Research articles for the 2020-01-13

A varying terminal time mean-variance model
Shuzhen Yang

To improve the efficient frontier of the classical mean-variance model in continuous time, we propose a varying terminal time mean-variance model with a constraint on the mean value of the portfolio asset, which moves with the varying terminal time. Using the embedding technique from stochastic optimal control in continuous time and varying the terminal time, we determine an optimal strategy and related deterministic terminal time for the model. Our results suggest that doing so for an investment plan requires minimizing the variance with a varying terminal time.

An Explanation for Momentum With a Rational Model Under Symmetric Information â€" Evidence From the US and Chinese Equity Markets
Koziol, Christian,Proelss, Juliane
In this paper, we show that momentum patterns in equity returns can arise even in a parsimonious model with rational investors having symmetric information. The special feature of our model is that investors obtain a signal before observing the true asset payoff. A more favorable signal, however, impacts both the standard deviation of the return and its skewness. Since investors under rational expectations account for the current risk properties of the asset, the risk-adjusted subsequent return is related to the signal and therefore to the previous asset return. Hence, momentum does not need to be an anomaly but can be consistent with informational market efficiency where a higher subsequent return comes from a higher standard deviation of the asset return and/or a more severe negative skewness. Due to this rationale, it can be present in the future even though investors will have no incentive to exploit it. A comparativestatic analysis of our model reveals under which conditions momentum isparticularly in effect. Furthermore, we test our approach on two different equity markets, U.S. and China which are known to be dominated by different types of investors. The structure of the model allows us to identify for which type of investor momentum pattern is especially likely. This outcome provides the basis for a more precise empirical test for the origin of momentum.

Approximating intractable short ratemodel distribution with neural network
Anna Knezevic,Nikolai Dokuchaev

We propose an algorithm which predicts each subsequent time step relative to the previous time step of intractable short rate model (when adjusted for drift and overall distribution of previous percentile result) and show that the method achieves superior outcomes to the unbiased estimate both on the trained dataset and different validation data.

Bank Performance in Europe and the US: A Divergence in Market-to-Book Ratios
Simoens, Mathieu,Vander Vennet, Rudi
Post 2008, the market-to-book ratios of European and US banks have diverged markedly. We use panel regressions to investigate the determinants of the M/B ratios of 112 European and US banks. We show that the underperformance of European banks is mainly driven by non-performing loans and by the negative impact of policy rates on bank interest margins. The higher US bank valuations are mainly driven by higher profitability and better cost efficiency. Our results for European banks stress the importance of timely NPL resolution and imply that low-for-long monetary policy may harm bank health.

Big Fish in a Small Pond: Institutional Trading of Penny Stocks
Huang, Wei,Jiang, George J.
There has been a steady increase in institutional ownership of penny stocks over the past decades. Nevertheless, we show that penny stocks bought by institutional investors significantly underperform other penny stocks in subsequent four quarters. This poor performance is mainly driven by quasi-indexers, i.e., institutions with passive and widely diversified investment strategies. In comparison, dedicated institutions, i.e., those with low turnover but large average investments in portfolio firms and a commitment to “relationship investing”, have marginally significant ability in trading penny stocks.

Commuting Service Platform: Concept and Analysis
Rong Fan,Xuegang

We propose and investigate the concept of commuting service platforms (CSP) that leverage emerging mobility services to provide commuting services and connect directly commuters (employees) and their worksites (employers). By applying the two-sided market analysis framework, we show under what conditions a CSP may present the two-sidedness. Both the monopoly and duopoly CSPs are then analyzed. We showhowthe price allocation, i.e., the prices charged to commuters and worksites, can impact the participation and profit of the CSPs. We also add demand constraints to the duopoly model so that the participation rates ofworksites and employees are (almost) the same. With demand constraints, the competition between the two CSPs becomes less intense in general. Discussions are presented on how the results and findings in this paper may help build CSP in practice and how to develop new, CSP-based travel demand management strategies.

Concepts, Components and Collections of Trading Strategies and Market Color
Ravi Kashyap

This paper acts as a collection of various trading strategies and useful pieces of market information that might help to implement such strategies. This list is meant to be comprehensive (though by no means exhaustive) and hence we only provide pointers and give further sources to explore each strategy further. To set the stage for this exploration, we consider the factors that determine good and bad trades, the notions of market efficiency, the real prospect amidst the seemingly high expectations of homogeneous expectations from human beings and the catch-22 connotations that arise while comprehending the true meaning of rational investing. We can broadly classify trading ideas and client market color material into Delta-One and Derivative strategies since this acts as a natural categorization that depends on the expertise of the various trading desks that will implement these strategies. For each strategy, we will have a core idea and we will present different flavors of this central theme to demonstrate that we can easily cater to the varying risk appetites, regional preferences, asset management styles, investment philosophies, liability constraints, investment horizons, notional trading size, trading frequency and other preferences of different market participants.

Do Self-Control and Financial Literacy Explain the Financial Behaviour? The Spanish Case
Oliva, Laura,Toscano, David
The aim of the present work is to analyze the effect that self-control and financial literacy has on the individual's financial behaviour, focusing specifically on the Spanish case. In order to do so, the survey of 8,554 people conducted by the Bank of Spain has been used and factors have been constructed for each of these variables based on the previous literature. These factors have been conditioned by socio-demographic and socio-economic characteristics, and they have been analysed by means of grouped regression methodology. The results show that: (i) there is a positive relationship between healthy financial behaviour, self-control and the financial culture of an individual, (ii) in addition, those individuals who have greater self-control have a greater risk propensity, (iii) being their feeling of financial security also superior. Finally, (iv) we have found a significant positive relationship between self-control and financial literacy, regarding the propensity to save both liquid and real estate and financial assets.

Econophysics Through Computation
Antika Sinha,Sudip Mukherjee,Bikas K Chakrabarti

We introduce here very briefly, through some selective choices of problems and through the sample computer simulation programs (following the request of the editor for this invited review in the Journal of Physics Through Computation), the newly developed field of econophysics. Though related attempts could be traced much earlier (see the Appendix), the formal researches in econophysics started in 1995. We hope, the readers (students \& researchers) can start themselves to enjoy the excitement, through the sample computer programs given, and eventually can undertake researches in the frontier problems, through the indicated survey literature provided.

Electricity prices and tariffs to keep everyone happy: a framework for compatible fixed and nodal structures to increase efficiency
Iacopo Savelli,Thomas Morstyn

Some consumers, such as householders, are unwilling to face volatile electricity prices, and perceive as unfair price differentiations based on location. For these reasons, nodal prices in distribution networks are rarely employed. However, the increasing availability of renewable resources in distribution grids, and emerging price-elastic behaviour, pave the way for the effective introduction of marginal nodal pricing schemes in distribution networks. The aim of the proposed framework is to show how traditional non-flexible consumers can coexist with flexible users in a local distribution area, where the latter pay nodal prices whereas the former are charged a fixed price, which is derived by the underlying nodal prices. In addition, it determines how the distribution system operator should manage the local grid by optimally determining the lines to be expanded, and the collected network tariff levied on network users, while accounting for both congestion rent and investment costs. The proposed framework is formulated as a non-linear integer bilevel model, which is then recast as an equivalent single optimization problem, by using integer algebra and complementarity relations. The power flows in the distribution area are modelled by resorting to a second-order cone relaxation, whose solution is exact for radial networks under mild assumptions. The final model results in a mixed-integer quadratically constrained program, which can be solved with off-the-shelf solvers. Numerical test cases based on a 5-bus and a 33-bus networks are reported to show the effectiveness of the proposed method.

Equity Premium Puzzle or Faulty Economic Modelling?
Abootaleb Shirvani,Stoyan V. Stoyanov,Frank J. Fabozzi,Svetlozar T. Rachev

In this paper, we revisit the equity premium puzzle reported in 1985 by Mehra and Prescott. We show that the large equity premium that they report can be explained by choosing a more appropriate distribution for the return data. We demonstrate that the high-risk aversion value observed by Mehra and Prescott may be attributable to the problem of fitting a proper distribution to the historical returns and partly caused by poorly fitting the tail of the return distribution. We describe a new distribution that better fits the return distribution and when used to describe historical returns can explain the large equity risk premium and thereby explains the puzzle.

Exponential moving average versus moving exponential average
Frank Klinker

In this note we discuss the mathematical tools to define trend indicators which are used to describe market trends. We explain the relation between averages and moving averages on the one hand and the so called exponential moving average (EMA) on the other hand. We present a lot of examples and give the definition of the most frequently used trend indicator, the MACD, and discuss its properties.

Food Supply Chain and Business Model Innovation
Saeed Nosratabadi,Amirhosein Mosavi,Zoltan Lakner

This paper investigates the contribution of business model innovations in improvement of food supply chains. Through a systematic literature review, the notable business model innovations in the food industry are identified, surveyed, and evaluated. Findings reveal that the innovations in value proposition, value creation processes, and value delivery processes of business models are the successful strategies proposed in food industry. It is further disclosed that rural female entrepreneurs, social movements, and also urban conditions are the most important driving forces inducing the farmers to reconsider their business models. In addition, the new technologies and environmental factors are the secondary contributors in business model innovation for the food processors. It is concluded that digitalization has disruptively changed the food distributors models. E-commerce models and internet of things are reported as the essential factors imposing the retailers to innovate their business models. Furthermore, the consumption demand and the product quality are two main factors affecting the business models of all the firms operating in the food supply chain regardless of their positions in the chain. The findings of the current study provide an insight into the food industry to design a sustainable business model to bridge the gap between food supply and food demand.

Gauge Transformations in the Dual Space, and Pricing and Estimation in the Long Run in Affine Jump-Diffusion Models
Boyarchenko, Svetlana,Levendorskii, Sergei
We suggest a simple reduction of pricing European options in affine jump-diffusion models to pricing options with modified payoffs in diffusion models. The procedure is based on the conjugation of the infinitesimal generator of the model with an operator of the form $e^{i\Phi(-\sqrt{-1}\dd_x)}$ (gauge transformation in the dual space). A general procedure for the calculation of the function $\Phi$ is given, with examples. As applications, we consider pricing in jump-diffusion models and their subordinated versions using the eigenfunction expansion technique, and estimation of the extremely rare jumps component. The beliefs of the market about yet unobserved extreme jumps and pricing kernel can be recovered: the market prices allow one to see ``the shape of things to come".

Global Accounting Standards, Financial Statement Comparability, and the Cost of Capital
Huang, Yong,Yan, Chao
This paper studies how financial statement comparability affects the cost of capital and investor welfare. We show that the cost of capital decreases with comparability if and only if the quality of accounting standards is sufficiently high, thus supporting the relative importance of comparability as proposed in the Conceptual Framework. We also find that current investors and new investors have different demands for comparability. The welfare of current investors increases in comparability, while the welfare of new investors decreases in comparability. Moreover, the effects of comparability on the cost of capital and investor welfare are enhanced when firms’ idiosyncratic accounting measurements are highly volatile and/or correlated. These basic findings hold in both an exchange economy and a production economy, but there is a certain threshold of investment cost above which the cost of capital and the welfare of new investors decreases with comparability in a production economy. These findings are helpful in understanding the role of comparability and have implications for the global convergence of accounting standards.

Global Demand Spillovers in Corporate Bond Issuance: The Effect of Underwriter Networks
Siani, Kerry
This paper studies how monetary policy shocks propagate across borders through bond issuance networks of firms, underwriters and investors. Using a difference-in-differences strategy, I find that the European Central Bank's quantitative easing program in 2016 spilled over to the U.S. corporate bond issuance market via an underwriting channel. U.S. firms connected to underwriters with more Eurozone investor clients faced greater orders for their bonds, achieved a lower cost of capital, and ended up issuing more bonds. The underlying mechanism is likely driven by costly search that underwriters face in locating potential investors, which incentivizes maintaining investor relationships for repeated business. As such, investor demand shocks transmitted through underwriters affect issuers heterogeneously based on preexisting issuer-underwriter-investor networks.

How ‘High’ on Herding are Cannabis Stocks?
Andrikopoulos, Panagiotis,Kallinterakis, Vasileios
We present the first study on investors’ behaviour in the nascent cannabis industry by examining herding among North American cannabis stocks. Canadian-listed cannabis stocks herd strongly across all market states and sectors, and for most capitalization-segments, unlike their US-listed counterparts whose herding appears more limited. Cannabis-legalization announcements rarely induce herding, while cross market herding between US- and Canadian-listed cannabis stocks is very weak. Herding is significant among US-listed Canadian cannabis stocks, yet absent among US domestic cannabis stocks. We attribute Canadian cannabis stocks’ stronger herding to their industry’s mature institutional environment that encourages investors to herd more confidently on them.

Interest Rates and the Design of Financial Contracts
Roberts, Michael R.,Schwert, Michael
We show that variation in short-term nominal interest rates produces an endogenous response in the design of and commitment to corporate loan contracts. Interest rates are inversely related to the cash flow rights and positively related to the control rights granted to creditors. An implication of this contractual response is a sharp increase in the ex post renegotiation of contracts originated in low interest rate environments, as well as a muted effect of interest rate variation on the cost of debt capital. Our findings illustrate how the design of financial contracts in practice reflects a multi-dimensional tradeoff among contract features that aligns incentives and apportions risk among the contracting parties in a state-contingent manner.

Linear Social Learning in Networks with Rational Agents
Krishna Dasaratha,Kevin He

We consider a sequential social-learning environment with rational agents and Gaussian private signals, focusing on how the observation network affects the speed of learning. Agents learn about a binary state and take turns choosing actions based on own signals and network neighbors' behavior. The observation network generally presents an obstruction to the efficient rate of signal aggregation, as agents compromise between incorporating the signals of the observed neighbors and not over-counting the confounding signals of the unobserved early movers. We show that on any network, equilibrium actions are a log-linear function of observations and each agent's accuracy admits a signal-counting interpretation. Adding links to the observation network can harm agents even without introducing new confounds. We then consider a network structure where agents move in generations and observe some members of the previous generation. When this observation structure is sufficiently connected and symmetric, the additional information aggregated by each generation is asymptotically equivalent to fewer than two independent signals, even when generations are arbitrarily large. When agents observe all predecessors from the previous generation, social learning aggregates no more than three signals per generation starting from the third generation, and the long-run learning rate is slower when generations are larger.

Liquidity, Solvency and Stability (Presentation Slides)
Thakor, Anjan V.
Presentation at Chapman Conference on Liquidity: Pricing, Management and Stability. The distinction between solvency crisis and liquidity crisis is discussed. Lessons from the 2008-9 crisis are drawn and areas for regulatory reform are identified.

Optimal Dividends Paid in a Foreign Currency for a L\'evy Insurance Risk Model
Julia Eisenberg,Zbigniew Palmowski

This paper considers an optimal dividend distribution problem for an insurance company where the dividends are paid in a foreign currency. In the absence of dividend payments, our risk process follows a spectrally negative L\'evy process. We assume that the exchange rate is described by a an exponentially L\'evy process, possibly containing the same risk sources like the surplus of the insurance company under consideration. The control mechanism chooses the amount of dividend payments. The objective is to maximise the expected dividend payments received until the time of ruin and a penalty payment at the time of ruin, which is an increasing function of the size of the shortfall at ruin. A complete solution is presented to the corresponding stochastic control problem. Via the corresponding Hamilton--Jacobi--Bellman equation we find the necessary and sufficient conditions for optimality of a single dividend barrier strategy. A number of numerical examples illustrate the theoretical analysis.

Pareto-Optimal Insurance Contracts With Premium Budget and Minimum Charge Constraints
Asimit, Alexandru Vali,Cheung, Ka Chun,Chong, Wing Fung,Hu, Junlei
In view of the fact that minimum charge and premium budget constraints are natural economic considerations in any risk-transfer between the insurance buyer and seller, this paper revisits the optimal insurance contract design problem in terms of Pareto optimality with imposing these practical constraints. Pareto optimal insurance contracts, with indemnity schedule and premium payment, are solved in the cases when the risk preferences of the buyer and seller are given by Value-at-Risk or Tail Value-at-Risk. The effect of our constraints and the relative bargaining powers of the buyer and seller on the Pareto optimal insurance contracts are highlighted. Numerical experiments are employed to further examine these effects for some given risk preferences.

Pricing Exchange Options under Stochastic Correlation
Enrique Villamor,Pablo Olivares

In this paper we study the pricing of exchange options when underlying assets have stochastic volatility and stochastic correlation. An approximation using a closed-form approximation based on a Taylor expansion of the conditional price is proposed. Numerical results are illustrated for exchanges between WTI and Brent type oil prices.

Reconstruction of Interbank Network using Ridge Entropy Maximization Model
Yuichi Ikeda,Hidetoshi Takeda

We develop a network reconstruction model based on the entropy maximization considering the sparsity of network. Here the reconstruction is to estimate network's adjacency matrix from node's local information. We reconstruct the interbank network in Japan from financial data in balance sheets of individual banks using the developed reconstruction model in the period from 2000 to 2016. The sparsity of the interbank network is successfully reproduced in the reconstructed network. We examine the accuracy of the reconstructed interbank network by comparing the actual data and analyze the characteristics of the interbank network. The comparison confirms that the accuracy of the reconstruction model is acceptably good. For the reconstructed interbank network, we obtain the following characteristics which are consistent with the previously known stylized facts: the short path length, the small clustering coefficient, the disassortative property, and the core and peripheral structure. Community analysis shows that the number of communities is 2-3 in the normal period, 1 in the economic crisis (2003, 2008-2013). The major nodes in each community have been the major commercial banks. Since 2013, the major commercial banks have lost the average PageRank and the leading regional banks have obtained both the average degree and the average PageRank. The observed changing role of banks is considered as a result of the quantitative and qualitative easing monetary policy started by Bank of Japan in April of 2013.

Reversing the Fortunes of Active Funds
Libson, Adi,Parchomovsky, Gideon
Recent years have witnessed a considerable growth of passive fund at the expense of active funds. This trend picked in 2019, a year that saw passive funds surpass active funds in terms of assets under management. The continuous decline of active funds is a cause for concern. Active funds engage in monitoring of firms and partake of decision-making in companies in their portfolio. The cost of these activities are born exclusively by active funds; the benefits, by contrast, are spread over all shareholders, including passive funds that freeride on the efforts of active funds. The contraction of active funds threatens to set back the quality of corporate governance in U.S. firms.This Essay proposes a way to reverse this trend. To preserve the benefits presented by active funds, we explore the possibility of employing tax mechanisms to help defray the extra-cost born by active funds. In particular, we establish a prima facie case for using tax credits to support active funds and enhance their market share. We discuss two types of tax credits: effort based tax credits and result-based tax credits. The use of targeted tax credits has four principal advantages over competing proposals. Effort based tax credits would be granted whenever an active funds undertake prespecified measures to improve corporate governance irrespective of their success. Result based tax credits would be contingent on the attainment of certain outcomes. The two types are not mutually exclusive and can be combined for maximal effect.Our proposal has three potential advantages over competing proposals that seek to force passive funds to become more active. First, taxes constitute a highly effective tool for altering behavior as they transform the underlying motivations of the subject. Second, our proposal has the potential to create a virtuous financial cycle: the expected increase in tax revenues from the improved performance of firms generated by the tax should far surpass the cost of providing the credits. Third and finally, from a political economy standpoint, due to its non-coercive nature, our proposal will not attract opposition from the investment industry and thus stands a realistic chance of being adopted.

Speculation-Driven Business Cycles
Bigio, Saki,Zilberman, Eduardo
Speculation, in the spirit of Harrison and Kreps [1978], is introduced into a standard real business cycle model. Investors (speculators) hold heterogeneous beliefs about firm growth. Firm ownership, and thus, the firm’s discount factor varies with waves of optimism and leverage. These waves ripple into firm investments in hours. The firm’s discount discount factor links the equity premium and labor volatility puzzles. We obtain an upper bound to the amplification that can be generated by speculation for any model of beliefs -- a factor of 1.5. A calibration based on diagnostic beliefs amplifies hours volatility by a factor of 1.15 and produces a bubble component of 20 percent.

The Global Effects of U.S. Monetary Policy on Equity and Bond Markets: A Spatial Panel Data Model Approach
Lu, Lina,Luo, Shaowen
We use spatial panel data model analysis to study the international transmission of U.S. monetary policy shocks in the global equity and bond markets. Through this analysis, we decompose the overall effect of such a shock into 1) direct effects, 2) higher-order network effects transmitted through global economic networks, and 3) simultaneous effects transmitted between local equity and bond markets. Theoretically, our analysis of the transmission mechanism for the shocks relies on a network model with monetary policy spillovers. Empirically, we study asset price responses around the scheduled Federal Reserve announcements to demonstrate the significant roles of all three effects in the transmission of shocks.

The Timing of Voluntary Delisting
El Kalak, Izidin,Azevedo, Alcino,Tunaru, Radu
We develop a theoretical real options model that advises firms on the timing of voluntary delisting. We apply this model to 2,358 U.S. listed firms (1980-2016) and classify them as listed (delisted) firms that should be listed (delisted), good decision (GD), and listed (delisted) firms which should be delisted (listed), bad decision (BD). We perform a survival analysis using a discrete-time duration-dependent hazard model, so as to investigate the effect of the firm’s characteristics on the likelihood of delisting, and examine the mean differences between the GD and BD samples. Most of the mean differences are statistically significant, which attests the economic rationale underlying our model. We highlight that the turnover, turnover growth and turnover volatility are largely neglected by the delisting literature, and conclude that these variables are however key determinants of voluntary delisting.

Zooming In on Equity Factor Crowding
Valerio Volpati,Michael Benzaquen,Zoltan Eisler,Iacopo Mastromatteo,Bence Toth,Jean-Philippe Bouchaud

Crowding is most likely an important factor in the deterioration of strategy performance, the increase of trading costs and the development of systemic risk. We study the imprints of \emph{crowding} on both anonymous market data and a large database of metaorders from institutional investors in the U.S. equity market. We propose direct metrics of crowding that capture the presence of investors contemporaneously trading the same stock in the same direction by looking at fluctuations of the imbalances of trades executed on the market. We identify significant signs of crowding in well known equity signals, such as Fama-French factors and especially Momentum. We show that the rebalancing of a Momentum portfolio can explain between 1-2\% of order flow, and that this percentage has been significantly increasing in recent years.