Research articles for the 2021-03-09

(Car)Bon Voyage: The Road to Low Carbon Investment Portfolios
Palazzolo, Christopher,Pomorski, Lukasz,Zhao, Alice
We discuss how an investment portfolio could dramatically reduce its carbon footprint, potentially even achieving ‘net zero.’ Our central message is that very large carbon reductions are feasible but not as straightforward as some commentators suggest. The usual approach of security selection (e.g., divesting from firms with highest emissions) can lead to a substantial carbon reduction but will not be enough for investors with the most ambitious reduction targets. Such investors will need other techniques to achieve their goals, for example shorting high carbon-footprint companies or trading instruments such as carbon offsets and carbon permits. We discuss the pros and cons of such techniques and their importance to allocators traveling on the pathway toward net zero.

Abnormal returns following goodwill impairment write-offs
Sherrill, Karen,Stretcher, Robert
The authors examine abnormal stock returns for firms that take goodwill impairment write-downs post 2002 when the accounting rules changed. Existing literature finds positive cumulative abnormal returns (CARs) for both six months and one-year post event. We add to the literature by testing if investors perceive that the relative size of the event is important and find that the larger the relative impairment size, the greater the abnormal return post-event. We further examine if this reaction is different based on the status of the market and find that abnormal returns are much greater post-event when the market is generally negative.

Big Data and Artificial Intelligence for Financial Inclusion: Benefits and Issues
Ozili, Peterson K
This paper discusses the benefits and issues associated with big data and artificial intelligence (AI) for financial inclusion. The discussion shows that there are several benefits of AI and big data for financial inclusion such as: improved efficiency and risk management for financial services providers, provision of smart financial products and services to banked adults, simplification of the account opening process for unbanked adults and the creation of credit scores for unbanked adults using alternative information. Several issues associated with AI and big data for financial inclusion that need to be addressed include: the shortage of skilled AI workers, increased level of unemployment in the financial ecosystem, the unconscious bias in the design of AI systems, and other barriers caused by strict data privacy laws.

Black-Litterman and Beyond: The Bayesian Paradigm in Investment Management
Kolm, Petter N.,Ritter, Gordon,Simonian, Joseph
The Black-Litterman model is one of the most popular models in quantitative finance, with numerous theoretical and practical achievements. From the standpoint of investment theory, the Black-Litterman model allows a seamless incorporation of Bayesian statistics into the portfolio optimization process. From a practical standpoint, it provides portfolio managers with a structured approach to express subjective views, thereby freeing their investment processes from a total reliance on backward-looking historical data. In this article, the authors provide an overview of the original Black-Litterman model and its various extensions and enhancements addressing issues in real-world trading and investment management.

Board Networks and Audit Fees
Cao, Zhangfan,Bui, Dien Giau
This paper studies whether board connectedness affects audit fees. We find that firms with well-connected boards pay higher audit fees. This result is robust to the exogenous variation in board connectedness due to directors’ death and retirement, an instrumental variable approach, and propensity score matching. We further observe that, relative to firms with poorly connected boards, firms with well-connected boards are more complex, have higher litigation risk, and prefer higher audit quality, which requires greater audit effort that auditors price into fees. In addition, we show that the effect is stronger in a more complex auditing environment and when government economic policy uncertainty is high. Collectively, our study extends the understanding of the consequential effect of board networks on audit fees and adds to the extant literature investigating the factors influencing the pricing of audit services.

City commercial banks and credit allocation: Firm-level evidence
Kang, Shulong,Dong, Jianfeng,Yu, Haiyue,Cao, Jin,Dinger, Valeriya
This paper investigates how government-led banking liberalization affects credit allocation by banks using as a quasi-natural experiment the establishment of city commercial banks (CCBs) in China. Based on more than three million corporate financial statements spanning over 16 years, we find that the establishment of CCBs led to a 6–14 % drop in debt funding for private firms, as well as a 1–2 % rise in their funding costs. At the same time, private infrastructure firms enjoyed a nearly 6 % increase in debt funding and more than 100-basis-point drop in interest costs despite their inferior credit quality. The debt financing of private firm appears most severely affected in municipalities where officials face high promotional pressures or fiscal constraints.

Climate Change Exposure and Firm Cash Holdings
Heo, Yuna
Using firm-level climate change exposure data, we show that firms significantly increase their cash holdings in response to increases in climate changes. Our results are robust to using alternative climate change measures and alternative cash ratio measures. We present that the increase in cash holdings is more pronounced in firms with higher financial constraints, higher cash flow volatility, and less cash resilience. We further find that, after Paris Agreement, firms exposed to more climate changes hoard more cash. We also find that firms in more vulnerable industries increase cash holdings more than firms in other industries.

Comments on GDPR Enforcement EDPB Decision 01/020
Hodges, Christopher
The European Data Protection Board issued its first Binding Decision on 9 November 2020 in a case in which the Irish Data Commissioner (DPA) was lead enforcement authority. In the judgment of the Irish DPA, a fine of up to EUR 275,000 was appropriate, taking into account all relevant circumstances, including aggravating and mitigating factors. Several other national DPAs raised objections, including the German DPA, which thought that a fine of up to EUR 22 million was relevant, on the basis that it should be 'dissuasive' and therefore 'must be high enough to make data processing uneconomic and objectively inefficient'. Under the DGPR, the EDPB considered all objections, and rejected a surprising number as not satisfying the 'relevant and reasoned' standard. The EDPB issued a binding decision that a sanction must be 'deterrent' and required The Irish DPA to revise its fine. The Irish DPA issued a fine of EUR 450,000. This paper highlights the major rift in theory and practice between different approaches to the effects, if any, of financial sanctions. The case raises fundamental issues over the consistency and coherence of EU enforcement policy, and the level of confidence that may be placed in it. It also raises an underlying conflict between pure economic theory on the effectiveness of penalties and the relevance of the findings on behavioral science on how to affect future behavior.

Data Visualization and Infographics in 10-K Filing
Christensen, Theodore E.,Fronk, Karson,Lee, Joshua A.,Nelson, Karen K.
The Securities and Exchange Commission encourages the presentation of financial data and information in graphical form (infographics) to assist users in better understanding financial disclosures. We find a significant increase in the use of infographics in 10-K filings from 2002-2017. Consistent with infographics improving the clarity of financial disclosures, we find a significantly positive association between the use of infographics and annual report readability. Further, we find that firms use GAAP-related infographics when earnings are more persistent and non-financial key performance indicator infographics when earnings are less persistent, consistent with firms using data visualization to emphasize the information that is most relevant in helping stakeholders to understand company performance. Overall, our evidence suggests that infographics are an important element of corporate disclosure that managers use to communicate with stakeholders.

Defusing Leverage: Liquidity Management and Labor Contracts
Acabbi, Edoardo Maria,Alati, Andrea
Rigidities in firms’ payroll structures are likely to increase the transmission of shocks to firms’ cash flows and profitability. By using Italian administrative data on workers careers and firms’ balance sheets, we study how the use of permanent and fixed-term labor contracts affects this pass-through. We document how firms use the contract composition of their workforce to manage the risk determined by their labor-induced operating leverage. First, we confirm that a higher labor share is associated with more volatile cash flows following unexpected real shocks, a telling indication of operating leverage at work through labor costs. Second, we show that firms with a greater share of temporary contracts are characterized by a smoother time-series behavior of their cash-flows. In particular, the smoothing effect is stronger for firms with higher labor share related to the permanent workforce. We complement this analysis with the study of the 2001 labor market reform that lifted constraints on the creation of temporary contracts. Exploiting the staggered implementation of the reform across different collective bargaining agreements, we show that, following the reform, firms increased on average their share of temporary contracts and decreased average labor compensation. In addition, we show that, only among firms with an ex-ante more rigid labor cost structure, earlier transition to a more flexible workforce composition led to a 1 percentage point increase in profit margins (against a -1.6pp average variation around the event) and a 5 percent decrease in the cross-sectional standard deviation of profits.

Dividend policy and investor pressure
Driver, Ciaran,Grosman, Anna,Scaramozzino, Pasquale
The economics of dividend policy has focused on the single tight narrative that dividends keep managers honest, mitigating concerns that they over-invest. This article provides a critique of that agency narrative, arguing that pressure from short-term focused investors, executives and board members pushes the firm into preemptive actions of returning too much cash via dividends. We analyze three channels of influence for investor pressure through 1) threat of takeovers, 2) shareholder value oriented corporate governance, measured by director independence and board equity incentives, and 3) trading and institutional ownership patterns. We find that firms adopt a higher dividend payout to discourage takeover bids. Also, FTSE 100 firms, that are most focused on shareholder value governance in the form of equity-based compensation and a higher share of independent directors, display a higher dividend payout. Frequency of trading and ownership by transient investors seeking current profits also predict increased dividend payout. Traditional agency theory, focused on dividends as a tool for managerial discipline, is not strongly supported by the results, which rather support a narrative of short-term investor pressure on firms irrespective of investment opportunities.

Do U.S. Firms Disguise Acquisitions to Avoid Taxes?
Harris, Jeremiah,O'Brien, William
Our study finds evidence consistent with U.S. multinational firms disguising domestic acquisitions as corporate reorganizations to avoid repatriation-related taxes. We find that a combination of high potential repatriation costs and large overseas earnings balances is positively associated with domestic acquisition volume, but only in deals with low visibility to regulators and investors. Consistent with repatriations of overseas cash, these firms’ low visibility acquisitions (but not their higher-visibility counterparts) are associated with 4-7% lower overseas earnings balances. After a 2017 tax reform reduced the value of this technique, the positive relationship between low visibility acquisitions and repatriation costs disappears or reverses.

Faking Trade for Capital Control Evasion: Evidence from Dual Exchange Rate Arbitrage in China
Liu, Renliang,Sheng, Liugang,Wang, Jian
Using a unique institutional setting of dual exchange rates of Chinese currency, this paper provides novel evidence that firms manipulate trade data to evade capital controls. We develop a model showing that the trade data over-reporting is positively (negatively) correlated with the exchange rate spread when the spread is positive (negative), and such correlations are more pronounced for products with low risks of being caught. Empirical results from threshold regressions using time series data and Benford's law using firm-product trade data between mainland China and Hong Kong support the theoretical predictions of dual exchange-rate arbitrage camouflaged under the trade account.

Flight-to-Quality, Economic Fundamentals, and Stock Returns
Kayacetin, Nuri Volkan,Kaul, Aditya
We find that the order flow differential (OFD), a flight-to-quality measure constructed as the difference between large- and small-cap stock order flows, strongly and negatively forecasts output growth and interest rates in the U.S. The predictive ability of OFD for future macroeconomic fundamentals is robust to the inclusion of return factors and business cycle predictors, and it is thus a state variable candidate in the spirit of Merton (1973). Consistent with this view, we document that OFD commands a statistically significant negative risk premium in cross-sectional asset pricing tests.

GST Compensation to States: An Ineluctable Obligation on the Union
Sinha, Yash
The Central Government in the year 2020 initially refused states a recompense for both actual and notional losses in their GST revenues for FY 2020-21. While the discombobulated state governments scrambled to find legal and fiduciary justification to their demands, the Center simply cited situational expediency and lack of any obligation for its denial. It suggested that two alternatives to the states, that involved them borrowing, as the only mechanism for compensation. As the GST Council debates and the 101st Constitutional Amendment Act would collectively reveal, the Center had promised to the contrary. The obligation of maintaining a constant supply of compensation-credit to states emanates from that promise and is all the more binding given the huge sacrifice made by the States. The historically unique creation of legislative tax-fields outside of the Schedule VII and the overwhelming dominance of the Center in administering them were both premised on this future consideration to the states. The proviso to Art. 368(2) has the same outcome as its laterally inverted version, Art. 252, insofar as it crafts a contract between two vertical government-branches operating in a ‘federal market’. This, then, adumbrates the foundation of what presently prevails in American Constitutional law as the ‘anti-coercion’ principle. The promise of GST compensation then becomes a contractual obligation at a Constitutional level, eliminating any legal space of revocability otherwise available to the Center.

Good Diversification is Never Wasted: How to Tilt Factor Portfolios with Sectors
Briere, Marie,Szafarz, Ariane
Using large-cap exchange-traded funds (ETFs), this paper provides guidance on enhancing the performance of long-only factor portfolios through sector-based blending. The blending method builds ETF portfolios that optimize the factor exposure of sectors. We use the original factors of Fama and French as benchmarks. The results show that blended portfolios combine the diversification benefits of sector investing with the risk premia of factor investing, and so constitute a promising extension of pure factor ETFs.

Governance and Sustainability in Southeast Asia
Tran, Mi,Beddewela, Eshani,Ntim, Collins G.
Purpose â€" This paper aims to examine the relationship between a diverse set of corporate governance (CG) mechanisms and corporate sustainability disclosures (CSD) in Southeast Asian countries under national stakeholder reform. Design/ methodology/ approach â€" Data analysis is based on 171 of the largest companies across six Southeast Asian countries using a 30-item CSD measure. Findings - The authors find that there are wide variations in the levels of CSD across the countries. The findings indicate that board size, board gender diversity, block ownership and the presence of a sustainability committee are significant determinants of CSD. Additionally, while more stringent stakeholder governance reform motivates firms to publish more sustainability information, it fails to influence the effectiveness of board of directors in promoting CSD.Practical implications â€" Findings of this study highlight the essential role internal governance structure plays in monitoring corporate actions and enabling corporations to reduce their legitimacy gap. The findings further encourage regulators and policy makers to question, with utmost importance, the effectiveness of stakeholder reform in making significant organisational changes.Originality/ value â€" There is a dearth of studies that examine the CG-CSD nexus in relation to specific institutional characteristics. Existing studies mainly focus on a single country with similar institutional environments, and thus limiting the ability to understand ‘context specificity’ of sustainability content development. This paper provides an overview of stakeholder reform in Southeast Asian countries and empirically substantiates the relationship between CG and CSD across six countries undergoing such reforms in the region.Keywords: Southeast Asia; corporate sustainability disclosure (CSD); content analysis; stakeholder reform; corporate governance; sustainable development.

Hedging Stocks with Oil
Batten, Jonathan A.,Kinateder, Harald,Szilagyi, Peter G.,Wagner, Niklas
We study the feasibility of hedging stocks with oil. The Dynamic Conditional Correlation (DCC) approach allows for the calculation of optimal hedge ratios and corresponding hedge portfolio returns. Our results show that there are distinct economic benefits from hedging stocks with oil, although the effectiveness of hedging is both time-varying and market-state-dependent. The event of the Global Financial Crisis (GFC) is shown to affect the effectiveness of hedging. During the GFC, a positive jump in the hedge ratios occurs and hedge effectiveness increases. Among a set of common financial and macroeconomic drivers, we identify the implied volatility index VIX as being the most important. During times of global financial uncertainty, investors reduce stock positions more than commodity positions, thus VIX shocks negatively affect the portfolio returns of stock-oil hedges. The results also show that an appreciation of the U.S. dollar against the euro is associated with reduced hedge portfolio returns. From the GFC onwards, we document an increased significance of the gold price and the term spread in explaining hedge portfolio returns.

Intergenerational Homeownership in France over the 20th Century
Garbinti, Bertrand,Savignac, Frederique
We estimate the intergenerational correlation in homeownership status between two generations for cohorts covering the 20th century. First, we find higher intergenerational correlation in France compared to previous results obtained for the U.K. for similar cohorts. Second, the intergenerational correlation is increasing across cohorts, with a relatively stable probability of being a homeowner for children of homeowners over time, and a decreasing probability for children whose parents were not homeowners. Third, the effect of parents’ tenure status is persistent over the children’s life cycle. Fourth, when isolating two subpopulations based on the receipt of intergenerational transfers, we find significant intergenerational correlation in tenure status for children who did not receive any gift or inheritance, as well as for children who received intergenerational transfers, suggesting that other factors such as intergenerational income correlation or the transmission of preferences might also explain this intergenerational correlation.

International Financial Contagion During the Subprime Crisis: Evidence from UK Financial Markets
Liu, Zijun,Zhou, Yang,Zhou, Zhiping
In this paper, we investigate the dynamics of contagion from the US low grade asset-backed securities (ABSs) market to UK financial markets during the 2007 subprime mortgage crisis and identify the contagion channels using both a single-state vector autoregressive (VAR) model and a Markov-switching vector autoregressive (MSVAR) model. We show that a shock to the US low grade ABS market results in a significant and persistent effect on the yields of UK financial assets, which demonstrates the existence of contagion. Moreover, contagion episodes mainly occur during periods of financial crisis. We also find that the contagion effects of the US lower grade ABS market are transmitted to UK financial markets through a number of channels, including flight to liquidity, risk premium, flight to quality, and correlated information.

Investor Emotions and Trading Behavior
Vamossy, Domonkos F.
Leveraging over a decade of social media data, I explore the relationship between investor emotions and stock market behavior. In particular, I test whether the emotional content of firm-specific social media messages is predictive of subsequent price movements. I confirm the findings of controlled laboratory experiments using field data. My findings reinforce the intuition that emotions and market dynamics are closely related, and highlight the importance of considering investor emotions when assessing a stock's short-term value.

Kicking Off the Corporate Governance Lifecycle: Seed Funding, Venture Capital and the Nascent Board
Lang, Nils Konstantin,Wirtz, Peter
Studying the creation of venture boards in a hand-collected sample of 296 VC investment rounds in 132 German high-tech ventures, we find that risk exposure and investor syndication are strong predictors of whether a formal board is created or not. Our setup allows to study the creation of the nascent board in a legal context where its existence is voluntary and at the same time imposes a strong cost on its members through personal liability. We find that the probability of board creation strongly increases with the amount invested and with conflicting interests among multiple investors. The need for a formalized corporate governance in form of a board is most amplified in seed rounds with three or more syndicating investors, in follow-on rounds with the entrance of any additional institutional investor, and in the presence of pre-planned exit. Hence, a venture board is most required when the stakes are high and when the divergence of interests among principalsis amplified.

Metodología para comparar comisiones por flujo y saldo en fondos de pensiones (Methodology to Compare Front-End Load and Balance Fees in Pension Funds)
Chavez-Bedoya, Luis
Spanish Abstract: El presente artículo analiza la demanda residencial española en los bienes que forman parte de los servicios básicos del hogar (electricidad, gas natural y agua potable) en 2012. El análisis se realiza utilizando un modelo QUAIDS adaptado para tratar la censura en el consumo de gas natural según el enfoque de Tauchmann (2010), uno de los últimos avances en esta materia. Los resultados muestran que la demanda de electricidad y agua potable es menos sensible a las variaciones de sus precios e ingreso residencial que la demanda de gas natural.English Abstract: In the present article we develop a discrete-time methodology to compare front end load and balance fees in the accumulation phase of a defined-contribution pension fund under the system of individual accounts. Additionally, using various methods, we study the effect of considering risk and density of contributions in the performance and suitability of the aforementioned types of fees. Finally, we perform a practical application of the methodology to the Peruvian Private Pension System.

Monetary Policy Surprises and their Transmission Through Term Premia and Expected Interest Rates
Kaminska, Iryna,Mumtaz, Haroon,Sustek, Roman
Monetary policy moves the yield curve. How much is due to expected interest rates versus term premia? And does it matter for macroeconomic outcomes? Using an affine term structure model, we shed new light on these questions. Estimation is subject to restrictions addressing estimation bias in expected interest rates obtained by previous studies. High-frequency yield curve decompositions around FOMC announcements into term premia and expected interest rates then provides instruments for a local projection model. The effects of interest rate expectations and term premia are found equally important for the transmission mechanism and broadly consistent with macroeconomic theory.

Multivariate tail covariance for generalized skew-elliptical distributions
Baishuai Zuo,Chuancun Yin

In this paper, the multivariate tail covariance (MTCov) for generalized skew-elliptical distributions is considered. Some special cases for this distribution, such as generalized skew-normal, generalized skew student-t, generalized skew-logistic and generalized skew-Laplace distributions, are also considered. In order to test the theoretical feasibility of our results, the MTCov for skewed and non skewed normal distributions are computed and compared. Finally, we give a special formula of the MTCov for generalized skew-elliptical distributions.

No-Fly Zone in the Loan Office: How CEOs’ Risky Hobbies Affect Credit Stakeholders’ Evaluation of Firms
Ouyang, Bo,Tang, Yi,Wang, Chong,Zhou, Jian
The extant research has often examined the work-related experiences of corporate executives, but their off-the-job activities could be just as insightful. This study employs a novel proxy for CEOs’ risky hobbiesâ€"CEOs’ hobby of piloting a private aircraftâ€"and investigates its effect on credit stakeholders’ evaluation of the firms led by the CEOs as reflected in bank loan contracting. Using a longitudinal dataset on CEOs of large U.S. listed firms across multiple industries between 1993 and 2010, we obtain strong evidence that bank loans to firms steered by CEOs who fly private jets as a hobby tend to incur a higher cost of debt, to be secured, to have more covenants, and to be syndicated. These effects are mainly driven by banks which perceive such firms as having a higher default risk. These relationships become stronger when the CEO is more important to the firm and/or can exercise stronger control over decision-making. Supplemented by field interviews, our results are also robust to various endogeneity checks using different experimental designs, the Heckman two-stage model, a propensity score matching approach, a difference-in-differences test, and the impact threshold of confounding variables.

On the Dependence of Investor’s Probability of Default on Climate Transition Scenarios
Battiston, Stefano,Monasterolo, Irene
Climate risk brings about a new type of financial risk that standard approaches to risk management are not adequate to handle. Amidst the growing concern about climate change, financial supervisors and risk managers are concerned with the risk of a disorderly low-carbon transition. We develop a model to compute i) the valuation adjustment of corporate bonds, depending both on climate transition risk scenarios and on companies’ shares of revenues across low/high-carbon activities, and ii) the corresponding adjustments of an investor’s Expected Shortfall and probability of default. Implications for central banks' climate financial risk management include that climate stress test exercises should allow for a wide enough set of scenarios in order to limit the underestimation of losses.

On the marginal utility of fiat money: insurmountable circularity or not?
Michael Reiss

The question of how a pure fiat currency is enforced and comes to have a non-zero value has been much debated \cite{10.2307/2077948}. What is less often addressed is, in the case where the enforcement is taken for granted and we ask what value (in terms of goods and services) the currency will end up taking. Establishing a decentralised mechanism for price formation has proven a challenge for economists: "Since no decentralized out-of-equilibrium adjustment mechanism has been discovered, we currently have no acceptable dynamical model of the Walrasian system" (Gintis 2006). In his paper, Gintis put forward a model for price discovery based on the evolution of the model's agents, i.e. "poorly performing agents dying and being replaced by copies of the well performing agents." It seems improbable that this mechanism is the driving force behind price discovery in the real world. This paper proposes a more realistic mechanism and presents results from a corresponding agent based model.

Optimal Transport of Information
Semyon Malamud,Anna Cieslak,Andreas Schrimpf

We study the general problem of Bayesian persuasion (optimal information design) with continuous actions and continuous state space in arbitrary dimensions. First, we show that with a finite signal space, the optimal information design is always given by a partition. Second, we take the limit of an infinite signal space and characterize the solution in terms of a Monge-Kantorovich optimal transport problem with an endogenous information transport cost. We use our novel approach to: 1. Derive necessary and sufficient conditions for optimality based on Bregman divergences for non-convex functions. 2. Compute exact bounds for the Hausdorff dimension of the support of an optimal policy. 3. Derive a non-linear, second-order partial differential equation whose solutions correspond to regular optimal policies. We illustrate the power of our approach by providing explicit solutions to several non-linear, multidimensional Bayesian persuasion problems.

Organisational Culture and Bank Risk
Suss, Joel,Bholat, David,Gillespie, Alex,Reader, Tom
Existing research has largely relied on employee surveys to measure organisational culture despite the significant shortcomings of this approach. We use multiple, unobtrusive sources of data to gain rich insights into bank culture without ever having to ask employees to ‘show us your culture’. Our measure is based on 20 individual indicators from six different sources, including information on internal fraud cases, customer complaints, and the quality of regulatory submissions. We use this data to investigate the hypothesised relationship between organisational culture and bank risk. We find robust evidence that poor culture leads to substantially higher risk, demonstrating the importance of bank culture for prudential outcomes.

Permanent and Transitory Responses to Capital Gains Taxes: Evidence from a Lifetime Exemption in Canada
Lavecchia, Adam,Tazhitdinova, Alisa
Using panel data on a 20% random sample of Canadian taxpayers, we study behavioral responses to the cancellation of a lifetime capital gains exemption that resulted in increased capital gains taxation for some individuals. The unique setting allows us to distinguish between short-term avoidance responses and permanent responses to capital gains taxes. We show that the exemption did not change the number of taxpayers reporting positive capital gains, and thus unlikely resulted in increased participation in capital markets. However, the exemption cancellation slightly increased capital gains realizations of the existing traders.

Portfolio Construction as Linearly Constrained Separable Optimization
Nicholas Moehle,Jack Gindi,Stephen Boyd,Mykel Kochenderfer

Mean-variance portfolio optimization problems often involve separable nonconvex terms, including penalties on capital gains, integer share constraints, and minimum position and trade sizes. We propose a heuristic algorithm for this problem based on the alternating direction method of multipliers (ADMM). This method allows for solve times in tens to hundreds of milliseconds with around 1000 securities and 100 risk factors. We also obtain a bound on the achievable performance. Our heuristic and bound are both derived from similar results for other optimization problems with a separable objective and affine equality constraints. We discuss a concrete implementation in the case where the separable terms in the objective are piecewise-quadratic, and we demonstrate their effectiveness empirically in realistic tax-aware portfolio construction problems.

Portfolio risk allocation through Shapley value
Patrick S. Hagan,Andrew Lesniewski,Georgios E. Skoufis,Diana E. Woodward

We argue that using the Shapley value of cooperative game theory as the scheme for risk allocation among non-orthogonal risk factors is a natural way of interpreting the contribution made by each of such factors to overall portfolio risk. We discuss a Shapley value scheme for allocating risk to non-orthogonal greeks in a portfolio of derivatives. Such a situation arises, for example, when using a stochastic volatility model to capture option volatility smile. We also show that Shapley value allows for a natural method of interpreting components of enterprise risk measures such as VaR and ES. For all applications discussed, we derive explicit formulas and / or numerical algorithms to calculate the allocations.

Problems with Risk Matrices Using Ordinal Scales
Michael Krisper

In this paper, we discuss various problems in the usage and definition of risk matrices. We give an overview of the general process of risk assessment with risk matrices and ordinal scales. Furthermore, we explain the fallacies in each phase of this process and give hints on which decisions may lead to more problems than others and how to avoid them. Among those 24 discussed problems are ordinal scales, semi-quantitative arithmetics, range compression, risk inversion, ambiguity, and neglection of uncertainty. Finally, we make a case for avoiding risk matrices altogether and instead propose using fully quantitative risk assessment methods.

Proximity and Information Content of Stock Prices â€" Evidence from a Natural Experiment
Chen, Kejing,Chi, J. Daniel,Guo, Wenqi
Does the proximity between a firm and its investors affect the information content of stock prices? We employ the staggered buildout of high-speed rail (HSR) in China as a natural experiment that reduces the virtual proximity between firms and investors. A difference-in-differences identification strategy shows that after a firm’s headquarters city is connected to HSR, the firm’s stock price reflects more firm-specific information and exhibits lower synchronicity with the market. The finding persists after numerous endogeneity and robustness checks. In particular, a severe HSR accident caused by a lightning strike led to nationwide speed reductions and safety concerns, which allow us to measure the counterfactuals of HSR connections and further confirm the causality of HSR on stock price synchronicity. We identify several information channels that explain the effect of HSR on synchronicity â€" after being connected to HSR, firms experience increased analyst coverage, institutional ownership, and media coverage. Along with lower synchronicity, stock crash risk also decreases.

Reshaping finance, accounting and corporate governance for business: A Survey of Blockchain and AI applications
Luong, Hoa
Abstract Background / Context: For decades, the global economy has experienced an array of financial, accounting and corporate governance scandals which have shaken the confidence of investors and have led to a dramatic decline in shareholders’ wealth. Lately, blockchain and artificial intelligence (AI) have progressed extraordinarily with a profound impact on the economy. Nonetheless, how businesses can strategically use these technologies to create value for stakeholders remains puzzling in many respects.Objective / Problem: This study provides a systematic review of the literature related to the applications of blockchain and AI for finance, accounting, and corporate governance practices for businesses. We review the existing use cases, highlight their benefits and challenges and discuss a future research agenda.Design/Methodology/Approach: This study analyses 1400 journal articles and conference papers published between 2000 and 2020. We follow the PRISMA guideline to assemble and investigate the dataset with the support of Tagme, CiteSpace and Stata software.Results / Findings: We find a fast growth of studies that report the applications of blockchain in long-term financing and of AI in financial reporting while applications on short-term funding, capital investment, asset management, management accounting and corporate governance are rather fragmented.Originality / Value: This study is interesting because it offers a much needed synthetic review on the applications of blockchain and AI for the intertwined and converging accounting, finance and corporate governance domains.Practical Implications: This study has practical value for businesses to take the advantages of innovations in order to create value for stakeholders.

Robustness and Dynamic Sentiment
Maenhout, Pascal J.,Vedolin, Andrea,Xing, Hao
Errors in survey expectations display waves of pessimism and optimism and significant sluggishness. This paper develops a novel theoretical framework of time-varying beliefs capturing these empirical facts. In our model, the dynamic beliefs arise endogenously due to agents’ attitude toward alternative models. Decision-maker’s distorted beliefs generate countercyclical risk aversion, procyclical portfolio weights, countercyclical equilibrium asset returns, and excess volatility. A calibrated version of our model is shown to match salient features in equity markets.

Short-selling risk in Australia
Ang, Tze Chuan 'Chewie',Hayat, Aziz,Li, Bob
We confirm the negative relation between short-selling risk and stock returns in the US. We estimate a measure of dynamic short-selling risk in Australia and find a similar negative relation in Australia. The negative relation is more pronounced amongst small Australian stocks, but is absent in large Australian stocks. Australian stocks have lower equity loan supply and short interest, but higher equity loan fees and longer loan length than US stocks. The higher variation in equity loan utilization rate and loan characteristics in Australian stocks possibly contribute to their higher short-selling risk compared to their US counterparts.

Stock and Bond Return Comovement as a Different Way to Assess Information Content: The Case of Debt Covenant Violation Disclosures
Griffin, Paul A.,Lont, David H.,Purdon, Kurt
We propose a supplementary way to assess the information content of a financial statement disclosure based on the comovement of asset returns in different markets in response to information that has price implications for both. The influence of a signal that strongly influences at least two asset markets measures a dimension of information content less clearly reflected in single-market responses. We apply our method to debt covenant violation (DCV) disclosures. These are the outcome of a debt renegotiation when the covenant promises in a debt agreement to manage the agency costs of debt are broken. We find that stock and bond return comovement is highest one day before DCV disclosure and differs depending on whether the debt covenant is waived or not waived. We find that stock and bond return comovement in the days following a DCV disclosure decreases more for non-waiver disclosures than waiver disclosures. This supports the theory that a non-waiver outcome shifts control rights and bargaining power to the creditors. Consistent with this theory, single-market tests show that bonds with a non-waiver disclosure versus a waiver disclosure earn positive excess returns following a DCV disclosure whereas the reverse is true for stocks.

The Financial Contagion Effect of the Subprime Crisis on Selected Developed Markets
Ayadi, Shiraz,Ben Said, Houda
The purpose of this empirical study is to explore and compare the effects of subprime crisis on some of developed markets (e.g. France, Germany, the United Kingdom and Japan). The VECM model and Johansen’s cointegration approach (1988) have been used to verify the existence of potential short and long run relationships between the United States market, where the subprime crisis has been triggered, and the other markets. The results indicated that all the markets are cointegrated in the long run and there is long run equilibrium. Dynamic interactions between the developed markets and the US increased during the subprime crisis. Our results shed light on financial contagion as the element that dramatically spreads the shock to the whole financial system as well as other financial markets. This contagion is a top priority for investors, financial regulators and international organizations whose goal is to improve the global financial regulation system and make it more resistant to shocks.

The Formulas for the Valuation of Annuities According to Modigliani-Miller and Miles-Ezzell
Becker, Denis M.
The purpose of this paper is to mathematically establish the equity method, the free-cash-flow method, the adjusted-present-value method, and the relationships between these methods when the free cash flow appears as an annuity. More particularly, we depart from the two most widely used evaluation settings. The first setting is this of Modigliani and Miller (1958, 1963) in which the free cash flow is stationary. The second setting is this of Miles and Ezzell (1980, 1985) where the free cash flow represents an autoregressive possess of first order.In the previous literature, few attempts have been made to mathematically state these methods and their relationships for the case of annuities. However, until now the complete set of formulas has not been developed yet. Particularly, the following relationships are not established: (a) the correct discount rate of the tax shield when the free cash flow takes the form of a first-order autoregressive annuity, (b) the direct valuation of the tax shield from the free cash flow for a first-order autoregressive annuity, (c) the correct translation from the required return on unlevered equity to the levered equity, when the free cash flow is a stationary annuity, and (d) direct calculations of the unlevered and levered firm values, and the value of the tax-shield for a stationary annuity. In this paper, these relationships will be established.

The Impact of Knowledge Management Strategies on the Relationship between Intellectual Capital and Innovation: Evidence from SMEs
Hayaeian, Sahar,Hesarzadeh, Reza,Abbaszadeh, Mohammad Reza
PurposeThe purpose of this study is to investigate the moderating role of knowledge management (KM) strategies in developing the effect of intellectual capital (IC) on innovation for small- and medium-sized enterprises (SMEs). Specifically, the current study explores how different interactions between IC and KM strategies lead to more powerful innovation in SMEs.Design/methodology/approachThis study analyzes survey responses from 170 owners/managers of SMEs in Iran. The study uses partial least square structural equation modeling methods within Smart PLS software.FindingsThis study reveals that first IC has an excellent level of engagement with both incremental and radical types of innovation, but its engagement level with radical innovation is higher than that for incremental innovation. Second, the human capital component of IC has a direct positive impact on radical innovation although it has no significant impact on incremental innovation. Third, the personalization strategy of KM positively moderates the impact of human capital on both incremental and radical innovation.Originality/valueThis paper is an empirical attempt in SMEs to combine IC and KM strategies to strengthen innovation. It presents research community for SMEs of a developing country that has been investigated in a limited way compared to large firms of developed nations and provides valuable insights into further research.

The Leptokurtic Crisis and the Discontinuous Turn in Financial Modelling
Walter, Christian Pierre
Heterodox economics has, since its inception, stressed the extreme importance of financial crises to understand the nature of finance. Heterodox modelling and heterodox economics were in line with their objective: a critical posture of the neoclassical finance arising from orthodox financial theory. Two distinct research programmes were established in financial modelling to tackle the leptokurtic issue: the first Mandelbrot programme based on stable Levy processes and the alternative non-stable Levy processes approach based on Merton's view. This chapter argues that some of the key differences between the competitive representations of financial uncertainty can be illuminated by reference to a familiar debate in philosophy over the principle of continuity. It also argues on the contrary that the divergent positions about the mind-set behind the price changes implicate entirely different views of what is important to capture and how to model it.

The Physics of Financial Networks
Marco Bardoscia,Paolo Barucca,Stefano Battiston,Fabio Caccioli,Giulio Cimini,Diego Garlaschelli,Fabio Saracco,Tiziano Squartini,Guido Caldarelli

The field of Financial Networks is a paramount example of the novel applications of Statistical Physics that have made possible by the present data revolution. As the total value of the global financial market has vastly outgrown the value of the real economy, financial institutions on this planet have created a web of interactions whose size and topology calls for a quantitative analysis by means of Complex Networks. Financial Networks are not only a playground for the use of basic tools of statistical physics as ensemble representation and entropy maximization; rather, their particular dynamics and evolution triggered theoretical advancements as the definition of DebtRank to measure the impact and diffusion of shocks in the whole systems. In this review we present the state of the art in this field, starting from the different definitions of financial networks (based either on loans, on assets ownership, on contracts involving several parties -- such as credit default swaps, to multiplex representation when firms are introduced in the game and a link with real economy is drawn) and then discussing the various dynamics of financial contagion as well as applications in financial network inference and validation. We believe that this analysis is particularly timely since financial stability as well as recent innovations in climate finance, once properly analysed and understood in terms of complex network theory, can play a pivotal role in the transformation of our society towards a more sustainable world.

The Role of Finance in Inclusive Human Development in Africa Revisited
Asongu, Simplice,Nting, Rexon Tayong
This study investigates direct and indirect linkages between financial development and inclusive human development in data panels for African countries. It employs a battery of estimation techniques, notably: Two-Stage Least Squares, Fixed Effects, Generalized Method of Moments and Tobit regressions. The dependent variable is the inequality adjusted human development index. All dimensions of the Financial Development and Structure Database (FDSD) of the World Bank are considered. The main finding is that financial dynamics of depth, activity and size improve inclusive human development, whereas the inability of banks to transform mobilized deposits into credit for financial access negatively affects inclusive human development. Policies should be tailored to improve mechanisms by which credit facilities can be provided to both households and business operators. Surplus liquidity issues resulting from the inability of banks to transform mobilized deposits into credit can be resolved by enhancing the introduction of information sharing offices (like public credit registries and private credit bureaus) that would reduce information asymmetry between lenders and borrowers. This study complements the extant literature by assessing the nexus between financial development and inclusive human development in Africa.

The dark side of CEO social capital: Evidence from real earnings management and future operating performance
Griffin, Paul A.,Hong, Hyun A.,Liu, Yun,Ryou, Ji Woo
We examine the role of CEO social capital as an important driver of the widespread practice of real earnings management (REM). Using the number of social connections to outside executives and directors to measure CEO social capital, we first find that well-connected CEOs associate with higher levels and volatilities of REM. The positive relation between REM and CEO network size is stronger when the CEO connects with more informed and influential persons, and when a more severe misalignment of interests can occur. Second, we find a contagion of REM among well-connected CEOs in an industry. Third, the level of REM induced by a large CEO social network associates negatively with future operating performance. This result is consistent with social capital circulating REM-related information ex-ante and increasing the power and influence for the CEO to deviate from optimal operating policies ex-post. Social capital shields the well-connected executive in the takeover and labor markets despite possible suboptimal future operating performance. While the prior literature finds that CEO social capital reduces accrual earnings management, our findings suggest a dark side of CEO social capital: it induces excessive levels and volatilities of REM costly to the firm in the long-run while imposing relatively low personal risk on the top executive.

To Sell or To Retain: Interest Rate Risk and Banks' Mortgage Securitization Decisions
Xiao, Zhanbing
I show that banks with interest-sensitive liabilities securitize more mortgages than banks with interest-insensitive liabilities do. This is because liabilities of interest-insensitive banks are similar to fixed-rate and long-term debt, thereby holding long-term and fixed-rate mortgages helps isolate their net interest income from interest rate risk. However, household mortgage refinancing in low-interest periods disrupts the isolation effect. Ex ante, anticipating the risk, interest-insensitive banks securitize more mortgages, resulting in a smaller securitization gap across banks. Ex post, interest-insensitive banks are less willing to meet household refinancing requests.

Turn-of-the-Month Effect: New Evidence from an Emerging Stock Market
Kayacetin, Nuri Volkan,Lekpek, Senad
This paper analyzes the turn-of-the-month (ToM) effect in Turkish equity returns. We show that the ToM effect is strongly significant in BIST100 index over 1988â€"2014, and distinct from other calendar anomalies. In particular, the mean daily index return is 0.46% in the three-day period that covers the last trading day of each month and the first two trading days of the next month, and 0.09% in the remaining days. The ToM effect is more significant following months with (a) significant information flow and (b) above average market performance, and the fraction of index returns generated within the ToM period increases secularly from 39% over 1988â€"1996 to 49% over 1997â€"2005 and to 86% over 2006â€"2014. A similar month-end seasonal does not exist in index trading volume or realized volatility, ruling out standard liquidity or risk-based explanations. Estimating an e-GARCH model with daily index returns, however, we link the ToM effect to a decline in expected volatility in the days leading to month-turns. These findings resonate best with a story where gradual resolution of uncertainty following high information risk periods releases a large pool of “liquid funds” accumulated during such periods into the equity market, creating an abundance of liquidity and pushing equity prices up.

Urban Epidemic Hazard Index for Chinese Cities: Why Did Small Cities Become Epidemic Hotspots?
Tianyi Li,Jiawen Luo,Cunrui Huang

Multiple small- to middle-scale cities, mostly located in northern China, became epidemic hotspots during the second wave of the spread of COVID-19 in early 2021. Despite qualitative discussions of potential social-economic causes, it remains unclear how this pattern could be accounted for from a quantitative approach. Through the development of an urban epidemic hazard index (EpiRank), we came up with a mathematical explanation for this phenomenon. The index is constructed from epidemic simulations on a multi-layer transportation network model on top of local SEIR transmission dynamics, which characterizes intra- and inter-city compartment population flow with a detailed mathematical description. Essentially, we argue that these highlighted cities possess greater epidemic hazards due to the combined effect of large regional population and small inter-city transportation. The proposed index, dynamic and applicable to different epidemic settings, could be a useful indicator for the risk assessment and response planning of urban epidemic hazards in China; the model framework is modularized and can be adapted for other nations without much difficulty.

Valuing Exotic Options and Estimating Model Risk
Cao, Jay,Chen, Jacky,Hull, John C.,Poulos, Zissis
A common approach to valuing exotic options involves choosing a model and then determining its parameters to fit the volatility surface as closely as possible. We refer to this as the model calibration approach (MCA). This paper proposes an alternative approach where the points on the volatility surface are features input to a neural network. We refer to this as the volatility feature approach (VFA). We conduct experiments showing that VFA can be expected to outperform MCA for the volatility surfaces encountered in practice. Once the upfront computational time has been invested in developing the neural network, the valuation of exotic options using VFA is very fast. VFA is a useful tool for the estimation of model risk. We illustrate this using S&P 500 data for the 2001 to 2019 period.

Volatility of Volatility: Estimation and Tests Based on Noisy High Frequency Data with Jumps
Li, Yingying,Liu, Guangying,Zhang, Zhiyuan
We establish a feasible central limit theorem with convergence rate $n^{1/8}$ for the estimation of the {integrated volatility of volatility} (VoV) based on noisy high-frequency data with jumps. This is the first inference theory ever built for VoV estimation under such a general setup. The central limit theorem is applied to provide interval estimates of the VoV and conduct hypothesis tests. Furthermore, when one is interested in the null hypothesis that the VoV is zero, we show that a more powerful test can be established based on a VoV estimator with a convergence rate $n^{1/5}$ under the null. Empirical results on the S\&P 500 and individual stocks show strong evidence of non-zero VoV.

Was there a COVID-19 harvesting effect in Northern Italy?
Augusto Cerqua,Roberta Di Stefano,Marco Letta,Sara Miccoli

We investigate the possibility of a harvesting effect, i.e. a temporary forward shift in mortality, associated with the COVID-19 pandemic by looking at the excess mortality trends of an area that registered one of the highest death tolls in the world during the first wave, Northern Italy. We do not find any evidence of a sizable COVID-19 harvesting effect, neither in the summer months after the slowdown of the first wave nor at the beginning of the second wave. According to our estimates, only a minor share of the total excess deaths detected in Northern Italian municipalities over the entire period under scrutiny (February - November 2020) can be attributed to an anticipatory role of COVID-19. A slightly higher share is detected for the most severely affected areas (the provinces of Bergamo and Brescia, in particular), but even in these territories, the harvesting effect can only account for less than 20% of excess deaths. Furthermore, the lower mortality rates observed in these areas at the beginning of the second wave may be due to several factors other than a harvesting effect, including behavioral change and some degree of temporary herd immunity. The very limited presence of short-run mortality displacement restates the case for containment policies aimed at minimizing the health impacts of the pandemic.

[enter Paper Title]Measuring Liquidity Risk Effects on Carry Trades across Currencies and Regimes
Blenman, Lloyd P.
We study the effects of FX liquidity risk on carry trade returns using a novel low-frequency market-wide liquidity measure. We show conclusively that the vast majority of variation in carry trade returns can be explained by two risk factors (liquidity risk and market risk). Our results are further corroborated when the mimicking liquidity risk factor is replaced with a non-tradable innovations risk factor. Safe-haven currencies (SHC) provide insurance against crash risk by having negative liquidity betas, across all time periods. SHCs provide the highest levels of protection during periods of extreme volatility. We find that liquidity risk is priced in the cross-section of carry trade returns, and estimate the liquidity risk premium in the FX market to be around 412 basis points per annum.