Review of Finance

We’re pleased to share that Review of Finance Volume 29, Issue 4 is now available. Here’s what’s inside: 🔹 Market Dominance in the Digital Age (Editor’s Choice) – Logan P. Emery 🔹 The green sin: how exchange rate volatility and financial openness affect green premia – Alessandro Moro, Andrea Zaghini 🔹 Pricing Event Risk: Evidence from Concave Implied Volatility Curves – Lykourgos Alexiou, Amit Goyal, Alexandros Kostakis, Leonidas Rompolis 🔹 Return Extrapolation and Dividends – Brad Cannon, John Lynch 🔹 Exchange-Traded Funds and Transparency in Over-the-Counter Markets – Viet-Dung Doan 🔹 Not In My Backyard: Intrinsic Motivation and Corporate Pollution Abatement – Angie Andrikogiannopoulou, Alexia Ventouri, Scott E. Yonker 🔹 Extrapolative Income Expectations and Retirement Savings – Marta Cota 🔹 Passive Ownership and Short Selling – Bastian von Beschwitz, Pekka Honkanen, Daniel Schmidt 🔹 Industry Tournament Incentives and the U.S. Financial Systemic Risk – Tu Nguyen, Sandy Suardi, Jing Zhao Click here to dive in: https://lnkd.in/dxMfStmN We’ll be posting summaries of these papers starting next week, so follow us to stay updated. #ReviewofFinance #FinanceResearch

My first experience with Nature Climate Change, writing about climate transition risk in banking and the work of Hyeyoon, Rob, and Dick. https://lnkd.in/eSKeKS5h

"Industry Tournament Incentives and the U.S. Financial Systemic Risk" by Tu Nguyen, Sandy Suardi, and Jing Zhao is now available #OpenAccess in Review of Finance, Volume 29, Issue 4. Digest: This study investigates the systemic implications of industry tournament incentives—the external pay disparities among CEOs across similar firms—for financial stability. Motivated by Coles, Li, and Wang (2020), who argue that industry tournament incentives increase managerial risk-seeking behavior, we extend their insight to assess whether these incentives contribute to systemic risk in the financial sector. Systemic risk refers to the possibility that distress at one financial institution could spill over to the broader financial system, due to the interconnectedness of institutions. Systemic risk can also stem from financial institutions engaging in correlated activities, increasing the likelihood of simultaneous failures. We focus on the U.S. financial industry from 1992 to 2021 and employ the ?CoVaR framework developed by Adrian and Brunnermeier (2016) to capture the cross-sectional tail-dependency and systemic risk accumulation. Our central finding is that industry tournament incentives—proxied by the pay gap between a firm’s CEO and the second-highest paid CEO in the same industry and size group—are positively associated with an institution’s contribution to systemic risk. This relationship is statistically and economically significant. A one-standard-deviation increase in the external pay gap is associated with a rise in systemic risk contribution, measured at the 95% (99%) confidence level, by 36% (49%) of its mean. We identify two broad channels through which industry tournament incentives exacerbate systemic risk. First, they are positively associated with the risk of financial institutions in isolation, measured by stock return volatility, Value at Risk, and crash risk. These findings suggest that industry tournament incentives can indirectly contribute to systemic risk due to financial institutions’ interconnectedness. Second, the external pay gap is positively related to an institution’s financial industry beta and encourages systemically risky activities, suggesting an important and novel impact channel through promoting correlated activities across institutions. Firms with higher industry tournament incentives engage in more non-interest income activities, maintain a lower Tier 1 capital buffer, and have their stock returns strongly correlated with the industry. The mediated effect of industry tournament incentives on systemic risk via this channel is substantial, accounting for 30-50% of the total effect. Finish reading the digest: https://lnkd.in/es59dpUJ #reviewoffinance #finance

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"Passive Ownership and Short Selling" by Bastian von Beschwitz, Pekka Honkanen, and Daniel Schmidt is now available in Review of Finance, Volume 29, Issue 4. Digest: Over the past two decades, passive investment has transformed financial markets, with passive funds surpassing active funds in assets under management in 2019. While much research has examined the broader consequences of passive ownership—such as its effects on corporate governance, price efficiency, and investment strategies—its impact on equity lending markets remains underexplored. In this paper, we investigate how passive ownership influences securities lending and short selling, leveraging the Russell 1000/2000 index reconstitution as a natural experiment. Short sellers rely on borrowed securities to maintain positions, making the equity lending market essential for price efficiency. Since passive funds are significant securities lenders, we hypothesize that increased passive ownership leads to greater lendable supply, facilitating short selling. While we indeed find that lendable supply grows, short selling demand increases even more, resulting in a rise in the utilization ratio. This suggests that passive ownership not only expands lending supply but also enhances its attractiveness to short sellers. Existing work attributes this increase in short selling demand to index inclusion, governance issues, or ETF arbitrage opportunities. However, we find that these explanations do not fully account for the observed increase in short selling. Instead, we argue that passive ownership attracts informed short sellers because passive funds are stable, long-term lenders unlikely to recall loans, thereby reducing uncertainty for borrowers. Following Appel, Gormley, and Keim (2019), we use Russell 2000 index membership as an instrumental variable to isolate the causal effect of passive ownership. We find strong evidence consistent with our hypothesis that passive owners increase both the quantity and the quality of lendable supply: in addition to increasing lendable supply and short selling, we document that passive ownership causes an increase in stock loan duration, a reduction in recalls (as proxied by fails-to-deliver), and fewer drops in lendable supply. Furthermore, we show that increased short selling by informed traders improves price efficiency, particularly around negative news events. Our research contributes to two key areas. First, we demonstrate that passive ownership enhances short selling by not only increasing supply but also improving its stability, thereby improving market efficiency. Second, we add to the literature on equity lending by showing how ownership structure influences lending market dynamics. Our findings imply that regulatory policies affecting passive ownership should also consider their impact on securities lending and short selling. Finish reading the digest: https://lnkd.in/e_hK3vCb #reviewoffinance #finance

"Extrapolative Income Expectations and Retirement Savings" by Marta Cota is now available #OpenAccess in Review of Finance, Volume 29, Issue 4. Digest: Biased income expectations shape retirement savings in ways that traditional policy models often overlook. In this paper, I outline a mechanism under which low-income workers, typically pessimistic about future earnings, delay retirement contributions, prioritizing liquidity as a buffer against uncertainty. High-income workers, conversely, overestimate income growth and postpone saving under the assumption of future financial flexibility. These expectation-driven behaviors contribute to persistent disparities in retirement preparedness. Using data from the Michigan Survey of Consumers (MSC), I establish three key empirical facts: (1) Income forecast errors vary systematically by income level—low earners tend to be overly pessimistic, while high earners are persistently optimistic. (2) Workers adjust expectations based on recent earnings shocks, reinforcing extrapolative beliefs. (3) All income groups overestimate future income uncertainty, strengthening precautionary savings motives. These biases reinforce saving in liquid accounts at the expense of illiquid retirement savings plans. A lifecycle model integrating these biases with 401(k) plan structures reveals that expectation distortions can explain observed delays in retirement savings, particularly among low-income workers. Policy simulations show that automatic enrollment increases retirement savings by 4.8% on average, with a 10% gain for the lowest-income quartile. However, contributions under auto-enrollment often decline over time relative to active enrollment. These findings suggest that dynamic policy mechanisms—such as auto-escalation—are necessary to address expectation-driven distortions. By embedding behavioral insights into retirement policy design, we can foster greater financial security and reduce long-term retirement inequality. Keep reading the digest: https://lnkd.in/e2Bgzft7 #reviewoffinance #finance

"Not In My Backyard: Intrinsic Motivation and Corporate Pollution Abatement" by Angie Andrikogiannopoulou, Alexia Ventouri, and Scott E. Yonker is now available #OpenAccess in Review of Finance, Volume 29, Issue 4. Abstract: We investigate whether managers’ intrinsic incentives affect firms’ environmental policies. Exploiting within-facility variation in facility-to-CEO-birthplace distances, we find that facilities located near CEOs’ birthplaces experience toxic emission reductions relative to those farther away. This is achieved by reducing waste generation at source rather than by downsizing operations or substituting pollution across locations. The effect is strongest for hometown facilities in high-polluting areas, and in firms with higher cash holdings and with CEOs with weaker pay incentives. Our results suggest that local representation in management could be a powerful means of encouraging corporate pollution abatement. Read the article: https://lnkd.in/enWkScsn #reviewoffinance #finance

"Exchange-Traded Funds and Transparency in Over-the-Counter Markets" by Viet-Dung Doan is now available #OpenAccess in Review of Finance, Volume 29, Issue 4. Abstract: This article explores a new channel through which exchange-traded funds (ETFs) can affect underlying asset prices. In over-the-counter markets, daily disclosure of ETF portfolio holdings increases price transparency and therefore retail investors’ bargaining power. I show that ETF-held municipal bonds have significantly lower dealer markups than observationally similar non-ETF-held bonds. This effect cannot be explained by bond selection or ETFs’ own trading activity. Rather, ETFs’ disclosure of end-of-day bond pricing is associated with lower retail markups by 5–9 basis points. Read the article: https://lnkd.in/enWkScsn #reviewoffinance #finance

"Return Extrapolation and Dividends" by Brad Cannon and John Lynch is now available in Review of Finance, Volume 29, Issue 4. Abstract: We provide evidence that dividend-paying stocks are less exposed to return extrapolation than non-dividend-paying stocks. In particular, social media sentiment and analyst price targets of dividend-paying stocks are significantly less sensitive to past returns. Our findings indicate that this difference stems from price changes playing a larger role in extrapolation and dividends diverting attention away from price changes for dividend-paying stocks. Consistent with models of return extrapolation, dividend-paying stocks earn lower momentum and long-term reversal returns. The value premium, however, is similar among both groups. Collectively, our findings suggest that return extrapolation is an important source of some anomaly returns. Read the article: https://lnkd.in/eG8Y37yk #reviewoffinance #finance

"Pricing Event Risk: Evidence from Concave Implied Volatility Curves" by Lykourgos Alexiou, Amit Goyal, Alexandros Kostakis, and Leonidas Rompolis is now available in Review of Finance, Volume 29, Issue 4. Digest: We document that the implied volatility (IV) curves of equity options frequently exhibit concavity prior to the earnings announcement dates (EAD). This shape is in stark contrast with the convex volatility smiles or smirks that are commonly observed for equity options. Concavity is most obvious in short-expiry options, it typically reflects a bimodal risk-neutral density (RND) for the underlying stock price, and quickly disappears after the announcement, as the uncertainty surrounding this event is resolved. As an example, the figure below shows the IV curve (left panel) and the corresponding RND (right panel) for Amazon, computed from options with 8 days to expiry on April 26, 2018, i.e., just before its quarterly earnings announcement. Despite the larger than average stock price moves on EAD following the formation of concave IV curves, we still find that the corresponding delta-neutral straddle returns are significantly lower than those for non-concave IV curves. We further show that concave IV curves are followed by large negative strangle and delta- and vega-neutral straddle returns on EADs, revealing that investors seek to hedge the gamma, rather than vega, risk that arises due to this corporate event. Overall, we show that investors can ex-ante identify the announcements that trigger larger than average stock price moves, and they pay a substantial premium to hedge against this event risk. This hedging activity impacts option prices, leading to the formation of a concave IV curve. We conclude that concavity in the IV curve constitutes an ex-ante option-implied signal for event risk in the underlying stock arising due to the impending announcement. The focus of our study is on scheduled corporate earnings announcements. However, our model as well as the empirical methodology can be applied to any type of scheduled announcement that may trigger large asset price moves. Finish reading the digest: https://lnkd.in/etgJ8CTK #reviewoffinance #finance