For a proper event study, it is worthwhile to take a look at the following diagram, depicting all the important events in the US during the 1990s42.
Sources: MSCI, Bloomberg Financial Markets and Citibank Analysis
2.17.1 Success of 1990s
In the late 1990s, many policymakers agreed that there have been fundamental changes in the US economy, of which remarkable economic performance has been the subject of so much analysis (for example see Baily, 2001; DeLong and Summers, 2001; Claussen and Staehr, 2001). Food and energy prices were stable, the volatility of growth, unemployment, and inflation was stable and the push for fiscal and monetary policies made interest rates more responsive to inflation than was the case in previous periods (Mankiw, 2001). As Friedman said “…I'm baffled. I find it hard to believe..What I'm puzzled about is whether, and if so how, they suddenly learned how to regulate the
42 Adapted from Chafkin (2002).
Table 3.1
64 economy. Does Alan Greenspan have an insight into movements in the economy and the shocks that other people don't have?…" (Taylor, 2001)
New Economy proponents argued that the use of new information and communication technology (ICT) has reformed the economy in important ways. Furthermore, many economies have become more integrated into the world economy with increased openness for trade and human capital (Mankiw, 2001). Other forces were also at work including the earlier deregulation of key US industries, financial innovation and a more intense pressure of competition. Up till 1999, the US stock market was just remarkable (Temple, 2002). Price-earning ratios for the aggregate US market were at the highest levels ever observed in the Twentieth Century. For example, the market value was a mere $7.4 trillion in January 1996, and the market value of publicly held company stock reached $17.5 trillion, in December 1999, hit a monthly peak in August of 2000 at $18.9 trillion, and had fallen to $15.5 trillion in April of 2001 (Baily, 2001). Temple (2002) also suggests that the US experience is exceptional, and have used it to criticise the apparent lack of progress in other countries, particularly of Europe. Governments outside the US are routinely blamed for presiding over sluggish economies that are overregulated and slow to innovate (Savag, 2004). Other factors behind the success of 1990s like stable food and energy price shocks, good performance of stock market, and macroeconomic policy can be found in found in Appendix 6.6.
2.17.2 Events and volatility
The way futures markets respond to important macroeconomic variables depends on how information in these variables change expectations of different parties. This, in turn, depends on the historical experiences of parties and on the anticipated reactions of policy makers and thus, may vary across countries and across policymaking regimes (Hakkio and Pearce, 1985). Some researchers concentrated their efforts into the investigation of the effects of news on various measures of volatility of asset returns. These include Bonser-Neal and Tanner (1996) and Hung (1997) who utilised option price implied volatilities for the US dollar exchange rates to look at the effet of news on
65 volatility. Kim (1998) uses the GARCH methodology to analyse the news effects on the Australian dollar exchange rate volatility. In general, these studies report an increase in volatility of asset returns in response to new information. For instance, it has been found that the bond volatility significantly rose in response to the surprise component of each announcement suggesting that when the market is presented with new information relevant for bond pricing, there are elevated trading activities with the result of higher price volatility (Kim, 1999).
Turbulence in financial markets over recent years gave birth to many propositions to restructure the international financial system to improve stability (Eichengreen, 1999; and Kenen, 2000). In fact, structural breaks have been identified for several futures contracts, implying that the volatility increase is in some cases due to upward shifts and not due to continuous changes (Menkhoff and Frommel, 2003). They also show that volatility has been increasing until the introduction of Euro in January 1999. Others like Flood and Rose (1999) demonstrate that exchange rate volatility can not be linked to changes in underlying fundamentals but rather to an influence by the regime in the sense that the float is related to higher volatility than the former Bretton Woods regime. Similarly, there is evidence in favour of the recent floating regime, indicating the usefulness of economic variables in explaining longer-term exchange rate movements (see Rogoff, 1996). Cheung (2001) argues that macroeconomic announcements have a smaller impact on the gold market than on the Treasury bond or foreign exchange markets. Patterson and Fung (2001) find that the Eurodollar, although influenced substantially by domestic US news, is an international asset that is traded globally. Thus, price changes in the Eurodollar may more readily reflect both world news and changes in risk premiums among different Eurocurrency rates in the international financial market. Conversely, the 3-month US Treasury bill is a prima facie domestic asset that may be less affected by offshore information Patterson and Fung (2001). While it is outside the scope of this study to look at all events of the last decade, an attempt is made with 8 macroeconomic global events namely:
• US tightening interest rates after a long period of easing in 1994-1995. • Mexico crisis in 1994
66 • Emerging markets slump and recovery in 1995-1996
• Temporary revival from Japanese Recession in 1994-1996. • Russian crisis of 1998
• Long Term Capital Management (LTCM) near financial collapse in 1998 • The introduction of the Euro Currency in early 1999.
Details for each of these events can be found in Appendix 6.9
2.18 Conclusion
The emphasis of most empirical studies on the behaviour and performance of key market players has been to look at either some really specific groups of traders like floor merchants, CTOs, CTAs and hedge funds, or some groups based on their behavioural features like contrarians, positive feedback traders, noise traders and herds. Very few studies have attempted to distinguish between the two key market players of the futures markets, namely large hedgers and large speculators. There is scarce evidence of the trading determinants of these key market players: their reliance on variables like dividend yield, sentiment data, three-month Treasury bill, corporate yield spread, and most importantly net positions in determining their actual returns; the existence of their superior market timing ability as opposed to significant risk premium in futures markets; their destabilizing features in futures markets; the betterment of standard deviation or variance as a proxy of risk in explaining these players’ actual return and forecasting one- month return under different error distribution assumptions; the relationship between risk and return for these players; the relationship between trading activity and risk; and the effect of major macroeconomic events upon the behaviour and performance of these key players in the US futures industry. By making use of the CFTC COT data and quantitative econometric models, this study fills in the gap in these areas to promote a better understanding of how the giants of the US futures industry behaved and performed during the Clinton era.
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Chapter 3: