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Master's Thesis Is Good News Actually Bad News?

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Master's Thesis Is Good News Actually Bad News? Master’s Thesis Is Good News Actually Bad News? Stock Market Reactions to Monetary Policy Surprises in Finland Jaakko Roope Ilmari Jääskeläinen University of Helsinki Faculty of Social Sciences Department of Political and Economic Studies Economics May 4, 2018 Tiedekunta/Osasto Fakultet/Sektion – Faculty Laitos/Institution– Department Faculty of Social Sciences Department of Political and Economic Studies Tekijä/Författare – Author Jaakko Roope Ilmari Jääskeläinen Työn nimi / Arbetets titel – Title Is good news actually bad news? Stock market reactions to monetary policy surprises in Finland Oppiaine /Läroämne – Subject Economics Työn laji/Arbetets art – Level Aika/Datum – Month and year Sivumäärä/ Sidoantal – Number of pages Master’s Thesis May 2018 58 Tiivistelmä/Referat – Abstract This thesis examines Finnish stock market reactions to European Central Bank monetary policy surprises after the Global Financial Crisis. The ECB provided excess liquidity to overcome the crisis and low inflation in Europe throughout the review period, April 2009 – January 2018. These actions improved liquidity conditions and caused a change in financial market environment. Rational investors who were searching return on their capital shifted funds from debt to equity markets. Effects of monetary policy surprises are studied using an event study methodology. The monetary policy surprises are estimated from changes in the term structure of Euribor futures around meetings of the Governing Council of the ECB. The surprises are calculated using factor analysis yielding two latent factors that explain the maximal fraction of the variation in the term structure. A target factor, which measures surprises at the level of the ECB policy rate, and a path factor, which measures surprises in the expected future path of the policy rate. These market-based measures attempt to explain daily returns in Finnish stock market. OMX Helsinki 25 index, which is the Helsinki Stock Exchange leading share index, is used in the thesis. The study shows that the target factor has a negative impact on stock returns, which is in line with previous literature. In turn, the path factor has a positive impact on stock returns, which contradicts the previous literature and the classic asset pricing theory. However, taking the changed market environment into account, the result contributes the understanding about asset pricing further. After a severe real economic activity shock, the unpredictable communication of future monetary policy easing affects stock prices adversely. An unanticipated announcement of future easing is a sign of a deteriorated future state of the economy. In turbulent times, equity traders revise their expectations of future corporate earnings downwards as a response to an easing announcement because a rate hike in the near future is not seen as a likely outcome. Tutkielma tarkastelee suomalaisten osakkeiden reaktioita Euroopan keskuspankin rahapoliittisiin yllätyksiin 2008 finanssikriisin jälkeen. Ohittaakseen kriisiajat ja matalan inflaation, EKP on tarjonnut likviditeettiä rahoitusmarkkinoille koko tutkimusjakson ajan, huhtikuusta 2009 tammikuuhun 2018. Nämä toimet ovat parantaneet likviditeettiä ja aiheuttaneet muutoksen rahoitusmarkkinaympäristössä. Rationaaliset sijoittajat, jotka etsivät tuottoa pääomalleen ovat siirtäneet varoja lainamarkkinoilta osakemarkkinoille. Sijoittajien käyttäytyminen on muuttunut huomattavasti näiden toimien seurauksena. Rahapoliittisten yllätysten vaikutuksia tutkitaan käyttäen tapahtumatutkimuksen menetelmää. Rahapoliittiset yllätykset estimoidaan muutoksista Euribor futuurien aikarakenteessa EKP:n neuvoston kokousten ympärillä. Yllätykset lasketaan käyttäen komponentti analyysiä. Analyysi tuottaa kaksi latenttia komponenttia, jotka selittävät maksimaalisen osan vaihteluista futuurien aikarakenteessa. Taso-komponentin, joka mittaa yllätystä EKP:n ohjauskoron tasossa, sekä suunta-komponentin, joka mittaa yllätystä odotetussa ohjauskoron tulevaisuuden suunnassa. Päivittäisiä osaketuottoja Suomessa yritetään selittää näillä rahapolitiikan yllätyksen mittareilla. Tutkimukseen valikoitui Helsingin pörssin johtava osake indeksi, OMX Helsinki 25 indeksi. Tutkimuksessa huomataan, että taso-komponentti vaikuttaa osaketuottoihin negatiivisesti. Tulos on yhtenevä aiemman kirjallisuuden kanssa. Toisaalta, suunta-komponentilla on positiivinen vaikutus osaketuottoihin. Tulos ei vastaa aiempaa kirjallisuutta, eikä klassista rahoitusvaateiden hinnoittelun teoriaa. Tutkimuksessa huomataan, että tulos on taloudellisesti merkitsevä lisäten rahoitusvaateiden teorian ymmärrystä. Tutkimus ehdottaa, että taloudellisesti vaikeina aikoina keskuspankin yllättävä ennakoiva viestintä tulevista elvyttävistä toimista vaikuttaa haitallisesti osakkeisiin. Yllättävä ilmoitus tulevasta elvytystoimesta on merkki heikentyneestä taloustilanteesta. Elvyttävän rahapoliittisen ilmoituksen seurauksena, osakemeklarit tarkastavat odotuksiaan yhtiöiden tulevista kassavirroista alaspäin, sillä koron nostoa ei voi pitää todennäköisenä vaihtoehtona vaikeina aikoina. Avainsanat – Nyckelord – Keywords stock returns, monetary policy surprises, unconventional monetary policy, turbulent times, efficient markets, time value of money Säilytyspaikka – Förvaringställe – Where deposited The Helsinki University Library – Helka database Muita tietoja – Övriga uppgifter – Additional information ACKNOWLEDGEMENTS I would first like to thank my supervisor, Professor Antti Ripatti. Your input and inspiring attitude helped me to manage the dreaded Master’s Thesis. Thank you Antti. I would also like to thank Nasdaq, Inc. for providing a unique trade level data for this project. Thank you, Simon Chrone, Josephine Gensø and Sonja Salminen for your help and endless patience. Thank you, Harri Mankinen, Teemu Pekkarinen and Mattias Lagerspetz, three close friends of mine. Without you, the whole project would have been a lot harder to handle. However, my family deserves the biggest thank. I am not able to put it in words, how important your support have been through the writing process and throughout my entire studies. Thank you, Minna, Matti, Eero and Salla. Roope Jääskeläinen Contents 1 Introduction and Motivation 4 2 Related Literature and Theory 6 2.1 Previous Studies . .7 2.2 Share Price is a Function of Expected Returns and Earnings . 10 2.2.1 Expected Earnings . 10 2.2.2 Expected Returns . 12 2.2.3 Efficient Capital Markets . 13 2.3 The Endogeneity Issue . 14 3 ECB’s Monetary Policy 16 3.1 ECB’s Monetary Policy Decisions . 16 3.2 Monetary Policy Expectations . 19 3.2.1 Monetary Policy Surprises . 20 3.2.2 Euribor Rates . 20 3.3 Two Dimensions of Monetary Policy Surprises . 22 3.3.1 Term Structure of Euribor Futures Rates . 22 3.3.2 The Forward Curve . 23 3.3.3 Principal Component Analysis . 26 3.3.4 Rotated Factors . 30 4 Model and Data 33 4.1 Event Study Methodology . 33 4.1.1 Other Factors and Market Microstructure Noise . 34 4.2 OMX Helsinki 25 Index Data . 35 1 4.3 Feature of the Trade Level Data . 36 4.4 Linear Regression Model . 40 5 Results 42 5.1 Diagnostic Testing . 43 5.2 Stock Market Reactions to Monetary Policy Decisions . 44 5.3 Controlling for Unconventional Monetary Policy Decisions . 48 5.4 Specific Stock Market Reactions to Monetary Policy Surprises . 50 5.4.1 Rate Drop and Unconventional Policy Decisions, 8 December 2011 . 51 5.4.2 QE Announcement, 22 January 2015 . 52 5.4.3 Extension of the QE, 10 March 2016 . 54 6 Conclusions 56 2 Acronyms ABS Asset-Backed Security ABSPP Asset-Backed Security Purchase Programme CAPM Capital Asset Pricing Model CBPP Covered Bond Purchase Programme EAPP Expanded Asset Purchase Programme ECB European Central Bank EMH Efficient Market Hypothesis ETF Exchange Traded Fund Fed Federal Reserve System FOMC Federal Open Market Committee GC The Governing Council of the ECB HFT High Frequency Trading LTRO Longer-Term Refinancing Operation OLS Ordinary Least Squares OMT Outright Monetary Transactions PCA Principal Component Analysis QE Quantitative Easing SVAR Structural Vector Autoregression TLTRO Targeted Longer-Term Refinancing Operation VAR Vector Autoregression 3 Chapter 1 Introduction and Motivation In aftermath of the European debt crisis, European economic recovery was subdued. The ECB began to extend stimulus by lowering the key rates and introducing un- conventional monetary policies. In 8 December 2011, the ECB introduced several unconventional monetary policy decisions. In more detail, new three-year longer-term refinancing operations, lower collateral requirements due to asset-backed securities, and a reduction in reserve ratio were introduced by the President of the ECB, Mario Draghi. As a result, market expectations of future monetary policy path were lowered in Euribor futures market. The decision led the leading stock indices into a turmoil in Europe. OMX Helsinki 25 index decreased by 1.43% until the end of the trading day. Clearly, the stock market expected lower future earnings. In a normal market environment, this would not have been the case. Either the expectations of future earnings or the future monetary policy path should have increased. The aim of this thesis is to explain financial market responses to monetary policy surprises in Finland. The above example is in contrast with the asset pricing theory, motivating the study to explain financial market reactions in turbulent times. The monetary policy surprises are found by finding two latent factors that explain the maximal fraction of the variation in Euribor forward curve around
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