Idiosyncratic volatility,option-based measures of informed trading,and investor attention

Review of Derivatives Research - We establish a direct link between sophisticated investors in the option market, private stock market investors, and the idiosyncratic volatility (IVol) puzzle. To...     

Modelling illiquidity spillovers with Hawkes processes: an application to the sovereign bond market

Modelling the dynamics of (il)liquidity across assets is an important yet complicated task, especially when considering significant deteriorations of liquidity conditions. Here, we propose a peak-over-threshold method to identify abrupt liquidity drops from limit order book data and we model the time-series of these illiquidity events across multiple assets as a multivariate Hawkes process. This allows us to quantify both the self-excitation of extreme changes of liquidity in the same asset (illiquidity spirals) and the cross-excitation across different assets (illiquidity spillovers). Applying the method to the MTS sovereign bond market, we find significant evidence for both illiquidity spillovers and spirals. The proportion of shocks explained by illiquidity spillovers roughly doubles from 2011 to 2015, suggesting an increased synchronization of extreme illiquidity across assets.     

Shadow economies around the world: novel insights, accepted knowledge, and new estimates

This paper is a first attempt to study the impact of enforcement on the shadow economy. Using a MIMIC model, we find that a higher share of sub-national government employment and the aspiration of public employees to follow rules significantly deter shadow economic activities. Our results also confirm previous findings: Increased burdens of taxation and regulation as well as the state of the “official” economy are important determinants of the shadow economy. The estimated weighted average informality in 162 countries around the world, including developing, Eastern European, Central Asian, and high-income OECD countries, is 17.1% of “official” GDP.     

Optimal portfolios when volatility can jump

We consider an asset allocation problem in a continuous-time model with stochastic volatility and jumps in both the asset price and its volatility. First, we derive the optimal portfolio for an investor with constant relative risk aversion. The demand for jump risk includes a hedging component, which is not present in models without volatility jumps. We further show that the introduction of derivative contracts can have substantial economic value. We also analyze the distribution of terminal wealth for an investor who uses the wrong model, either by ignoring volatility jumps or by falsely including such jumps, or who is subject to estimation risk. Whenever a model different from the true one is used, the terminal wealth distribution exhibits fatter tails and (in some cases) significant default risk.     

Maximum entropy distributions inferred from option portfolios on an asset

We obtain the maximum entropy distribution for an asset from call and digital option prices. A rigorous mathematical proof of its existence and exponential form is given, which can also be applied to legitimise a formal derivation by Buchen and Kelly (J. Financ. Quant. Anal. 31:143–159, 1996). We give a simple and robust algorithm for our method and compare our results to theirs. We present numerical results which show that our approach implies very realistic volatility surfaces even when calibrating only to at-the-money options. Finally, we apply our approach to options on the S&P 500 index.     

Model Uncertainty,Political Learning,and Institutions: A Broader View on Mancur Olson's Theory of Institutional Sclerosis

In his Rise and Decline of Nations, Mancur Olson argues that politically stable countries suffer from declining growth rates caused by the growing influence of distributional coalitions that accumulate over time. The empirical literature supports the notion of a negative relationship between a country's duration of political stability and its growth rates but finds only weak support for a negative influence of distributional coalitions on growth. This paper sketches a simple model of party competition under model uncertainty, which may explain this mixed empirical picture. It shows that politically stable democracies are less well equipped to adjust to shifts in their economic environment than democracies with a shorter history of political stability. In a further step, the paper relates the major theme of this theory and Olson's theory to the more recent literature on institutions and growth. Directions for further research are discussed.     

The Informativeness of Relative Performance Information and Its Effect on Effort Allocation in a Multitask Environment

Prior research documents that providing relative performance information (RPI) motivates employees to increase effort; however, a potential downside of RPI is that it also motivates employees to distort their effort allocations between tasks such that it can be detrimental to overall firm performance. This study investigates via an experiment how the informativeness of RPI affects employees' effort allocations and performance in a multitask environment. We investigate the informativeness of two RPI design choices that are observed in practice: detail level and temporal aggregation. Regarding detail level, firms may provide each employee's performance ranking on tasks, which is less informative than providing the actual performance score of each employee. Regarding temporal aggregation, firms may provide RPI that is reset each period, which is less informative than RPI that is based on cumulative performance. We find RPI detail level and temporal aggregation interact to influence effort distortion. Specifically, we find that, compared to reset RPI, cumulative RPI leads to greater distortion of effort away from firm‐preferred allocations and that this effect is magnified when RPI provides actual performance scores rather than performance rankings. Finally, high levels of effort distortion hurt overall performance, thereby demonstrating the potentially detrimental effect of effort distortion on performance. Results of our study enhance our understanding of how firms can use their control over the design of RPI to enhance its usefulness in directing employees' effort in multitask environments by highlighting the role that informativeness of information can have on employee behavior.     

How behavioural science can improve financial advice services

Evidence from the behavioural sciences, notably economics and psychology, has profoundly changed the way policymakers and practitioners view expert advice to consumers. In this article, we take stock of the behavioural science evidence on financial advice and explore its implications for the profession. We organise the evidence in a comprehensive theoretical framework that also serves a practical purpose: the design of behaviour change interventions. We suggest various ways in which financial advisers can use the insights from behavioural science to improve the take-up and effectiveness of their advice. Finally, we discuss ethical and practical considerations for the financial advisor wishing to put behavioural science knowledge to use.     

Involuntary Unemployment and Environmental Policy: The Double Dividend Hypothesis

An environmental tax reform might bring about gains over and above improved environmental quality. In particular, if tax revenues from environmental taxes are used to reduce the tax on wage income, positive employment effects can result in second-best economies. An efficiency wage model is used to analyze the impact of an ecological tax reform on involuntary unemployment. The government controls emissions by selling emission permits. Employment of labor and wages are determined endogenously. Conditions are identified under which an environmental tax reform reduces unemployment and increases welfare.     

Interpreting and responding to strategic issues: The impact of national culture

Perceptions of environmental uncertainty and organizational control influence strategic behavior. As national culture influences these perceptions we expect to find cultural differences in interpretation and response to strategic issues. Given a case describing an issue concerning deregulation of the U.S. banking industry, managers completed questionnaires rating interpretations and responses to that issue. National culture was found to influence interpretation and responses. In particular, Latin European managers when compared with other managers were more likely to interpret the issue as a crisis and as a threat. Latin Europeans were also more likely to recommend proactive behavior. This study indicates that different cultures are likely to interpret and respond to the same strategic issue in different ways. These differences may help to explain and predict different responses of European countries to ‘1992’.