The Efficiency of Arab Stock

Markets, Its Interrelationships

and Interactions with Developed
and Developing Stock Markets

PhD Thesis
 The Efficiency of Arab Stock Markets, Its
Interrelationships and Interactions with Developed and
Developing Stock Markets

Bashar Abu Zarour∗

Supervisor: Professor Konstantinious Siriopoulos

A thesis submitted to the fulfillment of the requirements for the PhD

program

Department of Business Administration, University of Patras, Greece

2006

∗
Email: bashar38@yahoo.com. Tell: 6934406294

II
This thesis is dedicated to the memory of my father, who
passed away this year, for his support, wisdom and
endless knowledge. I hope that I have achieved his wish.

I
 ACKNOWLEDJMENT

The process of this PhD research program is a long and complicated voyage. It is
also a learning adventure. I have had the good fortune of being the recipient of advice,
knowledge and effort from so many.
First and foremost, I am deeply grateful to my supervisor- Professor
Konstantinious Siriopoulos (Department of Business Administration, University of
Patras) - for the invaluable assistance, guidance, encouragement and patience that he
provided me during the preparation and execution of this research. His depth of insight,
understanding, involvement and dedicated supervision at every critical stage made
possible the completion of this study. Also, I would like to express my appreciation to the
members of the supervision committee.
I would like to thank The State Scholarship Foundation (I.K.Y) in Greece for the
financial support and the facility provided for the research program and allowing me the
time and freedom to pursue my research interests.
I would like also to express my appreciation to nine Arabian stock markets and
senior executives for their cooperation in providing me with the necessary data for the
research fieldwork.
Kharalambos Kokkales has kept me in touch with real life during the long years I
have been working on this thesis. He has patiently listened to all my troubles during our
long walks on Sundays. I am most grateful for him and his family, those who made me
one member of their family.
Especially, I desire to express my heartfelt obligation to my family, above all my
mother, for their wish and encouragement; and for their everlasting support and deep
understanding.
Finally, my appreciation is highly directed to the Great Greece (as I usually like to
name it) and Greek people for their hospitality and generosity which let me feel that I am
in my home land.

Bashar AbuZarour

II
Abstract

In an efficient market, prices adjust instantaneously toward their fundamental values; as a

consequence prices should always reflect all available information. Here we consider market
efficiency for new emerging markets in the Middle East region. Emerging markets are typically
characterized by illiquidity, thin trading, and possibly non-linearity in returns generating process.
Firstly, we adjust observed daily indices for nine Arab stock markets for infrequent trading, while
the logistic map has been used to determine whether non-linearity exists in returns generating
process. Next we used several econometric models to test for market efficiency. The results of
runs test, variance ratio, serial correlation, BDS, and regression analysis indicate that we can
reject the hypothesis that lagged price information cannot predict future prices. In other words,
prices do not follow random walk properties; even after correction for thin trading.
We next analyze volatility structure using GARCH models. The results of GARCH
(1,1) model indicate that volatility clustering still seems to characterize some markets. While in
three markets (Egypt, Kuwait, and Palestine) volatility seems to be persistent. Moreover, the
results of EGARCH (1,1) model show that four markets (Bahrain, Dubai, Kuwait, and Oman)
exhibit signs of leverage effect and asymmetric shocks to volatility. Compared with other
emerging and international markets; Arab stock markets display relatively low rate of excessive
volatility as indicated by Schwert model. Furthermore, the dependence in the second moment
found to be quite enough to characterize the non-linear structure in the time series. Finally, we
find that seasonality and calendar effects exist in Arab markets with three forms; day-of-the-week
effect, month-of-the-year effect and the Halloween indicator. We conclude that Arab stock
markets under examination are not efficient in the week form sense of efficient market
hypothesis.
There is a large body of empirical evidence that financial markets become highly
integrated. According to modern portfolio theory, gains from international portfolio
diversification are related inversely to the correlation of equity returns. The results of multivariate
cointegration techniques, structural vector autoregression (SVAR) and vector autoregression
(VAR) models indicate that, there is no cointegrating relation between Arab and international
stock markets. The results of SVAR show that the linkage between international and Arab
markets is very weak. Next we investigate the dynamic relationships among Arab markets them
selves, and how do other factors; such as oil prices, affect the performance of these markets
especially for Gulf Cooperation Council (GCC) stock markets. To do that, Arab markets have
been divided into two sub-groups: oil production countries (GCC countries) and non-oil
production countries (Jordan, Egypt, and Palestine). The results indicate the existence of long-run
relation between markets, however, the short-run linkages still very weak. Non-oil countries’
markets can offer diversification benefits for rich GCC investors. Moreover, oil prices found to
have a significant effect on GCC markets and dominate the long-run equilibrium. Oil prices play
a significant role in affecting GCC markets’ volatility. While after the raise in oil prices;
especially during the last two years, linkages between oil prices and GCC markets increased. Four
GCC markets have predictive power on oil prices, with two markets to be predicted by oil prices.
We conclude that Arab stock markets can offer diversification potentials for regional and
international investors. Oil prices have a significant effect on GCC markets.
Finally, we suggest a strategic plan to improve these markets based on two main broad
goals, improving market efficiency and increasing market liberalization. To achieve these goals
we identify specific targets and strategies that could be realized through tactical programs and
activities.

III
Contents
1- INTRODUCTION .................................................................................................................................... 1
1-1 THE MOTIVATION OF THIS STUDY ...................................................................................................... 1
1-2 MARKETS UNDER EXAMINATION........................................................................................................ 5
1-3 INTRODUCTIONS TO CHAPTER 4 ......................................................................................................... 7
1-4 INTRODUCTION TO CHAPTER 5 ..........................................................................................................10
1-5 CONTRIBUTION...................................................................................................................................11

2- EFFICIENT MARKET HYPOTHESIS (EMH) ..................................................................................15

2-1 DEFINITION ........................................................................................................................................15
2-2 SPECIFICATION OF THE INFORMATION SET ......................................................................................16
2-3 EMH AND ASSET PRICING MODELS ...................................................................................................18
2-3-1 Single security test .....................................................................................................................18
2-3-1-1 Expected returns or fair game......................................................................................................... 19
2-3-1-2 The submartingale model ................................................................................................................ 21
2-3-1-3 The Random Walk model ................................................................................................................ 21
2-3-2 Multiple security expected return models .................................................................................22
2-3-2-1 The Sharp-Lintner-Black model (SLB model) ............................................................................... 22
2-3-2-2 Market model ................................................................................................................................... 24
2-3-2-3 Multifactor models ........................................................................................................................... 25
2-3-2-4 Consumption-based Asset-Pricing models ..................................................................................... 26
2-4 EMH ITS ORIGINS AND EVIDENCE .....................................................................................................27
2-4-1 The origin of EMH ....................................................................................................................27
2-4-2 Weak-form efficiency (returns predictability) ..........................................................................28
2-4-2-1 Random Walk Hypothesis (RWH) .................................................................................................. 29
2-4-2-2 Return predictability........................................................................................................................ 33
2-4-3 Semi-strong-form of efficiency (event studies) .........................................................................37
2-4-4 Strong-form-efficiency (private information) ...........................................................................39
2-5 EVIDENCE AGAINST EMH AND ALTERNATIVE MODELS FOR MARKET BEHAVIOR ..........................42
2-5-1 Market anomalies ......................................................................................................................43
2-5-1-1 Long-term return anomalies ........................................................................................................... 43
2-5-1-1-1 Overreaction and underreaction ............................................................................................ 44
2-5-1-1-2 IPOs and SEOs......................................................................................................................... 45
2-5-1-1-3 Mergers..................................................................................................................................... 46
2-5-1-1-4 Stock splits ................................................................................................................................ 47
2-5-1-1-5 Self-tenders and share repurchases ........................................................................................ 47
2-5-1-1-6 Exchange listings...................................................................................................................... 48
2-5-1-1-7 Dividend initiations and omissions ......................................................................................... 49
2-5-1-1-8 Spinoffs ..................................................................................................................................... 49
2-5-1-1-9 Proxy contests .......................................................................................................................... 50
2-5-1-2 Calendar effects ................................................................................................................................ 51
2-5-1-2-1 January effect ........................................................................................................................... 51
2-5-1-2-2 The weekend effect (Monday effect) ....................................................................................... 53
2-5-1-2-3 Holidays’ effects ....................................................................................................................... 54
2-5-1-2-4 Turn of the month effect ......................................................................................................... 54
2-5-1-2-5 The Halloween effect ............................................................................................................... 55
2-5-1-3 Other anomalies ............................................................................................................................... 55
2-5-1-3-1 Small firm effect ....................................................................................................................... 56
2-5-1-3-2 Value-Line enigma ................................................................................................................... 56
2-5-1-3-3 Standard and Poor’s (S&P) Index effect ............................................................................... 56
2-5-1-3-4 The weather .............................................................................................................................. 56
2-5-2 Volatility tests, fads, noise trading ............................................................................................57

IV
 2-5-3 Models of human behavior .......................................................................................................59
2-6 EVIDENCE FROM EMERGING MARKETS ............................................................................................61

3- THE CASE OF ARAB STOCK MARKETS ........................................................................................64

3-1 ARAB STOCK MARKETS AND MARKET EFFICIENCY ..........................................................................64
3-2 THE FOUNDATION OF ARAB STOCK MARKETS .................................................................................69
3-3 ECONOMIC REFORMS AND DEVELOPMENT OF ARAB CAPITAL MARKETS........................................82
3-4 THE PERFORMANCE OF ARAB STOCK MARKETS ..............................................................................89
3-4-1 Market size .................................................................................................................................90
3-4-2 Market liquidity .........................................................................................................................93
3-4-3 Financial Valuation of Arab Stock Markets ............................................................................95
3-4-4 Market concentration ................................................................................................................96
3-5 DATA DESCRIPTION ...........................................................................................................................96

4- TESTING THE EFFICIENT MARKET HYPOTHESIS FOR ARAB STOCK MARKETS ........102
4-1 RANDOM WALK HYPOTHESIS (RWH)............................................................................................102
4-1-1 Estimating the true index-correcting for infrequent trading .................................................103
4-1-2 Regression analysis .................................................................................................................105
4-1-3 Serial correlation (autocorrelation) of the return series ........................................................106
4-1-4 Non-parametric runs test ........................................................................................................108
4-1-5 Variance ratio test ...................................................................................................................109
4-1-6 BDS test for returns independency .........................................................................................111
4-2 THE VOLATILITY OF ARAB STOCK MARKETS’ RETURNS ................................................................112
4-2-1 Generalized autoregressive conditional heteroskedasticity (GARCH) ..................................113
4-2-2 Exponential generalized autoregressive conditional heteroskedasticity (EGARCH)............116
4-2-3 Schewrt model..........................................................................................................................117
4-3 NON-LINEARITY AND CHAOS IN STOCK RETURNS ...........................................................................117
4-4 SEASONALITY AND CALENDAR EFFECTS .........................................................................................121
4-4-1 Day-of-the-week effect.............................................................................................................121
4-4-2 January effect or month-of –the-year effect ...........................................................................122
4-4-3 The Halloween effect...............................................................................................................123
4-5 EMPIRICAL RESULTS........................................................................................................................124
4-5-1 Random walk properties ..........................................................................................................124
4-5-2 Volatility of returns..................................................................................................................135
4-5-3 Non-linearity in stock returns .................................................................................................141
4-5-4 Calendar effects .......................................................................................................................145
4-6 SUMMARY ........................................................................................................................................154

5- FINANCIAL INTEGRATION AND DIVERSIFICATION BENEFITS AMONG ARAB AND

INTERNATIONAL STOCK MARKETS ...............................................................................................158
5-1 INTERNATIONAL INTEGRATION OF ARAB STOCK MARKETS ..........................................................160
5-1-1 Unit root test ............................................................................................................................160
5-1-2 Multivariate cointegration.......................................................................................................163
5-1-3 Structural VAR (SVAR) ..........................................................................................................167
5-2 TRANSMISSION OF STOCK PRICES MOVEMENTS BETWEEN ARAB STOCK MARKETS .....................174
5-2-1 Granger causality ....................................................................................................................175
5-2-2 Vector autoregression (VAR) ..................................................................................................176
5-3 EMPIRICAL RESULTS........................................................................................................................178

V
 5-3-1 Integration ...............................................................................................................................179
5-3-2 Long-run relationship (cointegration test) .............................................................................180
5-3-3 Short-run relationship between Arab and international stock markets ................................182
5-3-4 Short-run relationships among Arab stock markets ..............................................................184
5-3-4-1 Granger causality test .................................................................................................................... 185
5-3-4-2 Causality and error-correction models (VEC) ............................................................................. 186
5-3-5 Dynamic relationship between GCC stock markets and oil prices.........................................191
5-3-5-1 Oil prices and GCC markets volatility ......................................................................................... 192
5-3-5-2 Long-run relationship among GCC stock markets and oil prices .............................................. 194
5-3-5-3 The rise of oil prices and GCC stock markets.............................................................................. 196
5-4 SUMMARY .........................................................................................................................................203

6- VISION AND STRATEGIC PLAN FOR ARAB STOCK MARKETS ...........................................206

6-1 ENVIRONMENT ANALYSIS ................................................................................................................207
6-1-1 Demand and supply of financial papers .................................................................................207
6-1-2 Market microstructure.............................................................................................................209
6-1-3 Liberalization and markets integration...................................................................................209
6-1-4 Privatization .............................................................................................................................210
6-1-5 Legal and regulatory environment..........................................................................................212
6-2 STRENGTH, WEAKNESS, OPPORTUNITIES, AND THREATS (SWOT) ANALYSIS .............................214
6-3 VISION AND STRATEGIC GOALS .......................................................................................................218

7- CONCLUSIONS ...................................................................................................................................225
REFERENCES ..........................................................................................................................................229
APPENDIXES ...........................................................................................................................................246

VI
List of Tables
Table 3-1: Some Economic Indicators, Egypt…………………………………………………….72
Table 3-2: Some Economic Indicators, Jordan…………………………………………………...73
Table 3-3: Some Economic Indicators, Palestine…………………………………………………74
Table 3-4: Some Economic Indicators, Saudi Arabia……………………………………………76
Table 3-5: Some Economic Indicators, Kuwait…………………………………………………..77
Table 3-6: Some Economic Indicators, Oman……………………………………………………79
Table 3-7: Some Economic Indicators, UAE……………………………………………………..81
Table 3-8: Some Economic Indicators, Bahrain…………………………………………………82
Table 3-9: Market Structure for Arab Stock Markets…………………………………………..84
Table 3-10: Accessibility of Arab Stock Markets to Foreign Investments……………………...87
Table 3-11: Market Capitalization for Arab stock Markets…………………………………….91
Table 3-12: Total Number of Listed Companies, 2000-2005……………………………………92
Table 3-13: Market capitalization as Percentage of GDP……………………………………….92
Table 3-14: Total Value Traded to Market Capitalization (Turn Over Ratio)………………..94
Table 3-15: Average Daily Trading Value (million US$)………………………………………..94
Table 3-16: Total Value Traded as Percentage of GDP…………………………………………95
Table 3-17: Financial Valuation of Arab Stock Markets, End of 2005…………………………95
Table 3-18: Descriptive Statistics for Daily Market Returns for Arab Markets………………98
Table 4-1: Random Walk Model for Observed Indices…………………………………………124
Table 4-2: Random Walk Model for Observed Indices………………………………………...125
Table 4-3: Random Walk Model for Corrected Indices………………………………………..126
Table 4-4: Random Walk Model for Corrected Indices………………………………………..127
Table 4-5: Estimated Autocorrelations for Observed Indices Returns………………………..128
Table 4-6: Estimated Autocorrelations for Corrected Indices Returns……………………….128
Table 4-7: Results of Runs Test for Arab Stock Markets, Observed vs. Corrected Indicesc..130
Table 4-8: Variance Ratio Estimates and Heteroscedastic Test Statistics for Arab Stock
Markets…………………………………………………………………………………132
Table 4-9: BDS Test Results for Observed Return Indices……………………………………..133
Table 4-10: BDS Test Results for Adjusted Return Indices…………………………………….134
Table 4-11: Coefficient of Variation for Daily Returns for the Three Groups………………...135
Table 4-12: GARCH (1,1) Model for Daily Returns……………………………………………..138
Table 4-13: GARCH (1,1) Model for Weekly Returns…………………………………………...139
Table 4-14: EGARCH (1,1) Model for Daily Returns……………………………………………140
Table 4-15: Random Walk Models with Non-Linearity for Observed Indices…………………142
Table 4-16: Random Walk Models with Non-Linearity for Corrected Indices………………...143
Table 4-17: OLS Results for Day-of-the-Week Effect……………………………………………147

VII
Table 4-18: Chow Test for Structural Stability…………………………………………………..148
Table 4-19: Day-of-the Week Effect in the First Two Moments………………………………...148
Table 4-20: OLS Results for Month-of-the-Year Effect (January Effect)……………………...149
Table 4-21: Chow Test for Structural Stability…………………………………………………...151
Table 4-22: Month-of-the-Year Effect in the First Two Moments………………………………152
Table 4-23: The Halloween Indicator in Arab Stock Markets…………………………………..153
Table 4-24: The Halloween Indicator in Arab Stock Markets with January Effect
Adjustment……………………………………………………………………………154
Table 5-1: Unit Root Test for Each Individual Series, both in Levels and First
Differences………………………………………………………………………………..180
Table 5-2: Number of Cointegrating Relations for Four VARs Models…………………………181
Table 5-3: Johansen-Juselius Cointegration Test Results………………………………………...183
Table 5-4: Granger Causality Tests for Arab Stock Markets…………………………………….185
Table 5-5: Correlation Coefficient between Daily Arab Markets’ Returns……………………..186
Table 5-6: Cointegrating Equations of the VEC Models for VAR-9 and VAR-6……………….187
Table 5-7: Significant of Zero Restrictions on Coefficients of Cointegrating Equations of the
VEC Models of VAR-9 and VAR-6…………………………………………………….188
Table 5-8: VEC Model for 9 Arabian Indices in the VAR-9 Model……………………………...188
Table 5-9: VEC Model for 6 GCC Indices in the VAR-6…………………………………………190
Table 5-10: Weak Exogeneity Tests of the Endogenous Variables in the VEC Models of VAR-9
and VAR-6……………………………………………………………………………..190
Table 5-11: GARCH (1,1) Model for GCC Daily Returns with Oil Returns as a Regressor
in the Variance Equation……………………………………………………………...193
Table 5-12: Johansen-Juselius Cointegration Test Results………………………………………..194
Table 5-13: Cointegrating Equations of the VEC Model for VAR-7……………………………..194
Table 5-14: VEC Model for 6 GCC and Oil Price Indices in the VAR-7………………………....195
Table 5-15: Weak Exogeneity Tests of the Endogenous Variables in the VEC Model of
VAR-7…………………………………………………………………………………..196
Table 5-16: VAR System for GCC Stock Markets and Oil Returns for the First Sub-
Period…………………………………………………………………………………...198
Table 5-17: VAR System for GCC Stock Markets and Oil Returns for the Second Sub-
Period……………………………………………………………………………….......199
Table 5-18: Variance Decomposition for the Forecast Error of Daily Market Returns for
GCC Markets and Oil Returns during the First Sub-Period……………………….200
Table 5-19: Variance Decomposition for the Forecast Error of Daily Market Returns for
GCC Markets and Oil Returns during the Second Sub-Period…………………….201
Table 6-1: Strength, Weakness, Opportunities, and Threats for Arab Stock
Markets…………………………………………………………………………………...216

VIII
List of Figures
Figure 2-1: Information Set…………………………………………………………………………..17
Figure 3-1: Arab Stock Markets Performance Compared to other International Stock
Markets 9/2004-9/2005…………………………………………………………………89
Figure 3-2: Market Size for Arab Stock Markets between: 2000-2005…………………………...90
Figure 3-3: Relative Market Capitalization to all Markets 2005…………………………………..91
Figure 3-4: Market Liquidity Variables for Arab Stock Markets, 2000-2004…………………….93
Figure 3-5: Market Concentration, End of 2005……………………………………………………96
Figure 4-1: Markets Volatility (Schwert Model)…………………………………………………..136
Figure 4-2: Average Returns Among the Two Half-Year Periods……………………………….152
Figure 5-1: Cointegrating Relations VEC-9, VEC-6………………………………………………187

IX
1- Introduction
1-1 The motivation of this study
Investors require compensation for the postponement of current consumption as
they put their money into a stock market. A market in which prices always fully reflect
available information is called “efficient” (Fama, 1965, 1970). In an efficient market an
investor gets what he pays for and there are no profit opportunities available to
professional money managers or savvy investors. The market genuinely “knows best,”
and the prices of securities traded are equal to the values of the dividends which these
securities pay, also known as fundamental values.
However, one can ask whether hypothetical trading based on an explicitly
specified information set would earn superior returns. We would then need to specify an
information set first. Under weak-form efficiency the information set includes only the
history of prices or returns themselves. Under semi-strong-form efficiency the
information set includes all information known to all market participants, like the market
trading volume. Finally, strong-form efficiency means that the information set includes
all information known to any market participant, including private information (Campbell
et al., 1997).
By definition, in an efficient market the path of prices and the return per period
are unpredictable. Put more formally, the efficient market hypothesis (EMH) implies that
the expected value of tomorrow’s price Pt + 1, given all relevant information up to and
including today denoted as Ωt, should equal today’s price Pt, possibly up to a
deterministic growth component µ(drift). In other words, Et[Pt + 1| Ωt] = Pt + µ, where Et
denotes the mathematical expectation operator given the information at time t. In testing
the EMH the model commonly used is Pt = µ + Pt - 1 + et, where et ~ i.i.d (0, σ2), or returns
follow a random walk with drift ∆Pt = µ + et. For a long time these models were
maintained as an appropriate statistical model of stock market behavior.
The independence of increments {et} implies that the random walk is also a fair
game, but in a much stronger sense than the martingale. A martingale is a fair game, one
which is neither in your favor or your opponent’s, or a stochastic process {Pt}, which
satisfies the following condition: Et[Pt + 1|Pt,Pt - 1,...] = Pt or Et[Pt + 1- Pt|Pt,Pt - 1,...] = 0. In a
random walk, independence implies not only that increments are uncorrelated, but that

1
any nonlinear functions of the increments are also uncorrelated. Nevertheless, the
financial market literature recognizes several forms of the random walk hypothesis. First,
relaxing the assumption of identically distributed increments lets us allow unconditional
heteroskedasticity in the residuals, which is a useful feature given the empirically
observed fact of time-variation in the volatility of many financial asset return series. And
even more general version of the random walk hypothesis - the one most often tested in
the recent empirical literature - may be obtained by relaxing the independence
assumption of the model to include processes with dependent but uncorrelated
increments. Tests of random walk may thus be categorized as follows: tests of i.i.d.
increments in errors (runs tests), tests of independent increments without assuming
identical distributions over time (filter rules and technical analysis) and tests of
uncorrelated increments or testing the null hypothesis that autocorrelation coefficients of
the first differences of the level of the random walk at various lags are all zero.
The Efficient Market Hypothesis (EMH) has been the cornerstone of financial
research for more than thirty years. The first comprehensive study of the dependence in
stock prices can be attributed to Fama (1965) as he analyzed the daily returns of the 30
stocks that made up the Dow Jones Industrial average at the time of his study. He found
low levels of serial correlation in returns at short lags, and provided evidence concerning
the non-Gaussian nature of the empirical distribution of the daily returns. He gave two
explanations for these departures: the mixture of distributions and changing parameters
hypothesis. The next step in testing the EMH focused on explaining the empirical
observation that stock returns are negatively correlated in the long run. For example, the
presence of positive feedback traders, who buy (sell) when prices rise (fall), causes prices
to overreact to fundamentals. However, at some point in time prices start to revert back to
their fundamental values, hence we observe mean reversion in returns. This behavior runs
counter to the random walk hypothesis. As shocks are persistent in the case of a random
walk, this offers an alternative way to test the EMH (Cuthbertson, 1996).
Fama and French (1988) report that price movements for market portfolios of
common stocks tend to be at least partially offset over long horizons. They found
negative serial correlation in market returns over observational intervals of three to five
years. Nevertheless, evidence with respect to the presence of long-term dependence in

2
stock returns is still inconclusive (Poterba and Summers 1988; and Jegadeesh 1990). At
any rate, if the mean reversion hypothesis was rejected, researchers invalidated the asset
pricing models based on Brownian notion, random walk and martingale assumptions. We
now know many reasons why stock prices deviate from the random walk model. For
example, the variance in stock prices is typically not constant over time, since during
turbulent times the market reacts to the inflow of new information, beliefs are relatively
heterogeneous and volatility is high. During quiet times beliefs are more homogenous,
and much of the volatility comes from liquidity trading. This has led to the application of
(G)ARCH models in stock returns. Other types of deviation are calendar anomalies, like
the January effect, which had already been discovered in the stock market by Wachtel
(1942), among others.
Another important feature related to stock markets is market integration, and the
diversification benefits that a stock market could offer for portfolio investors. Capital
markets across countries or regions may exhibit varying degree of integration.
Theoretically, market linkages primarily stem from the “low of one price” that identical
assets (physical or financial) should bear the same price across countries after adjusting
for transaction costs. Rational (well-informed) investors would, or perhaps should,
arbitrage away price disparities, leading to more integrated markets.
Over the last 20 years, financial markets become highly integrated, mainly due to
reductions in the cost of information, improvements in trading systems’ technology and
the relaxation of legal restrictions on international capital flows. The changes have
accelerated the interaction among financial markets and the enlargements of capital
mobility. The body of empirical evidence suggests that significant capital market
integration exists among major industrialized countries, thus limiting the potential
benefits from international diversification (Meric and Meric 1989; Koutmos 1996;
Sinquefield 1996; Freimann 1998; Siriopoulos 1996; and Alexakis and Siriopoulos
1997). Moreover, gains from international portfolio diversification are related inversely
to the correlation of equity returns, according to modern portfolio theory. In line with this
theory, investors have become highly active, investing in foreign equity markets as a risk
diversification strategy.

3
 Numerous studies have demonstrated the advantages of international
diversification related to low correlation between various equity markets (Eun and Resick
1984; Whealy 1988; and Meric et al. 2001). This tendency for the global markets to
become integrated is a result of the increasing tendency toward liberalization and
deregulation in the money and capital markets, both in developed and developing
countries as well as on a bilateral and multilateral basis, commencing from; for example,
trade liberalization and multilateral trade initiatives. Such liberalization is important to
introduce structural reforms, to promote economic efficiency, to estimate trade and
investment, and to create a necessary climate for promoting sustainable economic growth
with a commitment to market-based reforms.
Furthermore, long-run linkages between stock markets have important regional
and global implications at the macro-level, as a domestic capital market cannot be
insulated adequately from external shocks, thus the scope for independent monetary
policy may become limited. It is argued in Errunza et al. (1999) that the use of return
correlations at the market index level to infer gains from international diversification,
involving foreign-traded assets overstates the potential benefits. The gains must be
measured beyond those attainable through home-made diversification by mimicking
returns on foreign market indices with domestically traded securities.

In this study, we address the following research tasks:

Are Arab stock markets efficient in the weak-form sense of Efficient
Market Hypothesis?

Is the view of predictability in stock returns (if there is) related to whether
we think that these time series are non-linear? How does thin trading
affect the predictability of these time series?

Are Arab stock markets characterized by excessive volatility of returns,
relative to other emerging and international stock markets?
Having answered these questions, then we ask whether this evidence suggests that
markets are efficient or not. This is the substance of chapter 4. We then address the
following new issues:

4

Are Arab stock markets integrated among themselves and with
international stock markets? If yes, how do shocks generated by
international stock markets especially UK, US, and Japan affect Arab
stock markets?

Can Arab stock markets offer, both regional and international investors
unique risk and returns characteristics to diversify international and
regional portfolios?

What is the effect of oil prices on the performance of Gulf Cooperation
Council (GCC) stock markets? And whether these markets have predictive
power on oil prices or vice versa?
These issues are addressed in chapter 5. The finding should suggest whether Arab
stock markets can offer diversification potentials for both international and regional
portfolio investors. Moreover, the results should suggest how other factors; such as oil
prices, affect stock markets, especially in GCC countries where oil prices play a crucial
role in their economies.

1-2 Markets under examination.

In this research, nine Arabian stock markets will be examined; these are Abu
Dhabi, Bahrain, Dubai, Egypt, Jordan, Kuwait, Oman, Palestine, and Saudi Arabia. Little
is known about these markets, by international standards, these markets are considered as
emerging markets and relatively new. Most of them started operating over the last two
decades, while Egyptian stock market; in particular, have been in existence for much
longer, but until recently its level of activity was not significant.
Moreover, six of these markets are from rich oil GCC countries (Abu Dhabi,
Bahrain, Dubai, Kuwait, Oman, and Saudi Arabia). Except Bahrain and Oman, the other
four countries are members in the Organization of Petroleum Exporting Countries
(OPEC). At the end of 2003, GCC countries collectively accounted for about 21 percent
of the world’s 68 million barrels a day of total production, they possess 43 percent of the
world’s 1105 billion barrels of oil proven reserve, given that one of these countries
(Saudi Arabia) is the largest oil producer and reserves in the world.

5
 There are significant differences between Arab stock markets’ characteristics, in
terms of market indicators, such as; number of listed companies, market capitalization,
and accessibility to foreign investors. But in general, there are dominant features for these
markets preventing their development, prominent among the hurdles were: deficiencies in
the legal framework governing these markets, the small number of listed companies, the
undiversified investment instruments, market illiquidity, narrowness and the lack of
market depth, highly concentrated markets, the absence of investors awareness in general,
and in many cases the lack of economic stability.
In the recent years, most Arabian countries witnessed considerable steps aiming to
improve their local stock markets. a number of Arab stock markets have been proceeded
to separate between the supervisory and executive roles. Moreover, Arab countries can be
divided into two groups regarding accessibility to direct foreign investment in stock
markets, the first includes countries which do not impose any restrictions on foreign
investments in financial papers; these are Egypt, Palestine, and Jordan. While the second
group contains countries where such restrictions exist in varying degrees; these are the
member states of GCC.
The focus of this study is not on the test of market efficiency as such, but also on
whether Arab stock markets are integrated with international and regional stock markets,
and therefore; to what degree these markets can offer diversification potentials for
regional and international portfolios investors. Moreover, GCC markets are among the
markets under examination here, and it is known that oil plays a significant role in these
economies. The study will investigate the effect that oil prices could have on the
performance of GCC stock markets; especially after the raise in oil prices during the last
two years.
The reminder of this study will be as follow, we start chapter 2 with the literature
review of the main work related to EMH. Starting with definition for the EMH, then
identifying the information set, following with a discussion of asset pricing models and
its relation with EMH. This is important since empirical tests of market efficiency –
especially those that examine asset price returns over extended period of time- are
necessarily joint test of market efficiency and particular asset-pricing model. when the
joint hypothesis is rejected, as it often, it is logically possible that this is a consequence of

6
deficiencies in the particular asset-price model rather than in the efficient market
hypothesis, the bad model problem (Fama 1991). Consequently chapter 2 proceeds in
presenting the original and evidence for EMH, then it presents evidence against EMH
such as volatility and anomalies, including long-term anomalies and calendar effects, and
alternative models of human behavior. Finally, evidence from emerging markets is
provided.
Chapter 3 presents Arab stock markets under examination, started with a survey
of existing literature related to these markets, then a brief economic indicators of these
countries with a brief history for each market are provided. Markets’ characteristics and
main performance indicators are presented. Finally we present data description and main
statistics.
Chapter 4 is projected to examine market efficiency in Arab stock markets while
chapter 5 presents the diversification potentials that Arab stock markets could offer for
international investors, and the effect of oil prices on GCC stock markets, while an
introduction for each of chapter 4 and 5 is coming later. The study continues with chapter
6, discussing the implication of the obtained empirical results. According to this
discussion and analysis of the surrounding environment, based on two main broad
strategic goals, a strategic plan has been built to improve the performance of Arab stock
markets. Chapter 7 concludes the thesis.

1-3 Introductions to chapter 4

Are Arab stock markets efficient? To answer this question we start chapter 4 by
testing market efficiency using most recent econometric techniques. However, the
conventional tests of market efficiency have been developed for testing markets which
are characterized by high level of liquidity, sophisticated investors with access to high
quality and reliable information and few institutional impediments. On the other hand,
emerging markets are typically characterized by illiquidity, thin trading, and possibly less
well informed investors with access to unreliable information and considerable volatility.
Moreover, efficiency implicitly assumes investors are rational; such rationality leads
prices responding linearly to new information. However, emerging markets; especially
during the early years of trading, may be characterized by investors who may not always

7
display risk aversion. For example, loss adverse investors; who have incurred losses, may
display risk loving behavior in an attempt to recover such losses. Such examples of
investors’ behavior may result in prices responding to information in a non-linear
fashion. So, it is important to take into account the institutional features of these markets
when testing for market efficiency.
As a result, firstly we adjust the observed indices for infrequent trading, using
Miller, Muthuswamy and Whaley (1994) approach. The procedures used to test for EMH
and random walk properties, were chosen on the basis of the implications of EMH. If all
relevant and available information is fully reflected in stock prices, then (a) successive
price changes will be independent, so that there will be no serial correlation over time
between returns. (b) Successive price changes will be identically distributed
log (Pt) = log (Pt-1) + εt (1-1)
where εt is an independent standard variable, that is; a series of identically distributed
random variables with zero mean and variance equal to unity. To test for the
independence of successive price changes (condition a), we employ runs test and serial
autocorrelation. Further, to test whether successive price changes are identically
distributed (condition b), we use regression analysis, variance ratio, and BDS tests. All
these tests were implemented for observed indices and for indices after have been
corrected for infrequent trading.
We proceed by testing returns’ volatility relative to other developed and emerging
markets. For this purpose, three emerging markets (India, Turkey and Israel) and three
developed markets (US, UK, and Japan) have been used to compare relative volatility
with Arab stock markets. It is well reported empirical fact that the (G)ARCH property is
found in examining stock returns. Schwert (1989), among others; examined how far the
conditional volatility in stock returns depends on its own past volatility as well as on the
volatility in other economic variables (fundamentals), such as bonds and the real out put.
Later, Hamilton and Lin (1996) claimed that recessions are the primary factors that drive
fluctuations in the stock returns’ volatility. Furthermore, asset markets are typically
characterized by periods of turbulence and tranquility. That is to say, large (small)
forecast errors tend to be followed by large (small) errors. Hence, the variance of the

8
forecast errors is often persistent, and the duration of market volatility may shed
additional light on the market efficiency issue.
The basic idea behind autoregressive conditional heteroskedasticity ARCH
models proposed by Engle (1982) is that, the second moments of the distribution may
have an autoregressive structure. Under rational expectations the forecast error is ut+1 =
yt+1-Et(yt+1), and the conditional distribution of yt+1 is assumed to be normal with mean
µt+1 and var(yt+1/Ωt) = ht+1 = a0+a1 u2t, where Ωt is the information set available at time t.
However, the ARCH process has a memory of only one period. To generalized this we
can start adding lags of ut-1 in the equation ht+1, ι = 1,…,q. but then the number of
parameters to estimate increases rabidly (Bollerslev 1986). For example, in the GARCH
(1,1) model the conditional variance depends on lagged variance terms: ht+1 = a0+a1+β1ht
= a0+(a1+ β1)ht+at(ut2-ht) in addition to the lagged ut where u0 is arbitrarily assumed to
be fixed and equal to zero. The parameters can be estimated by maximum likelihood
techniques. Conditional on time t information Ωt, (ut2-ht) has a mean of zero, and can be
thought as the shock to volatility. The coefficient a1 measures the extent to which a
volatility shock today feeds through into the volatility of the next period, while a1+ β1
measures the rate at which this effect dies out over time.
Since Engle’s seminal work, many generalization of this model have been
reported. For example, the GARCH (1,1) with a1+ β1=1 has a unit autoregressive root, so
that today’s volatility affects forecasts of volatility in to the indefinite future (persistent of
volatility), this is therefore known as the integrated GARCH or IGARCH model. Nelson
(1991) introduced the Exponential GARCH (EGARCH) model which allows for
asymmetric shocks to volatility and tests the leverage effect. The dependence of the
second moment in returns captured by the (G)ARCH process is known as volatility
clustering, i.e. large changes in price volatility are followed by large changes in either
sign.
Chapter 4 continued by using the logistic map to detect any non-linearity in
returns’ generating process. However, the logistic map is not able to determine the
precise nature of any non-linearity, but rather to ascertain whether non-linearity exists. It
is appropriate that non-linearity generated by dependence in the second moment. To
disentangle the non-linearity generated by changes in volatility from non-linearity arising

9
as a result of other causes, the standardized residuals of GARCH models will be
subjected to several diagnostic tests to “see what left” and whether non-linearity
generated by this form of dependence in the second moment or from other causes.
Finally, chapter 4 concluded by using an alternative approach for testing EMH
through testing for seasonality or calendar effects in stock returns. Three calendar effects
have been tested the-day-of-the-week effect, Month-of-the-year effect, and the
Halloween indicator.

1-4 Introduction to chapter 5

The main purpose of chapter 5 is to investigate the diversification potentials that
Arab stock markets may offer for international investors, through examining whether
Arab stock markets are integrated with international and regional stock markets. The
analysis has been undertaken with several directions. Firstly, we start by examining the
long-run relationships between Arab stock markets and international markets, which
represented by the US market (S&P 500). The analysis depends on multivariate
cointegration techniques proposed by Johansen (1991, 1995a), which based on the
autoregressive representation discussed in Johansen (1988). However, a prerequisite for
cointegration is that, non-stationary series are integrated of the same order. Therefore, the
first step is to determine the order of integration for each variable. To test for unit root,
the augmented Dickey-Fuller, the Phillips-Perron, and the Kwaitkowski-Phillips-
Schmidt-Shin (KPSS) tests (Dickey and Fuller, 1979; Phillips and Perron, 1988;
Kwaitkowski et al., 1992) have been used. The results of the multivariate cointegration
indicate that Arab stock markets are not integrated with international markets in the long-
run.
Next, we continue to investigate the short-run relationship between Arab and
international markets. More specifically, how do Arab markets react to shocks generated
by international markets (US, UK, and Japan)? Using structural vector autoregression
(SVAR) model and analyzing the impulse response functions. The model incorporate the
assumption that the returns on each of the three international markets, affect the returns
on Arab markets but NOT vice versa. A block recursive model, similar to the SVAR
model used by Zha (1999), Cushman and Zha (1997), and Berument and Ince (2005) has

10
been used to examine the effect of a large economy’s stock exchange movements (UK,
US, and Japan) on a small economy’s stock exchange movements (each of Arab
markets).
The next step in chapter 5 is to investigate the dynamic relationships between
Arab stock markets both on the long- and short-runs, using multivariate cointegration and
Granger causality. The total markets have been divided into two groups, oil (GCC
markets) and non-oil production countries (Jordan, Egypt, and Palestine). Chapter 5
proceeds by investigating the effect of oil prices on GCC stock markets especially during
the last two years, which witnessed huge rise in oil prices. Multivariate cointegration and
vector autoregression models were used. Moreover, oil returns have been added as an
additional regressor in the variance equation of the GARCH model, to trace the effect of
oil prices on the volatility of returns.

1-5 contribution
This section concludes by presenting the main empirical results of this thesis. The
author asked, among other things, whether Arab stock markets are efficient in the week
form sense, using daily prices for the general indices. This study concentrates on nine
new Arabian emerging markets in the Middle East region. Little is known about these
markets since most of them are new established, while for some of them (i.e. Palestine
stock exchange) this is the first empirical work examining these markets.
The first task of this research was to investigate market efficiency. For new
emerging markets, the outcomes of tests of EMH are important in assessing public policy
issues such as the desirability of mergers and takeovers. The EMH test results are also
useful for derivative market participants, whose success precariously depends on their
ability to forecast price movements, they are also important for international portfolio
investors who are looking for diversification benefits in emerging markets. Moreover,
they facilitate the important role of the stock market in efficient capital allocation. It is
important when testing market efficiency in an emerging market, to take into account the
specific features that characterize new emerging markets; such as, thin trading, non-
linearity in returns generating process, and excessive volatility. Using most recent
econometric techniques, the results indicate that returns in most Arab markets are

11
predictable. While volatility clustering still seems to characterize some markets, volatility
seems to be persistent in three markets (Egypt, Kuwait, and Palestine), other markets
(Bahrain, Dubai, Kuwait, and Oman) show signs of leverage effect and asymmetric
shocks to volatility. Moreover, return generating process found to be non-linear in these
markets, dependent in the second moment explains enough the existing non-linearity.
Furthermore, the results indicate that some kinds of anomalies exist in Arab stock
markets, we conclude

That the empirical evidence enables us to declare that Arab stock markets
are not efficient in the weak-form sense even after correction for
infrequent trading. While the dependence in the second moment found to
be enough to explain the non-linearity in return generating process.

These results provide new evidence to the existing literature for other emerging
markets. Since many evidence of predictability in emerging markets have been found and
reject the hypothesis that lagged price information cannot predict future prices (Bakaret
1995; Harvey 1995b, 1995c; Claessense et al. 1995; Buckbery 1995; Haque et al. 2001,
2004; and Bailey et al. 1990) among others.
Long-term investors are often advised to invest part of their money in stocks from
emerging markets, because developing markets are growing much faster than
industrialized countries, and less integrated with international stock markets. However,
over the last 20 years, financial markets become highly integrated; the tendency for the
global markets to become more integrated is a result of the increasing tendency toward
liberalization and deregulation in the money and capital markets. On the other hand and
according to modern portfolio theory, gains from international portfolio diversification
are related inversely to the correlation of equity markets. The integration between Arab
and international markets has been investigated, using multivariate cointegration
techniques, while structural vector autoregression (SVAR) has been employed to test the
respond of each Arabian market to shocks originated in international markets, we
conclude that

12

Arab stock markets can offer diversification potentials for both
international and regional portfolio investors, these markets found to be
segmented from international markets. In the short-term, the linkages
found to be weak in general, while UK market found to have the most
influence on Arab markets. Moreover, linkages among Arab markets still
very weak despite the existing long-term cointegration between them,
while non-oil countries’ markets can offer diversification benefits for rich
GCC investors.

These results are in line with the numerous studies that have demonstrated the
advantage of international diversification related to low correlation between various
equity markets, such as (Eun and Resick 1984; Wheatly 1988; Meric and Meric 1989;
Baily and Stulz 1990; Divecha et al. 1992; Michaud et al. 1996; Siriopoulos 1996;
Alexakis and Siriopoulos 1997; Meric et al. 2001; and Bulter and Joaquin 2002).
Gulf Cooperation Council (GCC) countries are among the most important oil
producing countries and a main player in the Organization of Petroleum Exporting
Countries (OPEC). Producing and exporting oil play a crucial role in determining foreign
earnings and governments’ budget revenues and expenditures for such countries, which
in tern affect all aspects of daily economic life. In addition, increase in oil prices has a
significant effect on local stock markets according to cash surplus. This in turn, shows the
importance of studying the relation between oil prices and stock markets in GCC
countries, especially after the huge increase in oil prices during the last two years. the
empirical results indicate that

Oil prices dominate the long-run equilibrium with GCC stock markets,
and have a significant effect in determining returns’ volatility in these
markets. Furthermore, after the raise in oil prices; the linkages between
oil prices and GCC markets increased, four GCC markets have predictive
power on oil prices, with only two markets to be predicted by oil prices.

13
 These results provide new evidence to the existing literature. Few studies have
looked into the relation between oil spot/future prices and stock markets, which mainly
concentrates on Canada, Germany, Japan, UK, and USA (see Johnes and Kaul 1996;
Huang et al. 1996; Sadorsky 1999; Papapetrou 2001; and Hammoudeh and Aleisa 2002,
2004).

14
2- Efficient Market Hypothesis (EMH)
2-1 Definition
When the term “efficient market” was introduced into the economic literature
thirty years ago, it was defined as a market which “adjusts rapidly to new information”
(Fama 1969). It soon became clear, however, that which rapid adjustment to new
information is an important element of an efficient market; it is not the only one. A more
modern definition is that asset prices in an efficient market ‘fully reflect all available
information ‘(Fama 1991). This implies that the market processes information rationally,
in the sense that relevant information is not ignored, and systematic errors are not made.
As a consequence, prices are always at levels consistent with ‘fundamentals’.
The words in this definition have been chosen carefully, but they nonetheless
mask some of the subtleties inherent in defining an efficient asset market. For one thing,
this is a strong version of the hypothesis that could only be literally true if “all available
information” was costless to obtain. If information was instead costly, there must be a
financial incentive to obtain it. But there would not be a financial incentive if the
information was already “fully reflect” in asset prices (Grossman and Stiglitz 1980). A
weaker, but economically more realistic, version of the hypothesis is therefore that prices
reflect information up to the point where the marginal benefits of acting on the
information (the expected profits to be made) do not exceed the marginal costs of
collecting it (Jensen 1978).
Secondly, we must have a model to provide a link from economic fundamentals to
asset prices. While there are candidate models in all asset markets that provide this link,
no-one is confident that these models fully capture the link in any empirically convincing
way. This is important since empirical tests of market efficiency-especially those that
examine asset price returns over extended periods of time-are necessarily joint test of
market efficiency and particular asset-pricing model. When the joint hypothesis is
rejected, as it often is, it is logically possible that this is a consequence of deficiencies in
the particular asset-price model rather than in the efficient market hypothesis. This is the
“bad model” problem (Fama 1991).
Finally, a comment about the word “efficient” It appears that the term was
originally chosen partly because it provides a link with the broader economic concept of

15
efficiency in resource allocation. Since there are three types of efficiency: (i) pricing
efficiency which refers to the notion that prices reflect rabidly in an unbiased way all
available information, (ii) operational efficiency: refers to the level of costs carrying out
transactions in capital markets, and (iii) allocational efficiency: refers to the extent to
which capital market is allocated to the most profitable enterprises (this should be a
product of pricing efficiency). When we refer to EMH, our concentration will be on
pricing efficiency. Thus Fama began his 1970 review of the efficient market hypothesis
(specially applied to the stock market):
“The primary role of the capital market is allocation of ownership of the economy’s
capital stock. In general terms, the ideal is a market in which prices provide accurate
signals for resource allocation: that is, a market in which firms can make production-
investment decisions, and investors can choose among the securities that represent
ownership of firms’ activities under the assumption that securities prices at any time
‘fully reflect’ all available information “(Fama, 1970, p. 383)
The link between an asset market that efficiently reflects available information (at
least to the point consistent with the cost of collecting the information) and its role in
efficient resource allocation may seem natural enough. An informationally efficient asset
market need not generate allocative or production efficiency in the economy more
generally. The two concepts are distinct for reasons to do with the completeness of
markets and the information-revealing role of prices when information is costly and
therefore valuable (Stiglitz 1981).

2-2 Specification of the information set

It follows that the next intellectual stage is naturally the explanation of the content
of the information set. In Fama’s statement, the information which should be reflected in
the price is presented as being “available” and ‘relevant”. How can this availability and
this relevance be characterized? Robert (1967) distinguishes between three kinds, or
levels, of information corresponding to three forms of informational efficiencies:
1. Weak-form efficiency: the information set includes only the history of prices or
returns them selves.

16
 2. Semi-strong form efficiency: the information set includes all information known
to all participants (publicly available information).
3. Strong-form efficiency: the information set includes all information known to
any market participant (private information).
The categorization of the tests into weak, semi-strong, and strong form, will serve the
useful purpose of allowing us to pinpoint the level of information at which the hypothesis
breaks down (Fama, 1991). The information set corresponding to the weak-form of
efficiency is composed by all past quoted prices of the market and only these, the weak-
form of the efficiency rules out the use of technical analysis, which appears as non-
efficient for obtaining profits higher than those of the market it self. Here again we
encounter the source of conflict with the technical analysts. The information set
corresponding to the semi-strong form of efficiency consists of the preceding set of past
prices, augmented by financial data of the firms. The semi-strong form of efficiency rules
out classic financial analysis, to obtain profits higher than those of the market. This is the
source of the conflict with the financial analysts and the economics research departments
of banks. Finally, the strong form of efficiency, which includes the two preceding sets of
information, is concerned with the existence of private information, i.e. not necessarily
public, for example the forecasts to which the professional pension funds managers have
access, unavailable to the general public. With a very strong form of efficient market, no
professional managers, even provided with high skill, can obtain profits higher than those
of the market on a long-time basis. This is the source of conflict with active managers of
portfolios, who spend a large part of their time looking for and choosing stocks which
they think will be profitable, and conjecturing as to the future development of the market.
Figure 2-1: Information Set.

17
 Fama (1991) renames these three categories. Instead of weak-form tests, he
suggests tests for return predictability, since this category now covers more general
area of return predictability. For the second and third categories, he proposes changes in
title, not coverage. Instead of semi-strong form tests of the adjustment of prices to
public announcements, he uses event studies. Instead of strong-form tests of whether
specific investors have information not in market prices, he suggests the more
descriptive title, tests for private information. This split of the information set into three
distinct categories, leads to definition of three fields of investigation into the concept of
efficiency, and then to test the efficiency. In the three cases, the gap between the return
on the portfolio and that of the market must be random variable of zero expectation.
The concept of efficiency thus becomes defined by the nature of the chosen information
as “available and relevant.”

2-3 EMH and asset pricing models

In most cases tests of market efficiency, are tests of a joint hypothesis (the joint
hypothesis problem, Fama 1991). Thus, market efficiency per se is not testable. It must
be tested with some model of equilibrium, an asset pricing model. One can say that
efficiency must be tested conditional on an asset pricing model or that asset pricing
models are tested conditional on efficiency. The point is that such tests are always joint
evidence on efficiency and an asset-pricing model. In this section we will discuss asset-
pricing models which can be divided into two main categories: single security test and
multiple security test.

2-3-1 Single security test

That is the price or return histories of individual securities are examined for
evidence of dependence that might be used as the basis of a trading system for that
security. This group includes: Fair game models, Martingle model, and Random Walk
Model (RWM).

18
2-3-1-1 Expected returns or fair game
The definitional statement that in an efficient market, prices “fully reflect” available
information is so general that it has no empirically testable implications. The process of
price formation must be specified in more detail. In essence we must define somewhat
more exactly what is meant by the term “fully reflect”. The conditions of market
equilibrium can be stated in terms of expected returns. All members of the class of such
“expected return theories” can, however, be described notationally as follows:

E ( ~p j ,t + 1 / Φ t ) = [1 + E (~r j ,t + 1 / Φ t )]p jt
(2-1)

Where E is the expected value operator; Pjt is the price of security j at time t; Pj,t+1 is its
price at t+1; rj,t+1 is the one period percentage return (Pj,t+1-Pjt)/Pjt; Φt is a general
symbol for whatever set of information is assumed to be “fully reflect” in the price at t;
and tildes indicate that Pj,t+1 and rj,t+1 are random variables at t. A “fair game” model as
summarized in (2-1) has properties which are implications of the assumptions that (i)
the conditions of market equilibrium can be stated in terms of expected returns, and (ii)
the information Φt if fully utilized by the market in forming equilibrium expected
returns and thus current prices. The role of “fair game” models in theory of efficient
markets was first recognized and studied by Mandelbrot (1966) and Samuelson
(1965).The value of the equilibrium expected return E (~
r / Φ ) projected on the basis
j , t +1 t

of information Φt would be determined from the particular expected return theory at

hand. The conditional expectation notation of (2-1) is meant to imply, however, that
what ever expected return model is assumed to apply, the information in Φt is fully
utilized in determining equilibrium expected returns. And this is the sense in which Φt
is “fully reflected” in the formation of the price Pjt.

The assumptions that the conditions of market equilibrium can be stated in terms
of expected returns and the equilibrium expected returns are formed on the basis of the
information set Φt, have a major empirical implication. They rule out the possibility of

19
trading system based only on information in Φt that has expected profits or returns. Thus,
let
X j , t +1 = P j ,t +1 − E (P j ,t +1 / Φ t ) (2-2)

Then E (~
x j ,t +1 / Φ t ) = 0 (2-3)

Which, by definition, says that the sequence {xjt} is a “fair game” with respect to the
information sequence {Φ}. Or, equivalently, let

Z j ,t + 1 = r j , t + 1 − E (~
r j ,t + 1 / Φ t ), (2-4)

Then E (Z j ,t + 1 / Φ t )= 0 (2-5)

So the sequence {Zit} is also a “fair game” with respect to the information sequence {Φ}.
In economic terms, Xj,t+1 is the excess market value of security j at time t+1 : it is the
difference between the observed price and the expected value of the price that was
projected at t on the basis of the information Φt, and similarly, Zj,t+1 is the return at t+1 in
excess of the equilibrium expected return projected at t. let

a (Φ t ) = [a1 (Φ t ), a 2 (Φ t ),..., a n (Φ t )]

be any trading system based on Φt which tells the investors the amounts aj(Φt) of funds
available at t that are to be invested in each of the n available securities. The total excess
market value at t+1 that will be generated by such a system is

n
V t +1 = ∑ aj (Φ t )[r j ,t + 1 − E (~r j ,t + 1 / Φ t )]
j =1

This, from the “fair game” property of (2-5) has expectation:

n
~
(
E V t +1 / Φ t = ) ∑ aj (Φ t )E (Z~ j , t + 1 / Φ t ) = 0.
j =1

20
2-3-1-2 The submartingale model
Assume that in (2-1) that for all t and Φt

(~
)
E Pj ,t +1 / Φ t ≥ Pjt , Or equivalently, E (~
r j ,t +1 / Φ t ) ≥ 0 (2-6)

this is a statement that the price sequence {Pjt} for security j follows a submartingale with
respect to the information sequence {Φt}, which is no thing more than that the expected
value of next period’s price, as projected on the basis of information Φt, is equal to or
grater than the current price. If (2-6) holds as an equality (so that expected returns and
price changes are zero), then the price sequence follows a martingale. A submartingale in
prices has one important empirical implication. Consider the set of “one security and
cash” mechanical trading rules, which systems that concentrate on individual securities
and are that define the conditions under which the investor would hold a given security,
sell it short, or simply hold cash at any time t. then the assumption of (2-6) that expected
returns conditional on Φt are non-negative directly implies that such trading rules must
based only on the information in Φt cannot have grater profits than a policy of always
buying-and-holding the security during the future period in question.

2-3-1-3 The Random Walk model

The statement that the current price of a security “fully reflects” available
information was assumed to imply that successive price changes (or more usually,
successive one period returns) are independent. In addition, it was usually assumed that
successive changes (or returns) are identically distributed. Together the two hypotheses
constitute the random walk model. Formally, the model is:

f (r j , t +1 / Φ t ) = f (r j , t +1 ), (2-7)

Which is the usual statement that the conditional or marginal probability distributions of
an independent random variable are identical. In addition, the density function f must be
the same for all t. expression (2-7) says much more than the general expected return

21
model summarized by (2-1). For example, if we restrict (2-1) by assuming that the
expected return on security j is constant over time, then we have

E (~
r j ,t +1 / Φ t ) = E (~r j ,t +1 ). (2-8)

This says that the mean of the distribution of rj,t+1 is independent of the
information available at t, Φt, whereas the random walk model of (2-7) in addition says
that the entire distribution is independent at Φt. Random walk model can be considered
as an extension of the general expected return of “fair game” efficient market model, in
the sense of making a more detailed statement about the economic environment. The “fair
game” model just says that the conditions of market equilibrium can be stated in terms of
expected returns, and thus it says little about the details of the stochastic process
generating returns. A random walk arises within the context of such a model when the
environment is such that the evolution of investor tastes and the process generating new
information combine to produce equilibria in which return distributions repeat themselves
through time.

2-3-2 Multiple security expected return models

The multiple securities expected return models test whether securities are “appropriately
priced” vis-à-vis one another. But to judge whether differences between average returns
are “appropriate”, an economic theory of equilibrium expected return is required. Such as
one-factor Sharp-Lintner-Black model, multifactor asset-pricing model and market
model.

2-3-2-1 The Sharp-Lintner-Black model (SLB model)

Sharp (1964) and Lintner (1965) propose the first version of this model. In this
model, the expected return on security j from time t to t+1 is

rm ,t +1 / Φ t ) − r f ,t +1  cov(~
 E (~ rm ,t +1 / Φ t )
r j ,t +1 , ~
E (r~ /Φ )= r f ,t +1 +   (2-9)
 σ (rm ,t +1 / Φ t )  σ (~ rm,t +1 / Φ t )
j ,t +1 t ~

22
Where rf,t+1 is the return from t to t+1 on an asset that is riskless in money terms; rm,t+1 is
the return on the “market portfolio” m; σ 2 (~r / Φ ) is the variance of the return on m;
m ,t +1 t

cov (~ rm ,t +1 / Φ t ) is the covariance between the return on j and m; and the appearance
r j ,t +1 , ~

of Φt indicates that the various expected returns, variance and covariance, could in
principle depend on Φt. Though Sharp and Lintner derive (2-9) as a one-period model,
the result is given a multiperiod justification and interpretation in (2-9). In words, (2-9)
says that the expected one-period return on a security is the one-period riskless rate of
interest rf,t+1 plus a “risk premium” that is proportional to
cov (~
r j ,t +1 , r~m ,t +1 / Φ t ) / σ (~
rm ,t +1 / Φ t ) . In the Sharp-Lintner model each investor holds some

combination of the riskless asset and the market portfolio, so that, given a mean-standard
deviation framework, the risk of an individual asset can be measured by its contribution
to the standard deviation of the return on the market portfolio. This contribution is in
fact cov (~
r j ,t +1 , r~m ,t +1 / Φ t ) / σ (~
rm ,t +1 / Φ t ) . The factor [E(~r
m,t +1 ]
/ Φt ) − rf ,t +1 / σ (~
rm,t +1 / Φt ),
which is the same for all securities is then regarded as the market price of risk.
The early 1970’s produce the first extensive tests of SLB model (Black, Jensen,
and Scholes 1972; Blum and Friend 1973; and Fama and MacBeth 1973). These early
studies suggest that the special prediction of the Sharp-Lintner version of the model, that
portfolios uncorrelated with the market have expected returns equal to the risk-free rate
of interest, does not fare well (the average returns on such “zero-β” portfolios are higher
than the risk-free rate), other predictions of the model seem to do better. The most
general implication of the SLB model is that equilibrium pricing implies that the market
portfolio is ex ante mean-variance efficient in the sense of Markwitz (1959). Consistent
with this hypothesis, the early studies suggest that (i) expected returns are a positive
linear function of market β (the covariance of a security’s return with the return on the
market portfolio divided by the variance of market return), and (ii) β is the only measure
of risk needed to explain the cross-section of expected returns. With this early support for
the SLB model, there was a brief euphoric period in 1970’s when market efficiency and
the SLB model seemed to be sufficient description of security returns.
However, the empirical attacks on the SLB model begin in the late 1970’s with
studies that identify variables that contradict the model’s prediction that market β’s

23
suffice to describe the cross-section of expected returns. Basu (1977, 1983) shows that
earning /price ratio (E/P) has marginal explanatory power; controlling for β, expected
returns are positively related to E/P. Bans (1981) shows that a stock’s size (price times
shares) helps explain expected returns; given their market β’s, expected returns on small
stocks are too high, and expected returns on large stocks are too low. Bhandari (1988)
shows that leverage is positively related to expected stock returns in tests that also
include market β’s. Finally, Chan, Hamao, and Lakonishok (1991) and Fama and French
(1991) find that book-to-market equity (the ratio of the book value of a common stock to
its market value) has strong explanatory power; controlling for β, higher book-to-market
ratios are associated with higher expected returns.

2-3-2-2 Market model

The market model, which is originally suggested by Markwitz (1959),
hypothesizes that we can represent the return on an individual security (or portfolio) as a
linear function of an index of market returns, let:

r~j ,t +1 = a j + β j ~
rm ,t +1 + u j ,t +1 (2-10)

Where rj,t+1 is the rate of return on security j for time t; rm,t+1 is the corresponding return
on a market index m; aj, βj are parameters that can vary from security to security; and
uj,t+1 is a random disturbance. Fama, Fisher, Jensen, and Roll (1969) and the more
extensive work of Blum (1968), test the market model using monthly return data. These
tests indicate that (2-10) is well specified as a linear regression model in that (i) the

estimated parameter â j and β̂ j remain fairly constant over long periods of time (e. g.,

the entire post-world war II period in the case of Blum), (ii) rm,t+1 and the estimated uˆ j ,t +1 ,

are close to serially independent, and (iii) the uˆ j ,t +1 seems to be independent of rm,t+1.

Thus, the observed properties of the market model are consistent with the expected return
efficient market model, and in addition, the market model tells us some thing about the
process generating expected returns from security to security. However, the results for the

24
market model are just a statistical description of the return generating process, and they
are probably somewhat consistent with other models of equilibrium expected returns.

2-3-2-3 Multifactor models

In the Sharp-Lintner-Black model, the cross-section of expected returns on
securities and portfolios is described by their market β’s, where β is the slope in the
simple regression of a security’s return on the market return. The multifactor asset-
pricing models of Merton (1973) and Ross (1976) generalize this result. In these models,
the return-generating process can involve multiple factors, and the cross-section of
expected returns is constrained by the cross-section of factor loadings (sensitivities). A
security’s factor loading are the lopes in a multiple regression of its return on the factors.
Ross (1976) suggests the Arbitrage-Pricing Theory (APT), uses factor analysis to
extract the common factors in returns and then tests whether expected returns are
explained by the cross-sections of the loadings of security returns on the factors (Roll and
Ross 1980; Chen 1983). Lehmann and Modest (1988) test this approach in detail. Most
interesting, using models with up to 15 factors, they test whether the multifactor model
explains the size anomaly of the SLB model. They find that the multifactor model leaves
an unexplained size effect much like the SLB model; that is, expected returns are too
high, relative to the model, for small stocks and too low for large stocks. The factor
analysis approach to tests for APT leads to un-resolvable squabbles about the number of
common factors in returns and expected returns (Dhrymes, Friend, and Gultekin 1984;
Roll and Ross 1984; Dhrymes, Friend, Gultekin and Gultekin 1984; Trzcinka 1986;
Conway and Reinganum 1988). Fama (1991) argues that the multifactor analysis
approach can confirm that there is more than one common factor in returns and expected
returns, which is useful.

25
2-3-2-4 Consumption-based Asset-Pricing models
The consumption-based model of Rubinsten (1976), Lucas (1978), Breeden
(1979), and others is the most elegant of the available intertemporal asset-pricing models.
In Breeden’s version, the interaction between optimal consumption and portfolio
decisions leads to a positive linear relation between expected returns on securities and
their consumption β’s. (a security’s consumption β’s is the slope in the regression of its
return on the growth rate of per capita consumption). The model thus summarizes all the
incentives to hedge shifts in consumption and portfolio opportunities that can appear in
Merton’s (1973) multifactor model with a one-factor relation between expected returns
and consumption β’s. The simple elegance of the consumption model produces a
sustained interest in empirical test. The tests use versions of the model that make strong
assumptions about tastes (time-additive utility for consumption and constant relative risk
aversion) and often about the joint distribution of consumption growth and returns
(multivariate normality). Because the model is then so highly specified, it produces a rich
set of testable predictions about the time series and cross-section properties of returns.
The empirical work on the consumption model often jointly tests its time series
and cross-section predictions, using the path breaking approach in Hansen and Singelton
(1982). Estimation is with Hansen’s (1982) generalized method of moments, the test is
based on a χ2 statistic that summarizes, in one number, how the data conform to the
model’s many restrictions. The tests usually reject. The disappointment comes when the
rejection is not pursued for additional descriptive information, obscure in the χ2 test,
about which restrictions of the model (time-series, cross-section, or both) are the
problem. In short, tests of the consumption model some times fail the test of usefulness;
they don’t enhance our ability to describe the behavior of returns, the tests of the
consumption model make no attempt to deal with the anomalies that have caused
problems for the SLB model. It would be interesting to confront consumption β’s with
variables like size and book-to-market equity, that have caused problems for the market
β’s of the SLB model. Given that the consumption model does not seem to fare well in
tests against the SLB model or the multifactor model, however, the consumption model
will do no better with the anomalies of the SLB model (Fama 1991).

26
 Finally, it is important to emphasize that the SLB model, the consumption model,
and the multifactor model are not mutually exclusive. Following Constantinides (1989),
one can view the models as different ways to formalize the asset-pricing implications of
common general assumption about tastes (risk aversion) and portfolio opportunities
(multivariate normality).

2-4 EMH its origins and evidence

The concept of efficiency is central to finance. And gained a lot of interest of
popularity that the literature now is so vast and impossible to be included in a single
review as correctly indicating by Fama (1991, pp.1575): “The literature is now so large
that a full review is impossible”. Therefore, the main work about market efficiency
especially that of particular interest to the purpose of this research, is included. We will
start with the origins of EMH, the Random Walk Model and EMH, evidence of EMH in
its three forms; weak-form tests (return predictability); semi-strong tests (event studies);
and strong-form tests (private information). After that we will come to the attack on
EMH through existing anomalies in the literature.

2-4-1 The origin of EMH

If capital markets are sufficiently competitive, then simple microeconomics
indicates that investors cannot expect to achieve superior profits from their investment
strategies. But although this appears self-evident today, it was far from obvious for the
majority of the century. Up to the end of the 1950s, there were few theoretical or
empirical studies of securities markets; and until Cootner (1964) collected a selection of
papers from a wide variety of sources, the literature was dispersed across journals in
statistics, operations research, mathematics and economics.
The concept of market efficiency had been anticipated at the beginning of the
century in a dissertation submitted by Bachelier (1900) to the Sorbonne for his PhD in
mathematics. In his opening paragraph, Bachelier recognizes that “past, present and even
discounted future events are reflected in market prices, but often show no apparent
relation to price changes”. This recognition of the informational efficiency of the market
leads Bachelier to continue, in his opening paragraphs, that “if the market, in effect, does

27
not predict its fluctuations, it does assess them as being more or less likely, and this
likelihood can be evaluated mathematically”. This gives rise to a brilliant analysis that
anticipates not only Albert Einstein’s subsequent derivation of the Einstein-Wiener
process of Brown motion, but also many of the analytical results that were rediscovered
by finance academics in the second half of the century. Bachelier’s contribution was
overlooked until it was circulated to economists by Paul Samuelson in the late 1950’s and
subsequently published in English by Cootner (1964).
Although there could have been an emerging theory of speculative markets during
the first half of the twentieth century, this was not to be. Instead, the early literature
followed the path of accumulating a variety of empirical observations that did not sit
easily alongside the paradigms of economics or the beliefs of practitioners. Bachelier had
concluded that commodity prices fluctuate randomly, and later studies by Working
(1934) and Cowels and Jones (1937) were to show that U.S stock prices and other
economic series also share the same characteristics. These studies were largely
overlooked by researchers until the late of 1950’s. There was in addition, disturbing
evidence about the difficulty of beating the equity markets. Alfred Cowels III, founder of
the Cowels Commission and benefactor of the Economic Society, published in the launch
issue in Econometrica a painstaking analysis of many thousands of stock selections made
by investment professionals. Cowels (1933) finds that there was no discernable evidence
of any ability to outguess the market. Subsequently, Cowels (1944) provides
corroborative results for a large number of forecasts over a much longer sample period.
By the 1940’s, there was therefore scattered evidence in favor of the weak and strong
form efficiency of the market, though these terms were not yet in use.

2-4-2 Weak-form efficiency (returns predictability)

The weak form of the efficient market hypothesis, which expanded by Fama
(1991) to include returns predictability, claims that prices fully reflect the information
implicit in the sequence of past prices and prices have no memory and follow random
walk properties. The literature begins, therefore, with studies of weak-form market
efficiency.

28
2-4-2-1 Random Walk Hypothesis (RWH)
The random walk theory asserts that price movement will not follow any patterns
or trends and that past price movements cannot be used to predict future price
movements. In the early literature, discussions of the efficient markets model were
phrased in terms of the even more special random walk model. Fama (1970) summarizes
the early random walk literature and his own contributions and other studies of the
information contained in the historical sequence of prices. It was not until the work of
Samuelson (1965) and Mandelbrot (1966) that the role of “fair game” expected return
models in the theory of efficient markets and the relationships between these models and
the theory of random walks were rigorously studied. And these papers come somewhat
offer the major empirical work on random walks. Until the Mandelbrot-Samuelson
models appeared, there exists a large body of empirical results in search of a rigorous
theory.
The first statement and test of the random walk model was that of Bachelier
(1900). But his “fundamental principle” for the behavior of prices was that speculation
should be a “fair game”; in particular, the expected profits to the speculator should be
zero. With the benefit of stochastic processes theory, the process implied by this
fundamental principle is a Martingle. After Bachelier, research on the behavior of
security prices lagged until the coming of computer. In 1933 Kendall (1953) examined
the behavior of weekly changes in nineteen indices of British industrial share prices and
in spot prices for cotton (New York) and wheat (Chicago). After extensive analysis of
serial correlations, he suggests: “the series looks like a wondering one, almost as if once
a week the Demon of Chance drew a random number from a symmetrical population of
fixed dispersion and added it to the current price to determine the next week’ price”
(Kendall 1953, p.13).
Kendall’s conclusion had been suggested earlier by Working (1934) though his
suggestion lacked the force provided by Kendall’s empirical results, and the implications
of the conclusion for stock market research and financial analysis were later underlined
by Roberts (1959). But the suggestion by Kendall, Working, and Roberts that series of
speculative prices may be well described by random walks was based on observations,
none of these authors attempted to provide much economic rational for the hypothesis,

29
and, indeed, Kendall felt that the economists would generally reject it. Osborne (1959)
suggests market conditions, similar to those assumed by Bachelier that would lead to a
random walk. But in his model, independence of successive price changes derives from
the assumption that the decisions of investors in an individual security are independent
from transaction to transaction.
Most of the empirical evidence in the random walk literature can easily be
interpreted as tests of more general expected return or “fair game” models, “fair game”
models imply the “impossibility” of various sorts of trading systems. Some of the random
walk literature has been concerned with testing the profitability of such systems. More of
the literature has, however, been concerned with tests of serial covariance of returns. The
serial covariances of a “fair game” are zero, like a random walk, so that these tests are
also relevant for the expected return models.
If xt is a “fair game”, its unconditional expectation is zero and its serial covariance can be
written in general form as:

~
( ~
E X t+r X t = ) ∫X t (~
E X t+r / X t ) f (x t )dx t ,
xt

Where f indicates a density function, but if xt is a “fair game”,

~
(
E X t +1 / X t = 0 )

From this, it follows that for all lags, the serial covariances between lagged values of a
“fair game” variable are zero.
Thus, observations of a “fair game” variable are linearly independent. But the “fair
game” model does not necessarily imply that the serial covariances of one-period returns
are zero. In the weak form tests of this model the “fair game” variable is:

z j ,t = r j ,t − E (~
r j ,t / r j ,t −1 , r j ,t − 2 ,... ) (2-11)

But the covariance between, for example, rjt and rj,t+1 is:

30
 E ([ ~
r j ,t + 1 − E ( ~r j , t + 1 )][ r~ jt − E ( ~ r jt )])
= ∫ [ r jt − E ( ~ r jt )][ E ( ~ r j , t + 1 / r jt ) − E ( ~r j , t + 1 )] f ( r jt ) dr jt
, (2-12)
r jt

And (2-11) does not imply that E (r~j ,t +1 / r jt ) = E (~

r j ,t +1 ) .

In the “fair game” efficient markets model, the deviation of the return for t+1
from its conditional expectation is a ”fair game” variable, but the conditional expectation
itself can depend on the return observed for t. In the random walk literature, this problem
is not recognized, since it is assumed that the expected return (and indeed the entire
distribution of returns) is stationary through time. In practice, this implies estimating
series covariances by taking cross products of deviations of observed returns from the
overall sample mean return. This procedure, which represents a rather gross
approximation from the view point of the general expected return efficient market model,
does not seem to greatly affect the results of the covariance tests, at least for common
stocks.
However, there are types of nonlinear dependence that imply the existence of
profitable trading systems, and yet do not imply non-zero serial covariance. The first
major evidence on trading rules was Alexander’s (1961, 1964). He tests a variety of
trading systems, such a y% filter, which is a “one security and cash” trading rule, so that
the results it produces are relevant for the submartingale expected return model.
Alexander concludes that there is some evidence in his results against the independence
assumption of the random walk model. But market efficiency does not require a random
walk, and from the view point of the submartingale model, the conclusion that the filters
cannot beat buy-and-hold is support for the efficient market hypothesis. Further support
is provided by Fama and Blum (1966) who compare the profitability of various filters to
buy-and-hold for the individual stocks of Dow-Jones Industrial Average. But some
evidence in the filter tests of both Alexander and Fama-Blum that is inconsistent with the
submartingale efficient markets model. In particular, the results for very small filters
indicate that it is possible to devise trading schemes based on very short-term (intra-day
but at most daily) price swings that will be on average outperform buy-and-hold.

31
 These results are evidence of persistence or positive dependence in very short-
term price movement. This is consistent with the evidence for slight positive linear
dependence in successive daily price changes produced by serial correlations. Thus, the
filter tests, like the serial correlations, produce empirically noticeable departures from the
strict implications of the efficient markets model. But, despite of any statistical
significance they might have, from the economic viewpoint the departures are so small
that it seems hardly justified to use them to declare the market inefficient. Another
departure from the pure independence assumption of the random walk model has been
noted by Osborne (1962), Fama (1965) and others. In particular, large daily price changes
tend to be followed by large daily changes. The signs of the successor changes are
apparently random, however, which indicates that the phenomenon represents a denial of
the random walk model but not of the market efficiency hypothesis. It may be that when
important new information comes into the market it cannot always be immediately
evaluated precisely. Thus, sometimes the initial price will over adjust to the information,
and other times it will under adjust. But since the evidence indicates that the price
changes on days following the initial large change are random. In sign, the initial large
change at least represents an unbiased adjustment to the ultimate price effects of the
information, and this is sufficient for the expected return efficient market model.
Niederhoffer and Osborne (1966) document two departures from complete
randomness in common stock price changes from transaction to transaction. First, their
data indicate that reversals (pairs of consecutive price changes of opposite signs) are from
two to three times as likely as continuations (pairs of consecutive price changes of the
same sign). Second, a continuation is slightly more frequent after a preceding
continuation than after a reversal. Niederhoffer and Osborne offer explanation for these
phenomena based on the market structure of the New York Stock Exchange (NYSE). But
though Niederhoffer and Osborne present convincing evidence of statistically significant
departures from independence in price changes from transaction to transaction, and
though their analysis of their findings presents interesting insights into the process of
market making on the major changes. Their analysis of market making does, however,
point clearly to the existence of market inefficiency, but with respect to strong form tests
of the efficient market model.

32
 The random walk literature also has centered on the nature of the distribution of
price changes, which is an important issue for the EMH. Since the nature of the
distribution affects both the types of statistical tools relevant for testing the hypothesis
and the interpretation of any results obtained. A model implying normally distributed
price changes was first proposed by Bachelier (1900), who assumed that price changes
from transaction to transaction are independent, identically distributed random variables
with finite variances. If transactions are fairly uniformly spread across time, and if the
number of transactions per day, week, or month is very large, then the Central Limit
Theorem leads us to expect that these prices changes will have normal or Guassian
distribution. Osborne (1959), Moore (1962), and Kendall (1953) although their empirical
evidence support the normality hypothesis, but all observed high tails in their data
distribution. Drawing on these finding and some empirical work of his own, Mandelbort
(1963) then suggests that these departures from normality could be explained by a more
general form of Bachelier model. In particular, if one does not assume that distributions
of price changes from transaction necessarily have finite variance, then the limiting
distributions for price changes over longer differencing intervals could be any member of
the stable class, which includes the normal as special case. Non-normal stable
distributions have higher tails than the normal, and so can account for this empirically
observed feature of distributions of price changes. Fama (1965), after extensive testing,
concludes that non-normal stable distributions are a better description of distributions of
daily returns on common stocks than the normal. This conclusion is also supported by the
empirical work of Blum (1968) on common stocks, and it has been extended to U.S
Government Treasury Bills by Roll (1968).

2-4-2-2 Return predictability

The tests of weak-form-efficiency up to this point, focused on forecasting returns
from past returns. However, and after 1970 the tests reject the market efficiency-constant
expected returns model that seems to do well in the early work. Since weak-form tests
concerned with the forecast power of past returns, Fama (1991) expands the coverage of
the first category of EMH to cover the more general area of tests for return predictability.
Such as forecast power of variables like dividend yield (D/P), earning/price ratio (E/P),

33
and term structure variables. Moreover, the early work of weak-form-efficiency
concentrated on the predictability of daily, weekly, and monthly returns, but the recent
tests also examine the predictability of returns for long horizons.
In the pre-1970 literature the common equilibrium-pricing model in tests of stock
market efficiency is the hypothesis that expected returns are constant through time.
Market efficiency then implies that returns are unpredictable from past returns or other
past variables, and the best forecast of return is its historical mean. After the 1970’s, daily
data on NYSE and AMEX stocks back to 1962, makes it possible to estimate precisely
the autocorrelation in daily and weekly returns. Lo and MacKinlay (1988) find that
weekly returns on portfolios of NYSE stocks grouped according to size, show reliable
positive autocorrelation. The autocorrelation is stronger for portfolios of small stocks.
This suggests, however, that the results are due in part to the nonsynchronous trading
effect (Fisher 1966). Fisher emphasizes that spurious autocorrelation in portfolio returns,
induced by nonsynchronous closing trades for securities in the portfolio, is likely to be
more important for portfolios titled toward small stocks. Conrad and Kaul (1988)
examine the autocorrelation of Wednesday-to-Wednesday returns for size-grouped
portfolios of stocks that trade on both Wednesdays. Like Lo and MacKinlay (1988), they
find that weekly returns are positively autocorrelated, and more for portfolios of small
stocks. French and Roll (1986) find that stock prices are more variable when the market
is open. On an hourly basis, the variance of price changes is 72 times higher during
trading hours than during weekend nontrading hours. Likewise, the hourly variance
during trading hours is 13 times the overnight nontrading hourly variance during the
trading week. One of the explanations that French and Roll test is a market inefficiency
hypothesis popular among academics; specifically, the higher variance of price changes
during trading hours is partly transitory, the results of noise trading by uninformed
investors (Black 1986). Under this hypothesis, pricing errors due to noise trading are
eventually reversed, and this induces negative autocorrelation in daily returns.
With the Center for Research in Security Prices (CRSP) daily data back to 1962,
post -1970’s research is able to show confidently that daily and weekly returns are
predictable from past returns. The work thus rejects the old market efficiency-constant
expected returns model on a statistical basis. The results tend to confirm the conclusion

34
of the early work that, at least for individual stocks, variation in daily and weekly
expected returns is a small part of the variance of returns. The early literature does not
interpret the autocorrelation in daily and weekly returns as important evidence against the
joint hypothesis of market efficiency and constant expected returns. The argument is that,
even when the autocorrelations deviate reliably from zero, they are close to zero and thus
economically insignificant. The view that autocorrelation of short-horizon returns close
to zero imply economic insignificance is challenged by Shiller (1984) and Summers
(1986). They present simple models in which stock prices take large slowly decaying
swings away from fundamentals values (fads, or irrational bubbles), but short-horizon
returns have little autocorrelation. In the Shiller-Summers model, the market is highly
inefficient, but in away that is missed in tests on short-horizon returns.
Stambaugh (1986) points out that although the Shiller-Summers model can
explain autocorrelation of short-horizon returns that are close to zero. The long swings
away from fundamental value proposed in the model imply that long-horizon returns
have strong negative autocorrelation. Since the swings away from fundamental value are
temporary, over long horizons they tend to be reversed. Another implication of the
negative autocorrelation induced by temporary price movements is that the variance of
returns should grow less than in proportion to the return horizon. Fama and French
(1988a) find that the autocorrelations of returns on diversified portfolios of NYSE stocks
for the 1926-1985 period have the pattern predicted by Shiller-Summers model. Even
with 60 years of data, however, the tests on long-horizon returns imply small sample size
and low power. When Fama and French delete the 1926-1940 period from the tests, the
evidence of strong negative autocorrelation in 3-to5 years’ returns disappears. Similarly,
Poterba and Summers (1988) find that, for N from 2 to 8 years, the variance of the N-year
returns on diversified portfolios grows much less than in proportion to N, this is
consistent with the hypothesis that there is negative autocorrelation in returns induced by
temporary price swings. Even with 115 years (1871-1985) of data, however, the variance
tests for long-horizon returns provide weak statistical evidence against the hypothesis that
returns have no autocorrelation and prices are random walks.
DeBondt and Thaler (1985, 1987) mount an aggressive empirical attack on market
efficiency, directed at unmasking irrational bubbles. They find that the NYSE stocks

35
identified as the most extreme losers over a 3-to 5 years period tend to have strong
returns relative to the market during the following years, especially in January of the
following years. Conversely, the stocks identified as extreme winners tend to have weak
returns relative to the market in subsequent years. They attribute these results to market
overreaction to extreme bad or good news about firms. Jagadeesh (1990), Lehmann
(1990), Lo and MacKinlay (1990) also find reversal behavior in the weekly and monthly
returns of extreme winners and losers. Lehmann’s weekly reversals seem to lack
economic significance. When he accounts for spurious reversals due to bouncing between
bid and ask price, trading costs of 0.2% per turnaround transaction suffice to make the
profits from his reversal trading rules close to zero.
An autocorrelation is the slope in a regression of the current return on a past
return. Since variation through time in expected returns is only part of the variation in
returns, tests based on autocorrelations lack power because past realized returns are noisy
measures of expected returns. Power in tests for return predictability can be enhanced if
one can identify forecasting variables that are less noisy proxies for expected returns than
past returns. A Puzzle of the 1970’s was to explain why monthly stock returns are
negatively related to expected inflation (Nelson 1976; Jaffe and Mandelker 1976; Fama
1981) and the level of short-term interest rates (Fama and Schwert 1977). Like the
autocorrelation tests, however, the early work on forecasts of short-horizon returns from
expected inflation and interest rates suggests that the implied variation in expected return
is a small part of the variance of returns. However, for long-horizon returns, predictable
variation is a larger part of return variances.
Fama and French (1988b) use dividend yields D/P to forecast returns on the
value-weighted and equally weighted portfolios of NYSE stocks for horizons from 1
month to 5 years. D/P explains small fractions of monthly and quarterly return variances.
Fractions of variances explained grow with the return horizon, however, and are around
25% for 2-to 4 years returns. Campbell and Shiller (1988b) find that E/P ratios have
reliable forecast power that also increased with return horizon. Fama and French (1988b)
argue that dividend yields track highly autocorrelated variation in expected returns that
becomes a large fraction of return variation for longer return horizons. The increasing
fraction of the variance of long-horizon returns explained by D/P is thus due in large part

36
to the slow mean reversion of expected returns. Examining the forecast power of
variables like D/P and E/P over a range of returns horizons nevertheless gives striking
perspective on the implications of slow-moving expected returns for the variation of
returns. Fama and French (1989) suggest a different way to judge the implications of
return predictability for market efficiency. They argue that if variation in expected returns
is common to different securities, then it is probably a rational result of variation in tastes
for current versus future consumption or in the investment opportunities. They push the
common expected returns argument for market efficiency one step farther, they argue that
there are systematic patterns in the variation of expected returns through time that suggest
that it is rational. They find that the variation in expected returns tracked by D/P and the
default spread (the slopes in the regressions of returns on D/P or the default spread)
increase from high-grade bonds to low-grade bonds, from bonds to stocks, and from large
stocks to small stocks, this ordering corresponds to intuition about the risks of the
securities.
On the other hand, the variation in expected returns tracked by the term spread is
similar for all long-term securities (bonds and stocks), which suggests that it reflects
variation in a common premium for maturity risks. The general message of the Fama-
French tests is that D/P and the default spread are high (expected returns on stocks and
bonds are high) when times have been poor (growth rates of output have been persistently
low). On the other hand, the term spread and expected returns are high when economic
conditions are weak but anticipated to improve (future growth rates of output are high).
Persistent poor times may signal low wealth and higher risks in security returns, both of
which can increase expected returns. In addition, if poor times (and low incomes) are
anticipated to be partly temporary, expected returns can be high because consumers
attempt to smooth consumption from the future to the present.

2-4-3 Semi-strong-form of efficiency (event studies)

Semi-strong form tests of efficient markets model are concerned with whether
current prices “fully reflect” all obviously publicly available information. Fama (1991)
proposes changes in title, not coverage. He uses the title “event studies” instead of semi-
strong-form tests of the adjustment of prices to public announcements. The study of stock

37
splits by Fama, Fisher, Jensen, and Roll (1969), was the original event study. The
purpose of the study was to have a work that made extensive use of the newly developed
CRSP monthly NYSE file at that time. They find that, if information in stock splits
concerning the firm’s future dividend payments is on average fully reflected in the price
of a split share at the time of the split. Event studies are now an important part of finance,
especially corporate finance. In 1970’s there was little evidence on the central issues of
corporate finance. Now we are overwhelmed with results, mostly from event studies,
using simple tools, this research documents interesting regularities in the response of
stock prices to investment decisions; financing decisions; and changes in corporate
control.
Regarding EMH, the CRSP files of daily returns on NYSE, AMEX, and
NASDAQ stocks are a major boost for the precision of event studies. When the
announcement of an event can be dated to the day, daily data allow precise measurement
of the speed of stock-price response- the central issue of market efficiency. Another
powerful advantage of daily data is that they can attenuate or eliminate the joint-
hypothesis problem, that market efficiency must be tested jointly with an asset-pricing
model. The typical result in event studies on daily data is that, on average, stock prices
seem to adjust within a day to the event announcement. The fact that quick adjustment is
consistent with efficiency is noted, and then the studies move on to other issues. In short,
in the only empirical work where the joint hypothesis problem is relatively unimportant,
the evidence typically says that, with respect to firm-specific events, the adjustment of
stock prices to new information is efficient (Fama 1991).
Moreover, when part of the response of prices to information seems to occur
slowly, event studies become subject to the joint-hypothesis problem. For example, the
early merger work finds that the stock prices of acquiring firms hardly react to merger
announcements, but therefore they drift slowly down (Asquith 1983). One possibility is
that acquiring firms on average pay too much for target firms, but the market only
realizes this slowly; the market is inefficient (Roll 1986). Another possibility is that the
post-announcement drift is due to bias in measured abnormal returns (Frank, Haris, and
Titman 1991). Still another possibility is that the drift in the stock prices of acquiring
firms in the early merger studies is sample-specific. Mitchell and Lehn (1990) find no

38
evidence of post announcement drift during the 1982-1986 period for a sample of about
400 acquiring firms. Post-announcement drift in abnormal return is also a common result
in studies of the response of stock prices to earnings announcements. Predictability, there
is a raging debate on the extent to which the drift can be attributed to problems in
measuring abnormal returns (Bernard and Thomas 1989; Ball, Kothari, and Watta 1990).
Bernard and Thomas (1990) identify a more direct challenge to market efficiency in the
way stock prices adjusted to earnings announcements; they argue that the market does not
understand the autocorrelation of quarterly earnings. As a result, part of the 3-day stock-
price response to this quarter’s earning announcement is predictable from earning 1 to 4
quarters back.
In short, some event studies suggest that stock prices do not respond quickly to
specific information. Given the event –study boom of the last 20 years, however, some
anomalies, spurious and real, are inevitable. Moreover, event studies are the cleanest
evidence we have on efficiency (the least encumbered by the joint-hypothesis problem).
With few exceptions, the evidence is supportive (Fama 1991).

2-4-4 Strong-form-efficiency (private information)

The strong tests of the efficient markets model are concerned with whether all
available information is fully reflected in prices in the sense that no individual has higher
expected trading profits than others because he has monopolistic access to some
information. Niederhoffer and Osborn (1966) show that NYSE specialists use their
monopolistic access to the book of limit orders to generate trading profits. Scholes (1972)
shows that corporate insiders have access to information not reflected in prices. Jaffe
(1974) finds that for insiders the stock market is not efficient; insiders have information
that is not reflected in prices, and market does not react quickly to public information
about insider trading, outsiders can profit from the knowledge that there has been heavy
insider trading for up to 8 months after information about trading becomes public.
Seyhun (1986) offers an explanation, he confirms that insiders profit from their
trades, but he does not confirm Jaffe’s finding that outsiders can profit from public
information about insider trading. Seyhun argues that Jaffe’s outsider profits arise
because he uses the Sharp-Lintner-Black model for expected returns, Seyhun shows that

39
insider buying is relatively more important in small firms, whereas insider selling is more
important in large firms. There is a general message in Seyhun’s results, highly
constrained asset-pricing model like the Sharp-Lintner-Black model are surely false.
They have systematic problems explaining the cross-section of expected returns that can
look like market inefficiencies. In market-efficiency tests, one should avoid models that
put strong restrictions on the cross-section of expected returns, if that is consistent with
the purpose at hand. Concretely, one should use formal asset-pricing models when the
phenomenon studied concerns the cross-section of expected returns (e.s. , tests for size,
leverage, and E/P effects). But when the phenomenon is firm-specific (most event
studies), one can use firm-specific “models”, like the market model or historical average
returns, to abstract from normal expected returns without putting unnecessary constraints
on the cross-section of expected returns (Fama 1991).
For security analysis, the Value Line Investment Survey publishes weekly
rankings of 1700 common stocks into 5 groups, group 1 has the best return prospect and
group 5 the worst. There is evidence that, adjusted for risk and size, group 1 stocks have
higher average returns than group 5 stocks for horizons out 1 year (Black 1973; Copeland
and Mayers 1982; and Huberman and Kandel 1987, 1990). Affleck-Graves and
Mendenhall (1990) argue however, that the Value Line ranks firms largely on the basis of
recent earnings surprises. As a result, the longer-term abnormal returns of the Value Line
rankings are just another anomaly in disguise, the post-earnings-announcement drift
identified by Ball and Brown (1968), Bernard and Thomas (1989), and others. Stickels
(1985) uses event-study methods to show that there is an announcement effect in rank
changes that more clearly implies that Value Line has information not reflected in prices.
Moreover, Hulbert (1990) reports that the strong long-term performance of Value Line’s
group 1 stocks is weaker after 1983. Over the 6.5 years from 1984 to mid-1990, group 1
stocks earned 16.9% per year compared with 15.2% for the Wilshire 5000 Index. During
the same period, Value Line’s Centurion Fund, which specializes in group 1, earned
12.7% per year, live testimony to the fact that there can be large gaps between simulated
profits from private information and what is available in practice.
Regarding professional portfolio management, Jensen (1968, 1969) early results
were bad news for the mutual-fund industry. He finds that for the 1945-1964 period,

40
returns to investors in funds (before load fees, but after management fees and other
expenses) are on average about 1% per year below the market line (from the risk free rate
through the S&P 500 market portfolio) of the Sharp-Lintner model, and average returns
on more than half of his funds below the line. Only when all published expenses of the
funds are added back do the average returns on the funds scatter randomly about the
market line. Jensen concludes that mutual-funds managers do not have private
information. Other studies do not always agree, in tests on 116 mutual funds for the
February 1968 to June 1980 period, Henriksson (1984) finds that average returns to fund
investors, before load fees but after other expenses, are trivially different (0.02% per
month) from the Sharp-Lintner market line. Chang and Lewellen (1984) get similar
results for 1971-1979. This work suggests that on average, fund managers have access to
enough private information to cover the expenses and management fees they charge to
investors. Ippolito (1989) provides a more extensive analysis of the performance of
mutual funds, he examines 143 funds for the 20-years post-Jensen’s period 1965-1984, he
finds that fund returns, before load fees but after other expenses, are on average 0.83%
per year above the Sharp-Lintner market line (from the 1-year Treasury Bill rate through
the S&P 500 portfolio). He finds no evidence that the deviations of funds from the market
line are related to management fees, other fund expenses, or turnover ratios. Ippolito
concludes that his results are in the spirit of the “noisy rational expectations” model of
Grossman and Stiglitz (1980), in which informed investors (mutual fund managers) are
compensated for their information costs.
Performance evaluation is known to be sensitive to methodology (Grinblatt and
Titman 1984). Ippolito (1989) uses the Sharp-Lintner model to estimate normal returns to
mutual funds. Brinson, Hood, and Beebower (1980) use passive portfolios meant to
match the bond and stock components of their pension funds. We know the Sharp-Lintner
model has systematic problems explaining expected returns (size, leverage, E/P, and
book-to-market equity effects) that can affect estimates of abnormal returns (Fama,
1991). Elton, Gruber, Das, and Hklarka (1991) test the importance of the Sharp-Lintner
methodology in Ippolito’s results, they find that during Ippolito’s 1965-1984 period, his
benchmark combinations of Treasury bills with the S&P 500 portfolio produce strong
positive estimates of “abnormal” returns for passive portfolios of non-S&P (smaller)

41
stocks-strong confirmation that there is a problem with the Sharp-Lintner benchmarks
(also used by Jensen 1968, 1969; Henriksson 1984; and Chang and Lewellen 1984).
Elton, Gruber, Das, and Hklarka then use a 3-factor model to evaluate the
performance of mutual funds for 1965-1984; the 3 factors are the S&P 500, a portfolio
titled toward non S&P stocks, and a proxy for the market portfolio of Government and
corporate bonds. As in Brinson, Hood, and Beebower (1986), the goal of the Elton-
Gruber-Das-Hklarka approach is to allow for the fact that mutual funds hold bonds and
stocks that are not in the universe covered by the combination of the Treasury bills and
the S&P 500 that Ippolito uses to evaluate performance. The Elton-Gruber-Das-Hklarka
benchmarks are the returns from passive combinations of Treasury bills with S&P stocks,
and bonds. They find that for Ippolito’s 1965-1984 period, their benchmarks produce an
abnormal return on mutual funds of -1.1% per year, much like the negative performance
for pension funds (Brinson, Hood, and Beebower 1986). Moreover, unlike Ippolito, but in
line with earlier work (Sharp 1966), Elton, Gruber, Das, and Hklarka find that abnormal
returns on mutual funds are negatively related to fund expenses (including management
fees) and turnover. In short, if mutual and pension fund managers are the informed
investors of the Grossman-Stiglitz (1980) model, they are pushing research and trading
beyond the point where marginal benefits equal marginal costs (Fama1990).
In summary, the investors studied in most detail for private information are
pension fund and mutual fund managers. Unlike event studies, however, evaluating the
access of investment managers to private information involves measuring abnormal
returns over long periods. The tests thus run head-on into the joint-hypothesis problem:
measured abnormal returns can result from market inefficiency, a bad model of market
equilibrium, or problems in the way the model is implemented.

2-5 Evidence against EMH and alternative models for market behavior
The EMH has provided the theoretical basis for the financial market research
during seventies and the eighties. In the past, most of the evidence seems to have been
consistent with the EMH. Prices were seem to follow a random walk model and the
predictable variations in equity returns, if any, were found to be statistically insignificant.
While most of the studies in the seventies focused on predicting prices from past prices,

42
studies in the eighties also look at the possibility of forecasting based on variables such as
dividend yield (e.g. , Fama and French 1988), P/E ratios (Campbell and Shiller 1988),
and term structure variables (e.g. , Harvey 1991). Studies in the nineties look at
inadequacies of current asset pricing models. The accumulating evidence suggests that
stock prices can be predicted with a fair degree of reliability. Two competing
explanations have been offered for such behavior, proponents of EMH (e.g. , Fama and
French 1995) maintain that such predictability results from time-varying equilibrium
expected returns generated by rational pricing in an efficient market that compensates for
the level of risk undertaken. Critics of EMH (e.g. , Laporta, Lakonishok, Shliefer, and
Vishny 1997), argue that the predictability of stock returns reflects the psychological
factors, social movements, noise trading, and fashions or “fads” of irrational investors in
a speculative market. The question about whether predictability of returns represents
rational variations in expected returns or arises due to irrational speculative deviations
from theoretical values has provided the impetus for fervent intellectual inquiries in the
recent years. The reminder of this section is motivated largely by this issue, and places
greater emphasis on the speculative aspects.

2-5-1 Market anomalies

The EMH became controversial especially after the detection of certain anomalies
in the capital markets, these anomalies can be divided into two main categories: long-
term return anomalies and calendar effects.

2-5-1-1 Long-term return anomalies

Fama (1998) provides a review of this literature; many of recent studies on long-
term returns suggest market inefficiency, specifically, long-term underreaction or
overreaction to information. Fama (1998) gives a “solid no” as an answer to the question
whether this literature (long-term return anomalies) viewed as a whole suggests that
efficiency should be discarded, and he gives two reasons for his answer: First, an efficient
market generates categories of events that individually suggest that prices overreact to
information, but in an efficient market, apparent underreaction will be about as frequent
as overreaction. If anomalies split randomly between underreaction and overreaction,

43
they are consistent with market efficiency. Second, long-term return anomalies are
sensitive to methodology, they tend to become marginal or disappear when exposed to
different models for expected (normal) returns or when different statistical approaches
are used to measure them. Thus, even viewed one-by-one, most-long term return
anomalies can be reasonably be attributed to chance (Fama 1998).

2-5-1-1-1 Overreaction and underreaction

One of the first papers on long-term return anomalies is DeBondt and Thaler
(1985). They find that when stocks are ranked on three-to five- year past returns, past
winners tend to be future losers, and vise versa. They attribute these long-term return
reversals to investors’ overreaction. In forming expectations, investors give too much
weight to the past performance of firms and too little to the fact that performance tends to
mean-revert. DeBondt and Thaler seem to argue that overreaction to past information is a
general prediction of the behavioral decision theory of Kahneman and Tversky (1982).
Thus, one could take overreaction to be the prediction of a behavioral finance alternative
to market efficiency. Lakonishok et al. (1994) argue that ratios involving stock prices
proxy for past performance, firms with high ratios of earnings to price (E/P), cash flow to
price (C/P), and book-to-market equity (BE/ME) tend to have poor past earning growth,
and firms with low E/P, C/P, and BE/ME tend to have strong past earnings growth.
Because the market over-reacts to past growth, it is surprised when earnings growth mean
reverts. As a result, high E/P, C/P, and BE/ME stocks (poor past performers) have high
future returns, and low E/P, C/P, and BE/ME stocks (strong past performers) have low
future returns.
If apparent overreaction was the general result in studies of long-term returns,
market efficiency would be dead, replaced by the behavioral alternative of DeBondt and
Thaler (1985). In fact, apparent underreaction is about as frequent, the granddaddy of
underreaction events is the evidence that stock prices seem to respond to earnings for
about a year after they are announced (Ball and Brown 1983; Bernard and Thomas 1990).
More recent is the momentum effect identified by Jagadeesh and Titman (1993); stocks
with high returns over the past year tend to have high returns over the following three to
six months. Over recent event studies also produce long-term post-event abnormal return

44
that suggest underreaction. Custias et al. (1993) find positive post-event abnormal returns
for divesting firms and the firms they divest. They attribute the result to market
underreaction to an enhanced probability that, after a spinoff, both the parent and the
spinoff are likely to become merger targets, and the recipients of premiums. Desai and
Jain (1997) and Ikenberry et al. (1996) find that firms that split their stock experience
long-term positive abnormal returns both before and after the split, they attribute the post-
split returns to market underreaction to the positive information signal of by split. Finally,
Michael et al. (1995) find that stock prices seem to under-react to the negative
information in dividend omissions and the positive information in initiations.

2-5-1-1-2 IPOs and SEOs

Among the more striking of the long-term return anomalies is the study of initial
public offerings (IPOs) and seasonal equity offerings (SEOs) by Loughran and Ritter
(1995). They find that the total wealth generated at the end of five years if one invests $1
in each IPO or SEO immediately following the event is about 70% of that produced by
the same buy-and-hold strategy applied to a sample of stocks matched to the IPOs and
SEOs on size. IPOs and SEOs clearly have poor long-term returns during the Loughran-
Ritter sample period (1970-1990). The interesting question is whether the returns are
really abnormal or whether they are shared with non-event firms similar on
characteristics related to average returns, during the Loughran-Ritter period, variables
known to be related to average stock return include size and book-to-market equity
(Fama and French, 1992), and short-term past return (Jagadeesh and Titman, 1993). Since
the long-term buy-and-hold returns in Loughran and Ritter only control for size, their
results might be affected by other variables that are systematically related to average
return. Following up on this possibility, Brav and Gompers (1997) compare five-year
buy-and-hold returns on IPOs with the returns on portfolios that match the IPOs on size
and book-to-market equity (BE/ME) but exclude SEOs as well as IPOs. The five-year
wealth relative (the ratio of five-year buy-and-hold wealth for IPOs to five-year buy-and-
hold wealth for the benchmarks) rises from about 0.7 with the Loughran-Ritter size
benchmarks to a bit more than 1.0 (that is the anomaly disappear) when the benchmarks
control for BE/ME as well as size.

45
 Similarly, Brav et al. (1995) find that the five-year buy-and-hold returns on SEOs
are closed to those of non-event portfolios matched on size and BE/ME, Brav (1997) and
Michell and Stafford (1997) show that IPOs and SEOs are typically small growth stocks,
Fama and French (1993) show that such stocks have low returns during the post-1963
period. The results of Brav and Gompers (1997) and Brav et al. (1995) then suggest that
explaining the IPO-SEO anomaly reduces to explaining why small growth stocks in
general have poor returns during the IPO-SEO sample period. In other words, if there is a
mispricing problem, it is not special to IPO-SEO stocks (Fama, 1998).
Fama (1998) argues that the results for IPOs and SEOs do not imply that
benchmark matching on size and BE/ME is always superior to estimating abnormal
returns, he also says that all methods for estimating abnormal returns are to bad-model
problems, and no method is likely to minimize bad-model problems for all classes of
events. The important general message from the IPO-SEO results is one of caution: two
approaches that seem closely related (both attempt to control for variation in average
returns related to size and BE/ME) can produce much different estimates of long-term
abnormal-returns.

2-5-1-1-3 Mergers
Asquith (1983) and Agrawal et al. (1992) find negative abnormal returns for
acquiring firms up to five years following merger announcement. Using a comprehensive
sample of mergers for 1960-1993, Mitchell and Stafford (1997) also find negative long-
term abnormal returns for acquiring firms. They find that the three-year post event buy-
and-hold return for equal-weighted acquiring firms is on average 4% lower than for
portfolios matched to acquiring firms on size and BE/ME. In economic terms, this is not
a dramatic anomaly. For formal inferences, Mitchell and Stafford (1997) estimate three
factor model on the monthly returns on a rolling portfolio that includes firms with
acquisitions during the preceding three years, when the acquirers are equal-weighted, the
intercept, that is, the average monthly abnormal returns for the three years after a merge
is -0.25% per month (-25 basis points, t = -3.49). When acquiring firms are value-
weighted, the intercept of the equation drops to -0.11% per month (t = -1.55). Thus, if
there is an anomaly, it is more important for smaller acquiring firms. They show that

46
abnormal post-announcement average returns to acquiring firms are limited to mergers
financed with stocks, that is, mergers that are also SEOs. When mergers are financed
without issuing stocks, the negative abnormal post-event returns disappear. This suggests
that there is no distinct merger anomaly; any merger anomaly may be the SEO anomaly
in disguise.

2-5-1-1-4 Stock splits

Desai and Jain (1997) and Ikenberry et al. (1996) find that for 17-year 1975-1991
period, stock splits are followed by positive abnormal returns of about 7% in the year
after the split. Abnormal returns are calculated relative to benchmarks that control for
size, BE/ME, and, in Desai and Jain, past one-year return. To test whether such an
anomaly is real or the sample-specific results of chance is to examine a different sample
period; Fama et al. (1969) examine splits during the 33-year 1927-1959 period. They find
no drift in cumulative abnormal returns during the 30 months following splits, since the
split anomaly fails the out-of sample test provided by Fama-Fisher-Jensen-Roll, it seems
reasonable to conclude that the 1975-1991 anomaly is not real, unless the market has
recently becomes inefficient (Fama 1998).

2-5-1-1-5 Self-tenders and share repurchases

Lakonishok and Vermaelen (1990) examine long-term returns following self-
tender offers (tenders by firms for their own shares) during 1962-1986 period. Ikenberry
et al. (1995) examine long-term returns following share repurchases during the 1980-
1990 period. Mitchell and Stafford (1997) study both self-tenders and repurchases for the
1960-1993 period, they find that three-year post-event buy-and-hold abnormal returns,
computed relative to matching portfolios that control for size and BE/ME, are 9% for
self-tenders (475 events) and 19% for much larger sample of 2542 repurchases. When
they estimate the three factor regression for monthly returns on an equal-weight portfolio
that contains all self-tenders and repurchases in the last three years, however, the average
abnormal return is 0.11% per month (t = 1.62). Any hint of significance, economic or
statistical, disappears entirely when the stocks in the rolling portfolio are value-weighted.
The intercept for the value-weight portfolio of self –tenders and repurchases is -0.03% (-3

47
basis point per month, t = -0.34). Fama (1998) argues that according to theses results,
there is no share repurchase anomaly. He adds, that two apparently similar methods for
estimating abnormal returns, (i) a matching portfolio control for size and BE/ME and (ii)
an asset pricing regression that adjusts for sensitivity to risk factors related to size and
BE/ME, produce somewhat different results, which illustrates that estimates of long-term
abnormal returns can be sensitive to apparently small changes in technique.

2-5-1-1-6 Exchange listings

Dharan and Ikenberry (1995) find that during the 1962-1990 period, stocks that
newly list on the NYSE, or move from Nasdaq to Amex, have negative post-listing
abnormal returns. When returns are risk-adjusted using matching portfolios formed on
size and BE/ME, the three-year average abnormal return is -7.02%. The t-statistic for this
CAR is -2.78, but this is without a full adjustment for the correlation of abnormal returns
across firms. Moreover, Dharan and Ikenberry show that the negative post-listing
abnormal returns are limited to firms below the NYSE-Amex median in size. Thus, once
again, an apparent anomaly is limited to small stocks. Mitchell and Stafford (1997) offer
concrete perspective on how significance levels can be overstated because of the failure
to adjust for the correlation across firms of post-event abnormal returns. Using the three
factor model, they calculate the standard deviations of abnormal returns for portfolios of
firms with an event during the most recent 36 months. The proportion vary somewhat
through time and cross their three event classes (mergers, share repurchases, and SEOs),
but on average the covariances of event-firm abnormal returns account for about half the
standard deviation of the event portfolio’s abnormal return. Thus, if the covariances are
ignored, the standard error of the abnormal portfolio return is too small by about 50%.
This estimate need not apply in fact to the exchange listing of Dharan and Ikenberry
(1995), but it suggests that a full adjustment for the cross-correlation of post-listing
abnormal returns could cause the statistical reliability (t = -2.78) of their -7.02% post-
event three-year CAR to disappear.
Dharan and Ikenberry’s explanation of their negative post-listing abnormal
returns is that firms are opportunistic, and they list their stocks to take advantage of the
market’s overreaction on their recent good times. This explanation seems shaky,

48
however, given that any overreaction to past performance has already occurred and will
soon be reversed. Moreover, standard signaling theory (e.g., Ross, 1977) does not predict
that firms will incur costs to make a false signal whose price effects are soon obliterated.
On the contrary, since listing involves costs, it should be a signal that the firm is under-
valued.

2-5-1-1-7 Dividend initiations and omissions

Michaely et al. (1995) find that during the 1964-1988 period, firms that initiate
dividends have positive abnormal stock returns for three years after the event, and firms
omitting dividends have negative abnormal returns. For the same sample, Brav (1997)
finds that the three-year post-event abnormal return following initiations disappears with
benchmarks that control for size and BE/ME. Michaely et al. (1995) show that the
negative three-year abnormal returns following omissions, confirmed by Brav (1997), are
largely concentrated in the second half of their 1964-1988 sample period. All this
suggests that inferences about long-term returns following changes in dividends should
probably await an out-of-sample test. The finding that stock prices under-react to
dividend announcements is suspect on other grounds. It seems reasonable that
underreaction would occur because the market underestimates the information in
dividends about future earnings. However, from Watts (1973) to Benartzi et al. (1997),
there is little evidence that changes in dividends predict changes in earnings.

2-5-1-1-8 Spinoffs
Cusatis et al. (1993) study the post-events returns of spinoffs1 and their parents for
the 1965-1988 period. The benchmarks are firms matched to the event firms on size and
industry, and abnormal returns are buy-and-hold abnormal returns (BHARs). Both
parents and spinoffs have positive abnormal returns in the three years after the event. The

1
A pure spinoff is defined as a tax-free, pro-rata distribution of shares of a wholly owned subsidiary to
shareholders. In both the academic literature and the popular press, spinoffs often consist of various types
of distributions of common stock in other companies. These alternative types of distributions include partial
as well as full distributions of stock in subsidiaries, taxable and nontaxable distributions, court-ordered as
well as voluntary stock distributions, distributions of common shares in publicly traded companies as
opposed to subsidiaries, and return of capital distributions. In some cases, a specialized stock distribution
such as split offs, and even stock sales such as equity carve outs, are referred to as spinoffs.

49
abnormal returns are, however, limited to event firms (parent and spinoffs) acquired in
mergers. The conclusion is that the market does not properly assess the increased
probability of takeover (and the attended buyout premiums) following spinoffs, the t-
statistic for the three-year BHARs for spinoffs range from 0.58 to 2.55, hardly
overwhelming. Moreover, in calculating the t-statistics, the BHARs of the event firms are
assumed to be independent. It would not take a large adjustment for cross-correlation to
produce t-statistics that suggest no real anomaly.

2-5-1-1-9 Proxy contests

Ikenberry and Lakonishok (1993) examine stock returns following proxy
contests2 during the 1968-1987 period. They find negative post-event abnormal return
relative to benchmarks that control for market β and size. In the results for all proxy
contests, the post-event abnormal returns are not statistically reliable. The negative post-
event returns are only statistically reliable for 50-odd proxy contests in which the
dissidents with board representation. Since this result is not an ex ante prediction, the
weak evidence for the overall sample seems more relevant, and it does not suggest a
reliable anomaly.
From the previous review, it appears that if reasonable change in the method of
estimating abnormal returns causes an anomaly to disappear, the anomaly is fragile, and
it is reasonable to suggest that it is an illusion. Included in this category are IPOs, SEOs,
self-tenders, share repurchases, and dividend initiations, other long-term return anomalies
are economically or statistically marginal. The negative post-event abnormal returns to
acquiring firms in mergers are economically small. For exchange listing, spinoffs, and
proxy contests, a full correction for the cross-correlation of long-term post-event
abnormal returns could easily reduce them to former anomalies. Whenever value-weight
returns are examined, apparent anomalies shrink a lot and typically become statistically
unreliable. At a minimum, this suggests that anomalies are largely limited to small stocks.
Fama (1998) presents a reasonable alternative explanation, he says that small stocks are
just a sure source of bad-model problems. Small stocks always pose problems in tests of

2
The proxy contest is one mean by which shareholders may exercise the control authority embedded in
their equity claims.

50
asset pricing models, so they are prime candidates for bad-model problems in tests of
market efficiency on long-term returns.

2-5-1-2 Calendar effects

Calendar effects in stock market returns have puzzled financial economists for
several years. EMH emphasizes that seasonal patterns should not exist or should only be
minor, since their existence implies the possibility of obtaining abnormal returns by
making timing strategies. There are many calendar effects exist in the literature, among
them the monthly or January effect, the day-of-the-week effect, the trading month effect,
holiday effect, and more recently the Halloween effect. Thaler (1987a, 1987b) provides
an early and partial survey, while Mills and Couts (1995) provide more recent references.

2-5-1-2-1 January effect

Rozeff and Kinney (1976) were the first to document evidence of higher mean
returns in January as compared to other months. Using NYSE stocks for the period 1904-
1974, they find the average return for January to be 3.48% compared to only 0.42% for
the other 11 months. Later studies document the effect persists in more recent years,
Bhardwaj and Brooks (1992) for 1977-1986 and Eleswarapu and Reinganum (1993) for
1961-1990. The effect has been found to be present in other countries as well (Gultekin
and Gultekin, 1983). The January effect has also been documented for bonds by Chang
and Pinegar (1986). Maxwell (1998) shows that the bond market effect is strong for non-
investment grade bonds, but not for investment grade bonds. More recently, Bharba,
Dhillon, and Ramirez (1999) document a November effect, which is observed only after
Tax Reform Act of 1986. They also find that the January effect is stronger since 1986.
A number of hypotheses have been suggested in the literature to explain the
January effect, among which the tax-loss-selling hypothesis has received most of the
recognition. These hypotheses can be grouped into three broad categories. First, are
hypotheses centered around measurement problems, particularly studies that focus on the
relation between market capitalization and seasonality in the stock market, the argument
here is simply that excess return on small firms is postulated to be either a deception
caused by poor measurement of the returns on these firms or a compensation for extra

51
risk investors bear by holding these stocks (Banz 1981; Brown et al. 1983; Keim 1983;
Reinganum 1983; and Roll 1983).
The second category comprises hypotheses related to buying pressure at the
beginning of the year. These hypotheses provide reasons why individuals and institutions
have a grater incentive to sell some of their holdings (particularly small firm’s stocks) at
the end of the year and repurchase these holdings at the beginning of the following year.
Individual investors have more idle cash (from year-end bonuses, holiday gifts and tax-
loss-selling) at the beginning of the year, which they want to put into the market (Branch
1977; Brown et al. 1983; Constantinides 1984; Chan 1986; Ritter 1988; and Sias and
Starks 1997). Meanwhile, institutional mangers engage in a lot of portfolio rebalancing
and, or, (window dressing) activities near the end of the year, which makes trades in
January of the following year reversals of these activities ( Lakonishok and Smidt 1986;
Haugen and Lakonishok 1987; Ritter and Shopra 1989; and Lakonishok et al. 1991).
Third are hypotheses related to the seasonality or the timing of information release,
because of the coincidental clustering of the calendar year-end and the tax year-end in the
USA; Rozeff and Kinney (1976) observed that January sees the release of an unusual
amount of accounting information, thus speculating that seasonality is perhaps associated
with accounting news. The seasonal difference in the information about the underlying
stocks has been examined by some researchers and considered as an alternative
explanation for the January effect (Brauer and Chang 1990).
Many authors try to obtain evidence for the tax-loss-selling hypothesis by
examining stock return patter in countries with different tax codes and tax-year-ends.
Significant seasonality was observed in international stock markets but it was not
persistent through time in many markets, providing mixed evidence on the tax-loss-
selling hypothesis. For example, Brown et al. (1983) find that while Australia has similar
tax law to the USA, it has a July-June tax year, which gives rise to December-January
and July-August seasonal. While the July-August seasonal is consistent with the tax-loss-
selling hypothesis, the authors conclude that the evidence is inconsistent with tax-loss-
selling hypothesis because of the existence of December-January seasonality. Hillier and
Marshall (2002) reach the same conclusion and reject the tax-loss-selling hypothesis for
UK stocks. Using value weighted stock markets in major industrial countries, Gultekin

52
and Gultekin (1983) find evidence for a persistent (though generally less significant than
that in the USA) January effect in most of the countries, which was construed as support
for the tax-loss-selling hypothesis.

2-5-1-2-2 The weekend effect (Monday effect)

The first study of weekend effect in security market appeared in the Journal of
Business in 1931, written by a graduate student at Harvard named M.J. Fields. He was
investigating the conventional Wall Street wisdom at the time that “the unwillingness of
traders to carry their holdings over the uncertainties of a week-end leads to a liquidation
of long accounts and a consequent decline of security prices on Saturday” (Fields, 1931,
p.415). Fields examines the pattern of the Dow Jones Industrial Average (DJIA) for the
period 1915-1930 to see if the conventional wisdom was true, he compares the closing
price of the DJIA for Saturday with the mean of the closing prices on the adjacent Friday
and Monday. He finds, in fact, that prices tend to rise on Saturdays, for the 717 weekends
he studies, the Saturday’s price was more than $ 0.10 higher than the Friday-Monday
mean 52 percent of the time, while it was lower only 36 percent of the time.
Cross (1973) studies the returns on the S&P 500 over the period 1953-1970, he
finds that the index rises on 62 percent of the Fridays, but only 39.5 percent of the
Mondays. French (1980) analysis daily returns of stocks for the period 1953-1977 and
finds that there is a tendency for returns to be negative on Mondays whereas they are
positive on the other days of the week; he notes that these negative returns are “caused
only by the weekend effect and not by a general closed-market effect”. A trading
strategy, which would be profitable in this case, would be to buy stocks on Monday and
sell them on Friday. Kamara (1997) shows that the S&P 500 has no significant Monday
effect after April 1982, yet he finds the Monday effect undiminished from 1962-1993 for
a portfolio of smaller U.S stocks. Internationally, Agrawal and Tandon (1994) find
significantly negative returns on Monday in nine countries and on Tuesday in eight
countries, yet large positive returns on Friday in 17 of the 18 countries studied, Steely
(2001) finds that the weekend in the UK has disappeared in the 1990s.
Numerous factors, might explain the weekend effect. The most logical
hypothesis-dubbed “calendar time hypothesis” by French (1980) is that, prices should rise

53
somewhat more on Mondays than on other days because the time between the close of
trading on Friday and the close of trading on Monday is three days, rather than the
normal one day between other trading days. Accordingly, Monday returns should be three
times higher than other weekday returns. French offers an alternative, the “trading time
hypothesis”, which states that returns are generated only during active trading and
implies that returns should be the same for every trading day. In any case, neither
hypothesis is consistent with the data, another explanation exist in the literature;
differences in settlement time of transaction; attitudes of certain investor groups; investor
tendency to postpone the announcement of bad news until the weekend so that the market
will have time to absorb the stock; and measurement errors.

2-5-1-2-3 Holidays’ effects

In French’s investigations of weekend effects he looks at the price behavior after
holidays and finds no thing special happening. However, in another early study Fields
(1934) finds that the DJIA shows a high proportion of advances the day before holidays.
In this case it takes over 50 years for Fields to be resurrected from obscurity by Ariel
(1985). Ariel looks at the returns on the 160 days that preceding holidays during the
period 1963-1982. For an equal weighted index of stocks he finds that the mean return on
the pre-holidays was 0.529 percent, compared to 0.056 percent on other days, a ratio of
grater than 9 to 1. For a value weighted index the pre-holiday returns average 0.365
percent compared to 0.026 percent on other days, a ratio of greater than 14 to 1. The
differences are both statistically and economically significant. These results were
replicated for the 90-year DJIA series by Lakonishok and Smidt (1987). They obtain an
average pre-holiday return of 0.219 percent, compared to normal daily rate of return of
0.0094 percent, ratio of grater than 23 to 1. Many suggestions proposed to explain
holidays’ effects, such as, differences in settlement time of transactions; investors’ good
mood before holidays; and other psychological reasons.

2-5-1-2-4 Turn of the month effect

Ariel (1987) examines the pattern of returns within months. For the period 1963-
1981 he divides months into two parts, the first part starting with the last day of the prior

54
month, he then compares the cumulative returns for the two periods using both equal-
weighted and value-weighted indices. The return for the latter half of the month is
negative, all the returns for the period occur in the first part of the month. This result has
been replicated by Lakonishok and Smidt (1987). Using 90-year series for the Dow, they
find that the return for the four days around the turn of the month, starting with the last
day of the prior month, is 0.473 percent (the average return for a four-day period is
0.0612 percent). Also, the turn-of-the-month four-day return is grater than the average
total monthly return which is 0.35 percent. End-of-the-month increases in purchasing
power due to salaries; and higher frequency of announcements of companies’ profit
during the first fortnight of the month, have been suggested as explanations for this
seasonality.

2-5-1-2-5 The Halloween effect

A more recent calendar effect is that described in Bouman and Jacobsen (2002).
They find that the return to stocks in 37 countries can be explained almost totally as a
result of what they term the Halloween Indicator. They find that the hypothesis of zero
mean return to equities in months May-October cannot be rejected. Thus, the old stock
market adage “Sell in May and Go Away, Don’t Come Back Till St.Leger’s Day”,
St.Lerger’s day being 2 October, but with the adage generally being seen as a references
to the running of the St.Leger race of Doncaster in late September, would seem to be
vindicated. They hypothesize that the cause of this may be the taking, by the general
economically active public and brokerage community, of significant holidays in summer
period. This has the effect of depressing economic and in particular stock market activity
in the summer period. Maberly and Pierce (2003) examine the robustness of the
Halloween effect to alternative model specifications for Japanese equity prices. They find
that the Halloween effect is concentrated in the period prior to the introduction of Nikkei
225 index in September 1986, while the Halloween effect disappear after 1986. In
addition, Maberly and Pierce (2004) find that Bouman and Jacobsen results are not robust
to alternative model specifications for U.S equity prices.

2-5-1-3 Other anomalies

55
2-5-1-3-1 Small firm effect
Banz (1981) publishes one of the earliest articles on the “small-firm effect” which
is also known as the “size-effect”. His analysis of the 1936-1975 period reveals that
excess returns would have been earned by holding stocks of low capitalization
companies. Supporting evidence is provided by Reinganum (1981) who reports that the
risk adjusted annual return of small firms was grater than 20 percent. If the market was
efficient, one would expect the prices of stocks of these companies to go up to a level
where the risk adjusted returns of future investors would be normal, but this did not
happen.

2-5-1-3-2 Value-Line enigma

The Value-Line organization divides the firms into five groups and ranks them
according to their estimated performance based on publicly available information. Over a
five year period starting from 1965, returns to investors correspond to the rankings given
to firms. That is, higher ranking firms earned higher returns. Several researchers (e.g.
Stickel (1985)) find positive risk-adjusted abnormal (above average) returns using Value-
Line rankings to form trading strategies, thus challenging the EMH.

2-5-1-3-3 Standard and Poor’s (S&P) Index effect

Harris and Gurel (1986) and Shleifer (1986) find a surprising increase in share
prices (up to 3 percent) on the announcement of stock’s inclusion into the S&P 500
index. Since in an efficient market only information should change prices, the positive
stock price reaction appears to be contrary to the EMH because there is no new
information about the firm other than its inclusion in the index.

2-5-1-3-4 The weather

Few would argue that sunshine puts people in a good mood. People in good mood
make more optimistic choices and judgments, Saunders (1993) shows that the New York
Stock Exchange index tends to be negative when it is cloudy. More recently, Hirshleifer
and Shumway (2001) analyze data for 26 countries from 1982-1997 and find that stock

56
market returns are positively correlated with sunshine in almost all of the countries
studied. Interestingly, they find that snow and rain have no predictive power.
The last two decades have witnessed an onslaught against the efficient market
hypothesis. Yet as Roll (1994) observes, it is remarkably hard to profit from even the
most extreme violations of market efficiency. Stock market anomalies are only too often
chance events that do not persist into the future. As Fama says “consistent with market
efficiency hypothesis that the anomalies are chance results, apparent overreaction to
information is about as common as underreaction, and post-event continuation of pre-
event abnormal returns is about as frequent as post event reversal. Most important,
consistent with the market efficiency prediction that apparent anomalies can be due to
methodology, most long-term return anomalies tend to disappear with reasonable
changes in technique” (Fama, 198, p. 283). The importance of the efficient markets
hypothesis is demonstrated by the fact that apparently profitable investment opportunities
are still referred to as “anomalies”. The efficient market model continues to provide a
framework that is widely used by financial economists.

2-5-2 Volatility tests, fads, noise trading

The greatest stir in academic circles has been created by the results of volatility
tests. These tests are designed to test for rationality of market behaviour by examining the
volatility of share prices relative to the volatility of the fundamental variables that affect
share prices. The first two studies applying these tests were by Shiller (1981) and LeRoy
and Porter (1981). Shiller tests a model in which stock prices are the present discounted
value of future dividends. LeRoy and Porter use a similar analysis for the bond market.
These studies reveal significant volatility in both the stock and bond markets.
Fluctuations in actual prices greater than those implied by changes in the fundamental
variables affecting the prices are inferred by Shiller as being the result of fads or waves of
optimistic or pessimistic market psychology. Schwert (1989) tests for a relation between
stocks return volatility and economic activity; he finds increased volatility in financial
asset returns during recessions which might suggest that operating leverage increases
during recessions; he also finds increased volatility in periods where the proportion of

57
new debt issues to new equity issues is larger than a firm’s existing capital structure. This
may be interpreted as evidence of financial leverage affecting volatility.
However neither of these factors plays a dominant role in explaining the time-
varying volatility of the stock market. The volatility tests of Shiller spawned a series of
articles. The results of excess volatility in the stock market have been confirmed by
Cochrane (1991), West (1988), Campbell and Shiller (1987), Mankiw, Romer, and
Shapiro (1985). The tests have been criticized, largely on methodological grounds, by
Ackert and Smith (1993), Marsh and Merton (1986), Kleidon (1986) and Flavin (1983).
The empirical evidence provided by volatility tests, suggests that movements in stock
prices cannot be attributed merely to the rational expectations of investors, but also
involves an irrational component. The irrational behavior has been emphasized by
Shleifer and Summers (1990) in their exposition of noise trading.

1. They posit that there are two types of investors in the market: (i) rational
speculators or arbitrageurs who trade on the basis of information and (ii) noise traders
who trade on the basis of imperfect information. Since noise traders act on imperfect
information, they will cause prices to deviate from their equilibrium values. It is
generally understood that arbitrageurs play the crucial role of stabilizing prices. While
arbitrageurs dilute such shifts in prices, they do not eliminate them completely. Shleifer
and Summers assert that the assumption of perfect arbitrage made under EMH is not
realistic. They observe that arbitrage is limited by two types of risk: (a) fundamental risk
and (b) unpredictability of future resale price. Given limited arbitrage, they argue that
securities prices do not merely respond to information but also to "changes in
expectations or sentiments that are not fully justified by information". An observation of
investors’ trading strategies (such as trend chasing) in the market provides evidence for
decision making being guided by "noise" rather than by the rational evaluation of
information. Further support is provided by professional financial analysts spending
considerable resources in trying to predict both the changes in fundamentals and also
possible changes in sentiment of other investors. Black (1986) also argues that noise
traders play a useful role in promoting transactions (and thus, influencing prices) as
informed traders like to trade with noise traders who provide liquidity. So long as risk is

58
rewarded and there is limited arbitrage, it is unlikely that market forces would eliminate
noise traders and maintain efficient prices.

2-5-3 Models of human behavior

In a market consisting of human beings, it seems logical that explanations rooted
in human and social psychology would hold great promise in advancing our
understanding of stock market behavior. More recent research has attempted to explain
the persistence of anomalies by adopting a psychological perspective. Evidence in the
psychology literature reveals that individuals have limited information processing
capabilities, exhibit systematic bias in processing information, are prone to making
mistakes, and often tend to rely on the opinion of others. The damaging attacks on the
assumption of human rationality have been spearheaded by Kahneman and Tversky
(1986) in their path breaking article on prospect theory. The findings of Kahneman and
Tversky have brought into question expected utility theory which has been used
descriptively and predictively in the finance and economics literature. They argue that
when faced with the complex task of assigning probabilities to uncertain outcomes,
individuals often tend to use cognitive heuristics, while useful in reducing the task to a
manageable proportion, these heuristics often lead to systematic biases.
Using simple decision tasks, Kahneman and Tversky are able to demonstrate
consistent decision inconsistencies by manipulating the decision frame. While expected
utility theory would predict that individuals would evaluate alternatives in terms of the
impact on these alternatives on their final wealth position, it is often found that
individuals tend to violate expected utility theory predictions by evaluating the situation
in terms of gains and losses relative to some reference point. The usefulness and validity
of Kahneman and Tversky's propositions have been established by several replications
and extensions for situations involving uncertainty by researchers in the fields of
accounting, economics, finance, and psychology. Rabin and Thaler (2001) show that
expected utility theory’s explanation of risk aversion is not plausible by providing
examples of how the theory can be wrong and misleading. They call for a better model of
describing choice under uncertainty. It is now widely agreed that the failure of expected

59
utility theory is due to the failure to recognize the psychological principles governing
decision tasks.
The literature on cognitive psychology provides a promising framework for
analyzing investors' behavior in the stock market, by dropping the stringent assumption
of rationality in conventional models; it might be possible to explain some of the
persistent anomalous findings. For example, the observation of overreaction is consistent
with the finding that subjects, in general, tend to overreact to new information (and
ignore base rates). Also, agents often allow their decision to be guided by irrelevant
points of reference, a phenomenon discussed under "anchoring and adjustment". Shiller
(1984) proposes an alternate model of stock prices that recognizes the influence of social
psychology; he attributes the movements in stock prices to social movements. Since there
is no objective evidence on which to base their predictions of stock prices, it is suggested
that the final opinion of individual investors may largely reflect the opinion of a larger
group. Thus, excessive volatility in the stock market is often caused by social "fads"
which may have very little rational or logical explanation.
Research into investor behavior in the securities markets is rapidly expanding
with very surprising results, again, results that are often counter to the notion of rational
behavior. Hirshleifer and Shumway (2001) find that sunshine is strongly correlated with
daily stock returns. Using a unique data set of two years of investor behavior for almost
the entire set of investors from Finland, Grinblatt and Keloharju (2001) find that distance,
language, and culture influence stock trades. Huberman and Regev (2001) provide an
example of how and not when information is released can cause stock price reactions.
They study the stock price effect of news about a firm developing a cure for cancer.
Although the information had been published a few months earlier in multiple media
outlets, the stock price more than quadrupled the day after receiving public attention in
the New York Times. The efficient market view of prices representing rational valuation
of fundamental factors has also been challenged by Summers (1986), who views the
market to be highly inefficient. He proposes that pricing should comprise a random walk
plus a fad variable, the fad variable is modelled as a slowly mean-reverting stationary
process. That is, stock prices will exercise some temporary aberrations, but will
eventually return to their equilibrium price levels.

60
 One may argue that market mechanisms may be able to correct the individual
decision biases, and thus individual differences may not matter in the aggregate.
However, the transition from micro behavior to macro behavior is still not well
established. For example, in their study of price differences among similar consumer
products, Pratt, Wise and Zeckhauser (1979) demonstrate the failure of the market to
correct individual biases. All arguments aside, the stock market crash of 1987 continues
to be problematic for the supporters of EMH, any attempt to accommodate a 22.7 percent
devaluation of the stocks within the theoretical framework of EMH would be a
formidable challenge. It seems reasonable to assume that the decline did not occur due to
a major shift in the perceived risk or expected future dividend. The crash of 1987
provides further credence to the argument that the market includes a significant number
of speculative investors who are guided by "non-fundamental" factors. Thus, the
assumption of rationality in conventional models needs to be rethought and reformulated.

2-6 Evidence from emerging markets

According to International Finance Corporation (IFC) classification criteria, an
emerging stock market is the one located in a developing country as defined by the World
Bank’s GNP per capita criterion. IFC, a leading compiler of emerging market returns,
considers the size (as measured by market capitalization) and liquidity (as measured by
turn over) in classifying a market as emerging and in deciding to include the securities in
the market in its Emerging Market Data Base (EMDB). In addition, inclusion in the
EMDB is affected by the industry in which a company operates; the IFC attempts to
provide broad coverage of industries important within the market. Thus, a smaller less
liquid security might be included, whereas a larger, more liquid one is excluded if the
smaller less liquid security represents a particular industry that would otherwise be under-
represented. Although the world (capital) market is neither fully integrated nor
completely segmented, there is no doubt that there is increasing interdependence among
its segments. Presently, the fully diversified portfolio must consist of a significant portion
of foreign securities to mitigate unnecessary risk. Global diversification depends on the
correlations among countries. According to the World Bank, a significant degree of
correlation between portfolio equity flows and the emerging stock markets development

61
indicators has been established. These correlations are enhanced by cross-border
investments and improving technology.
Moreover, the benefits of diversification are no longer sufficiently achieved
through developed markets. While emerging markets in many respects differ from the
developed markets, there is still substantial diversity among emerging stock markets in
terms of institutional infra structure, market size and liquidity. Emerging markets,
especially in the last decades, provide diversification benefits at an increasing rate. There
may be several factors to explain the unprecedented development of emerging markets,
but it is possible that economic reforms in these markets have left to a rapid increase in
equity flows from the industrial to the developing ones. The more established emerging
markets of Asia and Latin America and the new capital markets in Eastern Europe,
MENA will play a positive role in this process.
Most of the studies on EMH are conducted on the world’s largest stock markets;
the USA, Japan and Europe. In recent years, efficiency in emerging markets has been
investigated widely. Researchers have focused on whether these markets are
informationally efficient or whether anomalies exist. Barnes (1980) indicates that the
Kuala Lumpur stock market is inefficient. While Panas (1990) could not reject market
efficiency for Greece. Campbell (1995) examines 20 emerging markets in Latin America,
Asia, Middle East, Europe, and Africa. He finds that returns in these emerging markets
are more predictable than returns in developed markets and returns are influenced by
local rather than global information. Moreover, Antoniou, Ergul, and Holmes (1997)
study the Istanbul Stock exchange and find it to be inefficient in the early times and
efficiency improves as the country starts liberalization and deregulation. Dickinson and
Muragu (1994) find the Nairobi stock market to be efficient. Urrutia (1995), using the
variance ratio test, rejects the RWH for the Latin American emerging equity markets of
Argentina, Brazil, Chile, and Mexico, whereas the runs test indicates weak form
efficiency.
In contrast, Ojah and Kermera (1999) find that Latin American equity returns
follow a random walk and are generally weak-form efficient. Grieb and Reyes (1999) re-
examine the random walk properties of stocks traded in Brazil and Mexico using the
variance ratio test and conclude that index returns in Mexico exhibit mean reversion and

62
a tendency toward random walk in Brazil. In addition, predictable variations in the
emerging market returns have been documented in Bekaert (1995), Harvey (1995b,
1995c) and claessens et al. (1995). Buckberg (1995) also finds evidence of predictability
in emerging markets and rejects the hypothesis that lagged price information cannot
predict future prices. A low form of predictability in the emerging markets can be viewed
as some form of reward for risk taking. The conclusion is that predictability is more
likely to be influenced by local information and that lower degrees of predictability in
emerging markets can be viewed as a reward for added risk taking.
Furthermore, Bailey et al. (1990) present evidence that stock prices of several
Asian markets do not follow random walks. Bessembinder and Chan (1995) examine if
market participants in the emerging markets take advantage of profit opportunities that
may be present due to deviations from the random-walk model. They find that technical
rules have some predictive power, but they say technical signals from US markets have
stronger forecasting power. Haque et al. (2001) investigate the stability, volatility, risk
premiums and persistence of volatility of seven Latin American emerging markets and
find that Latin American markets have shown remarkable performance using return to
risk measures; predictability seems mixed and has volatility clustering with shocks that
decay with time. Haque et al. (2004) study of 10 Asian stock markets suggests that 8 out
of 10 Asian markets have returns that are stable over time. The predictability tests
suggest most of the Asian emerging markets to be predictable. The non-parametric runs
test for weak form of market efficiency decisively rejects the hypothesis for weak form
efficiency for all the Asian markets.

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3- The case of Arab stock markets
The markets of the Middle East have buzzed with activity since the beginning of
western civilization. Yet, these countries of the region that gave the world the basis of
modern commerce have been relative latecomers to global financial markets. Where the
Middle East is concerned, political and religious issues continue to dominate the
headlines. What differentiates the Middle East markets from other emerging markets is
the region’s heterogeneity. The financial sector in Middle Eastern countries is dominated
by commercial banks. The security markets in these countries are relatively small despite
the fact that the region contains some of the developing world’s largest institutional
investors in international markets. Foreign participation, even in the government bond
markets, is limited in most countries. Similarly, there have been few direct placements of
Middle Eastern equities on foreign markets.
Moreover, the use of market-based risk management instruments by countries in
the region has been extremely narrow despite the relatively limited degree of export
diversification. While there are considerable differences across countries in the
importance of equity markets, the supply of corporate securities remains generally limited
both in absolute terms and relative to the size of the economies. This reflects several
factors that have constrained the demand for and the supply of equities, including the
closed, family-owned nature of many companies in the region. Moreover, in several
countries public sector enterprises have continued to play a dominant role in a wide range
of economic activities. The number of effectively quoted companies thus has been
relatively small and the markets have, in general, remained thin.

3-1 Arab stock markets and market efficiency

As mentioned in the previous chapter, most of the studies on EMH are conducted
on the world’s largest stock markets. In recent years, efficiency in emerging markets has
been investigated widely. Very few studies, target countries from the Middle East region,
most of them concentrated on return predictability and markets integration and linkages.
In addition, most of these studies are usually focused on their individual or a small set of
countries for a short horizon.

64
 One early study undertaken by Gandhi et al. (1980) focuses on the Kuwaiti stock
market and attempts to measure its efficiency through the use of some empirical tests.
The authors find a high correlation in the market index and conclude that the market is
inefficient. Bulter and Malaikah (1992) examine individual stock returns in the Kuwaiti
and Saudi Arabian markets over the second half of 1980s. Their results indicate market
inefficiency in both markets, but significantly more in the Saudi market. However, Al-
loughani (1995) tests the weak form of EMH in the Kuwaiti stock market by using
various methods, both traditional and advanced. The author finds that when using
traditional methods, the results provide evidence of weak form efficiency, while when
using more recent methods, he obtains opposite results in the sense that the evidence
clearly indicates market inefficiency. Another study investigates the Kuwaiti stock
market has been done by Al-loughani and Moosa (1997), since they test the efficiency of
the Kuwaiti stock market by using a set of moving averages of different lengths. The
results obtained by the authors indicate market inefficiency.
Additionally, El-Erian and Kumar (1995) examines the RWH in emerging
markets by choosing two countries from the Middle East region, Jordan and Turkey, and
three other emerging markets from different regions. The study finds that there is serial
dependence among the day-to-day price changes in the stock markets of Jordan and
Turkey, indicating that the random walk model does not hold for these markets. Similar
results, obtained by Omran and Farrar (2002) who reject the RWH for 5 Middle Eastern
countries, while Abraham et al. (2002) reject both RWH and weak form efficiency for
three Gulf equity markets, Saudi Arabia, Kuwait, and Bahrain, when they use the
observed indices, while they cannot refuse them when they correct indices for infrequent
trading. Rao and Shankaraiah (2003) find evidence that Bahraini stock market is efficient
at the weak form level during the second half of 1990s. Hakeim and Neaime (2002) find
evidence that 4 MENA markets Egypt, Jordan, Morocco, and Turkey are mean reversion.
Limam (2003) using weekly data, finds long range dependence in eight Arab stock
markets, while Omet et al. (2002) reject the weak form efficiency for the Jordanian stock
market.
On the other hand, Moustafa (2004) finds that 40 stocks out of the 43 including in
the UAE index are random, using daily data for the period October 2, 2001 through

65
September 1, 2003, while Haque et al. (2004) examine the stability, predictability,
volatility, time varying risk premiums and persistence of shocks to volatility for 10
MENA stock markets; including 6 Arab stock markets. They find that 8 out of 10 markets
show evidence of volatility clustering, but in 8 MENA stock markets; the shocks are not
explosive. Whereas one market shows positive and significant time varying risk
premiums. They conclude that MENA equity markets are where investors may find a
good return for the investments, since the correlation is found to be low, which provide
investors with the opportunity for diversification. Moreover, Al-loughani (2000) studies
the relation between large stock and small stock returns in the Kuwaiti stock markets, he
finds further evidence on the informational inefficiency of the Kuwaiti market, since in
short term large stocks provide a lead in the bull phase. Dahel and Laabas (1999)
examine the behavior of stock prices in 4 GCC markets Bahrain, Kuwait, Oman, and
Saudi Arabia using weekly data from September 1994 to April 1998. They find that
Kuwaiti market to be efficient while for the other three markets; weak form of the EMH
was rejected based on regression of return test. However, when the sample is split into
two, the efficiency hypothesis is not rejected for the second sub period in two of the
markets and only by a small margin in the case of the Saudi Arabia.
Few researches concentrate on the volatility structure of Arab stock markets. For
instance, Dahel (2000) investigates whether Arab stock markets are characterized by
excessive volatility of returns. His study includes in addition to 8 Arab stock markets,
two emerging and three developed markets. He finds that Arab markets exhibit the lowest
level of volatility of returns compared to other emerging and developed markets, and they
were not affected by international financial crisis. In addition, Arab stock markets are
characterized by low correlations with each other and with international markets. While
Hammoudeh and Choi (2004) investigate the volatility of the decomposed stock returns
of members of the GCC stock markets into permanent and transitory components using
the unobserved-component model with Markov-switching heteroskedasticity (US-MS
model). They find that the GCC stock markets vary in terms of sensitivity to the
magnitude of return volatility and the duration of volatility. Oman and Saudi Arabia stock
markets exhibit extra volatility sensitivity during fad times of the other GCC stock
markets, while Kuwaiti, Bahraini, and Saudi Arabia have longer duration of volatility

66
during fad times. Moreover, they find that all GCC returns move in the same direction
whether in terms of total return, fundamentals or fads under both volatility regimes. They
find also that the correlations of the stock returns and their components with each other
and with oil price return are also weak, suggesting that country particularities in addition
to the oil price return influence the stock component returns.
Very few researchers also investigate EMH in Arab stock markets indirectly by
examining whether anomalies exist or not Such as calendar effects. For instance, Aly et
al. (2004) find no evidence for Monday effect in the Egyptian stock market, using daily
data for market index during the period April 26, 1998 to June 6, 2001, while Al-saad and
Moosa (2005) find that seasonality is found to take the form of a July effect, as opposed
to the better-recognized January effect for the Kuwaiti stock market. They conclude that
the finding is attributed to the “summer holiday effect”. Whereas, Maghayereh (2003)
finds no evidence of monthly seasonality and January effect for the Jordanian stock
market during the period January 1994 to December 2002. Finally, Al-loughani (2003)
documents mixed evidence on seasonality regarding the Kuwaiti stock markets.
Another line of research examines the properties and characteristics of the Arab
stock markets and the prospects and implications of enhanced financial liberalization in
the region. It also explores whether these markets can offer international investors unique
risk and returns characteristics to diversify international and regional portfolios. Darrat et
al. (2000) examine financial integration among three emerging markets in the Middle
East region Jordan, Egypt, and Morocco with the U.S market. Using monthly data for the
period October 1996 to August 1999, they find that according to Johansen-Juselius co-
integration test the Middle East emerging stock markets are segmented globally, but
appear highly integrated within the region. The result also indicates that, the Egyptian
stock market is a dominant force driving other markets in the region. In the same area,
Assaf (2003) using vector auto-regression, investigates the dynamic interactions among
stock market returns for 6 GCC countries. His results indicate that there is substantial
evidence of interdependence and feed back effects among GCC stock markets, the results
also indicate that Bahrain is the dominant market while Saudi Arabia shows slow process
in responding to shocks originated in other markets.

67
 Moreover, Mohd and Hassan (2003) find long term relationship between 3 GCC
stock markets Kuwait, Bahrain, and Oman. They also find that information on the price
levels is helpful for predicting their changes. In addition to the previous studies, the
international diversification benefits between U.S, Turkish, and Egyptian stock markets
have been investigated by Maneschiold (2005) who finds that long term relationship at
the general index level related to some but not all sub-indices investigated. U.S investors
can obtain diversification benefits at a sub-index level. Neaime (2002) studies the
liberalization and financial integration for 7 MENA stock markets with international
markets. He finds that GCC equity markets still offer international investors portfolio
diversification potentials while other emerging MENA stock markets like those of
Turkey, Egypt, and Morocco and to lesser extent Jordan have matured and are now
integrated with the world financial markets. However, shocks to U.S and UK stock
markets are transmitted to the MENA region but not to the GCC stock markets.
Girard et al. (2003) investigate relationships between market risk premium, time-
varying variance and time-varying covariance in 11 MENA markets and 8 developed
markets. They conclude that MENA capital markets are highly segmented and provide
diversification benefits to the global investors. From his side, Omran (2003) investigates
the impact of real interest rates on stock market activity and liquidity in the Egyptian
stock market. He finds that real interest rates have an impact upon stock market
performance. Finally, Hammoudeh and Aleisa (2004) study the daily relationships among
stock markets of the GCC members, excluding Qatar, and oil prices. They find that the
GCC stock markets are candidates for diversified regional portfolios at the country level,
while only the Saudi market can predict and be predicted by oil prices.
In general, it appears from the previous literature review that relatively less
explored area of research has been on the Arab stock markets. With few studies
undertaken to date, research on these markets has focused on the issue of efficiency as
well as on their integration with international markets. In addition, most of these studies
are concentrated on few markets and in many cases only one market and for short horizon
of time using monthly and weekly data.

68
3-2 The Foundation of Arab stock markets
MENA region have been receiving extensive media coverage and public attention
for various reasons. Many have recognized that most MENA countries have long
abstained from the global trend of further globalization, modernization and political and
economic liberalization. Some claim that the region is facing the reduction in oil wealth
that can no longer act as a cushion or employ the huge population growth, as a result,
Arab countries, as a part of MENA countries, going toward economic and political
reforms and increasing the role of the private sector. It is commonly recognized that the
availability of financial capital market is a prerequisite for the development and
transformation of any nation’s economy. Finding and efficiently managing the scarce
resources depend on the existing of financial institutions, whether they are banks or non-
bank financial institution such as insurance companies, issuing houses and stock markets.
Banks mobilize financial resources from the surplus sector of the economy and channel
such funds to the deficit units of the economy, whereas the stock market is a market
where trading activities for securities take place and its primary function is to allocate
resources to the most profitable investment opportunities.
Most Arab countries have stock markets which considered as emerging markets.
By international standards, Arab stock markets are considered relatively new. Most of
them started operating over the last two decades, while others have been in existence for
much longer but until recently; there level of activity was not significant. In general, there
are significant differences between Arab stock markets characteristics. In this contest,
Arab countries can be divided into two groups regarding natural resources: non oil
countries, and oil countries. Since the second group mainly constitute of the Gulf
Cooperation Council Countries (GCC), which is a customs union that consists of six
members, including four major oil-exporting countries, which are important decision
makers in the Organization of Petroleum Exporting Countries (OPEC). The six members
are Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates (UAE). The
non-OPEC members among them are Bahrain and Oman. This section will discuss the
foundation of Arab stock markets with some economical background for each country
including in this research.

69
 • Egypt
Economic reforms in Egypt have faltered due to the post September 11 downturn
in tourism, high Suez Canal tolls, and low level of exports. Little progress has been
achieved in privatizing or reforming the significantly large public sector. Social concerns
have taken precedence as the largest Arab country, with a population of 69 million,
suffers from growing unemployment and the need to maintain subsidies on food, energy,
and other commodities for the large percentage of the poor. Development of the natural
gas export may help the growth of the economy. While investment laws have been
revised to promote foreign investments, between 1998 and 2001, FDI actually fell by 50
percent, from approximately US$ 1 billion to 500 million due to bureaucratic constraints.
Although decreasing state-owned banking sector still holds the majority of the market
share, these banks are characterized by low capitalization, a high percentage of poorly
performing loans, massive overstaffing and stifling bureaucracy. The Egyptian legal code
is complex and often characterized by lengthy delays. Nevertheless, the legal system
protects private property. Regulations and regulatory agencies are influenced by private
interests and government corruption, which cause delays in clearing goods through
customs, arbitrary decision- making, and high market inefficiencies. The top income and
corporate tax are 40 percent. In January 2003, the Egyptian Pound changed from a
pegged to a floating exchange rate.
Egypt has a long history of financial markets, by the late of 1800s; Egypt had a
sophisticated financial structure including a mature stock exchange in both Alexandria
and Cairo. The Egyptian stock market has experienced fundamental changes during four
major periods from 1888-1958, 1959-1971, 1972-1992, and 1992-present. In the earliest
phase, the market was active and growing out at a remarkable rate. By the 1940s, both the
Cairo and Alexandria exchanges were very active, and the combined Egyptian stock
exchange ranked fifth in the world in terms of overall market capitalization. However, in
the second period from 1959-1971, the Egyptian stock market was seriously marginalized
by government intervention and restrictions that left it effectively inoperable. In the third
period (1972-1992), serious attempts were made to revive the failing stock market to no
avail, and the stock exchange continued to stagnate. Finally, in the 1990s (the forth
period), the Egyptian stock market went through a significant revival due to government

70
liberalization policies. The restructuring of financial markets and privatization programs
were key elements in stimulating economic development and capital investment in 1990s.
Major changes in the organization of the Egyptian stock exchange took place in
January 1997 that significantly reformed the stock market. Today, the stock market once
again encompasses the two exchanges at Cairo and Alexandria, both of which are
governed by the same regulatory agency, and share a common trading, clearing and
settlement system. In addition, several important steps have been taken by the Egyptian
government to modernize the stock exchanges. For example, a coherent organization
structure with clear division of authority and responsibilities has been created; a new
state-of-the-art trading, clearing and settlement system conforming to international
standards has been installed; new membership and trading rules have been legislated; and
new arbitration and dispute resolution procedures were developed.
The Capital Market Authority (CMA) was established in 1990s, as the primary
regulatory body for the Egyptian stock exchange, and it is responsible for the issuance of
licenses to all financial intermediaries including the central clearing and depository
company. The CMA is also responsible for the introduction of any laws and regulations
pertaining to the efficiency and transparency of the market. The company Misr Central
Clearing and Depository (MCSD) oversees the clearing and settlement of all securities
transactions. MCSD is a private company whose primary shareholders are 16 banks, 15
brokerage houses and the stock market exchange itself. Together with CMA, these two
agencies work to guarantee that the market functions efficiently and transparency.
Egypt’s recent economic reforms, mainly the successful implementation of a large
privatization program, is often cited as being largely responsible for the rapid growth in
Egyptian stock market activities over the last five years. Finally, the Egyptian stock
market has been included in the International Finance Corporation’s (IFC) composite
stock index since January 1997, with a 1 percent weighting in the overall index.
Furthermore, Morgan Stanley Capital International covers the Egyptian stock market on a
stand alone basis, although it has not yet included Egypt in its benchmark emerging
markets index.

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 Table 3-1
Some Economic Indicators, Egypt
2000 2001 2002 2003 2004
Population (million) 63.305 64.622 65.986 67.313 68.648
GDP (m US$) 97,655 90,285 85,710 81,495 78,491
GDP growth (%) 7.80 -7.55 -5.07 -4.92 -3.69
GDP per capita (US$) 1,543 1,397 1,299 1,211 1,143
Inflation rate (%) 2.7 2.3 2.7 4.2 -
Source: Uniform Arabian Economic Report 2005, Arab Monetary Fund (AMF)

• Jordan
With scarce economic resources, Jordan’s constitutional monarchy has generally
been dependent on foreign loans and aid. Legislative and regulatory reforms under king
Abdallah II allowed Jordan to accede to the WTO, leading to privatization and economic
growth. Although the country faces a heavy dept burden, high unemployment, and the
end of Iraqi-subsidized oil, Jordan can bring back tourism and foreign investment by
working towards a more peaceful and open Middle East. In 2001, its tariff rate was 13.5
percent. However, the inefficient customs pose a bigger hindrance to imports where they
are subject to arbitrary regulations frequent delays. The top income and corporate tax rate
in Jordan are 25 and 35 percent respectively. In 2001, the government consumed 23
percent of GDP.
While the government promotes foreign investments, investors face numerous
obstacles and restrictions such as the minimum capital requirement of $ 700000 and a
maximum of 49 percent ownership. The 2000 new banking law protects the interests of
investors and works against corruption. However, the US Department of State estimates
that 30 percent of Jordan’s loans are nonperforming. Subsidies still remain for oil, while
most price controls have been removed. The judiciary branch is designed to be
independent; however the strong executive branch can easily influence the judges in its
favor. Similarly, the government is attempting to bring reforms to foster a more
competitive environment, yet the bureaucratic and burdensome regulatory system
characterizing by red tape and arbitrary application of customs, tax, labor, and other laws
is a strong obstacle to attract investments.
Regarding the financial equity market, Amman Stock Market (ASM) was formed
on 1 January 1978. Since its formation, the market has experienced some growth in a

72
number of aspects. The ratio of market capitalization to GDP increases from 37 percent
in 1978 to about 160 percent in 2004, which indicates the importance of the market in the
national economy. However, the market can be seen highly concentrated; since
approximately 10 companies in each year accounted for a large proportion of the total
trading volume. In other words, most listed shares are thinly traded on the secondary
market.
The order-driven market making system of the ASM has no designated liquidity
providers and orders are prioritized for execution in terms of price and time. By
submitting a limit order, a trader provides liquidity for other market participants who
demand immediacy. In other words, investors can trade via market orders and consume
liquidity in the market. Given the importance of the ASM in the national economy, the
Jordanian capital market has seen the introduction of a number of major changes. At the
forefront of these changes is the June 2000 implementation of the Electronic Trading
System (ETS). This system was bought from the Paris Bourse and its’ cost (10.5 million
French Francs) was funded by the French government. This event can be considered as a
qualitative leap because it means more transparency and safety for traders and investors.
Since the establishments of the Jordanian capital market, investors have been enjoying a
zero tax rate on capital gains and dividends. However, in 1996, the government imposed
a 10 percent tax rate on dividends.

Table 3-2
Some Economic Indicators, Jordan
2000 2001 2002 2003 2004
Population (million) 4.820 4.940 5.070 5.200 5.323
GDP (m US$) 8,460 8,975 9,561 10,160 11,515
GDP growth (%) 3.82 6.09 6.53 6.27 13.34
GDP per capita (US$) 1,755 1,817 1,886 1,954 2,163
Inflation Rate (%) 0.7 1.8 1.8 2.3 -
Source: Uniform Arabian Economic Report 2005, Arab Monetary Fund (AMF)

• Palestine
Palestine Stock Exchange (PSE) was incorporated as a private shareholding
company in early 1995, with Palestine Development and Investment Company
(PADICO) and (SAMED) as its major investors. After the Palestinian National Authority

73
(PNA) approved a PADICO-sponsored design and work plan in July 1995, a project team
was put together by PSE and entrusted to establish a fully electronic exchange and
depository. EFA Software Service, a Canadian company provides both the trading,
settlement and clearing systems. By August 1996, the exchange was fully operational and
on November 7th of that year, PSE signed an operational agreement with PNA, allowing
for the licensing and qualification of brokerage firms to take place. On February 18th
1997, PSE conducted its first trading session. 28 shareholding companies have been
approved for listing.
As a self regulating organization, PSE is charged with enforcing its rule and
regulations until 2004, since pursuant to laws # 12 and 13 the supervisory and executive
roles have been separated. The first being discharged by a public sector affiliated body,
while the second role is being carried out by PSE. Regarding foreign investment, PSE
does not impose any restrictions on foreign investment. However, as a result of political
problems in Palestine since September 2000; the Palestinian economy suffered a sharp
recession. For instance, the unemployment ratio reached 81 percent in 2002. While GDP
dropped from $ 4712.6 million in 1999 to $ 3213.8 in 2002. All these developments
affected negatively the investment’s environment in Palestine, which in parallel affected
the performance of PSE sharply.

Table 3-3
Some Economic Indicators, Palestine
2000 2001 2002 2003 2004
Population (million) 3.224 3.312 3.560 3.720 3.880
GDP (m US$) 4,442 4,136 3,780 4,222 4,462
GDP growth (%) -1.65 -6.89 -8.61 11.69 5.68
GDP per capita (US$) 1,378 1,249 1,062 1,135 1,150
Inflation Rate (%) 5.54 2.79 5.71 4.4 -
Source: Uniform Arabian Economic Report 2005, Arab Monetary Fund (AMF)

• Saudi Arabia
Saudi Arabia, one of the prominent countries in the Organization of Petroleum
Exporting Countries (OPEC), has the largest oil reserves in the world. Oil exports
account for 90 percent of export earning, 38 percent of GDP, and 80 percent of the
budget revenues. At the same time, the country faces the challenges of a rabidly growing

74
population, water shortages, and political challenges from Islamic extremists. Although
the government recognizes the need for privatization to reduce its dependence on oil, the
transformation will not happen immediately as the private sector constitutes only about
25 percent of the economy.
The government imposes subsidies on state-owned industries, resulting in a
weighted average annual rate of inflation of -0.55 percent from 1993 to 2002.
Furthermore, the government lists sectors that are prohibited to foreign investment, while
many others are subject to tedious government regulations in favor of private interest. Its
banking sector is tightly controlled by the Saudi central bank and is heavily dependent on
the global oil market. While regarding stock market, the Saudi stock market started in
1952 with one company and continued in an unregulated manner till 1984. At this point,
the central bank (SAMA) took over as a regulatory body, entrusting all trading to take
place through commercial banks in the country.
In 1990, an electronic trading system was instituted consisting of a central
clearing mechanism connected via twelve trading units (CTU) to the twelve commercial
banks in the kingdom. Orders for buy and sell have to be entered by bank employees
manning these CTUs. Currently 77 companies are listed and eligible for trading, while
trading each day is broken into two, two hour sessions, Saturday to Wednesday; and one
two our session on Thursday. The minimum tick size is one Saudi Riyal (approximately $
0.26) and transaction costs starts from a minimum of SR 25. In addition, only limit order
are accepted by the system, where the typical order must specify the price and the
quantity intended for purchase or sell. A market order would therefore have to taken the
form of what is termed a “marketable order”, where the price is better than or equal to the
best bid or offer currently available. The best two bids and offers are publicly visible on
the electronic order book, settlement follows the end of the second trading session, and
printed certificates are available the next day.

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 Table 3-4
Some Economic Indicators, Saudi Arabia
2000 2001 2002 2003 2004
Population (million) 20.474 20.976 21.491 21.983 22.529
GDP (m US$) 188,442 183,012 188,551 214,573 250,558
GDP growth (%) 17.08 -2.88 3.03 13.8 16.77
GDP per capita (US$) 9,204 8,725 8,773 9,761 11,122
Inflation Rate (%) - -0.7 -0.2 0.6 -
Oil reserve (as % of world reserves) 25.42 25 25 25 24
Oil production (% of world production) 11.7 12.1 11.8 10.8 12.4
Contribution of oil to GDP (%) - - - 34 38
Source: Uniform Arabian Economic Report 2005, Arab Monetary Fund (AMF)

• Kuwait
Controlling approximately 9 percent of the world’s oil supply, 47 percent of
Kuwaiti GDP and 90 percent of its export revenues come from oil production. Reforms
by the government have been stalled by political pressure from Islamic and populist
parties who benefit from the current system. Similarly, the parliament has delayed
Kuwait project to develop oil fields in the northern part of the country due to opposition
of allowing foreign investors to gain control of the oil industries. Nevertheless, this
project and foreign participation in Kuwait will enable the country to participate in
reconstruction in Iraq and serve as a strategic transshipment port for goods bound to the
region. Kuwait has no income tax or corporate taxes for wholly owned Kuwaiti
companies while foreign corporations are subject to a 55 percent tax rate.
The government intervenes in the stock market. Along with the high tax rate,
foreign investment faces significant restrictions, such as inability to foreigner to own real
state and invest in the oil sector. The banking sector is more competitive and open to
foreign investment, although foreigners are restricted to maximum of 49 percent of
ownership. Key services that are subsidized by the government are subject to price
controls. While no minimum wages exist in the private sector, wages are set in the public
sector that employs 93 percent of Kuwaitis
In the case of financial market, Kuwait stock market was established in April
1978. In August 1982, the official Kuwaiti stock market fell 21 percent in value and the
unofficial market fell about 60 percent. From August 1982 until mid-1984, the Kuwaiti

76
government bought selected stocks to support prices. In September 1982, it is required
that investors in both markets report their open forward positions. At this time, the value
of outstanding post-dated checks in both markets was $ 93 billion ($17 billion in the
official market and $ 76 billion in the unofficial market) with settlement dates of up to 3
years. The market collapse and ensuring economic and financial crisis are referred to as
Al-manakh crisis. Kuwait’s response to Al-manakh crisis was to institute laws and
regulations governing information disclosure, securities registration, and capital and
credential requirements for brokers. As a result, a reorganized Kuwaiti Securities
Exchange began trading stocks, bonds and bank deposits in 1984, prices were determined
in a competitive auction, trades were conducted by floor brokers on instructions from
outside brokers so that floor brokers did not know the identity of their clients. In addition,
restrictions on margin trading and short selling were enforced.

Table 3-5
Some Economic Indicators,Kuwait
2000 2001 2002 2003 2004
Population (million) 2.228 2.243 2.363 2.484 2.645
GDP (m US$) 37,018 34,076 38,111 46,195 55,719
GDP growth (%) 22.40 -7.95 11.84 21.21 20.62
GDP per capita (US$) 16,615 15,192 16,128 18,597 21,066
Inflation Rate (%) - 1.7 1.4 1.2 -
Oil reserve (as % of world reserves) 9 9 9 9 9
Oil production (% of world production) 3 2.9 2.7 3.1 -
Contribution of oil to GDP (%) - - - 41 47
Source: Uniform Arabian Economic Report 2005, Arab Monetary Fund (AMF)

• Oman
Since the 18th century, Oman has been governed by an absolute monarchy. In
2001, 66 percent of the government’s total revenues came from state-owned enterprises
and its ownership of property. The oil industry has grown to be the dominating industry,
making up 86 percent of revenues and roughly 47 percent of GDP. At the current rate of
production, oil reserves are projected to last for only 18 years. The government realizes
that diversification is essential and is trying to respond by expanding its gas-based
industry, boosting economic activity, facilitating foreign investment and privatization,

77
and promoting private-sector employment. However, due to its constantly changes and
complex customs procedures and regulations, Oman’s restrictive trade policy is an
obstacle to open trade and considerable progress. Similarly, establishing a business in the
country can prove to be a tedious process, subject to the approval from various authorities
in respect to land acquisition and labor requirements. Lack of clear regulations that
explicitly codify Omani labor and tax laws cause ad hoc decisions and complicate the
process even further. Burdensome regulatory requirements for approvals cause
considerable delays and adverse condition for the private sector.
Additionally, political pressures have always influenced the judiciary branch.
However, 2001 and 2002 show significant changes in the restructuring of the legal
system, where the courts, the public prosecution service, the police and attorney-general
have all been separated to function independently. Unemployment remains a significant
concern, particularly among the fast-growing young population. To mitigate the problem,
the government has implemented a quota program that replaces foreign workers with
Omains, which poses another impediment to foreign investment. While individuals do
not have to pay an income tax, companies that are 70 percent foreign-owned incur a 30
percent tax, whereas other domestic companies only face a 12 percent tax rate.
In addition, foreign ownership above 70 percent requires the approval of the
Minister of Commerce and Industry, while certain industries are prohibited in the country
all together. With its participation in the WTO, Oman is pressured to open its service
sector of foreign firms. The rate of deflation in Oman is another factor of concern for
investors, where the weighted annual average was -0.76 percent from 1993 to 2002. The
inflationary pressure is kept in check by price controls and a subsidy system.
Additionally, the government-operated banking sector approves very favorable loans to
Omani citizens. Moreover, Oman’s Muscat stock market was established in 1989, with a
122 listed companies and a market capitalization of $ 9.317 billion in 2004. Furthermore,
only nationals of the GCC are permitted to invest in the local stock market.

78
 Table 3-6
Some Economic Indicators, Oman
2000 2001 2002 2003 2004
Population (million) 2.402 2.478 2.538 2.331 2.264
GDP (m US$) 19,868 19,949 20,304 21,698 24,824
GDP growth (%) 20.93 0.01 1.78 6.87 14.41
GDP per capita (US$) 8,271 8,050 8,000 9,308 10,965
Inflation Rate (%) - -1 -0.7 -0.3 -
Oil reserve (as % of world reserves) 0.6 0.6 0.5 0.5 -
Oil production (% of world production) 1.4 1.4 1.3 1.2 -
Contribution of oil to GDP (%) - - - 42 42
Source: Uniform Arabian Economic Report 2005, Arab Monetary Fund (AMF)

• United Arab Emirates (UAE)

The United Arab Emirates (UAE) controls approximately 9 percent of the global
oil supply and about 5 percent of the proven natural gas reserves in the world. Oil
revenues comprise about one-third of its GDP. Although the energy reserves expected to
last for more than 100 years at current rate of production, in recognizing the need for
diversification, UAE is focusing on the development of its service sector and non-oil and
gas industrial base. Foreign investment and privatization are sought in the interest of
modernizing technology and reducing costs; however, foreigners face widespread
restrictions in owning land and investing in specific industries. Where the land is not
state-owned, private property is generally well protected. Importers are required to have
an import license and are subject to various restrictive regulations. Prices on goods are
affected through government subsidies.
The public sector holds an important role in total employment and provides
subsidies services and an extensive welfare system. In 2001, for example, public
enterprises in the hydrocarbon sector alone accounted for 59 percent of the government
revenues. In providing loan guarantees, the government minimizes the risk of default to
attract international investment. The UAE has no income tax, and no other significant
taxes. However, foreign banks face 20 percent tax on profits and are subject to quotas to
hire UAE nationals, and other restrictions.
The UAE stock market is relatively new and small, which contains both official
and unofficial markets. The official market started in 2000 and represented two

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government stock markets, Dubai and Abu Dhabi, under the supervision of the Emirates
Securities and Commodities Authority. While the unofficial, or OTC, market works
through several brokerage firms with most of them affiliated to banks. Since its inception
as an unofficial market in the late of 1970s, the UAE stock market has experienced
several volatile periods in terms of share trading activity and price level. The period of
(1975-1982) had witnessed the creation of many companies due to rising oil prices and
the strong interest of the federal government to build a strong national economy.
However, the crisis of the Kuwaiti stock market, the crisis of Al-manakh market in 1982,
and the falling of oil prices in 1986 had a negative impact on the UAE capital market.
The UAE capital market rose again during the period of 1993-1998, due to the
establishments of many new companies.
While once again, the UAE capital market experienced a deep decline in the
summer of 1998 due to several reasons including: lack of regularity, manipulation of the
market by block traders and professional investors, negative speculative trading by all
participants, lack of financial disclosure, and the drop in oil prices. Since the summer of
1998, the market has suffered sharp declines in both trading volume and trading value to
such an extend that the market prices of most traded stocks have decreased under their
par value. In response to the stock market crisis in 1998, the UAE government responded
by officially recognizing its stock market. The Emirates Securities and Commodities
Authorities (ESCA) was established February 1st, 2000 pursuant to federal law # 4 of
2000 under the chairmanship of the Minister of Economy and Commerce. Its function is
to regulate and develop the primary and secondary markets, monitor the operations of the
market, and create a favorable environment for investment.
As a result, the Dubai Financial Market (DFM) was officially founded in March
2000 as the first organized stock market in UAE. DFM has been trying to increase the
investment alternatives available to investors, and sources of financing available to
companies, while Abu Dhabi Securities market (ADSM) started operating in November
2000. ADSM with its 35 listed companies in 2004 is larger than DFM. However, neither
bonds nor mutual funds are yet included. Since the establishments of the official UAE
stock market in 2000, it has been growing at the expense of the OTC market. In addition,
ESCA enacted a set of statutory orders and regulations that pertain to arbitration, listing,

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brokers’ practice, disclosure, transparency, financial markets operations, trading,
clearance and depository. Moreover, in 2001 ESCA launched an official capital weighted
average market index with 1000 points, called Emirates index, consisting of all listing
companies.

Table 3-7
Some Economic Indicators, United Arab Emirates (UAE)
2000 2001 2002 2003 2004
Population (million) 3.247 3.488 3.754 4.036 4.368
GDP (m US$) 70,521 69,546 75,694 88,645 103,833
GDP growth (%) 27.78 -1.38 8.84 17.11 17.13
GDP per capita (US$) 21,719 19,939 20,164 21,964 23,771
Inflation Rate (%) - 2.7 2.9 2.8 -
Oil reserve (as % of world reserves) 9 9 9 9 9
Oil production (% of world production) 3.3 3.3 3.3 3.3 -
Contribution of oil to GDP (%) - - 28 32 -
Source: Uniform Arabian Economic Report 2005, Arab Monetary Fund (AMF)

• Bahrain
The Bahraini Stock Exchange (BSE) was established in 1989, BSE has 45 listed
companies with a market capitalization of $ 13.5 billion in 2004. Electronic trading takes
place on the exchange floor facilitated the newly established clearing and settlement
house. Furthermore, new legislation allows GCC investors an unrestricted stake, and non-
GCC foreign investors up to 49 percent stake in listed companies. Although small by
international standard, BSE is positioning it self to be a major player in the Gulf financial
markets. The BSE continues to forge ahead with a development strategy aimed at putting
Bahrain on the map of the international capital markets. Several initiatives have been
launched by the BSE to provide an infrastructure that is modern and similar to systems
that are enforced in developed capital markets. The ultimate goal is to enable the BSE to
play a pivotal role in the national economy by mobilizing private sector savings and
attracting foreign investments, through a truly international market.
The ground is being carefully laid for the ultimate opening of the stock market to
overseas investors, which will significantly add to Bahrain’s ability to attract foreign
investment and will develop the financial markets in terms of volatility, market activity,

81
depth and liquidity. Another important development concerns disclosure regulations,
which have been initiated to enhance transparency and the safety of investors’ money. A
key objective is to attract a large number of small investors. The disclosure regulations
are aimed at making more information available on the share prices, performance of
listed companies and investors’ activity. Moreover, the approved disclosure standards are
based on the recommendations of IOSCO (International Organization of Securities
Commissions) and are similar to the standard applied internationally. In addition, the
BSE has also jointed the International Finance Corporations (IFC) Global Index, which is
expected to enhance transparency and disclosure in order to create investment
opportunities for foreign investors of individuals as well as internationals portfolios.

Table 3-8
Some Economic Indicators, Bahrain
2000 2001 2002 2003 2004
Population (million) 0.638 0.655 0.672 0.69 0.708
GDP (m US$) 7,970 7,929 8,448 9,606 11,067
GDP growth (%) 20.37 -0.01 6.55 13.71 15.21
GDP per capita (US$) 12,492 12,105 12,571 13,922 15,631
Inflation Rate (%) - -1.2 -0.5 1.6 -
Oil reserve (as % of world reserves) 0.02 0.02 0.02 0.02 0.02
Oil production (% of world production) 0.3 0.3 0.3 0.3 -
Contribution of oil to GDP (%) - - 25 25 -
Source: Uniform Arabian Economic Report 2005, Arab Monetary Fund (AMF)

3-3 Economic reforms and development of Arab capital markets

The economic reforms in the Arab countries have strengthened the recognition
that Arab capital markets play an important role in the economic development process.
The role of those markets in meeting financing requirements gained additional
importance with the increased reliance by the growing number of member countries on
market forces in resource allocation, greater participation of the private sector in the
economic activity and for security non-inflationary financing of budget deficits. As a
result, Arab capital markets witnessed remarkable developments in their various aspects,
including the legal and organization levels, there by contributing to their foundation on
sound structures, which are constantly evolving.

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 In this aspect, the Arab Monetary Fund (AMF) plays a significant role in
developing Arab stock markets. AMF is a regional institution and devised a work
program made up of three main components. These were: the conduct of surveys studies
aimed at analyzing the regulatory and institutional situation of capital markets in member
countries; the establishment of a database to provide information on the activities of those
markets; and finally, the provision of technical assistance to Arab countries for the
development of markets for financial papers operating in their jurisdiction. Using the data
generating by the database on Arab capital markets, AMF establish an AMF index
calculated for each market in addition to the market own index. As a result, the bulletin
publishes the AMF composite index in the calculation of which the sample shares of all
participating markets merged in a single sample. In addition, the Fund started the
publication of a quarterly report named “Quarterly Bulletin of the Arab Capital Markets
Database”, the bulletin’s first issue was published in April 1995. Each issue of this
bulletin reports on developments in the participating markets during the relevant quarter.
Furthermore, since June 10, 2002, the Fund started to publish on its website, on daily
basis, some basic indices for markets participating in the database.
Broadly, these developments involved an improvement in the performance of
capital markets, a strengthening of their supervision and increased trading on their floors.
They are also related to amendments of tax systems, streamlining of administrative
procedures, the creation of a favorable environment suited to the requirements of market
actors, the introduction of new financial instruments offering a greater variety of
investment opportunities, the acceleration and simplification of trading operations, and
the promotion of transparency and disclosure. Adding to these was the improvements in
skills of operating staff and enhanced discipline and professional ethics, these
developments can be summed as follows:

- Promotion of the market supervision function

A number of Arab countries have been proceeded to separate between the
supervisory and executive roles, the first being discharged by a public sector affiliated
body, while the second being mostly carried out by the private sector. In this area, most
Arab countries enacted capital market laws; aimed at restructuring the markets and

83
leading to the separation between the supervisory function, in charge of regulating the
issuance and trading of financial paper on the one hand, and the managements of the
stock exchange through which such papers are traded and the agency in charge of
registering the transfer, sale and purchase of those paper and keeping a registry of records
and ownership titles, on the other hand.
By end 2005, the separation between the supervisory and executive roles took
place in the following Arab capital markets: Jordan, Egypt, Palestine, and United Arab
Emirates. While the two roles continue to be simultaneously in the hands of the capital
markets itself in the rest of Arab countries.

Table 3-9
Market Structure for Arab Stock Markets
Supervisory and Existing of Only Duration
Market executive roles primary and secondary of
are seperated secondary markets market settlement
Bahrain No - Yes T+2
Egypt Yes Yes - T+3
Jordan Yes Yes - T+3
Palestine Yes - Yes T+3
Kuwat No - Yes T+3
Saudi Arabia No - Yes T+2
Oman No Yes - T+3
UAE Yes yes - T+3

- Promotion of transparency and disclosure

Arab capital markets have been attaching greater importance to the need for
increased transparency, and for adapting its exigencies to meet international standards in
order to enhance the supervisory role on the one hand, and to ensure equal opportunities
for market operators, on the other hand. Accordingly, the scope of instructions,
information and data disclosure of which became mandatory, widened. Such information
must now include, for example, the names of issuers of financial papers, those of market
members, authorized professionals as well as periodic data related to trading movements
and main financial indicators. In this connection, most Arab stock exchanges now publish
daily, weekly, monthly, and annual bulletins reporting general information on their

84
markets and executive boards’ decisions together with data on traded volumes and price
indices.
In addition, most of theses markets have signed agreements with world class
companies specialized in automated instant reporting on trading, including Reuters and
Bloomberg. It is worth noting that these markets are also disseminating their data through
the internet, in order to further publicize investment opportunities which they offer.
Moreover, the websites of these stock exchanges are now posting daily updated
information on trading effected on their floor; together with historical data containing
time-series on all data pertaining to exchange activities. On the other hand, these markets
have been endeavoring to ensure that joint-stock companies listed on their floors, strictly
up-hold the principles of disclosures and transparency. Additionally, to making the
submission of annual reports to financial markets authorities mandatory on listed
companies, new instructions in some Arab countries are now rendering it an obligation
for such companies to present bi-annual and quarterly reports.

- Development of the institutional investors’ role and expansion of investment

instruments
Most capital markets in the Arab countries have been seeking to develop that role,
as a means of enhancing market stability and protecting it from sharp fluctuations. In
general, the institutional investor is interested in medium and long-term investment and
basis his decision on scientific studies. By contrast, an individual investor seeks to
achieve quick capital gains; in view of his limited awareness, his behavior impacts
negatively the business of Arab stock exchanges. In this area, authorities in Arab
countries have been encouraging long-term savings by creating saving accounts in
market-listed shares, which enjoy low capital gain tax; and by authorizing pension funds
and insurance companies to deal with those markets.
In addition, Arab stock markets encourage the increase of available investment
instruments and alternatives such as bonds convertible into shares and investment funds.
Since investment funds, which have been established in most Arab capital markets, are
being viewed as the most suitable instrument for mobilizing savings and attracting
foreign capital. They provide a mechanism for placing resources in financial papers

85
carrying differentiated risks and returns, which an individual investor cannot achieve due
to his size. These funds enable Arab expatriates and overseas investors to place their
savings in Arab markets for financial papers, without having to be physically present in
the region. In addition, they offer to foreigners residing in Arab countries the opportunity
to enter local financial markets, since the investor’s right in those funds is confined to his
share in the financial papers in which the resources of the fund are invested, and to a
proportionate entitlement to its returns.

- Promotion of foreign investments

Investments by-laws in most Arab countries have witnessed a number of changes,
mostly aimed to attracting foreign investments, meeting the domestic financing
requirements, and smoothing the transfer of advanced technologies into their markets.
The changes involved, represent part of the steps taken by those countries to open the
door for the entry of foreign investments, by removing the obstacles which used to
impede their flows. In this context, Arab countries can be divided in two groups. The first
includes countries, which do not impose any restrictions on foreign investments in
financial papers; these are Egypt, Jordan, and Palestine, while the second group
comprises countries, where such restrictions exist in varying degrees; these are the
member states of GCC.
For instance, in Saudi Arabia and Kuwait, foreigners are allowed to invest in
shares through investment funds, the United Arab Emirates allows foreigners to both
invest through similar funds; and to own not more than 49 percent in shares of companies
whose internal by-laws so permit. However, in Oman, foreigners can buy shares of newly
listed companies in proportions of up to 49 percent, and in the case of certain companies,
up to 100 percent, while Bahrain allows for GCC nationals, to own up to 100 percent of
shares, if it is defined that this will serve the interests of the national economy. Table 3-
10 indicates that while GCC stock markets are fully accessible to GCC investors, they
have remained relatively closed to international foreign investors, even non-GCC Arab
investors, face restrictions on portfolio investment in these stock markets
It is expected that, the removal of the various restrictions which faced MENA
portfolios flows, will improve and enhance growth and liquidity in these markets; and

86
reduce the costs of raising capital in the local market. Although, the open access to
foreign investors will contribute significantly to the growth performances of Arab stock
markets, this is expected to gradually lower the diversification potentials; that used to be
offered to international investors. In addition, increasing financial integration within the
Arab countries is expected to bring considerable benefits to Arab investors, since a more
liquid capital market, offers lower borrowing costs for Arabian firms wishing to raise
funds locally. Moreover, international financial institutions will be willing to diversify
their portfolios by tapping the Arab financial markets.

Table 3-10
Accessibility of Arab Stock Markets to Foreign Investments
Market
- open to GCC nationals.
- Foreign residents in Bahrain for at least three years, may own up
Bahrain to 1% of the capital of 31 listed companies.
- Foreigners can trade shares in only 10 of the 45 listed companies
and up to 24%.
- Unristrected access to foreign investors.
Egypt
- Repatriation of capital and dividends allowed.
- Unristrected access to foreign investors, in specefic sectors
foreign investors can hold up to 50% of companies' capital.
Jordan
- Repatriation of capital and dividends allowed.
- open to GCC nationals.
Kuwait - Non-kuwaiti residents are allowed to own shares through matual
funds only.
- Unristrected access to foreign investors.
Palestine
- Repatriation of capital and dividends allowed.
- Open only to GCC nationals who can own up to 25% of listed
Saudi Arabia companies other than banks.
- Opened recently to foreign investors through matual funds only.
- Foreign investors can hold up to 49% of companies' capital.
Oman
- Repatriation of capital and dividends allowed.
- Foreign investors can own up to 49% in companies' capital
UAE
whose internal by-laws permit.

- Amendment of tax systems

Many Arab countries subjected their tax systems to thorough amendments
directed towards creating incentives, to encourage dealing in financial papers on the one

87
hand, and attracting foreign investments, on the other. By virtue of those changes, these
countries either reduced, or eliminated taxes on current returns and capital gains arising
from dealing in financial papers. It must be noted that no such taxes existed in all Arab
countries, which had regular financial markets. Moreover, some Arab countries also,
directed their tax reform towards encouraging joint-stock companies; to have their shares
listed in their exchanges.

- Computerization of dealing systems

Most Arab capital markets took vast steps to modernize their dealing systems, and
to introduce modern technologies in share trading operations with a view to improve
performance, enhance speed and accuracy in conduct of business and increase
transparency and operators’ confidence. As a result, high-tech automated dealing systems
were introduced to the markets. Also, some of these markets inaugurated distant-dealing
services, which constitute one of the innovation services witnessed by those markets, and
offered a mechanism enabling accredited brokers to conclude contracts without the need
to be represented on the physical floor, such as Palestine.

- Protocols among Arab stock markets

Arab stock exchanges have made major strides on the path of cooperation and
integration among them selves, by concluding bilateral and trilateral agreements. The
thrust of the latter is to increase collaboration between stock exchanges in the areas of
financial papers issue and trading, organizing and facilitating clearing and settlement
mechanism. These agreements also, aimed at developing cooperation between
intermediation institutions in those markets; and encourage joint/cross listing. In that
regard, agreements were signed between the stock exchange of Bahrain, Kuwait, and
Oman on the one hand, and those between the stock exchanges of Bahrain and Jordan,
Abu Dhabi and Palestine, on the other hand. Comparable agreements were also
concluded between Kuwait, Lebanon, and Egypt in one case. In addition, a memorandum
of understanding was signed in the case of Jordan and Kuwait, while in a third case, an
extended agreement was concluded between Abu Dhabi and Khartoum markets for
financial papers.

88
 All those agreements aimed at fostering cooperation and eliminating hurdles
hindering the flows of investments between the markets involved. The consolidation of
the trend towards greater integration among Arab capital markets; and the preparation of
the propitious conditions for upgrading bilateral and trilateral agreements for cross listing
to a collective level, call for a high degree of harmonization between the accounting
standards followed and legal systems and, particularly, coordination in the area of
clearing and settlement.

3-4 The performance of Arab stock markets

Most of Arab security markets’ indices increased at the end of 2005. In comparing
Arab stock market performance with other international and emerging markets, figure 3-1
presents indices’ returns between September 2004 and September 2005. One can see that
except of Bahrain stock market, Arab stock markets performance was better than other
international stock markets, while Dubai stock market stands to be the best in
performance followed by Palestine stock exchange, which index’s return increased with
250 percent during 2005.

Figure 3-1
Arab Stock Markets Performance Compared to other International Stock Markets
9/2004-9/2005

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3-4-1 Market size
With respect to market size, Arab stock markets are small by international
standards; their total market capitalization constitutes less than 5 percent of the US
market and only about 19 percent of that of UK stock market in 2004. However, within
the group of Arab security markets, their total capitalization value increased dramatically
during 2000 and 2005, from $ 135.657 billion up to $1166.154 billion, with a growing
rate more than 700 percent (see figure 3-2). It can be seen from figure 3-2 that most
market size variables witnessed dramatic changes, market capitalization as a percentage
of GDP, increased by 390 percent, while the volume of shares traded increased by 1081
percent. Moreover, the value of traded shares increased with 3924 percent during 2000
and 2005, on the other hand, the number of listed companies decreased by 8 percent, to
reach 1467 listed companies in all Arab markets at the end of 2005.

Figure 3-2
Market Size for Arab Stock Markets between: 2000-2005

However, for individual market size and in terms of market capitalization, Saudi
Arabia stands to be the largest market in the region at the end of 2005. It accounts for
about 55 percent of total market capitalization for all Arab stock markets. Followed by
Abu Dhabi stock market, while Palestine stock exchange stands to be the smallest among
Arab stock markets (see figure 3-3 and table 3-11 respectively).

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 Table 3-11
Market Capitalization for Arab Stock Markets
(Million US$)
Market 2000 2001 2002 2003 2004 2005
Abu DHABI - - 20,375.76 30,362.51 55,490.40 132,412.89
Jordan 4,943.16 6,314.16 7,087.03 10,962.89 18,383.40 37,638.81
Bahrain 6,624.35 6,601.27 7,716.39 9,701.77 13,513.18 17,364.31
Saudi arabia 67,166.04 73,201.35 74,851.38 157,306.44 306,255.70 646,120.80
Kuwait 19,847.98 26,661.70 35,098.89 59,528.01 73,580.54 123,892.58
Dubai - - 9,469.52 14,284.23 35,090.90 111,992.68
Oman 3,518.13 2,634.37 5,268.05 7,264.23 9,317.66 12,062.05
Egypt 30,791.26 24,308.57 26,338.69 27,847.48 38,076.84 79,507.56
Palestine 766.02 722.63 576.59 650.47 1,096.53 3,157.15
Total 135,656.94 142,445.04 188,784.29 319,911.03 552,809.15 1,166,153.83
Source: Arab Monetary Fund, AMDB

Figure 3-3
Relative Market Capitalization to All Markets 2005

The number of listed companies by it self, can provide an indication of the

choices of firms available to an investor. In this case, Egypt stands out among Arab
markets; with a total number of listed companies reaching 744 companies at the end of
2005 (table 3-12). However, if the number of listed companies is used in conjunction
with market capitalization, it will indicate the average market value of listed companies.

91
 Table 3-12
Total Number of Listed Companies, 2000-2005
Market 2000 2001 2002 2003 2004 2005
Abu DHABI - - 24 30 35 59
Jordan 163 161 158 161 192 201
Bahrain 41 42 40 44 45 47
Saudi Arabia 75 76 68 70 73 77
Kuwait 86 88 95 108 125 156
Dubai - - 12 13 18 30
Oman 131 96 140 141 123 125
Egypt 1,071 1,110 1,150 967 792 744
Palestine 22 23 23 26 26 28
Total 1,589 1,596 1,710 1,560 1,429 1,467
Source: Arab Monetary Fund, AMDB

In this case, Saudi Arabia has by far the highest market value per listed company
among Arab markets, at about $ 8391 million followed by Dubai at $ 3733 million, with
Egypt having the lowest market value per listed company, after Oman, at $ 107 million.
Since for Egypt, over 90 of the 744 companies listed at the end of 2005; are actively
traded, while more than 400 companies are classified as closed family corporations,
which are listed to qualify for certain tax benefits. Table 3-13 presents market
capitalization as a percentage of GDP, which indicates the relative role that a stock
market has in the national economy. In this area, it can be seen that the Jordanian stock
market has the highest rate of market capitalization as a percentage of GDP at the end of
2004 (160%), followed by Kuwaiti stock market, while Palestine stock exchange has the
lowest rate (25%) at the end of 2004.
Table 3-13
Market Capitalization as a Percentage of GDP
Market 2000 2001 2002 2003 2004
Abu DHABI - - 28.47% 37.85% 53.44%
Jordan 58.54% 70.64% 75.03% 110.19% 159.65%
Bahrain 83.12% 83.25% 91.34% 101.00% 122.10%
Saudi arabia 35.64% 40.00% 39.70% 73.35% 122.23%
Kuwait 53.62% 78.24% 99.79% 142.61% 132.06%
Dubai - - 13.23% 17.81% 33.80%
Oman 17.71% 13.21% 25.94% 33.64% 37.53%
Egypt 31.34% 26.92% 31.31% 39.26% 48.51%
Palestine 17.25% 17.47% 15.25% 15.41% 24.57%
Source: Arab Monetary Fund, AMDB

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3-4-2 Market liquidity
Arab stock markets’ liquidity has been improved during the last years. Market
liquidity variables for total Arab stock markets, witnessed significant changes during
2000 and 2005 (see figure 3-4). The total value traded to market capitalization (turnover
ratio) increased by 368 percent for total Arab markets, while total value traded to GDP
increased with 607 percent. Meanwhile, the average daily trading value increased sharply
by 3102 percent.

Figure 3-4
Market Liquidity Variables for Arab Stock Markets, 2000-2004

However, for individual markets and in the case of the yearly turnover ratio,
which is the ratio of yearly trading value to market capitalization at the end of the year,
the Saudi stock market is the most active and liquid among Arab stock markets. Its turn
over ratio reached 171 percent with average daily trading value $ 3691 million in 2005.
While the value traded as percentage of GDP reached 189 percent, which puts the Saudi
market to be the most active market among Arab stock markets. The Kuwaiti market
comes second in market liquidity, with turnover ratio 78 percent; $ 391 million and 93
percent as an average daily trading value and total value traded as a percentage of GDP in
2004 respectively. In addition, Jordanian and Dubai stock markets can be characterized as

93
active markets, while Bahraini stock market stands to be the least liquid market among
Arab stock markets as they are in 2005 (see tables 3-14, 3-15, and 3-16).

Table 3-14
Total Value Traded to Market Capitalization (Turnover Ratio)
Market 2000 2001 2002 2003 2004 2005
Abu Dhabi - - 1.78% 3.31% 8.02% 21.53%
Jordan 8.21% 14.80% 18.83% 23.78% 28.98% 63.25%
Bahrain 3.71% 3.79% 2.67% 2.69% 3.43% 4.10%
Saudi Arabia 25.78% 30.36% 41.38% 101.11% 154.44% 170.80%
Kuwait 21.20% 43.93% 63.03% 91.94% 70.42% 78.53%
Dubai - - 7.26% 7.19% 39.14% 98.49%
Oman 15.67% 15.94% 11.04% 18.37% 21.31% 27.53%
Egypt 38.32% 24.32% 24.46% 15.62% 17.95% 34.87%
Palestine 1.70% 0.94% 0.60% 0.76% 19.19% 14.10%
source :Arab Monetary Fund, AMDB
Table 3-15
Average Daily Trading Value (million US$)
Market 2000 2001 2002 2003 2004 2005
Abu Dhabi - - 1.46 3.70 15.13 95.02
Jordan 1.67 3.88 5.36 10.82 21.66 97.57
Bahrain 0.99 1.01 0.82 1.05 1.87 2.87
Saudi Arabia 60.96 73.83 102.23 530.19 1581.91 3690.91
Kuwait 16.93 47.36 88.85 225.22 208.94 390.72
Dubai - - 2.30 3.46 46.72 14.8
Oman 2.28 1.71 2.32 5.36 7.91 13.02
Egypt 48.01 24.44 25.95 17.82 27.45 111.78
Palestine - - 0.45 0.26 0.82 6.11
Total 130.84 152.23 229.73 797.88 1912.41 4422.80
source :Arab Monetary Fund, AMDB

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 Table 3-16
Total Value Traded as Percentage of GDP
Market 2000 2001 2002 2003 2004
Abu Dhabi - - 0.51% 1.25% 4.28%
Jordan 4.81% 10.45% 14.13% 26.21% 46.26%
Bahrain 3.08% 3.16% 2.44% 2.72% 4.18%
Saudi Arabia 9.19% 12.14% 16.43% 74.16% 188.77%
Kuwait 11.37% 34.37% 62.90% 131.11% 93.00%
Dubai - - 0.96% 1.28% 13.23%
Oman 2.78% 2.10% 2.86% 6.18% 8.00%
Egypt 12.04% 6.55% 7.66% 6.13% 8.71%
Palestine 4.25% 1.90% 1.46% 2.15% 4.49%
source :Arab Monetary Fund Database (AMDB)

3-4-3 Financial Valuation of Arab Stock Markets

Regarding financial valuation of Arab stock markets, Table 3-17 presents a
comparison between these markets. Clearly and according to the available data, the most
expensive markets at the end of 2005 were those of Saudi Arabia (based on both the P/E
and the P/BV ratios) and Jordan (based on P/E ratio), while the least expensive markets
were those of Oman (based on P/E ratio) and Bahrain (based on P/BV ratio).

Table 3-17
Financial Valuation of Arab Stock Markets, End of 2005
Market P/E ratio P/BV ratio Dividend Yeild (%)
Abu DHABI 20.90 4.33 1.20
Jordan 44.20 5.23 1.01
Bahrain 16.26 2.10 3.19
Saudi arabia 66.22 12.47 1.02
Kuwait - - -
Dubai 34.40 8.71 1.30
Oman 11.75 2.20 3.00
Egypt - - -
Palestine - - -
Notes : P/E ratio stands for the price/earning ratio and P/BV for the price/ book value ratio.
: (-) data not available.
source : Arab Monetary Fund Database (AMDB).

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3-4-4 Market concentration
Most Arab stock markets in general suffered from thin trading phenomenon,
which indeed affect market liquidity. In other words, most listed shares are thinly traded
on the market. Figure 3-5 shows the percentage of the 2 biggest companies’ share in
value traded and market capitalization respectively. It can be seen that in general, Arab
stock markets are highly concentrated. In the case of Palestine, the 2 biggest companies’
share in value traded and market capitalization in 2005 are 81, 76 percent respectively.
Which indicate that Palestine stock exchange is highly concentrated. In addition, the
percentage of the 2 biggest companies’ share in value traded and market capitalization for
Dubai was 56, 44 percent respectively. The Saudi and Bahraini stock markets also can be
characterized to be highly concentrated, since the percentage of the 2 biggest companies’
share in market capitalization were 38, 31 percent respectively.

Figure 3-5
Market Concentration, End of 2005

3-5 Data description

The data that will be used through this research consist of daily prices of Arab
stock markets. The time period vary from market to market, but usually run from about
1st January 1992 to 31 July 2005, the initial and final dates vary from market to market

96
due to the establishment date of the market and to the availability of the data, the data
was collected piece by piece directly from each stock market.
Moreover, all indices used in this study are value weighted indices. The Jordanian
stock market index consists of 71 listed companies distributed among 4 sectors at the end
of 2005, 33 industrial companies, 11 banks, 9 insurance companies, and 18 service
companies, while the Palestinian stock exchange index (Al-Quds index) has 10 listed
companies distributed among 4 sectors, 2 industrial, 2 banks, 2 insurance, and 4 service
companies. The Egyptian stock market index (CASE 30) has 30 companies. The Saudi
index is an all-share index constructed by the central bank, and includes the shares of all
listed companies on the Saudi market, the same index structure holds for the UAE, which
has two stock markets; Abu Dhabi index which has 59 listed companies and Dubai index
with its 30 listed companies. Oman’s Muscat stock exchange index has 33 listed
companies, of which 13 companies represented the banks and investment companies’
index sector; 11 represented the industry index sector; and 9 represented the service index
sector. Moreover, the Kuwaiti stock exchange index has 35 listed companies, while
Bahrain stock market has 25 listed companies.
Appendix 1 shows the plot graphs for the natural logarithm and return for each
index under examination here, while table 3-18 presents the main descriptive statistics for
Arab stock markets’ indices. The returns are the variables on which we want to focus our
attention on, that is Rt = 100 * log (Pt/Pt-1), where Pt denotes closing price for market
index. All the displayed Skewness statistics have asymmetric distributions that are
skewed to the right as shown by the positive Skewness statistics, except of Kuwait index
which is skewed to the left (negative Skewness). Moreover, kurtosis provides a measure
of the “thickness” of the tails of a distribution relative to the normal distribution. For
normal distribution, kurtosis is usually equal to three. The presence of excess kurtosis in
the series suggests that the return distributions have a much fatter tail than the normal
distribution. Finally, none of the series approximates the normal distribution as shown by
the Jarque-Bera statistics.

97
Table 3-18
Descriptive Statistics for Daily Market Returns for Arab Stock Markets,
R t = 100*log(p t /p t-1 )
Jordan Egypt Palestine Kuwait Saudi Bahrain AbuDhabi Dubai Oman

Mean 0.0355 0.0425 0.0820 0.1876 0.0370 0.0257 0.0847 0.0435 0.0251
Median -0.0090 -0.0289 0.0000 0.1618 0.0368 0.0104 0.0558 0.0206 -0.0043
Maximum 4.7465 18.3692 27.2330 4.0263 17.9204 20.6189 2.8665 21.6679 15.2225
Minimum -4.3097 -10.9751 -25.3643 -5.6757 -17.5253 -19.8569 -2.4741 -8.4913 -13.5602
Std. Dev. 0.7341 1.6658 1.8370 1.0386 0.9342 0.7269 0.5388 1.0084 1.0842
CV 20.68 39.21 22.40 5.54 25.22 28.25 6.36 23.19 43.23
Skewness 0.3075 0.7695 0.5314 -0.5134 0.1168 0.4033 0.1243 7.8917 0.7877
Kurtosis 7.7149 15.2906 73.4889 6.9037 93.8064 366.7102 7.8723 203.5124 50.9400

Jarque-Bera 2,940 10,651 244,349 466 1,058,905 18,321,581 640 1,850,786 182,045
Probability 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000

Sum 110.804 70.781 96.762 128.873 114.182 85.544 54.663 47.754 47.626
Sum Sq. Dev. 1,681.28 4,620.26 3,978.81 740.01 2,688.86 1,756.03 186.94 1,115.48 2,231.17

Observations 3,121 1,666 1,180 687 3,082 3,324 645 1,098 1,899

98
Methodology
Are Arab Stock Markets Efficient in the Weak Form
Sense of Efficient Market Hypothesis?

Estimating the true index correcting for infrequent trading.

Regression analysis.

Serial correlation test.

Non-parametric runs test.

Variance test.

BDS test for returns independency.

Seasonality and calendar effects (day of the week effect, monthly effect, and the Halloween
indicator).

Arab Stock Markets Are Not Efficient in the Weak Form

Findings Sense of Market Efficiency and Do Not Follow RWH.
These results are consistent with existing literature regarding
emerging markets (Bekaert 1995; Harvey 1995b, 1995c;
Claessens et al. 1995; and Buckberg 1995).

99
 Methodology Is the View of Predictability in Stock Returns (if there
is) Related to Whether We Think That These Time
Series Are Non-Linear? How Does Thin Trading
Affect the Predictability of These Time Series?

Estimating the true index correcting for infrequent trading, then reexamine the RW
properties.

Using logistic map to determine whether non-linearity exists.

Testing whether the second moment can characterize the existing non-linearity, through
subjecting the residuals of RW and GARCH models to several diagnostic tests.

Findings
Returns Generating Process in Arab Stock Markets
is Non-Linear, while the Second Moment Found to
Explain Well the Existing Non-Linearity.

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 Methodology Are Arab Stock Markets Characterized By Excessive
Volatility of Returns, Relative to Other Emerging And
International Stock Markets?

GARCH (1,1) model for daily returns of Arab stock markets, and two groups of emerging and
developed markets with a total of 15 stock markets.

GARCH (1,1) model for weekly data.

EGARCH model for daily data.

Schewrt model for the three groups Arab, emerging and developed markets to compare the
relative volatility.

Covariance coefficients.

Arab stock markets as a group characterized with a

low level of volatility relative to other emerging and
developed markets.
Findings
All Arab markets exhibit volatility clustering except
Dubai.

Egypt, Kuwait, and Palestine exhibit volatility
persistence.

Bahrain, Dubai, Kuwait and Oman show signs of
leverage effect and asymmetric shocks to volatility.

101
4- Testing the efficient market hypothesis for Arab stock markets

4-1 Random Walk Hypothesis (RWH)

There are three kinds of random walk, random walk 1, IID increments; random
walk 2, independent increments and random walk 3, uncorrelated increments. A useful
way to organize the various versions of the random walk and martingale models is to
consider the various kinds in dependence that can exist between an asset’s returns rt and
rt+k of two dates t and t+k. To do this, define the random variables f(rt) and g(rt+k) while
f(.) and g(.) are two arbitrage functions, and consider the situation in which

cov[ f (rt ), g (rt +k )] = 0 (4-1)

for all t and for k≠0. For appropriately chosen f(.) and g(.), virtually all versions of the
random walk and martingale hypothesis are captured by (4-1), which may be interpreted
as an orthogonality condition.
For example, if f(.) and g(.) are restricted to be arbitrary linear functions, then (4-
1) implies that returns are serially uncorrelated, corresponding to the random walk 3
model. Alternatively, if f(.) is unrestricted but g(.) is restricted to be linear, then (4-1) is
equivalent to martingale hypothesis. Finally, if (4-1) holds for all functions f(.) and g(.),
this implies that returns are mutually independent, corresponding to the random walk 1
and random walk 2 models.
The statement that prices, in an efficient market, “fully reflect” available
information, conveys the general idea of what is meant by market efficiency. However,
this statement is too general to be tested, encountering a need to develop mathematical
models of market equilibrium that would be used in testing market efficiency (Fama,
1965). The random walk model is one of those models; it assumes that successive price
changes are independent and identically distributed random variables, so that future price
changes cannot be predicted from historical price changes. Hence, the RWH has some
testable implications for the weak-form of EMH.

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Several tests have been suggested to test for EMH, the procedures used to test for RWH
were chosen on the basis of the implications of EMH. If all relevant and available
information is fully reflected in stock price, then:
a) Successive price changes will be independent, so that there will be no serial
correlation over time between returns;
b) Successive price changes will be identically distributed:
log (Pt) = log (Pt-1) + εt
Where εt is an independent standard random variable, that is; a series of identically
distributed random variables with zero mean and variance equal to unity.
So the distribution of the changes in stock price must be stationary over time, i.e. stock
prices are I(1) while stock returns are I(0).
In this research, in addition to the common models used in the literature, we
employ the most recent statistical and econometric models. To test for the independence
of successive price changes (condition a) we employ runs test, non-parametric tests for
detecting the frequency of the changes in the direction of a time series. In addition,
estimated serial autocorrelations are performed at various lags to determine whether the
autocorrelation between returns is equal to zero. Further, we utilize the Box-Pierce test to
determine whether the autocorrelation is equal to zero, based on the sum of squares of the
first K autocorrelation coefficients. If the set of auto correlations does not differ from the
null set, randomness of returns is implied. However, it is important to test whether
successive price changes are identically distributed (condition b). Hence, we use
regression analysis, variance ratio, and BDS tests.
Moreover, a major difficulty in interpreting the results from tests on thinly traded
markets is the confounding effect of infrequent trading on the observed index. Thus
rejection of the RWH or the efficient markets hypothesis could simply be a result of
having used the observed index. So it is important to take in account the effect of
infrequent trading and adjust the observed indices for thin trading.

4-1-1 Estimating the true index-correcting for infrequent trading

Infrequent trading is widespread in most emerging markets and it is particularly
so in the case of the markets under examination here. Infrequent trading has two forms:

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The first occurs when stocks are traded every consecutive interval, but not necessary at
the close of each interval. This form of infrequency, often dubbed “nonsynchronous
trading” has been studied by Scholes and Williams (1977a, 1977b) and Muthuswamy
(1990). Infrequent trading is also said to occur when stocks are not traded every
consecutive interval, Fisher (1966), Dimson (1979), Cohen et al. (1978, 1979), Lo and
MacKinlay (1990), and Stoll and Whaley (1990b) focus on this “non-trading” and its
consequences.
The key to distinguishing nonsynchronous trading from non-trading is the interval
over which price changes or returns are computed. When returns are measured on a
monthly basis, virtually all stocks will have been traded at least once, but not all stocks
will have been transacted exactly at the close of trading on the last trading day of the
month, that is nonsynchronous trading. When returns are measured over trading intervals
as short as for example fifteen minutes, however, all stocks in the market are unlikely to
have been traded at least once in every consecutive fifteen minutes interval, which is non-
trading. As the trading interval shrinks, nonsynchronous trading becomes non-trading.
The problem is created by the fact that the value of an asset over a certain time cannot be
directly observed, if the asset does not trade in that period. Since most indices are
computed on the basis of the most recent transaction prices of the constituent stocks, the
reported index becomes stale in the presence of infrequent trading; the result is that the
observed index does not reflect the true value of the underlying stock portfolio.
One of the consequences of infrequent trading is the spurious serial correlation it
induces in the observed index returns. Therefore, observed dependence is not necessarily
evidence of predictability, but rather may be a statistical illusion brought about by thin
trading. A number of different approaches have been suggested to correct for infrequent
trading, Stoll and Whaley (1990) use the residual from an ARMA (p,q) regression as a
proxy of the true index, whereas; Bassett et al. (1991) propose the use of a Kalman filter
to estimate the distribution of the true index, Jokivuolle (1995) suggests a modified
version of the Stoll and Whaley approach to estimate the true unobserved index from the
history of the observed index, the correction consists of decomposing the log of the
observed index into its random and stationary components, using the Beveredge and

104
Nelson (1981) methodology, in this; the random component can be shown to equal the
log of the true index.
To separate the effect of infrequent trading, the approach proposed by Miller,
Muthuswamy and Whaley (1994) has been applied. To correct for infrequent trading, this
methodology basically suggests that to remove the impact of thin trading, a moving
average model (MA) that reflects the number of non-trading days should be estimated
and then returns be adjusted accordingly. However, given the difficulties in identifying
the non-trading days, Miller et al. have shown that it is equivalent to estimate an AR (1)
model from which the non-trading adjustment can be obtained. Specifically, this model
involves estimating the following equation:

R t = a 1 + a 2 R t −1 + ε t (4-2)

Using the residual from the regression, adjusted returns are estimated as follows:

adj ε t
R = (4-3)
t
(1 − a 2 )

Where Rtadi is the return at time t adjusted for thin trading.

Miller, Muthuswamy, and Whaley find thin trading adjustment reduces the
negative correlation among returns. The model above assumes that non-trading
adjustment is constant over time, while this assumption may be correct for highly liquid
markets; it is not the case for emerging markets. Therefore, equation (4-2) will be
estimated recursively.

4-1-2 Regression analysis

In a random walk process, the distribution of the changes in stock prices must be
stationary over time and the constant term of the stationary series, should be
insignificantly different from zero. Consequently, to test for this proposition, we start our
analysis with naïve random walk, which is closely associated with weak-form EMH

105
 Pt = Pt-1+εt (4-4)

Where Pt = ln (Xt) represents the natural log of the original time series Xt; and εt is a zero-
mean pure white noise random variable. If the random walk hypothesis holds, then the
series Pt will have a single unit root (i.e. will be I(1)) and the series ∆Pt (= Pt-Pt-1 = Ln
(Xt/Xt-1) will be purely random. The series ∆Pt or Rt may be examined further by
estimating the equation

Rt = constant + εt (4-5)

Using ordinary least squares, under the random walk hypothesis, the constant term should
be insignificantly different from zero and the resultant residuals should be uncorrelated.
Additionally, the following regression will be estimated

Rt = a + Rt −1 + ε t (4-6)

Once again if the RWH holds, the constant term and returns lag should be insignificantly
different from zero, and εt to be a white noise random variable.

4-1-3 Serial correlation (autocorrelation) of the return series

Serial correlation (or autocorrelation) test measures the correlation coefficient
between a series of returns and lagged returns in the same series. A significant positive
serial correlation implies that a trend exists in the series, whereas, a negative serial
correlation indicates the existence of a reversal in price movements. A return series that is
truly random will have a zero serial correlation coefficients. The beta coefficient from the
following regression equation measures the serial correlation of stock i with a lag of K
periods:

ri ,t = a i + β i ri ,t − k + ε i ,t (4-7)

106
Where ri,t represents the return of stock i at time t; αi is a constant; βi is the lagged
return’s coefficient; εi,t represents random error, while k represents different time lags.
The serial correlation test assumes normal distribution for the stock price changes
(returns).
The null hypothesis to be tested is that no significant correlation exists between
price changes, i.e. β1= β2=...= βj=0. Since random walk 1 implies that all
autocorrelations are zero, a simple test statistic of random walk 1 that has the power
against many alternative hypotheses is the Q-statistics due to Box and Pierce (1970):

m
Qm ≡ T ∑ ρ 2 ( k ) (4-8)
k =1

m
under the random walk 1 null hypothesis, it is easy to see that Qˆ m = T ∑ ρˆ 2 (k ) is
k =1

asymptotically distributed as χ m2 . Ljung and Box (1978) provide the following finite-

sample correction which yields a better fit to the χ m2 for small sample size:

m
ρ 2 (k )
Qm' ≡ T (T + 2)∑ (4-9)
k =1 T −k

By summing the squared autocorrelations, the Box-Pierce Q-statistic is designed

to detect departures from zero autocorrelations in either direction and at all lags.
Therefore, it has power against a broad range of alternative hypothesis to the random
walk. However, selecting the number of autocorrelations m requires some care-if too few
are used, the presence of higher-order autocorrelation may be missed; if too many are
used, the test may not have much power to insignificant high-order autocorrelations.

107
4-1-4 Non-parametric runs test
A common test for random walk 1 is the runs test, in which the number of
sequences of consecutive positive and negative returns, or runs, is tabulated and
compared against its sampling distribution under the random walk hypothesis. For
example, a particular sequence of 10 returns may be represented by 1001110100,
containing three runs of 1s (of length 1, 3, and 1, respectively) and three runs of 0s (of
length 2, 1, and 2, respectively), thus six runs in total. In contrast, the sequence
0000011111 contains the same numbers of 0s and 1s, but only 2 runs. By comparing the
number of runs in the data with the expected number of runs under random walk 1, a test
of the IID random walk hypothesis may be constructed. To perform the test, we require
the sampling distribution of the total number of runs Rruns in a sample of n. Mood (1940)
was the first to provide a comprehensive analysis of runs.
Moreover, the runs test determines whether successive price changes are

independent. Unlike its parametric equivalent the serial correlation test, the runs test does

not require returns to be normally distributed. A run is a sequence of successive price

changes with the same sign, if the returns series exhibit grater tendency of change in one

direction, the average run will be longer and the number of runs fewer than that generated

by random process. To assign equal weight to each change and to consider only the

direction of consecutive changes, each change in returns was classified as positive (+),

negative (-), or no change (0). The runs test can also be designed to count the direction of

change from any base; for instance, a positive change could be one in which the return is

grater than the sample mean, a negative change one in which the return is less than the

mean, and zero change representing a change equal to the sample mean. The actual runs

(R) are then counted and compared to the expected number of runs (m) under the

assumption of independence as given in equation (4-10) below;

108
  3

 N ( N + 1) − ∑ n i
2

m =  i=1  (4-10)
N

Where N is the total number of return observations and ni is a count of price change in

each category. For a large number of observations (N>30), m approximately corresponds

to a normal distribution with a standard error (σm) of runs as specified in equation (4-11).

1
 3  3  3
2
σm =  ∑ n i2  ∑ n i2 + N ( N + 1)  − 2 N ∑ n i3 − N 3  (4-11)
 i =1  i =1  i =1 

The standard normal Z-statistic (Z=(R-m)/σm) can be used to test whether the

actual number of runs is consistent with the independence hypothesis. When actual

number of runs exceed (fall below) the expected runs, a positive (negative) Z value is

obtained. Positive (negative) Z value indicates negative (positive) serial correlation in the

return series.

4-1-5 Variance ratio test

A consequence of informational efficiency is that the variance of the increments

to the random walk process linearly increases with the sampling interval. Lo and

MaCkinlay (1988) proposed a simple specification test for evaluating the random walk

properties of asset prices. Specifically, if Xt is a pure random walk, the ratio of the

variance of the qth difference scaled by q to the variance of the first difference must be

unity. A variance ratio that is grater than one suggests that returns series is positively

109
serially correlated or that the shorter interval returns trend within the duration of the

longer interval. A variance ratio that is less than one suggests that the returns series is

negatively serially correlated or that the shorter interval returns tend toward mean

reversion within the duration of the longer interval. The variance ratio VR (q) is defined

as:

2
σ (q )
VR ( q ) = 2
(4-12)
σ (1 )

Where σ2 (q) is 1/q the variance of the q-differences and σ2 (1) is the variance of the first

differences.

1 nq
σ 2 (q) = ∑
m i=q
( x i − xi − q − qµˆ ) 2 (4-13)

Where:

 q 
m = q (nq − q + 1 ) 1 − 
 nq 

And

nq 2
1
(nq − 1) ∑
σ 2 (1) = (x i − x i −1 − µˆ ) (4-
i =1

14)

Where:

1
µˆ = (x nq − x0 )
nq

They developed test statistics both for homoscedastic and heteroscedastic

increments. Because it is the heteroscedasticity in the data that is of interest, we use the

more robust heteroscedastic test statistic that uses overlapping intervals. The test statistic

is:

110
 * VR ( q ) − 1 (4-15)
Z (q ) = 1
≈ N ( 0 ,1 )
[Φ *
(q ) ]
2

Where:
2
* q −1
 2(q − j)  ˆ
Φ (q ) = ∑   δ ( j)
j =1  q 

And
nq

∑ (x − x i −1 − µˆ ) (x i − j − x i − j −1 − µˆ )
2 2
i

δˆ ( j ) =
i = j +1
nq

∑ [(x ]
2 2
i − x i −1 − µˆ )
i =1

4-1-6 BDS test for returns independency

The null hypothesis for the BDS test (Brock et al., 1987, revised in 1996) is that the
data are independently and identically distributed (iid), and any departure from iid should
lead to rejection of this null in favor of an unspecified alternative. Hence the test can be
considered a broad portmanteau test which has been shown to have reasonable power
against a variety of nonlinear data generating processes (see Brock et al., 1991 for an
extensive Monte Carlo study). The BDS test statistic is calculated as follows. First, the
‘m-histories’ of the data xtm = ( xt , xt +1 ,..., xt − m +1 ) are calculated for t = 1, 2,…, T-m for
some integer embedding dimension m ≥ 2 . The Cointegration integral is then computed,
which counts the proportion of points in m-dimensional hyperspace that are within a
distance ε of each other:

2
c m ,T ( ε ) = ∑
(T − m + 1)(T − m ) t < s
I ε ( x tm , x sm ) (4-16)

Where Iε is an indicator function that equals one if xtm − x sm < ε and zero otherwise, and

||.|| denotes the sup. norm. BDS shows that, under the null hypothesis that the observed χt

111
are iid, then c m,T (ε ) → c1 (ε ) m with probability one as the sample size tends to infinity and

ε tends to zero. The BDS test statistic, which has a limiting standard normal distribution,
then, follows as:

[ C m , T (ε ) − C 1 , T (ε ) m ]
w m ,T (ε ) = T 1 / 2
σ m ,T (ε )
Where
m −1
σ m ,T (ε ) = 2[ K m + 2(∑ k m − j C1,T (ε ) 2 j ) − ( m − 1) 2 C1,T (ε ) 2 m − m 2 KC1,T (ε ) 2 m − 2 ]1 / 2
j =1

And K(ε) is estimated by

6 ∑
t< s< r
h ε ( x tm , x sm , x rm )
K (ε ) =
[(T − m + 1 )(T − m )(T − m − 1 )]

and he (i, j, k) = [Iε (i, j)Iε ( j, k) + Iε (i, k)Iε (k, j) + Iε ( j,i)Iε (i, k)]/ 3

Two parameters are to be chosen by the user: the value of ε (the radius of the
hypersphere which determines whether two points are ‘close’ or not), and m (the value of
the embedding dimension). Brock et al. (1991) recommend that ε is set to between half
and three halves the standard deviation of the actual data and m is set in line with the
number of observations available (e.g. use only m ≤ 5 for T ≤ 500 etc.)

4-2 The volatility of Arab stock markets’ returns

The weak-form of efficient market hypothesis implies that no past realizations
should help predict future values, a model that reveals a pattern in the behavior of daily
returns violates the weak form of market efficiency. Excessive volatility of stock prices is
an important phenomenon to investigate, because of its negative effect on risk-averse
investors. In this section, volatility structure of Arab markets returns will be analyzed
using several techniques such as GARCH (1,1), EGARCH (1,1), and Schewrt model.

112
4-2-1 Generalized autoregressive conditional heteroskedasticity (GARCH)
The basic idea behind autoregressive conditional heteroskedasticity ARCH
models proposed by Engle (1982) is that, the second moments of the distribution may
have an autoregressive structure. Under rational expectations the forecast error is ut+1 =
yt+1-Et(yt+1), and the conditional distribution of yt+1 is assumed to be normal with mean
µt+1 and var(yt+1/Ωt) = ht+1 = a0+a1 u2t, where Ωt is the information set available at time t.
However, the ARCH process has a memory of only one period. To generalized this we
can start adding lags of ut-1 in the equation ht+1, ι = 1,…,q. but then the number of
parameters to estimate increases rabidly (Bollerslev 1986). For example, in the GARCH
(1,1) model the conditional variance depends on lagged variance terms: ht+1 = a0+a1+β1ht
= a0+(a1+ β1)ht+at(ut2-ht) in addition to the lagged ut where u0 is arbitrarily assumed to
be fixed and equal to zero. The parameters can be estimated by maximum likelihood
techniques. Conditional on time t information Ωt, (ut2-ht) has a mean of zero, and can be
thought as the shock to volatility. The coefficient a1 measures the extent to which a
volatility shock today feeds through into the volatility of the next period, while a1+ β1
measures the rate at which this effect dies out over time.
Since Engle’s seminal work, many generalization of this model have been
reported. For example, the GARCH (1,1) with a1+ β1=1 has a unit autoregressive root, so
that today’s volatility affects forecasts of volatility in to the indefinite future (persistent of
volatility), this is therefore known as the integrated GARCH or IGARCH model. Nelson
(1991) introduced the Exponential GARCH (EGARCH) model which allows for
asymmetric shocks to volatility and tests the leverage effect. The dependence of the
second moment in returns captured by the (G)ARCH process is known as volatility
clustering, i.e. large changes in price volatility are followed by large changes in either
sign.
Leverage terms allow more realistic modeling of the observed asymmetric
behavior of stock returns according to which a “good-news” price increase yields lower
volatility, while some “bad-news” decrease in price yields an increase in volatility. For
example, when the value of (the stock of) a firm falls, the debt-to-equity ratio increases,
which in turn leads to an increase in the volatility of the returns to equity. This suggests
that returns could also be described by an autoregression whose residual follows an mth-

113
order ARCH-L process, where L stands for the leverage effect (Hamilton and Susmel,
1994). It is also worth mentioning a two-component GARCH which reflects differing
short- and long-term volatility dynamics (Ding et al., 1993).The GARCH in mean
(GARCH-M) model could be used to capture direct relationships between return and
possibly time-varying risk by including the conditional variance in the model for the
conditional mean of the variable of interest.
Autoregressive Conditional Heteroskedasticity (ARCH) models are specifically
designed to model and forecast conditional variances. The variance of the dependent
variable is modeled as a function of past values of the dependent variables and
independence, or exogenous variables. ARCH models are introduced by Engel (1982)
and generalized as GARCH by Bollerslev (1986). GARCH models were found to be
extremely useful in economic and finance, because it is very flexible in modeling second
2
moment. If the error term process is ε t v t ht
where σ v = 1 , E(vt)=0 and in the standard

GARCH (1,1):

h t = α 0 + α 1 ε t2−1 + β 1 h t −1 (4-17)

Then the sequence {vt} is a white noise process and the conditional and unconditional
means of εt are equal zero. A model for the mean is estimated as:

R t = β R t −1 + ε t (4-
18)
and ε t = R t − β R t −1

In the conditional variance equation written in (4-17), ht is the one-period ahead forecast
variance based on past information, it is called the conditional variance. Moreover, the
conditional variance equation (4-17) is a function of three terms:
• The mean, α0
• News about volatility from the previous period, measured as the lag of the
squared residual from mean equations ε t2−1 (the ARCH term).

114
 • Last period forecast variance ht-1 (the GARCH term).
Additionally, the sum of the parameters α1, β1 in the conditional variance equation,
measures the persistence in volatility and lies between 0 and 1.
The (1,1) in GARCH(1,1) refers to the presence of a first-order ARCH term (the
first term in parentheses) and a first-order GARCH term (the second term in parentheses).
An ordinary ARCH model is a special case of a GARCH specification in which there are
no lagged forecast variances in the conditional variance equation.
The GARCH models are estimated by the method of maximum likelihood under
the assumption that the errors are conditionally normally distributed. For example, for the
GARCH (1,1) model, the contribution to the log likelihood from observation t is

1 1 1
2 2 2
(2
lt = − log(2π ) − logσ t2 − yt | − χt' y / σ t2 , ) (4-19)

where
σ t2 = ω + α ( yt −1 − χt −1 ' y )2 + βσ t2−1 (4-20)

This specification is often interpreted in a financial context, where an agent or

trader predicts this period’s variance by forming a weighted average of a long term
average (the constant), the forecasted variance from last period (the GARCH term), and
information about volatility observed in the previous period (the ARCH term). If the asset
return was unexpectedly large in either the upward or the downward direction, then the
trader will increase the estimate of the variance for the next period. This model is also
consistent with the volatility clustering often seen in financial returns data, where large
changes in returns are likely to be followed by further large changes.
There are two alternative representations of the variance equation that may aid in
the interpretation of the model:
• If we recursively substitute for the lagged variance on the right-hand side of
the variance equation, we can express the conditional variance as a weighted
average of all of the lagged squared residuals:

115
 ∞
ω
2
σ = + α ∑ β j −1ε t2− j (4-21)
t
(1 − β ) j =1

• We see that the GARCH (1,1) variance specification is analogous to the

sample variance, but that it down-weights more distant lagged squared errors.
• The error in the squared returns is given by ut = ε t2 − σ t2 . Substituting for the
variances in the variance equation and rearranging terms we can write our
model in terms of the errors:

ε t2 = ω + (α + β )ε t2−1 + ut − β vt −1 (4-22)

• Thus, the squared errors follow a heteroscedastic ARMA (1,1) process. The
autoregressive root which governs the persistence of volatility shocks is the
sum of α plus β. In many applied settings, this root is very close to unity so
that shocks die out rather slowly.

4-2-2 Exponential generalized autoregressive conditional heteroskedasticity

(EGARCH)
The EGARCH or exponential GARCH was proposed by Nelson (1991), the
specification of conditional variance is

ε t −1 2 ε
log σ t2 = ω + β log σ t2−1 + α − + γ t −1 (4-
σ t −1 π σ t −1

23)

Note that the left hand side is the log of the conditional variance, this implies that
the leverage effect is exponential, rather than quadratic and the forecasts of the
conditional variance are guaranteed to be non-negative. The presence of leverage effects
can be tested by the hypothesis that γ>0. The impact is asymmetric if γ≠0; while ε
follows a generalized error distribution. Having estimating the EGARCH model, we will
be able to plot a News Impact Curve, since it is often observed that downward

116
movements in the market are followed by higher volatilities than upward movements. To
account for this phenomenon, Engle and Ng (1993) describe a News Impact Curve with
asymmetric response to good and bad news.
4-2-3 Schewrt model
In order to compare the volatility of Arab stock markets with other international
and emerging markets, Schewrt approach will be used (Schewrt, 1989). A two-step
regression technique is applied to estimate volatility of returns. In the first step, a 13th-
order auto-regression for returns will be estimated

13
Rt = ∑β
i =1
i R t −1 + ε t (4-24)

The absolute value of the residual from equation (4-24) is an estimate of the standard
deviation of the return for t.
In the second step, a 13th-order auto-regression for the absolute values of the
errors from equation (4-24) will be estimated

13
εˆ t = ∑
i =1
ρ τ εˆ t − i + u t (4-25)

the fitted values from this second equation, multiplied by (2/π)-1/2 , are estimates of the
conditional return standard deviation given information available before day t. After the
volatility measures are estimated for each market separately, an average measure of
volatility is then constructed for each group of markets. This measure is calculated by
taking the weighted average of the different market volatilities, with the weights
representing the share of each market in the total market capitalization of the group.

4-3 Non-linearity and chaos in stock returns

Market efficiency implicitly assumes that investors are rational, where rationality
implies risk aversion, unbiased forecasts and instantaneous responses to information.
Such rationality leads to prices responding linearly to new information. However,

117
emerging markets, especially during the early years of trading, may be characterized by
investors who do not have all these attributes. In particular, investors may not always
display risk aversion. For example, Benartzi and Thaler (1992) argue that investors may
be loss averse, in that they are more sensitive to losses than to gains. Such loss aversion
may lead to investors acting in a manner consistent with risk loving or risk neutral
behavior. For example, loss-averse investors who have incurred losses may display risk
loving behavior in an attempt to recover those losses. In addition, investors may place too
faith in their own forecasts introducing bias into their actions (Dabbas et al., 1991; and
Fraser and MacDonald, 1993). Similarly, as Schatzberg and Reiber (1992) point out,
investors do not always respond instantaneously to information. In particular, uninformed
traders may delay their response to see how informed market participants behave,
because they do not have the resources to fully analyze the information, or because the
information is not reliable. Such examples of investor behavior may result in prices
responding to information in a non-linear fashion.
There are several reasons why non-linearity may be observed in financial markets.
First, the characteristic of the market microstructure may lead to non-linearity because of
difficulties in carrying out arbitrage transactions. For example, differing microstructures
between stock markets and derivative markets may give rise to non-linear dependence.
Stoll and Whaley (1991) show that price discovery takes place in futures market and then
the information is carried to the stock market through the process of arbitrage. Delays in
transacting the stock market leg of the arbitrage means that the immediate response to the
mispricing would only be partial, reflecting the change in the futures price alone. This
may induce further arbitrage activity and could actually result in overshooting of the
arbitrage bounds. Furthermore, short sales in stock markets may lead to delays in
executing arbitrage transactions; this in turn may cause non-linear behavior.
Second, non-linearity may be explained in terms of non-linear feed back
mechanisms in price movements. When the price of an asset gets too high, self-regulating
forces usually drive the price down. If the feed back mechanism is non-linear, then the
correction will not always be proportional to the amount by which the price deviates from
the asset’s real value. Third, non-linearity could arise because of the presence of market
imperfections such as transaction costs. Although information arrives randomly to the

118
market, market participants respond to such information with a lag, due to transactions
costs. In other words, market participants do not trade every time news comes to the
market; rather, they trade whenever it is economically profitable, leading to clustering of
price changes.
Fourth, when announcements of important factors are made less often than the
frequency of observations, non-linearity may be observed. For example, monthly money
supply announcements will cause non-linearity in daily and weekly series, but not in
quarterly series. A fifth reason relates to the fact that, as mentioned above, capital market
theory is based on the notion of rational investors. It is assumed that investors are risk
averse, unbiased when they set their subjective probabilities and always react to
information as it received. The implication is that the data generating process is linear.
However, investors may well be risk lovers when taking a gamble in an attempt to
recover their losses. Moreover, they may have too much faith in their own forecast, thus
introducing bias into their subjective probabilities. In addition, they may not react to
information instantaneously, but may delay their response until other investors reveal
their preferences.
To investigate the existence of non-linearity in return series, the logistic map will
be used

Rt = α 0 + α 1 Rt −1 + α n Rtn−1 + ε t (4-26)

where Rt is the return at time t; and n = 2,3. For EMH to be hold, we would expect
α0=α1=αn=0 and εt to be a white noise process. The main purpose of using this approach
is not to determine the precise nature of any non-linearity, but rather to ascertain whether
any non-linearity exists.
Moreover, evidence of non-linearity per se does not provide an insight into the
sources of the non-linearity, or more importantly, the appropriate functional form for the
resultant non-linear model. For instance, Siriopoulos et al. (2001) find that the
inefficiency observed during the early years of their sample for Athens stock exchange,
was manifested through non-linear behavior, while efficiency has been improved with
time, according to institutional and regulatory evolution. Interest in non-linear chaotic

119
processes has in the recent past, experienced a tremendous rate of development. There are
many reasons of this interest, one of which being the ability of such process to generate
output that mimics the output of stochastic systems, thereby offering an alternative
explanation for the behavior of asset prices. In fact, the possible existence of chaos could
be exploitable and even invaluable. If, for example, chaos can be shown to exist in asset
prices, the implication would be that profitable, non-linearity-based trading rules exist (at
least in the short run and provided the actual generating mechanism is known).
Prediction, however, over long periods is all but impossible, due to the sensitive
dependence an initial conditions property of chaos.
In this contest, the BDS tests the null hypothesis of whiteness (independent and
identically distributed observations) against an unspecified alternative using a
nonparametric technique. Since the asymptotic distribution of the BDS test statistic is
known under the null hypothesis of whiteness, the BDS test provides a direct (formal)
statistical test for whiteness against general dependence, which includes both non white
linear and non white non-linear dependence. Hence, the BDS test does not provide a
direct test for non-linearity or for chaos, since the sampling distribution of the test
statistic is not known under the null hypothesis of non-linearity, linearity, or chaos. It is,
however, possible to use the BDS test to produce indirect evidence about non-linear
dependence [whether chaotic (i.e. non-linear deterministic) or stochastic], which is
necessary but not sufficient for chaos.
Moreover, the BDS test has reasonable power against the GARCH family of
models. However, it is often difficult to disentangle the non-linearity generated by this
form of dependence in the second moment, from non-linearity arising as a result of other
causes. One solution to this problem is to estimate some form of GARCH for the series
Rt, such as

Rt = µ + ut ut ∼N(0,ht)

ht = α 0 + α 1u t2−1 + β 1 ht −1

120
the standardized residual, u t ht−1 / 2 , may be subjected to the BDS test and the null
hypothesis then becomes one that the specified GARCH model is sufficient to model the
non-linear structure in the data against an unspecified alternative that is not. The
conclusion being that if the BDS test cannot reject the iid null using appropriate critical
values derived from simulation, then the model estimated is assumed to be an adequate
characterization of the data. In other words, it has been suggested (for example, Brock et
al. 1991, p.19 or p.69) that the BDS test can be used as a general test of model mis-
specification.
In this area, the effectiveness of the BDS test in detecting neglected asymmetries
in volatility will be examined. Engle and Ng (1993) and Henry (1998) discus the
difficulties in selecting between symmetric and asymmetric GARCH models, the
standardized residuals of the GARCH models will be subjected to BDS test to “see what
is left” and whether non-linearity generated by this form of dependence in the second
moment or from other causes.

4-4 Seasonality and calendar effects

An alternative approach to test the EMH especially the weak form is to test for
seasonal patterns or calendar effects in stock returns, since according to the weak form of
EMH, stock prices in an efficient market should fluctuate randomly through time in
response to the unanticipated components of news. This implies that the future path of
price level of an asset is no more predictable than the path of a series of cumulated
random numbers. As a result, seasonal patterns should not exist or should be minor, since
their existence implies the possibility of obtaining abnormal returns by making time
research strategies. In this sequence, three calendar effects will be examined, the day-of-
the-week effect, January effect, and the Halloween effect.

4-4-1 Day-of-the-week effect

The day-of-the-week effect was studied using a model originally proposed by
French (1980), the hypothesis to be evaluated is the trading time hypothesis, according to
which returns are created only on the working days of the week. This hypothesis is tested
using regression with dummy variables, such as

121
 5
Rt = ∑ α i Dit + ε t (4-27)
i =1

where Rt is the daily logarithmic returns on the general index; Dit is a dummy variable
taking the value 1 for day i and 0 for all other days (i=1,…,5 corresponding to Monday
through Friday); αi is the mean return on day i and εt is an error term assumed to be iid.
The hypothesis tested in equation (4-27) is Ho:α1=α2=α3=α4=α5.

4-4-2 January effect or month-of –the-year effect

To test for the January effect, the model described by the following equation will
be used (Gultekin and Gultekin 1983; Jaffe and Westerfield 1989; Raj and Thurston
1994):

12
Rt = ∑αi =1
i D it + ε t (4-28)

here Dit takes the value 1 if the return at time t belongs to month i and 0 if it belongs to
any other month (i=1,…,12 corresponds to January through December); αi is the mean
return in month i; and the other variables are defined as in equation (4-27). The
hypothesis to be tested in equation (4-28) is H0:α1=α2=...=α12.
Moreover, the mean return in a number of months exceeds the average mean
return and that this return would not appear to be a reflection of risk, as reflected in the
standard deviations of monthly returns. One can test this formally by examining whether
there exists a simultaneous month of the year effect in mean return, and in the standard
deviation of these returns. A formal test of the existence of monthly calendar effects in
mean returns is given by the ANOVA or Kruskal-Wallis statistics. Let R2j be the average
rank of observations in the jth group (each month of the year) and nj be the number of
observations in the jth group. Then with K groups and N observations in total, the
Kruskal-Wallis H statistic is

122
  12 k R2 
 N ( N + 1) ∑
H =  − 3( N + 1)
j
(4-29)
j =1 n j

 

distributed as χ2 distribution with N-1 degrees of freedom.

A formal test for monthly variation in the second moment is given by the Levene
test, which tests the hypotheses H0: σi=σj ∀i,j , Ha: σi≠σj, at least one i,j pair. The test
statistic is defined as

k
(N − K )∑ (Z i − Z j )2
i =1
W = k N
(4-30)
(K − 1)∑∑ (Z ij − Z i ) 2

i =1 j =1

~ ~
where Z ij = Υij − Υi , Υi the median of sup-group i.

4-4-3 The Halloween effect

To test for the existence of the Halloween effect, Bouman and Jacobsen (2002)
use regression analysis with dummy variables, which is equivalent to a simple means test,
their analysis is represented as:

Rt = µ + α1 st + ε t (4-31)

where Rt represents the continuously compounded index returns defined as the natural
logarithm of the price relatives. The dummy variable st takes on the value 1 if observation
t falls in month within the November-April period, and 0 otherwise. The intercept term µ
represents the mean return over the May-October period and µ+α1 represents the mean
return over the November-April periods, if α1 is positive and significant at a meaningful
level, then this is considered as an indication of a Halloween effect. However, the
unusually large monthly returns documented by Bouman and Jacobson (2002) during
November-April periods could be a symptom of the January effect. To test for this

123
possibility, equation (4-31) is modified by inserting a second dummy variable Jt, which is
set to equal 1 whenever month t is a January and 0 otherwise.

Rt = µ + α1 st +α 2J t + ε t (4-32)

4-5 Empirical results

4-5-1 Random walk properties
- Regression analysis
Table 4-1 and 4-2 show the results of the random walk carried out for the whole
period for the observed indices. Table 4-1 indicates that in 6 out of 9 markets, the null
hypothesis that the constant term is insignificantly different from zero can not be rejected.
While for both Saudi and Bahrain, the null hypothesis can be rejected at the 5% level.
Moreover, the results in table 4-1 indicate that for Abu Dhabi, Jordan and Kuwait, the
constant term found to be significantly different from zero at all acceptable levels.
However, when the return lag has been added to the model but without correction for
infrequent trading (table 4-2), the results still the same for both Palestine and Dubai. That
is, the coefficients α0 ,α1 found to be insignificantly different from zero, but for Saudi;
they found to be significant at 10% level, whereas, the coefficients found to be
significantly different from zero for the other markets.
Moreover, the RWH indicates that the residual term εt should be pure white noise
error. To test for this property, several diagnostic tests have been used and the results
presented in appendix 2 for each model. Table (1) in appendix 2 shows that the residuals
from the RW model presented in table 4-1 violate the white noise assumption, since they
were serially correlated except Dubai. Since only BDS test found to be significant, this
indicates that the residuals are not iid.

124
 Table 4-1
Random Walk Model for Observed Indices
R t = a + εt
Market Coefficient Std.Error t-value P -value
Abudhabi 0.000847 0.000212 3.995 0.000
Bahrain 0.000257 0.000126 2.041 0.041
Dubai 0.000435 0.000304 1.429 0.153
Egypt 0.000425 0.000408 1.041 0.298
Jordan 0.000355 0.000131 2.702 0.007
Kuwait 0.001876 0.000396 4.734 0.000
Oman 0.000251 0.000249 1.008 0.314
Palestine 0.00082 0.000535 1.533 0.126
Saudi 0.00037 0.000168 2.202 0.028

Table 4-2
Random Walk Model for Observed Indices
Rt = a0 + a1Rt-1 +εt
Market coefficient std.error t-value P -value
a0 0.0016 0.0004 3.923 0.000
Kuwait
a1 0.1657 0.0377 4.392 0.000
a0 0.0003 0.0004 0.839 0.402
Egypt
a1 0.2061 0.0240 8.585 0.000
a0 0.0004 0.0002 2.274 0.023
Saudi
a1 -0.0333 0.0180 -1.849 0.065
a0 0.0003 0.0001 2.336 0.020
Bahrain
a1 -0.1304 0.0172 -7.581 0.000
a0 0.0008 0.0005 1.561 0.119
Palestine
a1 -0.0165 0.0291 -0.566 0.572
a0 0.0004 0.0003 1.417 0.157
Dubai
a1 0.0071 0.0302 0.235 0.814
a0 0.0003 0.0001 2.128 0.033
Jordan
a1 0.2310 0.0174 13.256 0.000
a0 0.0002 0.0002 0.934 0.350
Oman
a1 0.0706 0.0229 3.083 0.002
a0 0.0007 0.0002 3.428 0.001
Abudhabi
a1 0.1412 0.0391 3.613 0.000

Tables 4-3 and 4-4 present the results for returns corrected for infrequent trading.
In general, the adjustment of returns to take account of thin trading appears to have

125
removed the apparent predictability shown in table 4-1 and 4-2. With one exception for
Saudi, Oman, and Palestine (see table 4-4). Since the coefficients α0 ,α1 found to be
statistically significant at 5 % level. Furthermore, the diagnostic tests indicate that only
the residuals for Dubai, Kuwait, and Egypt are not serially correlated, while all other
diagnostic tests were significant, indicating that the residuals do not follow white noise
process (see table 5 in appendix 2). While the diagnostic tests for other markets indicate
that the residuals are serially correlated. The result for Egypt presented in table 4-1 is
consistent with those of Omran (2002) but not for Jordan, since he finds that the return in
Jordanian stock market is not predictable when he uses the observed index.

Table 4-3
Random Walk Model for Corrected Indices
Radjt = a + εt
Market Coefficient Std.Error t-value P -value
Abudhabi -0.00015 0.00025 -0.622 0.534
Bahrain -0.00009 0.00011 -0.800 0.424
Dubai 0.00066 0.00031 2.157 0.031
Egypt 0.00096 0.00050 1.911 0.056
Jordan -0.00005 0.00017 -0.327 0.743
Kuwait 0.00043 0.00039 1.094 0.274
Oman -0.00067 0.00027 -2.500 0.013
Palestine -0.00127 0.00054 -2.373 0.018
Saudi 0.00045 0.00016 2.743 0.006

- Serial correlation test

Tests for the absence of serial correlation over time between returns were
implemented from lag 1 up to lag 30 for both observed and corrected indices. Table 4-5
shows that for the observed indices and on the base of the Box-Pierce test, there is highly
significant autocorrelation for all lags at the 1% level except Dubai, implying that the
series are not completely random.

126
 Table 4-4
Random walk Models for Corrected Indices
adj adj
Rt = a0 + a1 R t-1 +εt
Market coefficient std.error t-value P -value
a0 0.0004 0.0004 1.084 0.279
Kuwait
a1 -0.0051 0.0383 -0.132 0.895
a0 0.0010 0.0005 1.936 0.053
Egypt
a1 -0.0147 0.0246 -0.597 0.551
a0 0.0005 0.0002 3.233 0.001
Saudi
a1 -0.1652 0.0178 -9.280 0.000
a0 -0.0001 0.0001 -0.819 0.413
Bahrain
a1 -0.0150 0.0174 -0.866 0.386
a0 -0.0011 0.0005 -2.063 0.039
Palestine
a1 0.1388 0.0289 4.801 0.000
a0 0.0007 0.0003 2.192 0.029
Dubai
a1 -0.0118 0.0303 -0.390 0.697
a0 -0.0001 0.0002 -0.370 0.711
Jordan
a1 0.0127 0.0179 0.710 0.478
a0 -0.0005 0.0003 -1.808 0.071
Oman
a1 0.3029 0.0219 13.824 0.000
a0 -0.0001 0.0002 -0.576 0.565
Abudhabi
a1 0.0582 0.0395 1.473 0.141

However, when the corrected indices have been used (table 4-6), the higher P-
values for each of Dubai, Egypt, and Kuwait show that we can not reject the hypothesis
that the series are random at the 5 % level while the other markets still exhibit
autocorrelation in returns even after the adjustment for infrequent trading. These results
must be considered under caution, since serial correlation test is a parametric test
assuming that return series normally distributed. While none of the series under
examination came from normal distribution (see Jarque-Bera statistic in table 3-18). As a
result, it is more appropriate to use a non-parametric test such as the runs test.

127
Table 4-5
Estimated Autocorrelations for Observed Indices Returns
No. Abudhabi Bahrain Dubai Egypt Jordan
Lags Q stat. P -value Q stat. P -value Q stat. P -value Q stat. P -value Q stat. P -value
1 12.38 0.000 56.42 0.000 0.04 0.848 72.11 0.000 167.71 0.000
2 12.41 0.002 64.65 0.000 1.73 0.422 72.41 0.000 167.83 0.000
3 24.46 0.000 72.54 0.000 1.74 0.628 72.85 0.000 168.19 0.000
4 30.38 0.000 76.59 0.000 1.84 0.765 74.29 0.000 170.65 0.000
5 31.12 0.000 79.07 0.000 2.10 0.836 74.46 0.000 170.77 0.000
10 40.30 0.000 98.34 0.000 5.06 0.887 78.95 0.000 174.20 0.000
20 68.04 0.000 106.52 0.000 7.84 0.993 89.13 0.000 215.84 0.000
30 83.85 0.000 113.29 0.000 11.57 0.999 111.36 0.000 236.27 0.000

No. Kuwait Oman Palestine Saudi

Lags Q stat. P -value Q stat. P -value Q stat. P -value Q stat. P -value
1 19.04 0.000 9.93 0.002 0.04 0.849 0.08 0.774
2 19.45 0.000 25.73 0.000 7.33 0.026 6.01 0.050
3 19.51 0.000 33.94 0.000 15.30 0.002 13.14 0.004
4 20.66 0.000 44.83 0.000 15.41 0.004 18.16 0.001
5 23.47 0.000 44.91 0.000 15.59 0.008 25.57 0.000
10 32.66 0.000 52.71 0.000 24.00 0.008 31.29 0.001
20 45.73 0.001 139.86 0.000 58.81 0.000 47.58 0.000
30 54.70 0.004 144.95 0.000 74.69 0.000 95.15 0.000
Notes: Statistic ρ(κ) is the autocorrelation coefficient at lag k , Q(k) is the heteroscedasticity-adusted Box-Pierce Q-test
statistic for autucorrelation of order K with asociated P -values.

Table 4-6
Estimated Autocorrelations for Corrected Indices Returns
No. Abudhabi Bahrain Dubai Egypt Jordan
Lags Q stat. P -value Q stat. P -value Q stat. P -value Q stat. P -value Q stat. P -value
1 2.18 0.140 0.92 0.338 0.15 0.696 0.36 0.550 0.50 0.478
2 2.89 0.236 3.16 0.206 2.42 0.298 9.83 0.007 16.74 0.000
3 14.64 0.002 12.46 0.006 2.46 0.482 10.18 0.017 16.76 0.001
4 19.94 0.001 17.44 0.002 2.69 0.611 11.41 0.022 19.73 0.001
5 21.30 0.001 20.95 0.001 3.08 0.688 11.65 0.040 19.91 0.001
10 28.14 0.002 43.93 0.000 5.62 0.846 16.51 0.086 24.55 0.006
20 53.07 0.000 52.04 0.000 8.19 0.991 24.96 0.203 53.42 0.000
30 68.99 0.000 59.26 0.001 12.73 0.998 39.34 0.118 68.62 0.000

No. Kuwait Oman Palestine Saudi

Lags Q stat. P -value Q stat. P -value Q stat. P -value Q stat. P -value
1 0.02 0.894 174.03 0.000 22.72 0.000 83.80 0.000
2 3.23 0.199 174.22 0.000 22.75 0.000 106.66 0.000
3 3.23 0.358 186.96 0.000 31.80 0.000 112.22 0.000
4 3.72 0.446 199.18 0.000 32.80 0.000 113.33 0.000
5 5.36 0.374 199.48 0.000 33.11 0.000 116.10 0.000
10 12.08 0.280 208.41 0.000 42.70 0.000 121.97 0.000
20 26.41 0.153 263.55 0.000 86.51 0.000 138.93 0.000
30 31.51 0.390 272.84 0.000 109.38 0.000 202.41 0.000
Notes: Statistic ρ(κ) is the autocorrelation coefficient at lag k , Q(k) is the heteroscedasticity-adusted Box-Pierce Q-test
statistic for autucorrelation of order K with asociated P -values.

128
 - Non-parametric runs test
The runs test determines whether successive price changes are independent.
Unlike its parametric equivalent, the serial correlation test of independence, the runs test
does not require returns to be normally distributed. Results of the runs test are shown in
table 4-7, both for the observed and corrected indices.
Panel A presents the results for the observed indices, the actual number of runs
(R) in each of the Arab stock markets can be seen to fall short of the expected number of
runs under the null hypothesis of stock returns independence. The resultant negative Z
values indicate positive serial correlation. The runs test results show that the successive
returns for all Arab stock markets are not independent at 5% level. However, when the
indices are corrected for infrequent trading, the results are strikingly different for Egypt,
Kuwait, and Saudi Arabia. Since expected and actual number of runs are so close. While
for other markets, stock returns dependency still significantly exist even after corrected
for thin trading. Based on the corrected indices, we cannot reject weak-form market
efficiency for Egypt, Kuwait, and Saudi stock markets. Correcting for infrequent trading
in the case of these three markets, leads to absolute reversal in the inference on market
efficiency.
The results for both Saudi and Kuwait equity markets are consistent with those of
Abraham et al. (2002), the same results also obtained by Bulter and Malaikah (1992)
when they use the observed indices for Saudi and Kuwaiti markets. Additionally, Haque
et al. (2004) find that the RWH can be rejected for both Egypt and Oman but not for
Bahrain, Jordan, and Saudi Arabia according to runs test results, when they use weekly
data of the observed indices. Moreover, Omran (2002) rejects the RWH for Egypt
depending on runs test, when he uses the observed index.

129
Table 4-7
Results of Runs Test for Arab Stock Markets, Observed vs. Corrected Indices
Abudhabi Dubai Bahrain Jordan Oman Palestine Egypt Kuwait Saudi
Panel A:Observed Index Returns
Observations( N ) 645 1098 3323 3121 1899 1180 1666 687 3082
n (+) 293 510 1577 1449 914 523 774 331 1539
n (-) 352 588 1746 1672 985 657 892 356 1543
n (0) 0 0 0 0 0 0 0 0 0
Expected runs ( m ) 321 547 1658 1554 949 583 830 344 1542
Actual runs ( R ) 268 469 1456 1200 694 467 662 279 1249
Standard error ( σm ) 12.582 16.477 28.744 27.786 21.753 16.945 20.3 13.08 27.753
Z - statistic -4.197a -4.748a -7.035a -12.724a -11.731a -6.868a -8.267a -4.974a -10.557a
Panel B: Corrected Index Returns
Observations( N ) 642 1095 3321 3118 1896 1177 1663 684 3079
n (+) 300 502 1619 1460 1002 537 799 322 1537
n (-) 342 593 1702 1658 894 640 864 362 1542
n (0) 0 0 0 0 0 0 0 0 0
Expected runs ( m ) 321 545 1660 1554 946 585 831 342 1540
Actual runs ( R ) 288 482 1432 1473 696 445 811 330 1502
Standard error ( σm ) 12.605 16.424 28.792 27.802 21.695 17.015 20.353 13.022 27.740
Z - statistic -2.588a -3.819a -7.935a -2.903a -11.520a -8.228a -0.994 -0.908 -1.388
a
Indicates rejection of the null that successive price changes are independentat the 5% level.
The runs test tests for a statistically significant difference between the expected number of runs vs.the actual number of runs. A run is defined as a sequence of successive price changes with the same
sign. n(+)/n(-)/n(0) represent the number of positive/negative/zero price changes. panel B shows the results for the index, corrected for infrequent trading.

130
 - Variance ratio test
The RWH for each market is tested using the variance ratio test described in
section (4-1-5). The variance ratio is computed for multiples of 2, 4, and 8 days, with the
one-day return used as the base. Results for the observed and corrected indices are shown
in panel A and B of table 4-8, respectively. When the observed indices are used, the RWH
is strongly rejected for all markets except Kuwait and Palestine. The variance ratio is not
equal unity with the aggregation interval for the stock markets. While for both Kuwait
and Palestine, the variance ratio is the same and equal to unity for all multiples. However,
when the corrected indices are used, the RWH strongly rejected for all markets even for
Kuwait and Palestine.
The results for Saudi and Bahrain are different from those obtained by Abraham
et al. (2002) since they can not reject the RWH for Saudi and Kuwaiti equity markets,
when they implement the variance ratio test for the corrected indices. While the result of
the observed indices for Jordan and Egypt are consistent with those of Omran (2002). In
addition, the results obtained here for Bahrain, Oman, Kuwait, and Saudi Arabia,
contradict the results of Dahel and Laabas (1998) when they use weekly data of the
observed indices for these markets and can not reject the RWH using variance ratio test.
While Haque et al. (2004) find that Egypt, Bahrain, Oman, and Saudi Arabia show
predictability, whereas Jordan shows no signs of predictability when they use weekly
data of the observed indices.
- BDS test
The BDS tests the null hypothesis of whiteness (independent and identically
distributed observations) against an unspecified alternative. In other words, the BDS test
provides a direct statistical test for whiteness, against general dependence. Tables 4-9 and
4-10 report the BDS test statistics for each market both for observed and corrected
indices. The BDS test has been applied for embedding dimensions of m= 2, 3, 4 and 5.
For each m, ε is set to 0.5, 1.0, and 1.5 standard deviations (σ) of the data. The iid null
hypothesis is overwhelmingly rejected in all cases for the returns series and for all
markets even after the indices have been adjusted for thin trading. The results of the BDS
test indicate that the iid hypothesis is rejected in favor of an unspecified alternative or

131
general dependence, which may includes both non-white linear or non-linear dependence
in the time series.
Table 4-8
Variance Ratio Estimates and Heteroskedastic Test Statistics for
Arab Stock Markets
Panel A: variance ratio test for observed index returns
Market 2 4 8
Abudhabi 2.3618** 2.2894 1.7177
(2.7236) (1.9495) (0.9706)
Bahrain 5.1239** 0.8017 0.8604
(8.2478) (-0.2998) (-0.1887)
Dubai 1.3802 2.4779** 1.0259
(0.7603) (2.2345) (0.0351)
Egypt 5.8647** 3.0547** 0.7301
(9.7293) (3.1065) (-0.3645)
Jordan 3.1048** 1.1292 1.4556
(4.2095) (0.1953) (0.6161)
Kuwait 1.3259 1.1474 1.3255
(0.2652) (0.2229) (0.4402)
Oman 5.5315** 0.4729 3.8261**
(9.0629) (-0.7969) (3.8216)
Palestine 0.3694 0.6392 0.2336
(-1.2611) (-0.5455) (-1.0364)
Saudi 4.1643** 2.5845** 1.9269
(6.3285) (2.3956) (1.2535)
Panel B: variance ratio test for corrected index returns
Market 2 4 8
Abudhabi 4.7341** 1.1910 1.7788
(7.46827) (0.2888) (1.0531)
Bahrain 4.3877** 3.1357** 1.1398
(6.7754) (3.2289) (0.1890)
Dubai 5.7549** 1.8971 1.3779
(9.5099) (1.3563) (0.5110)
Egypt 1.5505 3.0018** 2.6571**
(1.1011) (3.0265) (2.2408)
Jordan 4.9824** 2.7599** 2.6877**
(7.9647) (2.6607) (2.2822)
Kuwait 2.9406** 1.3495 3.5323**
(3.8812) (0.5284) (3.4244)
Oman 3.4383** 3.2131** 2.0616**
(4.8767) (3.3459) (1.4356)
Palestine 4.2867** 2.1025 3.266**
(6.5733) (1.6668) (3.0642)
Saudi 3.4376** 0.5879 1.3840
(4.8752) (-0.623) (0.5193)
** Indicates rejection of the RWH at the 0.05 level.
Figures in parentheses are asymptotic Z statistic (H0:VR(q)=1).
2 2 2
The variance ratios are defined as the ratio of (1/q )σq to σ1 for values of q = 2, 4, and 8, where σi is
the variance of the index return defined as ln(p t /p t- i).Panel B shows the results for the index, corrected
for infrequent trading.

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Table 4-9
BDS Test Results for Observed Return Indices
Abudhabi Bahrain Dubai Egypt Jordan
ε/σ m
BDS Stat. Prob. BDS Stat. Prob. BDS Stat. Prob. BDS Stat. Prob. BDS Stat. Prob.
0.5 2 0.024** 0.000 0.029** 0.000 0.037** 0.000 0.017** 0.000 0.018** 0.000
3 0.025** 0.000 0.039** 0.000 0.056** 0.000 0.021** 0.000 0.018** 0.000
4 0.021** 0.000 0.039** 0.000 0.062** 0.000 0.016** 0.000 0.013** 0.000
5 0.015** 0.000 0.034** 0.000 0.058** 0.000 0.011** 0.000 0.008** 0.000

1.0 2 0.032** 0.000 0.032** 0.000 0.028** 0.000 0.027** 0.000 0.033** 0.000
3 0.055** 0.000 0.059** 0.000 0.057** 0.000 0.051** 0.000 0.051** 0.000
4 0.072** 0.000 0.08** 0.000 0.087** 0.000 0.063** 0.000 0.058** 0.000
5 0.076** 0.000 0.096** 0.000 0.110** 0.000 0.065** 0.000 0.056** 0.000

1.5 2 0.023** 0.000 0.019** 0.000 0.014** 0.000 0.021** 0.000 0.029** 0.000
3 0.048** 0.000 0.039** 0.000 0.030** 0.000 0.048** 0.000 0.054** 0.000
4 0.074** 0.000 0.059** 0.000 0.050** 0.000 0.071** 0.000 0.073** 0.000
5 0.094** 0.000 0.077** 0.000 0.069** 0.000 0.087** 0.000 0.087** 0.000
Observations 646 3325 1099 1667 3122

Kuwait Oman Palestine Saudi

ε/σ m
BDS Stat. Prob. BDS Stat. Prob. BDS Stat. Prob. BDS Stat. Prob.
0.5 2 0.014** 0.000 0.046** 0.000 0.047** 0.000 0.026** 0.000
3 0.013** 0.000 0.058** 0.000 0.056** 0.000 0.032** 0.000
4 0.009** 0.000 0.051** 0.000 0.047** 0.000 0.028** 0.000
5 0.005** 0.000 0.040** 0.000 0.035** 0.000 0.021** 0.000

1.0 2 0.027** 0.000 0.055** 0.000 0.062** 0.000 0.036** 0.000

3 0.043** 0.000 0.099** 0.000 0.105** 0.000 0.068** 0.000
4 0.051** 0.000 0.126** 0.000 0.127** 0.000 0.090** 0.000
5 0.052** 0.000 0.141** 0.000 0.135** 0.000 0.100** 0.000

1.5 2 0.023** 0.000 0.039** 0.000 0.039** 0.000 0.025** 0.000

3 0.045** 0.000 0.080** 0.000 0.079** 0.000 0.054** 0.000
4 0.064** 0.000 0.115** 0.000 0.109** 0.000 0.084** 0.000
5 0.078** 0.000 0.145** 0.000 0.133** 0.000 0.109** 0.000
Observations 688 1900 1181 3083
Notes: The BDS (m,ε) tests for i.i.d., where m is the embedding dimention and ε is distance set in terms of the standard deviation of the
data(σ) to 0.5,1.0 and 1.5 standard deviations.** indicates statistical significance at the 5% level.

133
Table 4-10
BDS Test Results for Adjusted Return Indices
Abudhabi Bahrain Dubai Egypt Jordan
ε/σ m
BDS Stat. Prob. BDS Stat. Prob. BDS Stat. Prob. BDS Stat. Prob. BDS Stat. Prob.
0.5 2 0.019** 0.000 0.037** 0.000 0.036** 0.000 0.014** 0.000 0.015** 0.000
3 0.020** 0.000 0.047** 0.000 0.054** 0.000 0.018** 0.000 0.017** 0.000
4 0.018** 0.000 0.045** 0.000 0.059** 0.000 0.014** 0.000 0.014** 0.000
5 0.013** 0.000 0.038** 0.000 0.055** 0.000 0.010** 0.000 0.009** 0.000

1.0 2 0.026** 0.000 0.039** 0.000 0.027** 0.000 0.021** 0.000 0.029** 0.000
3 0.047** 0.000 0.070** 0.000 0.056** 0.000 0.047** 0.000 0.051** 0.000
4 0.064** 0.000 0.091** 0.000 0.086** 0.000 0.059** 0.000 0.065** 0.000
5 0.068** 0.000 0.107** 0.000 0.109** 0.000 0.060** 0.000 0.071** 0.000

1.5 2 0.022** 0.000 0.025** 0.000 0.014** 0.000 0.015** 0.000 0.026** 0.000
3 0.047** 0.000 0.049** 0.000 0.029** 0.000 0.044** 0.000 0.054** 0.000
4 0.072** 0.000 0.072** 0.000 0.049** 0.000 0.068** 0.000 0.079** 0.000
5 0.092** 0.000 0.092** 0.000 0.068** 0.000 0.083** 0.000 0.100** 0.000
Observations 646 3325 1099 1667 3122

Kuwait Oman Palestine Saudi

ε/σ m
BDS Stat. Prob. BDS Stat. Prob. BDS Stat. Prob. BDS Stat. Prob.
0.5 2 0.012** 0.000 0.037** 0.000 0.045** 0.000 0.023** 0.000
3 0.012** 0.000 0.045** 0.000 0.052** 0.000 0.024** 0.000
4 0.009** 0.000 0.038** 0.000 0.043** 0.000 0.017** 0.000
5 0.005** 0.000 0.029** 0.000 0.032** 0.000 0.010** 0.000

1.0 2 0.024** 0.000 0.050** 0.000 0.058** 0.000 0.033** 0.000

3 0.040** 0.000 0.088** 0.000 0.099** 0.000 0.064** 0.000
4 0.049** 0.000 0.109** 0.000 0.121** 0.000 0.085** 0.000
5 0.051** 0.000 0.120** 0.000 0.128** 0.000 0.097** 0.000

1.5 2 0.021** 0.000 0.036** 0.000 0.037** 0.000 0.033** 0.000

3 0.042** 0.000 0.070** 0.000 0.076** 0.000 0.064** 0.000
4 0.060** 0.000 0.100** 0.000 0.106** 0.000 0.085** 0.000
5 0.075** 0.000 0.126** 0.000 0.129** 0.000 0.097** 0.000
Observations 688 1900 1181 3083
Notes: The BDS (m,ε) tests for i.i.d., where m is the embedding dimention and ε is distance set in terms of the standard deviation of the
data(σ) to 0.5,1.0 and 1.5 standard deviations.** indicates statistical significance at the 5% level.

134
4-5-2 Volatility of returns
Several methods have been suggested in the literature to test for volatility in stock
markets. Regardless of the debate over empirical testing of volatility, the fact remains
that volatility is a relative measure. The purpose of this section is to investigate the
volatility of Arab stock markets and whether these markets are characterized by excessive
volatility of returns, relative to other developed and emerging markets. To this end, in
addition to nine Arab stock markets, three emerging and three developed markets will be
tested. U.K (FTSE100), USA (S&P 500), and Japan (Nikkei 225) will be used for
developed markets, while Israel, Turkey, and India general equity markets’ indices will
be the representative of emerging markets. The data for both emerging and developed
markets consists of daily prices and obtained from Yahoo Finance.3
- Coefficient of variation
The coefficient of variation figures presented in table 4-11 measure the degree of
volatility of daily market returns relatives. For the group of Arab markets, Oman appears
to be, by far, the most volatile followed by Egypt, with Kuwait the least volatile. For the
developed markets, the coefficients of variation are higher in average than those for most
of the Arab markets, as well as for the developing markets except India. Overall based on
the coefficient of variation, the figures seem to indicate that Arab stock markets as a
group characterized with a low level of volatility relative to the other two groups.

Table 4-11
Coefficient of Variation (C.V) for Daily Returns for the Three Groups
Arab stock markets Emerging markets Developed markets
market C.V % market C.V % market C.V %
Abudhabi 6.4 3.0% India 73.9 59.5% Japan 44.3 30.7%
Bahrain 28.3 13.2% Israel 28.2 22.7% UK 65.5 45.4%
Dubai 23.2 10.8% Turkey 22.1 17.8% USA 34.5 23.9%
Egypt 39.2 18.3% Total 124.2 100.0% Total 144.3 100.0%
Jordan 20.7 9.7% Average 41.4 Average 48.1
Kuwait 5.5 2.6%
Oman 43.2 20.2%
Palestine 22.4 10.5%
Saudi 25.2 11.8%
Total 214.1 100.0%
Average 23.79

3
Although all Arab markets are emerging markets, the distinction between Arab and emerging markets is
made only for the purpose of the analysis.

135
 -Schwert measure
In the case of the coefficient of variation, volatility in Arab, emerging, and
developed markets has been investigated at the market level. The figures in table 4-11 do
not provide a clear assessment of the degree of volatility of returns in Arab markets as a
group, compared to that in other two groups of markets. The Schwert measure of
volatility used at the group level should reveal not only the potential trends in volatility of
returns in Arab markets, but also their level of volatility relative to that of emerging and
developed markets.
Figure 4-1 shows the Schwert measure of volatility for the 3 groups. The main
observation that could be made from the figure is that, Arab stock markets as a group
exhibit the lowest level of volatility while emerging markets found to be the highest.
However, Arab markets show a remarkable increase of volatility, particularly over the
period 2003 corresponding to the invasion on Iraq.4

Figure 4-1
Markets Volatility (Schwert Model)

4
The end of the year 2004 has been used to calculate the weights.

136
 - GARCH (1,1) models
The volatility and persistence of shocks to volatility for all markets, including
emerging and developed markets, are presented in table 4-12. Based on empirical
investigation conducted by GARCH (1,1) for daily data, one finds that only Dubai does
not show any volatility clustering. In other words, there is evidence of significantly
volatility clustering in 8 out of 9 Arab markets. ARCH parameter (α1 in table 4-12) is less
than unity for all fifteen markets, signifying that shocks are not explosive. Economic
interpretations of the ARCH effect in stock returns have been provided within both micro
and macro frameworks, according to Bollerslev et al. (1992) and other studies. The
ARCH effect in stock returns could be due to clustering of trade volumes, nominal
interest rate, dividends yields, money supply, oil prices etc.
Moreover, the persistence of shocks is measured by (α1+β1) in the GARCH
model. According to Engel and Bollerslev (1986), if α1+β1 = 1 in GARCH model, a
current shock persists indefinitely in conditioning the future variance. Since the sum
α1+β1 represents the change in response function of shocks to volatility persistence, a
value greater than unity implies that response function of volatility increases with time
and a value less than unity implies that shocks decay with time (Chou, 1988). The closer
to unity is the value of persistence measure; the slower is the decay rate. The findings
here reveal that in three Arab stock markets (Egypt, Kuwait, and Palestine), one fails to
reject that α1+β1 = 1, i.e. shocks to volatility are permanent. It implies that the conditional
variance is non-stationary. The volatility movements affects the stock markets of these
three countries, volatility is persistent and has a slow rate of decay. On the other hand,
Oman exhibits an increasing response function of volatility and shocks do not decay with
time, while the response function of volatility for the other 11 markets, decays with time.
Moreover, several diagnostic tools have been implemented. Table 2 in appendix 2
presents the results of five diagnostic tests for the standardized residuals of GARCH (1,1)
on a daily basis. The McLeod-Li test indicates that the squared residuals are not
correlated; while the BDS test reject the iid hypothesis of the standardized residuals for
three Arab markets only (Bahrain, Dubai, and Egypt).

137
Table 4-12
GARCH (1,1) Model for Daily Returns
Market Obs. α0 α1 β1 α 1 +β 1 ku Sk
Q(30) ARCH LM test
AbuDhabi 644 0.00000 0.19183 0.68194 0.87377 9.406 0.125
27.303 0.005
0.000 0.000 0.000 0.000 0.607 0.946
Jordan 3122 0.00000 0.21977 0.71952 0.93930 5.154 0.321 34.743 0.354
0.000 0.000 0.000 0.000 0.252 0.552
Bahrain 3323 0.00005 0.10708 -0.04331 0.06378 384.310 10.701 0.934 0.733
0.000 0.000 0.155 0.000 1.000 0.392
Dubai 1097 0.00000 0.00017 0.97739 0.97756 201.951 7.874 0.795 0.010
0.000 0.779 0.000 0.000 1.000 0.921
Egypt 1665 0.00001 0.13525 0.86008 0.99533 9.107 0.347 57.300 2.583
0.000 0.000 0.000 0.408 0.002 0.108
Kuwait 686 0.00000 0.19027 0.79472 0.98499 5.511 -0.345 16.147 0.000
0.000 0.000 0.000 0.308 0.981 0.997
Oman 1898 0.00000 0.29685 0.76219 1.05904 24.645 1.226 15.678 1.021
0.000 0.000 0.000 0.000 0.985 0.312
Palestine 1179 0.00002 0.44315 0.55360 0.99674 8.153 -0.138 33.593 0.021
0.000 0.000 0.000 0.904 0.297 0.885
Saudi 3081 0.00000 0.35268 0.61969 0.97237 10.094 -0.136 26.039 0.190
0.000 0.000 0.000 0.001 0.673 0.663
USA 3780 0.00000 0.06652 0.92710 0.99361 4.833 -0.351 26.621 3.881
0.000 0.000 0.000 0.005 0.643 0.144
UK 3789 0.00000 0.08126 0.90501 0.98626 3.791 -0.112 26.478 0.599
0.000 0.000 0.000 0.002 0.651 0.439
Japan 3692 0.00001 0.09297 0.87906 0.97202 4.652 -0.022 20.090 2.853
0.000 0.000 0.000 0.000 0.914 0.091
Turkey 1835 0.00001 0.09244 0.90088 0.99331 4.524 -0.173 28.834 1.924
0.000 0.000 0.000 0.000 0.526 0.165
India 1891 0.00001 0.13523 0.82516 0.96038 5.638 0.013 24.788 0.263
0.000 0.000 0.000 0.000 0.735 0.608
Israel 1500 0.00003 0.10942 0.77420 0.88362 5.210 -0.215 16.939 3.089
0.000 0.000 0.000 0.000 0.973 0.213
2
Significance levels are in italics. A Chi-square (χ ) tests (α 1 +β 1 ) = 1. Ku is the kurtosis of the residuals. Sk is the skewness of the residuals
and Q(30) is the Ljung-Box statistics serial correlation of the lags in the residuals. ARCH LM is a Lagrange multipler (LM) test for
autoregressive conditional heteroskedasticity (ARCH) in the residuals. The estimated variance equation is :
2
h t = a 0 + a 1ε t −1 + β 1 h t −1

The results change dramatically when we use weekly data, table 4-13 shows the
results of GARCH (1,1) for weekly returns. Volatility clustering disappears in 4 out of 9
Arab markets (Abu Dhabi, Dubai, Egypt, and Kuwait) in addition to India and Israel5,
while volatility found to be persistent in 11 markets at the 1 percent level. Within the
group of Arab stock markets, the results reveal that 5 of the 9 markets (Abu Dhabi,
Dubai, Egypt, Kuwait, and Oman) exhibit persistence of volatility. The results for Jordan,
Saudi, and Bahrain presented in table 4-13, are consistent with those obtained from

5
For Egypt, Kuwait, and India, volatility clustering disappears at 1 % level only.

138
Haque et al. (2004), since they find that these markets exhibit volatility clustering but not
Oman. In addition, they don not find volatility to be permanent in both Saudi and Jordan,
which is inconsistent with the results obtained here for these two markets.

Table 4-13
GARCH (1,1) Model for Weekly Returns
Country Obs. α0 α1 β1 α 1 +β 1 ku Sk Q(30) ARCH LM test
AbuDhabi 122 0.00007 0.02948 0.62006 0.64954 4.633 0.191 27.450 0.00198
0.716 0.748 0.529 0.712 0.600 0.964
Jordan 676 0.00004 0.15037 0.74845 0.89882 4.492 0.687 15.661 0.20044
0.003 0.000 0.000 0.007 0.985 0.654
Bahrain 699 0.00003 0.21698 0.64099 0.85797 6.266 -0.010 29.454 0.03697
0.000 0.000 0.000 0.000 0.494 0.848
Dubai 192 0.00023 0.06293 0.56224 0.62517 34.178 3.345 4.049 0.08971
0.188 0.210 0.062 0.189 1.000 0.765
Egypt 364 0.00012 0.06365 0.86453 0.92818 4.984 0.522 25.056 0.61368
0.036 0.013 0.000 0.045 0.722 0.433
Kuwait 140 0.00016 0.42045 0.35650 0.77695 3.861 -0.261 21.313 0.41905
0.038 0.023 0.129 0.142 0.878 0.517
Oman 400 0.00009 0.38872 0.53808 0.92680 7.324 0.626 15.417 0.07061
0.000 0.000 0.000 0.148 0.987 0.790
Palestine 388 0.00019 0.18439 0.60576 0.79014 5.729 0.457 22.052 0.64497
0.002 0.002 0.000 0.003 0.852 0.422
Saudi 975 0.00005 0.28539 0.61480 0.90020 7.298 -0.206 12.179 0.01132
0.000 0.000 0.000 0.000 0.998 0.915
USA 780 0.00000 0.08887 0.90487 0.99374 3.696 -0.336 29.912 4.43269
0.049 0.000 0.000 0.363 0.470 0.109
UK 785 0.00001 0.08452 0.89759 0.98211 3.983 -0.131 31.340 0.02157
0.082 0.000 0.000 0.155 0.399 0.883
Japan 779 0.00013 0.10219 0.75862 0.86081 3.897 -0.192 15.825 0.03263
0.012 0.000 0.000 0.018 0.984 0.857
Turkey 378 0.00013 0.10059 0.87942 0.98001 5.187 0.058 12.849 0.01552
0.049 0.000 0.000 0.264 0.997 0.901
India 398 0.00001 0.03884 0.95364 0.99249 4.044 -0.265 33.944 0.00148
0.433 0.014 0.000 0.343 0.283 0.969
Israel 396 0.00063 0.10671 0.23423 0.34093 5.550 -0.580 17.017 0.00775
0.014 0.056 0.056 0.016 0.972 0.930
Significance levels are in italics. A Chi-square (χ2) tests (α 1 +β 1 ) = 1. Ku is the kurtosis of the residuals. Sk is the skewness of the
residuals and Q(30) is the Ljung-Box statistics serial correlation of the lags in the residuals. ARCH LM is a Lagrange multipler (LM)
test for autoregressive conditional heteroskedasticity (ARCH) in the residuals. The estimated variance equation is :
2
h t = a 0 + a 1ε t −1 + β 1 h t −1

- EGARCH model
For equities, it is often observed that downward movements in the market are
followed by higher volatilities than upward movements of the same magnitude. To
account for this phenomenon, Nelson (1991) introduced the EGARCH model which

139
allows for asymmetric shocks to volatility and test for the leverage effect. Table 4-14
shows the results of EGARCH for daily returns. The presence of leverage effect can be
tested by the hypothesis that γ>0 in table 4-14 and the impact is asymmetric if γ≠0. The
results indicate that, in addition to the two groups (developed and emerging markets), 4
out of 9 Arab stock markets (Bahrain, Dubai, Kuwait, and Oman) exhibit leverage effect
and asymmetric shocks to volatility.

Table 4-14
EGARCH (1,1) Model for Daily Returns
Market Obs. ω α γ β ku Sk Q(30) ARCH LM test
AbuDhabi 644 -1.78165 0.34467 0.03506 0.85392 9.422 0.144 23.061 0.000
0.000 0.000 0.140 0.000 0.813 0.998
Jordan 3120 -1.23553 0.40366 0.02818 0.90722 5.170 0.304 39.202 0.511
0.000 0.000 0.007 0.000 0.121 0.475
Bahrain 3323 -12.65412 0.12159 -0.04447 -0.23169 362.367 9.934 27.014 26.161
0.000 0.000 0.000 0.006 0.623 0.000
Dubai 1097 -10.01361 0.74962 -0.50514 0.00253 141.089 4.862 0.466 0.014
0.000 0.000 0.000 0.892 1.000 0.905
Egypt 1665 -0.51351 0.24446 0.07710 0.89177 8.714 0.224 93.901 3.337
0.000 0.000 0.000 0.000 0.000 0.068
Kuwait 686 -1.27042 0.33540 -0.19960 0.89177 5.483 -0.310 19.498 8.533
0.000 0.000 0.000 0.000 0.929 0.577
Oman 1898 -0.89754 0.45511 -0.04685 0.94151 23.798 0.703 84.409 0.331
0.000 0.000 0.001 0.000 0.000 0.565
Palestine 1179 -1.44426 0.52062 0.07844 0.87744 8.998 -0.295 20.842 0.991
0.000 0.000 0.000 0.000 0.893 0.320
Saudi 3081 -1.88841 0.34616 0.01661 0.84125 11.776 -0.404 82.528 8.149
0.000 0.000 0.014 0.000 0.000 0.017
USA 3780 -0.24749 0.11417 -0.08903 0.98305 4.509 -0.294 34.760 1.143
0.000 0.000 0.000 0.000 0.251 0.285
UK 3789 -0.20915 0.11031 -0.06385 0.98696 3.843 -0.101 29.058 0.124
0.000 0.000 0.000 0.000 0.515 0.724
Japan 3692 -0.38034 0.15409 -0.09008 0.96930 4.515 0.022 26.524 2.547
0.000 0.000 0.000 0.000 0.648 0.110
Turkey 1835 -0.42437 0.27374 -0.05148 0.96941 4.356 -0.156 28.832 0.956
0.000 0.000 0.000 0.000 0.526 0.328
India 1891 -0.87231 0.25576 -0.12557 0.91961 4.964 0.023 27.438 0.036
0.000 0.000 0.000 0.000 0.600 0.850
Israel 1500 -1.49498 0.23604 -0.15123 0.84442 4.663 -0.123 19.965 0.166
0.000 0.000 0.000 0.000 0.917 0.684
Significance levels are in italics. A Chi-square (χ2) tests (α 1 +β 1 ) = 1. Ku is the kurtosis of the residuals. Sk is the skewness of the
residuals and Q(30) is the Ljung-Box statistics serial correlation of the lags in the residuals. ARCH LM is a Lagrange .EGARCH
equation estimated as: ε ε t −1
( ) (
log σ t2 = ω + β log σ t2−1 + a t −1 + γ) σ t −1 σ t −1

140
 The coefficient of the leverage term was negative and significant at the 5% level;
conditional variance is higher in the presence of negative innovations, which indicate that
the market becomes more nervous when negative shocks take place. Usually what
happens is that, small investors get panic from these negative shocks and sell their stocks
in order to avoid higher losses. Moreover, to see this effect clearly, the News Impact
Curve has been plotted for each market under examination (see figure 1 appendix 2).

4-5-3 Non-linearity in stock returns

Efficiency implicitly assumes that investors are rational, where rationality implies
risk aversion, unbiased forecasts and instantaneous responses to information. Such
rationality leads to price responding linearly to new information. In this contest, failure to
take into account the institutional features of emerging markets may lead to statistical
illusions regarding efficiency or inefficiency. With reference to evidence in favor of
efficiency, this is perhaps the outcome of using linear models for testing efficiency, in
markets characterized by inherent non-linearity. If the return generating process is non-
linear and a linear model is used to test for efficiency, then the hypothesis of no
predictability may be wrongly accepted, this is because non-linear system such as
“chaotic” ones looks very similar to a random walk.
Table 4-15 shows the results of the random walk model including non-linear
terms for the observed indices. It appears that with the introduction of non-linear
components, α1, α2, and α3 are statistically significant for all markets except Kuwait. This
seems to indicate predictability and inefficiency. The results reveal that the return
generating process in 8 out of 9 Arab markets is non-linear even after corrected the
indices for thin trading (see table 4-16). Moreover, most of the diagnostic tests; especially
BDS test, for the residuals indicate that the residual are not following white noise process
(see tables 6 and 7 in appendix 2).
However, the logistic map is not able to determine the precise nature of any non-
linearity, but rather to ascertain whether non-linearity exists. It is appropriate that non-
linearity generated by dependence in the second moment. To disentangle the nonlinearity
generated by changes in volatility from non-linearity arising as a result of other causes,
the standardized residuals resulted from GARCH models will be subjected to several

141
diagnostic tests to determine whether the specified GARCH model is sufficient to model
the nonlinear structure in the data against an unspecified alternative.
Table 4-15
Random Walk Models with Non-linearity for Observed
Indices
Rt = a0 + a1Rt-1 + a2R2t-1+ a3R3t-1+ εt
Market coefficients std.error t-value P -value
a0 0.000 0.000 1.788 0.074
a1 0.196 0.056 3.521 0.001
Abudhabi
a2 10.360 2.890 3.585 0.000
a3 -339.479 178.188 -1.905 0.057
a0 0.000 0.000 2.927 0.003
a1 0.205 0.021 9.814 0.000
Bahrain
a2 -2.137 0.109 -19.578 0.000
a3 -16.934 0.748 -22.646 0.000
a0 0.000 0.000 0.674 0.501
a1 0.115 0.046 2.521 0.012
Dubai
a2 3.148 0.814 3.867 0.000
a3 -17.391 4.343 -4.004 0.000
a0 0.000 0.000 0.510 0.610
a1 0.309 0.026 11.726 0.000
Egypt
a2 0.656 0.520 1.262 0.207
a3 -26.228 3.652 -7.182 0.000
a0 0.000 0.000 0.702 0.483
a1 0.295 0.023 13.017 0.000
Jordan
a2 3.440 0.928 3.708 0.000
a3 -177.321 35.219 -5.035 0.000
a0 0.002 0.000 3.555 0.000
a1 0.173 0.055 3.164 0.002
Kuwait
a2 -0.004 1.672 -0.003 0.998
a3 -10.638 56.159 -0.189 0.850
a0 0.000 0.000 -0.397 0.691
a1 0.308 0.026 11.736 0.000
Oman
a2 2.666 0.282 9.454 0.000
a3 -43.597 2.616 -16.663 0.000
a0 0.000 0.000 -0.059 0.953
a1 0.294 0.032 9.232 0.000
Palestine
a2 1.970 0.165 11.956 0.000
a3 -13.406 0.782 -17.136 0.000
a0 0.000 0.000 0.443 0.658
a1 0.143 0.020 7.205 0.000
Saudi
a2 2.907 0.186 15.635 0.000
a3 -22.097 1.296 -17.055 0.000

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 Table 4-16
Random Walk Models with Non-linearity for Corrected
Indices
Rtadj = a0 + a1Radjt-1 + a2R2adjt-1+ a3R3adjt-1+ εt
Market coefficient std.error t-value P -value
a0 -0.0004 0.0003 -1.613 0.107
a1 0.1408 0.0568 2.478 0.014
Abudhabi
a2 7.6016 2.4496 3.103 0.002
a3 -282.8010 137.9073 -2.051 0.041
a0 0.0001 0.0001 0.578 0.563
a1 0.2221 0.0206 10.784 0.000
Bahrain
a2 -2.8772 0.1565 -18.387 0.000
a3 -15.6601 1.1872 -13.191 0.000
a0 0.0004 0.0003 1.372 0.171
a1 0.0918 0.0457 2.008 0.045
Dubai
a2 3.1324 0.8146 3.845 0.000
a3 -16.9249 4.2789 -3.955 0.000
a0 0.0014 0.0005 2.696 0.007
a1 0.0847 0.0274 3.088 0.002
Egypt
a2 -1.0921 0.3122 -3.498 0.001
a3 -14.3869 2.0452 -7.034 0.000
a0 -0.0002 0.0002 -1.214 0.225
a1 0.0456 0.0219 2.084 0.037
Jordan
a2 1.9981 0.7423 2.692 0.007
a3 -53.1736 17.4916 -3.040 0.002
a0 0.0004 0.0004 1.004 0.316
a1 0.0343 0.0537 0.639 0.523
Kuwait
a2 -0.2291 1.6599 -0.138 0.890
a3 -56.2277 54.0341 -1.041 0.298
a0 -0.0004 0.0002 -1.820 0.069
a1 0.4879 0.0247 19.787 0.000
Oman
a2 0.5756 0.3791 1.518 0.129
a3 -46.0179 3.5874 -12.827 0.000
a0 -0.0015 0.0005 -3.115 0.002
a1 0.3323 0.0317 10.485 0.000
Palestine
a2 1.7837 0.2600 6.861 0.000
a3 -8.3673 1.2096 -6.917 0.000
a0 0.0002 0.0002 1.353 0.176
a1 -0.0432 0.0200 -2.163 0.031
Saudi
a2 3.2987 0.1905 17.312 0.000
a3 -17.4300 1.3537 -12.876 0.000

Since correct specification of the model implies that the residuals will be
uncorrelated and also will have a zero mean and unit variance. Five different tests are
considered in this exercise for testing the hypothesis that the residuals are iid. This will

143
allow us on one hand to obtain a deeper and more detailed insight into the series
properties, by generating useful information from the various tests and on the other hand,
to minimize the probability of missing some thing and thus drawing the wrong
conclusion. If our battery of tests displays a unanimous “consensus” in favor of a specific
result, we would interpret this “consensus” as strong corroboration of that output.
The five tests that are going to be used are the following: McLeod and Li (1983);
Engle (1982), Brock et al. BDS (1996); serial correlation and Jarque-Bera test for
normality. All these tests share the principle that once any linear structure is removed
from the data, any remaining structure should be due to a non-linear data generating
mechanism. The McLeod and Li test looks at the autocorrelation function of the squares
of the prewhitened data and test whether corr (e2t,e2t-k) is non-zero for some k and can be
considered as an LM statistic against ARCH effect (see Granger and Terasvirta 1993;
Patterson and Ashley 2000). The test suggested by Engle (1982) is an LM test, which
should have considerable power against GARCH alternatives. The BDS test is a non
parametric test for serial independence as described in section (4-1-6).
The corresponding diagnostic tests for random walk and GARCH models for each
daily observed index are presented in appendix 2. Table 1 in appendix 2 shows the
diagnostic tests for the ordinary residuals of the RW model, clear evidence emerges
across the spectrum of tests that the residuals of the RW are not iid. Almost all P-values
are 0, suggesting that some kind of hidden structure exists in the data. While for Dubai
equity market, only the BDS test rejects the iid hypothesis. The failure of the RW model
to explain the behavior of the series and considerations of the constant term that are
statistically different from zero, for some models, casts doubts on the validity of the
weak-form efficiency. The evidence against EMH is clear in all of the indices. Table 2 in
appendix 2 presents the results of diagnostic tests for the standardized residuals obtained
from GARCH models. Evidence emerges to support the hypothesis that the standardized
residuals are iid for all markets except Bahrain, Dubai, and Egypt, since the BDS test for
these three markets, reject the iid hypothesis.
Table 3 in appendix 2 presents the results for the standardized residuals obtained
from EGARCH model for observed daily indices. The results indicate that, we are not
able to reject the iid hypothesis for all markets. Most of the P-values presented in table 3,

144
are exceed the 5% benchmark. Moreover, the GARCH models produced lower SC’s
(Schwartz criterion) and as a result, are preferred to the RW in this respect. While for
Bahrain, Abu Dhabi, and Saudi, the EGARCH models produced the lowest SC’s values,
compared to the lowest SC’s values which have been produced by GARCH models for
the other markets. Additionally, evidence emerges to support the hypothesis that the
standardized residuals of the GARCH models are iid. Most of the P-values exceed the
5% level. Therefore, we could accept the randomness hypothesis.

4-5-4 Calendar effects

As mentioned previously, the existence of seasonality or calendar effects in stock
markets, contradicts the efficient market hypothesis, at least in its weak form, because the
predictable movements in asset prices provide investors with opportunities to generate
abnormal returns. In emerging markets, it is possible that the dissemination of
information is restricted due to the possible manipulation of financial information by
market participants, and a lack of strict disclosure requirements imposed by the stock
market regulatory agencies. In this section, we will examine three calendar effects, day-
of-the-week, month-of-the-year, and the Halloween effects for each of the Arab stock
markets under examination.
- Day-of-the-week effect
Table 4-17 shows the OLS results for the day-of-the-week effect. Because Arab
stock markets have different trading days during the week, the OLS equation will have
five dummy variables for markets which have five trading days, and six dummy variables
for those with six trading days. Moreover, our purpose here is to test for the effect of the
first trading day of the week for each market, which will be Saturday or Sunday, since
these days are trading days in Arab stock markets (weekend is Friday) and it is equivalent
to test for Monday effect in other international stock markets.6
The results in table 4-17 indicate that, the estimated coefficients for the first
trading day of the week are positive and statistically significant (at 5% level) in three
markets Abu Dhabi, Jordan, and Saudi Arabia. While these coefficients found to be

6
Palestine was not included in this test, since trading days are not consistent during the week, resulting
irregularity in trading days.

145
positive but not significant in the rest of the markets. Moreover, the coefficients for other
days found to be positive and significant for most of the markets, another important note
is that for Bahrain and Saudi, the next trading day found to be negative and statistically
significant (Monday and Sunday effects). It seems that in these two markets, bad news is
announced at week ends, in order for the shock to be more easily absorbed, but that the
information is not instantly reflected in prices, investors in these markets hesitant and act
with a delay of one day. Furthermore, the estimated coefficients for all trading days in
both Jordan and Abu Dhabi found to be positive and statistically significant (at 5% level).
In general, the results are inconsistent with the results reported in the finance literature
for a large number of countries, where significantly lower or negative Monday returns are
reported (the traditional Monday effect).
In addition, the results reject the trading time hypothesis (since the returns on the
first day is different from that of the other days of the week), as well as the calendar time
hypothesis (since the returns on the first trading day is not three times that of the other
days). Note also that, the other coefficients in several markets are significantly positive.
The results for Egypt are inconsistent with those obtained by Aly et al. (2004), since they
find that all estimated coefficients to be positive but statistically not significant. However,
a Chow test indicates that the estimated coefficients reported in table 4-17, are
structurally stable over the entire sample period for three markets only (Abu Dhabi,
Bahrain, and Kuwait), while the hypothesis that all parameters equal zero has been
soundly rejected for all markets (see table 4-18).
In order to further investigate the presence of a positive first trading day
seasonality in Arab stock markets, one can test this formally by examining whether there
exists a simultaneous day-of-the-week effect in mean returns and in the standard
deviation of these returns. A formal test of the existence of day-of-the-week calendar
effect is given by the ANOVA or Kruskal-Wallis statistics. While a formal test for daily
variation in the second moment is given by the Levene test. Table 4-19 shows the results
of the day-of-the-week effect in the first two moments. As can be seen in table

146
Table 4-17
OLS Results for Day-of-the-Week Effect
Market Variable Coefficient Std. Error t-Statistic Prob.
AbuDhabi
1/7/2001-31/12/2003 Saturday 0.0002 0.0001 2.240 0.026
Sunday 0.992 0.042 23.717 0.000
Monday 0.998 0.029 34.730 0.000
Tusday 0.994 0.039 25.322 0.000
Wedensday 0.995 0.029 33.864 0.000
Jordan
4/1/1992-14/3/2005 Sunday 0.282 0.037 7.635 0.000
Monday 0.117 0.036 3.267 0.001
Tusday 0.274 0.041 6.751 0.000
Wedensday 0.404 0.041 9.755 0.000
Thursday 0.335 0.065 5.165 0.000
Bahrain
2/1/1991-3/6/2004 Sunday 0.348 0.301 1.154 0.248
Monday -0.996 0.017 -57.032 0.000
Tusday 0.001 0.017 0.041 0.967
Wedensday 0.192 0.269 0.716 0.474
Thursday 0.191 0.307 0.621 0.535
Dubai
26/3/2000-31/12/2003 Saturday 0.286 0.146 1.964 0.050
Sunday 0.242 0.105 2.300 0.022
Monday 0.031 0.041 0.758 0.448
Tusday -0.170 0.076 -2.251 0.025
Wedensday -0.183 0.102 -1.800 0.072
Thursday 0.034 0.097 0.348 0.728
Egypt
1/1/1998-31/12/2004 Sunday 0.031 0.043 0.725 0.468
Monday 0.190 0.059 3.225 0.001
Tusday 0.174 0.056 3.105 0.002
Wedensday 0.254 0.053 4.767 0.000
Kuwait
17/6/2001-30/11/2005 Saturday 0.084 0.057 1.490 0.137
Sunday 0.211 0.071 2.976 0.003
Monday 0.354 0.075 4.692 0.000
Tusday 0.028 0.070 0.395 0.693
Wedensday 0.526 0.073 7.196 0.000
Oman
25/6/2000-13/10/2004 Sunday 0.000 0.000 1.112 0.266
Monday 1.000 0.029 34.647 0.000
Tusday 1.000 0.023 42.689 0.000
Wedensday 0.998 0.027 36.383 0.000
Thursday 0.997 0.032 31.555 0.000
Saudi Arabia
26/1/1994-14/3/2005 Saturday 0.170 0.038 4.489 0.000
Sunday -0.389 0.036 -10.888 0.000
Monday -0.010 0.035 -0.295 0.768
Tusday 0.017 0.046 0.364 0.716
Wedensday 0.107 0.046 2.337 0.020
Thursday 0.279 0.070 3.984 0.000
The estimated equation is: Rt = β 1 D1 + β 2 D2 + ... + β 6 D6 + ε.where
t
Rt is the daily return
which defined as ln(pt/pt-1);D1 through D6 are dummy variables such that if t is a Saturday, then D1=1 and D1=0 for all other days, if t
is a Sunday D2=1and D2=0 for all other days, and so forth; εt is a random term and β1-β6 are coefficients to be estimated using ordinary
least squares according to the trading days for each market.

147
Table 4-18
Chow Test for Structural Stability
Market AbuDhabi Jordan Bahrain Dubai Egypt Kuwait Oman Saudi
Break point 1-Jul-02 27-Jul-98 16-Sep-97 2-Mar-02 2-Jul-01 4-Nov-03 26-Aug-02 1-Sep-99
F -test 0.505 19.187 1.463 3.410 4.885 0.837 2.681 20.979
P -value 0.773 0.000 0.199 0.002 0.000 0.523 0.020 0.000
Chow test is implemented to test that the estimated coefficients are structurally stable over the entire sample period.

Wald Coefficient Restrections Test

Market AbuDhabi Jordan Bahrain Dubai Egypt Kuwait Oman Saudi
Chi-square 3518.986 236.374 3254.850 18.149 117.627 85.037 5327.819 160.265
Probability 0.000 0.000 0.000 0.006 0.000 0.000 0.000 0.000
Wald test tests the null hypothesis that β1 = β 2 = ... = β 6 = 0

Table 4-19
Day-of-the-Week Effect in the First Two Moments
Market AbuDhabi Jordan Bahrain
First trading day of the week Saturday Sunday Sunday
Mean Stand. Dev. Mean Stand. Dev. Mean Stand. Dev.
Returns on 1st trading day 0.0002 0.0019 0.0001 0.0035 0.0000 0.0023
Returns during Rest of the Week 0.0008 0.0053 0.0005 0.0076 0.0003 0.0568
Difference of Means Test 5.919** 6.147** 0.056
difference of Variance Test 207.518* 1263.56* 17.3*

Market Dubai Egypt Kuwait

First trading day of the week Saturday Sunday Saturday
Mean Stand. Dev. Mean Stand. Dev. Mean Stand. Dev.
Returns on 1st trading day 0.00000 0.0021 0.0001 0.0090 0.0005 0.0052
Returns during Rest of the Week 0.0004 0.0101 0.0005 0.0165 0.0020 0.0095
Difference of Means Test 1.920 1.119 18.06*
difference of Variance Test 199.78* 625.6* 306.91*

Market Oman Saudi

First trading day of the week Sunday Saturday
Mean Stand. Dev. Mean Stand. Dev.
Returns on 1st trading day 0.0001 0.0024 0.0001 0.0042
Returns during Rest of the Week 0.0004 0.0058 0.0005 0.0094
Difference of Means Test 3.619*** 4.452**
difference of Variance Test 397.969* 789.292*
*,**,*** indicate significant at 1%, 5%, 10% levels, respectively.
Difference of means test of the null hypothesis that the mean return of the first trading day of the week, is equal to the mean return during
the rest of the week. This test is based on a single-factor, between subjects, analysis of variance (ANOVA)
Difference of variance test of the null hypothesis that the variance of the first trading day return is equal to the variance return of the rest
of the week, depending on the Levene test

148
4-19, the difference-of-means test is statistically significant for all markets except
Bahrain, Dubai, and Egypt. Indicating that, the first trading day returns are significantly
positive and different from the returns during the rest of the week. Moreover, the standard
deviation of the first trading day is lower than the standard deviation during the rest of the
week, and a difference-of-variance test shows that the difference is statistically
significant for all markets, which indicate that first trading day returns are significantly
less volatile than returns during the rest of the week.
-Month-of-the-year effect (January effect)
Table 4-20 gives the results for January effect and those months, for which their
parameters found to be statistically significant. Despite the results that Bahrain, Dubai,
Oman, and Saudi Arabia do not exhibit January effect, all markets show signs of monthly
effect other than January; since several months’ parameters found to be positive and
statistically significant. The results for Jordan are incompatible with those of Maghayereh
(2003) since he does not find monthly effect in the Jordanian stock market, whilst the
results for Kuwait are constant with those of Al-saad and Moosa (2005) and Al-loughani
(2003).

Table 4-20
OLS Results for Month-of-the-Year Effect (January Effect)
Market Variable Coefficient Std. Error t-Statistic Prob.
Abu Dhabi
1/7/2001-31/12/2003 JANUARY 0.0002 0.0001 2.988 0.003
FEBROUARY 0.996 0.049 20.351 0.000
MARCH 1.002 0.033 30.489 0.000
ABRIL 0.999 0.027 36.988 0.000
MAY 1.003 0.035 28.401 0.000
JUNE 0.998 0.040 25.062 0.000
JULY 0.989 0.037 26.967 0.000
AUGUST 0.984 0.046 21.309 0.000
SEPTEMBER 1.000 0.025 39.953 0.000
OCTOBER 0.996 0.062 16.149 0.000
NOVEMBER 0.990 0.035 28.602 0.000
DECEMBER 0.989 0.033 29.636 0.000
Jordan
1/1/1992-14/3/2005 JANUARY 0.232 0.051 4.586 0.000
ABRIL 0.337 0.068 4.929 0.000
MAY 0.331 0.063 5.289 0.000
JUNE 0.310 0.070 4.456 0.000
JULY 0.216 0.048 4.468 0.000
AUGUST 0.241 0.055 4.342 0.000
SEPTEMBER 0.224 0.050 4.530 0.000
OCTOBER 0.280 0.071 3.974 0.000
NOVEMBER 0.372 0.060 6.197 0.000

149
…continue table 4-20
Market Variable Coefficient Std. Error t-Statistic Prob.
Bahrain
2/1/1991-3/6/2004 JANUARY 0.045 0.513 0.088 0.930
MAY -0.447 0.167 -2.685 0.007
AUGUST -0.499 0.015 -32.933 0.000
Dubai
26/3/2000-31/12/2003 JANUARY 0.186 0.189 0.988 0.323
JULY 0.259 0.125 2.073 0.038
AUGUST 0.417 0.176 2.370 0.018
Egypt
1/1/1998-31/12/2004 JANUARY 0.591 0.069 8.514 0.000
ABRIL 0.305 0.096 3.159 0.002
JULY 0.246 0.089 2.764 0.006
AUGUST 0.252 0.090 2.805 0.005
SEPTEMBER 0.237 0.076 3.120 0.002
OCTOBER 0.212 0.067 3.163 0.002
NOVEMBER 0.256 0.100 2.574 0.010
DECEMBER 0.319 0.090 3.525 0.000
Kuwait
17/6/2001-30/11/2005 JANUARY 0.361 0.155 2.323 0.020
MARCH 0.297 0.106 2.798 0.005
ABRIL 0.425 0.105 4.055 0.000
MAY 0.245 0.090 2.721 0.007
JUNE 0.279 0.089 3.138 0.002
SEPTEMBER 0.256 0.083 3.078 0.002
Oman
1/2/1997-13/10/2004 JANUARY 0.000 0.000 1.842 0.066
FEBROUARY 1.001 0.052 19.099 0.000
MARCH 0.997 0.045 22.168 0.000
ABRIL 0.999 0.032 31.412 0.000
MAY 0.996 0.030 33.267 0.000
JUNE 0.994 0.036 27.777 0.000
JULY 0.998 0.034 29.505 0.000
AUGUST 1.003 0.043 23.252 0.000
SEPTEMBER 1.000 0.036 27.835 0.000
OCTOBER 1.005 0.041 24.616 0.000
NOVEMBER 0.998 0.019 53.089 0.000
DECEMBER 1.001 0.030 33.892 0.000
Palestine
8/7/1997-28/2/2005 JANUARY 0.586 0.111 5.256 0.000
FEBROUARY 0.480 0.103 4.671 0.000
ABRIL 0.595 0.110 5.390 0.000
MAY 0.368 0.094 3.931 0.000
JULY -0.822 0.055 -14.943 0.000
SEPTEMBER 0.355 0.098 3.625 0.000
OCTOBER 0.320 0.086 3.713 0.000
Saudi Arabia
26/1/1994-14/3/2005 JANUARY 0.079 0.082 0.970 0.332
FEBROUARY 0.191 0.078 2.467 0.014
MARCH 0.247 0.067 3.714 0.000
ABRIL -0.302 0.032 -9.519 0.000
MAY 0.122 0.053 2.327 0.020
JULY 0.314 0.100 3.128 0.002
SEPTEMBER -0.116 0.051 -2.299 0.022
NOVEMBER 0.224 0.076 2.941 0.003
The estimated equation is: . Where
Rt = α 1 D1 + α 2 D2 + ... + α 12 D12 + ε t tR is the daily index
return which defined as ln(pt/pt-1), α1 through α12 are coefficients to be estimated using ordinary least
squares.D1-D12 are dummy variables such that if t is January, then D1=1 and D1=0 for all other monthes, if t

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 Furthermore, table 4-21 shows the result of Chow test which indicates that the
estimated coefficients are structurally unstable for three markets (Egypt, Palestine, and
Saudi), whereas the hypothesis that all parameters are insignificantly different from zero,
has been rejected for all markets.

Table 4-21
Chow Test for Structural Stability
Market AbuDhabi Jordan Bahrain Dubai Egypt Kuwait Oman Palestine Saudi
Break point 1-Jul-02 27-Jul-98 16-Sep-97 2-Mar-02 2-Jul-01 4-Nov-03 26-Aug-02 15-Oct-01 1-Sep-99
F -test 0.592 1.768 0.165 0.757 2.264 0.887 0.130 4.337 4.153
P -value 0.849 0.048 0.999 0.695 0.008 0.560 1.000 0.000 0.000
Chow test is implemented to test that the estimated coefficients are structurally stable over the entire sample period.

Wald Coefficient Restrections Test

Market AbuDhabi Jordan Bahrain Dubai Egypt Kuwait Oman Palestine Saudi
Chi-square 8787.846 220.879 1093.040 24.002 150.992 64.064 10466.45 352.900 144.061
Probability 0.000 0.000 0.000 0.020 0.000 0.000 0.000 0.000 0.000
Wald test tests the null hypothesis that β 1 = β 2 = ... = β 12 = 0

Moreover, table 4-22 indicates that the variance of returns are not equal, between
January and the rest of the year, while the mean returns in January and the rest of the year
found to be equal only in three markets (Bahrain, Dubai, and Egypt). The majority of
markets demonstrate some type of monthly effect, which could be confusing in that, it
cannot be explained under the umbrella of the existing explanations in the literature. For
instance, “window press” such that, investors sell in December those stocks that did not
doing well, in order to show reduced profit and pay less tax. This would results in lower
returns in December, whilst in January returns should rise due to reinvestment in new
stocks, but in our case, all returns in December are positive or not significant. Another
explanation could be “summer holiday”, in which we expect returns in July and August
to be negative, the case which exists only in Bahrain (negative August returns). However,
in the case of Arab stock markets; especially GCC stock markets; they witnessed a
considerable improvements in their activity and liquidity (see figures 2-2 and 2-4), as a
result of the huge raise in oil prices in the last two years, which produces a surplus in
liquidity in these countries, leading to increase the trading activity in their financial
markets.

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Table 4-22
Month-of-the-Year Effect in the First Two Moments
Market AbuDhabi Jordan Bahrain
Mean St. Dev. Mean St. Dev. Mean St. Dev.
Returns on January 0.0002 0.0012 0.0001 0.0026 -0.0001 0.0017
Returns during Rest of the year 0.0008 0.0053 0.0005 0.0076 0.0003 0.0568
Difference of Means Test 6.868** 7.621** 0.127
difference of Variance Test 281.24* 1868.31* 19.91*

Market Dubai Egypt Kuwait

Mean St. Dev. Mean St. Dev. Mean St. Dev.
Returns on January 0.0002 0.0016 0.0003 0.0055 0.0002 0.0019
Returns during Rest of the year 0.0004 0.0101 0.0005 0.0165 0.0020 0.0095
Difference of Means Test 0.829 0.236 34.99*
difference of Variance Test 218.4* 1027.5* 716.26*

Market Oman Palestine Saudi

Mean St. Dev. Mean St. Dev. Mean St. Dev.
Returns on January 0.0001 0.0018 0.0000 0.0041 0.0000 0.0020
Returns during Rest of the year 0.0004 0.0058 0.0011 0.0183 0.0005 0.0094
Difference of Means Test 3.49*** 4.081** 9.433*
difference of Variance Test 562.64* 593.31* 1383.88*
*,**,*** indicate significant at 1%, 5%, 10% levels respectively.
Difference of means test of the null hypothesis that the mean return of January, is equal to the mean return during the rest of the
months. This test is based on a single-factor, between subjects, analysis of variance (ANOVA)
Difference of variance test of the null hypothesis that the variance of January return is equal to the variance return of the rest months
depending on the Levene test.

- The Halloween effect

Figure 4-2 presents the average returns in the period May-October and the period
November-April for each market. As can be seen in figure 4-2, the differences in returns
among the two half-year periods are generally large and economically significant for 5
out of 9 markets.
Figure 4-2 Average Returns Among the Two Half-Year Periods

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 Table 4-23 shows the Halloween indicator in Arab stock markets. As mentioned
previously, a positive and significant α1 parameter is evidence of a Halloween effect.
Since α1 denotes the average returns in the period November-April in excess of the
average return during the other six months of the year. Table 4-23 indicates that, all
markets (except Dubai and Saudi) exhibit highly statistically significant Sell in May
effect at the 1% level.

Table 4-23
The Halloween Indicator in Arab Stock Markets
Rt = µ + α 1 S t + ε t

N. of
Countries observation Mean P-Value α1 P-value
AbuDhabi 512 0.0003 0.0873 0.9903 0.0000
Bahrain 3340 0.0003 0.7599 1.0008 0.0000
Dubai 1098 0.0004 0.1508 -0.0171 0.7654
Egypt 1733 0.0005 0.2468 0.1977 0.0000
Jordan 3226 0.0004 0.0008 0.2231 0.0000
Kuwait 688 0.0007 0.0549 0.9763 0.0000
Oman 1908 0.0001 0.4360 0.9998 0.0000
Palestine 1264 0.0003 0.4582 0.9973 0.0000
Saudi 3299 0.0005 0.0011 -0.0768 0.0008
R t represents monthly continuously compounded returns for the price indices. N , the number
of daily observations. The constant term µ represents the daily mean returns over the May-
October periods.The daily mean return over the November-April periods is represented by
µ+α 1 .

Following Fama’s arguments (Fama; 1998) that most long-term returns anomalies
tend to disappear with reasonable changes to technique, since Sell in May hypothesis
suggests that; average returns are higher during the period November-April than during
the period May-October. One might argues that, since the January effect generates high
positive returns in many stock markets, the Sell in May effect is simple a January effect
in disguise. To test for this hypothesis, we considered an additional regression and give
Sell in May Dummy the value 1 in the period November to April, except January. While
for January, we add an additional dummy. Table 4-24 presents the results of the
Halloween indicator with adjustment for January effect, the results indicate that all access
returns in January are entirely due to January effect (α2) and not caused by Sell in May
effect. Note that, the Halloween effect which presented by α1 still the same, highly

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statistically significant without any noticeable reduction in α1’s values except for Egypt.
Indicating that despite the addition of January dummy, the Sell in May effect still exists
in 7 out of 9 Arab stock markets.

Table 4-24
The Halloween Indicator in Arab Stock Markets with January
Effect Adjustment Rt = µ + α 1 S t + α 2 J t + ε t
Countries Mean P-Value α1 P-value α2 P-value
AbuDhabi 0.0003 0.0863 0.9925 0.0000 0.9710 0.0000
Bahrain 0.0003 0.7595 0.9988 0.0002 1.0103 0.0870
Dubai 0.0004 0.1795 -0.0349 0.5617 0.1618 0.3960
Egypt 0.0003 0.3919 0.0952 0.0088 0.5876 0.0000
Jordan 0.0004 0.0008 0.2227 0.0000 0.2243 0.0000
Kuwait 0.0007 0.0551 0.9770 0.0000 0.9721 0.0000
Oman 0.0001 0.4357 0.9999 0.0000 0.9979 0.0000
Palestine 0.0003 0.4582 0.9970 0.0000 0.9992 0.0000
Saudi 0.0005 0.0010 -0.0895 0.0002 0.0775 0.3502
R t represents monthly continuously compounded returns for the price indices. N , the number of daily
observations. The constant term µ represents the daily mean returns over the May-October periods.The daily
mean return over the November-April periods is represented by µ+α 1 . The impact of January returns
represented by α 2 .

4-6 Summary
We have tried to answer the question whether Arab stock markets are efficient in
the weak-form sense. The empirical results obtained, enable us to provide strong
evidence against the random walk hypothesis for Arab stock markets. The results
obtained from regression analysis, variance ratio, BDS, runs test, and serial correlation
tests, reject the randomness and independence of the returns generating process, even
after indices have been corrected for infrequent trading. These results are consistent with
the existing literature for emerging markets, since many evidences of predictability in
emerging markets have been found and rejected the hypothesis that lagged price
information cannot predict future prices (Bekaert 1995; Harvey 1995b, 1995c; Claessense
et al. 1995; Buckberg 1995; Haque et al. 2001, 2004; and Bailey at al. 1990). Moreover,
the results indicate that, prices responding non-linearly to new information, while
volatility clustering phenomenon still seems to characterized markets’ returns. The
GARCH (1,1) results for daily data indicate that, all markets exhibit volatility clustering
with one exception for Dubai. Furthermore, volatility seems to be persistent in three

154
markets (Egypt, Kuwait, and Palestine) with a slow rate of decay, Oman displays an
increasing response function of volatility; shocks do not decay with time. Additionally,
four Arab markets (Bahrain, Dubai, Kuwait, and Oman) show signs of leverage effect
and asymmetric shocks to volatility.
The results also indicate that, the GARCH models explain quite satisfactory the
dependencies of the first and second moments; that are presented in the stock return
series, while the second moment found to be quite enough to explain the non-linearity
structure that has been found in the time series. The next task of this chapter was to
investigate the existence of calendar effects in Arab stock markets. The results indicate
that three calendar effects found to be in Arab markets, day-of-the-week, month-of-the-
year effects, and the Halloween indicator. However, the style of the first two anomalies is
not consistent with the existing literature. For instance; for most of the Arab markets; the
first trading day of the week found to be positive and significantly different from the rest
of the week’s returns, while several months of the year found to be significantly positive.
None of the existing explanations in the literature (tax loss, trading time, calendar
time hypothesis) reveal to be appropriate to explain these anomalies. One explanation
might be; according to the surplus liquidity between investors (especially GCC
investors), as a result of the sharp rise in oil prices and according to the lack of other
investment opportunities, site these markets as an attractive target for these investments.
This leads to huge improvements in most markets indicators during the last three years
such as market size and liquidity indicators.
In sum, the results obtained from this chapter enable us to declare that, Arab stock
markets under examination here are not efficient in the weak-form sense.

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 Are Arab Stock markets
Methodology Integrated among themselves and
With Other International Stock
Markets? If Yes, How Do Shocks
Generated By International Stock
Markets Especially UK, US, and
Japan Affect Arab Stock
Markets?

Unit root test ADF, PP, and KPSS.

Multivariate cointegration, Johansen cointegration test.

Causality and vector error correction models (VEC).

Structural vector autoregressive (SVAR).

Vector auto regressive (VAR).

Granger causality test.

Correlation coefficients.
Findings
156
Can Arab Stock Markets Offer,
for Both Regional and
International Investors Unique
Risk and Returns Characteristics
to Diversify International and
Regional Portfolios?

Arab stock markets are segmented
from international markets, even in
the short term horizon.

The segmentation also exists between
non-oil countries.

One cointegrating relation was found
among Arab stock markets.

Weak linkages between Arab
markets in the short run.

GCC stock markets found to be
integrated with one cointegration
relation, with weak short-term
interrelation.

Arab stock markets can offer both
international and regional portfolio
investors with diversification
potentials.
 Methodology What Is the Effect of Oil Prices on the Performance of
GCC Stock Market?, And Whether These Markets
Have Predictive Power on Oil Prices or Vice Versa?

GARCH (1,1) model with oil prices as an additional regressor in variance

equation.

Multivariate cointegration analysis between GCC markets and oil prices.

Vector error correction model among oil prices and GCC markets.

Vector autoregressive (VAR) analysis between oil and GCC markets (under the
form of event studies).

There is cointegrating relation between oil and GCC

markets.

Oil prices have significant role on GCC returns’
Findings volatility.

After the raise in oil prices, four of GCC markets
can predict oil prices while only two markets can be
predicted by oil prices.

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5- Financial integration and diversification benefits among Arab and international
stock markets
Over the last 20 years, financial markets have become highly integrated, mainly
due to reductions in the cost of information, improvements in trading systems technology
and the relaxation of legal restrictions on international capital flows. The changes have
accelerated the interaction among financial markets and the enlargements of capital
mobility. Moreover, gains from international portfolio diversification are related
inversely to the correlation of equity returns, according to modern portfolio theory. In
line with this theory, investors have become highly active, investing in foreign equity
markets as a risk diversification strategy.
Numerous studies have demonstrated the advantage of international
diversification related to low correlation between various equity markets, such as Eun
and Resick (1984), Wheatly (1988), Meric and Meric (1989), Baily and Stulz (1990),
Divecha et al. (1992), Michaud et al. (1996), Meric et al. (2001), and Bulter and Joaquin
(2002). As developed in Gilmore and McManus (2002), the low correlations could be
explained by different types of barriers and regulations between the markets under
consideration. However, recent studies outlined in Gilmore and McManus (2002) reveal a
significant increase in correlations between equity markets, especially during and after
the 1987 international equity markets crash.
This tendency for the global markets to become more integrated is a result of the
increasing tendency toward liberalization and deregulation in the money and capital
markets, both in developed and developing countries as well as on a bilateral and
multilateral basis, commencing from, for example, trade liberalization and multilateral
trade initiatives. Such liberalization is important to introduce structural reforms, to
promote economic efficiency, to estimate trade and investment, and to create a necessary
climate for promoting sustainable economic growth with a commitment to market-based
reforms. As a sequence, increases in correlations between markets would imply a
decrease in the benefits from international diversification in line with portfolio theory.
Furthermore, long-run linkages between stock markets have important regional
and global implications at the macro-level, as a domestic capital market cannot be
insulated adequately from external shocks, thus the scope for independent monetary

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policy may become limited. It is argued in Errunza et al. (1999) that the use of return
correlations at the market index level to infer gains from international diversification,
involving foreign-traded assets overstates the potential benefits. The gains must be
measured beyond those attainable through home-made diversification by mimicking
returns on foreign market indices with domestically traded securities.
In addition, Kasa (1992) argued that benefits from international diversification
evaluated by low correlations, can be overstated if the investor has a long-term
investment horizon and the markets are trading together. The implication of this is that,
any benefits that arise from diversification will be eradicated in the long run and,
therefore, investors with long-run horizons may not actually benefit from international
portfolio diversification. As a sequence, recent studies have used cointegration techniques
to analyze long-run linkages and co-movements, especially between US and various
emerging markets. The results concerning long-term diversification benefits for US
investors are somewhat mixed. Long-term linkages between US and various European
stock markets are found in Kasa (1992) and Arshanapalli and Doukas (1993), but results
in Bayers and Peel (1993), Kanas (1998), and Maneschiold (2004) suggest that there are
no such linkages.
Mixed results also found between the USA and the Pacific area, as discussed in
Gultekin et al. (1989), Harvey (1991), Cambell and Hamao (1992), and Sewell et al.
(1996), as well as for a group of Asian countries, as discussed in Neih and Chang (2003),
Gilmore and McManus (2002). While the integration between some Arabian markets and
US discussed in Maneschiold (2005), who finds that Egypt can offer diversification
benefits for US investors. Darrat and Hakim (2000) find that stock markets in the Middle
East are segmented from the global markets. While Neaime (2002) finds that GCC stock
markets, still offer diversification benefits for international investors. However, the
results between US and international markets reveal, in general, a higher degree of
independence with emerging markets than developed markets. Given the increased
correlations in recent periods between various international equity markets and the
general results from previous studies, investors are searching for markets that are more
promising for diversification benefit, Gilmore and McManus (2002) find evidence of
diversification benefits between US markets and the newly re-opened markets in the

159
Czech Republic, Hungary and Poland, while Maneschiold (2004) finds evidence of this
between the USA and the Baltic states.
The purpose of this chapter is to analyze possible diversification benefits, which
Arab stock markets may offer for both regional and international investors. The analysis
will be carried out on different levels. Firstly, the diversification potentials for
international investors will be analyzed. The US stock market (S&P 500) will be used to
represent the world markets, in view of the growing evidence that assigns considerable
weight to the US market in global capital markets. Second, the integration among Arab
stock markets them selves will be investigated. And finally, it is important to take into
account the important features that affect Arab stock markets, such as oil prices, so the
dynamic relationships between GCC stock markets and oil prices will be analyzed.

5-1 International integration of Arab stock markets

In order to investigate the possible diversification benefits for international
investors in the Middle East region, the analysis will relay on the Johansen cointegration
procedures, as well as Granger causality and correlation tests, to reveal short and long-
run relationship between Arab and international markets, and the possible diversification
benefits for US investors on a multivariate basis. Moreover, to investigate the dynamic
relationship in the short-run between Arab and international stock markets, the structural
vector auto regressive (SVAR) will be used to trace the effect of shocks, generated by
international stock market, on Arab markets.

5-1-1 Unit root test

A prerequisite for cointegration is that non-stationary series are integrated of the
same order. Therefore, the first step is to determine the order of integration for each
variable. Three tests will be employed in this investigation: the augmented Dickey-Fuller,
the Phillips-Perron, and the Kwaitkowski-Phillips-Schmidt-Shin (KPSS) tests (Dickey
and Fuller 1979; Phillips and Perron 1988; Kwaitkowski et al. 1992).
The basic features of unit root tests can be presented as follows, consider a simple
AR(1) process:

160
 y t = ρy t −1 + δ ′x t + ε t , (5-1)

where xt are optional exogenous regressors which may consist of constant, or a constant
and trend, ρ and δ are parameters to be estimated, and the εt are assumed to be white
noise. If |ρ| ≥ 1, y is a non stationary series and the variance of y increases with time and
approaches infinity. If |ρ| <1, y is a (trend-) stationary series. Thus the hypothesis of
(trend-) stationary can be evaluated by testing whether the absolute value of ρ is strictly
less than one.
In general, one can test the null hypothesis H0: ρ=1against the one-side alternative
H1: ρ <1. In some cases, the null is tested against a point alternative. In contrast, the
KPSS Lagrange Multiplier test evaluates the null of H0: ρ<1 against the alternative H1:
ρ=1.
- The augmented Dickey-Fuller (ADF) test
The standard Dickey-Fuller test is carried out by estimating (5-1) after subtracting
yt-1 from both sides of the equation:

∆y t = αy t −1 + δ ′xt + ε t (5-2)

where α=ρ-1. The null and alternative hypothesis may be written as H0: α=0, H1: α<0
and evaluated using the conventional t-ratio for α:

ta = aˆ /( se( aˆ ))

where â is the estimated α, and se (aˆ ) is the coefficient standard error.

Dickey and Fuller (1979) show that under the null hypothesis of a unit root, the
statistic does not follow the conventional Student’s t-distribution, and they derive
asymptotic results and simulate critical values for various test and sample sizes. More
recently, MacKinnon (1991, 1996) implements a much larger set of simulations than
those tabulated by Dickey and Fuller. In addition, MacKinnon estimates response

161
surfaces for the simulation results, permitting the calculation of Dickey-Fuller critical
values and P-values for arbitrary sample size.
The simple Dickey-Fuller unit root test described above is valid only if the series
is an AR(1) process. If the series is correlated at higher order lags, the assumption of
white noise disturbances εt is violated. The Augmented Dickey-Fuller (ADF) test
constructs a parametric correction for higher order correlation by assuming that the y
series follows an AR(p) process and adding p lagged difference terms of the dependent
variable y to the right-hand side of the test regression:

∆y t = ay t −1 + δ ′xt + β 1 ∆y t −1 + β 2 ∆y t − 2 + ... + β p ∆y t − p + u t (5-3)

this augmented specification is then used to test the null hypothesis that H0: α=0 against
H1: α<0, using the t-ratio. An important result obtained by Fuller is that the asymptotic
distribution of the t-ratio for α is independent of the number of lagged first differences
included in the ADF regression.
Moreover, while the assumption that y follows an autoregressive (AR) process
may seem restrictive, Said and Dickey (1984) demonstrate that the ADF test is
asymptotically valid in the presence of a moving average (MA) component, provided that
sufficient lagged differences terms are included in the test regression.
Moreover, there are two practical issues in performing an ADF test. First, one
must choose whether to include exogenous variables in the test regression. You have the
choice of including a constant, a constant and a linear time trend, or neither, in the test
regression. One approach would be to run the test with both a constant and a linear trend
since the other two cases are just special cases of this more general specification.
However, including irrelevant regressors in the regression will reduce the power of the
test to reject the null of a unit root.
Second, you will have to specify the number of lagged difference terms, to be
added to the regression (zero yields the standard DF test; integers greater than zero
correspond to ADF tests).

162
 - The Phillips-Perron (PP) test
The PP method proposes as an alternative (non-parametric) method of controlling
the serial correlation with testing for a unit root. The PP method estimates the non-
augmented Dickey-Fuller test, and modify the t-ratio of the α coefficient, so that, serial
correlation does not affect the asymptotic distribution of the test statistic. The PP test is
based on the statistic

1/ 2
~ γ  T ( f 0 − γ 0 )(se(aˆ ))
ta = t a  0  − (5-4)
 f0  2 f 01 / 2 s

where â is the estimate; ta the t-ratio of α, se( â ) is coefficient standard error; s is the
standard error of the test regression. In addition, γ0 is a consistent estimate of the error
variance calculated as (T-k) s2/T, where k is the number of regressors. The remaining
term, ƒ0, is an estimator of the residual spectrum at frequent zero.

- The Kwiatkowski, Phillips, Schmidt, and Shin (KPSS) test

The Kwaitkowski et al. (1992) KPSS test, differs from the other unit root tests in
that, the series yt is assumed to be (trend-) stationary under the null. The KPSS statistic is
based on the residuals from the OLS regression of yt on the exogenous variables Xt:

yt = xt δ ′ + ut (5-5)
the LM statistic is be defined as:
LM = ∑ s (t ) / T 2 f 0
2
( ) (5-6)
t

where f0, is an estimator of the residual spectrum at frequency zero and where s(t) is a
cumulative residual function:
t
s (t ) = ∑ u t
r =1

5-1-2 Multivariate cointegration

The finding that many macro time series may contain a unit root has spurred the
development of the theory of non-stationary time series analysis. Engle and Granger

163
(1987) pointed out that a linear combination of two or more non-stationary series may be
stationary. If such a stationary linear combination exists, the non-stationary time series
are said to be cointegrated. The stationary linear combination is called the cointegrating
equation and may be interpreted as a long-run equilibrium relationship among the
variables.
The purpose of the cointegration test is to determine whether a group of non-
stationary series is cointegrated or not. The presence of a cointegrating relation forms the
basis of the VEC specification. To check whether the series are cointegrated, specifically,
having established the presence of a unit root in the first-difference of each variable, we
need to test whether the series in each market has different unit root (non-cointegrated),
or share the same unit root (cointegrated). Cointegrated variables, if disturbed, will not
drift apart from each other and thus possess a long-run equilibrium relationship. The
existence of cointegration between two series would imply that the two series would
never drift too far apart. A non-stationary variable, by definition, tends to wander
extensively over time, but a pair of non-stationary variables may have the property that a
particular linear combination would keep them together, that is, they do not drift too far
apart. Under this scenario, the two variables are said to be cointegrated, or possess a long-
run (equilibrium) relationship.
Cointegration can be tested on bivariate base using two stage method of Engle
and Granger (1987), while a multivariate cointegration test can be carried out using
Johansen (1988) approach based on the autoregressive representation.
If there are two variables, xt and yt, which are both non-stationary in levels but
stationary in first difference, then xt and yt are integrated of order one, I(1), and their
combination having the form z t = xt − ayt is also I(1). However, if zt is integrated of
order zero, I(0), the linear combination of xt and yt is stationary and the two variables are
said to be cointegrated. If two variables are cointegrated, there is an underlying long-run
relationship between them. In the short-run the series may drift apart, but if they are
cointegrated, they will move toward long-run equilibrium through an error-correction
mechanism.
If xt and yt are integrated of the same order, the Engle-Granger method then
estimates the long-run equilibrium relationship as:

164
 yt = β 0 + β1 xt + et (5-7)

using ordinary least squares (OLS). The residual series et is then tested for stationary:

∆et = α1et −1 + ε t (5-8)

rejection the null hypothesis α1 = 0 implies that the residual series is stationary and that
the two series are cointegrated. Engle and Granger provide statistics to test the hypothesis
α1 = 0. When more than two variables are involved, the appropriate tables are of those of
Engle and Yoo (1987). If the variables are found to be cointegrated, an error-correction
model can then be estimated using the residuals from the equilibrium regression:

∆y t = α 1 + α y et −1 + ∑ α 11 ∆y t −i + ∑ α 12 ∆xt −i + ε yt (5-9)

∆xt = α 2 + α x et −1 + ∑ α 21 ∆y t −i + ∑ α 22 ∆xt −i + ε xt (5-10)

The Engle-Granger procedure has several problems. It is a two-step procedure, so

any error introduced in estimating the error term comes into the error-correction model.
Also, it requires that one variable be placed on the left-hand side of the equation, with the
other variables as regressors in the cointegrating equation. The results of one regression
may indicate that the variables are cointegrated, while the other regression suggests no
cointegration.
The Johansen (1988) approach circumvents the use of two-step estimators and
estimates as well as tests for the presence of multiple cointegrating vectors. This method
relies on the relationship between the rank of a matrix and its characteristic roots, or
eigenvalues. Let xt be a vector on n time series variables, each of which is integrated of
order (1) and assume that xt can be modeled by a vector autoregressive (VAR):

yt = A1 yt −1 + ... + A p y t − p + β xt + ε t (5-11)

165
where yt is a k-vector of non-stationary I(1) variables; xt is a d-vector of deterministic
variables; and εt is a vector of innovations, we can write this VAR as

p −1
∆y t = ∏ y t −1 + ∑ Γi ∆y t −i + β xt + ε t (5-12)
i =1

where
p p

∏ = ∑ Ai − I , Γi = − ∑ A j
i =1 j =i +1
(5-13)

Granger’s representation theorem asserts that, if the coefficient matrix ∏ has

reduced rank r<k, then there exist k*r matrices a and β each with rank r such that
Π = α β ′ and β ′yt is I(o). r is the number of cointegrating relations (the cointegrating

rank) and each column of β is the cointegrating vector. The elements of α are known as
the adjustment parameters in the VEC model. Johansen’s method is to estimate the ∏
matrix from an unrestricted VAR, and test whether we can reject the restrictions implied
by the reduced rank of∏.
Three cases are possible, first, if Π is of full rank, all elements of y are stationary
and none of the series has a unit root. Second, if the rank of Π=0, there are no
combinations which are stationary and there are no cointegrating vectors. Third, if the
rank of Π is r such that 0<r<k, then the y variables are cointegrated and there exist r
cointegrating vectors. The number of distinct cointegrating vectors can be obtained by
determining the significance of the characteristics roots of Π. To identify the number of
characteristic roots that are not different from unity, we can use two statistics, the trace
test and the maximum eigenvalue test:

λtrace (r ) = −T ∑ ln(1 − λi ) (5-14)

λmax (r, r + 1) = −T ln(1 − λr +1 ) (5-15)

166
where λ equals the estimated values of the characteristic roots (eigenvalues) obtained
from the estimated Π matrix, r is the number of cointegrating vectors, and T equals the
number of usable observations.
The trace test evaluates the null hypothesis that the number of distinct
cointegrating vectors is less than or equal to r against a general alternative. The
maximum eigenvalue test examines the number of cointegrating vectors versus that
number plus one. If the variables in yt are not cointegrated, the rank Π is zero and all
characteristics roots are zero. Since Ln (1) = 0, each of the expression Ln (1-λi) will equal
zero in that case. Critical values for the test are provided by Johansen and Juselius (1990)
and by Osterwald-Lenum (1992).

5-1-3 Structural VAR (SVAR)

When Sims (1980) introduced vector autoregression (VAR) into economics, the
main thrust was that VAR modeling avoids “incredible” identifying assumptions made by
traditional large-scale macroeconomic models. Subsequently, the great bulk of structural
VAR work has focused on contemporaneous relationships between variables or between
residuals in a system of equations. Sims and Zha (1999) show how to make Bayesian
inference under a flat prior in both reduced-form VARs and identified VARs. In that
paper, they consider various types of identifying restrictions only on contemporaneous
coefficients.
There are instances, however, in which over-identification in VAR relates to lag
structure as certain lags do not enter certain equations. In many empirical applications,
such restrictions are not unreasonable; on the contrary, restrictions on the lag structure are
necessary precisely on the ground of economic reasoning. These situations frequently
stem from some block exogeneity restrictions such as the crucial small-open-economy
feature in international economics from some beliefs that certain lags do not appear in
certain equations (e.g., Zellner and Plam, 1974; Zellner, 1985; Leeper and Gordon, 1992;
Sims and Zha, 1995; Bernank et al., 1997). Failing to impose these restrictions because
they may complicate statistical inference not only is economically unappealing, but also
may result in misleading conclusions.

167
 In order to introduce the basic elements of VAR analysis, suppose that we can
represent a set of n economic variables using a vector (a column vector) yt of stochastic
processes, jointly covariance stationary without any deterministic part and possessing a
finite order (p) autoregressive representation

A( L) yt = ε t (5-16)

A( L ) = I − A1 L − ... − A p L p (5-17)

the roots of the equation det[A(L)] are outside the unit circle in the complex domain and
εt has an independent multivariate normal distribution with zero mean

εt ∼ IMN(0,Σ)
E(εt) = 0
E (ε t ε t′ ) = Σ det( Σ ) ≠ 0

E (ε t ε s′ ) = [0] s≠t

in other words, εt is a normal distributed vector white noise (VWN).

The yt process has a dual Vector Moving Average representation (Wold
representation)
Yt = C(L) εt
C(L) = A(L)-1
C(L) = I + C1L + C2L2 +…
Where C(L) is a matrix polynomial which can be of infinite order and for which it has
been assumed that the multivariate invertibility conditions hold, i.e. det[C(L)] = 0 has all
the roots outside the unit circle, so
C(L)-1 = A(L)
Suppose that there are T+p observations for each variable represented in the yt vector; we
are thus able to study the system

A(L)yt = εt t=1,…T (5-18)

168
This system can be conceived as a particular reduced form (in which all variables can be
seen as endogenous).
A VAR model has to be considered as a reduced form model where no
explanations of the instantaneous relationships among variables are provided. These
instantaneous relationships are naturally hidden in the correlation structure of Σ matrix,
and left completely un-interpreted. This becomes evident when the model is put into its
equivalent Vector Moving Average (VMA) representation, where the interpretability of
the coefficients becomes problematic, given the contemporaneous correlation structure of
the error terms. Sims’ (1980) original proposal consisted in moving from a non-
orthogonal VMA to an orthogonalized VMA representation via Choleski factorization of
the Σ matrix. This amounts to starting from the reduced form VAR representation
A(L)yt = εt , εt ∼ VWN(0,Σ)
where εt is a normal distributed vector white noise (VWN), and to pre-multiply the system
by the inverse Choleski factor of Σ

A*(L)yt = et , et ∼VWN (0,In)

p
A* ( L) = ∑ Ai* , A0* = p −1 , Ai* = p −1 Ai , pp ′ = Σ
i =0

where p is the Choleski factor of Σ, and clearly A0* is lower triangular with unit diagonal
elements. This amounts to modeling contemporaneous relationships among the
endogenous variables in a triangular recursive form. The resulting orthogonal VMA
representation is

∞ ∞
y t = ∑ C i pet −i = ∑ Φ i et −i , Φ i = Ci , Φ 0 = p
i =0 i =0

notice that, since Φ0 = p, the orthogonal VMA representation shocks et have instantaneous
effects on the elements of yt according to the triangular scheme given by the Choleski
factor p.

169
 Moreover, it is true that given the matrix Σ, the Choleski factor p is uniquely
determined. Nevertheless, if the elements of yt were permuted and arranged in y t* , the
rows and columns in Σ would have to be permuted accordingly to generate Σ*. The matrix
Σ* would then have a different Choleski factor: p * p′* = Σ * which would produce a
different orthogonalized VMA representation. Therefore, the orthogonal VMA
representation corresponding to the Choleski decomposition of variance covariance
matrix of the reduced form disturbances is unique only given a particular ordering of the
observable variables contained in yt.
The triangular representation, which is sometimes referred to as Wold causal
chain, is clearly a very particular one which cannot be considered suitable to every
applied context. Sometimes, the researcher might have in mind different schemes for
representing these instantaneous correlations, outside the straitjacket of the triangular
structures.
In recent literature, these alternative ways of modeling instantaneous correlation
can be summarized in the following terms. Recent literature on the so-called structural
VAR approach uses different ways of structuring the VAR model such as the K-model,
the C-model, and the AB-model.

- K-model
In the K-model, K is a (n*n) invertible matrix such that

KA(L)yt = K εt
K εt = et
E(et) = 0 E (et et′ ) = I n

The K matrix “premultiplies” the autoregressive representation and induces a

transformation on the εt disturbances by generating a vector (et) of orthogonalized
disturbances (its covariance matrix is not only diagonal, but also equal to the unit matrix
In). Contemporaneous correlations among the elements of y are therefore modeled

170
through the specification of the invertible matrix K. the structural K-model can be thought
of as a particular structural form with orthonormal disturbance vector.
Note that, assuming we know the true variance covariance matrix of εt terms from
Kε t = et

Kε t ε t′K ′ = et et′
taking expectations, one immediately obtains
KΣK ′ = I n
the previous equation implicitly imposes n(n+1)/2 non-linear restrictions on the K matrix,
leaving n(n-1)/2 free parameters in K.

- C-model
C is a (n*n) invertible matrix such that
A(L)yt = εt
εt = Cet
E(et) = 0 E (et et′ ) = I n
In this particular structural model, we have a structural form where no instantaneous
relationships among the endogenous variables are explicitly modeled. Each variable in
the system is affected by a set of orthonormal disturbances whose impact effect is
explicitly modeled via the C matrix.
Sims (1988) stresses the point that there is no theoretical reason to suppose that C
model should be a square matrix of the same order as K. If C were a square matrix, the
number of independent (orthonormal) transformed disturbances would be equal to the
number of equations. Many reasons lead us to think that the true number of originally
independent shocks to our system could be very large. In that case, the C matrix would be
a (n*m) matrix, with m much greater than n.
In this sense, this research path is opposite to the one studied by the factor
analysis, which attempts to find m (the number of independent factors) strictly smaller
than n. the case of a rectangular (n*m) matrix C, with m>n, conceals a number of
problems connected with the completeness of the model and the aggregation over agents
(see Blanchard and Quah, 1989). In the C-model, the εt vector is regarded as being

171
generated by a linear combination of independent (orthonormal) disturbances. This may
have a different meaning than that of the K-model, where one is concerned with the
explicit modeling of the instantaneous relationships among endogenous variables.
As for the C-model, notice that from
ε t = Cet
ε t ε t′ = Cet et′C ′
taking expectations,
Σ = CC ′
if, again, we assume to know Σ, the previous matrix equation implicitly imposes a set of
n(n+1)/2 non-linear restrictions on the C matrix, leaving n(n-1)/2 free elements in C.

- AB-model
A,B are (n*n) invertible matrices such that:
A A(L)yt = A εt
A εt = Bet
E(et) = 0 E (et et′ ) = I n
In this kind of structural model, it is possible to model explicitly the instantaneous links
among the endogenous variables, and the impact effect on the orthonormal random
shocks hitting the system. Notice that A matrix includes a transformation on the εt
disturbances vector, generating a new vector (Aεt) that can be conceived as being
generated by linear combinations (through the B matrix) of n independent (orthonormal)
disturbance. Obviously this structure might have a different meaning than those of
models K and C.
Notice also that the AB-model can be seen as the most general parameterization
nesting the C and K models as special cases. In fact, the C-model can be seen as a
particular case of the AB-model, where A is chosen to be the identity matrix and the K-
model corresponds to an AB-model with a diagonal B matrix. As in the previous case,
from
A εt = Bet
Aε t ε t′ A′ = BB′

172
for Σ known, this equation again imposes a set of n(n+1)/2 non-linear restrictions on the
parameters of the A and B matrices, leaving overall 2n2-n(n+1)/2 free elements.
For more investigation of the relationship between Arab and international stock
markets, the structural vector autoregression (SVAR) will be used to analyze the
importance of interconnection between financial markets. The relationship between
international markets (US, UK, and Japan) and each of the Arab stock markets will be
investigated. The model incorporate the assumption that the returns on each of the three
international markets, affect the returns on Arab markets but not vice versa. In other
words, how do Arab stock markets response to shocks generated by international stock
markets. The main purpose of SVAR is to obtain non-recursive orthogonolization of the
error terms for impulse response analysis.
In order to incorporate and capture the dynamic relationship among prospective
returns, a block recursive model, similar to the SVAR model used by Zha (1999),
Cushman and Zha (1997), and Berument and Ince (2005), will be used to examine the
effect of a large economy’s stock exchange movements (in our case US, UK, and Japan)
on a small economy’s stock exchange movements (each of the Arab stock markets). The
foreign stock exchange index follows its own dynamics (an AR process is used as a
proxy). Domestic stock exchange movements are affected by its own lag and movements
of the foreign stock exchange. Therefore, the foreign stock market can be thought to have
an exogenous effect on the domestic stock exchange. None of the lag variables of the
domestic market determine foreign stock exchange; however, lag values and spot values
of the foreign stock exchange affect domestic stock exchange.
The VAR model has some advantages relative to the single equation model, since
the VAR model allows dynamic interactions among variables and the VAR model has
predictive power compared to the single equation model. VAR with block exogeneity is
also used, since in conventional VAR; stock exchange movements of foreign markets are
affected by domestic stock exchanges including lag values. By block exogeneity, this
problem is overcome.
The general specification of the identified VAR model of Cushman and Zha
(1997) is:

173
 A(L) y(t ) = ε t (5-19)

in which, the A(L) is an mxm matrix polynomial in the lag operator L, y(t) is the mx1
observations vector and εt is the mx1 vector of structural disturbances. Equation (5-20)
shows the specification of the model.

 y (t )  A (L ) 0  ε (t )
y (t ) =  1 , A(L ) =  11 , ε (t ) =  1  (5-20)
 y 2 (t )  A21 (L ) A22 (L ) ε 2 (t )

in equation (5-20), it assumed that ε(t) is uncorrelated with y(t-j) for j>0 and A(0) is non-
singular. Block exogeneity is represented by A12(L) in the matrix, which is zero. This
means that y1(t) is exogenous to the second block both simultaneously and also for lagged
values. The observation matrices are such that y1 = [Foreign stock exchange], y2 =
[Domestic stock exchange].

5-2 Transmission of stock prices movements between Arab stock markets

Capital markets across countries or regions may exhibit varying degree of
integration (or segmentation). Theoretically, market linkages primarily stem from the
“low of one price” that identical assets; physical or financial, should bear the same price
across countries after adjusting for transaction costs. Rational (well-informed) investors
would, or perhaps should, arbitrage away price disparities, leading to more integrated
markets.
For the last few years, the development of financial markets in the Middle East
region has opened a new era of mobility of financial resources, whereby flow of private
capital has assumed an increasing role as a source of finance for these markets. More
favorable developments have been taking place in most Arab stock markets to attract
regional investors. Moreover, countries that share geographical proximity and have
similar groups of investors are more than likely to have markets that influence each other.
And when a stock is dually listed in two countries, shocks in one market can be
transmitted to the other market through the security, plus investors in one market may
react directly and indirectly to an initial stock in another market.

174
 In this sequence, questions of market integration among Arab tock markets
themselves, are of concern both to regional investors, and companies in the region that
make capital budgeting decisions. Specifically, if segmentation exists and a firm is forced
to raise capital locally, then its cost of capital is likely to be higher than that of a company
with unrestricted access to the regional and international capital markets. Therefore, one
would expect the restriction to the local capital market, to raise a firm’s cost of capital.
The focus of this section will be firstly, to examine the relationship among Arab
stock markets. Second, to what extent and how rapid shocks induced by innovations in
one market, are borne by another markets. Third, we explore whether there is a dominant
market among Arab markets that links all other markets and makes most of their
independence. Furthermore, despite the fact that Arab countries enjoy several common
features, there still exist some differences especially in natural resources, such as oil
production. So the whole markets will be divided into two groups: oil production
countries, represented by GCC stock markets, and non-oil production countries; which
includes Jordan, Egypt, and Palestine.
In order to investigate the long-run relationship among Arab markets, Johansen
cointegration technique will be used, while Granger causality, coefficient-correlation and
vector autoregressive (VAR) will be employed to trace the short-run dynamics.

5-2-1 Granger causality

Causality is defined as in Granger (1969), where the Granger method determines
to what degree a current endogenous variable; can be explained by past values of the
variable and whether the explanatory power; can be improved adding lagged values of
another exogenous variable. If this is the case, the exogenous variable is said to Granger
cause the endogenous variable. The Granger causality is measured by estimating an
unrestricted and a restricted version of the equation

n n
yt = α 0 + ∑ α i y t −1 + ∑ β t − j xt − j + ε t (5-21)
i =1 j =1

175
and employing an F-test to determine if the parameters of the exogenous variable are
significantly different from zero, i.e. if the exogenous variable Granger cause the
endogenous variable. The constant is denoted by α0 and εt is a white noise error term.

5-2-2 Vector autoregression (VAR)

The VAR technique as applied to a simultaneous equation system, estimates
unrestricted reduced form equations with uniform sets of the lagged dependent variables
of each equation as regressors. Because this approach sets no restrictions on the structural
relationships of the economic variables, it avoids mis- specification problems. The VAR
methodology is suitable when variables within the model are highly autocorrelated.
Furthermore, the VAR approach enables us to analyze the speed of information
transmission among variables in the system, which would provide insight into the
dynamic nature of the interactions between markets.
The VAR model can be expressed in its standard form as:

p
R (t ) = c + ∑ A (k )R (t − 1 ) + e (t )
k =1
(5-22)

Where R(t) is a 9x1 column vector of daily returns on the markets at time t. C is a 9x1
column vector of constant terms, A(k) is a 9x9 matrix of coefficients such that the (i, j)th
component of A(k) measures the direct effect that a change in the ith markets has upon
the jth market after k periods.
In particular, the ith component of e(t) is the innovation of the ith market that
cannot be predicted from the past returns of other returns in the system. e(t) is a 9x1
( ) ( )
column vector of innovations such that E (eit ) = 0 , E e it2 = σ i2 , E e it , e jt = σ ij and

E (eit , e jt − k ) = 0

Thus, the innovations, e(t), are serially uncorrelated but can be

contemporaneously correlated. To analyze the dynamics of the system, we trace out the
system’s moving average representation which may provide additional insight into the
dynamic interactions among the returns in the VAR model (Sims 1980). Thus, the VAR

176
model of equation (5-22) is typically transformed into its moving average representation
expressed as:

∞
R (t ) = ∑
k =0
B (k )e (t − k ) (5-23)

Equation (5-23) indicates that R(t) is a linear combination of current and past one-step-
ahead forecast errors (i.e. e(t)). The (i, j)th component of B(k) reveals the response of the
ith market return to a unit random shock in the jth market return after k periods. The
moving average model of equation (5-23) enables us to compute the m-step-ahead
forecast error of R(t) at time t-m+1 which can be expressed as ∑ B(k )e(t − k ) for K=0

to m-1. In addition, the variance decomposition of the forecast error gives us the
percentage of unexpected variation in each market’s return that is produced by shocks
from other returns in the system.
As stated earlier, the innovations, e(t) in equation (5-22) may be
contemporaneously correlated, i.e. the covariance matrix of innovations is not diagonal.
When innovations in market returns are contemporaneously correlated, a shock in one
market may work through the contemporaneous correlations with innovations in other
markets. It is customary to transform these correlations by orthogonalizing the
innovations in the VAR system according to a pre-specified causal ordering. After the
transformation, the above equation can be expressed as,

∞
R (t )= ∑ c (k )u (t − k ) (5-24)
k = 0

Where the transformed innovations, u(t), are now uncorrelated with each other at all lags
as well as contemporaneously. The moving-average representation of the VAR model
provides a convenient framework for tracing the dynamics to shocks in the system. The
(i, j)th component of C(k) in equation (5-24) represents the impulse response of the ith
market in k periods after a shock of one standard error in the jth market. That is, if there
is a unit shock in the innovation of the jth market in period t(ujt), the value of the ith

177
market (Ri), changes by cij,1 in the following period and by cij,2, cij,3 and so on in
successive future periods. The VAR model also makes it possible to analyze the
decomposition of forecast error variance thereby providing a measure of the overall
relative importance of an individual market in generating variations in its own returns and
in other markets. That is, the effect that each variable in the system has on itself and on
each other variables over different time horizons can be measured by decomposing this
forecast variance error.
In summary, the VAR analysis provides information on two important aspects of
the structure of interactions among the national stock markets: (i) if innovations in a
particular market explain a substantial amount of return variations in other markets and
cannot be accounted for by innovations in other markets, then the market is relatively
influential to other markets; and (ii) if the impulse response of a market to a shock in
another market tapers off quickly, then the transmission of information between these
markets is relatively efficient.
The VAR requires the determination of the appropriate lag structure in the
system. We chose the lag structure using the Akaike Information Criterion (AIC) in
conjunction with analyzing the estimated model’s residuals so they do not exhibit any
significant autocorrelation.

5-3 Empirical results

The empirical analysis of the relationships among Arab stock markets indices; as
an economic group, with international markets, and among Arab stock markets
themselves; requires that several time series tests to be conducted. The first step requires
that unit root tests be performed to determine whether the series are non-stationary in
levels and stationary in first differences, that is, integrated of degree one. The second step
is to use the cointegration test to determine whether these non-stationary series, have
common long-run relationships. Evidence of cointegration rules out the possibility that
the estimated relationships are spurious; thus, as long as the variables in a given VAR
have common trends, causality (in Granger sense but not the structural sense) must exist
in at least one direction. However, although cointegration implies the presence of
causality, it does not identify the direction of causality between variables. The dynamic

178
Granger causality can be captured through the vector error correction (VEC) models,
derived from the long-run cointegrating vectors. Furthermore, Engle and Granger (1987)
show that in the presence of cointegration, a corresponding error-correction model
representation always exist.
The data used for cointegration test consists of daily indices prices for Arab stock
markets and S&P 500 which has been used as a proxy for international markets. The data
comes from daily figures, run from 1st August 2001- 31 December 2004. The length of
this period is limited by the availability of data for all Arab stock markets included in this
test.

5-3-1 Integration
Integration for individual time series for each stock market index is tested by
means of unit root tests, which investigate the presence of a stochastic trend in the
individual series. The results of the three unit root tests (ADF, PP, and KPSS) are
presented in table 5-1.7

7
The indices used for the 13 markets are: Kuwait (KSEI); Jordan (JSMI); Bahrain (BSEI); Dubai (DFMI);
Egypt (EFMI); Oman (OSMI); Abu Dhabi (ABSMI); Palestine (PSEI); Saudi Arabia (SAUDI); Japan,
Nikkei 225 (JAPANI); US, S&P 500 (USAI); UK, FTSE100 (UKI); and oil prices (WTI) which is crude
stream produced in Texas and Southern Oklahoma .

179
Table 5-1
Unit Root Tests for Each Individual Series, Both in Levels and First Differences
Levels First Difference
Variables ADF Lags PP Lags KPSS BW ADF Lags PP Lags KPSS BW
KSEI -2.29 IT
1 -2.24 IT
9 0.32 IT
21 -17.72 I
1 -22.14 I
7 0.16 I 9
I
JSMI -1.12 IT 12 2.43 N 1 0.56 IT 43 -11.59 I 16 -43.63 I
12 0.29 1
BSEI -1.83 I 11 -1.61 I 24 0.42 IT 44 -14.08 I 10 -65.95 I 26 0.16 I 24
DFMI -1.61 IT 1 -1.56 IT 7 0.81 IT 25 -33.01 IT 1 -33.03 IT 8 0.03 IT 8
EFMI 0.22 IT 2 0.21 IT 6 0.81 IT 32 -27.38 IT 1 -32.95 IT 13 0.17 IT 5
OSMI -0.45 IT 6 0.74 N 15 0.98 IT 34 -17.12 N 4 -41.83 N 14 0.39 I 15
ABSMI 2.95 N 3 3.17 N 9 0.28 IT 21 -12.18 I 2 -22.25 I 7 0.15 I 9
PSEI -2.55 I 4 -2.46 I 4 0.44 IT 26 -13.82 N 5 -34.94 I 4 0.33 I 3
SAUDI -1.8 IT 6 -1.68 IT 8 0.83 IT 43 -17.85 IT 7 -57.46 IT
6 0.07 IT 17
JAPANI -2.96 IT 2 -3.01 IT 8 0.61 IT 45 -44.95 I 1 59.91 N 10 0.12 I 11
USAI 1.95 N 7 1.75 N 8 1.05 IT 45 -24.89 I 6 -59.24 I 7 0.26 I 27
UKI -1.38 I 8 0.91 N 8 1.18 IT 45 -21.82 N 7 -58.13 N
8 0.25 I 15
WTI -0.31 N 4 -0.45 N 6 0.53 IT 44 -22.31 N 7 -58.62 N
6 0.04 I 31

Nate: All variables are in natural logs. All unit root tests agree that all variables are I (1). The lag selection is based on the lowest values

for AIC criterion. Superscript N stands for no intercept and no trend. I for intercept only and no trend, and IT for both intercept and

trend. Significant statistics are in bold, and the series are stationary. BW stands for bandwidth.

The results of these three tests show that all variables appear to be non-stationary in
levels and stationary in the first differences or integrated of the first degree.

5-3-2 Long-run relationship (cointegration test)

Here we present the cointegration results to test the long-run relationships at
different levels, and for several sets of VARs: VAR-10 which includes all Arab and US
stock markets, and designed to investigate the long-run cointegrating relation between
Arab and international stock markets, VAR-9 which includes all Arab stock markets, so
as to investigate the cointegrating relation between Arab stock markets themselves.
While, after dividing Arab markets into two subgroups; oil production countries which
include the GCC markets and non-oil countries, VAR-6 consisting of the six GCC stock
markets, whereas VAR-3 contains non-oil countries (Jordan, Egypt, and Palestine).
Several criterions (Akaike, Schwarz, and likelihood ratio) have been used to
determine the appropriate lag length for each VAR. To select the adequate deterministic
component for the cointegration and VAR equations for each VAR, we exclude
specification 1 of the deterministic component (that is, no intercept and no trend in either

180
the data or the cointegrating relations) for all VARs because according to Johansen, this
specification is rare and does not usually provide the minimum to account for the
presence of deterministic components. We also exclude specification 5 (quadratic trend
with intercept), because it is also a rare case and produces implausible forecasts out of
sample. Next, to choose a specification from the remaining specifications 2, 3, and 4, we
use the Schwarz criterion to determine the suitable specification. As table 5-2 shows, the
selected deterministic specification for VAR-3 is specification 2 (i.e. data have no
deterministic trend, but the cointegrating equation have intercept). This selection also
holds for VAR-6 and VAR-9, while for VAR-10, the selected deterministic component is
specification 4 (both data and the cointegrating equations have linear trend).8

Table 5-2
Number of Cointegrating Relations for Four VARs Models
Specifications VAR-3 VAR-6 VAR-10 VAR-9
Nonea 0 1 1 1
b
Intercept 0* 1* 1 1*
c
Linear trend 0 0 0 0
d
Linear trend 0 0 0* 0
e
Quadratic trend 0 0 0 0
No. of lags(levels) 3 3 2 2
Observations 1262 514 515 515
Notes: All variables are expressed in natural logarithms.
Astrisks indicate the selected deterministic specifications for each VAR .
a
Data have no deterministic trend, and the cointegrating equations do not have intercepts.
b
Data have no deterministic trend, but the cointegrating equations have intercepts.
c
Data have linear trend, but the cointegrating equations have intercepts only.
d
Both data and the cointegrating equations have linear trend.
e
Data has quadratic trends, but the cointegrating equations have linear trends.
VAR-3 :ESMI, PSEI and JSMI; VAR-6: MSMI, KSEI, DFMI, BSEI, ABSEI and SAUDI;
VAR10: MSMI, KSEI, DFMI, BSEI, ESMI, PSEI, ABSEI, SAUD, JSMI and USAI; VAR-9:
MSMI, KSEI, DFMI, BSEI, ESMI, PSEI, ABSEI, SAUD AND JSMI

Table 5-3 presents the results of Johansen-Juselius cointegration test, both trace
and maximum eigenvalue tests for each of the 4 VARs models. Based on these
specifications, table 5-3 suggests that VAR-6 and VAR-9 have one cointegrating relation,

8
The indices used for the each market are: Kuwait (KSEI); Jordan (JSMI); Bahrain (BSEI); Dubai (DFMI);
Egypt (EFMI); Oman (OSMI); Abu Dhabi (ABSMI); Palestine (PSEI); Saudi Arabia (SAUDI); US, S&P
500 (USAI).

181
while the results of Johansen-Juselius cointegration test; indicate the absence of any
cointegrating relation between Arab and international stock markets (VAR-10). The
results also indicate no cointegrating relation between the non-oil production countries
Jordan, Egypt and Palestine (VAR-3). The presence of one cointegrating relation among
Arab stock markets as a group (VAR-9), GCC stock markets; oil production countries;
(VAR-6), suggests long-run relationships among variables.
These results are constant with the existing literature; fore example, Kasa (1992)
finds one cointegrating relation among monthly stock indices of the United States, Japan,
United Kingdom, Germany and Canada. Francis and Leachman (1998) also find one
cointegrating relation for United States, Japan, United Kingdom, and Germany for the
same period. Furthermore, Bassler and Yang (2003) find only one cointegrating relation
in the nine largest countries in terms of market capitalization. Regarding the Middle East
region, Hammoudeh and Al-Eisa (2004) find two cointegrating relations between five
GCC countries, Darrat et al. (2000) find that cointegrating relation exists between three
Arabian equity markets, Jordan, Egypt, and Morocco, but these markets found to be
isolated from international markets. Maneschiold (2005) finds one cointegrating relation
between USA and Egypt at the general index level, related to the industry sub-index but
not to the financial or services sub-indices.

5-3-3 Short-run relationship between Arab and international stock markets

The results of cointegration test indicate that, there is no cointegrating relation
between Arab and international stock markets in the long-run. The purpose of this section
is to investigate the short-run relationship between Arab and international stock markets,
through analyzing how shocks generating by US, UK, and Japan markets, affect each of
the Arabian markets using SVAR technique. The S&P 500, FTSE100, and Nikkei 225 are
used to represent US, UK, and Japan stock markets, respectively. The data includes daily
observations for different time horizons.9

9
The daily data for international stock markets S&P 500, FTSE100, and Nikkei 225 are obtained from
Yahoo. Finance website on the net through: www.Yahoo.Fianace.com .

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Table 5-3
Johansen-Juselius Cointegration Test Results
H0=Number of Trace Test Maximum Eigenvalue Test
Cointegrating
Statistics C.V (5%) C.V (1%) Statistics C.V (5%) C.V (1%)
Vectors
A. Cointegrating System: VAR-6b
None 120.536* 102.14 111.01 50.4* 40.30 46.82
At most 1 70.133 76.07 84.45 38.1** 34.40 39.79
At most 2 32.036 53.12 60.16 14.116 28.14 33.24
At most 3 17.920 34.91 41.07 9.966 22.00 26.81
At most 4 7.954 19.96 24.60 5.749 15.67 20.20
At most 5 2.205 9.24 12.97 2.205 9.24 12.97
B. Cointegrating System: VAR-9b
None 220.868* 202.92 215.74 63.52** 57.42 63.71
At most 1 157.348 165.58 177.20 50.252 52.00 57.95
At most 2 107.095 131.70 143.09 30.061 46.45 51.91
At most 3 77.035 102.14 111.01 27.777 40.30 46.82
At most 4 49.258 76.07 84.45 16.118 34.40 39.79
At most 5 33.140 53.12 60.16 15.149 28.14 33.24
At most 6 17.990 34.91 41.07 7.880 22.00 26.81
At most 7 10.111 19.96 24.60 7.228 15.67 20.20
At most 8 2.883 9.24 12.97 2.883 9.24 12.97
C. Cointegrating System: VAR-3b
None 34.841 34.91 41.07 20.950 22.00 26.81
At most 1 13.891 19.96 24.60 10.544 15.67 20.20
At most 2 3.347 9.24 12.97 3.347 9.24 12.97
D. Cointegrating System:VAR-10d
None 250.420 263.42 279.07 61.855 66.23 73.73
At most 1 188.565 222.21 234.41 48.548 61.29 67.88
At most 2 140.017 182.82 196.08 34.774 55.50 62.46
At most 3 105.243 146.76 158.49 26.371 49.42 54.71
At most 4 78.872 114.90 124.75 22.632 43.97 49.51
At most 5 56.240 87.31 96.58 15.941 37.52 42.36
At most 6 40.300 62.99 70.05 13.855 31.46 36.65
At most 7 26.445 42.44 48.45 11.403 25.54 30.34
At most 8 15.042 25.32 30.45 7.609 18.96 23.65
At most 9 7.433 12.25 16.26 7.433 12.25 16.26
Notes: All variables are expressed in natural logarithms.
**(*) denotes rejection of the hypothesis at the 5%(1%) level
b
Data have no deterministic trend, but the cointegrating equations have intercepts.
d
Both data and the cointegrating equations have linear trend.
VAR-3 :ESMI, PSEI and JSMI; VAR-6 : MSMI, KSEI, DFMI, BSEI, ABSEI and SAUDI; VAR10 : MSMI, KSEI, DFMI,
BSEI, ESMI, PSEI, ABSEI, SAUD, JSMI and USAI; VAR-9 : MSMI, KSEI, DFMI, BSEI, ESMI, PSEI, ABSEI, SAUD
AND JSMI
The critical values for the test statistics have been generated by Monte Carlo methods and tabulated by Osterwald-Lenum
(1992).

183
 Moreover, it is assumed that US, UK, and Japan stock exchanges performance, is
not affected by Arab stock markets; however, Arab markets are affected by both its own
dynamics and the three international markets. This assumption is reflected in the
specification by using block recursive VAR model described in section 5-1-3.
The results are presented in appendix 3. figure 1 in appendix 3 reports the impulse
response functions for 20 days concerning, how do Arab markets returns respond to one-
structural standard deviation shock to each of the three international markets, whilst
tables 1 and 2 in appendix 3 show the variance decomposition and the impulse response
functions, respectively. In general, it is important to recognize that shocks originated in
international markets, have a marginal effect on Arab stock markets’ returns. More
specifically, table 1 provides the variance decomposition of the 2-, 6-, and 10 days a head
forecast errors for each Arab stock markets, accumulated for by innovations in US, UK,
and Japan. The results indicate that all markets are strongly exogenous in the sense that;
the percentage of the foreign explanatory power as indicated by US, UK, and Japan, is
very weak, reaching 3.5% in the best cases (the case of Egypt).
Nevertheless, one can find that UK exerts the most influence effect on Arab stock
markets, since it has the most foreign explanatory power on 4 Arab markets (Bahrain,
Saudi, Palestine, and Jordan), while US has the most explanatory power of returns
variation in three Markets (Oman, Kuwait, and Dubai). With Japan to be the least
influencing market, since it has an explanatory power only on Abu Dhabi and Egypt.
Moreover, it is apparent that a shock originated in UK has a persistent impact on Bahrain,
Saudi, Palestine, and Jordan with duration up to 8 days in average. Among these markets,
only Jordan responds positively to UK shock. However, Oman, Kuwait, and Dubai show
a memory of 5 days to absorb shock originated in US market, it seems that these markets
react quickly and relatively efficient. Since their response tapers-off and decline rapidly
with a positive reaction from Dubai only. Finally, Egypt and Abu Dhabi react positively
and quickly, to a shock generated by Japan stock market with duration up to 4 and 6 days
for Abu Dhabi and Egypt, respectively (see appendix 3, figure1 and table 2).

5-3-4 Short-run relationships among Arab stock markets

184
 The presence of cointegrating relations in VAR-9 (all Arab stock markets) and
VAR-6 (GCC markets), suggests that causality among the variables in these systems
exists; in at least one direction. As a sequence, this section investigates the existing short-
run relationships among Arab stock markets.

5-3-4-1 Granger causality test

Granger causality test has been conducted, to investigate the interdependence
among the 9 Arab markets. The results are included in table 5-4. A lag order of seven (i.e.
m=7) is used. It is expected that 7 lags (7 days) should be long enough to complete the
transmission process, as similar results are obtained for higher-order lags used. Table 5-4
shows that there are some causal relationships observed among the nine markets, with
Egypt exerting significant influence and leading Bahrain and Kuwait, while Bahrain leads
Saudi but not vice versa, Another Granger causal relation exists from Oman to Egypt and
from Jordan to Palestine.

Table 5-4
Granger Causality Test for Arab Stock Markets 1st July, 2001 to 24 July, 2003
Dependent variables
Bahrain Oman Kuwait Saudi Jordan Egypt Palestine Dubai AbuDhabi
Bahrain 1.79(0.08) 0.56(0.78) 2.58(0.01) 0.82(0.57) 1.36(0.22) 1.53(0.15) 1.67(0.11) 0.82(0.57)
Oman 1.82(0.08) 1.2(0.3) 1.02(0.42) 0.88(0.52) 2.17(0.03) 2.02(0.06) 0.47(0.85) 0.66(0.7)
Kuwait 0.62(0.74) 0.8(0.59) 0.63(0.73) 0.95(0.46) 0.87(0.52) 0.58(0.77) 1.65(0.12) 0.95(0.46)
Saudi 0.38(0.92) 0.55(0.79) 0.57(0.77) 1.35(0.22) 1.35(0.85) 1.26(0.26) 0.48(0.84) 1.14(0.34)
Jordan 1.38(0.21) 1.5(0.16) 0.41(0.90) 1.65(0.12) 1.37(0.21) 2.06(0.04) 0.54(0.8) 1.09(0.37)
Egypt 2.21(0.03) 1.11(0.35) 2.33(0.02) 1.1(0.36) 1.29(0.25) 0.49(0.84) 0.22(0.98) 0.27(0.97)
Palestine 1.88(0.07) 1.64(0.12) 0.71(0.66) 0.59(0.76) 0.73 (0.64) 0.74 (0.63) 0.52(0.82) 0.6 (75)
Dubai 0.44(0.87) 1.66(0.11) 1.83(0.07) 1.77(0.09) 0.3(0.95) 0.22(0.98) 0.76(0.62) 0.16(0.99)
AbuDhabi 0.71(0.66) 0.88(0.51) 1.28(0.25) 0.68(0.69) 1.28(0.26) 0.85(0.54) 0.71(0.66) 0.86(0.54)

The numbers report the F -statistics for testing the null hypothesis that all 7 lags of the left column do not Granger-cause the dependent
variable. P -values are between brackets.

Furthermore, the correlation coefficient analysis between daily Arab markets’

indices is presented in table 5-5. The correlation between Arab stock markets’ indices,
are generally low and close to zero for most cases, indicating a low interdependence
between these indices.

185
Table 5-5
Correlation Coefficient Between Daily Arab Markets' Returns, 1st July, 2001 to 24
July, 2003
Saudi Oman Kuwait Dubai Bahrain AbuDhabi Egypt Jordan Palestine
Saudi 1.0000 0.0118 -0.0001 0.0371 0.0880 0.0302 0.0421 -0.1332 0.0827
Oman 1.0000 0.1041 -0.0124 0.0774 0.0853 0.1560 -0.0136 0.0384
Kuwait 1.0000 -0.0231 0.0785 0.0081 -0.0146 0.0028 -0.0042
Dubai 1.0000 -0.0078 0.0122 0.0432 -0.0313 -0.0446
Bahrain 1.0000 0.0109 0.0180 0.1302 -0.0654
AbuDhabi 1.0000 -0.0145 0.0233 0.0099
Egypt 1.0000 -0.0848 -0.1154
Jordan 1.0000 -0.0087
Palestine 1.0000

5-3-4-2 Causality and error-correction models (VEC)

The results for long-run relationship (cointegration analysis), indicate the
existence of one long-run cointegrating relation in VAR-9 and VAR-6. The existence of
these long-term relationships indicates the subsistence of causality among variables. One
way that causality may emerge in a VAR is through the cointegrating equations or the
error-correction terms of the associated VEC model. Testing the statistical significance of
the adjustment coefficients of these terms, amounts to testing if the long-run relationships
derive the endogenous variables to convergence to equilibrium over time, such testing of
the adjustment coefficients is known as testing weak exogeneity of the endogenous
variables, with respect to the parameters of the cointegrating equations. Therefore, we
will first present and interpret the cointegrating equations of the VEC models.
Table 5-6 presents the cointegrating equations for both VAR-9 and VAR-6, and
indicates that Kuwait has; by far, the greatest relative influence on Arab and GCC
indices. Thus, in the absence of global factors, such as oil prices, the Kuwaiti market
dominates the long-run relation with other GCC and Arab markets, followed by Saudi
Arabia. These results could be surprised, since one expects that the Saudi market to be
the leader in the long run, since Saudi’s economy is the largest among the Arabian
countries and its stock market makes up about 50% of the total Arab markets
capitalization followed by Kuwaiti economy. The results may suggest that local factors
(such as cross-listing of Kuwaiti companies on both UAE and Bahraini stock markets) as
well as global factors (i.e. oil prices) also have a strong influence on the long-run

186
relationship that derive the variables in the system to equilibrium over time. Figure 5-1
shows the cointegrating relations for the two systems.

Table 5-6
Cointegrating Equations of the VEC Models for VAR-9 and VAR-6, 1/8/2001-
31/12/2004
Model CE MSMI KSEI DFMI BSEI ESMI PSEI ABSEI SAUDI JSMI C
a a
VEC-9 CE1 1.000 -2.968 1.1226 0.504 -0.239 0.069 1.431 2.168 1.769 -29.117b
b

(0.57) (0.776) (1.771) (0.589) (0.447) (0.879) (0.685) (0.726) (13.632)

VEC-6 CE1 1.000 -1.083a 0.108 0.222 - - 0.301 0.768a - -9.621b
(0.225) (0.296) (0.661) - - (0.333) (0.248) - (4.761)
Notes: CE stands for a cointegrating equation. VEC-9 is the VEC model for the VAR-9 and VEC-6 is the VEC model for the VAR-6. a b
and c represent statistical significance at 1%, 5%, and 10% respectively.

Figure 5-1

.4 .2

.2
.1

.0
.0
-.2
-.1
-.4

-.2
-.6

-.8 -.3
100 200 300 400 500 600 700 800 100 200 300 400 500 600 700 800

Cointegrating relation VEC-9 Cointegrating relation VEC-6

Next, before presenting the estimated VEC models for the two VARs and tests for
weak exogeneity, we should test whether the variable of the VARs inter the cointegrating
equations significantly. Table 5-7 shows that only Kuwait and Saudi inter the
cointegrating relation significantly in VAR-9 while for VAR-6; in addition to Kuwait and
Saudi, Oman inters the equation significantly. This means that there are common factors
that make Kuwaiti, Saudi, and Omani indices, as a group form one long-relationship.
Furthermore, the finding of VAR-9 VEC model is presented in table 5-8. Broadly, the
short-term relationships between Arab markets found to be weak. Since on a daily basis,
there are two-way directional relation between Saudi and Jordan, one-way relation from
Oman to Bahrain, from Egypt to Oman, and from Abu Dhabi to Saudi.

187
 Table 5-7
Significant of Zero Restrictions on Coefficients of Cointegrating
Equations of the VEC Models of VAR-9 and VAR-6
VAR-9 VAR-6
Market
Chi-Square Probability Chi-Square Probability
MSMI 0.587 0.444 5.167 0.023
KSEI 10.599 0.001 5.932 0.015
DFMI 0.749 0.387 0.057 0.811
BSEI 0.027 0.869 0.084 0.772
ESMI 0.045 0.832 - -
PSEI 0.013 0.908 - -
ABSEI 1.529 0.216 0.420 0.517
SAUDI 5.268 0.022 3.083 0.079
JSMI 2.549 0.110 - -
Notes: Bolds numbers indicate that the LR tests reject the null hypothesis that the ith endogenous
variable does not enter the cointegrating equation significantly.which means that these variables form
long run equilibrium relationships.

Table 5-8
VEC Model for 9 Arabian Indices in the VAR-9, 1/8/2001- 31/12/2004
Model D(MSMI) D(KSEI) D(DFMI) D(BSEI) D(ESMI) D(PSEI) D(ABSEI) D(SAUDI) D(JSMI)
ECT1 -0.003a -0.004b -0.005a 0.001 -0.006b -0.006c 0.001 -0.008a -0.004a
D(MSMI(-1)) 0.438a -0.029 -0.074 0.081c -0.068 -0.073 -0.020 -0.122 0.101
a
D(KSEI(-1)) -0.010 0.161 -0.048 0.023 0.007 -0.092 0.033 -0.020 -0.057c
D(DFMI(-1)) 0.020 0.006 -0.002 0.024 -0.045 0.077 0.016 -0.056 -0.031
D(BSEI(-1)) -0.014 -0.111 -0.047 0.094b -0.219 -0.114 0.015 0.035 -0.006
a a
D(ESMI(-1)) -0.036 0.009 -0.029 0.015 0.167 0.034 0.004 0.043 0.003
a
D(PSEI(-1)) 0.010 -0.030 0.000 -0.004 -0.013 0.307 -0.010 0.032 -0.010
D(ABSEI(-1)) 0.001 0.016 -0.106 -0.021 0.154 0.001 0.095b 0.166c -0.006
c
D(SAUDI(-1)) 0.012 0.012 0.016 0.030 -0.008 -0.072 -0.012 -0.083 0.08b
D(JSMI(-1)) -0.014 -0.039 -0.027 0.006 0.071 -0.029 -0.039 -0.129b 0.17a
Stat. P.value
Log Likelihood 15495.7
Akaike Information Criteria -59.61
Schwarz Criteria -58.79
Serial Crrelation LM Stat.(up to lag 4 ) 96.73 0.112
Skewness 355.93 0.000
Kurtosis 2700.48 0.000
Normality 3056.42 0.000
White test 1597.02 0.000

Notes: ECT stands for the error-correction terms in the VEC equations. The number of lags is based on the Schwars criteria. The statistics for
skewness, kurtosis, normality, and the White test are chi-squares testing the null hypothesis. The statistics for the normality tests base are
a.b
based on Doornik-Hansen orthogonalization method. All variables are first differences of logs. and c represent statistical significance at
the 1%, 5% and 10% levels respectively.

188
 Another interesting finding from the VEC-9 model is that, the own short-run
adjustment term for Saudi is negative. This result may suggest that it takes a while for the
Saudi market to cool off after getting heated by hot hands of its momentum traders.
Moreover, the estimates show that Dubai index lacks linkages with other Arab markets
indices, even with its own lags. The estimated VEC model for VAR-6 (GCC markets) is
presented in table 5-9. The results indicate that Kuwaiti market can be considered as a
leader among GCC markets. Since it can predict both Bahrain and Abu Dhabi markets,
the results also indicate that two-way directional relationship exists between Kuwait and
Bahrain, Abu Dhabi and Dubai markets. Whereas, Oman and Saudi markets have the
weakest links with other GCC markets on the short-run relationship. Moreover, the Wald
test for the adjustment coefficients of the error-correction terms, which measures
deviations from the long-run equilibrium indicating that, for VEC-9, five among the nine
markets including in the model (Kuwait, Bahrain, Egypt, Palestine, and Abu Dhabi) are
weakly exogenous (see table 5-10).
In other words, it appears that Oman, Saudi, and Dubai equations contain all the
long-run information, since these are the only equations that their equilibrium adjustment
parameters inter the system significantly according to Wald test. While for the VEC-6
model, the results of Wald test indicate that Kuwait, Bahrain, and Abu Dhabi were
weakly exogenous, implying that these markets do not have the tendency to restore
equilibrium and take the brunt of the shocks to the system, whereas the Saudi market
contains the long-run information since its equation contains the large significant
equilibrium adjustment parameter.
The results for the interrelation between GCC stock markets in the short run
(VEC-6), are incompatible with those of Assaf (2003), since he finds; using VAR
analysis for weekly data, that Bahrain plays a dominant role in influencing the GCC
markets. While the results for GCC stock markets indicate that Kuwait can be considered
as a dominant market that influences the GCC markets in the short-run horizon.

189
Table 5-9
VEC Model for 6 GCC Indices in the VAR-6, 1/8/2001- 31/12/2004
Model D(MSMI) D(KSEI) D(DFMI) D(BSEI) D(ABSEI) D(SAUDI)
ECT1 -0.008a -0.008c -0.012a 0.003 0.002 -0.017a
D(MSMI(-1)) 0.447a -0.030 -0.026 0.055 -0.007 -0.085
D(MSMI(-2)) -0.020 -0.011 -0.100 0.058 -0.042 -0.082
D(KSEI(-1)) -0.015 0.179a -0.043 0.036 0.024 -0.001
D(KSEI(-2)) -0.004 -0.032 -0.044 -0.052b 0.046b -0.042
D(DFMI(-1)) 0.020 0.003 -0.024 0.023 0.013 -0.038
D(DFMI(-2)) -0.029 0.068 -0.048 0.021 0.052c -0.021
D(BSEI(-1)) -0.006 -0.128 -0.040 0.095b 0.003 0.038
D(BSEI(-2)) 0.024 0.152c 0.021 -0.013 -0.044 0.041
D(ABSEI(-1)) 0.003 0.010 -0.075 -0.015 0.098b 0.143
D(ABSEI(-2)) -0.010 0.046 -0.228a -0.004 -0.059 0.031
D(SAUDI(-1)) 0.011 0.018 0.027 0.031 -0.007 -0.067
D(SAUDI(-2)) -0.002 0.039 0.052 -0.023 0.043b -0.029
Stat. P.value
Log Likelihood 10945.88
Akaike Information Criteria -42.107
Schwarz Criteria -41.405
Serial Crrelation LM Stat.(up to lag 5 ) 48.143 0.085
Skewness 262.910 0.000
Kurtosis 948.193 0.000
Normality 1211.104 0.000
White test 797.898 0.000
Notes: ECT stands for the error-correction terms in the VEC equations. The number of lags is based on the Schwars criteria.
The statistics for skewness, kurtosis, normality, and the White test are chi-squares testing the null hypothesis. The statistics
for the normality tests base are based on Doornik-Hansen orthogonalization method. All variables are first differences of logs.
a.b
and c represent statistical significance at the 1%, 5% and 10% levels respectively.

Table 5-10
Weak Exogeneity Tests of the Endogenous Variables in the
VEC Models of VAR-9 and VAR-6, 1/8/2001-31/12/2004
VEC-9 VEC-6
Market
Chi-Square Probability Chi-Square Probability
MSMI 10.526 0.001 12.246 0.000
KSEI 1.966 0.161 1.161 0.281
DFMI 9.444 0.002 7.806 0.005
BSEI 1.530 0.216 1.558 0.212
ESMI 1.925 0.165 - -
PSEI 2.339 0.126 - -
ABSEI 0.005 0.946 0.247 0.619
SAUDI 12.561 0.000 8.534 0.003
JSMI 3.576 0.059 - -
Notes: Bolds numbers indicate that the LR tests do not reject the null hypothesis that the i th
endogenous variable is weakly exogenous with respect to the β parameters, implying that it does
not adjust to restore equilibrium after a shock hits the system.

190
5-3-5 Dynamic relationship between GCC stock markets and oil prices
The last two years have witnessed a sharp increase in oil prices as a result of the
increase in the international demand, among other things. It is known that this increase
negatively affects the economic development of industrial countries in particular and that
of other countries in general. This, in turn, leads to raising the inflation rate and
unemployment. Economic sectors in many countries have been influenced, especially
stock markets. Gulf Cooperation Council countries (GCC) are among the most important
oil producing countries, except Bahrain and Oman, the other four of these (Saudi Arabia,
Qatar, Kuwait and UAE) are members in the Organization of Petroleum Exporting
Countries (OPEC).
At the end of 2003, these countries collectively accounted for about 21% of the
world’s 68 million barrels a day of total production. They possess 43% of the world’s
1105.26 billion barrels of oil proven reserves10. Producing and exporting oil plays a
crucial role in determining foreign earnings and government’s budget revenues and
expenditures for those countries; thus they are the primary determinant of aggregate
demand, which in turn affects the domestic price levels as well as all aspects of daily
economic life. In addition, increase in oil prices causes increase in the trading volume in
the stock markets according to cash surplus. This shows the importance of studying the
relation between increase in oil prices and stock markets in GCC countries where oil
price has reached $ 70 a barrel, while it was $ 29.24 on 27 May 2003.
There are several studies and research articles which investigate the relation
between international financial markets and others examined the link between spot and
future petroleum prices. However, few studies have looked into the relation between oil
spot/future prices and stock markets. Such studies concentrated on countries such as
Canada, Germany, Japan, UK, and USA. The overall literature on the links between oil
markets and financial markets is very limited; Johnes and Kaul (1996) investigate the
relation of the U.S., Canadian, Japanese, and U.K stock prices to oil price shocks using
quarterly data. Utilizing a standard cash-flow dividend valuation model, they find that for
the United States and Canada, this relation can be accounted for entirely by the impact of

10
See the Uniform Arabian Economic Report 2004, Arab Monetary Fund (AMF), Abu Dhabi.

191
oil shocks or real cash flows. The results for Japan and the United Kingdom were not as
strong.
Moreover, Huang et al. (1996) use an unrestricted vector auto regression (VAR)
model to examine the relationship between daily oil future returns and daily U.S stock
returns. They find that the oil futures returns lead some individual oil company stock
returns, but they do not have much impact on broad-based market indices such as the
S&P 500. Sadorsky (1999), using monthly data examines the links between the U.S. fuel
oil prices and the S&P 500 in an unrestricted VAR model that also include the short-term
interest rate and industrial production. He finds that oil prices movements are important
in explaining movements in broad-based stock returns. Papapetrou (2001), employing an
error correction representation of a VAR macroeconomic model and using monthly data
for Greece, concludes that oil prices are important in explaining stock price movements.
Hammoudeh and Aleisa (2002) examine the links between oil-exporting countries,
including Bahrain, Indonesia, Mexico, and Venezuela, using monthly data, and find
spillovers from the oil markets to the stock indices of these countries.
However, one study (Hammoudeh and Al-Eisa, 2004) examines the relation
between oil prices and stock markets in GCC countries. For daily data during the period
1994-2001, they find that the Saudi market is the leader among GCC markets and can
predict-and be predicted by oil future prices.
The purpose of this section is firstly, to investigate the dynamic relationship
between oil prices and GCC stock markets both on the long and short-run, second, to
investigate how oil prices affect returns volatility in GCC markets, finally and most
important, this section will investigate the impact of the increase in oil prices on GCC
stock markets, and trying to identify the nature of the dynamic relationship between oil
prices and GCC markets.

5-3-5-1 Oil prices and GCC markets volatility

In order to investigate the effect of oil prices on the volatility of returns in GCC
markets, GARCH (1,1) will be estimated, while oil prices will be added as an additional
regressor in the conditional variance equation, such as:

192
 Rt = β 0 + β1 Rt −1 + ε t (5-
25)
εt ∼ N(0,ht)

ht = α 0 + α 1ε t2−1 + β1 ht2−1 + w1oil (5-26)

where Rt is log (Pt/Pt-1); and Pt is the stock price at time t. Equation (5-26) models the
variance of the unexpected returns, εt, as GARCH (1,1) process; and oil is oil return
log(Pt/Pt-1). While for oil spot prices, we use the spot oil prices (WTI), which is the crude
stream produced in Texas and South Oklahoma that is traded in domestic spot market at
the Cushing Center.
Table 5-11 shows the results of the estimated model, while table 4 in appendix 2
presents the results of diagnostic tools for the standardized residuals of GARCH (1,1)
model with oil prices. The coefficient of oil returns presented in table 5-11; w, is found to
be highly significant for all GCC stock markets except Kuwait.

Table 5-11
GARCH (1,1) Model for GCC Daily Returns with Oil Returns as a
Regressor in the Variance Equation
Market Obs. α0 α1 β1 α 1 +β 1 ω
AbuDhabi 605 0.000 0.205 0.631 0.836 0.000
1/7/01-31/12/03 0.000 0.000 0.000 0.000 0.001

Bahrain 3257 0.000 0.147 0.598 0.745 -0.001

1/1/91-3/6/04 0.000 0.001 0.000 0.000 0.000

Dubai 917 0.000 0.148 0.596 0.744 -0.002

26/3/00-31/12/03 0.000 0.063 0.000 0.007 0.000

Kuwait 750 0.000 0.182 0.811 0.992 0.000

17/6/01-9/3/05 0.001 0.000 0.000 0.552 0.265

Oman 1898 0.000 0.354 0.699 1.053 0.000

1/2/97-13/10/04 0.000 0.000 0.000 0.000 0.000

Saudi 2772 0.000 0.278 0.643 0.921 0.000

26/1/94-14/3/05 0.000 0.000 0.000 0.000 0.007
Significance levels are in italics. A Chi-square (χ2) tests (α 1 +β 1 ) = 1. The estimated variance
equation is : h = a + a ε 2 + β h + ω oilr
t 0 1 t −1 1 t −1

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 Note that, volatility persistence for all markets does not change with the addition
of oil returns (see table 4-12 in section 4-5-2). The results indicate that oil prices play a
significant role in affecting GCC markets volatility but not Kuwait, since it appears that
for Kuwaiti stock market, other factors than oil prices affect its volatility.

5-3-5-2 Long-run relationship among GCC stock markets and oil prices
The GCC countries are oil-dependent as well as economically and politically
similar. The forces that commove their stock markets are basically the forces that move
the oil prices. As a result, one would expect cointegrating relations among the markets of
countries that have had a cooperation council since 1981, and are now aiming to establish
a monetary union with a single currency in 2010. Table 5-12 presents the results of
Johansen cointegration test for 6 GCC indices with oil prices. The result of the trace test
indicates the existence of one long-run cointegrating relation between the variables.
While cointegrating equation is presented in table 5-13.

Table 5-12
Johansen-Juselius Cointegration Test Results
H0=Number of Trace Test Maximum Eigenvalue Test
Cointegrating
Statistics C.V (5%) C.V (1%) Statistics C.V (5%) C.V (1%)
Vectors
None 132.895** 131.70 143.09 44.279 46.45 51.91
At most 1 88.616 102.14 111.01 40.625** 40.30 46.82
At most 2 47.991 76.07 84.45 21.510 34.40 39.79
At most 3 26.481 53.12 60.16 13.977 28.14 33.24
At most 4 12.504 34.91 41.07 8.394 22.00 26.81
At most 5 4.110 19.96 24.60 3.581 15.67 20.20
At most 6 0.529 9.24 12.97 0.529 9.24 12.97
Notes: All variables are expressed in natural logarithms, where 3 lags have been used to estimate the VAR.
**(*) denotes rejection of the hypothesis at the 5%(1%) level
Data have no deterministic trend, but the cointegrating equations have intercepts.
VAR-7 : MSMI, KSEI, DFMI, BSEI, ABSEI, SAUDI and OILPI.

Table 5-13
Cointegrating Equations of the VEC Model for VAR-7, 1/8/2001-31/12/2004
Model CE MSMI KSEI DFMI BSEI ABSEI SAUDI C OILPI
VEC-7 CE1 1.000 -2.812b 2.327 0.121 -0.211 1.466 -16.40 2.554b
(1.138) (1.426) (3.228) (1.618) (1.248) (-21.996) (1.009)
ab c
Notes: CE stands for a cointegrating equation. VEC-7 is the VEC model for the VAR-7. and represent statistical
significance at 1%, 5%, and 10% respectively.

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 The oil price index found to have significant influence on the long-run
equilibrium after Kuwait stock market, which dominate the long-run relation among GCC
and oil prices.
The findings of the VAR-7 VEC model (table 5-14); suggest that 4 out of 6 GCC
markets (Oman, Kuwait, Bahrain, and Saudi) can predict and explain the future oil prices
movements in the short-run, while oil prices can explain both Saudi and Dubai indices
only. The existing two-way directional relation between oil prices and Saudi market;
could be explained by the fact that Saudi Arabia is the largest oil exporter and has the
largest oil reserves.

Table 5-14
VEC Model for 6 GCC and Oil Price Indices in the VAR-7, 1/8/2001- 31/12/2004
Model D(MSMI) D(KSEI) D(DFMI) D(BSEI) D(ABSEI) D(SAUDI) D(OILPI)
ECT1 -0.001 -0.004a -0.003a 0.000 -0.001 -0.004a -0.005b
D(MSMI(-1)) 0.451a 0.003 -0.024 0.036 0.005 -0.054 0.149
D(MSMI(-2)) -0.027 -0.102 -0.098 0.058 -0.041 -0.050 -0.511b
D(KSEI(-1)) -0.012 0.119b -0.038 0.033 0.011 -0.007 0.033
D(KSEI(-2)) 0.009 -0.044 -0.048 -0.057b 0.034 -0.062 0.289a
D(DFMI(-1)) 0.027 -0.009 -0.011 0.026 0.005 -0.021 0.056
D(DFMI(-2)) -0.031 0.057 -0.040 0.011 0.056c -0.024 0.103
D(BSEI(-1)) -0.003 -0.169c -0.060 0.097b 0.008 -0.010 0.413b
D(BSEI(-2)) 0.024 0.221b 0.004 -0.008 -0.042 0.021 0.325
D(ABSEI(-1)) 0.004 0.058 -0.134c -0.049 0.089c 0.090 -0.035
D(ABSEI(-2)) -0.059 0.009 -0.267a -0.008 -0.023 0.003 0.015
D(SAUDI(-1)) 0.013 -0.006 0.026 0.026 -0.006 -0.061 0.069
D(SAUDI(-2)) 0.010 0.033 0.032 -0.030 0.048b -0.037 -0.175c
D(OILPI(-1)) 0.006 0.016 0.022 -0.008 0.003 0.010 -0.123a
D(OILPI(-2)) 0.005 -0.028 0.046a 0.000 0.011 -0.037c 0.010
Stat. P.value
Log Likelihood 10748.54
Akaike Information Criteria -46.617
Schwarz Criteria -45.592
Serial Crrelation LM Stat.(up to lag 7 ) 57.430 0.191
Skewness 258.042 0.000
Kurtosis 855.838 0.000
Normality 1113.880 0.000
White test 1240.175 0.000
Notes: ECT stands for the error-correction terms in the VEC equations. The number of lags is based on the Schwars criteria. The statistics
for skewness, kurtosis, normality, and the White test are chi-squares testing the null hypothesis. The statistics for the normality tests base
are based on Doornik-Hansen orthogonalization method. All variables are first differences of logs. a.b and c represent statistical
significance at the 1%, 5% and 10% levels respectively.

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 Moreover, the Wald test for the adjustment coefficients of the error-correction
term, is presented in table 5-15 and indicates that all variables in the system are weakly
exogenous except oil prices and Dubai index. It appears that, oil and Dubai indices
contain the information of the long-run equilibrium in the system.

Table 5-15
Weak Exogeneity Tests of the Endogenous Variables
in the VEC Model of 1/8/2001-31/12/2004
VEC-7
Market
Chi-Square Probability
MSMI 0.659 0.417
KSEI 2.173 0.140
DFMI 3.632 0.057
BSEI 0.005 0.944
ABSEI 0.106 0.745
SAUDI 1.847 0.174
OILP 2.882 0.090
Notes: Bolds numbers indicate that the LR tests do not reject the null hypothesis that
the i th endogenous variable is weakly exogenous with respect to the β parameters,
implying that it does not adjust to restore equilibrium after a shock hits the sysytem.

These results are inconsistent with those obtained by Hammoudeh and Al-Eisa
(2004), since they found two equilibrium relations between GCC stock markets and oil
future prices, while Saudi market found to be the leader followed by Bahraini and United
Arab Emirates (UAE).

5-3-5-3 The rise of oil prices and GCC stock markets

This section will investigate the direct effect of the increasing oil prices on GCC
stock markets, during the period which witnessed unprecedented sharp raise, especially
through the last two years. Daily data for five GCC (Bahrain, Kuwait, Oman, Saudi
Arabia, and Abu Dhabi) and oil prices will be used, the data runs from 25 May 2001 to
24 May 200511. The WTI described in section 5-3-4-1 will be used as a proxy for oil
prices.
To facilitate the investigation of how the raise in oil prices affects GCC stock
markets and the dynamic relation between them, the whole period has been divided into

11
Dubai stock market was excluded according to the shortage of data for the later period.

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two sub-periods (event study), and a vector autoregression (VAR) system will be
estimated for each period. The first period spanning from 25 May 2001 to 23 May 2003,
while the second one from 27 May 2003 to 24 May 2005, which includes the stunning
rise in oil prices. Since at the end of the second period, the oil prices reached US$ 49.14
per barrel compared to 29.24 on 23 May 2003.
Table 5-16 presents the estimation of the VAR system for five GCC stock
markets returns and oil return for the first sub-period. The results indicate that there is no
any relationship between oil prices and the five GCC stock markets on a daily basis. The
oil prices can not predict- or be predicted by any of the five GCC markets12. However,
during the second period; and after the rise in oil prices, the results changed dramatically.
Table 5-17, which shows VAR estimation for the second period, indicates that oil prices
can predict all GCC stock markets but not Abu Dhabi. While oil prices can be predicted
by both Saudi and Omani stock markets.
The results of the VAR system for the second sub-period reflect the significant
role that the sharp increase in oil prices plays, which has, in turn, brought about
enhancing the predictive power of oil prices on those markets in comparison with the first
sub-period that preceded the sharp increase in oil prices. The results should not seem
strange if we take into consideration that these countries essentially depends; in varying
degree, on oil, and that one of them is Saudi Arabia, the world’s biggest oil exporting
country with its largest oil reserve in the world.
- Variance decomposition
The variance decomposition analysis measures the percentage of the forecast error
of a market return that is explained by another market or oil return. It indicates the
relative impact that one market has upon another market and oil return within the VAR
system. The variance decomposition enables us to assess the economic significance of
this impact as a percentage of the forecast error for a variable sum to one. The
orthogonolization procedure of the VAR system decomposes the forecast error variance,

12
These results contradict those obtained from cointegration analysis during the period 1 August 2001- 31
December 2004 presented in table (3-14), since the finding of VEC-7 model indicates that in the short run,
3 out of 6 GCC markets have predictive power on oil prices, while both Dubai and Saudi markets can be
predicted by oil prices.

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the component that measures the fraction in stock return of a particular market explained
by innovations in each of the six indices.
Table 5-18 provides the variance decomposition of the 3-, 6-, 9 days ahead
forecast errors of each index, accumulated for by innovations in each of the six indices
for the first sub-period. The results indicate that all markets and oil returns are strongly
exogenous in the sense that the percentage of the error variance accounted for by their
innovations around 98%. The percentage of the foreign explanatory power, as indicated
by the foreign column, is weak, reaching in the best cases 3%.

Table 5-16
VAR System for GCC Stock Markets and Oil Returns for the First Sub-
Period 25May, 2001 to 23May, 2003
BAHRAIN OIL OMAN KUWAIT ABUDHABI SAUDI
BAHRAIN(-1) 0.1162 -0.1418 -0.0022 -0.2264 -0.0258 0.0154
0.011 0.5545 0.9672 0.0132 0.563 0.8312
BAHRAIN(-2) 0.0658 -0.0199 0.0358 0.131 -0.0628 0.0271
0.1488 0.9338 0.4962 0.1509 0.1592 0.707
OIL(-1) -0.014 -0.0473 0.012 0.0013 -0.0038 -0.0039
0.1088 0.3032 0.2344 0.9404 0.6548 0.7789
OIL(-2) 0.0046 -0.0305 0.0052 0.0046 -0.0006 -0.002
0.5974 0.5077 0.6069 0.7914 0.9467 0.8828
OMAN(-1) -0.004 -0.1014 0.4111 0.0851 -0.0551 -0.0118
0.9183 0.6255 0.000 0.2811 0.1543 0.8497
OMAN(-2) 0.0103 0.3084 -0.0172 -0.0329 0.0206 0.0017
0.7945 0.1378 0.7056 0.6761 0.5928 0.9782
KUWAIT(-1) 0.0009 -0.0439 -0.0067 0.1802 0.0123 -0.0321
0.968 0.7159 0.7991 0.0001 0.5847 0.3772
KUWAIT(-2) 0.0025 0.0423 -0.0144 -0.0493 0.035 0.0475
0.9113 0.7246 0.585 0.2797 0.1169 0.189
ABUDHABI(-1) -0.0824 0.2067 -0.0341 -0.0221 0.0633 0.0242
0.0761 0.3981 0.5256 0.8122 0.1638 0.7425
ABUDHABI(-2) 0.0173 -0.1866 -0.1019 0.048 -0.0789 0.113
0.7104 0.4464 0.0587 0.6057 0.0834 0.1257
SAUDI(-1) 0.0165 0.013 0.0187 -0.0273 0.0081 0.0722
0.5657 0.9317 0.5754 0.6353 0.7738 0.1145
SAUDI(-2) -0.0049 -0.0065 -0.0413 0.0475 0.0378 -0.0399
0.866 0.9658 0.2149 0.4096 0.18 0.3825
C -0.0077 0.0025 0.0069 0.1689 0.0568 0.0699
0.7654 0.9852 0.8161 0.0011 0.0244 0.087
stat. P-value
PTA (12) 350.22 0.634
LM test (12) 21.61 0.972

Notes: Numbers in italic represent P-values. VAR system has been estimated with 2 lags according to Akaike
information selection criterion, C represents a constant in the VAR system. PTA represents Residual Portmanteau
Tests for Autocorrelations up to lag 12. LM represents Residual Serial Correlation LM Tests up to lag 12.

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Table 5-17
VAR System for GCC Stock Markets and Oil Returns for the Second
Sub-Period 27May, 2003 to 24May, 2005
BAHRAIN OIL OMAN KUWAIT ABUDHABI SAUDI
BAHRAIN(-1) 0.262 0.204 -0.014 0.151 -0.106 -0.047
0.000 0.420 0.761 0.070 0.638 0.742
BAHRAIN(-2) 0.021 -0.406 -0.053 -0.048 0.222 0.225
0.654 0.121 0.271 0.573 0.342 0.129
BAHRAIN(-3) 0.061 0.240 -0.009 -0.017 -0.086 0.026
0.185 0.345 0.850 0.839 0.703 0.854
OIL(-1) 0.016 -0.074 0.003 0.001 -0.042 0.047
0.046 0.106 0.699 0.947 0.297 0.070
OIL(-2) 0.000 -0.029 0.014 0.021 -0.014 0.007
0.961 0.533 0.090 0.170 0.736 0.792
OIL(-3) -0.002 0.017 0.001 -0.032 0.045 -0.059
0.761 0.713 0.900 0.031 0.266 0.022
OMAN(-1) 0.070 0.135 0.389 -0.076 -0.240 -0.107
0.121 0.588 0.000 0.347 0.279 0.448
OMAN(-2) -0.092 -0.473 -0.003 -0.024 -0.046 0.204
0.056 0.075 0.946 0.778 0.846 0.175
OMAN(-3) 0.077 0.506 0.097 0.042 -0.054 -0.040
0.085 0.042 0.036 0.604 0.808 0.775
KUWAIT(-1) 0.011 0.015 -0.014 0.228 -0.050 -0.010
0.651 0.915 0.601 0.000 0.688 0.900
KUWAIT(-2) 0.011 0.169 0.060 -0.062 0.204 0.005
0.659 0.237 0.024 0.188 0.110 0.950
KUWAIT(-3) -0.039 -0.100 -0.019 0.060 0.075 0.001
0.121 0.474 0.456 0.194 0.548 0.987
ABUDHABI(-1) -0.007 -0.037 0.012 -0.019 0.355 0.007
0.477 0.473 0.214 0.251 0.000 0.798
ABUDHABI(-2) 0.005 0.047 -0.013 0.007 -0.192 0.035
0.577 0.371 0.201 0.694 0.000 0.241
ABUDHABI(-3) -0.004 -0.018 -0.005 0.005 -0.156 -0.016
0.652 0.729 0.568 0.786 0.001 0.569
SAUDI(-1) 0.006 0.164 0.004 -0.010 0.072 -0.077
0.687 0.044 0.786 0.710 0.318 0.094
SAUDI(-2) -0.016 0.017 -0.007 -0.005 0.031 -0.068
0.269 0.835 0.621 0.863 0.665 0.138
SAUDI(-3) 0.003 -0.131 -0.003 -0.024 -0.057 0.010
0.829 0.106 0.831 0.363 0.428 0.826
C 0.038 0.062 0.066 0.164 0.194 0.203
0.086 0.613 0.004 0.000 0.075 0.003
stat. P-value
PTA (12) 347.53 0.177
LM test (12) 38.1 0.374

Notes: Numbers in italic represent P-values. VAR system has been estimated with 3 lags according to Akaike
information selection criterion, C represents a constant in the VAR system. PTA represents Residual Portmanteau
Tests for Autocorrelations up to lag 12. LM represents Residual Serial Correlation LM Tests up to lag 12.

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Table 5-18
Variance Decomposition for the Forecast Error of Daily Market Returns for GCC
Markets and Oil Return During the First Sub-Period
By innovations in
Market Horizon All
explained (days) BAHRAIN OIL OMAN KUWAIT ABUDHABI SAUDI foreign*
BAHRAIN 3 98.80 0.55 0.04 0.00 0.51 0.09 1.20
6 98.79 0.55 0.04 0.00 0.51 0.10 1.21
9 98.79 0.55 0.04 0.00 0.51 0.10 1.21
OIL 3 0.13 97.12 0.96 0.29 1.13 0.37 2.88
6 0.14 97.04 1.02 0.30 1.13 0.38 2.96
9 0.14 97.04 1.02 0.30 1.13 0.38 2.96
OMAN 3 0.10 0.39 98.19 0.14 0.96 0.22 1.81
6 0.17 0.41 97.77 0.19 1.16 0.29 2.23
9 0.17 0.41 97.77 0.19 1.17 0.29 2.23
KUWAIT 3 1.31 0.06 1.18 97.24 0.08 0.12 2.76
6 1.32 0.06 1.19 97.22 0.09 0.13 2.78
9 1.32 0.06 1.19 97.22 0.09 0.13 2.78
ABUDHABI 3 0.74 0.04 0.43 0.71 97.69 0.37 2.31
6 0.79 0.04 0.44 0.73 97.62 0.38 2.38
9 0.79 0.04 0.44 0.73 97.62 0.38 2.38
SAUDI 3 0.07 0.02 0.26 1.20 0.69 97.75 2.25
6 0.08 0.02 0.26 1.25 0.70 97.69 2.31
9 0.08 0.02 0.26 1.25 0.70 97.69 2.31
Entries in each cell are the percentage of forecast error variance of the market return in the first column explained by the market in the first
row
* Entries in the 'All foreign' column denote that the total percentage of forecast error variance of the market in the first column explained by
all foreign markets
Cholesky Ordering: BAHRAIN OMAN KUWAIT ABUDHABI SAUDI OIL
Standard Errors: Monte Carlo (1000 repetitions)

Table 5-19 presents the variance decomposition for the second sub-period. After
the sharp rise in oil prices, one can find that in general all variables in the system still
exogenous. The percentage of the foreign explanatory power is not very strong; it does
not exceed 5%; though the degree of influence differs across returns. Table 5-19 shows
that oil returns influences Saudi market and account for 46% of the variance in the Saudi
market explained by foreigners (1.88% out of 4.12% for 6 days horizon). The reverse is
right since the Saudi market accounts for most of the variance in the oil returns explained
by foreigners for 6 and 9 days horizon. In addition, Abu Dhabi market accounts for half
of the variance of Kuwaiti market explained by foreign markets. The results can not help
us to determine which the dominant market is in the system that influences all the others
and links their interdependence.

200
Table 5-19
Variance Decomposition for the Forecast Error of Daily Market Returns for GCC
Markets and Oil Return During the Second Sub-Period
By innovations in
Market Horizon All
explained (days) BAHRAIN OIL OMAN KUWAIT ABUDHABI SAUDI foreign*
BAHRAIN 3 98.17 0.78 0.67 0.13 0.07 0.18 1.83
6 97.54 0.78 0.98 0.44 0.09 0.18 2.46
9 97.49 0.78 1.02 0.44 0.09 0.18 2.51
OIL 3 0.57 97.19 0.66 0.30 0.45 0.82 2.81
6 0.77 95.72 1.08 0.42 0.45 1.57 4.28
9 0.78 95.70 1.09 0.42 0.45 1.57 4.30
OMAN 3 0.50 0.56 97.86 0.76 0.29 0.03 2.14
6 0.62 0.63 97.16 0.83 0.70 0.05 2.84
9 0.64 0.63 97.13 0.83 0.71 0.05 2.87
KUWAIT 3 1.19 0.47 0.39 97.65 0.27 0.04 2.35
6 1.18 1.31 0.39 96.58 0.35 0.20 3.42
9 1.18 1.31 0.39 96.56 0.35 0.20 3.44
ABUDHABI 3 0.18 0.26 0.39 0.91 98.01 0.24 1.99
6 0.20 0.50 0.46 1.43 97.03 0.37 2.97
9 0.20 0.52 0.46 1.48 96.96 0.37 3.04
SAUDI 3 0.61 0.66 1.08 0.09 0.31 97.25 2.75
6 0.65 1.88 1.11 0.11 0.37 95.88 4.12
9 0.65 1.89 1.11 0.11 0.38 95.87 4.13
Entries in each cell are the percentage of forecast error variance of the market return in the first column explained by the market in the first
row
* Entries in the 'All foreign' column denote that the total percentage of forecast error variance of the market in the first column explained by
all foreign markets
Cholesky Ordering: BAHRAIN OMAN KUWAIT ABUDHABI SAUDI OIL
Standard Errors: Monte Carlo (1000 repetitions)

- Impulse responses
The estimated impulse responses of the VAR system offer an additional way of
examining how each of the six variables responds to innovations from other variables in
the system. Table 1 through 4 and figure 1 and 2 in appendix 4; summarize the responses
of all markets to one standard deviation shock in oil returns and the responses of oil
returns to one standard deviation shock in each of the GCC markets for the two sub-
periods. Table 1 presents the response of all markets returns to one standard deviation
shock in oil return for the first sub-period. In general the responses are small starting
from day 2 and taper off very slowly indicating that markets are not efficient in
responding to shock generating from oil return. However, it is apparent that a shock
originated in oil return has a major and persistent impact on Omani market more than
other GCC markets. It took Omani market 2 days to start responding to oil return’s shock.

201
In addition, Kuwaiti and Omani markets respond positively while other markets respond
negatively to shock in oil return.
Table 2 in appendix 4 presents the response of oil return to shocks generated from
each of the GCC stock markets and reveals that, shocks generated from Bahraini and
Omani markets have large and persistent impact on oil return. Since oil response has a
memory up to 15 days reaching the value of -0.156, 0.198 at the end of 15 days horizon
for both Bahraini and Omani markets respectively. However, the response of oil returns
taper off quickly and died up to 7 days, for shocks generated from Kuwaiti, Abu Dhabi,
and Saudi markets. These results are for the first sub-period, but for the second period
which witnessed the sharp raising in oil prices, we have a different picture for the
interaction relationship between GCC stock markets and oil return.
Table 3 presents the responses of GCC stock markets to a shock generated from
oil returns. Saudi market stands to be the most influenced followed by Abu Dhabi market.
Saudi market reacts in day 2 through 5. The same reaction for Abu Dhabi and Kuwaiti
markets, it seems that these markets react quickly and relatively efficient since their
reaction taper off and decline rabidly up to day 5 to shock originated in oil return.
However, Bahraini and Omani markets show a small and slow process in responding to
oil shock. The impulse responses for shocks originated in the GCC stock markets for the
second sub-period and the influence on oil return are presented in table 4 of appendix 4.
It seems that a shock in the Saudi market has the most influence on oil return, since oil
returns has a memory up to 4 days to absorb shocks generated from Saudi market, 0.212
In day 2 reaching 0.003 at the end of day 4, while oil return exhibits slow and persistent
process in responding to Omani market’s shock, 0.134 at the end of 15 days. In addition,
the least response of oil return seems to be for a shock in Abu Dhabi market.
Despite the different magnitude of impulse response values, some observations can be
made from the above mentioned tables:
• For the first sub-period the response of GCC stock markets for a shock in oil
return seems to be small and taper off slowly. On the other hand and for the same
sub-period, the response of oil to shocks in Bahraini and Omani markets seems to
be large and persistent.

202
 • For the second sub-period and after oil prices get higher, the interaction between
oil return and GCC stock markets increased especially for Saudi, Abu Dhabi, and
Kuwaiti markets, they exhibit large and quick responses to oil shocks within 4
days horizon. The reverse also is true when oil responds to shocks generated from
these markets. Indicating that, the interaction process between these three markets
and oil appears to be efficient. While for Bahraini and Omani markets which are
Non- OPEC members, they interact slowly for oil shocks.
• The Saudi market exerts the great effect when oil prices get higher in the second
sub-period. This is must not be surprised, since Saudi Arabia is the largest oil
exporter and has the largest oil reserves in the world.
These findings reflect the important impact of the increase in oil prices on GCC stock
markets. This is quite natural since GCC countries produce about 21% of the world's
daily oil production, and they possess about 43% of the world's oil reserve.

5-4 summary
This chapter has examined the degree to which Arab stock markets are integrated
both regionally and globally. According to the fact that Arabian economies are not
similar, Arab stock markets have been divided into two groups: oil production countries
which mainly include GCC markets, and non-oil production countries (Jordan, Egypt,
and Palestine). The results indicated that Arab stock markets appear to be segmented
from international stock markets, since no cointegrating relation was found between
Arabian and international markets, represented by S&P 500, (VAR-10). Moreover,
evidence of regional financial integration between Arab stock markets is still weak, since
the results from VAR-9 and its VEC model indicate that, despite the existence of long-
run relationship, linkages on the short run still weak between these markets, even it is
difficult to identify the true leader between the nine Arab stock markets.
As for GCC markets, the results of VAR-6; which includes 6 GCC markets,
indicate that Kuwait market can be considered as a leader for these markets. In addition,
some directional relationships have been found between GCC indices, but one still
expects to find more short-run relations between countries, share many economic and
social aspects. The results for non-oil countries indicate that these markets are not

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cointegrated in the long-run (VAR-3). Moreover, the chapter also examined the effect of
the raise in oil prices in the last two years on GCC stock markets, through investigating
the dynamic structure between five member countries of the oil-rich GCC and oil prices.
The results show that oil prices dominate the long-run equilibrium with GCC stock
markets (VAR-7), and have a significant effect on returns volatility in these markets.
More important, the findings reflect the important impact of the increase in oil prices on
GCC stock markets, since after the rise in oil prices, four out five GCC markets can
predict oil prices while only two GCC markets can be predicted by oil prices. The results
on the link between oil prices and stock markets are consistent with the existing
international literature, since it is found that oil prices shocks have significant effect on
stock markets (see Johnes and Kaul 1996; Huang et al. 1996; Sadorsky 1999; Papapetrou
2001; and Hammoudeh and Aleisa 2002, 2004).
For portfolio diversification benefits, the message of these results for international
investors appears clear. Arab stock markets can offer diversification potentials for
international investors; both on the long and short-run horizons; since the body of
evidence in support of integration of major world stock markets is quite impressive,
international investors often search for new emerging markets which offer the risk-
reward trade-offs, they cannot get in more matured markets. The results here suggest that
Arab stock markets may have such potential benefits; stocks in these markets can
minimize the risk of spillovers from other foreign markets (like the US market), and thus
may limit the contagion effects which inflect more globally integrated markets. The
apparent segmentation of Arab stock markets suggests that these markets are not only
emerging, with enormous growing potentials, but they also offer international investors
diversification benefits unavailable elsewhere. For regional portfolio investments, non-oil
countries (Jordan, Egypt, and Palestine) could offer the rich GCC investors with
diversification benefits to diversify their portfolio regionally.
From a policy point of view, Arab policy makers should make regulatory and
accounting changes to promote financial integration among their markets especially for
GCC countries. They should allow more eligible companies to their own to be listed on
their exchanges, and permit cross-company listing. Privatization and privately held
companies will spread the risk and lead to greater market development. Furthermore, the

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results for GCC markets suggest that there is a bidirectional relationship between Saudi
market and oil prices, and a directional relation from Oman to oil prices, the things that
point to those countries’ predictive power on oil prices. This would also show that,
political and economic stability (or lack thereof), has a direct impact on stability in oil
prices. Saudi Arabia, for example, which has the largest oil reserve in the world (about
24%), does affect oil prices and simultaneously be affected by them.
Equally important is that; decision makers in those countries have to secure
diverse income resources, and try to increase their contribution (non-oil sectors) to GDP.
Since Oman, for instance, oil contribution to GDP amounts to about 42%, Kuwait 46.6%,
and Saudi Arabia 38%, in 2003. This may lead to risks, as a result of linking those
countries’ economies with oil prices in view of the risks in the oil market, which reflects
negatively on the performance and volatility of their stock markets; taking into account
that GCC countries are planning to perform a single currency before 2010.

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6- Vision and strategic plan for Arab stock markets
The empirical results indicate that the weak form of efficient market hypothesis
can be rejected in the Arab stock markets, and that these markets are characterized with
thin trading and non-linear return generating process.
Despite the noticeable developments in the performance of these markets, as
designated by markets performance and activity indicators, these markets are still
suffering from numerous problems and obstacles that detain their development and
growth, such problems are: the limitation of the investment opportunities available for
investors, caused by tiny number of listed companies, highly concentrated markets since
few number of listed companies possess most of trading activity, and fewness of the
institutional investors since most of the existing investors are individual ones, the fact
that these individual investors are less informed and lacked of investment awareness in
general which lead them to act in a manner similar to noise trading, which negatively
affect the stability and performance of Arab stock markets. In addition, such behavior
may lead returns to respond non-linearly to the arrival of new information to the market.
On the contrary, the institutional investor makes his decision based on scientific analysis
of the available information, a fact that leads to market stability and reduce sharp prices
fluctuations.
Moreover, the empirical results indicate that Arab stock markets are not integrated
with international markets or among themselves. Since no signs of cointegration were
found between oil and non-oil production countries’ stock markets and between Arab
markets as a group and international markets. The thing that may provide primary
indicators that Arab stock markets could offer diversification potentials for both regional
and international portfolio investors. But the fact that, GCC stock markets impose
restrictions on both foreign and non-GCC national Arab investors practically diminish
these diversification potentials.
Additionally, the results present the increasing risks resulting from direct linkages
between GCC economies and oil prices, and its important effect on the performance of
the GCC-stock markets. It is the time that GCC countries should take considerable steps
toward diversifying their GDP components, to decrease their dependence on oil sector.
For instance, it is expected that oil reserve in Oman to be consumed within 18 years with

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the current level of production, while oil contribution to GDP account for 42 percent, for
Saudi Arabia 38 percent, and Kuwait 42 percent, the thing that clarifies the risks caused
by high significant correlation and dependence between these economies and oil
production. As a result, political and economic stability (or lack thereof) of the largest oil
producers, also has implications for the stability of oil prices. Since Saudi Arabia has the
largest oil reserve and production in the world. Moreover, the GCC countries exist in a
region characterized with political instability and witnessed three regional wars during
the last two decades.

6-1 Environment analysis

To understand the causes and consequences of the obtained results, and its
implications on Arab stock markets, it is important to analyze the surrounding
environment where these markets exist. It can be concluded that among the problems that
these markets suffer and affect there performance and efficiency are thin trading,
narrowness and illiquidity, the fewness of the available investment opportunities, and the
segmentation from international and regional stock markets. The remaining of this
section will analyze the environment surrounding these markets and determine the
shortages. The thing that lead us to identify and determine the strength, weakness,
opportunities and threats that face Arab stock markets, as a way to draw a general
strategic plan to develop and enhance the performance of these markets.

6-1-1 Demand and supply of financial papers

In addition to the legal and institutional framework adequacy and completeness,
and the availability of efficient executive management, the development of the stock
market depends on the availability of sufficient demand and supply. The supply level in
Arab stock markets still weak, leading these markets to be narrow, and affects negatively
market liquidity and trading activities. Since one can find hundreds of listed companies in
one market, without any effective role on trading floor (i.e. Egyptian stock market).
Where listing for prestige and reputation purposes will not offer financial papers for the
market, it is important to handle and treat this negative phenomenon.

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 Financial paper supply could be enhanced by new issues for existing companies,
privatizing state owned shares in these companies, the conversion of individual owned
companies to corporate ones, in addition to the creation of new financial instruments, will
increase and improve investors investment options. To achieve the above, it is needed to
remove legal and legislation obstacles, facilitate stock market procedures, allowing for
cross-listing between markets, and increase investors confidence with financial
intermediaries in these markets.
On the other hand, supply policies should be followed with other policies to
attract investors’ attention. It is not expected that supply level still increasing with fixed
or slowly demand growth. Since weak demand level will be reflected with low level of
coverage for the new issues, which discourage companies to issue new issues. So it is
important for Arabian decision makers to implement polices that motivate the demand of
financial papers in their local stock markets, keeping supply growth at the same time. The
priority of such polices may switch between treating deficiencies in financial papers
supply, or increase and motivate financial papers’ demand, according to each market
specific features and conditions. For instance, GCC markets need to concentrate on
improving supply to absorb surplus liquidity resulting from huge raise in oil prices, and
to reduce negative speculations resultant from huge demand on financial papers.
There are several policies that can be followed to motivate demand, such as
increasing investment awareness, especially in Arabian countries who suffer from
financial deficit, where commercial banks dominate financing sector through short-run
finance. Arab stock markets are required to increase investment awareness with stock
market’s activities and investment opportunities that a stock market can offer. Moreover,
it is important to develop the specialized financial press, and create new financial and
investment instruments to achieve investors’ needs to increase the demand on financial
papers and improve stock market activities. Arab stock markets need to change the
current situation since trading took place only on bonds and common stocks. They have
to create new instruments and papers that mixed between bonds and stocks; such as
warrants and options, which will improve demand and supply on financial papers.
Furthermore, trading costs affect the demand and stock market microstructure,
which will be discussed in details later. In addition, to the policies that aimed to develop

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supply and demand, different policies could be used that affect both demand and supply,
such as improving the efficiency of intermediaries operations, increasing information,
and market control.

6-1-2 Market microstructure

The particular trading arrangements in an equity market may directly affect two
key functions of that country’s stock market: price discovery and liquidity. First, the
trading process should lead to “fair” and correct prices; in other words, no investor
should be able to manipulate market prices in his or her favor. Second, trading should
occur at a, low transaction cost, and large quantities should trade without affecting the
price. These issues are the topic of the field of market microstructure. It is generally
believed that microstructure improvements should greatly affect the liquidity of the
markets, which can best be approximated by the cost of trading and increasing the
turnover and liquidity in the market.
While in the case of Arab stock markets, trading costs (market commissions and
intermediaries costs) are significantly affect investors’ enthusiasm to deal with financial
market. That is why Arab markets not only need to reduce trading costs as possible, but
also to harmonize and unify these costs among markets, since it is noticeable the
existence of large Bid-Ask spread in these markets. Moreover, the differences between
trading costs make it difficult to discover the opening treading price, and affect
negatively market liquidity.

6-1-3 Liberalization and markets integration

Market integration is central to both questions. In finance, markets are considered
integrated when assets of identical risk command the same expected return irrespective of
their domicile. In theory, liberalization should bring about emerging market integration
with the global capital market, and its effect on emerging markets is then clear. Foreign
investors will bid up the prices of local stocks with diversification potential while all
investors will shun inefficient sectors. Overall, the cost of equity capital should go down,
which in term may increase investment and ultimately increase economic welfare.

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 Moreover, market integration is of concern both to equity investors, and
companies in the region that make capital budgeting decisions. Specifically, if
segmentation exists and firm is forced to raise capital locally, then its cost of capital is
likely to be higher than that of a company with unrestricted access to the regional and
international capital markets. The empirical results here indicate that Arab stock markets
are segmented from international stock markets. Segmentation also exists between oil and
non-oil Arabian countries. The thing that raise the needs for these markets to take
significant steps toward market liberalization, especially for GCC markets, which impose
several restrictions on foreign investors and in some cases even for Arabian investors
who are non-GCC nationals.
On the other hand, increases in correlations between markets would imply a
decrease in the benefits from international diversification in line with portfolio theory.
However, under the concept of cost-benefit analysis, Arab stock markets will gain more
benefits from market liberalization. Since the tendency for the global markets to become
more integrated; is a result of the increasing tendency toward liberalization and
deregulation in the money and capital markets, both in developed and developing
countries as well as on a bilateral and multilateral basis. Such liberalization is important
to introduce structural reforms, to promote economic efficiency, to stimulate trade and
investment, and to create a necessary climate for promoting sustainable economic growth
with a commitment to market-based reforms.

6-1-4 Privatization
In most emerging markets, privatization was intended to increase productivity of
state-owned economic enterprises (SOEs), and to help reduce government budget
deficits. In some cases, governments actively sought to promote capital market
development through privatization. Many governments intended to create a class of
people with a stake in the new economy, thereby making it more difficult for political
changes to be reversed. Regardless of the goal, privatization was not initiated, in order to
divest fully the government’s interest in the real economy. Nevertheless, even the partial
divestment under consideration was economically substantial.

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 Privatization programs impact emerging capital markets through various
mechanisms. For instance, share issued privatizations (SIPs) increase the market
capitalization and the value traded on local exchanges. Moreover, SIPs can change the
investment opportunity set of portfolio investors, public offers of SOEs whose cash flows
are not perfectly correlated with pre-existing companies; help investors to achieve gains
through diversification. Under this scenario, SIPs may help to lower the risk premium
investors require for holding the market portfolio of publicly traded equity. Other
methods of privatization, including the direct sale of former SOEs, the direct sale of
SOEs assets, or concessions of public sector monopolies, alter the dynamics of local
capital markets in less obvious ways. Consider the direct sale of an SOE to a private
investor, this sale does not increase the market capitalization or value traded of the local
exchange. However, the sale may alter the real investment opportunity set of the private
investor.
As viewed from this perspective, all forms of privatization can impact local
capital market dynamics. The common component of privatization that impacts capital
markets is the transfer of productive resources from the public sector to the private sector.
This transfer may allow investors to achieve benefits through diversification and may
affect the cost of capital in emerging markets. Even if private investors do not benefit
from the transfer of resources, i.e. their investment opportunity set does not change;
privatization programs may still influence capital markets. Privatization program can help
the government signal its commitment to free market polices. For most emerging markets
governments, the implementation of a privatization program reverses decades of state-led
economic development. Successful privatization of politically sensitive industries may
convince investors to reduce the ex ante perceived risk of government interference in
investment decisions and expropriation of productive assets. As a result of sustained
privatization efforts, the sovereign risk premium inherent in the governments fixed
income liabilities may be reduced. As this chain of events ripples through the economy,
local market entrepreneurs eventually benefit in their ability to obtain debt financing at
lower cost.
Despite the fact that most Arabian countries going toward privatization programs
of state-owned economic enterprises, investment opportunities are still limited, investors

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still facing a few number of listing companies with limited financial instruments. It is
important for such countries to continue with an effective privatization process to
enhance market depth, liquidity, and trading activities.

6-1-5 Legal and regulatory environment

Regulatory framework is a combination of laws, legislations, and instructions that
manage financial papers’ issuing and trading. In addition to the companies’ and financial
papers’ laws; which are the main components of the regulatory and legal framework,
there are several legislations related to financial papers such as investment and taxation
laws, auditing law, and banks and financial institutions laws. These legislation,
instructions and decisions produced by market supervision party, are forming the
fundamental structure that a stock market build on, determining the types and nature of
financial instruments, identifying listing requirements and conditions, disclosures’
standards, and brokerage rules. Moreover, these laws controlling trading process, deposits
and clearing settlements, and professional behavior and ethics.
- Companies laws
Companies’ law is the most important law that related to stock market. It manages
the establishment and registration procedures for corporate companies, and determines
the types of financial papers that companies can issue, issuing conditions and
requirements, and many other features that manage and protect owners and investors
rights, such as those related to financial disclosure and controlling requirements. So
companies’ law directly affects the supply of financial papers.
In this consequence, companies’ laws in several Arabian countries have been
reviewed and subjected to full comprehensive revision, mainly aimed to improve
companies’ establishments’ conditions, and enhancing the procedures that manage
financial papers issuing.
- Financial papers law and its related instructions
Financial papers’ law is the main step for establishing and organizing a stock
market. Despite the differences between financial papers’ laws among Arab stock
markets, they are generally similar in several aspects such as stock market establishing
procedures, regulatory framework, and its goals and objectives.

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 Despite the regulatory and legislation improvements in most Arab markets, there
are still several shortages and disadvantages, most of them may be resulted from the
inadequate, inefficient implementations of the contents of these laws, which will be
summarized as follows:
• Some regulatory and financial papers’ laws have been created in early stages,
according to theoretical framework without practical examination. This put these
laws disable to follow continuing improvements in international stock markets.
Moreover, continues adjustments for some of these laws’ articles make them
inconsistent and unstable over time.
• A disadvantage that face these markets that they are controlled by several laws
and regulations governed by numerous parties.
• The absence of regulations in some Arabian markets that separate between the
supervision and the executive role. The two roles continue to be simultaneously
in the hands of the capital market it self (as in Bahrain, Saudi Arabia, Kuwait,
and Oman).
• The absence of legislations in some Arabian markets that forced listed companies
to be committed with international accounting and auditing standards, since some
of financial statements lack of the adequate disclosure, ambiguity, and
incomparability.
• Despite the existence of legislation that oblige listed companies to issue mid and
quarterly financial statements, these statements in several cases came out too late
which make them useless.
• The lake of legislations that manage the establishments of issuing houses. Since
such houses promote and insure the full coverage of new issues, and play a
significant role in privatization programs especially when it is difficult for a stock
market to absorb a large number of new issues.
• The shortage of legislations that regulate the establishments of credit rating and
issuing credit status institutions.
• In many cases, the lack of regulations that manage and allow cross-listing
between Arabian markets, where in other cases; especially GCC markets,

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 accessibility of foreign investments is restricted, even for non-GCC nationals
Arab investors.
• The lack of coordination and harmonization between regulatory and legal
frameworks among Arab stock markets, which limit the integration ability among
these markets, especially for GCC countries which are planning to establish a
monetary union and have a single currency before 2010.

6-2 Strength, Weakness, Opportunities, and Threats (SWOT) analysis

According to the previous analysis, and taking into account each market special
features, characteristics, and environment, it is possible in general to determine the most
significant strength, weakness, threats, and opportunities that Arab stock markets enjoy as
follow:
- Strength
• According to international standards, Arab stock markets are considered as
emerging markets with promising growth potentials.
• The segmentation of Arab stock markets from international markets protects them
from the contagion effect caused by international financial crisis, and raises the
diversification potentials that these markets may offer.
- Weakness
• Arab stock markets can be characterized as inefficient markets in the sense of
weak-form of efficient market hypothesis.
• These markets are described as narrow markets and lack of depth.
• Thin trading and illiquidity.
• The narrowness of the available investment opportunities with little number of
listed companies and limited investment instruments.
• The lake of investment awareness in general between investors.
• The diminish role of institutional investor, since most investors are small and
individual ones.
• Highly concentrated markets, since a small portion of listed companies dominate
most of trading activities.

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• The unavailability of timely, adequate, and reliable financial information about
listed companies.
• The weak; and in some cases the absence, of the financial intermediaries role and
the lack of specialized financial information institutions.
• Several shortages in the legal and regulatory framework and in many cases the
inadequate implementation of these laws and legislations.
• The absence of effective coordination and cooperation among Arab stock
markets.
• Lack of harmonization and highly trading costs among these markets.
• The existence of many obstacles that hinder the direct flow of foreign investment
especially in GCC stock markets.
- Opportunities
• The benefits and advantages that may be obtained from market liberalization
process.
• The available opportunities of growth, since Arab stock markets are emerging
markets.
• The financing potentials that these markets can offer for local and regional
companies who are looking for raising funds with low cost of capital.
• The contributions of Arab stock markets in developing local economies and
facilitate privatization programs, through offering several investment channels,
encouraging saving, promoting investment, and efficient capital allocation.
• Attracting foreign investors through offering diversification potentials, after
removing all obstacles that prevent direct foreign investments.
• Offering profitable investment opportunities for expatriate Arab investments, and
encourage the return of these investments which are estimated with billions of
dollars.
- Threats
• The direct linkages between GCC economies and oil industry, which increase
risks in its financial markets and affected by sharp fluctuations in oil prices.

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 • The risk of sharp and extensive speculations that affect GCC stock markets
resultant from surplus liquidity and the narrowness of investment options
available for investors.

Table 6-1: Strength, Weakness, Opportunities, and Threats for Arab Stock Markets
STRENGTH BASED ON
According to international standards, Arab stock markets are Emerging markets have promising
considered as emerging markets with promising growth potentials. growth potentials.

The segmentation of Arab stock markets from international Results of cointegration test, Structural

markets protects them from the contagion effect caused by VAR.

international financial crisis, and raises the diversification

potentials that these markets may offer.

WEAKNESS BASED ON
Arab stock markets can be characterized as inefficient markets in Regression analysis, Variance ratio,

the sense of weak-form of efficient market hypothesis. Runs test, Serial correlation, BDS test,
and Volatility analysis GARCH models,
Existing anomalies.
These markets are described as narrow markets and lack of depth. The lack of several investment
opportunities and instruments.
Thin trading and illiquidity. Large Bid-Ask spread, see section 3-1-1

The narrowness of the available investment opportunities with little Few number of listed companies, limited

number of listed companies and limited investment instruments. investment instruments, see table 2-12.

The lake of investment awareness in general between investors. Large number of unwell informed
individual and small investors.
The diminish role of institutional investor, since most investors are Large waves of speculations, non-linear

small and individual ones. returns generating process, BDS test

Highly concentrated markets, since a small portion of listed See figure 2-5

companies dominate most of trading activities.

The unavailability of timely, adequate, and reliable financial The delay in issuing mid and quarterly

information about listed companies. financial statements.

The weak; and in some cases the absence, of the financial Lack of investments awareness,

intermediaries role and the lack of specialized financial information unavailability of specialized financial

institutions. press

Several shortages in the legal and regulatory framework and in Inaccessibility of direct foreign

many cases the inadequate implementation of these laws and investments to GCC markets.

legislations.

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The absence of effective coordination and cooperation among Arab Non-GCC national Arab investors are

stock markets. forbidden to directly invest in GCC

markets.
Lack of harmonization and highly trading costs among these Several differences between trading

markets. costs among Arab stock markets.

The existence of many obstacles that hinder the direct flow of Inaccessibility of direct foreign
foreign investment especially in GCC stock markets. investments to GCC markets, even for
non-GCC nationals Arab investors

OPPORTUNITIES BASED ON
The benefits and advantages that may be obtained from market Entrance of foreign investments,

liberalization process. improving market liquidity, depth, &

activities.
The financing potentials that these markets can offer for local and Cointegration test, SVAR results.

regional companies who are looking for raising funds with low cost
of capital
The contributions of Arab stock markets in developing local The effective role that stock market can

economies and facilitate privatization programs, through offering play in efficient capital allocation,

several investment channels, encouraging saving, and promote absorbing new issues.

investment.
Attracting foreign investors through offering diversification The segmentation between these

potentials, after removing all obstacles that prevent direct foreign markets and international financial

investments markets, cointegration test, and SVAR

Offering profitable investment opportunities for expatriate Arab The availability of profitable investment

investments, and encourage the return of these investments which options

are estimated with billions of dollars.

THREATS BASED ON
The direct linkages between GCC economies and oil industry, Cointegration test and VAR analysis for

which increase risks in its financial markets and affected by sharp oil prices and GCC markets, the

fluctuations in oil prices. significant role of oil prices on GCC

market volatility GARCH models.
The risk of sharp and extensive speculations that affect GCC stock High waves of speculations, weak

markets resultant from surplus liquidity and the narrowness of supply with growing demand on

investment options available for investors. financial papers.

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6-3 Vision and strategic goals
The objective of this action plan is therefore to achieve the following strategic
goals, which expected to enhance and develop Arab stock markets, increasing market
liberalization, improving market efficiency, through increasing market liquidity, depth,
and trading activities. The thing that put these markets in a position that able to attract
portfolio investors, signs these markets as a target from foreign investors, and facilitates
the integration and cointegration between Arab and international and regional financial
markets.
To achieve these goals, it was necessary to draw specific targets under the
umbrella of a general vision, which will be achieved through specific strategies that could
be realized through tactical programs and activities, as described bellow. Taking into
account the following couple of notes:
• The following programs are not exclusive, any other additional programs and
activities could be added, to achieve the goals.
• It is important to consider the specific conditions for each individual market,
regarding economic factors, regulatory frameworks, and the liberalization degree
that a stock market reached.
This strategic plan aims to achieve several objects in order to reach two main
goals: the first goal aims to enhance and improve market efficiency through enhancing
the legal and regulatory frameworks that manage these markets, improving market
microstructure, increasing market depth and liquidity, the thing that increasing the
capability to liberalize and open Arab stock markets with international markets, which is
the second main goal.

- Vision for Arab stock markets:

Toward liberalized, liquid and efficient Arab stock markets, with the
capability to attract foreign investments and portfolios by providing
several investment instruments and opportunities, that offer
diversification potentials.

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 - Strategic plan

The Main Goals:

Goal 1: Increasing and improving Arab stock markets efficiency.

Goal 2: Liberalizing Arab stock markets.

Goal 1: Increasing and improving Arab stock markets efficiency

Target 1: Increasing market depth and liquidity by enhancing trading activities.

Strategy 1: Increasing financial papers supply and diversify the available

investment opportunities and instruments.

Adopting the required legal procedures that encourage companies for
listing in stock markets.

Promoting cross-listing for financial papers among Arab markets

Increasing tax incentives for listing companies.

Offering new financial instruments through amending the related
legislations and adequate implementation of regulations.

Reviewing and reducing trading costs as possible.

Strategy 2: Increasing and enhancing demand on financial papers.

Increasing investment awareness in general.

Creating investment funds to attract the less informed small investors.

Providing frequent, qualified financial information.

Increasing and activating the role of financial intermediaries’ institutions.

Target 2: Protecting investors’ rights and keep on market stability away from
sharp fluctuations.
Strategy 1: The availability of adequate financial information regarding listed
companies’ activities and performance.

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Forcing listed companies with international accounting and auditing
standards especially those related to full financial disclosure

Creating specialized financial press.

Encouraging the existence of expert and credit rating houses.

Forcing listing companies to issue regulatory financial statements on its
time especially semi & quarterly statements.
Strategy 2: Improving market microstructure.

Reducing trading costs as possible.

Full isolation and clear determination of responsibilities between the
supervision & the executive functions according to the international stock
markets standards.
Strategy 3: Increasing and enhancing the role of institutional investor.

Goal 2: Liberalizing Arab stock markets

Target 1: Harmonization and conformance of regulations and legislations
among Arab stock markets.
Strategy 1: Relaxation of the legal and regulatory impediments.

Allowing non-GCC notional investors to directly invest in GCC stock
markets.
Strategy 2: Increasing correlation and integration between Arab stock markets.

Unification of listed conditions & commissions.

Unification of clearing & deposits regulations among Arab stock markets.

Eliminating the legal obstacles that hinder cross listing between markets.

Harmonizing tax laws among Arab countries especially those related to
financial markets.

Improving & renewing companies’ law.

Enhancing financial papers law.

Target 2: Facilitating the mobility of international and regional portfolios

especially to GCC markets.
Strategy 1: Attracting international and regional investments and portfolios.

220

Removing all obstacles that prevent foreign direct investments in GCC
markets.
Strategy 2: Emphasizing the diversification benefits that Arab stock markets may
offer for portfolio investors.

Providing reliable financial information for listed companies activities and
market performance.

Improving & introducing new trading techniques such as E. trading.

Target 3: Increasing Arab markets’ openness to international and regional

markets.
Strategy 1: Benefiting from advantages and experiences resultant from
integration with international markets.

Increasing investment and financing options available for investors.

Encouraging the establishments of institutions specialized in producing
financial information which promote Arab markets internationally.

Removing any obstacles that prevent foreign direct investment mobility to
GCC markets.

Target 4: Enhancing the role of financial market in economic development and

efficient capital allocation.
Strategy 1: Create investment tools and opportunities to encourage saving.

Establishing investment funds targeted small investors, i.e. pension funds.

Offering several saving tools and opportunities.

Encourage the return of Arab expatriate investments through offering
profitable investment options.

Absorbing the surplus liquidity resultant from raise in oil prices.
Strategy 2: offering different financing sources for those companies looking for
raising fund.

Absorbing the new companies’ issues via effective and deep stock market.

Offering several financing options for companies.

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Strategy 3: contribution in achieving governments’ privatization programs and
diversified GDP components in GCC countries to reduce oil risks.

Absorbing the state-owned enterprises (SOEs) issues resulting from
privatization programs.

The availability of issuing houses those secure the full coverage of the
new issues.

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Goal 1: Increasing and improving Arab stock markets efficiency

Strategic Goal 1 Increasing and improving Arab stock markets efficiency

Increasing market depth and liquidity by Protecting investors rights and keep on market
enhancing trading activity stability away from sharp fluctuations
Specific Objects

Increasing financial Increasing and The availability of Improving Increasing &

papers supply and enhancing the adequate financial market enhancing the
diversify the demand for financial information microstructur role of
Strategies
available investment papers regarding listed e institutional
opportunities and companies’ activities investor
instruments and performance

- Adopting the required legal

procedures that encourage companies
for listing in stock markets
- Promoting cross-listing for financial
papers among Arab markets
- Increasing tax incentives for listing
companies
- Offering new financial instruments
through amending the related
legislations and adequate
implementation of regulations
- Reviewing and reducing trading costs
as possible
- Increasing investment
awareness in general
- Creating investment funds to
attract the less informed small
investors
- Providing frequent, qualified
financial information
- Increasing and activating the
role of financial intermediaries
institutions
- Forcing listed companies with
international accounting and
auditing standards especially
those related to full financial
disclosure
- Creating specialized financial
press
- Encouraging the existence of
expert and credit rating houses
- Forcing listing companies to
issue regulatory financial
statements on its time especially
semi & quarterly statements
- Reducing trading costs as
possible
- Full isolation and clear
determination of
responsibilities between the
supervision & the executive
functions according to the
international stock markets
standards

223
Goal 2: Liberalizing Arab stock markets
Strategic Goal 2
Harmonization and conformance
Specific Objects
of regulations & legislations
among Arab stock markets
Relaxation of the Increasing
legal & regulatory correlation &
impediments integration between
Arab markets
- Allowing non-GCC - Unification of listed
notional investors to conditions & commissions
directly invest in GCC - Unification of clearing &
stock markets deposits regulations among
Arab stock markets
- Eliminating the legal
obstacles that hinder cross
listing between markets
- Harmonizing tax laws
among Arab countries
especially those related to
financial markets
- Improving & renewing
companies law
- Enhancing financial papers
law
Arab stock markets liberalization
Facilitating the mobility of Integrating & correlating Arab Enhancing the role of the financial
international & regional markets with international market in economic development
portfolios especially to GCC markets & efficient capital allocation
markets
Attracting Emphasizing the Benefiting from Create investment Offering different Contribution in
international & diversification advantages & tools and financing sources achieving
regional benefits that Arab experiences opportunities to for those governments’
investments & markets may resultant from encourage saving, companies privatization
portfolios offer for portfolio integration with looking for programs and
investors international raising fund diversified GDP
markets components in
GCC countries to
reduce oil risks
- Removing all - Providing reliable - Increasing investment - Establishing - Absorbing the new
obstacles that financial and financing options investment funds companies issues via
prevent foreign information for available for investors targeted small effective & deep stock
direct listed companies - Encouraging the investors, i.e. pension market
investments in activities & market establishments of funds - Offering several
GCC markets performance institutions specialized - Offering several financing options for
- Improving & producing financial saving tools and companies
introducing new information which opportunities
trading techniques promote Arab markets - Encourage the return
such as E. trading internationally of Arab expatriate
- removing any obstacles investments through - Absorbing the SOIs issues
that prevent foreign direct offering profitable resulting from privatization
investment mobility to investment options program
GCC markets - Absorbing the surplus - The availability of issuing
liquidity resultant from houses those secure the full
raise in oil prices coverage of the new issues
224
7- Conclusions
The Efficient Market Hypothesis (EMH) states that asset prices in financial
markets should reflect all available information. As a consequence, prices should always
be consistent with “fundamentals”. Most studies on EMH were conducted on the world’s
largest stock markets. However, the past twenty years have witnessed spectacular growth
in size and relative importance of emerging markets in developing countries. Emerging
markets have long posed a challenge for finance; standard models are often ill suited to
deal with the specific circumstances arising in these markets. However, the interest in
emerging markets has provided impetus for both the adaptation of current models to new
circumstances in these markets and the development of new models.
The focus of this thesis was toward nine Arab new emerging markets in the
Middle East region. Having presented the main literature regarding EMH, our attention
has been directed to test market efficiency in these markets. Consider the specific features
for these markets; we started firstly by adjusting daily observed indices for the possible
effect of infrequent trading. Based on the results obtained from chapter 4, random walk
properties have been rejected for Arab stock markets. The results obtained from
regression analysis, variance ratio, BDS, runs test, and serial correlation tests, rejected the
randomness and independence of returns, even after observed indices have been corrected
for infrequent trading. Moreover, the results indicated that, prices responding non-
linearly to the arrival of new information, while volatility clustering phenomenon still
seems to characterize markets’ returns. The GARCH (1,1) results for daily returns
indicated that all markets exhibited volatility clustering with one exception for Dubai.
Furthermore, volatility seems to be persistent in three markets (Egypt, Kuwait,
and Palestine) with a slow rate of decay. Additionally, four Arab markets (Bahrain,
Dubai, Kuwait, and Oman) showed signs of leverage effect with asymmetric shocks to
volatility. The GARCH models found to explain quite satisfactory the non-linear
dependence found in the time series. Furthermore, seasonality and calendar effects existed in
Arab markets with three forms; day-of-the-week effect, month-of-the-year effect and the
Halloween indicator.
Having answered the question regarding market efficiency in Arab stock markets, we
tried to examine the degree to which these markets are integrated with other international
markets. In other words, we tried to investigate if Arab stock markets can offer diversification

225
benefits for both regional and international portfolios investors. The analysis has been conducted
in two directions, firstly to investigate the cointegrating relation between Arab and international
markets, while the second direction was to examine the dynamic relationships between Arab
markets as a group.
The results of multivariate cointegration techniques indicated that Arab stock markets
appear to be segmented from international markets, since no cointegrating relation was found
among variables in the system. However, in the short-run there could be some interactions
between Arab and international markets. To examine this, a structural vector autoregression
(SVAR) model has been employed, to answer the question how do Arab markets react to shocks
originated in international markets (US, UK, and Japan) under the assumption that, the returns on
each of the three international markets affect the returns on Arab markets but not vise versa. The
resultant impulse response functions and variance decomposition indicated that, the linkages
between Arab and international markets still very weak in the short-run, with some signs that the
UK market exerted the most effect in influencing Arab markets.
Next we continued to examine the dynamic relationships between Arab markets
themselves. According to the fact that Arabian economies are not similar, the total markets have
been divided into two groups: oil production countries which mainly contain GCC markets, and
non-oil production countries (Jordan, Egypt, and Palestine). The results indicated that despite the
existing long-run cointegrating relation, the linkages between Arab markets still weak in the short
run, while for non-oil countries indicated that these markets are not integrated on the long-run.
It is known that several economic factors may affect stock market performance; such as
oil prices, given the fact that oil prices have a significant effect on GCC economies. We continue
chapter 5 by investigating the effect of oil prices on GCC stock markets. Several techniques have
been used, firstly to test the effect of oil prices on market volatility, oil returns have been added as
an additional regressor in the variance equation of the GARCH model, the results indicated that
oil prices have a significant role in affecting GCC markets’ volatility. Second, using multivariate
cointegration and vector autoregression (VAR) models, we concluded that oil prices formed and
dominated the long-run cointegration with GCC markets. Furthermore, after the raise in oil
prices; especially during the last two years, the linkages between oil and GCC markets increased,
four GCC markets have predictive power on oil prices, with only two markets (Saudi Arabia and
Oman) to be predicted by oil prices. Finally, and on the light of the obtained empirical results, a
strategic plan has been suggested to develop the performance of Arab stock markets based on two
main broad goals, improving market efficiency and increasing market liberalization. This will be

226
achieved through specific targets and strategies that could be realized through tactical programs
and activities.
In conclusion, based on the results of this thesis; some implications for economic policy
can be made. For portfolio diversification benefits, the message of these results for
international investors appears clear, Arab stock markets can offer diversification
potentials for international investors; both on the long and short-run horizons. The results
here suggested that Arab stock markets may have diversification potentials; stocks in
these markets can minimize the risk of spillovers from other foreign markets (like the US
market), and thus may limit the contagion effects which inflect more globally integrated
markets. The apparent segmentation of Arab stock markets suggested that these markets
are not only emerging, with enormous growing potentials, but they also offer
international investors diversification benefits unavailable elsewhere. For regional
portfolio investments, non-oil countries (Jordan, Egypt, and Palestine) could offer the
rich GCC investors with diversification benefits to diversify their portfolio regionally.
From a policy point of view, Arab policy makers should make necessary
relaxation to regulatory and legal framework, to promote financial integration among
their markets especially for GCC countries. They should allow more eligible companies
to their own to be listed on their exchanges, and permit cross-company listing.
Privatization and privately held companies will spread the risk and lead to greater market
development. Moreover, the results for GCC markets suggest that there is a bidirectional
relationship between Saudi market and oil prices, and a directional relation from Oman to
oil prices, the things that point to those countries’ predictive power on oil prices. This
would also show that, political and economic stability (or lack thereof), has a direct
impact on stability in oil prices. Saudi Arabia, for example, which has the largest oil
reserve in the world (about 24%), does affect oil prices and simultaneously be affected by
them.
Equally important is that; decision makers in these countries have to secure
diverse income resources, and try to increase the contribution of non-oil sectors to GDP.
Since Oman, for instance, oil contribution to GDP amounts to about 42%, Kuwait 46.6%,
and Saudi Arabia 38%, in 2003. This may lead to risks, as a result of linking these
countries’ economies with oil prices in view of the risks in the oil market, which reflected

227
negatively on the performance and volatility of their stock markets; taking into account
that GCC countries are planning to perform a single currency before 2010.

228
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Electronic References

Abu Dhabi Stock market: www.adsm.co.ae

Arab Monetary Fund (AMF): www.amf.org.ae
Bahraini Stock Market: www.bahrainstock.com
Dubai Financial Market: www.dfm.co.ae
Egyptian Stock market: www.egyptse.com
Jordanian Stock Market: www.ase.com.jo
Kuwaiti Stock Market: www.kuwaitse.com
Omani Stock Market: www.omanse.com
Palestinian Stock Exchange: www.p-s-e.com
Saudi Arabian Stock market: www.tadawul.com.sa

245
Appendixes

246
Appendix 1
Graph Plots for Each Arab Stock Market Index for both Levels and Returns on Daily Basis.

A: Indices Logarithm

Kuwait AbuDhabi Bahrain

8.8 7.5 8.0
8.6
7.4 7.8
8.4
7.3 7.6
8.2

8.0 7.2 7.4

7.8
7.1 7.2
7.6

7.4 7.0 7.0

7.2 6.9 6.8

100 200 300 400 500 600
100 200 300 400 500 600 500 1000 1500 2000 2500 3000

Saudi Dubai Oman

8.8 5.1 8.6

5.0 8.4
8.4
4.9
8.2

8.0 4.8
8.0
4.7
7.6 7.8
4.6
7.6
4.5
7.2
4.4 7.4

6.8 4.3 7.2

500 1000 1500 2000 2500 3000 250 500 750 1000 500 1000 1500

Palestine Jordan Egypt

5.8 8.0
5.8

5.6
5.6 7.6
5.4
5.4
7.2
5.2
5.2
5.0 6.8

4.8 5.0
6.4
4.6 4.8

4.4 6.0
4.6
250 500 750 1000 250 500 750 1000 1250 1500
500 1000 1500 2000 2500 3000

247
…continue appendix 1

B: Indices Returns

Kuwait AbuDhabi Bahrain

.06 .03 .3

.04 .02 .2

.02 .01 .1

.00 .00 .0

-.02 -.01 -.1

-.04 -.02 -.2

-.06 -.03 -.3

100 200 300 400 500 600 100 200 300 400 500 600 500 1000 1500 2000 2500 3000

Saudi Dubai Oman

.2 .25 .16

.20 .12

.1 .08
.15
.04
.10
.00
.0
.05
-.04
.00
-.08
-.1
-.05 -.12

-.10 -.16
-.2
250 500 750 1000 500 1000 1500
500 1000 1500 2000 2500 3000

Palestine Jordan Egypt

.3 .06 .20

.2 .04 .16

.12
.1 .02
.08

.0 .00 .04

-.02 .00
-.1
-.04
-.2 -.04
-.08

-.3 -.06 -.12

250 500 750 1000 500 1000 1500 2000 2500 3000 250 500 750 1000 1250 1500

248
 Appendix 2
Diagnostic Tools for both Random Walk and GARCH Models

Table 1

Diagnostic Tools for Reseduals of the RW Model Rt=α+εt for the Observed Indices
Abudhabi Bahrain Dubai
BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.000 0.000 0.000 2 0.000 0.000 0.000 2 0.000 0.000 0.000
3 0.000 0.000 0.000 3 0.000 0.000 0.000 3 0.000 0.000 0.000
4 0.000 0.000 0.000 4 0.000 0.000 0.000 4 0.000 0.000 0.000
5 0.000 0.000 0.000 5 0.000 0.000 0.000 5 0.000 0.000 0.000
McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob.
10 97.51 0.000 10 811.12 0.000 10 0.53 1.000
20 105.76 0.000 20 811.19 0.000 20 0.63 1.000
LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob.
2 13.26 0.001 2 60.10 0.000 2 1.51 0.470

ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1 14.90 0.000 1 810.10 0.000 1 0.01 0.918

Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 12.90 0.000 1 56.58 0.000 1 0.06 0.813
5 31.50 0.000 5 79.08 0.000 5 1.85 0.869
15 49.92 0.000 15 104.35 0.000 15 6.84 0.962
25 79.82 0.000 25 108.69 0.000 25 9.76 0.997
Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
639.65 0.000 18321581 0.000 1850786 0.000
SC -7.600903 SC -7.008137 SC -6.350289

249
… continue table 1

Egypt Jordan Kuwait

BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.000 0.000 0.000 2 0.000 0.000 0.000 2 0.000 0.000 0.000
3 0.000 0.000 0.000 3 0.000 0.000 0.000 3 0.000 0.000 0.000
4 0.000 0.000 0.000 4 0.000 0.000 0.000 4 0.000 0.000 0.000
5 0.000 0.000 0.000 5 0.000 0.000 0.000 5 0.000 0.000 0.000
McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob.
10 256.62 0.000 10 1079.20 0.000 10 143.59 0.000
20 269.36 0.000 20 1239.40 0.000 20 156.71 0.000
LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob.
2 76.19 0.000 2 179.87 0.000 2 20.48 0.000
ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1 213.76 0.000 1 396.16 0.000 1 41.12 0.000
Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 70.74 0.000 1 166.65 0.000 1 18.92 0.000
5 74.08 0.000 5 169.95 0.000 5 22.97 0.000
15 85.41 0.000 15 185.98 0.000 15 38.24 0.001
25 96.51 0.000 25 224.89 0.000 25 44.68 0.009
Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
10650.5 0.000 2940.03 0.000 466.39
SC -5.347986 SC -6.988481 SC -6.28863

250
… continue table 1

Oman Palestine Saudi

BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5
ε =1 ε =2
2 0.000 0.000 0.000 2 0.000 0.000 0.000 2 0.000
0.000 0.000
3 0.000 0.000 0.000 3 0.000 0.000 0.000 3 0.000
0.000 0.000
4 0.000 0.000 0.000 4 0.000 0.000 0.000 4 0.000
0.000 0.000
5 0.000 0.000 0.000 5 0.000 0.000 0.000 5 0.000
0.000 0.000
McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R 2
Prob. McLeod-Li test lags Obs*R2 Prob.
10 448.27 0.000 10 319.44 0.000 10 774.98 0.000
20 906.29 0.000 20 319.58 0.000 20 794.87 0.000
LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob.
2 23.23 0.000 2 7.42 0.025 2 11.15 0.004
ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R 2
Prob. ARCH test lags Obs*R2 Prob.
1 442.87 0.000 1 314.33 0.000 1 754.85 0.000
Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 9.49 0.002 1 0.32 0.571 1 3.42 0.065
5 43.59 0.000 5 15.78 0.007 5 28.46 0.000
15 134.70 0.000 15 47.06 0.000 15 42.66 0.000
25 142.15 0.000 25 68.35 0.000 25 68.85 0.000
Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
182045 0.000 244349 0.000 1058905 0.000
SC -6.20729 SC -5.15100 SC -6.506318

Notes:The reseduals of the RW model for the observed indices are under investigation in this part. The BDS test results were not altered and only P-values are reported.LM test stands for Breusch-
Godfrey LM test statistic with associated P -values and tests for serial correlations in the reseduals.ARCH test is a lagrange multiplier (LM) test for autoregressive conditional
heteroskedasticity(ARCH) in the residuals proposed by Engle 1982. Q -stattistic is the Ljung-Box Q -statistics and their P -values, The Q -statistic at lag K is a test statistic for the null hyputhesis
that there is no autocorrelation up to order K . J.B is Jarque-Bera statistic for testing normality, SC is the Schwartz criterion for random walk model.

251
Table 2

Diagnostic Tools for Standarised Reseduals of the GARCH(1,1) Model for Daily Returns of the Observed Indices
Abudhabi Bahrain Dubai
BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.072 0.145 0.536 2 0.000 0.000 0.000 2 0.000 0.000 0.000
3 0.189 0.126 0.651 3 0.000 0.000 0.000 3 0.000 0.000 0.000
4 0.036 0.028 0.424 4 0.000 0.000 0.000 4 0.000 0.000 0.000
5 0.008 0.007 0.282 5 0.000 0.000 0.000 5 0.000 0.000 0.000

McLeod-Li test lags Q-stat. Prob. McLeod-Li test lags Q-stat. Prob. McLeod-Li test lags Q-stat. Prob.
10 3.38 0.971 10 0.76 1.000 10 0.47 1.000
20 20.54 0.425 20 0.78 1.000 20 0.57 1.000

ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1 0.00 0.946 1 0.73 0.392 1 0.01 0.921

Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 0.49 0.485 1 6.60 0.010 1 0.04 0.842
5 14.32 0.014 5 21.43 0.001 5 1.53 0.910
15 43.49 0.000 15 43.34 0.000 15 6.73 0.965
25 71.70 0.000 25 52.97 0.001 25 9.61 0.998

Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
1102.8 0.000 2E+07 0.000 1820531 0.000

SC -7.753701 SC -7.248425 SC -6.328498

252
… continue table 2

Egypt Jordan Kuwait

BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.024 0.017 0.005 2 0.045 0.050 0.605 2 0.809 0.684 0.902
3 0.000 0.000 0.001 3 0.001 0.004 0.291 3 0.943 0.850 0.758
4 0.000 0.000 0.001 4 0.000 0.004 0.326 4 0.936 0.808 0.790
5 0.000 0.000 0.001 5 0.001 0.012 0.433 5 0.770 0.794 0.897

McLeod-Li test lags Q-stat. Prob. McLeod-Li test lags Q-stat. Prob. McLeod-Li test lags Q-stat. Prob.
10 13.94 0.176 10 12.40 0.259 10 5.48 0.857
20 53.76 0.000 20 17.45 0.624 20 9.85 0.971

ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1 2.58 0.108 1 0.35 0.552 1 0.00 0.997

Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 6.55 0.010 1 8.51 0.004 1 1.82 0.177
5 17.07 0.004 5 9.79 0.081 5 3.32 0.651
15 29.30 0.015 15 21.86 0.111 15 14.14 0.515
25 34.43 0.099 25 40.48 0.026 25 17.69 0.855

Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
2620 0.000 656.84 0.000 193.87 0.000

SC -5.612756 SC -7.273699 SC -6.495524

253
… continue table 2

Oman Palestine Saudi

BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.000 0.008 0.053 2 0.000 0.028 0.694 2 0.784 0.903 0.475
3 0.000 0.001 0.095 3 0.000 0.011 0.320 3 0.266 0.557 0.335
4 0.000 0.001 0.215 4 0.000 0.034 0.051 4 0.024 0.189 0.591
5 0.000 0.004 0.542 5 0.000 0.057 0.025 5 0.003 0.119 0.652

McLeod-Li test lags Q-stat. Prob. McLeod-Li test lags Q-stat. Prob. McLeod-Li test lags Q-stat. Prob.
10 3.06 0.980 10 6.93 0.732 10 5.06 0.887
20 11.57 0.930 20 13.32 0.863 20 16.44 0.689

ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1 1.02 0.312 1 0.02 0.885 1 0.19 0.663

Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 0.40 0.528 1 8.70 0.003 1 6.15 0.013
5 16.65 0.005 5 19.22 0.002 5 26.78 0.000
15 38.65 0.001 15 45.45 0.000 15 63.04 0.000
25 44.72 0.009 25 70.22 0.000 25 73.32 0.000

Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
37525 0.000 1308.27 0.000 6469.8 0.000

SC -6.984905 SC -5.818144 SC -7.209675

Notes:The reseduals of the GARCH(1,1) model for the observed indices with oil returns as a regressor are under investigation in this part. The BDS test results were not altered and only P-values
are reported.McLeod-Li test examen the serial correlation of the squered reseduals .ARCH test is a lagrange multiplier (LM) test for autoregressive conditional heteroskedasticity(ARCH) in the
residuals proposed by Engle 1982. Q -stattistic is the Ljung-Box Q -statistics and their P -values, The Q -statistic at lag K is a test statistic for the null hyputhesis that there is no autocorrelation up
to order K in the standarized resedual . J.B is Jarque-Bera statistic for testing normality of the standarized reseduals, SC is Schwartz criterion for GARCH model.

254
Table 3

Diagnostic Tools for Reseduals of the EGARCH(1,1) Model for Daily Returns of the Observed Indices
Abudhabi Bahrain Dubai
BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.227 0.468 0.892 2 0.279 0.162 0.958 2 0.004 0.214 0.322
3 0.805 0.226 0.365 3 0.291 0.081 0.721 3 0.000 0.073 0.522
4 0.817 0.174 0.150 4 0.811 0.159 0.777 4 0.000 0.055 0.159
5 0.887 0.164 0.072 5 0.404 0.335 0.895 5 0.000 0.002 0.730

ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1 0.00 0.998 1 26.16 0.000 1 0.01 0.905

Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 0.32 0.569 1 31.40 0.000 1 1.98 0.160
5 14.67 0.012 5 58.71 0.000 5 3.43 0.633
15 41.34 0.000 15 80.89 0.000 15 7.47 0.943
25 68.91 0.000 25 89.92 0.000 25 10.90 0.993

Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
1108.82 0.000 1.8E+07 0.000 875911 0.000

SC -7.74321 SC -7.239823 SC -6.483655

255
… continue table 3

Egypt Jordan Kuwait

BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.166 0.087 0.014 2 0.796 0.707 0.960 2 0.535 0.117 0.117
3 0.157 0.085 0.013 3 0.362 0.865 0.932 3 0.938 0.289 0.289
4 0.335 0.083 0.014 4 0.217 0.799 0.589 4 0.536 0.393 0.393
5 0.892 0.428 0.055 5 0.131 0.706 0.372 5 0.432 0.343 0.343

ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1 3.34 0.068 1 0.51 0.475 1 0.52 0.471

Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 4.11 0.043 1 6.75 0.009 1 0.06 0.806
5 13.75 0.017 5 7.86 0.164 5 1.55 0.908
15 26.04 0.038 15 20.28 0.162 15 12.96 0.606
25 32.44 0.146 25 39.86 0.030 25 18.24 0.832

Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
2279.33 0.000 660.36 0.000 187.16 0.000

256
… continue table 3

Oman Palestine Saudi

BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.021 0.299 0.762 2 0.000 0.059 0.100 2 0.000 0.000 0.186
3 0.000 0.248 0.876 3 0.000 0.010 0.873 3 0.000 0.000 0.086
4 0.000 0.646 0.987 4 0.000 0.001 0.395 4 0.000 0.000 0.112
5 0.000 0.518 0.894 5 0.000 0.007 0.571 5 0.910 0.000 0.172

ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1 0.33 0.565 1 0.99 0.320 1 7.66 0.006

Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 0.33 0.565 1 3.09 0.079 1 11.19 0.001
5 1.05 0.959 5 11.19 0.048 5 34.96 0.000
15 80.34 0.000 15 35.55 0.002 15 65.74 0.000
25 83.96 0.000 25 57.28 0.000 25 75.01 0.000

Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
34365 0.000 1784.4 0.000 9971.33 0.000

SC -6.997158 SC -5.82938 SC -7.135278

Notes:The standarised reseduals of the EGARCH(1,1) model for the observed indices are under investigation in this part. The BDS test results were not altered and only P-values are reported.LM
test stands for Breusch-Godfrey LM test statistic with associated P -values and tests for serial correlations in the reseduals.ARCH test is a lagrange multiplier (LM) test for autoregressive
conditional heteroskedasticity(ARCH) in the residuals proposed by Engle 1982. Q -stattistic is the Ljung-Box Q -statistics and their P -values, The Q -statistic at lag K is a test statistic for the
null hyputhesis that there is no autocorrelation up to order K . J.B is Jarque-Bera statistic for testing normality.

257
Table 4

Diagnostic Tools for Standarised Reseduals of the GARCH(1,1) Model for Daily Returns of GCC Markets with Oil Prices
Abudhabi Bahrain Dubai
BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.064 0.213 0.767 2 0.000 0.000 0.000 2 0.000 0.000 0.013
3 0.160 0.170 0.899 3 0.000 0.000 0.000 3 0.000 0.000 0.026
4 0.011 0.022 0.566 4 0.000 0.000 0.000 4 0.000 0.000 0.024
5 0.002 0.005 0.417 5 0.000 0.000 0.000 5 0.000 0.000 0.007

McLeod-Li test lags Q-stat. Prob. McLeod-Li test lags Q-stat. Prob. McLeod-Li test lags Q-stat. Prob.
10 6.77 0.747 10 0.61 1.000 10 0.07 1.000
20 21.82 0.351 20 0.64 1.000 20 0.18 1.000

ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1 0.03 0.863 1 0.00 0.950

Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 0.39 0.535 1 90.57 0.000 1 0.25 0.615
5 12.33 0.031 5 140.66 0.000 5 1.49 0.915
15 40.73 0.000 15 203.04 0.000 15 4.36 0.996
25 67.12 0.000 25 215.33 0.000 25 6.61 1.000

Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
720.89 0.000 1.5E+07 0.000 1193971 0.000

258
… conyinue table 4

Oman Kuwait Saudi

BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.000 0.001 0.032 2 0.676 0.466 0.774 2 0.131 0.239 0.835
3 0.000 0.000 0.035 3 0.864 0.548 0.859 3 0.008 0.060 0.841
4 0.000 0.000 0.051 4 0.988 0.535 0.869 4 0.000 0.009 0.989
5 0.000 0.000 0.172 5 0.765 0.477 0.999 5 0.000 0.003 0.862

McLeod-Li test lags Q-stat. Prob. McLeod-Li test lags Q-stat. Prob. McLeod-Li test lags Q-stat. Prob.
10 3.69 0.960 10 5.20 0.877 10 3.77 0.957
20 53.63 0.000 20 9.97 0.969 20 13.82 0.839

ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1 2.00 0.157 1 0.02 0.901 1 0.50 0.479

Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 0.57 0.449 1 2.06 0.152 1 7.61 0.006
5 13.05 0.023 5 3.89 0.565 5 25.05 0.000
15 35.42 0.002 15 12.82 0.616 15 52.77 0.000
25 42.32 0.017 25 15.13 0.938 25 63.65 0.000

Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
33194.7 0.000 198 0.000 4275 0.000

Notes:The reseduals of the GARCH(1,1) model for the observed indices with oil returns as a regressor are under investigation in this part. The BDS test results were not altered and only P-values
are reported.McLeod-Li test examen the serial correlation of the squered reseduals .ARCH test is a lagrange multiplier (LM) test for autoregressive conditional heteroskedasticity(ARCH) in the
residuals proposed by Engle 1982. Q -stattistic is the Ljung-Box Q -statistics and their P -values, The Q -statistic at lag K is a test statistic for the null hyputhesis that there is no autocorrelation up
to order K in the standarized resedual . J.B is Jarque-Bera statistic for testing normality of the standarized reseduals.

259
Table 5
adj
DiagnosticTools for reseduals from RW Model Rt =α+εt for the Corrected Indices
Abudhabi Bahrain Dubai
BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.000 0.000 0.000 2 0.000 0.000 0.000 2 0.000 0.000 0.000
3 0.000 0.000 0.000 3 0.000 0.000 0.000 3 0.000 0.000 0.000
4 0.000 0.000 0.000 4 0.000 0.000 0.000 4 0.000 0.000 0.000
5 0.000 0.000 0.000 5 0.000 0.000 0.000 5 0.000 0.000 0.000

McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob.
10 92.98 0.000 10 829.06 0.000 10 0.52 1.000
20 101.90 0.000 20 829.14 0.000 20 0.62 1.000

LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob.
2 3.03 0.220 2 2.95 0.229 2 2.43 0.297

ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1 11.90 0.001 1 818.77 0.000 1 0.02 0.899

Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 2.18 0.140 1 0.75 0.386 1 0.15 0.696
5 21.30 0.001 5 21.03 0.001 5 3.08 0.688
15 38.39 0.001 15 51.06 0.000 15 7.43 0.945
25 64.94 0.000 25 54.31 0.001 25 10.27 0.996

Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
599.088 0.000 1.2E+07 0.000 1913893 0.000

260
… continue table 5
Egypt Jordan Kuwait
BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.000 0.000 0.000 2 0.000 0.000 0.000 2 0.000 0.000 0.000
3 0.000 0.000 0.000 3 0.000 0.000 0.000 3 0.000 0.000 0.000
4 0.000 0.000 0.000 4 0.000 0.000 0.000 4 0.000 0.000 0.000
5 0.000 0.000 0.000 5 0.000 0.000 0.000 5 0.000 0.000 0.000

McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob.
10 377.92 0.000 10 859.68 0.000 10 137.55 0.000
20 391.56 0.000 20 991.12 0.000 20 151.28 0.000

LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob.
2 9.88 0.007 2 16.80 0.000 2 3.21 0.201

ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1 323.77 0.000 1 196.42 0.000 1 26.74 0.000

Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 0.36 0.550 1 0.50 0.478 1 0.02 0.894
5 11.65 0.040 5 19.91 0.001 5 5.36 0.374
15 22.84 0.088 15 36.76 0.001 15 20.92 0.139
25 28.47 0.286 25 60.93 0.000 25 26.75 0.369

Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
10574 0.000 4468.39 0.000 397.5 0.000

261
… continue table 5
Oman Palestine Saudi
BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.000 0.000 0.000 2 0.000 0.000 0.000 2 0.000 0.000 0.000
3 0.000 0.000 0.000 3 0.000 0.000 0.000 3 0.000 0.000 0.000
4 0.000 0.000 0.000 4 0.000 0.000 0.000 4 0.000 0.000 0.000
5 0.000 0.000 0.000 5 0.000 0.000 0.000 5 0.000 0.000 0.000
McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob.
10 394.22 0.000 10 273.94 0.000 10 768.63 0.000
20 784.10 0.000 20 274.12 0.000 20 789.14 0.000

LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob.
2 187.80 0.000 2 23.34 0.000 2 124.41 0.000
ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1 148.29 0.000 1 257.14 0.000 1 746.45 0.000

Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 174.03 0.000 1 22.72 0.000 1 83.80 0.000
5 199.48 0.000 5 33.11 0.000 5 116.10 0.000
15 257.12 0.000 15 71.16 0.000 15 127.32 0.000
25 271.03 0.000 25 103.50 0.000 25 156.46 0.000
Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
54379.66 0.000 115656 0.000 1193031 0.000
Notes:The reseduals of the RW model for the corrected indices are under investigation in this part. The BDS test results were not altered and only P-values are
reported.LM test stands for Breusch-Godfrey LM test statistic with associated P -values and tests for serial correlations in the reseduals.ARCH test is a lagrange
multiplier (LM) test for autoregressive conditional heteroskedasticity(ARCH) in the residuals proposed by Engle 1982. Q -stattistic is the Ljung-Box Q -statistics
and their P -values, The Q -statistic at lag K is a test statistic for the null hyputhesis that there is no autocorrelation up to order K . J.B is Jarque-Bera statistic for
testing normality.

262
Table 6
2 3
Diagnostic Tools for Reseduals from Non-linear model for Observed Indices Rt = a0 + a1Rt-1 + a2R t-1+ a3R t-1+ εt
Abudhabi Bahrain Dubai
BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.000 0.000 0.013 2 0.000 0.000 0.000 2 0.000 0.000 0.000
3 0.000 0.000 0.000 3 0.000 0.000 0.000 3 0.000 0.000 0.000
4 0.000 0.000 0.000 4 0.000 0.000 0.000 4 0.000 0.000 0.000
5 0.000 0.000 0.000 5 0.000 0.000 0.000 5 0.000 0.000 0.000

McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob.
10 63.73 0.000 10 0.02 1.000 10 0.45 1.000
20 73.20 0.000 20 0.05 1.000 20 0.54 1.000

LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob.
2 8.61 0.013 2 34.62 0.000 2 2.29 0.319

ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1 2.07 0.150 1 0.00 0.960 1 0.00 0.987

Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 0.05 0.823 1 0.55 0.457 1 0.02 0.892
5 20.17 0.001 5 13.20 0.022 5 1.54 0.909
15 35.65 0.002 15 36.47 0.002 15 6.02 0.979
25 59.17 0.000 25 47.83 0.004 25 8.93 0.999

Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
760.99 0.000 1.6E+07 0.000 1995149 0.000

263
 … continue table 6
Egypt Jordan Kuwait
BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.000 0.000 0.000 2 0.000 0.000 0.000 2 0.000 0.000 0.000
3 0.000 0.000 0.000 3 0.000 0.000 0.000 3 0.000 0.000 0.000
4 0.000 0.000 0.000 4 0.000 0.000 0.000 4 0.000 0.000 0.000
5 0.000 0.000 0.000 5 0.000 0.000 0.000 5 0.000 0.000 0.000

McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob.
10 58.74 0.000 10 1128.60 0.000 10 132.33 0.000
20 81.15 0.000 20 1299.00 0.000 20 144.35 0.000

LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob.
2 15.00 0.001 2 34.48 0.000 2 2.39 0.303

ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1.00 32.25 0.000 1 337.68 0.000 1 32.31 0.000

Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 0.29 0.592 1 0.16 0.691 1 0.04 0.834
5 15.48 0.009 5 18.83 0.002 5 4.82 0.439
15 28.33 0.020 15 35.29 0.002 15 20.34 0.159
25 35.21 0.085 25 58.93 0.000 25 26.03 0.406

Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
7798.5 0.000 3174.75 0.000 435.78 0.000

264
 … continue table 6
Oman Palestine Saudi
BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.000 0.000 0.000 2 0.000 0.000 0.000 2 0.000 0.000 0.000
3 0.000 0.000 0.000 3 0.000 0.000 0.000 3 0.000 0.000 0.000
4 0.000 0.000 0.000 4 0.000 0.000 0.000 4 0.000 0.000 0.000
5 0.000 0.000 0.000 5 0.000 0.000 0.000 5 0.000 0.000 0.000
McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob.
10 263.45 0.000 10 418.57 0.000 10 69.98 0.000
20 670.29 0.000 20 418.65 0.000 20 81.53 0.000
LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob.
2 73.49 0.000 2 462.75 0.000 2 9.36 0.009

ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1 228.01 0.000 1 343.61 0.000 1 22.52 0.000
Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 3.09 0.079 1 253.92 0.000 1 0.11 0.738
5 25.39 0.000 5 328.15 0.000 5 25.06 0.000
15 85.95 0.000 15 338.97 0.000 15 33.76 0.004
25 91.72 0.000 25 342.57 0.000 25 62.65 0.000

Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
161117 0.000 1734287 0.000 501184 0.000
Notes:The reseduals of the non-linear model for the observed indices are under investigation in this part. The BDS test results were not altered and only P-
values are reported.LM test stands for Breusch-Godfrey LM test statistic with associated P -values and tests for serial correlations in the reseduals.ARCH test
is a lagrange multiplier (LM) test for autoregressive conditional heteroskedasticity(ARCH) in the residuals proposed by Engle 1982. Q -stattistic is the Ljung-
Box Q -statistics and their P -values, The Q -statistic at lag K is a test statistic for the null hyputhesis that there is no autocorrelation up to order K . J.B is
Jarque-Bera statistic for testing normality.

265
Table 7
adj adj 2adj 3adj
Diagnostic Tools for Reseduals from Non-linear Model for Corrected Indices R t = a0 + a1 R t-1 + a2 R t-1+ a3 R t-1+ εt
Abudhabi Bahrain Dubai
BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.000 0.000 0.021 2 0.000 0.000 0.000 2 0.000 0.000 0.000
3 0.000 0.000 0.000 3 0.000 0.000 0.000 3 0.000 0.000 0.000
4 0.000 0.000 0.000 4 0.000 0.000 0.000 4 0.000 0.000 0.000
5 0.000 0.000 0.000 5 0.000 0.000 0.000 5 0.000 0.000 0.000

McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob.
10 65.09 0.000 10 0.78 1.000 10 0.46 1.000
20 74.70 0.000 20 0.81 1.000 20 0.56 1.000

LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob.
2 6.69 0.035 2 2.72 0.257 2 2.73 0.255

ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1 2.18 0.140 1 0.02 0.900 1 0.00 0.994

Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 0.07 0.795 1 0.13 0.723 1 0.02 0.880
5 20.99 0.001 5 24.29 0.000 5 2.41 0.790
15 38.21 0.001 15 47.92 0.000 15 6.36 0.973
25 61.46 0.000 25 58.64 0.000 25 9.44 0.998

Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
708.47 0.000 1.4E+07 0.000 2050188 0.000

266
 … continue table 7
Egypt Jordan Kuwait
BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.000 0.000 0.000 2 0.000 0.000 0.000 2 0.000 0.000 0.000
3 0.000 0.000 0.000 3 0.000 0.000 0.000 3 0.000 0.000 0.000
4 0.000 0.000 0.000 4 0.000 0.000 0.000 4 0.000 0.000 0.000
5 0.000 0.000 0.000 5 0.000 0.000 0.000 5 0.000 0.000 0.000

McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob.
10 73.30 0.000 10 974.94 0.000 10 144.89 0.000
20 93.65 0.000 20 1120.50 0.000 20 158.53 0.000

LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob.
2 12.72 0.002 2 32.27 0.000 2 4.27 0.119

ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1.00 44.70 0.000 1 242.93 0.000 1 30.90 0.000

Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 0.00 0.992 1 0.06 0.812 1 0.00 0.973
5 13.53 0.019 5 20.63 0.001 5 5.98 0.308
15 26.56 0.033 15 38.09 0.001 15 22.91 0.086
25 32.41 0.146 25 60.96 0.000 25 28.44 0.288

Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
8305.89 0.000 4012.9 0.000 390.22 0.000

267
 … continue table 7
Oman Palestine Saudi
BDS test BDS test BDS test
m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2 m ε =0.5 ε =1 ε =2
2 0.000 0.000 0.000 2 0.000 0.000 0.000 2 0.000 0.000 0.000
3 0.000 0.000 0.000 3 0.000 0.000 0.000 3 0.000 0.000 0.000
4 0.000 0.000 0.000 4 0.000 0.000 0.000 4 0.000 0.000 0.000
5 0.000 0.000 0.000 5 0.000 0.000 0.000 5 0.000 0.000 0.000
McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob. McLeod-Li test lags Obs*R2 Prob.
10 156.86 0.000 10 17.92 0.056 10 64.67 0.000
20 484.70 0.000 20 18.21 0.574 20 74.37 0.000

LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob. LM test lags Obs*R2 Prob.
2 97.80 0.000 2 7.15 0.028 2 16.37 0.000

ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob. ARCH test lags Obs*R2 Prob.
1 22.59 0.000 1 0.03 0.864 1 20.03 0.000
Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob. Serial correl. lags Q-stat. Prob.
1 0.46 0.497 1 0.48 0.487 1 0.07 0.798
5 61.46 0.000 5 13.05 0.023 5 26.92 0.000
15 98.55 0.000 15 31.75 0.007 15 34.93 0.003
25 106.02 0.000 25 48.81 0.003 25 63.84 0.000

Normality test J.B Prob. Normality test J.B Prob. Normality test J.B Prob.
94342 0.000 207284 0.000 566558 0.000
Notes:The reseduals of the non-linear model for the corrected indices are under investigation in this part. The BDS test results were not altered and only P-
values are reported.LM test stands for Breusch-Godfrey LM test statistic with associated P -values and tests for serial correlations in the reseduals.ARCH test
is a lagrange multiplier (LM) test for autoregressive conditional heteroskedasticity(ARCH) in the residuals proposed by Engle 1982. Q -stattistic is the Ljung-
Box Q -statistics and their P -values, The Q -statistic at lag K is a test statistic for the null hyputhesis that there is no autocorrelation up to order K . J.B is
Jarque-Bera statistic for testing normality.

268
Figure 1

News Impact Curve: Volatility σ2, Against the Impact Ζ = ε / σ where: ( )

ˆ + βˆ log σ t2−1 + aˆ Ζt −1 + γˆΖt −1
log σ t2 = ω ( )
0.005 0.0020
14
.04
news impact curve Dubai
0.004 news impact curve Jordan 12
news impact curve Palestine
news impact curve Egypt 0.0015
.03 10
0.003
Volatility
8
SIG 2

SIG 2
0.0010

SIG2
.02
0.002 6

0.0005 .01 4
0.001
2
0.000 0.0000 .00
0
-10 -5 0 5 -10 -5 0 5 -12 -8 -4 0 4 8 12
-10 -5 0 5
Z
Z Z
0.0008
0.012
0.005 0.0010
news impact curve Abudhabi 0.010 news impact curve Kuwait
0.0006
0.004 0.0008
news impact curve Saudi
0.008 news impact curve Oman
SIG 2

0.0004 0.0006
SIG2

0.006 0.003

SI G 2
SIG 2
0.004 0.002 0.0004
0.0002

0.002
0.001 0.0002
0.0000
0.000
-10 -5 0 5
-10 -5 0 5 0.000 0.0000
-10 -5 0 5 -10 -5 0 5
Z
Z
Z Z

.009 0.0020
0.00020
0.0004
.008

.007 news impact curve Israel 0.0015 news imoact curve Japan 0.00016
.006 0.0003 news impact curve UK news impact curve Bahrain

.005 0.00012
SIG 2
SIG 2

0.0010

SIG 2
SIG 2
.004 0.0002
.003 0.00008
0.0005
.002 0.0001
0.00004
.001

.000 0.0000
-5 0 5 0.0000 0.00000
-12 -8 -4 0 4 8 12
-5 0 5 -10 -5 0 5
Z Z
Z Z

0.020 0.0006
0.008

0.0005
0.015 news impact curve USA
news impact curve Turkey 0.006 news impact curve India
0.0004
SIG2
SIG2

SIG2
0.010 0.0003 0.004

0.0002
0.005 0.002
0.0001

0.000 0.0000 0.000

-10 -5 0 5 -10 -5 0 5
-10 -5 0 5

Z Z

269
Appendix 3

Table 1

Variance Decomposition of Forecast Error of Daily

Market Returns for Arab Stock Markets to Structural
Inovvations in International Markets
By innovations in
Market Horizon
USA UK Japan
explained (days)
Bahrain 2 0.212 0.989 0.328
6 0.422 1.193 0.372
10 0.549 1.428 0.373

Oman 2 0.848 0.040 0.020

6 0.887 0.172 0.030
10 0.887 0.173 0.030

Kuwait 2 2.256 0.129 0.078

6 2.380 0.892 0.503
10 2.380 1.685 0.646

Saudi 2 1.171 1.971 0.002

6 1.283 2.098 0.275
10 1.381 2.250 0.314

Dubai 2 0.699 0.574 0.004

6 0.981 0.697 0.020
10 0.982 0.697 0.020

AbuDhabi 2 0.000 0.662 0.702

6 0.594 0.797 1.504
10 0.601 0.797 1.534

Egypt 2 0.550 0.292 3.403

6 0.732 0.325 3.507
10 0.743 0.753 3.584

Palestine 2 0.089 0.291 0.249

6 0.609 0.811 0.503
10 0.611 1.500 0.504

Jordan 2 0.052 0.096 0.072

6 0.074 0.211 0.073
10 0.214 0.240 0.073
Entries in each cell are the percentage of forcast error variance of the market return in
the first column explained by the market in the first row.
Factorization: Structural Decomposition.

270
Table 2

Impulse Response of a Unit Shock Generated by International Markets on Arab Stock

Markets

Bahrain Oman Kuwait

Period USA UK Japan USA UK Japan USA UK Japan
1 0.0235 -0.0438 -0.0301 -0.0943 -0.0059 -0.0123 -0.1454 -0.0074 0.0036
2 0.0290 -0.0721 -0.0289 -0.1255 0.0150 -0.0213 -0.1164 -0.0419 -0.0238
3 0.0219 -0.0834 -0.0210 -0.1419 0.0395 -0.0320 -0.1237 -0.0508 -0.0458
4 0.0219 -0.0648 -0.0263 -0.1518 0.0500 -0.0340 -0.1297 -0.0036 -0.0083
5 -0.0013 -0.0528 -0.0280 -0.1361 0.0790 -0.0329 -0.1005 0.0338 0.0380
6 -0.0023 -0.0514 -0.0348 -0.1392 0.0817 -0.0341 -0.0797 0.0950 0.0256
7 0.0060 -0.0440 -0.0363 -0.1404 0.0848 -0.0346 -0.0784 0.1437 0.0622
8 0.0117 -0.0192 -0.0364 -0.1413 0.0848 -0.0347 -0.0796 0.1333 0.0709
9 0.0212 -0.0147 -0.0372 -0.1403 0.0880 -0.0349 -0.0796 0.2072 0.0703
10 0.0347 -0.0147 -0.0375 -0.1406 0.0887 -0.0350 -0.0783 0.2113 0.0731

Dubai AbuDhabi Egypt

Period USA UK Japan USA UK Japan USA UK Japan
1 0.0747 -0.0692 0.0044 0.0007 -0.0427 0.0377 0.1152 0.0778 0.3035
2 0.1142 -0.0363 0.0087 0.0004 -0.0519 0.0618 0.1581 0.1220 0.3405
3 0.1430 -0.0024 -0.0044 0.0289 -0.0313 0.0554 0.1323 0.1502 0.3637
4 0.1040 -0.0109 -0.0045 0.0592 -0.0282 0.0067 0.1445 0.1513 0.4108
5 0.0800 -0.0175 -0.0037 0.0615 -0.0298 0.0063 0.1631 0.1629 0.4262
6 0.0829 -0.0208 -0.0037 0.0645 -0.0301 0.0088 0.1004 0.1642 0.4399
7 0.0862 -0.0192 -0.0038 0.0691 -0.0303 -0.0005 0.0837 0.0898 0.3940
8 0.0862 -0.0183 -0.0038 0.0700 -0.0306 -0.0022 0.0862 0.1132 0.3833
9 0.0854 -0.0180 -0.0038 0.0703 -0.0302 -0.0016 0.0892 0.0378 0.3864
10 0.0850 -0.0182 -0.0038 0.0710 -0.0301 -0.0025 0.0858 0.0260 0.3831

Jordan Saudi Palestine

Period USA UK Japan USA UK Japan USA UK Japan
1 -0.0168 0.0101 -0.0143 -0.1002 -0.1314 0.0039 0.0461 -0.0699 0.0886
2 -0.0216 0.0315 0.0004 -0.1162 -0.1251 0.0023 0.0752 -0.1392 0.1108
3 -0.0273 0.0480 0.0012 -0.1177 -0.1446 -0.0011 0.0081 -0.2088 0.0676
4 -0.0195 0.0659 -0.0004 -0.1252 -0.1725 -0.0110 -0.1065 -0.2088 0.1504
5 -0.0160 0.0641 -0.0007 -0.1570 -0.1621 -0.0551 -0.0998 -0.2714 0.1492
6 -0.0111 0.0730 -0.0006 -0.1617 -0.1675 -0.0360 -0.1071 -0.1766 0.1512
7 0.0031 0.0855 -0.0006 -0.1693 -0.1741 -0.0185 -0.1135 -0.0514 0.1570
8 0.0276 0.0874 -0.0006 -0.1621 -0.2027 -0.0245 -0.1154 -0.1049 0.1570
9 0.0320 0.0851 -0.0006 -0.1472 -0.2116 -0.0263 -0.1157 -0.0414 0.1577
10 0.0307 0.0833 -0.0006 -0.1710 -0.2333 -0.0270 -0.1158 -0.0810 0.1582
Factorization: Structural Decomposition.
Standard Errors: Monte Carlo (1000 repetitions).

271
Figure 1

Response of AbuDhabi market from 1 July Response of Dubai market from 26 March Response of the Jordanian market from 1
2001 to 31 December 2003 2000 to 31 December 2003 January 1992 to 14 March 2005
Accumulated Response of ABUDHABI to Structural Accumulated Response of DUBAI to Structural
One S.D. Shock in Japan Accumulated Response of JORDAN to Structural
One S.D. Shock in Japan
One S.D. Shock in Japan
.07 .010
.004
.06 .008
.05 .006 .000

.04 .004
-.004
.03 .002
.02 .000 -.008
.01 -.002
.00 -.012
-.004
-.01 -.006
2 4 6 8 10 12 14 16 18 20 -.016
2 4 6 8 10 12 14 16 18 20
2 4 6 8 10 12 14 16 18 20
Accumulated Response of ABUDHABI to Structural Accumulated Response of DUBAI to Structural
Accumulated Response of JORDAN to Structural
One S.D. Shock in UK One S.D. Shock in UK
One S.D. Shock in UK
-.025 .01
.09
.00
.08
-.030
-.01
.07
-.035 -.02
.06
-.03
.05
-.040 -.04
.04
-.05
-.045 .03
-.06
.02
-.050 -.07
.01
-.08
.00
-.055 2 4 6 8 10 12 14 16 18 20
2 4 6 8 10 12 14 16 18 20
2 4 6 8 10 12 14 16 18 20
Accumulated Response of DUBAI to Structural
One S.D. Shock in USA Accumulated Response of JORDAN to Structural
Accumulated Response of ABUDHABI to Structural
One S.D. Shock in USA
One S.D. Shock in USA .15
.04
.08
.14
.07 .03
.13
.06 .02
.12
.05 .01
.11
.04
.10 .00
.03
.09 -.01
.02
.08 -.02
.01
.07
.00 2 4 6 8 10 12 14 16 18 20 -.03
2 4 6 8 10 12 14 16 18 20 2 4 6 8 10 12 14 16 18 20

272
… continue figure 1

Response of the Omani market from 1 Response of the Saudi market from 26 Response of the Palestinian market from 8
February 1997 to 13 October 2004 January 1994 to 14 March 2005 July 1997 to 28 February 2005
Accumulated Response of OMAN to Structural Accumulated Response of SAUDI to Structural Accumulated Response of PALESTINE to Structural
One S.D. Shock Japan One S.D. Shock in Japan One S.D. Shock in Japan
-.012 .01 .16

-.016 .00
.14
-.01
-.020
.12
-.02
-.024
-.03 .10
-.028
-.04
.08
-.032
-.05

-.036 -.06 .06

2 4 6 8 10 12 14 16 18 20 2 4 6 8 10 12 14 16 18 20 2 4 6 8 10 12 14 16 18 20

Accumulated Response of OMAN to Structural Accumulated Response of SAUDI to Structural Accumulated Response of PALESTINE to Structural
One S.D. Shock in UK One S.D. Shock in UK One S.D. Shock in UK
.10 -.12 .00

.08 -.05
-.16

.06 -.10
-.20
.04 -.15
-.24
.02 -.20

.00 -.28
-.25

-.02 -.32 -.30

2 4 6 8 10 12 14 16 18 20 2 4 6 8 10 12 14 16 18 20 2 4 6 8 10 12 14 16 18 20

Accumulated Response of OMAN to Structural Accumulated Response of SAUDI to Structural Accumulated Response of PALESTINE to Structural
One S.D. Shock in USA One S.D. Shock in USA One S.D. Shock in USA
-.09 -.09 .08
-.10
-.10
-.11 .04
-.11
-.12
-.12 .00
-.13

-.13 -.14
-.04
-.15
-.14
-.16
-.08
-.15
-.17

-.16 -.18 -.12

2 4 6 8 10 12 14 16 18 20 2 4 6 8 10 12 14 16 18 20 2 4 6 8 10 12 14 16 18 20

273
… continue figure 1
Response of the Bahraini market from 1 Response of the Egyptian market from 1 Response of the Kuwaiti market from 17
January 1991 to 3 June 2004 January 1998 to 31 December 2004 January 2001 to 9 March 2005
Accumulated Response of BAHRAIN to Structural Accumulated Response of EGYPT to Structural
Accumulated Response of KUWAIT to Structural
One S.D. Shock in Japan One S.D. Shock in Japan
One S.D. Shock in Japan
-.020 .46
.08
.44
.06
-.024
.42
.04
.40
-.028
.02
.38

-.032 .36 .00

.34 -.02
-.036
.32 -.04

-.040 .30
-.06
2 4 6 8 10 12 14 16 18 20 2 4 6 8 10 12 14 16 18 20
2 4 6 8 10 12 14 16 18 20

Accumulated Response of BAHRAIN to Structural Accumulated Response of EGYPT to Structural Accumulated Response of KUWAIT to Structural
One S.D. Shock in UK One S.D. Shock in UK One S.D. Shock in UK
-.01 .18 .25
-.02 .16
.20
-.03 .14
.15
-.04 .12
.10
-.05 .10
-.06 .05
.08
-.07 .06 .00

-.08 .04 -.05

-.09 .02 -.10
2 4 6 8 10 12 14 16 18 20 2 4 6 8 10 12 14 16 18 20 2 4 6 8 10 12 14 16 18 20
Accumulated Response of BAHRAIN to Structural Accumulated Response of EGYPT to Structural
One S.D. Shock in USA One S.D. Shocki in USA Accumulated Response of KUWAIT to Structural
.05 One S.D. Shock in USA
.17
-.07
.16
.04
-.08
.15
.03 -.09
.14
.13 -.10
.02
.12 -.11
.01 .11 -.12
.10 -.13
.00
.09
-.14
-.01 .08
2 4 6 8 10 12 14 16 18 20 2 4 6 8 10 12 14 16 18 20 -.15
2 4 6 8 10 12 14 16 18 20

274
Appendix 4

Table 1

Accumulated Response of All Markets to One S.D Oil Innovation for the First Sub-Period
Period BAHRAIN OIL OMAN KUWAIT ABUDHABI SAUDI
1 0.000 2.828 0.000 0.000 0.000 0.000
2 -0.040 2.694 0.034 0.004 -0.011 -0.011
3 -0.029 2.614 0.061 0.030 -0.013 -0.018
4 -0.029 2.629 0.070 0.026 -0.011 -0.021
5 -0.029 2.641 0.073 0.025 -0.011 -0.019
6 -0.029 2.642 0.075 0.025 -0.011 -0.019
7 -0.029 2.642 0.075 0.025 -0.011 -0.019
8 -0.029 2.642 0.075 0.025 -0.011 -0.019
9 -0.029 2.642 0.076 0.025 -0.011 -0.019
10 -0.029 2.642 0.076 0.025 -0.011 -0.019
11 -0.029 2.642 0.076 0.025 -0.011 -0.019
12 -0.029 2.642 0.076 0.025 -0.011 -0.019
13 -0.029 2.642 0.076 0.025 -0.011 -0.019
14 -0.029 2.642 0.076 0.025 -0.011 -0.019
15 -0.029 2.642 0.076 0.025 -0.011 -0.019

Table 2

Accumulated Response of Oil to One S.D Innovation in GCC Markets for

the First Sub-Period
Period BAHRAIN OMAN KUWAIT ABUDHABI SAUDI
1 -0.069 0.000 0.000 0.000 0.000
2 -0.147 -0.069 -0.044 0.110 0.011
3 -0.155 0.096 -0.005 0.021 0.005
4 -0.174 0.168 0.009 0.009 0.014
5 -0.165 0.186 -0.004 0.004 0.004
6 -0.160 0.192 -0.009 -0.002 -0.001
7 -0.158 0.195 -0.010 -0.006 -0.002
8 -0.157 0.197 -0.011 -0.007 -0.003
9 -0.157 0.197 -0.012 -0.007 -0.003
10 -0.156 0.197 -0.012 -0.007 -0.003
11 -0.156 0.197 -0.012 -0.007 -0.003
12 -0.156 0.198 -0.012 -0.007 -0.003
13 -0.156 0.198 -0.012 -0.007 -0.003
14 -0.156 0.198 -0.012 -0.007 -0.003
15 -0.156 0.198 -0.012 -0.007 -0.003

275
Table 3

Accumulated Response of All Markets to One S.D Oil Innovation for the Second Sub-Period
Period BAHRAIN OIL OMAN KUWAIT ABUDHABI SAUDI
1 0.000 2.296 0.000 0.000 0.000 0.000
2 0.038 2.127 0.007 0.002 -0.097 0.107
3 0.046 2.103 0.042 0.056 -0.154 0.103
4 0.043 2.135 0.052 -0.013 -0.049 -0.040
5 0.043 2.091 0.061 -0.034 -0.002 -0.007
6 0.044 2.100 0.064 -0.029 -0.013 0.004
7 0.046 2.127 0.064 -0.028 -0.042 -0.002
8 0.049 2.125 0.066 -0.028 -0.064 0.002
9 0.050 2.124 0.067 -0.027 -0.065 0.001
10 0.050 2.124 0.067 -0.028 -0.055 -0.001
11 0.050 2.124 0.068 -0.028 -0.048 0.000
12 0.050 2.125 0.068 -0.028 -0.048 0.001
13 0.051 2.125 0.068 -0.028 -0.050 0.001
14 0.051 2.125 0.068 -0.028 -0.053 0.001
15 0.051 2.125 0.068 -0.028 -0.053 0.001

Table 4

Accumulated Response of Oil to One S.D Innovation in other Markets for the
Second Sub-Period
Period BAHRAIN OMAN KUWAIT ABUDHABI SAUDI
1 -0.014 0.000 0.000 0.000 0.000
2 0.072 0.072 0.022 -0.074 0.212
3 -0.081 -0.102 0.146 0.004 0.201
4 0.018 0.025 0.087 0.002 0.003
5 0.049 0.109 0.046 0.005 0.056
6 0.018 0.089 0.085 -0.005 0.050
7 0.024 0.107 0.088 -0.017 0.039
8 0.025 0.122 0.078 -0.023 0.050
9 0.018 0.123 0.082 -0.018 0.047
10 0.019 0.128 0.082 -0.015 0.044
11 0.019 0.131 0.080 -0.014 0.046
12 0.018 0.132 0.082 -0.016 0.045
13 0.017 0.133 0.083 -0.017 0.045
14 0.017 0.133 0.082 -0.017 0.045
15 0.017 0.134 0.082 -0.017 0.045

276
Figure 1

Accumulated Response of all markets to One S.D. Innovations ± 2 S.E in oil for the first sub-period.

Response of OMAN to OIL Response of KUWAIT to OIL Response of ABUDHABI to OIL Response of SAUDI to OIL Response of BAHRAIN to OIL Response of OIL to OIL
.4 .2 .08
3.0
.3 .1 .0 .04
.0
2.8
.2 .0 .00

-.1 -.1 2.6

.1 -.1 -.04

.0 -.2 -.08 2.4

-.2
-.1 -.3 -.2 -.12 2.2
5 10 15 5 10 15 5 10 15 5 10 15 5 10 15 5 10 15

Accumulated Response of oil to One S.D. Innovations ± 2 S.E.in all markets for the first sub-period

Response of OIL to BAHRAIN Response of OIL to OMAN Response of OIL to KUWAIT Response of OIL to ABUDHABI Response of OIL to SAUDI
.8 .8 .8 .8 .8

.4 .4 .4 .4 .4

.0 .0 .0 .0 .0

-.4 -.4 -.4 -.4 -.4

-.8 -.8 -.8 -.8 -.8

5 10 15 5 10 15 5 10 15 5 10 15 5 10 15

277
Figure 2

Accumulated Response of all markets to One S.D. Innovations ± 2 S.E.in oil for the second sub-period

Response of OMAN to OIL Response of KUWAIT to OIL Response of ABUDHABI to OIL Response of SAUDI to OIL Response of BAHRAIN to OIL Response of OIL to OIL
.3 .4 .16 2.6
.2 .4 .12
.2 2.4
.2
.08
.1 .1
2.2
.0 .04
.0 .0
.00 2.0
.0
-.1 -.4 -.04
-.2 1.8
-.1 -.2 -.08
5 10 15 5 10 15 5 10 15 5 10 15 5 10 15 5 10 15

Accumulated Response of oil to One S.D. Innovations ± 2 S.E.in all markets for the second sub-period

Response of OIL to BAHRAIN Response of OIL to OMAN Response of OIL to KUWAIT Response of OIL to ABUDHABI Response of OIL to SAUDI
.8 .8 .8 .8 .8

.4 .4 .4 .4 .4

.0 .0 .0 .0 .0

-.4 -.4 -.4 -.4 -.4

5 10 15 5 10 15 5 10 15 5 10 15 5 10 15

278
Appendix 5: Middle East Map Including Arabian Countries under Examination.

A r ab ian c ou n tries
u n d e r ex a m in ation

279