It has been argued and empirically documented that with a looming financial crisis, the risk-reward trade-off of market participant changes, resulting in a decrease in market sentiment. Traders flock towards less risky securities which drives the returns of such securities higher. In this paper, based on a methodology developed by Persaud , by correlating the riskiness and returns of securities in various international equity markets, an index to measure the sentiment of market participants is constructed. We use the breaking point of the Lehman Brothers bankruptcy as the onset of the financial crisis in 2008.
We track the market sentiment that we construct in months leading to the bankruptcy. We find that while market sentiment was high at the beginning of the year it started declining drastically many months prior to the bankruptcy, indicating that market participants were behaving as if a financial crises was approaching. Market sentiment remains low in a few months after the crisis, shows some improvement thereafter in anticipation of policies to address the crisis, but still remains depressed as compared to pre-crisis levels as policy makers struggle to formulate regulatory changes.
The findings in this paper are consistent with an emerging strand of finance literature [see, e.g., Bezemer, 2009] which disputes the notion that the financial crisis could not be foreseen. Market participants were convinced of the impending crisis and were behaving in a manner consistent with that, even when policy makers and senior executives the financial services seemed oblivious.
Bandopadhyaya, Arindam and Truong, Derek, "Who Knew: Financial Crises and Investor Sentiment" (2010). Financial Services Forum Publications. Paper 10.