[R-SIG-Finance] self-fulfilling prophecies in financial study

Tue May 15 10:03:10 CEST 2012

Hi

A little bit late to answer this maybe...

You could take a completely different point of view, and study the 
effects of "self-fullfilling" prophecies on the dynamics of the price 
time series. The idea is that a self-fullfilling prophecy would induce 
over-reaction of the market, a sort of "trend following" behaviour. 
Translated this into time series properties, it can be interpreted as a 
change in the persistence of the time series, i.e. its auto-regressive 
coefficients, which becomes higher than 1.

This is actually what is done in the economic literature of for 
"bubbles", where bubbles are defined as an explosive behaviour of the 
series, i.e. a \rho >1. PCB Philips has recently worked on it and 
developed econometric tests very simple to implement in practice. We 
used this in a paper, where you can find an illustration (box 14.3) and 
few references:
http://www.fao.org/docrep/013/i2107e/i2107e14.pdf

Best

Matthieu

Le 09/05/2012 21:56, Nitish Ranjan a écrit :
> Sometimes, there is and sometimes there is not, which is why I was trying
> to make a distinction between real informational reason versus simple index
> benchmarking. Netflix was a very well known stock before S&P discovered it.
> Some other stocks are not so (Xilinx?). One would expect the index effect
> to be stronger among the later.
>
> Similarly, size effect could also be driven by economic forces. Small firms
> have typically more options embedded in them. To give an example from real
> life, any kid born in America has a higher probability for being a
> billionaire than any 65 year old American, that is the option value. Size
> effect may have a similar mechanism at play. The other way size effect is
> work could be through demand side. Imagine having a billion dollars to
> invest within 3 months. One is more likely to look for large investment
> opportunities. That would generate a bias away from small stocks. This in
> turn would generate a size effect is returns. Turns out size effect
> continues to exist, despite the claims in
> http://schwert.ssb.rochester.edu/hbfech15.pdf paper. We still have the
> anomaly that equally weighted index outperforms a value weighted index.
>
> Regards
>
> On Wed, May 9, 2012 at 2:44 PM, Richard Herron
> <richard.c.herron at gmail.com>wrote:
>
>> I don't want to argue semantics, but for your examples there is a
>> real, underlying change.
>>
>> Inclusion in an index improves liquidity and information production
>> for the real reasons you discuss (e.g., increased trading by index
>> funds or an increase in capitalization that added the firm to the
>> index).
>>
>> For the size effect the only thing that changed was that some
>> researchers said "I think that small stocks earn an abnormal return,"
>> and the effect diminished. I consider this a "prophecy" because there
>> is no real underlying change, just an idea planted by academic
>> research.
>>
>> Richard Herron
>>
>>
>> On Wed, May 9, 2012 at 10:49 AM, Nitish Ranjan<nitish.ranjan at gmail.com>
>> wrote:
>>> Disappearance of size effect will not be an example of self fulfilling
>>> prophesy (it disappeared rather than become stronger).
>>>
>>> In the stock market, possible examples are:
>>>
>>> 1. Index inclusion effect in returns
>>> 2. The tendency of traders to put in trades early in the day or later in
>>> the day but not in the middle of the day.
>>> 3. Most dispersion in returns during the earnings month.
>>>
>>> The second part of the email asked about R code/test which will test
>> these
>>> effects for self fulfilling prophecy. The null for such test is "Are
>> there
>>> any economic reasons why we would see self fulfilling prophecies to
>> work."
>>> A general test is hard (probably impossible, see the following
>> discussion)
>>> since different economic(or psychological) factors shape each of these
>>> examples. But we can formulate hypotheses for each one of these examples
>>> and write tests.
>>>
>>> Let me take the example of index inclusion effect. It is well known that
>>> after included in an index such as S&P 500, a stock performs well. Why?
>> For
>>> one, there are many funds which are pegged to S&P 500 and many more which
>>> simply follow the index. Both these kind of funds will have demand for
>> the
>>> newly inducted stock. Both these kind of funds will begin to buy the
>> stock
>>> and
>>> move the prices up for the newly inducted stock. Since neither of these
>>> demands have any informational origins, we would expect the permanent
>>> impact to be small (close to zero) and a large temporary impact. See the
>>> survey paper http://www4.ncsu.edu/~rswarr/fm2006.pdf for further
>> discussion.
>>> Another channel via which the effect might play out is through new
>>> information production. It is very possible that index inclusion actually
>>> brings a stock to the forefront of investors and produces new research
>> for
>>> the stock which in turn should make the stock less volatile. A
>>> Campbell-Schiller type decomposition might help with matters here. You
>>> could also examine the actual production of information (number of news
>>> articles, analyst following, analyst dispersion etc). This line of
>>> reasoning suggests that we would see this effect most for stocks which
>> come
>>> from relative anonymity to being famous. We would observe less of this
>>> effect for stocks which were famous before inclusion in an index (such as
>>> netflix for SP500 and any stock in Dow 30). But including such
>>> informational channels involve careful examination of multitude of data
>>> sources and ruling out the alternates one by one. It also involves
>>> understanding the various forces at play (or institutional knowledge).
>>>
>>> Regards
>>>
>>> Nitish
>>>
>>> p.s.: I think it is borderline not appropriate discussion for this list,
>>> but since it asked for an R code it deserves some consideration.
>>>
>>>
>>> On Wed, May 9, 2012 at 9:04 AM, Richard Herron
>>> <richard.c.herron at gmail.com>wrote:
>>>
>>>> Is this an R question?
>>>>
>>>> Are you taking about anomalies that disappear after we discover them?
>> If we
>>>> discover an anomaly and it disappears, then we have to wonder if we
>> priced
>>>> it right before or after. See the size effect.
>>>>
>>>> http://schwert.ssb.rochester.edu/hbfech15.pdf
>>>>
>>>> Richard Herron
>>>>
>>>>
>>>> On Wed, May 9, 2012 at 8:01 AM, Wei-han Liu<weihanliu2002 at yahoo.com>
>>>> wrote:
>>>>
>>>>> Hi R users:
>>>>>
>>>>> There are some possible candidates of self-fulfilling prophecies in
>>>>> financial study.
>>>>>
>>>>> Could some people share some thoughts about the relevant theories,
>>>>> econometric tests, and R packages for implementation?
>>>>>
>>>>> Thanks for your attention and sharing.
>>>>>
>>>>> Wei-han
>>>>>         [[alternative HTML version deleted]]
>>>>>
>>>>>
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>>>>
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>>>
>>>
>>> --
>>> Have fun.
>>>
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>>>
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