Finance Premium Research Articles

Labor Mobility and Productivity: Evidence from Finance

We use unique data on careers of investment managers to study the relation between labor markets and productivity differences across sectors in finance. We document significant labor mobility between mutual funds and hedge funds during the 1990s and 2000s. Descriptive evidence suggests potential inefficiencies in the allocation of skill and capital: switching from mutual funds to hedge funds results in large gains in return-based productivity and value-added. Hedge funds absorb mutual fund managers from the left and the right tails of the distribution of abnormal returns, lower Sharpe ratios, and higher volatility. To explain these patterns, we estimate a simple model of supply and demand for labor, with heterogeneous sector-specific skills. The model is identified using shocks to investor demand. Selection of low-skilled mutual managers into hedge funds was driven by a decrease in the mutual fund demand for such managers, an increase in hedge fund demand across the skill distribution, and idiosyncratic expected gains. Selection-adjusted average treatment effects show a much smaller hedge fund premium in return-based productivity and a we cannot reject a zero premium in value added.

Bank Leverage Cycles and the External Finance Premium

By combining the approaches of Gertler and Karadi (2011) (GK) and Bernanke, Gertler, and Gilchrist (1999) (BGG), I develop a Dynamic Stochastic General Equilibrium (DSGE) model with leverage constraints both in the banking and in the nonfinancial firm sector. I calibrate this “full model” to US data. The full model matches the relative volatility of the external finance premium and the procyclicality of bank leverage and thus outperforms both a BGG and a GK‐type model. For a reasonably calibrated combination of balance sheet shocks, the model reproduces a substantial share of the contraction (increase) of investment (the external finance premium) observed during the “Great Recession.”

Managerial Rents vs. Shareholder Value in Delegated Portfolio Management: The Case of Closed-End Funds

Based on the records of 1183 individual fund managers from 1985 to 2010, we investigate manager compensation and discipline in the closed-end fund industry and their implications for manager performance and fund discounts. We nd that managers generating high shareholder surplus, as proxied by fund premium, capture rents on their skills by expansions of assets under management and increases in management fees; however, managers with a high discount are not penalized accordingly. Managers with poor NAV performance suer from asset contractions, but such discipline is insignicant for managers with long tenure. In support of the hypotheses of manager entrenchment and decreasing returns to scale, NAV performance and premium decline with manager tenure and the size of assets under management. Finally, consistent with the conjecture that adjustments of assets under management and management fees in response to extreme performance break the premium-performance relation, the fund premium responds positively only to the NAV performance in the medium range.

Evaluating the Efficiency of Hedge Fund Replication: Return and Diversification Effects

This article analyzes the benefits of adding hedge fund replication products (clones) to an existing portfolio in comparison to adding actual hedge funds as represented by hedge fund indexes. The authors employ the marginal Sharpe methodology to evaluate the benefit of adding an investment to an existing long-only portfolio. The marginal Sharpe is decomposed into a return component and a diversification component, and the authors conduct separate tests on the two components and compare clones with hedge fund indexes. Hedge fund clones, which are liquid trading strategies, seem to be able to replicate the benefit stemming from the diversification component. With respect to the return component, the benefits of adding a hedge fund index to an existing portfolio are significantly higher than those obtained by the clones. However, these results are mitigated after accounting for fees and hedge fund premiums.

Evaluating the Efficiency of Hedge Fund Replication Products: Returns and Diversification Effect

This paper uses a unique data set to test the efficiency of hedge fund replication products. We employ a methodology for the valuation of the components of the marginal benefit of adding an investment to an existing portfolio, and compare the replication products with actual hedge fund indices. The conclusion from both cross-sectional non-parametric tests and from time-series analysis is that the benefits of adding a replication product to a traditional long only portfolio are typically positive, but significantly lower than those of adding an actual hedge fund portfolio as represented by an index of hedge funds. It seems that hedge funds have certain unique factor exposures that cannot be replicated through simple liquid trading strategies. However, after accounting for fees, biases, and hedge fund premiums, one cannot conclude that the replication products are inferior to a well-diversified portfolio of hedge funds. Moreover, there have been huge differences between the performance of various replication products and some have been able to deliver the replication properties better than others.

Future Economic Information Embedded in High Yield Spreads

Future Economic Information Embedded in High Yield Spreads The financial accelerator mechanism, also called credit channel theory (Bernanke and Gertler [1995] and Bernanke and Gertler, and Gilchrist [1996]), assumes external financing is more costly than internal financing in the absence of full collateralization. The difference between external and internal costs is called “external finance premium” and arises from agency costs associated with asymmetric information about the firm’s net worth, defined as the sum of all liquid and illiquid assets minus debt. The external finance premium is inversely related to the firm’s net worth. Firms with poor credit are at the heart of the financial accelerator mechanism, and one can proxy for “external finance premium” using the spread paid by the poor-quality (high-yield) firms over the high-quality firms. In the parlance of the “financial accelerator mechanism,” a reduction of high-yield spread is the harbinger of future boom, and an increase in high-yield spread predicts a decline in economic activity. This article examines the significance of the spread variable to predict various economic variables. We control for momentum in the economic variable by including the four lagged quarters of the economic variable. We look at the growth rate of a broad spectrum of the economy; having tested the relationship between 84 economic measures and the four lagged measures of growth in high-yield spread, we report that 58 of the economic variables tested have statistically significant coefficients.

External Finance Premium and Macroeconomic Outcomes in Nigeria

We develop a small open economy Dynamic Stochastic General Equilibrium model with financial frictions to emphasize the effects of credit market imperfections on macroeconomic outcomes in Nigeria. Financial frictions appear because of the existence of an agency problem that exposes entrepreneurs to high external finance premium. Findings demonstrate that financial frictions matter in the sluggishness of economy activity in Nigeria. Financial constraint lowered GDP level only by 10 percent in presence of domestic shocks, contrast to 30 percent in presence of foreign shocks. Furthermore, monetary policy can create pace to ease access to finance with end of fostering economy activity.

The External Finance Premium in Brazil: Empirical Analyses Using State Space Models

Our objective in this paper is to estimate the external finance premium (EFP), which is a non observable variable, of firms in Brazil using state space models. For this purpose, we built an original database with confidential and public data containing balance sheet information of 5,026 public and private firms from the third quarter of 1994 to the fourth quarter of 2010. Our results show that the average and volatility of the EFP of small firms is higher than those of large firms and that the EFP is more sensitive to monetary policy for small firms than for large firms. These empirical evidences point to the importance of the balance sheet channel of the transmission mechanism of monetary policy in Brazil.

Managerial Rents vs. Shareholder Value in Delegated Portfolio Management: The Case of Closed-End Funds

We examine the dynamics of assets under management (AUM) and management fees at the portfolio manager level in the closed-end fund industry. We find that managers capitalize on good past performance and favorable investor perception about future performance, as reflected in fund premiums, through AUM expansions and fee increases. However, the penalties for poor performance or unfavorable investor perception are either insignificant, or substantially mitigated by manager tenure. Long tenure is generally associated with poor performance and high discounts. Our findings suggest substantial managerial power in capturing CEF rents. We also document significant diseconomies of scale at the manager level.

Taking financial frictions to the data

We estimate a Dynamic Stochastic General Equilibrium (DSGE) model with various financial frictions and analyze how well the model explains the Great Recession. Predictive analysis shows that the model can only slightly better explain the large deviation from trend during the crisis relative to a model without financial frictions. Specifically, the risk premium shock, which is a shock to the external finance premium of the entrepreneurs׳ leverage, explains the largest part of the investment downfall during the crisis. However, the ‘balance sheet’ channel of financial frictions in the model, which structurally links balance sheet conditions of financial intermediaries and nonfinancial borrowers to their borrowing rates, is estimated to be weak. We examine alternative prior specifications for how the financial frictions enter the model and continue to find a limited role for these frictions. Rolling-window estimation provides evidence for substantial time variation in parameters governing financial frictions. We conclude that the well-known financial frictions studied in this paper are not able to explain the financial crisis in a linearized and estimated model.

Firm Investment and Financial Conditions in the Euro Area: Evidence from Firm-Level Data

We explore whether the sensitivity of firm-level investment to cash-flow, typically associated with an external financing premium, is time-varying and in particular whether it varies with overall financial conditions. We find that financial conditions have indeed played a significant role in corporate investment decisions over recent years, rendering financing constraints even more binding. This finding appears to be robust to a number of control variables and robustness tests. Moreover, the impact of credit conditions is not uniform across firms, but rather it varies depending on firm size and leverage, with constrained firms being substantially more likely to condition their investment decisions on overall credit conditions. Our results cast new light on the interplay between financial and real cycle downturns and underline the need for monetary, fiscal and macroprudential policy to be countercyclical with respect to financial conditions.

Closed-End Funds

Recent work suggests that investor sentiment drives the behavior of closed-end fund premiums. We develop a microstructure model that links the observed closed-end fund premiums to the interplay between the bid-ask spread of the fund with that of the fund's holdings. Employing a battery of investor sentiment measures, we find inconsistent evidence in support of an investor sentiment hypothesis, but robust support for the liquidity based explanation in explaining the closed-end fund premium. The importance of the microstructure explanation extends to pricing of the closed-end funds whereby significant cross-sectional pricing ability for the bid-ask spreads is found, but no significant pricing ability for either investor sentiment or closed-end fund premiums.

Losing Track of the Asset Markets: The Case of Housing and Stock

This paper revisits the relationships among macroeconomic variables and asset returns. Based on recent developments in econometrics, we categorize competing models of asset returns into different Equivalence Predictive Power Classes (EPPC). During the pre-crisis period (1975-2005), some models that emphasize imperfect capital markets outperform an AR(1) for the forecast of housing returns. After 2006, a model that includes both an external finance premium (EFP) and the TED spread learns and adjusts faster than competing models. Models that encompass GDP experience a significant decay in predictive power. We also demonstrate that a simulation-based approach is complementary to the EPPC methodology.

Bank liquidity creation and asset market liquidity

Consistent with the credit channel theory of monetary policy transmission, this paper finds novel evidence that asset market liquidity as one of the proxies for the external finance premium explains bank liquidity creation. While efficacy of monetary policy depends on how banks create liquidity, the existing literature does not find any conclusive evidence that monetary policy variables explain aggregate bank liquidity creation. We use both stock market and the Treasury bond market liquidity as proxies for asset market liquidity, and find that: (1) asset market liquidity and credit-spreads explain aggregate bank liquidity creation and liquidity creation of larger banks; (2) stock market liquidity rather than credit-spreads or the Treasury bond market liquidity has robust and higher impact on aggregate liquidity creation; (3) while stock market liquidity better explains off-balance sheet liquidity creation, the short-term off-the-run Treasury bond liquidity has higher impact on on-balance sheet liquidity creation; (4) the Federal funds rate as a proxy for monetary policy impacts liquidity creation of smaller banks more than it does liquidity creation of larger banks.

Bank Risks, Monetary Shocks and the Credit Channel in Brazil: Identification and Evidence from Panel Data

Using a large database of bank financial statements, this paper investigates the determinants of the bank lending channel (BLC) of monetary transmission in Brazil between 1995 and 2012. I extend the standard empirical approach in two main ways. First, I apply a micro-founded strategy for disentangling demand from supply shifts in credit. Using this identification scheme, I show that lending supply is negatively correlated with the short-term market interest rate over the long period. The sensitivity of credit supply to monetary shocks is not related to the bank characteristics generally used in the empirical literature, whereas a proxy of the individual bank external finance premium (EFP) tends to capture financial constraints better than size, liquid assets or capitalization ratios. However, the patterns of the BLC have changed since the onset of the global financial crisis. In the post-crisis period, the money market rate does not affect the lending supply of the average bank anymore, while small banks and those lacking access to long-term funds appear more sensitive to monetary shocks in some estimations. Second, I check whether several types of uncertainty may drive the BLC, beyond liquidity risk. Over the long period, I find evidence that higher market risk borne by banks’ securities portfolios (captured by a longer duration of public debt bonds) and lower uncertainty in the money market (captured by a lower volatility of rates) appear to consistently enhance the effectiveness of monetary policy through the BLC.

Bank risks, monetary shocks and the credit channel in Brazil: Identification and evidence from panel data

Using a large database of bank financial statements, this paper investigates the determinants of the bank lending channel (BLC) of monetary transmission in Brazil between 1995 and 2012. I extend the standard empirical approach in two main ways. First, I apply a micro-founded strategy for disentangling demand from supply shifts in credit. Using this identification scheme, I show that lending supply is negatively correlated with the short-term market interest rate over the long period. The sensitivity of credit supply to monetary shocks is not related to the bank characteristics generally used in the empirical literature, whereas a proxy of the individual bank external finance premium (EFP) tends to capture financial constraints better than size, liquid assets or capitalization ratios. However, the patterns of the BLC have changed since the onset of the global financial crisis. In the post-crisis period, the money market rate does not affect the lending supply of the average bank anymore, while small banks and those lacking access to long-term funds appear more sensitive to monetary shocks in some estimations. Second, I check whether several types of uncertainty may drive the BLC, beyond liquidity risk. Over the long period, I find evidence that higher market risk borne by banks' securities portfolios (captured by a longer duration of public debt bonds) and lower uncertainty in the money market (captured by a lower volatility of rates) appear to consistently enhance the effectiveness of monetary policy through the BLC.

Chained financial contracts and global banks

This paper studies a chained credit contract based on Hirakata et al. (2013) in which investors lend funds to banks and banks lend to entrepreneurs in an imperfect financial market. We show that the optimality condition of this contract has a simple, symmetric structure analogous to the one in Bernanke, Gertler and Gilchrist (1999), and that the external finance premium is increasing in both the entrepreneurs’ and the bank’s capital to net worth ratio. We apply the chained credit contract to analyse global banks, and show that the common lender effect drives the positive comovement of the external finance premia across economies.

THE EFFECT OF LABOR AND FINANCIAL FRICTIONS ON AGGREGATE FLUCTUATIONS

This paper embeds labor market search frictions into a New Keynesian model with financial frictions. The econometric estimation establishes that labor market frictions substantially improve the empirical fit of the model. The effect of the interaction between labor and financial frictions on aggregate fluctuations depends on the nature of the shock. For monetary policy, technology, and entrepreneurial wealth shocks, labor market frictions amplify the effect of financial frictions, because robust changes in hiring lead to persistent movements in employment and return on capital that reinforce the original effect of financial frictions. For cost-push, labor supply, marginal efficiency of investment, and preference shocks, labor market frictions dampen the effect of financial frictions by reducing the real cost of repaying existing debt, which lowers the external finance premium.

Exploiting Closed-End Fund Discounts: The Market May Be Much More Inefficient than You Thought

We systematically study the value of the information contained in closed-end fund (CEF) premiums. We parametrically estimate CEF expected returns as a function of the history of CEF premiums, in addition to the current premium, and buy the quintile of funds with the highest expected returns and sell the quintile of funds with the lowest expected returns. The return on this portfolio suggests that previous studies, which examine the information in current premiums only, have understated the value of the information in premiums. Our strategy values the information in the history of CEF premiums at an annualized return of 18.2%.

How Important are Financial Shocks for the Canadian Business Cycle?

In this paper, we investigate the importance of financial shocks for the Canadian business cycle employing the financial friction DSGE framework following Bernanke, Gertler, and Gilchrist with an extension of a small-open economy feature. In particular, we explored the importance of an external finance premium shock and an aggregate net worth shock. In order to identify financial shocks in the model, we utilized financial data in estimating our model. Our variance decomposition results showed that the external finance premium shock to account about 7.5% and the aggregate net worth shock to account about 5.6% of the variance of the business fixed investment in Canada. Also, our historical decomposition results and smoothing of the various financial variables showed that data on corporate leverage ratio to be particularly useful in identifying the financial shocks in the model. Finally, when the financial shocks were present in the model, relative importance of the investment-specific technology shock was substantially subdued that it accounted for only 17% of the variance of the business fixed investment –much lower than the results reported in the former empirical studies.