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AFA Ph.D. Student Poster Session

Poster Session

Friday, Jan. 5, 2018 7:30 AM - 6:00 PM

Loews Philadelphia, Commonwealth Pre-function
Hosted By: American Finance Association
  • Chair: Peter DeMarzo, Stanford University

An Anatomy of Arbitrageurs: Evidence from Open-End Structured Funds

Jie Li
,
INSEAD

Abstract

This paper exploits a unique account-level dataset of structured funds to study how arbitrageurs
trade during bubble periods (i.e., when large positive swings of mispricing occur in structured
funds). I find that arbitrageurs can both ride bubbles during the bubble-formation periods and
make arbitrage trades during the bubble-bursting periods. In particular, arbitrageurs ride bubbles
more aggressively when local unsophisticated investors start to trade in the direction of fueling
bubbles and quit this strategy when mispricing becomes excessive. Identification tests based on the
social contagion effect among unsophisticated investors support a causal interpretation. Moreover,
arbitrageurs who can ride bubbles make more trading profits than those who only conduct arbitrage
trades. These results suggest that arbitrageurs do not always trade in the direction of eliminating
mispricing and that local information may play a pivotal role in shaping their trading motivations.

When Good News Is Not That Good: The Asymmetric Effect of Correlation Uncertainty

Junya Jiang
,
University of North Carolina-Charlotte

Abstract

This paper examines how aversion to uncertainty about the information transfer across firms affects asset prices in an equilibrium. I show that a firm's stock price reacts more strongly to the bad news than the good news from its economically linked firms, and there is price inertia if the news is not strong enough. Moreover, I show that equilibrium prices do not always fully incorporate relevant firm-specific news. The stock price movement displays overreaction and underreaction, depending on the magnitude of the news, the information quality, the strength of the economic link, the firm size, and the firm risk. The model further explains the asymmetric pattern of financial time series, including the expected stock return and volatility, and the correlation and covariance. The model offers several testable predictions, which are consistent with recent empirical studies on how asset prices and returns are affected by the firm-specific news.

Are Mortgage Regulations Affecting Entrepreneurship?

Stephanie Johnson
,
Northwestern University

Abstract

I show that rules designed to prevent unaffordable mortgage lending restrict self-employed households' access to credit and reduce entrepreneurship. I use eligibility criteria for exemptions from the Ability-to-Repay rule - a key part of the U.S. policy response to the subprime mortgage crisis - to take a difference-in-differences approach. Comparing exempt and non-exempt bank lending behavior I find that the rule reduced access to mortgage credit in high self-employment census tracts. I then use geographic variation in access to banks receiving an exemption to identify broader economic effects. Growth in self-employment was lower in areas where exempt banks had a smaller market share. Locations farther from exempt branches experienced a relative reduction in new small business employment as a percentage of total employment.

As Uncertain as Taxes

Peter Brok
,
Tilburg University

Abstract

I investigate how the capital structure of firms is affected by uncertainty about the legal outcomes of corporate tax law. I create a simple model in which firms choose to either avoid taxes aggressively or conservatively, based on enforcement of laws and uncertainty about outcomes of the legal process. This theory shows under which conditions firms will avoid conservatively by using debt tax shields and when they will use more aggressive strategies. I suggest multiple novel proxies for the uncertainty about legal outcomes to provide empirical evidence to support the theory. This evidence is a first step towards understanding the effects of uncertainty about the interpretation of existing law on the decisions of companies.

Banking Competition Revisited: Shadow Banks vs. Commercial Banks

Chong Shu
,
University of Southern California

Abstract

In this paper, I first propose a novel and under-studied deposit competition from shadow banking sector that induces traditional commercial banks to offer higher deposit rates and hold riskier portfolios. The mechanism is through increased bankruptcy likelihood from higher deposit rates and it exacerbates the moral hazard problem. Then I show that through this channel of deposit competition, government could regulate both commercial banks' and shadow banks' risk by either a deposit ceiling regulation or an equity ratio requirement, even though shadow banks are not directly regulated. A panel data from 1987 to 2015 of 63 countries' 1811 banks confirm that higher deposit rates by shadow banks will cause commercial banks to increase their deposit rates and risk portfolios, especially in countries with generous deposit insurance, loose banking regulation, or weak supervisory power.

From Banks’ Macrofinancing to Endogenous Money Creation under Flexible Prices

Xuan Wang
,
University of Oxford

Abstract

Two most celebrated rules in monetary economics, the Friedman rule and the Taylor rule, provide contradictory policy prescriptions. We argue neither of these rules offers a sufficient theoretical foundation for the role of interest rate and fiat money. Building on Kumhof, Tsomocos and Wang (KTW 2017), this paper builds a novel Dynamic Stochastic General Equilibrium model to integrate endogenous liquidity creation with financial intermediation under flexible prices, simply by recognising money creation as an outcome of bank financing. Without appealing to nominal rigidities and the Taylor rule, we achieve both short-term and long-term money non-neutrality, and shed light on price level determinacy. We find that, to improve welfare, monetary policy needs to be active while bank capital regulation needs to be accommodative. We find that the first-best allocation under the Friedman rule can not be achieved because banks need a positive interest rate to establish the commitment power of fiat money.

Fiat Money Creation Credibility Price-level determinacy Zero Lower Bound Money and Banking

Best Friend or Worst Enemy? --Dynamics and Multiple Equilibria with Arbitrage, Production and Collateral Constraints

Ally Quan Zhang
,
Swiss Finance Institute and University of Zurich

Abstract

We develop a simple general equilibrium model to study the interactions between limits of arbitrage and aggregate economic activities within a conventional macroeconomic framework. Financially constrained arbitrageurs exploit price anomaly across segmented markets while collateralizing their arbitrage trades with capital investment in the production sector. We derive the model dynamics analytically to illustrate that mispricing arising from insufficient arbitrage activities helps boost the production by raising the marginal return of capital with collateral premium. However, limited arbitrage also renders the economy vulnerable to systemic risks. In addition, we analytically characterize the multiple equilibria to account for the nonlinear aspects of financial crises and the post-crisis recovery through regime shifts.

Capital Intensity and Investment Shocks: Implications for Stock Returns

Jiri Knesl
,
University of British Columbia

Abstract

I show that firm's capital intensity determines the asset pricing implications of investment-specific technology shocks. Capital-intensive stocks sorted by the exposure to the IMC portfolio (Investment Minus Consumption producers) generate a highly significant annual abnormal return of up to 5\%. This pattern is absent among labor-intensive stocks although the exposures are similar. I show that in contrast to the asset pricing implications of investment shock, value premium is independent of firm capital intensity. I extend prior models of the investment-specific technology shocks by a novel dimension, firm capital intensity. The model can rationalize many of the empirical findings.

Cash and Connections: The Importance of CFO Networks

Yaoyi Xi
,
University of Kansas

Abstract

We find that firms with CFOs who are connected with bankers tend to hold less cash. We show that this relationship does not hold for banker networks for CEOs and other directors. Further analyses indicate that this relationship is due to less information asymmetry between firms and banks, not sweetheart deals. We also document that cash holdings are less valuable for firms with CFO-banker relationships. Our results are robust to various tests dealing with the endogeneity issues. Our findings suggest that CFO-Banker networks play important roles in shaping firm cash holding strategies.

CEO Buying: Strategic News Tone Dispersion Around Purchasing Months

Dewan Mostafizur Rahman
,
University of Queensland

Abstract

We investigate whether CEOs strategically manipulate news releases, especially in terms of “tone”, surrounding their stock purchases. We find that CEOs, and particularly opportunistic CEOs, tend to release a higher volume of news surrounding their stock purchases. Specifically, in the month before and in the month of CEO stock purchases there is an increase in tone dispersion of news releases which is correlated with lower stock prices. These observations suggest strategic motives by CEOs to obtain favourable stock purchase prices, leading to abnormal profits. We provide further evidence supporting this strategic motive by using a quasi-natural experimental design. This design method attempts to separate analyst news releases from CEO news releases, relying on exogenous shocks coming from terminations in analyst coverage of the firm. We run several further robustness checks which also confirm our findings.

The Market with Negative Expected Return: Shrouded Fees and Ex-Post Returns of High Yield Structured Products

Petra Vokatá
,
Aalto University

Abstract

Banks engineer complex retail products called yield enhancement products that offer high yield in exchange for high risk and undisclosed embedded fee. The products became popular during the low interest environment and accounted for nearly $20 billions of issuance volumes in 2014. I employ option pricing methods and a novel database covering the market from 2006 through 2015 to quantify their performance and shrouded fees. I find widespread issuance of products having negative expected return under plausible assumptions. On average, investors paid 7.4% in hidden fees and lost 4.9% in raw and 6.4% in abnormal returns.

Cheaper Is Not Better: On the Superior Performance of High-Fee Mutual Funds

Jinfei Sheng
,
University of British Columbia
Mikhail Simutin
,
University of Toronto
Terry Zhang
,
University of British Columbia

Abstract

The well-established negative relation between expense ratios and future net-of-fees performance of actively managed equity mutual funds guides portfolio decisions of institutional and retail investors. We show that this relation is an artifact of the failure to adjust performance for exposure to the profitability and investment factors. High-fee funds exhibit a strong preference for stocks with low operating profitability and high investment rates, characteristics recently found to associate with low expected returns. We show that after controlling for exposures to profitability and investment factors, high-fee funds significantly outperform low-fee funds before expenses, and perform equally well net of fees. Our results have important implications for asset allocation decisions and support the theoretical prediction that skilled managers extract rents by charging high fees.

Diversification in Lottery-Like Features and Portfolio Pricing Discounts

Xin Liu
,
University of Hong Kong

Abstract

Why is a portfolio sometimes valued less than the sum of its underlying components? In this paper, I provide a novel explanation for this question by utilizing closed-end funds, mergers and acquisitions, and conglomerates, where the value of the aggregate portfolio and the values of the underlying components can be separately evaluated. Inspired by the model of Barberis and Huang (2008), in which lottery-like stocks are overvalued due to probability weighting, I argue that a portfolio holding lottery-like stocks should be valued less than the total value of its components, because lottery-like features get diversified away when lottery-like stocks do not hit “jackpots” together. I present evidence supporting this argument and provide a novel and unifying explanation for the closed-end fund discount puzzle, the announcement-day returns of mergers and acquisitions, and the conglomerate discount.

Competition and Adverse Selection in an Online Lending Market

Don Carmichael
,
University of Houston

Abstract

Using data from Lending Club and Prosper, the two largest peer-to-peer lenders in the U.S., we provide evidence of adverse selection in the online personal lending market. Borrowers who were rejected by a competitor are 2.5 times more likely to default than borrowers who were not rejected by a competitor, conditional on receiving the same contract. We also show that modeled competitors’ interest rate offers are significantly related to default; these offers provide explanatory power that is not captured by the actual interest rates on the loans.

Corporate Bond Dealers' Inventory Risk and FOMC

Wojciech Zurowski
,
Duke University, Swiss Finance Institute and University of Lugano
Alessio Ruzza
,
University of Lugano & Swiss Finance Institute

Abstract

We obtain measures of monetary policy uncertainty from 30 day Federal funds futures. We employ those variables to study the effect of FOMC announcements on the corporate bond market liquidity. Even if market expectations about future monetary policy are relatively easy to infer, the heterogeneous beliefs of agents can create effects similar to asymmetric information. Despite the low toxicity of order flow, dealers decrease their liquidity provision in the presence of monetary policy uncertainty and unexpected policy rate changes. We conclude that liquidity around the meetings is driven by inventory aversion and that a dealership market is inadequate to accommodate heterogeneous beliefs, even when adverse selection may be absent.

Corporate Inversions and Cost of Equity: A Tale of Two Strategies

Tianpeng Zhou
,
Michigan State University

Abstract

The exodus of U.S. corporations to tax-haven countries has led to a discussion among policy makers regarding appropriate tax and other regulatory reforms. This paper analyzes the impact of corporate inversion on the firms’ cost of equity, a topic that so far has largely been neglected. I find that pure-inversions cause the cost of equity to increase by about 10% of mean pre-inversion levels, and M&A-inversions cause the cost of equity to decrease by about 13% of mean pre-inversion levels. The difference is due to the difference in risk of changing jurisdiction between the two inversion strategies as well as synergy and diversification effects in M&A transactions. In addition, I document that M&A-inversions add more value to the original (pre-inversion) shareholders than self-inversions, which sheds light on the presence of managers’ moral hazard before the tax policy change.

Credit Spreads, Daily Business Cycle, and Corporate Bond Returns Predictability

Alexey Ivashchenko
,
University of Lausanne

Abstract

The part of credit spread that is not explained by corporate credit risk forecasts future economic activity. I show that the link with aggregate business risk and bond liquidity risk explains this finding. Once I project spreads on these two risk factors, which are readily measurable with the daily frequency, in addition to corporate credit risk, the forecasting power of the residual spread reduces substantially for some macro variables and disappears entirely for the others. Such residual, however, turns out to be an out-of-sample forecast of corporate bond market returns. An investment strategy based on such forecasts delivers risk-adjusted returns 50% higher than the corporate bond market.

December Doldrums, Investor Distraction, and Stock Market Reaction to Unscheduled News Events

Nikhil Paradkar
,
Georgia Institute of Technology

Abstract

We document that the stock market reaction to unscheduled firm-specific news is weaker during December as compared to other months. 8-K filings and credit rating downgrades generate immediate price responses that are 27% weaker and 44% weaker, respectively, when these events occur in December. In contrast, the market's reaction to scheduled earnings announcements is not significantly different in December. We find a similar pattern for trading volume. However, this December distraction does not affect firms with greater visibility, such as larger firms, firms with higher analyst following, or higher institutional ownership. Our results highlight how investor distraction during the December holiday season can lead to a muted market reaction to unscheduled, but salient, firm-specific news.

Demand Shocks, Financial Integration, and Local Economic Conditions

Minh Phan
,
Columbia University

Abstract

This paper analyzes the ability of banks to mobilize capital in response to increased credit demand. Following Bartik (1991) and Blanchard and Katz (1992), we construct local measures of employment or wage growth as predicted by national averages. These local predictions are plausibly exogenous to the supply of local funds or the nature of the banks servicing these areas. We then interact this with county level measures of banking integration. We find that more financially integrated counties are more sensitive to these exogenous shocks. Additionally, our results suggest that more financial integrated
areas are twice as sensitive to negative demand shocks as to positive shocks. Third, we decompose the Bartik shocks into tradable versus non-tradable sectors. Consistent with the hypothesis that tradable sectors have lower dependence on local bank financing, we find that conditional on receiving the same credit demand shock in the tradable sector, more financially integrated counties do not respond with greater economic growth. Finally, we examine how banks respond to these demand shocks. We find that banks that operate in counties with greater increases in demand for capital correspondingly respond to these shocks by growing their loan portfolio.

Capital Controls and Misallocation in the Market for Risk

Lorena Keller
,
Northwestern University

Abstract

I identify a novel side effect of managing capital flows: Macroprudential policies that regulate capital flows (capital controls) encourage domestic firms to take more dollar liabilities, and hence, increase the sensitivity of the economy to sudden stops. Capital controls induce firms to borrow more in dollars because banks in emerging markets have a fundamental risk problem: households save partially in dollars while firms borrow in local currency. Absent capital controls, banks hedge the associated currency risk with foreign investors. When capital controls are present, banks respond by lending in dollars to domestic firms. I exploit heterogeneity in the strictness of capital controls across Peruvian banks to provide evidence of this mechanism. Using a unique dataset, I show causal evidence that capital controls lead banks to transfer exchange rate risk from foreign investors to local firms. I observe that the exchange rate risk transfer has sizable real effects on the economy.

Idiosyncratic Shocks, Geographic Spillovers, and Asset Prices

Sima Jannati
,
University of Miami

Abstract

This paper shows that productivity shocks to the top 100 U.S. companies (as identified in Gabaix (2011)) contain systematic information. Specifically, shocks to the top 100 firms predict future shocks to geographically close firms. Intra-sector trade links are an important economic channel for the cascade effect. However, these geographic spillovers are not only restricted to firms' explicit interactions. State income tax payments is another dominant channel through which the shocks propagate. Market participants, including equity analysts, do not fully incorporate the geographic information contained in shocks to top 100 firms. Consequently, a trading strategy that exploits the slow diffusion of information generates an annual risk-adjusted return of 7.5%.

Do Peer Firms Affect Corporate Cash Saving Decisions?

Yuan Zhuang
,
Singapore Management University

Abstract

I show that peer firms play an important role in determining U.S. corporate cash saving decisions. Using an instrument variable identification strategy, I find that one standard deviation change in peer firms average cash savings leads to a 2.63% same-direction change in firm’s own cash savings, which exceeds the marginal effects of many previously identified determinants. The economic implications of such peer effects are large, which can significantly alter cash savings in an industry by 7.2%. In cross-sectional tests, I find that peer effects are stronger when the product market is highly competitive and when the economy is in recession. In addition, less powerful, smaller, and financially constrained firms respond more actively to their peers’ cash saving decisions. Finally, I provide evidence that such peer effects are asymmetric—cash-rich firms, who already hold enough cash, are less likely to mimic peers’ cash policies compared to cash-starved firms.

Homophily, Information Asymmetry and Performance in the Angels Market

Buvaneshwaran Venugopal
,
University of Houston

Abstract

Using unique hand-collected data on startups that were seed-funded by individual angel investors, I show that social connections between angels and entrepreneurs, obtained via schools, past employment and ethnicity, positively influence investment decisions of angels, and the subsequent performance of startups. Social connections, irrespective of the ranking of the school or employer in which they were formed, are crucial for obtaining early-stage startup financing particularly in markets with higher information asymmetry. Connected seed-stage startups are more likely to survive longer, raise more series A funds and are more likely to attract venture capital investments than unconnected startups. The estimates of a two-stage selection correction model show that the higher performance of connected startups is because of post-investment influence of angel investors, via better information exchange and coordination.

Do We Want These Two to Tango? On Zombie Firms and Stressed Banks in Europe

Manuela Storz
,
Frankfurt School of Finance & Management
Michael Koetter
,
Halle Institute for Economic Research
Ralph Setzer
,
European Central Bank
Andreas Westphal
,
European Central Bank

Abstract

We show that the speed and type of corporate deleveraging depends on the interaction between corporate and financial sector health. Based on granular bank-firm data pertaining to small and medium-sized enterprises (SME) from five stressed and two non-stressed euro area economies, we show that 'zombie' firms generally continued to lever up during the 2010-2014 period. Whereas relationships with stressed banks reduce SME leverage on average, we also show that zombie firms that are tied to weak banks in euro area periphery countries increase their indebtedness even further. Sustainable economic recovery therefore requires both: deleveraging of banks and firms.

Does Political Corruption Impede Firm Innovation? Evidence from the United States

Qianqian Huang
,
City University of Hong Kong
Tao Yuan
,
City University of Hong Kong

Abstract

We examine how local political corruption affects firm innovation in the United States. We find that firms located in more corrupt districts are less innovative, as measured by their patenting activities. We identify two possible economic channels through which corruption may affect innovation: a disincentive effect and a culture effect. We show that the negative impact of corruption on innovation is stronger for firms that have weaker bargaining power against corrupt officials and for firms that locate in areas with lower local religiosity. Overall, our results indicate that local political corruption impedes corporate innovation.

Uniform Mortgage Regulation and Distortion in Capital Allocation

Teng Zhang
,
Georgia Institute of Technology

Abstract

The U.S. economy is largely influenced by local features, but some federal policies are spatially uniform across regions. I study the unintended consequences of the uniformity of the national conforming loan limit (CLL) before 2008 on local jumbo mortgage lending. When the national CLL increased, the jumbo share of residential mortgages in low-income counties was significantly reduced relative to high-income counties. I find that banks responded to the national shock by significantly raising jumbo approval rates in low-income counties, consistent with the competition mechanism in which lenders expand jumbo credit to defend market share. The economic magnitude is significant: a county with a $10,000 lower median income is associated with, on average, a 6 percentage-point (or 11.77%) higher jumbo approval rate. The results are not driven by lender-specific changes, borrower quality changes, home price anticipation, or the demand channel. I find that banks in low-income counties lower jumbo mortgage rates and later suffer from worse mortgage performance. Furthermore, smaller and less informed banks expand jumbo credit more aggressively, and riskier borrowers receive more credit. Overall, my results highlight the negative consequences of the uniformity of federal policy in mortgage markets by showing how it can lead to distorted bank lending and reduce the efficiency of capital allocation across regions.

Effect of Financial Globalization on Bank Risk: Role of Rollover Risk

Xiang Li
,
Peking University
Dan Su
,
University of Minnesota

Abstract

This paper investigates the effects of financial globalization on bank risk by highlighting the role of rollover risk. We extend the canonical rollover risk model by allowing an “active” bank manager to choose excessive risk-taking or systemic risk-shifting actions. Financial globalization is characterized by an increase in investors’ opportunity cost, which affects the coordination problem among short-term creditors, and changes banks’ incentives for risk-taking and systemic risk-shifting. The model generates three predictions and we provide robust empirical evidence to verify them: (1) In the short term, financial globalization will induce those banks with more short-term funding to be more risk-taking; (2) The mid-tier banks are more sensitive to the effects of financial globalization and will become more risk-taking than the rest; and (3) In the long term, financial globalization tends to affect the systemic risk in the financial system, but the precise effects depend on the country’s economic fundamentals and institutional quality.

Endogenous Rare Disaster Risk: Solution for Counter-Cyclical Excess Return and Volatility?

Ville Savolainen
,
Hanken School of Economics

Abstract

This study proposes a model to endogenously generate counter-cyclical dividend and return volatilities, dividend/price ratios and expected excess returns from business cycle fluctuations in rare disaster framework, with constant stochastic discount factor parameters and rational agents exhibiting standard power utility. Contrary to orthodoxy, I assume monopolistic competition and increasing returns to scale. These two assumptions cause the riskiness of dividend stream to fluctuate over business cycle: when demand for goods is lower the firms operate on a more steeper part of their average cost curve, and therefore the dividends are more sensitive to conventional and rare disaster shocks. Consequently, this generates counter-cyclicality, and decreases the hurdle for any stochastic discount factor to generate historically observed risk premium. I estimate the fit of aggregate average cost curve from corporate profits using structural regression, employing it to generate the salient features of stock returns.

Environmental Social (ES) Engagement and Stock Returns: A Dynamic Perspective

Jiali Yan
,
Lancaster University
Mark Shackleton
,
Lancaster University
Chelsea Yao
,
Lancaster University

Abstract

We study how firms' environmental and social (ES) engagement interacts with stock returns using a PVAR model with firm fixed effects. Analysing a large sample of U.S. companies from 1991 to 2015, we provide evidence for a significantly negative and causal effect of stock returns on ES index. Further, we show that this pattern is stronger for firms which suffer more from agency concerns (lower book leverage, higher free cash flows, lower dividend payout, more stock repurchase and poorer corporate governance). We also find that firms engaging in ES activities does not affect their financial performance.

From Playground to Boardroom: Endowed Social Status and Managerial Performance

Fangfang Du
,
Arizona State University

Abstract

By matching a CEO's place of residence in his or her formative years with U.S.
Census survey data, I obtain an estimate of the CEO's family wealth and study
the link between the CEO's endowed social status and firm performance. I find
that CEOs born into poor families outperform those born into wealthy families, as
measured by a variety of proxies for firm performance. There is no evidence of higher
risk-taking by the CEOs from low social status backgrounds. Further, CEOs from
poor families are better able to preserve the firm's human capital during periods of
financial distress and demonstrate greater ability to develop successful innovation.
As a result, such CEOs perform better in firms with high R&D spending.

Fundamental Risk and Capital Structure

Jakub Hajda
,
University of Lausanne and SFI

Abstract

I develop a dynamic capital structure model to examine how the nature of risk affects firm's debt policy. In the model, firm's fundamental risk, captured by its cash flow process, consists of transitory and persistent parts with markedly different dynamics. The model explains the observed dispersion in the risk-leverage relationship. Firms with similar total volatility adopt distinctive debt policies when the composition of their risk differs and issue less debt when their cash flows are more persistent to preserve debt capacity needed to fund investment. The model also provides rationale why the observable dispersion in cash flow persistence is low, which is at odds with the large degree of heterogeneity in other firm characteristics, as well as why persistence and leverage are weakly related in the data.

Health Care Costs, Worker Mobility and Firm Leverage: Evidence from State Health Mandates

S.Lakshmi Naaraayanan
,
Hong Kong University of Science and Technology
Manpreet Singh
,
Georgia Institute of Technology

Abstract

We study how changes in intra-firm bargaining through health insurance induced ’job-lock’ affects financing decisions of firms. We use staggered adoption of state health mandates which significantly increased the cost of health insurance borne by firms, along with providing better insurance coverage for their employees. Higher health care costs reduce worker mobility and allow firms to increase financial leverage by lowering operating costs. Consistent with this, we show that following the adoption of high-cost mandates, job turnover among workers reduces significantly, specifically for workers with employer-sponsored health insurance. Further, we find that firms that experience greater benefit from this job-lock significantly increase their debt ratios. Particularly, the increase in leverage is stronger for a) firms with small labor pool, b) financially constrained firms, and c) firms that operate in industries where workers have high job mobility. Our results are robust to geographic regression discontinuity design where we focus on firms located in counties adjacent to state borders. Overall, these results are consistent with greater operational flexibility allowing firms to raise financial leverage via increase in intra-firm bargaining power.

Hedge Fund Activism and CEO Compensation

Jana Fidrmuc
,
University of Warwick
Swati Kanoria
,
University of Warwick

Abstract

Applying a difference-in-differences approach, we document the effect of hedge fund activism on the corporate governance of target firms via the specific channel of CEO compensation. We hand-collect data on managerial pay, for a sample of 244 U.S. publicly-listed firms that were targets of activist hedge funds from 2009 to 2011, and their corresponding 244 industry, size and book-to-market matched firms. We find that target CEOs receive higher stock and total compensation, as compared to their peers, prior to an activist's entry. The entry of hedge fund activists results in a decline in target CEO pay, to levels prevalent at matched firms. This decrease is not because target CEOs were extracting rents before activism, since CEO pay at target firms, prior to activism, was indeed sensitive to firm performance. Instead, we show that the entry of hedge fund activists results in a decline in not just the level, but also the pay-for-performance sensitivity of CEO stock awards and total pay at target firms. These findings indicate that incentive compensation and monitoring by activist hedge funds, act as substitutes in motivating CEOs to improve firm value.

Hispanic Culture, Stock Preferences, and Asset Prices

Carina Cuculiza
,
University of Miami

Abstract

We examine the effect of Hispanic culture on portfolio choice decisions and asset returns in the United States. We show that investors residing in zip codes with a high concentration of Hispanics are significantly more likely to chase returns and overweight local lottery stocks than the average US investor. To control for unobserved heterogeneity across zip codes that may be correlated with the concentration of Hispanics, we use the distance from the Canadian border to each zip code as an instrumental variable and find that our results are robust. We also find evidence that Hispanic investors' preferences affect prices and returns in local asset markets. In particular, we find that herding in local lottery stocks results in excess comovement in returns that cannot be explained by fundamentals. Furthermore, since investors who reside in high Hispanic areas tend to chase returns, we find geographic segmentation in the momentum effect, whereby momentum returns are more pronounced (nonexistent) among firms headquartered in MSAs with a high (low) proportion of Hispanics.

How Does Investor Protection Affect Innovation? Historical Evidence from Blue Sky Laws

Huseyin Akkoyun
,
Northwestern University

Abstract

This paper investigates the effect of investor protection on innovation. In the early twentieth century, states passed investor protection statutes called Blue Sky Laws when there was no federal regulation. These laws required companies to disclose information before selling their stocks, increased penalties in case of financial fraud, and setup local institutions regulating security issues. We find that private firms, with limited access to external capital markets, located in early adopting states produced 15-20% more patents. These results highlight the role of institutions and financial development in the economic growth.

Illuminating the Dark Side of Financial Innovation: The Role of Investor Information

Manuel Ammann
,
University of St. Gallen
Marc Arnold
,
University of St. Gallen
Simon Straumann
,
University of St. Gallen

Abstract

This paper investigates the impact of investor information on financial innovation. We identify specific channels through which issuers of financially engineered products exploit retail investors by using their privileged access to information. Our results imply that imperfect investor information regarding volatility and dividends is crucial to explain the pricing and design of financially engineered products. We confirm our conjecture by exploiting a discontinuity in issuers' informational advantage. The insights are of systemic importance because they suggest that product issuers' behavior in the financial innovation market aggravates investor information problems of the financial system.

Information Spillovers and Cross Monitoring between the Stock Market and Loan Market: Evidence from Reg SHO

Matthew Billett
,
Indiana University
Fangzhou Liu
,
Indiana University
Xuan Tian
,
Tsinghua University

Abstract

We explore information spillovers and cross monitoring between the stock and loan markets. To break simultaneity between the stock and loan markets, we use a regulatory experiment, Regulation SHO, that relaxes short selling constraints for a randomly selected sample of Russell-3000 stocks, which directly affects information production and monitoring by short sellers in the stock market but is exogenous to the loan market. We find that while firms without bank monitors exhibit a significant decline in stock prices upon the announcement of SHO, firms with bank monitors do not react. Further evidence shows that firms affected by SHO enjoy a 21 basis point lower loan spread that increases to 36 basis points for bank-dependent firms. Regulation SHO, however, does not appear to affect non-price loan terms such as loan maturity, amount, collateral, and covenants. Overall, our evidence suggests bi-directional information spillovers and cross monitoring between the stock and loan markets. The effects on loan markets are consistent with a reduction in the information monopoly that banks possess over their borrowers.

Innovative CEO-Directors

Ning Gao
,
University of Manchester, UK
Ian Garrett
,
University of Manchester, UK
Yan Xu
,
University of Manchester, UK

Abstract

The leadership to cultivate and promote technological innovation is one of the most important aspects of a CEO’s human capital. We investigate how this leadership affects a CEO’s attractiveness on the outside directorship market. We find a robust positive relationship between innovation performance of a CEO’s own firm and the number of outside directorships held by this CEO, which is primarily determined by appointing firms that are also innovative. We also find that the presence of innovative CEO-directors on a firm’s board significantly improves its innovation and operating performance in post-appointment years. Our results demonstrate that a CEO’s leadership in cultivating and promoting innovation is highly valued in the market for outside directorship. These results also suggest that innovative CEO-directors constitute an important mechanism to propagate knowledge on innovation across firms.

Institutional Investors and Loan Dynamics: Evidence from Loan Renegotiations

Ca Nguyen
,
University of Texas-San Antonio

Abstract

We examine how the participation of nonbank institutional investors in syndicated loans affects the loan renegotiation process and loan contracting. Nonbank syndicate participants, particularly CLOs, closed-end funds, and open-end mutual funds, are more likely than bank lenders to exit the syndicate rather than to participate in the renegotiated loan. In addition, changes in the composition of the lending syndicate are significantly related to how the loan contract is renegotiated. The addition of most nonbank institutions is associated with an increase in the cost of debt, particularly if the nonbank institution is an investment bank or insurance company. We argue that higher funding liquidity risk and higher renegotiation costs can explain some of the relations between the participation nonbank institutions and loan renegotiation results.

Internal Rating Based Model, Bank Regulatory Arbitrage and Eurozone Crisis

Cai Liu
,
University of Reading

Abstract

I investigate how the complicated model-based capital regulation can be misused by European banks for capital saving purposes. I find that banks may strategically manipulate the risk-weights under the internal rating-based (IRB) approach, which can be largely associated with banks from the Eurozone peripheral countries. I also show that banks have geographical preference regarding such manipulation - domestic exposure and foreign exposure when that foreign country is distressed. On the other hand, I provide evidence that banks may strategically avoid using IRB approach on certain exposures, e.g. domestic government debt, probably due to the widely criticised zero-risk-weights for EU banks’ exposure of EU governments. Those findings support the concerns raised in the recent regulatory proposal (EBA 2016). In particular, not only the use of IRB should be carefully granted and closely supervised, but also the (permanent) partial use of IRB should be limited, so that both strategic IRB modelling and the so-called cherry-picking can be properly confined.

Risk Premia and Coordinated Monetary Policy in a Two-country World

Hsuan Fu
,
Imperial College London

Abstract

I study the optimal monetary policy and the implications for equity risk premia in a two-country world. In particular, I explore the motivation for a large country to participate in monetary policy coordination. A sticky-price model with endogenous monetary actions from both countries is constructed to quantify the gains in consumption and excess equity returns. The coordinative equilibrium is generally associated with higher expected consumption and lower risk premia relative to the non-coordinative equilibrium. The smaller the country is, the larger stabilization gains from coordination would be achieved with respect to her larger neighbour. Nevertheless, monetary policy coordination is still beneficial to the large country because of the international risk sharing.

It’s Always Sunny in Finland: Investment and Extrapolation from Cash Flow Growth

Mikael Paaso
,
Aalto University

Abstract

Managerial expectations of cash flow growth are positively correlated with past growth rates, even when these growth rates convey no information about future growth rates. This can lead to overinvestment following good years. Using rainfall as an instrumental variable for cash flow shocks to firms which are weather sensitive, I find that companies increase investment 28.5% following a one-standard-deviation drop in summer rainfall, even though the drop is transitory. The excess investment appears to be driven by extrapolation from past cash flows while traditional explanations, such as loosening of credit constraints or agency problems, do not fully explain the result. High levels of investment are not optimal from the point of view of the firms, and the years following the cash flow shock feature an abnormally high number of companies closing down.

Customer Capital and Trade Credit: Evidence from Exports

Paul Beaumont
,
Paris Dauphine University

Abstract

Do liquidity constraints hinder the formation of customer capital? Exploiting an exogenous variation in payment delays triggered by a 2009 French reform, I use a unique combination of administrative datasets to test whether changes in working capital financing affects the formation of new customer-supplier relationships and the entry in new international markets. The effect of the reform on payment delays is isolated us-ing a threshold rule introduced by the law. The estimations strongly support the idea that access to working capital financing plays key role in the acquisition of a customer base: a decrease in payment delays by ten days is found to raise the probability to reach a new foreign market by 0.4 percentage points and to increase the probability of acquiring customers in markets in which the firm is already present by 1.0 percentage points.

Long-Term Passive Investors and Long CEO Compensation Duration: Evidence from Russell Index Threshold

In Ji Jang
,
Texas A&M University

Abstract

I study the effect of long-term passive institutions on CEOs' incentive horizons, namely, pay duration. I exploit exogenous variation in passive ownership associated with Russell 1000/2000 index assignments to establish a causal link between passive institutions and CEO compensation duration. A one-standard-deviation increase in passive ownership leads to a 0.65-standard-deviation increase in compensation duration. To identify the channel through which passive institutions affect CEO compensation duration, I examine their proxy voting behavior. I find that greater ownership by passive institutions increases the number of shareholder-sponsored compensation proposals and that passive institutions vote to support these proposals. I also find firms that receive more supporting votes from passive institutions in uncontested board of director elections experience a larger increase in CEO pay duration. Overall, my evidence suggests that passive institutions influence CEO compensation duration by utilizing their voting power to align managerial incentive horizons with their long-term investment horizons.

Mean-Swap Variance Portfolio Theory and Prospect Asset Pricing

Victor Chow
,
West Virginia University
Zhan Wang
,
West Virginia University

Abstract

Superior to the variance, "swap variance" summarizes the entire probability distribution of returns and is unbiased to distributional asymmetry. Retaining the same simplicity as mean-variance (MV) model, the mean-swap variance (MSwV) efficiency is necessary and sufficient for expected utility maximization. The MSwV portfolio optimization extends the MV model to a general framework incorporated with asymmetries in returns. The distinction between MSwV and MV characterizes the aggregated utility as a "domain-dependent" function with loss-aversion to the downside-asymmetries, risk-aversion to the symmetry, and increasing risk-aversion to the upside-asymmetries, respectively. A three-factor prospect asset pricing model is theoretically developed and is empirically robust.

Media News and Cross Industry Information Diffusion

Li Guo
,
Singapore Management University

Abstract

Media news serves as information intermediary that contributes to the cross industry return predictability. First, cross industry news contains valuable information about firm fundamentals that is not priced by the market. Second, consistent with high information costs hypothesis, cross industry news has long term effects on future returns with an annualized risk adjusted return 10.85% after 10 weeks of the signal. Third, cross industry news is more valuable to small stocks, illiquid stocks, and stocks with high return volatility or low analyst coverage. Fourth, analyst forecasts, institutional fund flows and media news might be the channels that interpret cross industry news to the market. Overall, this paper provides direct evidence to support the argument that news travels slowly across different industries.

Mortgage Choices in Equilibrium

Esben Christensen
,
London Business School

Abstract

This paper identifies the optimal mortgage choice of homeowners, who are subject to counter-cyclical income volatility and idiosyncratic income risk. The market equilibrium of investors with similar income risk exposures, leads to pro-cyclical equilibrium interest rates. The key determinant of the optimal mortgage choice is the correlation of income with the business cycle. Homeowners with high (low) correlation of income choose an ARM (FRM) and the more risk-averse homeowners are more likely to choose an ARM. Mortgage choices of homeowners have an impact on the financial market equilibrium, where interest rates become less volatile for larger shares of ARMs.

Multi-family Cofounders and Firm Value

So-Yeon Lim
,
Nanyang Technological University

Abstract

The paper shows the higher valuation of family firms occurs only for family firms founded by several non-related people (multi-family cofounding firms), particularly founder controlled multi-family cofounding firms. Agency problems are smallest when at least two cofounders are involved in management and can monitor each other, reducing the number of shareholder proposals and serving as a substitute for other governance mechanisms. Relative to single-family founding firms, multi-family cofounding firms are more likely to force out founders and less likely to allow descendants to take control after founders retire.

Mutual Fund Flows, Delayed Arbitrage, and Common Factors in Stock Returns

Jiacui Li
,
Stanford University

Abstract

Over the period of 1965-2015, retail investors frequently made large and uninformed capital reallocations at size and value style levels by trading equity mutual fund shares. Consistent with other market participants being slow to provide liquidity, fund flows are associated with large contemporaneous price impact which reverses in the subsequent years, explaining approximately 30% of SMB and HML factor return variance. Because price reversions are not accompanied by flow reversions, the evidence is inconsistent with standard “rational” or “behavioral” models with heterogeneous agents. Without slow-moving liquidity provision, flows would not be able to explain such a high fraction of broad-market price movements over long periods of time.

On Bank Business Models, Credit Supply, and House Prices: The Real Effects of Funding Shocks in Banking

Kristian Blickle
,
University of St. Gallen

Abstract

I exploit the large-scale migration of Swiss UBS customers to local banks in 2008. Using the distance between branches of the UBS and a group of nearly 300 homogenous S&L banks (Raiffeisenbanks), I identify a one-time exogenous deposit shock to 115 of these 250 S&Ls. I find that the shocked banks invest the newly acquired capital in accordance with their business model – local mortgage lending. Consequently, house prices around affected banks rise up to 50% more strongly than around unaffected banks. This paper contributes to research on the importance of local banking. It shows, however, that a bank’s business model, as well as its location, will govern the allocation of capital to the productive sector. This paper further contributes evidence that a positive shock to credit supply increases real asset prices (in this case house prices).

One Security, Two Prices: Evidence on Stock Market Bubbles from the Shanghai-Hong Kong Stock Connect Program

Shantaram Hegde
,
University of Connecticut
Jin Peng
,
University of Connecticut

Abstract

In this paper, a unique data sample from cross-listed stocks in two segmented but partially connected markets allows us to examine the implications of the bubble theories while controlling for fundamentals. We study price, volume, volatility and liquidity changes surrounding the launch of the Stock Connect program on 17 November 2014, which links trading in A shares listed on the Shanghai Stock Exchange (SSE) to their ‘twin’ (cross-listed) H shares traded on the Hong Kong Stock Exchange (SEHK). The price and price discovery gaps of the A-H shares should be larger after the Stock Connect if the speculative trading in Shanghai market explains most of the price differences. On the other hand, there should be a price convergence effect after the Stock Connect if the efficient market theories explain a fraction of the price disparity since information asymmetry and limits of arbitrage are reduced. Our analyses indicate a persistent, sharp increase in the price, volume, volatility, and liquidity of A shares relative to H shares, which dominates a general increase in the speed of convergence in these variables between the cross-listed shares lasting up to 15 months after the launch of the Connect program. These findings are consistent with the theoretical predictions of speculative demand shocks due to market overconfidence and trading bubbles.

Optimal Contracting in a Principal-Agent-Subagent Model

Qing Liu
,
Boston University

Abstract

This paper expands the classic principal-agent model and introduces a new continuous-time principal-agent-subagent model, in which the administrative manager has interpersonal authority over the productive employee. The two optimal dynamic contracts, (i) between the investors and the manager and (ii) between the manager and the employee, are uniquely determined in subgame perfect Nash equilibrium. The manager, getting paid earlier, is self-motivated to supervise the employee, and it is suboptimal for them to collude in shirking. When shirking is a more severe agency problem than stealing, the investors benefit from this three-layer hierarchy as they have limited liability, provide fewer minimum incentives, and their agency costs get mitigated. That twenty-year personnel data from a medium-sized firm shows that the agency costs are reduced when more work is conducted by hiring employees---rather than managers---lends support to my model.

Option-Implied Correlations, Factor Models, and Market Risk

Adrian Buss
,
INSEAD
Lorenzo Schoenleber
,
Frankfurt School of Finance & Management
Grigory Vilkov
,
Frankfurt School of Finance & Management

Abstract

Implied correlation and variance risk premium stand out in predicting market returns. However, while the predictive ability of implied correlation lasts for up to a year, the variance risk premium predicts market returns only for one quarter ahead. Contrary to the accepted view, implied correlation predicts the market return not through a diversification risk (average correlation) channel, but by predicting a concentration of market exposure, which defines the level of non-diversifiable market risk. Economy-wide implied correlation built exclusively from option prices of nine sector ETFs and the S&P500 efficiently predicts future market returns and systematic diversification risk in the form of market betas dispersion. Newly developed implied correlations for economic sectors provide industry-related information and are used to extract option-implied risk factors from sector-based covariances.

Peer Pressure in Corporate Earnings Management

Constantin Charles
,
University of Southern California
Markus Schmid
,
University of St. Gallen
Felix von Meyerinck
,
University of St. Gallen

Abstract

We show that peer firms play an important role in shaping corporate earnings management decisions. To overcome identification issues in isolating peer effects, we use fund flow-induced selling pressure by passive open-end equity mutual funds as exogenous shocks to firms’ stock prices. Managers respond to such exogenous price shocks by adjusting earnings management policies. We then measure individual firms’ reactions to changes in earnings management at peer firms as a result of such exogenous price shocks. The documented peer effect in earnings management is not only statistically, but also economically significant. Our results are robust to multiple measures of earnings management and fund flow-induced selling pressure as well as different peer group definitions. In an alternative setting, we exploit random variation in peer firms' earnings management from a regulatory experiment and continue to find strong peer effects. Finally, we show that firms respond most to the actions of large, profitable, and geographically close peers.

Performance, Persistence, and Pay: A New Perspective on CTAs

Ingomar Krohn
,
University of Warwick
Alexander Mende
,
RPM Risk and Portfolio Management
Michael Moore
,
University of Warwick
Vikas Raman
,
University of Warwick

Abstract

Using a large and representative dataset of commodity trading advisors (CTAs), we provide compelling evidence that CTAs generate significant net excess returns of at least 4.1% annually; that approximately 64% of the funds have positively skewed returns; and that there is considerable heterogeneity among CTAs, with systematic trend followers doing significantly better than other subcategories. More importantly, we find that CTAs not only beat passive, normative benchmarks, with a yearly gross alpha of at least 5.3% but also generate significant, incremental crisis alpha during periods of equity market turmoil. Finally, we show that cross-sectional differences in the performance of CTAs are persistent up to three years and that managerial compensation predicts fund performance. Our results are consistent with a rational market where investors compete to invest with successful CTA managers who use fees to signal their skills to investors.

Portfolio Pumping in Mutual Fund Families

Pingle Wang
,
University of Rochester

Abstract

I document portfolio pumping at the fund family level, a strategy that non-star fund managers buy stocks held by star funds in the family to inflate their performance at the quarter end. Families that heavily employ the strategy show strong evidence of inflated performance after 2002, when the SEC increased regulation on portfolio pumping at the fund level. Non-star fund managers pumping for star funds in the family receive 1.8% ($24 million) more inflows per quarter, conditional on the performance. Furthermore, pumping is concentrated in stocks that are buried deep down in the holdings of star funds.

Price Response to Factor Index Additions and Deletions

Georgi Kyosev
,
Erasmus University Rotterdam
Joop Huij
,
Erasmus University Rotterdam

Abstract

Abnormal price reaction around S&P 500 index changes has been considered as strong evidence that long term demand for stocks is downward sloping. This notion, however, has recently lost popularity due to the evidence that new additions are accompanied with a contemporaneous change in future earnings expectations. In this study we show that factor index rebalancing is a true information free event. The cumulative abnormal return from announcement to effective day is 1.07% for new additions and -0.91% for new deletions and around two-thirds of this effect is permanent. We find a direct relationship between the magnitude of abnormal returns and the abnormal volume coming from index funds. The documented effect results in a direct loss to index fund investors of 16.5 bps per annum.

Product Market Competition and the Profitability Premium

Yao Deng
,
University of Minnesota

Abstract

This paper studies the impact of product market competition on the positive relation between profitability and average stock returns. I find that profitability positively predicts returns, only among firms in competitive industries. This different performance is largely driven by firms' different exposures to investment-specific technology (IST) shocks. I develop a theory on competition, growth opportunities and expected returns. I show that market power lets firms better hedge IST shocks, thus lowering their risk exposures than firms in competitive industries. Empirical tests on investment responses confirm the model's predictions.

Public Pensions and State Government Debt Spreads

Chuck Boyer
,
University of Chicago

Abstract

I characterize the relationship between U.S. state government fiscal conditions, pension liabilities, and debt spreads. I find that public pension liabilities have a robust and statistically significant relationship with debt spreads. A one standard deviation change in the pension liability to GDP ratio is related to a a 18 basis point increase in CDS spreads, similar to the effect of an increase in bonded debt and equivalent to $20\%$ of the average total spread. States whose localities have higher pension liabilities also have higher spreads. Finally, I am unable to find strong evidence that states with more powerful unions pay higher borrowing costs. These findings highlight the fact that states are already paying for potential future pension problems in the form of higher borrowing costs.

Quantitative Easing and Equity: Evidence from the ETF Program of the Bank of Japan

Andrea Barbon
,
Swiss Finance Institute
Virginia Gianinazzi
,
Università della Svizzera italiana

Abstract

Since the introduction of its Quantitative and Qualitative Easing program in 2013, the Bank of Japan (BoJ) has been increasing its holdings of Japanese equity through large purchases of index-linked ETFs with the declared intention of "supporting asset prices and reducing the cost of capital" of domestic companies.
This program represents an ideal setting in which to clarify the mechanism through which unconventional monetary policy impacts asset prices, thanks to the rich and exogenous cross-sectional dimension of the purchase schedule and the long-term commitment of the central bank.
We exploit these unique features to develop our identification strategy, supported by an asset pricing model that accounts for the reduction in the free float induced by the program.
We document a positive, sizeable and persistent impact on stock prices, suggesting that demand curves for stocks are downward-sloping in the long-run.
We estimate 20 basis points increase in aggregate market valuation per trillion Yen invested into the program as a lower bound for the net effect of the policy. Finally, we show theoretically and empirically that the weighting scheme of the BoJ portfolio, tilted towards the price-weighted Nikkei 225 index, generates significant pricing distortions consistent with the portfolio balance channel.

Relationship Lending in Shadow Banking: Impacts of Financial Firms' Cross-Holding Relation in Money Market Funds

Ai He
,
Emory University

Abstract

This paper explores the nature and impacts of shadow banks' relationship lending by analyzing bilateral-connected financial firms who crossly hold each other's debt through their own affiliated money market funds (MMFs). Using novel MMFs' monthly holdings data, I show that, in the context of 2011 Eurozone crisis, non-European financial firms surprisingly increased their MMFs' stakes on bilateral-connected European financial firms, while MMFs generally reduced their exposure to European issuers. I provide evidences that this bias represents reciprocity between the bilateral-connected financial firms. In return, the European financial firms, through their affiliated MMFs, accepted more insecure debt than secure ones from their non-European partners during the same period. Issuer- or fund-characteristics do not explain the results. A further investigation shows that the cross-holding relation affects also issuers unconnected with MMFs, because they are unable to raise money from new funds in a short time after their old lenders cut off the financing.

Investor Sentiment and Stock Return Comovement: the Role of Information and Innovation

Haohan Ren
,
Chinese University of Hong Kong

Abstract

I find that stock return comovement following positive investor sentiment is lower than that following negative investor sentiment. Further analysis suggests that this difference is associated with higher firm-specific information production and innovation output following positive sentiment. Specifically, following positive investor sentiment, the media and financial analysts produce more firm-specific information, short sellers and institutional investors conduct more informed trading, and firms produce more innovations. Various cross-sectional tests confirm that the difference in information production and innovation output indeed contributes to the difference in comovement between positive sentiment periods and negative sentiment periods. Overall, my results shed light on the nontrivial role of information producers and innovation generators in shaping the relation between sentiment and comovement.

Sharing the Pain? Credit Supply and Real Effects of Bank Bail-ins

Thorsten Beck
,
City University of London and CEPR
Samuel Da-Rocha-Lopes
,
European Banking Authority and Nova SBE
Andre Silva
,
City University of London

Abstract

We analyze the credit supply and real sector effects of bank bail-ins by exploiting the unexpected failure of a major bank in Portugal and its subsequent resolution. Using a unique dataset of matched firm-bank data on credit exposures and interest rates from the Portuguese credit register, we show that while banks more exposed to the bail-in significantly reduced credit supply after the shock, affected firms were able to compensate this credit contraction with other sources of funding, including new lending relationships. Although there was no loss of external funding, we observe a moderate tightening of credit conditions as well as lower investment and employment at firms more exposed to the intervention, particularly SMEs. We explain the latter real effects by higher precautionary cash holdings due to increased uncertainty.

Should Corporate Pension Funds Invest in Risky Assets?

Wei Li
,
University of Iowa
Tong Yao
,
University of Iowa
Jie Ying
,
University of Iowa

Abstract

Should defined-benefit corporate pension plans invest in risky assets at all? This issue has always been subject to debate, and risky pension asset allocation frequently causes concerns. In this study, we model corporate pension decisions in a setting where a firm balances its risk management concern with employees' preference for systematic risk exposure. For a reasonable set of parameter values, the optimal pension investment risk and its relations with a firms' bankruptcy probability and pension funding ratio predicted by the model are consistent with empirical observations. We show that the inefficiency in systematic risk sharing by typical defined benefit plans may cause pensions to take even more investment risk than what employees desire if they were to manage their own retirement wealth. Further, firms may substantially reduce their overall pension funding costs under an alternative arrangement with employees bearing all systematic investment risk. This is consistent with the observed shift from defined benefit plans to defined contribution plans.

Strategic Patenting and Debt Financing

Ailin Dong
,
Hong Kong University of Science and Technology

Abstract

This paper studies whether financially constrained R&D firms strategically file patent applications to relieve borrowing constraints. We present evidence that firms choose to file for more patents when they encounter financial crisis and have difficulties in rolling over their long term debt, when their lending bank goes bankrupt, and when their lending banks face foreign capital shocks. The effect of increased patent applications when firms are financially constrained is more pronounced when the expected time of patent grants is shorter, among firms that are less creditworthy in the debt market, and when firms have a higher proportion of public debt on their balance sheet. These findings are consistent with the notion that patent can be used as collateral in debt financing, and firms use patent applications as a strategic tool to mitigate financial constraints.

Structural Breaks in the Variance Process and the Pricing Kernel Puzzle

Tobias Sichert
,
Goethe University Frankfurt

Abstract

Numerous empirical studies agree that the pricing kernel derived from option prices is not monotonically decreasing in index returns, but disagree whether it is U-shaped or S-shaped. This is not only empirically inconsistent, but the two observations also seem theoretically incompatible. In particular, the S-shape is conflicting with most modern asset pricing models. By providing novel time series evidence, this paper reconciles the so far conflicting empirical results. I show that the finding of S-shaped pricing kernels is spurious and is removed by including structural breaks in the data generating process into the estimation. In the sample period from 1992-2015 I identify five different high or low variance regimes. Conditional on the regime, the obtained pricing kernels appear U-shaped, while the S-shaped pricing kernels consistently disappear. The results are robust to numerous variations in the methodology. The empirical results can be explained by a variance-dependent pricing kernel, with structural breaks as a necessary component. Lastly, the results show that the fit of the option pricing model increases substantially when breaks are introduced.

Textual Disclosure in SEC Filings and Litigation Risk

Arup Ganguly
,
University of Pittsburgh

Abstract

Prior studies are quite ambivalent on the relation between disclosure and litigation risk since greater disclosure can be perceived as either ex ante deterrent or ex post misleading. I hypothesize that more information is disclosed in the non-numerical narratives in SEC filings than that has been analyzed in the extant literature. Using a comprehensive hand-collected data on federal securities class action lawsuits spanning nearly two decades, propensity-score matched sample, and widely used measures in natural language processing (NLP) that capture degree, readability and sentiments in textual disclosures, I find results consistent with the theoretical view that argues that more and difficult to comprehend disclosure is often perceived as ex post misleading, hence, precipitating litigations. After controlling for other numerical variables, these results are robust to various empirical specifications using difference-in-differences (DiD) and principal component analysis (PCA). Such findings indicate that there is a need to distinguish between more versus better disclosure.

Asset Pricing in the Information Age: Employee Expectations and Stock Returns

Jinfei Sheng
,
University of British Columbia

Abstract

This paper studies the investment value of non-professional forecasts in financial markets, using a unique dataset of nearly one million employee reviews. Employee beliefs about their employers' business prospects predict future returns at one- to five-month horizons, delivering an annualized abnormal return of 7% to 9%. The abnormal returns do not reverse during a 12-month holding period. Employee reviews are related to firms' fundamentals because they predict cash flow news. In addition, the reviews predict future trading activity by hedge funds, suggesting some sophisticated investors exploit this information or its underlying sources. There are information hierarchies within firms in the sense that the return predictability of forecasts increases with employee rank. Overall, this paper highlights the role of non-experts in forecasting firms' fundamentals through online platforms, which is beyond traditional information intermediaries such as equity analysts.

The First-Time in Private Equity: Does Experience Help to Raise Capital?

Florian Fuchs
,
University of St. Gallen

Abstract

Compared to mature investment firms, first-time funds in private equity lack an investment and performance track record, and require alternative signals to establish initial trust with investors. The paper finds that investors allocate more capital to first-time funds if they have a higher share of managers with relevant experience, such as from another private equity group or a bank. In particular, experience from high-reputation employers raises the fundraising outcome, while the relevance of experience with the same previous firm, heterogeneity in the exposure, and operational experience is limited at best.

Impact of Financial Markets on Payout Policy: Evidence from Short Selling

Bill Francis
,
Rensselaer Polytechnic Institute
Gilna Samuel
,
Rensselaer Polytechnic Institute
Qiang Wu
,
Rensselaer Polytechnic Institute

Abstract

This paper investigates the impact of the stock-price formation process on payout policy using the Regulation SHO pilot program which removed short selling constraints and increased the prospect of short selling for a random sample of pilot firms. We find that pilot firms are more likely to increase payouts during this program. Subsequent to the ending of the program, these firms continue to pay dividends but are less likely to increase dividends or repurchase shares. Consistent with signaling and agency-based models, our results are more pronounced for firms with higher information asymmetry and weaker governance. Importantly we find that pilot firms are less likely to smooth dividends and that dividends are more likely to be financed through debt when the prospect of short selling increases. Overall, this study shows that stock price dynamics within the secondary financial market have a significant and long-lasting impact on firms’ payout policy.

Complementarity of Passive and Active Investment on Stock Price Efficiency

Youngmin Choi
,
Georgia Institute of Technology

Abstract

I investigate the collective impact of passive and active investment on stock price efficiency using a quasi-natural experiment. I document an improvement in efficiency due to an exogenous increase in passive investment, specifically in stocks widely held by actively managed funds. These active funds are compensated with higher realized returns after an exogenous increase in passive investment. I use the reconstitution of Russell indexes as an instrument. My findings suggest that active funds seek out inefficient stocks and ultimately experience superior returns due to the improvement in efficiency from passive investment. An increase in analyst following and a decrease in analyst forecast dispersion are identified as economic channels of the efficiency improvement. Overall, my results highlight the complementary role of passive and active investment on price discovery due to symbiotic nature of their existence.

The Shine of Star: The Effect of Star Analyst Title on Market Reaction to Financial Analysts' Stock Recommendations

Runjing Lu
,
University of California-San Diego

Abstract

This paper studies how the award-winning titles of financial analysts affect the market reaction to their recommending stocks using a regression discontinuity (RD) design and a novel dataset. We find that, right after the award ceremony, investors react positively to the stocks previously recommended by winners, but negatively to the stocks recommended by finalists who fall short of being winners (failed finalists). We provide suggestive evidence that informed traders may know the list of finalists and buy their recommending stocks in the week before the ceremony, but sell the stocks by failed finalists after the ceremony. We further show that both the initial negative reaction to failed finalists and the positive reaction to winners completely reverse back to zero within six weeks after the ceremony. However, the market continues reacting more positively to subsequent stocks recommended by winners within one year after the ceremony, though the effect is much smaller. The short-term overreaction to star title and the speculative tradings around the announcement indicate that the star analyst award is a new factor generating excessive volatility and inefficiency in the market.

The Term-Structure of Systematic Risk

Nuno Clara
,
London Business School

Abstract

Using information embedded in option prices, we uncover the existence of a non-trivial term-structure of betas for individual stocks and portfolios. The slope of this term-structure is a priced factor in the cross-section of returns and spikes following relevant macroeconomic and firm-specific events. The slope of the term-structure of systematic risk is mainly driven by the slope of the term-structure of variance swaps. An investment model with uncertainty shocks in the spirit of Bloom (2009) can quantitatively explain the relation between the time-series and cross-sectional dynamics of the term-structure.

Trade Induced Productivity Change and Asset Prices

Ruchith Dissanayake
,
University of Alberta

Abstract

This study proposes a novel measure of trade induced productivity change and assesses its implications on macroeconomic dynamics and equity returns. Trade induced productivity leads to low consumption states since, in the short-run, resources are reallocated from consumption towards exports and investment. The decrease in terms-of-trade exacerbates the short-term effects on consumption. Assets with high sensitivity to the shock have lower expected returns since their payoffs co-vary negatively with investor's consumption. I show that the negative premium is stronger among high investment firms. Risk premium associated with the shock is robust to the inclusion of a multitude of other factors.

Trading Complex Risks

Felix Fattinger
,
University of Melbourne

Abstract

Complex risks differ from simple risks in that agents facing them only possess imperfect information about the underlying objective probabilities. This paper studies how complex risks are priced by and shared among heterogeneous investors in a Walrasian market. I apply decision theory under ambiguity to derive robust predictions regarding the trading of complex risks in the absence of aggregate uncertainty. I test these predictions in the laboratory. The experimental data provides strong evidence for theory’s predicted reduction in subjects’ price sensitivity under complex risks. While complexity induces more noise in individual trading decisions, market outcomes remain theory-consistent. This striking feature can be reconciled with a random choice model, where the bounds on rationality are reinforced by complexity. When moving from simple to complex risks, equilibrium prices become more whereas risk allocations become less sensitive to noise introduced by imperfectly rational subjects. Markets’ effectiveness in aggregating beliefs about complex risks is determined by the trade-off between reduced price sensitivity and reinforced bounded rationality. Moreover, my results imply that complexity has similar but more pronounced effects on market outcomes than ambiguity induced by conventional Ellsberg urns.

What Causes Passive Hedge Funds to Become Activists?

Marco Elia
,
Drexel University

Abstract

About 20% of the total activist hedge funds’ positions are initiated as passive holdings, that is without the intention of changing or influencing the control of the target firms. At some point, however, the hedge funds change their filing status and switch to activism. My paper investigates what triggers this switch. I hypothesize and find that hedge funds see the purchase price of their passive positions as a reference point. When hedge funds are suffering losses on these positions, they are more likely to switch to become activists, even after controlling for the firms’ underperformance. This study presents new evidence about what causes hedge fund activism.

When to Introduce Electronic Trading Platforms in Over-the-Counter Markets?

Sebastian Vogel
,
Ecole Polytechnique Federale de Lausanne and Swiss Finance Institute

Abstract

I study a hybrid over-the-counter (OTC) market structure in which traders have the choice of obtaining an asset either in a bilateral market or on an electronic trading platform. In a hybrid market (HM), turnover is higher and expected prices are lower than in a pure bilateral market (PBM). I present sufficient conditions under which dealers' profits are higher in the HM than in the PBM and vice versa. Dealers can increase their profits in the HM by colluding to keep their activity on the platform at a certain level. The model also delivers several other empirical implications regarding prices, trading volume and the traders' choices of trading venue under the two different market structures.

Why Can't CEOs Foresee a Crisis?

Kaushalendra Kishore
,
University of Minnesota

Abstract

This paper explains why CEOs are unable to curtail risky investments before a crisis. CEOs rely on the advice of their employees to understand the riskiness of their investments. When employees observe noisy signals, they may be reluctant to disclose their information for the fear of getting fired. So, the CEO needs to offer a contracts which provides incentive to disclose their information. The paper shows that in presence of moral hazard with respect to effort, it may not be possible to offer contracts which also incentivizes disclosure. Even when CEOs are able to offer such contract, there will be a coordination problem in disclosure of information. These frictions are accentuated when the prior beliefs about an investment strategy being good is high. If the task of disclosing signals is separated and assigned to a risk manager who receives signals of same quality, it can result in more efficient outcomes.
JEL Classifications
  • G0 - General