Research articles for the 2020-12-11
A Generalised Seasonality Test and Applications for Stock Market Seasonality
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This study develops a novel generalised seasonality test that utilises sequential dummy variable regressions for seasonality periodicity equal to prime numbers. It allows both to test for existence of any seasonal patterns against the broad null hypothesis of no seasonality and to isolate most prominent seasonal cycles while using harmonic mean p-values to control for multiple testing. The proposed test has numerous applications in time series analysis. As an example, it is applied to identify seasonal patterns in 76 national stock markets to detect trading cycles, determine their length, and test the weak-form efficient market hypothesis.
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This study develops a novel generalised seasonality test that utilises sequential dummy variable regressions for seasonality periodicity equal to prime numbers. It allows both to test for existence of any seasonal patterns against the broad null hypothesis of no seasonality and to isolate most prominent seasonal cycles while using harmonic mean p-values to control for multiple testing. The proposed test has numerous applications in time series analysis. As an example, it is applied to identify seasonal patterns in 76 national stock markets to detect trading cycles, determine their length, and test the weak-form efficient market hypothesis.
Attractiveness to Optimists and Stocks as Lotteries in the Cross-section of Expected Stock Returns
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Theoretical studies find that optimistic investors, who overweight the probabilities of better outcomes, can survive and influence asset prices even in a competitive market. To study the impact of optimistic investors on the cross-section of expected stock returns, I define the measure of attractiveness to optimists of a stock based on rank-dependent probability weighting. In both portfolio-level and firm-level analyses, I find an economically and statistically significant negative relation between the measure of attractiveness to optimists and the expected stock return even after controlling for a set of control variables in the cross-section of U.S. stock returns. Furthermore, this framework both conceptually and empirically subsumes the MAX effect, one of the most common characteristics for lottery-type stocks.
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Theoretical studies find that optimistic investors, who overweight the probabilities of better outcomes, can survive and influence asset prices even in a competitive market. To study the impact of optimistic investors on the cross-section of expected stock returns, I define the measure of attractiveness to optimists of a stock based on rank-dependent probability weighting. In both portfolio-level and firm-level analyses, I find an economically and statistically significant negative relation between the measure of attractiveness to optimists and the expected stock return even after controlling for a set of control variables in the cross-section of U.S. stock returns. Furthermore, this framework both conceptually and empirically subsumes the MAX effect, one of the most common characteristics for lottery-type stocks.
Bank Failures: Review and Comparison of Prediction Models
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The interest in banks’ bankruptcy prediction has rapidly increased especially after the 2008-2009 global financial crisis. The relevant consequences of bankruptcy cases have indeed highlighted the necessity for managers and regulators to develop and adopt appropriate early warning systems. The purpose of this paper is therefore to conduct a literature review of recent empirical contributions on bank’s default prediction by analyzing three underlying aspects: definition of default and financial distress, application of statistical and intelligent techniques, variables selection. The review also proposes some possible upgrades to promote future research on the topic, i.e. pointing out the potential role of non-financial information as good default predictors.
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The interest in banks’ bankruptcy prediction has rapidly increased especially after the 2008-2009 global financial crisis. The relevant consequences of bankruptcy cases have indeed highlighted the necessity for managers and regulators to develop and adopt appropriate early warning systems. The purpose of this paper is therefore to conduct a literature review of recent empirical contributions on bank’s default prediction by analyzing three underlying aspects: definition of default and financial distress, application of statistical and intelligent techniques, variables selection. The review also proposes some possible upgrades to promote future research on the topic, i.e. pointing out the potential role of non-financial information as good default predictors.
Betting on the Future: Online Gambling Goes Mainstream Financial
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This new CSFI report is written by two former accountants â€" Michael Mainelli, an expatriate American who now runs Z/Yen (which he describes as a risk/reward consultancy) and Sam Dibb (who is now a semi-professional gambler). Its main thesis is that the advent of the internet-based betting exchange â€" Betfair and its challengers â€" changes everything. These changes are greatly to the advantage of punters (no surprise there) â€" and greatly to the disadvantage of traditional High St. bookmakers, for whom the future is bleak. Adapt or die, is the message for them â€" and most will almost certainly die.Along with the threat to High St. bookies, the betting exchange is promoting the rapid convergence of gambling and mainstream financial products. If there is a willing seller and a willing buyer of any sort of risk and some sort of engine that will bring them together, why do we need traditional intermediaries? We can already trade sports contingency risk (promotion/relegation etc) over the internet. Ditto weather risk. It is not a big stretch to imagine all sorts of other risk transfer products being developed â€" disintermediating traditional insurers and banks. And, of course, betting-type products enjoy significant tax advantages over conventional insurance in the UK. (At least until Gordon Brown notices.)This is a serious paper about a serious industry. Betting shop turnover in the UK alone is now about £40 billion â€" or three times total premiums at Lloyd’s. (Which means that it is about time regulators took notice â€" particularly given the furore over money-laundering.) Globally, total gambling turnover is now well over US$400 billion â€" and rising. And, thanks in part to sympathetic tax treatment, the UK is home to about 30% of the global on-line betting industry â€" which is where the real action is.Our authors provide comprehensive odds on where the industry is going next â€" and what the broader impact on traditional bookies, society and politics is likely to be.They also tell you how to make money… As our Christmas present to you, there is a box (pages 11 and 12) which shows how a serious gambler can arbitrage the pricing inefficiencies between the online exchanges and the brain-dead bookies to make a risk-free return. Admittedly (in the example offered) it is only 3.2% - but that’s for half an hours work, and it compares very favourably with current equity or bond yields. It won’t last; but on the day it was written, this strategy really did make money for at least one of our authors.
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This new CSFI report is written by two former accountants â€" Michael Mainelli, an expatriate American who now runs Z/Yen (which he describes as a risk/reward consultancy) and Sam Dibb (who is now a semi-professional gambler). Its main thesis is that the advent of the internet-based betting exchange â€" Betfair and its challengers â€" changes everything. These changes are greatly to the advantage of punters (no surprise there) â€" and greatly to the disadvantage of traditional High St. bookmakers, for whom the future is bleak. Adapt or die, is the message for them â€" and most will almost certainly die.Along with the threat to High St. bookies, the betting exchange is promoting the rapid convergence of gambling and mainstream financial products. If there is a willing seller and a willing buyer of any sort of risk and some sort of engine that will bring them together, why do we need traditional intermediaries? We can already trade sports contingency risk (promotion/relegation etc) over the internet. Ditto weather risk. It is not a big stretch to imagine all sorts of other risk transfer products being developed â€" disintermediating traditional insurers and banks. And, of course, betting-type products enjoy significant tax advantages over conventional insurance in the UK. (At least until Gordon Brown notices.)This is a serious paper about a serious industry. Betting shop turnover in the UK alone is now about £40 billion â€" or three times total premiums at Lloyd’s. (Which means that it is about time regulators took notice â€" particularly given the furore over money-laundering.) Globally, total gambling turnover is now well over US$400 billion â€" and rising. And, thanks in part to sympathetic tax treatment, the UK is home to about 30% of the global on-line betting industry â€" which is where the real action is.Our authors provide comprehensive odds on where the industry is going next â€" and what the broader impact on traditional bookies, society and politics is likely to be.They also tell you how to make money… As our Christmas present to you, there is a box (pages 11 and 12) which shows how a serious gambler can arbitrage the pricing inefficiencies between the online exchanges and the brain-dead bookies to make a risk-free return. Admittedly (in the example offered) it is only 3.2% - but that’s for half an hours work, and it compares very favourably with current equity or bond yields. It won’t last; but on the day it was written, this strategy really did make money for at least one of our authors.
Competition and the Reputational Costs of Litigation
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We study the role of competition in customers' reactions to announcements of class action lawsuits against firms. We measure visits to retail outlets using aggregated and anonymized mobile phone data covering approximately 10% of all mobile devices in the United States. The announcement of a class action lawsuit results on average in 3-4% temporary reduction in customer visits to the target firm's outlets. The effect is strongly dependent on competition. Outlets facing more competition experience significantly larger negative effects. The effect of competition differs across geographic and industry proximity. Close peers, as measured by industry codes, have the largest effect, while geographically both very local (ZIP code-level) competition as well as state-level competition seem to matter. The announcement returns of class action lawsuits similarly depend on competition, with firms facing more competition experiencing more negative announcement returns. Using quarterly accounting revenues and a comprehensive sample of class action lawsuits yields similar results, with firms in more competitive industries experiencing larger reductions in revenue following the announcement of class action lawsuits. Our results suggest that competition is an important component in customers' ability to discipline firms for misbehavior.
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We study the role of competition in customers' reactions to announcements of class action lawsuits against firms. We measure visits to retail outlets using aggregated and anonymized mobile phone data covering approximately 10% of all mobile devices in the United States. The announcement of a class action lawsuit results on average in 3-4% temporary reduction in customer visits to the target firm's outlets. The effect is strongly dependent on competition. Outlets facing more competition experience significantly larger negative effects. The effect of competition differs across geographic and industry proximity. Close peers, as measured by industry codes, have the largest effect, while geographically both very local (ZIP code-level) competition as well as state-level competition seem to matter. The announcement returns of class action lawsuits similarly depend on competition, with firms facing more competition experiencing more negative announcement returns. Using quarterly accounting revenues and a comprehensive sample of class action lawsuits yields similar results, with firms in more competitive industries experiencing larger reductions in revenue following the announcement of class action lawsuits. Our results suggest that competition is an important component in customers' ability to discipline firms for misbehavior.
Contagion Accounting
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We provide a simple and tractable accounting-based stress-testing framework to assess loss dynamics in the banking sector, in a context of leverage targeting. Contagion can occur through direct interbank exposures, and indirect exposures due to overlapping portfolios with the associated price dynamics via fire sales. We apply the framework to three granular proprietary ECB datasets, including an interbank network of 26 large euro area banks as well as their overlapping portfolios of loans, derivatives and securities. A 5 percent shock to the price of assets held in the trading book leads to an initial loss of 30 percent of system equity and an additional loss of 1.3 percent due to fire sales spillovers. Direct interbank contagion is negligible in our analysis. Our findings underscore the importance of accurately estimating the price effects of fire sales.
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We provide a simple and tractable accounting-based stress-testing framework to assess loss dynamics in the banking sector, in a context of leverage targeting. Contagion can occur through direct interbank exposures, and indirect exposures due to overlapping portfolios with the associated price dynamics via fire sales. We apply the framework to three granular proprietary ECB datasets, including an interbank network of 26 large euro area banks as well as their overlapping portfolios of loans, derivatives and securities. A 5 percent shock to the price of assets held in the trading book leads to an initial loss of 30 percent of system equity and an additional loss of 1.3 percent due to fire sales spillovers. Direct interbank contagion is negligible in our analysis. Our findings underscore the importance of accurately estimating the price effects of fire sales.
ETF Heartbeat Trades, Tax Efficiencies, and Clienteles: The Role of Taxes in the Flow Migration from Active Mutual Funds to ETFs
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We study the use of “heartbeat trades†by ETFs in explaining their superior tax efficiency. Using the in-kind redemption exemption rule for ETF outflows, authorized participants help ETFs avoid distributing realized capital gains and reduce their tax overhang. As a result, ETFs with two heartbeat trades per year end up with approximately 0.86% in lower tax burdens, compared to similar mutual funds. Challenged by ETF tax efficiencies, mutual funds exhibit higher flow-tax sensitivity that is economically and statistically more significant than the flow-fee sensitivity. Active funds with relatively higher tax burdens had more outflows by tax-sensitive investors at the same time when ETFs with similar investment styles had stronger inflows. Using holdings data of institutions with high net-worth clients, we find that institutions with tax-sensitive investors allocate four times more assets to ETFs than other institutions, representing an important driver behind overall surge in ETF flows especially after the capital gains tax increase in 2013. We conclude that the migration of flows from mutual funds to ETFs appear to be driven mainly by tax considerations.
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We study the use of “heartbeat trades†by ETFs in explaining their superior tax efficiency. Using the in-kind redemption exemption rule for ETF outflows, authorized participants help ETFs avoid distributing realized capital gains and reduce their tax overhang. As a result, ETFs with two heartbeat trades per year end up with approximately 0.86% in lower tax burdens, compared to similar mutual funds. Challenged by ETF tax efficiencies, mutual funds exhibit higher flow-tax sensitivity that is economically and statistically more significant than the flow-fee sensitivity. Active funds with relatively higher tax burdens had more outflows by tax-sensitive investors at the same time when ETFs with similar investment styles had stronger inflows. Using holdings data of institutions with high net-worth clients, we find that institutions with tax-sensitive investors allocate four times more assets to ETFs than other institutions, representing an important driver behind overall surge in ETF flows especially after the capital gains tax increase in 2013. We conclude that the migration of flows from mutual funds to ETFs appear to be driven mainly by tax considerations.
Economic Consequences of IFRS Adoption: The Role of Changes in Disclosure Quality
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This study adopts a two-step approach to highlight the disclosure quality channel that drives economic consequences of International Financial Reporting Standards [IFRS] adoption. This approach helps address the identification challenge noted by Leuz and Wysocki (2006) and offer direct evidence on the role of disclosure quality. In the first step, we document the impact of the IFRS mandate on changes in disclosure quality proxied by the granularity of line-item disclosure in financial statements. We find that IFRS-adopting firms provide more disaggregated information upon IFRS adoption, such as more granular disclosure of intangible assets and long-term investments on the Balance Sheet and greater disaggregation of depreciation, amortization, and non-operating income items on the Income Statement. In the second step, we link the observed disclosure changes to the benefits and costs of IFRS adoption. We show that greater disaggregated information due to IFRS adoption enhances market liquidity and decreases information asymmetry, but does not affect audit fees differentially. Our evidence has implications for standard-setters as they evaluate cost-benefit tradeoffs when considering disclosure changes in the future.
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This study adopts a two-step approach to highlight the disclosure quality channel that drives economic consequences of International Financial Reporting Standards [IFRS] adoption. This approach helps address the identification challenge noted by Leuz and Wysocki (2006) and offer direct evidence on the role of disclosure quality. In the first step, we document the impact of the IFRS mandate on changes in disclosure quality proxied by the granularity of line-item disclosure in financial statements. We find that IFRS-adopting firms provide more disaggregated information upon IFRS adoption, such as more granular disclosure of intangible assets and long-term investments on the Balance Sheet and greater disaggregation of depreciation, amortization, and non-operating income items on the Income Statement. In the second step, we link the observed disclosure changes to the benefits and costs of IFRS adoption. We show that greater disaggregated information due to IFRS adoption enhances market liquidity and decreases information asymmetry, but does not affect audit fees differentially. Our evidence has implications for standard-setters as they evaluate cost-benefit tradeoffs when considering disclosure changes in the future.
Economic Simulation of Cryptocurrencies
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Cryptocurrencies have the potential to become effective currencies that give a higher level of macroeconomic control, thanks to the information that is available about holdings and transactions, and the potential for automated control mechanisms. However, these cryptocurrencies need to be designed properly and tested before launch. This paper reports the early results of an economic model that simulates a variety of behaviors by economic agents and some simple control mechanisms. An economic simulation model is likely to be a valuable tool in developing effective cryptocurrency systems and interacting with regulators.
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Cryptocurrencies have the potential to become effective currencies that give a higher level of macroeconomic control, thanks to the information that is available about holdings and transactions, and the potential for automated control mechanisms. However, these cryptocurrencies need to be designed properly and tested before launch. This paper reports the early results of an economic model that simulates a variety of behaviors by economic agents and some simple control mechanisms. An economic simulation model is likely to be a valuable tool in developing effective cryptocurrency systems and interacting with regulators.
Equity Factors and Firms’ Perceived Cost of Capital
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I study firms’ perceived cost of capital using a decade of survey data. Firms with higher market beta, higher book-to-market, and lower market size report a higher perceived cost of equity, consistent with the Fama and French (1993) model. The three factors explain 37% of the variation in perceived cost of equity and 26% of the variation in the hurdle rates used in capital budgeting. An increase in hurdle rates coming from exposure to the risk factors is associated with a decrease in investment rates. The results are consistent with rational mangers using risk factors in their discount rates, leading the risk factors to have real effects on the economy.
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I study firms’ perceived cost of capital using a decade of survey data. Firms with higher market beta, higher book-to-market, and lower market size report a higher perceived cost of equity, consistent with the Fama and French (1993) model. The three factors explain 37% of the variation in perceived cost of equity and 26% of the variation in the hurdle rates used in capital budgeting. An increase in hurdle rates coming from exposure to the risk factors is associated with a decrease in investment rates. The results are consistent with rational mangers using risk factors in their discount rates, leading the risk factors to have real effects on the economy.
Finance in the New U.S. Economy: Local Finance and Service Job Growth in the Post-Industrial Economy
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I examine whether local bank finance facilitated the transition to a service-based economy in the U.S. I identify a causal role for local finance in service job creation. I use county-level changes to alcohol laws as demand shocks to service employers across a subsample of U.S. counties. Counties with more local finance experience more service job creation. This leads to labor market transitions that reflect shifts in the broader U.S. economy. Information asymmetry and collateral constraints connect local finance to the service sector. The findings identify a unique role for local finance in the evolution to a post-industrial service-based economy.
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I examine whether local bank finance facilitated the transition to a service-based economy in the U.S. I identify a causal role for local finance in service job creation. I use county-level changes to alcohol laws as demand shocks to service employers across a subsample of U.S. counties. Counties with more local finance experience more service job creation. This leads to labor market transitions that reflect shifts in the broader U.S. economy. Information asymmetry and collateral constraints connect local finance to the service sector. The findings identify a unique role for local finance in the evolution to a post-industrial service-based economy.
Half Banked: The Economic Impact of Cash Management in the Marijuana Industry
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We investigate the economic effects of cash management services that banks and credit unions offer in the legal marijuana industry, where only half of businesses have access to cash management services. Administrative data from Washington state on marijuana sales, data on financial institutions, and our hand-collected survey on marijuana dispensaries allow us to investigate product-level effects. Dispensaries with cash management services have 40% higher profitability, and we find that this is due to reduced frictions with upstream suppliers. Specifically, dispensaries with cash management negotiate 10% lower wholesale prices. Through this channel, we find banking services provide large economic value.
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We investigate the economic effects of cash management services that banks and credit unions offer in the legal marijuana industry, where only half of businesses have access to cash management services. Administrative data from Washington state on marijuana sales, data on financial institutions, and our hand-collected survey on marijuana dispensaries allow us to investigate product-level effects. Dispensaries with cash management services have 40% higher profitability, and we find that this is due to reduced frictions with upstream suppliers. Specifically, dispensaries with cash management negotiate 10% lower wholesale prices. Through this channel, we find banking services provide large economic value.
How Are Institutions Informed? Proactive Trading, Information Flows, and Stock Selection Strategies
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Using the relationship between institutional trades and sequential public information, this study provides a systematic way to identify institutional trades that are informative about future equity returns. By studying the U.S. financial institutions from 1994 to 2016, I show that institutional trades initiated by managers responding proactively to upcoming informational signals strongly predict future stock returns. The predictability of informed institutions is more evident for stocks with higher information asymmetry and in periods of higher profit opportunities. The informed institutions outperform the uninformed ones by 2% on an annualized basis and their performance gap is persistent. Importantly, the return predictability of informed institutional trades is not subsumed by the return-predictive signals documented in prior research, computed either from institutional holdings or from financial statements. Further analyses show that the informed institutional investors derive their superior ability of forecasting future stock returns from processing corporate fundamentals and acquiring private information. This study derives a novel return predictor using the institutions’ proactive trading behavior and identifies various informational sources of informed traders.
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Using the relationship between institutional trades and sequential public information, this study provides a systematic way to identify institutional trades that are informative about future equity returns. By studying the U.S. financial institutions from 1994 to 2016, I show that institutional trades initiated by managers responding proactively to upcoming informational signals strongly predict future stock returns. The predictability of informed institutions is more evident for stocks with higher information asymmetry and in periods of higher profit opportunities. The informed institutions outperform the uninformed ones by 2% on an annualized basis and their performance gap is persistent. Importantly, the return predictability of informed institutional trades is not subsumed by the return-predictive signals documented in prior research, computed either from institutional holdings or from financial statements. Further analyses show that the informed institutional investors derive their superior ability of forecasting future stock returns from processing corporate fundamentals and acquiring private information. This study derives a novel return predictor using the institutions’ proactive trading behavior and identifies various informational sources of informed traders.
Insuring People Risks, Rewarding HRM: Proactive and Reactive Link of HRM to Business Strategy
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At times, HRM must be re-active, dealing with problems or opportunities as they arise, yet leading thinkers stress the importance of being pro-active, helping to shape the strategies of the organisation. A pro-active role means identifying, analysing and implementing solutions to problems and opportunities before they arise. How can these two roles be reconciled? What mechanisms can ensure that reactive and proactive roles support the business strategy?
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At times, HRM must be re-active, dealing with problems or opportunities as they arise, yet leading thinkers stress the importance of being pro-active, helping to shape the strategies of the organisation. A pro-active role means identifying, analysing and implementing solutions to problems and opportunities before they arise. How can these two roles be reconciled? What mechanisms can ensure that reactive and proactive roles support the business strategy?
International Banking Amidst COVID-19: Resilience and Drivers
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The claims of international banks held up well during the COVID-19 crisis, although economic output fell by even more than during the Great Financial Crisis (GFC). Both cross-border and local claims were resilient, in advanced and emerging market economies alike. Looking at lending to the real economy, we examine how borrower and lender characteristics relate to the growth of claims on the private non-financial sector during the pandemic. We find that countries with stronger economic activity and smaller financial vulnerabilities borrowed more. Likewise, better capitalised banking systems lent more. The economic stress also led advanced economy borrowers to draw on pre-existing credit lines from foreign banks.
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The claims of international banks held up well during the COVID-19 crisis, although economic output fell by even more than during the Great Financial Crisis (GFC). Both cross-border and local claims were resilient, in advanced and emerging market economies alike. Looking at lending to the real economy, we examine how borrower and lender characteristics relate to the growth of claims on the private non-financial sector during the pandemic. We find that countries with stronger economic activity and smaller financial vulnerabilities borrowed more. Likewise, better capitalised banking systems lent more. The economic stress also led advanced economy borrowers to draw on pre-existing credit lines from foreign banks.
Is Audit Committee Equity Compensation Related to Audit Fees?
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Section 301 of SOX implicitly assumes that audit committees can independently determine audit fees. Critics of Section 301 have questioned this assumption, in particular, and the efficacy of Section 301, more generally. In response, the SEC issued a concept release in 2015 calling for public disclosure of the process that audit committees follow for determining auditor compensation. Motivated by these calls and the widespread use of stocks and options to compensate firms’ independent directors, we examine the relation between equity compensation granted to audit committee members and audit fees. Using a sample of 3,685 firm-year observations during 2007-2015, we find a negative relation between audit committee equity compensation and audit fees, consistent with larger equity pay inducing audit committee members to compromise independence by paying lower audit fees. These findings are robust to controlling for endogeneity, firm size, alternative measures of equity compensation, alternative samples, and an alternative treatment of extreme values. We further show that larger equity compensation is associated with lower earnings quality. We also find that the negative effect of equity compensation on audit fees is stronger when city-level audit market competition is high. However, this negative relation disappears when (1) firms face high litigation risk, (2) auditors have stronger bargaining power, (3) the audit committee includes a high proportion of accounting experts, and (4) auditors are industry experts. Our results are relevant to regulators and investors.
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Section 301 of SOX implicitly assumes that audit committees can independently determine audit fees. Critics of Section 301 have questioned this assumption, in particular, and the efficacy of Section 301, more generally. In response, the SEC issued a concept release in 2015 calling for public disclosure of the process that audit committees follow for determining auditor compensation. Motivated by these calls and the widespread use of stocks and options to compensate firms’ independent directors, we examine the relation between equity compensation granted to audit committee members and audit fees. Using a sample of 3,685 firm-year observations during 2007-2015, we find a negative relation between audit committee equity compensation and audit fees, consistent with larger equity pay inducing audit committee members to compromise independence by paying lower audit fees. These findings are robust to controlling for endogeneity, firm size, alternative measures of equity compensation, alternative samples, and an alternative treatment of extreme values. We further show that larger equity compensation is associated with lower earnings quality. We also find that the negative effect of equity compensation on audit fees is stronger when city-level audit market competition is high. However, this negative relation disappears when (1) firms face high litigation risk, (2) auditors have stronger bargaining power, (3) the audit committee includes a high proportion of accounting experts, and (4) auditors are industry experts. Our results are relevant to regulators and investors.
Is the Tone of Risk Disclosures in MD&As Relevant to Debt Markets? Evidence from the Pricing of Credit Default Swaps
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This paper examines whether the tone of corporate textual disclosures related to risk and uncertainty conveys relevant information to the credit default swap (CDS) market. Prior studies largely focus on the amount of risk disclosures and provide inconclusive evidence on the usefulness of risk disclosures for investors in assessing firm risk. Using a large sample of textual risk disclosures in the Management’s Discussion and Analysis (MD&A) section of 10-K and 10-Q filings, I predict and find that the change in CDS spreads over the three-day window surrounding the 10-K/Q filing date is positively associated with the pessimism of the language used in the risk disclosures. I conduct several analyses to show that the effect of the tone of risk disclosures is distinguishable from that of the amount of such disclosures. Cross-sectional analyses reveal that the CDS market reaction to the tone of MD&A risk disclosures is more pronounced for reference entities closer to default, consistent with creditors’ particular concern about downside risk. Further, the CDS market reacts more significantly to the tone of MD&A risk disclosures for reference entities with a weaker information environment. Overall, these results support the view that the tone of textual risk disclosures in MD&As has information content for investors in the CDS market in particular and debt markets in general. My findings improve the understanding of textual risk disclosures by showing that the tone and the amount of such disclosures have different implications for debt market investors’ risk perceptions.
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This paper examines whether the tone of corporate textual disclosures related to risk and uncertainty conveys relevant information to the credit default swap (CDS) market. Prior studies largely focus on the amount of risk disclosures and provide inconclusive evidence on the usefulness of risk disclosures for investors in assessing firm risk. Using a large sample of textual risk disclosures in the Management’s Discussion and Analysis (MD&A) section of 10-K and 10-Q filings, I predict and find that the change in CDS spreads over the three-day window surrounding the 10-K/Q filing date is positively associated with the pessimism of the language used in the risk disclosures. I conduct several analyses to show that the effect of the tone of risk disclosures is distinguishable from that of the amount of such disclosures. Cross-sectional analyses reveal that the CDS market reaction to the tone of MD&A risk disclosures is more pronounced for reference entities closer to default, consistent with creditors’ particular concern about downside risk. Further, the CDS market reacts more significantly to the tone of MD&A risk disclosures for reference entities with a weaker information environment. Overall, these results support the view that the tone of textual risk disclosures in MD&As has information content for investors in the CDS market in particular and debt markets in general. My findings improve the understanding of textual risk disclosures by showing that the tone and the amount of such disclosures have different implications for debt market investors’ risk perceptions.
Labor Market Mobility and Expectation Management: Evidence from Enforceability of Non-Compete Provisions
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This study examines how managers’ use of expectation management is affected by their labor market mobility, which we measure by the enforceability of non-compete provisions in their employment contracts. Exploiting quasi-natural experiments, our difference-in-differences analyses provide new causal insights to the growing literature on how managers’ career concerns affect their disclosure choices. Consistent with a less mobile labor market imposing more pressure on managers to achieve earnings expectations, we predict and find that managers in U.S. states that tightened enforcement of non-compete provisions are more likely to manage analyst expectations downward. We also find that downward expectation management is used to a greater extent than other tools such as real and accrual-based earnings management. Additional analysis shows that the increase in expectation management is more pronounced for CEOs with lower general skills or shorter tenures, for firms with more independent boards, and for industries that are more homogeneous. Our path analysis suggests a significant link between increased use of expectation management after tightened non-compete enforcement and meeting and beating earnings expectations, which in turn is linked to lower executive turnover. Overall, our findings suggest that expectation management is an important channel through which non-compete enforcement reduces executive labor market mobility. Our study sheds light on the underlying mechanism through which labor market mobility affects disclosure choices and has important implications for both firms and regulators on the use and enforcement of non-compete provisions.
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This study examines how managers’ use of expectation management is affected by their labor market mobility, which we measure by the enforceability of non-compete provisions in their employment contracts. Exploiting quasi-natural experiments, our difference-in-differences analyses provide new causal insights to the growing literature on how managers’ career concerns affect their disclosure choices. Consistent with a less mobile labor market imposing more pressure on managers to achieve earnings expectations, we predict and find that managers in U.S. states that tightened enforcement of non-compete provisions are more likely to manage analyst expectations downward. We also find that downward expectation management is used to a greater extent than other tools such as real and accrual-based earnings management. Additional analysis shows that the increase in expectation management is more pronounced for CEOs with lower general skills or shorter tenures, for firms with more independent boards, and for industries that are more homogeneous. Our path analysis suggests a significant link between increased use of expectation management after tightened non-compete enforcement and meeting and beating earnings expectations, which in turn is linked to lower executive turnover. Overall, our findings suggest that expectation management is an important channel through which non-compete enforcement reduces executive labor market mobility. Our study sheds light on the underlying mechanism through which labor market mobility affects disclosure choices and has important implications for both firms and regulators on the use and enforcement of non-compete provisions.
Pay for Outsiders: Incentive Compensation for Nonfamily Executives in Family Firms
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We use a hand-collected sample of 1,628 S&P 1500 firms and more than 12,000 executives to examine how family firms compensate nonfamily executives. Family firms comprise a large percentage of firms around the world, and most of their executives are not members of the founding family. Moreover, the founding family’s engagement in the firm alters agency conflicts, which in turn should influence the design of incentive compensation. However, there is no empirical evidence on whether and how the incentive compensation of nonfamily executives differs between family and nonfamily firms. Our study intends to fill this gap in the literature. Consistent with our predictions, nonfamily executives in family firms receive significantly less performance-based pay and equity-based pay. Family monitoring, risk aversion, and a reluctance to dilute family ownership all contribute to the pay differences. Although incentive pay and total pay are lower in family firms, nonfamily executives receive safer pay and enjoy greater job stability. An analysis of executives’ moves across firms suggests that ownership structure, not executives’ preferences, is more likely the driver of pay differences between family and nonfamily firms. Our findings suggest that researchers should consider founding-family engagement to avoid misleading inferences with regard to the determinants of incentive compensation, and our findings should help compensation consultants better understand and implement pay packages for family firms and nonfamily firms. The results also imply that uniform compensation regulations intended to improve the monitoring of executives in widely held firms may not be as effective in family firms.
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We use a hand-collected sample of 1,628 S&P 1500 firms and more than 12,000 executives to examine how family firms compensate nonfamily executives. Family firms comprise a large percentage of firms around the world, and most of their executives are not members of the founding family. Moreover, the founding family’s engagement in the firm alters agency conflicts, which in turn should influence the design of incentive compensation. However, there is no empirical evidence on whether and how the incentive compensation of nonfamily executives differs between family and nonfamily firms. Our study intends to fill this gap in the literature. Consistent with our predictions, nonfamily executives in family firms receive significantly less performance-based pay and equity-based pay. Family monitoring, risk aversion, and a reluctance to dilute family ownership all contribute to the pay differences. Although incentive pay and total pay are lower in family firms, nonfamily executives receive safer pay and enjoy greater job stability. An analysis of executives’ moves across firms suggests that ownership structure, not executives’ preferences, is more likely the driver of pay differences between family and nonfamily firms. Our findings suggest that researchers should consider founding-family engagement to avoid misleading inferences with regard to the determinants of incentive compensation, and our findings should help compensation consultants better understand and implement pay packages for family firms and nonfamily firms. The results also imply that uniform compensation regulations intended to improve the monitoring of executives in widely held firms may not be as effective in family firms.
Predicting Litigation Risk via Machine Learning
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We demonstrate the value of machine learning in accounting through a detailed examination of litigation risk, an important and frequently used estimate in the literature. We evaluate a comprehensive set of twelve machine learning techniques and benchmark their performance against the logistic regression models in Kim and Skinner (2012). These models improve the prediction of litigation risk, with hourglass-shaped and convolutional neural networks the most effective. The improvements are substantial, and are driven by increased precision, the most salient attribute of litigation estimates in the accounting literature. We also produce firm-year litigation risk estimates for use in future research from a convolutional neural network model that uses recursive feature elimination on a pool of 68 possible parameters. Overall, our results suggest that the joint consideration of economically-meaningful predictors and machine learning techniques maximize the effectiveness of accounting estimates.
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We demonstrate the value of machine learning in accounting through a detailed examination of litigation risk, an important and frequently used estimate in the literature. We evaluate a comprehensive set of twelve machine learning techniques and benchmark their performance against the logistic regression models in Kim and Skinner (2012). These models improve the prediction of litigation risk, with hourglass-shaped and convolutional neural networks the most effective. The improvements are substantial, and are driven by increased precision, the most salient attribute of litigation estimates in the accounting literature. We also produce firm-year litigation risk estimates for use in future research from a convolutional neural network model that uses recursive feature elimination on a pool of 68 possible parameters. Overall, our results suggest that the joint consideration of economically-meaningful predictors and machine learning techniques maximize the effectiveness of accounting estimates.
Principal Eigenportfolios for U.S. Equities
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We analyze portfolios constructed from the principal eigenvector of the equity returns' correlation matrix and compare how well these portfolios track the capitalization weighted market portfolio. It is well known empirically that principal eigenportfolios are a good proxy for the market portfolio. We quantify this property through the large-dimensional asymptotic analysis of a spike model, which is comprised of a rank-1 matrix and a random matrix. We show that, in this limit, the top eigenvector of the correlation matrix is close to the vector of market betas divided component-wise by returns standard deviation. Historical returns data supports this analytical explanation for the correspondence between the top eigenportfolio and the market portfolio. We further examine this correspondence using eigenvectors obtained from hierarchically constructed tensors where stocks are separated into their respective industry sectors. This hierarchical approach provides robustness in eigenportfolio construction for a large number of equity returns when a shortened time window is used. For portfolios constructed using a rolling window of only one month of daily returns, our study shows improved tracking between the returns of the market portfolio and those from hierarchically constructed portfolios.
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We analyze portfolios constructed from the principal eigenvector of the equity returns' correlation matrix and compare how well these portfolios track the capitalization weighted market portfolio. It is well known empirically that principal eigenportfolios are a good proxy for the market portfolio. We quantify this property through the large-dimensional asymptotic analysis of a spike model, which is comprised of a rank-1 matrix and a random matrix. We show that, in this limit, the top eigenvector of the correlation matrix is close to the vector of market betas divided component-wise by returns standard deviation. Historical returns data supports this analytical explanation for the correspondence between the top eigenportfolio and the market portfolio. We further examine this correspondence using eigenvectors obtained from hierarchically constructed tensors where stocks are separated into their respective industry sectors. This hierarchical approach provides robustness in eigenportfolio construction for a large number of equity returns when a shortened time window is used. For portfolios constructed using a rolling window of only one month of daily returns, our study shows improved tracking between the returns of the market portfolio and those from hierarchically constructed portfolios.
Quid Pro Quo: Liquidity Insurance in Dealer-Fund Network
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Using a novel security-level data from SEC on US tri-party repo, this paper investigates how trading relationship impacts liquidity provision within the dealer-fund repo network. This paper documents a unique repo rate dynamic: in normal times, funds charge a premium to dealers with whom they have the strongest trading relationship; in market-wide liquidity shocks, these dealers are rewarded with lower repo rate markup and better immediacy. I exploit the 2016 Money Market Fund Reform as an exogenous liquidity shock to establish a liquidity insurance mechanism. As liquidity insurers are not easily replaceable, shown in the unexpected liquidation case of Charles Schwab Sweep Funds, costly search incentivizes dealers to engage in such stable quid pro quo relationship with money market funds.
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Using a novel security-level data from SEC on US tri-party repo, this paper investigates how trading relationship impacts liquidity provision within the dealer-fund repo network. This paper documents a unique repo rate dynamic: in normal times, funds charge a premium to dealers with whom they have the strongest trading relationship; in market-wide liquidity shocks, these dealers are rewarded with lower repo rate markup and better immediacy. I exploit the 2016 Money Market Fund Reform as an exogenous liquidity shock to establish a liquidity insurance mechanism. As liquidity insurers are not easily replaceable, shown in the unexpected liquidation case of Charles Schwab Sweep Funds, costly search incentivizes dealers to engage in such stable quid pro quo relationship with money market funds.
Technical Appendix for 'Exploring Breaks in the Distribution of Stock Returns: Empirical Evidence from Apple Inc.'
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This Appendix contains technical details on the changepoint detection algorithms applied in the paper.
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This Appendix contains technical details on the changepoint detection algorithms applied in the paper.
The Great Governance Debate â€" Towards a Good Governance Index for Listed Companies
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A reliable corporate governance (CG) index â€" a combination of individual governance indicators capable of measuring the overall quality of a firm’s governance â€" is regarded as the Holy Grail of governance research. Ideally a CG index would measure all of the characteristics that matter for corporate outcomes, and would be a valuable tool for informing both CG decisions within firms and investment decisions across firms. Over the past 20 years, academics and practitioners have made several attempts at producing CG indices, so far with limited success. Existing indices have often been criticised for adopting a ‘kitchen sink’ approach to the problem by simply combining large numbers of indicators (typically between 50 and 100) using an arbitrary weighting scheme to produce CG index scores for companies.3 Several critics have also argued that the ‘tick-box approach’ used to compile the basic CG databases for such indices can easily be gamed by companies. Such gaming can render them uninformative over time.The ultimate test of the quality of a CG index is its usefulness to both investors and to other stakeholders in identifying future company performance. By and large, existing indices continue to fail this test: they often do not identify the best-performing companies and in some cases fail to detect the worst-performing ones.The Institute of Directors, in partnership with Cass Business School and Z/Yen, is taking on this challenge. In this document we present two important innovations. First, we use a new list of indicators that are not simply related to compliance with the UK CG code. Although the emphasis is on public information, crucially, we do not only rely on the information disclosed in annual reports. Second, the weights assigned to the individual components are inferred on the basis of surveys of customer, investor and employee assessments of the quality of the corporate governance regime of the rated companies. This methodology automatically adjusts for the perceived importance of different governance mechanisms and implicitly creates a link between the index and firm performance. This could also significantly reduce the scope for gaming and preserve the relevance of an index over time.We believe, therefore, that these approaches could produce a more reliable index in the future, which will help us all learn what works and does not work in corporate governance.
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A reliable corporate governance (CG) index â€" a combination of individual governance indicators capable of measuring the overall quality of a firm’s governance â€" is regarded as the Holy Grail of governance research. Ideally a CG index would measure all of the characteristics that matter for corporate outcomes, and would be a valuable tool for informing both CG decisions within firms and investment decisions across firms. Over the past 20 years, academics and practitioners have made several attempts at producing CG indices, so far with limited success. Existing indices have often been criticised for adopting a ‘kitchen sink’ approach to the problem by simply combining large numbers of indicators (typically between 50 and 100) using an arbitrary weighting scheme to produce CG index scores for companies.3 Several critics have also argued that the ‘tick-box approach’ used to compile the basic CG databases for such indices can easily be gamed by companies. Such gaming can render them uninformative over time.The ultimate test of the quality of a CG index is its usefulness to both investors and to other stakeholders in identifying future company performance. By and large, existing indices continue to fail this test: they often do not identify the best-performing companies and in some cases fail to detect the worst-performing ones.The Institute of Directors, in partnership with Cass Business School and Z/Yen, is taking on this challenge. In this document we present two important innovations. First, we use a new list of indicators that are not simply related to compliance with the UK CG code. Although the emphasis is on public information, crucially, we do not only rely on the information disclosed in annual reports. Second, the weights assigned to the individual components are inferred on the basis of surveys of customer, investor and employee assessments of the quality of the corporate governance regime of the rated companies. This methodology automatically adjusts for the perceived importance of different governance mechanisms and implicitly creates a link between the index and firm performance. This could also significantly reduce the scope for gaming and preserve the relevance of an index over time.We believe, therefore, that these approaches could produce a more reliable index in the future, which will help us all learn what works and does not work in corporate governance.
Voting with their Sandals: Partisan Residential Sorting on Climate Change Risk
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Climate change partisanship is reflected in residential choice. Comparing individual occupants at properties in the same zip code with similar elevation and proximity to the coast, registered Republicans (Democrats) are more (less) likely than Independents to own houses exposed to sea level rise (SLR). Findings are unchanged controlling flexibly for other individual demographics and a variety of granular property characteristics, including the value of the home. This sorting is driven by differential perceptions of long-run SLR risks across the political spectrum not tolerance for current flood risk or preferences for correlated coastal amenities. Observed residential sorting manifests among owners regardless of occupancy, but not among renters. We also find no residential sorting in relation to storm surge exposure, which is a primary driver of current flood risk. Anticipatory sorting on climate change informs models of migration in the face of long-run risks and suggests households that are most likely to vote against climate friendly policies and least likely to adapt may ultimately bear the burden of climate change.
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Climate change partisanship is reflected in residential choice. Comparing individual occupants at properties in the same zip code with similar elevation and proximity to the coast, registered Republicans (Democrats) are more (less) likely than Independents to own houses exposed to sea level rise (SLR). Findings are unchanged controlling flexibly for other individual demographics and a variety of granular property characteristics, including the value of the home. This sorting is driven by differential perceptions of long-run SLR risks across the political spectrum not tolerance for current flood risk or preferences for correlated coastal amenities. Observed residential sorting manifests among owners regardless of occupancy, but not among renters. We also find no residential sorting in relation to storm surge exposure, which is a primary driver of current flood risk. Anticipatory sorting on climate change informs models of migration in the face of long-run risks and suggests households that are most likely to vote against climate friendly policies and least likely to adapt may ultimately bear the burden of climate change.
What Characterizes Farmers Who Purchase Crop Insurance in Poland?
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The purpose of the paper is to compare population of farmers that bought crop insurance with farmers that are uninsured. Based thereon, the author identified features characterizing the insured farmers. These findings were applied to draw more general conclusions concerning factors influencing the insurance awareness and propensity to buy insurance coverage. Demographic, social and economic criteria, individual perception of risk, the loss ratio, and the willingness to pay the insurance premium were taken into consideration. Empirical research is based upon a sample of 150 Polish farmers that were interviewed using the CATI approach. It was found that farms with greater production volume (annual income) and with a larger crop area present higher willingness to buy insurance. Farmers who experienced damage to crops are more inclined to buy insurance coverage. Moreover, higher insurance penetration rate can be found among farmers who are willing to pay a higher price for a crop insurance policy. Surprisingly, despite frequently formulated assumptions, variables such as age of farmer, level of education or individual perception of risk do not determine the decision on insurance purchase.
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The purpose of the paper is to compare population of farmers that bought crop insurance with farmers that are uninsured. Based thereon, the author identified features characterizing the insured farmers. These findings were applied to draw more general conclusions concerning factors influencing the insurance awareness and propensity to buy insurance coverage. Demographic, social and economic criteria, individual perception of risk, the loss ratio, and the willingness to pay the insurance premium were taken into consideration. Empirical research is based upon a sample of 150 Polish farmers that were interviewed using the CATI approach. It was found that farms with greater production volume (annual income) and with a larger crop area present higher willingness to buy insurance. Farmers who experienced damage to crops are more inclined to buy insurance coverage. Moreover, higher insurance penetration rate can be found among farmers who are willing to pay a higher price for a crop insurance policy. Surprisingly, despite frequently formulated assumptions, variables such as age of farmer, level of education or individual perception of risk do not determine the decision on insurance purchase.
When Do Corporate Bond Investors Earn a Premium for Bearing Risk? A Test Spanning the Great Depression of the 1930s
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For many years the Stocks, Bonds, Bills & Inflation yearbook has served as the primary source for calibrating historical asset returns. However, uneasiness has grown about its depiction of corporate bond returns prior to the second World War. I document problems with the source data used in the SBBI and replace its flawed dataset with new observations of bond prices from 1926 to 1946 for a sample of several hundred large bonds listed on the NYSE and rated investment-grade. I find that the SBBI overstates corporate bond returns in the 1930s and accordingly, gives an unreliable estimate of the premium received for owning investment grade corporate bonds rather than government bonds during the prewar years. To extend the analysis I collected additional bond price data from 1946 to 1974 and find that the SBBI also overstates corporate bond returns in the 1960s. The problem again stems from a reliance on flawed yield series in place of observing bond prices. I combine the new data with existing data to examine the corporate bond premium from 1909 through 2019. Using ten-year rolling returns, over the past century I find the average premium earned on long maturity corporate bonds to be small, about 15 basis points annualized. For many of the ten-year rolls, the premium was instead a deficit: a bond investor would have done better owning only long government bonds. The small and fitful premium contrasts with the yield spread on investment-grade bonds, which was always positive and substantial throughout the period. Because the premium has been much more variable, the relative size of the yield spread does not seem to be predictive of whether a premium will subsequently be earned and how much. Results are interpreted in terms of the importance of regime change in financial history: sometimes corporate bonds outperform government bonds, sometimes they do not, just as sometimes stocks outperform bonds, and sometimes they do not, contra Siegel (2014). The idea of regime change challenges the notion that a mean computed over a longer rather than a shorter interval contributes any additional predictive power to the study of asset returns over human horizons.
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For many years the Stocks, Bonds, Bills & Inflation yearbook has served as the primary source for calibrating historical asset returns. However, uneasiness has grown about its depiction of corporate bond returns prior to the second World War. I document problems with the source data used in the SBBI and replace its flawed dataset with new observations of bond prices from 1926 to 1946 for a sample of several hundred large bonds listed on the NYSE and rated investment-grade. I find that the SBBI overstates corporate bond returns in the 1930s and accordingly, gives an unreliable estimate of the premium received for owning investment grade corporate bonds rather than government bonds during the prewar years. To extend the analysis I collected additional bond price data from 1946 to 1974 and find that the SBBI also overstates corporate bond returns in the 1960s. The problem again stems from a reliance on flawed yield series in place of observing bond prices. I combine the new data with existing data to examine the corporate bond premium from 1909 through 2019. Using ten-year rolling returns, over the past century I find the average premium earned on long maturity corporate bonds to be small, about 15 basis points annualized. For many of the ten-year rolls, the premium was instead a deficit: a bond investor would have done better owning only long government bonds. The small and fitful premium contrasts with the yield spread on investment-grade bonds, which was always positive and substantial throughout the period. Because the premium has been much more variable, the relative size of the yield spread does not seem to be predictive of whether a premium will subsequently be earned and how much. Results are interpreted in terms of the importance of regime change in financial history: sometimes corporate bonds outperform government bonds, sometimes they do not, just as sometimes stocks outperform bonds, and sometimes they do not, contra Siegel (2014). The idea of regime change challenges the notion that a mean computed over a longer rather than a shorter interval contributes any additional predictive power to the study of asset returns over human horizons.
