Explaining the FOMC Drift
A new financial research paper related to:
#75 – Federal Open Market Committee Meeting Effect in Stocks
Title: Explaining the Pre-Announcement Drift
I propose a theoretical explanation for the puzzling pre-announcement positive drift that has been empirically documented before scheduled Federal Open Market Committee (FOMC) meetings. I construct a general equilibrium model of disagreement (difference-of-opinion) where two groups of agents react differently to the information released at the announcement and to signals available between two announcement releases. In contrast to traditional asset pricing explanations, this model matches key empirical facts such as (1) the upward drift in prices just before the announcement, (2) lower (higher) risk, price volatility, before (after) the announcement occurs, and (3) high trading volume after the announcement, while trading volume is low before the announcement occurs.
Notable quotations from the academic research paper:
"It seems implausible that price increases in the aggregate equity market occur persistently and at scheduled points in time without any associated risk. Still, this was the description of the pre-announcement drift puzzle found in
Lucca and Moench (2015), henceforth LM. The authors documented a persistent upward drift in equity prices together with very low volatility before the scheduled announcements of the FOMC meetings. This paper seeks to provide a theoretical framework to explain how such a positive drift persist and species what kind of risk is embedded in it.Over the past decades, stocks in aggregate have experienced large positive excess returns in anticipation of scheduled FOMC announcements and, to a certain extent, in anticipation of scheduled corporate earnings announcements. I will refer to this phenomenon as the pre-announcement drift. I will claim that, while traditional asset pricing explanations would fail to match the empirical evidence, a model of disagreement based on Dumas et al. (2009), henceforth DKU, creates sentiment risk that matches the stylized facts documented empirically in the literature.
I present a general equilibrium model in which two groups of agents have differences-of-opinion about the content of an announcement. In this economy, there is a continuous stream of dividends being paid, but the rate of growth
of these dividends is unknown and not directly observable. All investors receive information from the current dividend and a signal they may choose to acquire about the unknown growth rate. Agents have different beliefs about the
correlation between their information sources, announcement and signal, and the unobserved rate of growth of dividends. This heterogeneity in the correlation makes the expectations of two groups of agents differ; I will henceforth
call the fluctuations in the beliefs of the two groups as changes in "sentiment". The single parameter in this model that sets it apart from traditional rational-expectations general equilibrium models is the non-zero correlation between the information sources and the unobserved rate of growth. In this model, agents will always have a source of difference-of-opinion because they disagree on a fixed parameter of the model. They, therefore, do not learn from each other's behavior nor from price but simply "agree to disagree".
The intuition of the model in this paper is the following: When an announcement about the unobserved growth rate of the economy occurs, there will be a discontinuous jump in disagreement. This happens because agents will have different interpretations of the information released at the announcement; they assume different correlations of the announcement release and the unknown growth rate. Over time, in the period between announcements, agents will in general remain at a certain level of disagreement, because at least one group of agents acquires a signal about the unobserved growth rate of the economy that the other group of agents does not acquire. Once the next announcement becomes imminent, it would be optimal for all agents to stop acquiring any signal because a new announcement will make all previous information stale. There will be an optimal point in time when the acquiring costs will outweigh the benefits from potentially using the information to be acquired. Therefore, agents will choose not to acquire information, which will bring agents to drastically reduce their disagreement level.
When agents stop acquiring signals, the reduction in disagreement leads to a reduction of sentiment risk that manifests as an increase in prices; this increase in prices will match the pre-announcement drift. Low volatility will be observed in the pre-announcement period, where there is low sentiment risk; and high volatility will be observed after the announcement, where there is an increase in sentiment risk. Finally, high trading volume will occur just after the announcement is released, since this is the point in time with the highest level of disagreement and it would be at its lower point just before the next announcement occurs."
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