Research articles for the 2020-12-04

A Journey Into the Biotechnology Industry: Valuation of Early-Stage Companies. Allakos’ Case Study and the Monoclonal Antibody Therapy
Nocera, Giovanni,Montagna, Dennis Marco,Fino, Emanuele,Amendola, Antonio
High volatility, no predictable cash flows and technological uncertainties make BiotechHealthcare companies’ valuation a challenging task for analysts and investors. Translating clinical promises into economic value represents a rough obstacle of this attractive business, especially in measuring the potential implications that scientific breakthroughs can bring to society and the size of the financial markets’ reaction to such events. The aim of this work is to provide a deeper understanding of dynamics behind biotech companies analysis, moving from traditional valuation models to a risk-adjusted framework, including the technological and regulatory issues related to approval process. The efforts made have required a full immersion in a biological and clinical context. Our work was focused on Allakos, Inc., a clinical-stage biotechnology company developing therapeutic monoclonal antibody for the treatment of various mast cells and eosinophilic related disease. Allakos lead drug candidate is antolimab (AK002), an investigational humanized monoclonal antibody that targets an inhibitory receptor selectively expressed on the surface of immune effector cells, mast cells and eosinophils. The analysis conducted has been the object of a University of Pavia master’s degree thesis. The following slides are related to the final dissertation held in June 2020 and can be considered as an anticipation of a research paper soon to be published.

Arbitrage and Liquidity: Evidence from a Panel of Exchange Traded Funds
Rappoport W, David E,Tuzun, Tugkan
Market liquidity is expected to facilitate arbitrage, which in turn should affect the liquidity of the assets traded by arbitrageurs. We study this relationship using a unique dataset of equity and bond ETFs compiled from big trade-level data. We find that liquidity is an important determinant of the efficacy of the ETF arbitrage. For less liquid bond ETFs, Granger-causality tests and impulse responses suggest that this relationship is stronger and more persistent, and liquidity spillovers are observed from portfolio constituents to ETF shares. Our results inform the design of synthetic securities, especially when derived from less liquid instruments.

Asset Growth Effect and Q Theory of Investment
Kogan, Leonid,Li, Jun,Qiao, Xiaotuo
We extend the standard q theory of investment into a two-capital setup in which firms use both physical capital (long-term asset) and short-term capital (current asset) as production inputs. We find this simple extension is capable of explaining the stronger return predictive power of total asset growth than current and long-term asset growths. A novel asset imbalance channel creates negatively correlated comovement between current and long-term asset growths that are unrelated to the discount rate effect. Part of this comovement is cancelled out in the total asset growth, giving rise to its stronger return predictive power. Empirically, once controlling for this comovement, the return predictive power of current and long-term asset growths substantially improves. Furthermore, we document compelling evidences for the model's prediction that the asset growth effects are more prominent among firms with low asset imbalance. Our results support the q-theory based explanation for the asset growth effect.

Asymmetric Volatility in Nepalese Stock Market
Gajurel, Dinesh
This paper investigates the asymmetric volatility behavior of Nepalese stock market including the spillover effects from the US and Indian equity markets. We model asymmetric volatility within generalized autoregressive conditional heteroscedasticity framework using a comprehensive data for Nepal stock market index. The results reveal a very different asymmetry compared to the results in other international equity markets: positive shocks increase volatility by more than negative shocks. Our results further suggest that uninformed investors play a significant role in Nepalese stock market. The spillover effect from the Indian stock market to Nepalese stock market is negative. Overall, we conclude that a “fear of missing out” (FOMO) of noise traders as well as the deployment of pump and dump schemes are inherent features of the Nepalese stock market. The findings are very useful to policy makers and investors alike.

Attention Spillover in Asset Pricing
Chen, Xin,An, Li,Yu, Jianfeng
Exploiting a screen display feature whereby the order of stock display is determined by the stock listing codes, we lever a novel identification strategy and study the impact of attention spillover on stock prices and turnover. We find that stocks with neighbors on the display that experience higher returns in the past two weeks are associated with higher returns and turnover in the future week, after adjusting for a battery of risk and characteristic benchmarks. This finding is consistent with our conjectures that investors (a) tend to trade more after positive investment experience, and (b) are more likely to pay attention to neighboring stocks. Both conjectures are confirmed using trading data. We further sharpen the identification using a quasi-natural experiment in which the screen display for affected stocks is exogenously changed.

Automatic Differentiation for Diffusion Operator Integral Variance Reduction
Auster, Johan
We demonstrate applications of automatic differentiation in the diffusion operator integral variance reduction framework originally proposed by Heath and Platen. Combining this estimator with automatic differentiation techniques for computing derivatives allows for a flexible implementation without trade-offs in numerical stability or accuracy. This fully mitigates a key practical shortcoming of the original estimator, as we remove the dependency on error-prone and problem-specific manual calculations. We perform a relative error analysis of the estimator and standard Monte Carlo estimation against the numerical integration solution of the European call option in the Heston model. Benchmarks show computational time savings in excess of three orders of magnitude for comparable expected relative errors and sublinear growth of mean relative errors in strikes. The implementation is further applied to the valuation of floating-strike lookback put options, demonstrating the ease of generalizing the automatic differentiation approach and the ability of the estimator to mitigate the monitoring bias for this class of options.

Biom: A Biometric Currency a New Approach to Banking
Ech-Chatbi, Charaf
Our modern financial system traces its origin to the ancient Babylonian banking system. The same fractional lending idea that is used today was used by merchants in the regions of ancient Babylonia, Assyria and Sumeria around 2000 BC. Later, the idea found its way to ancient Greece, the Roman Empire, China, India and then to us. The fractional lending concept was not the fruit of scientific research like what is done in other scientific endeavors where most of the best ideas are the result of a long process of trial and error. Is it not time to rethink the way we do banking in this digital age and try other ideas? The last 40 years of cryptographic research culminated with the creation of Bitcoin currency system in 2009. We would like to expand on this and introduce three ideas to help rethink the banking system of the 21st century: 1) the concept of a biometric currency, 2) the concept of being your own bank and issue your own loans with zero-interest rate 3) and redefining the fractional reserve lending. We propose a biometric currency concept that will enable people to self finance and to safely store their money in their hands. Contrary to cryptocurrencies that are issued by blockchain miners and Fiat currencies that are issued by bankers, Biom will be issued by everyone. The goal is to create from human life a precious asset like Gold that will benefit all.

Composite Administrative Procedures in the European Union
Dambrosio, Raffaele,Eckes, Christina
The two contributions in this legal working paper discuss the various aspects of composite administrative procedures in the context of both Single Supervisory Mechanism (SSM) and Single Resolution Mechanism (SRM) decision-making procedures. It addresses the definition of such procedures, their relevance in the SSM and SRM context, the allocation of powers in such procedures, differences between composite procedures in the SSM and SRM spheres and differences between composite procedures and mere cooperation or exchange of information procedures. They were originally presented at the ECB legal colloquium on ‘Composite administrative procedures in the European Union’, which took place in Frankfurt am Main in 2020.

Convergence Analysis for Continuous-Time Markov Chain Approximation of Stochastic Local Volatility Models: Option Pricing and Greeks
Ma, Jingtang,Yang, Wensheng,Cui, Zhenyu
This paper establishes the precise second order convergence rates of the continuous-time Markov chain (CTMC) approximation method for pricing options and calculating its Greeks under the general framework of stochastic local volatility models, which include the Heston and SABR models as special cases. Numerical examples confirm the theoretical findings.

Evidence of Arbitrage Trading Activity: The Case of Chinese Copper Futures Contracts
Brooks, Robert,Li, Yang
Several unique insights are documented based on a study of copper futures contracts traded in the U.S. and China. Based on our unique measures, we present evidence that the U.S. gold and silver futures markets reflect a fully arbitraged market and U.S. copper nearly so. In contrast, the Chinese gold and silver futures markets appear to reflect an unarbitraged market whereas the Chinese copper market is characterized as somewhat arbitraged. We explore various reasons for this evidence as well as document the differences in gold, silver, and copper futures markets between China and the U.S.

Factors Influencing Investment Decisions of Individual Investors Working in Hazara Division Industrial Zone
Zulqarnain Safdar, Muhammad, Mateen, Malik Muhammad,Muddassar Khan, Muhammad,Mustafa, Kiran,Shafique, Danial Zahid
Behavioral finance examines psychological and sociological factors that affect decisions when individuals making investment decisions. Investors carry out investment analysis used to examine assets, trends in the market, and past market data. Investors' judgment is linked with decision choices. It is commonly used to analyze information and know-how about business, minimize risk, and their outcome. The current study objects to investigate the impact of different factors like accounting information, self/firm image, advocate recommendations, personal financial needs, and neutral Information on investment decisions. The population of the study consists of all levels of individual investors who have been investing and wanted to invest in selected industries of the Hazara Division. The study was conducted on the 300 investors out of 169 investors that constituted the sample size. The current research found that there is a positive and significant impact of these factors on investment decisions.

Financial Integration and the Co-Movement of Economic Activity: Evidence from U.S. States
-, ,Goetz, Martin Richard
We analyze the effect of the geographic expansion of banks across U.S. states on the comovement of economic activity between states. Exploiting the removal of interstate banking restrictions to construct time-varying instrumental variables at the state-pair level, we find that bilateral banking integration increases output co-movement between states. The effect of financial integration depends on the nature of the idiosyncratic shocks faced by states and is stronger for more financially dependent industries. Finally, we show that integration (1) increases the similarity of bank lending fluctuations between states and (2) contributes to the transmission of deposit shocks across states.

Financial Stability Policies and Bank Lending: Quasi-Experimental Evidence from Federal Reserve Interventions in 1920-21
Rieder, Kilian
I estimate the comparative causal effects of monetary policy \leaning against the wind" (LAW) and macroprudential policy on bank-level lending and leverage by drawing on a single natural experiment. In 1920, when U.S. monetary policy was still decentralized, four Federal Reserve Banks implemented a conventional rate hike to address financial stability concerns. Another four Reserve Banks resorted to macroprudential policy with the same goal. Using sharp geographic regression discontinuities, I exploit the resulting policy borders with the remaining four Federal Reserve districts which did not change policy stance. Macroprudential policy caused both bank-level lending and leverage to fall significantly (by 11%-14%), whereas LAW had only weak and, in some areas, even perverse effects on these bank-level outcomes. I show that the macroprudential tool reined in over-extended banks more effectively than LAW because it allowed Federal Reserve Banks to use price discrimination when lending to highly leveraged counterparties. The perverse effects of the rate hike in some areas ensued because LAW lifted a pre-existing credit supply friction by incentivizing regulatory arbitrage. My results highlight the importance of context, design and financial infrastructure for the effectiveness of financial stability policies.

Five Fundamental Questions on Central Counterparties
Berndsen, Ron
Central counterparties (CCPs) are designed to reduce aggregate counterparty credit risk and function as market infrastructures for capital markets in securities and derivatives. Although CCPs, also known as clearing houses, exist for well over a century, they have gained prominence since they became the main international public policy response to the Lehman crisis of making over-the-counter derivative transactions safer. This G20's response to the Lehman crisis of making central clearing mandatory for standardized over-the-counter derivative transactions has been translated into law, Dodd-Frank for the US and EMIR for the EU. However, CCPs remain to some extent controversial with adversaries claiming that they potentially increase systemic risk and proponents viewing them as systemic risk reducing when properly designed and maintained. In this article I review the booming literature on CCPs, of which about 60% is published in the last five years, by asking five fundamental questions about CCPs. The aim is to construct a broad, academically substantiated, synthesis about CCPs and to propose directions for future research in what can be considered as the most important niche of financial economics.

How New Fed Corporate Bond Programs Dampened the Financial Accelerator in the Covid-19 Recession
Bordo, Michael D.,Duca, John V.
In the financial crisis and recession induced by the COVID-19 pandemic, many investment-grade firms became unable to borrow from securities markets. In response, the Fed not only reopened its commercial paper funding facility but also announced it would purchase newly issued and seasoned bonds of corporations rated as investment grade before the COVID pandemic. A careful splicing of different unemployment rate series enables us to assess the effectiveness of recent Fed interventions in these long-term debt markets over long sample periods, spanning the Great Depression, Great Recession and COVID Recession. Findings indicate that the announcement of forthcoming corporate bond backstop facilities had helped stop risk premia from rising further than they had by late-March 2020. In doing so, these Fed facilities have limited the role of external finance premia in amplifying the macroeconomic impact of the COVID pandemic. Nevertheless, the corporate bond programs blend the roles of the Federal Reserve in conducting monetary policy via its balance sheet, acting as a lender of last resort and pursuing credit policies.

Learning (Not) to Trade: Lindy's Law in Retail Traders
Godina, Teodor,Kassibrakis, Serge,Malamud, Semyon,Teguia, Alberto,Xu, Jiahua
We develop a rational model of trading behavior in which the agents gradually learn about their ability to trade, and exit after poor trading performance. We demonstrate that it is optimal for experienced traders to "procrastinate" and postpone exit even after bad results. We embed this "optimal procrastination" in a model of population dynamics with entry and endogenous exit, and generate predictions about the dynamics of various cross-sectional characteristics. We test these population-level predictions using a large client data set of a major Swiss retail broker. Consistent with the model, we find that endogenous exit decisions produce non-trivial and non-monotonic population-wide linkages between performance, exits, and trading experience.

Liquidity in Resolution: Comparing Frameworks for Liquidity Provision Across Jurisdictions
Grund, Sebastian,Nomm, Nele,Walch, Florian
As a response to the global financial crisis that started in 2008, many countries established dedicated resolution regimes that seek to limit the use of taxpayer money while maintaining the functions of failing banks that are critical for financial stability. This paper extends the existing research by zooming in on the specific topic of liquidity provision to banks in resolution. It examines the provision of liquidity in the United States, the United Kingdom, Japan, Canada and the banking union of the European Union (thereafter: the “banking union”). The paper observes the differences and commonalities of policy choices across jurisdictions with regard to both the relationship between private prefunding and temporary public liquidity provision and the roles of the public budget and the central bank. The comparison also reveals that the role of fiscal authorities is strong and that guarantees from a public budget are a common feature. The framework for the provision of liquidity in the banking union is not yet complete as the construction of a public sector backstop of sufficient size and speed is comparatively more complex in the banking union than in other jurisdictions. Therefore, the idea of establishing a European-level guarantee framework â€" which would allow access to Eurosystem liquidity for banks coming out of resolution with limited collateral â€" is being further investigated.

Proof that MM Proposition I is Illogical
Mendes, António Marques
Despite some initial misgivings, the Modigliani-Miller proposition about the neutrality of the structure of capital was (enthusiastically) accepted by most academics and CEOs, and (reluctantly) agreed by most investors. In this paper we show that by ignoring the bidirectionality between the balance sheet and total revenue the proposition is logically inconsistent.

Spotlight on Biotechnology: From a Technological Breakthrough to Valuation Challenges. A Case Study on Crispr Therapeutics and Crispr/Cas 9 Revolution.
Fino, Emanuele,Montagna, Dennis Marco,Nocera, Giovanni,Amendola, Antonio
High volatility, no predictable cash flows and technological uncertainties make BiotechHealthcare companies’ valuation a challenging task for analysts and investors. Translating clinical promises into economic value represents a rough obstacle to be attractive business, especially in measuring the potential implications that scientific breakthroughs can bring to society and the size of the financial markets’ reaction to such events. The aim of this work is to provide a deeper understanding of dynamics behind biotech companies analysis, moving from traditional valuation models to a risk-adjusted framework, including the technological and regulatory issues approval process. We provide a full immersion in a biological and clinical context that is far and beyond the common practice proper of the financial valuation field. We focus on one of the potential technological disruptors within the clinical and healthcare framework: the CRISPR/Cas 9 system. These revolutionary “molecular scissors” are capable of editing genes by cutting out/repairing disease-causing DNA segment and inserting corrected ones, representing a potential “one-shot” cure for many diseases currently unmet by existing treatments. The potential of CRISPR/Cas9 companies inevitably pours over the financial markets and, in this work, we focus our analysis on CRISPR Therapeutics, the most advanced in clinical trials and the most complete in terms of pipeline products. This represents the perfect example of no-revenues company with an incredible technology breakthrough that could become a profitable investment opportunity. The analysis conducted has been the object of a University of Pavia master’s degree thesis. The following slides are related to the final dissertation held in June 2020 and can be considered as an anticipation of a research paper soon to be published.

Strategic Timing of IPOs and Disclosure: A Dynamic Model of Multiple Firms
Aghamolla, Cyrus,Guttman, Ilan
We study a dynamic timing game between multiple firms, who decide when to go public in the presence of possible information externalities. A firm's IPO pricing is a function of its privately observed idiosyncratic type and the level of investor sentiment, which follows a stochastic, mean-reverting process. Firms may wish to delay their IPOs in order to observe the market reception of the offerings of their peers. We characterize the unique symmetric threshold equilibrium, whereby pioneer firms with high idiosyncratic types endogenously emerge. The results provide novel implications regarding variation in IPO timing, sequential clustering, IPO droughts, the composition of new issues over time, and how IPO volume fluctuates over time. These include, among others, that in more populated industries, a lower proportion of firms emerge as industry pioneers, but follower IPO volume is intensified. Additionally, heightened uncertainty over investor sentiment exacerbates delay and leads to lower IPO volume.

The Impact of Climate Change on the Cost of Bank Loans
Masum, Abdullah Al,Javadi, Siamak
We find that firms in location with higher exposure to climate risk pay significantly higher spreads on their bank loans. This result is robust to different measures of climate risk. Exploiting the economic link between a firm and its customers, we find that the exposure of a firm’s customers to climate risk adversely affects that firm’s cost of borrowing. In the cross-section, we find that the effect is mainly driven by long-term loans of poorly rated firms that are highly exposed to climate risk. Overall, our evidence suggests a slow increase in lenders’ attention to climate risk and that lenders have yet to fully understand and price all dimensions of this risk.

Under Watchful Eyes: Analyst Site Visits and Earnings Management
Gao, Zhan,Quan, Xiaofeng,Xu, Xingmei
This paper investigates whether analyst site visits, where sell-side analysts visit corporate sites and interact with management, reduces earnings management by the host firms. Taking advantage of the disclosure of analyst site visits by Chinese listed firms, we find that the intensity of analyst site visits is negatively associated with discretionary accruals, and this relation is robust to controlling for endogeneity. Furthermore, we find that site visits attended by star analysts and including factory tours are associated with lower levels of discretionary accruals than those without these features. We also report that the number and coverage of questions posed during site visits are negatively associated with discretionary accruals. Our results demonstrate that site visits by sell-side analysts perform a vital monitoring role and exert significant constraints on firms’ opportunistic behaviors.

Valuation Risk: A Holistic Accounting and Prudential Approach
Onorato, Mario,Battaglia, Fabio,Lascala, Orazio,Ngjela, Arber
Valuation Risk (VR) is the risk that an entity will experience a loss due to the inaccurate determination of the fair value of the financial instruments on its balance sheet. This risk is particularly significant for financial instruments with complex features, with limited-to-no liquidity, or with valuations that rely on internally developed models that may be seldom verified using actual trades.Bank VR has been drawing international supervisory attention recently. In February, the European Systemic Risk Board warned that the substantial amounts of instruments with complex features and limited liquidity that sit on banks’ balance sheets are a source of risk for the global financial system. In parallel, the European Central Bank has put trading risk and asset valuations among its supervisory priorities for 2020 and said it plans to execute investigations on banks with significant portfolios of complex instruments measured at fair value based on pricing models.Measured in terms of possible losses from fair value calculations and/or estimation errors on capital ratios, the potential impact of VR can be significant for banks with a combination of a high ratio of fair valued assets to total assets and a high leverage ratio. In such cases, even a relatively small error in determining fair values may significantly decrease the Tier 1 ratio. From a business perspective, banks with opaque and incomplete disclosure about the methods used to estimate the fair value (and the variation thereof) of complex financial instruments may find their stock prices penalized by financial analysts.The nature of VR differs from other banking risks. Market and credit risks, for example, are defined in terms of potential losses derived from the uncertainty about instrument prices over time. VR, however, measures uncertainty surrounding the difference between the reported fair value and the “true” tradeable price that a bank could obtain if it were to sell an asset or transfer a liability at a specific point in time (i.e., the valuation date).Prudential and accounting frameworks have designated a set of mitigation measures to deal with VR uncertainty, which are interrelated. We have conducted a comprehensive analysis of bank VR, encompassing governance, regulatory, and prudential dimensions and summarize it in the paper linked below. We describe the VR framework for a bank through a holistic approach, provide a detailed analysis of the relationships between the accounting and the prudential frameworks, and outline a methodological approach for the prudential treatment of VR. We conclude that:1) Regulators will increasingly challenge banks over their fair value determination practices as part of a supervisory approach that looks for consistency and rigor across the whole valuation process. In this context, banks will face governance challenges on the clarity of the roles and responsibilities for different functions (namely, finance and risk.)2) The requirements of the current prudential regulatory framework do not ensure that banks build a capital buffer large enough to address VR. Researchers and regulators should undertake additional studies to develop a sound and agreed upon methodology to identify and measure VR.3) Regulators should require banks to provide more extensive disclosure about their exposure to VR. Increasing clarity and transparency around bank risks will enhance public trust and enable more accurate estimations of the risk embedded in banks’ balance sheets by observers and analysts. This would also be reflected in bank share prices.