Adverse Selection Risk Research Articles

Scoring the Ethics of AI Robo-Advice: Why We Need Gateways and Ratings

AbstractUnlike the many services already transformed by artificial intelligence (AI), the financial advice sector remains committed to a human interface. That is surprising as an AI-powered financial advisor (a robo-advisor) can offer personalised financial advice at much lower cost than traditional human advice. This is particularly important for those who need but cannot afford or access traditional financial advice. Robo-advice is easily accessible, available on-demand, and pools all relevant information in finding and implementing an optimal financial plan. In a perfectly competitive market for financial advice, robo-advice should prevail. Unfortunately, this market is imperfect with asymmetric information causing generalised advice aversion with a disproportionate lack of trust in robo-advice. Initial distrust makes advice clients reluctant to use, or switch to, robo-advice. This paper investigates the ethical concerns specific to robo-advice underpinning this lack of trust. We propose a regulatory framework addressing these concerns to ensure robo-advice can be an ethical resource for good, resolving the increasing complexity of financial decision-making. Fit for purpose regulation augments initial trust in robo-advice and supports advice clients in discriminating between high-trust and low-trust robo-advisors. Aspiring robo-advisors need to clear four licensing gateways to qualify for an AI Robo-Advice License (AIRAL). Licensed robo-advisors should then be monitored for ethical compliance. Using a balanced score card for ethical performance generates an ethics rating. This gateways-and-ratings methodology builds trust in the robo-advisory market through improved transparency, reduced information asymmetry, and lower risk of adverse selection.

Innovation Disclosures and the Design of Technology Acquisition Contracts: Evidence from the American Inventors Protection Act

Material adverse change (MAC) clauses and contingent earnouts are important contractual mechanisms used to protect acquirers from the risk of adverse selection. Yet, the extant literature has not sufficiently explored the antecedents of their use, in particular within the context of technology acquisitions. In this study, we take advantage of the passage of the American Inventors Protection Act (AIPA), which disseminated information through the publication of patent applications, to explore the impact of innovation disclosures on the design of technology acquisition contracts. Consistent with the view that an increase in the availability of information related to the broader technological landscape reduces the need for contractual protections in acquisition contracts, our analysis demonstrates that deals disproportionately affected by AIPA have less expansive MAC clauses and are less likely to feature contingent earnouts. These results provide new evidence linking the use of MAC clauses and earnouts with acquisitions subject to information frictions.

Deep Hawkes process for high-frequency market making

AbstractHigh-frequency market making is a liquidity-providing trading strategy that simultaneously generates many bids and asks for a security at ultra-low latency while maintaining a relatively neutral position. The strategy makes a profit from the bid-ask spread for every buy and sell transaction, against the risk of adverse selection, uncertain execution and inventory risk. We design realistic simulations of limit order markets and develop a high-frequency market making strategy in which agents process order book information to post the optimal price, order type and execution time. By introducing the Deep Hawkes process to the high-frequency market making strategy, we allow a feedback loop to be created between order arrival and the state of the limit order book, together with self- and cross-excitation effects. Our high-frequency market making strategy accounts for the cancellation of orders that influence order queue position, profitability, bid-ask spread and the value of the order. The experimental results show that our trading agent outperforms the baseline strategy, which uses a probability density estimate of the fundamental price. We investigate the effect of cancellations on market quality and the agent’s profitability. We validate how closely the simulation framework approximates reality by reproducing stylised facts from the empirical analysis of the simulated order book data.

Accruals anomalies could be explained by the adverse selection risk induced by the information structure: the case of the Japanese securities market

Accruals anomalies could be explained by the adverse selection risk induced by the information structure: the case of the Japanese securities market

Private health insurance incentives and passive adverse selection: is Lifetime Health Cover responsible for the excess ageing of Australia's hospital cover risk pool?

Objective Lifetime Health Cover (LHC) was introduced in mid-2000 to increase participation in private health insurance that includes hospital cover (PHI-HC) and improve the risk profile of PHI-HC participants. It initially achieved both objectives, but since 2001 the PHI-HC population has aged faster than the general population. The aim of this study was to determine if the excess ageing of the PHI-HC risk pool has been due to passive age-based adverse selection, an inherent risk of LHC. This study has potential implications for the retention of LHC. Methods A descriptive population-level analysis of publicly available administrative datasets was performed. Data relating to PHI-HC were obtained from the Australian Prudential Regulatory Authority. National population data were obtained from the Australian Bureau of Statistics. Trends in demography, PHI-HC participation rates and LHC loading payments were analysed. Results By 2021, age-based adverse selection had returned to the pre-LHC level. Based on the available data, this was due to passive age-based adverse selection not active age-based adverse selection. Specifically, it reflected the combination of an avoidable unintended consequence of the introduction of LHC (the over-representation, in 2001, of individuals aged 45-59) and one of LHC's intended effects (incentivisation of insured individuals to retain PHI-HC). Conclusions This study supports the retention of LHC. Nonetheless, it highlights the risk of passive age-based adverse selection created by incentivising insured individuals to retain PHI-HC in the presence of distortions in the age distribution of the PHI-HC risk pool. Early targeted interventions are required when such distortions arise.

Corporate bond price reversals

I demonstrate empirically that corporate bond dealers mitigate adverse selection risk by passing potentially informed transactions to institutional investors. I contrast price reversals following days with abnormal trading volume across bonds with different information asymmetry. In informed trading, the part of reversal specific to high-volume days should increase with information asymmetry. In uninformed trading, there is no such effect. Following high-volume days when investors provide liquidity, the reversals are consistent with the former case. When dealers provide liquidity, I observe the latter. The results suggest that the informational content of bond prices is higher when dealers do not take inventory.

Adverse Selection and Climate Risk: A Response to

Abstract We identify two issues in the work of Ouazad and Kahn (2022). Correcting either reverses the original result. The two changes are to use the correct FHFA conforming loan limits for each county and year and to compare the individual loan amount to that limit correctly. There is no evidence that lenders transfer climate risk by altering loan origination and securitization behavior. None of our results calls into question the value and importance of the O&K model as a test for adverse selection. The question addressed and the setup of the test are important and should be replicated over time.

An MA-MRR model for transaction-level analysis of high-frequency trading processes

The transaction-level analysis of security price changes by Madhavan, Richardson, and Roomans (1997, hereafter MRR) is a useful framework for financial analysis. The first-order Markov property of trading indicator variables is a critical assumption in the MRR model, which contradicts the information lag empirically demonstrated in high-frequency trading processes. In this study, a nonparametric test is employed, which shows that the Markov property of the trading indicator variables is rejected on most trading days. Based on the spread decomposed structure, an MA-MRR model was proposed with a moving average structure adopted to absorb the information lag as an extension. The empirical results show that the information lag plays an important role in measuring the adverse selection risk parameter and that the difference in this parameter between the original and the extension is significant. Furthermore, our analysis suggests that the information lag parameter is a useful measure of the average speed at which information is incorporated into prices.

Effects of Digital Inclusive Finance on Adverse Selection of Commercial Banks

The development of digital inclusive finance has changed commercial banks' credit to some extent. We construct the panel data of commercial banks from 2011-2021 and use a two-way fixed effect model to study effects of digital inclusive finance on the adverse selection of commercial banks. The results show that digital inclusive finance has a significant negative effect on adverse selection of commercial banks, and the effect is stronger in eastern regions and rural commercial banks. The evidence strongly suggests that digital inclusive finance reduces the risk of adverse selection of commercial banks by promoting the development of financial technology and reducing the risky asset ratio of commercial banks in a way that excludes the mechanism of action of commercial bank soundness. These results have important implications for the development of the traditional financial industry, and commercial banks could use digital inclusive finance to reduce adverse selection risk and achieve digital transformation.

Analisis Risiko Pembiayaan Mudharabah di Bank Syari’ah

Risks and obstacles to the implementation of mudharabah financing are one of the factors behind the low development of mudharabah financing in Islamic banks compared to other financing products. To anticipate risks and to enhance the development of mudharabah financing in Islamic banks, it is necessary to identify and in-depth study the risks of implementing mudharabah financing in Islamic banks so that strategies and solutions for these risks can be found. This research was conducted for this purpose by using quantitative research methods. The results of this study indicate that there are risks inherent in this financing, namely agency problems, adverse selection, moral hazard, and other risks that have not been studied in this study. These risks are a particular challenge for Islamic banks to implement mudharabah financing. The results of this study offer several strategies that can be carried out by Islamic banks in anticipating some of these risks, namely conducting analysis of prospective customers who are really good, conducting post-contract visits, providing managerial assistance as well as in preparing good and correct financial reports, conducting inspections and periodic monitoring, as well as immediately making decisions and following up when data is found that are not suitable for the implementation of the business carried out by the mudhorib. The solutions presented in this study can be further developed to support the implementation of mudharabah financing in Islamic banks.

Ambiguous price formation

We study the price and liquidity of an asset in a model where market makers face ambiguity about the asset payoff. This ambiguity explains liquidity deteriorations and improvements in financial markets. We show that the ambiguity influences how market makers perceive adverse selection risk, and therefore, distorts market liquidity. The perceived adverse selection risk increases (resp. decreases) with the ambiguity when the market maker is sufficiently (resp. insufficiently) ambiguity averse. Our model also helps to understand how ambiguity and ambiguity aversion of market makers impact price and liquidity dynamics under various trading histories.

Adverse Selection and Climate Risk: A Response to Ouazad and Kahn (2022)

Adverse Selection and Climate Risk: A Response to Ouazad and Kahn (2022)

Pre-welfare state provision and adverse selection: enrolment in a Swedish nationwide health insurance society

Mutual benefit societies evolved as the major provider for sickness, accident and life insurance in the late nineteenth and early twentieth centuries on both sides of the Atlantic. One of the major problems facing insurers was the risk of adverse selection, i.e. that unhealthy individuals had more incentives than healthy individuals to insure when priced for the average risk. By empirically examining whether longevity among insured individuals in a nationwide mutual health society was different from a matched sample of uninsured individuals, we seek to identify the presence of adverse selection. We find no compelling evidence showing that unhealthy individuals were more likely to insure, or reasons to believe that problems related to adverse selection would have been a major reason for government intervention in the health insurance market in Sweden.

How do hotels expand into new markets? The relationship between hotel agglomeration and entry mode

When a hotel decides to open in a new location, it must select a specific entry mode that determines its degree of control and ownership. This study combines agglomeration theory with information economics to explain how hotel agglomerations influence the entry modes of new hotels. In particular, we argue that when facing different levels of information asymmetry derived from hotel agglomerations, new hotels should reduce the risk of adverse selection in choosing their entry modes. Using a sample of new hotels in China, this study shows that in areas of co-located higher-quality hotels, new hotels choose shared-control modes (franchise or management contracts) over full-control modes. Evidence from a sample of foreign hotels also indicates that in areas of co-located same-country-of-origin hotels, new hotels are encouraged to choose shared-control modes (franchise or management contracts) over full-control modes.

How private equity-backed buyout contracts shape corporate governance

ABSTRACT This paper explores how contracts in private equity-backed buyouts shape corporate governance in portfolio companies. Drawing upon agency theory and incomplete contracting theory, 50 actual contracts are analyzed in detail. Contracts focus on reducing adverse selection risks through limiting pre-investment information asymmetries and aligning the goals of investors and sellers. Moral hazard risks vis-à-vis management are limited through limiting post-investment information asymmetries and limiting shirking behavior through limiting free cash flows. Goal alignment is achieved through high-powered incentive structures combined with shifting risk of underperformance to management. Managerial hold-up problems are addressed through restricting share transactions and limiting managerial actions. Residual powers and contingencies are mainly used to deal with incomplete contract designs due to uncertainties. Few clauses are used to address the reverse agency problem in which management is protected against moral hazard problems created by the private equity investor. PE contracts have transparent and very strong outcome-based cash flow rights, both limiting downside risk and rewarding upside potential. This contrasts with VC contracts which are especially contingency-based given the high levels of uncertainty of the portfolio companies.

The Effect of Categorical Typicality on Target Selection in Mergers and Acquisitions

The use of shared categories reduces uncertainty in markets, thus facilitating exchanges. Acquisitions are typical contexts in which uncertainty plays a dominant role since prospective acquirers usually face a high risk of adverse selection. Yet, prior research did not study the effects of categories on M&A activity. This paper argues that the extent to which a firm fits a clear category (how typical it is) will affect how easy it is to use category-specific schemas to interpret information about the firm and, in turn, how easily it can be evaluated as a target for an acquisition, thus influencing the likelihood of it being acquired. Conversely, we submit that information about difficult-to-classify firms and/or those that do not fit with a single category (atypical firms) is more complex to interpret and that they are thus comparatively less likely to be acquired. We test our hypotheses on a sample of 9,061 US-listed firms from 1995 to 2018, which represent the whole population of listed firms net of missing data. Our measure of typicality is constructed starting from annual reports (forms 10-K) and using a new methodology to locate the firm in the semantic space based on the meaning of the words contained in its annual report. Results indicate that typical firms are more likely to be acquisition targets. The acquirer's experience in acquisitions and with the target's category negatively moderate this effect. Using a sample of 4,528,585 dyads, we also analyze the categorical typicality of the acquiring firm as a boundary condition of our main effect and find that a typical acquirer is more likely to acquire typical firms.

The landscape of antimicrobial resistance in the neonatal and multi-host pathogen group B Streptococcus: review from a One Health perspective.

Group B Streptococcus (GBS) stands out as a major agent of pediatric disease in humans, being responsible for 392,000 invasive disease cases and 91,000 deaths in infants each year across the world. Moreover, GBS, also known as Streptococcus agalactiae, is an important agent of infections in animal hosts, notably cattle and fish. GBS population structure is composed of multiple clades that differ in virulence, antimicrobial resistance (AMR), and niche adaptation; however, there is growing evidence of interspecies transmission, both from evolutionary analysis and from disease investigations. The prevention of GBS infections through vaccination is desirable in humans as well as animals because it reduces the burden of GBS disease and reduces our reliance on antimicrobials, and the risk of adverse reactions or selection for AMR. In this perspective article, we navigate through the landscape of AMR in the pediatric and multi-host pathogen GBS under the One Health perspective and discuss the use of antimicrobials to control GBS disease, the evolution of AMR in the GBS population, and the future perspectives of resistant GBS infections in the post-pandemic era.

The liquidity and trading activity effects of acquisition payment methods: Evidence from the announcements of private firms' acquisitions

We investigate how the liquidity and trading activity effects of the announcement of the acquisition of private targets vary by payment method. We find significant increases in trading activity around acquisition announcement dates irrespective of the payment method used; however, fluctuations are lower for acquisitions financed by earnouts and cash. Similarly, the stocks of acquirers using cash and earnouts are also less affected by a general loss of liquidity that accompanies announcements. We show that these effects are explained by the interpretation of cash acquisition by the market as an option used when acquirers perceive no risk of being adversely selected, and the potential of earnout as an adverse selection risk reduction tool.

Agency Costs and Strategic Speculation in the U.S. Stock Market

Abstract This study investigates the notion that agency-driven information asymmetry may affect a firm’s stock liquidity. I postulate that less uncertainty about managerial agency problems may enhance liquidity provision by lowering dealers’ perceived adverse selection risk from trading with better-informed speculators. Consistent with my conjecture, I find that the staggered adoption of antitakeover provisions across U.S. states in the 1980s and 1990s — a plausibly exogenous shock unambiguously reducing the threat of (and speculators’ information advantage about) value-enhancing intervention — robustly improves the stock liquidity of affected firms relative to peer firms, especially at prior high fundamental or agency uncertainty and with poor governance. (JEL D22, G14, G34) Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Mixture modeling segmentation and singular spectrum analysis to model and forecast an asymmetric condor-like option index insurance for Colombian coffee crops

Weather-related hazards generate unfortunate risks, especially for low-income economies, such as populations dependent on agriculture. Index insurance offers structural advantages compared with conventional insurance, including moral hazard, adverse selection, and systemic risk. It also represents a promising financial tool because of its potential to provide timely economic relief after an unusual weather event by indemnifying policyholders based on the observed value of a particular index directly related to weather parameters. Because of these advantages, this type of insurance can potentially be extended to more crop-productive regions. This study examines the possible spread of weather index insurance programs for Arabica Coffee in Colombia in the short and medium terms in aggregated regions, according to the wet and dry crop seasons. Using a short historical precipitation data from 2010 to 2019 for 163 productive zones in 11 departments located at altitudes of 990–1,890 m, we use an unsupervised technique to first cluster the observations through mixture modeling. Then, we extract through singular spectrum analysis, the signal components of precipitation of each cluster and seasons to propose a simple index insurance model which determines the immediate payoff disbursals. We particularly identify the behavior of the tendency and seasonal payoffs. Finally, we forecast the tendency components in each cluster and season to derive a ratio of future payoffs in exceedance. This ratio serves as a measure of financial risk as it represents future additional payments that are expected to be disbursed due to the tendency component. The results have important implications for designing agricultural hedging instruments for coffee producers at an individual scale or as reinsurance instruments.