Research articles for the 2020-01-21

A Dynamic Bayesian Model for Interpretable Decompositions of Market Behaviour
Théophile Griveau-Billion,Ben Calderhead

We propose a heterogeneous simultaneous graphical dynamic linear model (H-SGDLM), which extends the standard SGDLM framework to incorporate a heterogeneous autoregressive realised volatility (HAR-RV) model. This novel approach creates a GPU-scalable multivariate volatility estimator, which decomposes multiple time series into economically-meaningful variables to explain the endogenous and exogenous factors driving the underlying variability. This unique decomposition goes beyond the classic one step ahead prediction; indeed, we investigate inferences up to one month into the future using stocks, FX futures and ETF futures, demonstrating its superior performance according to accuracy of large moves, longer-term prediction and consistency over time.

A New Index of the Business Cycle
Kinlaw, William B.,Kritzman, Mark,Turkington, David
The authors introduce a new index of the business cycle that uses the Mahalanobis distance to measure the statistical similarity of current economic conditions to past episodes of recession and robust growth. Their index has several important features that distinguish it from the Conference Board’s leading, coincident, and lagging indicators. It is efficient because as a single index it conveys reliable information about the path of the business cycle. Their index gives an independent assessment of the state of the economy because it is constructed from variables that are different than those used by the NBER to identify recessions. It is strictly data driven; hence, it is unaffected by human bias or persuasion. It gives an objective assessment of the business cycle because it is expressed in units of statistical likelihood. And it explicitly accounts for the interaction, along with the level, of the economic variables from which it is constructed.

A tail dependence-based MST and their topological indicators in modelling systemic risk in the European insurance sector
Anna Denkowska,Stanisław Wanat

In the present work we analyze the dynamics of indirect connections between insurance companies that result from market price channels. In our analysis we assume that the stock quotations of insurance companies reflect market sentiments which constitute a very important systemic risk factor. Interlinkages between insurers and their dynamics have a direct impact on systemic risk contagion in the insurance sector. We propose herein a new hybrid approach to the analysis of interlinkages dynamics based on combining the copula-DCC-GARCH model and Minimum Spanning Trees (MST). Using the copula-DCC-GARCH model we determine the correlation coefficients in the distribution tails. Then, for each analysed period we construct MST based on these coefficients. The dynamics is analysed by means of time series of selected topological indicators of the MSTs. Our empirical results show the usefulness of the proposed approach to the analysis of systemic risk in the insurance sector. The times series obtained from the proposed hybrid approach reflect the phenomena occurring on the market. The analysed MST topological indicators can be considered as systemic risk predictors.

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.

CEO Political Ideology, Shareholder Primacy and Dividend Policy
Bayat, Ali,Goergen, Marc
We argue that CEOs have different attitudes toward the firm’s stakeholders and that these differences in attitudes affect the firm’s decision making. We hypothesize that these differences stem from differences in political ideology: Liberal CEOs, as compared to their conservative counterparts, pay less attention to shareholders and this is reflected in dividend policy. To test the validity of our hypothesis, we measure CEO ideology by political donations. We study the CEOs of S&P 500 firms during 1997-2014 and find that firms with liberal CEOs are less likely to pay dividends and have significantly lower dividend payouts. In contrast, conservative CEOs pay more dividends, even if this requires redundancies.

Executive Compensation, Sustainable Compensation Policy, Carbon Performance and Market Value
Haque, Faizul,Ntim, Collins G.
We examine the interrelationships among executive compensation, environmental-social-governance-based (ESG) sustainable compensation policy, carbon performance and market value. Using one of the largest datasets to-date, consisting of 4,379 firm-year observations covering a period of 15 years (2002-2016) from 13 industrialised European countries and insights from neo-institutional theory (NIT), our findings are four-fold. First, our results suggest that process-oriented carbon performance is positively associated with market value, whereas actual-carbon performance has no effect on market value. Second, we show that the market valueâ€"process-oriented carbon performance nexus is moderated by executive compensation. Third, our results indicate that executive compensation has a positive effect on process-oriented carbon performance, but has no similar effect on actual-carbon performance. Fourth, we show that the process-oriented carbon performanceâ€"executive compensation nexus is reinforced for companies that adopt ESG-based sustainable compensation policy. Our results are generally robust to controlling for governance mechanisms, alternative measures/estimations and endogeneities. Overall, our evidence supports legitimisation aspect of NIT and suggests that the market tends to reward firms with superior process-oriented carbon performance instead of undervaluing firms with excessive actual-carbon emissions. This implies that firms appear to use incentive-based mechanisms to symbolically improve their process-oriented carbon performance without substantively improving their actual-carbon performance.

From Trulia to Akorn: A Ride on the Roller Coaster of M&A Litigation
Matera, Pierluigi,Sbarbaro, Ferruccio Maria
In recent years, M&A litigation has experienced a dramatic increase, culminating with a peak in 2015, when over 96% of publicly announced mergers were challenged in a shareholder lawsuit. A large number of these lawsuits were frivolous and vexatious, since most claims were filed by plaintiffs’ attorneys just to extract some fees with little effort. Some abusive practices emerged, signalling an alarming exploitation of the system. One scheme that plaintiffs’ attorneys put in place was the disclosure-only settlement. There, the stockholders obtained some modest supplemental disclosures, the plaintiff’s attorneys got significant fee awards from the defendant directors and the defendant directors secured some blanket class releases from future claims. The scheme relied upon courts’ routine practice of approving any settlement, even when there is no benefit for the corporation or its stockholders. A correction became critical. At the beginning of 2016, the Delaware Court of Chancery with In re Trulia marked a doctrinal shift in the standard of judicial review for disclosure-only settlements, by requiring that supplemental disclosures deliver a “plainly material benefit” to stockholders and that any releases from liability be “narrowly circumscribed”. But the approach in Trulia is not without some limitations. Whilst federal courts have soon followed Trulia with In Re Walgreen, other states have been slow and sometimes reluctant to do so. Even if Trulia succeeds in restricting disclosure-only settlements, another tactic has arisen to replace it: the mootness dismissal â€" that is a voluntary dismissal coupled with the payment of mootness fees to plaintiffs’ attorneys by the defendant. Data on merger litigation show that, like on a roller coaster, after a decline post Trulia, the number of litigated deals rose again in 2017. Notably, 87% of these claims were brought in a federal court and only 10% in Delaware. This trend is becoming more pronounced. A few of these lawsuits were settled; most cases were voluntarily dismissed, and plaintiffs’ attorneys received a mootness fee. Clearly, plaintiffs’ attorneys developed an adaptive response to the Trulia standard and devised the new scheme to replace the old stratagem. Unlike in the disclosure-only settlement cases, the mootness dismissal is without prejudice for the class, since the defendant obtains no release from future claims. Mootness fees are also on average much lower than the attorneys’ fees granted in a typical disclosure-only settlement. But, apart from that, the scheme is not less detrimental to corporations and stockholders. What is more, the Federal Rules of Civil Procedure do not explicitly allow a court to review mootness fees. Hence, in federal courts the new scheme can bypass any judicial scrutiny. This results in an additional opacity in the practice and explains the migration of cases to federal courts.In June 2019, in House v. Akorn, a U.S. District Court in Illinois invoked its equitable powers and scrutinised the mootness fees. The judge extended the Trulia-Walgreen standard and, accordingly, ordered the plaintiffs’ attorney to return the fees to the corporation. An appeal is pending before the 7th Circuit, and a landmark decision could be in the offing. We predict that the appellate court will affirm the district court’s decision. Yet, the affirmation may not be enough to halt overlitigation. On the face of it, it would discourage plaintiffs’ attorneys from starting a lawsuit just to extract mootness fees. But plaintiffs’ attorney could continue in mootness fee practice, exploiting the lack of transparency. In fact, courts could apply Akorn only if they become aware of the mootness fee. Plaintiffs’ attorneys could also revert to the scheme of disclosure-only settlements and file claims in those jurisdictions that have a more tolerant standard for these agreements. Trulia, Walgreen and Akorn (as well as other decisions) prove that the courts are reacting and correcting the abuse of litigation. Nevertheless, these decisions need to be confirmed, implemented and complemented. A failure by Trulia and Akorn to adequately address the issues could call into question the regulation-by-litigation model adopted by U.S. corporate law. The challenge cannot be underestimated, since some commentators are already advocating for a radical shift to a pure regulatory approach, such as the Anglo-Irish code and panel-based model.The overlitigation, with its significant costs and non-existent benefits for corporations and shareholders, is the manifestation of the crisis of a litigation system which has devolved into a non-adversarial process. We argue that such devolution is the outcome of the delayed and ineffective management â€" by legislatures and courts â€" of some conflicts of interest and of some incentives to collude in the process. But we also contend that the courts are currently addressing those conflicts, collusions and procedural gaps. The roller coaster of M&A litigation is likely to continue but, hopefully, it will be a gentler ride.

High-Frequency Jump Tests: Which Test Should We Use?
Worapree Maneesoonthorn,Gael M. Martin,Catherine S. Forbes

We conduct an extensive evaluation of price jump tests based on high-frequency financial data. After providing a concise review of multiple alternative tests, we document the size and power of all tests in a range of empirically relevant scenarios. Particular focus is given to the robustness of test performance to the presence of jumps in volatility and microstructure noise, and to the impact of sampling frequency. The paper concludes by providing guidelines for empirical researchers about which test to choose in any given setting.

Intermediated Implementation
Anqi Li,Yiqing Xing

We examine problems of ``intermediated implementation,'' in which a single principal can only regulate limited aspects of the consumption bundles traded between intermediaries and agents with hidden characteristics. An example is sales, in which retailers offer menus of consumption bundles to customers with hidden tastes, whereas a manufacturer with a potentially different goal from retailers' is limited to regulating sold consumption goods but not retail prices by legal barriers. We study how the principal can implement through intermediaries any social choice rule that is incentive compatible and individually rational for agents. We demonstrate the effectiveness of per-unit fee schedules and distribution regulations, which hinges on whether intermediaries have private or interdependent values. We give further applications to healthcare regulation and income redistribution.

Kernel-based collocation methods for Heath-Jarrow-Morton models with Musiela parametrization
Yuki Kinoshita,Yumiharu Nakano

We propose kernel-based collocation methods for numerical solutions to Heath-Jarrow-Morton models with Musiela parametrization. The methods can be seen as the Euler-Maruyama approximation of some finite dimensional stochastic differential equations, and allow us to compute the derivative prices by the usual Monte Carlo methods. We derive a bound on the rate of convergence under some decay condition on the inverse of the interpolation matrix and some regularity conditions on the volatility functionals.

Man Versus Machine: A Comparison of Robo-Analyst and Traditional Research Analyst Investment Recommendations
Coleman, Braiden,Merkley, Kenneth J.,Pacelli, Joseph
Advances in financial technology (FinTech) have revolutionized various product offerings in the financial services industry. One area of particular interest for this technology is the production of investment recommendations. Our study provides the first comprehensive analysis of the properties of investment recommendations generated by “Robo-Analysts,” which are human-analyst-assisted computer programs conducting automated research analysis. Our results indicate that Robo-Analysts differ from traditional “human” research analysts across several dimensions. First, Robo-Analysts collectively produce a more balanced distribution of buy, hold, and sell recommendations than do human analysts, which suggests that they are less subject to behavioral biases and conflicts of interest. Second, consistent with automation facilitating a greater scale of research production, Robo-Analysts revise their reports more frequently than human analysts and also adopt different production processes. Their revisions rely less on earnings announcements, and more on the large, volumes of data released in firms’ annual reports. Third, Robo-Analysts’ reports exhibit weaker short-window return reactions, suggesting that investors do not trade on their signals. Importantly, portfolios formed based on the buy recommendations of Robo-Analysts appear to outperform those of human analysts, suggesting that their buy calls are more profitable. Overall, our results suggest that Robo-Analysts are a valuable, alternative information intermediary to traditional sell-side analysts.

Markov risk mappings and risk-averse optimal stopping under ambiguity
Randall Martyr,John Moriarty

We aim to analyse a Markovian discrete-time optimal stopping problem for a risk-averse decision maker under model ambiguity. In contrast to the analytic approach based on transition risk mappings, a probabilistic setting is introduced based on novel concepts of regular conditional risk mapping and Markov update rule. To accommodate model ambiguity we introduce appropriate notions of history-consistent updating and of transition consistency for risk mappings on nested probability spaces.

Pathwise Optimization for Merchant Energy Production
Yang, Bo,Nadarajah, Selvaprabu,Secomandi, Nicola
We study merchant energy production modeled as a compound switching and timing option. The resulting Markov decision process is intractable. State-of-the-art approximate dynamic programming methods applied to realistic instances of this model yield policies with large optimality gaps that are attributed to a weak upper (dual) bound on the optimal policy value. We extend path-wise optimization from stopping models to merchant energy production to investigate this issue. We apply principal component analysis and block coordinate descent in novel ways to respectively precondition and solve the ensuing ill conditioned and large scale linear program, which even a cutting-edge commercial solver is unable to handle directly. Compared to standard methods, our approach leads to substantially tighter dual bounds and smaller optimality gaps at the expense of considerably larger computational effort. Specifically, we provide numerical evidence for the near optimality of the operating policies based on least squares Monte Carlo and compute slightly better ones using our approach on a set of existing benchmark ethanol production instances. These findings suggest that both these policies are effective for the class of models we investigate. Our research has potential relevance for other commodity merchant operations settings.

Profits and Risks of Banks in a Developing Country: A Case for Bank Taxation in Ghana
Chaudhry, Sajid M.
The big ten banks in Ghana are too profitable (in terms of what is socially optimal) and they earn much higher profits compared to other industries. Their excess profits are being made at the expense of the public and that they should contribute toward the public finances. We propose a bank tax that not only taxes the profits of banks but also aims to tax short term borrowing of banks, while assessing the individual and systemic bank risks in Ghana. We also investigate why the National Fiscal Stabilisation Levy (NFSL) should remain in place for banks in Ghana and gauge its impact on bank returns and profits. Specifically, we propose a bank tax of 1% of total liabilities net of equity and insured deposits or 5% of profit before tax, whichever is higher. It is estimated to raise revenue of about GHc 220 million per year, more than the amount of aid that Ghana receives every year. Our research has policy implications not only for Ghana but for all the developing countries that have a banking sector earning hefty profits.

Self-Fulfilling Debt Crises, Revisited
Aguiar, Mark,Chatterjee, Satyajit,Cole, Harold L.,Stangebye, Zachary
We revisit self-fulfilling rollover crises by exploring the potential uncertainty introduced by a gap in time (however small) between an auction of new debt and the payment of maturing liabilities. It is well known (Cole and Kehoe, 2000) that the lack of commitment at the time of auction to repayment of imminently maturing debt can generate a run on debt, leading to a failed auction and immediate default. We show that the same lack of commitment leads to a rich set of possible self-fulfilling crises, including a government that issues more debt because of the crisis, albeit at depressed prices. Another possible outcome is a “sudden stop” (or forced austerity) in which the government sharply curtails debt issuance. Both outcomes stem from the government’s incentive to eliminate uncertainty about imminent payments at the time of auction by altering the level of debt issuance. In an otherwise standard quantitative version of the model, including such crises in-crease the default probabilities by a factor of five and the spread volatility by a factor of twenty-five.

Shifting Contours of Directors’ Fiduciary Duties and Norms in Comparative Corporate Governance
Hill, Jennifer G.
Corporate law and corporate governance are often called upon to address problems in international and transnational contexts. Financial markets are global and the problems in those markets are often similar, if not identical, even though the capital market structure across jurisdictions differs significantly. The beginning of the 21st century was marked by a spate of international corporate scandals, and the 2007-2009 global financial crisis reflected the global “interconnectedness” of contemporary international capital markets.These events highlighted the issue of accountability for wrongful conduct by company directors and officers. Modern corporate governance is highly fragmented, encompassing an array of techniques to control the improper exercise of discretion and conflicts of interest. According to Professor Gilson, it is “a braided framework” that encompasses, not only autonomous legal rules, but also non-binding norms.This Article analyzes, from a comparative perspective, two core aspects of this “braided framework”. First, the Article considers fiduciary duties. It argues that, although there are broad similarities in the scope and operation of fiduciary duties in common law jurisdictions, such as the United States, United Kingdom and Australia, at a more granular level, there are important differences, which may affect the accountability of directors and officers. Secondly, the Article examines corporate codes. Although generally non-binding, corporate codes can create powerful norms concerning the role of directors and officers and the exercise of their powers. These codes may also interact with fiduciary duties in complex and interesting ways, either complementing, or creating tensions with, those duties. Yet, such codes are by no means homogeneous, and substantive differences can often be traced to the identity of the actors responsible for writing them.

Supermartingale deflators in the absence of a num\'eraire
Chong Liu,Ariel Neufeld,Philipp Harms

In this paper we study arbitrage theory of financial markets in the absence of a num\'eraire both in discrete and continuous time. In our main results, we provide a generalization of the classical equivalence between no unbounded profits with bounded risk (NUPBR) and the existence of a supermartingale deflator. To obtain the desired results, we introduce a new approach based on disintegration of the underlying probability space into spaces where the market crashes at deterministic times.

Swap Portfolios and Reverse-Weighted Portfolios, with an Application to Commodity Futures
Ricardo T. Fernholz,Robert Fernholz

A market portfolio is a portfolio in which each asset is held at a weight proportional to its market value. A swap portfolio is a portfolio in which each one of a pair of assets is held at a weight proportional to the market value of the other. A reverse-weighted index portfolio is a portfolio in which the weights of the market portfolio are swapped pairwise by rank. Swap portfolios are functionally generated, and in a coherent market they have higher asymptotic growth rates than the market portfolio. Although reverse-weighted portfolios with two or more pairs of assets are not functionally generated, in a market represented by a first-order model with symmetric variances, they will grow faster than the market portfolio. This result is applied to a market of commodity futures.

Term Structure Modeling under Volatility Uncertainty
Julian Hölzermann,Qian Lin

We study a forward rate model in the presence of volatility uncertainty. The forward rate is modeled as a diffusion process in the spirit of Heath, Jarrow, and Morton (1992). The uncertainty about the volatility is represented by a G-Brownian motion, being the driver of the forward rate dynamics. Within this framework, we derive a sufficient condition for the absence of arbitrage, known as the drift condition. In contrast to the traditional model, the drift condition consists of two equations and two market prices of risk and uncertainty, respectively. The drift condition is still consistent with the classical one if there is no volatility uncertainty. Similar to the traditional model, the risk-neutral dynamics of the forward rate are completely determined by the diffusion coefficient. Furthermore, we obtain some classical term structures under volatility uncertainty as examples of our model.

The Impact of Margin Changes on Commodity Futures Markets: Evidence From India
Thota, Nagaraju,Shah, Neel
Using 14 major commodity (bullion, base metal, agricultural and energy) futures contracts of Multi Commodity Exchange (MCX) from July 2009 to December 2018, we examine the effects of margin changes on commodity futures markets in India. Our empirical results indicate that all commodity futures except Aluminium, Copper and Brent Crude, net margin is maximum for the quartile closet to the maturity. Similarly, volatility of margin imposition is the highest for the quartile closet to maturity. The increasing margin has a negative effect for all non-agricultural futures contracts except Aluminium and Brent Crude. The impact of a margin decrease on volume is weaker compared to a margin increase except for Natural Gas and Crude Oil which show that volume increased on days when margin reduced. On the other hand, both increase and decrease in margins have negative impact on open interest in all the commodity futures contracts.

The Value of Managerial Discretion in Africa: Evidence from Acquired Intangible Assets Under IFRS 3
Tunyi, Abongeh A.,Ehalaiye, Dimu,Gyapong, Ernest,Ntim, Collins G.
The paper examines the value of managerial discretion in financial reporting by exploring the value relevance of intangible assets acquired in business combinations (AIA) before and after the 2008 International Financial Reporting Standard (IFRS) 3 amendment. The 2008 IFRS 3 amendment gave managers the discretion to recognize previously unrecognized intangibles in the target firm, hence, we posit that if managerial discretion improves the quality of financial reporting, we should observe an increase in the value relevance of AIA after the amendment. Our empirical analysis is based on a dataset of 603 mergers announced between 2004 to 2016, across 7 African countries. Consistent with our main hypothesis, we find that the value relevance of AIA, predominantly acquired goodwill (AGW), increased after the amendment, suggesting that managerial discretion improves the quality of financial information. Importantly, we highlight a caveat to this argument by showing that the value of discretion is moderated by the underlying institutional quality, with the value relevance of AIA being greater in high-quality institutional contexts. Our findings are robust to alternative measures of AIA, alternative models for testing value relevance and various controls for endogeneity. Overall, our findings have important implications for accounting standard-setters, governments, investors and practitioners.

Who voted for a No Deal Brexit? A Composition Model of Great Britains 2019 European Parliamentary Elections
Stephen Clark

The purpose of this paper is to use the votes cast at the 2019 European elections held in United Kingdom to re-visit the analysis conducted subsequent to its 2016 European Union referendum vote. This exercise provides a staging post on public opinion as the United Kingdom moves to leave the European Union during 2020. A composition data analysis in a seemingly unrelated regression framework is adopted that respects the compositional nature of the vote outcome; each outcome is a share that adds up to 100% and each outcome is related to the alternatives. Contemporary explanatory data for each counting area is sourced from the themes of socio-demographics, employment, life satisfaction and place. The study find that there are still strong and stark divisions in the United Kingdom, defined by age, qualifications, employment and place. The use of a compositional analysis approach produces challenges in regards to the interpretation of these models, but marginal plots are seen to aid the interpretation somewhat.