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RESEARCH PAPERS | RISK MANAGEMENT

FX Hedging

OFFSHORE ACTIVITIES AND FINANCIAL VS OPERATIONAL HEDGING

Gerard Hoberg, and S. Katie Moon
2016
A key question is why many multinational firms forgo foreign exchange derivative (FX) hedging and instead use operational hedging. We propose an explanation based on illiquidity and the unique advantages of operational hedges. We use 10-K filings to construct dynamically updated text-based measures of the offshore sale of output, purchase of input, and ownership of assets. We find that firms use FX derivatives when they are liquid and generally available. Otherwise, they often favor purchasing input from the same nations they sell output to, an operational hedge. Quasi-natural experiments based on new derivative product launches suggest a likely causal relation. >more


Option Markets and R&D

THE BRIGHT SIDE OF FINANCIAL DERIVATIVES: OPTIONS TRADING AND FIRM INNOVATION

Iván Blanco, and David Wehrheim
2016
Do financial derivatives enhance or impede innovation? We aim to answer this question by examining the relationship between equity options markets and standard measures of firm innovation. Our baseline results show that firms with more options trading activity generate more patents and patent citations per dollar of R&D invested. We then investigate how more active options markets affect firms' innovation strategy. Our results suggest that firms with greater trading activity pursue a more creative, diverse and risky innovation strategy. We discuss potential underlying mechanisms and show that options appear to mitigate managerial career concerns that would induce managers to take actions that boost short-term performance measures. Finally, using several econometric specifications that try to account for the potential endogeneity of options trading, we argue that the positive effect of options trading on firm innovation is causal. >more


OTC Markets

TO POOL OR NOT TO POOL? SECURITY DESIGN IN OTC MARKETS

Vincent Glode, Christian C. Opp, and Ruslan Sverchkov
2016
This paper studies the optimality of pooling and tranching for a privately informed security originator facing buyers endowed with market power (perhaps due to liquidity shortages). Contrary to the standard result that pooling and tranching are optimal practices, we find that selling assets separately may be preferred by originators. In this environment, originators sell securities separately to avoid being inefficiently screened by buyers with market power. Our results shed light on observed time-variations in the practice of pooling and tranching in financial markets, in particular, the dramatic decline in the size of the ABS market following the most recent financial crisis. >more


Liquidity Management

RISK MANAGEMENT WITH SUPPLY CONTRACTS

Heitor Almeida, Kristine Watson Hankins, and  Ryan Williams
2016
Purchase obligations are forward contracts with suppliers and are used more broadly than traded commodity derivatives. This paper is the first to document that these contracts are a risk management tool and have a material impact on corporate hedging activity. Firms that expand their risk management options following the introduction of steel futures contracts substitute financial hedging for purchase obligations. Contracting frictions – such as bargaining power and settlement risk – as well as potential hold-up issues associated with relationship-specific investment affects the use of purchase obligations in the cross-section as well as how firms respond to the introduction of steel futures. >more


Managerial Incentives

CASH HOLDINGS AND BANK COMPENSATION

Viral V. Acharya, Hamid Mehran, and Rangarajan K. Sundaram
2016
The experience of the 2007-09 financial crisis has prompted much consideration of the link between the structure of compensation in financial firms and excessive risk taking by their employees. A key concern has been that compensation design rewards managers for pursuing risky strategies but fails to exact penalties for decision making that leads to bank failures, financial system disruption, government bailouts, and taxpayer losses. As a way to better align management's interests with those of other stakeholders such as creditors and taxpayers, the authors propose a cash holding requirement designed to induce financial firms to adopt a conservative approach to risk taking. Firms meet the requirement by deferring employee compensation in an escrowed cash reserve account. The cash accrues to the earners on a vesting schedule, but is transferred to the firm in times of stress so that it can pay down its debt or otherwise bolster its assets. The cash requirement increases with the leverage of the firm and with the firm's vulnerability to aggregate stress; the authors provide illustrative calculations sizing the proposed cash requirement for many U.S. financial firms over the 2000-13 period. The analysis also compares the role of deferred cash compensation in promoting financial stability with that of other instruments, such as inside debt, deferred equity, and contingent capital. >more


Crash Beliefs

CRASH BELIEFS FROM INVESTOR SURVEYS

William N. Goetzmann, Dasol Kim, and  Robert J. Shiller
2016
Historical data suggest that the base rate for a severe, single-day stock market crash is relatively low. Surveys of individual and institutional investors, conducted regularly over a 26 year period in the United States, show that they assess the probability to be much higher. We examine the factors that influence investor responses and test the role of media influence. We find evidence consistent with an availability bias. Recent market declines and adverse market events made salient by the financial press are associated with higher subjective crash probabilities. Non-market-related, rare disasters are also associated with higher subjective crash probabilities. >more


Idiosyncratic Risk

WHY DOES IDIOSYNCRATIC RISK INCREASE WITH MARKET RISK?

Söhnke M. Bartram, Gregory W. Brown, and René M. Stulz
2016
From 1963 through 2015, idiosyncratic risk (IR) is high when market risk (MR) is high. We show that the positive relation between IR and MR is highly stable through time and is robust across exchanges, firm size, liquidity, and market-to-book groupings. Though stock liquidity affects the strength of the relation, the relation is strong for the most liquid stocks. The relation has roots in fundamentals as higher market risk predicts greater idiosyncratic earnings volatility and as firm characteristics related to the ability of firms to adjust to higher uncertainty help explain the strength of the relation. Consistent with the view that growth options provide a hedge against macroeconomic uncertainty, we find evidence that the relation is weaker for firms with more growth options. >more


Interest rate risk

RISK MANAGEMENT IN FINANCIAL INSTITUTIONS

Adriano A. Rampini, S. Viswanathan, and Guillaume Vuillemey
2016
We study risk management in financial institutions using data on hedging of interest rate risk by U.S. banks and bank holding companies. Theory predicts that more financially constrained institutions hedge less and that institutions whose net worth declines due to adverse shocks reduce hedging. We find strong evidence consistent with the theory both in the cross-section and within institutions over time. For identification, we exploit net worth shocks resulting from loan losses due to drops in house prices. Institutions which sustain such losses reduce hedging substantially relative to otherwise similar institutions. We find no evidence that risk shifting, changes in interest rate risk exposures, or regulatory capital explain hedging behavior. >more


Bank Default

THE SOVEREIGN-BANK DIABOLIC LOOP AND ESBIES

Markus K. Brunnermeier, Luis Garicano, Philip R. Lane, Marco Pagano, Ricardo Reis, Tano Santos, David Thesmar, Stijn Van Nieuwerburgh, and Dimitri Vayanos
2016
We propose a simple model of the sovereign-bank diabolic loop, and establish four results. First, the diabolic loop can be avoided by restricting banks’ domestic sovereign exposures relative to their equity. Second, equity requirements can be lowered if banks only hold senior domestic sovereign debt. Third, such requirements shrink even further if banks only hold the senior tranche of an internationally diversified sovereign portfolio – known as ESBies in the euro-area context. Finally, ESBies generate more safe assets than domestic debt tranching alone; and, insofar as the diabolic loop is defused, the junior tranche generated by the securitization is itself risk-free. >more


Exchange Rate Risk

DO DOLLAR-DENOMINATED EMERGING MARKET CORPORATE BONDS INSURE FOREIGN EXCHANGE RISK?

Stefanos Delikouras, Robert F. Dittmar, and Haitao Li
2015
Dollar-denominated emerging market debt is marketed to investors as a way of exposing investors emerging market fixed income securities without exposure to exchange rate risk. However, the development literature suggests that dollarization of debt leads to increased probability of financial distress, which would indirectly expose these securities to exchange rate risk. We empirically examine the exposure of dollar-denominated corporate bonds to exchange rate risk in 14 emerging markets. We find that nearly three-fourths of bonds have yield spreads with statistically significant exposure to innovations in exchange rates, exchange rate volatility, or both. In a reduced-form bond pricing model with default risk, we find economically significant exposures of credit spreads to exchange rates and exchange rate volatility. >more


Hedging

ARE STOCKS REAL ASSETS? STICKY DISCOUNT RATES IN STOCK MARKETS

Michael Katz, Hanno N. Lustig, and Lars N. Nielsen
2015
Local stock markets adjust sluggishly to changes in local inflation. Nominal returns on a country's local stock market index do not respond to country-specific variation in the rate of inflation. When the local rate of inflation increases, local investors subsequently earn significantly lower real returns on local stocks, but not on local bonds or foreign stocks. We provide evidence that local stock market investors use sticky long-run nominal discount rates that are too low when inflation increases. Small departures from rational inflation expectations that underweight current inflation suffice to match the real stock return predictability induced by inflation. >more


Investments Options

EMBRACING RISK: HEDGING POLICY FOR FIRMS WITH REAL OPTIONS

Ilona Babenko, and Yuri Tserlukevich    
2013
We analyze the dynamic risk management strategy of firms that face a tradeoff between minimizing the costs of financial distress and maximizing financing for future investment. Costly external financing of lumpy investment discourages full hedging because hedging can increase the financing costs and decrease the probability of investment. First, we find that firms with safe assets can choose to hedge more aggressively than firms with risky assets. Second, firms prefer to hedge systematic rather than firm-specic risk, even when hedging technologies for both types of risk are available and equally costly. Third, it is optimal to increase the volatility of cash flows when cash savings are low and do not cover investment needs. Therefore, more constrained firms may appear to hedge less aggressively. Our theory generates comprehensive results consistent with actual hedging policies, and without relying on the costs of risk management. >more


Tail Risk

WHAT DOES THE VOLATILITY RISK PREMIUM SAY ABOUT LIQUIDITY PROVISION AND DEMAND FOR HEDGING TAIL RISK?

Jianqing Fan, Michael B. Imerman, and Wei Dai 
2013
This paper examines the volatility risk premium, defined as the difference between expected future volatility under the risk-neutral measure and the expectation under the physical measure. This risk premium represents the price of volatility risk in financial markets. It is standard to use the VIX volatility index to proxy the expectation under the risk-neutral measure. Estimation under the physical measure is less straightforward. Using ultra-high-frequency transaction data on SPDR, the S&P500 ETF, we implement a novel approach for estimating integrated volatility on the frequency domain which allows us to isolate possibly autocorrelated microstructure noise from the true volatility. Once we compute the volatility risk premium, we perform a comprehensive econometric analysis to help identify its determinants. We find that analyzing the sign and magnitude components of the volatility risk premium provides greater insight into the underlying economic drivers, most notably supply and demand forces in the market for hedging tail risk as well as the role of intermediaries in this market. Our results are consistent with previous studies and are able to reconcile different interpretations of the volatility risk premium in the literature. >more


Exchange Rate Modelling

WHICH CONTINUOUS-TIME MODEL IS MOST APPROPRIATE FOR EXCHANGE RATES?

Deniz Erdemlioglu, Sébastien Laurent, and Christopher J. Neely 
2015
This paper determines the most appropriate ways to model diffusion and jump features of exchange rates. Simulations show that intraday periodicity in volatility prevents conventional tests from accurately identifying the frequency and location of jumps. We propose a two-stage correction for this periodicity that improves the properties of the test statistics. The most plausible model for 1-minute exchange rate data features Brownian motion and Poisson jumps but not infinite activity jumps. We also show that microstructure noise biases but does not unduly impair the statistical tests for jumps and diffusion behavior in finite samples. >more


Variance Risk

THE PRICE OF POLITICAL UNCERTAINTY: THEORY AND EVIDENCE FROM THE OPTION MARKET

Bryan T. Kelly, Lubos Pastor, and Pietro Veronesi      
2014
We empirically analyze the pricing of political uncertainty, guided by a theoretical model of government policy choice. To isolate political uncertainty, we exploit its variation around major political events, namely, national elections and global summits. We find that political uncertainty is priced in the equity option market in ways predicted by the theory. Options whose lives span political events tend to be more expensive. Such options provide valuable protection against the risk associated with political events, including not only price risk but also variance and tail risks. This protection is more valuable in a weaker economy as well as amid higher political uncertainty. >more


Variance Risk

VARIANCE RISK PREMIA IN COMMODITY MARKETS

Marcel Prokopczuk, and Chardin Wese Simen    
2014
We use a large panel of commodity option prices to study the market price of variance risk. We construct synthetic variance swaps and find significantly negative variance risk premia in nearly all commodity markets. An equally-weighted portfolio of short commodity variance swaps earns an annualized Sharpe Ratio of around 40%. We document increasing comovements across bonds, commodities and equity variance swap returns, suggesting that the variance swap markets are increasingly integrated. Finally, we show that commodity variance risk premia are distinct from price risk premia, indicating that variance risk is unspanned by commodity futures. >more


CEO Risk-taking Behavior

WHAT DOESN'T KILL YOU WILL ONLY MAKE YOU MORE RISK-LOVING: EARLY-LIFE DISASTERS AND CEO BEHAVIOR

Gennaro Bernile, Vineet Bhagwat, and P. Raghavendra Rau  
2014
The extant literature on managerial style posits a linear relation between a CEO’s exposure to risk and subsequent corporate policy. We show that there is a non-monotonic relation between CEO’s early-life exposure to natural disasters and risk-taking. Specifically, experiencing natural disasters without extremely negative consequences appears to desensitize CEOs to the negative consequences of risk. However, if a CEO was exposed to "extreme" levels of fatal disasters and experienced the downside potential of risky situations, he or she appears to be more cautious in their approach to risk when at the helm of a firm. These results hold across various corporate policies and outcomes including leverage, stock volatility, cash holdings, acquisitiveness, and CEO compensation structure. >more


Systematic Risk in Banking Sector

SYSTEMIC RISK IN THE US AND EUROPEAN BANKING SECTORS IN RECENT CRISES

Simone Varotto, and Lei Zhao
2014
In this paper we measure systemic risk in the banking sector by taking into account relevant bank characteristics such as size, leverage and interconnectedness. We analyse both aggregate and individual systemic risk for US and European banks. At the aggregate level, a new indicator of banking system fragility based on the “effective” level of short term debt in the industry reveals markedly different systemic risk patterns in the US and Europe over time. At the firm level, 9 months before the Lehman Brothers failure we are able to identify the most systemically important US banks that later either defaulted or received the largest bailouts from the US Treasury. We also find that a bank’s balance sheet characteristics can help to predict its systemic importance and, as a result, may be useful early warning indicators. Interestingly, the systemic risk of US and European banks appears to be driven by different factors. >more


Country Creditworthiness

SOVEREIGN CREDIT RISK AND GOVERNMENT EFFECTIVENESS

Jean-Claude Cosset, and Alexandre Jeanneret
2013
This paper investigates how the level of government effectiveness in a country affects its creditworthiness. We develop a structural model for sovereign credit risk in which the government adjusts its default and debt policies to the ability to collect and use fiscal revenues efficiently. We predict that better-governed countries exhibit lower incentives to default and thus benefit from a narrower sovereign credit spread. Moreover, the impact of government effectiveness on sovereign credit risk is highly non-linear. Specifically, the effect strengthens with the level of default risk, indebtedness, and a deterioration in economic conditions. Using a sample of 75 developed and emerging countries over the period 1996-2011, we provide strong empirical support for the model's predictions. >more


Option Theory

EARLY OPTION EXERCISE: NEVER SAY NEVER

Mads Vestergaard Jensen, and Lasse Heje Pedersen
2013
A classic no-arbitrage result by Merton (1973) is that one should never exercise a call option before maturity or dividend payments and one should never convert a convertible bond. We show theoretically that this classic result is overturned when investors face financial frictions and exercising an option early reduces 1) short-sale costs, 2) transaction costs, or 3) funding costs. We provide empirical evidence consistent with our theory, documenting friction-induced early exercise for equity call options and convertible bonds using unique datasets on actual exercise decisions and actual financial frictions. >more


Housing Bubble

WALL STREET AND THE HOUSING BUBBLE

Ing-Haw Cheng, Sahil Raina, and Wei Xiong
2013
We analyze whether mid-level managers in securitized finance were aware of the housing bubble in 2004-2006 using their personal home transaction data. We find little evidence of them timing the bubble or exercising cautious behavior in purchasing homes on average, relative to two uninformed control groups: one composed of non-housing equity analysts, and the other of non-real estate lawyers. Our findings cast doubt on the view that the average Wall Street securitization employee was aware of the housing bubble and knowingly ignored warning signs of a crash. >more


Securitization

SECURITIZATION AND THE FIXED-RATE MORTGAGE

Andreas Fuster, and James I. Vickery
2013
Fixed-rate mortgages (FRMs) dominate the U.S. mortgage market, with important consequences for household risk management, monetary policy, and systemic risk. In this paper, we show that securitization is a key driver of FRM supply. Our analysis compares the agency and nonagency mortgage-backed-securities (MBS) markets, exploiting the freeze in nonagency MBS liquidity in the third quarter of 2007. Using exogenous variation in access to the agency MBS market, we find that when both market segments are liquid they perform similarly in terms of supporting FRM supply. However, after the nonagency market freezes, the share of FRMs is sharply higher among mortgages eligible to be securitized through the still-liquid agency MBS market. Our interpretation is that securitization is particularly important for FRMs because of the prepayment and interest rate risk embedded in these loans. We highlight policy implications for ongoing reform of the U.S. mortgage finance system. >more


Currency Risk Premia

CURRENCY PREMIA AND GLOBAL IMBALANCES

Pasquale Della Corte, Steven J. Riddiough, and Lucio Sarno
2013
Global imbalances are a fundamental economic determinant of currency risk premia. We propose a factor that captures exposure to countries' external imbalances - termed the global imbalance risk factor - and show that it explains most of the cross-sectional variation in currency excess returns. The economic intuition of this factor is simple: net foreign debtor countries offer a currency risk premium to compensate investors willing to finance negative external imbalances. Investment currencies load positively on the global imbalance factor while funding currencies load negatively, implying that carry trade investors are compensated for taking on global imbalance risk. >more


OTC markets

THE MARKET FOR OTC DERIVATIVES

Andrew G. Atkeson, Andrea L. Eisfeldt and Pierre-Oliver Weill
2013
We develop a model of equilibrium entry, trade, and price formation in over-the-counter (OTC) markets. Banks trade derivatives to share an aggregate risk subject to two trading frictions: they must pay a fixed entry cost, and they must limit the size of the positions taken by their traders because of risk-management concerns. Although all banks in our model are endowed with access to the same trading technology, some large banks endogenously arise as "dealers," trading mainly to provide intermediation services, while medium sized banks endogenously participate as "customers" mainly to share risks. We use the model to address positive questions regarding the growth in OTC markets as trading frictions decline, and normative questions of how regulation of entry impacts welfare. >more


Option and Stock Market Relation

WHY DO OPTIONS PRICES PREDICT STOCK RETURNS?

Tse-Chun Lin, Xiaolong Lu, and Joost Driessen
2013
We use a new approach to assess the information transmission between the options market and stock market. We study whether the predictive power of options-implied volatilities (IVs) on stock returns lies in earnings-related and/or analyst-related news. We find that two proxies for options trading (IV skew and IV spread) predict earnings surprises, analyst recommendation changes, and analyst forecast revisions. Next, we show that the IV skew and IV spread predict stock returns, and that the degree of predictability more than doubles around earnings-related and analyst-related events. Additionally, we find that informed traders choose to use the options market particularly because of short-sale constraints on the underlying stock. We also find that the informed options trading increases with the options market liquidity. >more


Term Structure

SYSTEMATIC RISK, DEBT MATURITY, AND THE TERM STRUCTURE OF CREDIT SPREADS

Hui Chen, Yu Xu, and Jun Yang
2013
We build a structural model to explain corporate debt maturity dynamics over the business cycle and their implications for the term structure of credit spreads. Longer-term debt helps lower firms' default risks while shorter-term debt reduces investors' exposures to liquidity shocks. The joint variations in default risks and liquidity frictions over the business cycle cause debt maturity to lengthen in economic expansions and shorten in recessions. Our model predicts that firms with higher systematic risk exposures will favor longer debt maturity, and that this cross-sectional relation between systematic risk and debt maturity will be stronger when risk premium is high. It also shows that the pro-cyclical maturity dynamics induced by liquidity frictions can significantly amplify the impact of aggregate shocks on credit risk, with the effects differing across different parts of the term structure, and that maturity management is especially important in helping high-beta and high-leverage firms reduce the impact of a crisis event that shuts down long-term refinancing. Finally, we provide empirical evidence for the model predictions on both debt maturity and credit spreads. >more


Risk Management in Banks

SUPERVISING THE SUPERVISOR: ON THE CONCEPT AND PERFORMANCE OF REGULATORY RISK ASSESSMENT

Thomas Kick, and Andreas Pfingsten
2013
It is still an open question whether on-site inspections at banks provide additional insights, or supervisors simply duplicate the quantitative information. Applying a partial proportional odds model to a unique dataset of banks’ supervisory risk profiles we find that not only the quantitative CAMEL vector is clearly important for the final supervisory risk assessment; it is, indeed, also qualitative information on internal governance, ICAAP, and interest rate risk that play an equally important role. Moreover, basing our model on future bank default information, we find that undisclosed bank reserves mitigate bank distress while risk in the loan portfolio, in the ICAAP, and interest rate risk are the most significant drivers of future bank defaults. >more


Index Derivatives

TOWARD AN EARLY WARNING SYSTEM OF FINANCIAL CRISES: WHAT CAN INDEX DERIVATIVES TELL US?

Wei-Xuan Li, Chia-Sheng Chen, and Joseph J. French
2013
We develop an early warning system (EWS) for equity market crises based on multinomial logit models and variables relating to the information content of index futures and options. We show that the information impounded in S&P 500 futures and options is useful as leading indicators of financial crises. The current literature is absent of such studies. Results reveal that models estimated with futures and put options significantly improve the medium-term predictability of equity market crises. Variables that consistently provided information of an impending crisis include: the VIX, open interest, dollar volume, and put option prices. >more


Real Option Theory

VOLATILITY RISKS AND GROWTH OPTIONS

Hengjie Ai, and Dana Kiku
2012
This paper explores the relationship between volatility and growth options. The authors argue that while the value of a growth option increases with idiosyncratic volatility, its response to volatility of aggregate shocks is ambiguous. Building on these theoretical insights, they propose to measure option intensity by firms' exposure to idiosyncratic volatility. The authors show that their measure carries significant information about firms' future investment, even after controlling for conventional proxies of growth options such as book-to-market and other relevant firm characteristics. Consistent with their theoretical arguments, the authors also show that firm' exposure to aggregate volatility does not help predict their future growth. In addition, they show that option-intensive firms, identified using our volatility-based measure, earn a lower premium than do firms that rely more heavily on assets in place. >more


Fund Manager Skills

TIME-VARYING FUND MANAGER SKILL

Marcin T. Kacperczyk, Stijn Van Nieuwerburgh and Laura Veldkamp
AFA 2013 San Diego Meetings Paper
The authors introduce a new definition of skill as a general cognitive ability to either pick stocks or time the market at different times. They put forth evidence for stock picking in booms and for market timing in recessions. Additionally, the same fund managers that pick stocks well in expansions also time the market well in recessions. These fund managers remarkably outperform other funds and passive benchmarks. The results of this paper indicate a new measure of managerial ability that gives more weight to a fund’s market timing in recessions and to a fund’s stock picking in booms. >more


Hedge Funds

CAN HEDGE FUNDS TIME MARKET LIQUIDITY?

Charles Cao, Yong Chen, Bing Liang, and Andrew W. Lo
AFA 2013 San Diego Meetings Paper
This paper observes a new dimension of fund managers’ timing ability by examining whether they can time market liquidity through adjusting their portfolios’ market exposure as aggregate liquidity conditions change. Using a large sample of hedge funds, the authors find strong evidence of liquidity timing. Furthermore, a bootstrap analysis suggests that top-ranked liquidity timers are not attributable to pure luck. In out-of-sample tests, top liquidity timers outperform bottom timers by 4.0%–5.5% annually on a risk-adjusted basis. The authors also find that it is important to distinguish liquidity timing from liquidity reaction which primarily relies on public information. The results of this study are robust to alternative explanations, hedge fund data biases, and the use of alternative timing models, risk factors, and liquidity measures. The findings highlight the importance of understanding and incorporating market liquidity conditions in investment decision-making. >more


Hedge Funds

DO HEDGE FUNDS MANIPULATE STOCK PRICES?

 

Itzhak Ben-David, Francesco A. Franzoni, Augustin Landier and Rabih Moussawi
AFA 2013 San Diego Meetings Paper
This study puts forth evidence suggesting that some hedge funds manipulate stock prices on critical reporting dates. Stocks in the top quartile of hedge fund holdings exhibit abnormal returns of 0.30% on the last day of the quarter and a reversal of 0.25% on the following day. A significant part of the return is earned during the last minutes of trading. Analysis of intraday volume and order imbalance provides further evidence consistent with manipulation. These patterns are found to be stronger for funds that have higher incentives to improve their ranking relative to their peers. >more