Hongkong Stock Exchange from 1997-2007 - Essay Example

A Study of Market Efficiency and Overreaction at the Hongkong Stock Exchange from 1997-2007 Introduction A basic issue discussed in studies of financial markets is its efficiency. Financial market efficiency implies that prices reflect the intrinsic values of stocks being bought and sold in the market, and that stock price behaviour over time is a random walk. If prices develop in a predictable manner, arbitrageurs would discern the trends, act on them, and make money at a rate above normal market returns and their actions would quickly bring stock prices to their intrinsic values. This set of assumptions is defined by the Efficient Market Hypothesis (EMH) studied by Fama (1970). Several tests could be used to test for market efficiency. The most common tests are for market anomalies such as the January, Day-of-the-Week, and Size Effects. Another is to prove that any of the assumptions of EMH is not true; for example, that there is a way of predicting stock prices so that those who are able to do so can earn above normal market returns. Practitioners of finance and economics who have studied stock market behaviour have proposed several hypotheses, one of which is the so-called Overreaction Hypothesis (ORH). ORH originated from the field of applied psychology and is a statement of behavioural prediction that people tend to overreact to dramatic news and events, regardless of whether these events are positive or negative. On the other side and related to this hypothesis is its opposite: underreaction, a phenomenon that can also be considered. ORH provides a way of making decisions to buy and sell stocks, because if it is true, then some investors can earn above market returns by buying underperforming stocks and selling overperforming stocks, taking advantage of over- or under-reaction of other investors. The Hongkong economy has been identified as the one with the freest and, in the absence of artificial market barriers that cause inefficiency, therefore the most efficient financial markets, as it was given the highest Index of Economic Freedom1 (Heritage, 2006). This paper attempts to prove this by investigating whether the ORH phenomena exist in the Hongkong Stock Exchange (HKSE). Dissertation Objectives This dissertation has the following objectives: 1. Review the literature on the hypotheses of efficient markets (EMH) and overreaction (ORH). 2. Conduct a review of literature about the efficiency of the HKSE. 3. Investigate presence of ORH in HKSE for the period 1 April 1997 to 31 March 2007 using the methodology of Fung (1999) which is similar to DeBondt and Thaler (1985) but using the geometric mean, instead of the arithmetic mean, to reduce error caused by bid-ask spread as pointed out by Conrad and Kaul (1993). 4. Explain reasons for the presence of ORH, if any, in HKSE during the period. 5. Check for presence of other anomaly, e.g., January Effect, and explain reasons. Review of Literature Fama (1970) popularised the Efficient Markets Hypothesis (EMH) which states that stock prices reflect all available information and that it is not possible to beat the market by earning above normal returns. Several academics, proponents of so-called behavioural finance, think that it is possible to beat the market careful analysis of historical price trends and financial reports (Shiller, 1990; Daniel, Hirshleifer, and Subrahmanyam, 1998). They claim that the stock market has anomalies and market inefficiencies that allow investors to earn higher returns compared to the market. Those who believe in ORH belong to this group. Rosenburg and Rudd (1982) were the first to present empirical evidence of OR, but it was DeBondt and Thaler (1985; 1987) who confirmed the initial findings and whose research on the topic continue to be used to this day. Several academics investigated for ORH and found empirical evidence supporting it (Brown and Harlow, 1988; Zarowin, 1989). Evidence of ORH were found in large companies in the U.S. (Bremer and Sweeney, 1991), in the U.K. (Clare and Thomas, 1995), Taiwan (Lin, 1988), and Japan (Chang, McLeavey, and Rhee, 1995). Yang (1999) used 20-year monthly return data to examine how stock prices reflect available information in a biased manner by tending to either go abnormally high or unreasonably low and concluded that short-term overreaction in Taiwan is not as powerful as in other equity markets. In Hongkong (HKSE), Fung (1999) showed evidence of ORH for 33 stocks during the period 1994-1996. Otchere and Chan (2003) examined the short-run overreaction phenomenon in the HKSE using data from March 1996 to June 1998 during the pre- and post-Asian financial crisis period. They showed evidence of ORH in the market prior to the crisis with the phenomenon more pronounced for winners and losers, but that abnormal profits obtained from exploiting the occurrence are economically insignificant after accounting for transaction costs. They also explored the possibility that results were affected by factors such as bid-ask bounce, the size effect, and the day-of-the-week effect. Similar studies were conducted to investigate the ORH in other countries. Antoniou, Galariotis, and Spyrou (2005) found that, when January returns are excluded, profits in the Athens Stock Exchange (ASE) were influenced more by firm-specific rather than common factors, with results reinforced by allowing for time variations in factor sensitivities. Bowman and Iverson (1998) discovered significant price reversals in the New Zealand Stock Market, especially in the case of large price declines and that evidence showed that reversals increase in magnitude as the initial price change increases. Gaunt (2000) found evidence of price reversal where monthly portfolio rebalancing is employed in the Australian stock market, but such price reversal disappears when a buy and hold strategy is used. Mun, Vasconcellos, and Kish (2000) investigated ORH using a non-parametric methodology with a multi-factor asset pricing model within both the U.S. and Canadian stock markets. Experiments showed that, for the U.S., short-term and immediate-term portfolios yielded significant excess returns above market, whilst for the Canadian market, intermediate-term portfolio worked best. Although there was evidence of the ORH from the behaviour of stock prices in several markets, the next problem was how to explain it. Cox and Peterson (1994) attributed it to market liquidity and the bid-ask bounce. Others showed that profits from ORH are not significant if return calculations are adjusted for the following factors: Seasonality (Brown and Harlow, 1988; Zarowin, 1989; Pettengill and Jordan, 1990) Time frame used for return calculations (Ball, Kothari, and Wasley, 1995) Firm size effects (Zarowin, 1990) Use of bid instead of ask prices to calculate returns (Ball et al., 1995), and Risk change (Chan, 1988). One anomaly cited as proof of market inefficiency is the so-called January effect that can be stated simply as “stock prices tend to go up in January” (Gultekin and Gultekin, 1983). Methodology This paper will test for market efficiency by testing for evidence of the overreaction hypotheses (ORH) in the Hongkong Stock Exchange (HKSE). First, we observed HKSE stocks behaviour from 1 April 1997 to 31 March 2007 and noted that of the stocks that have been in the Hang Seng Index (HSI) during the period, there were 31 that have been in the index for at least five years. Table 1 shows what these are. Second, we selected these thirty-one (31) stocks in the Hang Seng Index (HSI) traded for more than five years during the period and download end-of-month prices, year-end market values, and other data. The HSI total return will give us a value for the market return. Third, using the formulas in Fung (1999), we calculate the cumulative return of each stock in a period of T months and the total return of the stocks in the HIS for the formation periods and testing periods, using the geometric mean instead of the arithmetic mean. The formation periods are for two years (1997-1998, 1998-1999…2006-2007) over a total of ten years. All the stocks from the data group in each of the formation periods are ranked on the basis of their excess cumulative returns (ECR). The portfolio of the six stocks with the highest prior ECRs will be the winner portfolio, whilst the portfolio of the six stocks with the lowest ECRs is the loser portfolio. One-year testing periods (1998, 1999…2007) will be used, and in each testing period, the average excess returns of the winner portfolio (AERW), the loser portfolio (AERL), and the arbitrage portfolio (AERA) are calculated. Fourth, again using Fung (1999), we calculate the average of AERW and AERL for all testing periods to get the grand average excess returns of the winner (GAECRW) and loser (GAECRL) portfolios. Fifth, we use the traditional t-test to know the statistical significance of the values of GAECRW, GAECRL or AERA to determine if there is evidence of ORH and discuss what would account for these. Sixth, we test for the January effect based on graphical presentation of our results. Dissertation Structure The dissertation is divided into five parts. The Introduction (1) gives an overview of the paper and the significant events in Hongkong during the period under study and summarise the hypotheses of our study of testing for market efficiency and the presence of above normal returns due to ORH. A literature review (2) summarises academic and empirical findings to-date on the problem. Data and methodology (3) discusses the process of gathering data, the detailed methodology used in the study, the problems and issues encountered in the course of the research, and the equations used for analyses. Empirical results (4) present the findings from our analyses of overreaction and January effect using data gathered for our study. The conclusion (5) summarises our findings and whether these prove or disprove our hypotheses. Table of Stocks # Code Company 1 1 Cheung Kong 2 2 China Light 3 3 HK & China Gas 4 4 Wharf (Holdings) 5 5 HSBC Holdings plc 6 6 HK Electric 7 8 HK Telecom  CWHKT (2000) 8 10 Hang Lung Dev 9 11 Hang Seng Bank 10 12 Henderson Land 11 13 Hutchison 12 14 Hysan Dev 13 16 SHK Prop 14 17 New World Dev 15 19 Swire Pacific A 16 20 Wheelock 17 23 Bank of E Asia 18 66 MTR Corporation 19 83 Sino Land 20 97 Henderson Inv 21 101 Amoy Prop 22 179 Johnson Electric 23 267 CITIC Pacific 24 291 China Resources 25 293 Cathay Pac Air 26 494 Li & Fung 27 511 TVB 28 762 China Unicom 29 883 CNOOC 30 941 China Mobile 31 1038 CKI Holdings Years in Index Ten (30/8/96 to-date) Six to 9 Six (in and out) Five Source: Hang Seng Index (2007) Reference List Antoniou, A., Galariotis, E. C. and Spyrou, S.I. (2005). Contrarian profits and the overreaction hypothesis: The case of the Athens Stock Exchange. European Financial Management, 11 (1), 71-98. Ball, R., Kothari, S. P., and Wasley, C. E. (1995). 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