Research articles for the 2020-02-11

Advertising, Market Concentration, and Firm Performance on the Distribution System
Choi, Byeongyong Paul
This paper examines the impact of advertising on the firm performance as measured two profit variables and market structure as measured by market concentrations and the relationship is analyzed by two different distribution systems: independent agency writers vs. direct writers. The empirical testing results show that a positive and non-significant relationship between concentration and advertising for both distribution systems, while a negative and significant relation between market share and advertising is found. These results are consistent with the two distribution systems. This paper, however, finds differences between the two distribution systems in the profit model. A negative and significant relationship is found between advertising and profits for independent agency writers, while there exists no significant relationship for direct writers. So, in this highly competitive market, advertising does not boost profit for independent agency writers.

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 timestep 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.

Art as an Asset: Evidence from Keynes the Collector
Chambers, David,Dimson, Elroy
The risk-return characteristics of art as an asset have been previously studied through aggregate price indexes. By contrast, we examine the long-run buy-and-hold performance of an actual portfolio, namely, the collection of John Maynard Keynes. We find that its performance has substantially exceeded existing estimates of art market returns. Our analysis of the collection identifies general attributes of art portfolios crucial in explaining why investor returns can substantially diverge from market returns: transaction-specific risk, buyer heterogeneity, return skewness, and portfolio concentration. Furthermore, our findings highlight the limitations of art price indexes as a guide to asset allocation or performance benchmarking.

Asset Pricing Model Estimation Errors During Rational and Irrational Investor Behavior Periods
Marsh, Michael G.,Muchnick, Marc
This paper examines the prediction that human behavior changes the outcome of market predictability, indicated by a difference in asset pricing model estimated prediction error, calculated using the Sharpe ratio, Jensen’s alpha, and the Treynor measure for publicly traded firms in the consumer discretionary and consumer staples sectors. Applying a series of independent t-tests to mean comparisons of these measures ultimately provided mixed results, demonstrating a statistically significant difference only with Jensen’s alpha and the Sharpe ratio in both sectors. This indicates a need for extra caution for asset pricing model use under potentially irrational periods.

Bad Bank Resolutions and Bank Lending
Brei, Michael,Gambacorta, Leonardo,Lucchetta, Marcella,Parigi, Bruno Maria
The paper investigates whether impaired asset segregation tools, otherwise known as bad banks, and recapitalisation lead to a recovery in the originating banks' lending and a reduction in non-performing loans (NPLs). Results are based on a novel data set covering 135 banks from 15 European banking systems over the period 2000-16. The main finding is that bad bank segregations are effective in cleaning up balance sheets and promoting bank lending only if they combine recapitalisation with asset segregation. Used in isolation, neither tool will suffice to spur lending and reduce future NPLs. Exploiting the heterogeneity in asset segregation events, we find that asset segregation is more effective when: (i) asset purchases are funded privately; (ii) smaller shares of the originating bank's assets are segregated; and (iii) asset segregation occurs in countries with more efficient legal systems. Our results continue to hold when we address the potential endogeneity problem associated with the creation of a bad bank.

Beyond Risk Parity - A Machine Learning-based Hierarchical Risk Parity Approach on Cryptocurrencies
Burggraf, Tobias,Vyas, Aditya
It has long been known that estimating large empirical covariance matrices can lead to very unstable solutions, with estimation errors more than offsetting the benefits of diversification. In this study, we employ the Hierarchical Risk Parity approach, which applies state-of-the-art mathematics including graph theory and unsupervised machine learning to a large portfolio of cryptocurrencies. An out-of-sample comparison with traditional risk-minimization methods reveals that Hierarchical Risk Parity outperforms in terms of tail risk-adjusted return, thereby working as a potential risk management tool that can help cryptocurrency investors to better manage portfolio risk. The results are robust to different covariance estimation windows and methodologies.

Cancer Diagnoses and Portfolio Choice
Doskeland, Trond,Kvaerner, Jens
We analyze portfolio choices of 70,000 households over a period where one in the family gets cancer. We find that a cancer diagnosis reduces risk-taking along the extensive margin. In contrast, having personal experience with cancer many years ago is not associated with the current portfolio choice. Fatal cancers change family composition. Widowhood increases the probability of a stock market exit for the widowed individual by a factor of 16 relative to non-fatal cancers. In line with theory, the relationship between widowhood and subsequent portfolio choice depends on the relative importance of the deceased's human capital

Competition of noise and collectivity in global cryptocurrency trading: route to a self-contained market
Stanisław Drożdż,Ludovico Minati,Paweł Oświęcimka,Marek Stanuszek,Marcin Wątorek

Cross-correlations in fluctuations of the daily exchange rates within the basket of the 100 highest-capitalization cryptocurrencies over the period October 1, 2015, through March 31, 2019, are studied. The corresponding dynamics predominantly involve one leading eigenvalue of the correlation matrix, while the others largely coincide with those of Wishart random matrices. However, the magnitude of the principal eigenvalue, and thus the degree of collectivity, strongly depends on which cryptocurrency is used as a base. It is largest when the base is the most peripheral cryptocurrency; when more significant ones are taken into consideration, its magnitude systematically decreases, nevertheless preserving a sizable gap with respect to the random bulk, which in turn indicates that the organization of correlations becomes more heterogeneous. This finding provides a criterion for recognizing which currencies or cryptocurrencies play a dominant role in the global crypto-market. The present study shows that over the period under consideration, the Bitcoin (BTC) predominates, hallmarking exchange rate dynamics at least as influential as the US dollar. The BTC started dominating around the year 2017, while further cryptocurrencies, like the Ethereum (ETH) and even Ripple (XRP), assumed similar trends. At the same time, the USD, an original value determinant for the cryptocurrency market, became increasingly disconnected, its related characteristics eventually approaching those of a fictitious currency. These results are strong indicators of incipient independence of the global cryptocurrency market, delineating a self-contained trade resembling the Forex.

Did Globalization Kill Contagion?
Accominotti, Olivier,Briere, Marie,Burietz, Aurore,Oosterlinck, Kim,Szafarz, Ariane
Does financial globalization lead to contagion? We scrutinize linkages between international stock markets in a long historical perspective (1880-2014). Our results highlight that without globalization, contagion cannot exist. However, if cross-market correlations are very high, globalization kills contagion. We show that financial contagion was absent from stock markets in both the period of deglobalization of 1918-1971 and the era of "extreme" globalization of 1972-2014 but was present in the period of "moderate" globalization of 1880-1914. Our results suggest that contagion could become a significant problem if financial markets return to a more moderate level of globalization.

Different No More: Country Spreads in Advanced and Emerging Economies
Born, Benjamin,Müller, Gernot J.,Pfeifer, Johannes,Wellmann, Susanne
Interest-rate spreads fluctuate widely across time and countries. We characterize their behavior using some 3,200 quarterly observations for 21 advanced and 17 emerging economies since the early 1990s. Before the financial crisis, spreads are 10 times more volatile in emerging economies than in advanced economies. Since 2008, the behavior of spreads has converged across country groups, largely because it has adjusted in advanced economies. We also provide evidence on the transmission of spread shocks and find it similar across sample periods and country groups. Spread shocks have become a more important source of output fluctuations in advanced economies after 2008.

Empirical Evidence on Bitcoin Returns and Portfolio Value
Mukherji, Sandip
This paper studies 60 months of recent returns to examine relationships between bitcoin and 16 exchange- traded funds of currencies, bonds, stocks, commodities, and alternative assets. Bitcoin provides much higher returns, positive skewness, volatility and extreme returns, than all the other assets. Only stocks offer a better risk-return tradeoff than bitcoin. Bitcoin returns have very weak positive correlations with stocks, commodities, and alternatives. Only two funds of stocks and commodities have significant explanatory power of about 3% each for bitcoin returns. The full model of all the 16 funds explains only 15.09% of bitcoin returns. A partial model, with the six funds that are significant in the full model, explains 12.78% of bitcoin returns; 3 stock funds and 1 commodity fund have significant coefficients in this model. These findings indicate that bitcoin is a unique asset which is only weakly related to stocks and commodities. The results also show that small allocations to bitcoin improve the risk-return tradeoffs of stock and bond portfolios.

Equity Market Reaction to Pay Dispersion: Evidence from CEO-Worker Pay Ratio Disclosure
Pan, Yihui,Pikulina, Elena,Siegel, Stephan,Wang, Tracy Yue
Starting in 2018, U.S. public companies are required to disclose the ratio of CEO to median worker pay, providing the first opportunity to examine equity markets’ reaction to within-firm pay dispersion. We find a negative market reaction to firms disclosing high pay ratios. Additional evidence suggests that equity markets “dislike” high pay dispersion independently of high CEO pay or low worker pay. In the cross-section, firms whose shareholders have stronger prosocial preferences experience a significantly more negative market response to high pay ratios. Consistent with investors’ prosocial preferences moderating the initial market reaction, we find that during 2018 investors with stronger prosocial preferences rebalance their portfolios away from high pay ratio stocks relative to other investors. Overall, our results suggest that investors’ prosocial preferences, in particular with respect to within-firm pay dispersion, is a channel through which high pay ratios negatively affect firm value.

Exchange Rate and Equity Price Relationship: Empirical Evidence from Mexican and Canadian Markets
Amba, Sekhar M.,Nguyen, Binh H.
This paper examines the relationship between stock prices and exchange rates in Mexican and Canadian Markets using weekly data from Jan 2013 to December 2018. Cointegration, Vector Error Correction model, Vector Auto Regression model and Granger causality tests are used to examine the long-term relationship and casual relationship between exchange rates and stock prices. Johansen cointegration tests confirm the insignificant existence of long-run relationships between stock prices and exchange rates in Canadian and Mexican markets. However, the Granger causality test confirms the existence of short-run unidirectional causal relationship from exchange rates to stock prices in the Mexican market.

Financial Decisions by Business Groups in India: Is It ‘Fair and Square’?
Basu, Debarati,Sen, Kaustav
Using a large sample of business-group-affiliated firms in India, we investigate whether corporate financial decisions that create internal capital markets are influenced by the extent of insider ownership. We hypothesize that insiders want to control more capital, motivated either by opportunism or efficiency.We distinguish opportunism from efficiency based on whether sales decrease or increase in the year after financial decisions are taken. We find that as insider ownership increases, a firm (i) transfers less capital into the group when sales increase in the following year, (ii) pays out less dividends when sales decrease in the following year and (iii) receives less capital from the group if it is struggling. This indicates that insiders act in an efficient manner when transferring capital across firms within the group. However, when deciding whether to return capital to investors, they retain resources even when future performance does not improve and thus act opportunistically.

Foreign Exchange Fixings and Returns Around the Clock
Krohn, Ingomar,Mueller, Philippe,Whelan, Paul
This paper documents a new stylised fact in foreign exchange markets: intraday currency returns display prolonged reversals around the major benchmark fixings, characterised by an appreciation of the U.S. dollar pre-fixing and a depreciation thereafter. Tracing returns around the clock, the major fixing during Asian trading hours (Tokyo) and two major fixings during European and U.S. hours (Frankfurt and London) generate a distinct `W' shaped return pattern over the 24-hour trading day. On either side of the reversal, price drifts persist for hours; moreover, they are a systematic feature of the data being present every day of the week, month of the year, and during each of the 20 years in our sample. We argue these findings require two ingredients (i) a structural demand for dollar immediacy at local currency fixing times; and (ii) pre-fix hedging risk management practices by financial intermediaries. Consistent with this conjecture, we show our findings are unique to the U.S dollar numeraire, amplified in states of high anticipated volatility, low liquidity, and that arbitrageurs can exploit these patterns after taking transaction costs into account.

Identifying Empty Creditors with a Shock and Micro-Data
Degryse, Hans,Gündüz, Yalin,O'Flynn, Kuchulain,Ongena, Steven
Firms with credit-default swaps (CDS) traded on their debt may face "empty creditors'' as hedged creditors have less incentive to participate in firm restructuring. We test for the existence of empty creditors by employing an exogenous change to the bankruptcy code in Germany, that effectively removes their potential impact on CDS firms. Using a unique dataset on bank-firm CDS net notional and credit exposures we find that the probability of default for firms with CDS traded on them drops when the effect of empty creditors is removed. This effect increases in the average CDS hedge position of a firm's creditors and in the concentration of the firm's debt. Further, we find that firms with longer credit relationships, with higher average collateral ratios of their debt, and financially safer firms are less affected by empty creditors. Banks that are not capital constrained, and that are liquidity constrained recognise the empty creditor effect to a larger extent. Furthermore, banks' business models affect the degree to which they recognise the empty creditor effect. Where banks that monitor their creditors less and that earn a smaller portion of their income from interest activities, recognise the empty creditor effect to a larger extent.

Impacts of Fiscal Reform on Dividends: Evidence from Mexico
Corona Dueñas, José Asunción,Corona Pacheco, César
This paper addresses the Mexican 2014 Tax Reform. Specifically, we examine the distribution of dividends made by thirty-five companies that make up the Price and Quotation Index of the Mexican Stock Exchange. We also examine shareholders who receive the dividends. Results show that companies refrained from declaring dividends in 2014 and payments normalized in 2015. Since 2015, as a result of the 2014 Tax Reform, which required shareholders who receive dividends to pay an extra tax of 10%, dividends have become les desirable. Companies have accumulated profits destined for reinvestment in the company.

International Factor Models
Huber, Daniel,Preissler, Fabian
We compare prominent factor models from Behavioral finance (Daniel, Hirshleifer, and Sun, 2019; Stambaugh and Yuan, 2016) and Neoclassical finance (Sharpe, 1964 and Lintner, 1965; Fama and French, 1993, 2015, 2018) on the four regions North America, Europe, Asia Pacific and Japan based on the maximum squared Sharpe ratio. Relying on the pairwise model comparison test introduced by Barillas et al. (2019), we find that the Daniel, Hirshleifer, and Sun (2019) three-factor model dominates all other models besides the Stambaugh and Yuan (2016) four-factor model in North America. In Europe, both the Daniel, Hirshleifer, and Sun (2019) and the Stambaugh and Yuan (2016) model dominate all other models, with no significant difference between them. In Asia Pacific, the Stambaugh and Yuan (2016) model dominates all other models besides the Daniel, Hirshleifer, and Sun (2019) model. In Japan, the Stambaugh and Yuan (2016) model has the highest in-sample maximum squared Sharpe ratio, but only the difference to the CAPM is significant. These results are supported by a multiple model comparison test and by means of a bootstrap simulation. Overall, it appears that the models from Behavioral finance are internationally very strong.

Investors' Appetite for Money-Like Assets: The Mmf Industry after the 2014 Regulatory Reform
Cipriani, Marco,La Spada, Gabriele
This paper uses a quasi-natural experiment to estimate the premium for money-likeness. The 2014 SEC reform of the money market fund (MMF) industry reduced the money-likeness of prime MMFs by increasing their information sensitivity, while leaving government MMFs unaffected. Investors fled from prime to government MMFs, with total outflows exceeding 1 trillion dollars. Using a difference-in-differences design, we estimate the premium for money-likeness to be between 20 and 30 basis points. These premiums are not due to changes in investors' risk tolerance or funds' risk taking. Our results support recent developments in monetary theory identifying information insensitivity as a key feature of money.

Knowledge Diffusion Process & Common Islamic Banking Governance Principles: Integrative Perspective (s) of Managers and Shariah Scholars
Adnan Malik,Dr. Karim Ullah,Dr. Shakir Ullah

Islamic banks being commercial entities strive to earn profit within shariah ambit. Therefore, they seem to be basing themselves upon two knowledge streams namely i) Islamic jurisprudence principles, and ii) banking principles. Islamic jurisprudence principles primarily aim at bringing shariah compliance while banking principles focus profitability. These principles, making two schools of thought in the discipline, however, have their unique philosophies, principles, and practices, which are now gradually diffusing into an emergent set of governance principles basing the contemporary Islamic banking theory and practice. Governance systems of Islamic banks have elements of both conventional as well as Shariah, and need to have principles having components of banking and shariah sufficiently diffused for their successful operations in a longer term. Aim of this research is to review the literature about the knowledge diffusion process of islamic banking principles which guides the governance of Islamic banks. This study review the literature using a method in which focus remain on bridging different areas which in this case are knowledge diffusion and islamic banking governance principles.

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. Equilibrium learning may be slow when agents do not observe all predecessors, 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 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.

Low-Carbon Investment and Credit Rationing
Haas, Christian,Kempa, Karol
This paper analyses low-carbon investments using a principal-agent model with information asymmetries between borrowing firms and lenders. Firms can choose between a risk-free dirty technology and a risky low-carbon technology requiring initial external funding. We find that an emission tax alone is not welfare-maximising due to credit rationing of firms. Public interest subsidies or loan guarantees eliminate credit rationing and yield a first-best outcome. If emission taxes are (politically) not feasible, financing instruments alone can yield a second-best outcome. Our dynamic analysis shows that any intervention on credit markets is finite. Without such intervention, there are social costs of delay.

Mathematical Foundations of Regression Methods for the approximation of the Forward Initial Margin
Lucia Cipolina Kun

Abundant literature has been published on approximation methods for the forward initial margin. The most popular ones being the family of regression methods. This paper describes the mathematical foundations on which these regression approximation methods lie. We introduce mathematical rigor to show that in essence, all the methods propose variations of approximations for the conditional expectation function, which is interpreted as an orthogonal projection on Hilbert spaces. We show that each method is simply choosing a different functional form to numerically estimate the conditional expectation. We cover in particular the most popular methods in the literature so far, Polynomial approximation, Kernel regressions and Neural Networks.

Measuring Regulatory Complexity
Colliard, Jean-Edouard,Georg, Co-Pierre
Despite a heated debate on the perceived increasing complexity of financial regulation, there is no available measure of regulatory complexity other than the mere length of regulatory documents. To fill this gap, we propose to apply simple measures from the computer science literature by treating regulation like an algorithm: a fixed set of rules that determine how an input (e.g., a bank balance sheet) leads to an output (a regulatory decision). We apply our measures to the regulation of a bank in a theoretical model, to an algorithm computing capital requirements based on Basel I, and to actual regulatory texts. Our measures capture dimensions of complexity beyond the mere length of a regulation. In particular, shorter regulations are not necessarily less complex, as they can also use more "high-level" language and concepts. Finally, we propose an experimental protocol to validate measures of regulatory complexity.

On the statistics of scaling exponents and the Multiscaling Value at Risk
Giuseppe Brandi,T. Di Matteo

Scaling and multiscaling financial time series have been widely studied in the literature. The research on this topic is vast and still flourishing. One way to analyse the scaling properties of time series is through the estimation of scaling exponents. These exponents are recognized as being valuable measures to discriminate between random, persistent, and anti-persistent behaviours in time series. In the literature, several methods have been proposed to study the multiscaling property and in this paper we use the generalized Hurst exponent (GHE). On the base of this methodology, we propose a novel statistical procedure to robustly estimate and test the multiscaling property and we name it RNSGHE. This methodology, together with a combination of t-tests and F-tests to discriminated between real and spurious scaling. Moreover, we also introduce a new methodology to estimate the optimal aggregation time used in our methodology. We numerically validate our procedure on simulated time series using the Multifractal Random Walk (MRW) and then apply it to real financial data. We also present results for times series with and without anomalies and we compute the bias that such anomalies introduce in the measurement of the scaling exponents. Finally, we show how the use of proper scaling and multiscaling can ameliorate the estimation of risk measures such as Value at Risk (VaR). We also propose a methodology based on Monte Carlo simulation, that we name Multiscaling Value at Risk (MSVaR), which takes into account the statical properties of multiscaling time series. We show that by using this statistical procedure in combination with the robustly estimated multiscaling exponents, the one year forecasted MSVaR mimics the VaR on the annual data for the majority of the stocks analysed.

Optimization by Hybridization of a Genetic Algorithm with the PROMOTHEE Method: Management of Multicriteria Localization
Myriem Alijo,Otman Abdoun,Mostafa Bachran,Amal Bergam

The decision to locate an economic activity of one or several countries is made taking into account numerous parameters and criteria. Several studies have been carried out in this field, but they generally use information in a reduced context. The majority are based solely on parameters, using traditional methods which often lead to unsatisfactory solutions.This work consists in hybridizing through genetic algorithms, economic intelligence (EI) and multicriteria analysis methods (MCA) to improve the decisions of territorial localization. The purpose is to lead the company to locate its activity in the place that would allow it a competitive advantage. This work also consists of identifying all the parameters that can influence the decision of the economic actors and equipping them with tools using all the national and international data available to lead to a mapping of countries, regions or departments favorable to the location. Throughout our research, we have as a goal the realization of a hybrid conceptual model of economic intelligence based on multicriteria on with genetic algorithms in order to optimize the decisions of localization, in this perspective we opted for the method of PROMETHEE (Preference Ranking Organization for Method of Enrichment Evaluation), which has made it possible to obtain the best compromise between the various visions and various points of view.

Organizational Form and Access to Capital: The Role of Regulatory Interventions
Basu, Debarati,Sen, Kaustav
We examine the impact of a regulation that requires only disclosure of ownership information and no real change of firm fundamentals, on a firm’s access to capital. As a first of its kind corporate governance regulation across the globe, Clause 35 of the Securities Exchange Board of India required firms to classify shareholders into insiders and outsiders only, with no other structural changes. Using a large sample of publicly traded firms in India, a market characterized by weak enforcement and concentrated ownership, we find that prior to the regulation and as expected from literature, group-affiliated firms exhibited better access to capital (lower investment-cash flow sensitivity) than standalone firms. However, this reverses after the regulation, i.e., group-affiliated firms face more financial constraints (higher investment-cash flow sensitivity). This increase in sensitivity is restricted to only group firms with higher insider ownership, especially for firms which have no compensating mechanisms (weaker governance/monitoring) or perform poorly in the future. In essence, we find that regulation exclusively requiring information disclosure has been effective in reallocating capital more efficiently to firms with fewer agency problems.

Quantum coupled-wave theory of price formation in financial markets: price measurement, dynamics and ergodicity
Jack Sarkissian

We explore nature of price formation in financial markets and develop a theory of bid and ask price dynamics in which the two prices form due to quantum-chaotic interaction between buy and sell orders. In this model bid and ask prices are represented by eigenvalues of a 2x2 price operator corresponding to 'bid' and 'ask' eigenstates, while randomness of price operator results in price fluctuations that destroy oscillatory effects. We show that this theory adequately captures behavior of bid-ask spread and allows to model bid and ask price dynamics in a coordinated way. We also discuss ergodicity properties of price formation and show how directional price movement occurs due to ergodicity violation in a quantum process instead of the commonly believed forces acting on price. This theory has wide range of applications such as trade execution modeling, large order pricing and risk valuation for illiquid securities.

Ramsey Optimal Policy versus Multiple Equilibria with Fiscal and Monetary Interactions
Jean-Bernard Chatelain,Kirsten Ralf

We consider a frictionless constant endowment economy based on Leeper (1991). In this economy, it is shown that, under an ad-hoc monetary rule and an ad-hoc fiscal rule, there are two equilibria. One has active monetary policy and passive fiscal policy, while the other has passive monetary policy and active fiscal policy. We consider an extended setup in which the policy maker minimizes a loss function under quasi-commitment, as in Schaumburg and Tambalotti (2007). Under this formulation there exists a unique Ramsey equilibrium, with an interest rate peg and a passive fiscal policy. We thank John P. Conley, Luis de Araujo and one referree for their very helpful comments.

Regulatory Forbearance in the U.S. Insurance Industry: The Effects of Eliminating Capital Requirements
Becker, Bo,Opp, Marcus M.,Saidi, Farzad
This paper documents the long-run effects of an important reform of capital regulation for U.S. insurance companies in 2009.

Statistical analysis and stochastic interest rate modelling for valuing the future with implications in climate change mitigation
Josep Perelló,Miquel Montero,Jaume Masoliver,J. Doyne Farmer,John Geanakoplos

High future discounting rates favor inaction on present expending while lower rates advise for a more immediate political action. A possible approach to this key issue in global economy is to take historical time series for nominal interest rates and inflation, and to construct then real interest rates and finally obtaining the resulting discount rate according to a specific stochastic model. Extended periods of negative real interest rates, in which inflation dominates over nominal rates, are commonly observed, occurring in many epochs and in all countries. This feature leads us to choose a well-known model in statistical physics, the Ornstein-Uhlenbeck model, as a basic dynamical tool in which real interest rates randomly fluctuate and can become negative, even if they tend to revert to a positive mean value. By covering 14 countries over hundreds of years we suggest different scenarios and include an error analysis in order to consider the impact of statistical uncertainty in our results. We find that only 4 of the countries have positive long-run discount rates while the other ten countries have negative rates. Even if one rejects the countries where hyperinflation has occurred, our results support the need to consider low discounting rates. The results provided by these fourteen countries significantly increase the priority of confronting global actions such as climate change mitigation. We finally extend the analysis by first allowing for fluctuations of the mean level in the Ornstein-Uhlenbeck model and secondly by considering modified versions of the Feller and lognormal models. In both cases, results remain basically unchanged thus demonstrating the robustness of the results presented.

Tail Option Pricing Under Power Laws
Nassim Nicholas Taleb,Brandon Yarckin,Chitpuneet Mann,Damir Delic,Mark Spitznagel

We build a methodology that takes a given option price in the tails with strike $K$ and extends (for calls, all strikes > $K$, for puts all strikes $< K$) assuming the continuation falls into what we define as "Karamata Constant" over which the strong Pareto law holds. The heuristic produces relative prices for options, with for sole parameter the tail index $\alpha$, under some mild arbitrage constraints.

Usual restrictions such as finiteness of variance are not required.

The methodology allows us to scrutinize the volatility surface and test various theories of relative tail option overpricing (usually built on thin tailed models and minor modifications/fudging of the Black-Scholes formula).

The Choice Channel of Financial Innovation
Iachan, Felipe,Nenov, Plamen,Simsek, Alp
Financial innovation in recent decades has expanded portfolio choice. We investigate how greater choice affects investors' savings and asset returns. We establish a choice channel by which greater portfolio choice increases investors' savings---by enabling them to earn the aggregate risk premium or to take speculative positions. In equilibrium, portfolio customization (access to risky assets beyond the market portfolio) reduces the risk-free rate. Participation (access to the market portfolio) reduces the risk premium but typically increases the risk-free rate. Empirically, stock market participants in the U.S. save more than nonparticipants, and have increasingly dispersed portfolio returns, consistent with the choice channel.

The European Supervisory Authorities (ESAs) As 'Direct' Supervisors in the EU Financial System
Gortsos, Christos,Lagaria, Katerina
The European Supervisory Authorities (the ‘ESAs’) form part of a large network of EU agencies and are classified as regulatory agencies, their principal tasks being the development and completion of the ‘single rulebook’ for the EU financial system. The ESAs also promote supervisory convergence in order to create a level-playing field in financial supervision and supervisory practices in the EU. In the absence of an explicit legal basis in the TFEU for the allocation of competence to EU agencies, their powers are delimited, shaped and amenable to judicial review in light of relevant CJEU jurisprudence, most importantly, the Meroni doctrine, laying down the core principles governing relations between EU institutions and EU agencies. In this study, we look into the gradually emerging (and increasing) asymmetry in supervisory terms between the ESMA, on the one hand, and the EBA and the EIOPA, on the other. The former’s direct supervisory powers have been progressively expanding and technocratic influence widening, accentuated by recent relevant case-law modernising the Meroni doctrine and the recent amendment of the ESAs’ founding Regulations mirroring the ambition to move towards further centralisation of supervision of EU capital markets. The aim of this paper is to contribute to the ongoing debate arising from the ESAs’ developing role and position within the EU financial system.

Timing Excess Returns A cross-universe approach to alpha
Marc Rohloff,Alexander Vogt

We present a simple model that uses time series momentum in order to construct strategies that systematically outperform their benchmark. The simplicity of our model is elegant: We only require a benchmark time series and several related investable indizes, not requiring regression or other models to estimate our parameters. We find that our one size fits all approach delivers significant outperformance in both equity and bond markets while meeting the ex-ante risk requirements, nearly doubling yearly returns vs. the MSCI World and Bloomberg Barclays Euro Aggregate Corporate Bond benchmarks in a long-only backtest. We then combine both approaches into an absolute return strategy by benchmarking vs. the Eonia Total Return Index and find significant outperformance at a sharpe ratio of 1.8. Furthermore, we demonstrate that our model delivers a benefit versus a static portfolio with fixed mean weights, showing that timing of excess return momentum has a sizeable benefit vs. static allocations. This also applies to the passively investable equity factors, where we outperform a static factor exposure portfolio with statistical significance. Also, we show that our model delivers an alpha after deducting transaction costs.

Unconditional Conservatism and Subsequent Real Earnings Management
Basu, Debarati,Sen, Kaustav
By focusing on the more pervasive unconditional conservatism, we provide fresh insights on how conservatism can be detrimental to financial reporting quality. We examine whether unconditionally conservative (UC) firms engage in more real earnings management (REM) in order to meet or beat earnings benchmarks (MBE). UC firms are expected to be prudent with persistently lower earnings. REM, on the contrary, is an expensive way, with long-term consequences, of manipulating earnings upwards. As expected, we find UC firms display higher discretionary expenses. However, UC firms suspected of engaging in MBE cut back on these expenses (REM) by 0.5 to 2 percent of earnings. Our results reveal differences in manipulation strategies adopted across different organizational forms: group-affiliated UC firms use this strategy opportunistically. Stronger monitoring decreases the level of REM at UC firms. Additionally, accruals manipulation and insider ownership affect an UC firm’s REM choices. Thus, decisions to manage real earnings and choose conservative reporting policies may be intertwined, adding to the debate about conservatism reducing reporting quality. Our findings identify opportunistic behaviour and real costs associated with being conservative which is counter-intuitive and a serious regulatory concern that standard setters and policy makers should consider.

Visualizing Treasury Issuance Strategy
Christopher Cameron

We introduce simple cost and risk proxy metrics that can be attached to Treasury issuance strategy to complement analysis of the resulting portfolio weighted-average maturity (WAM). These metrics are based on mapping issuance fractions to their long-term, asymptotic portfolio implications for cost and risk under mechanical debt-rolling dynamics. The resulting mapping enables one to visualize tradeoffs involved in contemplated issuance reallocation, and identify an efficient frontier and optimal tenor. Historical Treasury issuance strategy is analyzed empirically using these cost and risk metrics to illustrate how changes in issuance needs and strategy have translated into structural shifts in the cost and risk stance of Treasury issuance.