Asian and United States Market Reactions to Trade Restrictions

Qian Sun

• Publisher: Routledge
• Year: 2018
• Print ISBN: 9781138312838
• eBook ISBN: 9780429856426
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The effect of US protectionist policy on stock prices of firms in the US and abroad is still an open question. This book, first published in 1996, investigates the effects of trade restrictions at the level of the individual firm, focusing on US, Taiwan and South Korea.

III

Trade News and Stock Prices

3.1 A Dynamic Setup

In the simple efficient markets model, the stock price P_t of a share at the beginning of the time period t is given by

$${\mathbf{\text{P}}}_{\mathbf{\text{t}}}\mathbf{=}\underset{\mathbf{k}\mathbf{=}\mathbf{0}}{\overset{\mathbf{\infty }}{\mathbf{\Sigma }}}\frac{{\mathbf{\text{E}}}_{\mathbf{\text{t}}}{\mathbf{\text{D}}}_{\mathbf{\text{t+k}}}}{{\mathbf{(}\mathbf{1}\mathbf{+}\mathbf{\text{r}}\mathbf{)}}^{\mathbf{\text{k}}\mathbf{+}\mathbf{1}}}\mathrm{(3.1)}$$

where D_t is the dividend paid at the end of time t, E_t denotes the mathematical expectation conditional on information available at time t, and r is the expected cost of equity or required rate of return on equity for k+1 periods, i.e.,

$$\mathbf{\text{r}}\mathbf{=}{\mathbf{\text{E}}}_{\mathbf{\text{t}}}\mathbf{\left\{}\mathbf{\right(}\mathbf{1}\mathbf{+}{\mathbf{\text{r}}}_{\mathbf{\text{t}}}\mathbf{)}\mathbf{(}\mathbf{1}\mathbf{+}{\mathbf{\text{r}}}_{\mathbf{\text{t+1}}}\mathbf{)}\mathbf{...}\mathbf{(}\mathbf{1}\mathbf{+}{\mathbf{\text{r}}}_{\mathbf{\text{t+k}}}\mathbf{)}{{\mathbf{\}}}^{\mathbf{1}\mathbf{/}\mathbf{\left(}\mathbf{\text{k+1}}\mathbf{\right)}}}_{\mathbf{-}\mathbf{1}}\mathrm{(3.2)}$$

r_t+k for k≥0 is determined by the security market line,

$${\text{r}}_{\text{t}+\text{k}}={\text{R}}_{\text{f,}\text{t}+\text{k}}+{\text{b}}_{\text{t}+\text{k}}({\text{R}}_{\text{m},\text{t}+\text{k}}-{\text{R}}_{\text{f,}\text{t}+\text{k}})\mathrm{(3.3)}$$

where R_f and R_m are the risk free rate and the market rate respectively, and ß is the systematic risk of the firm. Therefore, r depends on the current and the expected future path of R_f, R_m and ß.

Following Shiller (1981), we adopt the innovation notation which will facilitate our analysis. We define the innovation operator as σ_t ≡ E_t - E_t-1. Then for any variable X_t, we can write

$${\sigma }_{\text{t}}{\text{X}}_{\text{t}+\text{k}}-{\text{E}}_{\text{t}}{\text{X}}_{\text{t+k}}={\text{E}}_{\text{t}}{\text{X}}_{\text{t}+\text{k}}\mathrm{(3.4)}$$

namely, σ_tX_t+k represents the change in the conditional expectation of X_t+k that is made in response to newly arrived information between time t-1 and t. Since conditional operators satisfy E_jE_k = E_min(j,k),

$${\text{E}}_{\text{t}-\text{m}}{\sigma }_{\text{t}}{\text{X}}_{\text{t+}\text{k}}={\text{E}}_{\text{t}-\text{m}}({\text{E}}_{\text{t}}{\text{X}}_{\text{t}+\text{k}}-{\text{E}}_{\text{t}+\text{k}})={\text{E}}_{\text{t}-\text{m}}{\text{X}}_{\text{t}+\text{k}}-{\text{E}}_{\text{t}+\text{m}}{\text{X}}_{\text{t}+\text{k}}=0\mathrm{(3.5)}$$

where m≥l.

The implication from (3.5) is that σ_tX_t+k must be uncorrelated with σ_t, X_t+j t’<t for all js and ks. This means that innovations in expectations are serially uncorrelated, which is consistent with efficient markets.

We know for one period holding, the stock price is:

$${\text{P}}_{\text{t}}=\frac{{\text{D}}_{\text{t}}+{\text{E}}_{\text{t}}{\text{P}}_{\text{t+1}}}{1+{\text{r}}_{\text{t}}}\mathrm{(3.6)}$$

or

$${\mathrm{E}}_{\mathrm{t}}{\mathrm{P}}_{\mathrm{t}\mathrm{+}\mathrm{1}}\mathrm{=}{\mathrm{P}}_{\mathrm{t}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{r}}_{\mathrm{t}}\mathrm{)}\mathrm{-}{\mathrm{D}}_{\mathrm{t}}\mathrm{(3.7)}$$

Therefore,

$${\mathrm{\sigma }}_{\mathrm{t}}{\mathrm{P}}_{\mathrm{t}}\mathrm{\equiv }{\mathrm{E}}_{\mathrm{t}}{\mathrm{P}}_{\mathrm{t}}\mathrm{-}{\mathrm{E}}_{\mathrm{t}\mathrm{-}\mathrm{1}}{\mathrm{P}}_{\mathrm{t}}\mathrm{=}{\mathrm{P}}_{\mathrm{t}}\mathrm{+}{\mathrm{D}}_{\mathrm{t}\mathrm{-}\mathrm{1}}\mathrm{-}{\mathrm{P}}_{\mathrm{t}\mathrm{-}\mathrm{1}}\mathrm{(}\mathrm{1}\mathrm{+}{\mathrm{r}}_{\mathrm{t}\mathrm{-}\mathrm{1}}\mathrm{)}\mathrm{=}\mathrm{\Delta }{\mathrm{P}}_{\mathrm{t}}\mathrm{+}{\mathrm{D}}_{\mathrm{t}\mathrm{-}\mathrm{1}}\mathrm{-}{\mathrm{P}}_{\mathrm{t}\mathrm{-}\mathrm{1}}{\mathrm{r}}_{\mathrm{t}\mathrm{-}\mathrm{1}}\mathrm{(3.8)}$$

where ΔP_t = P_t - P_t-1; D_t-1 - r_t-1P_t-1 is the adjustment for the dividend paid out at the end of time t-1 and the time value of P_t-1. Both D_t-1 and r_t-1P_t-1 are in the information set at time t and they constitute a forecastable part of the price innovation. However, D_t-1 - r_tP_t-1 is negligible in the data set that we are going to use. Therefore, σ_tP_t is approximately equal to the price change, ΔP_t. According to Samuelson (1965), σ_tP_t is unforecastable by efficient markets.

On the basis of the above analysis, we have

$$\mathrm{\Delta }{\mathrm{P}}_{\mathrm{t}}\mathrm{\cong }{\mathrm{\sigma }}_{\mathrm{t}}{\mathrm{P}}_{\mathrm{t}}\mathrm{=}{\mathrm{\sigma }}_{\mathrm{t}}\underset{\mathrm{k}\mathrm{=}\mathrm{0}}{\overset{\mathrm{\infty }}{\mathrm{\Sigma }}}\frac{{\mathrm{D}}_{\mathrm{t}\mathrm{+}\mathrm{k}}}{\mathrm{(}\mathrm{1}\mathrm{+}\mathrm{r}{\mathrm{)}}^{\mathrm{k}\mathrm{+}\mathrm{1}}}{\mathrm{\sigma }}_{\mathrm{t}}\mathrm{\left\{}\underset{\mathrm{k}\mathrm{=}\mathrm{0}}{\overset{\mathrm{\infty }}{\mathrm{\Sigma }}}{\mathrm{D}}_{\mathrm{t}\mathrm{+}\mathrm{k}}\underset{\mathrm{j}\mathrm{=}\mathrm{0}}{\overset{\mathrm{k}}{\mathrm{\Pi }}}\frac{\mathrm{1}}{\mathrm{1}\mathrm{+}{\mathrm{r}}_{\mathrm{t}\mathrm{+}\mathrm{j}}}\mathrm{\right\}}\mathrm{(3.9)}$$

This means that the price change depends on the innovation of the discounted future dividend stream. Any new information which can cause a revision of the expected future dividend stream and/or the discount rate will affect the stock price.

Suppose that the discounted future dividend stream is determined by a vector of fundamentals related to the earning power¹ and the discount rate, then the innovation of price will be affected by the innovations of all these fundamentals. For trade related firms, we can identify two fundamentals, trade restrictions TR and the exchange rates. For U.S. import-competing firms, an increase in the protection level, no matter if it is in the form of a tariff or non-tariff, will increase the barrier for foreign competitors. It will, in turn, increase the market power and profitability for the protected firms. The increased protection may also reduce the systematic risk ß for the protected firms because increased market power reduces the uncertainty these firms face relative to the market. For foreign export-oriented firms in general, if the protection is directed against them, they will lose their market share and their ß may also increase. Ceteris paribus, they should be made worse off. Therefore, an increase in U.S. trade protection will have a positive impact on the share prices of the protected firms and a negative impact on the share prices of the foreign rival firms.

Unexpected exchange rate changes may also have a significant impact on the share prices of trade related firms. A dollar depreciation will enhance the U.S. import-competing firms’ competitiveness in the market becau...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Original Title Page
• Original Copyright Page
• Dedication
• Table of Contents
• List of Tables
• List of Figures
• Foreword
• Preface
• I Introduction
• II Literature Review
• III Trade News and Stock Prices
• IV Empirical Investigation for U.S. Import-Competing Firms
• V Empirical Investigation for Taiwanese Export-Oriented Firms
• VI Empirical Investigation for South Korean Export-Oriented Firms
• VII Comparison and Conclusion
• Appendices
• Bibliography
• Index