Sentiment in Foreign Exchange Market Yanyan Yang Claremont Graduate University

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1 Sentiment in Foreign Exchange Market Yanyan Yang Claremont Graduate University 2015 ISEO Summer School 6/24/15 1 Your Lecture with Prof. Arkerlof

2 Outline Background Definition & Measurement of Sentiment Sentiment in FX Market Data Description & Sample Characteristics Methodology & Results Conclusion 2015 ISEO Summer School 6/24/15 2 Your Lecture with Prof. Arkerlof

Sample Characteristics Methodology & Results Conclusion

3 2015 ISEO Summer School 6/24/15 3 Your Lecture with Prof. Arkerlof

4 Market Sentiment: Why It Matters? Keynes(1932) the market will be subject to waves of optimistic and pessimistic sentiment. Winter (1986) Perceptions of phenomena in the external world, interpreted by the perceiver as perceptions of facts, are actually fundamentally (but unconsciously) shaped by the perceiver s own beliefs and expectations. It s all about perceptions 2015 ISEO Summer School 6/24/15 4 Your Lecture with Prof. Arkerlof

Winter (1986) Perceptions of phenomena in the external world, interpreted by the perceiver as perceptions of

5 Definition Previous Definition: Noise Traders Beliefs According to Delong, Shleifer, Summers, and Waldmann(DSSW) (1990), the investor sentiment, refers noise traders beliefs based on non-fundamentals and was originally attributed to the psychological theories. Definition of Market Sentiment: Economy sentiment is an aggregate level of individual beliefs about future economy performance. Exchange rate sentiment is an aggregate level of investors beliefs about the future risk and return of exchange rate ISEO Summer School 6/24/15 5 Your Lecture with Prof. Arkerlof

Definition of Market Sentiment: Economy sentiment is an aggregate level of individual beliefs about future economy performance.

6 Sentiment in FX Market Exchange Rate Fundamental Sentiment 2015 ISEO Summer School 6/24/15 Your Lecture with Prof. Arkerlof 6

7 Background Frankel and Froot (1986) have applied survey data in the Foreign Exchange Market to explain the US dollar bubble. The interest differential between Europe and US fell suggesting an increase of risk perception, if anything shifted to US. Cheung and Chinn (1999). Taylor and Allen (1992) focus on the use of technical analysis. This approach simply summarize the responses of the subjects and get the proportions of respondents and it leaves no space for other econometric analysis to test the causality and the marginal effects. 6/24/ ISEO Summer School Your Lecture with Prof. Arkerlof 7

Taylor and Allen (1992) focus on the use of technical analysis.

8 Sentiment Proxies Survey-Based Proxies US Consumer Confidence Index AAII UBS/GAllup ZEW SNX Survey-Based Proxies in FX Market Bloomberg Survey FX Expectation ZEW FX Sentiment SNX FX Sentiment Market-Based Proxies in Stock Market Trading Volume Dividend Premium Closed-End Fund Discount Option Implied Volatility VIX IPO first day returns/ IPO trading volume Market P/E Ratios or Put/Call Ratios Market-Based Proxies in FX Market Risk Reversal Forward Exchange Option Volatility Commitment of Traders Reports Futures Open Interest 2015 ISEO Summer School Your Lecture 6/24/15 8 with Prof. Arkerlof

Implied Volatility VIX IPO first day returns/ IPO trading volume Market P/E Ratios or Put/Call Ratios Market-Based Proxies in FX Market Risk

9 Economy Sentiment is Systematic Short-term Momentum & Long-term Reversal Autocorrelations of snxus Lag Bartlett's formula for MA(q) 95% confidence bands 2015 ISEO Summer School Your Lecture 6/24/15 9 with Prof. Arkerlof

00 0 10 20 30 40 Lag Bartlett's formula for MA(q) 95% confidence

10 Eurozone Sentiment Autocorrelations of snxeu Lag Bartlett's formula for MA(q) 95% confidence bands 6/24/ ISEO Summer School Your Lecture with Prof. Arkerlof 10

00 0 10 20 30 40 Lag Bartlett's formula for MA(q)

11 Japanese Sentiment Autocorrelations of snxjp Lag Bartlett's formula for MA(q) 95% confidence bands 6/24/ ISEO Summer School Your Lecture with Prof. Arkerlof 11

12 Data The investor sentiment indices dataset SENTIX, which surveyed more than 4,400 investors including over 1,000 institutional investors from As a very unique dataset first, distinguishes the institutional investors and private investors. Second, it s an online survey which allows different international investors take surveys in different locations. It has both economy sentiments for US, Europe and Japan, as well as the exchange rate sentiments for EUR/USD and USD/ JPY. SNX, ZEW and US consumer confidence index are correlated significantly. Survey-Based Data is also correlated with Market-Based Proxy such as VIX ISEO Summer School Your Lecture 6/24/15 12 with Prof. Arkerlof

Second, it s an online survey which allows different international investors take surveys in different locations.

13 Global Sentiment jan jan jan jan2015 date1 snxus0 snxjp0 snxeu ISEO Summer School Your Lecture 6/24/15 13 with Prof. Arkerlof

14 Contagion during Low Sentiment Episodes US Europe Japan Panel A: Overall Correlations US Europe Japan Panel B: Correlations during Low Sentiment Episodes US Europe Japan Panel C: Correlations during Normal Episodes US Europe Japan /24/15 14

0000 Panel B: Correlations during Low Sentiment Episodes US 1.0000 Europe 0.3240 1.

15 Sentiments during Recessions ZEW Economy Sentiment during Recession 01jan jan jan jan2015 date ussen usrecession eusen eurecession 2015 ISEO Summer School Your Lecture 6/24/15 15 with Prof. Arkerlof

16 Sentiments during Recessions SNX Economy Sentiment during Recession jan jan jan jan2015 date snxus0 usrecession snxeu0 eurecession 2015 ISEO Summer School Your Lecture 6/24/15 16 with Prof. Arkerlof

17 Sample Statistics for Sentiment Indices during Recessions Mean Median 25%- quant Panel A: All Periods 75%- quant Stand. Dev US Sentiment Europe Sentiment Japan Sentiment Panel B: Recessions US Sentiment Europe Sentiment Japan Sentiment ISEO Summer School 6/24/15 17 Your Lecture with Prof. Arkerlof

85-78.15-10.8 40.16 Panel B: Recessions US Sentiment -34.80-48.3-77.9-17 54.92 Europe Sentiment -48.3-76.3-65.15-31.

18 Episodes of High Sentiments (Top 10%) Episodes of Low Sentiments (Top 10%) 2015 ISEO Summer School Your Lecture 6/24/15 18 with Prof. Arkerlof

19 Some Striking Facts Sentiments during recessions are significantly lower than the normal periods. However, the standard deviation of the sentiment doesn t change a lot during recessions, since sentiment can be consistent over long periods. As you can see from the figure and table. Sentiment is usually very high right before the recessions, which is consistent with over-optimism. Low sentiments always happen during the recessions, but high sentiments are relatively random ISEO Summer School Your Lecture 6/24/15 19 with Prof. Arkerlof

periods. As you can see from the figure and table.

20 Methodology Oaxaca Decomposition Vector Error Correction (VEC) Model Variance Decomposition with Time Series 2015 ISEO Summer School Your Lecture 6/24/15 20 with Prof. Arkerlof

21 Oxaca Decomposition Zt Zt: Determinants based on Standard Exchange Rate Model: Interest Differential, Purchasing Power Parity The second term is the contribution of the change in coefficients (β1-β2). This can be thought of as the unexplained variables between different environments (recession and non-recession) ISEO Summer School Your Lecture 6/24/15 21 with Prof. Arkerlof

22 Results Market Sentiment will affect the predicting power of the fundamentals. 84.6% difference between the change in exchange rate during the normal period and high sentiment period is explained by the unexplained factor, the latent difference between high sentiment and low sentiment. Only 15.4% difference can be explained by the explained variable(the difference of the fundamental during different period) 2015 ISEO Summer School Your Lecture 6/24/15 22 with Prof. Arkerlof

23 Vector Error Correction(VEC) Model Cointegration Equation Sentiment (-1) = Inflation (-1) + EUR/USD (-1) + Bonds (-1) + Constant Coefficient 1 = ISEO Summer School Your Lecture 6/24/15 23 with Prof. Arkerlof

24 Error-Correction Equations 6/24/ ISEO Summer School Your Lecture with Prof. Arkerlof 24

25 Combined Impulse Responses Response of SNXEURUSD to Cholesky One S.D. Innovations Response of DEUR to Cholesky One S.D. Innovations SNXEUR USD D(EURCPID) D EUR D (EURID) SNXEURUSD D EUR D (EU RCPID) D (EU RID ) Response of D(EURCPID) to Cholesky One S.D. Innovations Response of D(EURID) to Cholesky One S.D. Innovations SNXEUR USD D(EURCPID) D EUR D (EURID) SNXEURUSD D EUR D (EU RCPID) D (EU RID ) 2015 ISEO Summer School 6/24/15 25 Your Lecture with Prof. Arkerlof

26 Variance Decomposition Variance Decomposition of SNXEURUSD Variance Decomposition of DEUR SNXEURUSD D(EURCPID) DEU R D(EURID) SNXEURUSD D(EURCPID) DEU R D(EURID) Variance Decomposition of D(EURCPID) Variance Decomposition of D(EURID) SNXEURUSD D(EURCPID) DEU R D(EURID) SNXEURUSD D(EURCPID) DEU R D(EURID) 6/24/ ISEO Summer School Your Lecture with Prof. Arkerlof 26

27 Conclusion One possible extension could be researching on sentiment in foreign exchange markets into other currencies, periods or surveys. Low sentiment can easily spread out, and it may lead to the instability in asset market. Do we need some financial regulations to offset the shift of market sentiment? High sentiment is relatively random, which could be an interesting topic to investigate ISEO Summer School 6/24/15 27 Your Lecture with Prof. Arkerlof

28 The End 2015 ISEO Summer School 6/24/15 28 Your Lecture with Prof. Arkerlof

Kiwi drivers the New Zealand dollar experience AN 2012/ 02

Kiwi drivers the New Zealand dollar experience AN 2012/ 02 Chris McDonald May 2012 Reserve Bank of New Zealand Analytical Note series ISSN 2230-5505 Reserve Bank of New Zealand PO Box 2498 Wellington NEW