Event study for efficient market hypothesis ex dividend data - Dissertation Example

? Research Proposal Event Study for Efficient Market Hypothesis – Ex Dividend Data Finance and Accounting Table of Contents 3 Efficient Market Hypothesis 4 Types of Market Efficiency 5 Literature Review 6 Purpose of the study 9 Event to be studied 9 Indian equity market 10 Why India? 10 Methodology and data 11 The event study approach 11 Data 12 Hypothesis 12 Reflections 14 Empirical data collection and analysis 14 Scope of Study 14 Conclusion 15 References 16 Abstract Today, every media source provides us with schemes in the stock market to get rich quick. Just follow this strategy, or here’s the hottest new stock guaranteed to make money. A large industry is devoted to providing information to investors so they can make decisions about their investments. An important issue in corporate finance involves the inferences the market draws from managerial decisions. Market efficiency is a very important hypothesis for investors who want to build a diversified portfolio. Recent empirical studies document stock price responses to announcements of events like dividends, stock-split and capital structure changes. A plausible explanation for these findings is that changes in the optimal dividend and debt levels stem from changes in, expected cash flows, and thus, signal a change in firm value. This research aims to test the efficient market hypothesis in the context of Indian stock market. We will study the same with ex-dividend declaration in the Indian stock markets. Keywords: Efficient market hypothesis, Random walk hypothesis, Indian stock market Efficient Market Hypothesis The theory ‘efficient market’ was formulated by Eugene Fama in 1970. He described an efficient market as a market where at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. The efficient market prices represent the intrinsic value of the securities. Researchers have developed this hypothesis to be known as the Efficient Market Hypothesis (EMH) which states that the market prices reflect all information known to the public. Market react to any new information available in the market immediately as reflected in stock prices rather than gradually adjust it. This theory is an important concept in the area of understanding equity markets and cost of equity capital. Another important concept in the area of equity markets is that of random walk hypothesis. According to this hypothesis, the anticipated price of an asset fluctuates randomly around its expected value (Samuelson, 1965). Both the efficient market and random walk hypothesis, it is a futile exercise to try and find overpriced and under-priced assets. This is because, in an efficient market, the assets in the stock market are already reflecting all the available information. There are no future predictions that can be made about how a market will behave. The price of any assets is already a reflection of the best estimates for the expected risk and return of the assets. The suggestion that all the information known about past, present and future events is reflected in the current market prices means that the financial analysts are snake oil salesmen. This is why the EMH is such a controversial hypothesis. However, in an inefficient market, investors can identify miss-priced assets. Identifying the same can enable an investor to achieve gains (Rutterford, 1993). Because of these reasons, these hypotheses provide a solid theoretical and predictive model about the operations of the financial markets and influence more people to invest in stock market (Will, 2006). Types of Market Efficiency There are three primary categorization of EMH given by Fama (1970) according to the type of information reflected in the stock price – 1. Weak-form efficiency - Share prices reflect all past information and thus, rules out the possibility of predicting future stock prices on the basis of past price data alone. 2. Semi strong-form efficiency - A market is semi strong-form if share prices reflect all the relevant publicly available information. It also includes earnings and dividend announcements, technological breakthroughs, mergers and splits, resignation of directors, and so on. 3. Strong-form efficiency -Market in which share prices reflect not only publicly but also the privately available information. It is assumed that all the information is available to everybody at the same time. Even an insider who has private information about a company cannot earn abnormal profits in strong form of market efficiency. Literature Review Event studies have a long history, including the original stock split event study by Fama, Fisher, Jensen, and Roll (1969). Fama (1970) organized the already growing empirical evidence on the efficient market hypothesis. He stated that the current market price of assets in equity markets fully reflect all the available information and the expected return on an asset is based on the price that is consistent with the risk. Bachelier (1990) stated that the asset prices follow a random walk. Inconsistent evidence with the efficient market, hypothesis started to accumulate in the late 1970s and early 1980s. Evidence on the post earnings announcement effects (Ball and Brown, 1968, and Jones and Litzenberger, 1970), size effect (Banz, 1981), and earnings yield effect (Basu, 1983) contributed to skepticism for Capital Asset Pricing Model as well as market efficiency.According to the theory of information efficiency, security prices should reflect immediately all information available to the efficient capital market. As positive information and trading cost can be expected, this extreme efficiency hypothesis cannot be held. Fama (1998) in his survey studied the various event studies that intend to validate if the stock prices respond to new information. The events studied include announcements such as earnings surprises, stock splits, dividend, mergers, new exchange listings and initial public offerings. It was found that under-reaction to information announcement is as common as overreaction to the information. Studies in testing the market efficiency in emerging markets like India are very few. Poshakwale (1996) used Bombay Stock Exchange (BSE) index data for period from 1987 to 1994 to test the hypothesis. He concluded that the Indian stock market is having weak form inefficient. Gupta and Basu (2007) found mixed evidence for weak form efficiency in the Indian stock market from 997 to 2006. In a study for efficient market hypothesis for major Asian markets, researchers found that these markets are weak form efficient (Barua, 1987 and Chan, Gup & Pan, 1997). Ho and Cheung (1994) found similar results for Asian market. Dickinson and Muragu (1994) studied the Nairobi stock market for the hypothesis and found out that it follows weak form efficient. Kuala Lampur stock market has been found to show high efficiency (Barnes, 1986). Groenewold and Kang (1993) found out that the Australian stock market is semi-strong. Kim and Shamasuddin (2008) studied a group of Asian stock markets. It was concluded that while Japanese and Taiwanese markets are weak-form efficient, the markets of Malaysia and Philippines are inefficient. Asian crisis has led to Singaporean and Thai market to be efficient. Ryoo and Smith (2002) used variance ratio test to test if the price limits of assets are relaxed during the period from March 1988 to Dec 1988 on Korea stock exchange. They found that the market prices follow a random walk process. Mahmood et al, 2011 applied ADF, DFGLS, PP and KPSS test on Shenzhen and Shanghai stock exchange and found that both are weak form efficient. They also found that the past stock data can’t be used to make excess returns. In a study to test the efficiency of Chinese stock market from 2001 to 2008, Liu (2010) used unit root test, autocorrelation function, BDSL, Engle – LM and AR (p) – EGARCH and AR (p) – TARCH. They found that the markets are not weak-form efficient. Other studies that have tested the efficient market hypothesis include Hong Kong (Jarrett, 2008 and Cheung & Coutts, 2001); Slovenia (Dezlan, 2000); Spain (Regulez and Zarraga, 2002); South Africa (Smith et al., 2002 and Appiah- kusi & Menyah, 2003); middle-east (Abraham et al., 2002). Healey and Palepu (1988) in their study found out that ex-dividend initiation are associated with positive stock price reactions while dividend omissions are associated with negative stock price reactions. There have been several research works done by various researchers to test the impact of dividend declaration on the stock price. Szewczyk et al. (1997) in their research studied the cumulative abnormal returns for a sample of companies announcing dividend omissions. They concluded that there was no movement in the CAR in the days following the announcement. This implies that the stock price already incorporates the bad news. Various studies (Pettit (1976); Watts (1973, 1976a, 1976b); Laub (1976); Aharony and Swary (1980); Eades (1982); Asquith and Mullins (1983); and Brickley (1983)) have concluded that the stock market’s reaction to dividend announcements is efficient. Eades, Hess and Kim (1984) in their paper “On interpreting security returns during the ex-dividend period” concluded that stock prices, on average, react positively to stock dividend announcements that are uncontaminated by other contemporaneous firm-specific announcements. In addition, they document significantly positive excess returns on and around the ex-dates of stock dividends. Both announcement and ex-date returns were found to be larger for stock dividends than for stock splits. Purpose of the study The purpose of this study is to study the effect of ex-dividend declaration on stocks listed in India. We want to test whether investors gain any abnormal returns using such surprise information. This will help us in analysing the efficiency of the Indian Stock Market. In addition, it will also provide food for thought to the policy makers in order to increase the market efficiency and thereby capital inflows. Event to be studied The event we studied is the effect of ex-dividend announcement on the return investors get in the stock market. Indian equity market We will be studying the effect of ex-dividend declaration on stocks listed in India. The two major stock exchanges in the country are – the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). BSE has more number of companies listed than any other stock exchange in the world. The market capitalization of BSE in December 2010 was US 1.63 trillion. While BSE is the oldest stock exchange in India, NSE is relatively new and is becoming more easily accessible to domestic and foreign investors. Why India? India is a very fast growing economy. Post the opening-up of the economy in 1991; the country has witnessed huge inflows of cash. This has resulted in an increased demand in investment funds. Equity markets have played a very crucial role in the growth phenomena. This makes it necessary to test the efficiency of the markets and their role in the economic development. However, there are very few studies that have tested the efficiency of the Indian stock markets. Most of these are inconclusive. This study will enable us to understand the form of efficiency for the Indian stock market. Methodology and data Market efficiency can be gauged by the short-term movements in the returns generated by the market. If there is no pattern in the movement, it can be said that the market return follows a random walk which implies that the market is efficient. Moreover, we can’t identify patterns to forecast future equity prices. In contrast, a pattern can be used to predict the market prices in case of non-efficient markets. Various researchers have used different statistical techniques to test for market efficiency. While Bradley (1968) used Runs test, Lo and MacKinlay (1988) used LOMAC variance ratio test to test weak form of efficiency and random walk hypothesis. Durbin and Watson (1951) used the Durbin-Watson test while Dickey and Fuller (1979) used augmented Dickey-Fuller test for testing random walk hypothesis. The event study approach Identify the event. In our case it is companies rolling out ex-dividend Identify the variable to be studied. We will study the variable stock returns Identify an “event horizon”. The event horizon is a set of days N before the event, and an equal number of days after over which we expect that the event could have had the major, if not the sole, impact on price. We have collected data for 90 days. 10 days (-5 to +5) have been removed to correct for any statistical anomalies that might be present in a single day of data Identify a set of firms K that have undergone this event. We have identified a set of 50 firms in India who have gone for ex-dividend in the recent past This is followed by calculating the alpha and beta for the firms as per the Capital Asset pricing model. This is followed by calculation of the expected return for each firm as per CAPM. From the expected return and actual return, the abnormal return is calculated which is the difference between the two. The formula for the same is: The abnormal returns for all the companies from -5 days to +5 days were added for each day to calculate the cumulative abnormal return (CAR). For each day, the CAR for each firm was added and divided by 50 to calculate the mean CAR. The t-statistic is calculated for each day’s CAR The t-statistic is then tested for significance to see if there is any impact on the returns of the announcement. If the t statistics are statistically significant, the event (ex-dividend announcement) affects returns The sign of the excess return determines whether the effect is positive or negative. Data The sample space comprises of 50 companies. We have collected data for 100 days before the event and 5 days after the event. The companies have been chosen randomly. The daily return of all these companies and their corresponding exchange (BSE or NSE) has been taken for the purpose of analysing the event. The data for the companies has been taken from the stock exchange websites. Hypothesis The t-test is the appropriate test used here. The hypothesis is: a. Formulation of hypothesis: Null hypothesis H0: Ex-dividend announcement does not affect the gains realized by investors. Alternative hypothesis H1: Ex-dividend announcement affects the gains realized by investors. b. Level of significance: The standard levels of significance for t statistics are: Significance Level One Tailed Two Tailed 1% 2.33 2.55 5% 1.66 1.96 For the purpose of our research, we will use the significance level of 1%. Since we do not intend to test the direction of the difference of the impact on the stock price, therefore we use the two-tailed test. Reflections Empirical data collection and analysis The study requires data for stock markets in India (BSE and NSE). We need to identify 50 stocks that have gone for dividend in our defined time period. This can be done from the stock market websites. Efforts will be made to ensure collecting the data for the most recent dividend declarations. We also need prices for these stocks over a long period. This data is easily available on websites like Yahoo! Finance. This suggests that data collection for this proposal will not incur any cost. The analysis of the data will be done using the statistical package SPSS 16.0. Proper understanding of the working of the software will be necessary in order to perform the required statistical test. Scope of Study The study involves the verification of stock market efficiency only with respect to dividend declaration. The study does not take into account any other events that might happen over the period. The event horizon becomes an important variable affecting robustness: the longer the horizon, the noisier the inference. However, some of the event studies are only meaningfully applied over the longer term. Conclusion This proposal provided for an overview of the research that will be undertaken to assess the market efficiency of Indian stock markets. The aim of this research is to understand the form of efficiency of Indian stock markets and contribute inputs to the policy makers on ways to improve the market efficiency. Thorough and in-depth literature will need to be carried out to understand the intricacies of the financial market and the importance of the market efficiency. For this purpose, a variety of sources shall be referred to from time to time, including news, media and academic texts. In addition to various sources, a variety of research papers published on similar issues will also be considered, such as papers referenced from various online databases such as EBSCO. The findings of the research will enable us to understand the concept of market efficiency in the context of Indian stock market. This will be done by validating if the market reacts to announcements such as ex-dividend declaration. With the progress of the study, and more analysis of past studies, I might make few necessary changes in the variable structure of the study. Changes in the model may also be made keeping in mind the findings of initial analysis. 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The Role of “Performances” in an Accounting Scandal: An Insider’s Perspective on How Things Went Wrong, Proceedings of 5th Global Conference on Business & economics, Cambridge University, UK, Paper No. 152. Read More