Chapter 1

Introduction

Capital Market Efficiency

1
The efficient market theory states that “prices of securities in financial markets fully
reflect all available information.” (Mishkin, 1997, 693) It is unrealistic to assume every player
in the stock market knows all the relevant information and how to analyze what it means.

However, “Economists have shown that efficient markets do not require that all participants have
information.” (Stiglitz, 1993, 267) It also is not important that all the participants know how to
analyze the information and have rational expectations as to what a securities price should be.
“Not everyone in a financial market must be well informed about a security or have rational
expectations for its price to be driven to the point at which the efficient markets condition holds.”
(Mishkin, 695) All the efficient market requires is that a few people have the information.
When a few participants have the information prices will move as if everyone in the entire
market were well informed. “All it takes is a few people knowledgeable enough to recognize a
bargain, and prices will quickly be bid up or down to levels that reflect complete information.
And if prices reflect complete information, even uninformed buyers, purchasing at current prices,
will reap the benefits.” (Stiglitz, 267)

If all information is reflected in a stock’s price it is unrealistic to assume an investor can

beat the average gains of the entire market, regardless of how much information he or she gathers since
all market participants know all the relevant information. If an individual is able to
outperform the market then it is a result of luck.

“You cannot ‘beat’ an efficient market any more than you can beat the track; you can only
get lucky in it. If you are trying to make money in an efficient stock market, it is not
enough to choose companies that you expect to be successful in the future. If you expect
a company to be successful and everyone else also expects it to be successful, based on
the available information, then the price of shares in that company will already be quite
high.” (Stiglitz, 267)
Under an efficient market, a stock’s price moves up and down only when new,
unexpected information becomes available. “Because prices in an efficient market already reflect
all of the available information, any price changes are a response to unanticipated news.”
(Stiglitz, 268) Since future news is unknown (whether it will be good or bad), it is impossible to
tell which direction the price of a stock is going to move in the future. Therefore, stocks have an
equal chance of increasing or decreasing in value, a phenomenon known as a random walk.

In conclusion, “The efficient market hypothesis assumes all available public information
is fully reflected in a security’s market price. It also assumes that no individual can have higher
expected trading profits than others because of monopolistic access to information.” (Finnerty
1976, 1141)

There is, however, a possible exception to the idea that it is impossible to systematically
beat the market. This exception comes in the form of insider trading.

Company insiders have information unavailable to the public. These individuals have
first hand knowledge of what the company is doing and better information concerning what the
future might hold. If there are likely problems for the company in the future, such as poor
earnings, slow growth, or lawsuits, then insiders can sell their stock before these events happen.
When this information becomes public, the stock’s price should decrease. However, this price
decrease occurs after the insider has sold his or her shares, thus avoiding the loss. In this case the
insider beat the market. On the other hand, insiders know when their company has a bright
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future, high potential earnings, innovative products being developed, etc. When the future looks
bright, insiders can buy shares before the public becomes aware of these facts. The price, later,
fully increases to represent the positive information. In both cases, insiders use private
information to beat the market.

Degrees of Efficiency

Accepting the EMH in its purest form may be difficult; however, there are three identified classifications
of the EMH, which are aimed at reflecting the degree to which it can be applied to markets.
1. Strong efficiency - This is the strongest version, which states that all information in a market, whether
public or private, is accounted for in a stock price. Not even insider information could give an investor an
advantage.

2. Semi-strong efficiency - This form of EMH implies that all public information is calculated into a
stock's current share price. Neither fundamental nor technical analysis can be used to achieve superior
gains.

3. Weak efficiency - This type of EMH claims that all past prices of a stock are reflected in today's stock
price. Therefore, technical analysis cannot be used to predict and beat a market.

In this project we aim at finding whether the capital markets of India,China and Malaysia
are efficient or not.

We ascertain this by performing various tests such as Correlation Tests,Runs Test and Event Study.

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4
CHAPTER
Correlation and run tests on Indian
market(BSE), Chinese (SSE) and Malaysian
(KLSE) market

5
Chapter
Composite Index: calculation and
maintenance

6
Index Calculation
• 1) Base Day, Base Period and Base Value
a) The Base Day for SSE New Composite Index is December 30, 2005 . The Base period is the total
market capitalization of all constituents of that day. The Base Value is 1000. The index was launched on
January 4, 2006 .
b) The Base Day for SSE Composite Index is December 19, 1990 . The Base period is the total market
capitalization of all stocks of that day. The Base Value is 100. The index was launched on July 15, 1991 .
c) The Base Day for SSE A Share Index is December 19, 1990 . The Base Period is the total market
capitalization of all A shares of that day. The Base Value is 100. The index was launched on February 21,
1992 .
d) The Base Day for SSE B Share Index is February 21, 1992 . The Base Period is the total market
capitalization of all B shares of that day. The Base Value is 100. The index was launched on August 17,
1992 .
e) The Base Day for SSE Sector Indices is April 30, 1993 . The Base Period is the total market
capitalization of all stocks of respective sector of that day. The Base Values for all sector indices are
1358.78(closing value for SSE Composite Index on April 30, 1993 ). The indices were launched on May
3, 1993 .

• 2) Calculation Formula
a) SSE Indices are all calculated using a Paasche weighted composite price index formula.
b) Composite Indices and Sector Indices are weighted by shares.
The formula is

Current total market cap of constituents

Current index = ────────────────────────────── × Base Value

Base Period

Total market capitalization = ∑ (price × shares issued)

c) B share Price unit
B share stocks are denominated in US dollars when B share index are calculated. For calculation
of other indices, B share stock prices are converted to RMB at the applicable exchange rate (the middle
price of US dollar on the last trading day of each week) at China Foreign Exchange Trading Center.

Index Maintenance
• 1) Maintenance formula
The “Divisor Adjustment Methodology” is used to adjust all SSE Indices.
When constituents are added or removed, the share structure changes or constituents' market value
changes due to non-trading factors, the divisor is adjusted to keep the index comparable overtime.
The formula is ：

Adjusted Market Cap before Adjustment Adjusted Market Cap after Adjustment
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──────────────────── = ────────────────────
Old Divisor New Divisor

Market Cap after Adjustment = Market cap before adjustment + Market cap increased or decreased ；
The new divisor (also called new base period) derived from this formula is used for later index
calculation.

• 2) Circumstances for index maintenance

a) New constituent for SSE New Composite Index: stocks completed Split-share Reform will be
added to the Index on the second trading day after implementation.
b) New listing: A newly issued stock is included in index calculation on the initial trading day since
September 23, 2002 .
c) Dividend: no index adjustment is required for dividend payment and the index is allowed to fallback
naturally.
d) Right issue and bonus issue: the index is adjusted the day before the issuance. Adjusted Market Cap
after the Adjustment = Adjusted Price × Adjusted No. of Shares + Adjusted Market Cap before the
Adjustment (excluding stocks adjusted for right issue and bonus issue)
e) Suspension from trading: Use last trading price to calculate index until trading is resumed.
f) Delisting: Adjust the index the day before the delisting.
g) Share changes: when shares of constituents change due to other reasons (e.g. re-issuance, listing of
right issue, listing of employee shares), the index is adjusted the day before the changes.
h) Exchange rate changes: indices are adjusted according to applicable exchange rate (middle price
between RMB and US dollar on the last trading day of each week) at China Foreign Exchange Trading
Center .
i) Stop trading: The Index will be calculated as usual if some constituents stop trading; the Index will not
be calculated if all constituents stop trading.

8
Chapter
Event study on Chinese markets

9
Aluminum Corp. of China Ltd. (ACH)

Objective: To find any traces of market inefficiency in Chinese market taking into preview the event of
dividend declaration by Aluminum corporation of china on 23rd sept 3008.

Abstract: This study is done to find any kind of traces of insider trading when the dividends of
Aluminum Corporation of china were declared in the year 2008. Trend analysis is done on the daily data
of ACH listed at shanghai stock exchange . Certain trends have been witnessed.

Dividend declared sept 23,2008

Introduction

Aluminum Corp of China- (ACH)- engage in bauxite mining, alumina refining, and aluminum smelting
businesses in the People's Republic of China. The company was founded in 2001 and is headquartered in
Beijing, the People's Republic of China. Aluminum Corporation of China Limited is a subsidiary of
Aluminum Corporation of China. This study is based on the report of the 2nd quarter which not upto the
expectations. The company announced that its profit in 2008 probably reached less than CNY 5 billion,
down 50% year on year due to dropping prices and declining demand. The company also declared a
dividend payout of 0.19$ per share on 23rd September.

10
Observation:

Volume: 1,524,610

Average Volume (3m): 1,561,240

Average Volume traded from sept 16 to sept 22 averaged 2.2 million shares

Conclusion:

This sudden increase in the trading of the stock and sharp increase in the falling prices due to a high
buying pressure suggested that the information was available to the insiders who tried to endure profit
aganst the sentiments of the market. This is not only reflected by the volume traded before the dividend
payout but also from the sharp increase the share prices caused by heavy buying pressure.

China Life Insurance Co. Ltd. (LFC)

Objective: To find any traces of market inefficiency in Chinese market taking into preview the event of
Share split announced by china Life insurance co. Ltd. (LFC) on 29 december2008.

11
Abstract: This study is done to find any kind of traces of insider trading when the Share split was
announced by china Life insurance co. Ltd. (LFC) on 29 december2008. Trend analysis is done on the
daily data of LFC listed at shanghai stock exchange . Certain trends have been witnessed.

Introduction

China Life Insurance Company Limited provides life insurance and annuity products to individuals and
groups in China. Its products include whole life and term life insurance, endowment insurance, and
annuities.
The board of directors at CHINA LIFE INSURANCE CO LTD approved a 13333 for 5000 stock split.
New shares will be granted on December 28, 2006 to shareholders of record on December 18, 2006.
Beginning on December 29, 2006, the security's price will reflect the split adjusted price.

Observation:

LFC has plenty of cash and no debts.

Average Volume: 1,702,110

Volume traded in a week before the announcement of share split is much more than the average volume
and 1 day before the announcement it hit 8 million mark too.

Which is much greater than the average volume traded usually, much of this trade being brought by
foreign investors from North America.

12
The share price rose steadily from just over 35 $ to over 47$ in a span of just one week.

Conclusion:

The alarmingly high trading volume in purchases of the LFC stock indicates market inefficiency of the
Chinese markets. The North American Investors got the news of the share split much earlier than the rest
of the market and thus reaped huge benefits.

This event clearly indicated that the information of share split was not available to the entire market and
thus insider trading took place heavily.

There was a huge buying pressure on the stock which took it climbing steadily from around 35$ to 47$
per share in just one week’s time before the announcement of share split.

China Southern Airlines Co. Ltd. (ZNH)

Objective: To find any traces of market inefficiency in Chinese market taking into preview the event of
Share split announced by china Southern Airlines Co. Ltd. (ZNH) on 23 September 2008.

Abstract: This study is done to find any kind of traces of insider trading when the Share split was
announced by Southern Airlines Co. Ltd. (ZNH) on 23 September 2008. Trend analysis is done on the
daily data of ZNH listed at shanghai stock exchange. Certain trends have been witnessed.

Introduction

China Southern Airlines Company Limited, together with its subsidiaries, provides air transportation
services. It offers domestic and international passenger, cargo, and mail airline services. The company
also involves in the logistics and property management operations; and provision of air catering, pilot
training, aircraft repair and maintenance, flight simulation, and airport ground services.

China Southern Airline Co(ZNH) has declared a 3 for 2 stock split payable to shareholders of record on
Thursday, September 04, 2008. Distribution date for the stock split will be Monday, September 22, 2008.
Ex-distribution date for the stock split will be Tuesday, September 23, 2008.

13
Observation

Average Volume of trade: 184,383

Volume of trade between 2nd and 4th September: 224,223

Volume of trade between 15th and 23rd September: 311,121

Conclusion:

The trade volume for the stock rose in time just before the announcement of stock split. There was a
selling pressure on the stock, as the inside trader knew that the share split would be given to the investor
holding the stock on 4th September 08.

Just 3 days before the announcement the stock traded almost 3 times the average volume

Also in the time period around 4th September, the trade volume was almost 2 times the average volume of
trade and there was a buying pressure on the stock, as it rose from 9.8$ to 11.5$ from 2nd September to 4th
September.

This ensures the presence of insider information about the announcement of share split.

14
Chapter
Event study on Malaysian market(KLSE)

15
 Study 1

Objective: To find any relation between stock split to be done in the future and share price of a stock on
KLSE sensex.

Abstract: This study is done to find any kind of trend in the stock price before a split.

Introduction: Several researches have been done in past to find certain calendar anomalies in the stock
markets. The reason for such anomalies has been difficult to decipher. But the fact that such anomalies
exist in the stock market continues to puzzle many.

Observation :

16
VADS Bhd, one of the country’s leading managed ICT services provider, fits the bill nicely for analysis
with its healthy growth, stable outlook, high dividend yield and attractive valuation. Since its listing on
Bursa Malaysia in 1992, VADS has achieved a laudable 16 years of continuous revenue growth. For
FY2007, the company recorded revenue of RM523.3 million – an increase of 42% compared to the last
financial year. Meanwhile, profits increased 67% to RM54.1 million.

On Oct 22 2007, VADS undertook a share split exercise on the basis of 1 share of RM1.00 par value into
2 shares of RM0.50 par value to increase stock liquidity.

A look at the volume traded shows that few people already had the information that a split is about to be
announced by the company.

Date Volume

Oct 17 2007 71000

Oct 18 2007 82000

Oct 19 2007 234000

Oct 22 2007 158200

Conclusion:

Even before its share split, the stock price has increased considerably as is evident by the chart proving
that the market is not strongly efficient.

17
 Study 2

Objective: To find any trace of insider information leading to increase in volume before a Dividend is
given for a stock on KLSE

Abstract: This study is done to find any spike before the dividend is announced.

Introduction: There has always been a belief that stock prices shoot up before the dividend is actually
declared. Although we have tried to ascertain what the pattern is but it is not guaranteed that it would
remain so in all the cases.

Observation :

1.PECD BHD

PECD stock volumes raised enormously just before the dividend was announced showing that some
amount of information must have leaked and insider trading did took place as is evident by the chart
above.

18
Note that the Volume traded on Jun 13 2005 was 111200 well 13 days before the first of the two
dividends was declared on Jun 27 2005.

Moreover a spike in the price of the stock was evident even after the next dividend roll out on July 6 2005
because of volumes being

Jul 4 2005 : 99500

Jul 5 2005 : 109000

Jul 6 2005 : 182000

The alarming spike can be appreciated by the fact that volume rose from 6000 on June 23 to 112000 on
the following day.

2. IOI Corporation BHD

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A look at the following data easily proves the point

Date of dividend declaration was Mar 13 2008.

Date Volume traded

Mar 7 2008 18462400

Mar 10 2008 32805200

Mar 11 2008 34296900

Mar 12 2008 26504300

Mar 13 2008 13585500

The huge volume shoot up the prices considerably so that those aware of the information were able to
make some quick money.

Conclusion:

All this proves that some insider information leakage is easily perceptible by the volumes being traded on
the Stock Exchange proving that inefficiencies exist in the Malaysian Market.

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Chapter
Market Efficiency Analysis of Indian
market(BSE)

21
 . Study 1
Objective: To find any trace of insider information leading to increase in volume before a Dividend is
given for a stock on BSE

Abstract: This study is done to find any spike before the dividend is announced.

Introduction: There has always been a belief that stock prices shoot up before the dividend is actually
declared. Although we have tried to ascertain what the pattern is but it is not guaranteed that it would
remain so in all the cases.

Observation :

Indian overseas bank declared dividend on 15 may 2006 but a heightened activity was observed in days
before the news. The volumes traded saw an abrupt spike. Besides, the activity observed also implies that
there can be an insider trading involved in increasing the prices just before the newswas observed.

22
The huge volume shoot up the prices considerably so that those aware of the information were able to
make some quick money.

Conclusion:

All this proves that some insider information leakage is easily perceptible by the volumes being traded on
the Stock Exchange proving that inefficiencies exist in the Indian Market.

23
 Study 2
Objective: To find any seasonal pattern or calendar anomalies in BSE sensex.

Abstract: This study is done to find any kind of seasonal trends in the monthly returns of sensex. Trend
analysis is done on the monthly data of BSE sensex for year 1997 to 2008. Certain trends have been
witnessed in the manner the sensex moves. Average monthly returns of the sensex were analyses for two
sets of data :

1. For the 12 year period ranging from 1997 to 2008.

2. For the 6 year period ranging from 2002 to 2007.

Both the period show certain peculiar trends and observations which are discussed in the report

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 Introduction: Several researches have been done in past to find certain calendar anomalies in the stock
markets. The reason for such anomalies have been difficult to decipher. But the fact that such anomalies
exist in the stock market continue to puzzle many. The same effect has been observed in international
markets. Over a 9 year period (1988-97) research done by Jardine Fleming showed that returns on the
S&P composite during December to July are always high, and 85% of annual gains were made by July.
Similar results were observed with the FT World Index, where in fact, the cyclicality is far more
pronounced. Though the reasons for this are unclear, one reason is the distinct seasonality of investment
flows from the US (the world’s largest investor) to other markets. The JF research shows that 82% of the
money leaves the US by August every year.

Data and methodology:

For BSE the closing market index for each month over the period between 2002 to 2007 and 1997 to 2008
was taken and it was used to calculate the average returns for each month. These average returns were
plotted on the graphs to observe any specific trends.

25
Observation :

Yellow dots show a maxima point

Red dots show a minima point.

In both the graphs dip at may and oct is visible while a peak is reached at december.

26
Conclusion

MONTHLY RETURNS
Trend analysis show that average monthly return show their low at specific time of year. Example:

1. For the 12 year period from 1997 to 2008, returns touched their lowest points in month of may,
October and January.

2. For the 6 year period ranging from 2002 to 2007, similar trend was observed and stocks returns
touched their lows in the months of may, October and January.

Trend analysis show that average monthly return show their highs at specific time of year. Example:

1. For the 12 year period from 1997 to 2008, returns touched their highest points in month of
December and july.

2. For the 6 year period ranging from 2002 to 2007, similar trend was observed and average
monthly returns on stocks touched their highs in the months of December, September and june.
However during july a minima is reached.

Thus overall :
High Low
Monthly return (97-08) Dec, jul Jan, may, oct,
Monthly return (02-07) Dec, sept, june Jan, may, oct,

27
Chapter
Comparative Market efficiency analysis of
Indian market(BSE), Chinese (SSE) and
Malaysian (KLSE) market

28
 Study 1

Objective: Understanding and comparing the impact of global event on market fluctuations for Indian
(BSE), Chinese (SSE) and Malaysian (KLSE) market.

Abstract

Year 2008 saw unprecedented fall in stock indexes across different markets. All the markets responded to
unfolding of global recession according to their ability to comprehend the situation and respond to it in
short term and long term. Several events in US economy sent ripples across markets as the world saw
unfolding of the crisis. Complete wipe out of investment banks in US, bailout packages across industries
and across nations had their impact on the markets around the world.

This study is based on understanding the immediate impact of global events on stock indexes of india,
china and Malaysia. Different markets respond differently depending upon several factors like :

• The degree to which the country’s economy is coupled with that of US.

• How efficient is the flow of information in the markets.

Event: The week beginning 16 sept 2008 which saw certain events that impacted the global markets ex:

• Bankruptcy of lehman bro, complete wipeout of investment banks in US.

• nationalization of AIG.

• And a ban on short selling etc.

29
Introduction :

Stocks markets of these three nations are closely correlated. They all are emerging economies of the
world and they all get huge inflows of FII’s. This makes them vulnerable to all the happenings in the
global market. As it was seen recently, subprime crisis in US has caused meltdown in the stock markets
across the world. However responsiveness of markets is understood by the response time taken by the
stock markets to discount the events and the kind of reaction shown by them.

Data collection and methodology:

For all of the three stock market ie : BSE, SSE, KLSE, the daily stock market index were collected. From
this data, daily variations were calculated. These daily variations were observed to find any trends or
patterns just before or after the event

30
Observation

1. The following graphs observe the change in daily returns of the markets before and after the
news. As expected the immediate effect is to show a negative returns but upto what extent and
upto which date the news effect the market is easily observed in the pictures

• Effect of the event on Bombay stock index:

around 2% of normal variation 5-6% variation after 6oct

• Effect of event on shanghai stock index:

2-3% of normal variation Normal variation of 2-3% after8 oct

• Effect of event on Kuala Lampur stock index:

31
3% normal variation Upto 8% normal variation seen immediately

2. Similarly the change is also seen in the volumes of the trade between all these indexes during
this period. Abnormal highs are observed in the volumes trade and the pattern shown is same as
shown in case of market variations.

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Conclusion

RESPONSE TIME:

1. As supported by data, years average of daily variation in BSE is around 2.18%. this is also
apparent in the graph of variation in period before the collapse of lehman brothers. But how does
market responds to such big news is shown in the graph after the collapse. This period is marked
with an abnormal high rate and intensity of variation. This abnormal behavior is observed not
immediately after the collapse but about a month after that i.e. after week starting 13 oct2008.

2. In case of behavior shown by shanghai composite index, the stock index immediately responds to
the global event. The abnormal variations are shown within two weeks immediately after 20 sept
after that it returns to normal.

3. In case of kuala lampur stock exchange, market immediately discounts the information and
responds to it by upto 8% negative market variations. After that, market markets returns to
normal activity within 3 weeks of news.

33
Conclusion

34
Efficient Market Hypothesis propagandists will state that profit seekers will, in practice, exploit whatever
abnormally exists until it disappears. In instances such as the January effect (a predictable pattern of price
movements), large transactions costs will most likely outweigh the benefits of trying to take advantage of
such a trend.

As is evident by our study and tests conducted on the three capital markets of India,China and
Malaysia - in the real world, markets cannot be absolutely efficient or wholly inefficient. It might be
reasonable to see markets as essentially a mixture of both, wherein daily decisions and events cannot
always be reflected immediately into a market. If all participants were to believe that the market is
efficient, no one would seek extraordinary profits, which is the force that keeps the wheels of the market
turning.

In the age of information technology (IT), however, markets all over the world are gaining greater
efficiency. IT allows for a more effective, faster means to disseminate information, and electronic trading
allows for prices to adjust more quickly to news entering the market. However, while the pace at which
we receive information and make transactions quickens, IT also restricts the time it takes to verify the
information used to make a trade. Thus, IT may inadvertently result in less efficiency if the quality of the
information we use no longer allows us to make profit-generating decisions.

35
 References
Burton, Jonathan. “Insider’s Edge”, Intelligent Investor; February 1998, pg. 53-68.
Finnerty, Joseph. “Insiders and Market Efficiency.” The Journal of Finance, 1976, 31, pp. 1141-
1148.
Stiglitz, Joseph E. Economics. New York, NY: W. W. Norton & Company, Inc., pg. 266-271.

www.wikipedia.org

www.investopedia.org

36