Research articles for the 2019-12-13

An Evaluation of Alternative Multiple Testing Methods for Finance Applications
Harvey, Campbell R.,Liu, Yan,Saretto, Alessio
In almost every area of empirical finance, researchers are confronted with multiple tests. One high profile example is the identification of investment managers that outperform. Many beat their benchmarks purely by luck. Multiple testing methods are designed to control for luck. Factor selection is another glaring case. However, there are numerous other applications that do not get as much attention. Importantly, for example, in a simple regression model where, say, five variables are tested, a t-statistic of 2.0 is not enough to establish significance â€" because five variables were tried. Our paper provides a guide to various multiple testing methods and details a number of applications. We provide simulation evidence on the relative performance of different methods across a variety of testing environments. The goal of our paper is to provide a menu that researchers can choose from to improve inference in financial economics.

Analysts’ Optimism and Stock Crash Risk
Cho, Hyunkwon,Kim, Robert
This paper investigates whether analysts’ optimism affects the stock crash risk. Analysts’ optimism can increase stock crash risk either by inducing overvaluation or by providing managers an opportunity to withhold bad news. Using analysts’ forecast error as a proxy for analysts’ optimism, we find that there is a positive association between analysts’ optimism and stock crash risk. Further, such a positive impact is more pronounced for firms with opaque information environment and for analysts who are considered ex ante credible. In addition, we show that analysts’ optimism does not increase stock crash risk when the prevailing market sentiment is high, lessening the concern that our findings are driven by market overvaluation. Overall, our results indicate that analysts’ optimism can be a source of stock crash risk.

Bank Loan Supply During Crises: The Importance of Geographic Diversification
Doerr, Sebastian,Schaz, Philipp
We classify a large sample of banks according to the geographic diversification of their international syndicated loan portfolio. Our results show that diversified banks maintain higher loan supply during banking crises in borrower countries. The positive loan supply effects lead to higher investment and employment growth for firms. Diversified banks have a stabilizing effect, thanks to their ability to raise additional funding during times of distress, which also shields connected markets from spillovers. Further distinguishing banks by nationality reveals a pecking order: diversified domestic banks are the most stable source of funding, while foreign banks with little diversification are the most fickle. Our findings suggest that the decline in financial integration since the recent crisis increases countries' vulnerability to local shocks.

Credibility of Bank Resolution Regimes and Market Discipline: Evidence from Corporate Deposits
Balke, Florian,Wahrenburg, Mark
This study examines changes in market discipline in European corporate deposit markets in response to different crisis periods and regulatory initiatives in the European Union. We measure market discipline by investigating the risk sensitivity of uninsured corporate deposits, i.e. by analyzing whether depositors demand risk premiums from risky banks. Depositors' risk sensitivity towards German banks substantially increased after the introduction of the German restructuring law. A similar effect can be observed for other eurozone banks after the introduction of the European bank recovery and resolution directive (BRRD). For German banks the introduction of the BRRD has no significant additional effect. Consequently, results suggest that both reforms have contributed to strengthen market discipline in the eurozone. We also document that the ECB's targeted long-term refinancing operations (TLTRO) weakened market discipline. As a response to the reduced liquidity risk of banks, corporate depositors became less risk sensitive.

Credit Supply and Corporate Social Responsibility
Dejan, Austin,Hassan, M. Kabir,Siraj, Ibrahim,Turunen-Red, Arja H.
We exploit the staggered nature of interstate banking and branching deregulation of the U.S. to examine the causal impact of bank competition on corporate socially responsible (CSR) activities. We find strong and robust evidence that bank deregulation significantly and negatively affects the CSR activities. Firms operating in high margin industry with low market power, and financially constrained firms operating in external finance dependent industries tend to predominantly show such a negative relationship between deregulation and CSR activities. Overall, our findings imply that deregulation-led rising competition in the product market makes the non-financial firms more concerned about protecting the interests of shareholders than other stakeholders. Our results are robust to the use of alternative empirical specifications and CSR measures.

Disentangling the Effect of Trust on Bank Lending
Nicolas, Christina,Tarazi, Amine
This paper examines the effect of trust on bank lending using a sample of commercial banks in 34 countries around the world. We distinguish between two forms of trust: In-group trust, which we define as the trust in people we know, and Out-group trust, which we define as the trust in people we meet for the first time. We find that that Out-group trust significantly boosts bank lending. A closer look shows that this effect only holds in countries with relatively lower levels of institutional and judicial development. As for In-group trust, we find that it affects bank lending indirectly by favoring the development of informal lending. Overall, this paper provides novel evidence on the importance of trust and the mechanisms by which it influences bank lending around the world.

El sector financiero ante la turbulencia del entorno y los nuevos desafíos competitivos en un marco de incertidumbre radical (The Financial Sector: Turbulence and Competitive Challenges Within a Radically Uncertain Environment)
Rodríguez - López, Manuel,Piñeiro-Sánchez, Carlos,de Llano-Monelos, Pablo
Spanish Abstract: Las entidades financieras se enfrentan al gran reto de mantener su actividad financiera en un entorno de grandes cambios y diversidad de factores que en su conjunto configuran un entorno cuya principal característica es de incertidumbre radical. En esta línea de trabajo se analizan de forma meramente descriptiva, dada su complejidad y envergadura, cuáles son los principales factores, cuál es su posible impacto y cómo tienen que adaptarse las entidades financieras a este nuevo escenario. Spanish Abstract: Financial institutions face the great challenge of maintaining their financial activity in a changing environment determined by a set of factors characterized by radical uncertainty. This work descriptively analyzes these factors; their impacts are discussed, and the way in which financial institutions can adapt to this new scenario.

Engaging with Discreteness: Gambling, Under-Participation, and Lotteries in Economies with Indivisible Goods
Dai, Bingcun,Savor, Pavel G.,Wilson, Mungo Ivor
We study an endowment economy with heterogeneous agents and two complementary consumption goods, one of which is indivisible. Although agents have standard concave preferences, the indivisibility gives rise to Friedman-Savage convexity in indirect utility. Agents care about relative, not just absolute, wealth, and about the magnitude of wealth differences as well as rankings. While agents dislike small risks, they like large ones. Poorer agents exhibit a preference for lottery-like assets with negative expected returns and also invest a smaller share of wealth than richer agents in assets with positive expected returns. If the difference in wealth is large, poor agents play a lottery among themselves with a single winner. In consequence, richer agents have a higher expected return on wealth and inequality is expected to increase. While initial inequality affects investment choices, it has only a minor effect on ultimate inequality. Therefore, standard prescriptions for reducing inequality may have little effect.

Entrepreneur Companies Abolished in Denmark and Belgium â€" For Very Different Reasons and With Very Different Results
Lilja, Troels Michael
The article begins with a historical view on the legal development of minimum capital requirements for the private limited companies in Europe. An introduction to the historically very different approaches in Ger-many and England is given, and it is shown that the international trend moves towards the English regime where creditor protection largely rests on the responsibility of company members or management towards the company and its creditors. The Belgian entrepreneur company (SPRL-starter) and the Danish entrepreneur company (IVS) were introduced in 2010 and 2014, respectively. In both countries, they were introduced to avoid a boom of branches of foreign companies after the cases from ECJ, Centros, Ãœberseering and Inspire Art. In April 2019, the opportunity to establish new entrepreneur companies was abolished in Denmark, and in May 2019, the same happened in Belgium. Even though it could indicate that the legal develop-ment in the two countries were alike, nothing could be more misleading. While Belgium followed the international trend and in reality abolished the minimum capital requirement for private limited companies, Denmark just abolished the IVS, while no real alternative to branches of foreign companies was introduced, leaving Denmark with the second highest minimum capital requirement in Europe, with a receding number of new businesses. At the same time, it leaves Denmark in the danger zone of having an invasion of branches of foreign low capital companies, with Danish entrepreneurs as shareholders.

Examining Macroprudential Policy and its Macroeconomic Effects â€" Some New Evidence
Kim, Soyoung,Mehrotra, Aaron N.
In this paper, we provide empirical evidence about the broader macroeconomic effects of macroprudential policies and the underlying transmission mechanism, as well as the response of macroprudential policy to financial risks. To this end, we use structural panel vector autoregressions and a dataset covering 32 advanced and emerging economies. We show that macroprudential policy shocks have effects on real GDP, the price level and credit that are very similar to those of monetary policy shocks, but the detailed transmission of the two policies is different. Whereas macroprudential policy shocks mostly affect residential investment and household credit, monetary policy shocks have more widespread effects on the economy. Moreover, while positive credit shocks are generally met with tighter macroprudential policy, macro-financial country characteristics such as the exchange rate regime and the level of financial development affect the policy response.

FX Liquidity and Market Metrics: Online Appendices 1 and 2
Hasbrouck, Joel,Levich, Richard M.
Online appendices for FX Liquidity and Market Metrics ( or DOI:10.2139/ssrn.2912976). Appendix 1 contains expanded tables and figures. Appendix 2 describes reconciliation and comparison of the CLS settlement data with other sources (BIS and EBS).

Financial Development and Economic Growth in Nigeria: Evidence from Threshold Modelling
Omisakin, Dr. Olusegun A.,Oyinlola, Mutiu Abimbola,Egwaikhide, Festus,Adeniyi, Oluwatosin
This paper re-examined the relationship between financial development and economic growth in Nigeria. Unlike existing studies, we attempted to assess the information content of non-linearities in the financeâ€"growth nexus for Nigeria. We also attempted to inventively gauge the impact of financial reforms on the Nigerian economy particularly in terms of economic growth. Using annual data covering the period 1960â€"2010, we factored in threshold effects through financial development (FD) measures. Following these, we unearth a number of interesting results. First, financial development negatively impacted growth but a sign reversal resulted in accounting for threshold-type effects. This is indicative of some turning points in the financeâ€"growth association. Second, using a composite index of FD led to a similar outcome. Third, on the heels of sample splitting, the coefficients for the pre- and post-reform era are hardly distinguishable casting doubt on the efficacy of financial system reforms. On the basis of the foregoing, broader structural reforms should pervade Nigeria’s policy space if the aim of sustained, inclusive and employment-generating growth is to be ​realized.

Financial Market Frictions and Learning from the Stock Price
Rösch, Dominik,Subrahmanyam, Avanidhar,Van Dijk, Mathijs A.
Liquid stocks may attract short-term traders who could attenuate the informativeness of stock prices about long-run fundamentals. As a result, managers may be less (more) likely to rely on the market prices of more (less) liquid stocks when making real investment decisions. Supporting this conjecture, we show that real investment is more sensitive to market prices for less liquid stocks. Using decimalization as an exogenous shock to liquidity, we show that stocks that experienced the greatest increase in liquidity also experienced the greatest decrease in the investment-to-price sensitivity. Thus, we propose that, by discouraging short-termism, illiquidity can increase the efficacy of corporate resource allocation.

Financial Risk and Its Performance: A Study on Cocoaland Holdings Berhad in Malaysia
Tan, Boon Jin
Financial risks are everywhere, and it will affect the performance of a company. Every company should manage financial risks efficiently. The purpose of this study is to identify the financial risks associated with Cocoaland Holdings Berhad which is a food and beverages company and how it affects the performance of company for the period of 2014-2018. This study used multiple linear regression models to identify how independent variables influence the company performance. The results show that operating margin is the most significant variable that positively influence the performance of the company. The findings also reveal that quick ratio is significantly and negatively influence the performance of the company. This study suggests that Cocoaland Holdings Berhad should manage their operating margin by increasing the revenue or reducing the cost, and quick ratio by using cash to purchase inventory or assets in order to increase the performance and profitability of the company.

Financial Risk and its Performance: A Study on Apollo Food Holdings Berhad in Malaysia
Ling, Coco Siu Yin
The performance of a company can be affected by the financial risks associated with it. It is important for a company to manage financial risks efficiently. The purpose of this study is to identify the impact of financial risks on the performance of Apollo Food Holdings Berhad which is a food and beverages company for the period of 2014-2018. This study develops multiple linear regression models to analyse the impact of financial risk on company performance. The findings show that operating margin is the most significant variable that positively influence the performance of the company. This study suggests that Apollo Food Holdings Berhad should deal with their operating margin in order to increase the performance and profitability of the company. This can be done by increasing the revenue or reducing its cost.

Heterogeneity and Asset Prices: A Different Approach
Garleanu, Nicolae,Panageas, Stavros
We develop a tractable asset-pricing framework characterized by imperfect risk sharing among cohorts, who experience different levels of integrated life-time endowments. While all asset-pricing implications stem from the heterogeneity of consumption among investors, cross-sectional measures of inequality are non-volatile, only weakly related to asset prices, and far more persistent than the price-to-dividend ratio. We show how to identify a marginal agent’s consumption growth in this framework by utilizing cross-sectional information. Our proposed notion of marginal-agent consumption growth exhibits different and more volatile low-frequency variation than the aggregate consumption growth per capita, which is normally used in representative agent models. These low frequency movements in our measure of marginal agent consumption growth can explain a large portion of the low frequency movements in real interest rates and, when combined with recursive preferences, can account quantitatively for the stylized asset-pricing facts (high market price of risk, equity premium, volatility, and return predictability).

How Does Board Structure Impact on Firm Performance in the UK?
Alqatan, Ahmad,Chbib, Imad,Hussainey, Khaled
The aim of this paper is to examine whether or not the structure of the board of directors and, in particular, board size, independence and remuneration have an impact on firm performance. The sample examined is UK FTSE 100 non-financial companies using data from the period 2012 to 2015. A regression analysis has been used concluding a significant positive correlation between board remuneration and firm performance, namely Return on Assets and Tobin’s Q. The study also concluded a positive correlation between board size and ROA, and between board independence and Tobin’s Q. Additionally, a significant negative correlation between the control variables (i.e. company size and industry) and Return on Assets.

IT Investments and Financial Performance, a Review: The Bankruptcy Perspective
Piñeiro-Sánchez, Carlos,Monelos, Pablo de Llano,Rodríguez - López, Manuel
This study examines whether IT resources and capabilities affect the risk of bankruptcy of SMEs. Drawing on previous literature on bankruptcy and the resource-based view of the firm (RBV), we offer conclusive evidence of the influence of IT resources on financial health, as measured by the odds of filing for bankruptcy within a certain period of time. Flexibility, Internet-related abilities, cooperation/networking, and management skills are consistent with huge reductions in the risk of bankruptcy, implying that they are high value resources. Our results also stress that companies should pay attention to the development of bundles of complementary IT assets and capabilities, to create synergies and leverage IT resources. From a methodological point of view, we reveal new links between organization literature and previous research on bankruptcy; our innovative measure of performance can be a valuable tool for future research in both fields.

International Linkage, Bank Financing, and Firm Innovation
Cheng, Yuxi
In this study, I explore the role of international bank linkages on firm innovation. I find robust evidence that borrowing from international-linked banks leads firms to become more innovative, in terms of both quantity and quality of innovation outcomes. Firms experience larger innovation gains borrowing more intensively from familiar international-linked banks and have higher growth opportunities in general. I argue that international bank linkages help connected banks share information and screen firms with higher innovation qualities, allowing additional credits available to higher-quality firms in conducting more innovation activities. Overall, the results shed light on the real effects of international bank linkages and the underlying determinants of innovations.

Intraday Time-series Momentum: Evidence from China
Jin, Muzhao,Kearney, Fearghal,Li, Youwei,Yang, Yung Chiang
This study conducts an investigation of intraday time-series momentum across four Chinese commodity futures contracts: copper, steel, soybean, and soybean meal. Our results indicate that the first half-hour return positively predicts the last half-hour return across all four futures. Furthermore, in metals markets, we find that first trading sessions with high volume or volatility are associated with the strongest intraday time-series momentum dynamics. Based on this, we propose an intraday momentum informed trading strategy that earns a return in excess of standard always long and buy-and-hold benchmarks.

Introduction to the Essays of Warren Buffett: Lessons for Corporate America
Cunningham, Lawrence A.
This is Professor Cunningham's Introduction to his renowned edited collection of Warren Buffett's famous letters to shareholders of Berkshire Hathaway Inc. The collection was originally prepared for a symposium held in New York City in 1997 and has been regularly updated through five editions, with additional Buffett material and Cunningham annotations. This Introduction, from the fifth edition (2019), serves as an encapsulation of the main themes of the resulting collection and locates them in contemporary debates on matters of corporate governance; corporate finance and investing; mergers and acquisitions; and accounting and taxation.

La brecha de expectativas en auditoría. Un enfoque alternativo (The Audit Expectations Gap. An Alternative Approach)
Piñeiro-Sánchez, Carlos,de Llano-Monelos, Pablo,Rodríguez - López, Manuel
Spanish Abstract: La brecha de expectativas es el resultado de la coexistencia de diferentes interpretaciones acerca de los límites y los resultados del trabajo de auditoría. Un componente esencial de esta asimetría es la convicción, profundamente asentada en los usuarios externos del informe, de que el auditor canalizará revelaciones acerca de fraudes, y también de disfunciones que puedan conducir a la empresa a una insolvencia temporal o a un proceso extintivo. Este trabajo contribuye al debate sobre esta asimetría demostrando que, incluso si el auditor no formula excepciones concretas en este sentido, el proceso de auditoría aporta indicios que permiten inferirlas con un muy alto grado de fiabilidad. Además, se propone un sistema de etiquetado lexicográfico para sintetizar el contenido de las salvedades, que demuestra contribuir muy eficazmente al diagnóstico financiero, y por tanto podría ser empleado tanto en los informes como en las bases de datos comerciales empleadas por los usuarios y en sistemas de comunicación de información contable a través de Internet. Nuestra principal conclusión es que, al margen de su incidencia en la restricción de la manipulación y los ajustes discrecionales, la auditoría externa canaliza información esencial para la detección de anomalías financieras y la evaluación del riesgo de la empresa.English Abstract: The expectations gap is the result of the coexistence of different interpretations about the limits and the results of the audit work. An essential component of this asymmetry is the conviction, deeply rooted in the external users of the report, that the auditor will channel disclosures about fraud, and also of dysfunctions that may lead the company to temporary insolvency or an extinction process. This work contributes to the debate on this asymmetry demonstrating that, even if the auditor does not formulate specific exceptions in this regard, the audit process provides evidence that allows them to be inferred with a very high degree of reliability. In addition, a lexicographic labeling system is proposed to synthesize the content of the qualifications, which proves to contribute very effectively to the financial diagnosis, and therefore could be used both in the reports and in the commercial databases used by users and in systems of communication of accounting information through the Internet. Our main conclusion is that, regardless of its impact on the restriction of manipulation and discretionary adjustments, the external audit channels essential information for the detection of financial anomalies and the risk assessment of the company.

Las inversiones en TIC y su incidencia en el desempeño empresarial: una reinterpretación desde la óptica de recursos y capacidade (IT Investments and Firms’ Performance: A Reinterpretation From the Perspective of Resources and Capabilities)
Piñeiro-Sánchez, Carlos,de Llano-Monelos, Pablo,Rodríguez - López, Manuel
Spanish Abstract: El enfoque de recursos y capacidades sugiere que el desempeño competitivo de la organización se relaciona con las características de los recursos disponibles, y con la presencia de habilidades complementarias. Este trabajo explora los recursos y capacidades clave en relación a las TIC, y profundiza en sus interacciones identificando bloques compactos de recursos interdependientes. Para ello se propone una medida alternativa de desempeño: la verosimilitud de incurrir en una insolvencia financiera.English Abstract: The resource based view suggests that firms' competitive performance is driven by the characteristics of the resources available, and the presence of complementary skills. This work explores IT key resources and capabilities, and depicts relevant bundles, i.e., compact blocks of interdependent resources. To to that, an alternative measure of performance is developed: the likelihood of going bankrupt.

Managers' Voluntary Disclosure Decisions and Business Press Attention
Krupa, Jake
I investigate the relation between business press attention and the incidence and properties of managers' voluntary disclosures. Specifically, I examine managers' disclosure responses to material lawsuits against firms (i.e., bad news events) that plausibly increase stakeholders' demand for information. I posit that managers' disclosure decisions are affected by press attention, since managers can no longer appear credibly uninformed if the press highlights a lawsuit event. Examining managers' voluntary Form 8-K Item 8.01 filings, I find that both anticipated and actual press attention of the lawsuit event are positively associated with the likelihood and timeliness of these filings. Moreover, I find that press attention is associated with the textual characteristics of the filings, including length, tone, and complexity. My study extends a growing literature on the monitoring role of the press and suggests that managers' disclosures of bad news respond to anticipated and actual press scrutiny.

Optimal Asset Allocation for DC Pension Decumulation with a Variable Spending Rule
Forsyth, Peter,Vetzal, Kenneth R.,Westmacott, Graham
We determine the optimal asset allocation to bonds and stocks using an Annually Recalculated Virtual Annuity (ARVA) spending rule for DC pension plan decumulation. Our objective function minimizes downside withdrawal variability for a given fixed value of total expected withdrawals. The optimal asset allocation is found using optimal stochastic control methods. We formulate the strategy as a solution to a Hamilton Jacobi Bellman (HJB) Partial Integro Differential Equation (PIDE). We impose realistic constraints on the controls (no shorting, no leverage, discrete rebalancing), and solve the HJB PIDEs numerically. Compared to a fixed weight strategy which has the same expected total withdrawals, the optimal strategy has a much smaller average allocation to stocks, and tends to de-risk rapidly over time. This conclusion holds in the case of a parametric model based on historical data, and also in a bootstrapped market based on the historical data.

Portfolio Rebalancing and Score-based Portfolio Choice
Cervicek, Dominic
Factor strategies in equity portfolio management come with high portfolio turnover. In this paper we propose a rebalancing strategy that balances transactions costs with the expected return contribution of the desired portfolio transaction. We follow score-based factor strategies, that sort stocks according to characteristics and seek to hold those stocks which score highest. Thus, high variability of characteristics translates into high propensity to change portfolio constituents. Our heuristic strategy forms expectations of how long a stock will be part of the portfolio and decides to transact only if the expected return contribution over the holding period exceeds transaction costs. We conduct our analysis for scores built on the characteristics underlying the five factor setting in Fama and French (2015). We find that in a large-cap transaction cost setting, neither our heuristic strategy nor automatic rebalancing significantly outperforms the other strategy. In an elevated transaction cost environment however, we find that our heuristic strategy significantly outperforms for three of the five characteristics with higher average returns also for the other two characteristics.

Portfolio Selection in Quantile Utility Models
de Castro, Luciano I.,Galvao, Antonio F.,Montes-Rojas, Gabriel,Olmo, Jose
This paper develops a model for optimal portfolio allocation for an investor with quantile preferences. The investor chooses optimal allocation of weights to maximize the τ-quantile of the utility of the portfolio, for τ ∈ (0,1). A central characteristic of this model is that the portfolio choice is independent of the utility function and related exclusively to the risk attitude, which is captured by the quantile τ. We derive conditions under which the optimal portfolio decision has an interior solution that guarantees diversification vis-a-vis fully investing in a single risky asset. For some families of popular distribution functions the optimal portfolio decision is characterized by two regions: a first region given by the lower quantiles in which diversification is optimal and a second region given by the upper quantiles in which the optimal portfolio allocation is characterized by no diversification. The presence of a risk-free asset produces an all-or-nothing optimal response of the investor to the risky asset that depends on the investors' quantile preferences. This result entails a different interpretation of standard mutual fund separation theorem. In an empirical application we compare the optimal asset allocation of expected utility and quantile utility individuals for a tactical portfolio of stocks, bonds and a risk-free asset.

Predicción del fracaso empresarial: 50 años del modelo seminal de Altman. Un contraste de su efectividad actual en la realidad empresarial de las pymes de Galicia (Forecasting Business Failure: 50 Years of Altman’s Seminal Model. A Contrast of Its Current Effectiveness Within Galician SMEs)
Rodríguez - López, Manuel,Piñeiro-Sánchez, Carlos,de Llano-Monelos, Pablo
Spanish Abstract: Han transcurrido 50 años del modelo de E. Altman, la primera herramienta multivariable paramétrica para predecir quiebras. Este trabajo rememora esa efeméride, aplicando el modelo original de 1968 y su posterior reestimación de 1995, sobre una muestra de pymes gallegas en el período 1999 - 2009. Se verifican sus resultados con los modelos multivariante paramétricos diseñados específicamente para este tipo de empresas por el grupo de investigación fysig.English Abstract: 50 years have passed since the model of E. Altman, the first multivariable parametric tool to predict bankruptcies. This work recalls that event, applying the original 1968 model and its subsequent re-estimation of 1995, on a sample of Galician SMEs in the period 1999 - 2009. Their results are verified with the multivariate parametric models designed specifically for this type of companies by the fysig research group.

Rescuing Rational Expectations from Undeserved Ridicule
Obrimah, Oghenovo A.
It is no secret that the rational expectations framework has endured what many consider to be a well deserved bashing. From problems, such as, ad hoc specifications of functional forms for utility functions, to adoption of utility functions as units of modeling, to absence of equilibriums that support tattonement processes, weaknesses of the conventional approach to modeling of rational expectations equilibriums (REE) are many, varied, and of pragmatic importance. Perhaps the most telling criticism is the belief that, with REE premised on presence of economic agents that are perfect, it is impossible that economic agents are capable of rationality. Consider, however, that all of the weaknesses of REE that have been raised have nothing to do with desirability of the framework, rather have to do with implementation of the framework, that is, are man made, are created by economists and financial economists. In presence of this insight, it is not rational expectations theory that is deficient, rather it is the conventional implementation of the framework that is deficient. Using weaknesses of rational expectations modeling that are raised in Farmer and Geanakoplos (2009) as anchor, this study provides evidence for existence of a new, pragmatic, and well demonstrated approach to modeling of REE that facilitates a rescue of implementation of the concept from all of it's well deserved bashing. An important feature of the new and robust implementation is the fact that, for arrival at REE, there is not any demand for perfection from economic agents. If economic agents are sufficiently aware, REEs are arrived at instantaneously. If economic agents are lacking in some important awareness, REEs are arrived at in context of tattonement processes that are premised on learning on part of investors.

Reserve Management and FX Intervention in Mexico
Calafell, Javier Guzmán
This note outlines Mexico’s recent experience with three closely interrelated issues. First, on the basis of a legal framework regulating transactions in foreign currency between the central bank and government entities, and preannounced market-based mechanisms, the stock of international reserves has reached adequate levels. Second, interventions have been made to restore orderly operating conditions in the FX market whenever this has been needed, with satisfactory results and consistent at all times with the free-floating exchange rate regime in place. Third, the continuous improvement of standards and practices has been instrumental in achieving the objectives set for reserve management at the Bank of Mexico (ie liquidity, capital preservation and return enhancement).Full Publication: Reserve Management and FX Intervention

Reserve Management and Motivations for FX Interventions
Singapore, Monetary Authority of
Unlike most central banks which target interest rates, Singapore runs an exchange rate-centred monetary policy framework, in which the Singapore Dollar Nominal Effective Exchange Rate (S$NEER) is the intermediate target of monetary policy. The S$NEER fluctuates within a policy band that is calibrated to ensure medium-term price stability. The Monetary Authority of Singapore (MAS) undertakes foreign exchange intervention operations to ensure that the S$NEER stays within the policy band. In the process of monetary policy implementation, the central bank accumulates or expends official foreign reserves, leading to changes in the size of its balance sheet. As with other central banks, the MAS’ main objective of holding reserves is to meet balance of payment needs, which underpin the effective implementation of monetary policy.Full Publication: Reserve Management and FX Intervention

Reserves Accumulation and Diversification: The Case of Poland
Berłowska, Beata,Bezzubik, Bogusława,Żaczek, Magdalena
The note provides an overview of foreign exchange reserves trends in Poland. At the end of October 2018, FX reserves reached the equivalent of USD 105.3 billion, placing Poland among the 20 largest reserves holders worldwide. Given the systematic inflow of EU funds and a crisis-driven fall in yields in major advanced economies, a consistent theme of reserves management by the Narodowy Bank Polski (NBP) over the past decade has been diversification into the so called non-traditional currencies. Along with the excursion into less traditional reserve currencies, the NBP has diversified its range of investable instruments. At present, in addition to sovereign bonds, which offer high liquidity and the lowest credit risk, the NBP invests in supranational bonds, bonds issued by local governments or agencies and corporate bonds. In 2018, the NBP made a strategic decision to expand its gold reserves by 25%. As a result, the share of gold in official reserve assets went up from 3.8% at the end of June 2018 to 4.5% in October 2018.Full Publication: Reserve Management and FX Intervention

Reserves Management
Alsayari, Ayman
This note discusses FX reserves management as practised by emerging market economies and, more specifically, by Saudi Arabia. It shares the Saudi Arabian Monetary Authority’s experience on reserve adequacy, investment objectives, philosophy and process, portfolio tranching, risk management and performance measurement. It also includes some discussion of active and passive investment strategies, investment committee governance and institutional values.Full Publication: Reserve Management and FX Intervention

Reserves Management and FX Intervention
(SARB), South African Reserve Bank
Emerging market economies (EMEs) have increased their reserves holdings primarily for self-insurance. The South African Reserve Bank (SARB) has accumulated its foreign exchange (FX) reserves for the same reason, recognising the need to reduce external vulnerability. Both debt issuance and the growth in the monetary base have been used to fund reserve accumulation, and therefore the cost (of holding reserves) comes through the cost of foreign debt issuance and the opportunity cost of forgone monetary accommodation to banks. As a benefit of FX reserve accumulation, reserves as a means of self-insurance can bolster investor confidence, particularly during a crisis, while the level of reserves often plays an important role in broader sovereign credit rating assessments. More recently, and in South Africa’s case, other macro factors such as GDP growth and fiscal debt metrics have tended to be ratings-sensitive.Most EMEs have remained active in the FX markets for various reasons, ranging from attempts to limit exchange rate volatility and/or influencing the level of the exchange rate, to accumulating foreign reserves. This note delves into the evolution of the SARB’s FX intervention objectives, strategies and tactics, as South Africa has become more integrated with the global financial markets. It also highlights the impact of FX intervention on official reserves and the rand exchange rate. Currently, the SARB’s intervention in the FX market is aimed at gradually building up the official reserves without unduly influencing the rand exchange rate in either direction.The SARB’s FX reserves management has matured over time, resulting in the introduction of new asset classes and currencies. There has been a growing focus on the cost of holding reserves as the size of the FX reserves has grown, and the note describes the use of tranches in the foreign exchange reserves portfolio to adequately address both the liability hedging requirements and return motivations. The note concludes by briefly touching on the SARB’s securities lending and external fund management programmes.Full Publication: Reserve Management and FX Intervention

Reserves Management and FX Intervention
Korea, Bank of
Korea’s FX reserves have increased steadily since 2008, to a total of $404 billion as of the end of 2018. This has helped reduce private foreign currency funding costs and exchange rate volatility by contributing to a stable sovereign credit rating. In turn, this has helped to stabilise domestic financial and economic conditions.Korea’s FX authorities have consistently adhered to the principle that the exchange rate should be determined by market forces that reflect economic fundamentals and FX supply and demand. Measures to stabilise the market are carried out only in exceptional circumstances, when there are excessive fluctuations in the exchange rate over a short period of time. FX market intervention is believed to effectively reduce market volatility by calming market sentiment through the use of intervention tools customised to specific circumstances such as temporary herd behaviour. Details of interventions are not disclosed, as they might affect market participants’ expectations. However, the authorities have recently decided to release the net dollar-won trading volumes, in order to increase transparency of FX policies in line with global standards.The Bank of Korea (BOK) decides on the composition of the FX reserves based on its investment objectives, the neutral currency composition and market forecasts. The BOK also has worked to improve its risk management techniques for each type of risk factor and it has expanded its use of external managers to enhance the efficiency of its reserve management.Full Publication: Reserve Management and FX Intervention

Risk-Factor Irrelevance
Chinco, Alex,Hartzmark, Samuel M.,Sussman, Abigail B.
Standard asset-pricing models assume that investors a) recognize correlations with important risk factors, b) prefer assets with lower risk-factor correlations, and c) adjust their demand accordingly. These assumptions are testable hypotheses. We provide a road map for testing them. Using aggregate consumption growth as a case study, we survey finance professionals, MTurkers, MBA students, and investors at a meeting for a large asset manager. We find no evidence that any of these participants view this variable as a priced risk factor. Participants do not adjust their demand in response to changes in correlation with consumption growth. Participants state that they do not consider the correlation with consumption growth in a manner consistent with standard finance theory. Return correlations with consumption growth are not widely reported, and participants are unable to recognize economically large differences in these correlations when presented graphically. Our results underscore the fact that risk-based explanations need to be paired with evidence that real-world investors recognize, think about, and trade on the proposed risk.

Scenario Design for Macro-Financial Stress Testing
De Meo, Emanuele
The goal of this paper is to provide a possible approach to Scenario Design for selecting a stress scenario on economic growth, inflation and long-term interest rates in Italy. The Scenario Design framework belongs to the class of Second Generation Stress Tests and is composed of a few building blocks. First, multiple scenarios on the risk factors are generated simulating a Large Bayesian VAR for the Italian economy. Second, we take the perspective of a representative investor who aims to select a severe yet plausible scenario on the systematic risk factors follwing a factor investing strategy. Moreover, we compare the stress scenarios selected under two different approaches to measure plausibility: the Mahalanobis distance and Entropy pooling under three alternative subjective views with a clear economic narrative. We give evidence that our framework is suitable for the selection of a proper forward-looking severe yet plausible stress scenario.

Social Media Effect, Investor Recognition and the Cross-Section of Stock Returns
Xiangtong, Meng,Zhang, Wei,Li, Youwei,Cao, Xing,Xu, Feng
Investor recognition affects cross-sectional stock returns. In informationally incomplete markets, investors have limited recognition of all securities, and their holding of stocks with low recognition requires compensation for being imperfectly diversified. Using the number of posts on the Chinese social media platform Guba to measure investor recognition of stocks, this paper provides a direct test of Merton's investor recognition hypothesis. We find a significant social media premium in the Chinese stock market. We further find that including a social media factor based on this premium significantly improves the explanatory power of Fama-French factor models of cross-sectional stock returns, and these results are robust when we control for the mass media effect and liquidity effect. Finally, we find that investment strategies based on the social media factor earn sizable risk-adjusted returns, which signifies the importance of the social media premium in portfolio management.

Social-Media Sentiment, Limited Attention, and Stock Returns
Leung, Woon Sau,Wong, Woon K.,Wong, Gabriel
Using tweets from StockTwits and machine-learning techniques in classifying them, we find that social-media sentiment predicts positively and significantly future stock returns, and, importantly, such positive predictability decreases when the number of stocks users tweeted about increases. Such return predictability likely stems from users’ ability in forecasting future earnings. Additional tests reveal that the reduced predictability due to stock coverage is significant only for firms that are complex, opaque, and thus hard-to-analyze. Together, our evidence suggests that stock analysis by users following many stocks is inferior due to attention and time constraints.

The Challenges of Managing Large FX Reserves: The Case of Israel
Benita, Golan,Baudot-Trajtenberg, Nadine,Friedman, Amit
This paper describes the Bank of Israel’s investment philosophy and policy. The paper focuses on the strategic asset allocation framework and the role of the Monetary Policy Committee in setting the investment strategy. The abundant FX reserves in recent years, and falling yields on traditional reserve assets, called for reform in reserves management. Institutional changes â€" the enactment of a new central bank law â€" made reform possible. The result was a dramatic shift in the BOI’s investment policy. In seven years, the BOI moved from a classic reserves portfolio to a multi-asset diversified portfolio that includes a sizeable allocation of equities and corporate bonds. These riskier assets significantly increased the returns on reserves in recent years. For example, between 2012 and 2017, investment in equities was the source of 64% of the total return, which was 9.2%. The contribution of equities to total return allowed the BOI to preserve the purchasing power of reserves at times when traditional reserve assets yielded negative real returns.Full Publication: Reserve Management and FX Intervention

The Cost of Clearing Fragmentation
Benos, Evangelos,Huang, Wenqian,Menkveld, Albert J.,Vasios, Michalis
Fragmenting clearing across multiple central counterparties (CCPs) is costly. This is because dealers providing liquidity globally, cannot net trades cleared in different CCPs and this increases their collateral costs. These costs are then passed on to their clients through price distortions which take the form of a price differential (basis) when the same products are cleared in different CCPs. Using proprietary data, we document an economically significant CCP basis for U.S. dollar swap contracts cleared both at the Chicago Mercantile Exchange (CME) and the LCH in London and provide evidence consistent with a collateral cost explanation of this basis.

The Dynamics of Stock Prices and Exchange Rates: Evidence From Nigeria
Omisakin, Dr. Olusegun A.,Oyinlola, Mutiu Abimbola,Adeniyi, Oluwatosin
This paper probed the long-run and short-run dynamics between stock prices and exchange rates in Nigeria using the Johansen and Gregory-Hansen cointegration analyses, causality test and Exponential General Autoregressive Conditional Heteroskedasticity modelling on daily data from January 2, 2002, to August 11, 2011. The results showed that there is no long-run relationship between stock prices and exchange rate in Nigeria, albeit, with a structural break date of mid-April 2007, which coincides with the period when the stock prices plumped precipitously from the impact of the global financial crisis in early 2007. In addition, the results indicated that there is a unidirectional relationship from stock prices to exchange rate and that the EGARCH modelling suggested that a 100% increase in stock prices would lead to a 1.66% appreciation of the exchange rate. Thus, it is imperative for monetary authorities in Nigeria to take into account the role of stock market development in the conduct of its exchange rate policy.

The Effect of IFRS Adoption on Corporate Cash Holdings: Evidence from MENA Countries
Ozkan, Serdar,Yaacoub, Chadi,El-Kanj, Nasser,Dzenopoljac, Vladimir
We investigate the relationship between IFRS adoption and firms’ cash holdings in ten Arab countries in the MENA. We first show that IFRS adoption reduces the cash holdings of the firms. The effect of IFRS adoption is robust for high-income countries in the Gulf region. This result implies that high-quality financial information reduces the information asymmetries; this, in turn, lowers the cost of capital and cash holdings. We suppose that strong macroeconomic conditions in Gulf countries facilitate the proper application of IFRS by weakening the incentives for earnings management. We also show that regardless of the income level of the countries, IFRS adoption reduces the cash holdings of large firms. Furthermore, we conclude that IFRS adoption is not able to reduce cash holdings in the case of high uncertainty (in terms of cash flow volatility of the firms) in the MENA.

The Implications of Heterogeneity and Inequality for Asset Pricing
Panageas, Stavros
Does heterogeneity matter for asset pricing? Starting with an irrelevance result, I classify the literature into two groups of papers taking different routes to make heterogeneity relevant for asset prices. The first group discusses models of investors who differ in terms of their preferences, beliefs, or access to markets. Despite their differences, these models have similar implications, and can be analyzed in a unified way. The second group of papers consists of models with investors experiencing uninsurable income shocks. I show that despite arriving at seemingly inconsistent conclusions, there is a common thread and a way to reconcile the results of this strand of the literature.

The New Conceptual Risk Budget Framework and Implementation of the New FX Reserves Investment Strategy at the Central Bank of Hungary
Nagy, Márton,Paulik, Éva,Kiss M., Norbert,Vereszki-Varga, Péter,Ladányi, Sándor
Reserve portfolios prior to the Global Financial Crisis provided positive (low) returns for central banks or had extremely low probabilities of earning negative returns. In the wake of the crisis, expansionary monetary policy created a low yield environment at a scale that was never seen before. Central banks like the Central Bank of Hungary (MNB) had to make a decision: either continue reserve management based on the traditional approach or increase their risk tolerance for higher yields. The Bank decided to embrace a new approach, i.e. put in place a risk budget framework in reserve management. This framework aims to find the optimal strategic asset allocation of the institution based on the risk appetite and capacity of the Bank and to prudently keep the risk of the portfolio within the predefined levels. In practice, the risk budget is a risk measure expressed in nominal terms that cannot be exceeded by the portfolio. This paper presents the implementation process of the MNB’s risk budget framework, including the determination of the risk budget size and the new strategic asset allocation.Full Publication: Reserve Management and FX Intervention

The R&D Tax Incentive as a Source of Funding for Early Stage Firms: Evidence From Australian Mining Exploration Entities
Ferguson, Andrew,Sherry, Samuel
Prior research documents impediments to raising external equity finance faced by early stage and R&D firms. The capital structure literature predicts that these firms prefer to finance their projects with internal funds, with equity used as a last resort. We examine the 2011 changes to the R&D Tax Incentive (“R&DTI”) in Australia, which allowed small firms in a tax loss position to exchange a portion of their unused losses for a cash refund of up to 45% of their eligible R&D expenditure, potentially providing an alternative funding channel. Using a sample of 322 ASX-listed mining exploration entities (“MEEs”) receiving R&D tax refunds between 2008 and 2015, we find that the number of firms accessing the R&DTI increased significantly after 2011, as did the average refund received. The increase in R&DTI claims are concentrated in firms having previously disclosed a mineral resource or ore reserve. We find that R&D firms are generally less risky than non-R&D firms of comparable size. This is likely due to companies engaged in greenfield exploration (the most high-risk form of exploration) investing less in R&D compared to those conducting R&D around an existing mineral deposit.

U.S. Firms’ Aversion to Inversions
Harris, Jeremiah,O'Brien, William
Our study hypothesizes that patent-using U.S. firms avoided inversions because they could replicate the two main tax-related benefits of inversions while remaining incorporated domestically. We find that patent use is negatively related to both U.S. firms’ propensity to invert and their foreign tax rates, and this relationship strengthens as patent-users’ foreign share of earnings increases. Patents also help explain heterogeneity in tax-mitigating techniques used by pharmaceutical firms. Consistent with patent-based profit shifting to reduce foreign taxes, patent-using firms had lower foreign tax rates. We also assemble a comprehensive series of tax-free repatriation techniques used prior to the 2017 tax reform and find that profit-shifting firms has a greater propensity to use these techniques. Finally, we use a quasi-natural experimental setting to find corporate tax cuts in countries where U.S. firms have longstanding inputs also result in domestic tax rate reductions in patent-using firms, consistent with the widespread use of tax-free repatriations. These firms’ ability to subvert the pre-2018 U.S. worldwide taxation rules, along with the 2017 tax reform’s failure to fully address patent-based profit shifting, may help explain the reform’s unexpectedly small impact.

Unintended Side Effects: Stress Tests, Entrepreneurship, and Innovation
Doerr, Sebastian
Post-crisis stress tests have helped to enhance financial stability and to reduce banks' risk-taking. In order to quantify their overall impact, regulators have turned to evaluating the effects of stress tests on financing and the real economy. Using the U.S. as a laboratory, this paper shows that stress tests have had potentially unintended side effects on entrepreneurship and innovation at young firms. Banks subject to stress tests have strongly cut small business loans secured by home equity, an important source of financing for entrepreneurs. Lower credit supply has led to a relative decline in entrepreneurship during the recovery in counties with higher exposure to stress tested banks. The decline has been steeper in sectors with a higher share of young firms using home equity financing, i.e. where the reduction in credit hit hardest. Counties with higher exposure have also seen a decline in patent applications by young firms. I provide suggestive evidence that the decline in credit has negatively affected labor productivity, reflecting young firms' disproportionate contribution to growth. My results do not imply that stress tests reduce welfare, but highlight a possible trade-off between financial stability and economic dynamism. The effects of stress tests on entrepreneurship should be taken into account when evaluating their effectiveness.

What to Expect When Everyone is Expecting: Self-Fulfilling Expectations and Asset-Pricing Puzzles
Garleanu, Nicolae,Panageas, Stavros
We study an economy without bubbles in which expectations about future discount rates can become self-fulfilling because asset valuations redistribute wealth across different investor cohorts. For such redistribution to take place, the wealth of arriving and existing cohorts must react differently to discount rates, and in addition only the existing agents be marginal in financial markets. The self-fulfilling nature of discount rate expectations means that the economy can address several well documented empirical asset pricing facts (excessive volatility, return predictability, low interest rate level and volatility), while all real quantities (aggregate consumption and dividend growth) are smooth.