The investment management industry has proven to be a fertile ground for theoretical and empirical research over the past forty years, particularly in relation to the nature and quantification of risk. However, the dominance of the U.S. industry has meant that much of the academic research has focused on the U.S. market. This thesis investigates aspects of investment risk using alternative data to that used in much of the prior published research. This thesis contains an extensive analysis of aspects of risk related to both the demand side and the supply side of the managed funds market in Australia. Among the demand side characteristics, attitudes towards risk and their impact on asset allocation decisions will be an important determinant of investors' financial well-being, particularly in retirement. Accordingly, the first part of the thesis examines the financial risk tolerance of investors, exploring the relationship between subjective financial risk tolerance and a range of demographic characteristics that are widely used as a basis for heuristically derived estimates of investors' attitudes towards financial risk. The second part of the thesis contains an analysis of the supply side of the industry, focusing on risk-shifting behavior by investment fund managers. Since the time when performance and risk-shifting behavior of fund managers was first put under the spotlight 40 years ago, it is possible to identify an evolving strand in the research where performance assessment is examined within the framework of the principal-agent literature. One focus that has emerged in this literature is the adaption of the tournament model to the analysis of investment manager behavior, wherein it is hypothesized that fund managers who were interim losers were likely to increase fund volatility in the latter part of the assessment period to a greater extent than interim winners. Against this background, the second part of the thesis examines risk-shifting behavior by Australian fund managers. Both the ability of fund managers to time the market and the applicability of the tournament model of funds management to a segment of the Australian

This dissertation contains two essays in empirical finance. The first essay studies the mutual fund industry, and the second essay looks into the stock market. Both studies provide insights in the underlying mechanism of some asset return patterns identified from the data currently available. The first essay investigates the sources of a recently identified performance pattern in mutual funds. Specifically, actively managed mutual funds, in general, underperform a passive benchmark; however, some recent studies find they, in fact, outperform the benchmark in bad economic states. I examine whether a state dependent risk shifting behavior of mutual fund managers contributes to this performance difference across states, and find supportive evidence. As shown in prior studies, the risk shifting behavior is motivated by a non-linear flow-performance relationship. Using a piece-wise linear regression, I demonstrate that the non-linearity exists mainly in good states; whereas in bad states, the flow-performance relationship is close to linear. Thus, non-zero risk shifting incentives are only expected in good states. I empirically measure these incentives in good states, and show that managers do react to the ``gambling'' (i.e., positive) incentives. In addition, higher ``gambling'' incentives are found to be associated with lower fund performance. The second essay, based on joint work with Hai Lu and Kevin Wang, examines how stock price shocks in the absence of public announcement of firm specific news affect future stock returns. We find that both large short term price drops and hikes are followed by negative abnormal returns over the subsequent twelve months. The pattern of asymmetric drifts, the return continuation for negative shocks versus the return reversal for positive shocks, is puzzling. We explore whether investor disagreement can explain the puzzle and find that the evidence is consistent with predictions of disagreement theory. Moreover, price shocks with public news disclosures are followed by weaker drifts, suggesting that reduction of information asymmetry from public disclosures mitigates disagreement-induced overpricing.

This dissertation contains two essays in empirical finance. The first essay studies the mutual fund industry, and the second essay looks into the stock market. Both studies provide insights in the underlying mechanism of some asset return patterns identified from the data currently available. The first essay investigates the sources of a recently identified performance pattern in mutual funds. Specifically, actively managed mutual funds, in general, underperform a passive benchmark; however, some recent studies find they, in fact, outperform the benchmark in bad economic states. I examine whether a state dependent risk shifting behavior of mutual fund managers contributes to this performance difference across states, and find supportive evidence. As shown in prior studies, the risk shifting behavior is motivated by a non-linear flow-performance relationship. Using a piece-wise linear regression, I demonstrate that the non-linearity exists mainly in good states; whereas in bad states, the flow-performance relationship is close to linear. Thus, non-zero risk shifting incentives are only expected in good states. I empirically measure these incentives in good states, and show that managers do react to the ``gambling'' (i.e., positive) incentives. In addition, higher ``gambling'' incentives are found to be associated with lower fund performance. The second essay, based on joint work with Hai Lu and Kevin Wang, examines how stock price shocks in the absence of public announcement of firm specific news affect future stock returns. We find that both large short term price drops and hikes are followed by negative abnormal returns over the subsequent twelve months. The pattern of asymmetric drifts, the return continuation for negative shocks versus the return reversal for positive shocks, is puzzling. We explore whether investor disagreement can explain the puzzle and find that the evidence is consistent with predictions of disagreement theory. Moreover, price shocks with public news disclosures are followed by weaker drifts, suggesting that reduction of information asymmetry from public disclosures mitigates disagreement-induced overpricing.

Essay One Under the principal-agent framework, we study and compare different compensation schemes commonly adopted by hedge fund and mutual fund managers. We find that the option-like performance fee structure prevalent among hedge funds is suboptimal to the symmetric performance fee structure. However, the use of high water mark (HWM) mitigates the suboptimality, though to a very limited extent. Bothour theoretical models and simulation results show that HWM will induce more managerial efforts only when a fund is slightly under the water but it will unfavorably dampen incentives when a fund is too deep under the water and when the manager's skill is poor. Allowing managers to invest personal wealth in their own funds, however, helps align interests and provides positive managerial incentives. Essay Two Existing literature has detected a "tournament behavior" among mutual fund managers that mid-year underperformers tend to take relatively higher risk than peers in the second half-year. We reexamine this issue and provide empirical evidence that such behavior does not exist among hedge fund managers, either at fund level or risk style level. Instead, hedge fund managers shift risk at mid-year in response to the moneyness of their incentive contracts. Also, risk shifting decisions are more driven by underperformance than by outperformance. HighWater Mark can strongly rein in excess risk-taking and therefore better aligns interests. Last, risk shifting on average does not improve either performance, moneyness of incentive contracts, or cash inflows. Essay Three We use factor models and optimal change point regression models to capture the intra-year risk dynamics of hedge fund managers. Those risk shifting managers are further divided into 'Informed', 'Uninformed' and 'Misinformed' groups, according to their post-shifting risk adjusted performance. We find evidence that supports the existence of an Adverse Selection' problem of managers compensation schemes. Namely, incentive contracts, designed to share risks and align interests, induce the strongest risk taking from the least informed or skilled hedge fund managers, whose risk-shifting decisions result in undesired or even deteriorated risk-adjusted returns for investors. We also find that the High Water Mark has only limited influence on mitigating excessive risk shifting.

The equity holders of a firm typically control investment choices but enjoy limited liability, since the value of equity is the firm’s value in excess of the value of debt and other fixed claims. The asset substitution problem allows equity holders to expropriate value from other claimants by shifting downside risk from failed projects. To do so, equity holders substitute riskier investments for those with less risk. In the context of tax choices, firms pursue uncertain tax projects to reduce their current or future tax payments. Given the negative consequences of tax uncertainty documented by prior studies, understanding why firms pursue more uncertain tax projects is important for both internal and external stakeholders. In this study, I construct a model of the firm that highlights how asset substitution incentives influence the adoption of uncertain tax projects. I confirm the inferences from this model empirically to illustrate when firms are more likely to prefer more uncertain tax projects due to the investment distortion created by asset substitution incentives. Specifically, I find that firms in financial distress, firms with high growth potential, and loss firms adopt more uncertain tax projects than other firms. These results provide relevant insight for debt holders, regulators, and enforcement bodies.

I corporate equity warrant rappresentano un affascinante metodo di finanziamento “ibrido” disponibile per le imprese. In prima approssimazione, un warrant è assimilabile ad una opzione call e, pertanto, il pricing è spesso effettuato applicando le formule di valutazione sviluppate per tali strumenti dalla teoria finanziaria. Tuttavia, la valutazione dei warrant presenta complicazioni ulteriori rispetto alla determinazione del prezzo di opzioni call, e la ragione risiede principalmente in alcuni elementi distintivi di maggiore complessità, tra cui l’effetto diluitivo del capitale esistente derivante dall’esercizio, ed il c.d. effetto “risk-shifting”, in base al quale si verifica un trasferimento di rischio sistematico dagli azionisti ai possessori di warrant, non appena questi strumenti vengono emessi. L’obiettivo di questa tesi è di analizzare il tema dell’emissione dei corporate warrant dal punto di vista della finanza d’impresa e derivare un metodo di pricing innovativo per tener conto di un fenomeno (risk-shifting effect) tuttora non considerato dalla letteratura finanziaria. Dopo aver derivato formalmente tale approccio e le formule ad esso conseguenti, il lavoro propone una simulazione teorica ed un test empirico condotto su un campione di warrant quotati sul mercato italiano. Entrambi tali verifiche dimostrano come il modello presentato incorpori una maggiore bontà previsiva del prezzo di mercato rispetto agli approcci esistenti. / Corporate equity warrants are one of the more fascinating capital-raising tools available to corporate finance officers. At a first approximation, they are option-like securities and according to this similarity, the pricing is usually performed by application of the standard option pricing theory. However, the theoretical and empirical analysis of warrants still remains an interesting research field within the finance literature. The reason is that warrants are more complex than call options. From an asset pricing point of view, the presence of some specific features (e.g., the equity dilution) prevents from using simple plain-vanilla formulas, while from a corporate finance standpoint, warrants offer several implications, principally because they affect the systematic risk of common stocks and are related to the choice of the firm’s capital structure. The purpose of this thesis is to analyse corporate warrants and address some of the main open questions about their value. In particular, after reviewing the financial literature about warrant pricing and presenting some commonly accepted formulas, the relationship between warrants and the volatility of the underlying stock return is examined. Contrarily to the classical call options, in fact, warrants affect the capital structure of the issuing firm and produce a risk-shifting effect among equity claimants. We derive an alternative approach to pricing equity warrant, embedding this risk-shifting feature, and we propose both a theoretical simulation and an empirical test based on a sample of Italian warrants proving its accuracy.

This thesis consists of three essays on banking in the U.S. The first two chapters study how supervisors and regulators influence bank behavior. The third chapter explores how bank CEOs allocate credit. The first chapter uses a quasi-natural experiment, the closure of regulatory offices, to identify the effects of supervision on bank behavior. Under the decentralized structure of U.S. bank supervision, banks in the same geographic area may be supervised by different regulatory offices. The chapter shows that, following the closure of a regulatory office, banks previously supervised by that office increase their solvency risk and lending compared with banks in the same counties that are supervised by a different regulatory office. Further, these banks exhibit lower risk-adjusted returns, lower asset quality, and opportunistic provisioning behavior for loan losses. Information asymmetry between banks and supervisors partly explains the results. The second chapter documents that nearly 30% of U.S. banks employ at least one board member who currently or previously served on a regulator’s advisory council or on the board of a regulator as a form of public service. The chapter shows that connections to regulators undermine regulatory discipline by decreasing the sensitivity of bank risk to capital. Connected banks are able to extract larger public subsidies than non-connected banks by shifting risk to the financial safety-net, resulting in wealth transfers from taxpayers to shareholders of risk-shifting connected banks. One potential reason for these effects is that connected banks receive preferential treatment in supervision from regulators. The third chapter uses the birthplace of U.S. bank CEOs to investigate the effect of hometown favoritism on bank business policies. Exploiting within-bank variation in distances to a CEO’s hometown, the chapter shows that banks make more mortgage and small business lending as well as branch expansions in counties that are proximate to the hometown of the CEO. This is due to the CEO’s altruistic attachment to her hometown; the effects are stronger during economic downturns, among altruistic CEOs, in poorer counties and marginal mortgage applicants. Further, hometown favoritism does not lead to worst bank performance. However, it is associated with positive economic outcomes in counties exposed to greater favoritism.

This dissertation explores the role of information frictions in the design of financial securities, the pricing of securities, and their business cycle implications. The first essay studies the risk- shifting problem between bondholders and shareholders, and the moral hazard problem between shareholders and the manager. Although, these two problems have been studied separately, my model is the first tractable frame-work to study these two frictions jointly. Using my model, I explore: i) How the presence of managerial moral hazard affects the risk-shifting problem, and ii) How optimal policies of the firm change in terms of leverage, managerial compensation, and investment decisions when the two problems are considered jointly. I show that the optimal amount of risk-shifting is amplified in the presence of managerial moral hazard. Moreover, my model delivers a non-monotonic relation between risk-shifting and leverage. This non-monotonicity has the potential to reconcile seemingly contradictory empirical evidence on the sign of this relation. The second essay (coauthored with Jianjun Miao) studies the design of an optimal contract for the manager when the shareholders are concerned about model misspecification. The model delivers counter-cyclical firm level equity premium, and has interesting implications for security design. The third essay incorporates accounting practices into models that generate business cycles through borrowing constraints. I show that the interaction of accounting frictions with the borrowing constraint has implications for the persistence and amplification of macroeconomic shocks.

Yes / The redesign of defined benefit pension schemes usually results in a substantial redistribution of wealth between age cohorts of members, pensioners, and the sponsor. This is the first study to quantify the redistributive effects of a rule change by a real world scheme (the Universities Superannuation Scheme, USS) where the sponsor underwrites the pension promise. In October 2011 USS closed its final salary scheme to new members, opened a career average revalued earnings (CARE) section, and moved to ‘cap and share’ contribution rates. We find that the pre-October 2011 scheme was not viable in the long run, while the post-October 2011 scheme is probably viable in the long run, but faces medium term problems. In October 2011 future members of USS lost 65% of their pension wealth (or roughly £100,000 per head), equivalent to a reduction of roughly 11% in their total compensation, while those aged over 57 years lost almost nothing. The riskiness of the pension wealth of future members increased by a third, while the riskiness of the present value of the sponsor’s future contributions reduced by 10%. Finally, the sponsor’s wealth increased by about £32.5 billion, equivalent to a reduction of 26% in their pension costs. / The full text will be available at the end of the publisher's embargo; Oct 16 2017

Abstract This dissertation explores two interrelated aspects of banking crises and bank regulations in perspective of regulator¡¦s soft budget constraints (SBCs in brief) and bank top management compensation. First, this paper models, in a game of incomplete information, bank behavior during banking crises when asymmetric information exists between regulators and banks. Here, I show that the situation creates the incentives for banks to roll over their defaulting loans to disguise their financial statements. Although a prudential regulator may mitigate this incentive by offering a ¡§slack¡¨ rescue packages, the bank¡¦s reputational concern may cause them to reject rescue offers. In this instance, regulators may be forced to offer amounts of recapitalization that will meet the amount necessary to restore banks to solvency. Otherwise, banks may have to gamble for resurrection, or wait until the banking crises become severe, and then more banks become insolvent, regulators have to offer optimal rescue packages subject to SBCs. New findings include (1) During banking crises, the optimal regulatory policies, on the one hand, may cause regulators have to offer rescue or bailout packages subject to different SBCs, on the other hand, mitigate banker¡¦s moral hazard. The more severe the crises will be, the greater soft budget constrained to regulators. (2) The potential severity of banking crises can be measured by the ratios, getting from net worth over the total amount of recapitalization offered by regulators and recovered from nonperforming loans. (3) As banking crises become severe, the cost of rescue becomes larger than that of bailout, the best regulatory policy is to intervene; On the contrary, if a situation labeled ¡§ too-many-to-fail¡¨ arises, the regulators may offer to rescue distressed banks subject to SBC. (4)As Bayesian equilibrium cost of regulator in crises is increasing, a random creative ambiguity for regulators to offer bailout or rescue plans may be the optimal policy to mitigate the expectation of SBC for banks . Second, this paper also shows that in the circumstances of universal banking or bank holding company, concentrating bank regulation on bank capital ratios and risk-based deposit insurance may be ineffective in controlling banker¡¦s risk-taking and moral hazard. Here, this paper follows, a more direct mechanism of influencing bank risk-taking incentives, in which the insurance premium scheme incorporate features of top management compensation. In a model of universal banking with two-periods and three-subsidiaries or departments, bank owner pre-commits to regulators to pick an optimal management compensation structure that induces the first-best value-maximizing investment choices by a bank¡¦s management. Findings include (1) If insurance premium is not fairly priced, the incentives are created for banks to have a ¡§regulatory arbitrage¡¨ by segregating its nonperforming assets from the investment bank, and shift it to the commercial bank, that increases the deposit-insurer an additional risk liability, and aggravates the risk-shifting within the universal bank; and vice versa. (2) Given management contracts{ fixed salary, a bonus paid, a fraction of equity of the bank} and { fixed salary, a penalty , a fraction of equity}for bank and security investment department respectively ; and a capitalization level corresponding must exceed the lower risky investment outcome , here bonus paid larger than 0, a penalty larger than 0, a fraction of equity between 0 and 1, then the investment policies implemented by managers, is less risky than when manger¡¦s interests are fully aligned with the equity interests. (3) Given a fairly priced insurance premium, and capitalization level corresponding must exceed the lower risky investment outcome, then the optimal management compensation structure can internalize the cost of moral hazard and induce the Pareto-optimal and department-equilibrium investment policies, thus mitigate moral hazard under universal banking. Finally, the state-owned and half-state-owned banks have experienced the institution-induced ineffectiveness; and the latter suffer from poor business performance level, partially because of the issues of ownership structure. This paper shows the investment policy with moral hazard under these banks incorporated with optimal compensation structures, and given capitalization level corresponding must exceed the lower risky investment outcome, then the optimal policies induced, that will improve their business performance level. This paper also shows that as the controlling shareholders have power over banks in excess of their cash flow rights, the incentives will be created for them to expropriate the minority shareholders. And, when the incentives for expropriation exists, the investment policy will be distorted with the managerial bias induced by their private benefits, and deteriorate morale of the banks. The regulatory mandatory requirements of one-share-one-vote principle may be proposed, instead.