Working Papers

2022


Working Paper No. 2202: India's Strategy for Achieving Net Zero

Authors: Nirvikar Singh

Abstract: 

This paper reviews and assesses India’s energy policy in the context of its commitment to achieve the target of Net Zero carbon emissions by 2070. It discusses policies outside the energy sector that need to be part of a strategy of achieving this target. Furthermore, it examines possible policy options for accelerating the target date to 2050. The paper also discusses the possible financial and growth implications of various strategy options.

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Working Paper No. 2201: Climate Risks and FDI

Authors: Grace Weishi Gu; Galina Hale

Abstract: 

Climate-related risks have increased in recent decades, both in terms of the frequency of ex-treme weather events (physical risk) and implementation of climate-change mitigation policies(transition risk). This paper explores whether multinational firms react to such risks by alteringtheir presence in countries that are more affected. We measure this by examining foreign directinvestment (FDI) dynamics in the aggregate as well as at firm level. We propose a theoret-ical framework for firm production location choice that explicitly incorporates transition andphysical risks. The model predicts a reduction in FDI resulting from both physical risks andtransition risks but an ambiguous interaction effect of these risks with emission productivity.These predictions are largely consistent with our empirical findings. But, in an extensive em-pirical analysis at six levels of aggregation we find only a minimal set of statistically significanteffects of physical and transition risks on multinational firms’ location decisions. Our firm-levelresults, however, suggest that growing attention to climate risks is likely to increase effects ofsuch risks on FDI going forward.

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2021


Working Paper No. 2111: Capital Account Liberalisation in a Large Emerging Economy: An Analysis of Onshore-Offshore Arbitrage

Authors: Nidhi Aggarwal, Sanchit Arora, Rajeswari Sengupta

Abstract: 

In this paper, we decipher the openness of India’s capital account by calculating the covered interest parity (CIP) deviations between the onshore-offshore rupee market. India is a country with an elaborate and comprehensive system of capital controls covering all kinds of international financial transactions. This has led to a thriving offshore rupee market of non-deliverable currency forward (NDF) contracts. We analyse more than 20 years (1999-2020) of daily return differentials in the NDF market vis-a-vis the onshore spot market, estimate structural breaks in CIP deviations and connect the sub-periods so obtained to the patterns of changes in de-jure capital control actions announced by the Indian authorities. We also estimate no-arbitrage bands around the CIP using a Self-Exciting Threshold Autoregressive (SETAR) model. We find that on average over the duration of our sample period the capital controls broadly restrict capital outflows more than they restrict capital inflows. While over time India has become more financially integrated with the rest of the world, the process of capital account opening has not been a continuous and smooth one. This is reflected in large variations in CIP deviations across the period. In recent times the deviations have become smaller and the no-arbitrage bands that capture the transactions costs and the degree to which the capital controls are binding have become narrower.

 

Working Paper No. 2110: Analysing India's Exchange Rate Regime

Authors: Ila Patnaik, Rajeswari Sengupta

Abstract: 

We analyse India's exchange rate regime through the prism of exchange market pressure. We estimate the various regimes that India’s de-facto exchange rate has been through during the period from 2000 to 2020. We find four specific regimes of the Indian rupee differentiated by the degree of flexibility of the exchange rate. We document the manner in which EMP in India has either been resisted through foreign exchange market intervention, or relieved through exchange rate change, across these four defacto exchange rate regimes. In particular, we find that after the 2008 global financial crisis the rupee-dollar exchange rate was relatively more flexible and the share of exchange rate in EMP absorption was the highest. After 2013 there was a change in the way the EMP was absorbed. The exchange rate was actively managed using spot as well as forward market intervention. We also find that the response of the RBI to EMP has been asymmetric. When there is pressure to appreciate, t he RBI has typically responded by purchasing reserves. On the other hand, in the periods in which there has been pressure to depreciate, only a tiny fraction of reserves are used for resisting the pressure. Such pressure is absorbed by rupee depreciation.

 

Working Paper No. 2109: Stock Market Spillovers via the Global Production Network: Transmission of U.S. Monetary Policy

Authors: Julian DiGiovanni, Galina Hale

Abstract: 

We quantify the role of global production linkages in explaining spillovers of U.S. monetary policy shocks to stock returns across countries and sectors using a newly constructed dataset. Our estimation strategy is based on a standard open-economy production network model that delivers a spillover pattern consistent with a spatial autoregression (SAR) process. We use the SAR model to decompose the overall impact of U.S. monetary policy on global stock returns into a direct and a network effect. We find that nearly 70% of the total impact of U.S. monetary policy shocks on country-sector stock returns are due to the network effect of global production linkages. Our results are robust to changes in the definitions of stock returns and monetary policy shocks, to controlling for correlates of the global financial cycle, foreign monetary policy shocks, and to alternative empirical specifications.

 

Working Paper No. 2108: Currency-Induced External Balance Sheet Effects at the Onset of the COVID-19 Crisis

Authors: Galina Hale, Luciana Juvenal

Abstract: 

At the onset of the COVID-19 economic crisis, as in other crisis episodes, the flight to safety was accompanied by a rapid appreciation of "safe haven" currencies. We quantify currency-induced balance sheet effects for total external positions as well as for individual asset classes using new data on the currency composition of cross-border assets for 48 countries for the first quarter as well as full year 2020. For the first quarter of 2020 we also conduct the stock-flow reconciliation of net international investment positions to measure overall valuation effects. We show that for many countries currency-induced valuation gains mitigated losses that resulted from declining asset prices in the first quarter of 2020. Moreover, for countries with excess capital outflows during this period, the impacts on external balance sheet positions were mitigated by valuation gains. This is because, in contrast with past financial crises, many emerging markets did not experience negative external balance sheet effects from their currency depreciation, partly due to currency-induced valuation gains on equity positions offsetting losses on debt positions, partly due to reduced currency mismatch on their external debt positions.

  

Working Paper No. 2107: Understanding the Black-White Wealth Gap in the United States

Authors: Nirvikar Singh

Abstract: 

This paper examines the relationship between wealth holdings and patterns of various household characteristics, including education, occupation, wealth portfolio structures and inheritance. The focus is on comparing the wealth levels of Black and White Americans, and relating differences in these levels to socio-economic characteristics. We find that a combination of inheritance, education and occupation is significantly related to differences in wealth levels. However, household characteristics such as education, homeownership or business ownership are not by themselves pathways to reducing wealth gaps, let alone eliminating them. Financial literacy also does not appear to play a role in explaining the wealth gap.

Link: External Link

 

Working Paper No. 2106: Firm-Bank Linkages and Optimal Policies in a Lockdown

Authors: Anatoli Segura, Alonso Villacorta

Abstract: 

We develop a novel framework that features loss amplification through firm-ban linkages. We use it to study optimal intervention in a lockdown that creates cash shortfalls to firms, which must borrow from banks to avoid liquidation. Firms’ increase in debt reduces firms’ output due to moral hazard. Banks need safe collateral to raise funds. Without intervention, aggregate risk constrains bank lending, increasing its cost and amplifying output losses. Optimal government support must provide sufficient aggregate risk insurance, and can be implemented with transfers to firms and fairly-priced guarantees on banks’ debt. Non-priced bank debt guarantees and loan guarantees are suboptimal policies.

Working Paper No. 2105: Measuring Monetary Policy Shocks in India

Authors: Aeimit Lakdawala and Rajeswari Sengupta

Abstract: 

We create new measures of monetary policy shocks for India using high-frequency derivatives data and study their transmission. These shocks capture two distinct dimensions of the Reserve Bank of India's (RBI) monetary policy announcements. In addition to reacting to surprise changes (or non-changes) in the RBI's policy rate, financial markets also infer substantial information about the future path of the policy rate from RBI's communication. We analyze official statements and the corresponding media narrative on prominent RBI announcement dates to help understand how markets use RBI communication to update their expectations. Overall, bond and stock markets react strongly to these monetary shocks, but exhibit notable heterogeneity across governor regimes. Finally, we use the monetary shocks as external instruments to identify the impact on macroeconomic variables in a structural vector autoregression. We find some evidence of the conventional transmission of monetary policy to prices but not to output.

Working Paper No. 2104: Leveraging Overconfidence

Authors: Brad Barber, Xing Huang, Jeremly Ko, Terrance Odean

Abstract: 

In theory, investors who have low security selection ability trade more, use leverage more, and perform worse if they are overconfident. We confirm these predictions empirically by analyzing the overconfidence, trading, and performance of retail investors who use margin. Using survey data, we measure overconfidence as the difference between an investor’s self-assessment of knowledge and tested knowledge; margin investors have greater overconfidence than cash investors. Using broker data, we find margin investors trade more, speculate more, and have worse security selection ability than cash investors. A long-short portfolio that follows the trades of margin investors loses 35 bps per day.

 

Working Paper No. 2103: Attention Induced Trading and Returns: Evidence from Robinhood Users

Authors: Brad Barber, Xing Huang, Terrance Odean, Christopher Schwarz

Abstract: 

We study the influence of financial innovation by fintech brokerages on individual investors’ trading and stock prices. Using data from Robinhood, we find that Robinhood investors engage in more attention-induced trading than other retail investors. For example, Robinhood outages disproportionately reduce trading in high-attention stocks. While this evidence is consistent with Robinhood attracting relatively inexperienced investors, we show that it can also be partially driven by the app’s unique features. Consistent with models of attention-induced trading, intense buying by Robinhood users forecast negative returns. Average 20-day abnormal returns are 4.7% for the top stocks purchased each day.

Link: External Link

 

Working Paper No. 2102: Resolving a Paradox: Retail Trades Positively Predict Returns but are Not Profitable

Authors: Brad Barber, Shengle Lin, Terrance Odean

Abstract: 

Retail order imbalance positively correlates with returns in the days following trades. However, in aggregate, retail investor trades lose money over these same periods. Why? 1) While order imbalance tests value or equally weight stocks, retail purchases are concentrated in stocks earning large negative abnormal returns. 2) Order imbalance tests ignore losses on the day of trade. Our results reconcile the literatures on the performance of retail investors, the predictive content of retail order imbalance, and attention-induced trading and returns. We also find evidence that trades by retail investors with less knowledge, experience, and wealth are more likely to underperform.

Link: External Link

 

Working Paper No. 2101: Costly Information and Sovereign Risk

Authors: Grace Gu, Zachary Stangebye

Abstract: 

 When investors' costly information acquisition and the sovereign's default decision are jointly endogenous, sovereign bond spread exhibits significant state-contingency and time-variation in its volatility. Without considering such state-contingent investor information acquisition behavior, model-based estimates of default risk from spread data could be downward biased during crisis periods. The welfare effects of costly information are small but non-monotone, as greater transparency can make the country mildly worse off by inducing more price volatility and default.

 

2020


Working Paper No. 2003: The Evolution of Offshore Renminbi Trading: 2016 to 2019

Authors: Yin-Wong Cheung, Louisa Grimm, Frank Westermann

Abstract: 

We study the evolution of offshore renminbi trading between 2016 and 2019. The geographical pattern of changes in offshore renminbi trading during this period is different from the one between 2013 and 2016. The pattern of changes in the 2016-2019 period, in addition to the previously reported convergence to the geographical trading pattern of all currencies, is affected by (geopolitical) disputes and trade intensity. Further, China-specific RQFII investment quota arrangements and offshore market’s equity market capitalization and level of financial development play a role in shaping the offshore RMB trading pattern.

 

Working Paper No. 2002: A Decade of RMB Internationalization

Authors: Yin-Wong Cheung

Abstract: 

This article recounts China’s renminbi (RMB) internationalisation experiences since the 2009 RMB cross-border trade settlement initiative. In the first few years, the RMB made inroads into global financial markets and had a few remarkable accomplishments, including the Special Drawing Right currency status. Since the 2015 market turmoil, RMB internationalisation has levelled off – possibly due to changes in both domestic and geopolitical conditions. The RMB is currently under-represented in the global market. China’s deliberate and schematic policies will elevate the RMB’s global stature in a gradual manner but there will not be a leapfrogging in the near term.

 

Working Paper No. 2001: The Paradox of Safe Asset Creation

Authors: Anatoli Segura, Alonso Villacorta

Abstract: 

We build a competitive equilibrium model of safe asset creation through securitization. Securitization vehicles create safe assets by pooling idiosyncratic risks from loan originators. Equity investors allocate their wealth between originators, who need skin-in-the-game, and vehicles, who need loss-absorption capacity against aggregate risk. When debt investors accept risk, all equity is invested in originators, while when they demand safe assets, some equity is reallocated towards vehicles. Safe asset creation may, paradoxically, increase the risk of originated loans and reduce expected output. Our model is consistent with a broad set of facts in the run-up to the global financial crisis.

Link: pdf

 

2019








 

Working Paper No. 61: Geographic Spread of Currency Trading: Th Renminbi and Other EM Currencies

Authors: Yin-Wong Cheung, Robert McCauley, Chang Shu



Abstract: 

This paper studies the ongoing diffusion of renminbi (RMB) trading across the globe, the first of such research of an international currency. It analyses the distribution in offshore RMB trading in 2013 and 2016 using comprehensive data from the Triennial Central Bank Survey of foreign exchange markets. In 2013, Asian centers favored by the policy of RMB internationalization had disproportionate shares in global RMB trading. Over the following three years, RMB trading seemed to converge to the spatial pattern of all currencies, with a half-life of seven to eight years. The previously most traded emerging market currency, the Mexican peso, shows a similar pattern, although it is converging to the global norm more slowly. Three other emerging market currencies show a qualitatively similar evolution in the geography of their offshore trading. Overall the RMB’s internationalization is tracing an arc from the influence of administrative measures to the working of market forces.



Link:

External Link

 

Working Paper No. 60: Truths and Myths about the RMB Misalignment: A Meta-Analysis

Authors: Yin-Wong Cheung, She He

Abstract: 

We conduct a meta-regression analysis of 69 studies that generated 937 renminbi (RMB) misalignment estimates. The Bayesian Model Averaging (BMA) approach is adopted to allow for model selection and sampling uncertainties in assessing effects of study characteristics on these RMB misalignment estimates. Misalignment estimates are found to be influenced by the eight selected study characteristic types. The RMB misalignment estimates from models with various hypothetical combinations of study characteristics, however, are mostly insignificantly different from zero. It is also shown that the set of significant study characteristics is sensitive to the use of the least squares estimation method.

 

Working Paper No. 59: The Hoarding of International Reserves: It’s a Neighborly Day in Asia

Authors: Yin-Wong Cheung, XingWang Qian, Eli Remolona

Abstract: 

To explain why Asian countries seem to have been hoarding international reserves, especially since the 1997 crisis, we consider various regional neighborhood effects. One such effect is that of “catching up with the Joneses” as documented by Cheung and Qian (2009). We revisit that effect by analyzing several refinements of it. We also consider the fear of the kind of contagion that the crisis-hit countries saw in 1997. Finally, we look at the possibility of a regional financial cycle, in which the conditions that led to the crisis might have been correlated across countries. We find that refining the Joneses effect to take account of trade links strengthens its power to explain the build-up of reserves. We also observe that a country that finds itself more vulnerable than its regional neighbors would tend to accumulate more reserves. Finally, we find that a common regional factor related to current-account balances spurs further reserve accumulation. Contrary to previous analyses, our results suggest that only a couple of Asian countries have been holding excessive reserves. Some were actually holding less reserves than would be optimal in the presence of neighborhood effects.

 

Working Paper No. 58: The Interest Rate Effect on Private Saving: Alternative Perspectives

Authors: Joshua Aizenman, Yin-Wong Cheung, Hiro Ito

Abstract: 

Lowering the policy interest rate could stimulate consumption and investment while discouraging people from saving. However, such a move may also prompt people to save more to compensate for the low rate of return. Using the data of 135 countries from 1995 to 2014, we show that a low-interest rate environment can yield different effects on private saving under different economic environments. The real interest rate affects private saving negatively if output volatility, old-age dependency, or financial development is above a certain threshold. Depending on a country’s specific economic circumstances, these effects are significant for the economy—a four-percentage point decline in the real interest rate, which is approximately the same as one standard deviation for China, would lead to a 1.52 percentage point increase in the Chinese private saving rate. Further, when the real interest rate is below 1.1%, greater output volatility would lead to higher private saving in developing countries.

 

Working Paper No. 57: A Jackknife Model Averaging Analysis of RMB Misalignment Estimates

Authors: Yin-Wong Cheung, Wenhao Wang

Abstract: 

We adopt the Jackknife Model Averaging (JMA) technique to conduct a meta-regression analysis of 925 renminbi (RMB) misalignment estimates generated by 69 studies. The JMA method accounts for model selection and sampling uncertainties, and allows for non-nested model specifications and heteroskedasticity in assessing effects of study characteristics. The RMB misalignment estimates are found to be systematically affected by the choices of data, the theoretical setup and the empirical strategy, in addition to publication attributes of these studies. These study characteristic effects are quite robust to the choice of benchmark study characteristics, to alternative model averaging methods including the heteroskedasticity-robust Mallows approach, the information criterion approach, and the Bayesian model averaging. In evaluating the probabilistic property of RMB misalignment estimates implied by hypothetical composites of study characteristics, we find the evidence of a misaligned RMB, in general, is weak.

 

Working Paper No. 56: A Tale of Two Surplus Countries: China and Germany

Authors: Yin-Wong Cheung, Sven Steinkamp, Frank Westermann

Abstract: 

We analyze current account imbalances through the lens of the two largest surplus countries; China and Germany. We observe two striking patterns visible since the 2007/8 Global Financial Crisis. First, while China has been gradually reducing its current account surplus, Germany’s surplus has continued to increase throughout and after the crisis. Second, for these two countries, there is a remarkable reversal in the patterns of exchange rate misalignment: China’s currency has turned from being undervalued to overvalued, Germany’s currency has erased its level of overvaluation and become undervalued. Our empirical analyses show that the current account balances of these two countries are quite well explained by currency misalignment, common economic factors, and country-specific factors. Furthermore, we highlight the global financial crisis effects and, for Germany, the importance of differentiating balances against euro and non-euro countries.

 

Working Paper No. 55: Capital Flight to Germany: Two Alternative Measures

Authors: Yin-Wong Cheung, Sven Steinkamp, Frank Westermann

Abstract: 

We use two measures to study two capital flight channels for Germany. One measure is based on the concept of trade misinvoicing and one on net claims and liabilities in the Eurosystem of central banks. For both measures, we propose refinements to enhance the assessment of capital flight. We find that capital flight towards Germany via these two channels has been quite sizable in the recent decade and can tally to about 2% of GDP annually. Regarding their determinants, we show that the two capital flight measures are driven by both common and measure-specific factors. Traditional determinants such as covered interest differentials only play a limited role, while crisis-specific factors such as economic policy uncertainty, the ECB collateral policy, as well as currency misalignment are driving factors of the investors’ apparent flight-to-safety behavior.

 

Working Paper No. 54: The Currency Composition of International Reserves, Demand for International Reserves, and Global Safe Assets

Authors: Joshua Aizenman, Yin-Wong Cheung, XingWang Qian

Abstract: 

This paper examines determinants of the international reserves (IR) currency composition before and after the Global Financial Crisis (GFC). Applying the annual data of 58 countries, we confirm that countries that trade more with the US, euro zone, UK, and Japan, and issue more debt denominated in the big four currencies (US dollar, euro, pound, and yen) hoard more IR in these currencies. We find scale effects in which countries tend to diversify from the big four currencies as they increase their IR/GDP and that a growing shortage of global safe assets (GSAs) induces countries to hold more big four currencies. Countries hold less big four currencies as IR after the 2008 GFC, while they hold more of such currencies since the tapering of the Fed’s quantitative easing (QE). The 2008 GFC and QE tapering weakened and sometimes reversed the effect of several economic factors. We also find that TARGET2 balances matter for the currency composition of IR in the euro zone; commodity-exporting countries tend to diversify their IR from the big four currencies when their terms of trade improve; and that the valuation effects induced by Euro/USD exchange rate changes diminish the significance of the GFC in explaining the currency composition of IR.

 

Working Paper No. 53: Analysing Monetary Policy Statements of the Reserve Bank of India

Authors: Aakriti Mathur, Rajeswari Sengupta

Abstract: 

In this paper we quantitatively analyse monetary policy statements of the Reserve Bank of India (RBI) from 1998 to 2017, across the regimes of five governors. We first ask whether the content and focus of the statements have changed with the adoption of inflation-targeting as a framework for conducting monetary policy. Next, we study the influence of various aspects of monetary policy communication on financial markets. Using natural language processing tools, we construct measures of linguistic and structural complexity that capture governor-specific trends in communication. We find that while RBI’s monetary policy communication is linguistically complex on average, the length of monetary policy statements has gone down and readability has improved significantly in the recent years. We also find that there has been a persistent semantic shift in RBI’s monetary policy communication since the adoption of inflation-targeting. Finally, using a simple regression model we find that lengthier and less readable statements are linked to both higher trading volumes and higher returns volatility in the equity markets, though the effects are not persistent.

Link: pdf

2018


Working Paper No. 52: Sweden’s Trilemma Trade-Offs

Authors: Orcan Cortuk

Abstract: 

In this paper, we empirically examine the theoretical concept of “impossible trinity” (financial trilemma) for Sweden for the period of 2010-2017. While doing this, we modified the Aizenman, Chinn and Ito approach by adding an extra interaction term to the main regression which shows whether these three policies are implemented in harmony without creating any trade-offs. Similarly, this interaction term also reflects the effectiveness of all supportive policies (i.e. hoarding international reserves, liquidity policies etc.) in order to eliminate the trade-offs between the monetary independence, exchange rate stability and capital openness. Our results indicate that the standard ACI approach is not sufficient in explaining Sweden’s economic policies and adding an interaction term to the main trilemma regression is both necessary and critical. From the latter perspective, the interaction term has a negative contribution indicating that Sweden could achieve to relax the binding trilemma trade-offs in this period. Lastly, our analysis continues by exploring the implications of the interaction term for inflation in a VAR and Granger Causality analyses where we find that interaction term has certain decreasing impact on inflation.

Link: pdf

Working Paper No. 51: Experiments in High-Frequency Trading: Testing the Frequent Batch Auction

Authors: Eric M. Aldrich and Kristian López Vargas

Abstract: 

Using laboratory experiments, we compare two leading financial market formats in the presence of high-frequency trading (HFT): the Continuous Double Auction (CDA), also known as the continuous limit order book, which organizes trade in the majority of equities, futures and currency exchanges around the world; and the Frequent Batch Auction (FBA), which gives equal time priority to orders received within a short batching period. Our evidence suggests that, relative to the CDA, the FBA (1) reduces predatory trading behavior, (2) disincentivizes investment in low-latency messaging technology, and (3) results in lower transaction costs. Further, volatility in minimum spreads and in liquidity is higher in CDA compared to the FBA. Finally, we examine transitory, off-equilibrium behavior. In the CDA, transitory changes in the environment affect market dynamics substantially more than in the FBA.

Link: pdf

Working Paper No. 50: Order Protection through Delayed Messaging

Authors: Eric M. Aldrich and Daniel Friedman

Abstract: 

Several financial exchanges have recently introduced messaging delays (e.g., a 350 microsecond delay at IEX and NYSE American) intended to protect ordinary investors from high-frequency traders who exploit stale orders. We propose an equilibrium model of this exchange design as a modification of the standard continuous double auction market format. The model predicts that a messaging delay will generally improve price efficiency and lower transactions cost but will increase queuing costs. Some of the predictions are testable in the field or in a laboratory environment.

Link: pdf

2017


Working Paper No. 49: FX spot and swap market liquidity and the effects of window dressing

Authors: Ingomar Krohn and Vladyslav Sushko

Abstract: 

This paper assesses liquidity conditions in foreign exchange (FX) spot and derivatives markets using intraday data against the background of FX dealers' response to recent regulatory changes. Given that FX swap markets are by some measures even deeper that the spot market, an assessment of FX liquidity requires taking such instruments into account. We find that spot and swap market liquidity is intimately linked. Furthermore, the co-movement between FX funding and market liquidity, as gleaned from the pricing of both types of instruments, has increased over time. This development relates to dealer balance sheet capacity. While top dealers continue to dominate liquidity provision in spot, they tend to pull back from market-making in FX swaps around regulatory reporting periods. This shifts market-making activity in FX derivatives towards smaller, more expensive and less informed, dealers, and also results in adverse spillovers to liquidity conditions in spot markets.

Link: pdf

Working Paper No. 48: Aggregation and Convergence in Experimental General Equilibrium Economies Constructed from Naturally Occurring Preferences

Authors: Sean Crockett, Daniel Friedman, and Ryan Oprea

Abstract: 

Prior laboratory experiments have studied general equilibrium economies constructed from “induced preferences” for artificial goods. We introduce new methods that allow us to study economies constructed instead from subjects’ actual, “homegrown” preferences. Our subjects reveal their preferences by choosing portfolios of Arrow securities from budget lines through fixed endowments for a series of prices. We then construct several different economies by sorting subjects according to their revealed preferences. The constructed economies exhibit a wide range of predicted outcomes, where predictions are competitive general equilibria given the revealed preferences. Perhaps surprisingly, in every one of our markets the predicted excess demand is well-behaved, and avoids the pathologies highlighted in the Sonnenschein-Mantel-Debreu theorem. (The main reason seems to be heterogeneity in revealed preferences.) Actual trade in the constructed economies using a tatonnement market institution closely tracks predictions in most markets. The exceptions occur in economies with severe wealth effects that generate excess demands that are flat relative to measured preference volatility.

Link: pdf

Working Paper No. 47: Industry-Level Home Bias

Authors: Chenyue Hu

Abstract: 

This paper examines the home bias phenomenon in international finance at the industry level. Using unique financial datasets, I calculate the sectoral home bias of 27 industries in 43 countries. The empirical findings include: (1) home bias is stronger when and where capital restrictions are greater, (2) nontradable sectors exhibit stronger home bias, and (3) home bias decreases in sectoral productivity, suggesting that investors show a stronger preference for domestic assets of less productive sectors. To rationalize this empirical finding, I build a model with a multi-sectoral setting to shed light on the implications of industrial structure for international portfolio choice.

Link: pdf

Working Paper No. 46: Industrial Specialization Matters: A New Angle on Equity Home Bias

Authors: Chenyue Hu

Abstract: 

This paper theoretically and empirically examines how industrial structure affects equity home bias. I embed portfolio choice in a multi-country, multi-sector Eaton-Kortum model in order to explore how sectoral productivity differences affect a country's risk exposure and hence influence home bias. The model predicts that investors from highly specialized economies who want to hedge their risk have a strong incentive to avoid domestic assets. I confirm the prediction with the data by finding that home bias is negatively correlated with a country's degree of industrial specialization. This finding unveils the interaction between intranational risk hedging across sectors and international risk hedging across countries.

Link: pdf

Working Paper No. 45: Are Credit Rating Agencies Discredited? Measuring Market Price Effects from Agency Sovereign Debt Announcements

Authors: Mahir Binici, Michael Hutchison, and Evan Weicheng Miao

Abstract: 

This paper investigates whether the price response to credit rating agency (CRA) announcements on sovereign bonds has diminished since the Global Financial Crisis (GFC). We characterize credit rating events more precisely than previous work, controlling agency announcements for the prior credit state – outlook, watch/review, or stable status as well as the level of the credit rating. Emphasizing the transition from one state to another allows us to distinguish between different types of announcements (rating changes, watch and outlook events) and their price effects. We employ an event study methodology and gauge market response by standardized cumulative abnormal returns and directional change statistics in daily credit default swap (CDS) spreads. We find that rating announcements provide a rich and varied set of information on how credit rating agencies influence market perceptions of sovereign default risk. However, we do not find evidence that markets have discounted the information value of these announcements since the GFC. Moreover, we find that accurate measurement of these effects depends on conditioning for the prior credit state of the sovereign bond.

Link: pdf

Working Paper No. 44: A Theoretical Model of the Investors Exchange

Authors: Eric M. Aldrich and Daniel Friedman

Abstract: 

Investors' Exchange LLC (IEX) is a newly approved public exchange that is designed to discourage aggressive high-frequency trading. We explain how IEX differs from traditional continuous double auction markets and present summary data on IEX transactions by trader class and order type. Our primary contribution is a simple analytic model of IEX as a constrained version of the continuous double auction. The model predicts that IEX will generally improve price efficiency and lower transactions cost while increasing delay costs. A subset of the model's predictions are testable in the field or in a laboratory environment.

Link: pdf

Working Paper No. 43: Financial Inclusion: Concepts, Issues and Policies for India

Author: Nirvikar Singh

Abstract: 

This paper lays out some of the basic concepts surrounding financial inclusion, including access to banking, digital payments and financial literacy, as well as markets for health insurance, crop insurance, agricultural credit, small firm finance, and microcredit/ microfinance. It goes on to discuss various empirical and institutional studies of these dimensions of financial inclusion in the context of developing countries. The paper then outlines several recent studies for India sponsored by the International Growth Centre, which pertain to these specific aspects of financial inclusion. Finally, the paper draws lessons for policy-making and future research directions. Important considerations that emerge from the overview are the significance of social and economic context, the need to consider behavioral biases connected to situations involving time and risk, the interaction of different dimensions of financial inclusion, the importance of details of policy design, and the limited understanding we still have of many of the factors underlying the functioning of financial markets.

Link: pdf

Working Paper No. 42: FOMC Sentiment Extraction and its Transmission to Financial Markets

Author: Raul Cruz Tadle

Abstract: 

I use Automated Content Analysis, adopted from computational linguistics and political science, to derive sentiments acquired from Federal Open Market Committee (FOMC) meeting documents. I assign an index to the minutes in order to determine if the sentiments obtained from the information therein can be classified as hawkish (analogous to improving economic conditions and stronger inflationary pressures) or dovish (related to deteriorating economic outlook and subdued price changes). I compare the sentiments of the discussions in the minutes to the sentiments of information in corresponding FOMC statements released immediately after the meetings and calculate the surprise component of the relative sentiments. I then evaluate how this news shock in the minutes impacts broad equity and real estate investment trust indices, as well as the exchange rate valuation of different world currencies against the U.S. Dollar. My findings indicate that financial assets respond to the minutes based on the type of news shock they contain and that financial markets react more significantly during the FOMC's date-based policy guidance period.

Link: pdf

Working Paper No. 41: Malleable Risk Preferences and Learning from Experience in an Asset Allocation Game

Authors: Sameh Habib

Abstract: 

Does experience modulate elicited risk preferences? How does experience shape expectations? This paper provides evidence that investors’ own experiences play a key role in shaping revealed risk preferences and the weighting of past observations when forming expectations. The results suggest that experiencing severe negative or positive returns leads subjects’ revealed preferences to become closer to risk neutrality, while subsequent asset allocation is affected primarily by subjects’ own returns relative to the market and not by the market experience itself, indicating that agents’ performance relative to a benchmark is what matters in shaping expectations.

Link: pdf

Working Paper No. 40: Does Competition Aggravate Moral Hazard? A Multi-Principal-Agent Experiment

Authors: Olga A. Rud, Jean Paul Rabanal, John Horowitz

Abstract: 

We conduct a Multi-Principal-Agent experiment to determine whether market structure affects intermediary behavior. The intermediaries (Agents) are perfectly informed regarding project types and can recommend that Principals either proceed or discontinue with a project. Agents earn revenues only when they recommend to continue. We find that monopolist Agents protect the interests of Principals better than when Agents compete. Our findings are robust to a significant fee increase. The results of our study apply to a number of economic and financial environments (e.g., money-managers and rating agencies) and provide additional evidence on the impact of market structure on individual incentives and equilibrium outcomes.

Link: pdf

Working Paper No. 39: Does competition affect truth-telling? An experiment with rating agencies

Authors: Jean Paul Rabanal 

Abstract:

We use an experimental approach to study the effect of market structure on the incidence of misreporting by credit rating agencies. In the game, agencies receive a signal regarding the type of asset held by the seller and issue a report. The sellers then present the asset, with the report if one is solicited, to the buyer for purchase. We find that competition among rating agencies significantly reduces the likelihood of misreporting.

Link: pdf

Working Paper No. 38: Do Oil Endowment and Productivity Matter for Accumulation of International Reserves?

Authors: Rasmus Fatum, Guozhong Zhu, Wenjie Hui 

Abstract:

We develop a dynamic stochastic optimization model with oil price shocks to show that countries with certain combinations of oil endowment and productivity have strong precautionary incentives to accumulate foreign reserves in response to oil price shocks. Using the Simulated Method of Moments to estimate the model we demonstrate how oil price shocks are absorbed by changes in foreign reserves which, in turn, leads to less variation in aggregate consumption. Along with productivity and oil endowment, we also consider as determinants of reserves holding conventional variables such as trade-to-GDP ratio and capital openness. Overall, our results suggest that productivity and oil endowment are potentially important determinants of foreign reserves that for some countries should be considered as complements to conventional determinants.

Link: pdf

Working Paper No. 37: The Pricing of Sovereign Risk Under Costly Information

Authors: Grace Weishi Gu, Zach Stangebye

Abstract:

We explore the consequences of costly information acquisition on the pricing of sovereign risk. We consider an environment in which lenders' information acquisition and the sovereign's default decision are jointly endogenous. We find that the model generates state- dependent allocation of investor attention, which has a number of implications: First, it serves as a microfoundation for country-specific time-varying volatility in the spread; second, it implies that model-based estimates of default risk from spread data will be negatively biased during crisis periods; and third, it suggests that some fiscal opacity, as opposed to full transparency, can improve sovereign welfare. We also contribute to the literature by developing an approach to identify the cost of information acquisition for structural model calibrations.

Link: pdf

2016


Working Paper No. 36: Do Credit Rating Agencies Provide Valuable Information in Market Evaluation of Sovereign Default Risk?

Authors: Mahir Binici and Michael Hutchison

Abstract:

This paper accesses the information value of the three largest credit rating agencies’ (CRA) announcements of sovereign credit rating changes, “outlook” changes and “watch” changes on market pricing of country default risk as embedded in credit default swap (CDS) spreads. A dynamic panel model is estimated with 56 advanced and emerging-market countries and monthly data over January 2004 through August 2012. This approach allows us to control for macroeconomic news in identifying the information value of the CRA announcements. We find marked asymmetries in market impact from watch and outlook designations; credit upgrades and downgrades; and across different CRA announcements. Credit rating downgrades and negative watch announcements have a large impact on CDS spreads even when controlling for macroeconomic and financial factors. Surprisingly, the effect of credit downgrades is substantially magnified if countries are placed on negative watch status prior to the credit rating change—presumably signaling rapidly deteriorating credit worthiness. Credit upgrades and positive watch/ outlook announcements, by contrast, have little impact on market prices. S&P and Fitch dominate Moody’s in terms of the impact of their credit announcements on CDS spreads. Negative CRA announcements have a large and persistent effect on the market perception of sovereign default risk, constituting important “news” to financial markets.

Link: pdf

Working Paper No. 35: The Flash Crash: A New Deconstruction

Authors: Eric M. Aldrich, Joseph A. Grundfest, and Gregory Laughlin

Abstract:

The "Flash Crash" of May 6th, 2010 comprised an unprecedented 1,000 point, five-minute decline in the Dow Jones Industrial Average that was followed by a rapid, disorderly recovery of prices. We illuminate the causes of this singular event with the first analysis that tracks the full order book activity at millisecond granularity. We document previously overlooked market data anomalies and establish that these anomalies Granger-caused liquidity withdrawal. We offer a simulation model that formalizes the process by which large sell orders, combined with widespread liquidity withdrawal, can generate Flash Crash-like events in the absence of fundamental information arrival.

Link: pdf 

Working Paper No. 34: A Dynamic Model of Firm Valuation

Authors: Natalia Lazzati and Amilcar A. Menichini

Abstract:

We propose a dynamic version of the dividend discount model, solve it in closed-form, and assess its empirical validity. The valuation method is tractable and can be easily implemented. We find that our model produces equity value forecasts that are, on average, very close to market prices, and explains a large proportion (around 83%) of the observed variation in share prices. Moreover, we find that a simple portfolio strategy based on the difference between market and estimated values earns considerably positive returns, on average. These returns are uncorrelated with the three risk factors in Fama and French (1993).

Link: pdf

Working Paper No. 33: Relative Spread and Price Discovery

Authors: Eric M. Aldrich and Seung Lee

Abstract:

We develop a theoretical model to highlight a previously unexplored mechanism of price discovery: relative minimum price increments for equivalent assets trading on distinct nancial exchanges. Although conventional wisdom dictates that futures market assets lead equities equivalents in terms of price formation, our model predicts that the opposite should be true when particular relative price conditions hold for the bids and offers of each asset. We develop a new empirical measure of price discovery which is suited to asynchronous, high-frequency transaction and quotation data, and apply it to the highly liquid E-mini/SPY pair in order to test the predictions of the model. Empirical evidence strongly supports the model and further demonstrates that relative minimum contract size plays an additional role in the formation of prices.

Link: pdf

Working Paper No. 32: Secondary Currency Acceptance: Experimental Evidence with a Dual Currency Search Model

Authors: Justin D. Rietz

Abstract:

I examine, in a controlled, experimental laboratory setting, the acceptance of a secondary currency when a primary currency already circulates in an economy. The underlying model is an indivisible good / indivisible money, dual currency search model similar to that in Kiyotaki and Wright (1993) and Craig and Waller (2000). In such models, there are two pure Nash equilibria - total acceptance or total rejection of the secondary currency - and one unstable, mixed equilibrium denoted as partial acceptance. This mixed equilibrium is considered an artifact of the indivisibility of money and goods in the model and is often ignored. I find that when barter between good holders is allowed, the equilibrium tends towards total rejection. Conversely, when barter is prohibited, the equilibrium tends towards total acceptance. However, in both cases, the economies as a whole display partial acceptance of the secondary currency.

Link: pdf

Working Paper No. 31: Bayesian Stochastic Volatility Models for High-Frequency Data

Authors: Georgi Dinolov, Abel Rodriguez, and Hongyun Wang

Abstract:

We formulate a discrete-time Bayesian stochastic volatility model for high-frequency stock-market data that directly accounts for microstructure noise, and outline a Markov chain Monte Carlo algorithm for parameter estimation. The methods described in this paper are designed to be coherent across all sampling timescales, with the goal of estimating the latent log-volatility signal from data collected at arbitrarily short sampling periods. In keeping with this goal, we carefully develop a method for eliciting priors. The empirical results derived from both simulated and real data show that directly accounting for microstructure in a state-space formulation allows for well-calibrated estimates of the log-volatility process driving prices.

Link: pdf 

Working Paper No. 30: Private Equity Performance, Fund Size and Historical Investment

Authors: Wentao Su

Abstract:

This paper discusses the performance pattern of US private equity fund from 2003 to 2013, measuring the effect of fund size and other fund characteristics as well as macroeconomic conditions on fund performance. The results shows that the number of historical investment decisively influences the performance of funds, and funds whose inception is at the peak of economic expansion seem to perform worse than those formed during other economic periods. Fund size effect is ambiguous in full sample specifications but appears to be concave with respect to return when we look at this relationship in segmentation. Overall, experience of investment plays an important role in continually improving the performance of the fund. More details of each investment within each fund are needed to further analyze the causality between fund total return, its investment characteristics and other unique factors.

Link: pdf

Working Paper No. 29: Underpricing, Institutional Investors and the JOBS Act

Authors: Wentao Su

Abstract:

Underpricing in IPOs, which is the first day stock price return, is a significant cost to the issuers of raising capital. The money left on the table also attracts attention from different financial players such as institutional investors and big underwriters for its profits and commissions. This paper reviews two hypotheses for IPO underpricing, the general information asymmetry theory that ‘underpricing’ is a consequence of investors needing to be compensated for uncertainty about the quality of the firm, and the more practical underwriter-institutional investor collusion that may explain the increase in underpricing in recent years. By studying underpricing in the context of the JOBS Act, a natural policy experiment that significantly reduces IPO disclosure requirement and yet increases the communication between institutional investors and issuers, I find that the JOBS Act increases the overall IPO underpricing 18 months after it was passed in 2012 compared to the same period before, in line with the traditional adverse selection phenomenon. However, empirical analysis shows underpricing also increases correspondingly with the rise in proportional shares of institutional investors in post-Act period, which supports the collusion hypothesis. The overall conclusion shows strong side effect of JOBS Act in terms of increasing underpricing to issuers and as a result more lucrative underwriting business.

Link: pdf

Working Paper 28: Determinants of Non-Performing Loans in China and the Ownership Effect

Authors: Wentao Su

Abstract:

This prospectus analyzes the potential determinants of Chinese non-performing loan (NPL) ratio in banking sector and its implications using panel data from different banks in China. By incorporating both bank specific factors and macro variables, it shows domestic credit growth rate, bank profitability measures and bank ownership play important roles in determining NPL ratio. Analysis of proportion of shares of different types of owners shows that increasing percentage of shares controlled by private institutional investors reduces the NPL ratio significantly. In addition, the declining quality of infrastructure loans indicates the side effect of Chinese economic stimulus plan of 2008, and explains the existing performance gap between Chinese state-owned banks and joint-equity banks. This prospectus discovers some evidence of growth disparity in three most prosperous regions in China where varied degrees of economic reform has led to different performance. By measuring IPO and foreign minority ownership event, it also finds the events of IPO and foreign minority ownership alone cannot improve the bank performance. China’s weak corporate governance needs an overhaul to deal with the nepotism towards state-owned enterprises (SOE) and state-owned banks (SOB), which fundamentally distorts the banking sector. Finally, the prospectus anticipates several lines of future research, like how SOE and SOB can be deinstitutionalized; what is the effect of the shadow banking system on financial stability and health; and whether a more developed equity market will help reduce the NPLs as firms have more financing tools to fund their business.

Link: pdf

Working Paper 27: Systematic Monetary Policy and the Effects of Exchange Rate Shocks

Authors: Orcan Cortuk, Mustafa Haluk Guler

Abstract:

Exchange rate shocks generally induce an endogenous response of monetary policy. However, increasing in exchange rates generally result in a higher interest rate with lower growth (expectations). It is argued that important part of this contractionary effect rising from the endogenous response of monetary policy to the shock. We take this debate as our starting point and conduct a VAR analysis with Turkish data by decomposing the total effects of a given exogenous exchange rate shock into the portion attributable directly to the shock itself and the part arising from the interest rate response to this shock. Due to endogenous response of monetary policy, rising interest rates is the main factor behind the lower growth and inflation. We find that half of the recessionary impact of an exchange rate shock results from the endogenous tightening of monetary policy.

Link: pdf

Working Paper 26: Foreign Currency Borrowing by Indian Firms: Towards a New Policy Framework

Authors: Ila Patnaik, Ajay Shah, Nirvikar Singh

Abstract:

India has a complex multidimensional system of capital controls for foreign currency borrowing by firms. In this paper, we summarize existing regulations, review the outcomes and discuss areas of concern and recent policy changes. Unhedged foreign currency exposure for firms, the complexity and uncertainty in the policy framework as it has evolved, and questions about regulation making processes are highlighted. In an emerging economy with a managed exchange rate and incomplete markets, foreign currency borrowing poses systemic risks when left unhedged by large firms that constitute a significant part of GDP. We identify policy directions to help address these concerns.

Link: pdf

Working Paper 25: Financial Development and Conflict Mitigation: Can Finance Combat Conflict?

Authors: Sankar De, Bharti Nandwani

Abstract: 

A typical conflict is a complex phenomenon. It can have multiple roots; social (ethnic and religious differences), political (civil wars), economic (control of natural resources in a contested area). In this paper, we investigate whether a given economic intervention can mitigate domestic conflicts of different types, regardless of their different origins and characteristics. The intervention that we consider is financial development, measured either as an increase in bank credit supply or an increase in the number of bank accounts, in a conflict-affected area. Using a model as well as extensive empirical tests with district-level data from India comprising different types of conflicts over a long sample period (1983- 2010), we find consistent evidence that supports our model’s prediction that financial development mitigates conflict, and that this negative relationship holds for conflicts of all types. Employment growth and economic expansion due to financial development serves as a beneficial channel from financial development to conflicts. Multiple identification checks establish causality of our findings. The findings suggest that all conflicts share common economic underpinnings, in particular low opportunity costs of conflict participation for the rank file insurgents. Consequently, conflicts of different types respond similarly to a given economic intervention that raises the opportunity costs. Our findings have important policy implications.

Link: pdf

Working Paper 24: Borrowing Culture and Debt Relief: Evidence from a Policy Experiment

Authors: Sankar De, Prasanna Tiwari

Abstract: 

The present paper investigates the effects of a large-scale debt relief program for delinquent borrowers on ex post loan repayment behavior of the relief recipients and on their access to new credit. We use audited transactions data of the loan accounts of a large sample of borrowers before and after a nation-wide rural debt waiver program undertaken by the Indian government in 2008, one of the largest such programs in history. Program eligibility cut-off based on landholdings of the farmers in our sample allows us to employ robust regression discontinuity designs as well as difference-in-difference methodologies in order to causally estimate the impact of the waiver program. We find no evidence that unconditional debt waiver leads to improvement in ex post behavior of the waiver beneficiaries. Moral hazard on the part of the borrowers caused by expectations of more waivers in future explains our findings. Further, we find indirect evidence that, rationally anticipating adverse borrower behavior, the loan officers ration credit, resulting in ex-ante inefficiency in credit markets. In order to disentangle demand and supply side factors in credit supply, we use unique loan officer level data and exploit mandatory loan officer rotation policy in Indian public sector banks. In sum, our work provides empirical evidence on both hidden information (ex ante selection based on unobserved anticipated efforts) and hidden action (ex post incentive effects) implications of a large government-initiated debt relief program. In the case of an unconditional debt waiver program, both types of evidence are negative.

Link: pdf

Working Paper 23: Are Banks Responsive to Exogenous Shocks to Credit Demand in Rural Economies? District – level Evidence from India

Authors: Sankar De, Siddharth Vij

Abstract: 

In the existing literature on rural financial markets in emerging economies, there has been much discussion on local bilateral contracts and mutual insurance arrangements, which are inadequate to deal with the typically correlated risks that individuals and households face in the rural sector. There have been discussions also on the costly and inefficient strategies that the households adopt to smooth their income or consumption. The discussions rest on the implicit premise that the financial intermediation system in the rural economy is inefficient in insuring the individual agents against idiosyncratic shocks to their income and consumption. However, the premise itself has remained largely unexamined. Using extensive district-level rainfall and bank credit data from India, we investigate whether the commercial banks respond positively to exogenous shocks to credit demand in the rural economy in the wake of droughts. We find that banks increase agricultural credit in drought-affected years compared to years of normal rainfall, but not personal loans or other types of non-agricultural credit. Further, agricultural credit increases in the intensive margin (average loan size per account), but not in the extensive margin (the number of accounts). We also find that private banks increase credit more than public-sector banks. Overall, our findings offer positive evidence on the role of commercial banks in rural financial markets and, in the process, contribute to several existing literatures.

Link: pdf

Working Paper 22: Online Ad Auctions: An Experiment

Authors: Daniel Friedman, Kevin McLaughlin

Abstract:

A human subject laboratory experiment compares the real-time market performance of the two most popular auction formats for online ad space, Vickrey-Clarke-Groves (VCG) and Generalized Second Price (GSP). Theoretical predictions made in papers by Varian (2007) and Edelman, et al. (2007) seem to organize the data well overall. Eciency under VCG exceeds that under GSP in nearly all treatments. The dierence is economically sign cant in the more competitive parameter co gurations and is statistically sign cant in most treatments. Revenue capture tends to be similar across auction formats in most treatments.

Link: pdf

2015


Working Paper 21: Beggar Thy Neighbor or Beggar Thy Domestic Firms? Evidence from 2000-2011 Chinese Customs Data

Authors: Rasmus Fatum, Runjuan Liu, Jiadong Tong and Jiayun Xu

Abstract: 

The premise of beggar-thy-neighbor policies and currency wars is that currency depreciations lead to export growth. This premise, however, is far from validated as the existing economic literature largely either fails to find significant trade flow effects of currency fluctuations or finds that these effects are only minor. We revisit the question of whether currency fluctuations are systematically associated with trade flows using rich and unique firm level Chinese customs data on China-US trade over the 2000 to 2011 period that allows us to consider firm involvement in processing trade and firm dynamics in both export and import markets. Our firm-level based estimation of trade elasticities suggest that the China-US trade balance strongly responds to changes in the CNY/USD rate. This finding is particularly pronounced when we distinguish between ordinary and processing firms. Our results thus suggest that the influence of exchange rates on trade flows is stronger than previously thought and add insights to the policy debate on beggar-thy-neighbor policies and currency wars by, at least in principle, validating the underlying premise of such policies.

Link: pdf

Working Paper 20: Heterogeneous Patterns of Financial Development: Implications for Asian Financial Integration

Authors: Linh Bun and Nirvikar Singh

Abstract: 

This paper analyzes detailed differences in patterns of financial development across the major Asian economies, including three of the region’s largest economies (China, Japan and South Korea), to understand how these differences might affect possibilities for greater regional financial integration. In particular, the paper argues that heterogeneous patterns of financial development, and not just differences in levels of financial development, may present an economic challenge to regional financial integration efforts, aside from possible political challenges. The paper provides background on the case for financial openness, Asian experiences with financial integration, and regional economic responses to external shocks. It also discusses policy options, including regulatory reform and coordination, and possible risk management policies and institutions, in the context of heterogeneous patterns of financial development.

Link: pdf

Working Paper 19: Market Mechanisms in Online Crowdfunding

Authors: Zaiyan Wei and Mingfeng Lin

Abstract: 

Online crowdfunding has emerged as an appealing new channel of financing in recent years. A fundamental but largely unanswered question in this nascent industry is the choice of market mechanisms, i.e., how the supply and demand of funds are matched, and the terms (price) at which transactions will occur. Two of the most popular such mechanisms are auctions (where the \crowd" determines the price of the transaction through an auction process) and posted prices (where the platform determines the price). While crowdfunding platforms typically use one or the other, there is little systematic research on the implications of such choices for the behavior of market participants, transaction outcomes, and social welfare. We address this question both theoretically and empirically in the context of debt-based crowdfunding. We first develop a game-theoretic model that yields empirically testable hypotheses, taking into account the incentive of the crowdfunding platform. We then test these hypotheses by exploiting a regime change from auctions to posted prices on one of the largest debt-based crowdfunding platforms. Consistent with our hypotheses, we find that under platform-mandated posted prices, loans are funded with higher probability, but the pre-set interest rates are higher than borrowers' starting interest rates in auctions. More important, all else equal, loans funded under the posted-price regime are more likely to default, thereby undermining lenders' returns on investment and their surplus from trading. Although platform-mandated posted prices may be faster in originating loans, auctions that rely on the “crowd” to discover prices are not necessarily inferior in terms of overall social welfare.

Link: pdf

Working Paper 18: Lemon or Cherry? The Value of Texts in Debt Crowdfunding

Authors: Qiang Gao and Mingfeng Lin

Abstract: 

Peer-to-peer (P2P) lending, as a form of debt-based crowdfunding, has received much attention in the past several years. Text, in particular, is a prevalent feature but much less understood. While there have been some studies on the role of text in this context, these studies typically consider text as a control variable, and use small, manually coded samples. Our study is one of the first to use a scalable approach to examine the informational value of texts borrowers write when requesting funds in debt crowdfunding. We first examine data from exogenous events on Prosper.com, and show that investors indeed consider textual descriptions when investing. Then, we show that text features can indeed explain and predict loan default, using both explanatory and predictive models. Finally, we show that investors correctly interpret the informational value of some, but not all, features of texts. Our study points to opportunities for efficiency improvement not yet documented in the crowdfunding literature, and has implications for researchers, platform owners, and regulators.

Link: pdf

Working Paper 17: Bayesian mixture modelling for spectral density estimation

Authors: Annalisa Cadonna, Athanasios Kottas and Raquel Prado

Abstract: 

We develop a Bayesian modelling approach for spectral densities, built from a local Gaussian mixture approximation to the Whittle log-likelihood. The implied model for the log-spectral density is a mixture of linear functions with frequency-dependent logistic weights, which allows for general shapes for smooth spectral densities. The proposed approach facilitates efficient posterior simulation as it casts the spectral density estimation problem in a mixture modelling framework for density estimation. It also sets the stage for hierarchical extensions for spectral analysis of multiple time series. The methodology is illustrated with synthetic and real data sets.

Link: pdf

Working Paper 16: Emergence of Networks and Market Institutions in a Large Virtual Economy

Authors: Curtis Kephart, Daniel Friedman and Matt Baumer

Abstract: 

A complete set of transactions, more than 40 million within a 1.8 year span, allows us to track the evolution of the trader network and the goods network in an on-line trading community. The computer platform was designed to make barter exchange as attractive as possible; money was not part of the design and all players were created equal. Yet, within weeks, several specific goods began to emerge as media of exchange, and not long after that various sorts of specialized traders began to appear. We track their progress using network-theoretic metrics such as node strength, assortativity, betweenness and closeness. By the end of our sample, virtually all trade was money-mediated and market makers played a major role.

Link: pdf

Working Paper 15: Uncertainty and Disagreement Measures from Treasury Auctions and Investment Activity

Authors: Orcan Çörtük, Mustafa Haluk Güler and Tandoğan Polat

Abstract: 

In this study, we propose a new methodology to extract the expected real interest rate uncertainty and disagreement measures with the use of micro data on Turkish treasury inflation indexed bond auctions. We argue that these newly formed indicators do not have the problems associated with other model and survey based uncertainty and disagreement measures. We also examine the effects of real interest rate uncertainty on investment by comparing not only the measures commonly used in literature but also the new ones that we construct. Estimation results indicate that real interest rate uncertainty has a positive effect on private investment. This is at odds with the effects of model based disagreement measures on private investment.

Link: pdf

Working Paper No. 14: Dynamic Model of Firm Valuation: A New Methodology and its Empirical Validity

Authors: Natalia Lazzati and Amilcar A. Menichini

Abstract: This study derives a dynamic version of the dividend discount model and assesses its empirical validity. The valuation method we propose can be easily implemented and uses widely available financial data. We find that our model produces equity value estimates that are, on average, very close to market prices, and explains a large proportion of the variation observed in contemporaneous share prices. However, we also find temporary deviations between the stock prices and model estimates that can be economically exploited by a simple buy-and-hold portfolio strategy. The strategy we implement earns on average 22%, 37%, and 49% returns after one, two, and three years of portfolio formation, respectively.

Link: pdf

Working Paper 13: How Do Extreme Global Shocks Affect Foreign Portfolio Investment? An Event Study for India 

Authors: Anick Yaha, Nirvikar Singh and Jean Paul Rabanal

Abstract: 

Foreign portfolio flows in and out of India are relevant for policymakers, and are often portrayed in the media as having a destabilizing effect on the domestic market. We use an event study approach to examine whether extreme global shocks trigger abnormal responses in foreign equity flows in and out of India, or abnormal responses in the Indian stock market. We do not find strong evidence of abnormal responses, even for the case of the global crisis of 2008.

Link: pdf

Working Paper No. 12: Revenue Growth and Capital Structure Constraints in Equity Crowd Funded (ECF) Enterprises

Authors: Paul Vroomen and Subhas Desa

Abstract: 

Title III of the JOBS Act of 2012 creates a new class of private equity investment known as equity crowd funding (ECF), widely expected to provide a new source of financing for small and medium enterprises which have had limited financing options in the past. Our analysis shows that the set of enterprises that qualify for ECF is, however, constrained by the returns required from such investments. We apply mean-variance portfolio theory to identify the expected returns required of ECF assets. To do this we construct the capital market line of established equity markets by empirically identifying the expected return and standard deviation of three private equity investment classes: equity buy-out, venture capital and angel investments. We then analyze the systematic risk of ECF assets relative to these other private equity classes, to estimate the standard deviation of the ECF asset class which we then apply to the capital market line to determine the commensurate expected return for ECF assets.We then define three enterprise classes that are likely candidates for equity crowd funding: low capitalization start-ups, high capitalization start-ups and single event projects. We build parameterized models for typical representatives of each enterprise class, using a set of parameters that together define the expected return of each representative enterprise. The target ECF expected return is then imposed as a constraint on these models. The constrained models enable us to identify the feasible region for the model parameters. We study the two parameters that are the primary determinants of value: revenue (and consequently earnings) growth and capital structure (as represented by percentage equity ownership of ECF investors) and illustrate the feasible regions with selected revenue growth and equity ownership values for the three enterprise classes.

Link: pdf

2014


Working Paper No. 11: Insights into High Frequency Trading From the Virtu Initial Public Offering

Authors: Gregory Laughlin

Abstract: 

The Virtu Initial Public Offering is analyzed to gain order-of-magnitude insights into the nature of high frequency trading of equities. We find that yearly profits from equity market making are likely of order $2.5B, and we estimate that market makers earn, on average, $0.0027 per share traded, and that their overall profitability is closely tied to market volumes.

Link: pdf

Working Paper No. 10: The Random Walk of High Frequency Trading

Authors: Eric M. Aldrich, Indra Heckenbach and Gregory Laughlin 

Abstract: 

This paper builds a model of high-frequency equity returns in clock time by separately modeling the dynamics of trade-time returns and trade arrivals. Our main contributions are threefold. First, we characterize the distributional behavior of high-frequency asset returns both in clock time and trade time and show that when controlling for pre-scheduled market news events, trade-time returns are well characterized by a Gaussian distribution at very fine time scales. Second, we develop a structured and parsimonious model of clock-time returns by subordinat- ing a trade- time Gaussian distribution with a trade arrival process that is associated with a modified Markov- Switching Multifractal Duration (MSMD) model of Chen et al. (2013). Our modification of the MSMD model provides a much better characterization of high-frequency inter-trade durations than the original model of Chen et al. (2013). Over-dispersion in this dis- tribution of inter-trade durations leads to leptokurtosis and volatility clustering in clock-time returns, even when trade- time returns are Gaussian. Finally, we use our model to extrapolate the empirical relationship between trade rate and volatility in an effort to understand condi- tions of market failure. Our model finds that physical separation of financial markets maintains a natural ceiling on systemic volatility and promotes market stability. 

Link: view online

Working Paper No. 9: The Disposition Effect and Realization Preferences: a Direct Test

Authors: Jacopo Magnani 

Abstract: 

This paper develops a new laboratory test of the hypothesis that individual investors have an irrational preference for selling winning stocks vis-`a-vis selling losing stocks. In the experiment, subjects invest in a security that bundles a risky asset, whose price evolves in near-continuous time, with a perpetual put option. Optimal behavior is characterized by an upper and a lower selling thresholds in the asset price space, thus producing a clear rational benchmark and eliminating known confounds. Subjects indeed tend to delay selling losers beyond the optimal point and to sell winners before reaching the optimal liquidation point. The median liquidation points imply the probability of realizing a gain conditional on a sale is 56% larger than optimal. Such behavior is shown to be consistent with a realization utility model and structural estimates reveal that the sensitivity of realization utility to gains and losses decreases faster than what is implied by canonical estimates of prospect-theoretic value functions. A direct estimate of the degree of diminishing sensitivity is an important input for behavioral finance theory as even qualitative results of realization utility models, such as whether investors voluntary realize losses or not, depend on the value of the sensitivity parameter. 

Link: pdf

Working Paper No. 8: International Evidence on Bank Funding Profiles and Performance: Are Banks “Overbanked”? 

Authors: Jose A. Lopez and Mark M. Spiegel 

Abstract: 

We investigate the implications of bank funding and lending strategies for bank performances using a large cross-country data set of individual bank outcomes. We find that increases in a bank’s reliance on deposits have adverse implications for its performance, as measured by return on assets. We also find evidence of spillovers from national banking system characteristics, as banks benefit from greater funding stability in their national banking systems. This finding is particularly strong in our domestic bank sub-sample, with foreign banks exhibiting the opposite result. However, the performance of bank system stability measures varies over time, as well as across bank types, and thus presents challenges in determining which measures of national banking characteristics are superior indicators of future bank performance.

Link: pdf

Working Paper No. 7: Do firms in developing countries grow as they age? 

Authors: Meghana Ayyagari, Asli Demirguc-Kunt and Vojislav Maksimovic 

Abstract: We examine the relation between establishment size and age in the formal sector using survey data from 120 developing countries. Existing research suggests that manufacturing establishments in developing countries do not grow over time, most likely due to market imperfections and regulations. To the contrary, we find that the average plant in developing countries that is over 40 years old employs almost five times as many workers as the average plant five years or younger. We find consistent evidence when we look within a large country, India, using detailed manufacturing census data over 23 years. We also find that differences in financial development across Indian states, while substantial, have a minor effect on firm growth, consistent with inefficiency of state-owned financial systems. These results hold controlling for differences in labor regulations across states, capital intensity, labor regulations, and for firms born before and after the major reforms. 

Link: pdf

Working Paper No. 6: Credit Rationing in Informal Markets: The Case of Small Firms in India 

Authors: Sankar De and Manpreet Singh 

Abstract: Using a unique dataset combining panel data of reported financial information for a sample of small and medium enterprises in India with data from a survey of the same firms regarding the role of relationships in supply of inter-firm credit, the present study examines the availability and importance of relationship-based informal credit for small firms given their total credit needs. We find that the firms that are unsuccessful in generating internal funds or bank loans appear to have better access to relationship-based credit. However, we also find persistent evidence of rationing of relationship-based credit, including credit driven by business relationships as well as social relationships. All firms in our sample face an upward-sloping credit supply function, while firms with limited collaterizable assets face an interest-inelastic supply curve. Though relationships mitigate information asymmetry problems between borrowers and lenders, our investigations suggest that moral hazard concerns still constrain credit supply. Credit providers decline credit when the interest rate reaches a critically high level and the heavy debt repayment obligations limit the borrowers’ stake in the debt-financed projects. This is the first study to document rationing of informal credit. Our findings have important research and policy implications. 

Link: pdf

Working Paper No. 5: “Near-Coincident” Indicators of Systemic Stress 

Authors: Ivailo Arsov, Elie Canetti, Laura Kodres and Srobona Mitra 

Abstract: The G-20 Data Gaps Initiative has called for the IMF to develop standard measures of tail risk, which we identify in this paper with systemic risk. To understand the conditions under which tail risk is present, it is first necessary to develop a measure of what constitutes a systemic stress, or tail, event. We develop such a measure and use it to assess the performance of eleven near-term systemic risk indicators as ‘early’ warning of distress among top financial institutions in the United States and the euro area. Two indicators perform particularly well in both regions, and a couple of other simple indicators do well across a number of criteria. We also find that the sizes of institutions do not necessarily correspond with their contribution to spillover risk. Some practical guidance for policies is provided. 

Link: pdf

Working Paper No. 4: The Offshore Renminbi Exchange Rate: Microstructure and Links to the Onshore Market

Authors: Yin-Wong Cheung and Dagfinn Rime

Abstract: The offshore renminbi (CNH) exchange rate is the exchange rate of the Chinese currency transacted outside China. We study the CNH exchange rate dynamics and its links with onshore exchange rates. Using a specialized microstructure dataset, we find that CNH is significantly affected by its order flow and limit-order imbalance. The offshore CNH exchange rate has an increasing impact on the onshore rate, and significant predictive power for the official RMB central parity rate. The CNH order flow also affects the onshore RMB exchange rate and the central parity rate. The interactions between variables are likely to be time-varying.

Link: pdf

Working Paper No. 3: Assessing systematic risk in the S&P500 index between 2000 and 2011: A Bayesian nonparametric approach

Authors: Abel Rodríguez, Ziwei Wang and Athanasios Kottas 

Abstract: We develop a Bayesian nonparametric model to assess the effect of systematic risks on multiple financial markets, and apply it to understand the behavior of the S&P500 sector indexes between January 1, 2000 and December 31, 2011. More than prediction, our main goal is to understand the evolution of systematic and idiosyncratic risks in the U.S. economy over this particular time period, leading to novel sector- specific risk indexes. To accomplish this goal, we model the appearance of extreme losses in each market using a superposition of two Poisson processes, one that corresponds to systematic risks that are shared by all sectors, and one that correspond to the idiosyncratic risk associated with a specific sector. In order to capture changes in the risk structure over time, the intensity functions associated with each of the underlying components are modeled using a Dirichlet process mixture model. Among other interesting results, our analysis of the S&P500 index suggests that there are few idiosyncratic risks associated with the consumer staples sector, whose extreme negative log returns appear to be driven mostly by systematic risks. 

Link: pdf

Working Paper No. 2: The Transmission of Federal Reserve Tapering News to Emerging Financial Markets

Authors: Joshua Aizenman, Mahir Binici and Michael M. Hutchison 

Abstract: This paper evaluates the impact of tapering “news” announcements by Fed senior policy makers on financial markets in emerging economies. We apply a panel framework using daily data, and find that emerging market asset prices respond most to statements by Fed Chairman Bernanke, and much less to other Fed officials. We group emerging markets into those with “robust” fundamentals (current account surpluses, high international reserves and low external debt) and those with “fragile” fundamentals and, intriguingly, find that the stronger group was more adversely exposed to tapering news than the weaker group. News of tapering coming from Chairman Bernanke is associated with much larger exchange rate depreciation, drops in the stock market, and increases in sovereign CDS spreads of the robust group compared with the fragile group. A possible interpretation is that tapering news had less impact on countries that received fewer inflows of funds in the first instance during the quantitative years and had less to lose in terms of repatriation of capital and reversal of carry-trade activities. 

Link: pdf

Working Paper No. 1: Risky Curves: On the Empirical Failure of Expected Utility 

Authors: Daniel Friedman, R. Mark Isaac, Duncan James and Shyam Sunder 

Abstract: This paper provides some extracts from a book of the same title. It raises issues with respect to the descriptive validity and predictive power of Expected Utility Theory (EUT). 

Link: pdf

We use an experimental approach to study the effect of market structure on the incidence of misreporting by credit rating agencies. In the game, agencies receive a signal regarding the type of asset held by the seller and issue a report. The sellers then present the asset, with the report if one is solicited, to the buyer for purchase. We find that competition among rating agencies significantly reduces the likelihood of misreporting.

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