Working Papers

2017


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.

See Also