Research articles for the 2019-12-26
A Quantum Algorithm for Linear PDEs Arising in Finance
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We propose a hybrid quantum-classical algorithm, originated from quantum chemistry, to price European and Asian options in the Black-Scholes model. Our approach is based on the equivalence between the pricing partial differential equation and the Schrodinger equation in imaginary time. We devise a strategy to build a shallow quantum circuit approximation to this equation, only requiring few qubits. This constitutes a promising candidate for the application of Quantum Computing techniques (with large number of qubits affected by noise) in Quantitative Finance.
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We propose a hybrid quantum-classical algorithm, originated from quantum chemistry, to price European and Asian options in the Black-Scholes model. Our approach is based on the equivalence between the pricing partial differential equation and the Schrodinger equation in imaginary time. We devise a strategy to build a shallow quantum circuit approximation to this equation, only requiring few qubits. This constitutes a promising candidate for the application of Quantum Computing techniques (with large number of qubits affected by noise) in Quantitative Finance.
Capital Adequacy Pre- and Post-Crisis and the Role of Stress Testing
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The financial crisis forced the development of new approaches for determining capital adequacy in banks since extant methods clearly did not prepare banks nor their supervisors sufficiently. The success of stress testing as a crisis response tool, particularly in the US in 2009, has led to its adoption post crisis as the tool of choice for assessing capital adequacy in banks and testing resiliency to economic and financial shocks. But the increased reliance on stress testing in financial peacetime has given rise to a new risk concentration, namely in the rather narrow set of scenarios and their translation to outcomes and impact on bank financials.
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The financial crisis forced the development of new approaches for determining capital adequacy in banks since extant methods clearly did not prepare banks nor their supervisors sufficiently. The success of stress testing as a crisis response tool, particularly in the US in 2009, has led to its adoption post crisis as the tool of choice for assessing capital adequacy in banks and testing resiliency to economic and financial shocks. But the increased reliance on stress testing in financial peacetime has given rise to a new risk concentration, namely in the rather narrow set of scenarios and their translation to outcomes and impact on bank financials.
Company-College Co-location: Do Universities Create Local Innovation Clusters?
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I show that firms headquartered geographically close to a top-university engage in more research and development and produce more valuable patents. To address the endogeneity of university and firm location, I use 19th century as-good-as-random allocation of land-grant colleges. I find that firms located close to these colleges are more innovative. Moving from the first to the fifth quintile of the distance distribution is associated with a 0.75 percentage point reduction in research and development expenditure and a 1.72 percentage point reduction in the value of patents, representing 15% and 21% of the mean, respectively. My findings suggest that universities help firms innovate by supplying local labor markets with high human capital and by generating ideas for local knowledge spillovers.
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I show that firms headquartered geographically close to a top-university engage in more research and development and produce more valuable patents. To address the endogeneity of university and firm location, I use 19th century as-good-as-random allocation of land-grant colleges. I find that firms located close to these colleges are more innovative. Moving from the first to the fifth quintile of the distance distribution is associated with a 0.75 percentage point reduction in research and development expenditure and a 1.72 percentage point reduction in the value of patents, representing 15% and 21% of the mean, respectively. My findings suggest that universities help firms innovate by supplying local labor markets with high human capital and by generating ideas for local knowledge spillovers.
Efficient Estimation of Multivariate Semi-nonparametric GARCH Filtered Copula Models
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This paper considers estimation of semi-nonparametric GARCH ï¬ltered copula models in which the individual time series are modelled by semi-nonparametric GARCH and the joint distributions of the multivariate standardized innovations are characterized by parametric copulas with nonparametric marginal distributions. The models extend those of Chen and Fan (2006) to allow for semi-nonparametric conditional means and volatilities, which are estimated via the method of sieves such as splines. The ï¬tted residuals are then used to estimate the copula parameters and the marginal densities of the standardized innovations jointly via the sieve maximum likelihood (SML). We show that, even using nonparametrically ï¬ltered data, both our SML and the two-step copula estimator of Chen and Fan (2006) are still root-n consistent and asymptotically normal, and the asymptotic variances of both estimators do not depend on the nonparametric ï¬ltering errors. Even more surprisingly, our SML copula estimator using the ï¬ltered data achieves the full semiparametric efficiency bound as if the standardized innovations were directly observed. These nice properties lead to simple and more accurate estimation of Value-at-Risk (VaR) for multivariate ï¬nancial data with flexible dynamics, contemporaneous tail dependence and asymmetric distributions of innovations. Monte Carlo studies demonstrate that our SML estimators of the copula parameters and the marginal distributions of the standardized innovations have smaller variances and smaller mean squared errors compared to those of the two-step estimators in ï¬nite samples. A real data application is presented.
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This paper considers estimation of semi-nonparametric GARCH ï¬ltered copula models in which the individual time series are modelled by semi-nonparametric GARCH and the joint distributions of the multivariate standardized innovations are characterized by parametric copulas with nonparametric marginal distributions. The models extend those of Chen and Fan (2006) to allow for semi-nonparametric conditional means and volatilities, which are estimated via the method of sieves such as splines. The ï¬tted residuals are then used to estimate the copula parameters and the marginal densities of the standardized innovations jointly via the sieve maximum likelihood (SML). We show that, even using nonparametrically ï¬ltered data, both our SML and the two-step copula estimator of Chen and Fan (2006) are still root-n consistent and asymptotically normal, and the asymptotic variances of both estimators do not depend on the nonparametric ï¬ltering errors. Even more surprisingly, our SML copula estimator using the ï¬ltered data achieves the full semiparametric efficiency bound as if the standardized innovations were directly observed. These nice properties lead to simple and more accurate estimation of Value-at-Risk (VaR) for multivariate ï¬nancial data with flexible dynamics, contemporaneous tail dependence and asymmetric distributions of innovations. Monte Carlo studies demonstrate that our SML estimators of the copula parameters and the marginal distributions of the standardized innovations have smaller variances and smaller mean squared errors compared to those of the two-step estimators in ï¬nite samples. A real data application is presented.
Financial Literacy and Its Influence on Consumers’ Internet Banking Behaviour
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This study examines the level and antecedents of financial literacy and investigates its influence on consumers’ internet banking behaviour. The focus is on Cyprus, a country that experienced an unprecedented financial crisis in 2013 that caused an enormous shrinkage of the banking sector. Ever since then, banks have been investing in financial innovations, such as internet banking (i-banking), aiming to enhance customer service and efficiency in the age of financial digitalization. Notwithstanding, the results show that financial literacy is yet too low in Cyprus, whereby only 37.33% of the study’s survey adults have a good financial knowledge proficiency level. The results indicate that financially literate consumers show a strong preference for frequent use of i-banking, whereby the odds of frequently using i-banking are increased by more than 64% for one standard deviation increase in the respondents’ financial knowledge score. The findings highlight the crucial interplay of digital and financial sophistication, and their positive influence on consumers’ usage of digital financial services. The evidence from Cyprus also points to policy directions according to which digital financial education programs should be a central element in national financial literacy strategies.
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This study examines the level and antecedents of financial literacy and investigates its influence on consumers’ internet banking behaviour. The focus is on Cyprus, a country that experienced an unprecedented financial crisis in 2013 that caused an enormous shrinkage of the banking sector. Ever since then, banks have been investing in financial innovations, such as internet banking (i-banking), aiming to enhance customer service and efficiency in the age of financial digitalization. Notwithstanding, the results show that financial literacy is yet too low in Cyprus, whereby only 37.33% of the study’s survey adults have a good financial knowledge proficiency level. The results indicate that financially literate consumers show a strong preference for frequent use of i-banking, whereby the odds of frequently using i-banking are increased by more than 64% for one standard deviation increase in the respondents’ financial knowledge score. The findings highlight the crucial interplay of digital and financial sophistication, and their positive influence on consumers’ usage of digital financial services. The evidence from Cyprus also points to policy directions according to which digital financial education programs should be a central element in national financial literacy strategies.
Monetary Policy and Systemic Risk
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We employ an event study approach to estimate the price reaction of U.S. financial stocks to 147 Federal Open Market Committee (FOMC) decisions about the Fed funds target rate for the period 2000-2015. We show that systemic risk tends to increase abnormal returns for announcements related to a positive unexpected change in the target rate (“Positive Surpriseâ€). On the other hand, systemic risk tends to reduce abnormal returns for dates related to a “Negative Surprise†and a “Zero Surprise†(the announced rate is the same as the expected one). These results suggest that a higher than expected target rate can be advantageous to institutions with high levels of systemic risk. High short-term interest rates and a flat yield curve can increase the risk of a crisis, and therefore this finding could be explained by a “Too-Big-To-Fail (TBTF) hypothesisâ€: whenever the likelihood of a systemic crisis increases, investors buy stocks of financial firms that are more likely to be rescued.
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We employ an event study approach to estimate the price reaction of U.S. financial stocks to 147 Federal Open Market Committee (FOMC) decisions about the Fed funds target rate for the period 2000-2015. We show that systemic risk tends to increase abnormal returns for announcements related to a positive unexpected change in the target rate (“Positive Surpriseâ€). On the other hand, systemic risk tends to reduce abnormal returns for dates related to a “Negative Surprise†and a “Zero Surprise†(the announced rate is the same as the expected one). These results suggest that a higher than expected target rate can be advantageous to institutions with high levels of systemic risk. High short-term interest rates and a flat yield curve can increase the risk of a crisis, and therefore this finding could be explained by a “Too-Big-To-Fail (TBTF) hypothesisâ€: whenever the likelihood of a systemic crisis increases, investors buy stocks of financial firms that are more likely to be rescued.
Reply to 'The Reg SHO Reanalysis Project: Reconsidering Fang, Huang and Karpoff (2016) on Reg SHO and Earnings Management' by Black et al. (2019)
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In a 2016 paper (Fang, Huang, and Karpoff, 2016), we report that firms exposed to an increase in the prospect of short selling during the Reg SHO pilot program have lower discretionary accruals during the pilot period. Black, Desai, Litvak, Yoo, and Yu (2019, hereafter, BDLYY) argue that this result is not replicable. We show that BDLYY’s claim is incorrect. The accruals result previously was replicated in papers by Massa, Zhang, and Zhang (2015) and Heath, Ringgenberg, Samadi, and Werner (2019), and is easily replicable using data and code that we have shared widely since 2014 â€" including with the BDLYY team in 2015 â€" and that we recently posted publicly. The accruals result also is robust to a wide range of specification changes, including those implied by the BDLYY paper, which include: various measures of performance-matched discretionary accruals and total accruals; using our original 2012 Compustat data or currently available 2019 Compustat data; including both firm and year fixed effects; including or excluding other covariates in the difference-in-differences (DiD) tests; and using unbalanced rather than balanced panels. We conjecture that BDLYY’s results are inconsistent with prior results because they rely partly on non-standard accruals measures and/or use samples that differ from those used by Fang et al. (2016), Massa et al. (2015), and Heath et al. (2019). We conclude by discussing two theoretical concerns. First, we reiterate that an observed increase in short selling during the Reg SHO period is neither necessary nor sufficient to establish that the prospect of short selling has a disciplinary effect on earnings management, as managers’ endogenous adjustments affect short sellers’ opportunities and observed short selling. Second, we discuss a concern that the Reg SHO change appears to be too small to explain a wide range of firm outcomes, as recent empirical findings suggest.
SSRN
In a 2016 paper (Fang, Huang, and Karpoff, 2016), we report that firms exposed to an increase in the prospect of short selling during the Reg SHO pilot program have lower discretionary accruals during the pilot period. Black, Desai, Litvak, Yoo, and Yu (2019, hereafter, BDLYY) argue that this result is not replicable. We show that BDLYY’s claim is incorrect. The accruals result previously was replicated in papers by Massa, Zhang, and Zhang (2015) and Heath, Ringgenberg, Samadi, and Werner (2019), and is easily replicable using data and code that we have shared widely since 2014 â€" including with the BDLYY team in 2015 â€" and that we recently posted publicly. The accruals result also is robust to a wide range of specification changes, including those implied by the BDLYY paper, which include: various measures of performance-matched discretionary accruals and total accruals; using our original 2012 Compustat data or currently available 2019 Compustat data; including both firm and year fixed effects; including or excluding other covariates in the difference-in-differences (DiD) tests; and using unbalanced rather than balanced panels. We conjecture that BDLYY’s results are inconsistent with prior results because they rely partly on non-standard accruals measures and/or use samples that differ from those used by Fang et al. (2016), Massa et al. (2015), and Heath et al. (2019). We conclude by discussing two theoretical concerns. First, we reiterate that an observed increase in short selling during the Reg SHO period is neither necessary nor sufficient to establish that the prospect of short selling has a disciplinary effect on earnings management, as managers’ endogenous adjustments affect short sellers’ opportunities and observed short selling. Second, we discuss a concern that the Reg SHO change appears to be too small to explain a wide range of firm outcomes, as recent empirical findings suggest.
The Effect of Enforcement on Auditor Conservatism
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This paper provides a new perspective on the effect of enforcement on auditor behavior and overall financial reporting quality by considering auditor conservatism as strategy towards uncertainty which might arise during the audit procedure. As an enforcement action reveals not only misconduct by the manager but also audit failures, the auditor in our theoretical model has incentive to carefully examine a managerial report in order to reveal and correct a potential manipulation. Whenever facing insufficient audit evidence, however, the auditor can require downward adjustments of the items in doubt (auditor conservatism). Given a manipulating manager, we show that if enforcement is relatively strict and further increased the auditor economizes on informative effort as the increased conservatism sufficiently shelters her from pending enforcement penalties. Although an increase in enforcement strictness prevents overstated reports, overall financial reporting quality is not necessarily increased. Stricter enforcement enhances financial reporting quality in environments of high manipulation risk but decreases it in environments of low manipulation risk. In environments of intermediate manipulation risk, it depends on the level of informative effort whether increased enforcement strictness increases the overall accuracy of reports.
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This paper provides a new perspective on the effect of enforcement on auditor behavior and overall financial reporting quality by considering auditor conservatism as strategy towards uncertainty which might arise during the audit procedure. As an enforcement action reveals not only misconduct by the manager but also audit failures, the auditor in our theoretical model has incentive to carefully examine a managerial report in order to reveal and correct a potential manipulation. Whenever facing insufficient audit evidence, however, the auditor can require downward adjustments of the items in doubt (auditor conservatism). Given a manipulating manager, we show that if enforcement is relatively strict and further increased the auditor economizes on informative effort as the increased conservatism sufficiently shelters her from pending enforcement penalties. Although an increase in enforcement strictness prevents overstated reports, overall financial reporting quality is not necessarily increased. Stricter enforcement enhances financial reporting quality in environments of high manipulation risk but decreases it in environments of low manipulation risk. In environments of intermediate manipulation risk, it depends on the level of informative effort whether increased enforcement strictness increases the overall accuracy of reports.
Who Intends to Become Financially Literate? Insights from the Theory of Planned Behaviour
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Despite the importance that policy-makers acknowledge to financial education, little is known about the demand for financial literacy (especially among the least literate individuals). We here build on the social-psychological framework of the Theory of Planned Behaviour (TPB) to study the intention to learn more about savings and investments as a function of attitudes, subjective norms, and perceived behavioural control, also controlling for individual background factors, including psychological traits. We develop a novel TPB-based module for the CONSOB 2018 Survey on financial investments by Italian households, administered to 1,601 individuals. Analyses of this module, also through structural equation models, show that attitudes, subjective norms and perceived behavioural control are significant determinants of intentions to learn more about savings and investments, as predicted by TPB. Differences in attitudes, subjective norms, and perceived behavioural control contribute to financial literacy gaps for women and less literate individuals in general. In analogy to other fields, interventions in the area of financial literacy should also target the determinants of individuals’ intentions, especially for adults that are generally involved in financial education programs on a voluntary basis.
SSRN
Despite the importance that policy-makers acknowledge to financial education, little is known about the demand for financial literacy (especially among the least literate individuals). We here build on the social-psychological framework of the Theory of Planned Behaviour (TPB) to study the intention to learn more about savings and investments as a function of attitudes, subjective norms, and perceived behavioural control, also controlling for individual background factors, including psychological traits. We develop a novel TPB-based module for the CONSOB 2018 Survey on financial investments by Italian households, administered to 1,601 individuals. Analyses of this module, also through structural equation models, show that attitudes, subjective norms and perceived behavioural control are significant determinants of intentions to learn more about savings and investments, as predicted by TPB. Differences in attitudes, subjective norms, and perceived behavioural control contribute to financial literacy gaps for women and less literate individuals in general. In analogy to other fields, interventions in the area of financial literacy should also target the determinants of individuals’ intentions, especially for adults that are generally involved in financial education programs on a voluntary basis.
