Research articles for the 2021-01-29
Broker Network Connectivity and the Cross-Section of Expected Returns
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This paper examines the relationship between broker network connectivity and stock returns in an order-driven market. Considering all stocks traded in Borsa Istanbul between January 2006 and November 2015, we estimate the monthly density, reciprocity and average weighted clustering coefficient as proxies for the broker network connectivity. Accordingly, firm-level cross-sectional regressions indicate a negative and significant predictive relationship between connectivity and one-month ahead stock returns. Specifically, 1% increase in network connectivity reduces the future returns by 2% even after controlling for other systematic factors. Our univariate and multivariate analyses show that stocks in the lowest connectivity quintile earn 1.0% - 1.6% monthly return premiums. We also document that the connectivity premium is stronger in terms of both economic and statistical significance for small size stocks.
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This paper examines the relationship between broker network connectivity and stock returns in an order-driven market. Considering all stocks traded in Borsa Istanbul between January 2006 and November 2015, we estimate the monthly density, reciprocity and average weighted clustering coefficient as proxies for the broker network connectivity. Accordingly, firm-level cross-sectional regressions indicate a negative and significant predictive relationship between connectivity and one-month ahead stock returns. Specifically, 1% increase in network connectivity reduces the future returns by 2% even after controlling for other systematic factors. Our univariate and multivariate analyses show that stocks in the lowest connectivity quintile earn 1.0% - 1.6% monthly return premiums. We also document that the connectivity premium is stronger in terms of both economic and statistical significance for small size stocks.
Build of Indicators of Operating Profitablenesses in Projects with Multiple Values IRR. Examples and Comments
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The technique of applying the method of replacement credits to build the operating and real profitableness of the investor and recipient in investment projects with multiple (simple and multiple) IRRs value is shown. In each of the replacement credits, the interest rate is chosen equal to one of the IRR values, and the areas of operating profitableness of project participants are defined as the intervals of the discount rate where the discounted amounts of interest payments are positive (for the investor) or negative (for the recipient). In such areas, the operating profitablenesses of project participants are taken equal to the selected IRRs value. As a result, the operating and real profitablenesses of the investor and the recipient are determined in the form of unequivocal piecewise-constant functions. A dynamic interpretation of the areas of operating profitableness as areas of attraction or repulsion of the singular points of a dynamic system with a phase velocity equal to NPV is given. Using a dynamic interpretation allows you to build profitability indicators in the form of piecewise constant functions of the discount rate for investment projects of the most general form solely on the basis of known IRR values.
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The technique of applying the method of replacement credits to build the operating and real profitableness of the investor and recipient in investment projects with multiple (simple and multiple) IRRs value is shown. In each of the replacement credits, the interest rate is chosen equal to one of the IRR values, and the areas of operating profitableness of project participants are defined as the intervals of the discount rate where the discounted amounts of interest payments are positive (for the investor) or negative (for the recipient). In such areas, the operating profitablenesses of project participants are taken equal to the selected IRRs value. As a result, the operating and real profitablenesses of the investor and the recipient are determined in the form of unequivocal piecewise-constant functions. A dynamic interpretation of the areas of operating profitableness as areas of attraction or repulsion of the singular points of a dynamic system with a phase velocity equal to NPV is given. Using a dynamic interpretation allows you to build profitability indicators in the form of piecewise constant functions of the discount rate for investment projects of the most general form solely on the basis of known IRR values.
Can Capital Adjustment Costs Explain the Decline in Investment-Cash Flow Sensitivity?
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It is well documented that since at least the 1970s investment-cash flow (I-CF) sensitivity has been decreasing over time to disappear almost completely by the late 2000s. Based on a neoclassical investment model with costly external financing, we show that this pattern can be explained by the gradual increase of capital adjustment costs. The result is corroborated in the supplementary analysis that exploits the cross-country and cross-industry variation of capital adjustment costs, as proxied by the level of technological advancement. More generally, our findings demonstrate that I-CF sensitivity should only be interpreted as a joint measure of financial and real frictions.
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It is well documented that since at least the 1970s investment-cash flow (I-CF) sensitivity has been decreasing over time to disappear almost completely by the late 2000s. Based on a neoclassical investment model with costly external financing, we show that this pattern can be explained by the gradual increase of capital adjustment costs. The result is corroborated in the supplementary analysis that exploits the cross-country and cross-industry variation of capital adjustment costs, as proxied by the level of technological advancement. More generally, our findings demonstrate that I-CF sensitivity should only be interpreted as a joint measure of financial and real frictions.
Capital Allocation Based Asset Pricing
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I explore an intricate interaction between a firm’s risk exposure, intangible capital accumulation, and physical capital accumulation by using a unified dynamic investment model of capital allocation. The model emphasizes both the importance of the marginal value of the intangible capital and the idiosyncratic risk for corporate decisions, then implicates the firm value and expected returns. A model feature that the good idiosyncratic volatility is endogenously generated, but bad idiosyncratic volatility does not. The model provides several implications: (1) high bad idiosyncratic volatility lowers the firm’s profitability, expected returns, and Tobin’s q due to risk management and capital misallocation. Typically, this effect is much stronger in value firms; (2) there is a positive interaction between the value effect, profitability effect, and momentum. The idiosyncratic volatility can also affect the other anomalies indirectly via a complicated interaction between the corporate investment, internal capital allocation, and risk management, which implies that the idiosyncratic risk is priced indirectly as well; (3) high-tech firm invests more in intangible capital, holds more cash, and finds it much harder to achieve its growth firm region than low-tech firm. This result applies to firms with high idiosyncratic volatility as well.
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I explore an intricate interaction between a firm’s risk exposure, intangible capital accumulation, and physical capital accumulation by using a unified dynamic investment model of capital allocation. The model emphasizes both the importance of the marginal value of the intangible capital and the idiosyncratic risk for corporate decisions, then implicates the firm value and expected returns. A model feature that the good idiosyncratic volatility is endogenously generated, but bad idiosyncratic volatility does not. The model provides several implications: (1) high bad idiosyncratic volatility lowers the firm’s profitability, expected returns, and Tobin’s q due to risk management and capital misallocation. Typically, this effect is much stronger in value firms; (2) there is a positive interaction between the value effect, profitability effect, and momentum. The idiosyncratic volatility can also affect the other anomalies indirectly via a complicated interaction between the corporate investment, internal capital allocation, and risk management, which implies that the idiosyncratic risk is priced indirectly as well; (3) high-tech firm invests more in intangible capital, holds more cash, and finds it much harder to achieve its growth firm region than low-tech firm. This result applies to firms with high idiosyncratic volatility as well.
Competition and R&D Financing: Evidence from the Biopharmaceutical Industry
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The interaction between product market competition, R&D investment, and the financing choices of R&D-intensive firms on the development of innovative products is only partially understood. To motivate empirical hypotheses about this interaction, we develop a model which predicts that as competition increases, R&D-intensive firms will: (1) increase R&D investment relative to assets in place that support existing products; (2) carry more cash; and (3) maintain less net debt. Using the Hatch-Waxman Act as an exogenous shock to competition, we provide causal evidence which supports these hypotheses through a differences-in-differences analysis that exploits differences between the biopharma industry and other industries, and heterogeneity within the biopharma industry. We also explore how these changes affect innovative output, and provide novel evidence that increased competition causes companies to increasingly “focus†their efforts, i.e., there is a decline in the total number of innovations, but an increase in their economic value.
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The interaction between product market competition, R&D investment, and the financing choices of R&D-intensive firms on the development of innovative products is only partially understood. To motivate empirical hypotheses about this interaction, we develop a model which predicts that as competition increases, R&D-intensive firms will: (1) increase R&D investment relative to assets in place that support existing products; (2) carry more cash; and (3) maintain less net debt. Using the Hatch-Waxman Act as an exogenous shock to competition, we provide causal evidence which supports these hypotheses through a differences-in-differences analysis that exploits differences between the biopharma industry and other industries, and heterogeneity within the biopharma industry. We also explore how these changes affect innovative output, and provide novel evidence that increased competition causes companies to increasingly “focus†their efforts, i.e., there is a decline in the total number of innovations, but an increase in their economic value.
Corporate-Sovereign Debt Nexus and Externalities
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I show that corporate debt accumulation during booms can explain increases in sovereign risk during stress periods. Using idiosyncratic shocks to large firms as instruments for aggregate corporate leverage, I show that rising corporate leverage during the period 2002-2007 causally increases sovereign spreads in six Eurozone countries during the debt crisis period of 2008-2012. To explain these findings, I build a dynamic quantitative model in which both firms and the government can default. Rising corporate debt increases sovereign default risk, as tax revenues are expected to decrease. Externalities arise because it can be privately optimal but socially suboptimal for firms to default given their limited liability. The fact that firms do not take into account the effect of their debt accumulation on aggregate sovereign spreads is an important externality, rationalizing macroprudential interventions in corporate debt markets. I propose a set of such optimal debt policies that reduce the number of defaulting firms, increase fiscal space, and boost household consumption during financial crises. Both constant and countercyclical debt tax schedules can correct overborrowing externalities. Contrary to conventional wisdom, countercyclical debt policy is less effective than constant debt policy, as the countercyclical policy induces more firm defaults.
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I show that corporate debt accumulation during booms can explain increases in sovereign risk during stress periods. Using idiosyncratic shocks to large firms as instruments for aggregate corporate leverage, I show that rising corporate leverage during the period 2002-2007 causally increases sovereign spreads in six Eurozone countries during the debt crisis period of 2008-2012. To explain these findings, I build a dynamic quantitative model in which both firms and the government can default. Rising corporate debt increases sovereign default risk, as tax revenues are expected to decrease. Externalities arise because it can be privately optimal but socially suboptimal for firms to default given their limited liability. The fact that firms do not take into account the effect of their debt accumulation on aggregate sovereign spreads is an important externality, rationalizing macroprudential interventions in corporate debt markets. I propose a set of such optimal debt policies that reduce the number of defaulting firms, increase fiscal space, and boost household consumption during financial crises. Both constant and countercyclical debt tax schedules can correct overborrowing externalities. Contrary to conventional wisdom, countercyclical debt policy is less effective than constant debt policy, as the countercyclical policy induces more firm defaults.
Dynamical Internal Rate of Return for the Investment Project
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A new indicator of profitableness (DIRR) of the investor and recipient of the investment project is proposed, which is a generalization and development of the concept of internal rate of return (IRR). It is formed in the form of the sum of the cost of the participant's capital and the project's own profitableness, which is determined by the ratio of NPV to the value of the aggregate discounted loan debts of the investor and the recipient accumulated in the project. In projects with multiple IRR value the indicator DIRR is described by a continuous function of discount rate and smoothes the gaps in the real operating profitableness indicator. For projects with a single (simple or multiple) value of IRR, there is a complete coincidence of DIRR with the real operating profitableness of the participant. An example of building a DIRR in a project with three simple and one double IRR values is considered.
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A new indicator of profitableness (DIRR) of the investor and recipient of the investment project is proposed, which is a generalization and development of the concept of internal rate of return (IRR). It is formed in the form of the sum of the cost of the participant's capital and the project's own profitableness, which is determined by the ratio of NPV to the value of the aggregate discounted loan debts of the investor and the recipient accumulated in the project. In projects with multiple IRR value the indicator DIRR is described by a continuous function of discount rate and smoothes the gaps in the real operating profitableness indicator. For projects with a single (simple or multiple) value of IRR, there is a complete coincidence of DIRR with the real operating profitableness of the participant. An example of building a DIRR in a project with three simple and one double IRR values is considered.
Economics of Capital Adjustment in the Us Commercial Banks: Empirical Analysis
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Using GMM framework on the data of the US commercial banks over the period from 2002 to 2018, this study shows that banks adjust their regulatory capital ratios faster than traditional capital ratios; and, in most cases, the speed of adjustment of a traditional capital ratio is lower than regulatory capital ratios. Our results show that the speed of regulatory capital ratio of well-capitalized banks is faster than adequately-capitalized and under-capitalized banks. Our analysis report that high-liquid banks adjust their capital ratios faster than low-liquid banks. We also find that the speed of adjustment of regulatory capital of too-big-to-fail banks is lower than well-capitalized, adequately-capitalized, nationally-chartered, and state-chartered banks. In addition, the speed of adjustment of regulatory capital ratios of commercial banks is higher in the post-crisis period than the pre-crisis era. Although scholars suggest that adjustment of capital ratios through rebalancing liabilities is more beneficial to the banks, our findings show that banks also use their assets side of balance sheet to rebalance their capital ratios. Our findings suggest that the regulators may consider the heterogeneity in the speed of capital adjustment across different bank characteristics for the formulation of new bank regulations; particularly, when assessing and adjusting the specific capital requirements through Pillar II of the Basel III agreement.
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Using GMM framework on the data of the US commercial banks over the period from 2002 to 2018, this study shows that banks adjust their regulatory capital ratios faster than traditional capital ratios; and, in most cases, the speed of adjustment of a traditional capital ratio is lower than regulatory capital ratios. Our results show that the speed of regulatory capital ratio of well-capitalized banks is faster than adequately-capitalized and under-capitalized banks. Our analysis report that high-liquid banks adjust their capital ratios faster than low-liquid banks. We also find that the speed of adjustment of regulatory capital of too-big-to-fail banks is lower than well-capitalized, adequately-capitalized, nationally-chartered, and state-chartered banks. In addition, the speed of adjustment of regulatory capital ratios of commercial banks is higher in the post-crisis period than the pre-crisis era. Although scholars suggest that adjustment of capital ratios through rebalancing liabilities is more beneficial to the banks, our findings show that banks also use their assets side of balance sheet to rebalance their capital ratios. Our findings suggest that the regulators may consider the heterogeneity in the speed of capital adjustment across different bank characteristics for the formulation of new bank regulations; particularly, when assessing and adjusting the specific capital requirements through Pillar II of the Basel III agreement.
Endogeneity in the mutual fund flow-performance relationship: An Instrumental Variable Solution
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We use an instrumental variables (IV) approach to examine the effects of dynamic endogeneity when estimating the relationship between mutual fund flows and performance. Unlike the one-stage estimation approach commonly used in prior research, the IV approach allows us to address reverse causality between flow and performance. Through rigorous exclusion tests, we conclude that fund media coverage, risk ranking, and management structure win in a horse race as exogenous instruments for fund flow, while the fund turnover ratio and institutional share perform best as instruments for fund performance. We then demonstrate that endogeneity bias leads to inaccurate inferences in one-stage estimates, as evidenced by the reversals of the signs of flow and performance coefficient estimates when we switch to the IV approach. We find that careful attention to model specification allows us to resolve several widespread inconsistencies in the literature that were likely driven by model misspecification.
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We use an instrumental variables (IV) approach to examine the effects of dynamic endogeneity when estimating the relationship between mutual fund flows and performance. Unlike the one-stage estimation approach commonly used in prior research, the IV approach allows us to address reverse causality between flow and performance. Through rigorous exclusion tests, we conclude that fund media coverage, risk ranking, and management structure win in a horse race as exogenous instruments for fund flow, while the fund turnover ratio and institutional share perform best as instruments for fund performance. We then demonstrate that endogeneity bias leads to inaccurate inferences in one-stage estimates, as evidenced by the reversals of the signs of flow and performance coefficient estimates when we switch to the IV approach. We find that careful attention to model specification allows us to resolve several widespread inconsistencies in the literature that were likely driven by model misspecification.
Finance Leases: A Hidden Channel of China’s Shadow Banking System
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By analyzing a hand-collected transaction-level dataset on the finance leases of China’s public firms for the period 2007-2019, this paper sheds light on China’s financial leasing industry. We find that banks use their affiliated leasing firms to provide credit to constrained clients in order to circumvent the government’s targeted monetary tightening policy, which offsets the expected decline in traditional bank loans in overcapacity industries and hampers the effectiveness of the monetary policy. Although this regulatory arbitrage may cause systemic risk at the macro level, bank-affiliated leasing firms exhibit much tighter risk control than other non-bank-affiliated leasing firms at the micro level, indicating that banks use finance leases as a channel to support their low-risk clients rather than to make excessive profit.
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By analyzing a hand-collected transaction-level dataset on the finance leases of China’s public firms for the period 2007-2019, this paper sheds light on China’s financial leasing industry. We find that banks use their affiliated leasing firms to provide credit to constrained clients in order to circumvent the government’s targeted monetary tightening policy, which offsets the expected decline in traditional bank loans in overcapacity industries and hampers the effectiveness of the monetary policy. Although this regulatory arbitrage may cause systemic risk at the macro level, bank-affiliated leasing firms exhibit much tighter risk control than other non-bank-affiliated leasing firms at the micro level, indicating that banks use finance leases as a channel to support their low-risk clients rather than to make excessive profit.
Firm-Level ESG News and Active Fund Management
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Using artificial intelligence and big data generated ESG news indices, we examine whether firm-level ESG news affects the investment choice of actively managed U.S. mutual funds. We find a positive relation between firm-level ESG news index and fund holdings. Fund managers incorporate ESG news to cater to investor demand and achieve higher risk-adjusted returns. Further, the ESG news-holding relation is stronger during periods of high ESG demand, and among funds located in Democratic states, with retail-oriented clienteles, better ESG ratings, higher marketing fees, and “domestic†fund managers. These results suggest that mutual fund managers successfully integrate ESG information into their portfolio decisions.
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Using artificial intelligence and big data generated ESG news indices, we examine whether firm-level ESG news affects the investment choice of actively managed U.S. mutual funds. We find a positive relation between firm-level ESG news index and fund holdings. Fund managers incorporate ESG news to cater to investor demand and achieve higher risk-adjusted returns. Further, the ESG news-holding relation is stronger during periods of high ESG demand, and among funds located in Democratic states, with retail-oriented clienteles, better ESG ratings, higher marketing fees, and “domestic†fund managers. These results suggest that mutual fund managers successfully integrate ESG information into their portfolio decisions.
Forward-looking Forward Rates: An Indicative SOFR Paradox
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As SOFR transition nears its deadline, publication of the term SOFR is recently requested by ARRC. In this paper we will present several paradoxes that will result from the publication of the indicative term SOFR: the complexity versus transparency of the methodology, the true risk-free rate versus market driven rate, the hedging inefficiency between cash market products versus derivative markets and the outcome of financial system instability. In light of the paradoxes, we believe that the indicative term SOFR does not possess the same economic justification as Libor, nor will it provide the necessary incentives for trading by hedgers, investors or other market participants. It is our view that these conceptual paradoxes of forward-looking term SOFR give rise to significant drawbacks in the applications, making the adoption of the rate problematic, thus posing significant risk for the Libor transition.
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As SOFR transition nears its deadline, publication of the term SOFR is recently requested by ARRC. In this paper we will present several paradoxes that will result from the publication of the indicative term SOFR: the complexity versus transparency of the methodology, the true risk-free rate versus market driven rate, the hedging inefficiency between cash market products versus derivative markets and the outcome of financial system instability. In light of the paradoxes, we believe that the indicative term SOFR does not possess the same economic justification as Libor, nor will it provide the necessary incentives for trading by hedgers, investors or other market participants. It is our view that these conceptual paradoxes of forward-looking term SOFR give rise to significant drawbacks in the applications, making the adoption of the rate problematic, thus posing significant risk for the Libor transition.
Frequent Batch Auctions vs. Continuous Trading: Evidence from Taiwan
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We exploit the shift from Frequent Batch Auctions to Continuous Trading at the Taiwan Stock Exchange to show that market quality generally decreased after the change. Following the implementation of Continuous Trading on March 23, 2020 we find higher quoted and effective spreads and trading volume while we don’t find any significant result for abnormal returns. Overall our results show that Frequent Batch Auctions were better than Continuous Trading for market liquidity.
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We exploit the shift from Frequent Batch Auctions to Continuous Trading at the Taiwan Stock Exchange to show that market quality generally decreased after the change. Following the implementation of Continuous Trading on March 23, 2020 we find higher quoted and effective spreads and trading volume while we don’t find any significant result for abnormal returns. Overall our results show that Frequent Batch Auctions were better than Continuous Trading for market liquidity.
Investor Emotions and Speculative Bubbles
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Between June 2005 and October 2007, when it peaked, the Chinese stock market rose five-fold. It then went into free fall losing 70% of its value over the following year, more than China’s total GDP. A similar trajectory played out between July 2014 and January 2016.This paper describes the powerful emotions unleashed during market crises of this nature. Specifically, we adopt a five-stage path-dependent model relevant to other bubbles and financial crises and test this empirically using the Chinese 2005-2008 stock market bubble as a case study. Results are consistent with investors experiencing a range of highly-charged emotions directly inter-related with different market states. Our evidence suggests that if we wish properly to understand and explain such destructive events we also need to recognise the vital role investor emotions play in their aetiology.
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Between June 2005 and October 2007, when it peaked, the Chinese stock market rose five-fold. It then went into free fall losing 70% of its value over the following year, more than China’s total GDP. A similar trajectory played out between July 2014 and January 2016.This paper describes the powerful emotions unleashed during market crises of this nature. Specifically, we adopt a five-stage path-dependent model relevant to other bubbles and financial crises and test this empirically using the Chinese 2005-2008 stock market bubble as a case study. Results are consistent with investors experiencing a range of highly-charged emotions directly inter-related with different market states. Our evidence suggests that if we wish properly to understand and explain such destructive events we also need to recognise the vital role investor emotions play in their aetiology.
Liquidity Level or Liquidity Risk? A Fresh Look with New Measures
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Lou and Sadka (2011) examine the effect of stock liquidity characteristics on stock performance during the 2008-2009 crisis. Their conclusion is that liquidity risk, and not the liquidity level, explains stock performance during the crisis. Lou and Sadka (2011) measure liquidity via Amihud’s (2002) illiquidity measure. I construct a new measure of illiquidity, based on transaction-by-transaction price changes and conduct a similar analysis to that in Lou and Sadka. My findings show that, controlling for liquidity risk, the level of liquidity has incremental explanatory power for stock performance during the crisis. My analysis suggests that the level of liquidity and liquidity risk are both important facets of stock liquidity and that there might be an interaction or overlap between the two.
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Lou and Sadka (2011) examine the effect of stock liquidity characteristics on stock performance during the 2008-2009 crisis. Their conclusion is that liquidity risk, and not the liquidity level, explains stock performance during the crisis. Lou and Sadka (2011) measure liquidity via Amihud’s (2002) illiquidity measure. I construct a new measure of illiquidity, based on transaction-by-transaction price changes and conduct a similar analysis to that in Lou and Sadka. My findings show that, controlling for liquidity risk, the level of liquidity has incremental explanatory power for stock performance during the crisis. My analysis suggests that the level of liquidity and liquidity risk are both important facets of stock liquidity and that there might be an interaction or overlap between the two.
Measuring the Quality of Mergers and Acquisitions
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We use accounting theory to develop a new measure of the quality of mergers and acquisitions, implied return-on-equity improvement (IRI), which quantifies the minimum improvement in the target’s accounting returns after acquisition needed to justify the offer price. We validate our measure by showing that it captures disclosed synergies and estimated EPS accretion. Consistent with larger performance improvements being less achievable, we find that high-IRI acquirers have worse post-acquisition ROE and more frequent and larger goodwill impairments. We also show that this worse long-run performance is likely driven by overconfident and poorly incentivized managers undertaking acquisitions of inferior quality.
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We use accounting theory to develop a new measure of the quality of mergers and acquisitions, implied return-on-equity improvement (IRI), which quantifies the minimum improvement in the target’s accounting returns after acquisition needed to justify the offer price. We validate our measure by showing that it captures disclosed synergies and estimated EPS accretion. Consistent with larger performance improvements being less achievable, we find that high-IRI acquirers have worse post-acquisition ROE and more frequent and larger goodwill impairments. We also show that this worse long-run performance is likely driven by overconfident and poorly incentivized managers undertaking acquisitions of inferior quality.
Moving from IBORs to Alternative Risk Free Rates
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In this short note we briefly review the state of the art of the ongoing transition from interbank rates (IBORs) to alternative risk free rates, with a focus on LIBOR and EUR benchmark rates. This note is a reduced version of a position paper published in December 2019 [1], reporting more details regarding the impacts of the transition on Bank’s internal processes, updated to December 2020.
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In this short note we briefly review the state of the art of the ongoing transition from interbank rates (IBORs) to alternative risk free rates, with a focus on LIBOR and EUR benchmark rates. This note is a reduced version of a position paper published in December 2019 [1], reporting more details regarding the impacts of the transition on Bank’s internal processes, updated to December 2020.
No-fault Default, Chapter 11 Bankruptcy, and Financial Institutions
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This paper analyzes the costs and benefits of a no-fault-default debt structure as an alternative to the typical bankruptcy process. We show that the deadweight costs of bankruptcy can be avoided or substantially reduced through no-fault-default debt, which permits a relatively seamless transfer of ownership from shareholders to bondholders in certain states of the world. We show that potential costs introduced by this scheme due to risk shifting can be attenuated via convertible debt, and we discuss the relationship of this to bail-in debt and contingent convertible (CoCo) debt for financial institutions. We then explore how, despite the advantages of no-fault-default debt, there may still be a functional role for the bankruptcy process to efficiently allow the renegotiation of labor contracts in certain cases. In sharp contrast to the human-capital-based theories of optimal capital structure in which the renegotiation of labor contract in bankruptcy is a cost associated with leverage, we show that it is a benefit. The normative implication of our analysis is that no-fault-default debt, when combined with specific features of the bankruptcy process, may reduce the deadweight costs associated with bankruptcy. We discuss how an orderly process for transfer of control and a predetermined admissibility of renegotiation of labor contracts can be a useful tool for resolving financial institution failure without harming financial stability.
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This paper analyzes the costs and benefits of a no-fault-default debt structure as an alternative to the typical bankruptcy process. We show that the deadweight costs of bankruptcy can be avoided or substantially reduced through no-fault-default debt, which permits a relatively seamless transfer of ownership from shareholders to bondholders in certain states of the world. We show that potential costs introduced by this scheme due to risk shifting can be attenuated via convertible debt, and we discuss the relationship of this to bail-in debt and contingent convertible (CoCo) debt for financial institutions. We then explore how, despite the advantages of no-fault-default debt, there may still be a functional role for the bankruptcy process to efficiently allow the renegotiation of labor contracts in certain cases. In sharp contrast to the human-capital-based theories of optimal capital structure in which the renegotiation of labor contract in bankruptcy is a cost associated with leverage, we show that it is a benefit. The normative implication of our analysis is that no-fault-default debt, when combined with specific features of the bankruptcy process, may reduce the deadweight costs associated with bankruptcy. We discuss how an orderly process for transfer of control and a predetermined admissibility of renegotiation of labor contracts can be a useful tool for resolving financial institution failure without harming financial stability.
Operating Profitableness in Projects with Multiply IRR Values. Reconstruction of Sense
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For the investment project, a family of replacement credits is built, in each of which one of the IRR values is taken as the interest rate. In all such replacement credits, the areas of operating profitableness of the investor and the recipient are defined as the intervals of the change in the discount rate, where the discounted amounts of interest payments are positive or negative, respectively. In these areas, which have IRR values as their internal or boundary point, the operational profitablenesses of project participants take constant values equal to the corresponding IRR value. For all non-negative values of the discount rate, the operating profitableness of the investor and the recipient have the form of unequivocal piecewise constant functions. Real returns of project participants with multiple IRR values in all intervals of the change in the discount rate between IRR values coincide with their operating profitableness. And only in the edge interval, at discount rates higher than the maximum IRR, the real returns of the participants are determined by the principle of conservation the project’s own profitableness.
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For the investment project, a family of replacement credits is built, in each of which one of the IRR values is taken as the interest rate. In all such replacement credits, the areas of operating profitableness of the investor and the recipient are defined as the intervals of the change in the discount rate, where the discounted amounts of interest payments are positive or negative, respectively. In these areas, which have IRR values as their internal or boundary point, the operational profitablenesses of project participants take constant values equal to the corresponding IRR value. For all non-negative values of the discount rate, the operating profitableness of the investor and the recipient have the form of unequivocal piecewise constant functions. Real returns of project participants with multiple IRR values in all intervals of the change in the discount rate between IRR values coincide with their operating profitableness. And only in the edge interval, at discount rates higher than the maximum IRR, the real returns of the participants are determined by the principle of conservation the project’s own profitableness.
Operating Profitableness of Investment Projects. In a Searching a Fictional Rate
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An investment project is considered as a borrowing project with two participants, an investor and a recipient, each of which has its own profitability. The concept of operating profitableness of participants is described, according to which the IRR is determined by the ratio of the discounted amounts of interest payments and loan indebtedness previously allocated from the project payment stream. This establishes the economic meaning of IRR as a ratio of income to the resources used to obtain it. It is shown that in projects with a single (simple or multifold) IRR value, the operational profitableness of participants is determined by this value, but at different intervals of the change in the discount rate. The concept of real profitability of participants is introduced, which, with positive NPV values, is identified as the profitability of the investor, and with negative values, as the profitability of the recipient. Indicators of real profitability of project participants with a single IRR value are built. The possibility of constructing indicators of operational and real profitability of participants in projects with multiple IRR values is discussed.
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An investment project is considered as a borrowing project with two participants, an investor and a recipient, each of which has its own profitability. The concept of operating profitableness of participants is described, according to which the IRR is determined by the ratio of the discounted amounts of interest payments and loan indebtedness previously allocated from the project payment stream. This establishes the economic meaning of IRR as a ratio of income to the resources used to obtain it. It is shown that in projects with a single (simple or multifold) IRR value, the operational profitableness of participants is determined by this value, but at different intervals of the change in the discount rate. The concept of real profitability of participants is introduced, which, with positive NPV values, is identified as the profitability of the investor, and with negative values, as the profitability of the recipient. Indicators of real profitability of project participants with a single IRR value are built. The possibility of constructing indicators of operational and real profitability of participants in projects with multiple IRR values is discussed.
Option Pricing Formula with Resource Scarcity in the Brain
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We show that considering the human brain as resource-rational leads to simple yet powerful adjustments in option pricing formulas. For a European call option, the risk-free rate is replaced with a higher rate which increases with the risk-premium on the underlying stock. For a European put option, apart from the replacement of the risk-free rate with a higher rate, an extra additive term appears which increases with the risk-premium on the underlying. The adjusted prices, which remain within the rational option pricing bounds derived in the literature, generate implied volatility skew and provide a unified explanation for several option pricing puzzles. This suggests that misspecification in option pricing formulas is due to ignoring the optimal resource allocation mechanism in the brain.
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We show that considering the human brain as resource-rational leads to simple yet powerful adjustments in option pricing formulas. For a European call option, the risk-free rate is replaced with a higher rate which increases with the risk-premium on the underlying stock. For a European put option, apart from the replacement of the risk-free rate with a higher rate, an extra additive term appears which increases with the risk-premium on the underlying. The adjusted prices, which remain within the rational option pricing bounds derived in the literature, generate implied volatility skew and provide a unified explanation for several option pricing puzzles. This suggests that misspecification in option pricing formulas is due to ignoring the optimal resource allocation mechanism in the brain.
Option Pricing under Generic Market Conditions
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A Black-Scholes replicating strategy with continuous revisions is no longer optimal or possible in the presence of transaction costs and discrete trading. This paper explores theoretical and practical solutions to revision frequency in a modified replicating strategy.
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A Black-Scholes replicating strategy with continuous revisions is no longer optimal or possible in the presence of transaction costs and discrete trading. This paper explores theoretical and practical solutions to revision frequency in a modified replicating strategy.
Ownership and Competition
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We develop a model in which the ownership structure and the degree of competition of industry rivals are jointly determined. Competing more aggressively improves an individual firm's performance but has negative externalities for its peers. Two types of investors endogenously arise in equilibrium. Common owners, who acquire positions in all firms and decrease competition. Undiversified investors, who acquire a position in only one firm and increase competition. As financial markets become more efficient, common ownership increases and competition decreases, which can lead to a disconnect between stock market efficiency and welfare. We derive further testable implications for ownership structure, product market competition, and welfare.
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We develop a model in which the ownership structure and the degree of competition of industry rivals are jointly determined. Competing more aggressively improves an individual firm's performance but has negative externalities for its peers. Two types of investors endogenously arise in equilibrium. Common owners, who acquire positions in all firms and decrease competition. Undiversified investors, who acquire a position in only one firm and increase competition. As financial markets become more efficient, common ownership increases and competition decreases, which can lead to a disconnect between stock market efficiency and welfare. We derive further testable implications for ownership structure, product market competition, and welfare.
Pareto Optima for a Class of Singular Control Games
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We study a class of N-player stochastic differential games of singular control, motivated by the study of a dynamic model of interbank lending with benchmark rates. We describe Pareto optima for this game and show how they may be achieved through the intervention of a regulator, whose policy is a solution to a singular stochastic control problem. Pareto optima are characterized in terms of the solution to a new class of Skorokhod problems with piecewise-continuous free boundary.Pareto optimal policies are shown to correspond to the enforcement of endogenous bounds on interbank lending rates. Analytical comparison between Pareto optima and Nash equilibria for the case of two players allows to quantify the impact of regulatory intervention on the stability of the interbank rate.
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We study a class of N-player stochastic differential games of singular control, motivated by the study of a dynamic model of interbank lending with benchmark rates. We describe Pareto optima for this game and show how they may be achieved through the intervention of a regulator, whose policy is a solution to a singular stochastic control problem. Pareto optima are characterized in terms of the solution to a new class of Skorokhod problems with piecewise-continuous free boundary.Pareto optimal policies are shown to correspond to the enforcement of endogenous bounds on interbank lending rates. Analytical comparison between Pareto optima and Nash equilibria for the case of two players allows to quantify the impact of regulatory intervention on the stability of the interbank rate.
Polarized Corporate Boards
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Political polarization has increased dramatically in recent decades. Yet, little is known about its economic consequences. Using a large sample of U.S. public firms, we find that polarization between the board of directors and the CEO significantly reduces the likelihood a CEO is fired following poor performance. The mechanism driving this result is an increase in director absenteeism which compromises a board’s monitoring and advising capacity. Finally, we show that polarization in the boardroom ultimately lowers the investment-Q sensitivity. Our findings highlight the real cost of political polarization.
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Political polarization has increased dramatically in recent decades. Yet, little is known about its economic consequences. Using a large sample of U.S. public firms, we find that polarization between the board of directors and the CEO significantly reduces the likelihood a CEO is fired following poor performance. The mechanism driving this result is an increase in director absenteeism which compromises a board’s monitoring and advising capacity. Finally, we show that polarization in the boardroom ultimately lowers the investment-Q sensitivity. Our findings highlight the real cost of political polarization.
Policy Uncertainty, Bad News Disclosure, and Stock Price Crash Risk
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This paper documents that policy uncertainty reduces future stock price crash risk. Our tests show that this negative relation is more pronounced among firms with more short-sale constraints, with no actively traded credit default swap contracts, or with higher firm-level political risks. The results from regressions adopting the instrumental variable approach and from a quasi-natural experiment suggest that the negative relation observed between policy uncertainty and stock price crash risk is unlikely to be driven by potential endogeneity. Additional tests show that this negative association is driven by firms’ decreased hoarding of bad news during periods of high policy uncertainty.
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This paper documents that policy uncertainty reduces future stock price crash risk. Our tests show that this negative relation is more pronounced among firms with more short-sale constraints, with no actively traded credit default swap contracts, or with higher firm-level political risks. The results from regressions adopting the instrumental variable approach and from a quasi-natural experiment suggest that the negative relation observed between policy uncertainty and stock price crash risk is unlikely to be driven by potential endogeneity. Additional tests show that this negative association is driven by firms’ decreased hoarding of bad news during periods of high policy uncertainty.
Profitableness of Investment and Borrowing Projects. Problems and Prospects
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The problems associated with the construction of a measure of profitableness of investment projects are discussed, including the problem of a meaningful interpretation of the sense of IRR in the traditional form for the economy of the ratio of income and expenses. In is proposed to build a profitableness analysis of investment and borrowing projects on the basis of a mathematical model with two participants in form an investor and a recipient, where recipient can be considered as representative of the financial market external to the project. Such a model was formed in the theory of credit, where the dynamics of the financial interaction of participants during its implementation is described by an sign alternating function of discrete time, in the form the current indebtedness of credit. For her adaption to the analysis of general investment projects (including projects with multiple simple and multifold IRR values), the main patterns of the dynamics of credit indebtedness are considered in detail. There is highlighted the general properties of investment and borrowing projects.
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The problems associated with the construction of a measure of profitableness of investment projects are discussed, including the problem of a meaningful interpretation of the sense of IRR in the traditional form for the economy of the ratio of income and expenses. In is proposed to build a profitableness analysis of investment and borrowing projects on the basis of a mathematical model with two participants in form an investor and a recipient, where recipient can be considered as representative of the financial market external to the project. Such a model was formed in the theory of credit, where the dynamics of the financial interaction of participants during its implementation is described by an sign alternating function of discrete time, in the form the current indebtedness of credit. For her adaption to the analysis of general investment projects (including projects with multiple simple and multifold IRR values), the main patterns of the dynamics of credit indebtedness are considered in detail. There is highlighted the general properties of investment and borrowing projects.
Providing Microinsurance to Smallholders to Increase Overall Yield
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This paper examines different types of agricultural insurance to find the best product to increase the yield of farmers in Aruppukottai, a small village in Tamil Nadu, India. The paper explores the best way to maximize the resources of​ my ​NGO, Khasanam, so as to have maximum impact in reducing the level of hunger in the village. It is found that a meso-level insurance policy is the most effective method to be used. The paper also puts forth a proposal that outlines how the meso-level insurance will be implemented to aid the farmers in the village.
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This paper examines different types of agricultural insurance to find the best product to increase the yield of farmers in Aruppukottai, a small village in Tamil Nadu, India. The paper explores the best way to maximize the resources of​ my ​NGO, Khasanam, so as to have maximum impact in reducing the level of hunger in the village. It is found that a meso-level insurance policy is the most effective method to be used. The paper also puts forth a proposal that outlines how the meso-level insurance will be implemented to aid the farmers in the village.
Reconnecting Exchange Rates with Gravitas
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We uncover a strong, temporal connection between trade and the exchange rate factor structure by instrumenting trade with trade deals. A typical agreement raises bilateral trade by 50 percent over five years which, in turn, reduces the systematic risk of the pair's exchange rate by a third of its standard deviation across countries. Our structurally estimated gravity model endogenizes the factor structure and shows that deals excel at pulling peripheral countries into the trade network's core, mitigating their currencies' systematic risk. Overall, our paper underscores that trade deals are not just about trade.
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We uncover a strong, temporal connection between trade and the exchange rate factor structure by instrumenting trade with trade deals. A typical agreement raises bilateral trade by 50 percent over five years which, in turn, reduces the systematic risk of the pair's exchange rate by a third of its standard deviation across countries. Our structurally estimated gravity model endogenizes the factor structure and shows that deals excel at pulling peripheral countries into the trade network's core, mitigating their currencies' systematic risk. Overall, our paper underscores that trade deals are not just about trade.
Reducing Credit Card Delinquency using Broadcast Repayment Reminders
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A timely reminder on an app or website prompts delinquent credit card debtors with strong credit records to repay but is ineffective for debtors with weak credit records. We study field data from a 2015-16 randomized controlled trial of a broadcast reminder received by 30-days-overdue credit card debtors who log into the app or website of their credit provider. On average, the treated debtors were 2.7 percentage points more likely to repay all arrears than debtors in the control group. However, the effect of the repayment reminder depended on the debtor type; the broadcast reminder significantly raised repayment rates of high credit score delinquent debtors but did not significantly raise, and may have lowered, the repayment rate of lower credit score delinquents.
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A timely reminder on an app or website prompts delinquent credit card debtors with strong credit records to repay but is ineffective for debtors with weak credit records. We study field data from a 2015-16 randomized controlled trial of a broadcast reminder received by 30-days-overdue credit card debtors who log into the app or website of their credit provider. On average, the treated debtors were 2.7 percentage points more likely to repay all arrears than debtors in the control group. However, the effect of the repayment reminder depended on the debtor type; the broadcast reminder significantly raised repayment rates of high credit score delinquent debtors but did not significantly raise, and may have lowered, the repayment rate of lower credit score delinquents.
Reflections on COVID-19, Insurance, Business Interruption, Systemic Risk, and the Future
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The COVID-19 pandemic is a major loss event for the insurance industry. This article begins with an overview of the pandemic’s most significant insurance implications. Because business interruption has been the most prominently discussed of these impacts, the article takes a closer look at business interruption insurance. In this part, the article describes how markets for this coverage are structured in the U.S., and then undertakes a detailed analysis of one of the most common business interruption policy forms, demonstrating that some aspects of this form, insofar as pandemic-caused business interruption is concerned, were not drafted with utmost precision. This part also discusses how disputes over common policy language used in the U.S. have unfolded, both in legislatures and the courts. The article concludes with a discussion of the future of insuring business continuity risk. It explores the limitations of private markets, the role of government, and the need for an overarching strategy for pandemic risk management, within which insurance would play a significant but partial role.
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The COVID-19 pandemic is a major loss event for the insurance industry. This article begins with an overview of the pandemic’s most significant insurance implications. Because business interruption has been the most prominently discussed of these impacts, the article takes a closer look at business interruption insurance. In this part, the article describes how markets for this coverage are structured in the U.S., and then undertakes a detailed analysis of one of the most common business interruption policy forms, demonstrating that some aspects of this form, insofar as pandemic-caused business interruption is concerned, were not drafted with utmost precision. This part also discusses how disputes over common policy language used in the U.S. have unfolded, both in legislatures and the courts. The article concludes with a discussion of the future of insuring business continuity risk. It explores the limitations of private markets, the role of government, and the need for an overarching strategy for pandemic risk management, within which insurance would play a significant but partial role.
Sustainability Efforts, Index Recognition, and Stock Performance
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We examine the long-term performance of stocks appearing in the Dow Jones Sustainability Index North America. We find that sustainability stocks exhibit abnormal returns for 12 to 30 months after the index listing while those stocks generate no excess returns before the index listing. Moreover, sustainability stocks experience an increase in institutional ownership after the index listing. However, we find no evidence that short sellers increase their position to exploit a possible overpricing for sustainability stocks. Overall, our analysis suggests that sustainability efforts translate into a permanent increase in demand for stocks, leading to the superior performance.
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We examine the long-term performance of stocks appearing in the Dow Jones Sustainability Index North America. We find that sustainability stocks exhibit abnormal returns for 12 to 30 months after the index listing while those stocks generate no excess returns before the index listing. Moreover, sustainability stocks experience an increase in institutional ownership after the index listing. However, we find no evidence that short sellers increase their position to exploit a possible overpricing for sustainability stocks. Overall, our analysis suggests that sustainability efforts translate into a permanent increase in demand for stocks, leading to the superior performance.
Testing and Modelling Time Series with Time Varying Tails
RePEC
The occurrence of extreme observations in a time series depends on the heaviness of the tails of its distribution. The paper proposes a dynamic conditional score model (DCS) for modelling dynamic shape parameters that govern the tail index. The model is based on the Generalised t family of conditional distributions, allowing for the presence of asymmetric tails and therefore the possibility of specifying different dynamics for the left and right tail indices. The paper examines through simulations both the convergence properties of the model and the implications of the link functions used. In addition the paper introduces and studies the size and power properties of a new Lagrange Multiplier (LM) test based on fitted scores to detect the presence of dynamics in the tail index parameter. The paper also shows that the novel LM test is more effective than existing tests based on fitted scores. The model is fitted to Equity Indices and Credit Default Swaps returns. It is found that the tail index for equities has dynamics driven mainly by either the upper or lower tail depending if leverage is taken or not into account. In the case of Credit Default Swaps the test identifies very persistent dynamics for both the tails. Finally the implications of dynamic tail indices for the estimated conditional distribution are assessed in terms of conditional distribution forecasting showing that the novel model predicts more accurately expected shortfalls and value-at-risk than existing models.
RePEC
The occurrence of extreme observations in a time series depends on the heaviness of the tails of its distribution. The paper proposes a dynamic conditional score model (DCS) for modelling dynamic shape parameters that govern the tail index. The model is based on the Generalised t family of conditional distributions, allowing for the presence of asymmetric tails and therefore the possibility of specifying different dynamics for the left and right tail indices. The paper examines through simulations both the convergence properties of the model and the implications of the link functions used. In addition the paper introduces and studies the size and power properties of a new Lagrange Multiplier (LM) test based on fitted scores to detect the presence of dynamics in the tail index parameter. The paper also shows that the novel LM test is more effective than existing tests based on fitted scores. The model is fitted to Equity Indices and Credit Default Swaps returns. It is found that the tail index for equities has dynamics driven mainly by either the upper or lower tail depending if leverage is taken or not into account. In the case of Credit Default Swaps the test identifies very persistent dynamics for both the tails. Finally the implications of dynamic tail indices for the estimated conditional distribution are assessed in terms of conditional distribution forecasting showing that the novel model predicts more accurately expected shortfalls and value-at-risk than existing models.
The Deposits Channel Revisited
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Drechsler, Savov, and Schnabl (2017) present a novel reformulation of the bank lending channel of monetary transmission based on market power in local deposits markets, which they term the deposits channel. In this paper we perform a successful narrow replication. We then further their study by reconciling their results on lending with two strands of related literature. First, recent studies have pointed out the unique dynamics of credit card loans in Community Reinvestment Act loan origination data. When accounting for this heterogeneity, we find some key results are sensitive to the inclusion of credit card banks. This confirms the importance of accounting for credit card loans when using CRA data. Second, we show that inconsistencies with related empirical studies can be explained by differences in market power measure, sample period, and the inclusion of alternative control variables. These results highlight that market power on opposing sides of bank balance sheets can impact monetary transmission through alternative channels.
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Drechsler, Savov, and Schnabl (2017) present a novel reformulation of the bank lending channel of monetary transmission based on market power in local deposits markets, which they term the deposits channel. In this paper we perform a successful narrow replication. We then further their study by reconciling their results on lending with two strands of related literature. First, recent studies have pointed out the unique dynamics of credit card loans in Community Reinvestment Act loan origination data. When accounting for this heterogeneity, we find some key results are sensitive to the inclusion of credit card banks. This confirms the importance of accounting for credit card loans when using CRA data. Second, we show that inconsistencies with related empirical studies can be explained by differences in market power measure, sample period, and the inclusion of alternative control variables. These results highlight that market power on opposing sides of bank balance sheets can impact monetary transmission through alternative channels.
The More the Merrier? Diversity and Private Equity Performance
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This paper explores how diversity among lead partner teams (LPTs) of private equity (PE) funds affects buyout performance. We argue that there is a trade-off between the “bright side†of diversity, i.e., improved decision-making due to a broader set of perspectives, and the “dark sideâ€, i.e., deteriorated decision-making due to a potential for clashes and a lack of cooperation. Our theoretical framework suggests that the net effect on performance depends on whether LPTs are diverse in socio-demographic or occupational aspects. To test this hypothesis, we develop a comprehensive index that measures LPT diversity along six dimensions. Using a sample of 241 buyouts and 547 involved PE partners, we find that higher scores in the socio-demographic component (gender, age, nationality) are associated with higher deal returns and multiple expansion. The opposite is true for higher scores in the occupational component (professional experience, educational background, university affiliation). Further results suggest that the “bright side†of diversity gets relatively more important in case of complex buyouts and uncertain deal environments.
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This paper explores how diversity among lead partner teams (LPTs) of private equity (PE) funds affects buyout performance. We argue that there is a trade-off between the “bright side†of diversity, i.e., improved decision-making due to a broader set of perspectives, and the “dark sideâ€, i.e., deteriorated decision-making due to a potential for clashes and a lack of cooperation. Our theoretical framework suggests that the net effect on performance depends on whether LPTs are diverse in socio-demographic or occupational aspects. To test this hypothesis, we develop a comprehensive index that measures LPT diversity along six dimensions. Using a sample of 241 buyouts and 547 involved PE partners, we find that higher scores in the socio-demographic component (gender, age, nationality) are associated with higher deal returns and multiple expansion. The opposite is true for higher scores in the occupational component (professional experience, educational background, university affiliation). Further results suggest that the “bright side†of diversity gets relatively more important in case of complex buyouts and uncertain deal environments.
Who Benefits from Anti-Corruption Enforcement?
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We exploit 88 violations of the US Foreign Corrupt Practices Act in non-OECD countries to study the effect of anti-bribery enforcement on unpunished local firms. After anti-bribery enforcement actions take effect, firms in the same country-industry as the violator experience significant increases in revenues (+6.4%) and productivity (+4.2%). These results are driven by business group affiliates, particularly foreign-owned affiliates, and stronger when parent firms are more productive and less exposed to corruption. Together with evidence that enforcement actions reduce corruption levels in host countries, our results support the view that anti-bribery enforcement levels a playing field roughened up by corruption.
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We exploit 88 violations of the US Foreign Corrupt Practices Act in non-OECD countries to study the effect of anti-bribery enforcement on unpunished local firms. After anti-bribery enforcement actions take effect, firms in the same country-industry as the violator experience significant increases in revenues (+6.4%) and productivity (+4.2%). These results are driven by business group affiliates, particularly foreign-owned affiliates, and stronger when parent firms are more productive and less exposed to corruption. Together with evidence that enforcement actions reduce corruption levels in host countries, our results support the view that anti-bribery enforcement levels a playing field roughened up by corruption.
