Research articles for the 2021-07-24
Characteristic-Based Returns: Alpha or Smart Beta?
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Abstract We propose new methodology to construct arbitrage portfolios by utilizing information contained in firm characteristics for both abnormal returns and betas (and, therefore, smart-beta risk premiums). Our methodology gives maximal weight to risk-based interpretations of characteristics' predictive power before any attribution to abnormal returns. The method allows the explanatory power of a characteristic for both alpha and beta to ebb and flow. This feature is particularly important when we expect that profit opportunities may be arbitraged away by investors. We apply the methodology to a large panel of U.S. stock returns from 1965â€"2018. Empirically, characteristics have time-varying explanatory power for both factor betas and alpha. We find the arbitrage portfolio has (statistically and economically) significant alpha and annualized Sharpe ratios ranging from 1.31 to 1.66.
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Abstract We propose new methodology to construct arbitrage portfolios by utilizing information contained in firm characteristics for both abnormal returns and betas (and, therefore, smart-beta risk premiums). Our methodology gives maximal weight to risk-based interpretations of characteristics' predictive power before any attribution to abnormal returns. The method allows the explanatory power of a characteristic for both alpha and beta to ebb and flow. This feature is particularly important when we expect that profit opportunities may be arbitraged away by investors. We apply the methodology to a large panel of U.S. stock returns from 1965â€"2018. Empirically, characteristics have time-varying explanatory power for both factor betas and alpha. We find the arbitrage portfolio has (statistically and economically) significant alpha and annualized Sharpe ratios ranging from 1.31 to 1.66.
Communication of Credit Rating Agencies and Financial Markets
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The ability of credit rating agencies (CRAs) to influence financial markets has been widely debated in the academic literature, policy circles and general press. While some commentators think that CRAs’ announcements have relevant effects on the markets, others reckon that they may simply follow investor opinion. To address the issue, the empirical literature has mainly employed the event study methodology, analyzing the behavior of financial markets around rating change announcements. Following a recent trend that has emphasized the use of high-frequency data to achieve credible identification in macroeconomics, in this paper, we use the instrumental variable-local projection (IV-LP) methodology to obtain the effect of structural shocks to CRAs’ communication on financial markets. Applying this approach to Mexico, we find that CRAs’ communication about the sovereign has statistically significant effects on CDS spreads, interest rates and the exchange rate.
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The ability of credit rating agencies (CRAs) to influence financial markets has been widely debated in the academic literature, policy circles and general press. While some commentators think that CRAs’ announcements have relevant effects on the markets, others reckon that they may simply follow investor opinion. To address the issue, the empirical literature has mainly employed the event study methodology, analyzing the behavior of financial markets around rating change announcements. Following a recent trend that has emphasized the use of high-frequency data to achieve credible identification in macroeconomics, in this paper, we use the instrumental variable-local projection (IV-LP) methodology to obtain the effect of structural shocks to CRAs’ communication on financial markets. Applying this approach to Mexico, we find that CRAs’ communication about the sovereign has statistically significant effects on CDS spreads, interest rates and the exchange rate.
Cryptocurrencies, Blockchain and Regulation: A Review
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This paper aims to provide a more comprehensive understanding of the impact of financial developments on output volatility. Using cross-sectional and panel datasets for 79 countries from 1961 to 2012, we find that financial expansion plays a significant role in mitigating output volatility, although the evidence is weak in some cases. The role of financial stability is more prominent than that of other measures of financial growth in mitigating output volatility. The volatility of terms of trade and inflation contributes positively to increasing output volatility. We also evaluate the channels through which financial developments can affect output volatility. Our model investigates the link between financial growth and output volatility through two potential channels, using four measures of financial development. The volatility of inflation and of terms of trade are used as proxies for monetary sector and real sector volatility, respectively. Financial development plays a mixed role in amplifying or mitigating output volatility through real and monetary sector volatility. Overall, there is some evidence to suggest that financial development amplifies monetary sector volatility, but weaker evidence that real sector volatility is reduced by financial development.
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This paper aims to provide a more comprehensive understanding of the impact of financial developments on output volatility. Using cross-sectional and panel datasets for 79 countries from 1961 to 2012, we find that financial expansion plays a significant role in mitigating output volatility, although the evidence is weak in some cases. The role of financial stability is more prominent than that of other measures of financial growth in mitigating output volatility. The volatility of terms of trade and inflation contributes positively to increasing output volatility. We also evaluate the channels through which financial developments can affect output volatility. Our model investigates the link between financial growth and output volatility through two potential channels, using four measures of financial development. The volatility of inflation and of terms of trade are used as proxies for monetary sector and real sector volatility, respectively. Financial development plays a mixed role in amplifying or mitigating output volatility through real and monetary sector volatility. Overall, there is some evidence to suggest that financial development amplifies monetary sector volatility, but weaker evidence that real sector volatility is reduced by financial development.
Cryptocurrencies, DLT and crypto assets â€" the road to regulatory recognition in Europe
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With Bitcoin, a new type of technology was born in 2008 when Satoshi Nakamoto released the white paper for a new cash payment system (Nakamoto 2008), which effectively invented blockchain technology. By 2015 the technology already gained a lot of interest among startups, financial institutions, and industrial enterprises. Besides Bitcoin, many other crypto assets emerged with various design approaches such as stablecoins, utility tokens, security tokens, decentralized finance (DeFi), and non-fungible tokens (NFTs). Many of these tokens have an identifiable issuer to whom existing regulatory frameworks could potentially apply. However, other types of assets that are based on fully decentralized protocols are governed entirely by technology and either do not have an issuer (like in the case of Bitcoin) or the initiators designed the technology in an ‘issuerless’ way - and have no relation to any ‘real-world asset’. It is the latter class of assets that are truly new and that have recently attracted increasing attention from regulatory authorities, international organizations, standard-setting bodies, and the like. On the part of regulators and policymakers, interest in and the activity surrounding cryptocurrencies, crypto assets, and stablecoins peaked in 2019 so far. Of the several key regulators and policymakers at the supra-national level, nearly all issued a report, warning, study, or recommendations on some aspect of blockchain technology in financial markets. This spike in interest is related to the increasing business activity in this area and growing interest of investors and consumers. The exponential rise in the price of Bitcoin also attracted the interest of a wider audience (Edwards et al. 2019). The increasing business activity always preceded the actions of regulators and policymakers, thus rendering the activities of the latter a ‘reaction’ to the market developments. According to the Financial Stability Board (FSB), crypto assets reached an estimated total market capitalization of $830 billion on January 8, 2018, before falling sharply in subsequent months (Financial Stability Board 2018). While the global value of the crypto assets market is still relatively small compared to the entire financial system, its absolute value and daily transaction volume are substantial, and its rapid development continues, gaining increasing market acceptance (Basel Committee on Banking Supervision 2019).This paper seeks to analyze regulators’ and policymakers’ efforts to understand and develop an adequate regulatory approach to crypto assets, tokens, and the distributed ledger technology (DLT) in general. After several years of innovation in the space of decentralized technologies, several principles became clear on how to treat both issuer-based tokens and issuerless tokens. However, when regulators and policymakers tried at first to understand these new decentralized technologies and the assets they enable, it was not clear to them from the beginning how to treat assets based on this new technology. Only recently has it been possible to identify best regulatory practices and to disentangle good approaches to regulation from the ‘noise’ of warnings, recommendations, or studies. Liechtenstein has adopted a remarkable perspective on and vision for crypto assets and tokens by creating a set of abstract definitions and models and applying them in their bespoke regulatory approach. The Liechtenstein Token Act has therefore inspired other policymakers and subsequent regulatory actions.The remainder of this paper is structured as follows. First, we seek to present the history of ‘opinions’' on behalf of regulatory bodies and policymakers over the last years. These opinions often lacked clear definitions, understanding, and models but also included valuable contributions. In the next section, we present key definitions and models of the Liechtenstein Token Act and describe how these have been included in Liechtenstein’s national framework to build a solid basis for the emerging token economy. Thereafter, we describe how the European Union’s approach to regulate crypto assets - the Markets in Crypto Assets Regulation (MiCA) - tackles crypto assets and tokens, and how it relates to the Liechtenstein Token Act. In the subsequent section, we review a variety of regulatory approaches and strategies. Finally, we offer concluding remarks.
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With Bitcoin, a new type of technology was born in 2008 when Satoshi Nakamoto released the white paper for a new cash payment system (Nakamoto 2008), which effectively invented blockchain technology. By 2015 the technology already gained a lot of interest among startups, financial institutions, and industrial enterprises. Besides Bitcoin, many other crypto assets emerged with various design approaches such as stablecoins, utility tokens, security tokens, decentralized finance (DeFi), and non-fungible tokens (NFTs). Many of these tokens have an identifiable issuer to whom existing regulatory frameworks could potentially apply. However, other types of assets that are based on fully decentralized protocols are governed entirely by technology and either do not have an issuer (like in the case of Bitcoin) or the initiators designed the technology in an ‘issuerless’ way - and have no relation to any ‘real-world asset’. It is the latter class of assets that are truly new and that have recently attracted increasing attention from regulatory authorities, international organizations, standard-setting bodies, and the like. On the part of regulators and policymakers, interest in and the activity surrounding cryptocurrencies, crypto assets, and stablecoins peaked in 2019 so far. Of the several key regulators and policymakers at the supra-national level, nearly all issued a report, warning, study, or recommendations on some aspect of blockchain technology in financial markets. This spike in interest is related to the increasing business activity in this area and growing interest of investors and consumers. The exponential rise in the price of Bitcoin also attracted the interest of a wider audience (Edwards et al. 2019). The increasing business activity always preceded the actions of regulators and policymakers, thus rendering the activities of the latter a ‘reaction’ to the market developments. According to the Financial Stability Board (FSB), crypto assets reached an estimated total market capitalization of $830 billion on January 8, 2018, before falling sharply in subsequent months (Financial Stability Board 2018). While the global value of the crypto assets market is still relatively small compared to the entire financial system, its absolute value and daily transaction volume are substantial, and its rapid development continues, gaining increasing market acceptance (Basel Committee on Banking Supervision 2019).This paper seeks to analyze regulators’ and policymakers’ efforts to understand and develop an adequate regulatory approach to crypto assets, tokens, and the distributed ledger technology (DLT) in general. After several years of innovation in the space of decentralized technologies, several principles became clear on how to treat both issuer-based tokens and issuerless tokens. However, when regulators and policymakers tried at first to understand these new decentralized technologies and the assets they enable, it was not clear to them from the beginning how to treat assets based on this new technology. Only recently has it been possible to identify best regulatory practices and to disentangle good approaches to regulation from the ‘noise’ of warnings, recommendations, or studies. Liechtenstein has adopted a remarkable perspective on and vision for crypto assets and tokens by creating a set of abstract definitions and models and applying them in their bespoke regulatory approach. The Liechtenstein Token Act has therefore inspired other policymakers and subsequent regulatory actions.The remainder of this paper is structured as follows. First, we seek to present the history of ‘opinions’' on behalf of regulatory bodies and policymakers over the last years. These opinions often lacked clear definitions, understanding, and models but also included valuable contributions. In the next section, we present key definitions and models of the Liechtenstein Token Act and describe how these have been included in Liechtenstein’s national framework to build a solid basis for the emerging token economy. Thereafter, we describe how the European Union’s approach to regulate crypto assets - the Markets in Crypto Assets Regulation (MiCA) - tackles crypto assets and tokens, and how it relates to the Liechtenstein Token Act. In the subsequent section, we review a variety of regulatory approaches and strategies. Finally, we offer concluding remarks.
Cryptocurrency, Decentralized Finance, and the Evolution of Exchange: A Transaction Costs Approach
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We leverage a transaction costs narrative to provide a theoretically unified presentation of the evolution of exchange, with the latest evolutionary frontier being cryptocurrency and decentralized finance. We show that with each new development in the evolution of money, the new form or medium of exchange must reduce transaction costs relative to relevant alternatives. The development of blockchain and cryptocurrency reduced the cost of transfering currency by removing the need for a trusted third party to intermediate funds while also providing the benefit of anonymity/pseudonymity. Likewise, decentralized finance does not require a third party to intermediate savings and investment and can provide contingent anonymity to borrowers. While these innovations have attracted investment in the economically developed world, they appear to have significantly reduced transaction costs for transactors who might otherwise be defrauded of funds by corrupt governments that extort third parties responsible for intermediating funds.
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We leverage a transaction costs narrative to provide a theoretically unified presentation of the evolution of exchange, with the latest evolutionary frontier being cryptocurrency and decentralized finance. We show that with each new development in the evolution of money, the new form or medium of exchange must reduce transaction costs relative to relevant alternatives. The development of blockchain and cryptocurrency reduced the cost of transfering currency by removing the need for a trusted third party to intermediate funds while also providing the benefit of anonymity/pseudonymity. Likewise, decentralized finance does not require a third party to intermediate savings and investment and can provide contingent anonymity to borrowers. While these innovations have attracted investment in the economically developed world, they appear to have significantly reduced transaction costs for transactors who might otherwise be defrauded of funds by corrupt governments that extort third parties responsible for intermediating funds.
Determinants of Credit Infections: Evidence from Banking Sector in an Emerging Economy
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This paper applies dynamic panel estimates on 22 commercial banks in Pakistan to determine the factors that affect their asset quality. Consequently, the study tests for a comprehensive array of both bank-specific and macroeconomic variables collected quarterly from 2008 to 2016. The empirical analysis confirms that bad asset quality can be explained by retarded GDP growth and unfavorable movement in exchange and lending rates. Within the bank-specific variables, non-performing loans are the most responsive to loans to the agriculture and energy sectors, level of capitalization, size of the lending institution and quality of management.
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This paper applies dynamic panel estimates on 22 commercial banks in Pakistan to determine the factors that affect their asset quality. Consequently, the study tests for a comprehensive array of both bank-specific and macroeconomic variables collected quarterly from 2008 to 2016. The empirical analysis confirms that bad asset quality can be explained by retarded GDP growth and unfavorable movement in exchange and lending rates. Within the bank-specific variables, non-performing loans are the most responsive to loans to the agriculture and energy sectors, level of capitalization, size of the lending institution and quality of management.
Dividend Announcements and Market Trends
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This research primarily aims to study the impact of dividend announcements on the stock price of companies listed in the Indian stock market. Incidental to the study, it is necessary to understand whether the market trends have any role in affecting the changes in share prices due to dividend announcements. The companies listed on the stock market are diverse in terms of the industry, market capitalization, and performance. We analyze the S&P BSE 500 index stocks, which declare cash dividend every year without fail for ten years from 2008 â€" 17. Total 1755 sample was tested for dividend announcement and sample divided into large, medium, and small sample sizes based on the market capitalization of the stocks to test the market trend effect. Event methodology market model used to calculate the abnormal returns on the dividend announcement day.The present research study examined the impact of dividend announcements on stocks in the Indian stock market. The results observe in twenty four times based on market capitalization wise and market trend-wise dividend announcements. The results of the study are not the same for all dividend announcement observations. The study found positive abnormal returns on event day in most of the dividend announcement observations and it is similar to Litzenberger and Ramaswamy (1982), Asquith and Mullins Jr (1983), Grinblatt, Masulis and Titman (1984), Chen, Nieh, Da Chen, and Tang (2009) and many previous research results studied in major developed stock markets and emerging stock markets. Full sample, large-cap, and small-cap final dividend average abnormal returns are positively significant only in bull market trend (period 2) similar to Below and Johnson (1996) and other market trends final dividend announcement abnormal returns are positive in most of the observations, but returns are not significant. Average abnormal returns are sensitive to market trends, especially abnormal small-cap returns more vulnerable to market trends.
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This research primarily aims to study the impact of dividend announcements on the stock price of companies listed in the Indian stock market. Incidental to the study, it is necessary to understand whether the market trends have any role in affecting the changes in share prices due to dividend announcements. The companies listed on the stock market are diverse in terms of the industry, market capitalization, and performance. We analyze the S&P BSE 500 index stocks, which declare cash dividend every year without fail for ten years from 2008 â€" 17. Total 1755 sample was tested for dividend announcement and sample divided into large, medium, and small sample sizes based on the market capitalization of the stocks to test the market trend effect. Event methodology market model used to calculate the abnormal returns on the dividend announcement day.The present research study examined the impact of dividend announcements on stocks in the Indian stock market. The results observe in twenty four times based on market capitalization wise and market trend-wise dividend announcements. The results of the study are not the same for all dividend announcement observations. The study found positive abnormal returns on event day in most of the dividend announcement observations and it is similar to Litzenberger and Ramaswamy (1982), Asquith and Mullins Jr (1983), Grinblatt, Masulis and Titman (1984), Chen, Nieh, Da Chen, and Tang (2009) and many previous research results studied in major developed stock markets and emerging stock markets. Full sample, large-cap, and small-cap final dividend average abnormal returns are positively significant only in bull market trend (period 2) similar to Below and Johnson (1996) and other market trends final dividend announcement abnormal returns are positive in most of the observations, but returns are not significant. Average abnormal returns are sensitive to market trends, especially abnormal small-cap returns more vulnerable to market trends.
Domestic Lending and the Pandemic: How Does Banks’ Exposure to COVID-19 Abroad Affect Their Lending in the United States?
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We study how U.S. banks’ exposure to the economic fallout due to governments’ response to COVID-19 in foreign countries has affected their credit provision to borrowers in the United States. We do so by combining a rarely accessed dataset on U.S. banks’ cross-border exposure to borrowers in foreign countries with the most detailed regulatory (“credit registryâ€) data that is available on their U.S.-based lending. We compare the change in the U.S. lending of banks that are more vs. less exposed to the pandemic abroad, during and after the onset of COVID-19. We document strong spillover effects: U.S. banks with higher global exposures in badly “COVID-19-hit†regions cut their U.S. lending substantially more. This effect is particularly strong for longer-maturity loans and term loans.
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We study how U.S. banks’ exposure to the economic fallout due to governments’ response to COVID-19 in foreign countries has affected their credit provision to borrowers in the United States. We do so by combining a rarely accessed dataset on U.S. banks’ cross-border exposure to borrowers in foreign countries with the most detailed regulatory (“credit registryâ€) data that is available on their U.S.-based lending. We compare the change in the U.S. lending of banks that are more vs. less exposed to the pandemic abroad, during and after the onset of COVID-19. We document strong spillover effects: U.S. banks with higher global exposures in badly “COVID-19-hit†regions cut their U.S. lending substantially more. This effect is particularly strong for longer-maturity loans and term loans.
ESGM: ESG scores and the Missing pillar
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Environmental, social, and governance (ESG) scores measure companies’ activities concerning sustainability and are organized on three pillars: Environmental (E-), Social (S-), and Governance (G-). Different approaches have been proposed to compute ESG scores for companies, which rely on the aggregation of many sources of information. These complementary non-financial ESG scores should provide information about the ESG performance and risks of different companies. However, the extent of missing information makes the reliability of ESG scores questionable. To account for the missing information in the underlying ESG pillars, we introduce a new pillar, the so-called Missing (M-) pillar, and propose an optimization approach to compute new ESG (ESGM) scores, which should be related to the company riskiness. The ESGM scores incorporate the extent of missing information and establish some meaningful relationship concerning the riskiness of the companies under consideration. Interesting insights into the current limitations of the ESG scoring methodology are discussed.
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Environmental, social, and governance (ESG) scores measure companies’ activities concerning sustainability and are organized on three pillars: Environmental (E-), Social (S-), and Governance (G-). Different approaches have been proposed to compute ESG scores for companies, which rely on the aggregation of many sources of information. These complementary non-financial ESG scores should provide information about the ESG performance and risks of different companies. However, the extent of missing information makes the reliability of ESG scores questionable. To account for the missing information in the underlying ESG pillars, we introduce a new pillar, the so-called Missing (M-) pillar, and propose an optimization approach to compute new ESG (ESGM) scores, which should be related to the company riskiness. The ESGM scores incorporate the extent of missing information and establish some meaningful relationship concerning the riskiness of the companies under consideration. Interesting insights into the current limitations of the ESG scoring methodology are discussed.
Eliciting Pension Beneficiaries’ Sustainability Preferences: Why and How?
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We explore whether beneficiaries of pension plans should have a voice in the fund’s sustainable investments. We hypothesize that the answer to this question depends on a fund’s legal and societal contexts, benchmarking pressure, and fund-specific factors such as the fund’s size and the board’s composition. We uncover heterogeneity in the degree to which beneficiaries are involved in decision-making. Some pension funds have started a dialogue with their participants, mainly using survey instruments. We provide an example of a fund that gave its participants a real vote, while avoiding the pitfalls that come with hypothetical surveys on individual preferences.
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We explore whether beneficiaries of pension plans should have a voice in the fund’s sustainable investments. We hypothesize that the answer to this question depends on a fund’s legal and societal contexts, benchmarking pressure, and fund-specific factors such as the fund’s size and the board’s composition. We uncover heterogeneity in the degree to which beneficiaries are involved in decision-making. Some pension funds have started a dialogue with their participants, mainly using survey instruments. We provide an example of a fund that gave its participants a real vote, while avoiding the pitfalls that come with hypothetical surveys on individual preferences.
Everything You Always Wanted to Know About XVA Model Risk but Were Afraid to Ask
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Valuation adjustments, collectively named XVA, play an important role in modern derivatives pricing. XVA are an exotic pricing component since they require the forward simulation of multiple risk factors in order to compute the portfolio exposure including collateral, leading to a significant model risk and computational effort, even in case of plain vanilla trades. This work analyses the most critical model risk factors, meant as those to which XVA are most sensitive, finding an acceptable compromise between accuracy and performance. This task has been conducted in a complete context including a market standard multi-curve G2++ model calibrated on real market data, both Variation Margin and ISDA-SIMM dynamic Initial Margin, different collateralization schemes, and the most common linear and non-linear interest rates derivatives. Moreover, we considered an alternative analytical approach for XVA in case of uncollateralized Swaps.We show that a crucial element is the construction of a parsimonious time grid capable of capturing all periodical spikes arising in collateralized exposure during the Margin Period of Risk. To this end, we propose a workaround to efficiently capture all spikes. Moreover, we show that there exists a parameterization which allows to obtain accurate results in a reasonable time, which is a very important feature for practical applications. In order to address the valuation uncertainty linked to the existence of a range of different parameterizations, we calculate the Model Risk AVA (Additional Valuation Adjustment) for XVA according to the provisions of the EU Prudent Valuation regulation.Finally, this work can serve as an handbook containing step-by-step instructions for the implementation of a complete, realistic and robust modelling framework of collateralized exposure and XVA.
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Valuation adjustments, collectively named XVA, play an important role in modern derivatives pricing. XVA are an exotic pricing component since they require the forward simulation of multiple risk factors in order to compute the portfolio exposure including collateral, leading to a significant model risk and computational effort, even in case of plain vanilla trades. This work analyses the most critical model risk factors, meant as those to which XVA are most sensitive, finding an acceptable compromise between accuracy and performance. This task has been conducted in a complete context including a market standard multi-curve G2++ model calibrated on real market data, both Variation Margin and ISDA-SIMM dynamic Initial Margin, different collateralization schemes, and the most common linear and non-linear interest rates derivatives. Moreover, we considered an alternative analytical approach for XVA in case of uncollateralized Swaps.We show that a crucial element is the construction of a parsimonious time grid capable of capturing all periodical spikes arising in collateralized exposure during the Margin Period of Risk. To this end, we propose a workaround to efficiently capture all spikes. Moreover, we show that there exists a parameterization which allows to obtain accurate results in a reasonable time, which is a very important feature for practical applications. In order to address the valuation uncertainty linked to the existence of a range of different parameterizations, we calculate the Model Risk AVA (Additional Valuation Adjustment) for XVA according to the provisions of the EU Prudent Valuation regulation.Finally, this work can serve as an handbook containing step-by-step instructions for the implementation of a complete, realistic and robust modelling framework of collateralized exposure and XVA.
External Shocks, Cross Border Flows and Macroeconomic Risks in Emerging Market Economies
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We study the relationship between cross border flows and risks to macroeconomic stability for a sample of ten major emerging market economies (EMEs) from 2000-2017 in the presence of external shocks. We examine this relationship with a focus on two key channels of cross border flows, namely external debt securities (EDS) and cross-border loans (CBL). A Markov regime switching analysis shows that EDS flows became the dominant channel of cross border flows post global financial crisis 2008 (GFC), confirming the idea of second phase of global liquidity \citep{shin2013sec}. We further estimate panel vector autoregression models to show that volatility in global risk perception plays a larger role in channelizing cross border flows to EMEs compared to the US monetary policy stance. Post GFC, EDS flows are particularly sensitive to shocks in global risk perception. CBL flows are associated with smaller risks pre GFC compared to the post GFC period which is in contrast to the result for EDS flows. Our results also show that EMEs with high levels of CBL flows face larger macroeconomic risks relative to EMEs with low levels of CBL flows whereas riskiness is high for EMEs with high and low levels of EDS flows. Finally, a panel threshold model confirms a non-linear association between EDS/CBL flows and macroeconomic risks. This results suggest that intensity of the association depends upon global risk uncertainty and that EDS flows present a larger macroeconomic risks to EMEs than CBL flows post-GFC.
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We study the relationship between cross border flows and risks to macroeconomic stability for a sample of ten major emerging market economies (EMEs) from 2000-2017 in the presence of external shocks. We examine this relationship with a focus on two key channels of cross border flows, namely external debt securities (EDS) and cross-border loans (CBL). A Markov regime switching analysis shows that EDS flows became the dominant channel of cross border flows post global financial crisis 2008 (GFC), confirming the idea of second phase of global liquidity \citep{shin2013sec}. We further estimate panel vector autoregression models to show that volatility in global risk perception plays a larger role in channelizing cross border flows to EMEs compared to the US monetary policy stance. Post GFC, EDS flows are particularly sensitive to shocks in global risk perception. CBL flows are associated with smaller risks pre GFC compared to the post GFC period which is in contrast to the result for EDS flows. Our results also show that EMEs with high levels of CBL flows face larger macroeconomic risks relative to EMEs with low levels of CBL flows whereas riskiness is high for EMEs with high and low levels of EDS flows. Finally, a panel threshold model confirms a non-linear association between EDS/CBL flows and macroeconomic risks. This results suggest that intensity of the association depends upon global risk uncertainty and that EDS flows present a larger macroeconomic risks to EMEs than CBL flows post-GFC.
Financial Inclusion, Banking Stability, and Digital Technology Development in ASEAN
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The purpose of this study is to examine the effect of financial inclusion, supported by digital technology development on income inequality, poverty, and banking stability in ASEAN’s emerging countries. This study employs the Generalized Method of Moment (GMM) and Generalized Least Square (GLS) methodology, using annual data for ten years from 2007 to 2016. The empirical results support the argument. First, digital technology development (usage of the mobile phone) can improve financial inclusion because technology makes it easier to access financial services to people who are difficult to reach. Second, financial inclusion decreases income inequality, but it has no significant effect on reducing poverty. This finding indicates that formal financial services seem to be unable to reach the poor. Finally, the empirical results show that the increasing use of banking services through financial inclusion contributes positively to banking stability. Results of this study could encourage the presence of better policies to reform the financial sector by showing that the expansion in the use of financial services has a direct impact on financial/economic distribution. In addition, the paper provides implication for the banking regulator that the usage of banking and formal financial services still dominated by middle- and high-income society. Furthermore, the synergies between promoting financial inclusion and financial stability can also exist if using the right tools.
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The purpose of this study is to examine the effect of financial inclusion, supported by digital technology development on income inequality, poverty, and banking stability in ASEAN’s emerging countries. This study employs the Generalized Method of Moment (GMM) and Generalized Least Square (GLS) methodology, using annual data for ten years from 2007 to 2016. The empirical results support the argument. First, digital technology development (usage of the mobile phone) can improve financial inclusion because technology makes it easier to access financial services to people who are difficult to reach. Second, financial inclusion decreases income inequality, but it has no significant effect on reducing poverty. This finding indicates that formal financial services seem to be unable to reach the poor. Finally, the empirical results show that the increasing use of banking services through financial inclusion contributes positively to banking stability. Results of this study could encourage the presence of better policies to reform the financial sector by showing that the expansion in the use of financial services has a direct impact on financial/economic distribution. In addition, the paper provides implication for the banking regulator that the usage of banking and formal financial services still dominated by middle- and high-income society. Furthermore, the synergies between promoting financial inclusion and financial stability can also exist if using the right tools.
Financial Statement Adequacy and Firms’ MD&A Disclosures
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Firms are required to provide financial information via the financial statements and the MD&Aâ€"a narrative explanation of the financial statements. Our study examines how firms use the MD&A channel when their financial statement channel is inadequate. We proxy for the adequacy of the financial statement channel by the value relevance of book value and earnings. We use several approaches to extract MD&A disclosure attributes: (1) keyword searches to identify non-GAAP disclosure, (2) supervised deep learning models to identify forward-looking statements, and (3) unsupervised topic models as well as text segmentation techniques to identify topics and topic locations. We find that firms with lower value relevance of financial statements (1) are more likely to provide non-GAAP disclosure in the MD&A, (2) include more forward-looking statements in the MD&A, and (3) use larger proportions of the MD&A to discuss intangibles and discuss them more prominently. Our findings suggest that managers use the MD&A, a relatively more flexible channel, to a greater extent to provide information when their financial statement channel is less adequate.
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Firms are required to provide financial information via the financial statements and the MD&Aâ€"a narrative explanation of the financial statements. Our study examines how firms use the MD&A channel when their financial statement channel is inadequate. We proxy for the adequacy of the financial statement channel by the value relevance of book value and earnings. We use several approaches to extract MD&A disclosure attributes: (1) keyword searches to identify non-GAAP disclosure, (2) supervised deep learning models to identify forward-looking statements, and (3) unsupervised topic models as well as text segmentation techniques to identify topics and topic locations. We find that firms with lower value relevance of financial statements (1) are more likely to provide non-GAAP disclosure in the MD&A, (2) include more forward-looking statements in the MD&A, and (3) use larger proportions of the MD&A to discuss intangibles and discuss them more prominently. Our findings suggest that managers use the MD&A, a relatively more flexible channel, to a greater extent to provide information when their financial statement channel is less adequate.
Fiscal Limits and the Pricing of Eurobonds
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This paper proposes a methodology to price bonds jointly issued by a group of countries---called Eurobonds in the euro-area context. We consider two types of bonds: the first is backed by several and joint (SJG) guarantees, the second features several but not joint (SNJG) guarantees. A crucial ingredient of the underlying pricing model is the fiscal limit, defined as the level of debt beyond which the risk of default is no longer zero. The pricing of the two types of Eurobonds reflects different assumptions regarding the pooling of the countries' fiscal resources and limits. We estimate fiscal limits for the four largest euro-area economies over 2008-2020 and deduce counterfactual Eurobond prices. Amid the euro-debt crisis, 5-year SNJG bond yield spreads would have been about twice larger than SJG ones. Hence, issuing SJG bonds would result in gains at the aggregate level. We finally show that (i) these gains can be shared among countries through post-issuance schemes so that all countries benefit from the issuance of SJG bonds, and that (ii) these redistribution schemes may alleviate the reduction in market discipline resulting from common bond issuances.
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This paper proposes a methodology to price bonds jointly issued by a group of countries---called Eurobonds in the euro-area context. We consider two types of bonds: the first is backed by several and joint (SJG) guarantees, the second features several but not joint (SNJG) guarantees. A crucial ingredient of the underlying pricing model is the fiscal limit, defined as the level of debt beyond which the risk of default is no longer zero. The pricing of the two types of Eurobonds reflects different assumptions regarding the pooling of the countries' fiscal resources and limits. We estimate fiscal limits for the four largest euro-area economies over 2008-2020 and deduce counterfactual Eurobond prices. Amid the euro-debt crisis, 5-year SNJG bond yield spreads would have been about twice larger than SJG ones. Hence, issuing SJG bonds would result in gains at the aggregate level. We finally show that (i) these gains can be shared among countries through post-issuance schemes so that all countries benefit from the issuance of SJG bonds, and that (ii) these redistribution schemes may alleviate the reduction in market discipline resulting from common bond issuances.
High-dimensional Cross-market Dependence Modeling and Portfolio Forecasting by Copula Variational LSTM
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In the increasingly connected world, many systems are more or less coupled with each other in various ways. A typical example is the cross-market portfolio management, where the products of heterogeneous markets are selected and configured for investment. In such cross-market problems, one market is coupled with and influenced by others, and the financial variables of a market are coupled over time. This work makes the first attempt to model both the observations-based and latent dependence degrees and structures of highdimensional financial variables in cross-market portfolios by integrating variational recurrent neural networks. It integrates the distribution-based sequential modeling of multivariate time series and the regular vine copula-based dependence structures for modeling variable dependencies. Our method addresses the needs and gaps of modeling non-normal and long-range distributional interactions across market variables. We verify the model in terms of both technical significance and portfolio investment performance against benchmarks including linear models, stochastic volatility models, deep neural networks, and variational recurrent networks for portfolio forecasting.
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In the increasingly connected world, many systems are more or less coupled with each other in various ways. A typical example is the cross-market portfolio management, where the products of heterogeneous markets are selected and configured for investment. In such cross-market problems, one market is coupled with and influenced by others, and the financial variables of a market are coupled over time. This work makes the first attempt to model both the observations-based and latent dependence degrees and structures of highdimensional financial variables in cross-market portfolios by integrating variational recurrent neural networks. It integrates the distribution-based sequential modeling of multivariate time series and the regular vine copula-based dependence structures for modeling variable dependencies. Our method addresses the needs and gaps of modeling non-normal and long-range distributional interactions across market variables. We verify the model in terms of both technical significance and portfolio investment performance against benchmarks including linear models, stochastic volatility models, deep neural networks, and variational recurrent networks for portfolio forecasting.
Income taxes and managerial incentives: Evidence from hedge funds
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We find a negative relation between hedge fund manager’s personal income tax rates and fund performance. Using changes in tax deferral regulation or state-level tax rates suggest causality in the tax-performance relation. Managers are less likely to hold stocks with greater information asymmetry when faced with higher tax rates, consistent with higher taxes disincentivizing managers to engage in more demanding acquisition and processing of information. However, higher incentives from compensation contracts and co-ownership can help investors mitigate the deterioration in fund performance from higher taxes. Overall, our findings are consistent with higher taxes reducing managers’ work incentives.
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We find a negative relation between hedge fund manager’s personal income tax rates and fund performance. Using changes in tax deferral regulation or state-level tax rates suggest causality in the tax-performance relation. Managers are less likely to hold stocks with greater information asymmetry when faced with higher tax rates, consistent with higher taxes disincentivizing managers to engage in more demanding acquisition and processing of information. However, higher incentives from compensation contracts and co-ownership can help investors mitigate the deterioration in fund performance from higher taxes. Overall, our findings are consistent with higher taxes reducing managers’ work incentives.
Inflation and Cryptocurrencies Revisited: A Time-Scale Analysis
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This letter revisits the time-series relation between cryptocurrency prices and forward inflation expectations. Using wavelet time-scale techniques, a positive link between cryptocurrencies and forward inflation rates is identified, focused on a brief period surrounding the onset of the COVID-19 pandemic. This coincides with a rapid and synchronized decrease in cryptocurrency prices and forward inflation expectations, followed by a swift recovery to pre-crisis levels. Outside of the crisis period, we find no clear evidence of any inflation hedging capacity of Bitcoin or Ethereum during times of increasing forward inflation expectations.
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This letter revisits the time-series relation between cryptocurrency prices and forward inflation expectations. Using wavelet time-scale techniques, a positive link between cryptocurrencies and forward inflation rates is identified, focused on a brief period surrounding the onset of the COVID-19 pandemic. This coincides with a rapid and synchronized decrease in cryptocurrency prices and forward inflation expectations, followed by a swift recovery to pre-crisis levels. Outside of the crisis period, we find no clear evidence of any inflation hedging capacity of Bitcoin or Ethereum during times of increasing forward inflation expectations.
Insider Trading in Family Firms: Impact of Family Ties and Management Involvement
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We study corporate insider trading and information leakages within family firms. We find that the prof-itability of insider purchases of family insiders is higher compared to those of nonfamily insiders. In contrast, the profitability of insider sales of family insiders is lower compared to those of nonfamily insiders, indicating that family members time their insider trades well when buying shares, but not when selling shares. Furthermore, family insiders without management involvement time their insider sales significantly better, compared to family insiders who are involved in the firm management. Regarding information leakage, abnormal short-selling volumes prior to insider sales are higher when shares are sold by family insiders without management involvement, compared to family insiders who are in-volved in management.
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We study corporate insider trading and information leakages within family firms. We find that the prof-itability of insider purchases of family insiders is higher compared to those of nonfamily insiders. In contrast, the profitability of insider sales of family insiders is lower compared to those of nonfamily insiders, indicating that family members time their insider trades well when buying shares, but not when selling shares. Furthermore, family insiders without management involvement time their insider sales significantly better, compared to family insiders who are involved in the firm management. Regarding information leakage, abnormal short-selling volumes prior to insider sales are higher when shares are sold by family insiders without management involvement, compared to family insiders who are in-volved in management.
Interlinkages between External Debt Financing, Credit Cycles and Output Fluctuations in Emerging Market Economies
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We examine the role of external debt financing (EDF) in shaping the credit cycle and output fluctuations in nine major emerging economies. We show that sharp fluctuations in EDF flows are significantly associated with credit surge and stop episodes in emerging market economies (EMEs). However the association is asymmetric in nature - a stop episode in EDF flows is more likely to bring about a credit stop episode compared to an EDF surge episode. We extend our framework to analyze the joint spillover of EDF flows and credit cycles on business cycle fluctuations in these EMEs. We find that EDF flows and credit together have a strong association with output growth. After dividing the sample into EDF surge and stop phases, we find evidence of asymmetric spillover of credit on output growth. Credit decline during EDF stop episode leads to a larger decline in GDP growth relative to the impact of an increase in credit growth during EDF surges. Our analysis points to the vulnerability of credit cycles of EMEs to the sharp movement in EDF flows which in turn is largely synchronized with external financing conditions. The strong negative spillover of EDF stop phases on the business cycle is a cause
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We examine the role of external debt financing (EDF) in shaping the credit cycle and output fluctuations in nine major emerging economies. We show that sharp fluctuations in EDF flows are significantly associated with credit surge and stop episodes in emerging market economies (EMEs). However the association is asymmetric in nature - a stop episode in EDF flows is more likely to bring about a credit stop episode compared to an EDF surge episode. We extend our framework to analyze the joint spillover of EDF flows and credit cycles on business cycle fluctuations in these EMEs. We find that EDF flows and credit together have a strong association with output growth. After dividing the sample into EDF surge and stop phases, we find evidence of asymmetric spillover of credit on output growth. Credit decline during EDF stop episode leads to a larger decline in GDP growth relative to the impact of an increase in credit growth during EDF surges. Our analysis points to the vulnerability of credit cycles of EMEs to the sharp movement in EDF flows which in turn is largely synchronized with external financing conditions. The strong negative spillover of EDF stop phases on the business cycle is a cause
Managing Political Risk in International Portfolios
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We show that internationally diversified portfolios carry sizeable political risk premia. We use a tail-risk portfolio selection model to obtain political efficient frontiers from skewed return distributions and manage political risk, and design an inference test to draw conclusions. We find that politically hedged international portfolios of US investors realize performance gains against a broad market index or an equally weighted portfolio, and currency hedging does not eliminate political risk. The diversification gains increase for long-horizon investors. Qualitatively identical results are obtained for Eurozone and Japanese investors, and our findings are robust to several model specifications.
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We show that internationally diversified portfolios carry sizeable political risk premia. We use a tail-risk portfolio selection model to obtain political efficient frontiers from skewed return distributions and manage political risk, and design an inference test to draw conclusions. We find that politically hedged international portfolios of US investors realize performance gains against a broad market index or an equally weighted portfolio, and currency hedging does not eliminate political risk. The diversification gains increase for long-horizon investors. Qualitatively identical results are obtained for Eurozone and Japanese investors, and our findings are robust to several model specifications.
Market Discipline in Commercial Banking: Evidence from the Market for Bank Equity
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This study presents empirical evidence of market discipline, using a panel dataset of listed banks on the Karachi Stock Exchange. We construct multiple riskbased measures from the stock prices between 2004 and 2009 to determine whether an increase in the risk profile results in an increase in compensation for depositors and other creditors. The risk variables used include market risk, value at risk, size and value premium, default likelihood indicator, price relatives, and a control variable representing gross domestic product growth. We find a significant relationship between our risk factors and cost of deposits, indicating that banks align deposit compensation with their risk perception. However, we cannot find a link between the market perception of risk and deposit switching. These findings have important implications for policymakers as market discipline could complement the state’s regulatory role and lower the cost of supervision. Our estimations of value at risk and the default likelihood indicator using stochastic simulations is a methodological contribution that could be used for effective risk management practices.
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This study presents empirical evidence of market discipline, using a panel dataset of listed banks on the Karachi Stock Exchange. We construct multiple riskbased measures from the stock prices between 2004 and 2009 to determine whether an increase in the risk profile results in an increase in compensation for depositors and other creditors. The risk variables used include market risk, value at risk, size and value premium, default likelihood indicator, price relatives, and a control variable representing gross domestic product growth. We find a significant relationship between our risk factors and cost of deposits, indicating that banks align deposit compensation with their risk perception. However, we cannot find a link between the market perception of risk and deposit switching. These findings have important implications for policymakers as market discipline could complement the state’s regulatory role and lower the cost of supervision. Our estimations of value at risk and the default likelihood indicator using stochastic simulations is a methodological contribution that could be used for effective risk management practices.
National Culture and Corporate Cash Holdings: Evidence from China
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This article identifies national culture as an important factor affecting corporate cashholdings by using China and its national culture, Confucianism, as a setting. We findthat firms located in regions with higher levels of Confucian culture hold higher levelsof cash and this high cash holdings status is also more persistent. Next, we employan instrumental variable to establish causal identification of the culture effect and theIV estimates show a compelling economic magnitude. The culture effect is strongerfor more financially-constrained and riskier firms, suggesting precautionary motives asthe underlying mechanism. Besides, we find that the culture effect remains intact aftercontrolling for corporate governance heterogeneity, which rules out the agency motives.Further, we find that higher Confucian culture firms make better investment decisions,have higher acquisition announcement returns, pay out more dividends and achievehigher profitability and lower profit volatility. These all are additional evidence arguingagainst agency motives, but supporting an efficient outcome argument. Finally, we alsoshow that the CEO/board chairman’s Confucian background and the firm’s headquartercultural environment together exert an influence.
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This article identifies national culture as an important factor affecting corporate cashholdings by using China and its national culture, Confucianism, as a setting. We findthat firms located in regions with higher levels of Confucian culture hold higher levelsof cash and this high cash holdings status is also more persistent. Next, we employan instrumental variable to establish causal identification of the culture effect and theIV estimates show a compelling economic magnitude. The culture effect is strongerfor more financially-constrained and riskier firms, suggesting precautionary motives asthe underlying mechanism. Besides, we find that the culture effect remains intact aftercontrolling for corporate governance heterogeneity, which rules out the agency motives.Further, we find that higher Confucian culture firms make better investment decisions,have higher acquisition announcement returns, pay out more dividends and achievehigher profitability and lower profit volatility. These all are additional evidence arguingagainst agency motives, but supporting an efficient outcome argument. Finally, we alsoshow that the CEO/board chairman’s Confucian background and the firm’s headquartercultural environment together exert an influence.
Optimal Investment, Tobin's q, and Cash Flow: Does Unobserved Productivity Matter?
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Abstract We study the classical relationship between a firm’s investment and Tobin’s q for which unobserved productivity is another factor of a firm’s decision. Besides the potential measurement problem of Tobin’s q, controlling unobserved productivity is a new challenge. We develop an econometric method that tackles both issues given timing and information set assumptions. Using 15,079 unique public firms in the U.S. for the period of 1975 to 2017, we find that cash flow remains a significant factor of investment even after controlling for the productivity and that investment becomes less sensitive to q and more sensitive to cash flow.
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Abstract We study the classical relationship between a firm’s investment and Tobin’s q for which unobserved productivity is another factor of a firm’s decision. Besides the potential measurement problem of Tobin’s q, controlling unobserved productivity is a new challenge. We develop an econometric method that tackles both issues given timing and information set assumptions. Using 15,079 unique public firms in the U.S. for the period of 1975 to 2017, we find that cash flow remains a significant factor of investment even after controlling for the productivity and that investment becomes less sensitive to q and more sensitive to cash flow.
Pandemic Waves, Government Response, and Bank Stock Returns: Evidence from 36 Countries
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This paper examines the impact of COVID-19 on bank stock returns over various time scales and frequencies. Considering FTSE banking sector returns in 36 countries, wavelet coherency analysis indicates that the number of confirmed COVID-19 cases negatively impacts bank stock returns during different waves of the pandemic in the medium-run. However, there is only little dependence in the very short-run. Moreover, fixed effects panel regression shows that the bank returns positively react to domestic COVID-19 policy. This ultimately demonstrates that governmental interventions not only reduce the spread of COVID-19 but thereby are also able to calm the financial markets.
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This paper examines the impact of COVID-19 on bank stock returns over various time scales and frequencies. Considering FTSE banking sector returns in 36 countries, wavelet coherency analysis indicates that the number of confirmed COVID-19 cases negatively impacts bank stock returns during different waves of the pandemic in the medium-run. However, there is only little dependence in the very short-run. Moreover, fixed effects panel regression shows that the bank returns positively react to domestic COVID-19 policy. This ultimately demonstrates that governmental interventions not only reduce the spread of COVID-19 but thereby are also able to calm the financial markets.
Playing the Field: Competing Bids for Anadarko Petroleum Corp.
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On April 8, 2019, Occidental’s Hollub made a private offer to buy Anadarko Petroleum Corporation for $72 in cash and stock. Anadarko's CEO Walker said he would consider the offer, yet three days later, on April 11, he signed a merger agreement with Chevron in a deal worth $65 per share in cash and stock. This agreement included a $1 billion “break-up" (termination) fee payable to Chevron if Anadarko accepted another offer. To avoid losing the deal, Hollub then made an initial public offer to buy Anadarko for $76 per share in cash and stock on April 24. When Anadarko failed to respond, Hollub, revised her offer on May 5. Although the revised offer had the same stated value of $76 per share, it included substantially more cash ($59 per share instead of the original $38 per share). With competing offers on the table, Walker now had to decide whether to accept Chevron’s $65 offer or pay the break-up fee and accept Occidental’s $76 offer? Of course, once he had made up his mind, he would have to convince his board that it was the right offer to accept and the right price. This case has four pedagogical objectives. It shows how to: 1) value a complex acquisition offer with equity consideration; 2) assess and value merger synergies; and 3) test whether acquisition funding is zero NPV and address the situation if it is not; 4) analyze deal completion risk and measures taken to increase deal certainty. The case also highlights several governance issues including the merits of requiring shareholder approval for large equity-financed, but not debt-financed, acquisitions, and the motivations for granting new "change in control" compensation to senior executives while they are negotiating a merger agreement.
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On April 8, 2019, Occidental’s Hollub made a private offer to buy Anadarko Petroleum Corporation for $72 in cash and stock. Anadarko's CEO Walker said he would consider the offer, yet three days later, on April 11, he signed a merger agreement with Chevron in a deal worth $65 per share in cash and stock. This agreement included a $1 billion “break-up" (termination) fee payable to Chevron if Anadarko accepted another offer. To avoid losing the deal, Hollub then made an initial public offer to buy Anadarko for $76 per share in cash and stock on April 24. When Anadarko failed to respond, Hollub, revised her offer on May 5. Although the revised offer had the same stated value of $76 per share, it included substantially more cash ($59 per share instead of the original $38 per share). With competing offers on the table, Walker now had to decide whether to accept Chevron’s $65 offer or pay the break-up fee and accept Occidental’s $76 offer? Of course, once he had made up his mind, he would have to convince his board that it was the right offer to accept and the right price. This case has four pedagogical objectives. It shows how to: 1) value a complex acquisition offer with equity consideration; 2) assess and value merger synergies; and 3) test whether acquisition funding is zero NPV and address the situation if it is not; 4) analyze deal completion risk and measures taken to increase deal certainty. The case also highlights several governance issues including the merits of requiring shareholder approval for large equity-financed, but not debt-financed, acquisitions, and the motivations for granting new "change in control" compensation to senior executives while they are negotiating a merger agreement.
Political Voice and (Mortgage) Market Participation: Evidence from Minority Disenfranchisement
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This paper documents the link between political voice and financial decision-making. Combining the repeal of Section 5 of the Voting Rights Act as a shock to the enfranchisement of black Americans with granular data on the US mortgage market, we document a 14% decline in mortgage origination for black Americans. This is driven by their self-selection out of the mortgage market rather than a change in denial rate. We observe a flight of black demand to black lenders, indicating an increase in racial homophily. Disenfranchisement reduces demand directly by increasing uncertainty, violence, and borrowing constraints and indirectly by increasing the threat of rejection. Overall, disenfranchisement results in exclusion from the mortgage markets by reducing the participation of the disenfranchised group.
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This paper documents the link between political voice and financial decision-making. Combining the repeal of Section 5 of the Voting Rights Act as a shock to the enfranchisement of black Americans with granular data on the US mortgage market, we document a 14% decline in mortgage origination for black Americans. This is driven by their self-selection out of the mortgage market rather than a change in denial rate. We observe a flight of black demand to black lenders, indicating an increase in racial homophily. Disenfranchisement reduces demand directly by increasing uncertainty, violence, and borrowing constraints and indirectly by increasing the threat of rejection. Overall, disenfranchisement results in exclusion from the mortgage markets by reducing the participation of the disenfranchised group.
Pooling and Valuation Revisited
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In light of the COVID-19 outbreak and the associated economic losses, we aim to revisit the fundamental insurance paradigms in particular pooling and valuation in the presence of systematic risk. We consider a pool of policyholders whose losses can be widely correlated through common shock. We have observed that from a mathematical standpoint, insurance as a pooling approach can manage the risk if the principle of insurance (POI), that is to keep the systematic risk secure, holds. Our study suggests that valuation cannot be independent of the risk pool, and the premium needs to be adjusted according to the systematic risk. Ex-post policies are another consideration that can vanish the systematic risk loading by introducing contingent premiums. This approach is rather novel and is motivated by systematic events like COVID-19 economic losses. We also look at the upper bounds for the pool valuation for two cases, first when we have no specific information about the dependency structure of the pool member losses, and second when the pool is influenced by a common shock. Finally, an alternative valuation of the pool risk based on risk allocation paradigms is compared with the standard approach we studied in this paper and the differences are observed.
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In light of the COVID-19 outbreak and the associated economic losses, we aim to revisit the fundamental insurance paradigms in particular pooling and valuation in the presence of systematic risk. We consider a pool of policyholders whose losses can be widely correlated through common shock. We have observed that from a mathematical standpoint, insurance as a pooling approach can manage the risk if the principle of insurance (POI), that is to keep the systematic risk secure, holds. Our study suggests that valuation cannot be independent of the risk pool, and the premium needs to be adjusted according to the systematic risk. Ex-post policies are another consideration that can vanish the systematic risk loading by introducing contingent premiums. This approach is rather novel and is motivated by systematic events like COVID-19 economic losses. We also look at the upper bounds for the pool valuation for two cases, first when we have no specific information about the dependency structure of the pool member losses, and second when the pool is influenced by a common shock. Finally, an alternative valuation of the pool risk based on risk allocation paradigms is compared with the standard approach we studied in this paper and the differences are observed.
Risk Management and Enterprise Risk Management
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This article discusses the differences between risk management and enterprise risk management. Though the concept of risk management is very old, almost as old as the beginning ofhuman existence the concept of ERM is new around two decades old. The importanceof enterprise risk management increased over the period of time due to various crises and the emergence risk based capital in the banking and insurance industry. The article discusses the various factors necessary for the success of enterprise risk management.
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This article discusses the differences between risk management and enterprise risk management. Though the concept of risk management is very old, almost as old as the beginning ofhuman existence the concept of ERM is new around two decades old. The importanceof enterprise risk management increased over the period of time due to various crises and the emergence risk based capital in the banking and insurance industry. The article discusses the various factors necessary for the success of enterprise risk management.
Size and Value Premium in International Portfolios: Evidence from 15 European Countries
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The current study evaluates the performance of the Fama and French three-factor model in a global setting with stocks selected from 15 European countries. We employed the multivariate regression approach after sorting six portfolios according to size and book-to-market. The constituent stocks were selected to represent each country of our sample. In order to homogenize the returns we used the spot exchange rates of non-euro-area countries to convert prices into euros. Since we were analyzing on a global portfolio level we used the MSCI EMU index as the proxy for the market portfolio. Daily returns were employed for a period of five years from January 2002 to December 2006. The results were not very encouraging for the three-factor model. Except for one portfolio, the three-factor model failed to explain the variations in returns, and even in the single portfolio that demonstrated size and value premiums, the market premium was insignificant. Our findings are consistent with Griffin (2002), who suggested that the three-factor model is domestic in nature and performs poorly for global portfolios.
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The current study evaluates the performance of the Fama and French three-factor model in a global setting with stocks selected from 15 European countries. We employed the multivariate regression approach after sorting six portfolios according to size and book-to-market. The constituent stocks were selected to represent each country of our sample. In order to homogenize the returns we used the spot exchange rates of non-euro-area countries to convert prices into euros. Since we were analyzing on a global portfolio level we used the MSCI EMU index as the proxy for the market portfolio. Daily returns were employed for a period of five years from January 2002 to December 2006. The results were not very encouraging for the three-factor model. Except for one portfolio, the three-factor model failed to explain the variations in returns, and even in the single portfolio that demonstrated size and value premiums, the market premium was insignificant. Our findings are consistent with Griffin (2002), who suggested that the three-factor model is domestic in nature and performs poorly for global portfolios.
Social Media Management: Evidence on Seasoned Equity Offerings
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We find that SEO firms receive more favorable messages on the financial social media platform, StockTwits, around the periods 62 trading days up to 10 trading days prior offerings and from 10 trading days after offerings to the expiration of lockup agreements, compared to their non-SEO matching controls. On average, evidence shows that SEO firms ranking in the top quartile of abnormal pre-SEO bullishness on social media reduce their underpricing by 1.12%. Moreover, insiders from active SEO firms exhibit higher net sales in the 90 days following the expiration of lockup agreements. A battery of validity tests rules out Irrational Exuberance and Investor Attention. Overall, our key findings are consistent with the Active Social Media Management Hypothesis.
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We find that SEO firms receive more favorable messages on the financial social media platform, StockTwits, around the periods 62 trading days up to 10 trading days prior offerings and from 10 trading days after offerings to the expiration of lockup agreements, compared to their non-SEO matching controls. On average, evidence shows that SEO firms ranking in the top quartile of abnormal pre-SEO bullishness on social media reduce their underpricing by 1.12%. Moreover, insiders from active SEO firms exhibit higher net sales in the 90 days following the expiration of lockup agreements. A battery of validity tests rules out Irrational Exuberance and Investor Attention. Overall, our key findings are consistent with the Active Social Media Management Hypothesis.
Some Preliminary Evidence on Stock Price Bubbles in an Emerging Market
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This paper analyzes the presence of a speculative component during the extra ordinary upsurge in Karachi Stock Exchange. We implement cointegration tests, between 1997 and 2008, on price and dividends of various market and sectoral indices. The no bubble hypothesis could not be rejected for market level indices establishing the presence of a speculative factor. Among sectoral indices, banking sector depicted a speculative component, however, the price level of Oil and Gas sector did not diverge from the related dividends. These results remained robust with evidence of persistent volatility shocks for the sample period.
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This paper analyzes the presence of a speculative component during the extra ordinary upsurge in Karachi Stock Exchange. We implement cointegration tests, between 1997 and 2008, on price and dividends of various market and sectoral indices. The no bubble hypothesis could not be rejected for market level indices establishing the presence of a speculative factor. Among sectoral indices, banking sector depicted a speculative component, however, the price level of Oil and Gas sector did not diverge from the related dividends. These results remained robust with evidence of persistent volatility shocks for the sample period.
Sovereign credit default swaps and macroeconomic fundamentals
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We provide evidence in favour of a significant non-linear, time-varying dependence between sovereign credit default swap (CDS) spreads and macroeconomic fundamentals for OECD countries. Macroeconomic conditions alone explain more than 80% of the out-of-sample variation in CDS spreads when non-linear random forest regressions are used. This is almost double the predictive performance of sparse and dense linear statistical learning methods. We test the coherence of the expected CDS spreads across different pure out-of-sample scenarios, e.g. training a random forest regression on EU countries and predicting CDS spreads for non-EU economies. The results suggest that non-linear machine learning methods enable “shadow†sovereign CDS pricing for countries and historical periods in which tradable sovereign CDS contracts are not available.
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We provide evidence in favour of a significant non-linear, time-varying dependence between sovereign credit default swap (CDS) spreads and macroeconomic fundamentals for OECD countries. Macroeconomic conditions alone explain more than 80% of the out-of-sample variation in CDS spreads when non-linear random forest regressions are used. This is almost double the predictive performance of sparse and dense linear statistical learning methods. We test the coherence of the expected CDS spreads across different pure out-of-sample scenarios, e.g. training a random forest regression on EU countries and predicting CDS spreads for non-EU economies. The results suggest that non-linear machine learning methods enable “shadow†sovereign CDS pricing for countries and historical periods in which tradable sovereign CDS contracts are not available.
Stock Price Crash Risk and the Managerial Rhetoric Channel: Evidence from Narrative R&D Disclosure
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This study proposes the managerial rhetoric channel, which is exploited as a vital conduit through which managers convey information to the investment community. Managerial narrative in corporate reports featuring technology and innovation disclosure activities is positively associated with one year ahead stock price crash risk. Moreover, the positive relation between managerial narrative and stock price crash risk is more pronounced for firms with powerful, more able, younger CEOs and CEOs with higher industry tournament incentives. The adverse impact of managerial narrative on future stock prices prevails among firms that face high competition and firms with lower anti-takeover provisions. Finally, this managerial rhetoric-crash relationship cannot be attenuated in the presence of stronger internal corporate governance.
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This study proposes the managerial rhetoric channel, which is exploited as a vital conduit through which managers convey information to the investment community. Managerial narrative in corporate reports featuring technology and innovation disclosure activities is positively associated with one year ahead stock price crash risk. Moreover, the positive relation between managerial narrative and stock price crash risk is more pronounced for firms with powerful, more able, younger CEOs and CEOs with higher industry tournament incentives. The adverse impact of managerial narrative on future stock prices prevails among firms that face high competition and firms with lower anti-takeover provisions. Finally, this managerial rhetoric-crash relationship cannot be attenuated in the presence of stronger internal corporate governance.
The Effects of Policy Uncertainty on Different Types of FDI - a Global Analysis
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Uncertainty incentivizes investors to wait-and-see and to hold back their investments. This paper investigates whether more liquid types of foreign direct investment are more affected by policy uncertainty than less liquid ones. Utilizing election data and the newly developed World Uncertainty Index, we examine how quarterly equity flows, reinvested earnings, and intra-company debt flows develop in times of high political uncertainty. In line with the real options theory, we find that reinvested earnings significantly drop in an election quarter. However, this only holds for high-income countries. In lower-middle- and low-income countries, electoral uncertainty negatively affects equity investments.
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Uncertainty incentivizes investors to wait-and-see and to hold back their investments. This paper investigates whether more liquid types of foreign direct investment are more affected by policy uncertainty than less liquid ones. Utilizing election data and the newly developed World Uncertainty Index, we examine how quarterly equity flows, reinvested earnings, and intra-company debt flows develop in times of high political uncertainty. In line with the real options theory, we find that reinvested earnings significantly drop in an election quarter. However, this only holds for high-income countries. In lower-middle- and low-income countries, electoral uncertainty negatively affects equity investments.
The Growth-at-Risk Perspective on the System-Wide Impact of Basel Iii Finalisation in the Euro Area
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This paper assesses the macroeconomic implications of the Basel III finalisation for the euro area, employing a large-scale semi-structural model encompassing over 90 banks and 19-euro area economies. The new regulatory framework will influence banks’ reactions to economic conditions and, as a result, affect the ability of the banking system to amplify or dampen economic shocks. The assessment covers the entire distribution of conditional economic predictions to measure the cost and benefit of the reforms. Looking at the means of conditional forecasts of output growth provides an indication of the costs of the reform, namely a transitory reduction in euro area gross domestic product (GDP) and in lending to the non-financial private sector. Looking at the lower percentile of output growth forecasts, i.e. growth at risk, captures the long-term benefits of the Basel III finalisation package in terms of improved resilience and the ability of the banking system to supply lending to the real economy under adverse conditions. These permanent growth-at-risk benefits ultimately outweigh the short-term costs of the reform.
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This paper assesses the macroeconomic implications of the Basel III finalisation for the euro area, employing a large-scale semi-structural model encompassing over 90 banks and 19-euro area economies. The new regulatory framework will influence banks’ reactions to economic conditions and, as a result, affect the ability of the banking system to amplify or dampen economic shocks. The assessment covers the entire distribution of conditional economic predictions to measure the cost and benefit of the reforms. Looking at the means of conditional forecasts of output growth provides an indication of the costs of the reform, namely a transitory reduction in euro area gross domestic product (GDP) and in lending to the non-financial private sector. Looking at the lower percentile of output growth forecasts, i.e. growth at risk, captures the long-term benefits of the Basel III finalisation package in terms of improved resilience and the ability of the banking system to supply lending to the real economy under adverse conditions. These permanent growth-at-risk benefits ultimately outweigh the short-term costs of the reform.
The Impact of Market Discipline on Banks’ Capital Adequacy: Evidence From an Emerging Economy
SSRN
This study presents empirical support for the role of market discipline in augmenting bank capital ratios in a competitive banking environment. Using a panel dataset on domestic commercial banks in Pakistan from 2009 to 2014, the study determines if the market penalized banks for any increase in their risk profile through a rise in the cost of raising funds. The results point to a significant relationship between capital adequacy and other risk factors, with the cost of deposits demonstrating how depositors align the required return to the perceived risk level of the bank. These findings have important implications for policymakers as market discipline could complement the role of regulators, which would eventually lower the cost of supervision. Moreover, the focus of international reforms as seen through the implementation of Basel III should continue to be on developing a more competitive and transparent banking system.
SSRN
This study presents empirical support for the role of market discipline in augmenting bank capital ratios in a competitive banking environment. Using a panel dataset on domestic commercial banks in Pakistan from 2009 to 2014, the study determines if the market penalized banks for any increase in their risk profile through a rise in the cost of raising funds. The results point to a significant relationship between capital adequacy and other risk factors, with the cost of deposits demonstrating how depositors align the required return to the perceived risk level of the bank. These findings have important implications for policymakers as market discipline could complement the role of regulators, which would eventually lower the cost of supervision. Moreover, the focus of international reforms as seen through the implementation of Basel III should continue to be on developing a more competitive and transparent banking system.
The impact of environmental, social and corporate governance responsibility on the cost of short- and long-term debt
SSRN
The aim of the paper is to examine the impact of environmental, social and corporate governance (ESG) responsibility on the short- and long-term cost of debt. Linear regression was applied to a unique dataset on CSR and cost of debt for 300 companies recognized in 2017 by Corporate Knights as the most sustainable companies in the world. The question about the link between CSR and cost of debt is important as there is still ongoing debate as to whether business should undertake activities in the field of CSRâ€"managers and other stakeholders are still unsure of the outcomes. The findings show that the involvement in environmental issues decreases the cost of long-term debt whereas the involvement in social issues brings benefits to short- and long-term debt. Surprisingly the greater the involvement in corporate governance, the higher the cost of debt in all time horizons. Managers should expect a lower cost of debt from environmental and social activities mostly in the long run. Corporate governance expenditures may in turn be seen as a waste of company resources, cost of forgone opportunities, orâ€"optionallyâ€"as an over-investment. The main novelty is the breakdown of CSR into three dimensions while examining various term structures of corporate debt.
SSRN
The aim of the paper is to examine the impact of environmental, social and corporate governance (ESG) responsibility on the short- and long-term cost of debt. Linear regression was applied to a unique dataset on CSR and cost of debt for 300 companies recognized in 2017 by Corporate Knights as the most sustainable companies in the world. The question about the link between CSR and cost of debt is important as there is still ongoing debate as to whether business should undertake activities in the field of CSRâ€"managers and other stakeholders are still unsure of the outcomes. The findings show that the involvement in environmental issues decreases the cost of long-term debt whereas the involvement in social issues brings benefits to short- and long-term debt. Surprisingly the greater the involvement in corporate governance, the higher the cost of debt in all time horizons. Managers should expect a lower cost of debt from environmental and social activities mostly in the long run. Corporate governance expenditures may in turn be seen as a waste of company resources, cost of forgone opportunities, orâ€"optionallyâ€"as an over-investment. The main novelty is the breakdown of CSR into three dimensions while examining various term structures of corporate debt.
Trust in the ECB in turbulent times
SSRN
Trust in the European Central Bank (ECB) is vital. Although it is important to study its level, drivers and effects especially in turbulent times, little is known about trust in the ECB during the COVID-19 pandemic. We use the pilot data from the ECB Consumer Expectations Survey during 2020-2021 to shed light on trust in the ECB during the pandemic. This is a new rich monthly dataset covering six key euro area countries. We find that there is ample room to improve consumers’ trust in the ECB. Trust is the lowest in Italy and Spain. Moreover, personal COVID-19 experiences play a role: respondents who reduced the number of hours worked due to COVID-19 have lower trust in the ECB than those with unchanged working hours. Trust in the ECB varies also within countries. It is highest among males and people with a good financial situation. It increases with financial knowledge, education, income, wealth, and trust in other people. Trust in the ECB and financial knowledge contribute to better anchoring of consumers’ inflation expectations three years ahead around the ECB’s medium-term inflation goal. Lastly, we show that consumers with higher inflation expectations are more likely to increase their household spending and buy a large item.
SSRN
Trust in the European Central Bank (ECB) is vital. Although it is important to study its level, drivers and effects especially in turbulent times, little is known about trust in the ECB during the COVID-19 pandemic. We use the pilot data from the ECB Consumer Expectations Survey during 2020-2021 to shed light on trust in the ECB during the pandemic. This is a new rich monthly dataset covering six key euro area countries. We find that there is ample room to improve consumers’ trust in the ECB. Trust is the lowest in Italy and Spain. Moreover, personal COVID-19 experiences play a role: respondents who reduced the number of hours worked due to COVID-19 have lower trust in the ECB than those with unchanged working hours. Trust in the ECB varies also within countries. It is highest among males and people with a good financial situation. It increases with financial knowledge, education, income, wealth, and trust in other people. Trust in the ECB and financial knowledge contribute to better anchoring of consumers’ inflation expectations three years ahead around the ECB’s medium-term inflation goal. Lastly, we show that consumers with higher inflation expectations are more likely to increase their household spending and buy a large item.
When Companies Don't Die: Analyzing Zombie and Distressed Firms in a Low Interest Rate Environment
SSRN
We analyze the phenomenon of zombification in Europe and show that monetary policy alone is not its only driver. Concurring phenomena explain zombie and distressed firms’ prevalence. Using Compustat data on public firms, we find that a rise in short-term interest rates is associated with a decrease in zombie status, suggesting that low rates constitute a favorable environment for zombie firms; there is no evidence of credit misallocation within the ECB’s Corporate Sector Purchase Program; and that a decrease in inflation and a lower state of the business cycle is associated with a rise in zombie prevalence.
SSRN
We analyze the phenomenon of zombification in Europe and show that monetary policy alone is not its only driver. Concurring phenomena explain zombie and distressed firms’ prevalence. Using Compustat data on public firms, we find that a rise in short-term interest rates is associated with a decrease in zombie status, suggesting that low rates constitute a favorable environment for zombie firms; there is no evidence of credit misallocation within the ECB’s Corporate Sector Purchase Program; and that a decrease in inflation and a lower state of the business cycle is associated with a rise in zombie prevalence.
