2013

PROJECTS FUNDED IN 2013

Asset Pricing in Production Networks

Link to PDF File: Production Networks

Bryan Kelly, University of Chicago
Brian M. Weller, Northwestern University

We develop a network-based asset pricing framework to explain the cross-section of expected returns. Production linkages among firms translate idiosyncratic shocks into innovations in (1) local cash flows and (2) the (aggregate) stochastic discount factor. The covariance of cash flow and SDF innovations induced by the network structure generates priced risks in moderately-sized networks. The resulting network CAPM delivers a classical CAPM with a network centrality factor. Using the LASSO statistical technique to infer underlying cross-industry production linkages, we demonstrate the potential of parsimonious network models for explaining the cross-section of expected industry and stock returns.

Company cash flows and valuations are connected to each other through their common dependence on conditions in their factor and product markets. Principles from network economics can characterize these connections. The proposed research will attempt to explain the cross-section of returns based on a network characterization of their common valuation factors. The results should help investment managers better understand the origins of investment performance and better manage their portfolio risks.

Information Flows Across Firms

Link to PDF File: Information Flows Across Firms
Anna Scherbina, UC Davis

Stocks undergoing important valuation-relevant news developments may emerge as temporary return leaders for other stocks that are potentially also affected by these developments. Since there could exist a multitude of reasons for return leadership, I will not seek to identify return leaders based on a set of a-priori known stock characteristics. Instead, I will identify leader stocks solely based on their ability to Granger-cause returns of other stocks over a rolling regression window and expect that the return leadership will persist for at least a short period in the future. This methodology will make it possible to identify not only stable but also transient lead-lag relations that cannot be uncovered using ex-ante stock characteristics.

All information common to the valuation of many firms does not get incorporated into prices simultaneously. Instead, some information affects some stocks-called return leaders-earlier than others. This research will attempt to identify return leaders and determine to what extent the leadership is persistent. The results will help managers better predict future returns to the laggards.

Do Hedge Funds Exploit Rare Disaster Concerns?

Link to PDF File: Disaster Concerns
George P. Gao,Cornell University
Pengjie Gao, University of Notre Dame
Zhaogang Song, Board of Governors of the Federal Reserve System

We investigate whether hedge fund managers with better skills of exploiting the market’s ex ante rare disaster concerns, which may not realize as disaster shocks ex post, deliver superior future fund performance. We measure fund skills on exploiting rare disaster concerns (SED) using the covariation between fund returns and a rare disaster concern index we develop through out-of-the-money puts on various economic sector indices. We document that high SED funds on average outperform low SED funds by 0.96% per month and even more during stressful market times. High SED funds also have less exposure to disaster risk.

The proposed research identifies hedge funds whose returns are more correlated with an index that reflects market concerns about extreme events. The authors propose to consider whether the managers of these funds can more skillful produce excess returns by effectively selling insurance when it is expensive and by market timing before extreme events. The preliminary results suggest that they may have such skills. These results will help managers better appreciate asset pricing issues surrounding extreme events, and they help investment sponsors identify productive strategies for identifying successful hedge fund managers.

Patient Capital Outperformance

Link to PDF File: Patient Investors
Klaas Jan Martijn Cremers,Notre Dame
Ankur Pareek,Rutgers

Our paper will examine the source of the apparent investment skill of truly active investors — whose holdings are substantially different from their benchmarks — by focusing on how it is related to fund holding durations. Patient investors are defined as those with quite active portfolios who trade relatively infrequent (i.e., they have long holding durations or low portfolio turnover). Our preliminary evidence suggests that patient investors have been more likely to outperform. Next, we want to further investigate how patient investor outperformance is related to stock characteristics such as liquidity, value, size, momentum, reversal and low beta.

Active managers with strong convictions and great discipline should outperform other managers over the long run as they patiently hold positions in which they presumably have strong expectations. These results suggest that patient active trading is a marker for managerial skill. Active investment managers and their clients will be interested in these results as they can help investors avoid selling funds when they drop and buying funds when they rise, which is the primary reason why average investor performance lags average fund performance.

Can Brokers Have It All? On the Relation between Make Take Fees & Limit Order Execution Quality

Link to PDF File:Can Brokers Have it All
Robert Battalio,Notre Dame
Shane Corwin, Notre Dame
Robert Jennings, Indiana University

Several retail brokerages appear to route orders to maximize order flow payments – selling marketable orders and routing limit orders to exchanges offering large rebates. As fees for taking liquidity fund rebates, venues with high rebates have large take fees. If, as predicted, limit orders on low-fee venues trade before similar orders on high-fee venues, maximizing rebates may be inconsistent with best execution. Using proprietary order data, we document a negative relation between limit order execution quality and fee levels. We employ the NYSE’s TAQ data to demonstrate that the negative relation between take fees and execution quality is pervasive.

The maker-taker exchange fee model creates perverse incentives to route orders to the venues at which they are least likely to trade. Results from this study should help investment managers better control their brokers. They should also inform the SEC and FIMRA who oversee how brokers handle their client’s order flow.

Financial Market Dislocations

Link to PDF File:Academic Research and Stock Return Predicatility
Paolo Pasquariello,University of Michigan

Dislocations occur when financial markets, operating under stressful conditions, experience large, widespread asset mispricings. This study documents systematic dislocations in world capital markets and the importance of their fluctuations for expected asset returns. Our novel, modelfree measure of these dislocations is a monthly average of hundreds of individual abnormal absolute violations of three textbook arbitrage parities in stock, foreign exchange, and money markets. We find that investors demand statistically and economically significant risk premiums to hold financial assets performing poorly during market dislocations, i.e., when both frictions to the trading activity of speculators and arbitrageurs and their marginal utility of wealth are likely to be high.

Security mispricing interests everyone involved in investment management- from sponsors to speculators. Knowing when mispricing occurs is valuable to managers implementing risk management programs and also speculative programs. This research provides a quantitative time-series measure of dislocation based upon violations of well-known arbitrage relations. The results suggest that the measure is priced, and thus of significant potential interest to asset managers.

Do Hedge Funds Exploit Rare Disaster Concerns?

Link to PDF File:Hedge Funds and Rare Disasters
George P. Gao,Cornell Univesity
Pengjie Gao, University of Notre Dame
Zhaogang Song, Federal Reserve Board

The authors investigate whether hedge fund managers with better skills of exploiting the market’s ex ante rare disaster concerns, which may not realize as disaster shocks ex post, deliver superior future fund performance. They measure fund skills in exploiting rare disaster concerns (SED) using the covariation between fund returns and a disaster concern index that they develop through out-of-the-money puts on various economic sector indices. Funds earning higher returns when the index is high possess better skills of exploiting disaster concerns. Their main result shows that high-SED funds on average outperform low-SED funds by 0.96% per month and even more during stressful market times. High-SED funds also have less exposure to disaster risk.

Many hedge funds have substantial exposures to rare disaster risk-generally risks associated with significant market downturns. This study examines the extent to which some hedge fund managers are able to profit from ex ante fears of substantial disasters. The results should interest investment sponsors who invest in hedge funds and those who believe that their funds can profit from effectively selling insurance to fearful traders.


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