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Abstract: This paper examines the nonlinear effects of investor sentiment on asset pricing in Bursa Malaysia. The Fama and French three-factor model is re-augmented within a time-varying Markov regime-switching framework to investigate the three risk premiums, conditioned by four different proxies for investor sentiment (i.e. market-wide indicators). The study finds evidence that the stock returns movement of Bursa Malaysia exhibits a nonlinear two regimes pattern. Besides, changes in the investor sentiment to some extent function as a mediator in the regime switching dynamics between bear and bull market cycles in Malaysian stock returns. It is also found that an increase in positive sentiment of investors leads to a higher transition probability of regime switching during bear markets. In addition, the three risk premiums are time-variant, contingent upon the fluctuation of the proxies for investor sentiment within discrete regimes. The study finds that in general, the market premium falls when the stock market switches from bull to bear markets. On the contrary, both the size and value premiums increase when the stock market moves from bull to bear markets.
Keywords: Asset pricing, Bursa Malaysia, investor sentiment, time-varying Markov regime-switching model
JEL classification: G120, G410, C580
(ProQuest: ... denotes formulae omitted.)
1. Introduction
Extreme market volatility in global financial markets is becoming more common. Such volatile fluctuations have been observed during the Brexit, U.S. presidency election, price drop in crude oil and more other world events in recent years. Chen, Tian and Zhao (2017) portrayed 2016 as the year of global black swan events. UK's Brexit (leaving the European Union) vote and Donald Trump's unexpected win in the US presidential election have caused the decline of several stock market indices in the European financial markets and global financial markets over a short period of time. The Malaysian stock market is not isolated from such external shocks and coupled with the 1MDB scandal, investors' confidence deteriorated while the ringgit has been steadily declining over the past one and a half years, according to prominent Malaysian economist Jomo Kwame Sundaram (Idris & Aziz, 2016). Up to date, no conventional finance theories, which perceive market to be rational, can fully explain the irrationalities of behaviour in the stock market. Standard asset pricing theories state that asset prices are determined...