Why would institutional investors not take advantage of arbitrage opportunities at year end? New groundbreaking research from Dr. Mark Griffiths offers an answer and argues against a popular academic explanation for why investors leave the commercial paper markets in December.
In December, institutional investors exit the markets by year-end selling and repurchasing of commercial papers issues and stocks – a phenomenon known as “turn-of-the-year” effect. The academic community still calls this effect an anomaly, even after 20 years of research, because a definitive explanation has yet to be accepted on why investors leave the markets to hold cash at year end. In addition, when investors exit the markets in December, they knowingly miss opportunities for arbitrage. Why?
To help explain why investors exit the market, one hypothesis called “risk shifting window dressing” has become popular. Part of the “risk shifting” hypothesis purports that investors exit the market to avoid risky positions that would have to be reported at year-end, i.e., large portfolio managers alter their portfolios at disclosure dates to under-represent the riskiness of portfolios held on non-disclosure dates.
However, Thunderbird Finance Professor Mark Griffiths, Ph.D. disagrees.
Griffiths and his colleague Drew B. Winters, Ph.D., from the University of Central Florida, argue that investors exit the money markets to meet year-end cash flow obligations (a hypothesis called “preferred habitat”). These obligations include year-end and holiday bonuses, dividends and payments on debt. They argue that because investors need cash to meet year-end obligations they then do not have the cash to take advantage of arbitrage opportunities that occur in December. In January, once the cash obligations are met, investors return to more illiquid investments but have missed the opportunity to profit from price discrepancies in the market.
Using data from the Chicago Mercantile Exchange, Federal Reserve Bank of St. Louis and other sources, Griffiths and Winters go beyond the data that was used to support the risk shifting hypothesis to support their cash flow obligation hypothesis. While previous researchers who supported the risk-shifting hypothesis analyzed data such as timing, rates and yields, Griffiths and Winters analyzed timing, rates and yields in a different way to better isolate the last few days of the year from the first few days of the next year.
Next, Griffiths and Winters analyzed private-issue money markets, levels of demand accounts and large time deposits in December and January. They analyzed these additional data elements to support the cash flow obligation theory that investors retrieve their cash during December to better meet their cash flow obligations, and then re-enter the market in January, causing demand deposits to drop at that time. The result is a new research paper entitled “The Turn-of-the-Year in Money Markets: Tests of the Risk-Shifting Window Dressing and Preferred Habitat Hypothesis” that will be published in the Journal of Business by the University of Chicago later this year.
Though other researchers have also tried to argue for the cash flow obligation hypothesis, the research from Giffiths and Winters is groundbreaking because it is the first time that all data elements (timing, rates, yields, private issue money markets, demand accounts, large time deposits) have been brought together to argue that “turn-of-the-year” effect is an issue not of risk shifting, but firms’ need for liquidity.
Thunderbird Associate Professor of Finance Mark Griffiths holds a Ph.D. in finance from The University of Western Ontario, an M.A. in economics from the University of Waterloo, and an MBA in finance from York University. He can be contacted at griffitm@thunderbird.edu.
