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Investor Sentiment As a Factor in an APT Model: an International Perspective Using the FEARS Index Kamini Solanki

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Investor Sentiment As a Factor in an APT Model: an International Perspective Using the FEARS Index Kamini Solanki Investor Sentiment as a Factor in an APT Model: An International Perspective Using the FEARS Index Kamini Solanki School of Economic and Business Sciences University of the Witwatersrand Johannesburg South Africa Investor Sentiment as a Factor in an APT Model: An International Perspective Using the FEARS Index Kamini Solanki 361490 Supervisor: Dr. Y. Seetharam School of Economic and Business Sciences A thesis submitted to the School of Economic and Business Sciences, Faculty of Commerce, Law and Management, University of the Witwatersrand in fulfilment of the requirements for the degree of Master of Commerce (M.Com) in Finance. Johannesburg, South Africa June 2017 i DECLARATION I, Kamini Solanki, declare that this thesis is my own unaided work. It is submitted in fulfilment of the requirements for the degree of Master of Commerce (M.Com) in Finance at the University of the Witwatersrand, Johannesburg. It has not been submitted before for any degree or examination at this or any other university. _______________________ Kamini Solanki June 2017 ii ACKNOWLEDGEMENTS “No one who achieves success does so without acknowledging the help of others. The wise and confident acknowledge this help with gratitude.” ~ Alfred North Whitehead I would like to express my gratitude to: - My supervisor, Yudhvir Seetharam – Thank you for your insight and guidance throughout this journey; without you I would not have been able to accomplish this - My parents, Anita and Narendra – Thank you for supporting and encouraging me throughout this journey. You were the light that guided me through the dark and this would not have been possible without you - My family and friends – Thank you for inspiring and encouraging me through this journey iii Definitions of Terms and Abbreviations Abreast of the Market (AOTM) – A column in the Wall Street Journal focusing purely on financial news. Arbitrage Pricing Theory (APT) – A theory of asset pricing that posits that the expected return of a financial asset can be modelled as a linear function of various factors, either macro- or micro-economic in nature. American Association of Independent Investors (AAII) – The AAII conducts a weekly survey of its member and their view of future market direction, specifically the survey asks members whether they have a bullish, bearish or neutral outlook on the stock market over the next six months. Animus X – The survey focuses on the prospects of the German stock market over the short- term and medium-term, where short-term sentiment concerns expectations for the following week and medium term sentiment covers respondents’ expectation over the next three months. Capital Asset Pricing Model (CAPM) – A model that describes the relationship between risk and expected return that is used to price risky assets. FNB/BER Consumer Confidence Index (CCI) – A survey-based sentiment index compiled by the Bureau of Economic Research in Stellenbosch, South Africa. The survey is constructed using three questions, each carrying a different weighting; the CCI is then computed as the average of the result of the three questions. The CCI is expressed as a net balance, therefore revealing changes in consumer expectations. The net balance is derived as the difference between the percentage of respondents expecting an improvement, and those expecting a decline. Global Mood Time Series (GMTS) – The Global Mood Time Series is provided by Wall Street Birds, a service that analyses Twitter posts to assess the global ‘mood’ of an economy. Wall Street Birds uses a mood assessment tool that assigns a weighting according to positive and negative tone. Google Search Volume Index (SVI) – Google Trends provides data on the frequency with which various search terms are searched for. The SVI is compiled using users’ searches and hence SVI data can be extracted for specific words, shares, events and so on. iv Gross National Happiness Index (GNHI) – The Gross National Happiness index is compiled from Facebook by determining the textual analysis of content from status updates. GNHI is calculated using the word-count methodology in which Facebook measures a status update’s positivity (negativity) according to the relative frequency with which positive (negative) emotion words are used. Investor Intelligence (II) – The Investor Intelligence survey reflects the sentiment of financial newsletter writers, with the sentiment of the writers being classified as bullish, bearish or neutral. Michigan Consumer Sentiment Index (MSCI) – A survey-based sentiment index compiled by the University of Michigan; this index is a weighted average of responses to five survey questions about respondents’ views on current and future financial conditions. Raging Bull (RB) – An online financial community that allows users to post and read messages, own a private board, follow company data and participate in discussions. Seeking Alpha (SA) – A personal finance social media website that serves as a platform for investors to provide insight and analysis garnered from their own personal experiences. Yahoo! Finance (YF) – An online platform that offers the latest financial and business news with a focus on US markets. v Investor Sentiment as a Factor in an APT Model: An International Perspective Using the FEARS Index ABSTRACT Traditional finance theory surrounding the risk-return relationship is underpinned by the CAPM which posits that a single risk factor, specifically market risk, is priced into asset returns. Even though it is a popular asset pricing model, the CAPM has been widely criticised due to its unrealistic assumptions and the APT was developed to address the CAPM’s weaknesses. The APT framework allows for a multitude of risk factors to be priced into asset returns; implying that it can be used to model returns using either macroeconomic or microeconomic factors. As such, the APT allows for non-traditional factors, such as investor sentiment, to be included. A macroeconomic APT framework was developed for nine countries using the variables outlined by Chen, Roll, and Ross (1986) and investor sentiment was measured by the FEARS index (Da, Engelberg, & Gao, 2015). Regression testing was used to determine whether FEARS is a statistically significant explanatory variable in the APT model for each country. The results show that investor sentiment is a statistically significant explanatory variable for market returns in five out of the nine countries examined. These results add to the existing APT literature as they show that investor sentiment has a significant explanatory role in explaining asset prices and their associated returns. The international nature of this study allows it to be extended by considering the role that volatility spill-over or the contagion effect would have on each model. vi Table of Contents List of Tables ............................................................................................................................ ix List of Figures ............................................................................................................................ x 1 Introduction ...................................................................................................................... 1 1.1 Issues and Problems to be Investigated ....................................................................... 5 1.2 Feasibility of Study ..................................................................................................... 6 1.3 Research Objective and Hypothesis ............................................................................ 6 1.3.1 Primary ................................................................................................................. 6 1.3.2 Secondary ............................................................................................................. 7 1.4 Summary of Results .................................................................................................... 7 1.5 Chapter Outline ........................................................................................................... 9 2 Literature Review ........................................................................................................... 10 2.1 Asset Pricing Models ................................................................................................ 10 2.1.1 The Capital Asset Pricing Model ....................................................................... 10 2.1.2 Fama and French Three-Factor Model .............................................................. 13 2.1.3 Carhart Four-Factor Model ................................................................................ 14 2.1.4 Fama and French Five-Factor Model ................................................................. 15 2.1.5 Summary ............................................................................................................ 16 2.2 Arbitrage Pricing Theory .......................................................................................... 17 2.2.1 International Arbitrage Pricing Theory .............................................................. 23 2.2.2 Empirical Testing of the APT ............................................................................ 24 2.2.3 Statistical Testing of the APT ............................................................................ 28 2.2.4 Summary ............................................................................................................ 36 2.3 Behavioural Finance and Investor Sentiment...........................................................
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