Researches On Investor Sentiment And Assets Pirce Volatility

Securities market is a typical information-asymmetric place where prices areinfluenced by many complex factors.The classical financial theory, represented byEfficient Market Hypothesis and Capital Asset Pricing Model, believes that investorsin the stock market are all rational, which means they make their invest decision baseon the fundamental information of stocks. But as a series of financial anomalies wasfound, including the “volatility puzzle”, classical theores can’t make a reasonableinterpretation of them, so people began to be skeptical about it. On the contrary, thebehavioral finance theory believes that investors, in stock market, are not rational andthe volatility of the stock price in the market reflect not only fundamental information,but also the investor sentiment that plays a significant role under the framework ofbehavior finance.Researches on investor sentiment and assets price volatility are the forefront fieldof behavioral finance. In this article, we investigate how sentiment affects assets pricevolatility from both theoretical and empirical ways. Theoretically, based on theassumption of investor irrationality, we investigat the impact of the feedback tradingto assets price volatility by constructing a basic feedback trading model. Empirically,combined with characteristics of China’s securities market, we choose some indirectsentiment proxy variables that can effectively distinguish the individual andinstitutional sentiment to construct a Chinese investor sentiment index. On this basis,we conduct some empirical studies on the relationship between institutional andindividual investor sentiment and assets prices volatilities in order to to explain theabnormal volatility of the Chinese stock market. On one hand, our studies can providesome empirical evidences from the developing market for the theoretical research ofBehavior Finance. On the other hand, we can give beneficial advice about our policyfor the long-term, healthy and stable development of China securities markets.As an emerging market born in1990s, Chinese securities market has made asignificant progress in the past thirty years and it plays an important part in the global market now. However, compared to the western markets, China’s securities market isimmature in many ways. The abnormal volatilities are very high. In this artical, ourstudies attempt to solve the following problems: first, based on a large number ofprevious studies, we focus on how investor sentiment, under the influence of thefeedback trading, cause the abnormal stock price volatility. Second, based on thebehavioral characteristics of our investors, we select some appropriate investorsentiment proxy variables to build a more effective investor sentiment index in orderthat it can accurately reflect the changes in investor sentiment of the market and itsabnormal fluctuations to assets price volatility. Third, our empirical researchesanalyze the relationship between investor sentiment and the cross-sectional of stockreturns to explain the cross-sectional volatility. Fourth, we investigate whetherinstitutional and individual sentiment has the same impact to different types of stocks.Our researches consist of the following sections.First, we investigate the relationship among feedback trading, investor sentimentand assets price volatility. It is a fact that Feedback trading theory is one of the mostprimitive theories about financial market. But for a long time, researches and modelson this topic are rarely seen. The model in this paper shows the effects of sentimentshocks on asset prices in a market characterized by feedback trading in the long run.We find that, generally, feedback trading will lead to cognitive bias effect and tradinginducement effect. Cognitive bias effect increases with the feedback trading parameter.But, trading inducement effect does not have a simple monotonous relation withfeedback trading parameter.Second, as the foundation of investor sentiment studies, the selection of asentiment proxy directly determines the outcome of empirical researches. In this paper,adopting the “top down” empirical method, we choose5indicators, includingturnover, New Account Opening Ratio, Consumer Confidence Index, RIPO and ADRindex, as sentiment proxies to test the relationship between investor sentiment andcross-sectional of stock returns in China. We construct a Chinese investors’ sentimentindex with the Principal Component Analysis, for the purpose to test whetherinvestors’ sentiment can affect the return of stocks and our results sentiment index gives a positive result.Third, Base on the three-factor model of Fame and French (1992,1993), we builta four-factor model by adding a sentiment index. We choose659stocks from securitymarket in China as the sample stocks after eliminating the stocks whose data are loses,including financial and real estate stocks. We found that the returns increase as thescale of the company decrease. But when the book-to-market value is bigger, thisstock always has a better return. These are the same with the conclusion of Fame andFrench.Using OLS method, we test the effect of investors’ sentiment on the returns ofstocks with different size and book-to-market value. Our result proved that investor’sentiment can affect the return of stocks with different size and book-to-market valuesignificantly, but the degree is not the same. Effect of investors’ sentiment on thestock portfolios with different size is U shape, which was came up by Baker andWurgler (2007), to analysis this result.Because the fear of a single book-to-market value can’t tell Value Stock andGrowth Stock, we separate the sample stocks into3*3groups by the index of PE andPB. At the same time, we also divide the sample stocks into3*3groups with thepurpose of eliminate the effect of the size of the company. And then we regresse thefour-factor model again and find that, compared with Value Stocks, Growth Stocks aremore sensitive to the effect of investors’ sentiment. At last, we studied the relationshipbetween investors’ sentiment and the yield spread of different stock groups, but nomatter different the size or book-to-market value, the effect of sentiment is notsignificant.Fourth, we break up the investor sentiment index to individual investor sentimentindex and institutional investors sentiment index and use the five-factor model,proposed by Carhart (1997), to study the relationship between each investor sentimentand each cross-section of stock returns. Our results show that the stocks, lower ratioof book-value to market value and high ex-earnings, are obvious preferred by both ofindividual and institutional investors. The difference is the stocks higher ratio ofbook-value to market value and lowest ex-earning, are obvious preferred by institutional investors but individual investors are not interested in them.Last but not the least, after dividding investor sentiment into rational andirrational sentiment, our empirical results show that, comparing to the irrationalsentiment, rational sentiment of institutional investors has a stronger stabilizing effectto the volatility of stock market and the individual’s irrational sentiment can greatlyexacerbate the volatility. Moreover, we also find that there are linkages betweeninvestor sentiment and stock market returns. On the one hand, the changes in investorsentiment have a significantly positive effect on current stock market returns, but anegative effect on next month stock market. In addition, small cap is more vulnerableto the impact of investor sentiment. On the other hand, previous and current stockmarket returns will bring a positive effect on investor sentiment. And by comparingthe impact on market sentiment, large cap have the greatest impact, small cap’s effectis weakest.