Third International Moscow Finance Conference

Aggregate Investment and Stock Returns

In this paper we study the relation between returns on the aggregate stock market and aggregate real investment. While it is well known that the aggregate investment rate is negatively correlated with subsequent excess stock market returns, we find that it is positively correlated with future stock market volatility. Thus, conditionally on pastaggregate investment, the mean-variance tradeoff in aggregate stock returns is negative. We interpret these patterns within a general equilibrium production economy. In ourmodel, investment is determined endogenously in response to two types of shocks: shocks to productivity and preference shocks affecting discount rates. Preference shocksaffect expected stock returns, aggregate investment rate, and stock return volatility in equilibrium, helping the model to reproduce the empirical relations between these variables. Thus, our results emphasize that the time-varying price of aggregate risk plays an important role in shaping the aggregate investment dynamics.

Volatility Risk Premia and Exchange Rate Predictability

We investigate the predictive information content in foreign exchange volatility risk premia for exchange rate returns. The volatility risk premium is the difference between realized volatility and a model-free measure of expected volatility that is derived from currency options, and reflects the cost of insurance against volatility fluctuations in theunderlying currency. We find that a portfolio that sells currencies with high insurance costs and buys currencies with low insurance costs generates sizeable out-of-sample returns and Sharpe ratios. These returns are almost entirely obtained via predictability of spot exchange rates rather than interest rate differentials, and these predictable spot returns are far stronger than those from carry trade and momentum strategies. Canonical risk factors cannot price the returns from this strategy, which can be understood, however, in terms of a simple mechanism with time-varying limits to arbitrage.

The Macroeconomic Determinants of Financial Predictability

In this paper we take a first pass at formalising the underlying questions and articulating a pertinent theory for predictability. The fundamental construct we will employ is the well-know family of dynamic stochastic general equilibrium macroeconomic models that form the foundation of business cycle theory, growth theory, monetary theory and nearly every other inter-temporal equilibrium construct whose attributes can be conveniently related to the data. We show that under fairly general assumptions the neo classical growth model implies that the stochastic process characterising equity returns is stationary and mean reverting. This forms the theoretical underpinnings of predictability.

Empirics of Executive Compensation: What Determines CEO Pay?

This paper is concerned with an adverse selection model of executive compensation. The structure of the optimal contract depends on the uncertainty about the productivity and reservation wage of the manager's type, and measures of performance of the firm. We analyze the sensitivity of the optimal contract to firm's characteristics such as volatility, size, technology and new economy, and CEO age.

Does Nationalization Work? Evidence from Russian State Takeovers

Nationalization and its consequences have attracted new interest in the recent financial crisis. We study the effects of nationalization on company performance using a sample of Russian firms. The Russian government has increased its role as an owner in several sectors of the economy in the 2000’s. We have assembled a comprehensive data set of nationalization transactions in Russia for the period from 2004 to 2008. Operating performance is measured relative to a close match of a non-nationalized firm that is found using propensity score matching. Overall, the empirical results show no significant effect of the fact of nationalization on performance. There is however, an increase in leverage over the first two years after nationalization. We also shed light on the changes in corporate governance going along with nationalization that can have intermediating effects onperformance.

Dealer Networks: Market Quality in Over-The-Counter Markets

We use the MSRB Transaction Reporting System audit trail to study dealer intermediation and liquidity provision in decentralized over-the-counter markets. The dealership network in municipal bonds exhibits a hierarchical core-periphery structure with about 20-30 highly interconnected dealers at its core and several hundred peripheral dealer firms. Market quality varies significantly across dealers depending on their interconnectedness and centrality within the trading network. Central dealers charge larger trading costs to investors and face lower loss probabilities than peripheral dealers. Yet, investor orders flow through central dealers. Central dealers place bonds more readily with investors than other dealers, consistent with smaller search frictions. Central dealers also provide more liquidity immediacy than peripheral dealers, leading central dealers to hold larger and more volatile inventories, keep bonds longer, and intermediate fewer pre-arranged trades. Investors trade with central dealers when liquidity is otherwise low. Central dealers canthus be considered liquidity providers of last resort.

Systemic Risk, Sovereign Yields and Bank Exposures in the Euro Crisis

Since 2008, euro-area sovereign yields have diverged sharply, and so have the corresponding CDS premia. At the same time, banks’ sovereign debt portfolios featured an increasing home bias. We investigate the relationship between these two facts, and its rationale. First, we inquire to what extent the dynamics of sovereign yield differentials relative to the swap rate and CDS premia reflect changes in perceived sovereign solvency risk or rather different responses to systemic risk due to the possible collapse of the euro. We do so by decomposing yield differentials and CDS spreads in a country-specific and a common risk component via a dynamic factor model. We then investigate how the home bias of banks’ sovereign portfolios responds to yield differentials and to their two components, by estimating a vector error-correction model on 2008-12 monthly data. We find that in most countries of the euro area, and especially in its periphery, banks’ sovereign exposures respond positively to increases in yields. When bank exposures are related to the country-risk and common-risk components of yields, it turns out that (i) in the periphery, banks increase their domestic exposure in response to increases in country risk, while in core countries they do not; (ii) in most euro area banks respond to an increase in the common risk factor by raising their domestic exposures. Finding (i) hints at distorted incentives in periphery banks’ response to changes in their own sovereign’s risk. Finding (ii) indicates that, when systemic risk increases, all banks tend to increase the home bias of their portfolios, making the euro-area sovereign market more segmented.

Who’s afraid of selection bias? Robust inference in the presence of competitive selection

This paper considers competitive selection dominance: what conditions on the unconditional distribution of of a random prospect will ensure that the prospect stochastically dominates a rival random prospect conditioned on competitive selection, i.e., conditioned on the prospect’s realized value exceeding its rivals? Because standard distributional orders, such as stochastic dominance and the monotone likelihood ratio property (MLRP), do not provide either necessary or sufficient restrictions on the unconditional distributions to ensure selection dominance, new distribution orders are required. We provide the requisite orders, which we term supermultiplicativity on average and geometric dominance. These orderings generate conditions, satisfied by many, but not all, scale shifts of standard textbook distributions, under which the selection-conditioned distribution is stochastically dominant if and only if the unconditional distribution is stochastically dominant. When these conditions are satisfied, robust qualitative inferences concerning the unconditional population distribution can be drawn from the selection-conditioned subsample distribution and vice versa.

Conditional alphas and realized betas

This paper proposes a two-step procedure to back out the conditional alpha of a given stock from high-frequency returns. We first estimate the realized factor loadings of the stock, and then retrieve the conditional alpha by estimating the conditional expectation of the stock return in excess over the realized risk premia. The estimation method is fully nonparametric in stark contrast with the literature on conditional alphas and betas. Apart from the methodological contribution, we employ NYSE data to determine the main drivers of conditional alphas as well as to track mispricing over time. In addition, we assess economic relevance of our conditional alpha estimates by means of a market-neutral trading strategy that longs stocks with positive alphas and shorts stocks with negative alphas. The preliminary results are very promising.

Hedge Fund (Non)Transparency: Skill or Risk-taking?

We use a proprietary dataset obtained from a fund of funds to document that funds that are more secretive about their strategies with investors significantly over-perform the more transparent funds during normal times. We further investigate the source of this over-performance and conclude that it cannot be explained purely by superior instrument-picking skill, trading strategy or market-timing ability of the more secretive funds. By looking separately at good and bad periods we infer that at least part of this over-performance is explained by secretive funds loading more than transparent ones on risk factors that earn a risk premium during good times, but crash
during bad times. We further offer a novel explanation for why highly concentrated funds command a risk premium by revealing that it is mostly prevalent among the non-transparent funds where investors are unaware about the exact risks they are facing and hence cannot diversify them away.

Competition among Portfolio Managers and Asset Specialization

This paper investigates the competition among portfolio managers as they attempt to outperform each other. We provide a tractable dynamic continuous-time model of competition between two risk-averse managers concerned about relative performance. To capture the managers' asset specialization, we consider two imperfectly correlated risky stocks whereby each manager trades in one of the stocks, and so faces incomplete markets. We show that a unique pure-strategy Nash equilibrium always obtains, and provide the ensuing equilibrium portfolio policies explicitly. We find that competition makes a relatively risk tolerant manager decrease, and a risk intolerant increase, her portfolio risk. Moreover, a higher own risk aversion induces a manager to take more risk when the opponent is advantaged, in that she specializes in the stock with the relatively higher Sharpe ratio. We then explore the link between our two key ingredients, competition and asset specialization, and show that competition can be conducive to asset specialization. In particular, we find that both managers, when relatively risk tolerant, can voluntarily opt for asset specialization and the corresponding loss of diversification to avoid competing on the same turf by trading in the same set of stocks. When they are risk intolerant, however, the no-specialization scenario is more likely. When we consider a client investor of a manager, we show that her preferences for or against asset specialization could well be the opposite to that of her manager. We also examine the potential costs to a client investor, arising as managerial turnover or changing stock characteristics misaligns the client manager's policy. We find that the client loses more when it is her manager who is replaced than the other manager. In contrast, the client's losses are the same for a given change in her manager's stock characteristics as for that in the competitor manager's stock.