Research articles for the 2020-05-22

A Dynamic Conditional Approach to Portfolio Weights Forecasting
Cipollini, Fabrizio,Gallo, Giampiero M.,Palandri, Alessandro
We build the time series of optimal realized portfolio weights from high-frequency data and we suggest a novel Dynamic Conditional Weights (DCW) model for their dynamics. DCW is benchmarked against popular model-based and model-free specifications in terms of weights forecasts and portfolio allocations. Next to portfolio variance, certainty equivalent, and turnover, we introduce the break-even transaction costs as an additional measure that identifies the range of transaction costs for which one allocation is preferred to another. By comparing minimum-variance portfolios built on the components of the Dow Jones 30 Index, the proposed DCW overall attains the best allocations with respect to the measures considered, for any degree of risk-aversion, transaction costs, and exposure.

Advantageous Selection with Intermediaries: A Study of GSE-Securitized Mortgage Loans
Tsai, Hsin-Tien
This paper studies inefficiencies arising from advantageous selection in the US mortgage market. I estimate an industry model, which exploits the GSE pricing rule on guarantee fees that creates exogenous variation in interest rates. I find that the GSEs’ mortgage subsidy leads to a deadweight loss of $8.38 billion relative to a benchmark without a mortgage subsidy. My counterfactual analysis studies how these inefficiencies interact with competition among intermediaries and information asymmetry. Under the mortgage subsidy condition, more competition among lenders (i.e., a 50% decrease in market concentration among lenders) and symmetric information reduce efficiency by $1.42 billion and $3.67 hundred million respectively. On the other hand, without the mortgage subsidy, the same increase in competition among lenders and symmetric information improve efficiency by $3.94 hundred million and $1.77 billion respectively.

Asymmetry in Liquidity Pricing in the Cross-Section and Time Series of Corporate Bond Returns
Dienemann, Fabian
The asymmetry in price pressure from seller vs. buyer-initiated transactions is identified as valuable measure of downside liquidity for corporate bonds. While the evidence of illiquidity on risk premium in the cross-section of corporate bonds is mixed, the aggregate liquidity asymmetry has a high explanatory power for the time series of market returns. It is statistically and economically more significant than the innovation in traditional roundtrip liquidity costs. Some evidence suggests that post-financial crisis regulation has increased the price impact of customer sell orders, which could exacerbate a market downturn in a flight-to-liquidity environment.

Bank Management Sentiment and Liquidity Hoarding
Berger, Allen N.,Kim, Hugh Hoikwang,Ma, Xiaonan (Flora)
We analyze how bank management sentiment affects liquidity hoarding by their banks. Our newly-created sentiment measure captures bank manager emotions based on language in their annual reports (10-Ks). We find that banks with more negative management sentiment hoard additional liquidity, rather than disbursing it to their customers. Our results also suggest how this tendency varies with bank and time period characteristics. Further analysis suggests that our findings incorporate bank volition to some degree, rather than only being driven by customers. Our findings are robust to using clearly exogenous weather conditions as instruments for sentiment. We suggest potential policy implications.

Clawback Provisions in Executive Compensation Contracts
Stark, Johanna
Clawbacks are contractual provisions in executive compensation contracts that allow for an ex post recoupment of variable pay if certain triggering conditions are met. As a result of regulatory responses to financial crises and corporate scandals as well as of growing shareholder pressure to implement effective measures against executive misbehaviour, the prevalence of such clauses has risen considerably in the recent past, beginning in the US after the 2000 financial crisis. As clawbacks have become a buzzword in the European debate about ensuring good corporate governance also beyond the financial sector, it is time to critically discuss the hopes that have been associated with various types of such provisions.

Consumption and Portfolio Rebalancing Response of Households to Monetary Policy: Evidence of the HANK Channel
Agarwal, Sumit,Chua, Yeow Hwee,Ghosh, Pulak,Song, Changcheng
This paper tests one specific monetary transmission mechanism through households: portfolio rebalancing. We use a unique panel dataset of household’s credit and debit card spending, ATM withdrawals, financial investments into risky assets such as mutual funds and equities, as well as bank deposits from a leading bank in India to study the impact of the monetary policy pass-through for term depositors. The difference-in-differences estimators show that when interest rate falls, households increase consumption by 2,095 rupees (30 USD) and risky investments by 20,728 rupees (300 USD) after the expiry of term deposits. The increase in risky investment is about 10 times as much as the increase in consumption, suggesting that savers rebalance their portfolio and “reach for yield” when interest rate falls, shifting from safe assets (bank deposits) to more risky assets (mutual funds and equities). We estimate the interest elasticity of consumption to be -1.02 and interest elasticity of risky investments to be -19.5. Furthermore, we find that the effects on consumption and risky investment are larger for households holding term deposits without automatic renewal feature. The consumption effect is larger for those with less liquid wealth and the portfolio rebalancing effect on risky investment is larger for those with more liquid wealth. These results highlight how the heterogeneity in contract design and household wealth affects the monetary policy pass-through.

Does Firm Investment Respond to Peers' Investment?
Bustamante, Maria Cecilia,Frésard, Laurent
We study whether, how, and why the investment of a firm depends on the investment of other firms in the same product market. Using an instrumental variable based on the presence of local knowledge externalities, we find a sizeable complementarity of investment among product market peers, holding across a large majority of sectors. Peer effects are stronger in concentrated markets, featuring more heterogeneous firms, and for smaller firms with less precise information. Our findings are consistent with a model in which managers are imperfectly informed about fundamentals and use peers' investments as a source of information. Product market peer effects in investment could amplify shocks in production networks.

Does Ownership Concentration Affect Corporate Bond Volatility? The Role of Illiquidity
Wang, Yan,Wang, Ying
This paper analyzes the relation between ownership concentration and corporate bond volatility. We show that increased ownership concentration is associated with higher volatility of corporate bonds. This relation is stronger among more illiquid bonds, during periods of heightened bond market illiquidity, and among the bonds held by corporate bond funds that invest in more illiquid assets and experience higher or correlated liquidity shocks. Using a sample of mutual fund mergers, we further show that increases in bond volatility are not driven by the endogenous ownership structure of bonds but rather the non-fundamental liquidity demand of large concentrated asset owners.

Financial Inclusion and Business Cycles
Ozili, Peterson K
The current debate on financial inclusion pays little attention to whether financial inclusion is pro-cyclical with the fluctuating business cycle. This article investigates the relationship between financial inclusion and the business cycle. The findings reveal that the level of savings and the number of active formal accounts are pro-cyclical with fluctuations in the business cycle. Also, the level of savings by adults particularly for women and poor people decreases during recessionary periods while the number of active formal accounts decline for the adult population especially for women during recessionary periods. The findings also reveal that not all indicators of financial inclusion are pro-cyclical with fluctuating business cycles. The implication of the findings is that poor people and women will exit the formal financial sector during a recession, as banks become unwilling to lend money to poor individuals and households during bad times, and this will lead to financial exclusion and vice versa. Policy makers seeking to increase the level of financial inclusion should focus on the timing of financial inclusion policies along the business cycle as the findings suggest that it might be more difficult to achieve financial inclusion objectives during recessions.

From Defined-Contribution Towards Target-Income Retirement Systems
Mantilla-Garcia, Daniel,Martinez-Carrasco, Miguel,Garcia Huitron, Manuel Enrique,Muralidhar, Arun
The current trend towards Defined Contribution (DC) retirement systems around the world has rendered the risk management of pension funds crucial for the financial health of millions of people. Severe market downturns have put in evidence the need for more effective practices to control losses of retirement income for pension funds' investors. Although the move from the static allocation of policy portfolios toward target-date funds (TDFs) encouraged by regulators features significant improvements, the latter strategies completely ignore the variations in the cost of financing future consumption, which lessens the strategies' ability to control losses in retirement income. While optimal long-term portfolio selection literature emphasizes the importance of hedging against changes in the discount rates that determine the cost of financing future consumption, TDFs strategies, regulatory incentives, and reporting to pension funds' investors disregard the variations in long-term discount rates by focusing in absolute returns. We address these shortcomings by (i) developing performance metrics, such as DC funding-ratios, that foster appropriate incentives for pension fund managers and more sensible and simple reporting to their investors, (ii) introducing a series of asset allocation rules designed to secure a minimum level of target-income in retirement regardless of the returns of the risky assets in the portfolio. The strategies are consistent with insights from long-term portfolio theory and have the critical advantage of being free of any model or parameter estimation risks. We illustrate its advantages relative to a standard TDF strategy in terms of retirement security.

Generation of Option-Like Investment Profiles in Open-Ended Funds
Gaussel, Nicolas,Bruder, Benjamin
Most of the financial litterature on optimal investment assumes that there exists both an initial and a final date between which the investment policy has to made optimal.. In practice, however, fund managers does not really have a starting point nor a final point at which the efficiency of their strategy can be assessed. The aim of this paper to explore the optimisation program of an open ended fund manager. Our contribution is twofold.First we introduce an endogenous reference level process which replaces the traditional "initial value". This allows us to derive new state variables. Those state variables, which can be interpreted as averaged past returns, are well suited to formulate open-ended investment issues.Second, combining the above with a random investment time, we formulate and solve the problem of how a wealth process can be made as close as possible to an option profile in an open-ended framework. In the risk-neutral limit, the result is obtained as the solution of an ODE. Some simulations illustrate the practical effectiveness of our approach.

Leasing as an Alternative Source of Finance for Small and Medium Enterprises in Nigeria
Oke, Olusola
The research work aims at exploring lease as an alternative source of finance to small and medium enterprises and by studying the challenges of SMEs in accessing leasing finance in Nigeria and whether leasing is preferred to other sources of finance in Nigeria. Relevant journals, articles, and textbooks were reviewed, most especially those relating to small and medium enterprises and leasing. The study population is the registered small and medium enterprises registered and operating in Lagos State, Nigeria while a non-probabilistic, purposive sampling method was used to select a sample size of 60 enterprises from all the major sectors in the economy with the highest from the manufacturing sector. The instrument validity was established by the research supervisor while the reliability was proven from the pilot study responses. Questionnaires were administered to collect quantitative data from the respondents, most of which are Chief Executive Owners or top-level managers in these organizations who have used or previously considered using lease finance at one point or the other. The research findings revealed that leasing is a good and alternative source of finance for SMEs operating in Nigeria. However, the results also show the challenges small and medium enterprises encounter in accessing lease finance in the country. Based on the findings, low lease awareness, poor and incomplete financial records, high cost of lease awareness, and discrimination and corruption tendencies of the financial institutions are significant factors that affect small and medium enterprises in accessing lease finance in Nigeria. It was therefore recommended that to mitigate the challenges faced by SMEs, the government must put in place programs and policies that will encourage and spur financial institutions including the lease providers to give concession to small and medium enterprises that desire to access lease finance. Additionally, Equipment Association Leasing of Nigeria (ELAN) who is the umbrella and self-regulating body of all lease providers in Nigeria should offer more educational awareness and training to lessors and lessees and to further use her position to sponsor programs, bills that will promote leasing business in Nigeria. This study is limited and focuses on only small and medium enterprises that operate in the city and state of Lagos in Nigeria. Future research should be conducted in other states of the country to further and widely test the validity of leasing as an alternative of finance and the challenges faced by small and medium enterprises in accessing the lease finance in Nigeria.

Pandemic Crisis and Financial Stability
Gortsos, Christos,Ringe, Wolf-Georg,Busch, Danny,Wymeersch, Eddy,Clarke, Blanaid J.,Lehmann, Matthias,Hadjiemmanuil, Christos,Lamandini, Marco,Ramos Muñoz, David,Morais, Luis Silva,Annunziata, Filippo,Siri, Michele,Joosen, Bart,Brescia Morra, Concetta,Enriques, Luca,Pagano, Marco,Sciarrone Alibrandi, Antonella,Frigeni, Claudio
Section I: The Broad Picture1 Is the European Union going to help us overcome the COVID-19 crisis (Danny Busch)2 COVID-19 and European banks: no time for lawyers (Wolf-Georg Ringe)3 The COVID-19 crisis and financial regulation (Eddy Wymeersch)4 Culutral reforms in Irish banks. Walking the walk during the COVID-19 pandemic (Blanaid Clarke)5 Mothballing the economy and the effects on banks (Matthias Lehmann)Section II: Fiscal Response6 European economic governance and the pandemic: Fiscal crisis management under a flawed policy process (Christos Hadjiemmanuil)7 What recovery fund for Europe? For a dedicated equity line for business, and sound fiscal policy (Marco Lamandini, Guido Ottolenghi & David Ramos Muñoz)8 The EU fiscal response to the COVID-19 crisis and the Banking sector: risks and opportunities (Luis Silva Morais)Section III: Banking Regulation9 Global pandemic crisis and financial stability (Filippo Annunziata & Michele Siri)10 Blancing macro- and micro-prudential powers in the SSM during the COVID-19 crisis (Bart P. M. Joosen)11 The application of the EU banking resolution framework amidst the pandemic crisis (Christos V. Gortsos)12 Lending activity in the time of coronavirus (Concetta Brescia Morra)Section IV: Capital Markets Regulation13 Emergency measures for equity trading: the case against short-selling bans and stock exchange shutdowns (Luca Enriques & Marco Pagano)14 Restrictions on Shareholder's Distribution in the COVID-19 Crisis: Insights on Corporate Purpose (Antonella Sciarrone Alibrandi & Claudio Frigeni)

Political Uncertainty and the US Market Risk Premium
Gregory, Richard Paul
[enter Abstract Body]Using a theoretical model and a vector autoregression, I examine the relationship between the market risk premium and political uncertainty in the United States from Feb. 1985 to Feb. 2019. I find that political uncertainty has a small positive, delayed effect on the market risk premium. The market risk premium, on the other hand, has a large permanent, negative effect on political uncertainty.

Relocate or Innovate? The Impact of Environmental Regulation Stringency on Pollution-Intensive Firms in China
Dong, Yizhe ,Hou, Wenxuan,Xi, Liang,Wang, Tianju
This paper assesses the impact of environmental regulation stringency on the relocation of pollution-intensive firms in China. Pollution haven hypothesis (Porter theory) suggests that firms would (not) choose to relocate (but to innovate). We proxy the regulation stringency with multidimensional institutional capacity and construct an index by using the entropy method and find that stringency reduces the number and growth rate of pollution-intensive firms in highly regulated regions, especially these in heavy industries. An important channel for stringent regulations to hold back firm creation is the increased financing cost. Stringent regulations are not found to promote technology innovation presumably because relocation is less costly. Overall, the results support pollution haven hypothesis.

Social Capital and Capital Structure
Gregory, Richard Paul
I demonstrate that in the context of a Modigliani-Miller-type model that a firm financing social capital and physical capital will favor equity financing over debt financing without bankruptcy. With bankruptcy, debt financing will be used, but equity financing will be favored by firms that use large amounts of social capital, as it will increase their value.

The Effect of Political Uncertainty on Financial Flexibility and Firm Value
Gregory, Richard Paul
[enter Abstract Body]Constructing a simple general equilibrium model, I examine the effect of local and international political uncertainty on financial flexibility and firm value. The model predicts that political uncertainty will have a negative effect on both. I then empirically examine the effects of political uncertainty on firms in the BRICs countries. I find that local political uncertainty has negative effects on financial flexibility, but not on firm value, while international political uncertainty has negative and larger effects on both. Part of the reason for this is that financial flexibility and long-term debt acts as a partial hedge to political uncertainty.

The Evolution of CEO Compensation in Venture Capital Backed Startups
Ewens, Michael,Nanda, Ramana,Stanton, Christopher
We use individual-level data to shed light on the evolution of founder-CEO compensation in venture capital-backed startups. We document that having a tangible, marketable product is a fundamental milestone in CEOs' compensation contracts, marking the point at which liquid cash compensation begins to increase significantly â€" well before a liquidity event. “Product market fit” also coincides with key human capital in the startup becoming more replaceable, marking an apparent transition in the firm's lifecycle from differentiation to standardization. Although substantial increases in cash compensation for founder-CEOs in response to milestones improves the certainty equivalent of attempting entrepreneurship relative to at pay, low cash compensation in the very early years can still deter entrepreneurship for potential entrants. We characterize the types of individuals most likely to be impacted by this constraint and hence those whose ideas are unlikely to be commercialized through VC-backed entrepreneurship.

The Impact of Oil Price Shocks on Turkish Sovereign Yield Curve
Cepni, Oguzhan,Gul, Selcuk,Lucey, Brian M.,Yilmaz, Muhammed Hasan
This paper investigates the impact of oil price shocks on the Turkish sovereign yield curve factors. The recent oil shock identification scheme of Ready (2018) is modified by using geopolitical oil price risk index in order to capture the changes in the risk perceptions of oil markets driven by geopolitical tensions such as terrorism, conflicts, and sanctions. The modified identification scheme attributes more power to demand shocks in explaining the variation of the oil price. Furthermore, our findings demonstrate that the various oil price shocks influence the yield curve factors quite differently. A supply shock leads to a statistically significant increase in the level factor. This result shows that elevated oil prices due to supply disruptions are interpreted as a signal of the surge in inflation expectations since the cost channel prevails. Moreover, unanticipated demand shocks have a positive impact on the slope factor as a result of the central bank policy response for offsetting the elevated inflation expectations. Overall, our results provide new insights to understand the driven forces of yield curve movements that are induced by various oil shocks in order to formulate appropriate policy responses.

The Pricing of Global Temperature Shocks in the Cost of Equity Capital
Gregory, Richard Paul
Using an APT model where global temperature shocks are a systematically priced factor, the risk premium is significant and positive. Evidence is provided that positive exposure to temperature shocks is related to increasing CO2 emissions by an industry or region. The global impact on the cost of equity could be as high as 2.8% per year, implying a global GDP loss of $2.2 Trillion per year due to global temperature shocks.

Time Series Momentum and Reversal: Intraday Information from Realized Semivariance
Liu, Zhenya,Lu, Shanglin,Li, Bo,Wang, Shixuan
The presence of time series momentum effect has been widely documented in the financial markets across asset classes and countries. We find a predictable pattern of the realized semi-variance to the future individual asset return, especially during the stressed states of time series momentum reversals. A rule-based decision function designed upon these insights aims to capture the life-cycle of the time series momentum. Its application on the Chinese commodity futures markets documents higher Sharpe ratio and Sortino ratio compared to the original one over different looking back windows.

Time Series Momentum in the US Stock Market: Empirical Evidence and Theoretical Implications
Zakamulin, Valeriy,Giner, Javier
We start this paper by presenting compelling evidence of short-term momentum in the excess returns on the S&P Composite stock price index. For the first time ever, we assume that the excess returns follow an autoregressive process of order p, AR(p), and evaluate the parameters of this process. Armed with a fairly accurate knowledge of the momentum generating process, we continue this paper by providing a number of important theoretical implications. First, we present analytical results on the profitability of long-only and long-short time-series momentum (TSMOM) strategies. Our results suggest that the long-only TSMOM strategy is profitable, while the long-short one is not. We find that over multiple periods the risk profile of the long-only TSMOM strategy resembles the risk profile of a portfolio insurance strategy. We estimate the power of the statistical test for superiority of the TSMOM strategy and find that the power is much below the acceptable level. Consequently, any empirical study tends not to reject the null hypothesis of no profitability of TSMOM strategy. Finally, we evaluate the precision of identification of the optimal number of lags in the TSMOM rule using a standard back-testing methodology and find that this precision is extremely poor. However, we demonstrate that the performance of the TSMOM rule is robust to the choice of the number of lags.

Understanding a Tax-Aware Defensive Equity Long-Short Strategy
Sosner, Nathan,Pyne, Ted,Liberman, Joseph,Liu, Steven
We describe a Tax-Aware Defensive Equity Long-Short (TADELS) strategy, including its construction and pre-tax and after-tax performance. TADELS closely replicates the pre-tax performance of a similar tax-agnostic strategy and has the potential to achieve a meaningful tax benefit for a taxable investor.TADELS tax benefit remains even when accounting for liquidation taxes. We show that TADELS is attractive in both up- and down-market periods and can diversify typical hedge fund allocations. Moreover, TADELS tax benefit can make an investor’s entire portfolio more tax-efficient.

Value Creation in Private Equity
Biesinger, Markus,Bircan, Cagatay,Ljungqvist, Alexander
We open up the black box of value creation in private equity with the help of confidential information on value creation plans and their execution. Plans are tailored to each portfolio company’s needs and circumstances, have become more hands-on, and vary with deal type, ownership, growth strategy, and geographic focus. Successful execution is subject to resource constraints, economies of specialization, and diminishing returns, and varies systematically across funds. Successful execution is a key driver of investor returns, especially in growth, buyout, and secondary deals. Company operations and profitability improve in ways consistent with successful execution, even beyond PE funds’ exit.

Value and Momentum from Investors' Perspective: Evidence from Professionals' Risk-Ratings
Merkle, Christoph,Sextroh, Christoph J.
We conduct a controlled experiment with financial professionals to examine more directly whether value and momentum reflect risk factors or mispricing. By eliciting their risk perceptions and return expectations for company stocks, we identify what constitutes a risky investment from the point of investors. Contrary to the risk factor hypothesis, value and momentum stocks are regarded as less risky. However, other factors such as size and beta fall in line with their traditional interpretation as risk factors. Consistent with empirical findings, we observe higher return expectations for momentum stocks, raising questions on analysts believing in a risk-return trade-off.

What Determines Manager and Investor Sentiment?
Gregory, Richard Paul
I find that Managerial and Investor Sentiment are determined by differing sets of economic variables, that share some common factors: Inflation, Liquidity and the Term Premium. Decomposing the Sentiment Indices, I find that the Investor Sentiment Model Component and the Managerial Sentiment Residual Component are primarily responsible for the predictive power of predicting cross-sectional stock returns that is much stronger than previous results. I present evidence that part of the predictive power is due to the components predicting priced market factors.