Research articles for the 2020-01-10
An Artificial Intelligence Approach to Shadow Rating
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We analyse the effectiveness of modern deep learning techniques in predicting credit ratings over a universe of thousands of global corporate entities obligations when compared to most popular, traditional machine-learning approaches such as linear models and tree-based classifiers. Our results show a adequate accuracy over different rating classes when applying categorical embeddings to artificial neural networks (ANN) architectures.
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We analyse the effectiveness of modern deep learning techniques in predicting credit ratings over a universe of thousands of global corporate entities obligations when compared to most popular, traditional machine-learning approaches such as linear models and tree-based classifiers. Our results show a adequate accuracy over different rating classes when applying categorical embeddings to artificial neural networks (ANN) architectures.
Are Stock Returns Predictable? Rewarding Patient Investors & Powerful Binding Equilibriums
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Stock markets worldwide have rewarded patient investors, hence the common advice to ‘buy and hold’. Yet even with a large body of research over a prolonged period, proving this concept remains an onerous exercise for academics. We use Tobin’s Q and the dividend yield to build an equilibrium relationship for the US aggregate stock market using 119 years of data. The resulting VECM model supports practitioners making long-horizon predictions and provides powerful forecasting ability. Our work is directly applicable to UK price controls.
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Stock markets worldwide have rewarded patient investors, hence the common advice to ‘buy and hold’. Yet even with a large body of research over a prolonged period, proving this concept remains an onerous exercise for academics. We use Tobin’s Q and the dividend yield to build an equilibrium relationship for the US aggregate stock market using 119 years of data. The resulting VECM model supports practitioners making long-horizon predictions and provides powerful forecasting ability. Our work is directly applicable to UK price controls.
Can Auditors Become Over-Conservative? Evidence From the Investors’ Perception of Auditor Changes
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This paper investigates whether investors perceive high levels of auditor conservatism as excessive. Auditors can reduce their litigation risk by issuing going concern opinions to firms with relatively low default risk. However, this strategy is costly for investors. Investors cannot observe the estimated probability of default but can only estimate the average threshold at which the audit office started to issue going concern opinions in the past. If they perceive the office’s threshold as too low, they should discount the firm’s market value because going concern opinions negatively affect the future cash flows. As the valuation should rebound if a firm replaces such an over-conservative auditor, I investigate the market reaction to auditor changes. I introduce a novel measure of auditor conservatism that is closely related to the audit offices’ going concern thresholds. Using a sample of 1,687 auditor changes from 2004 to 2014, I document a positive abnormal return if firms replace the most conservative auditors. However, additional analyses reveal that investors only perceive the most conservative non-Big 4 audit offices in the period after the financial crisis as over-conservative. That is, in the post-crisis period the non-Big 4 auditors increased their level of conservatism to levels that investors perceive as excessive.
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This paper investigates whether investors perceive high levels of auditor conservatism as excessive. Auditors can reduce their litigation risk by issuing going concern opinions to firms with relatively low default risk. However, this strategy is costly for investors. Investors cannot observe the estimated probability of default but can only estimate the average threshold at which the audit office started to issue going concern opinions in the past. If they perceive the office’s threshold as too low, they should discount the firm’s market value because going concern opinions negatively affect the future cash flows. As the valuation should rebound if a firm replaces such an over-conservative auditor, I investigate the market reaction to auditor changes. I introduce a novel measure of auditor conservatism that is closely related to the audit offices’ going concern thresholds. Using a sample of 1,687 auditor changes from 2004 to 2014, I document a positive abnormal return if firms replace the most conservative auditors. However, additional analyses reveal that investors only perceive the most conservative non-Big 4 audit offices in the period after the financial crisis as over-conservative. That is, in the post-crisis period the non-Big 4 auditors increased their level of conservatism to levels that investors perceive as excessive.
Capital Gains Taxes and Trading Incentives
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I define the effective tax rate on capital gains as the present value of all current and future tax consequences of a sale. I calibrate the effective tax rate for several major asset classes and show that deferral of gains offers little or no benefit for roughly half of all capital gains-producing financial assets held by households. I also show that the strength of the lock-in effect, where it exists, is heterogeneous across asset classes. As a demonstration, I predict and verify that property-casualty insurers are more reluctant to realize gains on tax-exempt bonds than on taxable bonds.
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I define the effective tax rate on capital gains as the present value of all current and future tax consequences of a sale. I calibrate the effective tax rate for several major asset classes and show that deferral of gains offers little or no benefit for roughly half of all capital gains-producing financial assets held by households. I also show that the strength of the lock-in effect, where it exists, is heterogeneous across asset classes. As a demonstration, I predict and verify that property-casualty insurers are more reluctant to realize gains on tax-exempt bonds than on taxable bonds.
Capital Structure and the Profitability-Liquidity Trade-off
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Theoretical guidance suggests a trade-off between profitability and liquidity in effect of capital structure decisions. This study investigates the link between capital structure and profitability-liquidity trade-off using descriptive and Panel-VAR analysis for 18 listed manufacturing companies in Nigeria. Findings from this study show no evidences of profitability-liquidity trade-off as function of capital structure. However, this study found that profitability and liquidity responds similarly to capital structure. Relative to equity share, debt ratios have negative effect on profitability and liquidity. Relative to asset, debt has positive effect on profitability and liquidity. Evidences further suggest that the way profitability and liquidity respond to capital structure is reliant on the business cycle position of the economy. Finance managers are advised to keep abreast the economic trend in the decision to adopt debt financing.
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Theoretical guidance suggests a trade-off between profitability and liquidity in effect of capital structure decisions. This study investigates the link between capital structure and profitability-liquidity trade-off using descriptive and Panel-VAR analysis for 18 listed manufacturing companies in Nigeria. Findings from this study show no evidences of profitability-liquidity trade-off as function of capital structure. However, this study found that profitability and liquidity responds similarly to capital structure. Relative to equity share, debt ratios have negative effect on profitability and liquidity. Relative to asset, debt has positive effect on profitability and liquidity. Evidences further suggest that the way profitability and liquidity respond to capital structure is reliant on the business cycle position of the economy. Finance managers are advised to keep abreast the economic trend in the decision to adopt debt financing.
Carbon Dioxide and Asset Pricing: Evidence from International Stock Markets
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We use carbon dioxide (CO2) emissions growth to measure consumption risk within a consumption-based capital asset pricing model (CCAPM) framework. Given the comprehensive worldwide coverage of CO2 emissions, this measure allows us to use the full history of stock market data in the United States, Europe, the world, and fifteen international markets. For the United States (Europe/the world), we are able to explain the observed equity market premium with a relative risk aversion (RRA) of 6 (10/12), which is less than half the size of that estimated using the canonical expenditures-based consumption growth measure. The average estimated RRA across fifteen other international markets is 7. We also find evidence that the growth of CO2 emissions is a priced risk factor that captures the cross section of stock portfolio returns.
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We use carbon dioxide (CO2) emissions growth to measure consumption risk within a consumption-based capital asset pricing model (CCAPM) framework. Given the comprehensive worldwide coverage of CO2 emissions, this measure allows us to use the full history of stock market data in the United States, Europe, the world, and fifteen international markets. For the United States (Europe/the world), we are able to explain the observed equity market premium with a relative risk aversion (RRA) of 6 (10/12), which is less than half the size of that estimated using the canonical expenditures-based consumption growth measure. The average estimated RRA across fifteen other international markets is 7. We also find evidence that the growth of CO2 emissions is a priced risk factor that captures the cross section of stock portfolio returns.
Characterizing Households' Large (and Small) Stakes Decisions: Evidence from Flood Insurance
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We examine the flood insurance decisions of over 100,000 households, using standard expected utility models and behaviorally-motivated, rank dependent utility models that incorporate probability distortions. Consumers’ insurance choices provide important insights into their risk attitudes. Previous research has typically examined modest stakes choices, such as deductibles, leaving important questions about larger stakes decisions. Features of U.S. flood insurance allow us to model risk attitudes over large stakes from consumers’ coverage limits. We find that consumers are willing to pay flood insurance premiums well above the expected value of their contracts. Explaining this with standard expected utility models requires extreme risk aversion. Models incorporating probability distortions greatly improve the ability to predict households’ decisions. These models explain consumers’ choices through their overweighting of small probabilities.
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We examine the flood insurance decisions of over 100,000 households, using standard expected utility models and behaviorally-motivated, rank dependent utility models that incorporate probability distortions. Consumers’ insurance choices provide important insights into their risk attitudes. Previous research has typically examined modest stakes choices, such as deductibles, leaving important questions about larger stakes decisions. Features of U.S. flood insurance allow us to model risk attitudes over large stakes from consumers’ coverage limits. We find that consumers are willing to pay flood insurance premiums well above the expected value of their contracts. Explaining this with standard expected utility models requires extreme risk aversion. Models incorporating probability distortions greatly improve the ability to predict households’ decisions. These models explain consumers’ choices through their overweighting of small probabilities.
Charity Auctions as Assets: All-Pay vs. Winner-Pay Mechanisms in Mean-Variance Space
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Auctions that generate public good benefits for bidders through revenue, such as those run by a charity, do not adhere to the revenue equivalence theorem. Instead, theory predicts that all-pay auctions will generate greater expected revenues than winner-pay mechanisms. However, this paper demonstrates these greater expected revenues are always accompanied by greater (and in some cases infinite) revenue variance. While a risk-neutral seller would be indifferent to this revenue variance, we show through a mean-variance portfolio approach that plausible levels of risk aversion would compel them to generally avoid all-pay auctions and instead use a combination of winner-pay designs.
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Auctions that generate public good benefits for bidders through revenue, such as those run by a charity, do not adhere to the revenue equivalence theorem. Instead, theory predicts that all-pay auctions will generate greater expected revenues than winner-pay mechanisms. However, this paper demonstrates these greater expected revenues are always accompanied by greater (and in some cases infinite) revenue variance. While a risk-neutral seller would be indifferent to this revenue variance, we show through a mean-variance portfolio approach that plausible levels of risk aversion would compel them to generally avoid all-pay auctions and instead use a combination of winner-pay designs.
Clustering (Presentation Slides)
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Many problems in finance require the clustering of variables or observations. Despite its usefulness, clustering is almost never taught in Econometrics courses. In this seminar we review two general clustering approaches: partitional and hierarchical.
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Many problems in finance require the clustering of variables or observations. Despite its usefulness, clustering is almost never taught in Econometrics courses. In this seminar we review two general clustering approaches: partitional and hierarchical.
Coalition-Proof Risk Sharing Under Frictions
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We analyze efficient risk-sharing arrangements when coalitions may deviate. Coalitions form to insure against idiosyncratic income risk. Self-enforcing contracts for both the original coalition and any deviating coalition rely on a belief in future cooperation, and we treat the contracting conditions of original and deviating coalitions symmetrically. We show that better belief coordination (higher social capital) tightens incentive constraints since it facilitates both the formation of the original as well as a deviating coalition. As a consequence, the payoff of successfully formed coalitions might be declining in the degree of belief coordination and equilibrium allocations might feature resource burning or utility burning.
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We analyze efficient risk-sharing arrangements when coalitions may deviate. Coalitions form to insure against idiosyncratic income risk. Self-enforcing contracts for both the original coalition and any deviating coalition rely on a belief in future cooperation, and we treat the contracting conditions of original and deviating coalitions symmetrically. We show that better belief coordination (higher social capital) tightens incentive constraints since it facilitates both the formation of the original as well as a deviating coalition. As a consequence, the payoff of successfully formed coalitions might be declining in the degree of belief coordination and equilibrium allocations might feature resource burning or utility burning.
Corporate Governance and Climate Change Risk Management: A Case Study of Transport Industry in Hong Kong
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This paper examines corporate governance and Climate Change risk management of transport industry in Hong Kong. This exploratory case study aims to investigate how the board of directors of an organization in the transport sector is addressing Climate Change risks through governance practices. Climate Change results from continued changes in climate pattern and the increase in frequency and intensity of extreme weather, and accordingly, every organization, especially the transportation company, is affected by the potential negative impacts caused by Climate Change, i.e. climate-related risks. We examine, to what extent, corporate governance plays a significant role in addressing climate-related risks. To answer this question, we reviewed several literature streams regarding the inter-relationship between climate-related risks, governance structure, board of directors and management. We also reviewed the literature on corporate governance and related theories, and regulatory policy in Hong Kong. Based on the interdisciplinary literature review, we developed a conceptual framework of our study and then we formulate the methodology. We selected 2 largest corporations, one from aviation and another one from railway, listed in Hong Kong Stock Exchange based on the criteria set by TCFD recommendations to conduct the study through two stages: secondary sourced data from annual report, sustainability report and website of the companies and primary sourced data through interview of sustainability manager. The research results suggest that governance structure and availability of resources have significant influence on the management of climate-related risks; however, external factors such as stakeholders show relatively less significant effects in influencing on the company’s policy on Climate Change. This study contributes to corporate governance and related theories in risks assessment on Climate Change and provides a picture of updated trend, phenomenon and framework in addressing climate-related risks for all stakeholders in Hong Kong.
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This paper examines corporate governance and Climate Change risk management of transport industry in Hong Kong. This exploratory case study aims to investigate how the board of directors of an organization in the transport sector is addressing Climate Change risks through governance practices. Climate Change results from continued changes in climate pattern and the increase in frequency and intensity of extreme weather, and accordingly, every organization, especially the transportation company, is affected by the potential negative impacts caused by Climate Change, i.e. climate-related risks. We examine, to what extent, corporate governance plays a significant role in addressing climate-related risks. To answer this question, we reviewed several literature streams regarding the inter-relationship between climate-related risks, governance structure, board of directors and management. We also reviewed the literature on corporate governance and related theories, and regulatory policy in Hong Kong. Based on the interdisciplinary literature review, we developed a conceptual framework of our study and then we formulate the methodology. We selected 2 largest corporations, one from aviation and another one from railway, listed in Hong Kong Stock Exchange based on the criteria set by TCFD recommendations to conduct the study through two stages: secondary sourced data from annual report, sustainability report and website of the companies and primary sourced data through interview of sustainability manager. The research results suggest that governance structure and availability of resources have significant influence on the management of climate-related risks; however, external factors such as stakeholders show relatively less significant effects in influencing on the company’s policy on Climate Change. This study contributes to corporate governance and related theories in risks assessment on Climate Change and provides a picture of updated trend, phenomenon and framework in addressing climate-related risks for all stakeholders in Hong Kong.
Debiasing the Measurement of Conditional Conservatism
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Basu’s (1997) measurement of conditional conservatism as the timelier response of earnings to bad news than to good news underlies hundreds of studies on the determinants and effects of this form of conservatism. However, numerous subsequent studies cast doubt on the extent to which Basu’s measure captures conditional conservatism as opposed to statistical biases or alternative constructs (collectively, “biasesâ€), and thereby question the validity of the inferences that empirical researchers draw from their analyses using the measure. We analyze the primary biases identified by these studies and modify Basu’s measure in two simple ways to remove these biases. Our key modification is the inclusion of interactive controls for return variance, a scale proxy motivated by Patatoukas and Thomas’ (2011) return variance effect that also captures economic optionality and adjustment costs. The inclusion of these interactive controls captures scale-related effects on both the level of earnings and the sensitivity of earnings to returns, and it allows the magnitudes of these effects to vary with the sign of returns. Using placebo tests, synthetic returns, alternative measures of conservatism, and other approaches, we show that our modified asymmetric timeliness measure is largely free of bias and associated with contracting-related variables as predicted by theory. We conclude that, after necessary surgical intervention, the news about the death of Basu’s measure has been greatly exaggerated.
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Basu’s (1997) measurement of conditional conservatism as the timelier response of earnings to bad news than to good news underlies hundreds of studies on the determinants and effects of this form of conservatism. However, numerous subsequent studies cast doubt on the extent to which Basu’s measure captures conditional conservatism as opposed to statistical biases or alternative constructs (collectively, “biasesâ€), and thereby question the validity of the inferences that empirical researchers draw from their analyses using the measure. We analyze the primary biases identified by these studies and modify Basu’s measure in two simple ways to remove these biases. Our key modification is the inclusion of interactive controls for return variance, a scale proxy motivated by Patatoukas and Thomas’ (2011) return variance effect that also captures economic optionality and adjustment costs. The inclusion of these interactive controls captures scale-related effects on both the level of earnings and the sensitivity of earnings to returns, and it allows the magnitudes of these effects to vary with the sign of returns. Using placebo tests, synthetic returns, alternative measures of conservatism, and other approaches, we show that our modified asymmetric timeliness measure is largely free of bias and associated with contracting-related variables as predicted by theory. We conclude that, after necessary surgical intervention, the news about the death of Basu’s measure has been greatly exaggerated.
Declining Fixed Investment and Increasing Financial Investment of Korean Corporations
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This paper aims to determine factors causing the stagnation of Korean firms’ fixed investment after the global financial crisis, using panel data for the period of 1999-2016. Fixed investment remained sensitive to cash flow and Tobin’s q although their effects decreased after the global financial crisis. A decreasing trend of cash flow and an increase in Tobin’s q since the early 2000’s imply that the worsening cash flow was a major factor behind the sluggish investment after the crisis. Meanwhile, debt-equity ratio remained significant for non-chaebol affiliated firms, reflecting disparity in access to external financing. Volatility of stock returns also became insignificant after the crisis, casting doubt on the argument that uncertainty was a major factor contributing to the decline of fixed investment. Analysis of financial investment confirmed the significant effect of cash flow, larger than that on financial investment than on fixed investment. In particular, debt repayment and other financial investment, except share repurchase, were sensitive to cash flow. However, the substitution of fixed investment by financial investment is a consequence, rather than a cause of declining fixed investment.
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This paper aims to determine factors causing the stagnation of Korean firms’ fixed investment after the global financial crisis, using panel data for the period of 1999-2016. Fixed investment remained sensitive to cash flow and Tobin’s q although their effects decreased after the global financial crisis. A decreasing trend of cash flow and an increase in Tobin’s q since the early 2000’s imply that the worsening cash flow was a major factor behind the sluggish investment after the crisis. Meanwhile, debt-equity ratio remained significant for non-chaebol affiliated firms, reflecting disparity in access to external financing. Volatility of stock returns also became insignificant after the crisis, casting doubt on the argument that uncertainty was a major factor contributing to the decline of fixed investment. Analysis of financial investment confirmed the significant effect of cash flow, larger than that on financial investment than on fixed investment. In particular, debt repayment and other financial investment, except share repurchase, were sensitive to cash flow. However, the substitution of fixed investment by financial investment is a consequence, rather than a cause of declining fixed investment.
Disentangling the Impact of Securitization on Bank Profitability
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We empirically evaluate the channels through which securitization impacts bank profitability. To this end, we analyze the role played by bank risk, cost of funding, liquidity and regulatory capital in explaining the relationship between securitization and bank profitability. We find that securitization activities tend to boost profitability. We also show that bank risk, cost of funding, liquidity and regulatory capital individually and jointly act as transmission channels in the securitization-profitability relationship. In addition, we break down the securitization effects on bank profitability into direct and indirect effects and identify the contribution of each individual transmission channel in the overall impact on bank profitability. Our findings have several implications for banks, financial markets, and regulators.
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We empirically evaluate the channels through which securitization impacts bank profitability. To this end, we analyze the role played by bank risk, cost of funding, liquidity and regulatory capital in explaining the relationship between securitization and bank profitability. We find that securitization activities tend to boost profitability. We also show that bank risk, cost of funding, liquidity and regulatory capital individually and jointly act as transmission channels in the securitization-profitability relationship. In addition, we break down the securitization effects on bank profitability into direct and indirect effects and identify the contribution of each individual transmission channel in the overall impact on bank profitability. Our findings have several implications for banks, financial markets, and regulators.
Do Banks Change Their Liquidity Ratios Based on Network Characteristics?
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By applying interbank network simulation, this paper investigates the impact of interbank network topology on bank liquidity ratios. Whereas regulators have put more emphasis on liquidity requirements since the global financial crisis of 2007-2008, how differently shaped interbank networks affect individual bank liquidity behavior remains an open issue. We look at how banks' interconnectedness within interbank loan and deposit networks affects their decisions to hold more or less liquidity during normal times and distress times. Our sample consists of commercial, investment, and real estate and mortgage banks in 28 European countries and allows us to differentiate large and small networks. Our results show that accounting for bank connections within a network is important to understand how banks set their liquidity ratios. Our findings have critical implications for the implementation of Basel III liquidity requirements and bank supervision more generally.
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By applying interbank network simulation, this paper investigates the impact of interbank network topology on bank liquidity ratios. Whereas regulators have put more emphasis on liquidity requirements since the global financial crisis of 2007-2008, how differently shaped interbank networks affect individual bank liquidity behavior remains an open issue. We look at how banks' interconnectedness within interbank loan and deposit networks affects their decisions to hold more or less liquidity during normal times and distress times. Our sample consists of commercial, investment, and real estate and mortgage banks in 28 European countries and allows us to differentiate large and small networks. Our results show that accounting for bank connections within a network is important to understand how banks set their liquidity ratios. Our findings have critical implications for the implementation of Basel III liquidity requirements and bank supervision more generally.
Does Managerial Ability Drive Firm Innovativeness?
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We investigate the impact of managerial ability on firm innovativeness. We further investigate how managerial ability impacts the association between firm innovativeness and competitive advantage. We employ two measures of managerial ability, namely strategic managerial ability and operational managerial ability. We find that firm innovativeness rises with strategic ability at an increasing rate. However, firm innovativeness initially falls and then rises with an increase in operational ability. Our results are consistent with the notion that a firm’s innovation activity is a trade-off between opportunity exploration and exploitation in that explorative and exploitative activities compete for manager’s fixed attention. The greater the strategic ability of management, the more opportunity-focused they are, the greater is their risk tolerance, and the greater is the investment in R&D. Strategic managers seek and cultivate growth opportunities to resolve the uncertainty associated with the growth opportunities in the firm’s favor, which enhances the firm’s competitive advantage.
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We investigate the impact of managerial ability on firm innovativeness. We further investigate how managerial ability impacts the association between firm innovativeness and competitive advantage. We employ two measures of managerial ability, namely strategic managerial ability and operational managerial ability. We find that firm innovativeness rises with strategic ability at an increasing rate. However, firm innovativeness initially falls and then rises with an increase in operational ability. Our results are consistent with the notion that a firm’s innovation activity is a trade-off between opportunity exploration and exploitation in that explorative and exploitative activities compete for manager’s fixed attention. The greater the strategic ability of management, the more opportunity-focused they are, the greater is their risk tolerance, and the greater is the investment in R&D. Strategic managers seek and cultivate growth opportunities to resolve the uncertainty associated with the growth opportunities in the firm’s favor, which enhances the firm’s competitive advantage.
Does Securities Commission Oversight Reduce the Complexity of Financial Reporting?
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We investigate whether securities commission oversight reduces the complexity of financial reporting (complexity). To measure the securities commission oversight, we use comment letters from securities commission of Iran. Further, to measure the complexity, we employ the Fog index. Using a difference-in-differences design with a propensity score matching approach, we find that the securities commission oversight reduces the complexity. Furthermore, we document that the impact of securities commission oversight on the complexity is stronger for firms with higher corporate governance quality. In addition, we document that the impact of securities commission oversight on the complexity (1) is not limited to one year and persists through at least two years later; and (2) is not higher for firms that receive more comment letters. We further document the spillover effect of securities commission oversight, in the sense that firms not receiving any comment letter reduce their complexity if the securities commission has commented on the industry leader or a close rival. Collectively, this paper, on the one hand, provides related evidence for the international debate on whether securities commissions could provide beneficial effects; and on the other hand, contributes to the literature on the complexity and its reducing factors that are among the most important issues in the context of international financial reporting.
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We investigate whether securities commission oversight reduces the complexity of financial reporting (complexity). To measure the securities commission oversight, we use comment letters from securities commission of Iran. Further, to measure the complexity, we employ the Fog index. Using a difference-in-differences design with a propensity score matching approach, we find that the securities commission oversight reduces the complexity. Furthermore, we document that the impact of securities commission oversight on the complexity is stronger for firms with higher corporate governance quality. In addition, we document that the impact of securities commission oversight on the complexity (1) is not limited to one year and persists through at least two years later; and (2) is not higher for firms that receive more comment letters. We further document the spillover effect of securities commission oversight, in the sense that firms not receiving any comment letter reduce their complexity if the securities commission has commented on the industry leader or a close rival. Collectively, this paper, on the one hand, provides related evidence for the international debate on whether securities commissions could provide beneficial effects; and on the other hand, contributes to the literature on the complexity and its reducing factors that are among the most important issues in the context of international financial reporting.
Economic Policy Uncertainty in the Euro Area: An Unsupervised Machine Learning Approach
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We model economic policy uncertainty (EPU) in the four largest euro area countries by applying machine learning techniques to news articles. The unsupervised machine learning algorithm used makes it possible to retrieve the individual components of overall EPU endogenously for a wide range of languages. The uncertainty indices computed from January 2000 to May 2019 capture episodes of regulatory change, trade tensions and financial stress. In an evaluation exercise, we use a structural vector autoregression model to study the relationship between different sources of uncertainty and investment in machinery and equipment as a proxy for business investment. We document strong heterogeneity and asymmetries in the relationship between investment and uncertainty across and within countries. For example, while investment in France, Italy and Spain reacts strongly to political uncertainty shocks, in Germany investment is more sensitive to trade uncertainty shocks.
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We model economic policy uncertainty (EPU) in the four largest euro area countries by applying machine learning techniques to news articles. The unsupervised machine learning algorithm used makes it possible to retrieve the individual components of overall EPU endogenously for a wide range of languages. The uncertainty indices computed from January 2000 to May 2019 capture episodes of regulatory change, trade tensions and financial stress. In an evaluation exercise, we use a structural vector autoregression model to study the relationship between different sources of uncertainty and investment in machinery and equipment as a proxy for business investment. We document strong heterogeneity and asymmetries in the relationship between investment and uncertainty across and within countries. For example, while investment in France, Italy and Spain reacts strongly to political uncertainty shocks, in Germany investment is more sensitive to trade uncertainty shocks.
Event Studies in Merger Analysis: Review and an Application Using U.S. TNIC Data
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There is a growing concern that U.S. merger control may have been too lenient, but empirical evidence remains limited. Event studies have been used as one method to acquire empirical insights into the competitive effects of mergers. However, existing work suffers from strong identifying assumptions, unreliable competitor identification or small samples. After reviewing the use and challenges of event studies in merger analysis, I use a novel application of Hoberg-Phillips (2010, 2016) Text-Based Network Industry Classification (TNIC) data to readily proxy a ranking of competitors to 1,751 of the largest U.S. mergers between 1997 and 2017. I document that following a merger announcement, the most likely competitors experience on average an abnormal return of around one percent. These abnormal returns are also associated with concerns of market power, which suggests that results are at least in part driven by an anticipation of anti-competitive effects, and hence insufficient merger control.
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There is a growing concern that U.S. merger control may have been too lenient, but empirical evidence remains limited. Event studies have been used as one method to acquire empirical insights into the competitive effects of mergers. However, existing work suffers from strong identifying assumptions, unreliable competitor identification or small samples. After reviewing the use and challenges of event studies in merger analysis, I use a novel application of Hoberg-Phillips (2010, 2016) Text-Based Network Industry Classification (TNIC) data to readily proxy a ranking of competitors to 1,751 of the largest U.S. mergers between 1997 and 2017. I document that following a merger announcement, the most likely competitors experience on average an abnormal return of around one percent. These abnormal returns are also associated with concerns of market power, which suggests that results are at least in part driven by an anticipation of anti-competitive effects, and hence insufficient merger control.
Explainable AI in Credit Risk Management
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The paper proposes an explainable AI model that can be used in credit risk management and, in particular, in measuring the risks that arise when credit is borrowed employing credit scoring platforms. The model applies similarity networks to Shapley values, so that AI predictions are grouped according to the similarity in the underlying explanatory variables.The empirical analysis of 15,000 small and medium companies asking for credit reveals that both risky and not risky borrowers can be grouped according to a set of similar financial characteristics, which can be employed to explain and understand their credit score and, therefore, to predict their future behaviour.
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The paper proposes an explainable AI model that can be used in credit risk management and, in particular, in measuring the risks that arise when credit is borrowed employing credit scoring platforms. The model applies similarity networks to Shapley values, so that AI predictions are grouped according to the similarity in the underlying explanatory variables.The empirical analysis of 15,000 small and medium companies asking for credit reveals that both risky and not risky borrowers can be grouped according to a set of similar financial characteristics, which can be employed to explain and understand their credit score and, therefore, to predict their future behaviour.
Firm Integration and Supply Chains
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Vertical integration is central to understanding patterns of economic activity, but there has been limited empirical work measuring the extent to which firms own and utilize direct upstream and downstream production links for sourcing physical inputs. We use administrative data from Karnataka, India on the movement of goods, both within and outside the firm, and find that 13% of input value can be sourced from vertically integrated upstream establishments. Of this potential 13%, somewhere between 30 - 40% of trade actually materializes. This suggests that the supply of physical goods along the production chain is an important rationale for vertical integration. Notably, within the set of vertically integrated firms, firms which source at least one product from within account for over three-quarters of economic activity. We look at factors associated with the decision to source a given product from within, and find that firm size, distance to outside and within firm suppliers, frequency of input requirement, product relationship specificity, volume, R&D requirements and competition both upstream and downstream are important factors. Finally, we look at factors associated with the ownership of an vertically integrated establishment and find that firm size, product specificity, R&D requirements and competition matter.
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Vertical integration is central to understanding patterns of economic activity, but there has been limited empirical work measuring the extent to which firms own and utilize direct upstream and downstream production links for sourcing physical inputs. We use administrative data from Karnataka, India on the movement of goods, both within and outside the firm, and find that 13% of input value can be sourced from vertically integrated upstream establishments. Of this potential 13%, somewhere between 30 - 40% of trade actually materializes. This suggests that the supply of physical goods along the production chain is an important rationale for vertical integration. Notably, within the set of vertically integrated firms, firms which source at least one product from within account for over three-quarters of economic activity. We look at factors associated with the decision to source a given product from within, and find that firm size, distance to outside and within firm suppliers, frequency of input requirement, product relationship specificity, volume, R&D requirements and competition both upstream and downstream are important factors. Finally, we look at factors associated with the ownership of an vertically integrated establishment and find that firm size, product specificity, R&D requirements and competition matter.
Firm or Bank Weakness? Access to Finance Since the European Sovereign Debt Crisis
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This paper uses a unique dataset where credit rejections experienced by euro area firms are matched with firm and bank characteristics. This allows us to study simultaneously the role that bank and firm weakness had in the credit reduction observed in the euro area during the sovereign debt crisis, and in credit developments characterising the post-crisis recovery. Compared with the existing literature matching borrowers’ and lenders’ characteristics, our dataset provides a better representation of euro area firms of small and medium size. Our findings suggest that, while firm balance sheet factors have been strong determinants of credit rejections, in the crisis period bank weakness made it harder to obtain external finance for firms located in stressed countries of the euro area.
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This paper uses a unique dataset where credit rejections experienced by euro area firms are matched with firm and bank characteristics. This allows us to study simultaneously the role that bank and firm weakness had in the credit reduction observed in the euro area during the sovereign debt crisis, and in credit developments characterising the post-crisis recovery. Compared with the existing literature matching borrowers’ and lenders’ characteristics, our dataset provides a better representation of euro area firms of small and medium size. Our findings suggest that, while firm balance sheet factors have been strong determinants of credit rejections, in the crisis period bank weakness made it harder to obtain external finance for firms located in stressed countries of the euro area.
Frequent Acquirers and Management Compensation
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We find significant positive contemporaneous, short-run, and long-run effects of an increase in the acquisition rate on management compensation. The long-run effect of an additional deal completed each year by an average acquirer increases management’s total, equity, and cash compensation by 21 percent, 7 percent, and 22 percent, respectively. Frequent acquirers, on average, pay their management 46 percent higher in total compensation, 55 percent higher in equity-based compensation, and 6 percent higher in cash-based (short-term) compensation, relative to non-frequent acquirers. Frequent acquirers pay higher equity-based compensation than cash-based compensation compared to non-frequent acquirers. Further, the impact of the acquisition rate on management compensation is higher for value-enhancing acquirers relative to value-destroying acquirers. We find a positive bi-directional influence between acquisition frequency and management compensation. Operationally more efficient acquirers are less likely to have a higher acquisition rate. Further, frequent acquisitions do not improve an acquirer’s operational efficiency, possibly due to constant post-acquisition integration challenges. We find a positive bi-directional causality between the total q (firm value) and the acquisition frequency, which may explain a positive association between overvalued stocks and acquisition frequency. A higher market value is likely to associate with higher acquisition frequency that is further likely to be associated with higher management compensation, Further, acquisition rate has a positive impact on the market share. Acquirers with a lower market share are more likely to become frequent acquirers. A causal order appears to exist from a lower market share to a higher acquisition frequency to a higher market value of the firm to higher management compensation. The increase in shareholder value associated with a higher acquisition frequency is not likely due to a gain in the operational efficiency, but morel likely due to an increase in the growth opportunities and market share of the acquirer. We find another causal order from a lower operational efficiency to a higher acquisition rate to a higher market share to higher management compensation. The causal orders may also explain why some studies may find a negative relation between management compensation and firm performance.
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We find significant positive contemporaneous, short-run, and long-run effects of an increase in the acquisition rate on management compensation. The long-run effect of an additional deal completed each year by an average acquirer increases management’s total, equity, and cash compensation by 21 percent, 7 percent, and 22 percent, respectively. Frequent acquirers, on average, pay their management 46 percent higher in total compensation, 55 percent higher in equity-based compensation, and 6 percent higher in cash-based (short-term) compensation, relative to non-frequent acquirers. Frequent acquirers pay higher equity-based compensation than cash-based compensation compared to non-frequent acquirers. Further, the impact of the acquisition rate on management compensation is higher for value-enhancing acquirers relative to value-destroying acquirers. We find a positive bi-directional influence between acquisition frequency and management compensation. Operationally more efficient acquirers are less likely to have a higher acquisition rate. Further, frequent acquisitions do not improve an acquirer’s operational efficiency, possibly due to constant post-acquisition integration challenges. We find a positive bi-directional causality between the total q (firm value) and the acquisition frequency, which may explain a positive association between overvalued stocks and acquisition frequency. A higher market value is likely to associate with higher acquisition frequency that is further likely to be associated with higher management compensation, Further, acquisition rate has a positive impact on the market share. Acquirers with a lower market share are more likely to become frequent acquirers. A causal order appears to exist from a lower market share to a higher acquisition frequency to a higher market value of the firm to higher management compensation. The increase in shareholder value associated with a higher acquisition frequency is not likely due to a gain in the operational efficiency, but morel likely due to an increase in the growth opportunities and market share of the acquirer. We find another causal order from a lower operational efficiency to a higher acquisition rate to a higher market share to higher management compensation. The causal orders may also explain why some studies may find a negative relation between management compensation and firm performance.
Hi J. Powell: From Where the “NORM†of 2 Percent Inflation Target Come From?
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This paper questions the Federal Reserve Chairman J. Powell on the 2% inflation target as “global norm.†We first survey works on monetary policy ranging from the 60’s Milton Friedman till recently Robert Lucas, and find no academic nor empirical support for the 2% optimal inflation rate. We then present our model to estimate the optimal inflation rate and show that there is a concave relationship between inflation and welfare gain, where the optimal inflation rate reached at 3%. Since optimal inflation rate at the annual level varies by market condition, our asset pricing model suggests inflation rate to be targeted between 4 and 6 years not annually. Finally, there is a welfare gain of 0.06% by raising the inflation target to 2.54% for the year 2020. Collectively, the answer of from where the 2% norm come from is from nowhere, because there should not be a “norm†as economics conditions varies each year and we should have long term target not annual.
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This paper questions the Federal Reserve Chairman J. Powell on the 2% inflation target as “global norm.†We first survey works on monetary policy ranging from the 60’s Milton Friedman till recently Robert Lucas, and find no academic nor empirical support for the 2% optimal inflation rate. We then present our model to estimate the optimal inflation rate and show that there is a concave relationship between inflation and welfare gain, where the optimal inflation rate reached at 3%. Since optimal inflation rate at the annual level varies by market condition, our asset pricing model suggests inflation rate to be targeted between 4 and 6 years not annually. Finally, there is a welfare gain of 0.06% by raising the inflation target to 2.54% for the year 2020. Collectively, the answer of from where the 2% norm come from is from nowhere, because there should not be a “norm†as economics conditions varies each year and we should have long term target not annual.
Mandatory Auditor Involvement in Bank Supervision
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This paper examines the mandatory involvement of auditors in bank supervision. We create a novel international dataset on auditor-regulator interaction by directly liaising with the European Central Bank and all 28 national bank regulators within the European Union, and by further reviewing the related laws. We document considerable heterogeneity in whether regulators require auditors to provide additional reports, give assurance on ratios, and hold regular meetings. We then investigate the effects of enhanced auditor-regulator interaction. We find a significant reduction in the riskiness of treatment banks as measured by counterparty risk, risk-weighted assets, nonperforming loans, and credit spreads. These findings are more pronounced for resource-constrained regulators, for small and medium-sized banks, and for banks in jurisdictions where supervisory strength is high. Finally, consistent with banks bearing some of the costs associated with the additional audit work, banks’ audit fees increase after their auditors are mandated to participate in bank supervision.
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This paper examines the mandatory involvement of auditors in bank supervision. We create a novel international dataset on auditor-regulator interaction by directly liaising with the European Central Bank and all 28 national bank regulators within the European Union, and by further reviewing the related laws. We document considerable heterogeneity in whether regulators require auditors to provide additional reports, give assurance on ratios, and hold regular meetings. We then investigate the effects of enhanced auditor-regulator interaction. We find a significant reduction in the riskiness of treatment banks as measured by counterparty risk, risk-weighted assets, nonperforming loans, and credit spreads. These findings are more pronounced for resource-constrained regulators, for small and medium-sized banks, and for banks in jurisdictions where supervisory strength is high. Finally, consistent with banks bearing some of the costs associated with the additional audit work, banks’ audit fees increase after their auditors are mandated to participate in bank supervision.
New Revenue Recognition Standard and Earnings Informativeness
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The implementation of the new revenue recognition standard (ASC 606) has profoundly changed the impact of earnings announcements on various measures of market quality and trading activities. In contrast to the finding of prior research, we show that earning announcements are accompanied by decreases in the bid-ask spread, the price impact of trades, informed trading, and pricing efficiency, and increases in the quoted depth, total trading volume, and odd-lot trades after the implementation of ASC 606. These results indicate that ASC 606 has improved the informativeness of earnings and changed the effect of earnings announcements on the firm’s information and trading environments accordingly.
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The implementation of the new revenue recognition standard (ASC 606) has profoundly changed the impact of earnings announcements on various measures of market quality and trading activities. In contrast to the finding of prior research, we show that earning announcements are accompanied by decreases in the bid-ask spread, the price impact of trades, informed trading, and pricing efficiency, and increases in the quoted depth, total trading volume, and odd-lot trades after the implementation of ASC 606. These results indicate that ASC 606 has improved the informativeness of earnings and changed the effect of earnings announcements on the firm’s information and trading environments accordingly.
Portfolio Optimization Based on Forecasting Models Using Vine Copulas: An Empirical Assessment for the Financial Crisis
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We employ and examine vine copulas in modeling symmetric and asymmetric dependency structures and forecasting financial returns. We analyze the asset allocations performed during the 2008â€"2009 financial crisis and test different portfolio strategies such as maximum Sharpe ratio, minimum variance, and minimum conditional Value-at-Risk. We then specify the regular, drawable, and canonical vine copulas, such as the Studentâˆ't, Clayton, Frank, Joe, Gumbel, and mixed copulas, and analyze both in-sample and out-of-sample portfolio performances. Out-of-sample portfolio back-testing shows that vine copulas reduce portfolio risk better than simple copulas. Our econometric analysis of the outcomes of the various models shows that in terms of reducing conditional Value-at-Risk, D-vines appear to be better than R- and C-vines. Overall, we find that the Studentâˆ't drawable vine copula models perform best with regard to risk reduction, both for the entire period 2005â€"2012 as well as during the financial crisis.
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We employ and examine vine copulas in modeling symmetric and asymmetric dependency structures and forecasting financial returns. We analyze the asset allocations performed during the 2008â€"2009 financial crisis and test different portfolio strategies such as maximum Sharpe ratio, minimum variance, and minimum conditional Value-at-Risk. We then specify the regular, drawable, and canonical vine copulas, such as the Studentâˆ't, Clayton, Frank, Joe, Gumbel, and mixed copulas, and analyze both in-sample and out-of-sample portfolio performances. Out-of-sample portfolio back-testing shows that vine copulas reduce portfolio risk better than simple copulas. Our econometric analysis of the outcomes of the various models shows that in terms of reducing conditional Value-at-Risk, D-vines appear to be better than R- and C-vines. Overall, we find that the Studentâˆ't drawable vine copula models perform best with regard to risk reduction, both for the entire period 2005â€"2012 as well as during the financial crisis.
Prudential Policies and Systemic Risk: the Role of Interconnections
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The impact of prudential policies in open economies depends not only on their intrinsic efficacy but also on the feedback of the policy through close financial partners. Using a dataset of advanced countries, we find that prudential policy measures reduce systemic risk in the financial system in the 2000-2014 time period. We show that indirect effect in case of uniform interventions enforces the direct one and accounts for up to 87% of total risk reduction. The policies, though, remain insignificant for GIIPS countries, which stay dependent on actions and responses of their financial counterparties.
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The impact of prudential policies in open economies depends not only on their intrinsic efficacy but also on the feedback of the policy through close financial partners. Using a dataset of advanced countries, we find that prudential policy measures reduce systemic risk in the financial system in the 2000-2014 time period. We show that indirect effect in case of uniform interventions enforces the direct one and accounts for up to 87% of total risk reduction. The policies, though, remain insignificant for GIIPS countries, which stay dependent on actions and responses of their financial counterparties.
Report on Financial Investments of Italian Households. Behavioural Attitudes and Approaches - 2019 Survey (Rapporto 2019 sulle scelte di investimento delle famiglie italiane)
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English Abstract: The 2019 edition of the CONSOB Report on financial investments of Italian households presents evidence on the financial choices of a representative sample of 3,058 Italian households while significantly deepening the analysis of financial knowledge and individual attitudes. After the first Section on trends in household wealth, savings and financial inclusion, the second Section examines several personal inclinations that may deeply affect financial behaviours. In particular, self-evaluation on preference for numerical information, need for cognition, financial anxiety, self-efficacy and self-control are elicited, as well as the attitude towards optimism and generalised trust. These traits are found to be associated with financial knowledge, both actual and perceived, and risk preferences (Section 3) as well as financial control and saving habits (Section 4), investment choices and demand for investment advice (Section 5). The last Section of the Report focuses on respondents’ knowledge and interest in sustainable and responsible investments (SRIs). Overall, the evidence gathered confirms that much remains to be done in order to raise Italian households’ financial knowledge, the quality of their financial choices as well as their awareness of the need to improve their financial competencies.Italian Abstract: Il Rapporto fornisce evidenze in merito a livello di conoscenze finanziarie, abitudini di investimento e domanda di consulenza finanziaria delle famiglie italiane. Il focus del Rapporto 2019 è dedicato agli investimenti socialmente responsabili.
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English Abstract: The 2019 edition of the CONSOB Report on financial investments of Italian households presents evidence on the financial choices of a representative sample of 3,058 Italian households while significantly deepening the analysis of financial knowledge and individual attitudes. After the first Section on trends in household wealth, savings and financial inclusion, the second Section examines several personal inclinations that may deeply affect financial behaviours. In particular, self-evaluation on preference for numerical information, need for cognition, financial anxiety, self-efficacy and self-control are elicited, as well as the attitude towards optimism and generalised trust. These traits are found to be associated with financial knowledge, both actual and perceived, and risk preferences (Section 3) as well as financial control and saving habits (Section 4), investment choices and demand for investment advice (Section 5). The last Section of the Report focuses on respondents’ knowledge and interest in sustainable and responsible investments (SRIs). Overall, the evidence gathered confirms that much remains to be done in order to raise Italian households’ financial knowledge, the quality of their financial choices as well as their awareness of the need to improve their financial competencies.Italian Abstract: Il Rapporto fornisce evidenze in merito a livello di conoscenze finanziarie, abitudini di investimento e domanda di consulenza finanziaria delle famiglie italiane. Il focus del Rapporto 2019 è dedicato agli investimenti socialmente responsabili.
Secular Changes in Bond Yields
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We build a small-scale representation of the economy with secular and cyclical changes that are jointly determined by common structural shocks. Bond yields are influenced by cyclical and secular changes to the inflation and real rate endpoints that we recover from the model, but we impose that expected excess returns of bonds are stationary. Once we account for the effects of secular economic changes, we uncover several facts about the relationship between the short-term rate and long-term yields. We find that inflation and output shocks cause the expectation component of long-term yields to rise but cause the term premium to decline. However, we find that short rate shocks push expectation and term premium in the same direction. Since, in the model, the relative contribution of macro shocks changes over time, unexpected changes to the short rate can have a large impact on the term premium but with a sign that depends on the nature of the structural shocks. When macro shocks are relatively more important, the term premium tends to mute the transmission to long-term yields. By contrast, when short rate shocks are more important, the term premium tends to amplify the transmission to long-term yields.
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We build a small-scale representation of the economy with secular and cyclical changes that are jointly determined by common structural shocks. Bond yields are influenced by cyclical and secular changes to the inflation and real rate endpoints that we recover from the model, but we impose that expected excess returns of bonds are stationary. Once we account for the effects of secular economic changes, we uncover several facts about the relationship between the short-term rate and long-term yields. We find that inflation and output shocks cause the expectation component of long-term yields to rise but cause the term premium to decline. However, we find that short rate shocks push expectation and term premium in the same direction. Since, in the model, the relative contribution of macro shocks changes over time, unexpected changes to the short rate can have a large impact on the term premium but with a sign that depends on the nature of the structural shocks. When macro shocks are relatively more important, the term premium tends to mute the transmission to long-term yields. By contrast, when short rate shocks are more important, the term premium tends to amplify the transmission to long-term yields.
Should State Governments Prohibit the Negotiated Sales of Municipal Bonds?
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Should legislation ban the negotiated sales of municipal bonds? What are the costs of forcing public auctions? We compare the offering yields of local governments that are forced by state law to use public auctions to the offering yields of local governments that can choose between auctions and negotiated sales. Using a sample of 369,482 school bonds issued between 2004 and 2014, we find that a restriction on negotiated sales has a negative cost instead of positive. The prohibition benefits issuers on average. The offering yields of constrained issuers are 17 basis points lower than the offering yields of unconstrained issuers. The effect is equivalent to a rating upgrade from non-rated to AA-. Nevertheless, most issuers prefer to use negotiated sales even if they do not maximize bond proceeds.
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Should legislation ban the negotiated sales of municipal bonds? What are the costs of forcing public auctions? We compare the offering yields of local governments that are forced by state law to use public auctions to the offering yields of local governments that can choose between auctions and negotiated sales. Using a sample of 369,482 school bonds issued between 2004 and 2014, we find that a restriction on negotiated sales has a negative cost instead of positive. The prohibition benefits issuers on average. The offering yields of constrained issuers are 17 basis points lower than the offering yields of unconstrained issuers. The effect is equivalent to a rating upgrade from non-rated to AA-. Nevertheless, most issuers prefer to use negotiated sales even if they do not maximize bond proceeds.
Show Me the Money: Option Moneyness Concentration and Future Stock Returns
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Informed traders often use options that are not in-the-money due to higher potential gains for a smaller upfront cost. Thus, trading activity by option moneyness should be a gauge of informed option trading. We construct a dollar volume-weighted average moneyness measure to capture option trading activity at different moneyness levels. Stock returns increase with this measure, suggesting more trading activity in options with higher leverage predicts future stock returns. Our results hold cross-sectionally and at the portfolio level yielding a Fama-French five-factor alpha of 12% per year for all stocks and 33% per year for high implied volatility stocks.
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Informed traders often use options that are not in-the-money due to higher potential gains for a smaller upfront cost. Thus, trading activity by option moneyness should be a gauge of informed option trading. We construct a dollar volume-weighted average moneyness measure to capture option trading activity at different moneyness levels. Stock returns increase with this measure, suggesting more trading activity in options with higher leverage predicts future stock returns. Our results hold cross-sectionally and at the portfolio level yielding a Fama-French five-factor alpha of 12% per year for all stocks and 33% per year for high implied volatility stocks.
The Decline of Secured Debt
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We document a steady decline in the share of secured debt issued (as a fraction of total debt) in the United States over the twentieth century, with some pickup in this century. Superimposed on this secular trend, the share of secured debt issued is countercyclical. The secular decline in secured debt issuance seems to result from creditors acquiring greater confidence over time that the priority of their debt claims will be respected even if they do not obtain security up front. Borrowers also do not seem to want to lose financial and operational flexibility by giving security up front. Instead, security is given on a contingent basis â€" when a firm approaches distress. Similar arguments explain why debt is more likely to be secured in the down phase of a cycle than in the up phase, thus accounting for the cyclicality of secured debt share.
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We document a steady decline in the share of secured debt issued (as a fraction of total debt) in the United States over the twentieth century, with some pickup in this century. Superimposed on this secular trend, the share of secured debt issued is countercyclical. The secular decline in secured debt issuance seems to result from creditors acquiring greater confidence over time that the priority of their debt claims will be respected even if they do not obtain security up front. Borrowers also do not seem to want to lose financial and operational flexibility by giving security up front. Instead, security is given on a contingent basis â€" when a firm approaches distress. Similar arguments explain why debt is more likely to be secured in the down phase of a cycle than in the up phase, thus accounting for the cyclicality of secured debt share.
The Four Seasons of Commodity Futures: Insights from Topological Data Analysis
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This study introduces a new technique to analyse the evolution of correlations for multiple time series. The technique is based on applying Topological Data Analysis (TDA) and we use it to gain insights about the evolution of commodity futures markets over the 1997-2017 period. Our findings complement the existing literature and provide new insights into the dynamics of commodity futures markets in the past two decades. Our analysis has both global and local aspects and could be applied to detect changes in correlation structure in a variety of time series as well as cross sectional settings.
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This study introduces a new technique to analyse the evolution of correlations for multiple time series. The technique is based on applying Topological Data Analysis (TDA) and we use it to gain insights about the evolution of commodity futures markets over the 1997-2017 period. Our findings complement the existing literature and provide new insights into the dynamics of commodity futures markets in the past two decades. Our analysis has both global and local aspects and could be applied to detect changes in correlation structure in a variety of time series as well as cross sectional settings.
The Global Sustainability Footprint of Sovereign Wealth Funds
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With the emergence of sovereign wealth funds (SWFs) around the world managing equity of over $8 trillion, their impact on the corporate landscape and social welfare are being scrutinized. This study investigates whether and how SWFs incorporate environmental, social, and governance (ESG) considerations in their investment decisions in publicly listed corporations, as well as the subsequent evolution of target firms’ ESG performance. We find that SWF funds do consider the level of past ESG performance as well as recent ESG score improvement when taking ownership stakes in listed companies. These results are driven by the SWF funds that do have an explicit or implicit ESG policy and are most transparent, and by SWF originating from developed countries and countries with civil law origins. In relation to engagement, we find by means of two natural experiments with exogenous shocks (the Deep Water Horizon catastrophe and Volkwagen Diesel scandal) that the ESG scores do not change significantly more for firms in which SWFs have ownership stakes. This potentially suggests that SWFs in general do not actively steer their target firms towards higher levels of ESG.
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With the emergence of sovereign wealth funds (SWFs) around the world managing equity of over $8 trillion, their impact on the corporate landscape and social welfare are being scrutinized. This study investigates whether and how SWFs incorporate environmental, social, and governance (ESG) considerations in their investment decisions in publicly listed corporations, as well as the subsequent evolution of target firms’ ESG performance. We find that SWF funds do consider the level of past ESG performance as well as recent ESG score improvement when taking ownership stakes in listed companies. These results are driven by the SWF funds that do have an explicit or implicit ESG policy and are most transparent, and by SWF originating from developed countries and countries with civil law origins. In relation to engagement, we find by means of two natural experiments with exogenous shocks (the Deep Water Horizon catastrophe and Volkwagen Diesel scandal) that the ESG scores do not change significantly more for firms in which SWFs have ownership stakes. This potentially suggests that SWFs in general do not actively steer their target firms towards higher levels of ESG.
The Impact of Misvaluation on Financing Decisions: Evidence from the Real Estate Investment Trust (REIT) Sector
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We investigate the effects of misvaluation (defined as fluctuation in the market value of equity relative to its intrinsic value) on financing decisions of REITs (Real Estate Investment Trusts). Our findings reveal that misvaluation increases the likelihood of capital-increasing decisions (i.e., equity issues, debt issues and dual issues) and decreases the likelihood of capital-reducing decisions (i.e., equity repurchases and debt retirements). The impact of misvaluation on the equity-related decisions is consistent with market timing behaviour, whereas its impact on debt-related decisions is peculiar. Our further analyses document that due to exogenously capital constraints, highly misvalued REITs, which are motivated to undertake merger activities or new investments, issue both equity and debt financing because single equity capital might be insufficient to finance their new projects. In addition, the effects of misvaluation on debt-related decisions are different between REITs and non-real estate firms (non-REs).
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We investigate the effects of misvaluation (defined as fluctuation in the market value of equity relative to its intrinsic value) on financing decisions of REITs (Real Estate Investment Trusts). Our findings reveal that misvaluation increases the likelihood of capital-increasing decisions (i.e., equity issues, debt issues and dual issues) and decreases the likelihood of capital-reducing decisions (i.e., equity repurchases and debt retirements). The impact of misvaluation on the equity-related decisions is consistent with market timing behaviour, whereas its impact on debt-related decisions is peculiar. Our further analyses document that due to exogenously capital constraints, highly misvalued REITs, which are motivated to undertake merger activities or new investments, issue both equity and debt financing because single equity capital might be insufficient to finance their new projects. In addition, the effects of misvaluation on debt-related decisions are different between REITs and non-real estate firms (non-REs).
The Legal and Regulatory Aspects of the Free Movement of Capital â€" Towards the Capital Markets Union
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The free movement of capital â€" as it is traditionally seen as the fourth freedom, after goods, workers and persons, services and establishment â€" is a long-standing objective of the European Union, a fundamental freedom at the heart of the single market. The paper summarizes the development of the free movement of capital by describing the provisions of the primary law sources and listing the prominent directives and regulations. The major challenges of the capital liberalization are demonstrated through the case law of the Court of Justice of the European Union, highlighting the different areas and judgments, legal principles. Finally, the situation of the Capital Market Union initiative and the Action plan are presented in details. The catching up is important for the non-euro zone states, since they could have experienced the disadvantages of the backlog in the case of the Bank Union, where the European Central Bank granted unlimited liquidity with favorable conditions for the euro-zone member banks after the financial crisis. Later even similar situation may occur on capital markets, and on the other hand, a boosting development can start. Whoever stays out, misses out.
SSRN
The free movement of capital â€" as it is traditionally seen as the fourth freedom, after goods, workers and persons, services and establishment â€" is a long-standing objective of the European Union, a fundamental freedom at the heart of the single market. The paper summarizes the development of the free movement of capital by describing the provisions of the primary law sources and listing the prominent directives and regulations. The major challenges of the capital liberalization are demonstrated through the case law of the Court of Justice of the European Union, highlighting the different areas and judgments, legal principles. Finally, the situation of the Capital Market Union initiative and the Action plan are presented in details. The catching up is important for the non-euro zone states, since they could have experienced the disadvantages of the backlog in the case of the Bank Union, where the European Central Bank granted unlimited liquidity with favorable conditions for the euro-zone member banks after the financial crisis. Later even similar situation may occur on capital markets, and on the other hand, a boosting development can start. Whoever stays out, misses out.
The Macro and Asset Pricing Implications of Fluctuating Information Quality
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I study the macroeconomic and asset pricing implications of variations in information quality in a real business cycle model. Learning and fluctuating information quality generate changes in the perception of macroeconomic outcomes, but do not modify the distribution of realized shocks. On the asset pricing side, the model generates stock market crashes that are disconnected from the fundamental shocks of the economy. Deterioration in the quality of information predicts spikes in macroeconomic and financial uncertainty. Consistent with the data, shocks to information quality forecast downside risk in macroeconomic aggregates like output and investment growth.
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I study the macroeconomic and asset pricing implications of variations in information quality in a real business cycle model. Learning and fluctuating information quality generate changes in the perception of macroeconomic outcomes, but do not modify the distribution of realized shocks. On the asset pricing side, the model generates stock market crashes that are disconnected from the fundamental shocks of the economy. Deterioration in the quality of information predicts spikes in macroeconomic and financial uncertainty. Consistent with the data, shocks to information quality forecast downside risk in macroeconomic aggregates like output and investment growth.
Trading on Overshooting
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This paper presents novel evidence that individual stocks are subject to mispricing amid shocks that permanently shift the long-run relationship between the price and the fundamentals (e.g., book value). When the long-run level of the price-to-fundamentals ratio increases/decreases, the price is expected to rise/drop during the mean shift. Based on higher/lower expected returns, uninformed investors, however, incorrectly infer that the stock is currently undervalued/overvalued and increase the purchases/sales, which causes mispricing. Trading strategies that exploit subsequent reversals of the returns yield significant positive returns. Buying/shortselling closed-end mutual funds with lowest/highest mean shifts of the price-to-NAV ratio produces risk-adjusted returns of 3% to 8% per year. Overreaction to news might not explain these results.
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This paper presents novel evidence that individual stocks are subject to mispricing amid shocks that permanently shift the long-run relationship between the price and the fundamentals (e.g., book value). When the long-run level of the price-to-fundamentals ratio increases/decreases, the price is expected to rise/drop during the mean shift. Based on higher/lower expected returns, uninformed investors, however, incorrectly infer that the stock is currently undervalued/overvalued and increase the purchases/sales, which causes mispricing. Trading strategies that exploit subsequent reversals of the returns yield significant positive returns. Buying/shortselling closed-end mutual funds with lowest/highest mean shifts of the price-to-NAV ratio produces risk-adjusted returns of 3% to 8% per year. Overreaction to news might not explain these results.
Undisclosed SEC Investigations
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One of the hallmarks of the SEC’s investigative process is that it is shrouded in secrecy â€"â€" only the SEC staff, high-level managers of the company being investigated, and outside counsel are typically aware of active investigations. We obtain novel data on the targets of all SEC investigations closed between 2000 and 2017 â€"â€" data that was heretofore non-public â€"â€" and find that such investigations portend economically meaningful declines in firm performance. Despite the materiality of these investigations, firms are not required to disclose them, and only 19% of targeted firms initially disclose the investigation. We examine whether corporate insiders exploit the undisclosed nature of these investigations for personal gain. We find a pronounced spike in insider trading at the outset of the investigation; that the increase in trading is attributable to corporate officers but not to independent directors; and that abnormal trading activity appears highly opportunistic and earns significant abnormal returns. Our results suggest that SEC investigations are often material non-public events, and that insiders trade based on private information about these events.
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One of the hallmarks of the SEC’s investigative process is that it is shrouded in secrecy â€"â€" only the SEC staff, high-level managers of the company being investigated, and outside counsel are typically aware of active investigations. We obtain novel data on the targets of all SEC investigations closed between 2000 and 2017 â€"â€" data that was heretofore non-public â€"â€" and find that such investigations portend economically meaningful declines in firm performance. Despite the materiality of these investigations, firms are not required to disclose them, and only 19% of targeted firms initially disclose the investigation. We examine whether corporate insiders exploit the undisclosed nature of these investigations for personal gain. We find a pronounced spike in insider trading at the outset of the investigation; that the increase in trading is attributable to corporate officers but not to independent directors; and that abnormal trading activity appears highly opportunistic and earns significant abnormal returns. Our results suggest that SEC investigations are often material non-public events, and that insiders trade based on private information about these events.
Violations of Price-Time Priority and Implications for Market Quality
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Using a proprietary dataset of a market maker’s limit orders and order acknowledgments timestamped to the nanosecond, we explore the consistency and reliability of an exchange’s price-time priority in practice. We find a high degree of variability in acknowledgment times, and we find that the proportion of times in which the first order entered is also first to be acknowledged is surprisingly low when consecutive orders are placed at very high frequencies. Furthermore, we provide suggestive evidence of impaired market quality in the form of: (i) excess messaging, and (ii) unabsorbed end-of-day order imbalance as a result.
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Using a proprietary dataset of a market maker’s limit orders and order acknowledgments timestamped to the nanosecond, we explore the consistency and reliability of an exchange’s price-time priority in practice. We find a high degree of variability in acknowledgment times, and we find that the proportion of times in which the first order entered is also first to be acknowledged is surprisingly low when consecutive orders are placed at very high frequencies. Furthermore, we provide suggestive evidence of impaired market quality in the form of: (i) excess messaging, and (ii) unabsorbed end-of-day order imbalance as a result.
What Keeps Stable Coins Stable?
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We take this question to be isomorphic to, "What Keeps Fixed Exchange Rates Fixed?" and address it with analysis familiar in exchange-rate economics. Stable coins aim to solve the volatility problem by pegging to a national currency, such as the US dollar, and are used as vehicle currencies for exchanging national currencies into non-stable cryptocurrencies. Using a rich dataset of signed trades and order books on multiple crypto exchanges, we examine how peg-sustaining arbitrage stabilizes the dollar price of the largest stable coin, Tether, as an alternative to the main mechanism with national-currency fixed rates, namely intervention by a central bank. We find that stable-coin issuance, the closest analogue to central-bank intervention, plays only a limited role in stabilization, pointing instead to the demand side as the fundamental stabilizing force. Order-flow data show that a 25 basis-point move requires arrival of a roughly two standard deviation change in net trading, equivalent to $3 million. Finally, we investigate which fundamentals drive the two-sided distribution of peg-price deviations; premiums are due to stable coins' role within the digital-asset economy as a safe-haven asset, whereas discounts derive from both liquidity effects and collateral concerns.
SSRN
We take this question to be isomorphic to, "What Keeps Fixed Exchange Rates Fixed?" and address it with analysis familiar in exchange-rate economics. Stable coins aim to solve the volatility problem by pegging to a national currency, such as the US dollar, and are used as vehicle currencies for exchanging national currencies into non-stable cryptocurrencies. Using a rich dataset of signed trades and order books on multiple crypto exchanges, we examine how peg-sustaining arbitrage stabilizes the dollar price of the largest stable coin, Tether, as an alternative to the main mechanism with national-currency fixed rates, namely intervention by a central bank. We find that stable-coin issuance, the closest analogue to central-bank intervention, plays only a limited role in stabilization, pointing instead to the demand side as the fundamental stabilizing force. Order-flow data show that a 25 basis-point move requires arrival of a roughly two standard deviation change in net trading, equivalent to $3 million. Finally, we investigate which fundamentals drive the two-sided distribution of peg-price deviations; premiums are due to stable coins' role within the digital-asset economy as a safe-haven asset, whereas discounts derive from both liquidity effects and collateral concerns.
When the Risk Premium Is Negative
SSRN
Making use of new restrictions from Martin (2017) and Kadan and Tang (2019) we show how the positivity of risk premia of positive-beta assets is a necessary condition for the existence of equilibrium in many asset pricing models and, whenever the fundamental theorem of asset pricing applies, a necessary condition for the absence of arbitrage. Using the last ninety-two years of U.S. stock market data we find evidence in favor of negative risk premia in some states of the world, defined by high volatile periods, containing all the NBER recessions, where consumption and production growth is low. These states of the world cause the first order conditions of equilibrium models to fail, implying non monotonic stochastic discount factors. Very profitable market timing strategies can be formed exploiting such failure.
SSRN
Making use of new restrictions from Martin (2017) and Kadan and Tang (2019) we show how the positivity of risk premia of positive-beta assets is a necessary condition for the existence of equilibrium in many asset pricing models and, whenever the fundamental theorem of asset pricing applies, a necessary condition for the absence of arbitrage. Using the last ninety-two years of U.S. stock market data we find evidence in favor of negative risk premia in some states of the world, defined by high volatile periods, containing all the NBER recessions, where consumption and production growth is low. These states of the world cause the first order conditions of equilibrium models to fail, implying non monotonic stochastic discount factors. Very profitable market timing strategies can be formed exploiting such failure.
