Positive feedback trading,institutional investors andsecurities price fluctuation
Yin HongBusiness School, East China Normal University,
Shanghai, Peoples Republic of China
Purpose The purpose of this paper is to research and analyze the influence of institutional investorsin the present securities market due to behavior alienation with running after rising and falling andherd behavior.
Design/methodology/approach A DeLong, Shleifer, Summers, and Waldmann (DSSW) modelwith positive feedback trading is established first to show the trading process, and these securitiesprices are calculated considering the investors emotion. Through numerical analysis, the influence ofinstitutional investors on securities price fluctuation is simulated. Further, the analysis of institutionalinvestors incomes is processed based on this model.
Findings Through these analyses, the following conclusions are drawn: it lies on the scale of positivefeedback traders and their sensitivity to past market performances whether the institutional investorscan stabilize the market, and it is not necessary for the institutional investors to benefit frommanipulating the market due to the existence of noise trader risk, so the positive feedback traders maysurvive in the security market over the long term.
Originality/value The DSSW model considering positive feedback trading, presented in the paper,is more effective in analyzing the relation among the behavior of institutional investors, securitiespricing and securities price fluctuation. The paper proposes some advice for policy decisions, which ishelpful for government and institutions to maintain the stability of securities markets.
Keywords China, Securities, Stock prices, Investors, Stakeholder analysis
Paper type Research paper
I. ForewordAs a result of policy orientation of developing institutional investors in a supernormalway, the number of institutional investors has risen sharply in China. But, practices of thesecurities market is opposition to what is expected, institutional investors have failed tostabilize the market and behavior characteristics of some institutional investors haveundergone serious variation and deformation. If so, then what on earth is the role ofinstitutional investors in the securities market where herd behavior and positivefeedback strategy are common, to make arbitrage move price to fundamental value andstabilize the market, or to magnify positive feedback trading and non-stabilize the market?This has been a hot issue attracting attention from both management and academia.
Studies on this issue have come to quite differing results. Some scholars, representedby Sosin (1998), believe that rational institutional investors can find a timely irrational
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This research was supported by the National Social Science Foundation under grantno. 10CGL014 and Open Project of Hubei Province Key Laboratory of Systems Science inMetallurgical Process (Wuhan University of Science and Technology) under grant no. B201004.The author would like to thank Changbo Wang for his help.
China Finance Review InternationalVol. 1 No. 2, 2011pp. 120-132q Emerald Group Publishing Limited2044-1398DOI 10.1108/20441391111100714
price in the market and take the opposite strategy to correct the mistaken price,which helps decrease fluctuations in the securities market. But the empirical studies(Dennis and Strickland, 2002) on mutual fund suggest that, due to the restriction ofperformance evaluation, institutional investors widely engage in herd behaviors andmomentum trading, and these irrational behaviors add to market fluctuations.
Besides, there are many literatures that study institutional behaviors and marketstabilization from the angle of positive feedback trading. Shleifer (2000) introduced arational arbitrageur into the model used to study positive feedback trading, andconsequently has discovered greater fluctuations in stock price. Some empirical studiesalso have found strong evidences to show that institutional investors who have takenpositive feedback trading strategies cause greater market fluctuations (Bennett et al.,2003; Sias, 2007). There are also scholars who hold the opposite opinions, like Gibson andSafieddine (2003) and Badrinath and Wahal (2002) who believe that, when positivefeedback effect causes price to deviate from its fundamental value, institutionalinvestors as rational arbitrageurs will take negative feedback strategies to correct suchdeviation, and as a result, positive feedback traders cannot benefit from trading and willeventually vanish from the market. Lakonishok et al. (1992) has thought thatinstitutional investors also have the possibility to take actively positive feedback tradingstrategies which do not necessarily bring the market more instability. The reason is thatinvestors actually need some time to digest information and then make an accordingreaction; therefore, for the market price to completely reflect the new information, aperiod of time is required; in this case, it may be rational for investors to take a positivefeedback trading strategy. Through empirical studies on institutional investors likemonetary fund and pension, Diebold and Kamil (2007) and Lipson and Puckett (2007)have found that institutional investors take negative feedback investment strategiesmore often than not, which helps reduce market fluctuations.
Therefore, it can be concluded that when market price is brought away fromfundamental value by positive feedback trading, the academia fall into two groupsholding different opinions upon the role of institutional investors: one group holds theopinion that rational arbitrage by institutional investors helps price return to value andstabilize the market, while the other group believes that behaviors of institutionalinvestors will magnify positive feedback trading in the market and make the situationworse. In view of this problem, this paper will build models and will try to reveal from theangle of normative analysis the logical relationship between behaviors of institutionalinvestors and securities price fluctuations in the presence of positive feedback trading.
DeLong et al. (1990a, b), Sentana and Wadhwani (1992) and Shleifer (2000)have conducted influential researches on positive feedback trading, but models built bythese scholars remain descriptive, failing to offer precise numerical solutions foraccurate quantization of the relations among positive feedback trading, behaviors ofinstitutional investors and assets price. The model built by Sentana is obviously flawedin that the proportion of rational traders or feedback traders may turn out to be negative.As for the noise trader model DeLong, Shleifer, Summers, and Waldmann (DSSW) builtby DeLong et al. on the pricing of risk assets, positive feedback trading is actuallyexcluded from consideration. We believe that in Chinas securities market wherethe philosophy of focus on hot spot and short-term speculation is greatly welcomedand the blind momentum strategy wins popularity, such irrational positive feedbacktrading will impose certain impacts on institutional investors expected function
of market stabilization. So, this paper has built a DSSW model taking into considerationof positive feedback trading to analyze the relationship between behaviors ofinstitutional investors and securities price fluctuations. By doing so, this paper has cometo some meaningful conclusions and has put forward corresponding policy suggestionsof practical significance for regulators to reasonably assess the role played byinstitutional investors and proceed to regulate their behaviors.
II. DSSW model considering positive feedback tradingA classic DSSW model is a stripped-down overlapping generation model, which iscomposed of two-term-surviving individuals. Such an economy consists of two kindsof assets: one is risk-free assets, for which fixed actual dividend income r is paid eachterm, and it is supplied in a completely elastic way at a fixed price one; the other is riskassets, and suppose it receives fixed dividend income r the same as that of risk-free asset.Supply of risk assets is not elastic and can be simplified as one unit. Pt represents themarket price of risk assets in term t.
The DSSW model consists of two types of investors: noise traders (marked by n)and sophisticated investors (marked by s) who have the ability of rational expectation.Suppose the proportion of noise traders is m (0 , m , 1), then the proportion ofsophisticated investors is 1 2 m, no difference in investors of the same type.Sophisticated investors can rationally expect the price of risk assets and know thedistribution of return on assets; however, the expectation of noise traders to the priceinvolves their mistaken view of the after-market. Suppose rt represents the mistakenevaluation of the expected price of risk assets in term t by young noise traders, thenrt . 0 (,0) indicates that noise traders hold the optimistic (pessimistic) motion forthe future price of assets.
Suppose individuals make no consumption when young and their investmentresource is exogenously given. When individuals become old, they sell their risk assetsto the younger generation at a price of Pt1 and use up all of their wealth. So the onlydecision they have to make is to select a portfolio when they are young to maximize theirsubjective expected utilities. Suppose for each individual, there exists a continuousabsolute risk aversion utility function: Ut 2e22gwt , where g stands for the absoluterisk aversion coefficient and wt the wealth realized by investors through investment interm t. This functions depends upon lt, the