The economics of sustainability-linked bonds (with L. Engelhardt, R. Gibson and P. Krueger)
Swiss Finance Institute Research Paper No. 22-26
We develop a framework to understand the incentive structure and pricing of sustainability-linked bonds (SLBs). It provides conditions under which SLBs are incentive compatible for firms. We propose a novel mispricing measure for SLBs. Using the model and mispricing measure, we derive and test several empirical predictions. We show that overpriced SLBs experience negative returns in the secondary market after issuance. When firms issue overpriced SLBs, the stock price reaction at issuance is significantly positive, consistent with a wealth transfer from bond- to shareholders. Finally, we document a significant nonlinear relationship between the mispricing measure and firms' ESG ratings.
Can the variance after-effect distort stock returns?
Swiss Finance Institute Research Paper No. 21-16
Variance after-effect is a perceptual bias in the dynamic assessment of variance. Experimental evidence shows that perceived variance is decreased after prolonged exposure to high variance and increased after exposure to low variance. We introduce this effect in an otherwise standard financial model where information about variance is incomplete and updated sequentially. We introduce a variance after- effect adjustment factor in a bayesian learning model and derive the associated predictive variance. We show theoretically how this adjustment factor affects both average and volatility of excess returns. We construct a proxy of the adjustment factor using the sequence of dispersion of analysts earnings forecast. We provide empirical evidence using US stock data over the sample 1982 - 2019, that fluctuations in this measure are significantly and positively related to excess volatility as predicted by the model. Further confirming the model's implications, we also show how stock returns are positively impacted by the adjustment factor and construct long short strategies that generate significant positive alpha with respect to the Fama-French 5 factor model.
Outperforming naive diversification with stock level information (with S. Coupy)
Swiss Finance Institute Research Paper No. 15-32
We construct mean-variance portfolios using a factor model approach. We show the importance of portfolio allocation for large unbalanced equity data sets using the full CRSP database. We compare the performance of our portfolio construction methodology to the 1/N naive diversification strategy, standard shrinkage procedures, and alternative factor model estimation. We document significant out-of-sample performance improvement in terms of Sharpe ratios, turnover and certainty equivalent. We show that it is due to improved expected returns estimation coming from the 2-pass regression approach.
Pairwise correlation dynamics and incomplete information (with S. Coupy and T. Tô)
We consider an economy with a continuum of firms paying out cash-flows which are affected by an aggregate shock and a firm specific shock. The representative agent has incomplete information and must learn about the aggregate cash flow process which follows a continuous time Markov chain. We study the dynamics of pairwise correlations and show that (i) pairwise correlations are U-shaped as a function of the probability of the good state (ii) correlations are stronger for higher beta stocks, and increase more during bad time for lower beta stocks. In addition, the model calibrated to the US business cycle matches the data in terms of volatility, correlation, and risk premium. We further study the implications of our model for portfolio allocation.
Swiss Finance Institute Research Paper No. 22-26
We develop a framework to understand the incentive structure and pricing of sustainability-linked bonds (SLBs). It provides conditions under which SLBs are incentive compatible for firms. We propose a novel mispricing measure for SLBs. Using the model and mispricing measure, we derive and test several empirical predictions. We show that overpriced SLBs experience negative returns in the secondary market after issuance. When firms issue overpriced SLBs, the stock price reaction at issuance is significantly positive, consistent with a wealth transfer from bond- to shareholders. Finally, we document a significant nonlinear relationship between the mispricing measure and firms' ESG ratings.
Can the variance after-effect distort stock returns?
Swiss Finance Institute Research Paper No. 21-16
Variance after-effect is a perceptual bias in the dynamic assessment of variance. Experimental evidence shows that perceived variance is decreased after prolonged exposure to high variance and increased after exposure to low variance. We introduce this effect in an otherwise standard financial model where information about variance is incomplete and updated sequentially. We introduce a variance after- effect adjustment factor in a bayesian learning model and derive the associated predictive variance. We show theoretically how this adjustment factor affects both average and volatility of excess returns. We construct a proxy of the adjustment factor using the sequence of dispersion of analysts earnings forecast. We provide empirical evidence using US stock data over the sample 1982 - 2019, that fluctuations in this measure are significantly and positively related to excess volatility as predicted by the model. Further confirming the model's implications, we also show how stock returns are positively impacted by the adjustment factor and construct long short strategies that generate significant positive alpha with respect to the Fama-French 5 factor model.
Outperforming naive diversification with stock level information (with S. Coupy)
Swiss Finance Institute Research Paper No. 15-32
We construct mean-variance portfolios using a factor model approach. We show the importance of portfolio allocation for large unbalanced equity data sets using the full CRSP database. We compare the performance of our portfolio construction methodology to the 1/N naive diversification strategy, standard shrinkage procedures, and alternative factor model estimation. We document significant out-of-sample performance improvement in terms of Sharpe ratios, turnover and certainty equivalent. We show that it is due to improved expected returns estimation coming from the 2-pass regression approach.
Pairwise correlation dynamics and incomplete information (with S. Coupy and T. Tô)
We consider an economy with a continuum of firms paying out cash-flows which are affected by an aggregate shock and a firm specific shock. The representative agent has incomplete information and must learn about the aggregate cash flow process which follows a continuous time Markov chain. We study the dynamics of pairwise correlations and show that (i) pairwise correlations are U-shaped as a function of the probability of the good state (ii) correlations are stronger for higher beta stocks, and increase more during bad time for lower beta stocks. In addition, the model calibrated to the US business cycle matches the data in terms of volatility, correlation, and risk premium. We further study the implications of our model for portfolio allocation.