is not adequate to the available capacity. The existence of contemporary institutions is the absolute requirement for a "good business environment", performing functions such as coordinating all other economic advantages, organizing appropriate arrangements, and risk management.
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The existence of a well-functioning business environment is a key factor in the diversification of the economy, the efficient use of available resources and ensuring sustainable growth. The business environment, in its turn, should be regarded as a composite of conditions that incorporate quite complex components. If one or more of the composition components are not functioning appropriately, the result you will get is not adequate to the available capacity. The existence of contemporary institutions is the absolute requirement for a "good business environment", performing functions such as coordinating all other economic advantages, organizing appropriate arrangements, and risk management.
The Impact of Executive Board Gender Diversity on Risk-Taking in Canadian and US Banks
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This paper examines the issue of board diversity and the role of women in the finance industry. Estimation of panel data regressions for a sample of all financial institutions in Canada and the US over the period 2008-2019 identified some qualitative and quantitative factors that allowed the Canadian banking system to withstand the 2008 financial crisis better than US financial institutions. We found that in Canadian banks risk-taking executive behaviour was moderated by gender diversity but no overall impact of gender diversity on financial risk-taking is evidenced in the US. Moreover, sub-sectoral analysis in the US shows that a higher relative number of women on executive boards actually increases risk-taking in investment banking, but not in commercial banking. Nonetheless, in investment management a higher female to male ratio on US executive boards tends to reduce leverage. There are no differences in the impact of number of female board members on Canadian investment banks relative to the overall financial services sector. Our analysis suggests that risk attitudes of female financial executives in the US financial industry is much more heterogeneous than in Canada, or in the general female population of both countries.
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This paper examines the issue of board diversity and the role of women in the finance industry. Estimation of panel data regressions for a sample of all financial institutions in Canada and the US over the period 2008-2019 identified some qualitative and quantitative factors that allowed the Canadian banking system to withstand the 2008 financial crisis better than US financial institutions. We found that in Canadian banks risk-taking executive behaviour was moderated by gender diversity but no overall impact of gender diversity on financial risk-taking is evidenced in the US. Moreover, sub-sectoral analysis in the US shows that a higher relative number of women on executive boards actually increases risk-taking in investment banking, but not in commercial banking. Nonetheless, in investment management a higher female to male ratio on US executive boards tends to reduce leverage. There are no differences in the impact of number of female board members on Canadian investment banks relative to the overall financial services sector. Our analysis suggests that risk attitudes of female financial executives in the US financial industry is much more heterogeneous than in Canada, or in the general female population of both countries.
Trends Everywhere? The Case of Hedge Fund Styles
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This paper investigates empirically whether time-series momentum returns can explain the per- formance of hedge funds in the cross-section. Relying on the trend following literature, a volatility- adjusted time-series momentum signal is applied on a daily basis across a large set of futures, covering the major asset classes. We build a hierarchical set of trend factors: the full version TREND can be split in summable factors across two dimensions: the horizon of the signals and the traded asset class. We show that Managed Futures, Global Macro and Fund of Hedge Funds strategies can be partly explained by a TREND exposure. Moreover, a TREND exposure is a significant determinant of hedge funds returns at the fund level, for Managed Futures and Global Macro but also, and more surprisingly, for the other styles.
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This paper investigates empirically whether time-series momentum returns can explain the per- formance of hedge funds in the cross-section. Relying on the trend following literature, a volatility- adjusted time-series momentum signal is applied on a daily basis across a large set of futures, covering the major asset classes. We build a hierarchical set of trend factors: the full version TREND can be split in summable factors across two dimensions: the horizon of the signals and the traded asset class. We show that Managed Futures, Global Macro and Fund of Hedge Funds strategies can be partly explained by a TREND exposure. Moreover, a TREND exposure is a significant determinant of hedge funds returns at the fund level, for Managed Futures and Global Macro but also, and more surprisingly, for the other styles.
