Higher Risk Premium Research Articles

Firm Networks and Asset Returns

Abstract Changes in the propagation of shocks along firm networks are important to understanding aggregate and cross-sectional features of stock returns. When calibrated to match key characteristics of supplier–customer networks in the United States, a model in which firms are interlinked via enduring relationships generates long-run consumption risks, high and volatile risk premiums, and a small and stable risk-free rate. The model also matches cross-sectional patterns of portfolio returns sorted by firm centrality, a feature unaccounted for by standard asset pricing models. (JEL C67, E30, G12, L14)

Neobanks in emerging markets: a risk assessment

Neobanks have risen as popular digital challengers to incumbent banks, especially in emerging markets (EMs) where the banking sector is often characterized by oligopolies. This article first estimates the value of Nubank and StoneCo in Brazil, two of the fastest-growing neobanks in Brazil. Normalizing revenue growth assumptions from their financial data, valuation models uncover that Nubank could be overvalued by about two times, whereas StoneCo could be undervalued by 80% of its fair value, as of March 19, 2024. This article then discusses firm-specific (high cumulative net operating losses, low long-term operating margins, high borrowing costs) and adherent macroeconomic (political uncertainty, foreign exchange risks, high equity risk premia) risks in EMs that explain the volatility in Nubank’s and StoneCo’s stock prices. These risks are instructive for understanding the challenges facing the business model of neobanks in EMs.

Fintech: Digital Transformation of Financial Services and Financial Regulation

This study offers a comprehensive analysis of critical aspects within the domains of financial technology (Fintech) and online payments, with a focal point on the regulatory dimension. It commences by exploring how Fintech, propelled by technological innovations, has orchestrated a paradigm shift, ushering in the digital economy and digital civilization. It underscores Fintech's role in mitigating longstanding issues in traditional finance, particularly information asymmetry and high-risk premiums, harnessing the potential of big data, cloud computing, blockchain, and artificial intelligence. The study extends to a detailed evaluation of the intelligent investment advisory sector (Robo-Advisor) and online payments, delving into security concerns and regulatory considerations. A pivotal highlight is the transformative potential of digital currencies, including central bank digital currencies (CBDCs) and cryptocurrencies, in revamping payment systems, fortifying security, and reducing cross-border transaction costs. Regulatory upgrades play a paramount role in shaping this transformation, ensuring the security of online payments and fostering compliance.

Debt-financed fiscal stimulus in South Africa

Levels of government debt-to-GDP have been rising substantially for over a decade in emerging market economies such as South Africa, which has led to much debate around the implementation of large-scale debt-financed fiscal stimulus programs in response to the economic fallout of the global covid-19 pandemic. Debt-financed fiscal policies directly stimulate aggregate demand through government expenditure or tax cuts, but their effectiveness is highly dependent on direct crowding-out of private sector expenditure, spill-over effects to the private sector through a higher risk premium on interest rates, and the interaction between fiscal policy and monetary policy. Using an open-economy dynamic stochastic general equilibrium model for South Africa, we identify the effect of six different fiscal policy instruments on short-term and long-term interest rates. These disaggregated expenditure and revenue shocks raise long-term real yields between 18 and 29 basis points, but there are non-negligible differences in the dynamic responses to each fiscal instrument. Our main findings suggest that, in the context of fiscal sustainability, an investment-driven debt-financed fiscal stimulus programme would reduce the government debt-to-GDP ratio, especially in periods of economic slack when monetary policy would typically be more accommodative. In fact, since the global financial crisis, monetary policy has reduced the burden of fiscal adjustment in response to rising debt and a rising risk premium. But further shocks to the risk premium could offset any gains from the current stance of monetary policy (for example, a credit rating shock raises the long-term government bond rate 155 basis points).

Auditing the Derivative Usage of Bank-Holding Companies

SYNOPSIS Auditing financial derivatives is complex and contentious. Our study examines the impact of derivative use on the risk premium charged by auditors of bank-holding companies (BHCs). We find that audit fees are higher regardless of whether derivative instruments are used for hedging and trading. This implies that auditors charge BHCs that use derivatives a risk premium to compensate for additional risk related to these instruments. We also find that trading derivatives tend to have a higher risk premium than hedging derivatives. Our results suggest that auditors price risks related to derivatives, and trading derivatives are perceived to be higher risk than hedging derivatives. Data Availability: All data are available from public databases identified in the paper. JEL Classifications: G21; M40; M41.

Bail-in and bank funding costs

We evaluate the impact of the bail-in, the new resolution policy adopted in 2016 within the Bank Recovery and Resolution Directive, on the cost of funding for EU banks. We first estimate the change in spreads of credit default swaps on subordinated and senior bonds issued by EU banks through an event study around the period when the policy became effective. We find that risk premia of junior bail-in-able bonds raised more compared to senior bonds. The results, however, point to a great heterogeneity in the impact of the policy, both for individual banks and across countries, while a simple theoretical model suggests possible sources of this heterogeneity. We therefore regressed the abnormal values derived from the event study on bank characteristics and macroeconomic factors. We uncovered several factors explaining the larger cost of funds for some of the EU banks after the implementation of bail-in: banks with more problematic loans, less capitalized, and headquartered in countries with a higher risk premium on sovereign debt have experienced a larger rise in their funding costs when issuing subordinated bonds. Overall, our paper provides evidence that the adoption of bail-in has prompted a more accurate evaluation of bank risk by junior creditors, leading to an increase in the cost of funds for banks.

Competition, investment reversibility, and equity risk premium

This paper investigates the role of investment reversibility in determining the relationship between product market competition and equity risk premium. We develop a unified real-option framework involving corporate investment and disinvestment decisions in a continuous-time Cournot–Nash equilibrium. The effect of competition on a firm’s risk premium induced by contraction options is negative and similar to that on the risk premium induced by expansion options; however, for assets in place, more competition results in a higher risk premium by increasing operating leverage. Notably, investment reversibility rather than product market demand moderates the competition-risk premium relationship. Our model predicts that the equity risk premium is more negatively correlated with the level of competition if investments are more reversible because firms are more likely to adjust their capacity in response to uncertain demand and this flexibility attenuates the positive operating leverage effect. We find robust empirical evidence to support our theoretical prediction.

Non-linearities in the relationship between public debt and inequality

ABSTRACT This paper examines the possible nonlinear relationship between public debt and income inequality. The literature extensively examines the non-linear growth effects of public debt, whereas its inequality effects are not investigated sufficiently. Public debt can be used to finance distributive policies, thereby improving income equality. However, high public debt levels can also harm economic growth and decrease the fiscal space due to sustainability concerns, high risk premia, and large debt service burden. Hence, it is possible that public debt can have non-linear effects on inequality. The empirical analysis documents that the relationship between public debt and inequality is positive with a declining marginal effect in the case of advanced countries. However, developing countries display a U-shape relationship, implying that public debt is initially associated with declines in inequality, while higher levels of debt are associated with higher levels of inequality. The analysis also shows that the determinants of inequality can differ greatly between advanced and developing countries.

The Variance Risk Premium in Equilibrium Models

Abstract The equity variance risk premium is the expected compensation earned for selling variance risk in equity markets. The variance risk premium is positive and shows only moderate persistence. High variance risk premiums coincide with the left tail of the consumption growth distribution shifting down. These facts, together with risk-neutral skewness being substantially more negative than physical return skewness, refute the bulk of the extant consumption-based asset pricing models. We introduce a tractable habit model that does fit the data. In the model, the variance risk premium depends positively (or negatively) on “bad” (or “good”) consumption growth uncertainty.

How Does Risk Tolerance Reflected in National Culture Affect Pay-Performance Sensitivity?

ABSTRACTThe standard principal-agent model predicts that, ceteris paribus, a negative relation exists between firm risk and CEO incentives or pay-performance sensitivity. We examine how a CEO’s risk tolerance (captured by national culture) affects pay-performance sensitivity using international data from 29 countries. We find that CEOs from countries with high (low) risk tolerance are associated with high (low) pay-performance sensitivity, suggesting that they require a low (high) risk premium. We contribute to the CEO compensation literature by introducing CEO risk tolerance, an overlooked factor, into CEO compensation contracts.

Supply chains and risk premia in Chinese stock market: A sorted‐portfolio approach

AbstractIn the recent literature, increasing attention has been paid to cases when the shocks to a small number of firms would lead to large volatility in many sectors. Theorists find that supply chains play a role, as the shocks to a firm or a sector may propagate through the input–output linkages and form risks in the whole network. In this paper, we investigate the impact of risks from supply‐chain variations on risk premia of the A‐listed firms in the Chinese stock market from 2007 to 2021. Based on network statistics, we measure a firm's local status in the supply chains by the customer‐ and supplier‐concentration, and its global position by the centrality. We then construct corresponding risk factors using diversified portfolios sorted according to these indices. It is found that the supply‐chain positions are related to risk exposure. Firms with de‐concentrated customers/suppliers have larger risk premia than concentrated firms. Moreover, with Size controlled, the firms in the center of cross‐sector trade have higher risk premia than the peripheral ones. When these supply‐chain factors are added to Fama and French's five‐factor model with Market, Size, B/M ratio, Operating profitability, and Investment, the proportion of return variances that could be explained would increase from 51.1% to 54.9% on average.

What do we know about the idiosyncratic risk of clean energy equities?

The COVID-19 pandemic stimulated the need to invest in clean energy firms for better returns and climate risk mitigation. This study provides a detailed overview of the impact of idiosyncratic risk (IVOL) on excess returns of 95 clean energy stocks. Overall, investors in clean energy stocks are guided by the pessimist group of investors who underprice the high IVOL stocks and demand high-risk premiums to diversify the firm-specific risk. Further, during the COVID-19 period, there is no significant relationship between clean energy excess stock returns and IVOL. During this period, clean energy stocks were exposed to higher information asymmetry, limiting the arbitrage opportunities and producing a weaker return-IVOL relation indicating that clean energy stocks reflect the properties of technology stocks. IVOL has a low level of persistence which may be helpful in forecasting. This study offers valuable insights for regulators and investors from the investment decisions, asset pricing, and diversification perspective.

A Look into ‘Market Manipulation’ With a Focus on Pump and Dump Schemes and Initial Considerations for Responding to a Regulatory Query

Public confidence in the fairness of markets enhances their liquidity and efficiency. Market manipulation harms the integrity of securities and derivatives markets by distorting prices, and creates an artificial appearance of market activity. Market manipulation damages the interests of retail and institutional investors alike by disrupting the smooth functioning of financial markets. This leads to a lack of trust in the fairness of the capital markets, resulting in higher risk premiums and reduced investor participation. This article provides an analytical framework (covering the United States, Switzerland, Singapore and the United Kingdom) for understanding select market manipulation behaviour with a focus on pump and dump schemes; and how to craft a preliminary defence strategy when a query is received from a markets regulator. Some tools for combating crossborder fraud and misconduct that can weaken global markets and undermine investor confidence, have been discussed. corporate governance, comparative law, shareholder primacy

The term structure of equity premia and the macroeconomy: some results

This letter analyses the relationship between the term structure of stock market risk premia and the key macroeconomic variables: inflation and GDP growth. The term structure of risk premia is obtained using a new method that utilises dividend future contracts and analysts’ dividend expectations. The results show that investors require high risk premia when GDP growth is expected to be low. The relationship between expected inflation and risk premia is less clear.

Theoretical Investigation on the Optimal Contracting for Directors Holding Multiple Directorships

This paper is the first (to our knowledge) to analytically model the optimal contracting for a member of the board of directors who holds multiple directorships. Prior literature has found conflicting evidence on the overall effect of multiple directorships on shareholder welfare: busy board members are usually detrimental to firm operating performance due to the limited time and effort they are able to devote to each board; however, multiple directorships can be beneficial to firms if the board members gain knowledge and expertise through their multiple appointments. The objective of our study is to expand the research on the effects of multiple directorships on shareholder welfare by modeling the relationship between optimal incentives (pay–performance sensitivity) and the number of directorships. Modeling within the Linear–Exponential–Normal framework, and solving using Subgame-Perfect Nash Equilibrium, we find that this relationship is positive when efforts across directorships are either substitutive or complementary, which highlights another potential significant downside to multiple directorships: companies need to offer high incentive-based pay to compete for directors’ efforts, leading to high-risk premia and welfare loss to shareholders. Our results may be of interest to policy makers considering setting limits on the number of board seats that may be held by directors at public companies, as well as shareholders considering appointing directors with multiple appointments.

Agent-based retail competition and portfolio optimization in liberalized electricity markets: A study involving real-world consumers

The liberalization of energy markets brought full competition to the electric power industry. In the wholesale sector, producers and retailers submit bids to day-ahead markets, where prices are uncertain, or alternatively, they sign bilateral contracts to hedge against pool price volatility. In the retail sector, retailers compete to sign bilateral contracts with end-use customers. Typically, such contracts are subject to a high-risk premium—that is, retailers request a high premium to consumers to cover their potential risk of trading energy in wholesale markets. Accordingly, consumers pay a price for energy typically higher than the wholesale market price. This article addresses the optimization of the portfolios of retailers, which are composed of end-use customers. To this end, it makes use of a risk-return optimization model based on the Markowitz theory. The article presents a simulation-based study conducted with the help of the MATREM system, involving 6 retailer agents, with different risk preferences, and 312 real-world consumers. The retailers select a pricing strategy and compute a tariff to offer to target consumers, optimize their portfolio of consumers using data from the Iberian market, sign bilateral contracts with consumers, and compute their target return during contract duration. The results support the conclusion that retail markets are more favourable to risk-seeking retailers, since substantial variations in return lead to small variations in risk. However, for a given target return, risk-averse retailers consider lower risk portfolios, meaning that they may obtain higher returns in both favourable and unfavourable situations.

Macroeconomic Implications of Inequality and Income Risk

<ns3:p>We explore the long-run relationship between income risk, inequality, and the macroeconomy in an overlapping-generations model in which households face uncertain streams of labor income and returns on their savings. To manage those risks, households can apportion their savings to a bond, whose return is safe and identical across households, and a productive asset, whose return is uncertain and can differ persistently across households. We find that greater polarization in households’ labor income and returns on their savings generally accentuates households’ demand for risk-free assets and the compensation they require for bearing risk, leading to higher measured income and wealth inequality, a lower risk-free real interest rate, and higher risk premiums. These findings suggest that the factors behind the observed rise in inequality over the past few decades might have contributed to the observed fall in the risk-free real interest rate and widening gap between the risk-free real interest rate and the rate of return on capital. We also find that the magnitude of the decline in the risk-free real interest rate and offsetting rise in risk premiums depend importantly on the source of income polarization, with the effects being especially large when greater inequality is caused by increased dispersion in returns on risky assets. Thus, the macroeconomic implications not only depend on the amount of inequality, but also the source of this inequality.</ns3:p>

Do Intermediaries Matter for Aggregate Asset Prices?

ABSTRACTPoor financial health of intermediaries coincides with low asset prices and high risk premiums. Is this because intermediaries matter for asset prices, or because their health correlates with economy‐wide risk aversion? In the first case, return predictability should be more pronounced for asset classes in which households are less active. We provide evidence supporting this prediction, suggesting that a quantitatively sizable fraction of risk premium variation in several large asset classes such as credit or mortgage‐backed securities (MBS) is due to intermediaries. Movements in economy‐wide risk aversion create the opposite pattern, and we find this channel also matters.

The Development of Digital Finance and Firms’ Transformation from Virtual to Real

Firms’ transformation from virtual to real means that firms allocate more capital from non-productive areas to productive areas, which is shown as the decrease of the level of firm financialization. The inefficient supply of traditional financial services is one of the factors that promotes firm financialization. In recent years, with the development and popularization of new technology, digital finance emerges at the historic moment. In essence, digital finance utilizes network technologies such as artificial intelligence, big data, cloud computing, Internet of Things, and blockchain to not only expand the accessibility of financial services, but also solve the problems of high risk premium and high operating cost generated in traditional financial services. Therefore, in view of the development scale of China’s internet economy and its leading position in the world’s technical practice, and considering the huge effect of digital finance on traditional financial services, it is necessary to explore the effect mechanism of digital finance on firm financialization from the perspective of Fintech progress.Based on the annual data of A-share listed firms in Shanghai and Shenzhen stock exchanges from 2011 to 2018, this paper examines the effect of digital finance development on firm financialization. The empirical study finds that the development of digital finance can reduce the level of firm financialization. The mechanism test finds that digital finance inhibits firm financialization mainly by weakening the precautionary motivation of firms. Further study finds that the inhibition of digital finance development on firm financialization only exists in the weak samples of the structural mismatch of traditional finance. In other words, the inhibitory effect of digital finance on firm financialization is more significant in private firms, manufacturing firms and growth-stage firms. Meanwhile, compared with short-term financial assets, long-term financial assets of firms are more significantly inhibited by the development of digital finance. With the standardization of the regulatory environment and the strengthening of supervision, the development of digital finance has a more significant inhibiting effect on firm financialization.The research contributions of this paper are mainly reflected in the following three aspects: Firstly, from the perspective of digital finance, it reveals the effect mechanism of Fintech progress on firm financialization, and clarifies the important role of Fintech progress in the interaction between real economy and virtual economy. Secondly, from the perspective of firm financialization, it empirically investigates the microeconomic consequences of digital finance, and supplements related literatures on the economic consequences of digital finance. Thirdly, the findings of this paper are conducive to understanding the positive role of digital finance in correcting financial mismatch. In terms of policy suggestions, on the one hand, for firms, digital finance can effectively alleviate the financial pressure and financing constraints. Especially for manufacturing firms, start-ups and private firms, digital finance can play a role of inclusive finance. On the other hand, for regulators, it is necessary to effectively regulate digital firms and the digital economy to avoid risks such as industry monopoly, data security and regulatory loopholes.

Monetary Policy Risk: Rules versus Discretion

AbstractLong-run asset pricing restrictions in a macro term structure model identify discretionary monetary policy separately from a policy rule. We find that policy discretion is an important contributor to aggregate risk. In addition, discretionary easing coincides with good news about the macroeconomy in the form of lower inflation, higher output growth, and lower risk premiums on short-term nominal bonds. However, it also coincides with bad news about long-term financial conditions in the form of higher risk premiums on long-term nominal bonds. Shocks to the rule correlate with changes in the yield curve’s level. Shocks to discretion correlate with changes in its slope.