Issue 4 of Review of Finance, Volume 26, 2022
August 2, 2022

Dear EFA Member,

As a current EFA member, we are pleased to forward you the contents of the recently published Issue 4 of Volume 26 of the Review of Finance – the EFA’s own journal – along with digests (short summaries) and abstracts.


Authors: Markus Leippold, Felix Matthys

Financial markets respond both acutely and swiftly to unanticipated political events. In times of elevated political uncertainty, safe assets such as government bonds are in high demand by investors. It is well known that such a flight-to-safety behavior pushes up bond prices, thereby lowering their yields. However, it is not apparent how political uncertainty affects other financial variables such as yield volatility, expectations of future short rates, and the term and bond risk premia. In our work, we not only aim to investigate how policy uncertainty shocks affect these financial variables empirically, but also we want to reconcile these responses through the lens of a theoretical model. To this end, we develop a general equilibrium model which contains both a real and a nominal sector and is populated by an uncertainty-averse agent. While the central bank controls the money supply based on a Taylor rule, the government influences the real sector of the economy using a set of different policy instruments. To introduce economic policy uncertainty, we let the representative agent form her expectation about what policy the government will select. The discrepancy between her expectation and the implemented policy constitutes our measure of policy uncertainty.

Traditional term structure models struggle to replicate the stylized empirical features of bond returns. Our model is up to this challenge. In particular, we can generate a positive bond risk premium under a pro-cyclical short rate. Moreover, in our model, bond risk premia can switch sign. Two mechanisms create this flexibility. First, the agent's uncertainty aversion generates positive bond risk premia in the long run. Second, the active role of the central bank simultaneously produces a negative bond risk premium at short maturities and a pro-cyclical short rate, which neither long-run risk models nor models with uncertainty averse agents can accomplish. In addition to replicating several features of bond risk premia, our model also fits the level and shape of the term structure of yields and volatilities. We find that the shape of the observed yield volatility curve is crucially impacted by policy uncertainty, which plays a decisive role in explaining why the yield volatility curve is hump-shaped. In addition, we find that expectations about future interest rates are strongly affected by policy uncertainty shocks. Again, our model can give an intuitive explanation for this finding. Since our representative investor is uncertainty-averse, elevated levels of policy uncertainty make her believe that economic growth prospects are worse going forward, which are fundamental to the agent's consumption and investment allocation decisions. Thus, in equilibrium, lower economic growth in conjunction with an active central bank will cause short rates to fall when policy uncertainty rises.


Authors: Sergey Kovbasyuk, Marco Pagano

Professional investors often "talk up their book." That is, they not only disclose their positions and express opinions, but to back their assertions with data on the allegedly mispriced assets. Examples range from hedge funds presenting their buy or sell recommendations on individual stocks at conferences attended by institutional investors to small investigative firms (like Muddy Waters Research, Glaucus Research Group, Citron Research and Gotham City Research) shorting companies while publishing evidence of fraudulent accounting. Empirical studies find that this advertising activity is typically associated with abnormal returns.

In this paper, we present a model showing that professional investors who detect mispriced securities (“arbitrageurs”) have the incentive to advertise their information about mispriced assets to rational investors with limited attention, as they can profit from it by exploiting the resulting price correction. Insofar as advertising catches the attention of other investors, it reduces the risk incurred by the arbitrageur in liquidating his position due to noise traders. This risk reduction in turn enhances the arbitrageur's willingness to bet on his private information, engendering a complementarity between advertising and investing in the advertised securities.

The model yields several predictions. First, even when an arbitrageur identifies a number of mispriced assets, he will concentrate his advertising on a few: diluting investors’ attention across too many assets would reduce the number of informed traders for each, diminish price discovery and leave a large liquidation risk for all. Indeed, in practice hedge fund managers who advertise their recommendations typically pitch a single asset at a time.

Second, concentrated advertising produces portfolio under-diversification. By lowering liquidation risk, advertising a given mispriced asset raises the arbitrageur's risk-adjusted expected return, inducing him to overweight that asset in his portfolio.

Thirdly, if an arbitrageur has private information about a number of assets, he will get the most out of his advertising if he pitches those for which mispricing is largest, his private information is most precise, and there is least noise trading. Moreover, the arbitrageur will prefer to advertise assets whose information is easy to process by investors, as the corresponding ads require less attention by investors.

Fourthly, multiple arbitrageurs with common information will exhibit “wolf pack” behavior, advertising and trading the same assets: no individual arbitrageur has the incentive to deviate and divert investors’ attention to assets not advertised by others. Hence, in equilibrium each arbitrageur mimics the others. However, this “piggybacking” tends to generate multiple equilibria, some of which are inefficient: arbitrageurs may get collectively trapped in a situation where they all advertise assets that are not the most sharply mispriced. This may explain why at times the market appears to pick up minor mispricing of some assets and neglect much more pronounced mispricing of others, such as RMBSs and CDOs before the financial crisis.


Authors: Toni Ahnert, Christoph Bertsch

Financial contagion is an important phenomenon contributing to the spread and severity of financial distress. Forbes (2012) distinguishes four different, but not mutually exclusive, channels of contagion: trade, banks and financial institutions, portfolio investors, and wake-up calls. Goldstein (1998) informally introduced the notion of wake-up call contagion, whereby a crisis in one region is a wake-up call to investors that induces them to re-assess and inquire about the fundamentals of other regions. Such a re-appraisal of risk can lead to a contagious spread of a financial crisis across regions or to other financial institutions.

Despite the popularity of the wake-up call contagion channel, including among policymakers, there has been little theoretical work. Our paper offers a theory to fill this gap. How can there be contagion even if there is no discernible exposure across countries or financial institutions ex-post, that is at the time of the contagious spread of a crisis? How do the magnitude of the wake-up call contagion effect and the demand for information during the re-appraisal of risk depend on the degree of ex-ante exposure across countries or financial institutions?

We develop a global coordination game of regime change with two regions that move sequentially. A financial crisis comprises a currency attack, a bank run, or a debt crisis and occurs when enough investors act against the regime in their region by attacking a currency peg, withdrawing funds from a bank, or refusing to roll over debt. We define contagion as an increase in the probability of a financial crisis in one region due to a crisis in the other region.

In our model regional fundamentals are linked via the exposure to a common macro shock, which captures common vulnerabilities and institutional similarities of regions. The wake-up call of observing a crisis elsewhere induces investors to acquire costly information about the actual exposure to the common macro shock.

Our first main result is that investors have a higher incentive to acquire information about the common macro shock after observing a crisis in the first region. Thus, for intermediate information costs, the shaded area in Figure 1, investors choose to learn only after a crisis—a wake-up call. In this case, an investor’s benefit of tailoring its attack decision with the help of better information about the realized macro shock is highest.

Our second main result is to isolate the wake-up call component of contagion. We show that contagion can occur even if all investors learn that the macro shock is zero, meaning that the second region has no ex-post exposure to the first region.

Our third main result is to derive a novel testable implication that may inform future empirical work. Information acquisition about the exposure to aggregate or market-wide shocks increases in the extent of ex-ante exposure across regions. We encourage future empirical work on this implication and discuss some directions.


Authors: Andreas Hackethal, Tobin Hanspal, Dominique M Lammer, Kevin Rink

Cryptocurrencies have received growing attention from individuals, the media, and regulators. However, little is known about the investors whom these financial instruments attract. Using administrative data, we describe the investment behavior of individuals who invest in cryptocurrencies with structured retail products. We find that cryptocurrency investors are active traders who are prone to investment biases and hold risky portfolios. Cryptocurrency investors are more likely to invest in stocks with high media sentiment and more likely to employ heuristics from technical analysis. In line with attention effects and anticipatory utility, we find that the average cryptocurrency investor substantially increases account logins and trading activity after his or her first cryptocurrency purchase. Furthermore, cryptocurrency investors tend to tilt their portfolios toward even more risky securities after cryptocurrency adoption. Our results document which investors are more likely to adopt new financial products and help inform regulators about investors’ vulnerability to cryptocurrency investments.


Authors: Manthos D Delis, Sizhe Hong, Nikos Paltalidis, Dennis Philip

We suggest that forward guidance, via publicly committing the central bank to future actions and creating associated expectations, fundamentally affects bank lending decisions independently of other forms of monetary policy. To test this hypothesis, we build a forward guidance measure based on the language used in the Federal Open Market Committee meetings and match this measure with syndicated loans. Our results show that expansionary forward guidance decreases corporate loan spreads and that this effect is stronger for well-capitalized banks lending to riskier firms. Forward guidance also affects nonprice lending terms, such as covenants, performance pricing provisions, and the loan syndicate structure. Additionally, banks tend to initiate new lending relationships with lower spreads after forward guidance issuance.


Authors: Igor Cunha, Miguel A Ferreira, Rui C Silva

The long-standing debate about the role of financial markets in society has recently received additional attention due to the 2007-2009 global financial crisis and the 2010-2012 European sovereign debt crisis. The fear that financial institutions may have too much power has been voiced by regulators, academics, politicians, and in public opinion polls.

We ask whether credit ratings influence the electoral prospects of incumbent political parties. To answer this question we study the effects of municipal bond ratings on gubernatorial and mayoral elections in the United States. Our identification strategy exploits the exogenous variation in municipal bond ratings stemming from Moody's recalibration of its municipal rating scale in 2010. Before the recalibration, Moody's used a dual-class rating system. Moody's Municipal Rating Scale measured the likelihood that a municipality reaches a financial position that would require support from a higher level of government. In contrast, Moody's Global Rating Scale measured the default probability and loss in default among sovereign and corporate bonds. In April-May 2010, Moody's recalibrated its Municipal Rating Scale to align it with the Global Rating Scale. The recalibration resulted in upgrades by up to three notches of nearly 18,000 local governments, corresponding to bonds worth more than $2.2 trillion in par value (about 70,000 bond issues).

We find that incumbent party candidates obtained a higher vote share in upgraded counties than in non-upgraded counties. Our results for gubernatorial elections show that a 10% increase in the fraction of upgraded local government units in a county is associated with a 0.7 percentage point increase in the incumbent's vote share relative to non-upgraded neighboring counties. Ratings affect election outcomes by energizing the incumbent's base and by decreasing electoral competition. Upgraded counties experience increases in the number of votes cast and a decrease in the number of candidates in the race.

Credit rating upgrades affect voting behavior by improving economic conditions and affecting voters' perceptions of the quality of incumbent politicians. The reduced borrowing costs generated by the upgrades allowed upgraded municipalities to increase bond issuance and spending (or reduce taxes). These fiscal policy changes spillover to the private sector, increasing employment and income, benefiting the incumbent party. Consistent with the certification channel, we also find that the recalibration had a more significant effect on elections where voters were more informed about the rating upgrades as proxied by the number of news searches for "credit ratings" and in states with more local newspapers.

Our results highlight the influence of financial markets on the political process. Credit Rating Agencies (CRAs) may have an outsize power, as they can affect elections' outcomes and, therefore, alter public policy choices. However, there is also a potential bright side. Democracy is an imperfect system. It is typically challenging to oust a politician during his or her term. CRAs can act as a disciplining force that limits the actions of politicians of ill will. Our findings suggest that regulators should be aware that financial markets can affect the political process when designing the financial system's rules.


Authors: Bjarne Florentsen, Ulf Nielsson, Peter Raahauge, Jesper Rangvid

We quantify the importance to mutual fund flows of affiliation between funds and their distributors. Bank failures create exogenous variation in retail customers’ exposure to bank-affiliated mutual funds. When a bank fails, its customers are moved to other banks that distribute their own affiliated mutual funds. Following such exogeneous bank shifts, customers sell their fund holdings and replace them with funds affiliated with their new banks. Customers react sequentially over time. After 4 years, a third of customers’ investments have been reallocated. In spite of large reallocations, investors do not end up with better-performing fund portfolios.


Authors: Tim Zhang

The economy in the United States is strongly influenced by local conditions, but some federal pricing policies are often nationally uniform and do not reflect the heterogeneity of local features across geography. In this study, I focus on one such uniform pricing in the U.S. residential mortgage markets, the conforming loan limit or CLL (i.e., the maximum dollar amount of a home loan that government-sponsored enterprises (GSEs) can guarantee) that was uniform across the U.S. before the 2008 financial crisis.

Prior to 2008, the CLL was adjusted every year by the Office of Federal Housing Enterprise Oversight (OFHEO) to reflect changes in the median house price at the national level, and the CLL was uniform across all contiguous continental states. Following each increase in the CLL, the fraction of jumbo loans under the new CLL would decline disproportionally in certain areas but not so much in others. Since the national CLL could be viewed as largely independent of local economic environments, I exploit the regional variation induced by the CLL as a tool to get cross-sectional variation in local jumbo-loan shares. Figure 1 summarizes the idea of this identification strategy, where the blue areas indicate loans that used to be jumbo loans based on the old CLL but are now conforming loans, and the orange areas indicate loans that are classified as jumbo based on the new CLL.

The figure shows the effect of the change in the conforming loan limit (CLL) on jumbo loan shares in low- and high-jumbo areas. Each bar indicates the mortgage size distribution in a local area. Moving from the bottom to the top, mortgage size increases. The middle part plus the top part in each bar indicate the jumbo mortgages defined by the old CLL. The top part in each bar indicates the jumbo mortgages defined by the new CLL.

Other than the obvious benefits such as expanding credit supply and supporting house prices especially in low-income areas, I document an unintended consequence of such uniform pricing policy in the residential mortgage market. I show that in areas that experienced a larger decline in the jumbo-loan share following an increase in the CLL, lenders raised jumbo-loan approval rates, lowered mortgage rates to defend short-term market share, extended credit to riskier borrowers, and incurred deteriorated asset quality in the long run. I conduct additional analyses to rule out alternative explanations and address endogeneity concerns, such as credit supply or demand changes, the bunching effect, and reverse causality. My results are not explained away by these factors. Instead, my evidence is consistent with a competition channel: the effect of CLL increases on jumbo-loan credit expansion is significantly exaggerated in a more competitive jumbo-lending market. Overall, my findings suggest that the securitization policies of the government-sponsored enterprises (GSEs) can induce spillovers on the jumbo-market segment and influence credit allocation.


NOTE: This and previous issues of Review of Finance [ISSN 1572-3097 | EISSN 1573-692X] are freely available to current EFA members as a benefit of annual membership.  For information on how to submit a manuscript to Review of Finance, please visit the RF Editorial Office website revfin.org.  Follow us on LinkedIn.


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