Available online at ijims.ms.tku.edu.tw/list.

asp

International Journal of Information and Management Sciences

21 (2010), 13-28

The Impact of Investor Sentiment on Excess Returns:

A Taiwan Stock Market Case

Wu-Jen Chuang Liang-Yuh Ouyang

Department of Banking and Finance Department of Management Sciences
Tamkang University and Decision Making
R.O.C. Tamkang University
R.O.C.
Wen-Chen Lo
Graduate Institute of Management Sciences
Tamkang University
R.O.C.

Abstract

In this paper, we use a proxy for investor sentiment and employ a generalized autore-
gressive conditional heteroskedasticity in mean (GARCH-M) model to show the impact of
investor sentiment on excess returns in Taiwan stock market. Firstly, the evidences suggest
that the change in trading volume is a suitable proxy for investor sentiment. Furthermore,
the conditional volatility and excess returns have a negative and significant relationship. We
argue that the irrational sentiment has influence on stock valuations.

Keywords: Trading Volume, Investor Sentiment, Excess Returns.

1. Introduction

Theoretically, investors are thought to be rational under the efficient market hypoth-
esis (EMH). Under EMH, investors are assumed to be rational and therefore to value
securities rationally. Even if some investors trade irrationally, they would trade in a
random way, and their irrational trading can be cancelled out by other different and
uncorrelated irrational trading.
Even though the EMH has dominated the field of finance for years, it still faces
many challenges, such as the big market crash on October 17 of 1987 in U.S.A. and the
irrational pricing of Internet stocks in 1990s. Many evidences indicate that irrational
behavior has an influence on security prices and it is deserved to observe thereafter.

Received October 2008; Revised May 2009; Accepted July 2009.

14 International Journal of Information and Management Sciences, Vol. 21, No. 1, March, 2010

In this paper, we find that irrational behavior has effects on security prices. First, we
develop a proxy for the unpredictable investor beliefs. And then, we employ a generalized
autoregressive conditional heteroskedasticity in mean (GARCH-M) model (Bollerslev [3,
4]; Engle et al.[14]) to test the relation between investor sentiment and excess returns in
Taiwan stock market.
The remainder of the study is organized as follows. In section 2, we discuss related
literature. In section 3, we present our methodology. In section 4, we show and interpret
our empirical results. Finally, in section 5, we summarize our conclusion and provide a
discussion of the implication.

2. Related Literature
2.1. Irrational investors’ behavior

Many empirical results show that the irrational investor behavior not only exists
in the stock market but also has significant influences on the formation of prices. In
addition, many studies argue the importance of investor sentiment in the stock market
and provide an interpretation of the influence of the sentiment beliefs on the formation of
stocks price. For instance, De Long et al. [12] propose a model to prove that noise traders
have influences on price formation. They name the risk resulting from noise traders as
“noise trader risk”. Noise trader risk is assumed to be market-wide and it has an influence
on the stock market. Most importantly, their findings validate the hypothesis that noise
traders may have a higher average return than rational investors.
De Bondt and Thaler [11] document overconfidence evidences in the stock market.
They compare the performance of two groups of companies: extreme losers and extreme
winners. The former group had poor performance in past periods, whilst the latter had
good profit. Because of irrational beliefs, investors predict that extreme winners are still
good in the future and overvalue them. Similarly, investors undervalue extreme losers.
De Bondt and Thaler [11] find that the returns of previous extreme losers are higher
than those of previous extreme winners.
Investors have a tendency to adjust their beliefs to the most recent data and to make
decision based on information they have at the present time. They also extrapolate past
experiences into future. Basu [2] provides evidences on this phenomenon. When investors
are pessimistic about the stocks characterized by series of earnings lower than expected,
they do not invest in them. As a result, such stocks have lower price earning (P/E)
ratio. As soon as the earnings increase, the prices of the stocks with extremely low
P/E ratios undergo a correction higher than the ones with extremely high P/E ratios.
And hence, low P/E stocks exhibit higher returns. The studies of Fama and French [15]
and Lakonishok et al. [20] support the result that low market-to-book ratio stocks have
bigger expected returns than high market-to-book ratio stocks. Such phenomena show
that investors usually make investment decisions based on their beliefs. Variables easy
to measure can be defined in order to describe investor’s behavior.
Furthermore, optimism is another psychological behavior that can have effects on the
formation of stock prices. The optimists believe that they have the ability to predict stock
 Fluid Model Driven by an M/M/1/N Queue with Single Exponential Vacation 15

prices and to make decisions depending on their intuitions. In addition, optimistic beliefs
cause investors underestimate risk. During the late 1990’s investors were overoptimistic
about the prospects of Internet companies. Thaler [33] estimates that the intrinsic values
of Internet stocks are only about fifty percent of their market values. The evidence shows
that irrational investors involved in high risks because of their cognitive misperceptions.
Moreover, there are other irrational investment phenomena in the stock market. For
example, Shefrin and Statman [28] interpret that investors usually avoid selling stocks of
which prices are lower than their costs, so that they do not feel regret. Odean [27] also
presents that due to regret aversion, investors are reluctant to realize loss.
The argument of De Long et al. [12] supports the hypothesis that the uncertain
nature of noise trader beliefs leads rational investors to limit their positions while trading
against noise traders to avoid loss. Noise traders take the risk that they create and earn
higher returns than rational arbitragers. Furthermore they conclude that the presence of
noise traders can be detected through an excess of volatility of the prices of risky assets.

2.2. Proxy for investor sentiment

As mentioned above, several prior studies have stated that uncertain belief in sen-
timent causes higher risks in the stock market and hence gives rise to higher returns.
Recently, several researches attempt to find a proxy for the unpredictable investor beliefs.
Lee et al. [21] consider the fluctuations in the discount on closed-end funds as a proxy
for investor sentiment. Neal and Wheatley [25] examine the level of discount on closed-
end funds, the ratio of odd-lot sales to purchase, and the net mutual fund redemptions
to measure the investment behavior. Lee et al. [23] use the sentiment index provided by
Investors’ Intelligence of New Rochelle in New York as a proxy for investor sentiment.
Investors’ Intelligence takes a poll of 135 investment advisory services every week and
produces three numbers– bullish, bearish and correction. Bullish is the percentage of
investment advisors recommending investors to buy stocks. Bearish is the percentage
of those predicting a bear market. Correction is the percentage of expecting a market
correction1 .
In addition, Brown and Cliff [5] examine several proxies for investor sentiment in-
cluding closed-end fund discount, the net flow of funds into mutual funds, the percentage
of mutual fund assets held as cash, and the number of IPOs during the month, the first-
day return on IPOs during the month, and the bull-bear spread. They also conclude
sentiment affects assets valuation. Tetlock [32] examines the interactions between media
content and the stock market by constructing a measure of media content corresponding
to negative investor sentiment. He finds high media pessimism inducing stock prices
downwards. Besides, Edmans et al. [13] investigate some important sports games and
find a significant loss effect of games on stock market. They show that the stock market
can react to a sudden change in investor mood.

1. The investment index is also used as a contrary indicator. According to the study of Colby and Meyers [9],
when the bullish sentiment index is 37.5%, a bull market is forthcoming and when the bullish index is 78.2%, a
bear market is imminent. Accordingly, investors buy stocks when the bullish index is low, and sell stocks when it
is high.
16 International Journal of Information and Management Sciences, Vol. 21, No. 1, March, 2010

Even though different proxies for investor sentiment have been used in various em-
pirical studies, they all have demonstrated significant effects on stock price formation.
In this study, we try to construct a proxy reflecting investor sentiment and investigate
its effect in Taiwan stock market.

2.3. Trading volume and investor sentiment

Lee and Swaminathan [22] demonstrate that investor expectations affect not only
the return but also the trading activity of the stock. They point out that past trading
volume can be used as a proxy for measuring the fluctuations in investor sentiment. When
most investors think companies are good to invest, they buy stocks, and the trading
volume of those stocks goes higher. And when most investors consider companies are
bad, they sell or stop buying stocks, the trading volume of those stocks would be lower.
Thus trading volume can reflect investors’ expectations. They also discover that trading
volume seems to provide information about investors’ misperception of future earnings.
The information content of trading volume reflects something about relative under- or
over-valuation of stocks. They propose the momentum life cycle (MLC) to imply that
trading volume should be correlated with value (or glamour) characteristics. According to
the MLC, trading volume is an important empirical link between intermediate-horizon
momentum and long-horizon return reversal. Investors would buy the securities with
good prospects. If more and more investors extrapolate good news into future, they
tend to overvalue these firms and to invest in them. Their irrational beliefs thus increase
trading volume. On the other hand, investors would be reluctant to buy the securities
with bad news. If investors believe that the bad news would last for a long time, they tend
to undervalue these firms. And thus their irrational behavior decreases trading volume.
Hence, the change in trading volume can reflect investors’ irrational expectations to some
extent.
Shiller [30] also proposes the feedback loop theory to explain the relationships among
stock returns, investor sentiment, and trading volume during a stock market cycle. At
first, when investors are encouraged by the past prices increases, they bid up stock prices
further and earn positive returns, thereby strengthening their confidence and inducing
more investors to do the same. When the process repeats itself, the speculative bubble
develops. As the speculative bubble takes place, high stock prices are sustained by
investors’ irrational enthusiasm rather than by their intrinsic values.
However, the irrational speculative bubble can not last forever. When the bubbles
reach a certain level, investors would undergo a sudden change in their beliefs, and thus
causing the bubble to bust. And yet, there is no apparent reason for the sudden bursts
of bubbles. Hart and Tauman [17] state that such sudden changes in behavior may result
from endogenous information process which is not observable.
The feedback loop also occurs in a downward side. The initial decline in stock prices
discourages investors. As investors reduce their holdings, stock prices decline further.
At the time when the bubbles burst, the market experiences both a high volatility and a
high trading volume because of the existence of noises in investors’ demand. However, as
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the downward correction process continues, market trading volume keeps shrinking due
to the loss aversion of some investors not willing to sell stocks to avoid regret. Prices
are also declining until at a certain point where the downward correction completes.
The situation where the market reaches its trough and at the same time the investors
feel extremely pessimistic is called the positive bubbles. Unlike the downward process
of a sudden burst of speculative bubbles, the positive bubbles will probably not reverse
instantaneously its upward path.
In conclusion, Lee and Swaminathan [22] find trading volume contains some informa-
tion about investors’ expectation and also link to intermediate-horizon price momentum
and long-horizon price reversal, which resulting from investors’ overconfidence bias and
conservatism bias (Daniel et al. [10], Barberis et al. [1]). With the feedback loop theory,
Shiller [30] explains the relationships among stock returns, investor sentiment, and trad-
ing volume during a stock market cycle. Even in Taiwan, Chuang and Chuang [6] find
trading volume contains many information by discovering warrants issuance in Taiwan
stock market. Based upon arguments above, we postulate that change in trading volume
can reflect fluctuations in investor sentiment.

3. Sample and Methodology

In this section, we will illustrate the proxy that represents investor sentiment and
specify a model suitable for describing the relationships between excess returns and
conditional volatility in the Taiwan stock market.

3.1. Sample period and market return proxies

The sample period of our study covers from January 4, 1990 to December 31, 2004
with a total of 779 weekly observations. The market index, Taiwan Stock Exchange Cap-
italization Weighted Stock Index (TAIEX), is used to evaluate the overall performance
of Taiwan stock market. TAIEX is the value-weighted index including all listed stocks.
The data for TAIEX and the trading volume are from the Securities and Futures Insti-
tute. The commercial paper rate, obtaining from the Taiwan Economic Journal (TEJ)
data bank, is used as a variable for the risk-free interest rate to obtain the weekly excess
returns.

3.2. Sentiment proxy

The sentiment proxy used in this study is the change in trading volume2 . The rela-
tionship between the trading volume and investor sentiment can be illustrated through
the time series of the market index and the trading volume as shown in Figure 1 and Fig-
ure 2, respectively. The market index and the trading volume exhibit a strong positive
relationship3 . At the tops of the market, the trading volume reaches its highest levels.
And around the troughs of the market, it obtains the lowest levels. The trading volume
18 International Journal of Information and Management Sciences, Vol. 21, No. 1, March, 2010

Figure 1: Taiwan Stock Exchange Capitalization Weighted Stock Index (TAIEX) from January
4, 1990 to December 31, 2004 (779 weekly observations).

declines during the periods of correction and increases as the market index goes up.

3.3. Hypothesis
Moreover, based upon findings of Lee and Swaminathan [22] and Shiller [30], high
trading volume implies that investors are optimistic about the stock or the market, and
conversely, low trading volume indicates that investors are pessimistic. That is, the
change of trading volume can represent the movement in the investor sentiment. A
positive change in the trading volume indicates a bullish change in investor sentiment,
while a negative change in volume indicates a bearish change in sentiment. That is, when
the market is going upward, investor sentiment shifts toward bullish; when the market
index is going down, investor sentiment shifts toward bearish. Moreover, the more the
changes in investor sentiment, the higher the excess returns. We will adopt the above
hypothesis and test its validity.

3.4. The model

In this paper, at first we attempt to construct a proxy for the unpredictable investor
beliefs. And then we want to examine the unpredictable investor beliefs can affect stock
valuation. The GARCH model is useful to find out the volatility in financial market and

2. We compute the change in trading volume by average weekly trading volume.

3. The correlation coefficient between the market index and the trading volume is 0.7413. Both are stationary
time series.
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Figure 2: The Trading volume of Taiwan Stock Exchange Capitalization Weighted Stock Index
(TAIEX) from January 4, 1990 to December 31, 2004 (779 weekly observations).

there are some studies concerning Taiwan financial market (Lai et al. [19]; Ni and Wu,
[26] ). We employ a GARCH-M model to test whether the relationship between investor
sentiment and excess returns is validated in the Taiwan stock market.
Lee et al. [23] employ a GARCH-M model to show that there are some relationships
among market volatility, excess returns, and investor sentiment. There are some main
results in their study. First, they find that the investor sentiment is a significant factor
in explaining the excess returns and the volatility of stocks. Second, the greater the
magnitude of the shifts in the sentiment is, the more the impacts on the conditional
volatility of returns and expected returns. Finally, bullish and bearish shifts in the
sentiment have significant influences on excess returns and volatility. That is, investor
sentiment is a priced factor on stock returns. The results consist with arguments of De
Long et al. [12]. Irrational investors can cause an excess of volatility of the prices of risky
assets and gain higher returns.
We modify the model proposed by Lee et al. [23]. The model specification is as
follows4 :

Rt − Rf t = γ0 + γ1 St + γ2 log(ht ) + γ3 Augt + εt (1)

ht = α0 + α1 ε2t−1 + α2 ε2t−1 It−1 + β1 ht−1 + φ1 (St−1 )2 Dt−1 + φ2 (St−1 )2 (1 − Dt−1 )
+φ3 Rf t + ut (2)

4. Lee et al. [23] test excess returns of Dow Jones Industrial Average (DJIA), Standard and Poos’s 500
(S&P500), and NASDAQ with sentiment index of Investors’ Intelligence. In our study, we use change in trading
volume as sentiment index in equation (1).
20 International Journal of Information and Management Sciences, Vol. 21, No. 1, March, 2010

where εt ∼ N (0, ht ) and ut is a random error.

In equation (1), the mean equation, Rt is the weekly return on the Taiwan market
index5 . The excess returns of the market index are obtained by subtracting the market
return (Rt ) by the risk-free rate (Rf t ). St , the change in trading volume, as explained
above, is used as the proxy for investor sentiment6 . ht is the conditional variance of
the market excess returns and appears in the logarithmic form in the mean equation to
capture the trade-off effect between risk and returns.
A seasonal dummy (Aug) for the month of August is also included in equation (1).
The companies in the Taiwan stock market tend to pay stock dividends instead of cash
dividends to their stockholders. When those stock dividends go public, investors are
likely to sell them and to realize gains. The result of this behavior is to depress the
stock prices. From 1990 to 2004, among 4,256 times of stock dividend distributions,
there are 696 times stock dividend released in August which accounts for 16.32% of the
total distributions.7 In the mean time, the average distribution per month is 8.33%.8
The statistics shows that the percentage of stock dividends going public in August is
higher than the average. It indicates that the stock prices should decline in the month
of August. That is, we expect there is negative relationship between returns and August
effect.
In financial markets, January effect is well known by investors. Lee et al. [23] doc-
ument that there were January effect for Dow Jones Industrial Average (DJIA) from
January 5, 1973 to October 6, 1995, and for NASDAQ from May 25, 1984 to October
6, 1995. For the Taiwan stock market, some studies (Chiou and Hwang [7]; Lee and Hu
[24]) show that January effect does exist. However, Hwang and Guo [18] indicate that
any consistent and long term seasonal effects, including the January effect, do not exist in
the Taiwan stock market. Chuang and Lai[8] investigate several factors have significant
effect on Taiwan stock market from 1992 to 2006 and January effect only shows lower
explanatory power on stock returns. In addition, Shyu and Liou[31] indicate the January
effect seems to be weaker because of higher proportion of institutional holdings. We try
to include the January effect in our model but the results are insignificant. Moreover,
we find that when the seasonal dummy (AUG) is excluded, the mean equation loses its
descriptive power. However, when it is included, the model becomes well defined.
In equation (2), the variance equation, a GARCH (1, 1) model, which incorporates
the asymmetric or leverage effects, is specified. The value of the dummy variable It−1
equals one when bad news occurs in the preceding period (εt−1 < 0), and zero otherwise.
We expect α2 to be positive as indicated by Glosten et al. [16] to show an asymmetric
effect of a higher volatility resulting from bad news than from good news.
Furthermore, in equation (2), we recognize the effect of shifts and magnitude in
investor sentiment on the volatility. The dummy variable Dt−1 equals one when there is

5. We construct the weekly rate of return on the index as Rt = ln(M It /M It−1 ), where M It is ending weekly
market index at time t.
6. St = V OLt − V OLt−1 , where V OLt is average weekly trading volume at time t. Hence, St represents the
change in trading volume at time t.
7. The data is from Taiwan Economic Journal (TEJ) data bank.
8. The average probability is equal to 8.33% (=1/12).
 Fluid Model Driven by an M/M/1/N Queue with Single Exponential Vacation 21

Figure 3: The Excess Returns of TAIEX from January 4, 1990 to December 31, 2004.

a bullish shift in investor sentiment (St−1 > 0) and zero otherwise. Thus, φ1 represents
the impact of bullish shift in investor sentiment on the volatility and φ2 is the impact of
a bearish shift on the volatility. The asymmetric impacts of investor sentiment on the
volatility can thus be observed.
Finally, the risk-free rate variable is included in the variance equation to capture the
effect of inflation on the volatility as suggested by Lee et al. [23].

4. The Empirical Results

4.1. Summary statistics

The time series of the excess returns and the sentiment proxy for the Taiwan stock
market are shown in Figure 3 and Figure 4, respectively. The sample statistics of these
two series are tabulated in Table 1. During the period of investigation, the average of
weekly excess returns is -5.67% with a maximum return of 15.42%, and a minimum -
34.89%. The sentiment proxy has a negative average value indicating a negative investor
sentiment for the sample period. It seems to show that there is on average bearish shifts
in investor sentiment, and market participants gain negative excess returns.
As we have hypothesized in section 3.3, when the market index is going down,
investor sentiment shifts toward bearish. Investors become more conservative and as a
result the market trading volume decreases. When the market index goes downward,
investors get negative returns and become more pessimistic because they tend to keep
under-cost stocks to avoid regret (Shefrin and Statman [28], Odean [27]). Table 1 exhibits
the implication similar to our hypotheses. Hence, it is reasonable to assume that there is
a connection among the change in trading volume, sentiment proxy, and excess returns.
22 International Journal of Information and Management Sciences, Vol. 21, No. 1, March, 2010

Figure 4: The Sentiment Proxy of TAIEX from January 4, 1990 to December 31, 2004.

4.2. Estimated results

The estimated results of the four different GARCH-M models are shown in Table
2.9 We employ alternative forms of sentiment proxy into the model and then find which
may be a better proxy for investor sentiment. The base model does not include the
effect of sentiment proxy. Model 1 uses the change in trading volume in current period
(St ) and the model 2 considers the change in trading volume of previous period (St−1 )
as the sentiment proxy, while the model 3 and model 4 take the percentage change in
trading volume of the current period (%St ) and of previous period (%St−1 ) respectively
to consider the effect of investor sentiment.10
The estimated coefficients of the sentiment proxy (γ1 ) are significant in the model 1
and 3, but not in the model 2 and 4. The results suggest that contemporary sentiment
proxy has better explanatory power in excess return and conditional volatility. That is,
investors consider more recent information to make investing decisions. Furthermore,
the model 1 with St as the sentiment proxy seems to be more suitable to explain the
relationships among excess returns, investor sentiment, and volatility. Compared with
other models, most estimated parameters of the model 1 are significant at 5% level, no
significant serial correlation remained and all of the estimated GARCH coefficients are
significant.
Lee and Swaminathan [22] indicate that trading volume provides information about
the degree of investors’ favoritism or neglect, and the change in trading volume gives
most predictive power, rather than the lagged volume. Our results are consistent with
their findings. The change in trading volume documents more convincing evidences on

9. The model is estimated by using EViews 5.1. software package. The estimation method is the maximum
likelihood method with Marquardt iterative algorithm.
10. St−1 = V OLt−1 − V OLt−2 ; %St = ln(V OLt /V OLt−1 ); %St−1 = ln(V OLt−1 /V OLt−2 ).
 Fluid Model Driven by an M/M/1/N Queue with Single Exponential Vacation 23

Table 1: Summary statistics of excess returns and sentiment proxy.

Sentiment proxy (St )

Excess returns
(10 million NT dollar)
Mean -0.0567 -0.0115
Standard deviation 0.0545 2.1406
Min -0.3489 -9.5155
Max 0.1542 8.5324
Skewness -0.6576 0.3291
Kurtosis 6.1230 4.9121
Jarque-Bera 371.2898 132.2232
(P-value) (0.0000) (0.0000)

the excess returns. In stock markets, the change in trading volume is a popular market
indicator. Trading volume always signals stock prices. Investors observe the most recent
changes in trading volume to make their investment decisions. As a result, the change
in trading volume at the current period (St ) can reflect more useful information.
We summarize some findings from the model 1 of Table 2 as follows. First, the
estimated coefficient for the time-invariant long term average excess returns γ0 is negative
and significant. The results are consistent with Table 1 which indicates that excess
returns for Taiwan stock market has a negative average during the sample period.
Second, the investor sentiment has a positive and significant influence on excess
returns. Consistent with our mention in section 3.3, positive change in the trading volume
indicates bullish shift in investor sentiment and a negative change in volume is bearish
shift. That is, when investors are optimistic about the market, they gain higher returns;
when investors are pessimistic about the market, they earn lower returns. Lee et al. [23]
report the similar findings. They also find that there is a positive correlation between
excess returns and changes in sentiment in DJIA, S&P500, and NASDAQ. Moreover,
our results confirm the validity of the hypothesis that the more the changes in investor
sentiment, the higher the excess returns on the considered period.
Third, the estimated coefficient for the time-variant excess returns γ2 indicates that
there is a negative and significant relationship between the conditional volatility and
time-varying portion of excess returns. γ2 is a measure of the risk-return tradeoff. This
result seems to contradict the CAPM, but consists with previous finding of Glosten et
al. [16] and Lee et al.[23]. They argue that investors are rewarded by taking reasonable
amount of risk, but are hurt by taking high level of risk. Based upon conventional CAPM,
investors earn higher return by taking more systematic risk, but not the idiosyncratic
risk. Only if the noise trader risk is the systematic risk, investor can receive rewards for
taking such risk. Our results imply that the volatility resulting from investor sentiment
should be the unsystematic risk, not market risk.
Fourth, all of estimated GARCH coefficients are significant. α2 is positive and
significant. The results reveal there is leverage effect between positive and negative
shock. And which confirms the bad news cause higher conditional volatility. The result
is consistent with the finding of Glosten et al. [16].
24 International Journal of Information and Management Sciences, Vol. 21, No. 1, March, 2010

Table 2: Investor sentiment, excess returns, and conditional volatility.

Base model Model 1 Model 2 Model 3 Model 4

Parameters
(without St ) (with St ) (with St−1 ) (with %St ) (with %St−1 )
γ0 0.2141*** -0.0949*** 0.2102*** 0.2174*** -0.8972***
γ1 ——— 0.0089*** - 0.0006 0.0762*** -0.0018
γ2 0.0425*** -0.0061** 0.0419*** 0.0407*** -0.1344***
γ3 -0.0055 -0.0084 -0.0005 -0.0028 -0.0039
α0 0.0008*** 0.0012*** 0.0007*** 0.0005*** 0.0001***
α1 0.0253 ** 0.1398*** 0.0359*** 0.0010 0.0006
α2 0.0575** 0.1731** 0.0463*** 0.0563*** 0.0027***
β1 0.7805*** 0.4545*** 0.7804*** 0.8152*** 0.9009***
φ1 0.00001 -0.00001 0.0000 0.0007*** -0.0003***
φ2 -0.00001 -0.00004*** -0.0000 -0.0006*** 0.0004***
φ3 -0.0077*** -0.0061*** -0.0077*** -0.0049*** 0.0015***
Log-likelihood 1305.32 1304.45 1304.71 1435.32 1365.70
LB Q-Statistic 2.7932 1.2272 2.4614 1.3738 28.3626
P-value (0.0254) (0.2978) (0.0040) (0.2413) (0.0000)
*, **, *** denotes coefficient estimates significant at 10%, 5%, and 1% level, respectively.
The base model does not include the effect of sentiment proxy. Model 1 uses the change
in trading volume in current period (St ) to consider the effect of sentiment index. Model
2 takes the change in trading volume of previous period (St−1 ) to consider the effect of
investor sentiment. Model 3 takes the percentage change in trading volume of current
period (%St ) to consider the effect of sentiment. Model 4 employs the percentage change
in trading volume of previous period (%St−1 ) to consider the effect of investor sentiment.

Furthermore, the coefficient φ1 measures the bullish magnitude in investor sentiment

and the coefficient φ2 is for the bearish magnitude in investor sentiment. The components
of bullish and bearish magnitude in sentiment consider the lagged investor sentiment,
∆St−1 . Even in the model 2 and model 4, lagged sentiment proxies in the mean equation
are not significant, they are important to form the market’s conditional volatility. Our
results find that only bearish magnitude in sentiment has significant and negative effect
on conditional volatility and excess return. That implies volatility is influenced by the
magnitude of lagged bearish sentiment. When the magnitude of lagged bearish sentiment
increases, the market’s conditional volatility gets lower. However, there is no significant
finding for bullish magnitude in investor sentiment. Based upon results of Lee et al. [23],
bullish and bearish shifts in investor sentiment have an asymmetric impact on conditional
volatility. Investors buy stocks when they are optimistic about the stock market. They
would buy the same stocks at roughly the same time or imitate their judgment with
others (Shiller [29]). Consequently, the trading volume of the stock market increases
along with a rising volatility and stock prices rise at the same time. On the other hand,
when investors are pessimistic about the market during the period of the downward
correction, some investors decide not to sell stocks to avoid realizing loss, and some
decide not to buy any stocks until the price correction completes. Thus, the trading
 Fluid Model Driven by an M/M/1/N Queue with Single Exponential Vacation 25

volume of stock market decreases with a declining volatility and stock prices fall. The
empirical results are consistent with the arguments of Shiller [30]
Finally, based upon the finding of Lee et al. [23], the risk-free rate exhibits positive
influence on volatility. However, Glosten et al. [16] state when the inflation rates are
higher in the future, the volatility is general greater. Our results show the risk-free rate
has negative and significant impact on the volatility. The reason might be there is no
high inflation rate in the sample period. Especially after year 2000, the interest rate gets
lower and the economy suffers from the deflation, so we find negative relationship be-
tween the risk-free rate and conditional volatility. Overall, our empirical results support
the sentiment proxy provides significant effects on excess returns and the formation of
conditional volatility.

4.3. Robustness check over subperiods

In this section we examine the robustness of our results. We divide the whole sample
period into two subperiods. Subperiod I is from January 4, 1990 to July 27, 1996 and
Subperiod II is from July 29, 1996 to December 31, 2004. For each subperiod, we do the
same procedures as we do for the whole sample period, running all of the Models. The
results are presented in Table 3.
From Table 3, in each subperiod we also find the contemporary sentiment proxy
has better explanatory power in excess return and conditional volatility, not the lagged
sentiment proxy. Moreover, in subperiod I, Model 1 with St as the sentiment proxy also
shows better explanatory among excess returns, investor sentiment, and volatility. Most
results consist with the whole sample period. However, bullish magnitude in sentiment
shows significant and positive effect on conditional volatility and excess return. This
finding is consistent with the argument of section 4.2. Moreover, the risk-free rate shows
positive and significant impact on the volatility. In the subperiod I, the interest rate is
higher, so the results do not contradict to Glosten et al. [16]. In subperid II, there is
no well-specified model with sentiment proxy. During this subperiod, the stock market
experiences the Internet bubble and market crash, which causes unusual volatility. This
is a possible reason we can not find well-specified model with sentiment proxy.

5. Concluding Remarks

In this paper, we use the change in trading volume as a proxy for unpredictable
investor beliefs and model the impact of investor sentiment on excess returns. First,
we find the change in trading volume can be used as a proxy for investor sentiment.
The change in trading volume can provide some information about investors’ irrational
behavior. When investor sentiment is bullish, the trading volume increases. On the other
hand, bearish sentiment induces investors to sell stocks at first and then decrease trading
to avoid loss realization afterwards. In addition, we find the change in trading volume
at current period has more persuading power for investor sentiment.
Secondly, a GARCH-M model with asymmetric effects is suitable to explain the re-
lationship among the investor sentiment, excess returns, and the volatility in the Taiwan
26 International Journal of Information and Management Sciences, Vol. 21, No. 1, March, 2010

Table 3: Robustness of Investor sentiment, excess returns, and conditional volatility over subpe-
riods.
Base model Model 1 Model 2 Model 3 Model 4
(without St ) (with St ) (with St−1 ) (with %St ) (with %St−1 )
Panel A: Subperiod I (January 4, 1990 ∼ July 27, 1996)
γ0 0.2186*** -0.1575*** -0.2395*** -0.2168*** -0.2024***
γ1 ——— 0.0158*** -0.0009 0.0753*** -0.0033
γ2 -0.0240*** -0.0136*** -0.0274*** -0.0227*** -0.0214***
γ3 -0.0223** -0.0203*** -0.0224** -0.0134* -0.0223**
α0 -0.0004*** -0.0002*** -0.0005*** -0.0007*** -0.0006***
α1 0.0115 -0.0493*** 0.0367 0.1520*** 0.0824**
α2 0.0411 0.0416*** 0.0175 -0.0438 0.0086
β1 0.9219*** 1.0222*** 0.8728*** 0.6308*** 0.8509***
φ1 0.00004 0.00002*** 0.00001 -0.0013*** -0.0001
φ2 -0.00004 0.0000 -0.000002 0.0013 0.0008
φ3 0.0070*** 0.0019* 0.0096*** 0.0161*** 0.0113***
Log-likelihood 554.69 613.38 554.51 611.78 554.57
Panel B: Subperiod II (July 29, 1996 ∼ December 31, 2004)
γ0 2.0169 -1.3630* 0.0482** -0.9374*** 2.2255***
γ1 ——— 0.0078*** -0.0004 0.0819*** -0.0055
γ2 0.3241 -0.1989* 0.0145*** -0.1319*** 0.3577***
γ3 -0.0026 0.0021 -0.0004 0.0029 0.0011
α0 0.0004* 0.0004** 0.0007*** 0.0001*** 0.0002***
α1 0.0020 0.0021 0.0528 -0.0017 0.0015
α2 -0.0001 -0.0070 0.1263** -0.0051 -0.0023
β1 0.8012*** 0.5954*** 0.7086*** 0.8941*** 0.8803***
φ1 0.0000 -0.00001* 0.0000 -0.0004*** 0.0001**
φ2 -0.0000 0.00001 0.0000 0.0002 0.0002***
φ3 -0.0012 0.0029 -0.0090*** -0.0010*** -0.0006**
Log-likelihood 814.84 894.72 763.64 915.35 820.10
*, **, *** denotes coefficient estimates significant at 10%, 5%, and 1% level, respectively.
The base model does not include the effect of sentiment proxy. Model 1 uses the change
in trading volume in current period (St ) to consider the effect of sentiment index. Model
2 takes the change in trading volume of previous period (St−1 ) to consider the effect of
investor sentiment. Model 3 takes the percentage change in trading volume of current
period (%St ) to consider the effect of investor sentiment. Model 4 employs the percentage
change in trading volume of previous period (%St−1 ) to consider the effect of investor
sentiment.

stock market. Investor sentiment has a positive and significant influence on excess re-
turns. Shifts in the beliefs of investor sentiment have significant effects on the market
volatility. The results show that noise traders do have influences on the price formation
of stocks and the market volatility.
Finally, the conditional volatility and excess returns have a negative and significant
relationship. The irrational sentiment affects on stock valuations. However, the volatility
resulting from investor sentiment gives rise to idiosyncratic risk, not systematic risk.
 Fluid Model Driven by an M/M/1/N Queue with Single Exponential Vacation 27

Our results imply that the volatility resulting from investor sentiment should be the
unsystematic risk, not market risk.
In conclusion, our study shows that investor sentiment affects stock prices in Taiwan
stock market. In Taiwan stock market, the change in trading volume is a common market
indicator for investors. Investors usually observe the change in trading volume first and
then make their investment decisions. Hence, the change in trading volume can reflect
some degree of investors’ expectations in Taiwan stock market. Indeed, our findings
highlight the importance of investor sentiment on the prices and volatility formation.
Nevertheless, questions remain as to make investment strategies based upon investor
sentiment. We hope to address such topic in our ongoing research.

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Authors’ Information
Wu-Jen Chuang is currently the associate professor in Department of Banking and Finance, Tamkang
University, Taiwan, R.O.C.. His research interests are Financial Markets, Econometrics, and Banking.
Department of Banking and Finance, Tamkang University, Tamsui, Taipei, Taiwan 251, R.O.C.
E-mail: ewjch@mail.tku.edu.tw TEL: +886-2-2621-5656 ext. 3335
Liang-Yuh Ouyang is a Professor in the Department of Management Sciences and Decision Making at
Tamkang University in Taiwan. He earned his Ph.D. in Management Sciences from Tamkang University.
His research interests are in the field of Production/Inventory Control, Probability and Statistics.
Department of Management Sciences and Decision Making, Tamkang University, Tamsui, Taipei 251,Tai-
wan, R.O.C.
E-mail: liangyuh@mail.tku.edu.tw TEL: +886-2-2621-5656 ext. 2075
Wen-Chen Lo is currently the Ph.D. candidate in Graduate Institute of Management Sciences, Tamkang
University, Taiwan, R.O.C. and the Instructor of Department of Finance in St. John’s University, Taiwan,
R.O.C.. Her research interests are Financial Markets and Behavioral Finance.
Department of Finance, St. John’s Universiry, Taiwan, R.O.C.
E-mail: wenchen@mail.sju.edu.tw TEL: +886-2-2801-3131 ext. 6553