Market Impacts in Major Events: An Analysis Using State Price Distributions

1. Market Impacts in Major Events: An Analysis Using State Price Distributions Ph.D. Dissertation Proposal Merlyn Foo merlynf@athabascau.ca March 28, 2008

2. Purpose of study • A better understanding of characteristics of aggregate market reactions during major events in terms of • information leakage • impact duration • impact size • Differences of reactions in different markets during different events

3. Which Events? • 1998: Long Term Capital Management collapse • 2000: Tech-Bubble Burst • 2001: September 11

4. Why these 3 events? • They are three of the largest events in the last decade • They occurred at three different levels of the economy: • LTCM: organizational level • 2000-Burst: industry level • 9/11: national and global levels

5. Which markets? • S&P 500 calls (SPX calls) • S&P 500 puts (SPX puts) • Nasdaq 100 calls (NDX calls) • Nasdaq 100 puts (NDX puts)

6. Which time period? • Event dates are hard to pin down for two of the three events • Event months: • LTCM: August 1998; loss of $1.9 billion or 45% of LTCM’s capital • 2000-Burst: March 2000; largest decline in NDX, dropping 438.62 points in 10 days • 9/11: September 2001

7. Time period (cont.) • 7-month period surrounding the event month • 3 months prior to event • 1 event month • 3 months post-event

8. Literature Review Behavioural finance literature • 12 propositions based on Hong and Stein (1999) Claims-based asset pricing literature • Estimation of discrete state price distributions • Based on Breeden and Litzenberger (1978) and refinements in Ross (2000)

9. Data sets • Daily option prices for 7 months for each of the 3 events • SPX calls • NDX calls • SPX puts • NDX puts • Daily underlying index values, April 1998 - December 2001 • SPX • NDX • Daily, 1-month T-bill rates, April 1998 – December 2001

10. Methodology • Estimation and optimization procedure for state prices based on the no-arbitrage equation (Breeden and Litzenberger (1978), Ross (2000)) • Estimation state prices (q) and estimated objective probabilities (p) to calculate state price density, L= (Rosenberg and Engle (2002)) • Disaggregating state price density into 3 portfolios: L, CL, and PL (Yang (2003))

11. Summary of impact measures

12. Summary of Results

13. Some interesting resultson LTCM • Largest impacts occurred prior to August event month • NDX reacts less and slower than SPX • Calls have longer duration of reaction than puts • Skewness of SPDs and two sets of volatilities show distinct patterns of reactions

14. Figure 2b. Cross-market comparisons of Volatilities during LTCM.

15. Some interesting resultson 2000-Burst • No significant information leakage for NDX calls, NDX puts, and SPX puts • Largest impacts in NDX calls • Longer duration of impacts in NDX markets • Reactions in calls larger and longer-lasting • SPD skewness and volatilities on excess returns on PL yield consistent conclusions

16. Figure 3a. Cross-market comparisons of volatilities during 2000- Burst.

17. Some interesting resultson 9/11 • No information leakage – good control • No significant post-event impact in two puts markets • Larger immediate and cumulative impacts in NDX markets • Calls have larger immediate impacts • Most sensitive measure: volatilities in excess returns on PL

18. Cross-market comparisons of volatilities during 9/11

19. Cross-market comparisons of volatilities during 9/11

20. Some interesting resultsCross-event • Calls sustain larger and longer impacts from all three events • LTCM had largest effects on SPX markets • 9/11 had largest effects on NDX markets

21. Conclusions General Conclusions: • Calls markets reacted more to the events than puts markets -- unexpected • No information leakage during 9/11 – as expected • No information leakage during 2000-Burst – not as expected • Significant information leakage during LTCM – as expected • Longest duration of impacts during 2000-Burst; shortest during 9/11 – as expected • Largest volatility changes in 9/11; smallest in LTCM – as expected • LTCM more effects on SPX markets – as expected • 2000-Burst more effects on NDX markets – as expected • 9/11 more effects on NDX markets – not as expected • Skewness and volatilities more reliable measures of impacts

22. Other conclusions • Contamination effects from pre-existing conditions and/or post-event actions For the future: • Hypotheses need to be tightened • Statistical testing of monthly changes in impact measures (t-tests and F-tests) • More work to be done!