Research articles for the 2020-01-07

A note on the worst case approach for a market with a stochastic interest rate
Dariusz Zawisza

We solve robust optimization problem and show the example of the market model for which the worst case measure is not a martingale measure. In our model the instantaneous interest rate is determined by the Hull-White model and the investor employs the HARA utility to measure his satisfaction.To protect against the model uncertainty he uses the worst case measure approach. The problem is formulated as a stochastic game between the investor and the market from the other side. PDE methods are used to find the saddle point and the precise verification argument is provided.

A simple microstructural explanation of concave pice impact
Sergey Nadtochiy

This article describes a simple model of market microstructure which explains a concave price impact. In the proposed model, the local relationship between the order flow and the fundamental price (i.e. the local price impact) is linear, which makes the model dynamically consistent. Nevertheless, the expected impact on midprice from a large sequence of co-directional trades is nonlinear and asymptotically concave. The main practical conclusion of the model is that, throughout a meta-order, the volumes at the best bid and ask prices change (on average) in favor of the executor. This conclusion, in turn, relies on two more concrete predictions of the model, one of which is tested using publicly available market data without the information about meta-orders.

Corporate Governance for Sustainability
Johnston, Andrew,Veldman, Jeroen,Eccles, Robert G.,Deakin, Simon,Davis, Jerry,Djelic, Marie-Laure,Pistor, Katharina,Segrestin, Blanche,Williams, Cynthia A.,Millon, David,Ireland, Paddy ,Sjåfjell, Beate,Bruner, Christopher M.,Talbot, Lorraine E.,Willmott, Hugh Christopher,Villiers, Charlotte,Liao, Carol,Valiorgue, Bertrand,Glynos, Jason,Sayre, Todd L.,Morgan, Bronwen,Wartzman, Rick,Sikka, Prem,Gregor, Filip,Jacobs, David Carroll,Gill, Roger,Brown, Roger,Bavoso, Vincenzo,Lancastle, Neil,Matthaei, Julie,Taylor, Scott,Larsson-Olaison, Ulf,Cullen, Jay,Dignam, Alan J.,Joo, Thomas Wuil,O'Kelly, Ciarán,Keating, Con,Tomasic, Roman,Lilley, Simon,Tennent, Kevin,Robson, Keith,Maley, Willy,Chiu, Iris H-Y,McGaughey, Ewan,Rees, Chris,Boeger, Nina,Leaver, Adam,Moore, Marc T.,Paape, Leen,Meyer, Alan D.,Palazzi, Marcello,Kaul, Nitasha,Espinosa-Cristia, Juan Felipe ,Kuhn, Timothy,Cooper, David J.,Soederberg, Susanne,Jansson, Andreas,Watson, Susan,Sitbon, Ofer,Loughrey, Joan,Collison, David,McCulloch, Maureen,McCulloch, Maureen,Samanta, Navajyoti,Greenwood, Daniel J.H.,Thompson, Grahame F.,Keay, Andrew R.,Contu, Alessia,Rühmkorf, Andreas,Hull, Richard,Esser, Irene-Marie,Chabrak, Nihel
The current model of corporate governance needs reform. There is mounting evidence that the practices of shareholder primacy drive company directors and executives to adopt the same short time horizon as financial markets. Pressure to meet the demands of the financial markets drives stock buybacks, excessive dividends and a failure to invest in productive capabilities. The result is a ‘tragedy of the horizon’, with corporations and their shareholders failing to consider environmental, social or even their own, long-term, economic sustainability.With less than a decade left to address the threat of climate change, and with consensus emerging that businesses need to be held accountable for their contribution, it is time to act and reform corporate governance in the EU. The statement puts forward specific recommendations to clarify the obligations of company boards and directors and make corporate governance practice significantly more sustainable and focused on the long term.

Cross-Industry Information Sharing and Analyst Performance
Huang, Allen,Lin, An-Ping,Zang, Amy
This study shows that analyst research benefits from the sharing of information about economically connected industries among colleagues. Measuring the intensity of potential information sharing with the level of economic connection between an analyst’s industry and her colleagues’ industries, we find that it is positively correlated with an analyst’s earnings forecast accuracy, stock recommendation profitability, coverage breadth, and report frequency after controlling for other determinants including broker or analyst fixed effects. We also find that analysts are more likely to issue reports when highly connected colleagues produce information. We show that sharing information with colleagues covering downstream (upstream) industries benefits an analyst’s revenue (expense) forecasts, and that an analyst’s performance improves (deteriorates) after an economically connected colleague joins (departs) the brokerage firm. Cross-sectionally, information sharing benefits an analyst’s research more when her colleagues have higher research quality, and when she and her colleagues have stronger social ties. Finally, we find that investors recognize the benefits of information sharing: they react more strongly to research reports issued by analysts whose covered industries have a higher level of economic connection to those of colleagues, and are more likely to vote such analysts as All-Stars.

Does Diversification Outweigh Superior Information In Enforcement of Loan Contracts?
Agarwal, Sumit,Murlidharan, Aditya,Nishesh, Naman,Tantri, Prasanna L.
Although information and diversification are fundamental to lending, not much is known about their relative impact on loan performance, especially when they are in conflict. Using the group loan structure in India, we find that even in an economic setting dominated by asymmetry of information and inefficient enforcement of contracts, heterogeneity in groups (diversification) leads to better loan performance when compared to homogeneity (superior information). Using machine learning techniques, we show that rigid social ties not only enhance the risk of common shocks but also lead to contagion. Relative informational superiority is not sufficient to overcome the above costs.

Equity Momentum: The Global Engine of Credit Rating Migration and Performance
Spielmann, Timo,Wenzler, Josef-Stefan
Spillover effects from equity momentum to credit markets have been shown to lead to excessive premia and, simultaneously, reduced risk measures in credit securities. Here, we present an intuitive theory for this anomaly based on the premise that equity momentum drives leverage to invoke rating changes that ultimately spur the performance of credit securities for as long as corporate financiers deem it economically beneficial. We support this theory by empirically relating idiosyncratic equity momentum to rating migration and the corresponding anomaly and by demonstrating that these dynamics loose steam for higher rating classes as the value proposition of further rating upgrades declines exponentially. In fact, we observe that on average corporate financiers pursue a target rating of BBB. Furthermore, we demonstrate how deeply this anomaly percolates credit markets by confirming its existence across various neglected, yet economically meaningful and scientifically interesting subsamples including international credit markets, emerging markets and subordinate credit securities.

Ethics, ESG, and ERISA: Ethical-Factor Investing of Savings and Retirement Benefits Part 2
Feuer, Albert
Ethical-factor investing is investment decision-making that takes into account ethical factors. Part 1 described the three prudent approaches to ethical-factor investing: (1) the Incorporation approach, which does the right thing only if it improves financial returns; (2) the Tie-Breaker approach, which does the right thing if there no financial cost to doing so; and (3) the concessionary approach, which does the right thing if it does not reduce financial returns too substantially. Fiduciaries making investments on behalf of ERISA plans, other than Top-Hat plans, may use the Incorporation approach, and must use it, to the extent it is part of prudent investing. They may use the Tie-Breaker approach, but not the Concessionary approach. The latter would violate the fiduciary duty to act for the exclusive purpose of providing benefits to plan participants and beneficiaries for ERISA plans, other than Top-Hat Plans. Participants and beneficiaries of individual retirement arrangements or of self-directed ERISA savings and retirement plans, such as most 401(k) plans, may use any of the three ethical-factor investment approaches. Sponsors of Top-Hat plans may do the same. Fiduciaries choosing an investment option for most self-directed ERISA plans, other than Top-Hat plans, must use the Incorporation approach to the extent that it is prudent. They may also choose an option that uses the Tie-Breaker approach, but if it was also chosen by the Tie-Breaker approach it may only supplement rather than replace another investment option, such as an S&P 500 Index® fund.

Evaluating Private Equity Performance Using Stochastic Discount Factors
Gredil, Oleg,Sorensen, Morten,Waller, William
We examine the performance of 2,790 private equity (PE) funds incepted during 1979-2008 using Stochastic Discount Factors (SDFs) implied by the two leading consumption-based asset pricing models (CBAPMs) â€" external habit and long-run risks â€" as their assumptions appear consistent with investment objectives of avid PE investors. In contrast to CAPM-based inference, venture funds did not destroy value under these CBAPMs in post-2000 vintages and may even have outperformed buyouts and generalists in the full sample. We find that 2007-08 venture vintages provide a better hedge for post-crises consumption shocks than other types of PE, and that the temporal variation in PE excess returns is significantly smaller under CBAPMs. Our contribution is also methodological. We extend the realized risk premia matching insight of Korteweg and Nagel (2016) to a more general class of SDFs, namely portfolio-specific discount factors that reflect non-tradeable assets unspanned by standard benchmarks. To this end, we propose a more efficient estimation of SDF parameters in this context and develop a finite sample bias correction for NPV-based inference with long-duration assets.

Identifying Svars from Sparse Narrative Instruments: Dynamic Effects of U.S. Macroprudential Policies
Budnik, Katarzyna Barbara,Rünstler, Gerhard
We study the identification of policy shocks in Bayesian proxy VARs for the case that the instrument consists of sparse qualitative observations indicating the signs of certain shocks. We propose two identification schemes, i.e. linear discriminant analysis and a non-parametric sign concordance criterion. Monte Carlo simulations suggest that these provide more accurate confidence bounds than standard proxy VARs and are more efficient than local projections. Our application to U.S. macroprudential policies finds persistent effects of capital requirements and mortgage underwriting standards on credit volumes and house prices together with moderate effects on GDP and inflation.

Investor Sentiment and the Expected Returns of Socially and Environmentally Responsible Firms
Azevedo, Vitor,Kaserer, Christoph,M. S. Campos, Lucila
Social and environmental investments tend to make firms' valuations more subjective, which can make their financial performance more vulnerable to the level of investor sentiment. We study whether investor sentiment drives the financial performance of socially as well as environmentally responsible firms compared to firms that do not meet these criteria. We find that socially responsible firms have a relative monthly excess return of 0.70% higher following periods of low investor sentiment level than periods of high, whereas environmentally responsible firms have 0.88%. Although standard risk factors do not fully explain the impact of investor sentiment level on subsequent risk-adjusted returns of environmentally and socially responsible firms, we find that a risk factor, estimated as the second component of portfolios sorted on qualitative issue areas, can explain this relation.

Linking Executive Compensation to Retained Earnings â€" A Study of German Savings Banks
Blochinger, Daniel
Performance linked compensation for executives can incentivize effort and commitment but can also induce increased risk taking. The German savings bank associations RSGV and SVWL recommend their members to make executive compensation increase both in performance and in the stock of retained earnings. We use a unique public data set to analyze the relationships of retained earnings, executive compensation, risk and state level savings bank laws in German savings banks. We find that the recommendation of RSGV and SVWL provides a good fit to compensation data. However, we find a marginally significant negative relationship of equity ratios and executive compensation, which is especially strong for members of RSGV and SVWL. This is the opposite of what the recommendation suggests. Finally, we identify several properties of state level savings bank laws as further determinants of equity ratios.

Medallion Fund: The Ultimate Counterexample?
Cornell, Bradford
The performance of Renaissance Technologies’ Medallion fund provides the ultimate counterexample to the hypothesis of market efficiency. Over the period from the start of trading in 1988 to 2018, $100 invested in Medallion would have grown to $398.7 million, representing a compound return of 63.3%. Returns of this magnitude over such an extended period far outstrip anything reported in the academic literature. Furthermore, during the entire 31-year period, Medallion never had a negative return despite the crash and the financial crisis. Despite this remarkable performance, the fund’s market beta and factor loadings were all negative, so that Medallion’s performance cannot be interpreted as a premium for risk bearing. To date, there is no adequate rational market explanation for this performance.

Mergers, Branch Consolidation and Financial Exclusion in the US Bank Market
Calzada, Joan,Fageda, Xavier,Martínez-Santos, Fernando
We analyze the role of bank mergers as determinants of the evolution of branch presence at the county level. Panel regressions based on county-level branch density are used to study differences across urban versus rural counties as well as pre- and post-crisis. The results indicate that bank mergers contributed to the increase of branches in the pre-crisis period and to its reduction in the post-crisis period, but the expansion effect of the mergers before the crisis mainly took place in metropolitan counties. Additional results show that broadband penetration has contributed to the reduction in the number of branches after the crisis and that branch closures are associated with an increase in the share of unbanked and underbanked households at the county level.

Optimal insurance contract with benefits in kind under adverse selection
Clémence Alasseur,Corinne Chaton,Emma Hubert

A significant loss of income can have a negative impact on households who are forced to reduce their consumption of some particular staple goods. This can lead to health issues and consequently generates significant costs for society. In order to prevent these negative consequences, we suggest that consumers can buy an insurance to have a sufficient amount of staple good in case they lose a part of their income. We develop a two-period/two-good Principal-Agent problem with adverse selection and endogenous reservation utility to model an insurance with in kind benefits. This model allows us to obtain semi-explicit solutions for the insurance contract and is applied to the context of fuel poverty.

Passengers' Travel Behavior in Response to Unplanned Transit Disruptions
Nima Golshani,Ehsan Rahimi,Ramin Shabanpour,Kouros Mohammadian,Joshua Auld,Hubert Ley

Public transit disruption is becoming more common across different transit services, which can have a destructive influence on the resiliency and reliability of the transportation system. Utilizing a recently collected data of transit users in the Chicago Metropolitan Area, the current study aims to analyze how transit users respond to unplanned service disruption and disclose the factors that affect their behavior.

Ride the Lightning: Turning Bitcoin into Money
Divakaruni, Anantha,Zimmerman, Peter
We show that recent technological innovations have significantly improved the efficiency of Bitcoin as a means of payment. We study three particular innovations: the Lightning Network, a means of netting payments off the blockchain; SegWit, an improvement to the way data are stored on the blockchain; and Bitcoin Cash, a new cryptocurrency forked from Bitcoin. We find a robust and significant association between adoption of the Lightning Network and reduced blockchain congestion. This improvement cannot be explained by other factors, such as changes in speculative demand for Bitcoin. We show that the Lightning Network has become increasingly centralised, with payments channelled through relatively few intermediaries. Finally, we argue that improved functioning of Bitcoin is positive for welfare, and may reduce the environmental footprint of Bitcoin mining.

The quadratic rough Heston model and the joint S&P 500/VIX smile calibration problem
Jim Gatheral,Paul Jusselin,Mathieu Rosenbaum

Fitting simultaneously SPX and VIX smiles is known to be one of the most challenging problems in volatility modeling. A long-standing conjecture due to Julien Guyon is that it may not be possible to calibrate jointly these two quantities with a model with continuous sample-paths. We present the quadratic rough Heston model as a counterexample to this conjecture. The key idea is the combination of rough volatility together with a price-feedback (Zumbach) effect.

Understanding the Great Recession Using Machine Learning Algorithms
Rickard Nyman,Paul Ormerod

Nyman and Ormerod (2017) show that the machine learning technique of random forests has the potential to give early warning of recessions. Applying the approach to a small set of financial variables and replicating as far as possible a genuine ex ante forecasting situation, over the period since 1990 the accuracy of the four-step ahead predictions is distinctly superior to those actually made by the professional forecasters. Here we extend the analysis by examining the contributions made to the Great Recession of the late 2000s by each of the explanatory variables. We disaggregate private sector debt into its household and non-financial corporate components. We find that both household and non-financial corporate debt were key determinants of the Great Recession. We find a considerable degree of non-linearity in the explanatory models. In contrast, the public sector debt to GDP ratio appears to have made very little contribution. It did rise sharply during the Great Recession, but this was as a consequence of the sharp fall in economic activity rather than it being a cause. We obtain similar results for both the United States and the United Kingdom.

Value at Risk, Legislative Framework, Crises, and Procyclicality: What Goes Wrong?
Vasileiou, Evangelos,Samitas, Aristeidis
This study highlights some deficiencies of the stock markets’ risk legislation framework, and particularly the CESR (2010) guidelines. We show that the current legislative framework fails to offer incentives to financial management companies to invest in advanced models for more representative Value at Risk (VaR) estimations, and for this reason, in many cases conventional VaR models are applied. We use data from the DAX, CAC 40, FTSE, FTSEMIB and IBEX indices, and then we apply them to the widely accepted Delta Normal VaR model. The empirical findings show that the conventional VaR models not only fail to provide information for the upcoming financial crises, but also contribute to such phenomena as procyclicality and overreaction in the stock market. We suggest additional tests and we empirically show how these tests could reduce the procyclicality issue and promote a more sustainable investment environment. Even though this study is mainly focused on CESR (2010) guidelines, it could be useful for any similar legislative framework, such as the Basel Accords.

Whos Ditching the Bus?
Simon J. Berrebi,Kari E. Watkins

This paper uses stop-level passenger count data in four cities to understand the nation-wide bus ridership decline between 2012 and 2018. The local characteristics associated with ridership decline are evaluated in Portland, Miami, Minneapolis/St-Paul, and Atlanta. Poisson models explain ridership as a cross-section and the change thereof as a panel. While controlling for change in frequency, jobs, and population, the correlation with local socio-demographic characteristics are investigated using data from the American Community Survey. The effect of changing neighborhood socio-demographics on bus ridership are modeled using Longitudinal Employer Household Dynamics data. At a point in time, neighborhoods with high proportions of non-white, carless, and most significantly, high-school-educated residents are the most likely to have high ridership. Over time, white neighborhoods are losing the most ridership across all four cities. Places with high concentrations of residents with college education and without access to a car also lose ridership at a faster rate in two of the cities. The sign and significance of these results remain consistent even when controlling for intra-urban migration. Although bus ridership is declining across neighborhood characteristics, these results suggest that the underlying cause must be primarily affecting the travel behavior of white bus riders. Shifts in neighborhood socio-demographics, however, were found to be modest in most cities and unlikely to be causing the nation-wide ridership crisis. In Miami, the increasing proportion of white residents surrounding bus stops could be a factor aggravating the decline.