The role of the temporary component in spot prices in the revision of expected future spot prices: Evidence from index futures quotes

Abstract

It is frequently argued that foreign investors have extrapolative expectations due to their informational disadvantages. That is, in the absence of other sources of information, foreigners revise their expectations on the future price of a domestic stock more in line with its current price change than do domestic investors. In this study, we analytically show that foreigners might respond more to a price change because they pay relatively less attention to a temporary component in pricei.e. because they are more well-informed. We confirm this hypothesis with a simple yet powerful test that is designed by the identification schemes arising directly from the nature of a temporary component and by the access to a direct measure of the investor's expectation, namely, the quote for futures contracts. After controlling for the temporary component effect and using the leadlag relationship between the spot and futures markets, we show that foreign investors are indeed most well-informed, whereas domestic individuals are at the other end with the most extrapolative expectations. Finally, domestic institutions are largely indistinguishable from foreigners but are noticeably different from domestic individuals.