Tag Archives: Chicago Booth

Updates from Chicago Booth

Are investors chronically pessimistic?
No—but that doesn’t mean they adhere to rational expectations
By Dwyer Gunn – The assumption that investors hold rational expectations of market returns is central to many asset pricing models. However, in recent years, surveys of investors have revealed that market participants’ reported expectations often deviate from the objective predictions of financial models working with large pools of data. One theory is that these deviations are the result of persistent pessimism on the part of investors: survey respondents, according to this hypothesis, are discounting the rationally expected rate of return to reflect the risk of investing in stocks.

To examine whether investors have a pessimistic bias, Oxford’s Klaus Adam, the Bank of Canada’s Dmitry Matveev, and Chicago Booth’s Stefan Nagel examined existing evidence—including surveys of individual investors, professional investors, and CFOs going back to the 1980s—to compare expected returns with realized returns.

The research suggests that, contrary to the pessimism hypothesis, investors are just as likely to be optimistic.

Investor expectations closely matched realized market returns over the full length of time the researchers examined. But at any given time, expectations tended to be procyclical: investors expected higher returns during boom times in the stock market and lower returns during market contractions, even though many asset pricing models work in precisely the opposite direction.

Thus, the apparent conformity of investor expectations to market returns on average over time actually reflected investors’ biases—alternately optimistic and pessimistic, with the two balancing each other out. more>

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Updates from Chicago Booth

How machine learning can improve money management<
By Michael Maiello – Two disciplines familiar to econometricians, factor analysis of equities returns and machine learning, have grown up alongside each other. Used in tandem, these fields of study can build effective investment-management tools, according to City University of Hong Kong’s Guanho Feng (a graduate of Chicago Booth’s PhD Program), Booth’s Nicholas Polson, and Booth PhD candidate Jianeng Xu.

The researchers set out to determine whether they could create a deep-learning model to automate the management of a portfolio built on buying stocks that are expected to rise and short selling those that are expected to fall, known as a long-short strategy. They created a machine-learning algorithm that built a long-short equity portfolio from the top and bottom 20 percent of a 3,000-stock universe.

They ranked the equities using the five-factor model of Chicago Booth’s Eugene F. Fama and Dartmouth’s Kenneth R. French. Fama and French break down the components of stock returns over time into five factors: market risk, in which stocks with less risk relative to their benchmark outperform those with more risk; size, in which companies with small market capitalizations outperform larger companies; value, where a low price-to-book ratio outperforms high; profitability, where higher operating profits outperform; and reinvestment, in which companies that reinvest outperform those that don’t. more>

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Free markets for free men
By Milton Friedman – Do free markets make free men, or do free men make the free markets?

That might seem like a play on words or a purely semantic question, but it is not. It is a very real and very important question, and I think it contributes a great deal to understanding the kind of world we live in, and might live in.

One’s offhand impression is to say, “Well it must be free men who make free markets.” There’s an element of truth in that, but I think to a far greater extent, free markets make free men and not the other way around.

It’s true that there have been free men who have made free markets. The founders of the United States were free men who believed in individual and personal freedom, and they set up a constitution that was designed to preserve free markets.

But many people who regarded themselves as free men have produced totalitarian societies. The intellectual creators of the Soviet Union would have called themselves free men and would have said that they believed in individual and personal freedom. Yet they created not free markets but controlled markets. more>

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Updates from Chicago Booth

How bookies can outwit smart bettors
By Michael Maiello – Sports-betting markets are based entirely on predictions. A bettor has to pick a winning contestant, and a market maker―a bookie―bets on the opponent. The predictions rely on available information about both sides as well as conditions that might affect the outcome. As bookies have to take the other side of every bet, they have to know what they’re doing. But a bookie can be manipulated by a skillful bettor.

Chicago Booth’s John R. Birge, Booth PhD candidate Yifan Feng, Duke’s N. Bora Keskin, and Uber’s Adam Schultz explore the dynamics of how a bookie can keep from being manipulated. Because the sports-betting market shares features with financial markets that rely on spreads―including credit default swaps and options―the implications of the research could apply far beyond the $4.9 billion-a-year Nevada sports-betting industry. The findings may interest sports bettors and hedge-fund managers alike.

The researchers identify a key problem for bookies and financial market makers: they are vulnerable to being bluffed by knowledgeable bettors or bettors with inside information, such as whether a star is able to play. The bets being placed are the bookie’s best source of information—by analyzing betting patterns, a bookie can effectively crowdsource information about the expected outcome of an event.

However, a clever bettor might place some phony bets to throw the bookie off. Through the application of a theoretical model, the researchers identify a set of policies, which they call inertial policies, that enable bookies to strike a balance between learning from market participants and bluff proofing their business. more>

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Updates from Chicago Booth

Why banning plastic bags doesn’t work as intended
Benefits of bag regulations are mitigated by changes in consumer behavior
By Rebecca Stropoli – As well-intentioned bans on plastic shopping bags roll out across the United States, there’s an unintended consequence that policy makers should take into account. It turns out that when shoppers stop receiving free bags from supermarkets and other retailers, they make up for it by buying more plastic trash bags, significantly reducing the environmental effectiveness of bag bans by substituting one form of plastic film for another, according to University of Sydney’s Rebecca L. C. Taylor.

Economists call this phenomenon “leakage”—when partial regulation of a product results in increased consumption of unregulated goods, Taylor writes. But her research focusing on the rollout of bag bans across 139 California cities and counties from 2007 to 2015 puts a figure on the leakage and develops an estimate for how much consumers already reuse those flimsy plastic shopping bags.

This is a live issue. After all those localities banned disposable bags, California outlawed them statewide, in 2016. In April 2019, New York became the second US state to impose a broad ban on single-use plastic bags. Since 2007, more than 240 local governments in the US have enacted similar policies.

She finds that the bag bans reduced the use of disposable shopping bags by 40 million pounds a year. But purchases of trash bags increased by almost 12 million pounds annually, offsetting about 29 percent of the benefit, her model demonstrates. Sales of small trash bags jumped 120 percent, of medium bags, 64 percent, and of tall kitchen garbage bags, 6 percent. Moreover, use of paper bags rose by more than 80 million pounds, or 652 million sacks, she finds. more>

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How to curb short-termism and boost the US economy
End the requirement for quarterly reporting
By Haresh Sapra – The United States is in the middle of that rarest of events: a public conversation on accounting standards. Since 1970, public companies in the US have been required to report quarterly. The Securities and Exchange Commission is now considering changing that frequency to biannual reporting, and in December 2018 issued a request for public comment on the matter.

Admittedly, the issue isn’t exactly igniting the passions of the masses, but the implications of these discussions could significantly affect the US economy. For the first time in many years, policy makers are seriously reconsidering the rules on corporate financial reporting. The SEC is examining how to change the system to lighten the burdens on corporations, and to reduce what it calls the “overly short-term focus by managers” of listed companies.

My research suggests there would be great benefits to the US ending mandatory quarterly reporting. It would help to kick-start innovation among US companies, for one. That should be of particular interest to the SEC, which stated in its request that it is interested in how the current system “may affect corporate decision making and strategic thinking.” more>

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Updates from Chicago Booth

Who’s at fault for student-loan defaults?
By Howard R. Gold – A central driver of growing income inequality in recent decades has been the earnings premium commanded by those with technical skills, and a widening gap between college graduates and those with a high-school diploma or less.

Workers in the United States have responded by seeking college courses to improve their skills, and many have been drawn to for-profit institutions, which offer two- or four-year degrees or professional certificates in fields such as health administration, culinary arts, and cosmetology. But rather than enjoying an income boost, many graduates of for-profit schools have found themselves struggling to pay back student loans, and defaulting on their debts.

This has particularly affected nontraditional students, according to research by Harvard’s David J. Deming, Claudia Goldin, and Lawrence F. Katz.

Nontraditional students tend to be older than 25 and often they are the first in their families to attend college. They tend to have lower family incomes than typical college students. They are disproportionately women and single parents. They are more likely to be Hispanic or African American.

To be sure, college tuition rose almost 360 percent between 1985 and 2015, and graduates of professional schools, which boast some of the highest tuition rates, tend to owe the most. The median student debt of a new medical-school graduate was $190,000 in 2017, as reported by the Association of American Medical Colleges, while the average debt for graduates of US business schools was $70,000, according to the consumer-finance site SoFi.com, which derived the figure from 60,000 student-loan refinancing applications submitted between January 2014 and September 2016. more>

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How to fight corruption—and why we should
Petty corruption was long thought to grease the wheels of business. But economists are learning how much it can hold back some companies and local economies.
By Rose Jacobs – In the oil, gas, and mining industries, the temptation to pay a bribe can be strong.

Multinational companies that dominate these industries typically agree to pay host countries for the extraction of natural resources, which involves acquiring licenses and setting up agreements that specify the terms of the process and any payments to the host country, including royalties, license fees, and bonuses.

But each company strikes its own deal with a host country, so why not just pay a bribe in exchange for a more favorable agreement? Some might see it as necessary grease in the wheels of business, the price of getting work done in countries where regulation is lax and bureaucracy the law.

However, research suggests that avoiding bribes might be a good thing—and not just because businesses could get caught and might have to pay fines, such as the $1.78 billion in penalties Brazilian oil-and-gas company Petrobras agreed to pay last year.

Starting in 2013, the European Union and Canada established rules meant to crack down on corruption in the extractive industries, requiring detailed disclosures meant to give activists and other watchdogs the ability to spot signs that corruption may have taken place. Analyzing data in the wake of the anti-corruption measures, researchers find that companies forced to increase their disclosures also increased their official payments to foreign governments, potentially making more money available to the local communities.

Academics have debated for decades whether corruption hampers economic development. In the 1960s through the ’80s, one popular notion was that corruption played a positive role, at least in the developing world. Economists such as Columbia’s Nathaniel H. Leff and political scientists such as the late Samuel P. Huntington of Harvard argued that bribes serve as a means of skirting inefficient bureaucracy, and help to promote economic growth and its many benefits. more>

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Updates from Chicago Booth

A.I. is only human
By Jeff Cockrell – If you applied for a mortgage, would you be comfortable with a computer using a collection of data about you to assess how likely you are to default on the loan?

If you applied for a job, would you be comfortable with the company’s human-resources department running your information through software that will determine how likely it is that you will, say, steal from the company, or leave the job within two years?

If you were arrested for a crime, would you be comfortable with the court plugging your personal data into an algorithm-based tool, which will then advise your judge on whether you should await trial in jail or at home? If you were convicted, would you be comfortable with the same tool weighing in on your sentencing?

Much of the hand-wringing about advances in artificial intelligence has been concerned with AI’s effects on the labor market. “AI will gradually invade almost all employment sectors, requiring a shift away from human labor that computers are able to take over,” reads a report of the 2015 study panel of Stanford’s One Hundred Year Study on Artificial Intelligence. But whether AI ultimately creates massive unemployment or inspires new, as-yet-unknown professional fields, its perils and promises extend beyond the job market. By replacing human decision-making with automated processes, we can make businesses and public institutions more effective and efficient—or further entrench systemic biases, institutionalize discrimination, and exacerbate inequalities.

It’s an axiom of computing that results are dependent on inputs: garbage in, garbage out.

What if companies’ machine-learning projects come up with analyses that, while logical and algorithmically based, are premised on faulty assumptions or mismeasured data?

What if these analyses lead to bad or ethically questionable decisions—either among business leaders or among policy makers and public authorities? more>

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Updates from Chicago Booth

Financial contagion spreads through supply chains
By Michael Maiello – As big financial institutions such as Lehman Brothers fell into distress in 2008, a credit contagion spread through the financial industry, creating a credit drought for the economy as lenders retrenched and hoarded capital.

It has been less clear how credit contagion can spread through other industries, but research by George Washington’s Şenay Ağca, Georgetown’s Volodymyr Babich, Chicago Booth’s John R. Birge, and City University of Hong Kong’s Jing Wu suggests that credit shocks follow the supply chains of distressed companies.

Ağca, Babich, Birge, and Wu examined daily changes in credit default swap (CDS) spreads for all contracts with a five-year maturity between 2003 and 2014. A CDS is a derivative contract guaranteeing the owner a payout in the event that the borrower defaults. The contract’s price is known as the spread, which is the cost to insure against the default of $100 of the issuer’s debt. A widening spread signals that the market believes the issuer is more likely to default. Because the CDS market is deep and liquid, with information priced rapidly into the spread, the researchers argue that it is a better indicator of default expectations than laggard credit ratings or notes from bond analysts.

Take Ford Motor Company’s November 2008 earnings report, which highlighted massive losses, looming layoffs, and drastic cuts in capital spending. The CDS spreads linked to the company’s debt quickly widened, as one might expect. CDS spreads of American Axle & Manufacturing, a major Ford supplier, did the same, the researchers find. It makes sense that if Ford was slashing spending, its suppliers would have been suffering, they note.

But by contrast, CDS spreads were unchanged for companies with no relationship to either Ford or American Axle, such as semiconductor manufacturer Advanced Micro Devices. This suggests the mechanism by which contagion spreads is based on quantifiable business relationships, the researchers find. more>

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