European Financial Management 2020 Archive

January 2021, VOL 27:1 March 2021, VOL 27:2

European Financial Management, VOL 27:1, January 2021


Eugene F. Fama

This is a compendium of notes on taxes. Section 2 presents a general tax scheme. It is a tax on value added by labor and capital that does not favor one or the other. Section 3 contrasts taxation of business income for pass-through entities and corporations. Section 4 discusses property taxes as taxes on housing services and so a form of income tax. Section 5 turns to wealth taxes. The closing Section 6 attempts to explain why people donate to nonprofits but minimize tax payments to governments, even though governments and nonprofits engage in many of the same activities.

Keywords: H2, business tax, nonprofits, value added tax, wealth tax.

JEL Classification:

ESG preferences, risk and return

Bradford Cornell

There are two primary factors that affect expected returns for companies with high ESG (environmental, social and governance) ratings—investor preferences and risk. Although investor preferences for highly rated ESG companies can lower the cost of capital, the flip side of the coin is lower expected returns for investors. Regarding risk, the jury remains out on whether there is an ESG‐related risk factor. However, to the extent, ESG is a risk factor it also points towards lower expected returns for investments in highly rated companies. Though ESG investing may have social benefits, higher expected returns for investors are not among them.

Keywords: ESG, expected returns, investor preferences, risk.

JEL Classification: G0, G1

How to build a factor portfolio: Does the allocation strategy matter?

Hubert Dichtl, Wolfgang Drobetz, Viktoria‐Sophie Wendt

Factor‐based allocation embraces the idea of factors, as opposed to asset classes, as the ultimate building blocks of investment portfolios. We examine whether there is a superior way of combining factors in a portfolio and provide a comparison of factor‐based allocation strategies within a multiple testing framework. Factor‐based allocation is profitable beyond exploiting genuine risk premia, even when applying multiple testing corrections. Investment portfolios can be efficiently diversified using factor‐based allocation strategies, as demonstrated by robust economic performance over various economic scenarios. The naïve equally weighted factor portfolio, albeit simple and cost‐efficient, cannot be outperformed by more sophisticated allocation strategies.

Keywords:factor‐based allocation, multiple testing

JEL Classification: G20, G21, G22, G23

Firm vertical boundaries, internal capital markets, and firm performance

We investigate how vertical relatedness between business segments of firms affects capital allocation within internal capital markets. Using a battery of tests including exogenous import tariff reductions, we show that investments flow toward segments with better investment opportunities in firms with significant vertical relatedness between segments. This benefit of vertical relatedness is more pronounced in economic environments prone to information problems and in imperfectly competitive industries. Firms with significant inter‐segment vertical relatedness also exhibit superior productivity and operating profitability. Overall, we show that superior capital allocation is a channel through which vertical integration impacts real outcomes of firms.

Keywords:internal capital markets, firm boundaries, firm performance, product market relations, vertical integration.

JEL Classification: G30, L25, L22

Banks' noninterest income and securities holdings in a low interest rate environment: The case of Italy

Philip Molyneux, Alessio Reghezza, Chiara Torriero, Jonathan Williams

Using a sample of 440 Italian banks over 2007-2016, we find low interest rates motivate banks to expand their fee and commission income and to restructure their securities portfolios. A granular breakdown suggests banks grow non-interest income in various ways including portfolio management, brokerage and consultancy services and increase fee income from current account and payment services. In addition, banks re-balance securities portfolios away from those ‘held-for-trading’ to securities ‘available-for-sale’ and ‘held-to-maturity’. Our findings allude to different behaviour between large and small banks: while larger banks increase brokerage, consultancy and portfolio management services, smaller banks generate fees from customer current accounts.

Keywords: Fee and Commission Income; Securities; Low Interest Rates; Unconventional Monetary Policy; Italian Banking Sector

JEL Classification: E43; E44; E52; G21; F4

Disentangling types of liquidity and testing limits‐to‐arbitrage theories in the CDS–bond basis

Patrick Augustin, Jan Schnitzler

We disentangle asset‐specific, market, and funding liquidity in the CDS–bond basis outside and during the 2007–9 global financial crisis. Our findings stress the importance of separating different types of liquidity, since all three measures have independently negative impacts on the basis. Funding liquidity emerges as the economically most important liquidity metric. While asset‐specific liquidity is cross‐correlated in both the cash and derivative markets, funding and market liquidity only matter for the cash market. We exploit the decomposition of the basis to test predictions of limits‐to‐arbitrage theories. We find strong evidence in favor of margin‐based asset pricing and flight‐to‐quality effects.

Keywords: Arbitrage, Basis, Credit Default Swaps, Corporate Bonds, Credit Risk, Counterparty Risk, Liquidity.

JEL Classification: C1, C23, G01, G12, G14

Recovering the market risk premium from higher‐order moment risks

George Chalamandaris, Leonidas S. Rompolis

We propose a consistent approach for the estimation of the market risk premium. As a first step, we define the broadest possible set of ex ante estimators from the viewpoint of a power utility optimiser holding the market portfolio. We then employ an evaluation framework to optimise the parametrisation of the methodology. We show that this theoretical framework can still produce reasonable market risk premium estimates, even when the representative agent is not a power utility optimiser. Our results show that the inclusion of higher‐order moment risk premia improves the accuracy of the method.

Keywords: Ex ante market risk premium; risk aversion coefficient; physical cumulants; risk-neutral cumulants

JEL Classification: G12, G17, C51, C53

European Financial Management, VOL 27:2, March 2021

Contract Costs, Stakeholder Capitalism, and ESG

Eugene F. Fama

Observed contract structures are competitive solutions to the problem of maximizing stakeholder welfare when contracting is costly. Winning contract structures typically set fixed payoffs for most stakeholders, with residual risk borne by shareholders, who then get most of the decision rights. With rising interest in environmental, social, and governance (ESG) issues, there is sentiment for replacing the max shareholder wealth decision rule with max shareholder welfare. This view does not recognize that investors view max welfare in terms of their overall consumption‐investment portfolios. Since firms are not privy to the total ESG exposures of shareholders, max shareholder wealth is the appropriate decision rule.

Keywords:contract structures, decision rules, stakeholders

JEL Classification:

Corporate stakeholders, corporate valuation and ESG

Bradford Cornell, Alan C. Shapiro

In addition to explicit contracts, corporations issue their stakeholders implicit claims, including fair treatment of employees and the promise of continuing service to customers. Corporate value is created by selling these implicit claims for more than it costs to honor them. Recently, a new class of non-investor stakeholders, related to ESG issues, has arisen. Although many ESG advocates stress their role in creating shareholder value, they do not explain how this value creation occurs. This paper shows that implicit claims provide a critical link that ties non-investor stakeholders and ESG to shareholder value, both its creation and its possible destruction

Keywords:ESG, Non-Investor Stakeholders, Contracting, Implicit Claims

JEL Classification: G0, G1

Sentiment‐scaled CAPM and market mispricing

John A. Doukas, Xiao Han

This study explores the conditional version of the capital asset pricing model on sentiment to provide a behavioural intuition behind the value premium and market mispricing. We find betas (β) and the market risk premium to vary over time across different sentiment indices and portfolios. More importantly, the state β derived from this sentiment‐scaled model provides a behavioural explanation of the value premium and a set of anomalies driven by mispricing. Different from the static β–return relation that gives a flat security market line, we document upward security market lines when plotting portfolio returns against their state βs and portfolios with higher state βs earn higher returns.

Keywords:conditional CAPM, market anomalies, security market line, state beta, stochastic discount factor, time‐varying risk premium, value premium.

JEL Classification:

Shedding light on a dark matter: Jump diffusion and option‐implied investor preferences

Hamed Ghanbari, Michael Oancea, Stylianos Perrakis

We compare equilibrium jump diffusion option prices with endogenously determined stochastic dominance (SD) option bounds. We use model parameters from earlier studies and find that most equilibrium model prices consistent with SD bounds yield economically meaningless results. Further, the implied distributions of the SD bounds exhibit a tail risk comparable to that of the underlying return data, thus shedding light on the dark matter of the inconsistency of physical and risk‐neutral tail probabilities. Since the SD bound assumptions are weaker, we conclude that these bounds should either replace or be used to verify the equilibrium model results.

Keywords:jump diffusion; option pricing; stochastic dominance; risk aversion; tail risk; incomplete markets

JEL Classification: G12; G13

Neglected Risk in Financial Innovation: Evidence from Structured Product Counterparty Exposure

Marc Arnold, Dustin Schuette, Alexander Wagner

We investigate the compensation of counterparty exposure in the prices of structured products. Our analysis reveals that product issuers did not compensate retail investors for counterparty exposure before the Lehman default. Post‐Lehman, retail prices have no longer neglected this risk. We also measure retail investor attention towards issuer credit risk. For a given level of issuer credit risk, counterparty exposure is compensated more when attention is higher. Furthermore, issuers tend to construct products with larger counterparty exposure. Overall, our results shed light on the conditions under which financial engineering generates neglected risk.

Keywords:Neglected risk, structured products, counterparty risk, investor attention

JEL Classification: D8, G34, M52

Is faster or slower trading better? An examination of order type execution speed and costs

Ryan Garvey, Tao Huang, Fei Wu

We examine order type execution speed and costs for U.S. equity traders. Marketable orders that execute slower exhibit lower execution costs. Those who remove liquidity faster and pay higher trading costs transact in smaller size, spread trading across more venues, take more liquidity, and are better informed. Non-marketable limit orders that execute slower exhibit greater adverse selection; and, larger, uninformed traders who concentrate their trading in fewer venues submit them. Our findings suggest that slowing down the trading process, when faster options exist, can benefit certain market participants who seek to cross the bid-ask spread.

Keywords:Trading, U.S. Equities, Execution Speed, Execution Costs

JEL Classification: G10

Financial constraints and the growth and survival of innovative start‐ups: An analysis of Italian firms

Edoardo Ferrucci, Roberto Guida, Valentina Meliciani

We study the impact of measures devoted to relieving financial constraints for the growth and survival of Italian innovative start-ups. Using balance sheet data on innovative start-ups and information on the use of the Italian Central Guarantee Fund for small and medium-sized enterprises, we evaluate whether access to the fund, relieving financial constraints, helps innovative start-ups survive and grow. We find innovative start-ups benefit significantly more than similar control firms. We shed light on the relevance of policies aimed at reducing financial constraints for the growth and survival of innovative start-ups, an issue receiving increasing attention at the European level.

Keywords:: innovative start-ups, financial constraints, growth, survival

JEL Classification: D45, G14, G21, G32