Explain the impact of sentiment on financial markets.


Dissertation proposal

The Impact of Sentiment on Financial Markets


There is a debate in the financial economic on the role and effect of sentiments among investors on asset prices. Sentiment refers to the feeling of the market and traders psychology which is revealed through price movement and activities of traded securities.  It is the optimism and pessimism on the price of an asset.  Investors’ sentiment shows a certain degree of predictability of stock returns.  Risk premiums such as size, volatility, beta and value of a firm are permanent and have the potential of providing excess returns after being discovered. However, research focused on the relationship between sentiments among investors, and stock returns have mixed results that are not definite.  This study assesses the role of investors’ sentiment on the stock market.

Literature Review

Investors’ sentiment results from their biased expectation regarding the current and the future price of an asset which is not justified by the fundamentals.  Stocks of low capitalization, non-dividend, and high volatility are more likely to be disproportionately sensitive to broad waves of investor sentiment.  Stocks returns are high when the level of sentiment among investors is low and when the pattern attenuates when sentiment proxies are high. Arguably, investors’ sentiment has a substantial effect on the cross-section of stock returns.  There are two types of investors in the financial market including rational and irrational investors.  Trades among irrational investors increase risks and becomes a deterrent to the arbitrage activities among rational traders.  Discounts on closed-end funds are influenced by changes in individual sentiments among investors.  When investors are pessimistic, the discounts are high and low when they are optimistic. A market characterized by sales constraints utilizes market liquidity as the sentiment indicator.  In addition, the effect of investors’ sentiment on stock markets is more pronounce in nations that are prone to overreaction and those with low institutional involvement.

Research Hypothesis

  1. Sentiment among investors has an effect of the aggregate stock market returns. The correlation between return expectation and sentiment is negative to the controlling for fundamental factors controlling the stock market.
  2. The impact of sentiment on returns is stronger for stocks are difficult to value and arbitrage.

Research Methodology

In assessing the effect of sentiment on the stock returns, the research will use empirical design.  The aggregate measure of investors sentiment is evaluated by use of sentiment proxies and idiosyncratic variation related to sentiment and non-sentiment components among investors.  Regression residual is considered as a cleaner proxy, which is independent of major business cycle effects.  The empirical model is as follows;

In the equation, i is securities, X is security characteristics, t is time, T is the time series variable that proxies for investors’ sentiment, and b2 is the non-zero impact as a result of rational compensation.

The research will utilize secondary data compiled by Harvard Business School.  Used data compiled of characteristics of listed companies in New York Exchange or SSE Composite Index and delisted firm between 2010 and 2015.  Firm characteristics include size, age, market equity, book equity and volatility.  Obtained data will be used to examine the effect of sentiments on the stock market in the US and China.

The first proxy that will be employed in the construction of index is premium volatility.  The approach identifies times when the valuation of whether stock volatility is high or low. Volatile stocks are riskier and are unattractive to arbitrageurs. As a result, the unattractive stock is more likely to be affected by irrational investor sentiment.  The second and third proxies are derived from the initial public offering. The investigator will assess the returns on initial public offering in volatile markets.  In analyzing returns from proxies that are not related to sentiments three macroeconomics series will be utilized, including employment growth, inflation, and industrial production growth.  These data will be extracted from New York Exchange and the International Monetary Fund website.

Expected Results

When investors’ sentiment is highly volatile stocks, small company stocks, and young stock experience low future returns about other securities.  Such stocks are more likely to attract speculator while at the same time they are unattractive to arbitrageurs.  The expected results will give credence to argument developed by financial researchers which neglect behavior aspects among investors.  Sentiments will be incorporated into classical financial theories to enhance traditional asset pricing and risk models.

The study will assist in examining whether investor sentiment can be used in crashes in the stock market.  Understanding investor sentiment will assist in identifying when the market crash will occur in the global financial market.  The study will assist in incorporating investor sentiment with a selection of portfolio. Financial markets are dominated by arbitrageur and rational investors who choose stocks on the basis of fundamental values. The study will assist in combining investor sentiment with asset allocation to constructing portfolios that generate substantial returns.

Study Limitation

The main study limitation is based on the fact that the study relies on secondary data and not firsthand data.  The investigator has less control over variables, and there are chances of data biases.

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