The Second International Moscow Finance Conference

Are Institutions Informed about News?

This paper combines daily non-public data on buy and sell volume by institutions from 2003 through 2005 for NYSE-listed stocks with all news announcements from Reuters. Natural language processing categorizes the sentiment associated with each news story. We use institutional order flow (buy volume minus sell volume) as a quantitative measure of net trading by institutions. We find evidence institutional investors are informed: i) institutional trading volume predicts the occurrence of news announcements; ii) institutional order flow predicts the sentiment of the news; iii) institutional order flow predicts the stock market reaction on news announcement days; and iv) institutional order flow predicts earnings announcement surprises.

Asset Pricing with Heterogeneous Investors and Portfolio Constraints

We study dynamic general equilibrium in one-tree and two-trees Lucas economies with one consumption good and two CRRA investors with heterogeneous risk aversions and portfolio constraints. We provide a tractable characterization of equilibrium without relying on the assumption of logarithmic constrained investors, popular in the literature, under which wealth consumption ratios of these investors are unaffected by constraints. In one-tree economy we focus on the impact of limited stock market participation and margin constraints on market prices of risk, interest rates, stock return volatilities and price-dividend ratios. We demonstrate conditions under which constraints increase or decrease these equilibrium processes, and generate dynamic patterns consistent with empirical findings. In a two-trees economy we demonstrate that investor heterogeneity gives rise to large countercyclical excess stock return correlations, but margin constraints significantly reduce them by restricting the leverage in the economy, and give rise to rich saddle-type patterns. We also derive a new closed- form consumption CAPM that captures the impact of constraints on stock risk premia.

Optimal life-cycle portfolios for heterogeneous workers

Household portfolios include risky bonds, beyond stocks, and respond to permanent labour income shocks. This paper brings these features into a life-cycle setting, and shows that optimal stock investment is constant or increasing in age before retirement for realistic parameter combinations. The driver of such inversion in the life-cycle profile is the resolution of uncertainty regarding social security pension, which increases the investor’s risk appetite. This occurs if a small positive contemporaneous correlation between permanent labour income shocks and stock returns is matched by a realistically high variance of such shocks and/or risk aversion. Absent this combination, the typical downward sloping profile obtains. Overlooking differences in optimal investment profiles across heterogeneous workers results in large welfare losses, in the order of 17-26% of lifetime consumption.

Agency, Firm Growth, and Managerial Turnover

We study managerial incentive provision under moral hazard in a firm subject to stochastic growth opportunities. In our model, managers are dismissed after poor performance, but also when an alternative manager is more capable of growing the firm. The optimal contract may involve managerial entrenchment, such that growth opportunities are foregone after good performance. Firms with better growth prospects have higher managerial turnover and more front-loaded compensation. Firms may pay severance to incentivize their managers to report truthfully the arrival of growth opportunities. By ignoring the externality of the dismissal policy onto future managers, the optimal contract implies excessive retention.

Getting by with a Little Help from My Friends: Does Political Affinity Lead to Lower Acquisition Premiums?

While there is regular anecdotal evidence of political involvement in international business deals we still know very little on the importance of political affinity, or national preference alignment, on the cross-border acquisition process and particularly the initial acquisition premium. We argue that political affinity, as revealed by UN voting patterns, produces a positive environment for cross-border deals. It facilitates access to political and business elites and renders commercial diplomacy efforts more effective. Using a dataset of 925 cross-border deals (1990-2008) we find that political affinity between acquirer and target countries leads to lower bid premiums. Moreover, we show that this effect is moderated by the size of the firms involved and the level of political constraints faced by the government in the host country.

Financial Market Openness and Monetary Control

How emerging market financial assets respond to local monetary policy shocks has important implications for the asset allocation and risk management strategies of U.S. investors, for local policymakers in liberalized and pre-liberalized economies, and for international financial integration. We examine the claim that emerging market liberalization led to a loss of local monetary control, thereby rendering local monetary policy ineffective in influencing local asset prices and the economy. Using a structural VAR to model the reaction function of local monetary authorities in 25 emerging markets, we find that 18 stock markets respond significantly to local monetary policy shocks. Specifically, a one standard deviation positive shock causes an immediate decline of 2.07% in stock prices. The evidence indicates that local monetary policy generally has no lesser influence on the stocks of investable firms than on the stocks of non-investable firms. Importantly, while foreign monetary policy affects local asset prices there is no evidence that it dominates local policy. For instance, only a fraction of markets that are unresponsive to local monetary policy are simultaneously responsive to foreign monetary policy. Moreover, foreign monetary policy has statistically indistinguishable effects on investable and non-investable stocks, suggesting that liberalization has not created a dichotomous equity market in which non-investable stocks remain segmented.

Deposit Insurance and Deposit Contracts

This study examines the design of insured and uninsured deposit contract in an emerging market with severe competition for limited retail deposit funds. Using detailed data from almost 80,000 deposit contract observations in a large sample of Russian banks, we find that banks use a broad variety of implicitly and explicitly priced contract terms to aggressively compete for limited household funds in the fast-growing emerging banking market. Consistent with the market discipline hypothesis, we also find that uninsured deposit contract are highly sensitive to the bank risk profiles. From a regulatory perspective, our findings suggest that the policy measures of deposit rates monitoring or imposing deposit rate ceilings for preventing deposit accumulation by risky bank could be ineffective. Our results show that banks can complement deposit contracts with embedded options attractive for depositors thus enabling banks to compete for insured deposits even in the presence of deposit rate monitoring.

Liquidity and the Marginal Value of Information

We revisit the Kyle (1985) model of price formation in the presence of private information. We begin by using Back's (1992) approach, demonstrating that if standard assumptions are imposed, the model has a unique equilibrium solution, and that the insider's trading strategy has a martingale property. That in turn implies that the insider's strategies are linear in total order flow. We also show that for arbitrary prior distributions, the insider's trading strategy is determined by a Radon-Nikodym derivative that expresses the insider's informational advantage. This allows us to reformulate the model so that Kyle's liquidity parameter λ is characterized by a Lagrange multiplier that is the marginal value or shadow price of information. Based on these findings, we can then interpret liquidity as the marginal value of information.

Uniqueness of Equilibrium in the Single-Period Kyle'85 Model

We analyze a one-period Kyle model (Kyle (1985)) where the risk-neutral informed trader can use arbitrary (linear or non-linear) deterministic strategies, and the market maker can use arbitrary pricing rules. We show that the standard linear insider's strategy, and correspondingly, the linear pricing rule, lead to the unique equilibrium in the model, even if the possible strategies are extended to arbitrary nonlinear piece-wise continuously differentiable functions of the fundamental. This means that there is a unique equilibrium in Kyle (1985), achieved on the standard linear insider's strategy, and the linear pricing rule.

A General Equilibrium Exploration of Minsky’s Financial Instability Hypothesis…

The worst and longest depressions have tended to occur after periods of prolonged, and reasonably stable, prosperity. This results in part from agents rationally updating their expectations during good times and hence becoming more optimistic about future economic prospects. Investors then increase their leverage and shift their portfolios towards projects that would previously have been considered too risky. So, when a downturn does eventually occur, the financial crisis, and the extent of default, become more severe. Whereas a general appreciation of this syndrome dates back to Minsky [1992, Jerome Levy Economics Institute, WP 74] and even beyond, to Irving Fisher [1933, Econometrica 1, 337-357], we model it formally. Endogenous default introduces a pecuniary externality, since investors do not factor in the impact of their decision to take risk and default on the borrowing cost. We explore the relative advantages of alternative regulations in reducing financial fragility, and suggest a novel criterion for improvement of aggregate welfare.

Monetary Policy and Quantitative Easing in an Open Economy: Prices, Exchange Rates and Risk Premia

Under Quantitative Easing, Open Market Operations involve arbitrary portfolios of assets and not exclusively nominally risk free bonds held with a specific target composition. In a simple stochastic cash-in-advance model of a large open economy, quantitative easing inhibits the ability of the central bank to control the path of prices and exchange rates. This is the case even with non-Ricardian fiscal policy. Alternative modes of conduct of monetary policy have measurable implications. A financial stability target, where the central bank trades only in nominally risk free bonds, implies that the risk premium is positively correlated with future interest rates. A price stability, or inflation, target induces the same correlation, while a monetary stability target reverses the sign of the correlation. Naive estimations of aggregate risk premi may be misleading if monetary policy is not accounted for.