Research articles for the 2020-02-20

A Kaleidoscopic View on the Impact of Financial Knowledge on Investment Decision of Individual Investors
Silvester, Mercy,Kumar, Vijaya,Nawaz, Nishad
The study was directed to know the individual investor’s behavior with the primary objective of exploring the role of financial knowledge on decisions of investment in the Chennai city of Tamil Nadu. For the purpose of study exploratory research design deployed to get required data by having convenient nonprobability sampling method and analyzed using PSPP Version 1.0.1, and the statistical tools such as descriptive statistics, reverse weighted average mean ranking, factor analysis & multiple regression analysis statistical techniques used to draw significant answers to study objectives. The empirical evidence reveals that the underlying dominant dimensions of financial knowledge variables are grouped into nine dominant factors and investment decision variables are significantly grouped into seven independent factors. Further, the awareness factor has the significant influence on investment decisions of individual investors followed by interest factor, Risk & Return Factor, Portfolio Management Factor, and information factor in their order of influence. This study find that the individual investors are shown positive intend towards the investment decision and need to develop in many aspects related to the enrichment for betterment in their financial knowledge to gain more awareness information before making their investment decisions.

Algorithmic trading in a microstructural limit order book model
Frédéric Abergel,Côme Huré,Huyên Pham

We propose a microstructural modeling framework for studying optimal market making policies in a FIFO (first in first out) limit order book (LOB). In this context, the limit orders, market orders, and cancel orders arrivals in the LOB are modeled as Cox point processes with intensities that only depend on the state of the LOB. These are high-dimensional models which are realistic from a micro-structure point of view and have been recently developed in the literature. In this context, we consider a market maker who stands ready to buy and sell stock on a regular and continuous basis at a publicly quoted price, and identifies the strategies that maximize her P\&L penalized by her inventory. We apply the theory of Markov Decision Processes and dynamic programming method to characterize analytically the solutions to our optimal market making problem. The second part of the paper deals with the numerical aspect of the high-dimensional trading problem. We use a control randomization method combined with quantization method to compute the optimal strategies. Several computational tests are performed on simulated data to illustrate the efficiency of the computed optimal strategy. In particular, we simulated an order book with constant/ symmet-ric/ asymmetrical/ state dependent intensities, and compared the computed optimal strategy with naive strategies. Some codes are available on

Bilateral Risk Sharing with No Aggregate Uncertainty under Rank-Dependent Utility
Boonen, Tim J.,Ghossoub, Mario
This paper studies bilateral risk-sharing with no aggregate uncertainty, when agents maximize rank-dependent utilities. We characterize the structure of Pareto optimal risk-sharing contracts in full generality. We then derive a necessary and sufficient condition for Pareto optima to be no-betting allocations (i.e., deterministic allocations), thereby answering the question of when sunspots do not exist in this economy. This condition depends only on the probability weighting functions of the two agents, and not on their (concave) utility functions.

Consumer Debt and Default: A Macro Perspective
Exler, Florian,Tertilt, Michèle
In this survey, we review the quantitative macroeconomic literature analyzing consumer debt and default. We start by providing an overview of consumer bankruptcy law in the US and document the relevant institutional changes over time. We proceed with a comprehensive empirical section, describing key facts about consumer debt, defaults and delinquencies, as well as charge-off and interest rates for the United States. In addition to the evolution of these variables over time, we construct life-cycle profiles using data from the Survey of Consumer Finances and show that debt and defaults display a clear hump-shaped profile by age. Third, we show how credit card debt has evolved along the income distribution. Finally, we document a large amount of heterogeneity in credit card interest rates across consumers. In the second part of the survey, we describe what has by now become the workhorse model of consumer credit and default. We discuss a quantitative version of the model and use it to decompose the main reasons for default. We also use the model to illustrate how the details of default costs matter. The remainder of the survey then discusses the literature centered around two questions. First, what are the welfare implications of various bankruptcy laws? And second, what caused the rise in filings over time? We end with a discussion of open questions and fruitful avenues for future research.

Cournot-Nash equilibrium and optimal transport in a dynamic setting
Beatrice Acciaio,Julio Backhoff-Veraguas,Junchao Jia

We consider a large population dynamic game in discrete time. The peculiarity of the game is that players are characterized by time-evolving types, and so reasonably their actions should not anticipate the future values of their types. When interactions between players are of mean-field kind, we relate Nash equilibria for such games to an asymptotic notion of dynamic Cournot-Nash equilibria. Inspired by the works of Blanchet and Carlier for the static situation, we interpret dynamic Cournot-Nash equilibria in the light of causal optimal transport theory. Further specializing to games of potential type, we establish existence, uniqueness and characterization of equilibria. Moreover we develop, for the first time, a numerical scheme for causal optimal transport, which is then leveraged in order to compute dynamic Cournot-Nash equilibria. This is illustrated in a detailed case study of a congestion game.

Criptocurrencies, Fiat Money, Blockchains and Databases
Jorge Barrera

Two taxonomies of money that include cryptocurrencies are analyzed. A definition of the term cryptocurrency is given and a taxonomy of them is presented, based on how its price is fixed. The characteristics of the use of current fiat money and the operation of two-level banking systems are discussed. Cryptocurrencies are compared with fiat money and the aspects in which the latter cannot be overcome are indicated. The characteristics of blockchains and databases are described. The possible cases of use of both technologies are compared, and it is noted that blockchains, in addition to cryptocurrencies and certain records, have not yet shown their usefulness, while databases constitute the foundation of most of the automated systems in operation.

Debtholder Wealth Effects in Mergers and Acquisitions: Evidence from the CDS Market
Huettermann, Kai,Lleshaj, Denisa
This paper examines changes in acquirer and target companies’ Credit Default Swap (CDS) spreads as a proxy for default risk around official mergers and acquisitions (M&A) announce-ments. Related literature extensively documents wealth effects triggered by M&A from the shareholders’ perspective, but there is only a slight evidence on the wealth effects experienced by the transaction firms’ debtholders. Therefore, this study adds to the literature by exploring the impact of M&A announcements on CDS spreads empirically. A negative correlation between M&A and the development of the value of debt securities is increasingly being addressed as a central theme from the acquirer’s perspective. In contrast, the literature assumes that the target’s debtholders earn positive wealth effects from acquisition. Hence, we detect acquiring and target firms’ abnormal changes in CDS spreads between 2004 and 2016 as a basis for regression analyses. In this regard, we take deal characteristics as well as other determinants that could have influenced respective company’s credit risk into account. Our evidence suggests that M&A, on average, increase the acquiring firms’ default risk, but tend to improve the target firms’ risk position.

Derivatives Discounting Explained
Wujiang Lou

Derivative pricing is about cash flow discounting at the riskfree rate. This teaching has lost its meaning post the financial crisis, due to the addition of extra value adjustments (XVA), which also made derivatives pricing and valuation a very difficult task for investors. This article recovers a properly defined discount rate that corresponds to different collateral and margin schemes. A binomial tree model is developed, enabling end-users to price in counterparty default and funding risk. Coherent XVAs, if needed, naturally result from decomposing the discount rate, and can be computed on the same tree.

Equal risk option pricing with deep reinforcement learning
Alexandre Carbonneau,Frédéric Godin

This article presents a deep reinforcement learning approach to price and hedge financial derivatives. This approach extends the work of Guo and Zhu (2017) who recently introduced the equal risk pricing framework, where the price of a contingent claim is determined by equating the optimally hedged residual risk exposure associated respectively with the long and short positions in the derivative. Modifications to the latter scheme are considered to circumvent theoretical pitfalls associated with the original approach. Derivative prices obtained through this modified approach are shown to be arbitrage-free.

The current paper also presents a general and tractable implementation for the equal risk pricing framework inspired by the deep hedging algorithm of Buehler et al. (2019). An $\epsilon$-completeness measure allowing for the quantification of the residual hedging risk associated with a derivative is also proposed. The latter measure generalizes the one presented in Bertsimas et al. (2001) based on the quadratic penalty.

Monte Carlo simulations are performed under a large variety of market dynamics to demonstrate the practicability of our approach, to perform benchmarking with respect to traditional methods and to conduct sensitivity analyses.

Equity Duration and Predictability
Golez, Benjamin,Koudijs, Peter
One of the most puzzling findings in asset pricing is that expected returns dominate variation in the dividend-to-price ratio, leaving little room for dividend growth rates. Even more puzzling is that this dominance only emerged after 1945. We develop a present value model to argue that a general increase in equity duration can explain these findings. As cash flows to investors accrue further into the future, shocks to highly persistent expected returns become relatively more important than shocks to growth rates. We provide supportive empirical evidence from dividend strips, the time-series, and the cross-section of stocks.

Estimating the Probability of Default for No-Default and Low-Default Portfolios
Blümke, Oliver
The paper proposes a sequential Bayesian updating approach to estimate default probabilities on rating grade level for no- and low-default portfolios.Bayesian sequential updating enables default probabilities to be obtained also for those rating grades for which no defaults have been observed.The advantage of this approach is that it preserves the rank order of rating grades in the case of no defaults. Rank preservation is not ensured when using an identical prior distribution across all rating grades. We discuss Bayesian sequential updating for the betaâ€"binomial model and a model incorporating the asymptotic single-risk factor model of the Basel Accord. Practical aspects such as incorporating information from external sources and the margin of conservatism are addressed.

Exploiting the Dividend Month Premium: Evidence from Germany
Kreidl, Felix,Scholz, Hendrik
Dividend payments are recurring firm events on a predictable basis, which are related to positive abnormal returns. High returns in the period between announcement-date and ex-dividend date are the main driver for the so-called dividend month premium, being abnormal returns in months of predicted dividend payments. In our empirical analysis, we find a robust dividend month premium for German stocks. Our results suggest that post-announcement drifts are especially strong for stocks with positive dividend surprise. The predictable date of dividend payments enables portfolio managers to exploit the dividend month premium. We show that simple portfolio-enhancing strategies lead to highly significant abnormal returns, also under consideration of tracking error and transaction costs.

Forecasting Realized Volatility Matrix With Copula-Based Models
Wenjing Wang,Minjing Tao

Multivariate volatility modeling and forecasting are crucial in financial economics. This paper develops a copula-based approach to model and forecast realized volatility matrices. The proposed copula-based time series models can capture the hidden dependence structure of realized volatility matrices. Also, this approach can automatically guarantee the positive definiteness of the forecasts through either Cholesky decomposition or matrix logarithm transformation. In this paper we consider both multivariate and bivariate copulas; the types of copulas include Student's t, Clayton and Gumbel copulas. In an empirical application, we find that for one-day ahead volatility matrix forecasting, these copula-based models can achieve significant performance both in terms of statistical precision as well as creating economically mean-variance efficient portfolio. Among the copulas we considered, the multivariate-t copula performs better in statistical precision, while bivariate-t copula has better economical performance.

Interest and Credit Risk Management in German Banks: Evidence From a Quantitative Survey
Drager, Vanessa,Heckmann-Draisbach, Lotta,Memmel, Christoph
Using unique data of a survey among small and medium-sized German banks, we analyze various aspects of risk management over a short-term and medium-term horizon. We especially analyze the effect of a 200-bp increase in the interest level. We find that, in the first year, the impairments of banks' bond portfolios are much larger than the reductions in their net interest income, that banks attenuate the resulting write-downs by liquidating hidden reserves and that banks which use interest derivatives have lower impairments in their bond portfolios. In addition, we find that banks' exposures to interest rate risk and to credit risk are remunerated, that banks' try to stabilize the mid-term net interest margin with exposure to interest rate risk and that they act as if they have a risk budget which they allocate either to interest rate risk or credit risk.

Linking Different Data Sources of Venture Capital and Private Equity in China
Fei, Celine Yue
This report gives a summary on different data sources of venture capital and private equity in China. It also provides a roadmap on how to link the different sources to a consolidated database. This is a supplementary report on data collection and consolidation of the paper “Can governments foster the development of venture capital (Fei (2018)).

Marketplace Lending of Smes
Cumming, Doulas J.,Hornuf, Lars
Peer-to-business lending refers to online platforms facilitating loans from individuals to smalland medium-sized enterprises (SMEs). We conjecture that easy-to-understand risk ratings conveyed by the platform play a pronounced role in influencing the borrowing success of SMEs and that more sophisticated financial information and adverse selection are largely absent in these markets. We introduce a dataset of 414 SME marketplace loans and 8,236 online loan days to test these propositions. The data examined provide strong support for the importance of simple platform ratings in influencing investor behavior, while the effect of more detailed financial information is less pronounced.

Pricing commodity swing options
Daluiso, Roberto,Nastasi, Emanuele,Pallavicini, Andrea,Sartorelli, Giulio
In commodity and energy markets swing options allow the buyer to hedge against futures price fluctuations and to select its preferred delivery strategy within daily or periodic constraints, possibly fixed by observing quoted futures contracts. In this paper we focus on the natural gas market and we present a dynamical model for commodity futures prices able to calibrate liquid market quotes and to imply the volatility smile for futures contracts with different delivery periods. We implement the numerical problem by means of a least-square Monte Carlo simulation and we investigate alternative approaches based on reinforcement learning algorithms.

Private Equity and the Leverage Myth
Czasonis, Megan,Kinlaw, William B.,Kritzman, Mark,Turkington, David
Investors have traditionally relied on mean-variance analysis to determine a portfolio’s optimal asset mix, but they have struggled to incorporate private equity into this framework because they do not know how to estimate its risk. The observed volatility of private equity returns is unrealistically low because the recorded returns of private equity are based on appraised values, which are serially linked to each other. These linked appraisals, therefore, significantly dampen the observed volatility. As an alternative to observed volatility some investors have argued that private equity volatility should be estimated as leveraged public equity volatility, because private equity companies are more highly levered than publicly traded companies. However, this approach yields unrealistically high values for private equity volatility, which invites the following question. Why isn’t the appropriately leveraged volatility of public companies a reasonable approximation of private equity volatility? This paper offers an answer to this puzzle.

Simulating Fire Sales in a System of Banks and Asset Managers
Calimani, Susanna,Hałaj, Grzegorz,Żochowski, Dawid
We develop an agent-based model of traditional banks and asset managers to investigate the contagion risk related to fire sales and balance sheet interactions. We take a structural approach to the price formation in fire sales as in Bluhm et al. (2014) and introduce a market clearing mechanism with endogenous formation of asset prices. We find that, first, banks which are active in both the interbank and securities markets may channel financial distress between the two markets. Second, while higher bank capital requirements decrease default risk and funding costs, they make it also more profitable to invest into less-liquid assets financed by interbank borrowing. Third, asset managers absorb small liquidity shocks, but they exacerbate contagion when their voluntary liquid buffers are fully utilised. Fourth, a system with larger and more interconnected agents is more prone to contagion risk stemming from funding shocks.

Supervisory Shocks to Banks’ Credit Standards and Their Macro Impact
Lucidi, Francesco Simone,Semmler, Willi
Credit standards reported in the Bank Lending Surveys (BLS) of the ECB summarize banks' sentiment about credit market tightness and they strongly co-move with credit growth. This paper builds a new external instrument which captures an exogenous source of variation in credit standards, in order to identify a structural shock stemming exclusively from the banking system. The instrument accounts for mandatory rotations of external auditors within the biggest banking institutions of nine euro-area countries. By estimating IV-local projections, this paper finds a significant dynamic causal impact of the shock to credit standards on both real and financial variables. The results suggest that such a structural shock may represent the effects of an unexpected supervisory measure at banking-system level which resemble the implementation of a macroprudential measure.

The Application of National Law by the European Central Bank: Challenging European Legal Doctrine?
Amtenbrink, Fabian
The operationalisation in late 2014 of European Regulation 1024/2013 conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions and establishing a Single Supervisory Mechanism (SSMR) has profoundly changed the European financial market regulatory and supervisory landscape. The most apparent change is the role of the European Central Bank (ECB) in the new integrated single supervisory framework in which it is responsible for the effective and consistent functioning of the Single Supervisory Mechanism (SSM). One prominent feature of the SSM are the arrangements concerning the application of national law by the ECB. Pursuant to Article 4 (3) sub-para. 1 SSMR, in applying all relevant Union law for the purpose of carrying out the tasks conferred on it by the SSMR, including all relevant secondary law, the ECB must not only apply national legislation by which options explicitly granted in regulations have been exercised, but also national legislation transposing relevant EU Directives. These arrangements have implications that surpass the operation of the SSMR itself, as they touch upon fundamental aspects of European legal doctrine that have received comparably less attention until now. By way of illustration, in this short written version of a contribution to the 2019 ECB Legal Conference the implications of two aspects linked to the application by a Union institution of national law are discussed: the direct application by the ECB of Directives that have been inadequately implemented into national law and, moreover, the exercise of public power by the ECB that is at least partially rooted in national law. The latter point has recently also been scrutinised by the German Federal Constitutional Court (Bundesverfassungsgericht) in its decision on the compatibility with the German Federal Constitution of the Single Supervisory Mechanism and the Single Resolution Mechanism.

The Case for Non-Binary, Contingent, Shareholder Action
Ganor, Mira
Shareholder action is exercised mainly through a binary system: for example, the shareholders either vote to approve a proposal or to reject it. They either follow the recommendation of management and vote with management or vote against it. In case of contention between incumbents and insurgents, shareholders need to determine whom to trust. Disclosures and proxy advisory firms’ recommendations add to the information the shareholders might consider before casting their binary vote. However, retail investors as well as small investors are generally underequipped and restricted economically from reaching an informed and educated shareholder decision, and thus vote infrequently. Abuse of insider information further disadvantages retail investors. Yet, corporate decisions are based on the choice of the majority of the shareholder vote and retail investors are assumed to rely on disclosed information when making investment decisions.The new generation of Special Purpose Acquisition Companies (SPACs), currently representing about one in three U.S. going-public transactions, is one example that illustrates the weakness of the binary system and the consequent vulnerability of small and unsophisticated shareholders. Remarkably, investors in SPACs can vote yes on management proposed acquisition transaction and, nonetheless, simultaneously choose to redeem their shares. Unsophisticated retail investors may not realize that they, as well, will be better off if they redeem their shares even though the transaction received the approval of the majority of the shareholder vote.This Article puts forward a proposal to amend the law and allow shareholders to act in a way that is contingent upon a simultaneous non-contingent action by other shareholders. For example, a shareholder of a SPAC should be able to choose to redeem her shares iff at least a specified percentage of redemption rights are exercised unconditionally. Similarly, a shareholder who has preemptive rights should have the right to exercise her rights with a limit that caps her participation and maintains her percentage holdings in the company.Generally, shareholders should have the option to act contingently when they are exercising a shareholder right, such as preemptive rights, appraisal rights, and when they are given a choice to participate in transactions such as tender offers and stock-buy-backs. Unlike mandatory disclosure rules imposed on insiders, the proposed non-binary, contingent, shareholder action treats all shareholders equally and increases the power of the shareholder action without incurring high costs of collaboration and communication among the shareholders.

The Fair Basis: Funding and capital in the reduced form framework
Wujiang Lou

A negative basis trade enters a long bond position and buys protection on the issuer of the bond through credit default swap (CDS), aiming at arbitrage profit due to the bond-CDS basis. To classic reduced form model theorists, the existence of the basis is an abnormality or merely liquidity noise. Such a view, however, fails to explain large basis trading losses incurred during the financial crisis. Employing a bond continuously hedged by CDS under a dynamic spread model with bond repo financing, we find that there is unhedged and unhedgeable residual jump to default risk that can't be diversified because of credit correlation. An economic capital approach has to apply and a charge on the use of capital follows. Together with the hedge funding cost, it allows us to better understand the basis's economics and to predict its fair level.

The Interbank Market Puzzle
Allen, Franklin,Covi, Giovanni,Gu, Xian,Kowalewski, Oskar,Montagna, Mattia
This study documents significant differences in the interbank market lending and borrowing levels across countries. We argue that the existing differences in interbank market usage can be explained by the trust of the market participants in the stability of the country’s banking sector and counterparties, proxied by the history of banking crises and failures. Specifically, banks originating from a country that has lower level of trust tend to have lower interbank borrowing. Using a proprietary dataset on bilateral exposures, we investigate the Euro Area interbank network and find the effect of trust relies on the network structure of interbank markets. Core banks acting as interbank intermediaries in the network are more significantly influenced by trust in obtaining interbank funding, while being more exposed in a community can mitigate the negative effect of low trust. Country-level institutional factors might partially substitute for the limited trust and enhance interbank activity.

The Politics of News Personalization
Lin Hu,Anqi Li,Ilya Segal

We study how news personalization affects policy polarization. In a two-candidate electoral competition model, an attention-maximizing infomediary aggregates information about candidate valence into news, whereas voters decide whether to consume news, trading off the expected utility gain from improved expressive voting against the attention cost. Broadcast news attracts a broad audience by offering a symmetric signal. Personalized news serves extreme voters with skewed signals featuring own-party bias and occasional big surprise. Rational news aggregation yields policy polarization even if candidates are office-motivated. Personalization makes extreme voters the disciplining entity for equilibrium polarization and increases polarization through occasional big surprise.