The Implications of Investor Behaviour to Financial Markets

Abstract

Financial markets are subject to sentiment from within and beyond their nation's borders. Fund flows either flood markets with liquidity, or drain them to the point of asset fire sales. This typically occurs in accordance with investors' beliefs and risk preferences and ultimately renders markets unstable. This thesis serves to establish the implications of investor behaviour to financial markets. Chapter 2 proposes macro sentiment as a leading indicator for financial instability within the Early Warning Framework of Borio & Lowe (2002). This signalling method identifies imbalances within the financial system. Key indicators include real equity and property prices, and private credit. Macro sentiment is then shown to display excess pessimism prior to systemic crises and therefore, is a relevant leading indicator. US institutional investor sentiment is measured through the demand for portfolio insurance in Chapter 3. Shefrin (1999) advocates index option markets as the manifestation of institutional investor sentiment. A decrease in index option skewness is associated with bearish sentiment. This chapter applies a non-parametric method to extract the risk-neutral distribution to gauge sentiment based on the 30-day probability of the underlying reaching the at-the-money futures level, and the third moment. These measures are examined in relation to the VIX, the put-call ratio, the slope of the implied volatility function and the Bakshi, Kapadia & Madan (2003) skew. Chapter 4 proposes a theory of sentiment propagation and examines the link between global and investor sentiment within the US. An extensive literature review of mutual fund flows and sentiment within the broad context of the macroeconomy affirms the use of cross-border fund flows as the channel through which sentiment propagates. The empirical section then establishes congruency between global sentiment, as measured by dedicated USA equity and bond fund flows of US and non-US domiciled investors and sentiment within the US.