Research articles for the 2021-06-10

A Novel Sampling Method based on Orthogonal Polynomial Expansions and Applications
Cui, Zhenyu,Kirkby, Justin,Nguyen, Duy,Taylor, Stephen Michael
We present a new method to sample random variables through the use of orthogonal polynomial expansions of the associated quantile function that utilize the inverse transform technique. In particular, we obtain an explicit representation of the quantile function through an orthogonal expansion using Legendre polynomials as a basis. This enables the sampling of a broad class of random variables directly through the inverse transform method, which are otherwise quite challenging or inefficient to sample with more traditional alternative techniques such as acceptance-rejection sampling. We illustrate the accuracy and efficiency of the new method through numerical examples and by comparing to benchmark cases in the literature.

Abnormal Sector Option Correlation Premiums and Predictable Changes in Implied Volatility
Koticha, Apoorva,Li, Chen (Lilly),Marks, Joseph M.
We examine options listed on sector ETFs that constitute the S&P 500 and nd evidence of predictability in implied volatilities associated with abnormally high or low implied correlations. We show that sector implied volatilities evolve to maintain stable relations between sector correlation premiums and the correlation premium on the S&P 500. The predictable variation in sector implied volatilities associated with changes in implied correlation forms the basis for protable trading signals that dominate strategies based directly on sector volatility premiums.

Are characteristic interactions important to the cross-section of expected returns?
Ross, Landon
Characteristic interactions play an important role in describing the cross-section of expected returns. I use a Fama-Macbeth regression modified to accommodate more vari- ables than observations to study the cross-sectional relationship between characteristic interactions and expected returns. The modified Fama-Macbeth regression uses a form of dimension reduction called an envelope, which does not require variable selection or slope regularization. I use the method to estimate the information in 3,655 character- istic interactions about the cross-section of expected returns. About 100 interactions have incremental information about expected returns. Standard long-short portfolios constructed from interaction-based estimates of expected returns have significant risk- adjusted returns compared to standard factor models.

Blockholder Exit Threats and Corporate Cash Holdings
Sun, Lingna,Phan, Hieu V.,Simpson, Thuy
We investigate the effects of blockholder exit threats, which increase with stock liquidity, on corporate cash holdings and the value of cash to shareholders. Exploiting decimalization as an exogenous shock to stock liquidity to identify the effects of blockholder exit threats, we find robust evidence that blockholder exit threats have a negative effect on corporate cash holdings and a positive effect on the value of cash to shareholders. Further analysis indicates that exit threat induces firms to increase stock repurchases and improve investment efficiency. Our evidence is consistent with the view that blockholder exit threats are an effective corporate governance mechanism.

Corporate Venture Capital and Firm Scope
Zhang, Yifei
This paper studies whether and how corporate venture capital (CVC) reshapes the firm scope of CVC corporate parent. Using two sets of firm scope measures, the text-based emerging business measures and Compustat segment measures, I document that CVC investments are strongly associated with the subsequent firm scope changes, including integrating emerging businesses, establishing new divisions, and terminating obsolete divisions. A learning-through-experimentation process helps to explain how CVC spurs the firm scope changes. To sharpen the causality, I explore the idiosyncratic fund inflow shocks of those past-connected independent VCs in each CVC program, as well as the US non-stop airline routes. Overall, this paper explores and discovers a novel channel of firm scope change through corporate venture capital.

Do Family Firms Engage in Less Tax Avoidance than Non-Family Firms? The Corporate Opacity Perspective
Lee, Cheng-Hsun,Bose, Sudipta
We examine the moderating effect of corporate opacity on the relationship between family firms and tax avoidance. We find, ceteris paribus, that family firms and tax avoidance are negatively associated. However, the negative association is attenuated when corporate opacity increases. Our results indicate that corporate opacity affects firms’ tax avoidance, with this effect stronger for family firms than for non-family firms. We also find that tax avoidance by and corporate opacity of family firms are negatively associated with firm valuation. These results are consistent with the opportunistic perspective that family firms engage in more tax avoidance than non-family firms when corporate opacity is higher.

Enigmatic Forecasts of Enigmatic Risks
Osband, Kent
Most risks in finance are chronically enigmatic. We cannot deduce them from symmetries,gauge them precisely, or have confidence that they are stable. Yet capital markets force theirestimation and pricing. The excess volatility, propensity to turbulence, and high trading volumesof capital markets have long been interpreted as evidence of arbitrary and irrational drivers. Yetsimulations and mathematical analysis show that rational learning about unstable risks inducesthose features too. Indeed, a capital market can operate like a single rational mind even whentraders are fiercely competitive. This casts doubts on many presumptions of market irrationality.

Equilibrium Executive Compensation
Chemla, Gilles,Rivera, Alejandro,Shi, Liyan
We examine a general equilibrium dynamic economy in which each firm hires a manager who privately observes cash flows and can fire him after poor performance, generating costs to both parties. The contract is terminated when the manager's continuation value reaches his compensation at another firm net of his search cost. The unique competitive equilibrium features overcompensation, short-termism, and excessive executive tenure. When a firm increases executive pay, it increases the cost to other firms to retain their managers, in turn forcing them to raise and front-load their compensation packages. Inefficiencies decrease with the firm's discount rate and increase with the manager's discount rate, the termination cost to the firm, and the proxy for moral hazard. An increase in the search cost to the manager increases social welfare. In the competitive equilibrium, the private optimal contract can be implemented via inside equity relinquished by the manager upon moving to a new firm. Optimal corporate and income tax schedules can generate the social planner's allocation.

Financer l'extension de l'assurance sociale aux travailleurs de l'économie informelle à l'aide des transferts de fonds
Kolev, Alexandre,La, Justina
L'emploi informel, défini par l'absence de protection sociale basée sur l'emploi, constitue la majeure partie de l'emploi dans les pays en développement, et entraîne un niveau de vulnérabilité à la pauvreté et à d'autres risques qui sont supportés par tous ceux qui dépendent des revenus du travail informel. Les résultats de la base de données des Indicateurs clés de l'informalité en fonction des individus et leurs ménages (KIIbIH) montrent qu'un nombre disproportionné de travailleurs de l'économie informelle de la classe moyenne reçoivent des transferts de fonds. Ces résultats confirment que les stratégies de gestion des risques, telles que la migration, jouent un rôle dans la minimisation des risques potentiels du travail informel pour les ménages informels de la classe moyenne qui peuvent ne pas être éligibles à l'aide sociale. Ils suggèrent en outre que les travailleurs informels de classe moyenne peuvent avoir une demande solvable d'assurance sociale, de sorte que, si des régimes d'assurance sociale adaptés aux besoins des travailleurs informels leur étaient accessibles, les transferts de fonds pourraient potentiellement être canalisés pour financer l'extension de l'assurance sociale à l'économie informelle.

Firm Differences: Skill Sorting and Software
Bessen, James E.,Denk, Erich,Meng, Chen
Recent research shows that much recent rise in wage inequality comes from growing differences between firms, especially sorting of skilled workers to high-paying firms. This paper explores the role of proprietary software in these changes. Using job ad data, we find that proprietary software is strongly associated with firm wage fixed effects and also with firm skills. Software accounts for half or more of skill sorting across firms. Moreover, both skill sorting and firm wage effects are greater for larger firms. The huge growth in proprietary software helps explain the growth in skill sorting that increases wage inequality.

From Productivity to Firm Growth
Bessen, James E.,Denk, Erich
It is widely held that more productive firms grow faster, thus reallocating resources and raising aggregate productivity. Yet little empirical research identifies the features of the mechanisms affecting this process. This paper develops and tests a general model encompassing several mechanisms used to overcome informational frictions to growth. We find that firm size, productivity dispersion, and large firm investments in intangibles are all significantly related to changes in firm growth in response to productivity. These factors can account for much of the decline in the response to productivity since 2000 (Decker et al. 2020). Also, industry concentration is directly related to aggregate productivity growth.

Government Intervention through Informed Trading in Financial Markets
Huang, Shao'an,Qiu, Zhigang,Wang, Gaowang,Wang, Xiaodan
We develop a theoretical model of government intervention in which a government with private information trades strategically with other market participants to achieve its policy goal of stabilizing asset prices. When the government has precise information and prioritizes its policy goal, both the government and the informed insider engage in reversed trading strategies, but they trade against each other. Government intervention can improve both market liquidity and price efficiency, and the effectiveness of government intervention depends crucially on the quality of information possessed by the government.

Hidden Advertising: The Streetlight Effect and Stock Mispricing
Gefen, Ofir,Hsu, Po-Hsuan,Lee, Hsiao-Hui,Reeb, David M.
Security regulators charge firms with providing material information about intangible investments to outside investors. Among the many firms that do not report their advertising, 25% are in the top decile of observed advertising. We find that relying on managerial judgment for disclosure replaces transparent, regulatory thresholds, such as 1% of sales, with opaque, auditor-specific minimums (e.g., EY vs. Deloitte). Forced and voluntary auditor changes lead firms to alter advertising disclosures. Financial analysts ask executives of hidden advertising firms 65% fewer questions about advertising than their reporting peers. Our final tests demonstrate that hidden advertising is associated with stock mispricing.

Information Technology and Bank Competition
Vives, Xavier,Ye, Zhiqiang
We consider a spatial model of bank competition to study how the development and diffusion of information technology affect competition in the lending market, stability of the banking sector, and social welfare. We find that the effects of an overall improvement in information technology depend on whether or not it weakens the influence of bankâ€"borrower distance on monitoring/screening costs. If so, then competition intensifies and banks are less stable; otherwise, competition intensity does not vary and banks are more stable. In line with recent empirical evidence, we find that a technologically more advanced bank always commands greater market power and is more stable. The welfare effect of progress in information technology is ambiguous when such progress increases the intensity of competition. However, if banks have local monopolies then technological progress always improves social welfare.

Investing like conglomerates: is diversification a blessing or curse for China’s local governments?
Bailey, Warren,Fan, Jianchao,Liu, Jing,Zhou, Yinggang
We examine government investment in business by studying Chinese local government financing vehicles (LGFVs), an often-criticised funding and investment channel. We find an inverted U-shaped relationship between LGFV diversification and subsequent local economic growth confirmed by identification using policy, regulatory, and enforcement events. The inverted U-shape is stronger when local economic development or government indebtedness is higher. Diversification appears to crowd out private investment and reflects career concerns and decision-making biases of local political leaders. LGFV business returns display similar inverted U-shapes. Thus, local government industrial diversification is associated with bad outcomes only if extensive and funded by heavy borrowing.

It Takes Two to Dance: Institutional Dynamics and Climate-Related Financial Policies
Baer, Moritz,Campiglio, Emanuele,Deyris, Jérôme
This article studies how institutional dynamics might affect the implementation of climate- related financial policies. First, we propose a three-dimensional framework to distinguish: i) motives for policy implementation (prudential or promotional); ii) policy instruments (informational, incentive or coercive); and iii) implementing authorities (political or delegated). Second, we use this framework to show how sustainable financial interventions in certain jurisdictions - most notably, Europe - rely solely on informational policies to achieve both promotional and prudential objectives. Policymakers in other jurisdictions - e.g., China - also implement incentive or coercive financial policies to achieve promotional objectives. Third, we identify two main institutional explanations for this European ‘promotional gap’: i) limited control of political authorities on financial dynamics; and ii) strong powers and independence of delegated authorities. This governance configuration leads to an institutional deadlock in which only measures fitting with both political and delegated authorities’ objectives can be implemented. Finally, we discuss the scenarios that might originate from the current institutional setting. We identify three possible evolutionary paths: i) a drift towards a green financial technocracy; ii) a re-politicization of delegated authorities; iii) a move towards fiscal-monetary coordination.

Linear Classifiers Under Infinite Imbalance
Paul Glasserman,Mike Li

We study the behavior of linear discriminant functions for binary classification in the infinite-imbalance limit, where the sample size of one class grows without bound while the sample size of the other remains fixed. The coefficients of the classifier minimize an expected loss specified through a weight function. We show that for a broad class of weight functions, the intercept diverges but the rest of the coefficient vector has a finite limit under infinite imbalance, extending prior work on logistic regression. The limit depends on the left tail of the weight function, for which we distinguish three cases: bounded, asymptotically polynomial, and asymptotically exponential. The limiting coefficient vectors reflect robustness or conservatism properties in the sense that they optimize against certain worst-case alternatives. In the bounded and polynomial cases, the limit is equivalent to an implicit choice of upsampling distribution for the minority class. We apply these ideas in a credit risk setting, with particular emphasis on performance in the high-sensitivity and high-specificity regions.

Market reactions of multinationals to the OECD BEPS Action Plan
Petutschnig, Matthias,Resenig, Kristin
This paper investigates the equity market reactions to the publication of the OECD BEPS Action Plan. We examine abnormal stock returns for firms incorporated and traded on the stock market in 36 OECD member states for various event dates during the developmental phase of the OECD BEPS Action Plan. Overall, we find a negative market reaction of multinational companies across the relevant events, which suggests that the additional tax costs from limiting tax avoiding behaviour outweigh the benefits such as more transparency, better international tax dispute resolution, etc related to the introduction of the OECD BEPS Action Plan. The conclusion of the Multilateral Instrument (MLI) results in the most negative cumulative reaction. US corporations show a significant negative mean return across all events, but we find less pronounced evidence for market reactions across the European Union (EU). We find that more tax avoiding firms have stronger negative reactions to the events than less tax avoiding firms. Additionally, we show that there are some spill over effects onto the equity markets for purely domestic firms. We provide first evidence as to how investors reacted to the introduction of the OECD BEPS Action Plan and contribute to the literature by further investigating the association between tax avoidance and stock return.

Mitigating Information Imperfections in Proxy Contests: The Effect of Dissidents’ Proxy Solicitation
Lee, Choonsik
This study examines dissidents’ expenses related to proxy solicitation activities in a contested director election. I find that dissidents’ solicitation expenses are associated with higher chances of winning board seats. This association is consistent with my conjecture that dissidents extend their efforts in proxy solicitation and thus persuade more shareholders in dissidents’ favor, but this is not likely driven by retained solicitor’s reputation, dissidents’ opportunistic behavior for reimbursement, or other popular strategic activities in proxy contests. Furthermore, I show that proxy solicitation activities are considered to be an information channel that substitutes for investors’ own search for proxy statements from the SEC’s EDGAR. Overall, this study suggests that proxy solicitation plays an important role in proxy contests.

Move to Success? Headquarters Relocation, Political Favoritism, and Corporate Performance
Chen, Shuo,Yan, Xun,Yang, Bo
This study documents an unexplored corporate rent-seeking phenomenon in non-representative regimesâ€"relocating headquarters (HQ) to the political center. Focusing on China, we find thatfirms that relocate their HQs to Beijing (the political center) enjoy increased political favors, butthose that move to Shanghai or Shenzhen (the country's two main economic centers) do not. Although both groups of movers experience improved profitability, their sustainable growthpaths diverge after relocating. Firm productivity and innovation worsen after relocating to Beijing, but improve after moving to Shanghai or Shenzhen. Overall, these findings support theargument that political favoritism benefits firms' profitability but impairs their productivity andinnovation.

On survivor stocks in the S&P 500 stock index
Grobys, Klaus,Kolari, James W.
This paper investigates the performance and characteristics of survivor stocks in the S&P 500 index. Using both in-sample and out-of-sample comparisons, survivor stocks outperformed this market index by a considerable margin. Relative to other S&P 500 index companies, survivor stocks tend to be small value stocks that exhibit high profitability and invest conservatively. Surprisingly, survivor stocks tend to be loser stocks with negative exposure to the momentum factor. Further analyses show that the volatility of the survivor stocks portfolio is less exposed to tail risks and responds less to shocks in the innovation process.

Recession managers and mutual fund performance
Chen, Jie,Lasfer, Meziane,Song, Wei,Zhou, Si
We find that fund managers who began their careers during recessions produce superior returns. This superior performance is not unconditional, as they exhibit better market timing than their non-recession counterparts in recessions, but do not demonstrate better stock picking in booms. Exploring managers’ portfolio choices across years, we find that recession managers tilt their investments towards defensive, rather than cyclical, industries during and before recession periods. Overall, our findings support the argument that the economic conditions under which an individual initially entered the labour market exert a long-term impact on her career outcomes and decision-making.

Risk-Adjusted Valuation in the Worker’s Economic Decision Making
Lee, Hangsuck,Ryu, Doojin,Son, Jihoon
We suggest an overlapping generations model incorporating the risk-adjusted valuation in a worker’s decision problem. The risk-adjusted probabilities allow risk-averse workers to place more weight on cash flows upon retirement when assessing lifetime income at present value. The risk-adjusted valuation is consistently applied to any non-financial asset, allowing them to be evaluated collectively or separately. We predict capital returns under demographic structure, consumption preference, and social security policy changes.

Semi-equilibrium Pricing: The CAPM Formula
Abad, Pharos
We present a new type of pricing method, the semi-equilibrium pricing method, which solves the optimal portfolios of investors first. This stage is consistent with the equilibrium pricing method, but the second stage of the semi-equilibrium pricing method uses only a part of the market clearing conditions rather than the entirety. Based on this, we show that the pricing formula by capital asset pricing model (CAPM) is not an equilibrium pricing formula but a semi-equilibrium pricing formula: When the CAPM formula is valid, the market may not be cleared. Only when the total market value of risky securities is given can the CAPM formula completely determine the price vector of the risky securities. Additionally, we point out that the stochastic discount factor (SDF) pricing formula is the result of investors' portfolio optimization, and the market clearing conditions are not involved at all. The SDF pricing formula is presented in the form of a linear pricing function and can be used as a foundation template to establish pricing functions.

Shareholder Financial Difficulties and Firms’ Risk-Shifting Behavior: Evidence from the 2003 Mutual Fund Scandal
Kang , Jun-Koo ,Si, Fangbo
We examine how shareholder financial difficulties affect firms’ risk-shifting behavior. Using the 2003 mutual fund scandal as a financial shock to institutions’ risk-shifting incentives, we find that lenders charge higher loan spreads after the scandal. The results are more evident when the scandal is more severe, when tainted institutions have poorer performance and stronger abilities to influence firms, and when firms have higher shareholder-debtholder conflict and greater information asymmetry. Lenders also impose more covenants after the scandal. We further find that bond and stock returns around scandal announcements are negatively correlated and that firms’ post-scandal investments and riskiness increase significantly.

Sparse High-Order Portfolios via Proximal DCA and SCA
Jinxin Wang,Zengde Deng,Taoli Zheng,Anthony Man-Cho So

In this paper, we aim at solving the cardinality constrained high-order portfolio optimization, i.e., mean-variance-skewness-kurtosis model with cardinality constraint (MVSKC). Optimization for the MVSKC model is of great difficulty in two parts. One is that the objective function is non-convex, the other is the combinational nature of the cardinality constraint, leading to non-convexity as well dis-continuity. Based on the observation that cardinality constraint has the difference-of-convex (DC) property, we transform the cardinality constraint into a penalty term and then propose three algorithms including the proximal difference of convex algorithm (pDCA), pDCA with extrapolation (pDCAe) and the successive convex approximation (SCA) to handle the resulting penalized MVSK (PMVSK) formulation. Moreover, theoretical convergence results of these algorithms are established respectively. Numerical experiments on the real datasets demonstrate the superiority of our proposed methods in obtaining high utility and sparse solutions as well as efficiency in terms of time usage.

Stock Liquidity and Algorithmic Market Making During the COVID-19 Crisis
Chakrabarty, Bidisha,Pascual, Roberto
As the role of designated market makers in liquidity supply has diminished over time, algorithmic traders (ATs) have stepped up to fill that gap in modern equity markets. Prompted by concerns of fragility introduced by such voluntary market making, we examine ATs’ liquidity-provision role during the COVID-19 crisis. Amidst the turmoil as overall market liquidity declined, we find that ATs did not (disproportionately) withdraw liquidity supply. Stocks with the highest algorithmic trading (AT) activity experienced lower liquidity reduction compared to stocks with low AT activity, although profits from market making in high AT stocks fell more. High AT stocks did not experience greater reduction in either competition for liquidity provision or price improvements than low AT stocks. Multiple tests indicate that high AT activity did not associate with any greater deterioration in price efficiency vis-à-vis low AT stocks. Stocks in industries hardest hit by COVID-19 did not see any less AT competition for liquidity supply or price efficiency than stocks in the least affected ones. Overall, our results allay some recent concerns that the current levels of AT have made markets more susceptible to liquidity withdrawal in times of crises.

Sustainable Institutional Investment in the COVID-19 Pandemic
Hoang, Lai T.,Yang, Joey (Wenling)
This paper examines institutions’ investment strategies towards environmental and social (E&S) stocks during the COVID-19 pandemic. We find a shift towards E&S by institutions in the first quarter of 2020 when the pandemic hit the financial market. We then demonstrate that high E&S portfolios exhibit lower risk and returns, and they outperform (underperform) low E&S portfolios on market-down (-up) days. Further analysis show that institutions’ increase in E&S preferences triggered by the pandemic is not persistent throughout the rest of 2020, rather it reversed with the financial market recovery from the second quarter. These results imply that seeking protection against downside risk is the underlying driver of E&S-oriented investment decisions by institutions.

The Effect of Retail Sentiment on Government Bonds
Abudy, Menachem (Meni),Nathan, Daniel,Wohl, Avi
We investigate daily flows to Israeli mutual funds, which are held primarily by retail investors. We find that daily net flows are contemporaneously correlated with price changes of all government bond categories (nominal/CPI-linked; short-term, intermediate-term, and long-term maturity). These price changes are subsequently reversed fully or partially within three months. The price reversals indicate that the initial price changes are due to “noise”. We find that these price distortions affect break-even inflation â€" a popular measure of inflation expectations. Our findings indicate that even securities that are held by institutions and professional investors are affected by retail sentiment.

The Gender Effects of COVID-19 on Equity Analysts
Li, Frank Weikai,Wang, Baolian
We use the COVID-19 pandemic as a natural experiment to study the effects of childcare and household duties on analysts. The richness of this setting allows us to compare female and male analysts while requiring them to perform the same tasks. We find that female analysts' forecast accuracy declined more than male analysts, especially when schools were closed and among analysts who were more likely to have young children, inexperienced, and were likely busier before the pandemic. Female analysts also reduced the timeliness of their forecasts and resorted to more heuristic forecasts. The stock market was aware of this and became less responsive to female analysts' forecasts. However, female analysts did not reduce their coverage or updating frequency relative to male analysts. We also find the above widening gender gap was temporary and disappeared by May/June 2020. Overall, our results show that the pandemic impacted female analysts more than males through the quality of their forecasts but not the quantity.

The Post-IPO Dynamics of Investor Trust in Corporate Disclosure
Moers, Frank,Peek, Erik,Vorst, Patrick
This study examines the development of investor trust in corporate disclosure during a time in a firm’s life when this matters most: at and after its initial public offering (IPO). Analyzing a sample of 3,202 US IPOs between 1985 and 2013, we provide evidence of two key features of investor trust. First, investor trust development is incomplete at the IPO and hence continues after the IPO. In particular, we find that (a) the variance of investors’ disclosure credibility perceptions across firms increases during the five-year post-IPO period and (b) firm-specific post-IPO trends in perceived disclosure credibility correlate with credibility signals known to investors at the IPO. Second, post-IPO trends and innovations in analyst coverage and institutional ownership correlate with trends and innovations in perceived disclosure credibility. Thus, analysts and institutional investors act as facilitators of investor trust in corporate disclosure after the IPO. Collectively, our findings shed light on the time-consuming nature of investor trust development and document a previously unexplored role for analysts and institutional investors.