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Cambridge Endowment for Research in Finance (CERF)


Dr. Yuan Li, CERF Research Associate, December 2017

Book-to-market ratio and inflexibility: The effect of unrecorded R&D capital

R&D investment has been playing an increasingly important role in the economy. However, accounting standard requires firms to immediately expense R&D as incurred. Therefore, R&D investment is not capitalized on the balance sheet. Could the unrecorded R&D capital affect our assessment of a firm’s risk? The answer is affirmative, according to the findings from a research project conducted by CERF research associate Yuan Li.

Finance theory suggests that a firm’s risk is negatively related to its flexibility to adjust capital investment. The more flexibility a firm has in this regard, the less its cash flows are affected by economic-wide conditions, and the lower its risk. Flexibility is hard to observe directly, but it can be inferred from the book-to-market ratio (BM). High-BM firms are generally burdened with more unproductive capital and hence less flexible to downsize in bad times. Thus, according to the theory, high-BM firms are riskier than low-BM firms, especially in bad times.

However, results from this project suggest that the above theory should not be followed blindly. This is because book-to-market ratio calculated from the balance sheet data increasingly misrepresents inflexibility and risk. This in turn is because book value is understated by the unrecorded R&D capital, which is even less flexible to adjust than physical capital. Results also suggest that considering book-to-market ratio and R&D capital together is a better way to evaluate a firm’s inflexibility and risk.

Dr. Edoardo Gallo, CERF Fellow, November 2017

Financial networks and systemic collapse

In the aftermath of the 2008 crisis, Haldane – the Chief Economist at the Bank of England – stated that “the regulation of the network is needed to ensure appropriate control of large, interconnected institutions […] the financial network should be structured so as to reduce the chances of future systemic collapse”.

A project by CERF Fellow Edoardo Gallo and his research collaborators Syngjoo Choi (Seoul National University) and Brian Wallace (UCL) investigates what type of network structures cause financial contagion. In a lab experiment, participants can buy or sell assets in an artificial market knowing that one participant has been hit by a monetary shock and there is a possibility that it may spill over to others because all participants are connected by a network of liabilities. Each participant faces a trade-off between selling to raise liquidity in the short term to avoid bankruptcy or hold on to assets to realize a return in the long-term. The researchers vary the network of liabilities and the size of shocks.

The results show that contagion is particularly prevalent in core-periphery networks formed by a small number of highly connected participants – the core – and with the remaining participants at the sparsely connected periphery. The dynamics of contagion involves sharp falls in the price of assets because all participants are trying to sell to raise liquidity, and this leads to systemic collapse even for moderately sized shocks.  The researchers find evidence that a participant’s ability to comprehend the network-driven risk is predictive of how likely they are to go bankrupt. 

Core-periphery networks are ubiquitous in financial markets, and the results of this project suggest they may be particularly susceptible to systemic collapse.

The paper is available here.


Dr. Alex S.L. Tse, CERF Research Associate, September 2017

Probability weighting and stock trading behaviours

Humans are far from being a perfect machine of decision making especially in the face of uncertainty. One prevalent phenomenon is that individuals tend to overweight probabilities associated with extreme events. Examples include lottery punters’ optimism towards winning a jackpot and air passengers’ anxiety towards plane crash. In the context of finance, what are the implications of such psychological bias on investment decisions?

CCFin research associate Alex Tse and his collaborators Vicky Henderson and David Hobson investigated the effect of probability weighting on stock trading behaviours through a theoretical model of asset sale. They found that agents with probability weighting will adopt trading strategies in form of stop-loss but not gain-exit: on the one hand, probability overweighting of the worst scenario encourages investors to offload a losing stock. On the other hand, probability magnification of the best outcome encourages investors to maintain participation on the rally. This provides a potential justification of the popular usage of stop-loss orders among retail investors.

Probability weighting is also useful to explain the “price disposition effect”, a well-documented financial anomaly where investors are selling winning stocks much more often than losing stocks. Existing models typically generate a very extreme disposition effect. With inclusion of probability weighting, however, investors are now more incentivised to hold a winning stock relative to a losing stock as they find a lottery-like payoff with positive skewness attractive. This enables the model to deliver a level of disposition effect much closer to what empirical literature suggests.


Dr. Yuan Li, CERF Research Associate, July 2017

In his best-selling book—Thinking, Fast and Slow, Nobel Memorial Prize in Economics laureate Daniel Kahneman describes anchoring as “ of the most reliable and robust results of experimental psychology”. Using data from the real financial markets, CERF research associate Yuan Li and her research collaborators Thomas George and Chuan-Yang Hwang find evidence suggesting that anchoring impedes investors’ interpretation of earnings news.

Anchoring is the tendency for individuals to base their forecasts of an unknown quantity upon a salient statistic (the anchor) that might have nothing to do with the quantity being forecasted. The classic example is an experiment in which individuals observe the generation of a random number, after which they are asked to estimate the percentage of African nations in the UN as an increment to the random number. The estimates are higher (lower) for individuals who observe higher (lower) random numbers. This random number is the anchor in this experiment.

In the real financial markets, investors anchor on the 52-week high price (52WH), which is often featured in financial websites and papers. If the stock price prior to a positive (negative) earnings announcement is already close to (far from) the 52WH, investors would think the positive (negative) news has already been incorporated into the price, and hence be reluctant to bid the price higher (lower). In other words, investors behave as if future price levels are constrained not to deviate too far from the 52WH. 


Dr. Jisok Kang, CERF Research Associate, June 2017

Does the Stock Market Benefit the Economy?

A research project carried out by a CERF Research Associate, Jisok Kang, and his co-author, Kee-Hong Bae, suggests evidence that a functionally efficient stock market do promote economic growth.

Finance researchers have extensively investigated the role of stock market on real economic sector. For instance, whether well-functioning stock markets promote economic growth has received a great deal of attention from academics and policy makers. However, how to measure the functionality of stock markets has been a big empirical challenge. Researchers so far have typically used size measures (e.g., total stock market capitalization) as a proxy for stock market functionality and not found robust evidence to suggest that stock market development is associated with future economic growth.

The Research proposes a new measure of functional efficiency of stock market: stock market concentration. It has shown that concentrated stock markets dominated by a small number of large firms negatively affect economic growth; in countries with concentrated stock markets, capital is allocated inefficiently, which results in sluggish IPO activity, innovation, and economic growth. These findings suggest that a concentrated stock market offers insufficient funds for emerging, innovative firms; discourages entrepreneurship; and is ultimately detrimental to economic growth.


Dr. Chryssi Giannitsarou, CERF Fellow, May 2017

Our social interactions are informative of our investment decisions.

 When we are investing, we don’t mindlessly copy our peers, according to new research carried out by CERF fellow Chryssi Giannitsarou and her research collaborators Luc Arrondel, Hector Calvo Pardo and Michael Haliassos. Instead, we are more likely to participate in the stock market if we believe that our immediate social circle is more informed about it.

The authors surveyed a representative sample of French households in 2014 and 2015 to capture measures of stock market participation and social connectedness, but also beliefs and perceptions of stock market returns. They wanted to find out whether those households invested by mindless copying, which may lead to stock market bubbles and fads, or by processing information and trying to copy good practice.

The results show that people who perceive a higher share of their financial circle as being informed about the stock market or participating in it are more likely to invest in stocks themselves. The conditional portfolio share invested in stocks is influenced by social interactions only to the extent that social interactions influence perceptions of past stock market performance and, through them, stock market expectations. There is a trace of mindless copying of behaviour, but only in the decision of whether or not to participate at all in the stock market.
All in all, their research findings suggest that social interactions tend to reduce rather than exacerbate financial literacy limitations, and to affect financial decision-making by being informative rather than ‘contagious’.

If you would like to read the relevant paper it is available here