Research articles for the 2020-11-06

(Sub)Optimal Asset Allocation to ETFs
Brown, David C.,Cederburg, Scott,Towner, Mitch
We study the allocation of capital to U.S. equity exchange-traded funds (ETFs). Investors tend to invest more in ETFs with lower fees and higher liquidity, consistent with common intuition. We also find, however, that investors make substantial allocations to ETFs that are similar to existing ETFs while incurring the costs of higher fees and lower liquidity. We estimate the aggregate cost to ETF investors from investing in dominated funds to be \$1.1 billion to \$17.5 billion since 2000 depending on the bench-marking approach. We conclude that ETF investors may be better off, as a whole, by concentrating on a relatively small set of low-fee, high-liquidity funds.

An Alternative Approach to Fundamental Analysis: The Asset Side of the Equation
Downs, Thomas W.
A standard approach for determining the fundamental value of financial claims is to compute the discounted value of the expected dividend stream. This paper discusses an alternative approach that estimates fundamental value as the discounted value of the cash flows expected from underlying real assets. Illustrative empirical estimates indicate that the ratio of market to fundamental value varies over time and across industries.Downloadable document available at:

Apple, Microsoft, Amazon and Google - A Correlation Analysis: Evidence from a DCC-GARCH Model
Koser, Christoph,Klaus, Juergen
In this paper, we examine time-varying correlations among stock returns of Apple, Microsoft, Amazon and Google. Employing a multivariate DCC-GARCH model, we find that there are strong linkages among these four assets. Starting from lower levels, correlation values for most asset pairs exhibit a stable ascending movement in recent upward trended markets to, in an exceptional case, almost hit the perfect positive correlation mark. We show that correlations among these assets jump during downturn market periods, suggesting limits in the diversification of risk within the segment of large cap U.S. technology stocks. Our results are helpful for portfolio management and asset allocation.

Asset-side Bank Runs and Liquidity Rationing: A Vicious Cycle
Huang, Zongbo
This paper studies financial vulnerability in a dynamic banking model with credit line runs on the asset side of a bank’s balance sheet. I show that a strategic complementarity between bankers and borrowers arises from the contingency in credit lines and costly intermediation. Panic drawdowns by credit line borrowers and liquidity rationing by bankers reinforce each other and lead to a vicious cycle. Using data from U.S. banks, I estimate an infinite-horizon model in which banker-borrower strategic complementarity amplifies shocks on intermediation costs. The amplification channel accounts for one-third of the overall credit contraction during the 2008-09 crisis.

Bank Risk and Bank Rents: The Franchise Value Hypothesis Reconsidered
De Nicolo, Gianni,Zotova, Viktoriya
The predictive relationship between franchise value, measured by Tobin Q, and a theory-based measure of bank risk of insolvency is highly non-linear. Using large samples of publicly quoted banks in the US, Europe, and Asia during 1985-2017, we find that higher values of Q predict lower bank risk of insolvency up to values of Q close to 1, but this prediction is reverted when franchise value is priced and Q exceeds unity, as higher values of Q predict higher bank risk of insolvency. We then construct proxy measures of bank efficiency rents, loan and deposit pricing power rents, and rents due to government guarantees, and show that an increase in these rents is associated with higher market valuation and higher franchise value. Thus, an increase of any of these rents predicts a higher bank risk of insolvency. The franchise value hypothesis is thus rejected in our samples. An interpretation of these findings in light of existing theories is discussed.

Corporate Social and Financial Performance in Chemical Industry in the United States
Rahman, Jahidur Md,Luo, Yuyang
The purpose of this study is to investigate the impact of corporation social performance (CSP) on corporate financial performance (CFP). This study uses return on assets (ROA) to measure corporate financial performance. This study uses KLD index and TRI index to measure corporate social performance separately. Using ordinary least squares (OLS) regression to analyze data from the sample of 123 U.S chemical firms from 2009-2018, this paper finds that KLD index has a significantly positive impact on CFP, while TRI index does not have a significantly impact on CFP. Meanwhile, this paper also finds that the seven individual dimensions of CSP have a significantly impact on CFP except for the environment dimension. The result contributes to the effect of CSP measurement methods in a single industry and the impact of various dimensions of CSP,expands the importance of CSP measurement methods from cross-industry research to single industry research.

Data Reporting: Market Structures and Regulatory Framework
Schmies, Christian,Sajnovits, Alexander
The European legislature has identified weaknesses in the functioning and transparency of financial markets as major shortcomings of the regulatory framework under MiFID I. The new MiFID II/MiFIR regime essentially addresses these identified deficits by means of three regulatory measures: First, it considerably extends the scope and increases the stringency of the obligations with regard to pre- and post-trade transparency with a view to improving the quality of pre- and post-trade transparency data. Second, it instigates a shift towards increased trading on regulated trading venues or on other regulated platforms (more extensive market regulation and trading obligations) and, third, it extends the scope of reporting obligations vis-à-vis the supervisory authorities to enable better monitoring of the financial markets. The already extensive Level 1 requirements have been further specified by numerous pieces of highly detailed Level 2 legal acts. In addition, ESMA has already issued several guidelines and Q&As to harmonize supervisory practice. The resulting network of regulations poses immense challenges for legal practice - as is increasingly characteristic of European capital market law today .The paper sets out to shed some light on the subject.

Dissecting the Idiosyncratic Volatility Anomaly
Chen, Linda H.,Jiang, George J.,Xu, Danielle,Yao, Tong
The idiosyncratic volatility (IVOL) anomaly, documented in Ang, Hodrick, Xing, and Zhang (2006), has garnered a great deal of attention in the literature. Yet, questions remain regarding the robustness and pervasiveness of the IVOL anomaly, with a particular concern that the IVOL anomaly might simply be the manifestation of market microstructure effect. In this paper, we show that the IVOL anomaly is strong and pervasive after we exclude stocks most susceptible to market microstructure noise â€" such as microcap stocks, penny stocks, and stocks with strong short-term return reversal. These results are robust to equal-weighting or value-weighting stocks in the IVOL portfolios. Our findings suggest that rather than being the cause of the anomaly, market microstructure noise actually weakens the IVOL anomaly.

Does Blockchain Technology Democratize Entrepreneurial Finance? An Empirical Comparison of ICOs, Venture Capital, and REITs
Fisch, Christian,Meoli, Michele,Vismara, Silvio
Initial coin offerings (ICOs) are one of the major innovations that characterize the digital revolution of financial markets. Among the expectations created by the digital revolution is the democratization of entrepreneurial finance, defined in terms of the creation of more equality regarding the access to financial resources by categories known to be underrepresented among potential entrepreneurs. Following this line of research, we investigate, through two complementary empirical studies, whether gender, ethnicity, and geography affect the choice of ICOs vs. traditional financing alternatives. Additionally, we assess whether these characteristics in-crease the amount of money an entrepreneur can raise. In Study I, we compare 390 ICO ventures to a sample of 1,078 VC-backed block-chain ventures, identifying a negative correlation between the choice of an ICO (vs. VC-backing) and a location in an urban area. In Study II, we compare 160 ICO ventures to 163 real estate investment trusts (REITs), reaffirming the results of Study I. The findings show significant participation and likelihood of successful campaigns for ethnical minorities in ICOs, with the latter also being able to collect, ceteris pari-bus, larger amounts of funding. In contrast, female entrepreneurs do not have higher chances to participate nor raise funds in ICOs.

Does Technology Lower the Cost of Education without Reducing Quality? A Financial Modeling Approach to Flipping the Classroom
Eberhart, Allan
Colleges and universities are rapidly expanding their use of technology to flip courses, where at least some of the content delivered synchronously in a traditional class is converted to asynchronous materials (e.g., recorded videos) the students learn from online in lieu of attending class. Flipped courses offer the potential to improve the quality of education and lower the cost of delivering it. However, the question of whether flipped courses are fulfilling this potential remains unanswered. I address this gap in the literature by developing a model that compares the cost of a flipped course to its traditional version. The model solves the problem of comparing the uneven cost structure of a flipped course, with its large upfront investment in asynchronous materials followed by lower subsequent costs because of the reduction in synchronous sessions, to its traditional version, with its relatively constant cost per offering. With this model, a new pooled cross-section database consisting of 2,060 students enrolled in seven cohorts over a six-year period, and the application of rigorous educational-quality metrics, I test the hypothesis of whether technology lowers the cost of education without diminishing quality. I report consistent evidence of a significant decrease (36% on average) in the cost of developing and delivering a flipped course relative to its traditional version without a reduction in quality. I also show the circumstances under which a flipped course can be more expensive than its traditional version, and demonstrate how the model can be a practical tool for deciding when it makes sense to invest in technology and how to do so.

Does the Yield Curve Predict Output?
Haubrich, Joseph G.
Does the yield curve have the ability to predict output and recessions? At some times and in certain places, of course! But many details are matters of dispute: When and where does the yield curve predict successfully, which aspects of the curve matter most, and which economic forces account for the predictive ability? Over the years, an increasingly sophisticated set of tools, both statistical and theoretical, have addressed these issues. For the US, an inverted yield curve, particularly when the spread between the yield on 10-year and 3-month Treasuries becomes negative, has been a robust indicator of recessions in the post-World War Two period. The spread also predicts future real GDP growth for the US, although the forecast ability varies by time period, in ways that appear to depend on monetary policy. The evidence is less clear in other countries, but the yield curve shows some predictive ability for the UK and Germany, among others. [This paper was prepared for and has been submitted to the Annual Review of Financial Economics.]

Economic Evaluation of Cryptocurrency Investment
Sakemoto, Ryuta
This study proposes a method to enhance cryptocurrency portfolio returns constructed by forecast models. We forecast returns on four liquid cryptocurrencies and determine the weights on the cryptocurrencies based upon a dynamic allocation framework. We assess the performances of the portfolios using the performance fee measures. Our results present that the proposed portfolios outperform the benchmark portfolio. The economic gain for an investor is sensitive to a change in the risk aversion parameter, which contrasts to the studies of exchange rates.

First Duration, Then Convexity, Then What? Tilt?
Angel, James,Chen, Jiadi,Pacheco, Nikkie
Standard treatments of the impact of interest rate changes on bond prices include duration and convexity. These concepts derive from the first and second derivatives of a Taylor series expansion of an option-free bond price as a function of interest rates. Does the third derivative matter? This paper derives the formula for the third derivative- based term, which we call tilt, and explores its properties. Tilt tells how quickly the convexity changes. Similar to the properties of duration, a higher yield reduces tilt, a longer maturity increases tilt, and a higher coupon reduces tilt, ceteris paribus. Tilt adds little to the accuracy of the impact of small interest rate changes for default-free option-free bonds. Tilt becomes interesting for bonds with embedded options such as callable bonds and mortgage-backed securities. Such bonds can experience rapidly changing convexity and price under certain interest rate regimes.

High-Frequency Expectations from Asset Prices: A Machine Learning Approach
Chaudhry, Aditya,Oh, Sangmin
We propose a novel reinforcement learning approach to extract high-frequency aggregate growth expectations from asset prices. While much expectations-based research in macroeconomics and finance relies on low-frequency surveys, the multitude of events that pass between survey dates renders identification of causal effects on expectations difficult. Our method allows us to construct a daily time-series of the cross-sectional mean of a panel of GDP growth forecasts. The high-frequency nature of our series enables clean identification in event studies. In particular, we use our estimated daily growth expectations series to test the “Fed information effect” and find little evidence to support its existence. Extensions of our framework can obtain daily expectations series of any macroeconomic variable for which a low-frequency panel of forecasts is available. In this way, our method provides a sharp empirical tool to advance understanding of how expectations are formed.

Household Constraints and Financial Decisions
Leung, Woon Sau,Zhu, Zhongyan
We introduce debt-wealth constraints to analyze the financial decisions of typical households. Unlike an unconstrained household in normative finance, a constrained household is indebted with limited wealth. Due to binding debt repayments, a constrained household is conservative in risk tolerance and chooses not to engage risky investments or withdraws earlier than does an unconstrained unit. Empirically, we test differential financial decisions through fixed income mutual fund data. When funds deliver below-average returns, conservative investors withdraw, whereas those with aggressive risk tolerance keep risky engagements. Flows to funds with high-risk exposure are significantly larger than funds with low-risk exposure.

Prudential Policy with Distorted Beliefs
Davila, Eduardo,Walther, Ansgar
This paper studies financial and monetary policy in environments in which equity investors and creditors may have distorted beliefs. We characterize conditions under which it is optimal to tighten or relax leverage caps in response to arbitrary changes in beliefs. The optimal policy response to belief distortions depends on the type as well as the extent of exuberance, and it is not generally true that regulators should lean against the wind by tightening leverage caps in response to optimism. We show that increased optimism by investors is associated with relaxing the optimal leverage cap, while increased optimism by creditors, or jointly by both investors and creditors is associated with a tighter optimal leverage cap. In the presence of government bailouts, increased optimism by equity investors may call for a tighter optimal leverage cap too, depending on whether equity optimism is concentrated on upside or downside risk. Increased optimism by either equity investors or creditors is associated with higher incentives to raise interest rates, so monetary tightening can act as a useful substitute for financial regulation.

Signaling Value Through Gender Diversity: Evidence from Initial Coin Offerings
Guzmán, Alexander,Pinto-Gutierrez, Cristian A.,Trujillo, Maria-Andrea
We analyze the effects of team gender diversity on initial coin offering (ICO) success measured by the total funding amount raised in the actual ICO and the long-term survival of the project. Using a database featuring 875 initial coin offerings between 2017 and 2019, we find that team gender diversity increases the total funding raised in the ICO. Moreover, when we separate team members into areas of expertise or roles in the project, we find that the presence of women in critical positions, such as being a founder or having financial or legal responsibilities, significantly reduces the likelihood of long-term coin failure. Our results are consistent with the notion that investors perceive women’s participation in leadership positions as a positive signal of desirable organizational practices that will translate into better performance. Our results are also consistent with the idea that having women, who abide by ethical values and are less prone to fraud, reduces the likelihood that informationally opaque ICOs turn out to be scams.

Sustaining Competitive Advantage Through Good Governance and Fiscal Controls: Risk Determinants in Internal Controls
Rahman, Jahidur Md,Marjerison, Rob Kim
This study conducts a comprehensive review of the literature published during 1989-2020 to identify the factors that can cause internal control weakness. This review is organized around five main groups, namely: 1) rapid growth and restructuring, 2) financial reporting complexity, 3) auditor tenure, 4) cultural differences, and 5) corporate governance. We perform an integrated literature review approach. Among the several factors found, some factors (the proportion of managerial ownership, Individualism, power distance, financial reporting complexity, rapid growth, and auditor-customer geographic distance) have a positive relationship with internal control weakness while others (the quality of the board of directors and auditing committees, directors’ compensation, and uncertainty avoidance) have a negative relationship. The findings contribute to future research by examining the factors that can cause internal control weakness from different perspectives, which will prove to be useful for investors, auditors, audit committee members, managers, and other stakeholders regarding the prevention of internal controls weaknesses through the application of solid internal controls as well as a path towards the improvement of existing problems of internal control weakness.

Transition Risks and Opportunities in Residential Mortgages
Schuetze, Franziska
A range of studies has analysed how climate-related risks can impact financial markets, focusing on equity and corporate bond holdings. This article takes a closer look at transition risks and opportunities in residential mortgages. Mortgage loans are important from a financial perspective due to their large share in banks’ assets and their long credit lifetime, and from a climate perspective due to their large share in fossil fuel consumption. The analysis combines data on the energy-performance of buildings with financial data on mortgages for Germany and identifies two risk drivers â€" a carbon price and a performance standard. The scenario analysis shows that expected credit loss can be substantially higher for a “brown” portfolio compared to a “green” portfolio. Taking climate policy into account in risk management and strategy can reduce the transition risk and open up new lending opportunities. Financial regulation can promote such behaviour.