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Algorithmic Trading and Event Studies in Finance Research Paper


Abstract

Terrorism is a great disaster of the present time and its linkage with algorithmic trading has been questioned. Research has been designed for considering the relations between terroristic acts and their impact on algorithmic trading by means of testing abnormal return prior to the terrorist attack, on the day of the attack, and several days after it. The research has shown that terroristic acts influence algorithmic trading only on the day of the event and even at a small rate.

Introduction

Algorithmic trading is trading which takes place on special electronic platforms that do not require making decisions from the traders, but special programs do it instead, they automatically submit orders and manage them.1 The notion of algorithmic trading in a broader sense may be defined as “trading in an automated manner according to a set of rules”.2 It is obvious that such trading can impact market modeling, the use of market microstructure effects, etc.

Nowadays, innovative technologies have become powerful tools for attacks.3 Terrorism is defined as a “transnational event when an incident in one country involves perpetrators, victims, institutions, governments or citizens in another country”.4 It is obvious that has affected a number of aspects of human life, terrorism cannot avoid trading, as “the economical ratifications of [terrorist] attacks can be felt beyond the borders of the country under attack”.5

The research conducted among American and Israeli companies has confirmed that terrorist attacks have an impact on the companies. However, this effect is different depending on the company activities, non defense-related companies were negatively impacted, while defense-related felt the positive influence.6,7

The impact of terrorist attacks has been proved by checking the effect of terrors on the stock market and volatility, and the effect was seen in mean and variance.8 The research conducted in Columbia has proved that if the political system and social affairs suffer after the terrorist attack, the stock market is influenced as well.9 It is important to understand that such global acts like those which took place on 9/11 influenced many countries and declined their income and stock in different spheres.10

Using “a subsequent analysis of the cross-sectional variation in the stock price reaction”,11 it can be concluded that the losses after terrorist attacks are great and can reach $401 million per attack.12 The investors’ overreaction is mostly explained by the behavioral bias, as “significantly negative abnormal returns on the first day of trading are followed by significant positive abnormal returns”.13 So, the events which took place on 9/11 did not play a direct role in the changes in the stock and return.14

Moreover, supporting the same idea, Drakos has managed to prove that the risk perception of the terrorism in the country plays important role in the abnormal returns’ variation, as “countries with higher (lower) terrorism risk perception are more likely to witness a higher (lower) stock market reaction”.15 Malaysian scholars conclude that feeling negative abnormal returns in a short-term period as a reaction to 9/11, other terrorist acts like, Madrid and London bombings, Bali bombing, or Mumbai attack, did not affect stock markets greatly.16

Methodology

Palestine is going to be a country for the research. The hypothesis we state is that terroristic acts influence abnormal returns of Palestine Exchange (PEX) in Nablus, but this influence is short-term and too small that investors should overreact. We are going to define abnormal return, conduct parametric and non-parametric tests, and regression analysis using the Capital Asset Pricing Model (CAPM), relying on the methodology used for the Malaysian Stock Exchange market.17 The research is going to be conducted on the basis of the information prior to the attack, on the day of the attack, and 15 days after the attack.

Defining the abnormal returns, we are going to rely on the daily returns and expected daily returns. Therefore, Equation

where ” is the daily return for stock i, is the stock return index for stock i at time t and is the stock return index for stock i at time t-1”.18

Focusing attention on the reaction to the terrorist attack and measure the stock price reaction, the following equation should be used,

Equation , where

Equation

Thus, “the abnormal return for industry i at time t, , is obtained by averaging the abnormal return of each firm within the industry”,19

Equation

Using a parametric test, we are going to check the cumulative abnormal return for 5 days implementing an assumption that “the industry abnormal returns and cumulative abnormal returns are normally distributed”.20 Therefore, the standard t-statistic for abnormal return may be calculated by means of the following equation,

Equation , where Equation is “an estimate of the standard deviation of the abnormal returns”.21

Estimating the cumulative abnormal return for 5 days, we calculate this parameter as Equation and get the following, Equation.22

Testing the hypothesis that the Palestine Exchange (PEX) in Nablus does not experience abnormal returns, we are going to use a non-parametric test as it is more powerful for rejecting this hypothesis by transforming the companies’ abnormal returns into ranks, over the combined period of 260 days Equation.

As the purpose of our research is to compare and contrast the abnormal return prior to the terrorist attack (244 days), the day of the attack, and 15 days after it, “the ranks in the event period for each firm are then compared with the expected average rank under the null hypothesis of no abnormal returns”,23 Equation and we get the non-parametric t-statistics as follows, Equation , where is a standard deviation of the average rank and can be considered as Equation24

It should be mentioned that a non-parametric test is considered to be the most appropriate for analyzing the impact of terrorist attacks on the financial market of the country.25

To assess whether the terrorist attacks have an impact on the systemic risk of Palestine Exchange (PEX) in Nablus on the day of the event, the multiplicative dummy variable should be included in the standard CAPM. CAPM model with an additive dummy variable has the following look, Equation,26 where is the return of the industry I at time t, is a free risk-return at time t , and D is a dummy variable? Estimating this model, we should accept that D takes 1 after the day of the terrorist attack, and 0 prior to that day. If the outcome of this research is less than zero this indicates a positive return.

Conclusion

In conclusion, it should be stated that after literature research we predicted to see a significant negative abnormal return on the day of the attacks, but the next 15 days were predicted to be positive in abnormal return. The same results were obtained by Drakos who conducted similar research in 22 countries.27 Terrorist attacks do not influence abnormal returns directly.

Bibliography

Arin, K. P., Cifferi, D. & Spagnolo, N., 2008. The price of terror: The effect of terrorism on the stock market and volatility. Economic Letters, 101, p. 164-167.

Berrie, C., & Klor, E. F., 2008, The impact of terrorism on the defense industry. Working paper.

Chesney, M., Reshetar, G. & Karaman, M., 2010. The impact of terrorism on financial markets: An empirical study. Journal of Banking and Finance, 35(2), pp. 253-267.

Drakos, K., 2009. Cross-country stock market reactions to major terror events: The role of risk perception. Economics of Security Working Paper, 16, pp. 1-42.

Drakos, K., 2010. Terrorism activity, investor sentiment and stock returns. Review of Financial Economics, 19, pp. 128-135.

Edmonds, C. & Mak, J., 2006. Terrorism and tourism: Is travel and tourism in a new World after 9/11? Economic Series, 86, pp. 1-23.

Enders, W. & Sandler, T., 2009. The political economy of terrorism. Cambridge University Press, Cambridge.

Franco, J. C., Varua,M. E. & Garces-Ozanne, A., 2009. Understanding crime, political uncertainty and stock market returns: A case study of the Columbian stock market. World Economics, 10(2), pp. 102-116.

Graham, M. A & Ramiah, V., 2009. The economic impact of terrorism in Indonesia. Centre for finance Working Paper Series.

Hallahan, T., Ramiah, V., Naughton, T. & Anderson, J.A., n.d. The stock market impact of transnational terrorist attacks: Evidence from Malaysian equity market. School of Economics, Finance and Marketing, p. 1-34.

Hendershott, T., & Riordan, R., 2009. Algorithmic trading and information.

Jackson, O. A., 2008. The impact of the 9/11 terrorist attacks on the US economy.

Karolyi, G. A. & Martell, R., 2005. Terrorism and the stock market.

Kolm, P. N., & Maclin, L., 2006. Algorithmic trading. Journal of Business Finance & Accounting, 33 (7) & (8), pp. 1-11.

Park, S. C., 2008. Investor’s overreaction to an extreme event: Evidence from the World Trade Center terrorist attack. pp. 1-34.

Poonam, 2009. Impact of terror attacks on Indian stock prices. All India Professional & Management Association.

The impact of terrorism across industries: An empirical study, n.d. pp. 1-37.

Footnotes

  1. Terrence Hendershott, & Ryan Riordan, 2009. Algorithmic trading and information. p. 2.
  2. Petter N. Kolm & Lee Maclin, 2006. Algorithmic trading. Journal of Business Finance & Accounting, 33 (7)&(8), p. 1.
  3. Poonam, 2009. Impact of terror attacks on Indian stock prices. All India Professional & Management Association. Web.
  4. Walter Enders & Todd Sandler, 2009. The political economy of terrorism. Cambridge University Press, Cambridge, p. 31.
  5. Michael A. Graham & Vikash Ramiah, 2009. The economic impact of terrorism in Indonesia. Centre for finance Working Paper Series. p. 2.
  6. Claude Berrie, & Esteban F. Klor, 2008, The impact of terrorism on the defense industry. Working paper. p. 23.
  7. The impact of terrorism across industries: An empirical study. p. 28.
  8. K. Peter Arin, Davide Cifferi, Nicola Spagnolo, 2008. The price of terror: The effect of terrorism on the stock market and volatility. Economic Letters, 101, p. 166.
  9. Juan Carlos Franco, Maria Estela Varua, &Arlene Garces-Ozanne, 2009. Understanding crime, political uncertainty, and stock market return: A case study of the Columbian stock market. World Economics, 10(2), p. 113.
  10. Christopher Edmonds & James Mak, 2006. Terrorism and tourism: Is travel and tourism in a New World after 9/11? Economic Series, 86, p. 5.
  11. G. Andrew Karolyi & Rodolf Martell, 2005. Terrorism and the stock market. p. 17
  12. Karolyi & Martell, p. 17.
  13. Sojung Carol Park, 2008. Investor’s overreaction to an extreme event: Evidence from the World Trade Center terrorist attack. p. 30.
  14. Olivia A. Jackson, 2008. The impact of the 9/11 terrorist attacks on the US economy. p. 20.
  15. Konstantinos Drakos, 2009. Cross-country stock market reactions to major terror events: The role of risk perception. Economics of Security Working Paper, 16, p. 22.
  16. Terrence Hallahan, Vikash Ramiah, Tony Naughton, & John A. Anderson, n.d. The stock market impact of transnational terrorist attacks: Evidence from the Malaysian equity market. School of Economics, Finance, and Marketing, p. 16.
  17. Hallahan, Ramiah, Naughton, & Anderson, p. 7.
  18. Hallahan, Ramiah, Naughton, & Anderson, p. 7.
  19. Hallahan, Ramiah, Naughton, & Anderson, p. 7.
  20. Hallahan, Ramiah, Naughton, & Anderson, p. 8.
  21. Hallahan, Ramiah, Naughton, & Anderson, p. 8.
  22. Hallahan, Ramiah, Naughton, & Anderson, p. 8.
  23. Hallahan, Ramiah, Naughton, & Anderson, p. 9.
  24. Hallahan, Ramiah, Naughton, & Anderson, p. 10.
  25. Marc Chesney, Ganna Reshetar, & Mustafa Karaman, 2010. The impact of terrorism on financial markets: An empirical study. Journal of Banking and Finance, 35(2), p. 266.
  26. Hallahan, Ramiah, Naughton, & Anderson, p. 10.
  27. Konstantinos Drakos, 2010. Terrorism activity, investor sentiment, and stock returns. Review of Financial Economics, 19, pp. 132.
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IvyPanda. (2021, January 27). Algorithmic Trading and Event Studies in Finance. Retrieved from https://ivypanda.com/essays/algorithmic-trading-and-event-studies-in-finance/

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"Algorithmic Trading and Event Studies in Finance." IvyPanda, 27 Jan. 2021, ivypanda.com/essays/algorithmic-trading-and-event-studies-in-finance/.

1. IvyPanda. "Algorithmic Trading and Event Studies in Finance." January 27, 2021. https://ivypanda.com/essays/algorithmic-trading-and-event-studies-in-finance/.


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IvyPanda. "Algorithmic Trading and Event Studies in Finance." January 27, 2021. https://ivypanda.com/essays/algorithmic-trading-and-event-studies-in-finance/.

References

IvyPanda. 2021. "Algorithmic Trading and Event Studies in Finance." January 27, 2021. https://ivypanda.com/essays/algorithmic-trading-and-event-studies-in-finance/.

References

IvyPanda. (2021) 'Algorithmic Trading and Event Studies in Finance'. 27 January.

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