Research articles for the 2020-10-02

A Case Study in Multiperiod Portfolio Optimization: A Classic Problem Revisited
Tarlie, Martin
Conventional wisdom holds that multiperiod portfolio optimization problems are best, if not only, solved by dynamic programming. But dynamic programming suffers from the curse of dimensionality whereby optimization becomes exponentially more difficult as time horizon and number of assets increase, thereby limiting its practical applications. In this paper I show for a classic multiperiod investment problem that an open-loop procedure, amenable to solution by conventional methods and not subject to the curse of dimensionality, generates 'here and now' portfolios identical to those generated by the dynamic programming approach. This result suggests that an 'open-loop with recourse' process is a viable closed-loop approach for some practically useful multiperiod investment problems.

A Quantitative Theory of the Credit Score
Chatterjee, Satyajit,Corbae, Dean,Dempsey, Kyle,Rios-Rull, Jose-Victor
What is the role of credit scores in credit markets? We argue that it is a stand-in for a market assessment of a person’s unobservable type (which here we take to be patience). We pose a model of persistent hidden types where observable actions shape the public assessment of a person’s type via Bayesian updating. We show how dynamic reputation can incentivize repayment without monetary costs of default beyond the administrative cost of filing for bankruptcy. Importantly, we show how an economy with credit scores implements the same equilibrium allocation. We estimate the model using both credit market data and the evolution of individuals’ credit scores. We find a 3% difference in patience in almost equally sized groups in the population with significant turnover and a shift towards becoming more patient with age. If tracking of individual credit actions is outlawed, the benefits of bankruptcy forgiveness are outweighed by the higher interest rates associated with lower incentives to repay.

Ambiguity Aversion Can Lead to Lower Foreign Bias: New Empirical Evidence From an International Panel Study
Dlugosch, Dennis,Wang, Mei
We argue that after an increase in domestic ambiguity, countries with higher ambiguity aversion should see a larger fall in foreign bias than countries with lower ambiguity aversion. We empirically test this hypothesis using cross-border equity holdings from 22 developed and emerging countries and a new measure of ambiguity aversion from a worldwide survey based on an Ellsberg-type urn experiment. We proxy for country-level ambiguity by using the prediction errors of variance forecasts of a state-of-the-art volatility forecasting model. First, we show that the new proxy for ambiguity aversion is indeed positively correlated with foreign bias, even after controlling for quality of institutions, disclosure requirements and investor protection. Second by interacting the level of ambiguity with aversion to ambiguity, we provide evidence that an increase in domestic ambiguity is associated with a fall in foreign bias ratios that is greater for countries that are more ambiguity averse. The results hold while controlling for a broad range of other factors, in particular uncertainty. Further results suggest that this fall in foreign bias is, however, not associated with an improvement of international diversification.

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.

Behavioral Factors and Investment Decision: A Case of Nepal
Pokharel, Post Raj
The main objective of this study is to examine the investors’ opinions or behavior in Nepalese stock market. Based on many researches, this study used four independent variables heuristic, prospect, market, and herding and a dependent variable investment performance of Nepal Stock Exchange. This study is an empirical research based on primary data collected from 120 respondents who have made investment in shares of listed companies in NEPSE. The results of correlation analysis showed that market factor has significant impact on the investment performance. The findings of the study suggested that heuristic (including anchoring, representative, overconfidence, availability bias and gamble’s fallacy), herding (choice of trading stocks; buying and selling; volume of trading stocks, speed of herding) and prospect (loss aversion, regret aversion, and mental accounting) have no significant relationship with investment performance.

Co-Movement of Africa’s Emerging Stock Markets: A New Look under the COVID-19 Crisis
Omane-Adjepong, Maurice,Amewu, Godfred,Paul Alagidede, Imhotep,Akosah, Nana Kwame
We investigate the behaviour of the largest Africa’s stock markets and their relatedness with international assets amid the ongoing COVID-19 crisis using the rolling window wavelet correlation measure. Our results suggest that the crisis has had negligible influence on the pairwise correlations of emerging equity markets in Africa, and for that matter, they can still be largely considered as separate assets. Further results, generally, indicate weak positive connectedness and inverse relationship between Africa’s emerging equities and the international markets, signalling hedging potential of the former. The findings presage some crucial implications for investors regarding short-run portfolio diversification and risk management.

Comment Letter - Office of the Comptroller of the Currency: Warning of the Dangers Posed by the Shadow Payment System and Shadow Digital Money
Awrey, Dan,Menand, Lev,McAndrews, James
This comment letter was submitted in response to the Office of the Comptroller of the Currency (OCC) advance notice of proposed rule-making regarding the digital activities of National Banks and Savings Associations. For the reasons set out in this letter, we believe that the OCC’s proposed approach to regulating new financial technologies, institutions, and platforms is fundamentally flawed. Rather than focus on relaxing the regulatory framework governing banks, we believe that the OCC should consider how to strengthen the legal regime governing an emerging contingent of non-bank financial institutions that now compete with banks in the realm of money and payments. This comment letter describes the business models of these new institutions, the antiquated and inadequate legal regimes that currently govern them, and the serious and growing risks they pose. This letter suggests modest and straightforward reforms that the OCC should recommend to Congress that would require these firms to back their monetary liabilities 1:1 with bank deposits. These reforms would harmonize state and federal law, prevent a weakening of the prudential safeguards that ensure the safety and soundness of money institutions, and yet still allow both banks and non-bank payment platforms to offer innovative services. These reforms would also be superior to alternative approaches such as a federal payments charter, which would likely prompt a dangerous race to the bottom between state and federal regulators.

Decoding Systematic Relative Investing: A Pairs Approach
Goulding, Christian L.,Harvey, Campbell R.,Pickard, Alex
We propose a novel theory that brings to light three fundamental performance drivers of zero-cost systematic investment strategies: (1) high (positive) own-asset signal-return predictability; (2) low (or negative) cross-asset signal correlation; and (3) low (or negative) cross-asset signal-return predictability. We develop these insights in the context of long-short pair strategies used as portfolio building blocks. We test our approach empirically using momentum signals for major asset classes, though our method can generalize to any signal. Our investable pairs-based portfolio harvests over double the average returns of a conventional rank-based portfolio over the last 20 years.

Do Analysts Change Their Behavior After Winning an All-star Award? Evidence from a Regression Discontinuity Design
Jung, Michael J.,Lü, Yiqing,Wu, Hong,Xuan, Yuhai
We examine whether winning an industry award affects the behavior of capital market professionals. Using a novel data set on analyst rankings, we employ a regression discontinuity design that compares the research outputs of and market reactions to third-place, all-star analysts with runner-up analysts who rank immediately below them and are not considered all-stars. We find evidence that winning an award emboldens analysts to be more optimistic and enables them to move the markets. These results are consistent with the notion that award winners can leverage or exploit their reputation to their own and their employers’ benefit.

Efficiency and Revenue in Linear-Quadratic Double Auctions
Chen, Daniel,Zhang, Anthony Lee
We study the effects of a class of subsidy schemes on traders' behavior in private-valued multi-unit double auctions. Using these subsidies, the auction operator can implement any profile of linear demand schedules as an equilibrium outcome. By revenue equivalence, all other mechanisms that implement linear equilibria in double auctions are essentially equivalent to a subsidy scheme in our class. We demonstrate that, under a certain linear dependency condition on primitives, budget-balanced, individually rational, and fully efficient trade is possible. However, a monopolist platform has incentives to reduce allocative efficiency to increase revenue, even as the number of traders becomes large.

Growth Uncertainty, Rational Learning, and Asset Prices
Babiak, Mykola,Kozhan, Roman
We demonstrate that incorporating parameter learning into a production economy can capture salient properties of the variance premium and index option prices with empirically consistent equity returns, the risk-free rate, and macroeconomic quantities. In a model estimated on the post-war U.S. data, the investor learns about the true parameters governing persistence, mean, and volatility of productivity growth. Rational belief updating amplifies the impact of shocks on prices and conditional moments. The agent, in turn, pays a large premium for variance swaps and index options because they hedge his concerns about future revisions, particularly concerning mean and volatility of productivity growth.

Growth of Financial Derivatives Market with Special Reference to National Stock Exchange â€" An Analysis
Egurla, Kishan
The Derivative Market in India, like its counterparts abroad, is increasingly gaining significance. Since the time derivatives were introduced in the year 2000, their popularity has grown manifold. This can be seen from the fact that the daily turnover in the derivatives segment on the National Stock Exchange currently stands at crores, much higher than the turnover clocked in the cash markets on the same exchange. In fiscal 2016-17, the total turnover in equity cash market stood at about Rs 60.5 lakh crore, whereas the same for equity derivatives was at a high of Rs 944 lakh crore. While the cash market has grown at an annual compounded growth rate of 11 per cent since 2004-05, the same for equity derivatives is over 35 per cent. Managing Financial Risk is one of the most essential activities that every firm needs to consider.Various tools were and are used for managing financial risk and out of all, derivatives are the most widely used tool to manage financial risk.The present study focus on the evolution,business growth and trends of products which are trading at NSE in derivatives segment with the help of AAGR, CAGR, Standard Deviation, Correlation and ANOVA.

Household Financial Distress and the Burden of 'Aggregate' Shocks
Athreya, Kartik,Mather, Ryan,Mustre-del-Rio, Jose,Sánchez, Juan M.
The goal of this paper is to show that household-level financial distress (FD) varies greatly, meaning there is unequal exposure to macroeconomic risk, and that FD can increase macroeconomic vulnerability. To do this, we first establish three facts: (i) regions in the U.S. vary significantly in their "FD-intensity," measured either by how much additional credit households therein can access, or in how delinquent they typically are on debts, (ii) shocks that are typically viewed as "aggregate" in nature hit geographic areas quite differently, and (iii) FD is an economic "pre-existing condition": the share of an aggregate shock borne by a region is positively correlated with the level of FD present at the time of the shock. Using an empirically disciplined and institutionally rich model of consumer debt and default, we show that in the shocks dealt by the Great Recession and in the initial months in the COVID-19 pandemic, FD mattered. Our model implies that the uneven distribution of FD creates widely varying consumption responses to shocks. This is true even when subjecting regions (with differing levels of FD) to the same shocks, which highlights the importance of FD independently of its correlation with shocks.

How Do Independent Directors View Corporate Social Responsibility (CSR) During a Stressful Time? Evidence From the Financial Crisis
Chintrakarn, Pandej,Jiraporn, Pornsit,Treepongkaruna, Sirimon
We explore the effect of board independence on CSR investments during a stressful time, i.e. during the Great Recession. Our results show that independent directors exhibit an unfavorable view of CSR investments during the crisis. Stronger board independence leads to a significant reduction in CSR. In particular, a rise in board independence by one standard deviation reduces CSR investments by about 8.22%. Further analysis shows that managers raised CSR investments during the crisis, consistent with the risk-mitigation view, where managers invest in CSR to reduce their risk exposure. However, managers appear to over-invest in CSR during the crisis as they are forced to cut back in the presence of a strong board, implying that part of the CSR investments during the crisis is motivated by managers’ own risk preference. Additional robustness checks corroborate the results, including fixed- and random-effects regressions, propensity score matching, and instrumental-variable analysis. Our study is the first to shed light on how independent directors view CSR during a stressful time. Finally, we show that CSR reduces firm risk substantially during the crisis, strongly confirming the risk-mitigation hypothesis.

Illiquidity, R&D Investment, and Stock Returns
Ahmed, Shamim,Bu, Ziwen,Ye, Xiaoxia
We propose a dynamic model of research and development (R&D) venture, which predicts that the positive relation between the firm's R&D investment and the expected stock returns strengthens with illiquidity. Consistent with the model's prediction, empirical evidence based on cross-sectional regressions and double-sorted portfolios suggests a stronger and positive R&D-return relation among illiquid stocks. A further analysis shows that the important role of illiquidity in the R&D-return relation cannot be explained by factors such as financial constraints, innovation ability, and product market competition. Collectively, our results suggest that stock illiquidity is an independent driver of the R&D premium.

Industry Tournament Incentives and Stock Price Crash Risk
Kubick, Thomas R.,Lockhart, G. Brandon
Theoretical and empirical studies argue that managerial hoarding of negative firm-specific information can result in large negative stock price corrections once the accumulated information is revealed. A managerial labor market with tournament-like progression provides managers with the incentive to withhold negative information. We find that CEOs with stronger incentives to progress in the managerial labor market tournament have significantly greater stock price crash risk, consistent with a greater propensity for these executives to withhold negative firm-specific information. The empirical patterns that we document suggest a negative externality to the positive incentive effects provided by the managerial labor market.

Integration of Income and Estate Tax Planning
Sosner, Nathan,Liberman, Joseph,Liu, Steven
Preservation and transfer of wealth to future generations is one of the central financial goals for most high-net-worth families. In this study, using a stylized theoretical model and Monte-Carlo simulations, we quantify the benefits of income and estate tax planning for growing wealth over generations. We show that a family that invests with income and estate tax efficiency in mind can achieve substantially higher wealth levels than a family oblivious to taxes. More importantly, we show that there is a significant value in integrating income tax efficiency and estate tax planning: Becoming efficient with respect to one tax should make the family even more eager to become efficient with respect to the other.

Managerial Entrenchment and Capital Structure Decision: A Case of Nepal
Pokharel, Post Raj
This paper tests the influence of managerial entrenchment and capital structure decisions using Nepalese firms' data and executives view. A majority of earlier studies show that firm leverage is negatively associated with the degree of entrenchment of managers. This study examines whether or not this is consistent in the context of Nepal. The data were taken from top listed companies on NEPSE, pharmaceuticals companies registered in Department of Drug Administration and other non-listed companies. To achieve the objective of the study, a descriptive and causal comparative research design has been administered. The managerial entrenchment index has been calculated using Principal Component Analysis. The major finding of the study shows that the managerial entrenchment increases as the percentage of CEO ownership rises. There exists positive association of managerial entrenchment and CEO percent ownership which suggests that increase in equity holding by CEO or top executives leads to lower shareholder rights or higher managerial entrenchment.

Matrix Evolutions: Synthetic Correlations and Explainable Machine Learning for Constructing Robust Investment Portfolios
Papenbrock, Jochen,Schwendner, Peter,Jaeger, Markus,Krügel, Stephan
In this paper we present a novel and highly flexible method to simulate correlation matrices of financial markets. It produces realistic outcomes regarding stylized facts of empirical correlation matrices and requires no asset return input data. The matrix generation is based on a multi-objective evolutionary algorithm so we call the approach ‘Matrix Evolutions’. It is suitable for parallel implementation and can be accelerated by graphics processing units (GPUs) and quantum-inspired algorithms. The approach can be used for pricing, hedging and trading correlation-based financial products. We demonstrate the potential of Matrix Evolutions in a machine learning case study for robust portfolio construction in a multi-asset universe. In this study we organize an explainable machine learning program to establish a link from the simulated matrices to relative investment performance. The training data consists of the synthetic matrices produced by Matrix Evolutions and an automatic labeling by Monte-Carlo simulation of the relative investment performance of the following two approaches for portfolio construction: the novel Hierarchical Risk Parity approach by Lopez de Prado (2016b) which is based on representation learning and the traditional equal risk contribution approach.

Post Earnings Announcement Drift (PEAD) in Polish Stock Market
Sojka PhD, Marek
This paper is devoted to studying stock market behaviour after earnings announcement, which is often referred to as Post Earnings Announcement Drift (PEAD). In this work I present details how the anomaly works in the Polish stock market. I examined data series in period from 1998 to 2017. The general conclusions of this paper are very similar to the academic studies based on US market. The Post Earnings Announcement Drift is present in the polish market beyond doubt, its magnitude is around 6.1% in 90 days, with larger magnitude found among smaller companies 5.2% and smaller among large cap 3.1%. Its course is also similar to previous academic evidence â€" the highest abnormal returns are achieved in the first 10 days after announcement and in the 14 days preceding next report announcement. The effect lasts for more than a year, with longer effect among small caps and shorter effect among large caps.

Securities Lending and Corporate Financing: Evidence from Bond Issuance
Bai, Jennie,Massa, Massimo,Zhang, Hong
The security lending market allows institutional investors, such as insurance companies, to lend out their holding assets in exchange for cash collateral, an important but understudied source of funding to conduct off-balance sheet transactions. Since these lenders are also primary investors of corporate bonds, we hypothesize that their lending preference on certain types of bonds can influence corporate financing policies. Indeed, we observe that lenders’ preference for long-term bonds stimulates firms to issue more such bonds and helps boost bond prices. Analysis exploiting a quasi-experiment on the regulatory change of insurance companies in 2010 supports a causal interpretation. Our results shed new insight on the potential impact of security lending on corporate financing policies and bond pricing.

Seventy-Five Years of Investing for Future Generations
Chambers, David,Dimson, Elroy,Kaffe, Charikleia
University endowments invest for future generations, so their strategy should reflect their long horizon. We researched whether they really do behave like long-term investors. We examined the behavior of US endowments since 1945 and drew comparisons with earlier periods. Using a long-run data set on 12 major universities, we examined their preferences for risky assets and documented their big strategic moves into equities and, later, into alternatives. We then analysed how they invest at the time of crises and the extent to which they exploit their long-horizon advantage. We found that, on average, endowments invested counter-cyclically at crisis times, particularly by increasing their allocations to risky assets after a crisis.

Shifting Sands Whilst Sifting for Profits: Evolving Patterns of Firm Size and Performance in the U.S. Economy
Muthusamy, Senthil Kumar
Research Summary: Firm size has long been recognized as a source of competitive advantage. However, the disruptions arising from the knowledge-based global economy are decoupling the link between firm size and profitability. We demonstrate in this article, the structural shifts and evolving patterns in the U.S. industrial economy by capturing the emerging disconnect in the relationships between firm size, growth, and financial performance across multiple industries with a long-range COMPUSTAT panel data. We highlight the emerging challenges to the field of management from the paradigm shifts occurring due to the disruptive technologies, broadening global competition, dynamic consumer trends, and volatile financial markets for the past three decades. We further discuss the implications for corporate strategy, governance, and organization. Managerial Implications: Although it has been a well-established notion that large organizations with more capital and assets will enjoy the advantages of high profitability, in recent times, the large firms are increasingly experiencing the financial crisis. The widening gap between firm size, capital structure and, profitability for the past three decades implies increased risk to long-term investors. The trodden path of mergers and acquisitions for quick growth, consolidation, or diversification is not translating into long-term shareholder value. Given the disruptive technologies, shortened product life cycles, and continuously changing industry structures, firms’ growth strategy must incorporate the agility, speed, and responsiveness. Firms need to build trust-driven, symbiotic, and dis-aggregated form of organization and reconfigure the value chain to reduce both coordination cost and investment risk.

The COVID-19 Shock and Equity Shortfall: Firm-level Evidence from Italy
Carletti, Elena,Oliviero, Tommaso,Pagano, Marco,Pelizzon, Loriana,Subrahmanyam, Marti G.
We forecast the drop in profits and the equity shortfall triggered by the COVID-19 lockdown, using a representative sample of 80,972 Italian firms. A 3-month lockdown entails an aggregate yearly drop in profits of about 10% of GDP and results in financial distress for 17% of the sample firms, employing 8.8% of the sample employees. Distress is more frequent for small and medium-sized enterprises, for firms with high pre-COVID-19 leverage, and those belonging to the Manufacturing and Wholesale Trading sectors. Listed companies are less likely to enter distress, while there is no clear correlation between distress rates and family firm ownership.

The Effect of Environmental Regulations on the Profitability of Philippine SMEs
Caboverde, Christopher Ed
Climate change, attributed to the increasing use of greenhouse gases, has caused the intensification of storms, the rise in sea levels, and other natural disasters. The implementation of environmental regulations is important especially in the context of the Philippines, which is among the most vulnerable countries to the consequences of climate change. Nevertheless, Philippine SMEs, which significantly contribute to national employment and gross value added, may have to deal with environmental regulations that may negatively affect their financial performance and competitiveness. This paper is among the first to explore the relationship between environmental regulations and profitability of Philippine SMEs (as determined by profit growth rate). Based on a sample of 590 SMEs located in Metro Manila, Metro Cebu, and Metro Davao, our results show a statistically insignificant relationship between environmental regulations and profit growth rate among Philippine SMEs. However, we find a positive relationship between a low perceived extent of corruption and profit growth. Our results also indicate that the interaction of environmental regulation burden and low perceived extent of corruption among SMEs has a positive relationship with profit growth, suggesting that when firms perceive corruption to be low, more environmental regulation may have a positive effect on profit growth. Our findings suggest that, among others, the government must strengthen the implementation of anti-corruption initiatives to help improve the ease-of-doing business.

The Impacts of Advertising Assets and R&D Assets on Reducing Bankruptcy Risk
Jindal, Niket
Research has shown that advertising assets and R&D (research and development) assets increase shareholder value. Although one might conclude that their impacts on bankruptcy risk are merely the inverse of their impacts on shareholder value, we argue otherwise and show that the differences hinge on the fact that share- holder value is a function of expected cash flows from all future periods, whereas bankruptcy risk is a function of expected cash flow from only the next period. We show that current market turbulence moderates the impacts of advertising assets and R&D assets on expected cash flow from the next period but not on expected cash flows from more distant future periods. Therefore, market turbulence moderates the impacts of advertising assets and R&D assets on bankruptcy risk but not shareholder value. Market stability increases the impact of advertising assets on reducing bankruptcy risk, whereas market turbulence increases the impact of R&D assets on reducing bankruptcy risk. Using a data set of more than 1,000 firms covering three decades, we find support for our hypotheses. Out-of-sample validation indicates that bankruptcy prediction performance improves when including marketing variables in addition to the usual financial predictors.

The Rich Get Richer and the Poor Get Poorer: Behavior of Investors in Pharmaceutical Firms Post-IPOs
Rothman, Tiran,Siev, Smadar
This paper analyzes stocks’ price behavior after IPO events in the pharmaceutical sector and explores the role of social media in determining this behavior. The results indicate positive and significant cumulative average abnormal returns (CAAR) of 3.70% in the first 20 days following an IPO until the end of quiet period, and a decline of tens of percent over the next three years. However, when dividing the sample into two sub-samples according to firm size, using a separation market value of $500 million, the overall picture changes dramatically. Firms with a market value lower than $500 million yielded a positive yet not significant CAAR 20 days post-IPO and a significant negative CAAR from day 50 onwards. Firms with a market value higher than $500 million experienced a significant positive CAAR from day 20 after the IPO and throughout the following year. These findings can be attributed to the limited attention of investors. Attention to the new IPOs increases until the end of quiet period and, in the case of small-sized firms, diminishes during the post-IPO years. An examination of social media and share returns demonstrates a robust correlation between the two, which may indicate that investors’ attention to these firms is also reflected in social media.

Working with CRSP/COMPUSTAT in R: Reproducible Empirical Asset Pricing
Simaan, Majeed
It is common to come across SAS or Stata manuals while working on academic empirical finance research. Nonetheless, given the popularity of open-source programming languages such as R, there are fewer resources in R covering popular databases such as CRSP and COMPUSTAT. The aim of this article is to bridge the gap and illustrate how to leverage R in working with both datasets. As an application, I illustrate how to form size-value portfolios with respect to Fama and French (1993) and study the sensitivity of the results with respect to different inputs. Ultimately, the purpose of the article is to advocate reproducible finance research and to contribute to the recent idea of "Open Source Cross-Sectional Asset Pricing'', proposed by Chen and Zimmermann (2020).