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Working Paper
Undiversifying during Crises: Is It a Good Idea?
High levels of correlation among financial assets, as well as extreme losses, are typical during crisis periods. In such situations, quantitative asset allocation models are often not robust enough to deal with estimation errors and lead to identifying underperforming investment strategies. It is an open question if in such periods, it would be better to hold diversified portfolios, such as the equally weighted, rather than investing in few selected assets. In this paper, we show that alternative strategies developed by constraining the level of diversification of the portfolio, by means of a regularization constraint on the sparse lq-norm of portfolio weights, can better deal with the trade-off between risk diversification and estimation error. In fact, the proposed approach automatically selects portfolios with a small number of active weights and low risk exposure. Insights on the diversification relationships between the classical minimum variance portfolio, risk budgeting strategies, and diversification-constrained portfolios are also provided. Finally, we show empirically that the diversification-constrained-based lq-strategy outperforms state-of-art methods during crises, with remarkable out-of-sample performance in risk minimization.
AUTHORS: Giuzio, Margherita; Paterlini, Sandra
DATE: 2016-12-02

Working Paper
Can Leverage Constraints Help Investors?
This paper provides causal evidence that leverage constraints can reduce the underperformance of individual investors. In accordance with Dodd-Frank, the CFTC was given regulatory authority over the retail market for foreign exchange and capped the maximum permissible leverage available to U.S. traders. By comparing U.S. traders on the same brokerages with their unregulated European counterparts, I show that the leverage constraint reduces average per-trade losses even after adjusting for risk. Since this causal approach holds constant contemporaneous market factors, these findings challenge the concept that individuals are better off when they are unconstrained in their risk-taking.
AUTHORS: Heimer, Rawley
DATE: 2014-12-03

Working Paper
Peer Pressure: Social Interaction and the Disposition Effect
Social interaction contributes to some traders? disposition effect. New data from an investment-specific social network linked to individual-level trading records builds evidence of this connection. To credibly estimate causal peer effects, I exploit the staggered entry of retail brokerages into partnerships with the social trading web platform and compare trader activity before and after exposure to these new social conditions. Access to the social network nearly doubles the magnitude of a trader?s disposition effect. Traders connected in the network develop correlated levels of the disposition effect, a finding that can be replicated using workhorse data from a large discount brokerage.
AUTHORS: Heimer, Rawley
DATE: 2016-07-14

Working Paper
Venture Capital and Underpricing: Capacity Constraints and Early Sales
I present a model of the venture capital (VC) and public markets in which VCs suffer from capacity constraints, due to the shortage of skilled VC managers. Consequently, VC firms can only handle a limited number of new projects at once, having to take ongoing projects public in order to take advantage of new opportunities. This framework is able to match key features presented by the VC and initial public offer (IPO) empirical literatures: (1) VC-backed firms are younger, smaller, and less profitable at the IPO than their non-VC backed counterparts; (2) VC-backed IPOs are more underpriced than non-VC backed ones; (3) There is a positive relationship between underpricing and VC fundraising; (4) Small and young VC firms usually take portfolio firms public earlier than their large and mature counterparts; and (5) In hot IPO markets, VCs are more likely to take public both very young and small firms as well as mature and large firms, compared to cold markets. Differently, non-VC backed firms are usually smaller and younger in hot markets than in cold ones.
AUTHORS: Pinheiro, Roberto
DATE: 2016-11-14

Working Paper
Where the Wild Things Are: Measuring Systemic Risk through Investor Sentiment
In this paper, I develop a systemic risk measure derived from investor sentiment that has predictive power over future economic activity and market returns. Unlike existing measures, it is not focused on flagging investors? heightened awareness of risk at the end of a boom episode but rather on capturing shifts in their trading behavior at the beginning of the episode. The method allows investors and regulators to observe industries in which risks could be building and provides regulators some lead time in deploying their macroprudential tools.
AUTHORS: Ergungor, O. Emre
DATE: 2016-02-19

Working Paper
The Effect of Possible EU Diversification Requirements on the Risk of Banks’ Sovereign Bond Portfolios
Recent policy discussion includes the introduction of diversification requirements for sovereign bond portfolios of European banks. In this paper, we evaluate the possible effects of these constraints on risk and diversification in the sovereign bond portfolios of the major European banks. First, we capture the dependence structure of European countries? sovereign risks and identify the common factors driving European sovereign CDS spreads by means of an independent component analysis. We then analyze the risk and diversification in the sovereign bond portfolios of the largest European banks and discuss the role of ?home bias,? i.e., the tendency of banks to concentrate their sovereign bond holdings in their domicile country. Finally, we evaluate the effect of diversification requirements on the tail risk of sovereign bond portfolios and quantify the system-wide losses in the presence of fire-sales. Under our assumptions about how banks respond to the new requirements, demanding that banks modify their holdings to increase their portfolio diversification may mitigate fire-sale externalities, but it may be ineffective in reducing portfolio risk, including tail risk.
AUTHORS: Paterlini, Sandra; Craig, Ben R.; Giuzio, Margherita
DATE: 2019-05-28

Working Paper
What we learn from China's rising shadow banking: exploring the nexus of monetary tightening and banks' role in entrusted lending
We argue that China's rising shadow banking was inextricably linked to potential balance-sheet risks in the banking system. We substantiate this argument with three didactic findings: (1) commercial banks in general were prone to engage in channeling risky entrusted loans; (2) shadow banking through entrusted lending masked small banks' exposure to balance-sheet risks; and (3) two well-intended regulations and institutional asymmetry between large and small banks combined to give small banks an incentive to exploit regulatory arbitrage by bringing off-balance-sheet risks into the balance sheet. We reveal these findings by constructing a comprehensive transaction-based loan dataset, providing robust empirical evidence, and developing a theoretical framework to explain the linkages between monetary policy, shadow banking, and traditional banking (the banking system) in China.
AUTHORS: Chen, Kaiji; Ren, Jue; Zha, Tao
DATE: 2016-01-01

Working Paper
Hedging and Pricing in Imperfect Markets under Non-Convexity
This paper proposes a robust approach to hedging and pricing in the presence of market imperfections such as market incompleteness and frictions. The generality of this framework allows us to conduct an in-depth theoretical analysis of hedging strategies for a wide family of risk measures and pricing rules, which are possibly non-convex. The practical implications of our proposed theoretical approach are illustrated with an application on hedging economic risk.
AUTHORS: Assa, Hirbod; Gospodinov, Nikolay
DATE: 2014-08-01

Working Paper
Bayesian Inference and Prediction of a Multiple-Change-Point Panel Model with Nonparametric Priors
Change point models using hierarchical priors share in the information of each regime when estimating the parameter values of a regime. Because of this sharing, hierarchical priors have been very successful when estimating the parameter values of short-lived regimes and predicting the out-of-sample behavior of the regime parameters. However, the hierarchical priors have been parametric. Their parametric nature leads to global shrinkage that biases the estimates of the parameter coefficient of extraordinary regimes toward the value of the average regime. To overcome this shrinkage, we model the hierarchical prior nonparametrically by letting the hyperparameter's prior?in other words, the hyperprior?be unknown and modeling it with a Dirichlet processes prior. To apply a nonparametric hierarchical prior to the probability of a break occurring, we extend the change point model to a multiple-change-point panel model. The hierarchical prior then shares in the cross-sectional information of the break processes to estimate the transition probabilities. We apply our multiple-change-point panel model to a longitudinal data set of actively managed, U.S. equity, mutual fund returns to measure fund performance and investigate the chances of a skilled fund being skilled in the future.
AUTHORS: Fisher, Mark; Jensen, Mark J.
DATE: 2018-02-01

Working Paper
Bayesian Nonparametric Learning of How Skill Is Distributed across the Mutual Fund Industry
In this paper, we use Bayesian nonparametric learning to estimate the skill of actively managed mutual funds and also to estimate the population distribution for this skill. A nonparametric hierarchical prior, where the hyperprior distribution is unknown and modeled with a Dirichlet process prior, is used for the skill parameter, with its posterior predictive distribution being an estimate of the population distribution. Our nonparametric approach is equivalent to an infinitely ordered mixture of normals where we resolve the uncertainty in the mixture order by partitioning the funds into groups according to the group's average ability and variability. Applying our Bayesian nonparametric learning approach to a panel of actively managed, domestic equity funds, we find the population distribution of skill to be fat-tailed, skewed towards higher levels of performance. We also find that it has three distinct modes: a primary mode where the average ability covers the average fees charged by funds, a secondary mode at a performance level where a fund loses money for its investors, and lastly, a minor mode at an exceptionally high skill level.
AUTHORS: Fisher, Mark; Jensen, Mark J.; Tkac, Paula A.
DATE: 2019-03-01

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