Research articles for the 2020-02-19

AutoAlpha: an Efficient Hierarchical Evolutionary Algorithm for Mining Alpha Factors in Quantitative Investment
Tianping Zhang,Yuanqi Li,Yifei Jin,Jian Li

The multi-factor model is a widely used model in quantitative investment. The success of a multi-factor model is largely determined by the effectiveness of the alpha factors used in the model. This paper proposes a new evolutionary algorithm called AutoAlpha to automatically generate effective formulaic alphas from massive stock datasets. Specifically, first we discover an inherent pattern of the formulaic alphas and propose a hierarchical structure to quickly locate the promising part of space for search. Then we propose a new Quality Diversity search based on the Principal Component Analysis (PCA-QD) to guide the search away from the well-explored space for more desirable results. Next, we utilize the warm start method and the replacement method to prevent the premature convergence problem. Based on the formulaic alphas we discover, we propose an ensemble learning-to-rank model for generating the portfolio. The backtests in the Chinese stock market and the comparisons with several baselines further demonstrate the effectiveness of AutoAlpha in mining formulaic alphas for quantitative trading.

Bad Money
Awrey, Dan
Money is, always and everywhere, a legal phenomenon. In the United States, the vast majority of the money supply consists of monetary liabilities â€" contractually enforceable promises â€" issued by commercial banks and money market funds. These private financial institutions are subject to highly sophisticated public regulatory frameworks designed, in part, to enhance the credibility of these promises. These regulatory frameworks thus give banks and money market funds an enormous comparative advantage in the issuance of monetary liabilities, transforming otherwise risky legal claims into so-called “safe assets” â€" good money. Despite this advantage, recent years have witnessed an explosion in the number and variety of financial institutions seeking to issue monetary liabilities. This new breed of monetary institutions includes peer-to-peer payment platforms such as PayPal and aspiring stablecoin issuers such as Facebook’s Libra Association. The defining feature of these new monetary institutions is that they seek to issue money outside the perimeter of conventional bank and money market fund regulation. This paper represents the first comprehensive examination of the antiquated patchwork of state regulatory frameworks that currently, or might soon, govern these new institutions. It finds that these frameworks are characterized by significant heterogeneity and often fail to meaningfully enhance the credibility of the promises that these institutions make to the holders of their monetary liabilities. Put bluntly: these institutions are issuing bad money. This paper therefore proposes a National Money Act designed to strengthen and harmonize the regulatory frameworks governing these new institutions and promote a more level competitive playing field.

Beautiful Asset: Art as Investment
Mei, Jianping,Moses, Michael
For centuries, wealthy individuals and institutions have collected and consumed art for aesthetic pleasure. While anecdotal evidence suggests that some artworks have appreciated in value over time, few studies have documented investment returns in art systematically. In this article, we demonstrate that art could be an important asset class in many respects, worthy of addition to the long-term investment portfolios of individuals and institutions. Because individual works of art are not securitized, studying the value of works of art from financial sources is not possible. Gallery or direct-from-artists prices tend not to be reliable or easily obtainable. Auction prices, however, are reliable and publicly available. As a result, auction prices can be used as the basis for a database for determining the change in value of art objects over various holding periods.

Do Actions Speak Louder than Words? Evidence from Microblogs
Goutte, Maud
This research identifies the determinants of investors' future beliefs by analyzing more than 50 million tweets on thousands of stocks from the microblogging platform StockTwits. To distinguish between the different sources of changes in beliefs, I divide tweets into two categories: beliefs, representing the average sentiment of all investors regarding a particular stock, and actions, representing the actual transactions disclosed by StockTwits' users in their tweets. The results show that investors’ average next-period beliefs are positively impacted by the average sentiment (beliefs and actions) of the previous day. The effect is stronger once the quality of the investment advice is taken into account. Finally, more communication between investors is associated with greater diversity in beliefs as well as higher uncertainty.

Do Profit Margins Expand for High Growth Firms?
Ertan, Aytekin,Lewellen, Stefan,Thomas, Jacob K.
It is common in business analyses to invoke different efficiencies generated by scale. Growth is associated with declining average costs/sales and rising profit margins. Factors cited include the relatively fixed nature of some costs, increased bargaining power, and network effects. We investigate how different cost lines evolve for a sample of US firms after their IPO. To our surprise, costs/sales do not generally decline and margins do not increase, even during the early years when growth is highest. We observe similar results for other samples of domestic and overseas firms, both public and private. We explore possible explanations for our results and discuss implications, especially for cost allocation and financial projections.

Does Corporate Governance Quality Influence Private In-House Meeting Frequency and Insider Trading?
Bowen, Robert M.,Dutta, Shantanu,Tang, Songlian,Zhu, PengCheng
We examine the effectiveness of corporate governance in monitoring private in-house meetings between management and investors. Consistent with better corporate governance curbing the opportunistic corporate disclosure and insider trading behavior, we find a negative association between governance quality and (i) private in-house meeting frequency, (ii) reduced insider trading frequency and value around private in-house meetings, and (iii) reduced insider trading profitability around these meetings. We document a potential channel that may explain these findings. Particularly, we find that firms with better corporate governance tend to reduce leakage of price-sensitive information during private in-house meetings, which limits the opportunity to make profitable insider trades. Our results are robust using instrumental variable and propensity score matching approaches to address endogeneity. We argue that improving corporate governance quality may be a partial substitute for costly government regulation designed to curb negative consequences of private in-house meetings.

Endogenous Liquidity Crises
Antoine Fosset,Jean-Philippe Bouchaud,Michael Benzaquen

Empirical data reveals that the liquidity flow into the order book (depositions, cancellations andmarket orders) is influenced by past price changes. In particular, we show that liquidity tends todecrease with the amplitude of past volatility and price trends. Such a feedback mechanism inturn increases the volatility, possibly leading to a liquidity crisis. Accounting for such effects withina stylized order book model, we demonstrate numerically that there exists a second order phasetransition between a stable regime for weak feedback to an unstable regime for strong feedback,in which liquidity crises arise with probability one. We characterize the critical exponents, whichappear to belong to a new universality class. We then propose a simpler model for spread dynamicsthat maps onto a linear Hawkes process which also exhibits liquidity crises. If relevant for thereal markets, such a phase transition scenario requires the system to sit below, but very close tothe instability threshold (self-organised criticality), or else that the feedback intensity is itself timedependent and occasionally visits the unstable region. An alternative scenario is provided by a classof non-linear Hawkes process that show occasional "activated" liquidity crises, without having to bepoised at the edge of instability.

Evidence on the Performance of Infrastructure Mutual Fund
Kammoun, Manel,Tandja M., Djerry C.
This paper investigates, empirically, whether infrastructure-focused mutual funds provide superior performance (higher alphas) than their comparable equity mutual funds not investing in infrastructure. Using monthly returns on U.S. equity mutual funds, the “best clientele performance measure” developed by Chrétien and Kammoun (2017) and the generalized method of moments (GMM) estimation, we find that infrastructure-focused mutual funds have higher alphas (higher best clientele alphas) than their comparable not investing in infrastructure. Our results support the growing belief that infrastructure-focused equity mutual funds are able to provide superior performance resulting from the financial characteristics of infrastructure. Furthermore, our results show also that the investor disagreement about the performance of infrastructure-focused equity mutual funds is not significantly different from that of their comparable not investing in infrastructure.

Executive stock option exercise with full and partial information on a drift change point
Vicky Henderson,Kamil Kladívko,Michael Monoyios,Christoph Reisinger

We analyse the optimal exercise of an American call ESO written on a stock whose drift parameter falls to a lower value at a \emph{change point}, an exponentially distributed random time independent of the Brownian motion driving the stock. Two agents, who do not trade the stock, have differing information on the change point, and seek to optimally exercise the option by maximising its discounted payoff under the physical measure. The first agent has full information, and observes the change point. The second agent has partial information and filters the change point from price observations. This scenario is designed to mimic the positions of two employees of varying seniority, a fully informed executive and a partially informed less senior employee, each of whom receives an ESO. The partial information scenario yields a model under the observation filtration $\widehat{\mathbb{F}}$ in which the stock drift becomes a diffusion driven by the innovations process, an $\widehat{\mathbb{F}}$-Brownian motion also driving the stock under $\widehat{\mathbb{F}}$, and the partial information optimal stopping value function has two spatial dimensions. We rigorously characterise the free boundary PDEs for both agents, establish shape and regularity properties of the associated optimal exercise boundaries, and prove the smooth pasting property in both information scenarios, exploiting some stochastic flow ideas to do so in the partial information case. We develop finite difference algorithms to numerically solve both agents' exercise and valuation problems and illustrate that the additional information of the fully informed agent can result in exercise patterns which exploit the information on the change point, lending credence to empirical studies which suggest that privileged information of bad news is a factor leading to early exercise of ESOs prior to poor stock price performance.

How Do Expectations Affect Learning About Fundamentals? Some Experimental Evidence
Kieran Marray,Nikhil Krishna,Jarel Tang

Individuals' output often depends not just on their ability and actions, but also on external factors or fundamentals, whose effect they cannot separately identify. At the same time, many individuals have incorrect beliefs about their own ability. Heidhues et al. (2018) characterise overconfident and underconfident individuals' equilibrium beliefs and learning process in these situations. They argue overconfident individuals will act sub-optimally because of how they learn. We carry out the first experimental test of their theory. Subjects take incorrectly marked tests, and we measure how they learn about the marker's accuracy over time. We use machine learning to identify heterogeneous effects. Overconfident subjects have lower beliefs about the fundamental, as Heidhues et al. predict, and thus would make sub-optimal decisions. But we find no evidence it is because of how they learn.

Inventory effects on the price dynamics of VSTOXX futures quantified via machine learning
Daniel Guterding

The VSTOXX index tracks the expected 30-day volatility of the EURO STOXX 50 equity index. Futures on the VSTOXX index can, therefore, be used to hedge against economic uncertainty. We investigate the effect of trader inventory on the price of VSTOXX futures through a combination of stochastic processes and machine learning methods. We formulate a simple and efficient pricing methodology for VSTOXX futures, which assumes a Heston-type stochastic process for the underlying EURO STOXX 50 market. Under these dynamics, approximate analytical formulas for the implied volatility smile and the VSTOXX index have recently been derived. We use the EURO STOXX 50 option implied volatilities and the VSTOXX index value to estimate the parameters of this Heston model. Following the calibration, we calculate theoretical VSTOXX future prices and compare them to the actual market prices. While theoretical and market prices are usually in line, we also observe time periods, during which the market price does not agree with our Heston model. We collect a variety of market features that could potentially explain the price deviations and calibrate two machine learning models to the price difference: a regularized linear model and a random forest. We find that both models indicate a strong influence of accumulated trader positions on the VSTOXX futures price.

Is Average Correlation Related to Expected Returns: Evidence From Global Markets
Peterburgsky, Stanley,Baek, Seungho
We examine whether average country-level stock market correlation is related to global equity returns. Previous research focusing on the U.S. suggests that average firm-level correlation captures some of the risk not accounted for by other variables and is positively related to returns on the broad stock market. In contrast, we find that average country-level correlation does not appear to be related to global returns, and that the Roll (1977) critique is not responsible for this lack of relation. Empirically, average correlation does not help forecast returns.

Low-carbon Mutual Funds
Ceccarelli, Marco,Ramelli, Stefano,Wagner, Alexander F.
We show that mutual funds compete for climate-conscious investment flows. In April 2018, Morningstar introduced a climate-focused label for mutual funds. The release of the "Low Carbon Designation" induced reactions on both the demand and supply sides of the market. First, investors flocked to funds receiving this eco-label. Second, active funds that missed the label at its initial release responded to the new incentive by shifting their holdings towards more climate-friendly firms. In sum, climate-related information can trigger competition by financial intermediaries along their climate performance. However, the resulting portfolio shifts may also expose investors to higher idiosyncratic risks.

Managerial Ability and Revenue-Expense Matching: Accrual Estimation versus Business Decision
Cho, Hyungjin
This study investigates the association between managerial ability and the matching between revenue and expense. I expect the firms having managers with better ability to exhibit better contemporaneous revenue-expense matching because more capable managers are able to estimate accruals more accurately and select the projects with smaller early cash outflows. The empirical analysis presents that firms with higher managerial ability have better contemporaneous revenue-expense matching, whereas the relation between current revenue and past expense is weaker for such firms. These findings are attributable to both accrual estimations and project selections, while the former effect seems to be stronger than the latter. These results indicate that the relation between managerial ability and earnings quality measure implies the accrual estimation effect as well as the project selection effect.

Momentum Effect, Value Effect, Risk Premium and Predictability of Stock Returns â€" A Study on Indian Market
Banerjee, Arindam,De, Anupam,Bandyopadhyay, Gautam
The efficient market hypothesis (EMH), one of the central pillars of modern financial theories, often fails to explain the ‘financial anomalies’. One fatal challenge of EMH probably comes from the theoretical assumption of ‘rational man’. According to EMH, the fully rational investor may change his demand for financial assets on the basis of available information. According to EMH, at any given point of time, the stock price should reflect all the available information, and predictability of stock returns should be impossible. However, the literature shows ample evidence of abnormal returns related to firm and market-specific attributes. In financial literature, these variations are often termed as ‘financial anomalies’. Within the framework of behavioral finance, there are research results that contain evidence on the predictability of future stock market returns based on financial anomalies (Stanivuk et al., 2012). Value effect and momentum effect are the two prominent financial anomalies (Ho, 2012). This paper explores the predictability of Indian stock market returns using multiple discriminant analysis. Our result shows that the risk premium, momentum and value effect may have significant power for predicting the Indian stock market returns. The validity test of the model also corroborates the impact of financial anomalies over the predictability of stock returns.

Mutual Fund Participation in Private In-house Meetings: Evidence from Firms Listed on the Shenzhen Stock Exchange
Bowen, Robert M.,Dutta, Shantanu,Tang, Songlian,Zhu, PengCheng
The Shenzhen Stock Exchange (SZSE) in China is unique worldwide in requiring disclosure of the timing, participants and selected content of private in-house meetings between firm managers and outside investors. We investigate whether these private meetings benefit hosting-firms and their major outside institutional investors, mutual funds. Using a large hand-collected dataset of SZSE firms, we find that mutual funds with relatively large ownership in the hosting firm (i) have more access to private in-house meetings, particularly those meetings that reveal negative information, (ii) interact more often with top management, (iii) attend more exclusive meetings, and (iv) have longer meetings with hosting firms. When mutual funds with relatively large ownership attend negative news meetings, firms tend to experience lower post-meeting stock return volatility. This finding suggests that allowing managers and select institutional investors to discuss negative developments in a private setting â€" possibly to provide elaboration and manage the news â€" helps minimize stock sell-offs and mitigate stock return volatility.

On the Reliability of Structural Methods in Merger Review. Evidence from the US Airline Industry
Capodaglio, Giacomo
The objective of this study is to provide evidence on the accuracy of merger simulation methods, which have become common instruments to evaluate ex-ante the effects of complex transactions. In particular, I study the price effects of one of the most important mergers in the U.S. airline industry, namely the 2013 American Airlines â€" US Airways merger. Drawing from the theoretical background of the Empirical Industrial Organization, I perform an empirical investigation in three steps. In the first place, I estimate a nested logit demand system. Secondly, I use the retrieved parameters to predict the effects of the merger under scrutiny. Lastly, the forecast is evaluated ex post using data from the period following the transaction, by means of difference-in-differences techniques. Results show that, in this case, simulation methods underpredicted - although not substantially - the increases in prices.

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

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

Price impact equilibrium with transaction costs and TWAP trading
Eunjung Noh,Kim Weston

We prove the existence of an equilibrium in a model with transaction costs and price impact where two agents are incentivized to trade towards a target. The two types of frictions -- price impact and transaction costs -- lead the agents to two distinct changes in their optimal investment approach: price impact causes agents to continuously trade in smaller amounts, while transaction costs cause the agents to cease trading before the end of the trading period. As the agents lose wealth because of transaction costs, the exchange makes a profit. We prove the existence of a strictly positive optimal transaction cost from the exchange's perspective.

Private Equity Value Creation in Finance: Evidence from Life Insurance
Kirti, Divya,Sarin, Natasha
This paper studies how private equity buyouts create value in the insurance industry, where decentralized regulation creates opportunities for aggressive tax and capital management. Using novel data on 57 large private equity deals in the insurance industry, we show that buyouts create value by decreasing insurers’ tax liabilities; and by reaching-for-yield: PE firms tilt their subsidiaries’ bond portfolios toward junk bonds while avoiding corresponding capital charges. Previous work on affiliated or “shadow” reinsurance and capital management misses the important role that private equity buyouts play as recent drivers of these phenomenon. The trend we document is of growing importance in the private equity industry, with insurance accounting for close to a tenth of all PE deals from 2010-2014.

Serial Entrepreneurs: Evidence from SPACs
Marvin, Kristi,Tykvova, Tereza,Vulanovic, Milos
This study examines whether the serial entrepreneurial experience of founders contributes to improved overall performance using a sample of Specified Purpose Acquisition Companies (SPACs) innovative firms that entered the U.S. financial markets since August 2003. Based on subsample analysis, evidence shows that previous experience has significant positive implications for the likelihood of the SPACs merger and consequently for value creation.

Shareholder Stewardship in the Netherlands: The Role of Institutional Investors in a Stakeholder Oriented Jurisdiction
Van der Elst, Christoph,Lafarre, Anne
We study institutional investors’ voice in the Netherlands, focusing on shareholder voting in particular. The Dutch Stewardship Code, developed by institutional investor platform Eumedion, came into force in January 2019, emphasises engagement and responsibilities of institutional investors in Dutch listed companies and should further boost the engagement with the investees. With a new dataset, we observe that institutional investors critically consider (non) current voting items which could negatively affect shareholder rights, like some of the amendments of the articles of association as well as remuneration packages of directors that contain insufficient or inappropriate incentives. Compared to other investors, institutional investors show significantly higher opposition rates. Particularly, Eumedion members show even higher opposition rates than other institutional investors. However, there may still be room for a stronger focus on the activities and outcomes of stewardship, including changing the behaviour of companies, and not just policy statements.

Shelter from the Storm: Which Safe Asset for Climate Disasters?
Lanfear, Matthew,Lioui, Abraham,Siebert, Mark
Hurricanes give rise to flight-to-safety episodes during which equity market realized volatility increases and stock prices are depressed. Using an event study, we show that High Tech stocks consistently behave differently from stocks in other indus- tries. Converting their abnormal, risk-adjusted, returns into a certainty equivalent, we show that it is systematically greater than the short-term bond return. High Tech stocks’ prices include a safety premium of at least 3.75% annualized and peaks at 16% annualized for periods of up to 20 days after hurricanes made landfall. This safe asset feature and the safety premium attached to it has strengthened in the period since the 2008 Global Financial Crisis. The flight-to-safety is not associated with a flight-to-liquidity episode, nor with changing risk aversion, but is a flight-to- quality. The robust findings confirm that risky assets (High Tech stocks) can act as safe assets during periods of market distress caused by extreme weather events.

The interconnectedness of the economic content in the speeches of the US Presidents
Matteo Cinellia Valerio Ficcadenti,Jessica Riccionib

The speeches stated by influential politicians can have a decisive impact on the future of a country. In particular, the economic content of such speeches affects the economy of countries and their financial markets. For this reason, we examine a novel dataset containing the economic content of 951 speeches stated by 45 US Presidents from George Washington (April 1789) to Donald Trump (February 2017). In doing so, we use an economic glossary carried out by means of text mining techniques. The goal of our study is to examine the structure of significant interconnections within a network obtained from the economic content of presidential speeches. In such a network, nodes are represented by talks and links by values of cosine similarity, the latter computed using the occurrences of the economic terms in the speeches. The resulting network displays a peculiar structure made up of a core (i.e. a set of highly central and densely connected nodes) and a periphery (i.e. a set of non-central and sparsely connected nodes). The presence of different economic dictionaries employed by the Presidents characterize the core-periphery structure. The Presidents' talks belonging to the network's core share the usage of generic (non-technical) economic locutions like "interest" or "trade". While the use of more technical and less frequent terms characterizes the periphery (e.g. "yield" ). Furthermore, the speeches close in time share a common economic dictionary. These results together with the economics glossary usages during the US periods of boom and crisis provide unique insights on the economic content relationships among Presidents' speeches.

Twin Default Crises
Mendicino, Caterina,Nikolov, Kalin,Rubio Ramírez, Juan,Suarez, Javier,Supera, Dominik
We study the interaction between borrowers' and banks' solvency in a quantitative macroeconomic model with financial frictions in which bank assets are a portfolio of defaultable loans. We show that ex-ante imperfect diversification of bank lending generates bank asset returns with limited upside but significant downside risk. The asymmetric distribution of these returns and their implications for the evolution of bank net worth are important for capturing the frequency and severity of twin default crises -- simultaneous rises in firm and bank defaults associated with sizeable negative effects on economic activity. As a result, our model implies higher optimal capital requirements than common specifications of bank asset returns, which neglect or underestimate the impact of borrower default on bank solvency.