University College of Takestan

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UCT Journal of Management and Accounting Studies UCT . J.Educa.Manag .Account. Stud., (UJMAS)

Volume 4,Issue1 138138138 ---138 145145145-145 (((20 202020 161616( )))16 ) ISSN 2382 974- 5

Martingles and financial crises

Jila Bahrami

Lecturer, Isfahan (Khorasgan) Branch, Islamic Azad University, Isfahan, Iran

Original Article: Received 24 Jan. 2015 Accepted 22 Feb. 2016 Published 11 March. 2016

ABSTRACT Keyword: V Speculators When a financial crisis occurs, speculators typically get the blame whereas fundamentalists V Fundamentalist are presented as the safeguard against excessive .This paper consider two types: V efficient market speculators and fundamentals who have the same information. In this paper, excess volatility V bubbles

not only exists, but is actually fueled by fundamental trading. Consequently, efficient V maringles markets are more volatile with a few speculators than with many speculators and Existence of fundamentals ruins market’s liquidity and this may pose problems for traders, who intend to undertake frequent transactions.

* Corresponding author: Jila Bahrami

Peer review under responsibility of UCT Journal of

Management and Accounting Studies

Bahrami UCT Journal of Management and Accounting Studies INTRODUCTION these issues and using Martingle’s behavior model, this Investment is one of key factors to reach a country-level study assesses the role of traders in creating bubbles or economic growth. Investment market, as an eminent dropping equity prices in efficient markets. investment alternative, provides a proper to attract 3.Investment Methods in a Exchange Market capitals. consider their own level of risk taking Investment and trading equity in an exchange market have a together with their expected outcomes to evaluate and direct relationship with its investment method. In other choose an appropriate equity. Hence, investment markets words, investors always try to raise their own benefits, must possess required efficiency to attract investors, obtain which is inter-related with an increased turnover. To this financial resources, and as a result be able to optimize aim, there are three different methods of investment in a turnovers by allocating the resources in the most proper market: i) , ii) technical way. To reach the efficiency, market volatilities are required analysis, iii) buy and hold (B&H) method. to be logical and fundamental. Although -run 4.Fundamental Analysis volatilities are inevitable and natural, -run equity prices Fundamental analysis assumes that each has an must be determined based on firms’ logic factors and their intrinsic value that can be estimated by investors. The value disclosed information. of a security is a function of a series of fundamental Financial philosophers and market activists persistently variables and a combination of these variables determines consider crashes and their unexpected the expected turnover associated with a specific risk level. changes. There is no clear definition for a market crash, but In a fundamental analysis approximation of an intrinsic it usually refers to a two-digit negative market index for value of equity is obtained using the fundamental variables. multiple days and in a short period of time. Simply In the next step, the estimated intrinsic value is compared speaking, a financial market crash is a sudden drop in the with the market value of the equity. If the intrinsic value equity index for a short time. Equity price volatilities and exceeds the market value, then it is the right time to buy the price bubbles may root in investors’ purchasing activities equity. Otherwise, the equity holder would have sufficient and their short- or long-run investment vision. evidence to sell the equity. Identifying investors and considering their investment Eventually, if the analyst will be convinced that it is the visions can impede equity price bubbles and as a result, right time to invest (e.g. there are appropriate industries with prevent financial crisis to take place. This study aims to high levels of turnovers in the economy), then he will explore the role of fundamental investors in creation of analyze competing firms and evaluates equity prices. A equity price volatilities for qualified companies in Tehran general approach to analyze firms’ equities consists of four Stock Exchange market. major steps including: i) analysis of the economy and the 2.Problem Statement market, ii) analysis of the industry, iii) analysis of the firm, The characteristics of stock exchange markets led the firms and iv) analysis of the equity price. and investors to find capital markets a suitable place to 5.The Role of Fundamental Analysts attract financial resources and investments. Therefore, today Contribution of analysts in codification of accounting stock exchange markets are recognized as an economic standards approves their traditional role as appliers of the entity within developed societies and their operations financial information. Analysts, as agents for financial represent socio-economic situations in such nations. On the information transmission, privilege their own covered other hand, any kind of insecurities in these markets can companies. Based on a modern theory on information result in an enormous financial crisis. Equity market crises disclosure, companies with a larger number of analysts are are important events in both scientific and practical more valuable. Existence of a higher number of analysts in perspectives, such that they are a constant source of anxiety such companies provides a higher level of investment and stress for investors and traders and by their emergence opportunity awareness amongst investors. Empirical studies many lives could be ruined. So, one of the major reasons for reveal that in companies, which are subjected to more a market crash is existence of bubbles and as they start to financial analysis, commercial costs are lower. This is while blown out several crises associated with long-lasting for companies with lower level of financial analysis, negative consequences may appear. In the traditional utilization of proper information disclosure policies only perspective after emergence of a crisis, speculators are reduces financial costs. blamed; this is while fundamental analysts can successfully Forecasting future revenues, the most frequent issue in identify bubbles and protect the market from exorbitance financial analysts’ reports, is an example of how analysts volatilities in the face of crises. apply financial information. Analysts use the future Being bubble-free is considered as an assumption for an revenues as a mean to recommend investment in certain efficient market. In efficient markets people and investors companies and as an index to evaluate the companies’ have a homogeneous access to the information, while their performances. expectations and investment visions may vary. Several 6.Equity Price Volatility studies evaluated exorbitance volatilities, all assuming a In capital markets, profit information is one of the short-run vision for traders and speculators. But, the predominant information in decision making of investors, literature failed to account for traders with various analysts, and other information user groups. If forecasted investment visions. profit by firms suffers of inaccuracy, then investors will be The main issues in this research are considering people and anxious and confused and the market will lose its traders with various expectations and investment visions, investment security in the . Many investors symmetric information, and rational traders. Having said have lost a large portion of their capital because of reliance University College of Takestan on disclosed information in markets, where profits were bubbles as an intense and continuous increase in the price of highly volatile and were subjected to negative deviations an asset or a set of assets. Initial price growth was due to and volatilities. Equity turnover volatility is one of the price rocket expectations resulted from attracting new challenging financial issues that is been studied frequently investors. This growth often associated with reverse in the emerging capital markets over the recent years expectations and a steep drop in prices, which caused (Leledakis, 2004). The main reason for this tendency is the financial crises. relationship between the price volatility and turnover and Soltani (2007) in his PhD dissertation evaluated price their impacts on financial sector performance and nation- bubbles in the Market for 70 active wide economy. On the other hand, equity turnover volatility companies in the over 1991-2005. To this aim could be considered as a measure to evaluate risks and he applied co-integration method. Using Johanson’s co- therefore may aid policy makers to assess vulnerability of integration test on each firm’s real equity price and its real the equity market (Zafar &Urooj, 2008, 14) equity profit, he explored bubbles in the firms’ equity 7.Price Bubble prices. His findings indicated that with 95% confidence, The concept of bubbles was introduced to the economics there exist bubbles in the equity prices of 55% of the studied literature during the 17th century. However, there is no companies. In the next step, he applied Fisher’s test to evidence of scientific studies on this issue till late 20th. extract relationship between price bubbles, firms’ sizes, After the first debates on this issue in the Persian literature price volatilities, and industries. The latter evaluation results in 2003, any type of rapid price growth have mistakenly shown a meaningful relationship between price bubbles, considered a bubble, while bubbles are created if a firms’ sizes, and intense price volatilities; however, there in a financial tool (e.g. equity) leads to a price were not sufficient evidence to approve a relationship growth associated with more speculations. In this situation between price bubbles and industries. prices irrationally grow to a high level. Bubbles generally Torki (2008) in his study, titled “Price Bubbles and Iran’s end up with a sudden price drop, often called “market Capital Market”, used RALS technique and applied Monte crash”. Due to its similarity to the soap bubble, which Carlo’s simulation method to evaluate existence of price appears and vanishes in a short period of time, the name bubbles in Iran’s equity market. He discussed that equity “bubble” is devoted to this financial event. Bubbles often prices diverged from their own long-run balance path emerge following real productivity advancements and/or (current value of expected future profits), and therefore initial profitability of the firms or industries. Historical Iranian capital market possesses bubbles. evidence show that investors in such situations over In addition to the afore-mentioned studies, a research done exaggerate the economic capability of their own invested by Shaw Wong et al. evaluated attributes and behaviors of company (Greenspan, 2002) investment managers in market forecasting and equity 8.Literature Review choosing in Hong Kong stock market. Chosen managers Available studies indicate that Tehran Stock Exchange were asked to specify relative importance of each of the Market suffers of low efficiency. Findings of these studies technique in forecasting the market and choosing equities. aid investors and other information applicants to Results exhibited that Hongkonger analysts tend to use differentiate more efficient companies easier and benefit fundamental and to forecast the market. In from a more rational investment. terms of choosing equities to invest, fundamental analysis The paper “Do Stock Prices Move Too Much to be Justified followed by technical analysis and portfolio analysis were by Subsequent Changes in ?” by Shiller (1981) the most attributed techniques. was one of the initial researches on the bubbles. Shiller in 9.Research Hypothesis this study utilized the annual data for the period of 1871- The main Hypothesis: fundamental traders have a role in 1986 on the variance bound test or price over volatility. His creating price bubbles in efficient markets. findings revealed that current cash profit value changes does 10.Definition of Research’s Key (Words and Phrases) : not explain price changes. Definition of key applied concepts and phrases in this Larsen (1997) assessed price bubbles in Norwegian Stock research are summarized as follows: Market and evaluated their impact on Norway’s economy Securities : Any paper or document that certifies over 1982-1997. Using West’s (1987) recognition method transferrable financial rights for its owner or benefits of a and Shiller’s (1981) ANOVA, he rejected the null holder (Yekta, 2008). hypothesis of market efficiency (e.g. non-existence of price Capital Market: An integrated official market, in which bubbles) over the study period. equities and other securities with more than one year White (2004) studied the US Stock Market Crisis in 1929. maturity are purchased under certain rules and regulations Applying Shiller’s method, he introduced structural (Arabi, 1999). modifications as the main reason for price and profit Equity Price : A market or transaction price, which includes volatilities. the value that seller and buyer agreed upon. The price of Amongst the Persian literature on the price bubbles in the each equity that appears daily on the stock market board is Tehran Stock Exchange Market, it is worth to mention the the last transaction price for that specific equity (Khakpour, study by Majid Eshghi (2006) in the Imam Sadegh 2008). University. He applied correlation tests on periodical Equity Price Change: Any change in the transaction value of sequences of the equity prices. His findings indicated that equities that are purchased in the stock market (Khakpour, price bubbles existed in the Tehran Stock Exchange Market 2008). over 2004-2006. Fundamental Investors: Traders, who evaluate and study all Godari (2006) in his article, “Exploring Price Bubbles in the the factors that directly or indirectly contribute to a market’s Tehran Stock Exchange Market, 2004-2005”, defined supply and demand.

Bahrami UCT Journal of Management and Accounting Studies Price Bubble : The difference between intrinsic and market This Model is look alike fundamental pricing.But long-term value of an asset is called a price bubble. traders model is special case of short-term pricing. Market Crash : A sudden drop in a market index that Mt is random process that obtan by filtering informations occurs following numerous factors. and rational expected is equivalent to present value: This research is based on statistical analysis and statistical ∞ F E [d+ |I] modeling. The statistical simulations are R (6) p = t i t t ∑ + i program.First,express summary of what we will do and then i =1 (1 r) represent the statistical program which we need for That's why the second part of the Equation 5 is random. For analyzing the data. this reason, the bubble will refer to components that often Consider a market where a single risky asset called stock. occurs in the market,especially when most of them are Assume that all traders have rational expectations, and share speculators. These components are defined as bubbles and their investing horizon in the market. This happens in two illustrate with B: ways: (7) B=(1 + r )t M 1.All traders are fundamental and have long-term horizon. t t 2.All investors are speculators and have short-term horizon. As a result, bubble prices can represent a dynamic vast Each of these two types of pricing, and price equilibrium is market. This makes it difficult to make the model. One way to release bubbles is the assumption Mt=0 which obtained. Consider that all traders are rational, which means illustrate it : that same rational expectations based on the same data set.Our purpose is minimizing the mean of square (Rational 1 = (8) limE [dt+ i |I] t 0 Expectation) i →∞ (1+ r )i RE is defined, as conditional expectation for t: It means that bubble of short-term pricing model fall in long 2 (1) E[x+ | I ]= argmin ∈++ E (xˆ − x ) –term and returns to rational long-term prices. tt1 xIttˆt+1 t 1 1 Which  is information sets. Suppose that we have a set of traders that share fundamental In this research, the expectations will cause the change share isand speculators share is .Then we use LT for equation 1. Long-term investors and short-term investors are fundamentals and ST for speculators. As fundamentals different, but all of them decided rationally in their investing calculate price according to equation 3, speculators have no horizan. effect on the price. But speculators need to be inform the 1.All the fundamental and ratioanal investors have long- basic price comparison. ST = term prospects: pˆt+1 E (p t + 1 | I t ) All the long-term traders are fundamentals.their strategies are buy and hold and assume price expectations in an infinite horizon. ∞ LT E [d+ + | I ] Price modeling is discounted cash flows and we assume no pˆ = t1 i t t +1 ∑ + i transaction oppurtunities: i =1 (1r ) ∞ ˆ d + (2) p = t i Expected avalue in t+i = t+i t ∑ + i i =1 (1 r) 1 ST LT ˆ p=[(1 −µ) ppdˆ+ + µ ˆ + + + ] 2.All the speculators and rational investors have short-term t1+ r ttt1 1 1 prospect: Short term traders are called speculators in which buy and Also They are aware of predicting next price ( means price sell at the moment.So, their expectations are between for speculators for t+1) and fundamental’s price determine t , t+1 periods.Stock’s present price (Pt) which calculate by by equation 3 and equal to . discounting future expected price and future .with Fundamentals are indifferent to bubbles, But they are these rational assumptions: looking to see when the correct model can forecast future ∞ E [d+ | I ] cash profits. As a result, long-term does not need to (3) p = t i t t ∑ + i predict the price, but investigated and predicted are based on i =1 (1 r) predicted cash dividends and no need of bubbles analyses It’s obvious that formule (1) is straight but formula (3) and always have rational strategy. needs to have current price and future expected price Equation 11can be generalized as Equation 4, but in Model together. 4, which represents the value of µ as LT investors share is There are few econometric modeling which can solve considered zero, which means all the investors are rational equation (3).this model(4) is one of the accepted model for and Short-term. The equation as well as DeLong, r (the rate rational pricing: of return on investment) is equal to the cash dividends.so 1 (for long-term). Therefore, fundamental price is equal to p=(E[p+ |I] + E [d + |I]) t1+ r tt1 tt 1 and all the long- term traders have the same horizon in And we assume is predicted price for t+1 due to current which LT = γ information (It) : F t p pˆt =F + + t ppt t(1 rM) . t Notice that if Mt=0, equation is like equation (4). University College of Takestan 1 Thus, the variance of expected speculators’ price as follows: )12 ( p=[(1 −µ)(p E |I) ++ µγ r ] Equation t+ t+1 t 1 r ε= ε = σ 2 12 is linear model and with martingle technics and (18) E[tt | I−1 ] 0,V[ tt | I − 1 ] hypothesis µ≠ . : t = ε M t∑ i t i =0 1+ r  (13) p= pF + M t t− µ  t 1  t 1+ r  t The result can be state : fundamentals are essential for B = ε rational speculators in order to take advantage of shrt – t− µ  ∑ i 1  i =0 terstrategy.As a result, as the definition of fundamentals in t which buy and hold stocks and trade less than 1+ r  V [pST |I] = σ speculators.Accurantely, when fundamentals buy the stock t+1 t − µ  inorder to hold it forever and disappear it from market. 1  11.Martingles Flactuation depends on fundamentals role µ in the market. In probability theory, Martingles are model of a fair game in Formula (20), as the time goes on, the effect of the which the passive information will not help in predict the parameter µ parameter r will dominate.Fundamentals future.In other words, martingle is a sequence of infinite dramatic effect on the intensity of the bubble becomes random variables (in other words random process) in which apparent. expected future variable is equal to current one. 12.Simulation : famous example of Martngles are Brownian motion or At this phase as we do the simulation, we analyzed and Wiener process . An example of a model to express, first described results. allow me to give more explanation about Martingles. As shown in Equation 20is the fundamental effect on the Assume that no bubbles are at t=0 and for t, we have: level of market volatility is exponential. If the fundamentals t are not in the market, the bubble effect in the first period (t 1+ r  (14) B=   M = 1) is equal to the standard deviation. This will simulate the t1− µ  t stages of logic is very clear. The simulation is performed in And assume  with constant variance: the R programming code. t +1 When the fundamental percentage is 5% results are as +  follows: ST = + 1 r (15) pˆ + 1   M t1 1− µ t For simulating,we simulate the bubbles . Here, we simulate   1000 bubbles at t = 1  values are calculated ,too. There Random variable can can be isolated into components of the are 1000 1 and standard deviations are calculated. shock at time 0 to t and bubble factor is as follows:. Volatility increases little, the value of 0.1 to 0.1149.

LT = (16) pˆt +1 1

Bahrami UCT Journal of Management and Accounting Studies

As a result of fundamentals increase in market, standard deviation (volatility) also rises exponentially (meaning that a large number of speculator is better than small ones.) The following diagram illustrates that volatility increases exponentially.

Bahrami UCT Journal of Management and Accounting Studies When the market does not have any speculator, any shock in the behavioral finance, on the other hand, traders make the market will not happen. Unfortunately, this situation is efforts to find accurate prices; thus they may neglect the unrealistic, at least in the stock market are not allowed And right model. To resolve this problem they discuss their own it's impossible that the economic system omit speculators , beliefs about future prices, which are rooted in their but this paper showed that the elimination of speculators transactional strategy. To be more specific, behavioral will have bad effect on market. finance fundamentals believe that future prices converge to 13.Summary of Findings the intrinsic values. 1. Fundamental traders have a role in creating bubbles or Considering short-run fluctuations (the difference between dropping equity prices in efficient markets. market prices and intrinsic values), traders tend to make 2. In an efficient market without having speculators, equity transactions based on intrinsic values. Hence, they stabilize prices are determined by fundamental traders. However, as the market. It should be considered that people with rational, the market opens up to the speculators, equity prices start to fundamental, and long-run vision, who do not respond to change and become volatile. As a short-run volatilities, are too few to count. result, more speculators enter the market. Policy makers Irrational speculators irregularly or mistakenly respond to must consider that having a fewer number of speculators is all news, but rational speculators only take important and worse than having a larger number of them. relevant news efficiently. 3. Existence of fundamentals ruins market’s liquidity and The only common factor among rational and irrational this may pose problems for traders, who intend to undertake speculators is their short-run vision. Irrational speculators frequent transactions. In presence of speculators (few or are able to raise or drop the equity prices, but they create more), fundamentals determine equity market volatilities. instability. Although rational speculators implement 4. As a result, as the number of fundamentals increase in the fluctuation strategies in the short-run and diverge the prices market, standard deviation (volatility) also grows form their intrinsic values (create bubbles), they are aware exponentially. This means that the larger the number of of the real prices. Their feedbacks do not create a significant speculators, the better. change in the intrinsic values and long-run strategies. 5. Presence of fundamentals is mandatory for rational The concepts of fundamentality and are defined speculators to reach their short-run strategy. As a result, based on models. Considering the assumptions and considering the definition of fundamentals, who buy and rationality of the traders the definitions may vary. For hold equities, they contribute to the transactions less than instance, in behavioral finance models, speculators are speculators. To be more specific, fundamentals purchase introduced as people with irrational behaviors. In our model, equity and hold it forever until it vanishes from the market. considering the assumptions of an efficient market, traders all have rational expectations and fundamentals also can 6. As the bubble still exists, speculators’ expectations create instability. increase the equity prices to a higher level and considering Fear from behaviors of a few speculators may convince the share of long-run traders in the market, this effect will policy makers to impede opening up the market to more intensify. Consequently, this will magnify volatility and speculators. This will cause market instability and liquidity drop in equity prices. drop. This is while policy makers must stop fearing from a 14.Comparing the Findings with the Results of Similar large number of speculators and accept the fact that taxes on Studies transactions and/or profits can disappoint speculators from In this section we aim to compare the findings with the entering the market. As a result, volatilities will increase, available literature. extreme responds will take place, and the number of bubbles Findings of this study are in line with what ArianeSzafarz will boost up. 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