Contributions published at Department of Banking and Finance (Pablo Koch Medina)

We study the effect of using fractional returns instead of log returns on improving portfolio optimization. The fractional return is defined as a fractional difference of log prices. The rationale behind the substitution lies in the fractional return’s similarity to log returns and its memory richness nature. We conduct extensive experiments on 8 groups of stocks with Gaussian and COMFORT models, with the optimization objective of maximizing the Sharpe ratio, with or without short-selling. Our findings are the following. First, qualitatively, portfolios using fractional returns behave generally more turbulent. Second, the Sharpe ratio demonstrates a pattern of first increasing and then decreasing with respect to degrees of fractional returns. Third, application of fractional returns yields improved Sharpe ratios in most groups. Fourth, the improvement effect is greater for portfolios with short selling. We also give an interpretation of the findings and conclude with future directions.

Secured Overnight Financing Rate (SOFR) and CME Term SOFR Rates will replace LIBOR as the new reference rate for U.S. Dollar financial contracts. This thesis investigates the feasibility of replicating CME Term SOFR Rates Benchmark. We develop a new approach for calculating SOFR Futures prices and follow the methodology from CME Group. The empirical results show that our estimation is close to the real Term SOFR with less than one basis point error. Our findings suggest that CME Term SOFR Rates can be replicated with small errors using free and accessible data, and contributes to hedge the risk of forward SOFR rate in further study.

We exploit the exogenous Covid-19 shock in a bicultural area of Italy to identify cultural differences in the way companies respond to economic shocks. Firms with managers of diverse cultural backgrounds resort to different forms of government aid, diverge in their investment decisions, and have different growth rates. These findings are consistent with cultural differences in time preferences and debt aversion. Specifically, we find that the response of managers belonging to a more long-term oriented culture is characterized by a lower recourse to debt, more investments and higher growth rates. Overall, our results show that the cultural origin of managers significantly affects firms' reaction to economic shocks and real economic outcomes.

The Black-Litterman model is a widely used and well established application of the Bayesian framework to asset allocation problems. It is, however, difficult to calibrate, as it requires the specification of abstract uncertainty parameters. We propose a new, more flexible model that allows the empirical estimation of the equilibrium, alleviating the need for parametrization. In an empirical application, we illustrate the sensitivity of the classical Black-Litterman model to the choice of the uncertainty parameter. We then demonstrate that the flexible model successfully exploits information in the cross-section of index constituents’ returns to find an optimal trade-off in calibration of the uncertainty.

We develop a method that identifies the attention paid by earnings call participants to firms' climate change exposures. The method adapts a machine learning keyword discovery algorithm and captures exposures related to opportunity, physical, and regulatory shocks associated with climate change. The measures are available for more than 10,000 firms from 34 countries between 2002 and 2020. We show that the measures are useful in predicting important real outcomes related to the net-zero transition, in particular, job creation in disruptive green technologies and green patenting, and that they contain information that is priced in options and equity markets.

We hypothesize that financial risk-taking originates in preindustrial interpersonal population diversity. We use data on immigrants residing in the United States and show that controlling for all known determinants of portfolio decisions and more than 100 control variables, diversity in the country of immigrants’ origin positively affects stock market participation and the level of risky asset holdings. Our results remain robust when instrumenting diversity with plant variety. We also identify the channels through which the effect of diversity operates (mostly individualism and human capital), but also conclude that diversity exerts an independent effect.

Arbitrage opportunities in markets for cryptocurrencies are well-documented. In this paper, we confirm that they exist; however, their magnitude decreased greatly from April 2018 onward. Analyzing various trading strategies, we show that it is barely possible to exploit existing price differences since then. We discuss and test several mechanisms that may be responsible for the increased market efficiency and find that informed trading is correlated with a reduction in arbitrage opportunities.

In this article we investigate the influence that information asymmetry may have on future volatility, liquidity, market toxicity, and returns within cryptocurrency markets. We use the adverse-selection component of the effective spread as a proxy for overall information asymmetry. Using order and trade data from the Bitfinex exchange, we first document statistically significant adverse-selection costs for major cryptocurrencies. Also, our results suggest that adverse-selection costs, on average, correspond to 10% of the estimated effective spread, indicating an economically significant impact of adverse-selection risk on transaction costs in cryptocurrency markets. Finally, we document that adverse-selection costs are important predictors of intraday volatility, liquidity, market toxicity, and returns.

The economic downturn caused by the Covid-19 pandemic has brought unprecedented uncertainty to the global banking system. Banks are facing critical market challenges driven by uncertain monetary policies, deterioration in credit quality, and regulation and compliance pressures. These challenges highlight the importance of better understanding the new role of financial intermediations in facilitating efficient capital allocations and economic development. This article reviews the related literature on monetary policy uncertainty, bank performance, digital finance, and introduces articles on these themes. Finally, we propose potential areas for future research.

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Does competition affect moral behavior? This fundamental question has been debated among leading scholars for centuries, and more recently, it has been tested in experimental studies yielding a body of rather inconclusive empirical evidence. A potential source of ambivalent empirical results on the same hypothesis is design heterogeneity—variation in true effect sizes across various reasonable experimental research protocols. To provide further evidence on whether competition affects moral behavior and to examine whether the generalizability of a single experimental study is jeopardized by design heterogeneity, we invited independent research teams to contribute experimental designs to a crowd-sourced project. In a large-scale online data collection, 18,123 experimental participants were randomly allocated to 45 randomly selected experimental designs out of 95 submitted designs. We find a small adverse effect of competition on moral behavior in a meta-analysis of the pooled data. The crowd-sourced design of our study allows for a clean identification and estimation of the variation in effect sizes above and beyond what could be expected due to sampling variance. We find substantial design heterogeneity—estimated to be about 1.6 times as large as the average standard error of effect size estimates of the 45 research designs—indicating that the informativeness and generalizability of results based on a single experimental design are limited. Drawing strong conclusions about the underlying hypotheses in the presence of substantive design heterogeneity requires moving toward much larger data collections on various experimental designs testing the same hypothesis.

How do China’s government-owned commercial banks respond to informal guidance from The People’s Bank of China? Their reaction to recent guidance designed to cool off mortgage lending offers a fascinating insight into how the banking sector works in China. Michel Habib of the University of Zurich talks to Tim Phillips.

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In this paper, we introduce an expert-annotated dataset for detecting real-world environmental claims made by listed companies. We train and release baseline models for detecting environmental claims using this new dataset. We further preview potential applications of our dataset: We use our fine-tuned model to detect environmental claims made in answer sections of quarterly earning calls between 2012 and 2020 -- and we find that the amount of environmental claims steadily increased since the Paris Agreement in 2015.

Credit Valuation Adjustment captures the difference in the value of derivative contracts when the counterparty default probability is taken into account. However, in the context of a network of contracts, the default probability of a direct counterparty can depend substantially on the default probabilities of indirect counterparties. We develop a model to clarify when and how these network effects matter for CVA, in particular in the presence of correlation among counterparties defaults. We provide an approximate analytical solution for the default probabilities. This solution allows for identifying conditions on key parameters such as network degree, leverage and correlation, where network effects yield large differences in CVA (e.g. above 50%), and thus relevant for practical applications. Moreover, we find evidence that network effects induce a multi-modal distribution of CVA values.

This research examines the incorporation of Environmental, Social, and Governance (ESG) factors into portfolio construction, focusing on identifying companies with strong ESG practices and their relationship with financial performance. Drawing on a US sample of companies and timely ESG data provided by RepRisk, the research proposes a relative approach for constructing a portfolio with a desired exposure to traditional risk premia while tilting the final portfolio towards a quantitative ESG objective. The methodology combines bottom-up and top-down approaches to identify a potential ESG alpha while neutralizing the relative exposure to risk premia associated with traditional factors. The findings indicate a significant and positive ESG premium in the US market while addressing criticisms regarding the lack of forward-looking ESG data. The study makes a novel contribution to the literature on ESG investing by demonstrating the potential of a more flexible and nuanced approach to portfolio construction that incorporates timely ESG information. The results have general implications for investors seeking to align their investments with ESG principles, achieve better risk-adjusted returns, and generate sustainable and resilient portfolios.

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Inflation can significantly undermine companies’ relationships with their customers, employees, and other stakeholders, spawning a crisis of trust. This is particularly true in a period when many citizens accuse corporations of excessively raising prices to maximize profits. Studying the cross-sectional reactions of U.S. stocks to inflation over the period 2018-2022, we find that in the month following a higher inflation rate, equity investors reward firms with stronger social capital, as proxied by their corporate social responsibility (CSR) levels. The effect holds using different measures of inflation, including region-specific ones. The inflation-hedging property of CSR is stronger for firms headquartered in Democratic U.S. states (those most exposed to the “corporate greed” narrative of inflation) and appears to operate through the firm’s cash flows. Analyst forecast revisions provide additional evidence of the value of CSR in inflationary periods. Overall, the findings spotlight inflation as a crisis in stakeholder trust and provide new insights into the importance of social capital for firm value.

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Mergers and acquisitions are often motivated by the intention of creating value from intangible assets. We develop a novel word list of intangibles and apply it to takeover announcements. The value of these deals to the acquirer, as shown by abnormal announcement returns, is questionable: One standard deviation more in intangibles talk lowers returns by 0.50 percentage points. Agency problems explain little of these results. Rather, the cross-section of announcement returns, payment mode choices, and insider trades suggest that intangibles talk reflects managerial overoptimism. In sum, takeover announcements reveal important information regarding the quality of deals.