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Ongoing Research, Data and Technical Appendices
Real Effects of Stock Underpricing Abstract: This paper provides evidence for a causal effect of equity prices on corporate investment and employment. We use fire sales by distressed equity funds during the 2007-2009 financial crisis to identify substantial exogenous underpricing. Firms whose stocks are most underpriced have considerably lower investment and employment than industry peers not subject to any fire sale discount. The causal effect of underpricing on investment is found to be largely concentrated on the most financially constrained firms. The Role of Equity Funds in the Financial Crisis Propagation Abstract: This paper identifies equity funds most affected by portfolio losses in financial stocks and examines the consequences for non-financial stocks owned by the same funds. We find that (i) ownership links to "distressed equity funds" relate to large underperformance for the most exposed stocks and contribute an additional 10% to the overall stock market downturn; (ii) distressed fire sales and the associated price discounts are concentrated among the best performing stocks; and (iii) stocks with a high share of fund ownership generally performed much better throughout the crisis. Related VoxEU article: Understanding and quantifying contagion Web Appendix with more robustness. Global Portfolio Rebalancing under the Microscope Abstract: The dramatic increase in gross stock of foreign assets and liability has revived interest in the portfolio balance theory of international investment. Evidence on the validity of this theory has always been scarce and inconclusive. The current paper derives testable empirical implications from microeconomic foundations, which we confront with a new comprehensive data set on the stock allocations of approximately 6,500 international equity funds domiciled in four different currency areas. The disaggregated data structure allows us to examine whether foreign exchange and equity risk measures trigger the predicted rebalancing behavior at the fund and stock level. The data provide strong support for portfolio rebalancing behavior aimed at reducing both exchange rate and equity risk exposure. Related VoxEU article: International Portfolio Investment under the Microscope Dealer Intermediation Between Market Abstract: We develop a dynamic model of dealer intermediation between a monopolistic customer-dealer (B2C) market and a competitive inter-dealer (B2B) market. Dealers face inventory constraints and adverse selection. We characterize the optimal quote setting and inventory management behavior in both markets in closed form and test the model implications for the European sovereign bond market. The model can explain (i) the high dispersion of quoted and executed customer prices due to the inventory dependence of optimal quotes, (ii) the more pronounced bid-ask spread deterioration under volatility increases for B2B relative to the B2C market, (iii) why aggregate dealer inventory imbalances coincide with asymmetric execution quality between the bid and ask side in the customer segment. The Exchange Rate Effect of Multi-Currency Risk Arbitrage Abstract: This paper (i) develops a multi-currency portfolio approach to speculative foreign exchange (FX) trading, (ii) presents a natural experiment to characterize the feedback effect of such trading on short-run exchange rate behavior, and (iii) proposes a new spectral inference method to strengthen the statistical evidence on the predicted short-run currency dynamics. Cross-sectional currency hedging effects are qualitatively large in their price impact and contribute to the disconnect between exchange rates and fundamentals.
Global versus Local Asset Pricing: A Speculation-Based Test of Market Integration Abstract: Should capital cost calculations be based on a global or local market benchmark? The December 2000 redefinition of the global MSCI equity index was a natural experiment addressing this question. It is argued that this event triggered a portfolio shift (by index funds) large enough to affect the residual asset supplies constituting the global and local market benchmarks of all actively managed capital. Changes in the market benchmarks imply distinct and predictable changes to global and local stock betas. Exploring whether global or local beta changes best explain the cross section of event returns reveals that stocks in developed markets are priced globally and not locally. Previous working paper version: A Generalized Portfolio Approach to Limited Risk Arbitrage: Evidence from the MSCI Global Index Change
Do Demand Curves for Currency Slope Down? Evidence from the MSCI Global Index Change Abstract: Traditional portfolio balance theory derives a downward sloping currency demand function from limited international asset substitutability. Historically, this theory enjoyed little empirical support. We provide direct evidence by examining the exchange rate effect of a major redefinition of the MSCI Global Equity Index in 2001 and 2002. The index redefinition implied large changes in the representation of different countries in the MSCI Global Equity Index and therefore produced strong exogenous equity flows by index funds. Our event study reveals that countries with a relatively increasing equity representation experienced a relative currency appreciation upon announcement of the index change. Moreover, stock markets that are upweighted (downweighted) feature a higher (lower) permanent comovement of their currency with the basket of other MSCI currencies.
Macroeconomic Order Flows: Explaining Equity and Exchange Rate Returns Abstract: Macroeconomic models of equity and exchange rate returns perform poorly. The proportion of daily returns that these models explain is essentially zero. Instead of relying on macroeconomic determinants, we model equity price and exchange rate behavior based on a concept from microstructure - order flow. The international order flows are derived from belief changes of different investor groups in a two country setting. We obtain a structural relationship between equity returns, exchange rate returns and their relationship to home and foreign market order flow. To test the model we construct daily aggregate order flow data from all equity trades in the U.S. and France from 1999 to 2003. Almost 60 percent of the daily returns in the S&P100 index is explained jointly by exchange rate returns and aggregate order flows.
Home Bias at the Fund Level Abstract: This paper presents new stylized facts on the distribution of the home bias at the fund level. We find (i) a large heterogeneity in the degree of home bias across mutual funds; (ii) a positive correlation between the size of funds and home bias; and (iii) a positive correlation between the size of funds, the number of foreign countries and the number of sectors in which they invest. These facts constitute a challenge for existing theories.
Exchange Rates, Equity Prices and Capital Flows Previous versions: CEPR discussion paper no. 3735; NBER working paper no. 9398 Abstract: We develop an equilibrium model in which exchange rates, stock prices and capital flows are jointly determined under incomplete forex risk trading. Incomplete hedging of forex risk, documented for U.S. global mutual funds, has three important implications: 1) exchange rates are almost as volatile as equity prices when the forex liquidity supply is not infinitely price elastic; 2) higher returns in the home equity market relative to the foreign equity market are associated with a home currency depreciation; 3) net equity flows into the foreign market are positively correlated with a foreign currency appreciation. The model predictions are strongly supported at daily, monthly and quarterly frequencies for 17 OECD countries vis-ŕ-vis the U.S. Moreover, correlations are strongest after 1990 and for countries with higher market capitalization relative to GDP, suggesting that the observed exchange rate dynamics is indeed related to equity market development.
The Role of Transaction Costs for Financial Volatility: Evidence from the Paris Bourse Abstract: The paper analyzes the causal linkage between transaction costs and financial volatility under two methodological improvements over the existing literature. First, we use panel data in which exogenous transaction cost differences in the French stock market are induced by price level dependent minimum price variation rules (tick size rules). Unlike in previous studies based on one-time regulatory tick size changes (like the U.S. decimalization), we can separately identify and control for market-wide volatility changes. Second, we avoid the pitfalls of biased volatility measurement across regimes by using the range as a tick size robust volatility metric. Panel regressions controlling for market-wide volatility effects show at high levels of statistical significance that the (log) range volatility of individual stocks increases by more than 20 percent for a 20 percent exogenous increase in transaction costs due to tick size variations in the French trading system. In the light of this evidence, higher transaction costs in general, and security transaction taxes in particular, should be considered as volatility increasing.
Can Portfolio Rebalancing Explain the Dynamics of Equity Returns, Equity Flows, and Exchange Rates? Previous versions: CEPR discussion paper no. 4517; NBER working paper no. 10476 Abstract: We explore whether the pattern of international equity returns, equity portfolio flows, and exchange rate returns are consistent with the hypothesis that (unhedged) global investors rebalance their portfolio in order to limit their exchange rate exposure when there are (1) relative equity return and (2) exchange rate shocks. We also explore whether (3) equity flow shocks influence the exchange rates and relative equity prices. In the estimation of the VAR system we do not impose any causal ordering upon the primitive shocks, but instead identify the system based on theoretical priors about the contemporaneous conditional correlations between the three variables. International data for the five largest equity markets are consistent with a theory in which equity returns and portfolio rebalancing are an important source of exchange rate dynamics.
Real Exchange Rate Volatility and Economic Openness: Theory and Evidence Abstract: This paper relates the volatility of the trade-weighted effective real exchange rate to the degree of trade openness of an economy. The theoretical part presents an intertemporal monetary model of a small open economy with nominal rigidities. Both monetary and aggregate supply shocks are shown to produce (ceteris paribus) smaller real exchange rate movements if the country is more open to foreign trade. Empirical evidence on a cross-section of 48 countries confirms this relationship: Differences in trade openness explain a large part of the cross-country variation in the volatility of the effective real exchange rate. Excel spreadsheet with raw data
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