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The Stock Market’s Reaction to Unemployment News : Why Bad News Is Usually Good for Stocks

The Stock Market’s Reaction to Unemployment News : Why Bad News Is Usually Good for Stocks. John H. Boyd, Jian Hu, and Ravi Jagannathan Reporter : 吳嘉洋 October 20, 2010. Introduction.

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The Stock Market’s Reaction to Unemployment News : Why Bad News Is Usually Good for Stocks

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  1. The Stock Market’s Reaction to Unemployment News : Why Bad News Is Usually Good for Stocks John H. Boyd, Jian Hu, and Ravi Jagannathan Reporter :吳嘉洋 October 20, 2010

  2. Introduction • The stock market’s response to unemployment news arrival depends on whether the economy is expanding or contracting. • The stock market responds positively to news of rising unemployment in expansions, and negatively in contractions. • The economy is usually in an expansion phase, it follows that the stock market usually rises on the announcement of bad news from the labor market.

  3. Three Primitive Factors Determine Stock Price Risk-free rate of interest Stock price Unemployment news Growth expectations Equity risk premium

  4. Outline • Data and Methodology • Stock and Bond Price Responses to Unemployment News • Unemployment News, Growth Expectations, and the Equity Risk Premium • Summary and Conclusions

  5. Data • Unemployment Announcements • From February 1957 to December 2000. • At 8:30 a.m. on Friday. • It also releases revisions of past unemployment announcements for the previous 3 months.

  6. Unemployment news • Anticipated • Unanticipated (Surprise component) Surprise component = actual unemployment rate–forecasted unemployment rate

  7. Measuring Unemployment News • DUMPt : the change in the unemployment rate. • IPGRATEt : the growth rate of monthly industrialproduction. • DTB3t : the change in the 3-month T-bill rate. • DBAt : the change in the default yield spread between Baa and Aaa corporate bonds.

  8. Estimation Method (1) • We used final release numbers for unemployment and industrial production and we also included a dummy variable, which took on the value 1.0 during contractions and 0.0 during expansions.

  9. Estimation Method (2) • Second estimation method uses final release numbers for unemployment and industrial production and omits the business cycle dummy variable.

  10. Estimation Method (3) • The third forecasting method use final release figures for the unemployment rate and the IIP, but only employs data available up to 1 year before the estimation date. Then we employ the estimated parameters and the initial release numbers of the unemployment rate data and originally published and subsequently revised IIP to construct our estimate of the unemployment surprise. Final data Initial data 2009.12 2010.12 Estimate parameters

  11. Daily Returns on Stocks and Bonds • Define daily stock returns as the percentage change in theS&P 500 stock index. • Daily bond returns are constructed from daily yields.

  12. -0.01 0.41 0.36 -0.24 0.115 0.109

  13. Stock Price Responses to Unemployment News • SPRTRNt : the return on day t on the S&P 500 index. • ERRUMPt : thesurprise component of the unemployment rate announcement. • XRICt : an estimate of the probability that the economy was in a recession.

  14. Bond Price Responses to Unemployment News • BRTRNt : the return on the bond of interest on date t. • The dependent variables are the return on ahypothetical 1-year government bond, the 3-month T-bill, and the 10-year government bond.

  15. Summary - Stock and Bond • Government bond price responses to the arrival of unemployment news are different from stock prices. • Moreover, the unemployment news must convey information about the other two primitive factors, namely, growth rate expectations and the equity risk premium.

  16. Unemployment News, Growth Expectations, and the Equity Risk Premium • Gordon model • r : interest rate on long-term risk-free • P : price of a security or portfolio • D : the current dividend • g : weighted average of expected future growth rates • π : the risk premium investors required to invest in stocks

  17. u denote the unanticipated surprise in the unemployment rate (ERRUMP)

  18. The Equity Risk Premium: Its Response to Unemployment News • Lee, Myers, and Swaminathan (1999) (hereafter LMS) show that theintrinsic value to price ratio (V/P) of Dow 30 stocks has a statistically and economically significant ability to predict future excess returns on the Dow 30 stocks. • We employ the V/P ratio they compute as a proxy for the equity premium.

  19. Growth Expectations: Their Response to Unemployment News • We estimated the true relationship between the announced unemployment rate (the actual rate, not the surprise component) and subsequent dividend growth, using the IIP as a monthly proxy for corporate dividends.

  20. Summary and Conclusions • Stock prices rise when there is bad labor market news during expansions, and fall during contractions. • There are two factors that affect the price of stocks. One is the equity risk premium and the other is the expected future growth rate of dividends. • Stock price responds to unemployment shocks, and is larger during contractions than during expansions.

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