Leverage Constraints Research Articles

Empirical properties of a heterogeneous agent model in large dimensions

We introduce a variant of the Adaptive Beliefs System (ABS) of Brock and Hommes (1998) based on returns instead of prices. Agents form their demands according to the degree to which they are trend-following or contrarian. Empirically, the model requires that agents’ demands be coerced by leverage constraints. Using five samples of US stock returns, we show that the fit to realized returns is essentially driven by the total dispersion of the model’s returns. We also find that the latter are more realistic when forecasts are based on short-term estimates and when trend-followers and contrarians have the same ex-ante importance. We then provide evidence that the model is able to mimic most stylized facts observed on financial markets (tail decay, volatility clustering and autocorrelation patterns) quite closely. Finally, we find that portfolio policies designed according to the model’s predictions outperform the naive 1/N portfolio out-of-sample by 2% per annum.

The Low-Risk Anomaly: Evidence from The Thai Stock Market

In many developed countries, low-risk stocks tend to earn superior risk-adjusted returns compared to high-risk stock. Using data on the Stock Exchange of Thailand between 2004 and 2015, this paper shows that the abnormal returns associated with investing in low-beta stocks are significant and robust. The zero-cost portfolio that longs low-beta stocks and shorts high-beta stocks delivers monthly four-factor alpha of 1.26%. This paper provides suggestive evidence that, in addition to leverage constraints, the low-risk anomaly can be caused by institutional designs that favour stocks that are index constituents.

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.”

Determinants of being acquired in Indian manufacturing sector: a panel data analysis

Purpose The purpose of this study is to examine the firms’ determinants of being acquired in Indian manufacturing sector. There is evidence of relationship between likelihood of being acquired and several firm specific characteristics such as age, size, research and development (R&D), advertising intensity, productivity, leverage, profitability, intangible assets and financial constraints. However, little is known about the association between these characteristics and likelihood of acquisition in Indian manufacturing sector. Design/methodology/approach The sample is a panel of 2,189 Indian manufacturing firms spanning almost 10 years (1998-2007). Random effects logistic (REL) regression model is adopted to control the firm specific unobserved heterogeneity in the sample. This is an essential requirement for providing accurate and effective determinants of being acquired. Findings Empirical results reveal that the determinants of being acquired in Indian manufacturing sector are age, size, R&D intensity, advertising intensity, productivity and leverage. The findings indicate that increase in firms’ age, size, R&D intensity and advertising intensity increases the likelihood of being acquired. However, increase in productivity and leverage decreases the likelihood of being acquired. Research limitations/implications Findings of this study may be useful for potential targets to arrive at more thoughtful assessment of their attractiveness and, accordingly, promote their acquisition as a more efficient mode of exit. Originality/value The paper contributes some empirical evidence on the determinants of being acquired in Indian manufacturing sector by using panel data and REL regression model.

Characteristics-based portfolio choice with leverage constraints

We show that the introduction of a leverage constraint improves the practical implementation of characteristics-based portfolios. The addition of the constraint leads to significantly lower transaction costs, to a reduction of negative portfolio weights, and to a decrease in volatility and misspecification risk. Furthermore, it allows investors to implement any desired level of leverage. In this study, we include 12 characteristics, thereby extending the classical size, book-to-market and momentum paradigm. We report several key indicators such as the proportion of negative weights, Sharpe ratio, volatility, transaction costs, the transaction cost-adjusted certainty equivalent returns, and the Herfindahl–Hirschman index. Analyzing the sensitivity of these key indicators to the choice of multiple combinations of the 12 characteristics, to risk aversion, and to estimation sample size, we show that constrained policies are much less sensitive to these parameters than their unconstrained counterparts. Finally, for quadratic utility, we derive a semi-closed analytical form for the portfolio weights. Overall, we provide a comprehensive extension of characteristics-based portfolio choice and contribute to a better understanding and implementation of the allocation process.

Adverse effects of leverage and short-selling constraints in a financial market model with heterogeneous agents

This paper investigates the impact of leverage and short-selling constraints on financial market stability. Investors׳ demand is modelled in a well-known asset pricing model with heterogeneous beliefs. In particular, I generalise the heterogeneous agents model of Brock and Hommes (1998) and Anufriev and Tuinstra (2013) to allow for leverage constraints as well as a short-selling tax. I consider two examples of adaptive belief systems describing the coevolution of prices and investors׳ beliefs. First, if the market is inhabited by fundamentalist and chartist traders, demand constraints have potential adverse effects and may restrict the stabilising fundamentalist strategy such that mispricing and price volatility increase. Second, if the market is inhabited by fundamentalists, optimists and pessimists with fixed beliefs, demand constraints drive down price volatility, but mispricing remains. The results suggest the stabilising effects of demand constraints in financial markets are limited. Only if asset prices are too high compared to fundamentals, policy makers should consider constraining leverage ratios in order to deflate financial bubbles.

Low-risk equity investment – From theory to practice

Financial theory assumes that higher risk is compensated on average by higher returns. However, the outperformance of low-volatility stocks during the last 50 years has been among the most puzzling anomalies in equity markets. At the same time, low-risk investing has recently gained a remarkable interest, due to its documented performance coupled with the unprecedented volatility experienced during the last global financial crisis. The section ‘Literature Review’ of our study discusses how researchers have been documenting such anomaly and explaining (since the early nineties) this phenomenon with theories referring to leverage constraints, behavioral bias, delegated portfolio, benchmarking and the utility function of fund managers. Recognizing that most of the available empirical research focuses on the US equity market, section ‘Empirical Evidence in the International Arena’ is dedicated to some additional tests that we have run on the persistency and significance of the anomaly in the international arena: We find that the relationship between risk-adjusted returns and risk is negative indeed, and that the relationship holds regardless of the risk measure employed for tests (Beta or volatility). In section ‘Can Skewness And Convexity Explain the Low-Risk Anomaly?’, we investigate two possible explanations of the anomaly related to the distribution of equity returns, namely skewness and convexity. We find that high-risk stocks exhibit higher skewness and higher convexity than low-risk stocks. These results may effectively explain the anomaly because, if the price paid for stocks with higher-than-average skewness and convexity is inflated, their subsequent returns are consequently lower-than-average, at least in risk-adjusted terms. In the last section of our research, we discuss two popular risk-based smart beta strategies (minimum variance and risk parity) proving that both of them benefit from the low-risk anomaly via a significant and systematic bias toward low-risk stocks. We ultimately discuss some best practices of implementing the minimum-variance process, and provide an effective and parsimonious portfolio construction rule for the risk parity process.

A Macroeconomic Model with Financially Constrained Producers and Intermediaries

We evaluate the quantitative effects of macroprudential policy. To do so, we solve a general equilibrium model with three types of agents and a government. Borrower-entrepreneurs produce output financed with long-term debt issued by financial intermediaries, subject to a leverage constraint. Intermediaries fund these loans combining deposits and their own equity, and are subject to a regulatory capital constraint. Savers provide funding to banks and to the government. Both entrepreneurs and banks make optimal default decisions. The government issues debt to finance budget deficits and to pay for bank rescue operations. We solve for macroeconomic quantities, the price of capital, the yield on safe bonds, and the credit spread. We study how financial and non-financial recessions differ, show that high credit spreads forecasts future declines in economic activity, and study macro-prudential policies. Policies that limit corporate leverage and financial leverage reduce welfare. Their benefits for financial and macro-economic stability are outweighed by the costs from a smaller-sized economy. The two types of macroprudential policies have different implications for the wealth distribution.

Characteristics-Based Portfolio Choice with Leverage Constraints

We show that the introduction of a leverage constraint improves the practical implementation of characteristics-based portfolios. The addition of the constraint leads to significantly lower transaction costs, to a reduction of negative portfolio weights, and to a decrease in volatility and misspecification risk. Furthermore, it allows investors to implement any desired level of leverage. In this study, we include 12 characteristics, thereby extending the classical size, book-to-market and momentum paradigm. We report several key indicators such as the proportion of negative weights, Sharpe ratio, volatility, transaction costs, the transaction cost-adjusted certainty equivalent returns, and the Herfindahl-Hirschman index. Analyzing the sensitivity of these key indicators to the choice of multiple combinations of the 12 characteristics, to risk aversion, and to estimation sample size, we show that constrained policies are much less sensitive to these parameters than their unconstrained counterparts. Finally, for quadratic utility, we derive a semi-closed analytical form for the portfolio weights. Overall, we provide a comprehensive extension of characteristics-based portfolio choice and contribute to a better understanding and implementation of the allocation process.

Betting Against Correlation: Testing Theories of the Low-Risk Effect

We test whether the low-risk effect is driven by (a) leverage constraints and thus risk should be measured using beta vs. (b) behavioral effects and thus risk should be measured by idiosyncratic risk. Beta depends on volatility and correlation, where only volatility is related to idiosyncratic risk. Hence, the new factor betting against correlation (BAC) is particularly suited to differentiating between leverage constraints vs. lottery explanations. BAC produces strong performance in the US and internationally, supporting leverage constraint theories. Similarly, we construct the new factor SMAX to isolate lottery demand, which also produces positive returns. Consistent with both leverage and lottery theories contributing to the low-risk effect, we find that BAC is related to margin debt while idiosyncratic risk factors are related to sentiment and casino profits.

Financial Intermediation, Resource Allocation, and Macroeconomic Interdependence

This paper studies the role of the financial sector in affecting domestic resource allocation and cross-border capital flows. I develop a quantitative, two-country, macroeconomic model in which banks face endogenous and occasionally binding leverage constraints. Banks lend funds to be invested in tradable or non-tradable sector capital and there is international financial integration in the market for bank liabilities. I focus on news about economic fundamentals as the key source of fluctuations. Specifically, in the case of positive news on the valuation of non-traded sector capital that turn out to be incorrect at a later date, the model generates an asymmetric, belief-driven boom-bust cycle that reproduces key features of the recent Eurozone crisis. Bank balance sheets amplify and propagate fluctuations through three channels when leverage constraints bind: First, amplified wealth effects induce jumps in import-demand (demand channel). Second, changes in the value of non-tradable sector assets alter bank lending to tradable sector firms (intra-national spillover channel). Third, domestic and foreign households re-adjust their savings in domestic banks, and capital flows further amplify fluctuations (international spillover channel). A common central bank’s unconventional policies of private asset purchases and liquidity facilities in response to unfulfilled expectations are successful at ameliorating the economic downturn.

The Effects of Government Bond Purchases on Leverage Constraints of Banks and Non-Financial Firms

The Effects of Government Bond Purchases on Leverage Constraints of Banks and Non-Financial Firms

Financial Regulation in a Quantitative Model of the Modern Banking System

This paper builds a quantitative general equilibrium model with commercial banks and shadow banks to study the unintended consequences of capital requirements. In particular, we investigate how the shadow banking system responds to capital regulation changes for traditional banks. A key feature of our model are defaultable bank liabilities that provide liquidity services to households. In case of default, commercial bank debt is fully insured and thus provides full liquidity services. In contrast, shadow banks are only randomly bailed out. Thus, shadow banks' liquidity services also depend on their default rate. Commercial banks are subject to a capital requirement. Tightening the requirement from the status quo, leads households to substitute shadow bank liquidity for commercial bank liquidity and therefore to more shadow banking activity in the economy. But this relationship is non-monotonic due to an endogenous leverage constraint on shadow banks that limits their ability to deliver liquidity services. The basic trade-off of a higher requirement is between bank liquidity provision and stability. Calibrating the model to data from the Financial Accounts of the U.S., the optimal capital requirement is around 20\%.

The ECB's Asset Purchase Programme: An Early Assessment

This paper analyses the effects of the European Central Bank's expanded asset purchase programme (APP) on yields and on the macroeconomy, and sheds some light on its transmission channels. It shows, first, that the January 2015 announcement of the programme has significantly and persistently reduced sovereign yields on long-term bonds and raised the share prices of banks that held more sovereign bonds in their portfolios. This evidence is consistent with versions of the portfolio rebalancing channel acting through the removal of duration risk and the relaxation of leverage constraints for financial intermediaries. It then presents a stylised macroeconomic model that incorporates the aforementioned transmission channels. The model suggests that the macroeconomic impact of the programme can be expected to be sizable.

Option-Writing Strategies in a Low-Volatility Framework

Covered call buy–write strategies have risk–return profiles that are similar to those of low volatility equity portfolios, and both approaches appear to extract return premium from investors with leverage constraints and a preference for lottery-like bets. We analyzed simulated long-term (1996–2012) returns of buy–write strategies using one-month and three-month call options on the S&P 500 Index, across a range of strike levels, with monthly and quarterly rebalancing. We found that monthly rebalancing of three-month options generated the most favorable results. We also found that the improvement in risk-adjusted performance achieved with buy–write strategies comes from the skewness premium earned for accepting exposure to the tail risk of substantial losses. In addition, we determined that, due to differences in factor loadings, a buy–write strategy would likely serve well to diversify the risks of a low volatility equity portfolio.

Leverage Constraints and Real Interest Rates

This paper investigates the macroeconomic dynamics of consumption and real interest rates when there are constraints on debt finance, used both for insurance against income shocks and transferability of resources over time. We amend a standard continuous‐time deterministic model, with patient and impatient household sectors, introducing sector level income shocks. Shocks that push the impatient sector towards its leverage limit increase precautionary saving and result in a substantial but transient decline of the real interest rate relative to the deterministic benchmark. We discuss the resulting dynamics of consumption, leverage and interest rates, and implications for macroeconomic modelling and policy.

Betting Against Beta (and Gamma) Using Government Bonds

Purportedly consistent with “risk parity” (RP) asset allocation, recent studies document compelling “low risk” trading strategies that exploit a persistently negative relation between Sharpe ratios (SRs) and maturity along the U.S. Treasury (UST) term structure. This paper extends this evidence on betting against beta with government bonds (BABgov) in four respects. First, out-of-sample tests suggest that excess returns may have waned somewhat recently and that the pattern seems most pronounced for USTs given data on ten other previously unexamined government bond markets. Second, BABgov appears robust when hedged ex-ante against covariance with equities and thereby does not resemble selling volatility, but these results nonetheless belie a possible tension rather than consistency between leverage constraints and low-risk investing: namely, that investors bid longer-dated UST prices higher (lower) under BAB (RP). Third, the fact that Gaussian affine term structure models of USTs also imply an inverted SR schedule suggests that investors cannot, in fact, realize abnormal returns if they are fully hedged to the underlying model factors, and BABgov excess returns are indeed not robust to ex-ante constraints on exposure to the yield curve’s principal components. Fourth, some evidence suggests that previous BABgov results reflect coskew preferences, alternative BABgov strategies hedged to coskew risks ex-ante forgo substantial returns, and there is no indication that investors can earn excess returns betting against gamma. However, the sign of investors’ coskew preferences in government bond markets remains ambiguous.

Optimal deleveraging with nonlinear temporary price impact

Abstract In this paper, we first propose a portfolio management model where the objective is to balance equity and liability. The asset price dynamics includes both permanent and temporary price impact, where the permanent impact is a linear function of the cumulative trading amount and the temporary impact is a k th (between 0 and 1) order power function of the instantaneous trading rate. We construct efficient frontiers to visualize the tradeoff between equity and liability and obtain analytical properties regarding the optimal trading strategies. In the second part, we further consider an optimal deleveraging problem with leverage constraints. It reduces to a non-convex polynomial optimization program with polynomial and box constraints. A Lagrangian method for solving the problem is presented and the quality of the solution is studied.

Betting Against Beta (and Gamma) Using Government Bonds

Purportedly consistent with ?risk parity? (RP) asset allocation, recent studies document compelling ?low risk? trading strategies that exploit a persistently negative relation between Sharpe ratios (SRs) and maturity along the U.S. Treasury (UST) term structure. This paper extends this evidence on betting against beta with government bonds (BABgov) in four respects. First, out-of-sample tests suggest that excess returns may have waned somewhat recently and that the pattern seems most pronounced for USTs given data on ten other previously unexamined government bond markets. Second, BABgov appears robust when hedged ex-ante against covariance with equities and thereby does not resemble selling volatility, but these results nonetheless belie a possible tension rather than consistency between leverage constraints and low-risk investing: namely, that investors bid longer-dated UST prices higher (lower) under BAB (RP). Third, the fact that Gaussian affine term structure models of USTs also imply an inverted SR schedule suggests that investors cannot, in fact, realize abnormal returns if they are fully hedged to the underlying model factors, and BABgov excess returns are indeed not robust to ex-ante constraints on exposure to the yield curve?s principal components. Fourth, some evidence suggests that previous BABgov results reflect coskew preferences, alternative BABgov strategies hedged to coskew risks ex-ante forgo substantial returns, and there is no indication that investors can earn excess returns betting against gamma. However, the sign of investors? coskew preferences in government bond markets remains ambiguous.

Can Leverage Constraints Help Investors?

This paper provides causal evidence that leverage constraints can reduce the under performance 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.