Research/working papers

Andrei Simonov

Research interests:

Individual Investors' behavior.

Role of social interaction in portfolio choice.

Financial Intermediation

Economics of Asymmetric Information.
Asset pricing.
Market Microstructure, links between Market Microstructure and Asset Pricing.
Information asymmetries in rational expectations, equilibrium models
Decision theory

Publications:

Which Investors Fear Expropriation? Evidence from Investors' Portfolio Choices (with Mariassunta Giannetti), Journal of Finance (2005)

Abstract

Using a data set that provides unprecedented detail on investors' stockholdings, we analyze whether investors take the quality of corporate governance into account when selecting stocks. We find that all categories of investors who generally enjoy only security benefits (domestic and foreign, institutional and small individual investors) are reluctant to invest in companies with weak corporate governance. In contrast, individuals who are well connected with the local financial community because they are board members or hold large blocks of at least some listed companies behave differently. They seem not to care about the expected extraction of private benefits and even prefer to invest in companies where there is more scope for it. These findings shed new light on the determinants of investor behavior and portfolio choice, and suggest that it is important to distinguish between investors who enjoy private benefits or access private information and investors who enjoy only security benefits.

Hedging, Familiarity and Portfolio Choice. (with Massimo Massa), Review of Financial Studies (2005)

Abstract

We exploit the restrictions of intertemporal portfolio choice in the presence of non-financial income risk to design and implement tests of hedging that use the information contained in the actual portfolio of the investor. We use a unique dataset of Swedish investors with information broken down at the investor level and into various components of wealth, investor income, tax positions and investor demographic characteristics. Portfolio holdings are identified at the stock level. We show that investors do not engage in hedging, but invest in stocks closely related to their non-financial income. We explain this with familiarity, that is, the tendency to concentrate holdings in stocks to which the investor is geographically or professionally close or that he has held for a long period. We show that familiarity is not a behavioral bias, but is information-driven. Familiarity-based investment allows investors to earn higher returns than they would have otherwise earned if they had hedged.

Is learning a dimension of risk? (with Massimo Massa), Journal of Banking and Finance (2005).

Abstract

This paper is an empirical investigation of how the uncertainty induced by investors' learning about the fundamentals affects stock prices. We identify two components of induced uncertainty: learning and dispersion of beliefs. We characterize these in terms of their relationship to uncertainty about the fundamentals as estimated by surveys of economic forecasters and macro-economic indicators, and with measures of uncertainty embedded in derivative markets (open interest and implied volatility). We show that learning uncertainty is a risk factor and it is priced. Furthermore, we show that, in a conditional pricing model, investor learning and dispersion of beliefs affect the time-variation of the economic risk premium.

On the Determinants of Entrepreneurial Activity: Individual Characteristics, Economic Environment, and Social Norms (joint with M. Giannetti), Swedish Economic Policy Review, vol.11 (2004), pp. 269-313.

Abstract

This paper reviews the literature on the determinants of entrepreneurial activity and investigates to what extent differences in population, business environment and cultural values contribute to explaining differences in entrepreneurial activity across Swedish municipalities. Individual characteristics and business environment are the most important factors in explaining entrepreneurial choice. However, we find that cultural values and, most likely, social norms also matter. The data suggest that individuals are more likely to become entrepreneurs where there are more entrepreneurs, even if entrepreneurial income is lower. We explain why and to what extent this may be interpreted as evidence of social norms.

Reputation and dealers' trading. (with Massimo Massa) Journal of Financial Markets, vol. 6 (2003), pp. 99-141.

Abstract

Trading generates not only information about the payoff of the assets traded, but also information about the traders themselves. Over time this information creates reputation. By using a unique dataset on the Treasury bond market we derive a measure of reputation. This is then used to group dealers on the basis of their reputation and to analyze how they react to the reputation of other dealers. We show that the same type of trade, on the same asset, in the same market can generate different volume and volatility patterns depending on the type of dealers originating it.

Additional tables Full Text ftom

Working papers:

Competition in Markets for Information

Abstract
Competition among sellers of information in a noisy rational expectation equilibrium is considered. Trader's preferences for information are explicitly characterized. It is shown that the competition on market for information makes providers of financial information to price their products in a way that leads traders to purchase all signals available. If signals are substitutes, competition pushes the price of information lower than that in monopolistic settings. However, if signals are complements, the price of an individual signal in duopoly actually exceeds the one in monopolistic settings, and information producers are involved in tacit collusion. Externalities of information lead to counterintuitive results that (a) efficiency of the competitive market for information (as measured by quality of signals offered for sale) is no better than in monopolistic setting, and (b) competition leads to no improvement on the part of the traders as providers of financial information are still able to appropriate all of the consumer surplus.

The Sneaky, the Sleepy and the Skeptic: a Behavioral Model of Market Making: Evidence of Strategic Market Making on the Treasury Bond Market.

(with Massimo Massa)

Abstract
We study the behavior of market makers in the Treasury bond market, by using an unique dataset that allows us to observe market makers' strategies jointly on the primary and secondary markets. We show that market makers actively learn from the dealers they are trading with. This allows them to react strategically to the information content of the orders they receive. Unlike the standard inventory or asymmetric information models, we allow market makers to directly place orders with other market makers.\ We identify two main types of strategic reaction to the informational content of trade: ``hiding'' and ``experimenting''. We show that all the market makers can be grouped into three classes (the sneakies, the sleepies and the sceptics), depending on their strategies. In particular, some market makers selectively choose the other market makers they place orders with in order to minimize the price impact of their trade. Others, on the contrary, choose their counterparts so as to learn the true quality of their information by observing the way they react to their trade. The choice of the type of strategy depends on market makers' priors regarding the degree of informativeness of the other market makers they are dealing with. We also show that the information acquired by trading in the secondary market affects market makers' behavior in the primary market. Bidding aggressiveness and dispersion of bids are a function of market makers' learning.

Can Strategic Market Making Explain Asset Pricing? A Microstructure Analysis of the T-Bond Market.

(with Massimo Massa)

Abstract
How much of asset volume and volatility can be explained in terms of market makers's strategic interaction and through which channel does this effect take place? In the present paper we address these issues by using an unique dataset on the Treasury bond market. We show that the same type of trade, on the same asset, in the same market can generate different volume and volatility patterns, depending on the type of market makers who are intermediating it. We identify the ''marginal traders'' as the class of traders that affects market conditions. We show that the marginal traders who have the greatest impact in the short run differ from those who have the greatest impact in the long run. We also show that the class of marginal traders is never most numerous nor does it generate the highest volume of trade. The main implication is that it is not the trade per se that generates volatility, but the informed trade of a particular class of agents. We argue that these results have strong implications in terms of forecastability of future returns and volatility, by showing that most of the explanatory power of trades is due to the ''marginal traders''. Finally, we show how market volatility is influenced not only by traders' actual behavior, but also by their perception of the degree of informativeness and dispersion of beliefs of the other traders they are dealing with.

Shareholder Diversification and IPOs   
  
(with Andriy Bodnaruk, Eugene Kandel and Massimo Massa)

Abstract

We study IPOs by focusing on the degree of portfolio diversification of the shareholders taking the company public. We argue that a less diversified shareholder has more to gain from taking the company public and would be more willing to accept a lower price for the sale of its shares, i.e. tolerate higher underpricing. We test these hypotheses by considering all the IPOs that took place in Sweden in the period 1995-2001. We have obtained detailed information on the portfolio composition of all the investors in the companies being taken public, both before and after the IPO, as well as the portfolio composition of investors in similar (in terms of size, book-to-market and industry) companies not taken public. The information is detailed at the stock level, for both private and public companies. We construct several proxies for portfolio diversification of the shareholders and relate them to both the probability of the IPO and the underpricing. We show that companies held by less diversified shareholders are more likely to go public and suffer a higher underpricing. We show that, as predicted, the degree of diversification explains a significant (economically and statistically) part of the probability of going public, and may account for between one third and one half of the reported underpricing. This suggests that the degree of diversification of controlling shareholders should play a prominent role in the discussion of the process of going public.

Behavioral biases and investment

(with Massimo Massa)

Abstract

We use a new and unique dataset to investigate the way investors react to prior gains/losses and the so called ''familiarity'' bias. We distinguish between different behavioral theories (loss aversion, house-money effect) and between behavioral and rational hypotheses (pure familiarity and information-based familiarity). We show that, on an yearly horizon, investors react to previous gains/losses according to the house-money effect. In terms of individual stock picking, we provide evidence in favor of the information-based theory and show that familiarity can be considered as a proxy for the availability of information as opposed to a behavioral heuristics.

Does prestige matter more than profits? Evidence from entrepreneurial choices

(with Mariassunta Giannetti)

Abstract

This paper studies whether social interactions affect the decision to become an entrepreneur. We find that in municipalities where entrepreneurship is more widespread individuals are more likely to become entrepreneurs even after controlling for individual characteristics, and local economic conditions. We also find that the effect is stronger within groups of individuals who belong to the same social group and are likely to have more frequent interactions. Moreover, the potential economic determinants of cross-municipalities differences in the rate of entrepreneurship, such as differences in income, wealth, or transport costs are unimportant for the individual occupational choice. What seems to matter, instead, are differences in cultural values across communities, which we proxy with indicators of religious, voting and household behavior. These findings support the importance of social interactions and peer group effects for entrepreneurial choices. We also evaluate alternative explanations, like the existence of agglomeration economies, using moving decisions and the success of entrepreneurial activity. However, they do not seem to find support in the data.

Portfolio diversification and city agglomeration

(with William. N. Goetzmann and Massimo Massa)

Abstract

We study portfolio under-diversification from a novel perspective, linking it to the process of professional specialization and knowledge spillover that drive city agglomeration. We show these factors, on the one hand, limit the capacity to elaborate financial information, induce them to invest in familiar stocks and reduce portfolio diversification. On the other hand, by increasing prosperity raise the relative information and increase portfolio diversification. We use a new and unique dataset that contains that contains information on individual investors, traced over time. We have available information on investors' wealth, broken down into their components (cash, stocks and mutual funds, real estate, loans, bonds and other assets), their income and tax position as well as their demographic characteristics. We compare our theory based on city agglomeration to the other existing theories of portfolio diversification, such as background risk, district risk and familiarity/limited information. We provide evidence in favor of the city agglomeration theory and the limited information theory, while we reject the ones based on background risk and district risk.

Portfolio choice and menu exposure

(with Anders Karlsson and Massimo Massa)

Abstract

We study the impact of the menu representation on portfolio choice and we show that investors choose assets as a function of the way they are represented in the menu available to them. We use the choices of mutual funds for retirement accounts of the Swedish population. We show that investors prefer the funds that belong to categories that are more represented in the menu. More numerous categories attract more investment, regardless of their weight in the optimal or world market portfolio. Moreover, an exogenous change in the menu changes investor demand. An increase in the representation of a category in the menu increases investment in all the funds belonging to the same category, including the already existing ones. By using information on the performance of the funds that investors choose, we show that there is a consistent positive correlation between the investor’s sensitivity to the menu exposure and his inability to select over-performing funds. This suggests that the menu exposure represents a rational way of coping with limited (private) information that decreases as information improves. Also, the higher the exposure, the lower degree of portfolio concentration. Our findings shed light on the home exposure puzzle and insight of the determinants of style investing. They also have direct normative implications in terms of Social Security reform.

Stock market participation and pension reform

(with Anders Karlsson and Massimo Massa)

Abstract

We study how the introduction of a defined contribution market based retirement system affects the propensity of the investor to participate in the stock market. By using data on the “Swedish experiment”, we focus on the decision to invest directly in stocks and we see how it changes once the households are allowed to participate to the new pension system. We show that, the introduction of the possibility to invest in retirement funds increases the probability of stock market participation. That is, an individual that did not participate in the stock market has a higher probability of entering it once he has been presented with the new pension scheme. Moreover, the individuals who are more likely to enter the stock market are the ones who make a deliberate portfolio choice for the retirement money. This finding is not consistent with investors perceiving the investment in retirement accounts as a close substitute to investment in equity. Quite the contrary, it suggests that being induced to choose among different pension funds does “educate” the individual, inducing him to participate in the stock market.

The Dark Role of Investment Banks in the Market for Corporate Control

(joint with A. Bodnaruk, M. Massa)

Abstract:
We study the dark side of the advisory banks in the market for corporate control. We argue that advisors are privy to information about the deal that they directly exploit in the market by investing in the target. We show that the banks advisors to the bidders tend to have positions in the target before the deal. The existence of a direct stake of the advisor to the bidder increases the probability of the bid and the target premium. Advisory banks profit from such a position. A trading strategy that conditions on the stake of the advisors delivers a net-of-risk performance of 4.08% per month. This cannot be replicated with available information. We also show that advisors not only take positions in the deals they advise on, but also directly affect the outcome of the deal and its probability of success. This has negative implications for the viability of the new entity.

Keywords: inside trading, risk arbitrage, mergers and acquisitions

Work in progress:

Private information, dispersion of beliefs and strategic behavior on T-Bond auctions.

Diversification motives in IPO.

Who knows what and when? Stock market analysts and macroeconomic forecast.

Look Homeward: Excess returns on local investments

Physics-related publications:

For list of physics-related publication click here

My papers at SSRN

Others

Discussion of "Psychological Factors, Stock Price Paths, and Trading Volume" by STEVEN J. HUDDART, MARK H. LANG, MICHELLE YETMAN, RFS Behavioral Finance Conference, Mannheim, Dec. 2002.