Research articles for the 2021-06-28

Accounting-Based Equity Valuation as a Bayesian Discipline Part 1: Conceptual Foundations and Modelling for Fundamental Investors
Rueenaufer, Marcel
This paper serves as the first in a two-part discussion and empirical application of Bayesian inference in accounting-based equity valuation. In this first paper, I discuss whether a fundamental investor à la Graham & Dodd (1934) can be considered as "Bayesian" or "Frequentist". It is remarkable that despite the inevitably subjective (i.e. Bayesian) nature of valuation under uncertainty, the majority of researchers in capital market-based accounting research (CMAR) and textbooks on fundamental analysis rely on frequentist methods for inference. Seein this inconsistency in the field, I argue that Bayesian methodology is much more intuitive and suitable for the practical decision problem that investors face. Afterwards, I derive a Bayesian notion of the Ohlson (1995) model that provides a more suitable framework for decision-making than existing models. Based on the model, I suggest weakly informative priors for speculative variables that should lead to improved valuation practice by keeping estimates of intrinsic value within a reasonable range.

Assessing the Safety of Central Counterparties
Paddrik, Mark E.,Young, Peyton
A proposed framework for empirically assessing a central counterparty’s capacity to cope with severe financial stress. Using public disclosure data for global central counterparties (CCPs), we show how to estimate the probability that a CCP could cover any specified fraction of payment defaults by its members. This framework supplements conventional standards of risk management such as Cover 2 and provides a comparative and comprehensive approach to assessing risk protection across CCPs that is not predicated on a specific number of member defaults. We apply the approach to a wide range of CCPs in different geographical jurisdictions and asset classes and find that there are substantial differences in protection coverage. In particular, large European CCPs appear to be significantly safer than their counterparts in Asia-Pacific and North America. These differences are also reflected in supervisory data that provide CCP members’ risk assessments of the CCPs to which they belong.

Bertram's Pairs Trading Strategy with Bounded Risk
Vladimír Holý,Michal Černý

Finding Bertram's optimal trading strategy for a pair of cointegrated assets following the Ornstein--Uhlenbeck price difference process can be formulated as an unconstrained convex optimization problem for maximization of expected profit per unit of time. This model is generalized to the form where the riskiness of profit, measured by its per-time-unit volatility, is controlled (e.g. in case of existence of limits on riskiness of trading strategies imposed by regulatory bodies). The resulting optimization problem need not be convex. In spite of this undesirable fact, it is demonstrated that the problem is still efficiently solvable. In addition, the problem that parameters of the price difference process are never known exactly and are imprecisely estimated from an observed finite sample is investigated (recalling that this problem is critical for practice). It is shown how the imprecision affects the optimal trading strategy by quantification of the loss caused by the imprecise estimate compared to a theoretical trader knowing the parameters exactly. The main results focus on the geometric and optimization-theoretic viewpoint of the risk-bounded trading strategy and the imprecision resulting from the statistical estimates.

Bitcoin, Currencies, and Bubbles
Nassim Nicholas Taleb

We apply quantitative finance methods and economic arguments to cryptocurrencies in general and bitcoin in particular -- as there are about $10,000$ cryptocurrencies, we focus (unless otherwise specified) on the most discussed crypto of those that claim to hew to the original protocol (Nakamoto, 2009) and the one with, by far, the largest market capitalization.

In its current version, in spite of the hype, bitcoin failed to satisfy the notion of "currency without government" (it proved to not even be a currency at all), can be neither a short nor long term store of value (its expected value is no higher than $0$), cannot operate as a reliable inflation hedge, and, worst of all, does not constitute, not even remotely, a safe haven for one's investments, a shield against government tyranny, nor a tail protection vehicle for catastrophic episodes.

Furthermore, there appears to be an underlying conflation between the success of a payment mechanism (as a decentralized mode of exchange), which so far has failed, and the speculative variations in the price of a zero-sum asset with massive negative externalities.

Going through monetary history, we also show how a true numeraire must be one of minimum variance with respect to an arbitrary basket of goods and services, how gold and silver lost their inflation hedge status during the Hunt brothers squeeze in the late 1970s and what would be required from a true inflation hedged store of value.

Board Gender Diversity and Firm Value in Times of Crisis: Evidence from the COVID-19 Pandemic
Akhtar, Farida,Veeraraghavan, Madhu,Zolotoy, Leon
We study the impact of board gender diversity on stock price reactions to the outbreak of the COVID-19 pandemic. We provide robust evidence that stocks of the firms with gender-diverse boards experienced higher abnormal returns during the period when negative market sentiment induced by the outbreak of pandemic was at its peak. In cross-sectional analysis, we find that the documented effect was amplified among financially constrained firms and firms with longer cash conversion cycle, while was mitigated for firms led by management teams with higher managerial ability. We also find that the documented effect was amplified among firms with high information uncertainty. Collectively, our findings are consistent with the view that market interpreted board gender diversity as a positive signal about firm’s ability to weather the implications of crisis triggered by the COVID-19 pandemic.

COVID-19, Credit Risk and Macro Fundamentals
Dubinova, Anna,Lucas, Andre,Telg, Sean
We investigate the relationship between macro fundamentals and credit risk, rating migrations and defaults during the start of the COVID-19 pandemic. We find that credit risk models that use macro fundamentals as covariates overestimate credit risk incidence due to the unprecedented drops in economic activity in the first lockdowns. We argue that this break in the macro-credit linkage is less affected if we take an unobserved components modeling framework, both at shorter and longer credit risk horizons.

Career Concerns and Financial Reporting Quality
Pae, Suil
Managerial career concerns could affect firm efficiency through financial reporting quality, but this important link has received relatively little attention in the literature. The present study examines this link by developing a model that has the following elements. A risk-neutral manager provides effort to increase the market value of the firm and to favorably influence the market assessment of the manager’s ability. Depending on the magnitude of career concerns, the manager either under- or overinvests effort relative to an efficiency-maximizing level. The analysis identifies conditions un-der which higher-quality reporting induces the manager to invest more effort. Under these condi-tions, the model is extended to a setting in which the manager also chooses the quality of financial reporting at some cost. In doing so, the manager seeks to reduce distortion in their effort invest-ment. The equilibrium reporting quality and effort investment are determined by a trade-off be-tween them. In the presence of high uncertainty about the firm’s future cash flows, if the manager’s career concerns exceed a threshold, the manager underinvests in reporting quality and overinvests effort. The empirical implication is a negative relation between managerial career concerns and fi-nancial reporting quality. To a large extent, this is consistent with findings in prior empirical studies. Thus, the present study offers a theoretical explanation for the empirical findings as an equilibrium outcome.

Deep Reinforcement Learning on a Multi-Asset Environment for Trading
Hirsa, Ali,Hadji Misheva, Branka,Osterrieder, Joerg,Posth, Jan-Alexander
Financial trading has been widely analyzed for decades with market participants and academics always looking for advanced methods to improve trading performance. Deep reinforcement learning (DRL), a recently reinvigorated method with significant success in multiple domains, still has to show its benefit in the financial markets. We use a deep Q-network (DQN) to design long-short trading strategies for futures contracts. The state space consists of volatility-normalized daily returns, with buying or selling being the reinforcement learning action and the total reward defined as the cumulative profits from our actions. Our trading strategy is trained and tested both on real and simulated price series and we compare the results with an index benchmark. We analyze how training based on a combination of artificial data and actual price series can be successfully deployed in real markets.The trained reinforcement learning agent is applied to trading the E-mini S&P 500 continuous futures contract. Our results in this study are preliminary and need further improvement.

Do Firms Cater to Corporate QE? Evidence from the Bank of Japan’s Corporate Bond Purchases during the COVID-19 Pandemic
Tsujimoto, Yusuke
The Federal Reserve and Bank of Japan corporate bond purchase programs in response to the COVID-19 crisis primarily target bonds with five years or less remaining to maturity. This paper documents evidence suggesting that firms in Japan, but not in the U.S., have catered to the maturity-specific demand shock by shifting the maturity of new bond issues. Most strikingly, in Japan, there is a large and disproportionate reduction in issuance of bonds maturing in seven years, a previously popular maturity just above the maturity eligibility criterion. I argue that Japanese results are consistent with heterogeneous firms facing a trade-off between the gain from shortening maturities to match the positive demand shock and the cost of deviating from their intrinsically optimal maturities. An analysis of simultaneous issuances of multiple-maturity bonds further supports the catering explanation. Thus, this paper documents a novel unintended effect of corporate quantitative easing (QE) and has important policy implications.

Does It Pay to Be Environmentally Responsible? Investigating the Effect on the Weighted Average Cost of Capital
Mariani, Massimo,Pizzutilo, Fabio,Caragnano, Alessandra,Zito, Marianna
This research aims at investigating the effect of firms' environmental policies on the weighted average cost of capital (WACC) in order to catch capital markets' reaction towards corporate environmental commitment and effectiveness in reducing carbon emissions. We refer to the European market and analysed a sample of companies listed on the Stoxx Europe 600 Index during the timeframe 2014â€"2018. Our results show that capital markets have become particularly sensitive to environmental issues and therefore reward environmentally virtuous firms with a lower after tax WACC. We also argue that this effect is prominent for both high emitting and low emitting industries.

Dynamics of Disruption in Science and Technology
Michael Park,Erin Leahey,Russell Funk

Although the number of new scientific discoveries and technological inventions has increased dramatically over the past century, there have also been concerns of a slowdown in the progress of science and technology. We analyze 25 million papers and 4 million patents across 6 decades and find that science and technology are becoming less disruptive of existing knowledge, a pattern that holds nearly universally across fields. We link this decline in disruptiveness to a narrowing in the utilization of existing knowledge. Diminishing quality of published science and changes in citation practices are unlikely to be responsible for this trend, suggesting that this pattern represents a fundamental shift in science and technology.

Even Finance Professors Lean Left
Kuvvet, Emre
As in most academic fields, the top academic finance departments and journals guide the direction of scholarly research. Preferences, tastes, and sensibilities of the faculty at the top finance departments and the editorial boards at top finance journals can have a considerable effect on the acceptable research questions in those journals. It is well known that a person’s political ideology shapes his outlook on scientific issues. Yet little is known about the political ideologies of finance professors at these elite institutions and journals. This analysis of the political party affiliations of faculty at the top twenty finance departments and of the editorial boards at the top three finance journals shows that both institutions lean considerably to the left. Results also suggest that finance departments will become even less politically diverse in the future.

Exclusion of Extreme Jurors and Minority Representation: The Effect of Jury Selection Procedures
Andrea Moro,Martin Van der Linden

We compare two established jury selection procedures meant to safeguard against the inclusion of biased jurors that are also perceived as causing minorities to be under-represented in juries. The Strike and Replace procedure presents potential jurors one-by-one to the parties, while the Struck procedure presents all potential jurors before the parties exercise vetoes. In equilibrium, Struck more effectively excludes extreme jurors than Strike and Replace but leads to a worse representation of minorities. Simulations suggest that the advantage of Struck in terms of excluding extremes is sizable in a wide range of cases. In contrast, Strike and Replace only provides a significantly better representation of minorities if the minority and majority are heavily polarized. When parameters are estimated to match the parties' selection of jurors by race with jury-selection data from Mississippi in trials against black defendants, the procedures' outcomes are substantially different, and the size of the trade-off between objectives can be quantitatively evaluated.

Finance 4.0â€"Towards a Socio-Ecological Finance System a Participatory Framework to Promote Sustainability
Dapp, Marcus M.,Helbing, Dirk,Klauser, Stefan
This Open Access book outlines ideas for a novel, scalable and, above all, sustainable financial system.We all know that today’s global markets are unsustainable and global governance is not effective enough. Given this situation, could one boost smart human coordination, sustainability and resilience by tweaking society at its core: the monetary system? A Computational Social Science team at ETH Zürich has indeed worked on a concept and little demonstrator for a new financial system, called “Finance 4.0” or just “FIN4”, which combines blockchain technology with the Internet of Things (“IoT”). What if communities could reward sustainable actions by issuing their own money (“tokens”)? Would people behave differently, when various externalities became visible and were actionable through cryptographic tokens? Could a novel, participatory, multi-dimensional financial system be created? Could it be run by the people for the people and lead to more societal resilience than today’s financial system (which is effectively one-dimensional due to its almost frictionless exchange)? How could one manage such a system in an ethical and democratic way?This book presents some early attempts in a nascent field, but provides a fresh view on what cryptoeconomic systems could do for us, for a circular economy, and for scalable, sustainable action.

Financial Reporting and Employee Job Search
deHaan, Ed,Li, Nan,Zhou, Frank
We investigate the effects of financial reporting on current employee job search; i.e., whether firms' public financial reports cause their employees to reevaluate their jobs and consider leaving. We develop a simple model in which current employees use earnings announcements to inform job search decisions, and empirically measure job search based on employees' activity on a popular job market website. We find that job search by current employees increases significantly during earnings announcement weeks, especially when employees are more mobile and when within-firm information frictions are greater. We also find that employees use earnings announcements to update their expectations about their employers' economic prospects, consistent with learning. Our paper contributes to the burgeoning labor and accounting literature by providing among the first evidence closely linking financial reports to employee learning and job search.

Firm Characteristics and Stock Price Levels: A Long-Term Discount Rate Perspective
Chen, Yixin,Kaniel, Ron
We study how firm characteristics are correlated with stock price levels by measuring the long-term discount rates (defined as the internal rate of return) of anomaly portfolios over a long horizon. We develop a simple, non-parametric methodology to estimate the long-term equity discount rate from ex-post realized payouts and prices. Our estimates show that the cross-sectional patterns in the long-term discount rates can be substantially different from that of the average short-term holding period returns; and appealing to mean-reversion in anomaly premia does not reconcile the wedge between the two for a group of prominent anomalies. We argue that the long-term discount rate is a better measure of firm's equity financing cost than the premium from a dynamically-rebalanced trading strategy; and we demonstrate with a representative example that structural models that interpret the spreads in the latter as the differences in the former could generate counterfactual patterns in the long-term discount rates. Our empirical exercise uncovers numerous new stylized facts regarding firms' equity financing cost; and these findings could shed new light on the mechanisms underlying various asset pricing anomalies, and advance our understanding about the determinants of stock price levels.

Game theory and scholarly publishing: premises for an agreement around open access
Abdelghani Maddi

Actors in research and scientific publishing are gradually joining the Open-Access (OA) movement, which is gaining momentum to become nowadays at the heart of scientific policies in high-income countries. The rise of OA generates profound changes in the chain of production and dissemination of knowledge. Free access to peer-reviewed research methods and results has contributed to the dynamics of science observed in recent years. The modes of publication and access have also evolved; the classic model, based on journal subscriptions is gradually giving way to new economic models that have appeared with the arrival of OA. The objective of this article is twofold. First, propose a model for the publishing market based on the literature as well as on changes in open science policies. Second, analyze publishing strategies of publishers and institutions. To do so, we relied on game theory in economics. Results show that in the short term, the publisher's equilibrium strategy is to adopt a hybridpublishing model, while the institutions' equilibrium strategy is to publish in OA. This equilibrium is not stable and that in the medium/long term, the two players will converge on an OA publishing strategy. The analysis of the equilibrium in mixed-strategies confirms this result.

Hierarchical contagions in the interdependent financial network
William A. Barnett,Xue Wang,Hai-Chuan Xu,Wei-Xing Zhou

We model hierarchical cascades of failures among banks linked through an interdependent network. The interaction among banks include not only direct cross-holding, but also indirect dependency by holding mutual assets outside the banking system. Using data extracted from the European Banking Authority, we present the interdependency network composed of 48 banks and 21 asset classes. Since interbank exposures are not public, we first reconstruct the asset/liability cross-holding network using the aggregated claims. For the robustness, we employ three reconstruction methods, called $\textit{Anan}$, $\textit{Ha\l{}a}$ and $\textit{Maxe}$. Then we combine the external portfolio holdings of each bank to compute the interdependency matrix. The interdependency network is much denser than the direct cross-holding network, showing the complex latent interaction among banks. Finally, we perform macroprudential stress tests for the European banking system, using the adverse scenario in EBA stress test as the initial shock. For different reconstructed networks, we illustrate the hierarchical cascades and show that the failure hierarchies are roughly the same except for a few banks, reflecting the overlapping portfolio holding accounts for the majority of defaults. Understanding the interdependency network and the hierarchy of the cascades should help to improve policy intervention and implement rescue strategy.

High-Frequency Connectedness between Bitcoin and Other Top-Traded Crypto Assets during the COVID-19 Crisis
Katsiampa, Paraskevi,Yarovaya, Larisa,Zięba, Damian
In this paper, we analyse co-movements and correlations between Bitcoin and thirty-one of the most-tradable crypto assets using high-frequency data for the period from January 2019 to December 2020. We apply the Diagonal-BEKK model to data from the pre-COVID and COVID-19 periods, and identify significant changes in patterns of co-movements and correlations during the pandemic period. We also employ the Minimum Spanning Tree (MST) and Planar Maximally Filtered Graph (PMFG) methods to study the changes of the crypto asset network structure after the COVID-19 outbreak. While the influential role of Bitcoin in the digital asset ecosystem has been confirmed, our novel findings reveal that due to recent developments in the blockchain ecosystem, crypto assets that can be categorised as dApps and Protocols have become more attractive to investors than pure cryptocurrencies, with dApps exhibiting the highest average degree of correlations with all crypto assets in the sample during the COVID-19 pandemic period.

How do Family and Managerial Ownership Structure Effect Real Earnings Management?
Siraji, Meerakkuddy,abdul, Nazar
Despite several works on corporate governance examine the ownership structure on earnings management, the empirical research on Real Earnings Management (REM) is limited. Thus, the main purpose of the research is to examine the effect of family and managerial ownership on real earnings management of selected non-financial listed companies at the Colombo Stock Exchange (CSE) in Sri Lanka. The researchers use a quantitative approach to address this current issue, and the data were collected using a sample of 206 firms listed at the CSE during the highest market capitalization period from 2015/2016 to 2019/2020 and eliminated the companies listed in the industry of bank, finance and insurance because the companies are governing by rules and regulation. The study found that family and managerial ownership play a prominent role and negatively related to real earning management activity. The finding of the study contributes to knowledge in earnings management of agency theory literature in developing economies, and help the investors, supplier auditors and policymakers for their decision-making activities by detecting the real earning management in different ownership structure.

Inheritances, social classes, and wealth distribution
Pedro Patrício,Nuno A. M. Araújo

We consider a simple theoretical model to investigate the impact of inheritances on the wealth distribution. Wealth is described as a finite resource, which remains constant over different generations and is divided equally among offspring. All other sources of wealth are neglected. We consider different societies characterized by a different offspring probability distribution. We find that, if the population remains constant, the society reaches a stationary wealth distribution. We show that inequality emerges every time the number of children per family is not always the same. For realistic offspring distributions from developed countries, the model predicts a Gini coefficient of $G\approx 0.3$. If we divide the society into wealth classes and set the probability of getting married to depend on the distance between classes, the stationary wealth distribution crosses over from an exponential to a power-law regime as the number of wealth classes and the level of class distinction increase.

Is Cash the Panacea of the COVID-19 Pandemic? Evidence from Corporate Performance
Zheng, Michael
This study investigates the impact of COVID-19 crisis on corporate investment and financing policies. Using a difference-in-difference approach, I find while firms suffer from a real negative shock from the pandemic on average, firms with an abundant cash reserve prior to the crisis outperform firms without. Consistent with the precautionary motive behind corporate cash holdings, this paper demonstrates the effect of cash holdings is meaningful to mitigate adverse effect of the aggregate market. My finding also highlights the difficulty in estimating the optimal cash level when rare market condition is considered.

Learning from SARS: Return and Volatility Connectedness in COVID-19
Bissoondoyal-Bheenick, Banita,Do, Hung Xuan,Hu, Xiaolu,Zhong, Angel
Using a sample of the G20 countries, we examine the impact of COVID-19 on stock return and volatility connectedness, and whether the connectedness measures behave differently for countries with SARS 2003 experience. We find that both stock return and volatility connectedness increase across the phases of the COVID-19 pandemic which is more pronounced as the severity of the pandemic builds up. However, the degree of connectedness is significantly lower in countries with SARS 2003 death experience. Our results are robust to different measures of COVID-19 severity and controlling for a number of cross-country differences in economic development.

On Stochastic PDEs for the pricing of derivatives in a multi-dimensional diffusion framework
Kaustav Das,Ivan Guo,Grégoire Loeper

In a multi-dimensional diffusion framework, the price of a financial derivative can be expressed as an iterated conditional expectation, where the inner conditional expectation conditions on the future of an auxiliary process that enters into the dynamics for the spot. Inspired by results from non-linear filtering theory, we show that this inner conditional expectation solves a backward SPDE (a so-called `conditional Feynman-Kac formula'), thereby establishing a connection between SPDE and derivative pricing theory. The benefits of this representation are potentially significant and of both theoretical and practical interest. In particular, this representation leads to an alternative class of so-called mixed Monte-Carlo / PDE numerical methods.

On the Design of an Insurance Mechanism for Reliability Differentiation in Electricity Markets
Farhad Billimoria,Filiberto Fele,Iacopo Savelli,Thomas Morstyn,Malcolm McCulloch

Securing an adequate supply of dispatchable resources is critical for keeping a power system reliable under high penetrations of variable generation. Traditional resource adequacy mechanisms are poorly suited to exploiting the growing flexibility and heterogeneity of load enabled by advancements in distributed resource and control technology. To address these challenges this paper develops a resource adequacy mechanism for the electricity sector utilising insurance risk management frameworks that is adapted to a future with variable generation and flexible demand. The proposed design introduces a central insurance scheme with prudential requirements that align diverse consumer reliability preferences with the financial objectives of an insurer-of-last-resort. We illustrate the benefits of the scheme in (i) differentiating load by usage to enable better management of the system during times of extreme scarcity, (ii) incentivising incremental investment in generation infrastructure that is aligned with consumer reliability preferences and (iii) improving overall reliability outcomes for consumers.

Optimal investment and proportional reinsurance in a regime-switching market model under forward preferences
Katia Colaneri,Alessandra Cretarola,Benedetta Salterini

In this paper we study the optimal investment and reinsurance problem of an insurance company whose investment preferences are described via a forward dynamic exponential utility in a regime-switching market model. Financial and actuarial frameworks are dependent since stock prices and insurance claims vary according to a common factor given by a continuous time finite state Markov chain. We construct the value function and we prove that it is a forward dynamic utility. Then, we characterize the investment strategy and the optimal proportional level of reinsurance. We also perform numerical experiments and provide sensitivity analyses with respect to some model parameters.

Optimalni hedžing valutnim forvardima (Optimal Hedging with Currency Forwards)
Cupic, Milan
Serbian abstract: Valutni forvardi su najjednostavniji valutni derivati, a obično se definiÅ¡u kao ugovori o kupovini ili prodaji odreÄ'ene količine strane valute, po odreÄ'enoj ceni, odreÄ'enog dana u budućnosti. Budući da se ugovaraju privatno, forvardi mogu glasiti na bilo koji iznos strane valute i imati bilo koji rok dospeća, tako da ih preduzeće može lako prilagoditi profilu svoje izloženosti deviznom riziku. S tim u vezi, nije neobično da empirijska istraživanja ukazuju na njihovu Å¡iroku primenu u poslovnoj praksi. Cilj rad je da se istaknu mogućnosti i pristupi za hedžing deviznog rizika korišćenjem valutnih forvarda, kao i da se ukaže na prostupak i značaj procene hedžing racija u kontekstu optimizacije efekata hedžinga valutnim forvardima.U radu se ističe da valutni forvardi mogu biti ugovoreni tako da obezbede eliminaciju deviznog rizika, mada to obično nije optimalno reÅ¡enje. Umesto toga, preduzeća mogu valutne forvarde ugovoriti u skladu sa optimalnim hedžing raciom, koji omogućava optimizaciju efekata hedžinga.English abstract: Currency forwards are the simplest currency derivatives, and are usually defined as contracts to buy or sell a certain amount of foreign currency, at a certain price, on a certain day in the future. Because they are negotiated privately, forwards can be denominated in any amount of foreign currency and can have any maturity, so that the company can easily adjust them to the profile of its exposure to foreign exchange risk. It is, therefore, not uncommon for empirical research to indicate their widespread application in business practice. The aim of the paper is to point out the possibilities and approaches for hedging foreign exchange risk using currency forwards, as well as the procedure and importance of assessing hedging ratio in the context of optimizing the effects of hedging with currency forwards. Paper shows that currency forwards can be negotiated to allow elimination of the foreign exchange risk, although this is usually not the optimal solution. Instead, companies can negotiate currency forwards in accordance with the optimal hedging ratio, which allows optimizing the effects of hedging.

Prospect Theory and Mutual Fund Flows
Han, Bing,Sui, Pengfei,Yang, Wenhao
Using mutual fund flow, we empirically test whether choices made by investors are consistent with preferences implied by prospect theory. Our findings support this hypothesis. When allocating capital to mutual funds, investors evaluate funds based on the past performance distribution and choose the ones that deliver the highest utility according to prospect theory. This predictive relation is robust when we control for a large set of known drivers of fund flows, notably alphas. The pattern is more salient among retail and less sophisticated investors. Moreover, all the features of prospect theory contribute to the predictive power.

Rational Pricing of Leveraged ETF Expense Ratios
Alex Garivaltis

This paper studies the general relationship between the gearing ratio of a Leveraged ETF and its corresponding expense ratio, viz., the investment management fees that are charged for the provision of this levered financial service. It must not be possible for an investor to combine two or more LETFs in such a way that his (continuously-rebalanced) LETF portfolio can match the gearing ratio of a given, professionally managed product and, at the same time, enjoy lower weighted-average expenses than the existing LETF. Given a finite set of LETFs that exist in the marketplace, I give necessary and sufficient conditions for these products to be undominated in the price-gearing plane. In a beautiful application of the duality theorem of linear programming, I prove a kind of two-fund theorem for LETFs: given a target gearing ratio for the investor, the cheapest way to achieve it is to combine (uniquely) the two nearest undominated LETF products that bracket it on the leverage axis. This also happens to be the implementation that has the lowest annual turnover. For the writer's enjoyment, we supply a second proof of the Main Theorem on LETFs that is based on Carath\'eodory's theorem in convex geometry. Thus, say, a triple-leveraged ("UltraPro") exchange-traded product should never be mixed with cash, if the investor is able to trade in the underlying index. In terms of financial innovation, our two-fund theorem for LETFs implies that the introduction of new, undominated 2.5x products would increase the welfare of all investors whose preferred gearing ratios lie between 2x ("Ultra") and 3x ("UltraPro"). Similarly for a 1.5x product.

Regulation of Compensation and Systemic Risk: Evidence from the UK
Kleymenova, Anya,Tuna, A. Irem
This paper studies the consequences of regulating executive compensation at financial institutions by examining the introduction of the UK Remuneration Code in 2010, which aimed to change the decision-making horizon and risk-taking incentives of bank executives. We find that, although both banks and nonbanks show increased contribution and sensitivity to systemic risk in the United Kingdom post-2010, this increase is lower for UK banks, in line with the intent of the regulation. However, UK banks also experience higher unforced CEO turnover when compared to other UK firms. Therefore, while the regulation may have had the desired effect on systemic risk, it may also have given rise to some unintended consequences.

Report 2020 on Non-financial Reporting of Italian Listed Companies (Rapporto 2020 sulla rendicontazione non finanziaria delle società quotate italiane)
Linciano, Nadia,Ciavarella, Angela,Di Stefano, Giovanna,Pierantoni, Lucia,piermattei, livia
English Abstract: The third edition of this Report analyses the implementation of the Directive 2014/95/UE, transposed in Italy by the Legislative Decree no. 254/2016 (the Decree), in Italian listed companies. The Report highlights those behaviours of companies and boards, which show a cultural transformation towards an integration of ESG (Environmental, Social and Governance) factors into the corporate decision-making. The first section of the Report covers non-financial statements published pursuant to the Decree, focusing on the materiality analysis carried out by companies, and on Strategic plans presented to investors. The second and the third sections explore the relevance of non-financial issues respectively at the board level and within CEOs’ remuneration policies. To this aim, on the basis of a desk analysis, evidence was gathered from the guidelines issued by companies prior to the board appointment and from the corporate governance reports. Finally, the report includes a Survey on board leadership and sustainable business involving members of Nedcommunity, the Italian Association of non-executive and independent directors.The progression of the cultural transformation triggered by the compliance with obligations on non-financial reporting can be thought as a three-stage phased process including Awareness, Capabilities and Engagement. In this Report, the first two stages are identified through the analysis of NFSs while the third stage refers to the information drawn from the abstracts of Strategic plans. Awareness is the precondition for change. It originates from compliance with reporting obligations and results into the acknowledgement of the relevance of ESG issues and of their ability to kick-off the transformation process. Compared to 2019, while the number of companies publishing a NFS and performing materiality analysis is unchanged, some behaviours have become more frequent. In 2020, the involvement of the BoD in the materiality analysis has been recorded in 39 companies, up from 21 in the previous year. Board inductions on ESG subjects, whose frequency had declined over 2018-2019, were held in 32 cases compared to 28, even if description of depth, length and implementation of the inductions are still not available. The number of firms establishing a Sustainability committee reported a significant increase, from 54 to 73 out of 151 companies who published an NFS. Capabilities is the area that registered the most relevant changes in 2020. As for the materiality analysis, stakeholder engagement kept on recording progress although at a slower pace than that documented in 2019. In detail, external stakeholder engagement was reported in 83 cases (70 in 2019 and 44 in 2018) while engagement with the top management hit 74 cases (69 in 2019 and 47 in 2018). In addition, 20 companies put in place ESG data collection systems and 12 issuers used platforms for stakeholder engagement or big data analytics tools to enrich materiality analysis. Behaviours related to governance and the BoD show the most relevant increases perhaps as a consequence of the introduction of the new Corporate Governance Code in January 2020. The integration of ESG factors into board renewal guidelines passed from 12 out of 43 cases in 2019 to 39 over 50 cases in 2020, while the ESG integration into board self-evaluations grew from 21 to 37 companies. The integration of ESG criteria into CEO’s remuneration packages almost doubled over the last year (from 33 to 63 companies) and can be considered as a booster of transformation. The area Engagement represents the last step in the transformation of strategies and business models towards the integration of ESG factors. In this phase new behaviours are spontaneously carried out. To capture this process, the analysis moved from NFSs to the abstracts of the Strategic plans presented to investors in the road shows and published in the Investor Relation section of the companies’ websites, in order to verify how and to what extent they describe a strategy integrating and connecting financial and non-financial issues. In 2020 59 companies vs 47 in 2019 published the abstracts of the Strategic plans. Of these, 28 (vs 24 in 2019) mentioned some long-term business consideration and 15 (vs 12 in 2019) connected the strategy to the UN Sustainable Development Goals. Seven companies (five in 2019), still all in the Energy/Oil and Gas industry, fully integrated in their strategy storytelling issues that generate value in the short and in the long term and described the connections between financial and non-financial matters. Among these companies, one mentioned the materiality analysis as a pillar of its Strategic plan.Italian Abstract: Il presente Rapporto esamina, per il terzo anno consecutivo, le modalità attraverso cui le società italiane con azioni ordinarie quotate sull’MTA hanno dato attuazione alla normativa in materia di rendicontazione non finanziaria, introdotta dalla Direttiva 2014/95/UE e recepita in Italia con il d.lgs. 254/2016. L’analisi riguarda, tra le altre cose, i comportamenti che possono segnalare progressi nel processo di trasformazione culturale legato alla considerazione dei fattori ESG (Environmental, Social and Governance) nella definizione dei modelli di business, delle strategie aziendali e dei modelli di corporate governance. La prima parte del Rapporto analizza i documenti pubblicati dalle società come dichiarazione non finanziaria (DNF), concentrandosi sulle informazioni concernenti l’analisi di materialità e i Piani strategici presentati agli investitori. La seconda parte analizza, alla luce delle evidenze tratte dalle Linee guida del board uscente e dalle Relazioni sul Governo Societario, il coinvolgimento degli organi di amministra¬zione nelle tematiche di sostenibilità. La terza parte approfondisce l’integrazione dei fattori non finanziari nelle politiche di remunerazione degli amministratori delegati. Al Rapporto si aggiunge, infine, una Survey rivolta ai membri di Nedcommunity, l’associazione italiana degli amministratori non esecutivi e indipendenti, su board leadership e business sostenibile.Il processo di trasformazione culturale innescato dall’adempimento degli obblighi di rendicontazione non finanziaria è riconducibile a tre fasi: Consapevolezza, Capacità e Coinvolgimento. In questo Rapporto, le prime due fasi sono individuate attraverso l’analisi delle DNF, mentre la terza viene valutata attraverso l’esame degli estratti dei Piani strategici. La Consapevolezza è la precondizione per il cambiamento, che parte dal rispetto degli obblighi normativi (compliance) e si sviluppa nel riconoscimento dell’importanza dei fattori ESG e del ruolo che potrebbero svolgere nell’avviare il processo trasformativo. Con riferimento al primo profilo, sono stati censiti i comportamenti delle infrastrutture organizzative delle imprese rispetto alla rendicontazione non finanziaria, mentre con riguardo al secondo profilo è stato preso in esame il coinvolgimento dell’organo di amministrazione. Nel confronto con il 2019, a fronte di un numero immutato di società che hanno pubblicato una DNF e condotto l’analisi di materialità, alcuni comportamenti hanno registrato una maggiore diffusione. Il coinvolgimento diretto del consiglio di amministrazione nell’analisi di materialità è indicato da 39 società a fronte di 21 nel 2019. Il numero di emittenti che ha erogato induction sui temi ESG al board â€" che nel 2019 era risultato l’unico dato in diminuzione rispetto all’anno precedente â€" è aumentato da 28 a 32, anche se perdura l’assenza di informazioni relative a profondità, durata e modalità di esecuzione delle induction. Tra le imprese che pubblicano la DNF, il comitato di sostenibilità è presente in 73 casi, un incremento significativo rispetto ai 54 nell’anno precedente. L’Allenamento delle capacità, colto con riferimento all’analisi di materialità e all’integrazione dei fattori ESG a livello di funzionamento del board, è l’area che nel 2020 ha registrato i cambiamenti più rilevanti. Nell’ambito dell’analisi di materialità, i comportamenti legati allo stakeholder engagement confermano la tendenza già rilevata nel biennio precedente, sebbene la crescita non sia altrettanto significativa. In particolare, nel 2020 sono 83 le imprese che riportano l’engagement con gli stakeholders esterni, a fronte di 70 nel 2019 e 44 nel 2018, mentre l’engagement con il top management ricorre in 74 casi nel 2020 da 69 nel 2019 e 47 nell’anno precedente. Nel 2020 in 12 casi gli emittenti hanno utilizzato piattaforme di stakeholder engagement o strumenti di big data analytics per affinare l’analisi di materialità e in 20 casi hanno dichiarato di avere attivato sistemi per la raccolta di dati non finanziari. Probabilmente anche a seguito delle modifiche al Codice di autodisciplina nel gennaio 2020, la considerazione della sostenibilità a livello di board è diventata più diffusa. L’integrazione dei fattori ESG nelle linee guida sulla composizione del nuovo consiglio di amministrazione predisposte dal board uscente è passata da 12 su 43 casi nel 2019 a 39 su 50 casi nel 2020, mentre le società che vi fanno riferimento nel processo di autovalutazione del board sono passate da 21 a 37. Il riferimento a temi ESG nelle politiche di remunerazione degli amministratori delegati coinvolge nel 2020 quasi il doppio degli emittenti rilevati nel 2019 (rispettivamente, 63 e 33 aziende) e può essere considerato un fattore rilevante di accelerazione della trasformazione. Il Coinvolgimento è la fase più avanzata della trasformazione, in cui i nuovi comportamenti vengono spontaneamente posti in essere a prescindere dagli obblighi legislativi e dalle sollecitazioni derivanti dal Codice di autodisciplina. Per cogliere questo processo, l’analisi si è concentrata sugli estratti dei Piani strategici presentati nei Road Show e pubblicati nella pagina Investor Relations del sito web aziendale, per verificare se e a quale livello descrivono una strategia che integra e collega fattori finanziari e non finanziari. Nel 2020, delle 59 società (erano 47 nel 2019) che hanno pubblicato gli estratti dei Piani strategici presentati agli investitori, 28 (24 nel 2019) hanno menzionato considerazioni di lungo periodo e 15 (12 nel 2019) hanno collegato la strategia aziendale agli obiettivi di sviluppo sostenibile delle Nazioni Unite (SDGs). In questa area è emblematico il comportamento di 7 società (5 nel 2019) â€" tutte nel settore energetico e petrolifero â€" che nell’illustrazione della loro strategia hanno integrato pienamente fattori che generano valore nel breve e nel lungo periodo e hanno descritto le connessioni tra fattori finanziari e non finanziari. Tra queste, un’impresa menziona l’analisi di materialità come un pilastro della pianificazione strategica (dato immutato rispetto al 2019).

Retail Bond Investors and Credit Ratings
deHaan, Ed,Li, Jiacui,Watts, Edward M.
Using comprehensive data on U.S. corporate bond trades since 2002, we find that retail bond investors over-rely on untimely credit ratings, neglect firm fundamentals, and appear to misunderstand the trade-off between bond risk and yields. Specifically, retail investors appear to select bonds by first screening on a credit rating level and then sorting by yield, buying the highest-yielding bonds within each rating level. Because yields lead credit ratings, selecting on yield-within-rating means that retail investors systematically trade in the opposite direction of accounting fundamentals, buy in advance of credit downgrades and defaults, and generate negative average future returns. Overall, our findings indicate that retail bond investors systematically mislearn from prices, which is hard to reconcile with standard notions of rationality. Our study provides new evidence of ill-informed trading in a market that is thought to be relatively sophisticated, and contributes to our understanding of the roles and consequences of credit ratings in debt markets.

Risk contributions of lambda quantiles
Akif Ince,Ilaria Peri,Silvana Pesenti

Risk contributions of portfolios form an indispensable part of risk adjusted performance measurement. The risk contribution of a portfolio, e.g., in the Euler or Aumann-Shapley framework, is given by the partial derivatives of a risk measure applied to the portfolio return in direction of the asset weights. For risk measures that are not positively homogeneous of degree 1, however, known capital allocation principles do not apply. We study the class of lambda quantile risk measures, that includes the well-known Value-at-Risk as a special case, but for which no known allocation rule is applicable. We prove differentiability and derive explicit formulae of the derivatives of lambda quantiles with respect to their portfolio composition, that is their risk contribution. For this purpose, we define lambda quantiles on the space of portfolio compositions and consider generic (also non-linear) portfolio operators.

We further derive the Euler decomposition of lambda quantiles for generic portfolios and show that lambda quantiles are homogeneous in the space of portfolio compositions, with a homogeneity degree that depends on the portfolio composition and the lambda function. This result is in stark contrast to the positive homogeneity properties of risk measures defined on the space of random variables which admit a constant homogeneity degree. We introduce a generalised version of Euler contributions and Euler allocation rule, which are compatible with risk measures of any homogeneity degree and non-linear portfolios. We further provide financial interpretations of the homogeneity degree of lambda quantiles and introduce the notion of event-specific homogeneity of portfolio operators.

Shareholder Meetings and Freedom Rides: The Story of Peck v Greyhound
Wells, Harwell
In 1947 the civil rights pioneers James Peck and Bayard Rustin, members of the radical religious group the Fellowship of Reconciliation and its offshoot the Congress of Racial Equality (CORE), prepared to embark on the Journey of Reconciliation an interracial protest against segregated busing in the American South. But first they did something else radical: they bought shares in a corporation. A year later, after their travels in the South had led to terror, death threats, beatings, and in Rustin’s case a term on a chain gang, they brought their civil rights activism to a new site of protest, the shareholder meeting of that corporation, Greyhound. Invoking the shareholder proposal rule adopted a few years before by the Securities and Exchange Commission (SEC), Peck and Rustin insisted that as shareholders they had a right to voice their opinions about Greyhound’s segregation policies and to poll other shareholders on the issue. When Greyhound refused to send their proposal to other shareholders in its proxy statement, they brought the case that became known as Peck v Greyhound. In 1952, to end the case and future litigation, the SEC changed its rules and held that shareholders could not use the shareholder proposal mechanism “primarily for the purpose of promoting . . . racial, religious, or social or similar causes.” In this landmark case we see the collision of race and the corporate and securities laws, as radicals attempted to use those laws to pursue social justice while those charged with administering them insisted that race had no role to play in the corporationâ€"in the process paradoxically writing race into the nation’s securities laws.

Short-Term Institutions, Analyst Recommendations, and Mispricing: The Role of Higher Order Beliefs
Cremers, Martijn,Pareek, Ankur,Sautner, Zacharias
We document that stocks that have optimistic (pessimistic) consensus recommendations and are currently held by many short-term institutions exhibit large stock-return reversals: Their large past outperformance (underperformance) is followed by large negative (positive) future alphas. The predictable return reversals originate from overreaction to past recommendation releases and the correction of these overreactions around future releases. Results are stronger when earnings news is released and at firms with higher fundamental uncertainty. Further, firms with more short-term institutions show stronger announcement returns and price drift after recommendation changes. Our results are consistent with models of higher order beliefs where short-term institutions coordinate trading around public signals.

Switching from Incurred to Expected Loan Loss Provisioning: Early Evidence
López-Espinosa, Germán,Ormazabal, Gaizka,Sakasai, Yuki
This paper provides early evidence on the effect of global regulation mandating a switch from loan loss provisioning (LLP) based on incurred credit losses (ICLs) to LLP based on expected credit losses (ECLs). Using a sample of systemically important banks from 74 countries, we find that ECL provisions are more predictive of future bank risk than ICL provisions. Corroborating that the switch to ECL provisioning results in more information to assess bank risk, we also observe that the announcement of a larger first-time impact of the accounting change elicits lower stock returns and higher changes in credit default swap spreads. Critically, these patterns are most pronounced when credit conditions deteriorate. Additional analyses show that the higher information content of the ECL model stems from the provisions for nondefaulted loans, which did not exist under ICL. Our study contributes to the debate on the effect of the ECL model on procyclicality, an especially pressing issue in the context of the current pandemic.

Testing Forecast Rationality for Measures of Central Tendency
Timo Dimitriadis,Andrew J. Patton,Patrick W. Schmidt

Rational respondents to economic surveys may report as a point forecast any measure of the central tendency of their (possibly latent) predictive distribution, for example the mean, median, mode, or any convex combination thereof. We propose tests of forecast rationality when the measure of central tendency used by the respondent is unknown. We overcome an identification problem that arises when the measures of central tendency are equal or in a local neighborhood of each other, as is the case for (exactly or nearly) symmetric distributions. As a building block, we also present novel tests for the rationality of mode forecasts. We apply our tests to survey forecasts of individual income, Greenbook forecasts of U.S. GDP, and random walk forecasts for exchange rates. We find that the Greenbook and random walk forecasts are best rationalized as mean, or near-mean forecasts, while the income survey forecasts are best rationalized as mode forecasts.

The Effects of Usury Ceilings on Consumers Welfare: Evidence from the Microcredit Market in Colombia
Romero, Laura Marcela Capera
Interest rate caps, also called usury ceilings, are a widely used policy tool to protect consumers from excessive charges by loan providers. However, they are often cited as a barrier for the advancement of financial inclusion, as they may reduce the incentives to provide loans to lower-income borrowers and and to invest in branching networks, particularly in remote and isolated locations. In this paper, I exploit a change in the usury ceiling applied to micro-loans in Colombia to understand the effects of this policy across geographic markets. To quantify the welfare implications of this policy, I structurally estimate a demand and supply model that incorporates the changes in size and composition of the potential market caused by this policy change, in a context where the distribution of branching networks has a crucial role in the optimal pricing strategies of loan providers. I find that the policy generated an increase in consumer surplus at the national level that is explained by greater credit availability for riskier borrowers and the expansion of branching networks in areas that were previously under-served. A counterfactual exercise reveals that the welfare gains associated to this policy depend greatly on additional investment in branching networks, as the opening of new branches in some locations is needed to compensate the consumer welfare loss associated with the subsequent increase in interest rates after the relaxation of the ceiling.

The medium is the message: learning channels, financial literacy, and stock market participation
Hermansson, Cecilia,Jonsson, Sara,Liu, Lu
This paper investigates the effects of learning channels on stock market participation. More specifically, we investigate the direct effects of learning about financial matters from one's private network, financial advisors, and the media, as well as the interactive effects of financial literacy and these learning channels. Analyzing a unique cross-section data that combine survey data and bank register data on retail investors, we find that media are the only learning channel that increases the likelihood of stock market participation. Interactions point to the joint importance of financial literacy and media as a learning channel for individuals' stock market participation. Constructing theme–based literacy measures, we conclude that only financial knowledge related to investments in risky assets affects stock market participation. Our findings suggest implications to policymakers when designing financial education programs.

Threat of Hedge Fund Activism and Risky Investment
Lakkis, Emil
I study the effect of a threat of hedge fund activism on corporate investment. I find that managers are less likely to undertake acquisitions when subject to a higher threat of activism. They decrease the number of risky, value-creating acquisitions undertaken by the firm. I present evidence that the results can be explained by the manager's exposure to firm-level risk. Hedge fund activists often pursue a restructuring of the target firms, which may increase the riskiness of the firm's assets and reduce the manager's incentives to take on new risky projects. Overall, my results demonstrate that activists can create ex-ante inefficiencies by altering the incentives-risk sharing tradeoff of the manager's compensation contract.

UNISWAP: Impermanent Loss and Risk Profile of a Liquidity Provider
Andreas A. Aigner,Gurvinder Dhaliwal

Uniswap is a decentralized exchange (DEX) and was first launched on November 2, 2018 on the Ethereum mainnet [1] and is part of an Ecosystem of products in Decentralized Finance (DeFi). It replaces a traditional order book type of trading common on centralized exchanges (CEX) with a deterministic model that swaps currencies (or tokens/assets) along a fixed price function determined by the amount of currencies supplied by the liquidity providers. Liquidity providers can be regarded as investors in the decentralized exchange and earn fixed commissions per trade. They lock up funds in liquidity pools for distinct pairs of currencies allowing market participants to swap them using the fixed price function. Liquidity providers take on market risk as a liquidity provider in exchange for earning commissions on each trade. Here we analyze the risk profile of a liquidity provider and the so called impermanent (unrealized) loss in particular. We provide an improved version of the commonly denoted impermanent loss function for Uniswap v2 on the semi-infinite domain. The differences between Uniswap v2 and v3 are also discussed.