The impact of algorithmic trading on Event studies in Finance Essay Example

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Impact of Terrorism Attacks on Australian Stock Exchange and Algorithmic Trading

Impact of Terrorism Attacks on Australian Stock Exchange and Algorithmic Trading

Literature Review

Impact of Terrorism Attacks on Australian Stock Exchange and Algorithmic Trading

According to Chan (2008), algorithm trading is one of the key drivers to improving efficiency of online financial trading. Besides, algorithmic trading is accredited for inter-linking various financial markets across the world on real time basis. However, the adverse technological effects that accompany computerization of financial markets have taken tool on financial markets. Such has been rendered by the increase in cyber-terrorism. Terrorists have gone a notch higher to using various technological tools to hamper online trading via sabotage, botnets, phishing and spoofing (Radu, 2010). As a result, there is increase in risk perception by investors thereby resulting in decreased demand for online buying and selling of stocks. On the other hand, impacts of terrorism such as the September 11, 2001 in New York, was felt within were felt within a few hours as a result of inter-linkage of various financial markets across the world via computerized trading. For instance, the demand for American Dollar and stocks of various US companies were drastically affected –decreased demand. This is largely due to increased risk perception by investors that there is a high chance of them losing In that case, with the advancement in technology and the globalization of financial markets, algorithmic trading come in handy in observing the behavior of financial markets on real-time basis (Radu, 2010).

Impact of Terrorism Attacks on Australian Stock Exchange

In his work Cam (2006) has provided a comprehensive evaluation on the impact of international terrorism on financial markets; especially the September II terrorist attack. Marc et al. (2010), in their article argues that a critical analysis of the impact of terrorism on international markets depicts that significant percentage the research has a descriptive character and puts much emphasis on the impact of very few terrorist events i.e. September 11 2001.

In the same note, Karohyi (2006) argues that there a lot of known and unknown effects of terrorist attacks on various financial markets across the world. Most of such negative effects impacts heavily on the financial and economic perspectives of a country. In a recent research article by Ann et al. (2008), investigating results have been shown that relate to the impact of terrorist attack on the markets behaviors based on the avoidance from six different financial markets (UK, Turkey, Spain, Israel, Thailand and Indonesia). In their work, Ann et al (2008) argues that terrorism not only impacts heavily on equity markets but also on the volatility equity markets. It is in the research work that the authors concluded there is a significant impact of terrorism attacks on both current and emerging financial markets. In another research study by Johston and Nedelescu (2005), where direct and indirect effects of terrorism on financial markets were investigated, the authors concluded that financial markets are not only faced with major disruptions caused by the extensive damage to property and communication systems, but also with high levels of market volatility and uncertainties. This is especially the case for 9/11 terrorist attacks in New York, USA (Vincent et al. 2005).

Subsequently, Marc et al. (2010) in their article argues that although some terrorist attacks impacts regionally, some like 9/11 attack impacted heavily on the global financial markets. To date most of the research studies have emphasized much on the impact of 9/11 terrorist attack on the USA financial markets. However there is little or no research available on the impact of terrorist attacks on countries for instance in Australia. In this regard, Cam (2006) and Nikkinen et al (2008) concurs with Andrew et al. 2005, Anthony 2009 and Jussi et al. 2008 that attack-response of 9/11 differed in various financial markets with respect to integration with USA economy. In his work Cam (2006) takes a closer look at the impact of five recent terrorist attacks on the Equity market of Australia. In which case the author does not make the widely perceived assumption that investors would automatically react negatively after terrorist attacks. Marc et al. (2010) in their article argues that equity holders would only respond negatively on terrorism would significantly increase in the near future. In this regard, Marc et al. (2010) argues that investors may not respond negatively if they lack perception of the impact of terrorism on they return they expect in the future. Thus, a perception is made that financial markets may react differently to various terrorist attacks and the difference in risk and returns differs distinctly across various sectors in an economy (Howard et al. 2007).

As Kim and In (2002) have demonstrated in their work, the Australian financial market is highly affected by international events for instance terrorism. Therefore, according to Ref 0, an ideal ground for evaluating the impact of terrorism on financial markets would be Australian stock Exchange. As Ref 0 notes in their work, the geographical isolation of Australia portrays it as an investment haven. However, the bilateral relations of Australia with USA with respect to ‘war on terror’ predispose it to terrorist attacks. Besides Marc et al. (2010) argues that immediately after September II attacks, Australia Stock Exchange opened immediately although Worthington and Valadkhani (2005) depicts how ASE reacted negatively though regression analysis and assessment. Richman et al (2005) argues that ASE nearly stumbled following the 9/11 attacks and in this respect Marc et al. (2010) evaluates the negative impact on ASE by first identifying the notable terrorist attacks across the world and reason why they would affect ASE.

igure 1. Terrorist attacks that had potential effect on Australian Stock MarketThe impact of algorithmic trading on Event studies in FinanceF

Source:
Milind S, Dharmendra S, Shuangzhe L & Girija, C, ‘Impact of terrorism on Australian stock market: An empirical investigation’

Therefore, this paper employs events methodology to evaluate impact of terrorism on Australian Stock Exchange.

METHODOLOGY SECTION

Vikash et al. (2010), in their research article argues that research on the effects of terrorism on ASE is unique in the sense that Australia is geographically situated in isolation and a number of the recent terrorist attacks have targeted Australian assets as displayed in the above table. The authors have used daily stock return indexes and returns from all ordinary share price index as well as ten – year bond rate for the period between starting August 1999 up to August 2006.

In the sample taken stock amounting to 1191 has been used to construct an industry portfolio according to Global Industry Classification standards (GICS). However, one of the biggest challenges of applying GICS on ASE is the small size of some firms and for that reason only 13 industries were studied out of the available 14. Although the average daily returns for sectors such as Health, Computer, Defense, Retail and Water were negative, the banking sector recorded positive return and the had zero returns. Besides, the authors accepted the hypothesis in some industries such as Capital Goods, Defense, Insurance, Utilities, Banks and Water have normally distributed returns. By making use of daily stock returns, the following formulae can be used to calculate the effect of terrorism on ASE performance.

The impact of algorithmic trading on Event studies in Finance 1

…………..Equation 1

However, Cam (2006) in his article argues that Ex–post abnormal returns can be precisely estimated. For every firm, Ex – post abnormal returns (ARit) may be determined by calculating the difference between observed returns of firm I at event day t and expected return E (Rit)

The impact of algorithmic trading on Event studies in Finance 2 ………………. Equation 2

By applying Capital Asset Pricing Model (CAPM) for daily returns which have been amounting to 260, the daily expected return E (Rit) can be estimated.

The impact of algorithmic trading on Event studies in Finance 3 ……………….Equation 3

ubsequently, to obtain abnormal return for industry I, ARThe impact of algorithmic trading on Event studies in Finance 4Sit at time t, the abnormal return of every firm in the industry is averaged.

… …………Equation 4

In order to incorporate only the effects of terrorist attacks on ASE, the model used eliminates firms that released particular information within 15 days before and especially after the attack.

ubsequently, some of the parametric tests applied in this research are based on the assumption that there is normal distribution of both the cumulative abnormal returns and industry abnormal returns. Thus, as illustrated below, the standard t-statistic with regard to abnormal return is: The impact of algorithmic trading on Event studies in Finance 5S

……………………Equation 5

Where, ARIt is the abnormal return for industry at time t

SD (ARit) is the approximation of the standard deviation of the abnormal returns

ased on the above, by accumulating the consequent abnormal returns of every industry fro more than five days would lead to deviation of five day cumulative return, CAR5itThe impact of algorithmic trading on Event studies in Finance 6B

…………………………. Equation 6

Dividing CAR5iT by the standard deviation of five day cumulative abnormal return, SD (CAR5it) would result in t-statistic of five day cumulative abnormal return (CAR 5).

The impact of algorithmic trading on Event studies in Finance 7

……….Equation 7

Parametric tests have the tendency of rejecting null hypothesis frequently when applied in testing positive abnormal performance as well as when testing abnormal returns. In that case, Ref 0 proposes the use of non-parametric tests to establish the false null hypothesis associated with abnormal returns.

Thus abnormal returns of every firm ARit are transformed into ranks Ki throughout a combined period Ti of 260 days which is illustrated as follows

The impact of algorithmic trading on Event studies in Finance 8 ………………… Equation 8

As suggested by Cam (2006), the whole period can be divided into 224 days before the occurrence of the vent, the specific event. Ranks are then compared with the average rank (Ki) with respect to null hypothesis associated with abnormal returns. Thus,

The impact of algorithmic trading on Event studies in Finance 9

……………………. Equation 9

Non-parametric t-statistic, tnp, of the null hypothesis for normal returns of every industry is given by

The impact of algorithmic trading on Event studies in Finance 10 ……………………….Equation 10

Where, SD (k) is the standard deviation of the average rank and it is represented by

The impact of algorithmic trading on Event studies in Finance 11

………….Equation 11

Furthermore, to sufficiently determine whether or not there was any impact of terrorism on ASE, a CAPM can be made use of. Besides, testing such probability, a multiplicative dummy variable is included in the standard CAPM as follows

The impact of algorithmic trading on Event studies in Finance 12 ….Equation 12

The impact of algorithmic trading on Event studies in Finance 13

The impact of algorithmic trading on Event studies in Finance 14

As appears in Equation 12, a variance-covariance matrix results and for that reason an independent equation can be used to test whether or not the intercept was impacted on by the terrorist attacks.

The impact of algorithmic trading on Event studies in Finance 15 ……….Equation 13

Upon performance of residual diagnostics and standard tests it was established there have been no major concern of the above two econometric models. Thus Wald test can be used to test the redundancy of dummy variables in the above equations. Besides, using Chow test to test any change on CAPM, it is possible to determine the long-term systematic risk. This is done by using the following formula.

The impact of algorithmic trading on Event studies in Finance 16 ………….Equation 14

Conclusion

There is sufficient evidence that Australian stock market was largely affected by the aforementioned five major terrorist attacks across the world that targeted its assets. More so the September 11 terrorist attack in New York. Using the above theories it is evident that majority of firms were and have been drastically affected by the terrorist attacks and algorithmic trading facilitated in spreading their impact on real-time basis. .

References

Andrew W & Abbas V 2005, ‘Catastrophic shocks and capital markets: A comparative analysis by disaster and sector’, viewed May 10, 2011<http://ro.uow.edu.au/commpapers/23>.

Anthony C H, 2009, ‘The impact of 9/11 on the persistence of financial return volatility of marine firms’, Eastern Economic Journal, vol. 35, pp. 71–83.

Arin K., Ciferri D., & Spagnolo N., 2008, ‘The price of terror: The effects of terrorism on stock market returns and volatility’, Economics Letters, vol. 101, no. 3, pp. 164-167.

Cam, M., 2006. The impact of terrorism on United States industry indexes. School of Economics, Finance and Marketing. InRoyal Melbourne Institute of Technology, Melbourne.

Chan, E. P. 2008. Quantitative Trading: How to Build Your Own Algorithmic Trading Business. New York: John Wiley and Sons. Pp. 167-169

Howard C. Kunreuther & Erwann O. Michel-Kerjan 2007, ‘Evaluating the effectiveness of terrorism risk financing solutions’, NBER Working paper series, no. 13359, viewed May 10, 2011 <http://www.nber.org/papers/w13359.>.

Johnston, R., & Nedelescu O 2005, ‘The Impact of Terrorism on Financial Markets’, Working Paper, Washington: International Monetary Fund.

Jussi, N, Mohammad, MO, Petri S, & Janne Ä 2008, ‘Stock returns and volatility following the September 11 attacks: Evidence from 53 equity markets’, International Review of Financial Analysis, vol. 17, pp. 27–46.

Karolyi, G., & R. Martell 2006, ‘Terrorism and the Stock Market’ Working paper, The Ohio State University.

Kim, S, & In, F 2002, ‘The influence of foreign stock markets and macroeconomic news announcements on Australian financial markets’, Pacific-Basin Finance Journal, vol. 10, pp. 571–582.

Marc C, Mustafa K & Ganna R 2010, ‘The Impact of Terrorism on Financial MarketsSSRN Working Paper Series: An Empirical Study, . Rochester.

Milind S, Dharmendra S, Shuangzhe L & Girija, C, ‘Impact of terrorism on Australian stock market: An empirical investigation’, viewed May 10, 2011 <http://www.apjfs.org/conference/2008/thesis/2008_12_2_%20Impact%20of%20terrorism%20on%20Australian%20_Milind%20Sathye,%20Dharmendra%20Sharma,%20Shuangzhe%20Liu%20and%20Girija%20Chetty_.pdf.>.

Nikkinen J., Omran M.M., Sahltrom P., & Aijo J 2008, ‘Stock returns and volatility following the September 11 attacks: evidence from 53 equity markets’, International Review of Financial Analysis, vol. 17, pp. 27–46.

Radu, S. 2010. Financial Cryptography and Data Security: 14th International Conference, FC
2010, Tenerife, Canary Islands, January 25-28, 2010, Revised Selected Papers. New York: Springer. Pp. 302-312.

Vikash R, Marie-Anne C, Michael C, David M, & Shahab G 2010, ‘Changes in equity returns and volatility across different Australian industries following the recent terrorist attacks’, Pacific-Basin Finance Journal, vol. 18, pp. 64–76.

Vikash R, Marie AC, Michael C, David M, & Shahab G, ‘An empirical investigation of the short term impact of the recent international terrorist attacks on the Australian equity market’, viewed May 10, 2011 <http://www.melbournecentre.com.au/Finsisa-MCFSConference08_RamiahCamCalabroMaherGhafouri.pdf>.

Vincent, R, Michael, RS, & John TB
2005, ‘Short- and long-term effects of the 9/11 event:
The international evidence’, International Journal of Theoretical and Applied Finance, vol. 8, no. 7, pp. 947–958.

Worthington, A., Valadkhani, A 2005, ‘Catastrophic shocks and capital markets: A comparative analysis by disaster and sector’, Economics Working Paper, InUniversity of Wollongong, Australia.