Research Paper Series

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Year RPS # Title Author/s
2014 2014-013 (FN) THE VALUE OF CROSS-TRADING TO MUTUAL FUND FAMILIES IN ILLIQUID MARKETS Luis Goncalves-Pinto & Juan Sotes-Paladino

We analyze a liquidity-constrained dynamic asset allocation problem in which investors delegate their portfolios to mutual funds that operate under a family organization. The funds are allowed to cross their trades of illiquid common holdings in response to the interests of the family as a whole, and investors' flows are assumed to reward funds with good past performance disproportionately more than they penalize poorly performing ones. We focus on a previously unexplored channel through which fund families can play favorites among affiliated funds: to have some funds avoid the costs of illiquidity by making others adopt suboptimal investment decisions. We find that families' ability to cross-trade among member funds allows them to save on transaction costs but at the same time elicits higher risk-taking by affiliated fund managers, compared to their standalone counterparts. Moreover, we show that the optimal investment strategies might induce changes in the risk-return profile of the affiliated funds, turning a priori relatively conservative, low return funds, into aggressive, high return ones, and vice versa. We also find that the additional costs of agency that investors incur under a fund family arrangement are likely to increase with asset liquidity. Finally, we show that investors can be better off in general when imposing position limits on their funds' portfolios.

2014 2014-012 (FN) STRATEGIC NEWS RELEASES IN EQUITY VESTING MONTHS Alex Edmans, Luis Goncalves-Pinto, Yanbo Wang & Moqi Xu

We show that CEOs strategically time the release of corporate news to coincide with months in which their equity vests. These vesting months are determined by equity grants made several years prior and thus unlikely to be driven by the current information environment. We also find a reduction in news releases in the months before and after vesting. CEOs release 6% more discretionary news in vesting months than prior months. These effects only arise for releases of discretionary news and not non-discretionary news. The tone of the media coverage suggests that such news are predominantly positive. News releases lead to a temporary run-up in stock prices and market liquidity, potentially resulting from increased investor attention or reduced information asymmetry. The CEO takes advantage of these effects by cashing out shortly after the news releases.

2014 2014-011 (FN) INCOMPLETE INFORMATION, TIME-VARYING INVESTMENT OPPORTUNITIES, AND LIQUIDITY PREMIA Yingshan Chen, Min Dai & Luis Goncalves-Pinto

We study the optimal asset allocation of an investor who trades in a market with regime shifts. The investor cannot fully observe the state of the market and incurs transaction costs. We show that the investor is mainly a trend follower, buying on price upswings and selling on downswings. Moreover, compared to the full information case, we find that the effect of transaction costs on liquidity premia is significantly larger when the investor only has access to limited information about the time-varying investment opportunity set. Overall, trading costs play a stronger first-order role in asset pricing under incomplete information. 

2014 2014-010 (FN) IMPLICIT INCENTIVES OF MUTUAL FUND MANAGERS AND THE VALUE OF STOCK LIQUIDITY Min Dai, Luis Goncalves-Pinto & Jing Xu

We study the optimal investment policy of an open-end equity fund manager who needs to deal with periodic and tradable money flows into and out of her fund. The fund manager invests in a benchmark portfolio and in an alternative asset. We assume that trading on the alternative asset incurs transaction costs, while trading on the benchmark is costless. We assume a positive and convex sensitivity of fund flows to relative past performance, which gives the manager implicit incentives to use the alternative asset to gamble so as to finish ahead of the benchmark portfolio. We show that such implicit incentives significantly increase the frequency and volume of endogenous trading of the fund manager, while keeping the exogenous trading (induced by the tradable flows) at negligible levels. As a result, if the fund manager is the marginal investor in the alternative asset, transaction costs can have a strong first-order effect on its liquidity premium, which is defined as the expected return the fund manager is willing to exchange for zero transaction costs.

2014 2014-009 (FN) CO-INSURANCE IN MUTUAL FUND FAMILIES Luis Goncalves-Pinto & Breno Schmidt

We show that fire sales by distressed funds are systematically offset by purchases of other funds in the same family. Our results suggest that such offsetting trades are mainly the outcome of coordinated strategies at the fund manager level. They are more likely when (i) there is reciprocity in repeated interactions, (ii) the same manager oversees the funds on both sides of the transaction, and (iii) the distressed fund holds more illiquid assets. Overall, this type of co-insurance diminishes the price impact of widespread selling by distressed funds, and helps illiquid funds pay a lower cost of distress.

2014 2014-008 (FN) CROSS-MARKET AND CROSS-FIRM EFFECTS IN IMPLIED DEFAULT PROBABILITIES AND RECOVERY VALUES Jennifer Conrad, Robert F. Dittmar & Allaudeen Hameed

We propose a novel approach to separately identify default probabilities and losses given default by using information in two markets: credit default swaps and equity options. We show that inferred option-implied default probabilities capture information about default risk, and that inferred losses given default exhibit significant cross-sectional and time series variation. We apply our methodology to the time series of security prices for a sample of firms during the financial crisis and find that information in default probabilities of financial firms deemed systemically important is transmitted to the default probabilities and losses given default of other firms.
 
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2014 Revised Version: 2014-007 (FN) [2014-006 (FN): July 2014 and 2013-012 (FN): December 2013] IS TRANSPARENCY IN THE EQUITY LENDING MARKET GOOD NEWS? Zsuzsa R. Huszár, Ruth Tan Seow Kuan & Weina Zhang

Using novel U.S. equity lending market data from 2007 to 2010, we find that stock lending fees strongly predict future returns. We posit that, in the newly transparent lending market, active institutional lenders are proactive in pricing. We show that lending fees are raised in expectation of higher shorting demand, especially before earnings announcements and after the Lehman’s collapse. In addition, we find that active institutions’ presence is more like to be associated with higher fees in low information asymmetry environment. Overall, our results imply that increased transparency in the lending market could cause more binding short-sale constraints.

2014 Revised Version: 2014-006 (FN) [2013-012 (FN): December 2013] Stock Lending from Lenders’ Perspective: Are Lenders Price Takers? Zsuzsa R. Huszár, Ruth Tan Seow Kuan & Weina Zhang

This study provides new insights about the source of short sale constraints, by showing that lending fees predict future returns beyond shorting demand in recent years. Focusing on lenders’ perspective, we reveal that lending fees are on average significantly higher for stocks with large active intuitional ownership. For stocks with high active institutional ownership lending fees not only respond to shorting demand but are raised in anticipation of new future shorting demand. Specifically, fees are about 8% higher before earnings announcements and 15% higher before dividend declaration dates for stocks with 50% active institutional ownership than for stocks without active institutional ownership. Lastly, we find that the negative relationship between future returns and lending fees strengthens after the Lehman Brothers collapse as active institutions’ likely become more proactive in capitalizing lending fee revenues in the newly transparent and automated stock lending market.

2014 2014-005 (FN) SPECULATORS AND PRICE OVERREACTION IN THE HOUSING MARKET Yuming Fu & Wenlan Qian

This paper investigates the role of speculators in the housing market, specifically their contribution to price overreaction through positive feedback trading (or momentum trading). We exploit a unique dataset of condominium transactions in a residential real estate market where transaction traits associated with short-term speculation can be identified. In the cross-section of housing projects, a 10 percentage point increase in trading activity following a strong short-run market price rise predicts a negative subsequent monthly price change of 0.5% at the project level. Moreover, the price reversal effect associated with the momentum trading by short-term speculators is two to three times stronger and, holding such trading constant, momentum trading in general has little additional impact. Our findings further suggest that momentum trading by short-term speculators contribute to price overreaction largely in submarkets with lower information efficiency.  

2014 2014-004 (FN) TRANSACTION TAX: THE DOUBLE-EDGED SWORD EFFECTS ON PRICE STABILITY Yuming Fu, Wenlan Qian & Bernard Yeung

We offer direct evidence that a transaction tax can undermine price stability by deterring informed short-term speculators. The evidence is based on a difference-in-differences analysis of a policy intervention in the residential real estate market in Singapore that raised the transaction tax only in one submarket, where short-term speculation is more active. The transaction tax increase reduced short-term trading activities in the affected submarket by 70%, and the reduction was more pronounced in projects arguably more attractive to informed short-term traders. The tax increase led to a 25% rise in price volatility in the affected market and made prices less informative. This finding suggests a disproportionate withdrawal by informed short-term traders after the implementation of the transaction tax. The effectiveness of a transaction tax for restoring price stability during periods of financial and asset market (excess) volatility has been widely debated. Our findings caution against such a tax as it can achieve the opposite of its intended objectives.

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